PrefBlog

I periodically get asked why my assets under management are so small. Perhaps I should behave more like the big boys:

Staff of the Compliance and Registrant Regulation Branch (Staff or we) of the Ontario Securities Commission (OSC) recently conducted a targeted review or sweep of a sample of large investment fund managers (IFMs), based on assets under management. The reviews focused on the IFMs’ compliance with Ontario securities law in key operational areas. This Notice provides a summary of our findings and related guidance.
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Aside from the issuance of deficiency reports, the sweep did not result in further regulatory action on any of the IFMs reviewed. However, we identified areas where deficiencies were more prevalent and additional guidance is needed. These areas are discussed in dedicated parts below and include:

• I. sales practices
• II. allocation of expenses to investment funds
• III. mutual fund borrowings
• IV. prohibited cross trades
• V. outsourcing and oversight of service providers

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Section 5.1 permits IFMs to pay a portion of the costs of a sales communication, investor conference or investor seminar (collectively, cooperative marketing practices) that participating dealers organize and present to investors.

The major findings in this area, shown along with their incidence rate, were:

• • cooperative marketing practices did not meet the primary purpose of promoting or providing educational information concerning a mutual fund, a mutual fund family or mutual funds generally in order to be eligible for support (25%)
• • inadequate disclosure on cooperative marketing materials to indicate that the IFM paid for a portion of the costs of the cooperative marketing practice (25%)
• • inconsistent application of the IFM’s methodology to calculate primary purpose across all cooperative marketing practice requests (13%)

ii) Section 5.2 — Mutual fund sponsored conferences

Section 5.2 outlines the conditions under which IFMs may provide a non-monetary benefit to a sales representative of a participating dealer to attend a conference or seminar organized and presented by the IFM.

The major findings in this area, shown along with their incidence rate, were:

• • IFMs paid for expenses of the sales representatives, such as travel and accommodation, not permitted under section 5.2 (50%)
• • the non-monetary benefits relating to the mutual fund sponsored conference, such as meals and entertainment, were excessive having regard to the purpose of the conference (25%)

iii) Section 5.5 — Participating dealer sponsored events

Section 5.5 permits IFMs to pay a portion of the costs of conferences and seminars organized and presented by dealers (that are not investor conferences or seminars referred to in section 5.1), within certain parameters.

The major findings in this area, shown along with their incidence rate, were:

• • IFMs provided support for dealer organized conferences which included amounts related to meals and entertainment that were excessive having regard to the purpose of the conference (25%)
• • IFMs provided support for dealer organized conferences in excess of the 10% reimbursement limit of direct costs incurred by the dealer relating to the conference (25%)

The municipal pension wars are starting:

Police officers and firefighters lighting a bonfire on the street in front of Montreal’s City Hall are an unusual sight. They were among several hundred union members protesting the Quebec government’s intention to reform the pension plans for municipal workers.

One of the proposals is a 50-50 split between Quebec’s cities and their 122,000 employees when it comes to premiums and covering future shortfalls. Indexation would be partly frozen. Current plan members and retirees would be tapped to pay down past deficits. The aim is to reach a negotiated settlement within 12 months.

Municipal Affairs Minister Pierre Moreau estimated the pension plans have a combined deficit of $3.9-billion – late last year it was pegged at north of $5-billion – when he unveiled draft legislation last week.

Eighty Montreal firefighters retired on the spot, causing the brief closure of two stations.

The OMERS deficit is being erased … slowly:

OMERS manages $65.1-billion in pension assets for 440,000 employees and retirees of municipal governments across Ontario. The fund said its assets climbed by over $4-billion from $60.8-billion in 2012, and its funded ratio improved last year by three per cent to 88 per cent, which means the fund has assets equal to 88 per cent of its long-term obligation to fund members’ pensions on a solvency basis.

The pension manager said the remaining $8.6-billion deficit will probably be erased at some point between 2021 and 2025 depending on investment returns. OMERS plan members have increased their pension contributions since 2011 to help improve plan funding, but the increases are expected to be removed when OMERS returns to a surplus.

