PrefBlog

I was sent a link to an article from 2007 by Keith Ambachsheer and Rob Bauer titled Losing ground: Do Canadian mutual funds produce fair value for their customers?:

The study specifically compares the net excess returns produced by a large sample of Canadian mutual funds with domestic equity mandates against the net excess returns produced by a large sample of the domestic equity components of Canadian pension funds. An important study finding is that, over the nine-year period from 1996 to 2004, the Canadian equity components of Canadian pension funds outperformed their Canadian equity market benchmark by an average +1.2% per annum, net of expenses. Over the same nine-year period, Canadian equity mutual funds with domestic mandates underperformed their Canadian equity market benchmark by an average -2.6% per annum, net of management fees, but before any applicable sales charges. Any such sales charges would reduce mutual fund net returns even further.

Very sweet, but nowhere does the article attempt to attribute reported outperformance of Canadian pension funds, which I suggest was due to enormous post-Tech-Wreck outperformance overcompensating for pre-Tech-Wreck underperformance. In addition, it does not attempt to address the outperformance itself, which any first-year B-School student will be pleased to tell you cannot be persistent.

The authors then ask:

Why would Canadian mutual fund investors subject themselves to an average wealth-loss of 3.8% per annum relative to implementing the same basic investment policy through Canadian pension funds? Or equivalently, why would Canadian mutual fund investors pay an average 2.75%(or more including sales charges)for an investment service that is available to Canadian pension fund participants for an average 0.25%, and which produced inferior investment results even before the far greater expenses?

… but of their four hypotheses, only one seems plausible:

Mutual funds are sold, not bought: the market for investment management services is highly asymmetric, with the buyers of these services knowing far less about what they are buying than the sellers know about what they are selling. Information economics predicts that in such a market buyers will pay too much for too little. Research results from the field of behavioural finance support this conclusion. This research shows people to be generally unsophisticated, inconsistent, hesitant, and even irrational regarding financial matters, which creates the opportunity for the for-profit financial services industry to proactively step in and sell their products and services at too-high prices.8 The veracity of his third explanation is supported by the findings of a recent survey of 1865 Canadian mutual fund investors. When asked why they had bought mutual funds, 85% said they were persuaded by “someone who provided me with advice and guidance.”9 In our view, it is the combined effects of informational asymmetry and behavioural dysfunction on the part of the customers, and opportunistic acuity on the part of the suppliers, that best explains the findings summarized in Table 1. Mahoney(2004)reaches similar conclusions in a paper titled “Manager-Investor Conflicts in Mutual Funds.”

This emphasis on prices is reasonable, but there is no attempt to reconcile the fees charged with the performance gap. In addition, the authors conveniently ignore the investment environment of the first half of their period: tech sold! Dividends were old-fashioned; managers had a choice between throwing a good portion of their mutual fund assets into tech or, alternatively, just stay home and catch up on sleep. Without tech on offer, nobody would come to the office and the ‘phones wouldn’t ring.

All this is meant to tout the idea of Government Investment Management:

We favour a middle way: the “paternalistic libertarian” approach currently in the process of being adopted in the UK. The basic idea is to create a number of arm’s-length, expert, pension delivery organizations, and then to automatically enroll the entire non-covered part of the workforce into one of them. People can elect to opt out if they do not wish to participate.
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A key assumption in these calculations is that the pension delivery organizations operate in the sole best interests of plan participants, with expense ratios of 0.3%.

I wonder if Mr. Ambachsheer is involved with the proposed Ontario Pension Plan? It sounds rather similar …

The battle to make life easier for incompetent bond investors is heating up:

The Canadian Securities Administrators, a coalition of the country’s provincial and territorial securities regulators, announced last month it’s starting a review of transparency in the $390-billion corporate bond market. The CSA questioned whether the private sector-led transparency model currently in place is working, and if more active regulation is needed.

The move comes as bond trading falls under closer scrutiny worldwide with the top regulator in the U.S. calling for more public information on private trading, and the European Union seeking to build a system to publicly disclose prices in real time.

