Tuesday, July 31, 2012

Income Product Risk: Pref Shares

With investors flocking to “income” products it is worth taking a moment to understand the risks that can be associated with innocuous sounding investments in the “income” generating asset pool. The current Canadian regulatory standards apply virtually no meaningful assistance in assessing product risk. As such, many investors fall into the trap of believing an “income” security is similar to the risk profile of “fixed income” securities that provide on-going income. This is not a surprise given that investment advisors/salespeople generally speak of “income” products as a replacement for “fixed income” securities such as investment grade bonds. Given the growth in the number of “income” products, now is a great time to lift the hood on preferred shares; one of the basic income securities growing in popularity.
Preferred Shares (or prefs) is a hybrid product which has features of both equities (common shares) and fixed income (bonds). There are several types of preferred shares and the various types can have very different risk profiles. As a general rule the type of preferred share issued will vary based upon a combination of what the issuing company requires and what terms investors will accept at the time of issue.
Preferred Dividend Position: The primary benefit of a preferred share is first call on dividends at a pre-set rate. The pref share dividend is more secure than the common share dividend and may have assets backing the shares in the event of corporate default. A 3.5% pref share will be paid 3.5% of the face price annually, at the discretion of the board of the issuing company. Should the company not have sufficient cash to pay all dividends, the pref shares have first right to any dividends paid before the common shareholders receive any dividend declared. As always the dividends are paid at the direction of the company’s board of directors. When you hear about a company cutting its dividend that is almost always the “common share” dividend being reduced and only very rarely would it include the “preferred share” dividend.
Features of Pref Shares:Pref shares are issued by “charter”. The charter is similar to the trust deed of a bond issue in that it describes the rights of the pref share holder as a debtor of the company. It is the preferential access to dividends stated in the charter that give these shares their name. In return for this preference the holders of pref shares give up any right to vote as a shareholder of the company. In general the common share holders are entitled to a vote for each share owned (I am ignoring the few companies that have non-voting common share classes as they are the exception not the rule.). The lack of voting rights does not tend to hamper the average retail investor although it may discourage some large institutional investors.
Market Value of a Preferred Share: The preference shares will be sold with a face value such as $25.00 per share and it is this value that the dividend is based upon. For example a 4% pref share issued at $25.00 would pay a fixed annual dividend of $1.00 at the company’s discretion. The pref shares have no claim to any growth in profits and as such they trade at a value that is based primarily upon the dividend guarantee. In this sense the pref share value behaves very much like a bond or debt instrument. The value of the stream of dividends is comparable to the interest yield on a corporate bond. As such, an increase in the market yields of either bonds or new pref shares will cause pref shares to drop in value. A decrease in yields will similarly cause pref shares to rise in value.
Cumulative or Non-cumulative Dividends: Pref shares can have dividends suspended should a company need to do so. However, a “cumulative” pref shareholder must receive all missed dividend payments before any common share dividend can be paid by the company and before any pref share is redeemed by the company. A non-cumulative pref share has no right to recover missed dividend payments when regular dividends are re-started by a company.
Restricted Terms: A preferred share charter may restrict the company from issuing any future pref share series with a senior debt position to the specified preferred share issue. In some situations the restrictions may prevent a company from selling specified assets prior to redeeming the preferred shares referred to in the charter.
Risk Profile: Preferred shares are exposed to a unique set of risks that many retail investors are not aware of. The hybrid nature of the shares provides both additional security and additional risk characteristics. The risks of each pref share series must be determined separately prior to making a purchase.
Debt Risk: An example may be the best way to showcase the unique issues around evaluating pref shares within a company:
Company ABC currently has several series of preferred shares outstanding as follows:
-          One “preference share series A, 4%” and 3 series of preferred shares B.C, and D at 5%.
-          The holders of the “preference” shares are holding a preferred share similar to B, C, and D series holders. The difference is that the “preference” series has a higher ranking of security should the firm default on their obligations.
-          The B, C, and D series are legally defined as “pari passu”, which means they all have equal rights to the firm’s assets. These rights however are subordinate to the series A shares.
-          Should the company go into receivership the series A pref shares will recover their capital before the series B, C or D even though all are “preferred shares”.
The above example is intended to show that a preferred share is a subordinated debt instrument. When determining the risk profile of a pref share it is important to understand the security backing the share series and how it ranks relative to both corporate bonds, loans, and other outstanding pref series of the company. That also means it is important to understand the debt risk profile of the issuing company. The failure to understand this debtor risk is proving to be a significant issue for many investors who hold bank pref shares. More on this later!
Price Risk: Preferred shares tend to trade off the dividend yield as mentioned earlier. The price risk is often misunderstood as it is much more difficult to measure and understand. Again, let’s use a hypothetical example to clarify the issue:
An investor has his eye on two high flying firms that have great free cash flow and solid balance sheets. Not wanting to risk investing directly in the equity markets he decides to invest $10,000 in pref shares of each firm, Sino China and Banana. Subsequent to the purchases each company has a very different experience. Banana launches a new computer tablet and shares soar to massive heights with common share prices tripling in value. Sino China, in contrast, is subject to fraud charges and the company goes into receivership.
So how did our investor do when the share prices fluctuated? Taking the positive first; the pref shares of Banana are still worth $10,000 and dividends are very secure. As a pref shareholder however, our investor receives no direct benefit from the remarkable success of Banana and the increase in common share price. As for Sino China, the company is taken into receivership and eventually taken over by the creditors. There are insufficient assets to pay all debtors and as such banks are paid, bond holders lose much of their investments and the pref shares are priced to $0.00. Our investor gets no dividends and no return of capital from Sino China.
