December 27, 2012

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.

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.

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.

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.

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.

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.

“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.

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.

HIMIPref™ Preferred Indices
These values reflect the December 2008 revision of the HIMIPref™ Indices

Values are provisional and are finalized monthly
Index Mean
(at bid)
Mod Dur
Issues Day’s Perf. Index Value
Ratchet 0.00 % 0.00 % 0 0.00 0 0.0401 % 2,481.8
FixedFloater 4.41 % 3.78 % 31,419 17.73 1 -1.0575 % 3,645.0
Floater 2.80 % 3.00 % 54,676 19.73 4 0.0401 % 2,679.7
OpRet 4.61 % -2.03 % 54,547 0.43 4 0.2575 % 2,604.7
SplitShare 4.64 % 4.76 % 55,306 4.37 2 -0.3218 % 2,870.1
Interest-Bearing 0.00 % 0.00 % 0 0.00 0 0.2575 % 2,381.7
Perpetual-Premium 5.26 % 1.21 % 70,830 0.78 30 0.0935 % 2,329.8
Perpetual-Discount 4.85 % 4.88 % 131,186 15.58 4 -0.0507 % 2,639.7
FixedReset 4.92 % 2.99 % 219,486 4.10 77 0.0128 % 2,461.7
Deemed-Retractible 4.87 % 0.09 % 118,079 0.33 46 -0.0914 % 2,428.8
Performance Highlights
Issue Index Change Notes
IAG.PR.F Deemed-Retractible -1.30 % YTW SCENARIO
Maturity Type : Call
Maturity Date : 2015-03-31
Maturity Price : 26.00
Evaluated at bid price : 26.65
Bid-YTW : 4.50 %
MFC.PR.G FixedReset -1.07 % YTW SCENARIO
Maturity Type : Call
Maturity Date : 2016-12-19
Maturity Price : 25.00
Evaluated at bid price : 25.96
Bid-YTW : 3.40 %
BAM.PR.G FixedFloater -1.06 % YTW SCENARIO
Maturity Type : Limit Maturity
Maturity Date : 2042-12-27
Maturity Price : 22.22
Evaluated at bid price : 21.52
Bid-YTW : 3.78 %
Volume Highlights
Issue Index Shares
CM.PR.M FixedReset 75,000 Nesbitt crossed 75,000 at 26.60.
Maturity Type : Call
Maturity Date : 2014-07-31
Maturity Price : 25.00
Evaluated at bid price : 26.58
Bid-YTW : 2.09 %
CM.PR.L FixedReset 27,050 Nesbitt crossed 25,000 at 26.35.
Maturity Type : Call
Maturity Date : 2014-04-30
Maturity Price : 25.00
Evaluated at bid price : 26.30
Bid-YTW : 2.10 %
BNS.PR.Y FixedReset 25,600 Nesbitt sold 10,000 to RBC at 24.14.
Maturity Type : Hard Maturity
Maturity Date : 2022-01-31
Maturity Price : 25.00
Evaluated at bid price : 24.14
Bid-YTW : 3.30 %
ENB.PR.T FixedReset 15,574 Recent new issue.
Maturity Type : Limit Maturity
Maturity Date : 2042-12-27
Maturity Price : 23.17
Evaluated at bid price : 25.23
Bid-YTW : 3.74 %
GWO.PR.Q Deemed-Retractible 13,355 YTW SCENARIO
Maturity Type : Hard Maturity
Maturity Date : 2022-01-31
Maturity Price : 25.00
Evaluated at bid price : 26.25
Bid-YTW : 4.50 %
BNS.PR.J Deemed-Retractible 13,325 Desjardins crossed 10,000 at 26.45.
Maturity Type : Call
Maturity Date : 2013-10-29
Maturity Price : 25.00
Evaluated at bid price : 26.43
Bid-YTW : -0.58 %
There were 6 other index-included issues trading in excess of 10,000 shares.
Wide Spread Highlights
Issue Index Quote Data and Yield Notes
W.PR.H Perpetual-Premium Quote: 25.75 – 26.43
Spot Rate : 0.6800
Average : 0.4172

Maturity Type : Call
Maturity Date : 2013-02-14
Maturity Price : 25.00
Evaluated at bid price : 25.75
Bid-YTW : -17.83 %

PWF.PR.P FixedReset Quote: 25.30 – 25.74
Spot Rate : 0.4400
Average : 0.2607

Maturity Type : Limit Maturity
Maturity Date : 2042-12-27
Maturity Price : 23.47
Evaluated at bid price : 25.30
Bid-YTW : 3.01 %

CM.PR.K FixedReset Quote: 25.99 – 26.45
Spot Rate : 0.4600
Average : 0.3053

Maturity Type : Call
Maturity Date : 2014-07-31
Maturity Price : 25.00
Evaluated at bid price : 25.99
Bid-YTW : 2.50 %

MFC.PR.G FixedReset Quote: 25.96 – 26.25
Spot Rate : 0.2900
Average : 0.1796

Maturity Type : Call
Maturity Date : 2016-12-19
Maturity Price : 25.00
Evaluated at bid price : 25.96
Bid-YTW : 3.40 %

IAG.PR.A Deemed-Retractible Quote: 24.59 – 24.85
Spot Rate : 0.2600
Average : 0.1585

Maturity Type : Hard Maturity
Maturity Date : 2022-01-31
Maturity Price : 25.00
Evaluated at bid price : 24.59
Bid-YTW : 4.85 %

GWO.PR.L Deemed-Retractible Quote: 26.32 – 26.59
Spot Rate : 0.2700
Average : 0.1708

Maturity Type : Call
Maturity Date : 2014-12-31
Maturity Price : 26.00
Evaluated at bid price : 26.32
Bid-YTW : 4.79 %

5 Responses to “December 27, 2012”

  1. jiHymas says:

    An Assiduous Reader writes in and says:

    Mutual funds and online brokers don’t seem like an obvious combination, yet funds account for 14 per cent of the $228-billion invested through online brokerage firms, the latest retail brokerage report from Investor Economics shows.

    The little bit of extra money sapped from fund assets equals 0.14x $228,000,000,000 x 0.01= $319,000,000 assuming 1 % trailer

    Also I wouldn’t say DIY investors don’t mind- they are pissed at the

    That’s why Questrade is getting so much of their business vis trailer

  2. jiHymas says:

    That’s why Questrade is getting so much of their business vis trailer rebating

    Good for them! If the business model works in a general way, other discount brokerages will adopt the same strategy.

    If it’s only a niche product, things will continue as they are.

    It’s very nice to see the market making this decision, not the regulators.

  3. […] PrefBlog Canadian Preferred Shares – Data and Discussion « December 27, 2012 […]

  4. […] PerpetualDiscounts now yield 4.88%, equivalent to 6.34% interest at the standard equivalency factor of 1.3x. Long corporates now yield about 4.25%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) is now about 210bp, unchanged from the figure reported December 27. […]

  5. […] may recall my musing on housing affordability, last mused on December 27. If only 60% of the population own a house, is it appropriate to use the average income of […]

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