Unlike stocks, bonds aren’t traded on public exchanges but as private transactions with securities dealers acting as middlemen, giving the brokerages — many of whom are owned by banks — an informational advantage.
It’s historically been more profitable for firms to trade bonds than stocks because the debt markets are less transparent, making it easier for brokers to take a bigger fee for each exchange.

“We have a sort of oligopolistic banking system where the banks kind of set their own rules, and there’s been a lack of transparency in the bond market forever,” said Ed Waitzer, chairman of the Ontario Securities Commission from 1993 to 1997 and a senior partner at Toronto-based law firm Stikeman Elliot LLP. “It sounds like the commission is feeling a little bit of heat again because the rest of the world is kind of shining a light on dark markets.”

Yellen is still dovish on rates:

Federal Reserve Chair Janet Yellen told lawmakers the central bank must press on with record monetary stimulus to combat persistent job-market weakness.

“There are mixed signals concerning the economy,” Yellen said in response to questions during testimony to the Senate Banking Committee today. “We need to be careful to make sure that the economy is on a solid trajectory before we consider raising interest rates.”

While her “overall view is more positive,” Yellen said low wages are one sign of “significant slack” in labor markets, even after the jobless rate fell to an almost six-year low.
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In prepared testimony, Yellen repeated that interest rates are likely to stay low for a “considerable period” after the Fed ends its asset-purchase program, which she said could happen following the October meeting.

“A high degree of monetary policy accommodation remains appropriate,” Yellen said in her semi-annual testimony. “Although the economy continues to improve, the recovery is not yet complete.”

She also commented on irrational exuberance:

Ms. Yellen delivered her observation during off-script Congressional testimony on Tuesday. Well, sort of: She was actually singling out social media and biotech stocks – along with lower-rated corporate debt – as pockets of the market that look frothy and are vulnerable to setbacks, particularly when the Fed starts raising its key interest rate.

The fact that a Fed chair would discuss stock valuations of any kind is highly unusual and should push investors into evaluating market conditions after a 190 per cent rally by the S&P 500 over the past five-and-a-half years.

Dubai’s making an effort to attract the hated hedge funds:

When Ahmad Zuaiter started a frontier-markets hedge fund, the former Soros Fund Management LLC money manager chose Dubai over New York and London.

Zuaiter’s Jadara Capital Partners LP and VY Capital Management Co. Ltd. opened in the emirate in the past year, bringing to three the number of hedge-fund firms in the Dubai International Financial Centre, according to Dechert LLP, a law firm that helped establish both companies in the sheikhdom.

“If you want to run a boutique model, the best way is to be located in a centrally positioned hub like Dubai and use it as a nexus to travel extensively and frequently to your target markets,” Zuaiter, 46, said in an interview in his office, close to celebrity chef Marco Pierre White’s Wheeler’s of St James’s restaurant.

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For Dubai to rival London as a finance and hedge-fund capital, it must overcome concerns about political instability in the region and 50 degree Celsius (122 degrees Fahrenheit) temperatures that drive residents to seek refuge in Geneva and other European cities during the summer. Still, zero tax, office rents one-third the price of London’s West End and an airport that connects with 90 percent of frontier markets make it attractive to startups, Zuaiter said.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts winning 19bp, FixedResets up 13bp and DeemedRetractibles gaining 8bp. Volatility was reasonable, highlighted by FixedReset winners. Volume was low.

Fitch is urging government micromanagement of housing:

Canadian home prices remain overvalued relative to historical macroeconomic fundamental drivers, Fitch Ratings says. Despite government efforts to moderate growth, home prices rose 7.1% in May (on a year-over-year basis) according to the Canadian Real Estate Association. In addition, both property sales and building permits for residential construction have picked up in recent months. Home prices also continue to be supported by historically low interest rates and a lack of supply in the major metropolitan areas; these factors have propped up affordability and drive demand. According to Fitch’s sustainable home price model, which measures home prices relative to long-term fundamentals, Canadian home prices remain approximately 20% overvalued in real terms.
We believe high household debt relative to disposable income has made the market more susceptible to market stresses like unemployment or interest rate increases. The ratio reached a high of 164.1% in third-quarter 2013 before declining slightly in the following two quarters. Fitch projects unemployment will likely remain in its current 7% range. But low interest rates are unlikely to fall further. Rising interest rates could pressure the market more than others given high borrower leverage and the short-term structure of Canadian mortgages.

