PrefBlog

Fiscal madness continues in the US, with proposals to embed milkfare:

Under President Harry S. Truman’s farm policy, the government bought supplies of a product until its price reached “parity” with the cost immediately before World War I. Adjusted for a century of inflation, the Agriculture Department’s milk-support price today would be $39.08 per hundred pounds, more than double the dairy futures price of $18.60 at 8:34 a.m. in New York today.

Under the revised dairy plan, written by [Minnesota Rep. Collin] Peterson [D], the government would manage the milk supply by setting milk- production limits for farmers who enroll in a market- stabilization program. The proposal eliminates programs that pay farmers when prices fall below a certain level, replacing them with initiatives designed to protect profit margins through insurance programs and by limiting output, which would raise prices.

The year ended on a positive note, with PerpetualPremiums and DeemedRetractibles both up 2bp and FixedResets winning 12bp. Volatility was muted. Volume was near non-existent.

And that’s a wrap for 2012! The fund’s done rather well over the year … I’ve earned an extra half spoonful of cinnamon in my coffee tonight!

I mentioned the report from Deloitte UK yesterday, titled Bridging the Advice Gap: Delivering Investment Products in a Post-RDR World. Under the new UK regime of prohibiting payments by fund sponsors to salesmen, Deloitte suggests that bank advisors will be hardest hit, since they have greatest exposure to “mass market” clientele (up to £10,000 in portfolio value) and are perceived as being too sales-oriented and not as skilled as other advisors.

In preparation for the change:

• Lloyds will offer face-to-face advice only to those with £100,000+ to invest
• HSBC will offer face-to-face advice only to those with £100,000 income or £50,000 savings; peasants will get a DIY website
• Barclays Financial Planning will shut down and the bank will focus on high net worth individuals
• On the other hand, Santander is hiring frantically to add to its 1,000+ existing staff

What might happen in Canada if similar regulations are enacted? I suggest:

• No change in MF fees (why bother? Those few people who care moved to other products long ago)
• Much more tied selling (don’t expect to see a Bank “A” advisor recommending a Bank “B” product)
• Even stranger PPN products from the banks (Nobody pays anyone! It’s EXACTLY like a GIC, except you can MAKE UP TO 10%!!!!)

Credit Suisse is advocating increased regulation for exchanges:

The botched initial offering of Facebook Inc. (FB) is the catalyst that should lead to U.S. exchanges being stripped of self-regulatory powers and their related benefits, a Credit Suisse Group AG (CS) executive said.

Nasdaq Stock Market’s claim of immunity from liability for $500 million in brokerage losses stemming from technology problems on May 18 exposes a conflict between the historical, quasi-governmental role of exchanges and their status as profit- seeking public companies, Dan Mathisson, head of U.S. equity trading at Credit Suisse, told U.S. senators in Washington last week. Those tensions can’t be managed fairly and should spur a regulatory overhaul of the securities market, he said.
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Like the Commonwealth of Virginia and Indian tribes, exchanges have absolute immunity for actions taken as part of their regulatory duties. The doctrine arose when exchanges were not-for-profit organizations owned by their member firms. The shield protects them from lawsuits related to the exercise of powers delegated by the SEC and prevents financial losses that could jeopardize institutions seen as vital to the U.S. economy.

The Globe has an opinion piece titled CMHC must stay in government hands, which argues that … well, you figure it out! The concluding paragraph is:

Governments must be wary of intervention for its own sake, but governments should step in where the market fails to achieve an economically efficient outcome. J.P. Morgan may have been the “lender of last resort” in 1907 , but no one would suggest privatizing the Bank of Canada today. We need a government-owned (if reformed) CHMC to curb excesses in housing. Too often in the financial system, the invisible hand likes to roll the dice, fuelling speculative bubbles and the risk of financial collapse. Like musical chairs, everyone has fun until the music stops.

The problem with this argument is that it makes the implicit assumption of a wise, benevolent government carefully tempering the enthusiasm and despair of childish bankers – a view that has gained many adherents in the past years. Trouble is … in just as many cases, and in the case of Canadian housing in particular, it is the government that is the villain. CMHC has been pumping up Canadian housing prices like no man’s business for the past six years (as alluded to yesterday); in the US, it was Fannie and Freddie that ran amok. In the current instance, CMHC is aided by the Bank of Canada, which has kept the price of money down … for very good reasons, but with the unavoidable side-effect of pumped-up prices for houses.

The author also makes the claim that:

Organizations from the Financial Stability Board to the International Monetary Fund praise CMHC as a lynchpin of Canada’s financial stability (albeit calling for improved governance and risk management by CMHC).

I am unable to detect much “praise”, although the word “lynchpin” is justified by paragraph 40 of the IMF report.

I am advised by Financial Webring Forum that the comments to the CSA fiduciary duty proposals are being published. Those who are fascinated with the issue and have a LOT of time to spare may be interested in the SEC Study on Investment Advisers and Broker-Dealers and the Comments on Study Regarding Obligations of Brokers, Dealers, and Investment Advisers.

It was a day of modest movement for the Canadian preferred share market, with PerpetualPremiums up 6bp and both FixedResets and DeemedRetractibles gaining 1bp. Volatility was low. Volume was extremely low, with a notable presence in the highlights of BNS issues, which went ex-Dividend.

Quick! Call the handwringers! There’s been another market distortion!

California, the world’s ninth- largest economy, has Edison International (EIX) to thank for selling all of its carbon permits in the state’s first auction. The company unintentionally bid for twice as many allowances as were for sale.

Edison, owner of the state’s second-biggest power utility, submitted a proposal in the wrong format and offered to buy 21 times more allowances than it wanted on Nov. 14, documents obtained by Bloomberg show.

When the state Air Resources Board said last month that it had received three bids for every available permit, it failed to mention that Edison accounted for nearly 72 percent of the offers. Had the company submitted its proposals in the right format, about 225,000 permits would have gone unsold at auction, Bloomberg calculations based on data from the report show.

