The Securities Litigation Expert Blog

Leveraged and Inverse ETFs - Tracking Error

Posted by Jack Duval

Mar 12, 2018 8:07:34 AM

This blog post continues a series exploring leveraged and inverse ETFs.  Our previous posts can be read here and here.

February was a volatile month for the S&P 500.  Leveraged and inverse ETFs that track the S&P 500 saw volatility commensurate with their leverage.  However, compared to their un-leveraged peers, the major leveraged and inverse ETFs did not track the market closely.

Because of the constant leverage trap, we know that leveraged and inverse ETFs are forced to buy high and sell low on a daily basis.  This, plus the management fees of the funds, essentially lock in losses.

On a day to day basis, these factors are de minimis.  Over time, they are fatal.

Table 1: Leveraged and Inverse ETF Performance - February 2018

Screen Shot 2018-03-12 at 7.44.04 AM.png

Source: Bloomberg

As can be seen in Table 1, all the ETFs underperformed.  The underperformance increased with leverage and being directionally wrong.

As with all investments, volatility hurts returns.  For investors in leveraged and inverse ETFs, volatility leads to significant underperformance even over short holding periods.

Because of this complexity risk, these products are only suitable for sophisticated investors wishing to speculate by day trading or for one-day holding periods.

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Topics: suitability, Complexity Risk, Tracking Error, Leveraged and Inverse ETF

Volatility-Linked Products - Complexity Risk Strikes Again

Posted by Jack Duval

Feb 6, 2018 10:41:24 AM

This blog post continues a series exploring volatility-linked exchange-traded products.  Our previous posts can be read here, here, and here.

The VIX S&P 500 volatility index ripped higher by 115 percent yesterday.  This effectively destroyed most, if not all, inverse VIX ETPs.

Common sense will inform that if an index increases by more than 100 percent, an investment vehicle designed to give the opposite (inverse) performance should decline to zero.  (In most cases, if an investment doesn't use leverage, a potential loss is limited to 100 percent.)

Indeed, experience is now bearing this out.

VelocityShares Inverse VIX Short Term ETNs (XIV)

The XIV ETN halted trading yesterday and fund manager Credit Suisse is almost certain to close the fund.

The prospectus language allows Credit Suisse to shutter the fund if the Intraday Indicative Value is equal to or less than 20 percent of the prior day's Closing Indicative Value (among other reasons).  That has happened.

Table 1: XIV Indicative Value

XIV - Indicative Value.gif

Source: Bloomberg

The XIV Indicative Value collapsed from 108.37 to 4.22, a 96 percent decline, and well under the 20 percent threshold.

The difference in the XIV price and indicative value was widening over the past few days of the market selloff, and then blew out yesterday.

Chart 1: XIV Price and Indicative Value

XIV Price v. XIV Indicative Value Chart.gif

Source: Bloomberg

Unfortunately, a significant amount of hot money had been flowing into this ETN due to it's returns over the past few years.  The XIV market cap was just off its all-time high, at $1.48B yesterday.

Chart 2: XIV Historical Market Cap

XIV Market Cap Chart.gif

Source: Bloomberg

A Bitter Irony

In a classic example of complexity risk, investors who bought the XIV at the close yesterday (thinking that the VIX had risen too far, too fast), will be wiped out, just like longer term holders.

As of this writing at 10:20am, the XIV is down 31 percent, meaning that those buyers would have been directionally correct, but will suffer virtually complete losses anyway with no chance to get out.

Suitability and Supervision of Volatility-Linked Products

For years, investors have been seeing their principal destroyed as unknowing advisors bought and held inverse and leveraged ETPs.  Indeed, the XIV prospectus (PS-16) gives this warning:

Screen Shot 2018-02-06 at 9.16.52 AM.png

Advisors putting their clients into inverse and leveraged ETPs should have known about the risks of long-term holding and the risk of complete overnight ruin.

Likewise, firms that allowed their advisors to sell these products should have implemented special training for them.  Furthermore, specific policies and procedures should have been written to insure these products were only utilized in speculative accounts, and for sophisticated investors, who were aware of, and accepted the risk of, total loss.

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Topics: suitability, Complexity Risk, supervision, Complex Investments, volatility-linked products, XIV, VelocityShares Inverse Short Term ETN

Volatility-Linked Products - Bank of America Strategic Return Notes

Posted by Jack Duval

Dec 1, 2017 10:07:27 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In this post, I examine the Bank of America Strategic Return Notes Linked to the Investable Volatility Index (“SRNs”), which were issued on November 23, 2010 and matured on November 27, 2015.

