PrefBlog

Bloomberg has a fascinating article on the value of liquidity:

For an extreme case, look at Bridgewater Associates. The investment manager is the largest holder of the iShares MSCI Emerging Markets ETF (EEM), with $3.3 billion worth of shares. It’s charged 0.67 percent in fees, about four times more than what’s charged for several other liquid, emerging markets ETFs that trade similarly to EEM.

If Bridgewater switched to the iShares Core MSCI Emerging Markets ETF (IEMG), which charges 0.18 percent, they’d save about $15 million each year. But while IEMG trades a healthy $54 million worth of shares daily, EEM trades $2.1 billion worth. With a $3.3 billion stake, you can see why they’d prefer EEM. For the rest of us, IEMG trades plenty.
…
EEM also costs the Ontario Teachers’ Pension Plan and the State of New Jersey Common Pension Plan about $7 million per year. And there are many other high-profile holders of EEM, which has $43 billion in assets. Its cheaper, equally effective, better-performing sibling IEMG has $5 billion.

A high-cost ETF is also a big part of hedge fund manager John Paulson’s portfolio. He has $1.3 billion in SPDR Gold Shares (GLD), which charges 0.40 percent. If Paulson moved into the iShares Gold Trust (IAU), which charges 0.25 percent, he’d save $1.9 million per year. Again, there’s a liquidity gap: IAU’s respectable $26 million worth of shares traded daily pales next to GLD’s $768 million.

Let’s see … it’s about seven years since the start of the credit crunch and already we’re seeing demands for growth at all costs. Huh. It usually takes about twenty, but then, we’re Canadian and are therefore smarter bankers than everybody else (1980s excepted):

Peter Routledge at National Bank of Financial says the bank is misguided in limiting its growth in capital markets.

“Some observers argue that RY must limit its growth in capital markets, maintaining this segment’s contribution in the neighborhood of 25% of total earnings, and justify this self-imposed limitation on the view that capital markets activities contain exorbitant tail risks that will ultimately threaten the bank’s capital. We disagree.”

He points to a number of reasons. Even when the financial crisis hit, RBC’s capital markets arm “earned its way through this infamous period and avoided the financial traps into which many other financial institutions fell. The segment also avoided material earnings hits during the equity market correction of the early 2000s.”

That was no accident, he argues. RBC is simply better at risk-return calculations. “This competitive advantage would, if the bank decided to exploit it more aggressively, enable the bank to expand its capital markets revenues and earnings without putting shareholder capital at undue risk.”

Investors and forecasters believe different things:

After giving up on calls last month that Treasury yields will rise in 2014, forecasters are sticking to estimates those on the 10-year note will climb next year and reach 3.6 percent as the Federal Reserve increases interest rates. Yet based on the performance of long-term Treasuries, implied yields suggest investors don’t foresee yields that high for a decade or more.

Getting it right has never been more important. With America’s outstanding public debt at a record $17.7 trillion, Fed Chair Janet Yellen faces the task of lifting rates from close to zero without sparking a surge in funding costs. While economists point to unrest in Ukraine and Gaza for why Treasuries remain in demand, the bond market’s view that the U.S. expansion isn’t strong enough to force the Fed’s hand suggests yields can stay low for years to come.
…
Peak rates, known as the neutral or terminal rate, have averaged 4.25 percent when inflation has historically been at the bank’s current target, New York Fed President William Dudley said in May. Trading in the interest-rate swaps suggests benchmark borrowing costs will top out closer to 3 percent.

Swaps based on the Fed funds effective rate, a proxy for the target rate, indicate it will average 2.84 percent in 2019. Another gauge, the one-year swap traded five years forward, has fallen a full percentage point this year to 3.2 percent.

Those peak levels are lower than the Fed’s own “dot plot” projections released in June, which showed a long-term forecast of 3.75 percent based on the median estimate. If the bond-market indicators prove to be accurate, they would also be the lowest since the 1950s, according to MKM’s Darda.

