PrefBlog

A number of questions regarding the fund were asked on Financial Webring Forum. While that is certainly a great venue for asking questions, I don’t feel comfortable answering them there – so I’ll answer here.

Is Malachite MAPF good alternative (to DPS.UN) for qualified accredited investors? Well, I certainly like to think so! DPS.UN is a closed-end passive fund trading on the TSX with a MER of about 56bp. As far as MAPF is concerned, it is my belief that the preferred share market is sufficiently inefficient that significant gains can be made by trading between issues from time to time. The historical results that the fund has been able to achieve support this view. There can be no guarantee that outperformance will continue, but I think that index +2% (after expenses, before fees) is achievable with a portfolio size much greater than I currently have. With the fee schedule currently in place, net return to unitholders should handsomely exceed the 56-bp-less-than-Index returns expected from a diversified passive fund with a 56bp MER.

What is its MER besides 1% annual fee? Fund expenses have been capped at 50bp, with excess expenses being absorbed by the manager. The fund’s total expenses are sufficiently low that the fund will not have to grow very much before I can stop paying out this money and the rate goes down. Fund expenses are almost entirely due to Audit Fees. Further details are available from the Annual Reports of the fund, which are published on my website.

If its duration is same as 10 year bond, is it safe investment for redemption after 10 years? That depends largely on what you mean by “safe”! It is my opinion that, given the high credit quality of the fund’s investments and their nature, the risk profile of the fund is similar to a corporate bond fund such as iShares CDN Corporate Bond Index Fund (XCB) , with a greater expected after-tax return due to the Dividend Tax Credit and trading based on market inefficiency.

Its returns are better than index since inception. Why is its fund size so small after 5 years? There are a number of hurdles that have to be overcome before the fund can grow in size.

• Investor disbelief that active trading is possible. Liquidity is a problem in the preferred share marketplace, but can be turned into an opportunity. It is difficult for an investor to place an order of, say, 10,000 shares on the TSX and get filled at a known and reasonable price in a short period of time. Patience is required. Many investors are completely unaware of the existence of the Institutional “Upstairs” Market – every brokerage has a pref trader. Institutions can call and ask him to execute a trade – it then becomes his job to find a counterparty and charge both sides a nickel per share commission (or, sometimes, do the trade out of inventory, like David Berry!). Sometimes you get filled, sometimes you get a partial fill, sometimes you get no fill at all. But the market is there – look at the daily volumes I report as part of the highlights every day! Virtually every cross that I mention happened in this manner.
• Pre-tax Returns are (generally) lower than on bonds A silly reason, but important. People compare performances based on pre-tax returns.
• I’m not big enough to be sold through brokers Hymas Investment is not (yet) as big as Investors Group. The brokerage houses will not put MAPF on their permitted list.
• I might run away with all the money. I hate this reason, but I have to face facts. Anybody who knows me won’t worry about this, but those who don’t will account for this risk and sometimes make it the deciding factor. There’s nothing I can do about it, except offer segregated accounts.
• I am a lousy salesman People don’t like being told that everything they thought they knew about the preferred share market is wrong. Those who are willing to believe that active management is possible want a somewhat more exciting story than I’m able to tell … they want to hear that my Crystal Ball tells me the direction of interest rates, and my chicken entrails tell me what’s going to happen to the credit ratings of particular companies … not that there are frequent supply-and-demand imbalances in the marketplace and that you can frequently make as much as twenty cents a share by catering to them. I don’t like going out and chit-chatting – what I like best is to work on my analytical systems and keep improving them. I took the view, when I started the firm, that if I was able to deliver three years of outperformance (five at the outside) the fund would sell itself. I was wrong – but I’m learning a lot about how the fund selling business really works.

