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New BONO ETF Has Undocumented Foreign Currency Exposure

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Van Eck last Thursday (5/12/11) launched the Market Vectors LatAm Aggregate Bond ETF (BONO), claiming it is the first U.S.-listed ETF offering exclusive exposure to Latin America’s debt markets.  The new ETF will try to replicate the BofA Merrill Lynch Broad Latin America Bond Index using a 4% sampling technique.

The underlying index is composed of external and local currency Latin American sovereign debt, and the external debt of non-sovereign Latin American issuers denominated in USD or Euros.  The index consists of debt that is 64.3% sovereign issued, 33.8% corporate, and 1.9% quasi-governmental.

When buying a foreign debt fund, investors want to know the issuers, quality, yield, and currency exposure of the overall fund.  Van Eck fails on half of these items by providing no indication regarding the yield or currency exposure (summary page).

The marketing literature fails to supply the currency exposure of either the fund or the index.  However, the downloadable spreadsheet of holdings supplies the currency on a bond by bond basis.  With some effort, I modified the spreadsheet to determine that 40.8% of the fund is currently denominated in four foreign currencies.  However, shareholders should not be forced to perform these types of calculations.  Data of this nature should be calculated and supplied by Van Eck.  Currency exposure isn’t even identified as one of the risks on the fact sheet(pdf).

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On Longevity Derivatives

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I am a firm believer in “you can’t get something for nothing.”  So it is when a new derivative is proposed.  Either there are natural counterparties to take up the exposure (reducing their risk), or speculators must be encouraged to take the risk (more likely).

So, with longevity derivatives, the risk is people living too long leading to more pension payments in future years.  The proposition is: find a party that is willing to make more payments if mortality is better than expected, and offer him a payment, or series of payments, as an inducement to enter the transaction.

Let’s think for a moment, what entities benefit from a rise in longevity?  I can think of one: life insurers.  But there is a problem: anti-selection.  People who buy life insurance tend to be sicker than those of the general population, who tend to be sicker than annuitants.  Annuitants live the longest, and their lifespans improve the most on average.  Life insurers would find taking on longevity risk to be a dirty hedge at best for their life insurance books.  In general there have been few reinsurance agreements for longevity risk for immediate annuity portfolios, but then, that would be a really small component of the life insurance industry at present.

Even when terminal funding was permitted (back in the 1980s to early 90s) — where plan sponsors could buy annuities from insurers to free themselves from their

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How to Deal With Excessive Risk Concentration?

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Jonathan Jacob of Forethought Risk, an independent risk advisory firm, sent me his Benefits Canada article, How to deal with excessive risk concentration:

In my previous column, Examining portfolio risk, we discussed ex-ante risk, ex-post risk and how both measures can provide greater understanding of portfolio risk. In this column I would like to discuss the options that are available to a pension fund manager that discovers excessive risk concentration in a fund through ex-ante risk reports.When a pension fund utilizes the services of multiple investment managers, there is potential for overlap of risk, causing excessive concentration of risk. Excessive risk concentration can be found in exposure to a single company, a sector of the economy, or a currency among others. If the pension fund manager receives ex-ante reports on risk which aggregate all investment manager portfolios, he or she may recognize an exposure as excessive prior to a potential blow-up.

One potential approach to the excessive risk is to ask one of the investment managers to trim risk to the asset with excess exposure. The investment manager will likely disapprove the request, justifiably claiming that the initial agreement did not include such restrictions and any future measurement of their performance will be tainted by this decision.

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Mid-Week Reads…

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Linked-In, The Most Expensive Stock in America and that was pre 90% jump (Smart Money) Rating Agencies Face Crackdown (Dealbook) Earthquake and Aftermath Push Japan Into a Recession (NYT) Collateral Damage: the True Cost of a U.S. Default (Barron’s) Ten High-Conviction … Read more.