Barry Ritholtz of Bloomberg has some wise words on numeracy in general and investing in general:

When it comes to stock picking and portfolio construction, understanding probabilities goes a long way. You must assume that some of your picks aren’t going to work out. Once you recognize that simple reality, you then can have an exit strategy for when those eventualities occur.

Same with portfolio construction. As we showed last week in the annual asset-class performance chart, recognizing what you don’t and can’t possibly know is a key to long-term planning.

Some have suggested starting statistics education in kindergarten. That might be a little radical, but beginning early is crucial. Having an educated population that understands probability and statistics is the key to an informed citizenry and a better economy.

… while Jeff Green and John Irwin of Bloomberg remind us that actually being able to do something is a rare and valuable talent:

Two years out of high school, Evan Fischbach is earning $40,000 a year. His secret: shop class.

Fischbach, 19, has known he wanted to work on cars ever since he took an automotive class in his junior year of high school in Saline, Michigan. His college-educated parents wondered if he was aiming too low.

Then when Fischbach was still a junior, a local auto dealer desperate for mechanics hired him as an apprentice in the service bay. Now he’s earning about three times as much as the average 19-year-old high school grad and slightly more than the national median, according the Bureau of Labor Statistics.
…
Fifty years ago, most American kids in middle and high school attended shop class, where they learned to make ash trays, rebuild engines, weld metal and even market products. As the space race gave way to the high-tech era, policy makers decided such skills were unnecessary. College prep classes gradually supplanted shop, which by then was perceived as a place for slackers and stoners.

The average number of high school credits earned in career and technical education fell 15 percent from 1990 to 2009 at the same time core academic credits in study areas such as English, math and science rose 20 percent, according to the U.S. Department of Education.

DBRS has some comments on the proposed Burger King – Tim Horton’s tie-up:

Should an official agreement or offer be announced, DBRS would review the value and form of financing, structure of the transaction and resulting combined entity, as well as the business plan and financial management intentions going forward. The combination of THI and Burger King would result the third-largest quick-serve restaurant in the world with 18,000 restaurants in over 100 countries. DBRS notes that Burger King has significantly higher leverage than THI (approximately 5.0 times (x) lease-adjusted debt-to-EBITDAR versus approximately 2.77x for THI, both for the last 12-months ended Q2 2014).

DBRS also notes that THI’s Senior Unsecured Debt contains a change of control trigger provision that requires the occurrence of both a change of control and a rating event (i.e., downgrade below investment grade). If triggered, the provision requires than an offer be made to repurchase at a price equal to 101% of the outstanding Senior Unsecured Debt of the Company.

Towers Perrin has released the Pension Finance Watch for July 2014:

Negative equity returns pushed the pension index down in July. The Towers Watson Pension Index declined 1.6% for the month to 73.9, and has now dropped 5.5% for the year.
…
Our liability index (based on projected benefit obligations) increased 0.3% for July, all of which represents interest accumulation. The changes in asset and liability values caused the Towers Watson Pension Index to drop 1.6% to 73.9.

The 73.9% funding figure is at the high-end of the post-Credit Crunch Range, but well below the pre-Credit Crunch range.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 12bp, FixedResets off 6bp and DeemedRetractibles gaining 10bp. Volatility was minimal. Volume was very extremely awfully low.

The times, they are a-changing:

More than half of the asset managers polled that use ETFs have fixed income funds in their portfolios now, and the category has seen major growth in the last two years. That compares to more than 80 per cent who use international and domestic equity funds in their investing.
…
Mr. Walker attributes this to regulatory changes making traditional markets more expensive, as well as the maturity and size of the ETF market with secondary markets now available on larger funds.

The WSJ points out:

While it’s important to look at how ETF shares are trading, the fund’s underlying holdings are really the heart of the liquidity issue, experts say.