The SRNs were supposed to offer investors exposure to a volatility index over a five-year period.  However, due to high upfront and ongoing annual fees and the negative roll yield (previously discussed here and here), the investment resulted in almost a complete loss.

What is remarkable is that anyone who understood volatility products and negative roll yield would have known this ex-ante, that is, before the product was brought to market.  This is an example of how complexity risk manifests itself in investments, the people who created the investment didn’t understand it.

Disclosures, Negative Roll Yield, and Principal Destruction

The SRN Pricing Supplement lists the two percent upfront fee and the 0.75% annual internal fee as costs but does not mention the negative roll yield as a cost.  This is remarkable given that the negative roll yield is the primary cost of the strategy as it was to be implemented.

There was one disclosure in the SRN Pricing Supplement (on page 14) which addressed the negative roll yield (however, the phrase “negative roll yield” was not used):[1]

If the level of forward implied volatility is higher in the more distant S&P 500 Index options expirations months than it is in the nearer expiration months, then the level of the Index could be adversely affected as the Index positions are rebalanced daily to maintain a constant maturity.  The rebalancing involves increasing exposure to more distant forward implied volatility and decreasing exposure to more near-term forward implied volatility which may decrease the payment you receive at maturity or upon exchange.  Historically, the more distant expiration months have typically had a higher level of forward implied volatility than the nearer expiration months.

This explanation does not make it clear that the negative roll yield will be an almost certain daily destroyer of the investor’s principal.  Given the five-year term of the investment, the negative roll yield, coupled with the two percent up-front fee, and the 0.75% annual internal fee are virtually guaranteed to result in a catastrophic loss to the investor.

Of course, that is what happened.  The SRN’s were issued at $10/share and matured at $0.50/share.[2]  A 95 percent loss.  The negative roll yield was costing between four and 12 percent per quarter in 2011.[3]

Complexity Risk

This is a classic example of complexity risk, which I have written about extensively here and here.  Merrill Lynch broker Glen Ringwall was quoted saying:[4]

The roll costs are far larger than we ever understood or were disclosed to us…  This is borderline crooked.

To Mr. Ringwall’s point, if we assume that the negative roll yield was four percent per quarter that equals 16 percent per year.  Apply that over the five-year term of the SRNs and you get an 80 percent decline in principal.  Add the 5.6 percent total term costs from the front-end load and the ongoing management fees and the SRN is programmed to decline by 85.6 percent over its lifetime (assuming no movement in the underlying index).  Put another way, the underlying index would need to have and 85.6 percent return just to break even.

It is hard to believe that anyone associated with the SRNs creation understood these economics.  It appears that the brokers who sold it certainly did not understand.  And I can assure you that not one client who was sold the SRNs understood them.

DIY Client Due Diligence

In fairness, the SRN Annex to the Pricing Supplement did provide these user-friendly explanations what would help clients understand how to calculate the negative roll yield themselves:[5]

 

Screen Shot 2017-12-01 at 8.16.17 AM.png

Screen Shot 2017-12-01 at 8.16.29 AM.png

Screen Shot 2017-12-01 at 8.16.45 AM.png

Obviously, no client is working through these equations.

The written and formula disclosures above illustrate the primary point of investment complexity risk:  the more complex an investment is, the more likely it is to behave in ways that are unexpected.

This is the reason why complexity should generally be avoided and even sophisticated institutional investors should have a complexity risk budget to track and limit their exposures.

Supervison

As I have discussed in my previous posts, there are other volatility products such as the iPath VXX ETN trading today that have the same internal negative roll yield dynamics.

Supervisors must be knowledgeable about these investments and how they are not meant to be held longer than one day.  Supervisory policies and procedures should be implemented to insure that any holding periods longer than one day are flagged in exception reports and remedied immediately.

_________________

Notes:

[1]       Strategic Return Notes Pricing Supplement; PS-14.

[2]       Jean Eaglesham, The Wall Street Journal; SEC Readies Case Against Merrill Lynch Over Notes That Lost 95%; Available at: https://www.wsj.com/articles/sec-readies-case-against-merrill-over-notes-that-lost-95-1466544740; Accessed December 1, 2017.

[3]       Id.

[4]       Id.

[5]       Strategic Return Notes Pricing Supplement; Annex A; A1-2.  I have only produced part of them here.

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Topics: suitability, Complexity Risk, supervision, Complex Investments, volatility-linked products, negative roll yield

Private Equity - Due Diligence

Posted by Jack Duval

Nov 16, 2017 8:30:16 AM

This blog post begins a series examining the risks and returns of private equity investments.

Apollo Group Structure:  Got it?