There’s a new study on HFT by Matthew Baron, Jonathan Brogaard and Andrei Kirilenko titled The Trading Profits of High Frequency Traders:

We examine the profitability of high frequency traders (HFTs). Using transaction level data with user identifications, we find that high frequency trading (HFT) is highly profitable: HFTs collectively earn over $23 million in trading profits in the E-mini S&P 500 futures contract during the month of August 2010. The profits of HFTs are mainly derived from Opportunistic traders, but also from Fundamental (institutional) traders, Small (retail) traders, and Non-HFT Market Makers. While HFTs bear some risk, they generate unusually high average Sharpe ratios with a median of 4.5 across firms in August 2010. Finally, HFTs profits are persistent, new entrants have a higher propensity to underperform and exit, and the fastest firms (in absolute and in relative terms) earn the highest profits.
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We find that the aggressiveness of a given HFT firm is highly persistent not only across days but over a two-year span, and use this finding to classify HFTs into three categories based on liquidity provision: Aggressive HFTs (if >60% of their trades are liquidity taking), Mixed (if between 20% and 60% of their trades are liquidity taking), and Passive (if <20% of their trades are liquidity taking). We show that the level of profits is significantly higher for liquidity-taking HFTs than for liquidity-providing ones: The average Aggressive HFTs earns $45,267 in gross trading profits in August 2010, while Mixed and Passive HFTs earn significantly less: only $19,466 and $2,461 per day, respectively.
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Small traders are defined as firms that trade less than a median of 20 contracts a day of all the days that firm is active. This is the majority of traders, with 21,761 participants in August 2010.
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Small traders in particular suffer the highest short-term losses to HFTs on a per contract basis: $3.49 per contract to Aggressive HFTs compared to $1.92 for Fundamental traders and $2.49 for Opportunistic traders, for a contract valued at approximately $50,000.
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Under the informed trader hypothesis we expect to see HFT profits being small, or even negative, when trading with Fundamental traders. However, a growing literature shows that Fundamental traders may trade in a way that makes their order flow noticeable (Hirschey, 2011). Heston, Korajczyk, and Sadka (2010) show that institutional traders leave a detectable pattern in their trading activity. Under the detectable patterns hypothesis we would expect HFT profits to be higher when trading with Fundamental traders than with others.
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For example, Fundamental traders incur a loss of -$1.92 (Column 2, Row 5) when trading with Aggressive HFTs, while Small traders experience a much larger loss of -$3.49 (Column 2, Row 7). Interestingly, Small traders lose similar amounts per contract to non-HFT traders. The empirical results support the first hypothesis that Fundamental (institutional) traders are generally informed traders able to evade leaving a detectable pattern in their trading activity from which HFTs glean information. The results also support the hypothesis that Small (retail) traders are noise traders who incur the largest effective transaction costs per contract.

I often get asked about Business Continuity Plans. Imagine what they look like in Israel!

Tal Keinan, an Israeli fund manager, was ready for the question he’s always asked when he met with investors in New York in October: Why put your money with a manager whose country Iran has threatened to obliterate.

“We tell them ‘if the Iranians attack, the worst thing that can happen is you lose your money manager not your money,’” Keinan, chief executive officer of Tel Aviv-based KCPS & Company, which oversees $1 billion in assets, said in an interview on Oct. 14. “The notion is trade global markets with global assets and clients, but just do it from Israel because of the concentration of talent here.”

The country is becoming a magnet for hedge fund managers as lower operating costs, the world’s highest number of Ph.D.s and hi-tech startups per capita overshadow concern that Israel may be attacked by missiles from Tehran. The number of funds has grown to 60 overseeing about $2 billion from 13 in 2006, according to a survey of the local industry published in July by Tzur Management. Israel may be on track to replicate the growth that propelled Singapore’s industry from fewer than 20 managers in 2001 to 320 overseeing $48 billion in 2009, Yitz Raab, founder and managing partner of the Tel Aviv-based fund administration company, said in an interview on Nov. 11.

Did you have a lot of downgrades in your bond portfolio in 2012? You’re not alone:

Standard & Poor’s and Moody’s Investors Service are cutting corporate debt ratings at the fastest pace since 2009 as a global economic slowdown and record borrowing erode credit quality.

The ratio of ratings downgrades to upgrades worldwide climbed to 1.85 this year from 1.23 in 2011, according to S&P data. PSA Peugeot Citroen (UG), Europe’s second-largest carmaker, was cut three times by Moody’s since March to speculative grade. Fort Worth, Texas-based RadioShack Corp. (RSH) was lowered four steps this year by S&P to seven levels below investment grade. Defaults rose to 80 issuers from 52 in 2011, according to S&P.

Europe’s second recession in four years and slowing global economic growth are helping to push a measure of corporate debt to earnings to a three-year high, Barclays Plc data show. Companies from the neediest to the most creditworthy sold unprecedented amounts of debt at record-low yields in 2012 as the Federal Reserve held interest rates at almost zero for a fourth year in an effort to boost the U.S. economy.

There’s a good article in the Globe titled CMHC: Ottawa’s $800-billion housing problem:

To Mr. Dodge, these were irresponsible moves that would encourage some people to borrow too much or jump into the market before they were ready, creating new risks for the economy. “This is a mistake,” he told CMHC brass bluntly.

Lower mortgage standards were going to cause already-frothy house prices to inflate even more – an “excessive exuberance,” the governor called it – as buyers rushed in, borrowing greater amounts of money and purchasing bigger homes than they could otherwise afford.

“This is absolutely not the appropriate thing to do,” a frustrated Mr. Dodge told the meeting.

Even more about housing in the Globe, in an article titled Frozen out: Behind Canada’s housing ‘affordability crisis’:

The average home in Canada now costs about $350,000, roughly five times the average household income. In the mid-1970s, it was three times average income, says University of British Columbia professor Paul Kershaw, who crunched the numbers for a recent report on generational income gaps.

There are many ways to judge how affordable a house is, but on that most basic measure – how many years of earnings it takes to buy a typical home – houses in Canada are dramatically more expensive than they were four or five decades ago.

Building up enough cash for a down payment can be crippling for many people, Prof. Kershaw says.

“Take an average 25– to 34-year-old in 1976, working full-time and making the average wage. That person had to save for five years to build up a 20-per-cent down payment for an average home,” he said. “Today, take the same 25– to 34-year-old. Now, they have to save for 10 years. And in B.C., it is 15 years.”