… which is OK, but:

OMERS needs to earn a long-term annualized return of 7 per cent on its investments to meet its pension obligations.
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Mr. Nobrega, who is retiring on April 1, said the introduction of the new “risk-balanced” portfolio last year was the final step in a restructuring launched in 2004 to reduce volatility risk in the investment portfolio. The fund now has 57 per cent of its investments in public markets and 43 per cent in private markets, and is working toward a goal of 53 per cent public market holdings.

Split Share aficionados will be familiar with the concept of Sequence of Returns risk – average return doesn’t mean as much as one might think in the presence of cash flows and portfolio volatility. And let’s just hope they are very conservative with the private equity valuations. Ha ha. By the way – the CPPIB’s return assumption is:

The Chief Actuary’s projections are based on the assumption that the fund will attain an average annual real rate of return, which takes into account the impact of inflation, of 4% over the 75-year projection period in his report, to help sustain the plan at the current contribution rate.

Today’s redemption of MFC.PR.D hasn’t changed anything with respect to the MFC FixedReset Implied Volatility … still 40%+:

Click for Big

It was a positive day for the Canadian preferred share market, with PerpetualDiscounts winning 13bp, FixedResets gaining 1bp and DeemedRetractibles up 10bp. Volatility was very low, except for the illiquid and hypervolatile Floaters. Volume was average.

An audit of the Chinese Sovereign Wealth Fund has brought an amusing nugget:

Auditors also found irregularities at Beijing-based CIC’s domestic units. Among them, Central Huijin Investment Ltd. lost 1.26 billion yuan ($202 million) in potential investment gains in 2011 by selling a stake in a local securities company at the cost price and not conducting an asset appraisal as required, according to the report.

It would be most interesting to learn who the buyer was!

Today’s FOMC statement was ‘steady as she goes’:

nformation received since the Federal Open Market Committee met in April indicates that growth in economic activity has rebounded in recent months. Labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated. Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow. Fiscal policy is restraining economic growth, although the extent of restraint is diminishing. Inflation has been running below the Committee’s longer-run objective, but longer-term inflation expectations have remained stable.
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The Committee currently judges that there is sufficient underlying strength in the broader economy to support ongoing improvement in labor market conditions. In light of the cumulative progress toward maximum employment and the improvement in the outlook for labor market conditions since the inception of the current asset purchase program, the Committee decided to make a further measured reduction in the pace of its asset purchases. Beginning in July, the Committee will add to its holdings of agency mortgage-backed securities at a pace of $15 billion per month rather than $20 billion per month, and will add to its holdings of longer-term Treasury securities at a pace of $20 billion per month rather than $25 billion per month. The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. The Committee’s sizable and still-increasing holdings of longer-term securities should maintain downward pressure on longer-term interest rates, support mortgage markets, and help to make broader financial conditions more accommodative, which in turn should promote a stronger economic recovery and help to ensure that inflation, over time, is at the rate most consistent with the Committee’s dual mandate.
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To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation.

Thoughts of how the Great Moderation ended are causing some nervousness:

The Chicago Board Options Exchange Volatility Index, a gauge of S&P 500 swings, fell to the lowest since early 2007. Foreign-exchange volatility also has slowed, falling to an almost seven-year low.

Low financial-market volatility has stirred concern among some policy makers. New York Fed President William C. Dudley said last month it may signal investor complacency about risk, making him “a little nervous.”

… and has a notable effect on the Treasury market:

Just because U.S. Treasuries (USGG10YR) look more and more stable doesn’t mean they are.

With trading volumes plunging, the lack of volatility may be more a result of the market becoming less liquid as the Federal Reserve hoards trillions of dollars of bonds and banks pull back from debt trading, not because there’s less risk.

Historically, lower volatility has meant more — not less – – trading. What’s happening instead is unprecedented central-bank stimulus has sent everyone into the same risk-on bets, while it’s also becoming more difficult to trade as banks shore up their balance sheets in the face of new regulations.