Apollo Group Structure.jpg

Source: Apollo Group S-1

On July 28, 2017, Apollo Group Management LLC announced the largest ever capital raise for a private equity fund.  While this $23.5B fund will be the largest ever, it may not hold the title for long.  The New York Times reports there are two other private equity funds in raises with higher targets.[1]

While these capital raises are impressive, they also raise questions.  As the private equity space has become increasingly crowded, returns have declined.  Industry statistics are sobering.

The most recent data from Prequin reveals that for the time period ending 2016:[2] 

  • Private equity AUM were at $2.491T, an all-time high;
  • Cash held by private equity funds was at $820M, an increase of $65B from 2015;
  • Median net IRRs have declined from 20+ percent in the early 1990’s to 12.6 percent in 2013 (the most recent vintage with meaningful numbers)
  • Likewise, median net multiples have declined from around two to around one over the same time period.

The reduction in returns has led to a number of abusive practices at private equity funds.  These abuses were highlighted by the SEC in a high-profile campaign in 2015.[3]  However, the continued bull market has helped to keep valuations high and has served to reduce litigation.  This will not always be the case.

When the market turns, successful exits will become harder to realize and this will depress IRRs.  At that point, private equity funds and the advisors who sold them may find themselves in the difficult position of having to justify total fund expenses that can amount to six percent of committed capital, annually.

While private equity remains a legitimate asset class, a tremendous amount of diligence must be conducted in order to insure that abusive practices are not being utilized by funds at the expense of their limited partners.

I will give an overview of some areas that disserve heightened diligence and then explore them in later blog posts.

Private Equity Due Diligence

Diligence into private equity funds is a time-consuming and laborious process.  Most investors are not equipped to undertake this due diligence as the private placement memorandums are written in legalese and encompass concepts from finance, economics, accounting, and law.  This is a form of complexity risk, something I have written about extensively.  Indeed, because of their complexity, many professionals are ill-equipped to properly evaluate private equity investments.

An example of private equity complexity risk can be seen at CalPERS, the massive California Pension manager.  CalPERS endured public embarrassment in 2015 when it had to admit it could not account for the fees being paid to the pension's private equity fund managers.[4]  This fact is even more remarkable in context of CalPERS’ investment staff of nearly 400.[5]

Advisors must have extensive training and experience with private equity investments before they can undertake the rigorous due diligence required to make a suitability determination.

Areas requiring heightened diligence include: 

  • General Partner/Limited Partner Conflicts, which include:
    • Non-performance based compensation;
    • Waivers of fiduciary responsibility;
    • Shifting expenses to funds (i.e. limited partners);
  • Valuation:
    • How are marks set?;
    • Assumptions used in marks?;
  • IRRs:
    • Do they reflect the economic returns to limited partners (even if “accurate” at the fund level)?;
    • Treatment of timing of flows;
    • Timing of allocation of unrealized losses;
    • Omissions of key assumptions;
  • Performance
    • Leverage-adjusted returns;
    • De-smoothed returns and volatility;

I will examine these and other factors of private equity risk and return, as well as their implications for suitability and supervision, in subsequent blog posts.

_________________

Notes:

[1]       Tom Buerkle, “Apollo’s Huge Buyout Fund Provides for a Large Margin of Error”, New York Time’s; June 28,2017.  Available at: https://www.nytimes.com/2017/06/28/business/dealbook/apollo-global-management-buyout-fund.html; Accessed November 16, 2017.

[2]       Prequin 2017 Global Private Equity and Venture Capital Report.  Available at: www.prequin.com; Accessed November 16, 2017.

[3]       SEC Announces Enforcement Results for FY 2015; October 22, 2015.  Available at: https://www.sec.gov/news/pressrelease/2015-245.html; Accessed November 16, 2017.

[4]       Randy Diamond; “CalPERS CIO looking at possible drastic cuts to private equity, citing transparency”; Pensions & Investments; June 19, 2017.  Available at: http://www.pionline.com/article/20170619/ONLINE/170619871/calpers-cio-looking-at-possible-drastic-cuts-to-private-equity-citing-transparency?newsletter=investments-digest&issue=20170619; Accessed November 16, 2017.

[5]       CalPERS biography of Ted Eliopoulos, Chief Investment Officer.  Available at: http://www.pionline.com/article/20170619/ONLINE/170619871/calpers-cio-looking-at-possible-drastic-cuts-to-private-equity-citing-transparency?newsletter=investments-digest&issue=20170619; Accessed November 16, 2017.

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Topics: private equity, Due Diligence, supervision, suitability, IRR, leverage-adjusted returns, de-smoothed returns

Volatility-Linked Products - Death By a Thousand Cuts

Posted by Jack Duval

Oct 25, 2017 9:11:58 AM

This blog post continues a series exploring volatility-linked exchange-traded products.