The underlying reason for this, Prof. Kershaw points out, is that housing prices have risen dramatically, while household incomes – adjusted for inflation – have barely moved at all since the mid-1970s.

Now, I have no doubt but that those figures are accurate, and I have no doubt but that houses are more expensive than they were forty years ago (whatever that means, however it’s measured). But my question is: how meaningful are these averages? The average Canadian is not the same guy as the average house-buyer, and never has been. What happens if you leave house prices as they are, but restrict the calculation of average income to the upper – say – 60%?

There’s an article in the Globe today titled The great pension shift: Goodbye safe, dull government bonds. Standard market timing chatter I generally don’t pass on, but there was one good snippet:

Low rates have hit pension funds especially hard. As interest rates fall, the amount of money that funds have to put aside to meet their future obligations increases. Even solid investment returns in recent years haven’t been enough to offset the impact of low rates, which have mired many pension funds in deficits, said Jim Leech, president and chief executive of Ontario Teachers’ Pension Plan, consistently one of the country’s top performing pension funds.

The cost of funding a typical pension for a teacher in Ontario has risen to close to $1-million from about $600,000 in the mid 2000s, Mr. Leech said.

Weary readers of the comments to the post of December 24 will be aware that I have been deluged with Mutual Fund links recently – so I’ll highlight a few of them that didn’t get into the comments. Most come with a hat-tip to Ken Kivenko’s “Fund OBSERVER”.

I mentioned the Hargreaves discount brokerage in the UK on December 17, which is trying to determine how to make any money now that the UK has banned fundcos from making payments to brokerages. Deloitte’s has come out with a report titled “Bridging the Advice Gap: Delivering Investment Products in a Post-RDR World, which is summarized by Morningstar as:

estimates that up to 5.5 million disenfranchised customers will choose to stop using financial advisers or be unable to access financial advice.

This shift is being brought about by the Retail Distribution Review (RDR), which is a set of new industry rules that will be put in place in 2013. The rules stipulate that financial advisers must start making upfront payment agreements with clients instead of taking commissions from investment product providers. These rules are being put in place to ensure there is more transparency about fees in the industry, but they could have the unintended consequence of turning investors away from advice because they want to avoid fees.
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“Many customers are unlikely to accept adviser charges for the services currently on offer. According to our research, some 33% of UK adults with less than £50,000 in savings, and 32% of those with more than £50,000, indicate they would cease using advisers for all [investment] products if they were charged directly.”

Of those people surveyed who said they would continue to seek out financial advice, many indicated that they would likely cut down on their adviser meetings in an effort to avoid high fees.

Coming up next: regulators to continue the inevitable downward spiral of a command economy, and make advice mandatory, at a set fee, paid to their brothers-in-law.

The report found that most large IFA firms and high street banks have begun channelling resources towards serving customers with at least £50,000 in investable assets.

And along those lines, we learn that (holy smokes, whoever woulda thunk it?) shelf space is valuable and businesses like to increase profit:

It came to our attention recently that earlier this year, RBC’s discount brokerage, RBC Direct Investing, ceased to offer funds sponsored by Leith Wheeler, Mawer and Steadyhand. The move was described by RBC as a “business decision,” and we assume this reflects the fact that the funds offered by these firms do not pay trailers, and thus RBC does not receive any revenue from their sale.

TDW also has enabling language in its Account Agreement:

5. Commissions: We reserve the right to charge fees or commissions which are not noted in the fund company’s prospectus. All such fees will be communicated in writing.

6. Minimum Investment: We reserve the right to set our own minimum purchase or redemption amount, which may differ from what is noted in the fund company’s prospectus.

7. Jurisdictional Purchase Limitations: We will only transact a purchase request for a Client if the applicable fund is fully registered for sale in the jurisdiction in which the Client resides.

8. Rights of Rescission: We will only accept requests to rescind the purchase if it does not exceed the sum of $50,000 and if you give us notice in writing within 48 hours of your receipt of the confirmation for a lump sum purchase. The trade confirmation will be deemed conclusively to have been received in the ordinary mail by you within five (5) days of the date it is mailed.

Yes, shelf space is valuable. I know there are restrictions on the availability of High Interest Savings Accounts; I would imagine that these restrictions, imposed by both manufacturer and brokerage, will increase as time goes on. You can’t get President’s Choice at Dominion!

This one will please all the advisor-bashers out there! John Chalmers and Jonathan Reuter write a paper titled What is the Impact of Financial Advisors on Retirement Portfolio Choices and Outcomes?:

We study choices and outcomes in the Oregon University System’s Optional Retirement Plan (ORP). ORP participants can choose to invest through a firm that uses brokers to provide personal face-to-face financial services, or through three lower-service firms. We find that younger, less highly educated, and less highly paid employees are more likely to invest through a broker, suggesting that demand for broker services is higher among those with lower levels of financial literacy. We also find significant differences in portfolio choice and outcomes. Broker clients allocate their retirement contributions across a larger number of investments, are less likely to remain fully invested in the default investment option, and less likely to change their equity allocation during the recent financial crisis. However, the portfolios of broker clients are significantly riskier, and underperform by as much as 2 percent per year on a risk-adjusted basis. Moreover, we are able to exploit variation in the broker fees paid by different investments to show that retirement contributions are higher when broker fees are higher. This highlights the agency conflict that can arise when unsophisticated investors seek financial advice from intermediaries. Although we cannot conclude that those investing through a broker would have been better off investing on their own, our findings suggest that brokers are a costly and imperfect substitute for financial literacy.

Well, sure. You don’t make any money by telling your clients that they’re wrong. You make money by telling your clients that they’re perfectly right, and it is a good time to get out of X and into Y. It helps if you deluge your client with a blizzard of information, so they’ll latch on to a piece of it and make a provisional decision that you can agree with, so that’s why brokerages have analysts. After all: the customer is always right!