Had our investor bought common shares he would have still lost $10k on Sino China but also would have made $20,000 profit on Banana shares. He would be ahead by a net $10,000.00. Instead he avoided the risk of the equity markets and miscalculated the risk in the pref share market to his determent. As an aside, this example works equally well if you substitute Nortel or Lehman Brothers for Sino China in our hypothetical scenario. The bottom line is that investors need to determine the relative risk of holding pref shares instead of common shares or bonds. The investor needs to consider both an upward and downward scenario for share prices before deciding to buy pref shares.
Interest Rate Risk: Preferred Shares are similar to bonds in that the value of the preferred shares can be greatly impacted by interest rate changes. As you would expect, a pref share paying 6%, all things being equal, would have a greater value than a pref share paying 4% dividend. Unlike bonds, the income payment on a pref share is not generally set for a fixed period. Pref shares are generally issued for a set amount such as $25.00/share and the owner would expect to receive $25.00 on redemption. As discussed earlier, however, pref shares are issued based upon what the market will accept. Given that the big brokerages make more money from issuing companies than from investors in a pref issue; some of the common terms have greatly increased the risk to the investor and lowered the risk to the corporate issuer. This is the only way I can think of to explain “perpetual preferred shares”. These shares are issued with no maturity date or reset date and are redeemed at the option of the issuing company. In effect the issuing company will leave these pref shares outstanding only if the dividend is below the current market rates. This means these shares will trade either at or below the expected debt market yield available to the company. As an example, if the perpetual pref share pays 4% yield then the company will not redeem the shares unless they feel they can issue new shares at less than 4%. If the market rates should rise significantly then the value of the 4% perpetual would be expected to plunge. With no way for investors to improve yield and no way to redeem the shares, the investor must watch the value continue to erode or the share must be sold at a loss based upon the current market price of the share. Interest rate sensitivity of securities is based upon duration which generally means the longer the time until maturity the higher the sensitivity of the security value to interest rate changes. The duration would theoretically be at its absolute highest when there is no maturity date. In contrast, when market yields drop below the 4% the issuing company can call the shares for a forced redemption thus lowering the companies borrowing costs. In short you lose out if market yields rise and you are bought out if yields drop.
Why preferred Shares? The issuing companies generally pay more to raise money via a preferred share issue than from a bond issue. The reasons they would choose to do so reflect the current needs of the company and of the market place.
For example:
-           If the company has poor credit ratings it may not wish to go to the debt market directly and thus will pay a premium in the pref market to raise money.
-          If the company is concerned it may need to miss interest/dividend payments in the future it is easier to miss a dividend payment than a mandatory bond or loan payment
-          If the company finds it cannot sell common shares due to a poor market it may issue pref shares instead. The company may provide an option to convert the pref shares to common shares at a set date at either the company or investor’s option.
Benefits to the Investor: Pref shares do have some benefits that can make the shares attractive to investors.
-                 Greater security than the common shares
-          Dividend income can have favourable tax treatment versus the interest income earned on bonds
-          Dividend rates may be higher than the bond rates available in the current market
-          Pref shares may have conversion rights imbedded in the share terms
Convertible Preferreds: Some pref shares come with an option to convert the pref share to common stock based upon a pre-set formula. Typically these offerings have a set period of time when the holder can elect to make the conversion (retractable prefs) such as quarterly after the 5th year and until the 10th year after the issue date. As a hypothetical example; the pref share may trade at $25.00 and be convertible to common shares based upon the $25.00 pref face value plus all dividends earned divided by the 20 day average market price prior to the conversion dates. Convertible pref shares would be expected to be issued at a premium to perpetual pref shares due to the implied value of the conversion option. Occasionally the company will have an option to force the conversion after a set period of time regardless of the investor wishes. There is also a risk of declining market price for the pref if the convertibility option loses value (i.e. shares drop significantly in price).
Variable Preferred Shares: Our preference in preferred share options would be variable preferred shares. These pref shares have a reset date at which dividends are adjusted to reflect market rates. In these situations the risk of holding a perpetually “under market” dividend rate is mitigated. As an example, the dividend payout may be reset every five years at bank prime plus 4%. This allows the rate to adjust up or down but assures the yield remains somewhat consistent with the current benchmark market rates.
Flat Tail Risk: Pref shares are susceptible to significant losses when markets or companies are in turmoil. The lack of understanding of event based risks are leaving many investors with significant risk that they are not qualified to understand or evaluate. A perfect example is now playing out in Europe with respect to pref shares of large Spanish banks. The banks are experiencing significant losses as sovereign bonds they hold are being reduced in value. This in turn has left a number of banks nearly insolvent and turning to governments to be nationalized rather than facing bankruptcy. As the banks negotiate terms with creditors the pref share investors are left holding the bag. The bond holders can negotiate from some strength as they hold hard asset security in most cases. Many of the pref shares hold only a claim against general revenues. As these banks work out terms with creditors the pref share holders will likely be decimated.
 Now we ask some relevant questions: Did the retail pref share holder know that she was exposed to a significant loss based upon the bonds of sovereign nations being reduced in value? Did the retail pref share holder know that central banks encouraged large banks to hold sovereign debt in their capital reserves even though these bonds were of questionable value when issued, thus putting pref shares at significantly higher levels of risk? Did the average advisor/salesperson understand the risk of holding bank pref shares in a financial crisis?
Preferred shares do have a place in the security markets. They are not however your plain vanilla investments. They are not an equal risk substitute for investment grade bonds. Hybrid, complex financial instruments should not be sold to unsophisticated investors and should not be sold by your basic stock salespeople. I suspect that a number of income hungry seniors will be burnt by poor advice and basic overconfidence. After the fact many will complain they should never have been sold these securities....and they will be right.... and they will suffer significant losses that will not be recoverable. The most likely causes of a large loss will be dysfunctional credit markets, spiking corporate cost of borrowing, and lack of foresight to get out of the security before the prices collapse. Only sophisticated investors with support from top quality independent analysts should invest in complex securities.
p.s. Your mutual fund salesperson is not independent and is not likely an analyst.