One reason: Big investors known as “authorized participants” can swap a basket of the fund’s underlying holdings for ETF shares—or vice versa. This process helps arbitrage away significant gaps between the ETF’s share price and its NAV, the value of its underlying holdings. But when the underlying holdings are costly to trade and tough to obtain, authorized participants are less willing to round up that basket of securities. That means big gaps can develop between an ETF’s share price and its NAV.

One place to watch out for these premiums and discounts is in bond ETFs, especially those focused on areas like corporate investment-grade and high-yield, or “junk,” bonds. The iShares iBoxx $ High Yield Corporate Bond Fund closed within 0.5% of NAV on only four days in the fourth quarter, iShares says, and traded at a premium as large as 2.1% in that period.
…
When underlying holdings are traded less frequently, or not at all, an ETF’s returns also may diverge from the benchmark it is designed to track. That became an issue for some bond ETFs recently as the Federal Reserve bought up large quantities of agency bonds and mortgage-backed securities, essentially removing them from the market. Vanguard Group recently changed some of its bond index funds and ETFs to benchmarks that exclude these securities purchased by the Fed.

The biggest test of bond-ETF liquidity may be yet to come. So far investors have poured money into these products, and many bond ETFs are trading at significant premiums to NAV. But if investors reverse course and stampede out, the trading could get ugly, experts say. Given the relative illiquidity of many of the underlying bonds, the ETFs could start trading at significant discounts to NAV.

“When everybody tries to get out, it’s going to be a debacle,” says Scott Freeze, president of Street One Financial.

Yellen’s speech at Jackson Hole dealt with the labour market:

Labor force participation peaked in early 2000, so its decline began well before the Great Recession. A portion of that decline clearly relates to the aging of the baby boom generation. But the pace of decline accelerated with the recession. As an accounting matter, the drop in the participation rate since 2008 can be attributed to increases in four factors: retirement, disability, school enrollment, and other reasons, including worker discouragement. Of these, greater worker discouragement is most directly the result of a weak labor market, so we could reasonably expect further increases in labor demand to pull a sizable share of discouraged workers back into the workforce. Indeed, the flattening out of the labor force participation rate since late last year could partly reflect discouraged workers rejoining the labor force in response to the significant improvements that we have seen in labor market conditions. If so, the cyclical shortfall in labor force participation may have diminished.
…
One convenient way to summarize the information contained in a large number of indicators is through the use of so-called factor models. Following this methodology, Federal Reserve Board staff developed a labor market conditions index from 19 labor market indicators, including four I just discussed.14 This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions.

Finally, changes in labor compensation may also help shed light on the degree of labor market slack, although here, too, there are significant challenges in distinguishing between cyclical and structural influences. Over the past several years, wage inflation, as measured by several different indexes, has averaged about 2 percent, and there has been little evidence of any broad-based acceleration in either wages or compensation. Indeed, in real terms, wages have been about flat, growing less than labor productivity. This pattern of subdued real wage gains suggests that nominal compensation could rise more quickly without exerting any meaningful upward pressure on inflation. And, since wage movements have historically been sensitive to tightness in the labor market, the recent behavior of both nominal and real wages point to weaker labor market conditions than would be indicated by the current unemployment rate.
…
Overall, I suspect that many of the labor market issues you will be discussing at this conference will be at the center of FOMC discussions for some time to come. I thank you in advance for the insights you will offer and encourage you to continue the important research that advances our understanding of cyclical and structural labor market issues.

On a more practical note, the Fed will have to implement monetary policy in a more complicated than usual way when the tightening eventually comes:

The Federal Reserve will probably borrow “several hundred billion” dollars from money-market mutual funds and others to anchor the federal funds rate when it begins tightening policy, according to St. Louis Fed President James Bullard.

“I don’t think it would have to be that large of a program. Possibly several hundred billion would be enough,” Bullard said, referring to the Fed’s overnight reverse repurchase facility, which it has been testing since September.
…
The Fed’s need for a tool to influence repo rates directly arose after almost six years of bond buying to stimulate faster economic growth flooded the banking system with $2.79 trillion of excess reserves. Banks no longer need to borrow reserves in the once-vibrant fed funds market, so the fed funds rate no longer represents the true cost of overnight credit.