You think that’s cynical? Well, just remember that a cynic is an educated idealist. For instance, Brad M. Barber, Terrance Odean and Lu Zheng wrote a paper titled Out of Sight, Out of Mind: The Effects of Expenses on Mutual Fund Flows:

We argue that the purchase decisions of mutual fund investors are influenced by salient, attention-grabbing information. Investors are more sensitive to salient in-your-face fees, like front-end loads and commissions, than operating expenses; they are likely to buy funds that attract their attention through exceptional performance, marketing, or advertising. Our empirical analysis of mutual fund flows over the last 30 years yields strong support for our contention. We find consistently negative relations between fund flows and front-end load fees. We also document a negative relation between fund flows and commissions charged by brokerage firms. In contrast, we find no relation (or a perverse positive relation) between operating expenses and fund flows. Additional analyses indicate that mutual fund marketing and advertising, the costs of which are often embedded in a fund’s operating expenses, account for this surprising result.

It is something of a relief to find a recent paper by Jesus Sierra titled Consumer Interest Rates and Retail Mutual Fund Flows that at least finds some correlation between equity fund flows and the actual economy:

This paper documents a link between the real and financial sides of the economy. We find that retail equity mutual fund flows in Canada are negatively related to current and past changes in a component of the prime and 5-year mortgage rates that is uncorrelated with government rates. The effect is present when we control for other determinants of fund flows and is more pronounced for big and old funds. The results suggest that consumers’ investments in domestic equity mutual funds take time to respond to changes in interest rates, and that developments in the market for consumer debt may have spillovers into other areas of the financial services industry.

Joseph Groia (famed for incivility to the OSC) and Owais Ahmed write a marvellous piece titled Extending a Fiduciary Duty to All Financial Advisors and Brokers: Will it Make a Difference?:

A fiduciary duty will also not help victims of boiler room fraud, Ponzi schemes, unregistered representatives, and unregistered products. We are amazed at how little real regulatory work is being done to prevent these schems and how ineffective the regulators are in helping injured investors received [sic] compensation for their losses. If there is one area of the marketplace, above all others, in which there should be a renewed effort, it is here.
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A statutory fiduciary standard which puts all investment advisors and brokers in the same position does not reflect the realities of the market place, and will not improve the remedies available to investors. There are other areas where more meaningful progress can be made, such as the mechanics of the relationship between investors and financial advisors and brokers.

And, just to wrap up today’s episode of Mutual Fund Argumentation, Assiduous Careful Readers will remember one of the arguments put forth by the Assiduous Reader who sent in all his comments by eMail:

Finally, OSC rules impose a fiduciary duty on fund managers. They must act solely in the Best interests of the fund.Paying trailers to discount brokers who provide no advice or incremental service is robbing fund assets to enhance Fund manufacturer AUM only.

This turned into a huge argument, with my view being that since the trailer fee component of MER is simply part of the fundcos’ gross revenue, they can pay it out to whoever they like. The argument was, essentially, whether the fundco is acting as agent or principal with respect to this portion of MER, a point on which we were unable to agree.

I understand my correspondent has consulted People Who Should Know, and been advised that he is correct (the customer is always right!), since the payments are disclosed in the prospectus and other documents; I understand that the word “may”, as in “may pay dealers a trailer” is a complicating factor in this reasoning.

However, Assiduous Readers and Loyal Fans will be relieved to know that I have a fallback argument:
i) The fundco charges a set MER so that they can pay for advice
ii) By purchasing the fund through a discount brokerage, the investor has indicated that he wants the fund, and doesn’t mind paying full price, but he doesn’t want advice, thank you very much.
iii) Therefore, the fundcos have a little bit of extra money that they don’t need to pay anybody
iv) They elect to pay it to the discount brokerages

I have no doubt but that eventually a few lawyers will get a nice car or two out of this.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums up 9bp, FixedResets gaining 1bp and DeemedRetractibles down 9bp. Volatility was average-ish, but entirely to the downside. Volume was extremely light.

PerpetualDiscounts now yield 4.88% equivalent to 6.34% interest at the standard equivalency factor of 1.3x. Long corporates now yield 4.25%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 210bp, a slight (and perhaps spurious) widening from the 205 bp reported December 19.

It is always interesting to compare Dollar-Weighted returns with Time-Weighted returns as an indicator of how much retail loses by trying to time the market. Bloomberg estimates an enormous figure:

Americans have missed out on almost $200 billion of stock gains as they drained money from the market in the past four years, haunted by the financial crisis.

Assets in equity mutual, exchange-traded and closed-end funds increased about 85 percent to $5.6 trillion since the bull market began in March 2009, trailing the Standard & Poor’s 500 Index’s 94 percent advance, according to data compiled by Bloomberg and Morningstar Inc. The proportion of retirement funds in stocks fell about 0.5 percentage point, compared with an average rise of 8.2 percentage points in rallies since 1990.

The retreat shows that even the biggest gain since 1998 failed to heal investor confidence after the financial collapse that wiped out $11 trillion in U.S. equity value was followed by record price swings in equities, a market breakdown that briefly erased $862 billion in share value and the slowest recovery from a recession since World War II. Individuals are withdrawing money as political leaders struggle to avert budget cuts that threaten to throw the economy into a new slump.

Unintended consequences is a persistent theme on PrefBlog – largely because regulators never think things through:

Policy makers are disappointed that lower yields on mortgage-backed securities haven’t led to more savings on home loans after the Fed expanded its balance sheet to an all-time high of almost $3 trillion through bond purchases. Bernanke this month called the trend “unfortunate,” and the Federal Reserve Bank of New York held a workshop to examine the issue.

The gap between the bond yields and home-loan rates is blunting the economic benefits of the Fed’s record accommodation, New York Fed President William C. Dudley said in a speech in New York this month. Among the reasons for the spread: banks are reluctant to take on the expensive fixed costs of new staff to process the paperwork and tougher capital requirements are making it less attractive to service loans.
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It’s also tough to find and train workers, and harder for new mortgage companies to gain approval to enter the business as oversight becomes more stringent in the wake of the financial crisis, said Willie Newman, head of Taylor Capital Group Inc.’s home-loan unit, which originated $1.4 billion of mortgages last quarter

An Assiduous Reader sends me a link to Ken Kivenko comments on Trailer Fees – which, regretably, strays far afield from the subject of trailer fees. The arguments rest on the same fallacious assumption made in most other arguments I have seen: an assumption that the salesman has or should have some kind of duty to serve the best interest of the investor – even though the investor is paying nothing for this service. Life sure would be nice if we could all get something for nothing! Mr. Kivenko goes so far as to assert:

Fund manufacturers pay online brokers a trailer but no service is provided- at a minimum ,this s a breach of portfolio manager fiduciary duty; worst case: an illegal misappropriation of fund assets.