Fitch believes the Canadian government has taken several proactive steps in recent years to mitigate some of the risks to the housing market. The underwriting guidelines for loans insured by the Canadian Mortgage and Housing Corporation (CMHC) have been tightened. CMHC has also pulled back on the amount of low-ratio portfolio insurance offered to lenders and limited securitization of insured mortgages to CMHC-administered programs. Furthermore, The Office of the Superintendent of Financial Institutions has issued a guideline for prudent bank underwriting that must be adhered to for bank originations as well as those purchased from nonbank lenders. However, the long-term impacts remain unclear, and policy makers may be required to take additional steps over the short term to engineer a soft landing.

Sadly, there is nothing in today’s Ontario budget about buying us all new houses. They missed that one:

Most of the budget, however, lays out long-term plans for new spending.

It provides for $29-billion in new funds for transit, roads and bridges over the next decade, plus tens of billions more for other capital costs, including schools. The budget puts more than a billion dollars into various social programs, with raises for personal support workers and more funds for programs for people with developmental disabilities.

A new $2.5-billion fund for businesses is meant to help lure corporations to the province and encourage existing operations to expand.

The plan also allocates a billion for a new road or rail link to the Ring of Fire, a Northern Ontario mineral deposit that the government estimates will yield $60-billion worth of economic activity.

The document further introduces the Ontario Retirement Pension Plan, a pension system for people who do not already have one through their employer, that aims to double the benefits of the Canada Pension Plan for retirees.

There have been an interesting couple of articles lately on US employment trends. The first approves of extreme pickiness when hiring:

Since the recession, many employers halted widely distributed cost-of-living raises. Instead, they’re giving big bonuses and salary boosts to a select few. The average pay raise might be 2 percent, but the extra cash is shared among a small group of employees who have leverage, says Thomas Gimbel, chief executive officer of Chicago-based staffing company LaSalle Network. For them, he says, “Things are better than they’ve ever been.”

These wily pay strategies may also explain why there are so many open jobs. According to data released July 8, there were 4.6 million job openings in the U.S. in May, up from 3.9 million a year before. For key positions, companies are letting job openings stay open until they find exactly the right person, Gimbel says. In the meantime, existing employees must work harder to fill the gap. Then, for the perfect job candidate, they’ll pay up, he says. For example, a job listed for a $125,000 salary might be vacant for a year but then filled by someone who demands — and receives — $140,000.

The second one blames it on algorithms (beloved of Human Resources departments):

Expanding use of technology that uses ultra-specific criteria to screen and winnow candidates may be perpetuating one of the most unusual features of the slow rebound in the U.S. labor market: Despite a steady increase in openings since the recession ended in 2009, these positions are being matched with job seekers less efficiently than in the past. For each 100,000 new openings, for example, companies have hired about 48,000 people, compared with about 54,000 following the 2001 recession.

Software provided by Taleo, a unit of Oracle Corp. (ORCL), allows recruiters to conduct “precision matching” through a “profile-based recruiting system” that uses “advanced search and artificial intelligence to find and short list top talent,” according to a brochure on Oracle’s website.

For workers and job-seekers with exactly the right skills industries need today, the software programs can be a boon, filling their e-mail with notes from recruiters, talent scouts said. There’s also a benefit for companies in lower talent-acquisition and training costs.

There are also disadvantages for other job prospects: A candidate with some, but not all, of the required attributes may be eliminated or moved down the list. This may be one reason why people out of work for 27 weeks or more still represent about a third of the total unemployed, compared with an average of 19 percent between 2004 and 2007. The share is down from about 37 percent in June 2013.

Well, the proof of the pudding is in the eating and I would be loathe to pontificate about the evils of HR algorithms. But I will bet a nickel that over the long run, it is more costly for a company to be too lean than it is for it to be slightly over-staffed, with guys who are familiar with InventoryMaster 8.0, but – critically – unfamiliar with InventoryMaster 9.1.