Tuesday, July 3, 2012

False Prophets Revisited

On Feb 14th our blog for Weigh House Investor Services commented on the poor job of forecasting by the financial industry. We expressed concern that the market forecasters were glossing over a lot of real problems that had yet to be solved. Specifically on the macro side we referenced the Euro crisis and Greece’s bond default, significant on-going debt issues for consumers, and a dysfunctional U.S. government. Our take on these issues was that advisor/salespeople were ignoring the storm clouds that were obvious to everybody and pushing equities as the best option for your portfolio. The common mantra was “dividends can pay you nearly 4% per year while bonds and GIC’s are stuck at 1-2%”. It seemed "risk" was being treated as equal for equities and fixed income securities.
We had also discussed pending credit downgrades from Moody’s for the big banks and sure enough those downgrades arrived recently and included Royal Bank of Canada. We discussed the dysfunctional U.S. government and we are disappointed to see that no solution is in sight for the pending mandatory spending cuts and the expiry of investment tax credits in the new year. It seems the U.S. politicians will be arguing immigration policy issues when the country drives over the debt cliff!

We pointed out that the Greek fiscal problems were far from solved and now find the world watching the recent Greek elections to see if the tiny population of Greece could cause the whole of Europe to plunge. If Greece should chose to reject Europe’s requirement that Greece drive it’s economy (what little is left) into the ground - then look for a massive bank run across southern Europe as everybody tries to safeguard their bank savings under a mattress.

In the financial markets we noted the challenges brokers were having with selling overpriced IPO’s into the market. It appears that the folks over at FaceBook were too busy counting future option payments to pay attention. FaceBook has the potential to be the worst IPO ever by the time the dust settles but it did serve to expose the price fixing strategies of the deal makers. They clearly were able to prop up an over-priced IPO while waiting for retail suckers to buy in.

On the debt side we commented on how the 99% needed two jobs to pay their debt payments and the housing market was still in the dumps. Now we have seen the Canadian government adjust mortgage insurance policy for the third time in an effort to cool the debt growth in Canada.

When we wrote the article forecasters were priming the RRSP pump to flood the equity markets with what is lovingly known as “dumb money”. The TSX index ETF “XIU” ( it represents the major Canadian stocks) was at $17.82 and would be pushed up to $18.25 by Feb 28th as salespeople drove RRSP deposits into the equity markets. Today, with all the troubles still bubbling, the “XIU” sits at $16.46! It has dropped almost 8% but more importantly for RRSP investors it is down almost 10% since you made your end of February purchase. Even with your 4% dividend yield paying out over the next 12 months, that looks like a bad bet in the short term and who knows how it will look by year end.
So what? Are we suggesting we “knew” what would happen over the last quarter or that we are smarter that the stock guru’s? Absolutely not!

What we can say however is that we saw the high level of risk in the markets the same as everybody else did. It did not take a genius to see this was a pretty likely outcome for both the past quarter and likely for the next several quarters. The key difference is that we were not motivated to ignore the risk in the markets in order to exploit retail investors heading into the hype of the RRSP season.

The solution is for investors to follow a comprehensive investment policy statement. Based upon the policy guidelines it is possible to use RRSP deposits to re balance to the low end of the high risk assets and the high side of the low risk assets. While we do not suggest you can time the markets, we do suggest your financial advisor/salesperson has the flexibility to make tactical decisions to keep you off the train tracks until the obvious danger has passed. After all, what are you paying for if not prudent advice and commonsense for your investing strategy.

Or, referring back to the original blog’s ending statement; it was a time “not to be all in” to the equity markets. At the end of the day the issue is rarely about good forecasting and almost always about having a quality strategy and an advisor/salesperson who follows your investment plan first and his/her commission schedule second.

