Inverse ETFs

ETFs have grown tremendously since the launch of the first ETF in 1993. The chart below is from BlackRock’s iShares website and illustrates ETF growth.

The most notable benefits of ETFs are their trading flexibility. ETFs are priced throughout the trading day, and because ETFs trade like stocks on an exchange, you can buy them on margin and place limit and stop orders. You are able to trade it like a normal stock, but it is a package of 500 or more stocks. Trading flexibility, however, can be a double-edged sword. The ability to trade anytime is a benefit to busy investors and active traders, but that flexibility can draw some people to trade too much. As John Bogle, Burton Malkiel, Warren Buffet, Benjamin Graham, and other long-term investors have all published via various mediums, a high turnover of a portfolio increases its cost and reduces returns. In just 20 years, ETFs have gone from relative obscurity to accounting for 40% (as of 2011) of daily trading volume. However, these products do exactly what they are supposed to do: reflect market sentiment. In my opinion, I believe regular investors can benefit greater by following a more conservative, time-tested strategy, such as investing in an index fund by means of dollar cost averaging.

One of the most interesting ETF products is inverse ETFs. Inverse ETFs short the index it is tracking. For instance, Direxion Daily Large Cap Bear 3X Shares (NYSEARCA: SPXS) moves opposite the S&P. The fund seeks daily investment results of 300% of the inverse of the performance of the S&P by investing in futures contracts, options on securities, indices and futures contracts, equity caps, swap agreements, forward contracts, short positions, and reverse repo agreements. For example, today the S&P was down 1.1% and the SPXS was up 3.3%. If tomorrow the S&P is up 0.5%, the SPSX will be down 1.5%. Moreover, if the S&P follows with a 2% drop, the SPXS will rise 6%. Keep in mind that not all inverse ETFs seek an investment result greater than 100% and some will move exactly 1-1 opposite of its respective index.

Inverse ETFs provide an easy means for a regular investor to hedge their bets by indirectly investing in complex derivative products. However, as mentioned above, this increased flexibility can cause some traders to trade too much.

What are your thoughts on inverse ETFs?

Bank Consolidation: For the money, duh!

Why are small business and retail depositor banks being created? To make money, duh!

Steven Syre, Boston Globe columnist, published an opinion piece today on community banks in Massachusetts that are lining up to go public. Banks rolling out plans for the public market include:

• Beverly Bank, which has four branches and oversees $324 million worth of assets.
• Melrose Cooperative and Pilgrim Bank of Cohasset, which together hope to raise about $45 million.
• The parent company of East Boston Savings Bank, which sold a minority interest to the public in 2008, plans to go all-in by the end of 2014.
• Blue Hills Bank, which customers knew as Hyde Park Savings for more than a century, hopes to raise nearly $240 million by going public.


Taking a company public can have many fundamental and underlying reasons, but (in my opinion) bringing in massive profits is surely at the top of the list. Lots of people make big money in the process of an IPO – including the executives who took the bank public. And a lot of people make big money in the process of M&A – including the executives who took the bank public. A lot of small, regional banks are acquired by larger banks shortly after their public offering, and according to a new analyst report, M&A activity among regional banks is off to a better start this year contrasted with the prior two years. A way for struggling banks to increase shareholder value is to hitch their wagon to the star, serving as a way for management of the local bank to bring in wads of cash. 28 "whole-bank" deals — those in excess of $5 million — have been announced during the first quarter. That compares to 24 during Q1 2013 and 22 in Q1 2012 (Investor’s Business Daily). M&A activity does not drive this, but rather it is a byproduct of a bull-attitude toward the financial services industry. The fact that there are a lot of banks getting ready to go public is an encouraging sign for our economy, and the line forming at the moment suggests that many bankers believe the economy of the next several years will be strong enough to grow and avoid serious loan problems (Boston Globe).


References:

http://www.bostonglobe.com/business/2014/03/31/community-banks-line-public/gkvGKzMtkUxqkZOQrnevfJ/story.html http://news.investors.com/business/033114-695245-regional-banks-manda-activity-rises-in-2014.htm

Derivative-based market indicators

It seems the importance and speculative value of using derivatives as an indicator of risk increased tremendously following the credit crisis, which, for the most part, I think is due to rating agencies maintaining AAA ratings before the panic. Considering the volume of derivatives contracts (MBS, CDO) amplified during the real estate boom, and rating agencies failed to respond and adjust their ratings, investors now view the strategy of financers as a way to judge market risk. The logic: if derivative volume is growing, investors must be preparing for default (or a significant drop in the market).

Some derivatives, such as typical stock options, trade on exchanges.  But many are private contracts between banks or other investors.  As a result, it is hard to know the total volume of derivatives now outstanding. That is both an advantage and disadvantage of using a derivative-based index to measure risk. While price discovery is stimulated and there is a greater degree of market “completeness,” volatility increases since a larger number of derivative participants leads to speculation and raises impulsiveness in the markets (compare historic VIX charts and you’ll see that a majority of spikes have taken place in the last 5 years). Moreover, since OTC derivative trading is still going through massive international regulation, I think derivative-based indicators, as well as other market breadth indicators, should be used with reservations when making an investment decision.