I fail to see how this is a breach of portfolio manager fiductiary duty, much less how the it becomes an “illegal misappropriation of fund assets.

However, I did agree with one part!

Encourage competition by allowing Canadians access to lower cost U.S. Mutual funds

I would go further: encourage competition by allowing Canadians to sponsor lower cost Canadian funds! Let us, for instance look at the Acker Finley Canada Focus Fund 2011 Interim Management Report of Fund Performance and Financial Report, which is available on SEDAR dated August 24, 2011. Specifically, we’ll look at “Statements of Investment Operations Six months ended June 30 (Unaudited)” The fund had slightly under $4.3-million under management at the time of the report.

Holy smokaramas, look at those expenses! The MER was 5.95%! It may well be that the sponsor was simply paying above the market rate for the various things a public mutual fund might have – it’s not a question I have investigated closely – but when you add the cost for preparing and filing a prospectus (about $100,000, I believe), I suspect most readers will understand why my fund is not a PUBLIC mutual fund but relies on prospectus exemptions.

At any rate, all the various arguments against trailer fees run into the same problem: a salesman is not a fiduciary. Maybe he should be a fiduciary (in which case, who will the salesmen be?), but right now, he ain’t. The trailer fee debate, as it has been framed by the CSA should be abandoned, as it is simply a subset of the fiduciary vs. salesman debate, which is being discussed separately for some reason.

It has also occurred to me to question why new issue commissions have not been included in the trailer fee debate, assuming that we want a trailer fee debate. Salesman can make 3% (before his brokerage gets its cut) for selling a perfectly routine preferred share new issue. All the principles applicable to mutual fund trailer fees are applicable to new issue commissions, as far as I can see.

The motto of Mr. Kivenko’s organization, Kenmar Associates, is “The Voice of the retail Investor”, but it is unclear to me whether this is more than just another marketting slogan. Neither Kenmar nor Kivenko is registered with the OSC – but, of course, some might consider this a good thing!

Mr. Kivenko’s comment letter did lead me (by a circuitous route) to a most illuminating article by Kieth Ambachtsheer and Rob Bauer titled Losing Ground:

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.

This in turn led me to another interesting paper by R. Bauer, R. Frehen, H. Lumb and R. Otten titled Economies of Scale, Lack of Skill or Misalignment of Interest?:

This paper provides empirical evidence on the comparative performance of three important players in the US financial services industry: defined benefit (DB) pension funds, defined contribution (DC) pension funds, and mutual funds. We have access to a pension fund database, which provides fund-specific cost, benchmark and equity return information at the total plan level. This allows us to study both net and gross equity returns in great detail. Our empirical results clearly show that equity investments of DB and DC pension funds perform according to their fund-specific benchmarks, whereas mutual funds on average under-perform by about 150-200 basis points in the same period. We find modest evidence of persistence in mutual fund returns, while there is none in pension fund returns. The performance differential between pension and mutual funds cannot be fully explained either by differences in costs, as a result of economies of scale, or by size, risk and style deviations. We conclude that other factors must play an important role. Agency costs are a usual suspect.
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How do we interpret these results? Do pension fund managers have more skill than mutual fund managers in relative terms? Yes, but both are unable to beat the corresponding benchmarks. Moreover, pension funds hire (and fire) institutional asset managers who provide mutual funds to individual investors as well. So, if they are using the same portfolio managers, why do we find different returns? Is the lower cost level of pension funds an explanation? Potentially, but it cannot fully explain the difference in returns. Moreover, the multi-level panel analysis shows that other drivers of the return difference cannot be found.

Based on my own, totally anecdotal observations, I’ll vote for “manager skill” as the big factor, which is exacerbated by cash flows and the fear of cash flows.

It was another good day for the Canadian preferred share market, with PerpetualPremiums gaining 2bp, FixedResets up 8bp and DeemedRetractibles winning 22bp. Volatility was low. Volume, as befits the season and the market hours, was extremely low.

Spend-Every-Penny is continuing his heroic efforts to pump up a Canadian housing bubble:

Ottawa has increased by $50-billion the amount of residential mortgages that it is willing to guarantee.

But this time the Canada Mortgage and Housing Corp., the biggest provider of mortgage default insurance, is not getting any. Instead, the additional backing is going only to private-sector players such as Genworth Canada, who will see their maximum raised to $300-billion from $250-billion.

Genworth Canada disclosed the news on Thursday, which helped drive its shares up more than 3% to $22.73.

The mortgate insurance market in this country is dominated by a handful of players including the CMHC, Genworth Canada and Canada Guarantee, with CMHC accounting for the lion’s share. In the interests of fair competition, all are given access to government guarantees.

Yes, here in Canada, lenders can freely compete to see who can suck arse in Ottawa enough to get mortgage guarantees. Auctioning off the guarantees would be uncivilized; especially since there are those who have a rather peculiar take on the necessity of government guarantees:

In the financial institutions legislation we have a requirement that all mortgages over 80% have mortgage insurance, so on the one hand, we have a requirement that a mortgage lender must receive mortgage insurance from either CMHC or a private mortgage insurer in order to take on the mortgage of a Canadian who wishes to purchase a house with a down payment of less than 20%. With that mandatory requirement in legislation, the government would be under an obligation to ensure that mortgage insurance is available.

The Toronto Exchange will be close the regular session at 1pm on December 24. That will allow us members of the highest paid profession on earth to go shopping and complain about how lazy the clerks are.

CMHC has released the Canadian Registered Covered Bond Programs Guide. DBRS notes:

Upon an initial review of the Guide, DBRS expects that the current Canadian covered bond issuers will either amend their existing respective programs or create new programs to comply with the Guide. Given the substantial requirements prescribed in the Guide, DBRS does not expect any new Canadian covered bond issuances over the next few months while the issuers are implementing the changes to existing programs or establishing new programs. DBRS will not assign any final ratings to any proposed new issuances until DBRS has received confirmation that the relevant issuer, the program and series have been registered in accordance with the Guide.