Thursday, June 7, 2012

Generational Challenges

A common theme in today’s financial news is to bemoan the large debt obligation which will be a legacy to today’s youth. In fact this is not really a new idea as Canadian federal governments since Trudeau have piled on the debt with little thought beyond the next election. However, many commentators look at direct comparisons of dollars owed today versus the deficits in say 1980 or 1990. A dollar in 1980 is not the same value as a dollar in 2012! Similarly debt as a percentage of GDP can often ignore the differing impacts of high versus low interest rates on debt repayments.
A number of journalists have focused on the challenges of being a University student today versus back in the "good old days"! On a smaller scale let’s look at an example of a university student graduating in 1979 ( like me) and one graduating today. Recent articles have suggested today’s youth have a much tougher road to hoe, however I would suggest it is just a different road to a similar end. I graduated with $9,000.00 in Student Loan’s and my interest rates (2 loans) averaged just over 10%. My payments were roughly $100/mo for 15 years (note: I paid it off in 5 years). Today’s students are graduating with more debt but with lower interest rates as well. A student graduating with $18,000.00 in debt and with a 5% interest rate would have payments of $143/mo.
Here is where the current thought process on debt comparisons becomes questionable. While today’s students have a larger monthly payment, my job after graduating in 1979 paid $9,000.00 per year. The equivalent graduate level full time job today pays well over double my 1979 stipend.  Similar to today's youth, I was underemployed for a couple of years after graduating and I ended up moving several hundred miles to find the job I took. As well, unemployment was virtually the same as today but in 1979 was on its way to 12% within the next 36 month. We can only hope not to repeat that same mess today. My point here is not to say how easy today’s students have it but rather to suggest the change to a more stable employment( trust me 7.5% is more stable than 12%) and lower interest rate environment have provided some advantages that are being ignored by many. Again, this is NOT an attempt to say it is easier today but rather it is an attempt to show each generation has it's challenges. The end group of baby boomers did not have an easier ride given early boomers took all the good jobs and were too young to be retiring as us tail-enders tried to climb the ladder of success. Similarly today, boomers turning 65 still do not seem to want to get out of the way and let younger workers move forward; effectively blocking late boomers in the early years and also blocking graduates looking for work today!
On a much larger scale, today’s young families are benefiting from the low cost of borrowing and the much lower inflation rate today versus the early 80’s. Carrying costs on homes are much lower and today’s youth are buying homes larger than their parents could even contemplate. Yesterdays 900 square foot bungalows are replaced by homes over double that size and still called “starter homes”. Obviously homes today are significantly more expensive; however wages, interest rates, and living standards are also very different. My first mortgage was at 14%!
A more significant legacy benefit today is the income and lifestyle transfer from today’s seniors to today’s youth. Seniors have given up significant portions of their income as a consequence of low interest rate policies. By keeping rates artificially low the government is effectively reducing investment income seniors require for living expenses and forcing seniors to spend their capital assets. This is dramatically reducing the income, lifestyle and asset base of seniors and benefits borrowers who are accumulating assets. A senior who saved $500,000 would have expected to earn 5%-6% in a bond/GIC portfolio using long-term return trends. That should provide $27,500 in income before taxes. Instead seniors buying bonds today can expect returns of 2%-3% or $12,500 in income. The net result is seniors are eroding their capital as they attempt to increase cash flow for living expenses. At the same time young families are financing homes and cars at historic low rates of interest. As for the debt bomb, I am not sure any generation will ever pay back our debt. We will cover the interest payments for generations to come and wait for long term inflation to erode the value of the debt.
So who has it easier yesterdays tail-end boomers or today's new graduates? Neither, I would suggest. Today’s youth face today’s challenges and yesterday’s youth faced equally challenging but different issues. We all hope that the hyper inflation, stagflation, “price and wage controls” (6 and 5 for those old enough to remember) and twelve percent unemployment are never repeated. Today’s parents are accustomed to having the children move back in after school to offset school loan expenses and to help the young adults save money for their first car and first home. Youth today feel constrained by challenging job markets and a sense of peer pressure to have it all “day one” and work out the payments later. Today’s seniors worry about how long the money will last, pensions under threat, eroding benefits and a government that is still and always spending too much and saving too little. Perhaps it is time to chill and all agree that we can be glad we faced our biggest deficit challenges in the 90’s and young and old alike can be glad we are in Canada and not Greece!
p.s. I know readers do not come here for social commentary but I felt the need to stray a bit today. Next blog will be back on topic, I promise.

Friday, May 25, 2012

One Small Step For Investors, One Small Set Back for Investors Group

The sudden announcement that Investors Group will lower MERs (the hidden fee an investor pays every year to hold a firms mutual funds) on two thirds of their funds is a victory for retail investors (that’s you if you own IC funds). The fees are being reduced by approximately 0.4% to 0.5% per year. In short you will save approximately $450.00 every year for each $100,000.00 in IG funds you own! Given IG has approximately $60 billion in funds it manages, and using the two thirds ratio, that means Canadian investors will see annual fees drop by a collective $180 million dollars annually!

As a backgrounder, IG is extremely large in the Canadian Fund industry and has been known historically for charging MERs that were relatively high compared to their peers. In fact, IG is a primary reason why fund fees in Canada are deemed the highest in the developed world! Given the size of IG you would have expected an economy of scale advantage that would have enabled the firm to be a low cost provider in Canada. Instead, Investors Group took the approach that Canadian investors are fee tolerant and either did not care or did not react to very high fees. In short, small uninformed investors are ripe for being fleeced on fees. In fairness to IG, that seems to have been a smart bet over the past couple of decades. IG has built a huge business by being everywhere with a horde of well trained sales people. The sales pitch has been slick and having sales people coming into investors homes has built a huge base of goodwill and trust. Almost every Canadian town has a ball team, hockey team, or soccer team sponsored by the local IG office. In fact, IG has been to fund companies as Tim Horton’s has been to coffee shops.....that is if Tim’s charged $3.00 for a double double!

Investors Group has always downplayed fees and promoted the softer benefits of having a financial plan and a trusted hand to guide investors. At the same time, however, IG has kept fees high across the board. If investors try to leave IG they often find themselves having to pay thousands in penalties that the investor did not really understand. By selling large quantities of funds with Deferred Sales Charges (DSC or Back-end Loads) IG has reaped a windfall of profits even as dissatisfied investors have left. Which brings us to the crux of the matter for Investors Group: Investors have been paying the penalties, albeit not happily, and moving on to firms that charge lower fees. Consumers have become more informed, thanks in no small part to journalists such as Jonathan Chevreau (ex-National Post, Money Sense) and Rob Carrick (Globe & Mail), and fee only advice firms such as Weigh House. As well blogs, a new breed of low cost fund firms (Steadyhand, Mawer, ING, TD eFunds), and a more cynical attitude towards big financial firms has helped spread the story on fund fees in Canada.