“We blame the wave of central-bank liquidity, which has pushed up asset prices irrespective of fundamentals,” Citigroup Inc. (C) strategists led by Matt King in London wrote in a note today. “This creates a vicious circle: ever-higher prices, ever-less trading and liquidity.”
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Lower volatility used to lead to more trading before the 2008 financial crisis. The opposite has been the case since then, as the Fed has held its benchmark rate near zero and bought trillions of dollars of Treasuries and mortgage debt.

The average volume of Treasuries traded each day has fallen to $504 billion this year from $545 billion in 2013 and as high as $570 billion in 2007, according to data compiled by the Securities Industry and Financial Markets Association. From 2002 to 2006, U.S. government-debt volumes rose 43 percent.

The drop in trading comes as a measure of volatility in Treasury yields has fallen 69 percent since 2008, according to Bank of America Merrill Lynch’s MOVE Index.

The explosion of fixed-income derivatives trading also speaks to the difficulty investors are having buying and selling bonds. As bond trading has slumped, the notional value of over-the-counter futures contracts has soared, based on the latest data from the Bank for International Settlements compiled by Deutsche Bank AG.

Meanwhile, yields on riskier assets are dropping faster than those on safer securities as investors pile into already crowded trades. The gap between yields on junk bonds and investment-grade notes has shrunk to 2.99 percentage points, the least since 2007, Bank of America Merrill Lynch index data show.

Apparently we may soon see the reappearance of Bank Sub-Debt New Issues:

The banks are also getting ready to issue a type of subordinated debt. In March Royal Bank of Canada chief financial officer Janice Fukakusa said she and her counterparts at rival lenders are working with regulators to determine what triggers should be used to determine when these issues are converted to common shares, and how the resulting shareholder dilution should be managed.

The big question is: will these non-bonds get foisted into the indices, so little Granny Oakum can contribute to bank capital with her $5,000 investment in a bond ETF? I’ve warned about the potential for this. Hmmm … let’s see … I should lobby the main index-maker to ensure that only bonds are in the bond indices … even better, lobby the owner of the index maker … so the main pension performance target indices are the PC Bond Canadian Debt Market Indices … that’s a division of the Toronto Stock Exchange … and the Toronto Stock Exchange is owned by … well, never mind. Thanks for the equity, Granny!

A Bloomberg editorial lauds the batch-auction idea:

Fixing the problems will require more than a tweak here and there. One idea that’s winning converts would replace the 24-hour, continuous trading of stocks with frequent auctions at regular intervals.
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The idea has a good pedigree. It has been around at least since 1960, when Milton Friedman proposed a version for the sale of U.S. Treasury bonds. Researchers led by the University of Chicago’s Eric Budish refined the concept in a paper last year.

Under their system, orders would be sent to the exchanges, as they are now, but instead of being processed immediately, they’d be collected into batches, based on when they arrived at the exchange. A computer would then use an algorithm to match the orders. Auctions would take place at least every second (for 23,400 auctions per day, per stock), matching supply with demand at the midpoint, or the uniform price. Orders that don’t get matched — either because they exceeded the volume of shares available or because their buy or sell quotes didn’t conform to the uniform price — would automatically be included in the next auction.
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Goldman Sachs Group Inc., among others, is interested enough in frequent batch auctions that it’s working with Budish to find an exchange that will conduct a pilot program and a regulatory agency that will monitor the results. Mary Jo White, the Securities and Exchange Commission chair, indicated in a June 5 speech her interest in batch auctions. She should make it a priority to conduct a test program. It’s a promising idea.

This editorial contains two assertions that surprise me:

As well as prioritizing price over speed, this approach would make another flash crash less likely. That’s because it would stem the flood of buy, sell and cancel commands that high-frequency traders issue every second in their efforts to probe the market.

I have never seen any evidence at all that a ‘flood of buy, sell and cancel commands’ had anything to do with the Flash Crash.

Auctions would also reduce the need for dark pools, because the orders of institutional investors wouldn’t be visible to other participants. The fear among big investors such as mutual funds — that placing an order will move the price against them — is the reason dark pools caught on in the first place. The result should be lower transaction costs and higher investment returns for 401(k) owners and other savers.