On Longevity Derivatives

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I am a firm believer in “you can’t get something for nothing.”  So it is when a new derivative is proposed.  Either there are natural counterparties to take up the exposure (reducing their risk), or speculators must be encouraged to take the risk (more likely).

So, with longevity derivatives, the risk is people living too long leading to more pension payments in future years.  The proposition is: find a party that is willing to make more payments if mortality is better than expected, and offer him a payment, or series of payments, as an inducement to enter the transaction.

Let’s think for a moment, what entities benefit from a rise in longevity?  I can think of one: life insurers.  But there is a problem: anti-selection.  People who buy life insurance tend to be sicker than those of the general population, who tend to be sicker than annuitants.  Annuitants live the longest, and their lifespans improve the most on average.  Life insurers would find taking on longevity risk to be a dirty hedge at best for their life insurance books.  In general there have been few reinsurance agreements for longevity risk for immediate annuity portfolios, but then, that would be a really small component of the life insurance industry at present.

Even when terminal funding was permitted (back in the 1980s to early 90s) — where plan sponsors could buy annuities from insurers to

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Investors Turning to Active Commodities Strategies?

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I hooked up for lunch with commodity relative value fund manager I spoke to on Monday. He’s looking to raise raise capital for this new fund which he will be managing with other experienced traders and we went through his pitch book. 

I’ve sat with some of the best hedge fund managers in the world. The best of the best know the theory but more importantly, they can give you tons of examples of actual trades that went for and against them. That’s exactly how this manager presented his views. He has the academic and industry credentials, but it’s his actual commodity trading experience in Canada and the US that came through as he walked me through one trading example after another.

I love talented alpha managers. I’ll repeat what I’ve been stating the last few posts, there is exceptional alpha talent in Quebec that is being underutilized or worse still, totally ignored. I met two of Montreal’s best hedge fund managers today and I wouldn’t bat an eyelash to invest in either one of them (the other is an equity market neutral manager).

The question I get from outside-Quebec investors is if they’re so good how come the Caisse and other large Quebec institutions don’t invest in these new and existing hedge funds? There are a lot of reasons. First, reputation risk. There have been quite a few scandals in Quebec with institutions getting burned with funds like Lancer, Norshield, Norbourg, and other frauds. The last thing any institution here needs is to read that some hedge fund they invested with blew up, especially if it’s a local fund (the media in Quebec are merciless).

Second, unlike other places, Quebec lacks the entrepreneurial drive to develop the absolute return industry here in Montreal. There

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Rebalancing through wage increases

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Is China currently rebalancing?  The currency has been appreciating, the PBoC has hiked interest rates four times, and wages have been surging.  Because of all of this I am often asked if China has finally begun the long-waited rebalancing process and whether we have yet seen an improvement in the underlying economy caused by a rising consumption share.

Those who were hoping the answer was yes will have been disappointed by the release Thursday of the World Bank’s China Quarterly Update – April 2011. Here is their summary:

China’s economic growth has remained resilient as the macro stance moved towards normalization. Both fiscal and monetary policy contributed to the normalization. Consumption growth slowed in early 2011. But overall domestic demand held up well, supported by still strong investment growth. Real estate investment has so far remained robust to measures to contain housing prices—a policy focus. Reducing inflation is the other policy priority, after inflation rose to 5.4%, largely on higher food prices.

So what is going on?  Isn’t China doing all the right things – raising wages, the exchange rate and interest rates – and, if so, why isn’t the economy rebalancing towards higher levels of household income and consumption?

The key, I think, is in distinguishing between real and nominal changes.  On a nominal basis, for example, it is clear that the currency is appreciating, interest

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Second Automotive Fund Now Available

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First Trust Advisors last week (5/10/11) introduced the First Trust NASDAQ Global Auto Index Fund (CARZ).  CARZ becomes the second fund to focus on the global automotive industry and the first in an ETF format.  The underlying index is a modified market capitalization weighted index of companies classified as automobile manufacturers.  The index caps the five largest stocks at 8% and all others at 4% during each quarterly rebalancing.