Housing pundit Will Dunning, who I featured in the post How to Dissect a Housing Bubble, is in the news again, criticizing government micro-management of housing:

“If and when there is a correction in the condo market, the severity will have been aggravated by the actions of the federal government, which elected to depress demand at a time when demand was already beginning to weaken organically and a wave of supply has been developing,” Mr. Dunning writes in a new research note.
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He sketched out a scenario in which Toronto’s condo prices would fall by about 10 per cent, as a result of rising supply and falling demand.

“I believe that the federal mortgage insurance policy changes of the past few years will continue to weigh on demand, for both owner-occupants and investors,” Mr. Dunning writes.

His 10-per-cent-price-correction scenario also assumes that job creation does not bounce back to a healthier rate in Canada’s most populous city, and that interest rates remain constant.

“The timing of this process is highly uncertain – it probably won’t start for at least a half-year, and if there are further delays in (condo construction) completions, it could be a long way off,” he writes.

But micro-management is all the rage:

Banks shouldn’t count on a fresh round of European Central Bank cash to trade sovereign debt and reap big profits, Mario Draghi said.

“The convenience to use the ECB cheap money to buy government bonds is much less” than in a previous funding round which started in 2011, the ECB president said in testimony to the European Parliament in Strasbourg, France yesterday. “The general situation is such that these carry trades are going to be much less profitable.”

As spreads on government debt from Spain to Italy over similar German securities have fallen to record lows, a carry trade that was lucrative two years ago may now yield less, Draghi said. In a liquidity drive that pins cash to banks’ performance in extending loans to the economy, the Frankfurt-based ECB could extend as much as 1 trillion euros ($1.36 trillion) in its so-called TLTRO program starting in September.

A condition of that program is that banks have to meet a benchmark on lending to businesses and households, excluding mortgages, or else hand back the money in 2016.

“If banks don’t lend to the non-financial private sector, they’ll have to repay,” Draghi said.

It was a good day for the Canadian preferred share market, with PerpetualDiscounts winning 13bp, FixedResets up 9bp and DeemedRetractibles gaining 8bp. Volatility looks pretty good at first – until you realize it’s half Floaters, which always bounce around a lot. Still, the Performance Highlights table is comprised exclusively of winners! Volume was low.

Tammy Schirle of Wilfrid Laurier writes a good piece titled Six questions Ontario must answer before it starts a pension plan (although the headline writer confused ‘exhortations’ with ‘questions’):

• 1. Be clear about the market failures you are trying to address.
• 2. Be precise about the policy target.
• 3. Be clear about any redistribution that will occur.
• 4. Notice that low-income families won’t benefit from a simple expansion of benefits
• 5. How are you going to deal with interprovincial migration and interprovincial employment arrangements?
• 6. Enhancing the CPP remains the Ontario government’s preferred solution.

It was mixed day for the Canadian preferred share market, with PerpetualDiscounts gaining 1bp, FixedResets off 7bp and DeemedRetractibles up 2bp. Volatility was minimal. Volume was extremely low.

And now it’s time to start work on the July PrefLetter!

Looks like Canadian shadow banking is picking up:

Canada’s banks developed their commercial banking arms over decades by lending to companies that typically generate annual revenue of $50-million or less, nurturing scores of client relationships. Since the financial crisis, however, private equity firms have been scooping up smaller companies, shaking up their historical banking relationships.
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Anatol von Hahn, Bank of Nova Scotia’s head of personal and commercial banking, said he would be “be very surprised if we don’t have double, triple” the number of small Canadian companies that are owned by private equity firms twenty years from now. Because they are flush with cash that they simply can’t sit on, private equity firms are often willing to pay big multiples to buy small businesses. “They’re playing a huge role,” he said.
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To adapt to the changing dynamics, Scotiabank has gone so far as to invest in certain private equity funds in order to get access to the companies they acquire, according to Mr. von Hahn, allowing the bank to pitch itself as a potential banking partner.

The trend isn’t playing out in Canada alone. U.S. firms are looking for mid-market acquisitions north of the border. In May, New Jersey-based private equity player Swander Pace Capital acquired Montreal’s Recochem, marking its 10th acquisition north of the border in the past decade. More acquisitions could come because the firm recently raised a brand new $350-million fund.