On November 26 I referred to Ontario lawyers’ claims that there were too many lawyers; I was interested to see some American numbers on the topic in a rather whiny Bloomberg article:

The same housing crash that hammered young architects and loan officers also slammed lawyers. Law schools are turning out about 45,000 degree holders a year for about 25,000 full-time positions available to them, according to the National Association for Law Placement Inc. in Washington. The class of 2011 had the lowest placement with law firms, 49.5 percent, in 36 years.

Whiny? Yes, whiny:

Only one-fifth of those who graduated college since 2006 expect greater success than their parents, a Rutgers survey found earlier this year.

Uh … yeah. You’re only six years out of school, chumps, and a rather significant recession got in the way. Call me back in twenty years and then we can discuss your success relative to your parents.

The Canadian preferred share market was hot today, with PerpetualPremiums up 6bp, FixedResets winning 22bp and DeemedRetractibles gaining 18bp. Volatility was good, all positive and heavily skewed towards FixedResets. Volume was average.

An article of mine has been published in the December Advisor’s Edge Report, titled OSFI’s Academic Foray, which discusses a paper published by OSFI titled Evidence for Mean Reversion in Equity Prices, which they explain as:

OSFI has had discussions with some life insurance industry representatives on equity return models that incorporate mean reversion assumptions. This was done as part of its work on the use of internal models to determine capital requirements for segregated fund guarantees.

OSFI has considered the question of whether such assumptions are prudent, and has decided that it will not review requests for approval to use internal models that incorporate mean reversion in equity returns.

The paper “Evidence for Mean Reversion in Equity Prices” accompanying this letter explains the rationale behind OSFI’s decision. It is being released so that industry participants and other stakeholders can better understand OSFI’s views on this subject.

Sadly, as I conclude:

The OSFI paper held great promise to explain to the investing public why it made a particular decision—a practice that allows us to become more familiar with OSFI’s priorities and the underlying philosophy that forms the framework for its decisions. This promise was not fulfilled.

If OSFI wishes to gain credibility as a knowledgeable and effective regulator of the Canadian financial system, it needs to produce analysis at a much higher standard. Both academia and the private sector offer considerable expertise on regulatory practice, and it should be harnessed.

I’ll post a PDF of the article as published and of my footnoted draft version after a decent interval.

ICE wants to buy the NYSE:

IntercontinentalExchange Inc., the 12-year-old energy and commodity futures bourse, agreed to acquire NYSE Euronext (NYX) for cash and stock worth $8.2 billion, moving to take control of the world’s biggest equities market.

IntercontinentalExchange, based in Atlanta, will pay $33.12 a share for the owner of the New York Stock Exchange, 38 percent above yesterday’s closing price, according to a statement today. Both boards approved the proposal and the companies expect to complete the transaction in the second half of 2013. Last year, the U.S. blocked a joint hostile bid by IntercontinentalExchange and Nasdaq OMX Group Inc. (NDAQ) for the New York-based company on concern the combination would dominate U.S. stock listings.

Merging NYSE Euronext, which owns the biggest exchanges by value of listings in the U.S., France and the Netherlands, with the second-largest futures market underscores both the growing importance of derivatives and the diminishing influence of the 220-year-old NYSE. The Big Board, once the benchmark for global free markets, has seen its share of trading in stocks listed on the exchange decline to 21 percent from 82 percent.

Boyd Erman in the Globe reports:

The trend of international consolidation of stock exchanges appears to be not just over, but unravelling.

As part of their planned combination, IntercontinentalExchange (ICE) and NYSE Euronext say they will look to sell their European equity markets, known as Euronext, in an initial public offering.
…
NYSE and Euronext combined. NYSE Euronext then tried another deal with Deutsche Boerse of Germany. TMX looked to merge with London Stock Exchange Plc. Singapore’s market looked for a tie-up with Australia’s.

For various reasons, most of those deals failed. The only big one that really got done was the creation of NYSE Euronext. And Thursday, management of NYSE declared the experiment over after synergies between the companies had been limited, and the value of Euronext, such as it is, lost within NYSE. ICE executives also pointed to a need to cut down on the number of businesses the companies would run, and regulatory changes that they said make it hard to run an international stock exchange business.

On a conference call to discuss NYSE Euronext’s planned acquisition by ICE, NYSE chief executive officer Duncan Niederauer conceded the Euronext transaction had been a bust.

“We’ve yet to deliver those returns and prove that hypotheses,” he said.

Pension chickens coming home to roost in the US:

A firefighter in Allentown, Pennsylvania, which plans to lease its water system to meet retirement costs, left last year with an annual pension of $99,289, more than double what state law says was due.
…
The unauthorized benefits, which some cities resort to partly because they prefer pension perks over raises, add to financial burdens lingering from the recession that ended in 2009. Localities in the sixth-most-populous state face $8.5 billion in unfunded pension liabilities, according to the retirement commission.
…
Audits of Pennsylvania cities that fall under pension restrictions show that 26 percent have given illegal benefits.

One such municipality was Allentown, a city of 119,000 whose plans are 64 percent funded, according to the retirement commission.

Here’s a good idea from Facebook:

Facebook said the test will start with a “small number of people” and will charge an unspecified fee to ensure a message gets sent to the main inbox — rather than a lower-priority queue — of another user, even a stranger. Facebook will test different fees, starting initially at about $1 per e-mail, according to a person with knowledge of the matter, who asked not to be identified because pricing is private.

“Several commentators and researchers have noted that imposing a financial cost on the sender may be the most effective way to discourage unwanted messages and facilitate delivery of messages that are relevant and useful,” the Menlo Park, California-based company said on its website.

For years, I’ve advocated a system for eMail whereby users pay $0.01 to send each eMail, and receive $0.01 for each email received; balance remitted or billed by the ISP monthly, balances of less than $10 either way are eliminated without payment.

Most individuals would receive payments, if any. Businesses would probably have to pay something, but $0.01 is a very cheap delivery charge for a legitimate business communication.