For instance, consider the charts below. The first displays a comparison of OTC derivative markets in 2010 and 2013. The second is a breadth charting showing an Advance-Decline (AD) line for the NYSE.

Short sellers using derivative-based market indicators over the last few years have not profited. The derivative market has grown by over $100B, but AD indicators show no sign of slowing down. We are definitely experiencing a bull market. However, 2008 showed us that breadth charts could move rapidly, and bulls can turn to bears in seconds. A market/bubble “pop” is always something to consider. Who knows, maybe there is another Mike Burry lurking and waiting to capitalize on the next bear market.

A bit off-topic, but since the subject of short selling, derivatives and risk management is on the table, what are your thoughts on inverse and leveraged ETFs?

References used:

http://business.time.com/2013/03/27/why-derivatives-may-be-the-biggest-risk-for-the-global-economy/
http://www.risk.net/risk-magazine/feature/2332503/otc-reforms-numbers-only-tell-part-of-the-story
http://www.financialsense.com/contributors/matthew-kerkhoff/market-breadth-indicators-important

The $1 billion bet on Herbalife’s collapse

Lobbying to bring down Herbalife

There’s an interesting event taking place in the activism world: Bill Ackman is attempting to use every weapon that Washington has to bring down Herbalife, a vitamin a health supplement company. I’m sure most of you have heard the story – Ackman is accusing Herbalife of being a pyramid scheme that stays afloat by means of recruiting new distributors, many of whom are low-income individuals. Fraud reports and business investigations are common, but what makes this case interesting is that Ackman’s hedge fund recently took a $1B short position that will only pay off if Herbalife’s stock drops. Ackman’s attack, the value of the attack, and the lobbying attempt at hand is unprecedented in its scale.

Ackman has pressured state and federal regulators to investigate Herbalife by helping organize protests, news conferences, and letter-writing campaigns in California, Nevada, Connecticut, New York and Illinois. His team has also paid civil rights organizations at least $130,000 to join his effort by helping him collect the names of people who claim Herbalife victimized them, doing so to send the reports to regulators. Ackman’s team also provided the money used by some of these individuals to travel to Washington to participate in a rally’s against Herbalife. Ackman has presented investigators in New York with a year’s worth of financial research that he said showed that Herbalife was misleading investors by failing to disclose that most of its sales were generated by simply recruiting more distributors, rather than by selling large amounts of its product to consumers.

Nevertheless, Herbalife has grown into a powerhouse, with a worldwide team of more than 3 million members and distributors who operate as independent contractors through a system that rewards many of them not only based on actual sales, but also on their ability to recruit more distributors. Currently, Ackman has little to show for his fight: Herbalife’s stock has climbed higher over the years, which is partly due to billionaire investor Carl C. Icahn buying a large stake in the company. In addition, regulators lobbied by Mr. Ackman have not taken any formal action against the company.

While this is not “traditional” activism – traditional meaning a large institutional shareholder using its power to influence and make decisions, such as proposed M&A, compensation, and other strategy – Ackman is trying to find a way to undermine public confidence in Herbalife so that his $1 billion bet will produce an equally enormous return. What makes Herbalife interesting is that other known activist investors, such as Carl Icahn, are betting that Herbalife will continue to grow. The chart below illustrates how "active" Herbalife has been in the activist investor community.

What are your thoughts? Who will win this battle?

Cheers, Josh

Reference used: http://www.nytimes.com/2014/03/10/business/staking-1-billion-that-herbalife-will-fail-then-ackman-lobbying-to-bring-it-down.html?_r=0

Strange Phenomena in the Bond Market

Detroit, Puerto Rico, and the Madness of Crowds 

Municipal bonds have, traditionally, been much less volatile than Treasury yields – and muni yields have (like bond yields in most other markets) rose with Treasury yields. The chart below illustrates rolling one year changes in Treasury and 10 year AAA muni bond yields between 1986 and 2012.

As shown above, the sensitivity of muni to Treasury returns is roughly 0.5. Many investors believe this relationship exists because investors tend to compare the after-tax returns of Treasuries to municipal yields. Why has that relationship changed recently? Fundamentally, the answer is because of the fear of default. Specifically and recently, last year investors ran worried as interest rates began rising - and that fear intensified after Detroit filed for bankruptcy and concerns for the finances of Puerto Rico ascended. Puerto Rico is one of the largest issuers of muni bonds with $70B of debt, and US investors have pulled over $20B from muni funds containing Puerto Rico’s junk-rated debt. These events have and heavy outflows have forced municipal bond managers to keep bigger positions of well-known and highly-rated securities. For that reason, prices fell sharply and muni yields rose more than they usually would, to include faster than Treasury yields, explaining the rise to these unusual circumstances.