In my previous blog post, I discussed how volatility-linked ETPs are likely to lead to significant, if not catastrophic, losses if they are used in a buy-and-hold strategy.

In this post, I want to explain the mechanics of how this process works.

Constant Maturity

Most volatility-linked ETPs must, by prospectus, maintain a constant maturity.  For instance, the VXX pricing supplement states:[1]

(The VXX) is linked to the performance of the S&P 500 VIX Short-Term Futures Index TR that is calculated based on the strategy of continuously owning a rolling portfolio of one-month and two-month VIX futures to target a constant weighted average futures maturity of 1 month.

In order to keep the weighted average futures maturity of one month, the two contracts will have to be adjusted on a daily basis.  This necessarily implies buying more of the two-month VIX futures and selling the one-month VIX futures.

Having to keep buying longer dated futures and selling shorter dated futures is what creates losses over time.

Contango

Contango is a term describing the typical futures market curve where longer dated contracts are more expensive than shorter dated contracts, all else being equal.  (The opposite of this is known as “backwardation”, and is rare.)

The VXX pricing supplement describes contango as follows:[2]

… many of the contracts included in the Indices have historically traded in “contango” markets.  Contango markets are those in which the prices of contracts are higher in the distant delivery months than in the nearer delivery months.  VIX futures have frequently exhibited very high contango in the past, resulting in a significant cost to “roll” the futures.  The existence of contango in the futures markets could result in negative “roll yields”, which could adversely affect the value of the Index underlying your ETNs and, accordingly, decrease the payment you receive at maturity or upon redemption.  (Emphasis added)

Chart 1: VIX Futures Curve[3]

 VIX Volatility Chart.gif

 

Negative Roll Yield

In plain English, by continuously buying longer-term VIX contracts and selling shorter-term VIX contracts the VXX ETN is buying high and selling low every day.  This phenomenon is known as “negative roll yield”.

It is a mathematical certainty that negative roll yield will erode the value of any investment that maintains a constant maturity such as the VXX.  As discussed in my previous post, the longer volatility-linked ETPs are held, the longer their holders are subjected to negative roll yield.

This results in a death by a thousand cuts, one each day.  The certainty of negative roll yield over time is why constant maturity volatility-linked ETPs all head towards zero.  Due to Zeno’s paradox and the magic of reverse splits, they never reach zero.  However, that is cold comfort for anyone who has lost 99.9 percent of their investment.

Supervision

The supervisors of any firm allowing their advisors to trade in volatility-linked ETPs should be well versed in the mechanics of these products.  Clients certainly don't understand these complex products and frequently their advisors do not either.  Their suitability is limited to trading clients who want to speculate on intra-day or one-day changes in the VIX index, and they are unsuitable for a buy-and-hold strategy.

Furthermore, supervisory systems should flag any volatility-linked positions held more than a day.

_________________

Notes:

[1]       Barclays iPath S&P 500 VIX Short-Term Futures ETN pricing supplement; July 18, 2018; Available at: http://www.ipathetn.com/US/16/en/documentation.app?instrumentId=259118&documentId=6091544;  Accessed October 25, 2017; PS-1.

[2]       Id. at PS-13.

[3]       VIX Volatility Curve; Bloomberg; Accessed October 25, 2017.

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Topics: suitability, Complexity Risk, supervision, Complex Investments, volatility-linked products

Volatility-Linked Exchange-Traded Products

Posted by Jack Duval

Oct 20, 2017 8:04:35 AM

This blog post begins a series exploring volatility-linked exchange-traded products.

VXX LT Chart.gif

The VXX has declined from 11,940 to 34.39 (split adjusted).  Source: Bloomberg.

A recent FINRA Acceptance, Waiver, and Consent (“AWC”), with Wells Fargo and the issuance of FINRA RN 17-32, highlights the risks of volatility-linked exchange-traded products (“ETPs”).  In particular, using them as part of a buy-and-hold strategy is virtually certain to produce losses.

Wells Fargo AWC

On October 16, 2017, FINRA ordered Wells Fargo to pay $3.4 million in restitution to clients who had been recommended volatility-linked exchange-traded products.  FINRA found that Wells Fargo registered representatives had sold the volatility-linked ETPs without fully understanding their risks and features and that the firm had failed to supervise solicited sales of the products.

The FINRA AWC press release stated:[1]

Certain Wells Fargo representatives mistakenly believed that the products could be used as a long-term hedge on their customers’ equity positions in the event of a market downturn.  In fact, volatility-linked ETPs are generally short-term trading products that degrade significantly over time and should not be used as part of a long-term buy-and-hold investment strategy.