You want a spam-less eMail system? That’s how you get a spam-less eMail system. But all the damn hippies chant: ‘The Internet should be free!’ and I don’t think we’ll ever see that on a public system. Hippies destroyed the Internet!

It was a positive day for the Canadian preferred share market, with both PerpetualPremiums and FixedResets gaining 3bp, while DeemedRetractibles won 14bp. Volatility was low. Volume was very high.

There’s a smoking gun in the LIBOR fixing scandal:

According to transcripts released by the U.K. Financial Services Authority today, an employee identified as Trader A led efforts to influence Japanese Yen Libor submissions included paying brokers as much as 15,000 pounds ($24,400) a quarter and offering a payment to another for helping him keep that day’s rate low. Trader A worked at UBS in Tokyo from 2006 to 2009 and directly contacted employees at other banks to influence their submissions at least 80 times.

“I need you to keep it as low as possible,” Trader A wrote to the broker on Sept. 18, 2008, referring to six-month yen Libor. “If you do that … I’ll pay you, you know, $50,000, $100,000… whatever you want … I’m a man of my word,” according to the transcripts.
…
Between Sept. 19 and Aug. 25, 2008, Trader A and a colleague entered into nine so-called wash trades as a means of rewarding an unidentified broker with more than 170,000 pounds for helping rig the rate. Wash trades are where a trader puts through two or more risk-free trades through a broker which cancel each other out while leading to a payment of brokerage fees to the broker arranging the trade.

For how long will the Greeks tolerate this?

In the Greek mountain town of Kastoria, less than an hour from the Albanian border, Kostas Tsitskos, 88, can’t afford fuel to heat his home against the winter’s cold. So he and his son live in a single bedroom, warmed by a small electric heater.

“One room is enough,” said Tsitskos, who lives on a 734 euro-a-month ($971) pension and doesn’t have the 1,000 euros a month he needs to buy heating oil.

Greece is facing a heating-oil crisis. With an economy that has contracted for five years and an unemployment rate at a record 25 percent, residents in northern Greece can’t heat their homes. Kastoria hasn’t received funds from the central government to warm schools and the mayor said he will close all 53 of them rather than let children freeze, a step already taken in a nearby town. Truckloads of wood are arriving from Bulgaria as families search for alternative fuels.

Canadians shouldn’t get too cocky:

The Canadian economy is expected to pick up speed – a little – by the middle of next year, though external risks still “loom large,” a new forecast said Wednesday.

The country’s gross domestic product will grow 1.8 per cent next year and accelerate to 2.25 per cent in 2014, the International Monetary Fund said in its preliminary assessment of the Canadian economy. That’s down slightly from its October forecast of 2 per cent growth for next year.

It was a mixed day for the Canadian preferred share market, with PerpetualPremiums off 2bp, FixedResets gaining 7bp and DeemedRetractibles up 12bp. Volatility was average, but the highlights are all negative. Volume was quite high – presumably due to traders trying to get ready for year-end before the holiday lull.

PerpetualDiscounts now yield 4.88%, equivalent to 6.34% interest at the standard equivalency factor of 1.3x. Long corporates yield just under 4.3%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 205bp, a slight (and perhaps spurious) decline from the 210bp reported December 12.

As mentioned yesterday, I received a query from an Assiduous Reader asking me to clarify my remarks of December 13 regarding the recent CSA Discussion Paper and Request for Comments on Mutual Fund Fees.

Having reviewed my comments, I confess to some surprise that clarification should be required – they seem plain enough to me. But here goes:

i) The CSA is concerned that:

investors have no say in the extent to which their mutual fund assets are used to pay for advisor compensation.

I pointed out that this is like every other product sold to retail. When I buy a can of beans for $2.49 at the grocery story, I have no say in how that $2.49 is split between the producer, the middlemen and the store itself. Why should I? The deal’s right there: $2.49 for a can of beans, take it or leave it. What’s wrong with that? The price is disclosed and the nature of the product is disclosed: it makes no difference to me whether the Chilean farmer who planted and harvested the beans gets a nickel or quarter out of the deal.

Some people, of course, get all worked up about things like this and start “Fair Trade” organizations with the stated intent of increasing the proportion of the retail price paid to the producer, even if this increases the retail price. Well, more power to them! But most people don’t care because the question is totally irrelevant to them.

As far as mutual funds are concerned – the amount to be taken from the fund by the sponsor as management fees is stated in the prospectus and this figure is (as pointed out by Assiduous Reader mclachlan8) widely publicized. What happens to the fees afterwards is irrelevant to the investor.

ii) I found the following bland assertion rather breathtaking:

Using fund assets to pay for trailing commissions could encourage additional sales of the fund. This could increase the fund’s assets under management, which would increase the management fees payable. This creates an actual or a perceived conflict of interest between the mutual fund manufacturer and the fund’s investors. [footnote]

[Footnote reads:] G. Stromberg, supra note 81, at pages 16-17, comments on this conflict of interest as follows: “A result of this perspective is that independent investment fund organizations have increasingly become marketing companies, more focussed on gaining market share than on being investment management companies focussed on managing investment funds for the benefit of the investors in these funds. The major concern that arises from the focus on marketing considerations is whether marketing considerations are prevailing over investment management decisions and resulting in conflicts of interest between the fund manager and the fund investors.

One reason this is breathtaking is lack of a logical connection between the footnote and the text. Ms. Stromberg was concerned about investment management decisions, which do not have anything to do with the level of fees charged.

An example of an investment management decision that could be influenced by marketing considerations is the decision to invest in security XYZ because it was popular with retail; or because it enabled the marketing department to trumpet the holding as a bold example of incisive logic; or some such rationale. If this rationale conflicted with the portfolio manager’s honest opinion of security XYZ as an investment – yes, that’s a clear breach of duty, that’s bad, take them out and shoot them.

But it has nothing to do with the fee charged.

However, the most offensive portion of the chain of thought lies in the implication that fund assets are used to pay trailer fees. This is, generally speaking, false: fund assets are not used to pay trailer fees. Fund assets are used to pay the Management Expense Ratio; once this payment has been received by the fund sponsor, the funds become property of the sponsor and lose their identity as fund assets. And the fund sponsor is perfectly entitled to do whatever it wants with its property.