Lower transaction costs … well, maybe. It could well be that a small (retail) market order to buy enters the same auction as a major sale – we could assume that this will force the price down to bid levels, and so Granny gets to buy her shares at the bid. Maybe. And frankly, I fail to see how making the exchange dark – by not publishing resting limit orders (of institutional investors only?) – will assist in price discovery. This is all a little strange.

The paper by Budish, et al, was discussed on PrefBlog on March 19.

More immediately, it looks like maker-taker exchange pricing is in trouble:

Executives from exchange operators and fund companies are starting to join lawmakers and regulators in warning that the world’s largest equities market is beset with conflicts that can harm investors and undermine confidence.

Support for a solution increased yesterday at a hearing led by Senator Carl Levin as representatives from New York Stock Exchange owner Intercontinental Exchange Inc. (ICE), IEX Group Inc. and Vanguard Group Inc. said trading rebates and payments to brokers for investor trades warrant greater government scrutiny. The systems, embedded in market plumbing over the last two decades, were cited as one of the reasons high-frequency firms now account for about half of volume.

“Hopefully the regulatory agencies are going to take action,” Levin, a Michigan Democrat, said at the end of the half-day hearing of the Senate’s Permanent Subcommittee on Investigations. “There are steps which must be taken either by regulators or by Congress to deal with conflicts and to deal with the other kinds of problems which exist in the current market, because it’s clear there can be improvements.”

I’ll have to give the question some thought; I feel quite certain there are wheels within wheels here. It may be simply that this is the just another battle in the struggle of established market-makers to defend their turf against HFT, much of which profits a lot by maker-taker pricing. You know, by actually making a market. A better one than the big bank smiley-boys.

There’s a shake-up at Harvard’s captive investment manager:

After years of subpar results at Harvard Management Co., three high-level managers have exited the $32.7 billion endowment and the university is searching for new leadership.

Apoorva K. Koticha, 48, among the highest-paid traders at Harvard Management in 2011, has left, according to two people familiar with the matter. News of his departure comes a week after Jane Mendillo, chief executive officer of the university’s investment company since July 2008, said she will resign at the end of the year. Mark McKenna, 43, a money manager at the endowment, moved to BlackRock Inc. (BLK) this month to start an event-driven hedge fund. Since April 2013, Harvard Management has also parted ways with two heads of its private-equity unit.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts up 15pb, FixedResets winning 19bp and DeemedRetractibles gaining 9bp. Volatility was quite good, all winners, dominated by FixedResets. Volume was well above average.

PerpetualDiscounts now yield 5.27%, equivalent to 6.85% interest at the standard equivalency factor of 1.3x. Long Corporates now yield a little under 4.4%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 245bp, a slight (and perhaps spurious) tightening from the 250bp reported June 11.

Good news, folks! When you (or your bank) applies for mortgage insurance now, there will be a large bureaucracy in place to determine whether the house is appropriate for you:

The head of Canada Mortgage and Housing Corp. is shifting the priority of the mortgage insurer to helping Canadians buy homes they need, not the bigger, pricier homes they might want.
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“We help Canadians meet their housing needs, not exceed them,” Mr. Siddall told The Globe and Mail’s editorial board, as he outlined the mandate that will guide his time at the helm of the mortgage insurer.

Assiduous Readers will remember (probably while grinning) how annoyed I get when the old World Economic Forum survey is trotted out to buttress claims that ‘Canadian banks are the stongest in the world’, thanks to our wise and woefully underpaid regulators.

Bloomberg Markets magazine has compiled its own list of the world’s individually strongest banks; not the same thing as ‘strongest national system’ admittedly; but on the other hand at least banks were ranked against each other on a basis that at least purports to be consistent. And guess what?

Click for Big

How much is are market orders worth? Quite a bit!