FINRA RN 17-32 – Volatility-Linked Exchange Traded Products

The language in the Wells Fargo AWC press release is echoed in FINRA RN 17-32:[2]

… many volatility-linked ETPs are highly likely to lose value over time.  Accordingly, volatility-linked ETPs may be unsuitable for certain retail investors, particularly those who plan to use them as traditional buy-and-hold investments.

Buy-and-Hold

Using a buy-and-hold strategy with volatility-linked products is almost guaranteed to produce losses for investors.  These products are designed to be traded intra-day or over one day holding periods.  Even relatively short-term holding periods of a week or two can be enough to lock in losses.  Longer holding periods can produce catastrophic losses.

How these losses are built into the structure of volatility-linked ETPs will be explored in my next post.

_________________

Notes:

[1]       FINRA News Release; Available at: http://www.finra.org/newsroom/2017/finra-orders-wells-fargo-broker-dealers-pay-34-million-restitution-and-reminds-firms; Accessed October 19, 2017.

[2]       FINRA RN 17-32; Volatility-Linked Exchange-Traded Products; October 2017; Available at: https://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-32.pdf; Accessed October 19, 2017; 1.

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Topics: suitability, Complexity Risk, supervision, Complex Investments, volatility-linked products

The DOL Fiduciary Rule - Risk Tolerance Questionnaires

Posted by Jack Duval

Aug 2, 2017 7:31:02 AM

DOL - Accelerant Fiduciary Rule Expert.jpeg

This blog post continues a series exploring the DOL Fiduciary Rule (“DOL FR”).  My previous blog posts can be found here.

In my last blog post, I discussed how the traditional three-choice Investment Objective and Risk Tolerance options would no longer be sufficient under the DOL FR.  In this post, I will expand on topic of Investment Policy Statements (“IPS”) and an often-missed aspect of their drafting – determining both the client’s ability and willingness to take risk.

The Difference Between the Ability and Willingness to Take Risk

Most financial plans focus on the client’s ability to take risk.  This is usually accomplished mathematically, by predicting cash flows and evaluating those against known liabilities.  Generally, the thinking is if the client can sustain losses and still meet her needs, then she has the ability to take risk.  (For instance, if the client needs $20,000 per month to sustain her lifestyle, but her portfolio can generate $40,000 per month, after fees and taxes, then she has a high ability to take risk.) 

The client’s willingness to take risk is a softer metric that requires getting to know the client and their history, going through questionnaires, and scenario planning.  Many of the questionnaires and scenario plans revolve around a series of questions, hypothetical situations, and attempt to determine the client’s probable responses to market events.  For instance: what would you do it your portfolio declined by 10, 20, or 30 percent?

Problems with Risk Tolerance Questionnaires

In my experience, most risk tolerance questionnaires lead to inflated risk tolerances.  The reason is that unless the most conservative answer is given to every question, the client will be scored with a moderate or moderate-aggressive risk tolerance.  Furthermore, if even one question is answered with the most aggressive option, the client will typically end up with a moderate-aggressive or aggressive risk tolerance.

Another flaw in risk tolerance questionnaire design is that they are generic and rely on percentage gains and declines in their examples.  Percentage losses don’t live for clients, but dollar losses do.  For instance, many clients can be philosophical about a 30 percent decline in their portfolio, but most would not be as sanguine about a $3 million decline on a $10 million portfolio.

These flaws can have far-reaching implications.  The skewing towards aggressive Risk Tolerances can lead to misaligned asset allocations, unsuitable investments, and higher than expected volatility.  This frequently leads to clients changing their Risk Tolerance (to what it should have been originally) after a market decline.

Ironically, if litigation should ensue from misaligned asset allocations originating from skewed Risk Tolerances, the questionnaires underlying the improper allocations will be presented as proof of the client’s willingness to take risk, and used to justify aggressive and/or speculative investments.

The Prudent Expert and Risk Tolerance

For background on the Prudent Expert Standard required under the Best Interest Contract Exemption, see my previous posts here and here.

Simplistic, one-dimensional Risk Tolerance Questionnaires will not meet the Prudent Expert Standard.  Instead, the due diligence required to "know the client" is at least a two-dimensional approach to risk tolerance that encompasses both the ability and willingness to take risk.

If only one type of Risk Tolerance is identified, the advisor cannot make a Prudent Expert determination of the client’s true Risk Tolerance.  This will not meet the fiduciary standard, nor even the suitability standard.

One of the few financial writers to address the two dimensions of Risk Tolerance is Michael Kitces.  Some of his writings on risk tolerance can be found here, here, and here.  Kitces has created some very useful charts comparing Risk Tolerances that arise from the one- and two-dimensional Risk Tolerance methodologies.