How has this impacted Investors Group? For a long time now the IG fund family has struggled to provide quality returns. Since returns are shown net of the MER, the fund managers at IG need to overcome the impact of the large fees when comparing returns with funds who charge lower fees. This problem becomes even more challenging when fund performance is measured against low cost exchange traded funds (ETFs are the fastest growing segment of the fund market worldwide and in Canada). The result is that IG has amongst the lowest percentage of funds of all the major fund families ranked in the top categories by independent rating firm, Morningstar. Although very large, IG has only 18% of funds ranked 4 or 5 stars out of 5 on the Morningstar scale. On average fund families have 28% of funds ranked in the 4 or 5 category.

This has resulted in retail investors shunning the mediocre performers. IG has had net outflows of funds for the last three quarters. In Q1 2012, year over year inflows dropped by 65%. When these types of numbers are appearing it likely follows that the sales team at IG is starting to defect. With sales driven by relationships, a salesperson often takes a large number of clients with them when they defect. In the fund industry competitors will often make it attractive for sales teams to switch firms. Being able to show existing clients that a new firm has better ratings and lower fees is a big sales assist for disgruntled sales people.

So, in the end IG is making the changes necessary to ensure they can continue to retain sales teams. They are not making changes in order to benefit investors nor are they reducing the fees on all their funds. What is happening is that IG is being forced to acknowledge that the days of fat profit margins and poor performance are threatened. IG is a smart company and they will spin their decision to seem more consumer focused than it is. The way to force changes is to threaten profits and thousands of small investors have done just that! It is the first small step in a long journey but it is a welcome site for all investor advocates.

In the end IG will act in an economically sensible way, as they always have. The company still has a large profitable business and a large well trained sales team. They will make revenue adjustments when forced to and not a moment before. That is no different than a bank lowering a credit card rate or a car company dropping prices. The main difference is that MERs are hidden from monthly statements and thus consumer awareness is slower to develop. While many advocates hold IG in contempt for gouging consumers for decades, the truth is always somewhere in the middle. IG exploited a business opportunity which is now being slowly eroded. As retail investors continue to become more enlightened IG will find new areas to exploit. This is more evolution than revolution but it is a great start on the road to a fair and level investment market for Canadians.

In the meantime, congratulations to the thousands of investors who voted with their wallets and forced a major change in the behaviour of the fund industry! Keep up the great work!


Thursday, May 10, 2012

Leafs, Mutual Funds, and Other Addictions

As I watched in awestruck horror, my Maple Leaf hockey team slowly disintegrated before my eyes this winter. It is a very difficult time to be a Leaf fan and it is getting harder to say ‘we will get’em next year”.  Of course my friends all claim to be long time fans of Boston or Chicago or anybody else that has had recent success. Many who claim to be friends seem to take great joy in pointing to the folly of being a fan of such an incredibly bumbling organization. The senior leaders in the Leaf hierarchy continue to insist they care more about winning than making enormous profits; yet year after year they manage to seem cheerful when they tell shareholders about the huge profits they have ‘earned’ (?) for the owners. As I watch this unfold I struggled to find an analogy for being a loyal Leafs fan.

Then, I had an epiphany!  I opened my investment statement and it all became clear. Cheering for the Leafs is the very same as investing in Mutual Funds! How could I not see it before? Think about the following points and see if you agree:

1.       They both seemed like a good idea years ago when I invested in them. In the early years (I am mid-fifties in age) the Leafs were winners and life was good for Leaf fans. In the early years Mutual Funds paid double digit returns and investors all made money!

2.       Being a fan of the Leafs is an emotional journey. They raise you up just to knock you down again and then they repeat the pattern endlessly. My Mutual Funds have also had great days, weeks, months and even years but they are now worth no more (and often less) than they were worth when I originally invested in them. The crashes are sudden, without warning, and devastating. Sound familiar?

3.       The Maple Leafs cannot seem to recognize quality assets. They trade draft picks and young ‘stars- to- be’ for old tired and worn out players. When they do get a good spot in the draft they still manage to find a dud. Not surprising all the top free agents stay away. Funny, when I look back at my fund holdings I see the same story. Stocks bought when they were past their prime and stocks sold just before they went on a tear. Top fund managers leaving for better firms and no quality replacements in sight.

4.       Leaf tickets are priced as if the Leafs of old were still here winning championships. Why am I forced to pay huge ticket prices to see a team that stinks! Similarly, Mutual Fund fees are the highest in the world here in Canada and performance also stinks. Paying a couple or 3 per cent on returns of 12-15% was not bad in the eighties. But paying over 2% now for funds that return nothing over a decade seems a bit much. I am being ripped off every way I turn!

5.       Sports analysts (talking heads) continually pump up the volume on how great the Leafs will be soon..... not now, but soon! Come the trade deadlines or draft day you would think the Leafs had phenomenal assets to trade or the next great star about to be drafted. Soon we realize it was all B.S. designed to get us to buy more tickets and Leaf jerseys with a new saviors name on the back. As for Mutual Funds, every terrible statement comes with an explanation of why now is the time to invest. Markets are just about to go on a bull run and the newest stock picker hired by the fund company is a real genius! Remember this RRSP season you need to double up on your deposits because this coming year is the big one for investors.....right?

6.       Perhaps the biggest similarity is my inability to wean myself off of these addictions. Why would I continue to work with an advisor that I have come to realize is just a salesperson sucking me dry? Why as a Leafs fan do I still turn on the game and start every season thinking this year will be different? Alas to this simple question there is no simple answer!