CARZ presently has 32 holdings, and the annual index reconstitution is scheduled for next month.  The ten largest stocks are Daimler AG (DDAIF) 7.9%, Ford Motor Company (F) 7.8%, General Motors Company (GM) 7.2%, Toyota Motor Corporation (TM) 7.1%, Honda Motor Co., Ltd. (HMC) 7.0%, Hyundai Motor Co. 5.2%, Kia Motors Corporation 5.0%, Volkswagen AG (VLKAY) 4.3%, Bayerische Motoren Werke AG (BAMXY) 4.2%, and Nissan Motor Co., Ltd. (NSANY) 3.9%.

Nine countries are represented in the fund with Japan at 32.7%, Germany 20.2%, U.S. 17.7%, South Korea 9.9%, France 7.0%, China 5.2%, Italy 5.0%, Taiwan 1.4%, and Malaysia 1.0%.

Fidelity Select Automotive (FSAVX), the first automotive industry fund, was launched nearly 25 years ago in June 1986.  It limped along with assets under $40

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Kroszner and Shiller, Reforming U.S. Financial Markets

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A slight but nonetheless thoughtful book,Reforming U.S. Financial Markets: Reflections Before and Beyond Dodd-Frank (MIT Press, 2011) grew out of the fifth Alvin Hansen Symposium on Public Policy held at Harvard in 2009. At this symposium Robert J. Shiller and Randall S. Kroszner presented papers, which were then commented on by Benjamin M. Friedman (the editor of this volume), George G. Kaufman, Robert C. Pozen, and Hal S. Scott. 

I assume those readers who watch CNBC are acquainted with Shiller and Kroszner, since both are frequent guests. Shiller, a professor of economics at Yale University, is probably best known for his bookIrrational Exuberance. He also developed, with Karl E. Case, the Case-Shiller home price indices that depress us month after month. Kroszner, a professor of economics at the University of Chicago’s Booth School of Business, is a former fed governor.

In this post I want to concentrate on a couple of points in Shiller’s more controversial paper, “Democratizing and Humanizing Finance,” described by Pozen as “almost philosophical.” (p. 102)

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What’s a house worth?

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By Harvey Sax

I was having a discussion with a  hedge fund manager friend of mine about what determines  house values and it dawned on me, this is really a complex question.  Having been a stock trader for so long, I was quick to jump to the conclusion that a house is worth what someone would be willing to pay for it in a reasonable period of time.  I’m not sure what reasonable means but perhaps a sixty to ninety day auction process would determine the real value.  Of course there are the various real estate appraisal methods of valuation but that doesn’t really interest me.  Instead what creates the value?

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Economic Issues for the Telecom Industry: 2011-2012

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By Dr. Bill Conerly

Economic uncertainty is only one significant issue facing the telecom industry now, but it intertwines with the technological changes and social changes that are causing so much turmoil in the industry. Once the path for consumer and business spending is defined, the other changes affecting the industry will fall into clearer focus.

Nutshell

Consumer spending is reviving and now exceeds its pre-recession peak. Consumers were slow to get going after the financial crisis and even now are being conservative. Key to the growth is the increase in consumer incomes. That’s surprising to many given the weak employment numbers, but there is solid explanation for rising incomes. First, hours worked per employee has risen since the depths of the recession. Second, those with jobs have earned pay raises averaging about two percent per year. Third, taxes as a share of consumer income have fallen in the past two years, partly for stimulus policy and partly because lower incomes are subject to lower tax rates. Finally, we’ve actually enjoyed job growth in recent months, with the employment count about one percent higher than a year ago. So consumers have more money than they used to.