The fed funds market is “a mere shadow of its former self, but I think we can maintain some of the focus on the federal funds rate on the grounds that that’s the usual rate that we’ve used to communicate to people,” Bullard said.

What a day for central bankers! Even Parakeet Poloz was handed a script:

Bank of Canada Governor Stephen Poloz said the economy has “lots of room to grow,” suggesting a spate of stronger data points won’t sway the central bank from its plan to leave interest rates unchanged at least until well into next year.

Mr. Poloz made the comments in an interview Friday, after Statistics Canada reported milder inflation and stronger-than- expected retail sales. At the same time, the vast majority of jobs created this year in Canada are part-time positions, a phenomenon that Mr. Poloz said is a “symptom of slack” in the labour market. That argues in favour of maintaining a policy of low borrowing costs, as the economy is a long way from putting pressure on inflation.

There is a thought-provoking piece on The Dish:

As the indispensable Valleywag tells us this morning, people within the app economy are catching on to the fact that it’s not, actually, an industry in which they can achieve long-term economic security, let alone riches. The bottom 47% of developers make less than $100 a month. Studies have shown that the vast majority of revenues goes to a tiny fraction of developers. The numbers are even more stark when it comes to in-app revenue. Less than .01% of all apps will be considered a financial success, according to some estimates. It turns out that, as in so many other things in the American economy, the app industry is a winner-take-all field, a lottery ticket economy where a tiny number make out like bandits and most people can’t get ahead. And as usual, it’s only the biggest firms– Apple, Google, Microsoft– which are getting ahead.

So all the kids who heard the clarion call and rushed out to get CS degrees, or to drop out under the advice of Peter Thiel, and start coding in their basements– are they all chumps? Do they deserve scorn? Do they deserve to be unable to scratch out a living? Of course not. Like so many others, most of them did what their society told them to do to pursue the good life: work hard, go to school, and try to provide value for people so that you can earn a living. They were sold on a social contract that is failing them. No one can be reasonably expected to predict what skills the economy will value five, ten, twenty years in advance. The urge to call out others for what you perceive as their bad choices is destructive in a labor economy where, despite gains in overall unemployment rate, workers still have remarkably little bargaining power, thanks to underemployment, lack of benefits, low pay, and poor hours. Rather than succumbing to our petty insecurities by blaming others for their economic conditions, we need to look at the macroeconomic factors that are hurting our labor markets. We need to recognize that automation and artificial intelligence are pushing us towards a new era of work– one with tremendous potential productivity gains, but also tremendous uncertainty for labor, even educated labor. It’s time to stop calling people chumps and start building the kind of social system that can guarantee basic material security for all of our people, so that we can all share in the staggering gains of efficiency and productivity that technology is bringing about.

deBoer is too pessimistic. While apps are clearly the sexy part of the coding world, they’re not the total of it. A skilled coder can make good money working for … just about any company big enough to write its own code. Of more interest is the emphasis on macro-economic factors … I believe that we are heading towards an era of increased personal service in a polarized economy; personal service up to and including a return of full-time servants. That’s a shift that will take some getting used to!

Tim Kiladze of the Globe writes a good piece on private equity valuation:

The issue is a hot one at the University of Toronto’s Rotman International Centre for Pension Management, which is run by renowned pension expert Keith Ambachtsheer. At this very moment the ICPM is doing research to find better ways to come up with mid-point valuations for illiquid, private assets.
…
When pressed about their private equity exposures, Canada’s pension funds often point out that their private asset portfolios are largely comprised of infrastructure investments, such as toll roads or water utilities. Because these assets are government regulated and are often essential to daily life, they are widely viewed as extremely safe alternatives that are bound to see their values rise in the long run.