Could we be heading towards European banking crisis redux?

Shares in Banco Espírito Santo SA … were suspended from trading Thursday after falling an additional 17%. Shares of the lender’s controlling shareholder, Espírito Santo Financial Group SA, were also suspended because, it said, of “ongoing material difficulties” at its parent company, Espírito Santo International. “ESFG is currently assessing the financial impact of its exposure to ESI.”

A spokesman for Espírito Santo International declined to comment.

This week’s downward spiral has knocked 32% off the bank’s market value and has dragged down Portugal’s main stock index with it.

On Thursday, the turmoil spread elsewhere in Southern Europe, illustrating how investors remain nervous about the fragility of the continent’s financial system. In Spain, a bank and a construction company each called off planned bond sales. In Italy, a drug company pulled its stock offering. In Greece, a government-bond sale came in smaller than expected. And stock markets across the continent fell, along with the euro.
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It has been more than a year since fears about the health of a European bank rattled markets. Lately, after years of crisis, investors, bankers and regulators have been growing more confident about the stability of the continent’s financial system. Regulators hoped the banking industry’s improving health would be on display in coming months as they conduct so-called stress tests on more than 120 large banks.

Instead, Espírito Santo’s rapid descent, and the collateral damage in other European markets, suggests that conditions remain precarious.

Critics of Espírito Santo’s complex corporate structure have worried for years about the linkages among companies within the conglomerate. Among the concerns: whether the group’s nonfinancial companies—including a hotel chain and a hospital operator—were using the bank and its customers to raise funds.

Here in Ontario, our wise masters are protecting us from lower prices:

Ontario’s governing Liberals say they want to remove barriers to interprovincial trade, but suggest they’re reluctant to lift some restrictions that give Ontario companies an advantage.

Finance Minister Charles Sousa says there are a number of sectors within Ontario’s economy that are strong because they’re protected.

Sousa says he’s open to talks on how to grow the economy, but he doesn’t want to jeopardize the livelihood of Ontario companies.
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Sousa’s comments come after the leaders of three western provinces called for the removal of trade barriers to reduce the cost of doing business and help provincial economies grow.

As far as I can tell, Mr. Sousa did not explain why strong companies need protection.

It was a mixed day for the Canadian preferred share market, with PerpetualDiscounts down 4bp, FixedResets gaining 14bp and DeemedRetractibles off 3bp. Volatility was average, but uniformly positive. Volume was below average overall, and concentrated in a handful of issues.

The National Securities Regulator has just gotten a little more national:

Two more provinces have agreed to join a voluntary national securities regulator expected to begin operations in the fall of 2015, bringing the total number on board to four and giving the upcoming capital markets watchdog a more pan-Canadian scope.

Sources say Saskatchewan and New Brunswick will sign on to the Cooperative Capital Markets Regulator Wednesday in a ceremony in Ottawa with federal Finance Minister Joe Oliver, embracing a plan backed by Ontario and British Columbia last September.

Marketwatch has a nice chart on market trends:

This chart shows how much money is flooding into investment vehicles — index mutual funds and exchange-traded funds — that track stock indexes. These two types of funds have grabbed about 24% of the U.S. mutual fund and ETF market, down from less than 5% in 1998, according to Deutsche Bank data.

Big full-service brokerages, “which control 50% of all invested household wealth in America, have successfully pushed the majority of their advisors’ practices toward more hands-off investing approaches,” said Josh Brown of The Reformed Broker in a recent blog post, referring to charging a flat percentage fee on assets, rather than commissions. “At the same time, do-it-yourselfers have made Vanguard, State Street and BlackRock’s iShares three of the world’s largest asset managers — and they are primarily purveyors of passive indexing products.”

There were modest gains for the Canadian preferred share market, with PerpetualDiscounts winning 7bp, FixedResets gaining 1bp and DeemedRetractibles up 2bp. Volatility was minimal. Volume was average.

PerpetualDiscounts now yield 5.17%, equivalent to 6.72% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.3%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 240bp, a slight (and perhaps spurious) narrowing from the 245bp reported July 2.