Consumers are being prudent with their extra income. About 88 cents out of every additional dollar of take home pay is being spent, with 12 cents going into savings and paying down debt. The average savings rate is about six percent now, so the practice of saving 12 percent of additional earnings will raise the average savings rate over time. This is sound financial practice for most households. Although more money is going into savings, more money is also going into spending. That ensures that the current economic strength will continue.

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Stock Price Gaps – Why They Happen And How To Trade Them

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By Kirk Du Plessis

Beginning traders were probably shocked the first time they experienced a stock price gap. I guess even the most experienced traders still get taken back when there is an unexpected stock price gap in a stock they are trading. Either way I wanted to cover once again why they happen and what you can do (if anything) to trade them.

It Happens When The Market Is Closed

Nearly all stock price gaps happen in pre market trading or during after hours trading. Call them Black Swans if you want since they seemingly come when you least expect it.

Generally speaking gaps are rare for the normal stock. Most mutual funds, ETF’s, and other illiquid assets actually gap more frequently which make the gaps less important.

How The Actual Price Gap Is Created

A price gap is created when a stock closes at say $91.50 (as AAPL did below) for the day which is at 4:00 PM EST and then the next day opens dramatically higher or lower than it’s previous closing price of $91.50.

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Just Another Manic Monday?

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On Monday, I hooked up for lunch with someone who works at a successful Montreal hedge fund. He complimented me on my blog and then we started talking about alpha talent in Quebec. There are some exceptional hedge fund managers in this province that are being totally ignored by Quebec’s large institutions (for God knows what reason!). 

I would like all the global funds that read my blog to contact me (LKolivakis@gmail.com) and I’ll be glad to share more information on our alpha talent in Quebec. Many managers have worked in London, New York, Chicago and decided to move back to Montreal for personal reasons. I want to support them as much as possible because Montreal’s hedge fund community is small but offers tremendous potential. I want Montreal to become the fastest growing hedge fund center and will do everything I can to support our talented alpha managers.

The person who I had lunch with today introduced me to another person who is in the process of starting a relative value commodity fund. I spoke with this manager late this afternoon and was blown away by how sharp this guy is. Unlike most commodity fund managers who mostly trade front end oil futures, this manager and his small team have years of experience trading all commodities, including energy, metals, corn, sugar, and other soft commodities.

We had a great discussion on the financial crisis. Like me, he was extremely bearish back in 2006. I told him I was researching all these complex CDO-squared and CDO-

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On Systemic Risk

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There are five factors for systemic risk.  Here they are:

  1. Asset size of the institution, including synthetic exposures.
  2. Degree of leverage of the institution, including synthetic exposures.
  3. Asset-Liability mismatch, particularly financing long assets with short liabilities (including derivatives and margin agreements — think of AIG, or mortgage REITs on repo).
  4. Degree to which the institutions owns financial companies equity or debt, or vice-versa, where other financial companies have claims on the institution in question.
  5. Riskiness of the assets owned by the institution in question.

Contributing to the risks include easy monetary policy, which can lead/has led  to the neglect of risk control.  Personally, if I were a regulator of systemic risk, I would throw my effort at companies that fit factors 1 and 2, and analyze them for the other three factors.

Systemic risk is layered levered credit risk. A lent to B, who lent to C, who lent to D, who financed a bunch of bad mortgages.

#5 is underwriting risk

#4 is connectedness risk

#3 is liquidity risk

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Summary IMF Org Chart

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With much attention focusing on Dominique Strauss-Kahn and the IMF, Reuters has compiled a useful org chart summarizing the complete flow of executive power at the Washington D.C.-based developing world rescue organization. Source: Reuters

Inflation Speculation

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When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.  Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.  The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.  The exchanges are in cahoots with the other side.  Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.  Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.  Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.  Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.  Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

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The Insomniac Hedge Fund Guy

The Insomniac Hedge Fund Guy provides market macro-analytics and public-file aggregation models for data-tracking purposes. Content should not be treated as individualized investment advice or a professional financial-planning directive. Past performance does not guarantee future performance cycles.

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