There are some rare cases in which fund assets are used to pay trailers: for instance, CPD.A differs from CPD in that the former pays a trailer to the advisors of the holder. This is fully disclosed in the prospectus and reported in the financial statements – I fail to see any problem with this. The payments are included in the reported Management Expense Ratio, and investors can take it or leave it, as they see fit. One of the CSA’s proposed changes [# (iii)] envisions all mutual funds having such a carve-out of trailers … but this is a proposed CHANGE, not a reflection of the current state of affairs.

iii) However, the CSA logic becomes even more convoluted – and even more offensive – in the latter part of the paragraph quoted:

This practice could put the mutual fund manufacturer at odds with its statutory duty to act in the best interest of the mutual fund [First Footnote] to the extent the mutual fund manufacturer, rather than the fund and its investors, is the primary beneficiary of the fund’s asset growth. The mutual fund manufacturer must be able to demonstrate that it is acting in the best interests of the mutual fund and its investors, and not itself, when engaging in this practice.[Second Footnote]

[First Footnote reads] See s. 2.1 of National Instrument 81-107 Independent Review Committee for Investment Funds, which requires the manager of the investment fund to (a) act honestly and in good faith, and in the best interests of the investment fund, and (b) exercise the degree of care, diligence and skill that a reasonably prudent person would exercise in comparable circumstances. The Securities Acts of most of the CSA jurisdictions also contain a similar provision.

[Second Footnote reads] A mutual fund manufacturer could demonstrate this, for example, by reducing the management fees and expenses it charges to a mutual fund as its assets grow, thus yielding a benefit to the fund and its investors. Interestingly however, U.S. studies on trailing commissions, known in the U.S. as “12b-1 fees”, have concluded that trailing commissions don’t yield the expected benefit for investors. When 12b-1 fees were originally adopted in the U.S., mutual funds were experiencing net redemptions. The belief was that if fund flows could be attracted through the use of 12b-1 fees, existing investors would benefit through lower expense ratios as assets under management increased. Subsequent U.S. experience has shown this not to be the case with 12b-1 fees increasing expense ratios on a one-for-one basis even as assets under management increase. See S. Collins, The Effect of 12b-1 Plans on Mutual Fund Investors, Revisited (March 2004) ICI working paper, and L. Walsh, The Costs and Benefits to Fund Shareholders of 12b-1 Plans: An Examination of Fund Flows, Expenses and Returns (June 2004) SEC discussion paper available at: http://www.sec.gov/rules/proposed/s70904/lwalsh042604.pdf.

The logic of the part up to and including the first footnote is absurd. It continues the conflation of the roles of portfolio manager and sponsor discussed above. The Portfolio Manager certainly has a fiduciary duty to the fund to exert care and prudence in portfolio management – that much is basic. But this is an entirely separate topic from how much is charged for that Portfolio Manager’s care and prudence.

A criminal lawyer, for instance, owes fiduciary duty to his clients. But we don’t (often) see Clayton Ruby work for free, although I’m sure he does his share of pro bono work in the public interest. As a matter of general principle, most people will attempt to charge whatever the market will bear for their services, regardless of what those services might be. And why not? It’s certainly not unethical to ask your boss for a raise, or to find a better paying job.

The premise underlying the last sentence of the quoted CSA paragraph, leading up to the second footnote, is offensive to any conception of justice: “The mutual fund manufacturer must be able to demonstrate that it is acting in the best interests of the mutual fund and its investors, and not itself, when engaging in this practice.” Since when, in Canada, has it been necessary to prove innocence? I assert that it is the regulators, or aggrieved parties, who bear the onus of proving that the fiduciary duty of the portfolio manager has been breached.

iv) With respect to the part (ii) of the “possible changes”:

ii. A standard class for DIY investors with no or reduced trailing commission
Every mutual fund could have a low-cost ‘execution-only’ series or class of securities available for direct purchase by investors. The lower management fees of this series or class would reflect that no or nominal trailing commissions are paid to advisors, in light of the lack of advice sought by DIY investors who purchase and hold securities of this series or class. This low-cost series or class of securities could be made available to investors through a discount brokerage, or alternatively, be distributed directly by the mutual fund manufacturer, in which case the mutual fund manufacturer would need to be registered as a mutual fund dealer.

As I remarked, it’s not clear how the discount brokerages will bet paid for this service; it’s also not clear what the manufacturers’ responsibility to the clients will be for this additional service, or how (if?) they will get paid.

With respect to the discount brokerages, I mentioned yesterday the sabre-rattling that has commenced in the UK, with the discount brokerage Hargreaves mulling over how it should be paid for its services given the pending illegality of trailer fees in the UK. The UK has already passed the damn law, and the resolution of this question is not clear!

v) My last remark was with respect to:

v. Cap commissions
There could be a maximum limit set on the portion of mutual fund assets that could be used to pay trailing commissions to advisors as a way to mitigate the perceived conflicts of interests and the lack of alignment of advisor compensation and services described in Part V. …

I stated that the level of trailers is “just plain none of the regulators’ damn business.”, and stand by that remark. Disclosure? Sure – that’s regulatorary business. Level? No way.

A further problem with the regulatory proposals with respect to trailers has arisen in the comments to yesterday’s post with respect to fiduciary duty. If fees are charged directly by the advisor to the investor, then the advisor will have a fiduciary duty towards that client. This is basic, and is currently embedded in the securities laws in the case of secondary trading, where a commission is paid with respect to a trade and the advisor has a number of explicit duties with respect to that trade, e.g., to seek best execution and not to front-run the order.

Now, if one feels that stockbrokers should have a fiduciary duty to clients, that’s all well and good – but is best addressed under the heading “Fiduciary Duty” rather than “Trailer Fees”. Many of the CSA suggested changes have the effect of imposing fiduciary duty on advisors without being quite brave enough to say the word – which is already the subject of a completely different set of regulatory proposals anyway.

It was a mildly positive day for the Canadian preferred share market, with PerpetualPremiums up 8bp, FixedResets flat and DeemedRetractibles gaining 2bp. Volatility was low. Volume was average.