Chart 1:  One- and Two-Dimensional Risk Tolerance Methodologies[1] 

Accelerant - Risk Tolerance - The Ability and Willingness to Take Risk.png

The central idea illustrated in these charts is that in the one-dimensional methodology (left pane), both the ability and willingness to take risk act as a floor to the resulting Risk Tolerance.  Conversely, in the two-dimensional Risk Tolerance methodology (right pane), both the ability and willingness to take risk act as a ceiling to the resulting Risk Tolerance. 

Unpacking One- and Two-Dimensional Risk Tolerance

In the one-dimensional Risk Tolerance methodology, both the ability and willingness to take risk increase Risk Tolerance.  Thus, if the client has either a high ability or high willingness to take risk, she will end up with an aggressive Risk Tolerance.  However, this is the perverse Risk Tolerance outcome discussed above.

Under the one-dimensional Risk Tolerance methodology, a low ability to take risk is overridden by a high willingness to take risk, at the same time a low willingness to take risk is overridden by a high ability to take risk. 

However, under the two-dimensional Risk Tolerance methodology, this cannot happen because both the ability and willingness to take risk decrease Risk Tolerance.  Thus, if the client has either a low ability or low willingness to take risk, she will end up with a conservative Risk Tolerance.

Under the two-dimensional Risk Tolerance methodology, a high ability to take risk is overridden by a low willingness to take risk, at the same time a high willingness to take risk is overridden by a low ability to take risk.

The two-dimensional Risk Tolerance methodology results in much more accurate Risk Tolerances and helps implement a financial advisor’s version of the Hippocratic Oath: help clients achieve their goals with the least amount of risk possible.

----------

Notes:

[1]       Michael Kitces; Nerd’s Eye View; Adopting a Two-Dimensional Risk Tolerance Assessment Process; January 25, 2017.  Available at: https://www.kitces.com/blog/tolerisk-aligning-risk-tolerance-and-risk-capacity-on-two-dimensions/; Accessed August 1, 2017.

 

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Topics: dol fiduciary rule, fiduciary obligations, erisa fiduciary expert, securities litigation, prudent expert standard, Due Diligence, litigation, Investment Policy Statement, risk tolerance, suitability

Money Market Fund "Liquidity"

Posted by Jack Duval

Dec 22, 2016 8:16:00 AM

This blog post continues a series looking at liquidity in common investments such as ETFs and mutual funds.  See previous posts on high yield and the Third Avenue Focused Credit Fund.

Greek Bank Run.jpg

Bank run at the National Bank of Greece                                 

Background

As the banks and brokers/dealers have reduced their risk appetites (and balance sheets devoted to market making/inventory) liquidity has shifted to investment funds.

This shift has occurred during a globally coordinated central bank easing/asset purchase cycle heretofore unknown in financial history.  Liquidity has not been needed because all assets (with the exception of volatility) have risen in price.

When asset prices fall, liquidity will be needed again.  With the banks and broker/dealers less willing to buy, liquidity will be at a premium.  It will be a buyers market and prices will have to fall further to entice liquidity back into the markets.

As will be explored, the potential for suspended redemptions is very real, often in places where investors least expect it.

Money Market Funds - Your Money is Safe with Us (from you)

Most investors would be surprised to learn that their money market fund has a "gate" just like a hedge fund.  Yet that is the case with the vast majority of money market funds.  In addition to a gate, most money market funds also have the ability to charge a one or two percent fee for investors to redeem their shares, if certain conditions are met.

Vanguard Prime Money Market Fund

The Vanuard Prime Money Market Fund is the second largest in the world.  Here are some excerpts from the prospectus that might surprise its investors (emphasis added):

You could lose money by investing in the Fund. Although the Fund seeks to preserve the value of your investment at $1.00 per share, it cannot guarantee it will do so. The Fund may impose a fee upon sale of your shares or may temporarily suspend your ability to sell shares if the Fund’s liquidity falls below required minimums because of market conditions or other factors. An investment in the Fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. The Fund’s sponsor has no legal obligation to provide financial support to the Fund, and you should not expect that the sponsor will provide financial support to the Fund at any time.

Emergency circumstances. Vanguard funds can postpone payment of redemption proceeds for up to seven calendar days. In addition, Vanguard funds can suspend redemptions and/or postpone payments of redemption proceeds beyond seven calendar days at times when the NYSE is closed or during emergency circumstances, as determined by the SEC. In connection with a determination by the board of trustees, in accordance with Rule 22e-3 under the Investment Company Act of 1940, a money market fund may suspend redemptions and postpone payment of redemption proceeds in order to facilitate an orderly liquidation of the fund. In addition, in accordance with Rule 2a-7 under the Investment Company Act of 1940, the board of trustees of a retail or institutional money market fund may implement liquidity fees and redemption gates if a retail or institutional money market fund's weekly liquid assets fall below established thresholds.