Not everyone is convinced. Jim Keohane, chief executive officer of HOOPP, the pension plan for Ontario health care workers, stresses that these assets are still illiquid. “Liquidity can have tremendous value at certain points in time,” he said, adding that the risk premiums embedded in the values for these rarely traded assets often aren’t high enough. “From what we can see in pricing, it’s just not there.”
…
“I go to meeting after meeting, and I hear over and over again, ‘I just made this investment last year and the regulator came in and changed the rules on me.’ That happens all the time,” he said.

The Canada Pension Plan Investment Board, for one, recently invested in Gassled, Norway’s offshore gas pipeline system, and shortly after, the country announced major cuts to gas transportation tariffs, prompting the Canadian fund and its investment partners to sue, tying them – and their capital – to a lawsuit that could drag on for years.

Speaking of government regulation, maybe we’ll get more interference from the feds in the rail system, to deal with this year’s projected bumper harvest:

The ripening corn and soybean fields stretch for miles in every direction from Dennis Wentworth’s farm in Downs, Illinois. As he marveled at his best-yielding crops ever, he wondered aloud where the heck he’ll put it all.

“Logistics are going to be a huge problem for everyone,” the 62-year-old grower said, adding that he has invested in boosting output rather than grain bins. When harvesting starts in a few weeks, Wentworth expects his 150-year-old family farm to produce 10 percent more than last year’s record. “There are going to be some big piles of grain on the ground this fall.”
…
Surging crop supplies may exacerbate the squeeze on grain storage and shipping. BNSF Railway Co., owned by Warren Buffett’s Berkshire Hathaway Inc. (BRK/B), and Canadian Pacific Railway Ltd. struggled with “greater-than normal” demand from shippers of coal, oil and Midwest crops, the USDA said this month in a report.

Combined with inventories left from the 2013 harvest, production of all grains and oilseeds will boost 2014 supply to 26.97 billion bushels, USDA data show. That’s more than the 23.4 billion of storage on farms and grain-company silos as of Dec. 1, the government estimated in a Jan. 10 report.

“I don’t know where it will all go this year,” said Richard Guse, a 54-year-old farmer from Waseca, Minnesota, who owns a 1 million-bushel grain elevator that he expanded in the past year by 275,000 bushels. “We need better roads and faster train shipping to keep the grain moving,” Guse said this week while inspecting fields as part of the Pro Farmer crop tour.

As a concerned citizen, I have finally been brave enough to buy some early corn for dinner and will work night and day to reduce the surplus to the best of my ability.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts winning 19bp, FixedResets up 12bp and DeemedRetractibles gaining 8bp. Volatility was nil. Volume was low.

Nothing happened again today. Dull week.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts off 6bp, FixedResets up 10bp and DeemedRetractibles gaining 4bp. Volatility was nil. Volume was very low.

Nothing happened today, either.

It was another mixed day for the Canadian preferred share market, with PerpetualDiscounts flat, FixedResets gaining 1bp and DeemedRetractibles off 8bp. Volatility was minimal. Volume was on the low side of average.

US inflation news is pretty good:

The cost of living in the U.S. climbed in July at the slowest pace in five months, indicating price pressures remain limited even as the economy picks up.

The consumer price index increased 0.1 percent, matching the median forecast of 80 economists surveyed by Bloomberg, after rising 0.3 percent the prior month, a Labor Department report showed today in Washington. Stripping out volatile food and fuel, the so-called core measure also climbed 0.1 percent, less than projected.
…
Overall consumer prices rose 2 percent in the 12 months ended July, following a 2.1 percent year-over-year advance the prior month. The core measure increased 1.9 percent from July 2013, the same as in the prior 12-month period.

The Fed’s 2-percent inflation goal is based on the Commerce Department’s price gauge that is tied to consumer spending. That measure climbed 1.6 percent in the 12 months through June.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 3bp, FixedResets gaining 3bp and DeemedRetractibles off 2bp. Volatility was non-existent. Volume was very low.

Nothing happened today.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts off 3bp, FixedResets up 10bp and DeemedRetractibles gaining 1bp. Volatility was nil. Volume was very low.