Having carried the analogy far enough I now see there is one huge difference. I do not really love my advisor/salesperson. I can picture life without them. I can manage my own investments or I can find a low cost fund firm like SteadyHand or Mawer or Leith Wheeler or I can buy low cost ETFs. In short, I have control over whether I use an advisor/salesperson.

As for the Leafs, well matters of the heart are more difficult. I will continue to try to grow apart from the Leafs but I can never, ever, ever, ever cheer for Montreal or Ottawa! That would just be too much to ask of a recovering Leafs addict!

Sunday, April 22, 2012

Investor Traps: Covered Call ETFs

One significant challenge for investors is to ignore information that they discover while researching investment options. A classic example of this is information which seems straight forward but may not be suitable for the portfolio strategy an investor is trying to implement. Part of the challenge is that the marketing arm of the product manufacturers (mutual fund or EFT companies specifically) do a great job of hyping the benefits and an even greater job of downplaying or ignoring the risks of the product. Often new investment products are created for a specific requirement, such as enhancing income or hedging a long position and then they become popular as the “new hot product”!
Let’s look at the example of Jane Smith, an investor in her 60’s approaching retirement shortly and managing her portfolio with a conventional diversified ETF portfolio. Her holdings include ETF’s tracking the TSX60, the S&P 500, EAFE Index (Europe, Australia & Far East) and the Dex Bond Universe. Jane has a strategic asset allocation that is 75% fixed income and 25% equity exposure. This strategy is designed to protect her substantial RRSP holdings from market volatility while holding sufficient equity exposure to protect against any uptick in inflation through equity growth. Jane is looking for returns of inflation plus 2%.
In researching her investment options Jane comes across a new ETF that has been gaining in popularity; a fund that writes covered calls on bank shares. In checking out the ETF Jane sees that the current yield is over 6% at a time when her fixed income portfolio is yielding 3.68% in comparison. Given her concerns about the low interest rates on her large fixed income portfolio Jane contemplates reducing her fixed income ETF holdings by 10% of the portfolio and adding 10% to a “covered call elf” holding.
What Could Go Wrong?
In further reviewing the covered call strategy Jane starts to feel a little less excited about her new strategy. While current yield is great, Jane begins to understand that the greater yield comes with certain risks that are not always readily apparent. That prompts Jane to run through a few scenarios to see how her “new” strategy would react to certain market changes that might occur.

1-      What if interest rates remain low or even go lower? The covered call strategy is based upon implied volatility in stock prices so it does not directly react to interest rate changes. As such it does not directly assist the portfolio to have low interest rates; however if the ETF continues to provide a 6% yield it should have a positive impact on Jane’s portfolio.....right? In fact, since current yield is defined as recent period income divided by portfolio value, a $6 income on a $100 portfolio provides a 6% current yield. If the portfolio drops in value to $75, the current yield becomes 8%. In looking at the 1 year performance of the new fund (just over 1 year old now) Jane discovers the rate of return has been -1.5% from March 2011 to March 2012. That seems perplexing given the fund is yielding such a high amount? Maybe current yield is not the best way to look at this ETF!

2-      What if rates rise sharply? If rates rise the value of Jane’s existing fixed income will likely drop. Fixed income values generally move opposite of interest rates. Obviously the higher rate scenario favours holding covered calls versus fixed income..... right. Well, maybe! If rates rise what will the bank stocks held by the ETF do? Will investors sell stock and buy fixed income when rates rise? If so what will happen to the value of the underlying bank stock? In fact, banks tend to benefit from higher interest rates (think of interest rate spreads as banks raise mortgage rates and credit card rates). While no outcome is guaranteed, Jane is comfortable that if rates rise this strategy should be either slightly positive or neutral in her portfolio.

3-      What if stocks go on a big bull run? If bank stocks benefit from positive stock markets there could well be a doubling or tripling of some bank stocks. After all, TD Bank common stock went from the high $20’s to the low $70’s after the 2008 crash ended! Holding the long positions on bank stock in the ETF might bring a real growth spurt to the portfolio. Right? Well, actually no. While the ETF holds a lot of bank stock, the gain from an increase in the underlying stock values would benefit the investors that bought the covered call options. If a stock was valued at $60 and a covered call was sold at $62.00, the ETF would make a profit of $2.00 plus the option premium of perhaps $1.00. If the bank stock went to $80/share the ETF would still only see a maximum of $3.00 from the $20.00 increase! Suddenly giving up a $20/share gain for $3 does not seem as positive.

4-      What if the stock market plunges downward?  The covered call strategy is a “defensive strategy” (according to the marketing material anyway) so it must protect my portfolio from large losses.....right? It would seem to make sense that the offset to sacrificing large gains when markets rise (scenario 3 above) would be that my portfolio would be sheltered from large losses in return..... right?  Well, actually, no! That is not the case with covered calls. If the bank stocks dropped from $60/share to $40/share the fund would need to hold the shares for the length of time that the call option remains in place to insure the option remains a “covered call” and not a “naked call”. The fund holds the stock regardless of the market performance and the only income to offset the loss is the small call premium (our $1 theoretical premium as above). The net result is that the fund looses $19/share instead of the $20/share the market drop infers. 

Given the above analysis, Jane pulls out her original Investment Policy Statement and reviews her strategy. The equity holdings are designed to provide growth which protects the portfolio from being eroded by inflation. That is accomplished by using gains from a rising stock market to cushion any losses in fixed income values caused by inflation. Since the covered call strategy limits market gains the covered call strategy works against Jane’s overall strategy.
Jane's original strategy called for limited equity exposure to ensure stock market losses do not diminish Jane’s nest egg. The covered call strategy leaves the portfolio exposed to any significant market drops so that also works against Jane’s original strategy. 