 Discretionary liquidity fee. The Fund may impose a liquidity fee of up to 2% on all redemptions in the event that the Fund’s weekly liquid assets fall below 30% of its total assets if the Board determines that it is in the best interest of the Fund. Once the Fund has restored its weekly liquidity asset to 30% of total assets, any liquidity fee must be suspended.

 Default liquidity fee. The Fund is required to impose a liquidity fee of 1% on all redemptions in the event that the Fund’s weekly liquid assets fall below 10% of its total assets unless the Fund’s Board determines that (1) the fee is not in the best interest of the Fund or (2) a lesser/higher fee (up to 2%) is in the best interest of the Fund.

 In addition to, or in lieu of, the liquidity fee, the Fund is permitted to implement temporarily a redemption gate (i.e., suspend redemptions) if the Fund’s weekly liquid assets fall below 30% of its total assets. The gate could remain in effect for no longer than 10 days in any 90-day period. Once the Fund has restored its weekly liquidity assets to 30% of total assets, the gate must be lifted.

I am not picking on Vanguard, every money market fund (with the exception of some government money market funds), has identical language in their prospectuses.

Suitability and Alternatives to Money Market Funds

In light of the liquidity risks to holding mutual funds, it is not suitable for investors to hold all of their cash equivalents in money market funds.  Instead, investors should hold three-month Treasury bills and just roll them four times a year.  They will have a lower yield than the money market funds, but this is trivial compared to a suspension of redemptions or a two percent haircut on the proceeds.

Litigation

While the losses from a one or two percent redemption fee are limited, the secondary effects of preventing clients from making investments they otherwise could have made, will be considerable.

Supervision

Supervisors at banks and broker-dealers should make sure their advisors are aware of the potential gates and liquidity fees and encourage diversification out of money market funds.

Complexity Risk

While money market funds have traditionally been less complex than other investments, the new regulations have changed that.  As we have discussed here, here, and here, investment complexity is a frequent destroyer of capital.

For money market funds, investors can be harmed by market events unrelated to the money market fund they hold.  For example, a Bloomberg stress test on the Vanguard Prime Money Market Fund shows that another Russian Financial Crisis would hit the fund's P&L for 1.32 percent.  This is enough to break the buck and/or require the fund to close the gate or implement liquidity fees.

Vanguard Prime MM - BBG Stress Test.gif

If you think this is an extreme event, consider that it is merely a "18-year storm".

_________________

Notes:

 For information about securities expert Jack Duval, click here.

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Topics: suitability, Complexity Risk, Money Market Funds, supervision, Complex Investments, Liquidity

Jack Duval Publishes Municipal Bond and MSRB Rule E-Book

Posted by Jack Duval

Oct 26, 2016 10:27:08 AM

I am pleased to announce the publishing of a new e-book focused on the municipal bond market and MSRB Rules.  

Detroit_Packard_Plant_-_shutterstock_115828237.jpgAbandoned Packard factory in Detroit.

The book covers many topics, including:

  • The continued deterioration of municipal fundamentals;
  • The municipal bond rating whipsaw since 2007;
  • Background on the MSRB;
  • Anti-fraud and fair dealing rules;
  • Suitability rules;
  • Due diligence requirements;
  • Disclosure obligations;
  • Affirmative discosure requirements;
  • Informed consent, and;
  • Supervision.

The book is available for download on Amazon's Kindle for $9.99, or you can download the PDF by clicking on the link below.

Click to Download E-Book

To learn more about author Jack Duval, click here.

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Topics: msrb, suitability, supervision, Due Diligence, disclosure, informed consent, anti-fraud, fair dealing, municipal bonds

Warning: Contingent Convertible Bonds are Insurance

Posted by Jack Duval

Feb 16, 2016 8:06:02 AM

This post continues our series on insurance-liked securities ("ILS").

There has been a excessive amount of worry surrounding Deutsche Bank Contingent Convertible bonds ("CoCos") in the past week. (See our previous coverage here.)  As the weak sister in the European banking community, Deutsche Bank has been the focus of bond selling and consternation, as well it should be. The bank's stock is trading lower than during the Global Financial Crisis.

Chart 1: Deutsche Bank Stock Price Chart from 1999[1]

 Deutsche_Bank_Stock_Price_from_1999.gif

However, should anyone be surprised that Deutsche Bank's CoCo bonds have sold off? Absolutely not. Indeed, they have performed exactly as advertised.

