PrefBlog

The fund had sub-par performance in October, affected by its relatively high concentration in PerpetualDiscount issues backed by insurers. However, the month was certainly no disaster, as the fund outperformed DPS.UN and the fund’s trading back and forth between similar issues (see the example in MAPF Portfolio Composition: October 2008) continued to show the value of of selling liquidity.

The fund’s Net Asset Value per Unit as of the close October was $12.0660.

MAPF returns assume reinvestment of dividends, and are shown after expenses but before fees. Past performance is not a guarantee of future performance. You can lose money investing in Malachite Aggressive Preferred Fund or any other fund. For more information, see the fund’s main page.

I am very pleased with the returns over the past year, but implore Assiduous Readers not to project this level of outperformance for the indefinite future. The year in the preferred share market was filled with episodes of panic and euphoria, together with many new entrants who do not appear to know what they are doing; perfect conditions for a disciplined quantitative approach.

Sometimes everything works … sometimes the trading works, but sectoral shifts overwhelm the increment … sometimes nothing works. The fund seeks to earn incremental return by selling liquidity (that is, taking the other side of trades that other market participants are strongly motivated to execute), which can also be referred to as ‘trading noise’. There have been a lot of strongly motivated market participants in the past year, generating a lot of noise! Things won’t always be this good … but for as long as it lasts the fund will attempt to make hay while the sun shines.

There’s plenty of room for new money left in the fund. Just don’t expect the current level of outperformance every year, OK? While I will continue to exert utmost efforts to outperform, it should be borne in mind that beating the index by 500bp represents a good year, and there will almost inevitably be periods of underperformance in the future.

October’s results were impacted by the overweighting in PerpetualDiscounts, as noted earlier. See the post Index Performance: October 2009 for a review of the performance of the different indices; it will be noted that the pre-tax interest-equivalent spread of PerpetualDiscounts over Long Corporates increased to 250bp on October 30 from 215bp on September 30, indicating at the very least that the broader bond market does not share any concerns preferred share investors might have about the future. 250bp is a very large spread, unheard of in the ten years prior to the Credit Crunch, during which the normal range was 100-150bp. In the October edition of PrefLetter, I used some conservative assumptions to demonstrate my belief that 45bp amply covers any excess default risk and that the excess interest-equivalent yield on PerpetualDiscounts covers inflation risk.

The other factor negatively impacting fund performance was the overweighting within the PerpetualDiscount class on insurers. If we look at the change in yields in the sector for the major issuers, we find:

The difference between the two classes of issuer was much smaller in October than it was in September, but is still there. Throughout the month the fund largely maintained its weightings to MFC, SLF and the GWO/PWF/POW group, although there was a certain amount of intra-issuer trading.

The yields available on high quality preferred shares remain elevated, which is reflected in the current estimate of sustainable income.

As discussed in the post MAPF Portfolio Composition: September 2009, the fund has positions in splitShares (almost all BNA.PR.C) and an operating retractible (YPG.PR.B), both of which have high yields that are not sustainable: at some point they will be called or mature (or default!) and the funds will have to be reinvested. Therefore, both of these positions skew the calculation upwards.. Since the yield on these positions is higher than that of the perpetuals despite the fact that the term is limited, the sustainability of the calculated “sustainable yield” is suspect, as discussed in August, 2008.

Significant positions were also held in Fixed-Reset issues on October 30; all of which currently have their yields calculated with the presumption that they will be called by the issuers at par at the first possible opportunity. This presents another complication in the calculation of sustainable yield.

However, if the entire portfolio except for the PerpetualDiscounts were to be sold and reinvested in these issues, the yield of the portfolio would be the 6.16% shown in the October 30 Portfolio Composition analysis (which is in excess of the 6.04% index yield on October 30). Given such reinvestment, the sustainable yield would be 12.0660 * 0.0616 = 0.7433, a significant increase from the $0.7297 derived by a similar calculation last month.

Different assumptions lead to different results from the calculation, but the overall positive trend is apparent. I’m very pleased with the results! It will be noted that if there was no trading in the portfolio, one would expect the sustainable yield to be constant (before fees and expenses). The success of the fund’s trading is showing up in

• the very good performance against the index
• the long term increases in sustainable income per unit

As has been noted, the fund has maintained a credit quality equal to or better than the index; outperformance is due to constant exploitation of trading anomalies.

Again, there are no predictions for the future! The fund will continue to trade between issues in an attempt to exploit market gaps in liquidity, in an effort to outperform the index and keep the sustainable income per unit – however calculated! – growing.

Turnover slowed markedly in October to about 46%. This is the lowest monthly turnover in 2009 and about one-third of this year’s peak in February – the waves of alternating panic and euphoria are declining!

Trades were, as ever, triggered by a desire to exploit transient mispricing in the preferred share market (which may the thought of as “selling liquidity”), rather than any particular view being taken on market direction, sectoral performance or credit anticipation.

The “total” reflects the un-leveraged total portfolio (i.e., cash is included in the portfolio calculations and is deemed to have a duration and yield of 0.00.). MAPF will often have relatively large cash balances, both credit and debit, to facilitate trading. Figures presented in the table have been rounded to the indicated precision.

Virtually all trades during the month were intra-sector; that is, there were no major moves back and forth between sectors.

Credit distribution is:

The decline in Pfd-2(high) holdings is mainly due to selling of HSB.PR.E:

Note that the swap from RY.PR.R to HSB.PR.E was discussed in the September composition report: that swap was executed at approximately even price, while earning the September dividend on HSB.PR.E of $0.4125. I’d say the round-trip worked out rather well!

Liquidity Distribution is:

MAPF is, of course, Malachite Aggressive Preferred Fund, a “unit trust” managed by Hymas Investment Management Inc. Further information and links to performance, audited financials and subscription information are available the fund’s web page. A “unit trust” is like a regular mutual fund, but is sold by offering memorandum rather than prospectus. This is cheaper, but means subscription is restricted to “accredited investors” (as defined by the Ontario Securities Commission) and those who subscribe for $150,000+. Fund past performances are not a guarantee of future performance. You can lose money investing in MAPF or any other fund.

A similar portfolio composition analysis has been performed on the Claymore Preferred Share ETF (symbol CPD) as of August 17. When comparing CPD and MAPF:

• MAPF credit quality is better
• MAPF liquidity is a little better
• MAPF Yield is higher
• Weightings in
  • MAPF is much more exposed to PerpetualDiscounts
  • MAPF is much less exposed to Operating Retractibles
  • MAPF is more exposed to SplitShares
  • MAPF is less exposed to FixFloat / Floater / Ratchet
  • MAPF weighting in FixedResets is much lower