The OSC is taking an interest in high-MERs:

Recently, staff completed a review of investment funds with high management expense ratios (MERs). In selecting our sample, we focussed on investment funds domiciled in Ontario, excluding labour sponsored investment funds due to their different fee structure. We sent letters to seven fund managers, asking questions relating to 11 of their investment funds which, in aggregate, had a net asset value (NAV) of $43.2 million.

Approximately half of the investment funds in our sample were selected because they disclosed MERs in excess of 5%. In our comment letters, we asked the fund managers of these funds to explain the nature and appropriateness of expenses charged to their funds. The average NAV for funds in this category was $3.4 million. These fund managers consistently commented that most fund expenses are fixed and the small size of the investment funds contributed to high MERs. The fund managers are planning to make their funds grow by focussing on marketing and distribution channels going forward, in an effort to increase the fund size and reduce MER. While fixed expenses are higher in proportion to the NAV of new funds, if such funds are not able to demonstrate that they are viable after a reasonable period of time, we would expect fund managers to consider all options available to them in order to improve performance, increase fund size, manage fund costs, achieve efficiencies of scale and, ultimately, reduce MER.

For the other half of our sample, fund managers had absorbed a significant level of expenses in order to present MERs after absorptions consistent with the industry average. We asked the fund managers whether this level of absorption was sustainable and what their plan was to reduce MERs in the future. Consistently, we heard that funds in this category were new funds and each fund manager intended to absorb expenses until their NAV grew to a size associated with an MER that investors would feel is reasonable. While waiving fund expenses is within the rights of fund managers, a pattern of absorbing expenses for many years may set investor expectations. Fund managers should make sure that those expectations are managed appropriately so that investors understand that waivers or absorptions could cease in the future, potentially resulting in a higher MER.

I don’t know which funds they looked at, but did dig out one fund – subsequently closed – with a Management Expense Ratio in excess of 5%:

That was an MER of 5.23%

In 2010, the MER increased to 5.44%:

“Holy Smokes”, I can hear you guys thinking. “The Independent Review Committee made almost as much as the manager! They must have done a lot of work!”.

You silly, gullible people. The IRC report for 2010 states:

Recommendations and Approvals

The Committee made no recommendations or approvals during the Reporting Period.

It’s a regulatory requirement to have an Independent Review Committee; this rule, introduced in mid-2000’s, was enthusiastically supported by Investor Advocates because people who describe themselves as Investor Advocates are basically brain-dead.

As far as I am aware, there has never been a review of the concept to determine whether these things have actually accomplished anything since inception and, if by odd chance they have, whether these things could have been accomplished more cheaply. It would also be interesting to perform a detailed analysis of the other expenses to determine how much of these expenses are incurred simply because of regulation and whether those regulated expenses served any useful purpose. Then, of course, there’s the whole question of inflated prices being charged for simple services by effective monopolies … owned by the banks, but that’s OK because they charge the bank funds the exact same amount! Also, of course, banks get forbearance with respect to the Competition act because they pay a kickback to the regulators. To hire more staff, you know.

But we’ll never see the regulators examining themselves to see if they and their friends should be laid off. And no pressure from the politicians, either.

In other news, the previously announced recession has been cancelled:

The Canadian economy created 42,000 jobs in July – not 200 as mistakenly reported last week by Statistics Canada – as revised numbers beat market expectations.

The unemployment rate declined 0.1 percentage points to 7 per cent.

The release of a revised Labour Force Survey comes after the federal agency took the unprecedented move Tuesday of pulling its monthly Labour Force Survey that had been released last Friday. The agency had said it uncovered an error but had declined to quantify the mistake or offer much of an explanation until Friday morning.

It was a mildly negative day for the Canadian preferred share market, with PerpetualDiscounts down 3bp, FixedResets off 1bp and DeemedRetractibles losing 7bp. Volatility was minimal. Volume was pathetically low.