So why the angst?

I believe it is another case of complexity risk. The CoCo bond structures are so complex that they have not been understood, even within the institutional investing community.

How could the sophisticated institutional investing community not understand a bond issuance? Days before the CoCo bond priced, Deutsche Bank issued a 44 page presentation to explain it's plans for strengthening it's balance sheet. I have extracted on page from that presentation below.

Chart 2: Deutsche Bank Explanation of "Comprehensively strengthening capital and leverage ratios for the longer-term"[2]

 P.6_5.19.15_DB_Presenation_on_Capital_increase.jpg

In order to understand this slide, you need to have facility with the following concepts:

Luckily, Deutsche Bank provided some footnotes to help investors understand at these regulatory items, for example:[3]

Global systemically important banks buffer may vary between 1% and 3.5%… DB currently assessed in the 2% bucket. Alternatively, a buffer for macro-prudential and /or systemic risk of up to 5% can be set by EU member states. The higher of the G-SIB buffer and this systemic risk buffer is then applicable... (the 2019 Requirements) currently excludes the potential for a countercyclical buffer of up to 2.5%… (the Adjusted Ratio) comprises fully loaded CET1, plus all current eligible AT1 outstanding (under phase-in).

Trying to figure out EU member bank capital requirements may have led to investors taking their eye off the bond prospectus. The Deutsche Bank CoCo bond prospectus disclosed a number of red flags that should have put investors on notice about the speculative nature of the debt. Some of those include:[4]

  • The bonds were rated below investment grade by S&P (BB), Moody's (Ba3), and Fitch (BB+) at issuance (P.1,7);
  • The interest payments are made (or not made) at the complete discretion of Deutsche Bank and "depend on the Issuers Available Distributable Items ("ADI")… ADI means: the profit at the end of the financial year... any profits carried forward... minus any losses carried forward, and any profits which are non-distributable pursuant to applicable law". (P.8) Thus, any hit to profits, whether from an economic slowdown, loan loses, or settlement/litigation costs from regulators or others, would put the interest payments in jeopardy;
  • Principal write-downs if Deutsche Bank's Tier 1 capital ratio fell to below 5.125% (P.11);
  • A reduction in liquidity of the Notes from any event that could result in a write-down (P.11);
  • Adverse price affects from changes in the Issuers Common Equity Tier 1 Capital Ratio (P.11);
  • No scheduled maturity date for the Notes and redemption at the sole discretion of the Issuer (P.11);

Insurance, not Bonds

Deutsche Bank's investors seem to be upset that the CoCo bonds have declined in value.[5] They should not be. CoCo bonds are a form of insurance-linked security. By purchasing them, the bond holders have chosen to insure the bank's Tier 1 capital ratio.

Once this is understood, it becomes obvious how the bonds should trade. The principal is not the bond holders, it is the "insurers" (bond holders) reserves. If the insured event comes to be (Tier 1 capital declining below 5.125 percent), the reserves go to the insured.

An insurer would be willing to make this bet in perpetuity (while adjusting premiums along the way for changes in risk). The fact that CoCo holders are now complaining about their returns shows that they are not willing to make this bet over and over and that they didn't understand it to begin with.

Chart 3: Deutsche Bank 3.7% of 24, CoCo, and Common Equity Price Chart[6]

 Deutsche_Bank_CoCo_Bond_and_Equity_Chart.gif

It appears likely that the complexities of CoCos blinded buyers to the fact that they were entering the insurance business, and that they didn't know how to do proper underwriting.

CoCo bonds are only suitable for those who have the ability to underwrite insurance on complex financial entities and who understand the shifting sands of European bank regulation.  (These two criteria probably eliminate the vast majority of CoCo owners.)

As most investors learn at some point: the market is an expensive place to get an education.

_________________

Notes:

[1]     Source: Bloomberg.

[2]     Deutsche Bank Investor Relations website; Available at: https://www.db.com/ir/en/images/Capital_increase_19_May_2014.pdf; Accessed February 15, 2016.

[3]     Id.

[4]     Deutsche Bank Undated Non-cumulative Fixed to Reset Rate Additional Tier 1 Notes of 2014 prospectus.

[5]     The Economist, Deutsche Bank's unappetising cocos, February 13, 2016; Available at: http://www.economist.com/news/finance-and-economics/21692933-investors-are-reassessing-yet-another-complicated-financial; Accessed February 16, 2016.

[6]     Source: Bloomberg.

 For information about insurance-linked securities expert Jack Duval, click here.

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Topics: suitability, Deutsche Bank, Complexity Risk, Contingent Convertible Bond, ILS, insurance-linked securities, CoCo

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