Senators led by Carl Levin grilled brokerage and stock-market executives at a hearing over the various incentives that underpin U.S. equity trading, including rebates exchanges use to lure volume, and the payments market-making firms such Citadel LLC and Citigroup Inc. (C) give retail brokers.
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TD Ameritrade Holding Corp. (AMTD), one of the biggest online brokers, last week gave an inkling of the money involved. The Omaha, Nebraska-based firm revealed that it pocketed $236 million in 2013 from firms that paid to execute its customers’ orders.
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Larry Tabb, CEO of Tabb Group LLC, estimates that retail orders that are sent to market-makers and executed away from exchanges account for 15 percent of total U.S. volume. He doesn’t anticipate that the SEC will take any imminent action to limit the practice.
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Under the payment for order flow system, online brokers agree to send their customers’ trades to specific securities firms for execution. These wholesalers include Citadel, KCG Holdings Inc. (KCG) and Citigroup.

Tabb said among the benefits of selling customer orders are that online brokers don’t need to set up their own trading desks. The payment system also keeps relationships above-board, he said, though the regulator “could do a better job in terms of forcing greater transparency,” he said.

Tabb was mentioned on June 12, pushing block trades,

There was another TD Ameritrade nugget:

One telling moment occurred during the questioning of Steven Quirk, senior vice-president at TD Ameritrade, the retail brokerage partially owned by Toronto-Dominion Bank. Mr. Quirk said that nearly all of the broker’s limit orders – that is, orders that do not have to be placed immediately – are routed to the trading venue that pays the highest rebate to receive such traffic. Critics allege that such a practice can result in customers receiving less advantageous pricing.

Not so much less advantageous pricing – it’s a limit order – but slower execution (at best) for resting orders on an expensive exchange, as discussed on May 22 and April 21.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts off 8bp, FixedResets up 5bp and DeemedRetractibles gaining 2bp. Volatility was low. Volume was average.

There was some commentary on Friday’s Treasury action:

Treasury five-year notes extended the longest losing streak this year as traders bet improving economic data will push the Federal Reserve to raise rates as early as July 2015.

The gap between five- and 30-year yields narrowed to almost the least in five years before the Federal Open Market Committee meets next week to discuss a stimulus-exit strategy. The chance of a rate increase to 0.5 percent or more by the end of next July is 58 percent, according to data compiled by Bloomberg based on federal fund futures, up from 43 percent at the end of last month. Long bonds rose as investors reached for higher yields amid U.S. data showing low inflation and unrest in Iraq.
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A report yesterday showed a 0.2 percent decrease in the producer price index compared with the median estimate in a Bloomberg survey of 71 economists that called for a 0.1 percent gain. Over the past 12 months, costs climbed 2 percent, figures from the Labor Department showed.

The IMF had some more to say about the US economy:

The International Monetary Fund cut its growth forecast for the U.S. economy this year and said the Federal Reserve may have scope to keep interest rates at zero for longer than investors expect.

The Washington-based IMF now sees the world’s largest economy growing 2 percent this year, down from an April estimate of 2.8 percent. The IMF left a 2015 prediction unchanged at 3 percent, and said it doesn’t expect the U.S. to see full employment until the end of 2017, amid low inflation.

And it appears that even government bond markets are losing liquidity:

Dealers globally have slashed their bond inventories 75 percent since 2007. Five of the six biggest Wall Street firms reported declines in fixed-income trading revenue last quarter.

“That has to bite and prevent dealers from supplying the balance sheet they did in the old days,” Gregory Whiteley, who manages government debt at Los Angeles-based DoubleLine Capital LP, which oversees about $50 billion, said by telephone June 10. “It’s the sort of thing that rears its ugly head when it is least welcome — when it’s the greatest problem.”

Some cracks emerged in Europe last month, when investors dumped Italian, Spanish and Greek debt on speculation political parties opposed to the European Union would gain seats in parliamentary elections and derail the euro area’s recovery.

As the selloff intensified and liquidity decreased, the disparity in yields of 10-year Italian bonds between buyers and sellers based on bids and offers doubled to 6 basis points, or 0.06 percentage point, on May 23, the highest this year.

It was a positive day for the Canadian preferred share market, with PerpetualDiscounts winning 18bp, FixedResets up 6bp and DeemedRetractibles gaining 1bp. Volatility was reasonable. Volume was low.