Decision: In looking at all options Jane realizes that the covered call option is a higher risk strategy than holding fixed income and it has the potential to 1) dampen equity growth, 2) expose the portfolio to large equity losses, and 3) in a low volatility stock market with concurrent low interest rates, it could increase current yield slightly. In short the covered call strategy can help a little or hurt a lot, but it cannot significantly improve her portfolio. Jane reviews her portfolio performance against her goal of making returns of “inflation plus 2%” and finds she is currently still meeting her target rate of return. As such she decides not to utilize the covered call ETF that all her friends are excited about. What she will do is file away the information. Every product serves a purpose but not every purpose serves a portfolio strategy. In this case doing what is popular with investors today and what appears to offer some immediate benefit, would actually weaken the investment strategy and change the risk profile on Jane's portfolio. Sacrificing equity gains while taking full equity market risk is a poor trade off. As well, not making the addition to the portfolio keeps the MER lower, reduces trading costs to rebalance the portfolio, and makes the portfolio simpler to monitor. Jane knows that an investment portfolio is like a bar of soap....the more you handle it the smaller it tends to get! 

Note: Covered calls on bank equities were the most popular strategic ETFs in the first quarter of 2012. The largest volume growth was a bank shares focused covered call ETF that provided returns of just over 7%. Holding direct common shares in TD bank provided over 10% capital gains as well as additional dividend income. The covered call strategy provided an enhancement in returns versus fixed income however it provides the risk profile of equity. When properly compared to narrow focused bank equity returns the results were less than stellar. The message is not that covered calls are a bad strategy for everybody. The important message is that any security you purchase needs to support your overall investment strategy, your portfolio risk profile, and your investment return requirement. Covered call strategies are marketed as a lower risk strategy and generally compared to fixed income investments. In fact they are equity and should be considered a higher risk strategy with a potential downside far greater than any typical fixed income strategy. Risking a 20% or 30% downside or missing a 20% or 30% gain are high prices to pay for the extra yield you may see in the short term.
sois mike

Tuesday, March 27, 2012

SROs Fiddle While Investors Get Burned

IIROC has recently released new information on the implementation of its chosen Customer Relationship Model (CRM). Before I add any comments let us take a look at how IIROC describes itself and the quality of their efforts.

“IIROC is the national self-regulatory organization which oversees all investment dealers and trading activity on debt and equity marketplaces in Canada. IIROC sets high quality regulatory and investment industry standards, protects investors and strengthens market integrity while maintaining efficient and competitive capital markets.”
This gem is found in the March 26th news release issued by IIROC.  Perhaps a less egocentric organization might have stated that it has “a mandate to set high quality regulatory and investment industry standards.....”, however IIROC appears to have declared victory.
Sadly, IIROC acts just like most self regulatory organizations (SRO). They react late, water down the regulations to reflect the desires of the dealers, and generally only act when the pressure to do something becomes embarrassing. And do not kid yourselves, these folks do not embarrass easily.
The move to clarify fees in the CRM is far too late and the ability of salespeople to call themselves advisors regardless of any qualification standards seems to go unnoticed. As to having salespeople provide better information on risk, well that is almost impossible since no credible standard exists on how to rank a mutual fund’s risk profile. In effect, the standard is that each fund can set its own risk ranking so long as they feel it is appropriate. Wow, feel safe?
The mandate to set high quality standards was never intended to read as “minimum standard that is acceptable to all stakeholders”. In fact the idea of utilizing an SRO seems to be something that is never questioned in Canada. Whether it is the Canadian Medical Association never seeming to sanction doctors until the media gets involved or the regulatory bodies that rarely expel a Certified Financial Analyst in spite of the numerous investor complaints; it seems that in Canada the major role of an SRO is to lie low, deflect criticism, and act only when forced to. It is safe to say no bold initiative ever originates with an SRO.
“So what”, you say? The net result is that Canada continues to fall further behind other nations when it comes to protecting investors. Specifically, I mean small retail investors. So what would make me happy you ask? How about some big thoughts! Some regulations that would actually drive real change and turn the industry in a different direction. Here are three ideas that would change the landscape for investors in Canada:
1-      The first is a very simple move to protect investors and is at least partially in place in a number of countries. Ban deferred sales charges (DSC, Back End Load) and trailer fees. Investors can either pay the salesperson an up-front fee or pay an on-going fee to the salesperson directly. hidden third party fees are never a good solution for investors.

2-      Require all mutual fund salespeople to become licensed to sell ETF securities. No salesperson selling mutual funds should be able to do so without providing a comparison to the top selling ETF fund in terms of performance and fees, as well as the cheapest priced mutual fund in the same category. This is a low threshold but one that is not even being talked about. Consumers do not know their options and this would force salespeople to at least acknowledge that lower cost options are available.

3-      Any person selling securities should have a fiduciary obligation to put the client’s interest before their own. Most investors already think this is the case and are shocked to find their interests are not primary and often not even secondary in the process. Salespeople currently can first look to what pays the most commission, then look to see what most benefits their parent company, and then select any fund that meets those requirements and is deemed “suitable” for the client and sell it to an unsuspecting investor.
Do I think any of these changes will happen? Actually, yes I do. They will happen when every other major country has already made similar changes. It will be very late and not likely in my lifetime. Look to Australia where governments are not afraid to challenge the financial status quo; look to the U.S. where litigation helps shape regulations; and look to Britain where government has created regulatory bodies with a true focus on protecting investors.