When will passive fund version be available? As soon as I am in a position to offer it. MAPF is small and doesn’t make me any net management fees. That’s OK (if disappointing) – the fund serves as an advertisement for my software, for the consulting side of my business (I offer advice to other firms about preferred shares in particular, fixed-income in general and quantitative systems) and for the possibility that a major fundco will (finally!) put their sales force behind an active preferred share product with my firm as manager. But I don’t need two advertisements, especially if the second one advertises passive management! I’ll start a passive fund as soon as I get committments for investment that will allow me to offer a good product and make a little money on the deal … that would be about $5-million, done for fund expenses + 20bp management fee (which would put the total MER in the 30-35 bp range)

Update & Bump, 2007-05-07 from 2007-2-2: A careful reader commented on this thread and I thought it was an important enough question to be worth a reply in the body of the post. The comment is:

MAPF is a very interesting alternative to DPS.UN or CPD. However there is very high turnover on MAPF, with consequent transaction costs and tax implications. Assuming MAPF outperformance of +2% over index, won’t the 1% to 1.5% fee + transaction costs + c.g. taxes minimize any potential outperformance for segregated fund? Thanks.

OK, there are several parts to this question!

The first has to do with turnover & transaction costs. Yes, MAPF has a very high turnover and proportionately high transaction costs. However, I will note that the performance figures presented are NET of transaction costs – I’m not trying to present returns as if commissions were zero! They’re all right there, embedded in the reported returns.

The current focus on Transaction Costs is, I am convinced, a plot by the banks (who just want to sell plain-vanilla closet-index funds run by plain-vanilla portfolio managers making plain-vanilla salaries … but to sell these funds at a high fee), aided and abetted by the securities commissions staff (very few of whom have ever gotten on the ‘phone and told the dealer “Done” in their lives). Because, in and of itself, Transaction Costs don’t mean squat.

Reporting transaction costs for an investment fund is like reporting “Cost of Pencils” for a Bank. Does the bank spend money on pencils? Yup. Would the bank make more money if it got all its pencils for free? Yup. Does breaking out this figure give you any idea as to whether the bank is wisely using its pencil budget to make (however indirectly) more profit? Um … no.

The philosophy of the fund is the same as my philosophy towards investing: you can make good money selling liquidity. When the price of a particular issue goes – as far as I can tell, to the best of my ability – out of bounds by $0.25, do you really want me to forgo the opportunity to trade on this, because I’ll have to pay $0.10 commission? I don’t think you do, really. The $0.10 is simply a cost of doing business and how good I am at judging the potential for such business will be reflected in my returns net of transaction costs versus the index.

“Tax implications” is a much more reasonable concern, but you must remember that preferred shares are – in terms of investment behaviour – fixed income instruments. They are not equities. Equities can double – octuple – n-tuple, which is why turnover & tax is a much more important factor. It’s a very nice thing to defer punishing amounts of capital gains tax until your estate is wound up. Pref’s ain’t gonna do that. The most optimistic long-term view you can take on a pref – or a bond – is that eventually it will be priced at par, when the company forces you to sell it.

While tax implications are accounted for in HIMIPref™ it’s not a major factor. In simulations, I do see some tax-loss selling (for instance, most parameterizations for simulations will swap the Transcanada issues when they went down to about $35 (from par value $50) in 1999/2000), but not much. The tax implications in the system are mainly: do I sell this today and take a capital gain? Or do I sell it tomorrow and take a dividend? Now that these forms of income are taxed very similarly, even this little finesse isn’t very important any more … I just sell when I think I can make some money!

So that takes care of two things: it is mainly through incurring transaction costs that I am able to make some money in the first place; and long term capital gains on bonds are zero (OK, sometimes a pref gets called at a premium. That’s a minor detail.), so you should be happy – no, thrilled! – to pay lovely capital gains taxes on a consistent basis.

Fees. Yes, fees will reduce your returns relative to no fees but, as with transaction costs, it’s the price of doing business. Note that a passively managed fund (such as DPS and CPD) should not be expected to outperform the index gross of fees and expenses on a long term basis; therefore, your expected long term return is the index less fees and expenses, currently 45-50bp on these products. I’m happy with my past track record of delivering returns that exceed the index net of fees and expenses and spend a lot of time trying to figure out how to continue doing it.