In Canada we can dream big......but we do not have the courage to take on the establishment....yet!


Tuesday, January 24, 2012


The current investment climate is about as bad as it gets when you look back over an extended time period. Canadian investors have watched as equities vary between days of terror (huge market drops) and days of despair (slow death via multiple days of small declines). The odd good day or week in the markets seems to just tease us for what might have been had we invested in the 90’s instead of this century! Even the old standby, the Money Market Fund, has proven to be neither safe nor profitable. We lamented the lost decade for equities from 2000 to 2010, and then started the new decade with negative equity markets for 2011.
So what can we do and what should we do!
1-      We CAN stop adding to the problems by making poor decisions about our investment strategy. The typical investor in a MF or ETF Index fund will make significantly less than the fund itself over the course of a typical year. That is because investors jump in and out of the equities market based upon the current emotions they are feeling. Studies show that this undisciplined approach will cost investors up to 4% less return than a mutual fund would make on average. Professionals do NOT jump in and out of the markets based upon emotions. They follow an Investment policy Statement (IPS) that outlines the minimum and maximum percentages of equity that MUST be held in the portfolio. For those that wondered about the definition of “rebalancing” a portfolio; that is the term used for bringing a portfolio in line with its IPS guidelines. Without an IPS you CANNOT rebalance your portfolio!

2-      We CAN stop pretending that the folks who make a good living managing investments have an ability to predict what stocks will go up or down next week or next year. Professionals can help you select stocks which have good balance sheets and good management in place. They can also help you ensure your portfolio is well diversified. Other than that, professional stock traders are of little use unless they can provide insider information (which in general is illegal). In 2011 the consensus forecast of investment managers in Canada was for stocks to outperform bonds and commodities. It will come as no shock that a) they were wrong, and b) they have made the same forecast for 2012. In fairness.....they eventually will be correct just based on the law of averages!

3-      We CAN reduce the fees we pay. With investor returns at historic lows we cannot continue to give a guaranteed 2-2.5% return to investment salespeople. If markets were to provide you with the 4%-5% returns we expect in the near future, a fee of 2.25% would be 45-55% of your total investment return. In years where markets drop, like 2011, the fee just increases your losses. If you negotiated a fee of 1.25% you would be giving up only 25% of the same return forecast! If you used ETF Index funds you could reduce the fee drain to a fee of .25% and have only a 6% fee drain.
While markets are certainly tough it does not mean we cannot do better. A little effort, some simple strategies and a calm demeanour can go a long way to lessening the pain of being an investor today!
If you need an IPS then ask an independent (non-selling) firm to customize one for you!


Monday, January 23, 2012

Well, it was another year of frustration for “real investors”. By “real investor” I mean those of us who trade without access to inside information and who cannot augment our returns through hidden fees or commissions. While we will lick our wounds and carry on, we should also track where the smart “professionals” were focused in 2011 to see where we missed the boat.

Consensus Forecasting for 2011: The “professionals” forecast the market performances every year and then a “consensus report” is tabulated to allow us to peak under the curtain and see what active traders are doing to beat the markets. The asset class forecasts were very clear that security performance in 2011 would see returns ranked as follows:

-          Equity stocks would be the best performing asset class

-          Commodities would be the second best performing class of assets, and

-          Bonds would trail the above classes and provide weak performance

Based upon the forecast, you would overweight equities, diversify with commodities, and minimize your bond holdings.Let’s see how well the smart money did in forecasting 2011.

-          Equity returns in Canada ( TSX broad market total return index) -8.71% and if you choose to look just at the blue chip TSX 60 returns were -9.08%

-          Commodities as measured by the Auspice Broad Commodity Index was 1.78% to the positive side

-          Bonds as measured by the Dex Bond Universe was up 9.7%

Wow, the smartest guys on the street managed to show an amazing dyslexia of returns! They used thousands of analysts to crank out the research math and got everything backwards! In fairness however, the forecasts were great for revenues at the brokerage firms as investors traded heavily into the markets based upon the forecasts. By the end of the investment rich RRSP seasons investors had bid up the equity markets and the research looked great. However, once all the suckers....um, investors were fully invested, the professionals did a quick sprint to the exits, leaving the retail investors holding a smelly mess of equities. The TSX dropped from the lofty mid 12,000’s to the more realistic low 11,000’s. Unfortunately, those who followed the advice in late February and early March can only wish they had lost 8 or 9%! In fact many will see 15-20% drops with their RRSP investment money.
So, how did a conservative indexer do in this type of market? If the pro’s got it wrong we can only assume the indexers got creamed! Our conservative 50/50 balanced model would have received the returns of a typical mix of ETFs somewhat like the following: 

Cdn Equity
US Equity


Well, it was definitely a tough year; however staying diversified reduced the damage significantly. Even if investors reduced the risk by splitting the fixed income between short and long duration bonds (50% XBB and 50% XSB), the overall return would be -0.3% for the year 2011.
Obviously the higher the Canadian equity component or the EAFE equity component, the worse the overall portfolio performance. For those active traders that jumped on the gold bandwagon the entry point was a challenge. On the whole XGD (the gold ETF) was down 14% and the much recommended emerging markets saw a decline of 16.4% as measured by the emerging market index. So, if you followed the professionals you were heavy equities, heavy emerging markets, heavy gold and light weight bonds. If you followed your Investment Policy Strategy as a conservative investor you retained your capital! Thank goodness I am a dull investor with a conservative IPS!