This strange relationship is beginning to wind down. Currently munis have returned 2.2 per cent year-to-date, ahead of the broad US Treasuries index which has delivered 1.2 per cent. Investors deposited a net $342 million in January, a significant improvement from the nearly $10B that flowed out of muni funds in December. Nevertheless, the gains this year have come from interest rates dropping - the yield on the 10-year Treasury note has sunk to about 2.73 percent from 3 percent in early January. Most major news network and financial advisory firms are praising an investment in municipal bonds this year, and most retail investors will surely tag along. A Google News search will present numerous articles journaling the pick-up in the muni marker. While there are certainly opportunities in munis this year, there are some significant concerns that could limit returns and further prolong this unusual muni market:

• Credit concerns: muni-bond fund managers say they are hearing more questions now from investors about Puerto Rico. Although the default rate for municipal bonds in Puerto Rico remains below 1 percent, a reoccurrence of negative attention can be devastating for the muni market.

• Tax exemption: Congress is debating whether to strip away, or at least reduce their tax-exempt income. If the proposals turn into law, it could drive down demand.

References used:

1. http://www.bostonglobe.com/business/2014/03/09/can-calm-last-municipal-bond-market/pePmcosGXSuLq5YgeFI6MO/story.html

2. http://www.reuters.com/article/2014/02/21/us-puertorico-funds-idUSL2N0LP2MK20140221

3. http://www.ft.com/intl/cms/s/0/35f47b76-93ed-11e3-a0e1-00144feab7de.html#axzz2voEP7jem

4. http://blog.alliancebernstein.com/index.php/2013/07/25/municipal-bonds-equipped-to-weather-rising-rates/

Derivatives - Who's Trading with Who?

Discussion from Investment Analysis and Portfolio Management at Boston University:

Quick breakdown of derivatives: Unlike stocks, derivatives are not traded on exchanges.  They are bilateral contracts between a bank and another financial firm or a company.  As a result, figuring out who is on the other side of a deal during a period of financial stress can become quite challenging.  I highly recommend – especially for those pursing the MSBFSM degree – to watch the documentary “Inside Job.”  It is an Oscar winning documentary that provides a comprehensive analysis of the global financial crisis and how derivatives played a role.  Forewarning: it takes a stab at capitalism, which I’m sure is a touchy subject for anyone making or pursuing a career in the financial sector.  Nonetheless, it’s informative.  Watch it free here: http://www.filmsforaction.org/watch/inside_job_2010/

On to business: everything addressed about derivatives in this week’s discussion is true; they promote efficiency, however, many bankers do not understand the underlying risks.  For instance, in a recent WSJ article, it was showcased that 13 of the 19 firms managed to report weekly data on derivatives contracts to a central database within three days—the standard set by regulators.  Nevertheless, some other U.S. banks provided worse data in 2012 than in previous years, and eight European Union banks, one U.S. and, one Canadian firm couldn’t update critical metrics required by regulators (1).

In my opinion, I think there needs to be a well-defined transparent market for derivatives.  If some firms don’t know what exactly is tied to what in some of their complicated products, I think that will prove to be a disastrous domino effect during a time of crisis.  Finance is a powerful technology, and I think that finance professionals have a moral obligations to be responsible.  After receiving the Deutsche Bank Price in Financial Economics, Robert Shiller said, “Finance is a powerful technology, but a technology that has been only imperfectly applied for the betterment of humankind”(3).

Europe is taking the charge on inputting regulation and transparency in the derivatives field; however, even the proposed regulations are choppy.  Heck, in a recent press release, the European Securities Markets Authority said that it had asked the Commission "to clarify the definition of a derivative or derivative contracts” (2).  If regulators and bankers don’t know what is considered a derivative, how can we even go about trying to regulate it?!

To clarify my thoughts: yes, I think derivatives can promote efficiency, especially in risk management. However, the instruments are currently so complex that it may produce entirely opposite results; since the products are intertwined they can increase riskiness in the entire financial market.  Transparency regulations in the derivatives market need to clearly defined.


Josh


(1) http://blogs.wsj.com/moneybeat/2014/01/20/banks-remain-vulnerable-in-a-key-area-years-after-the-crisis/?KEYWORDS=Derivatives

(2) http://online.wsj.com/news/articles/SB10001424052702304703804579383054267338542?KEYWORDS=Derivatives&mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702304703804579383054267338542.html%3FKEYWORDS%3DDerivatives

(3) https://www.db.com/presse/en/content/press_releases_2009_4619.htm

High-frequency trading: too fast for human comprehension

On May 6, 2010, following concerns about debt crisis in Greece, the DJIA to plunged roughly 9% in five minutes. Twenty minutes later, the market had regained most of the drop (1). High frequency trading (HFT) is credited for playing a major role in this flash crash. The simple fact is computerization of Wall Street is happening rapidly; HFT firms are responsible for about 50% of trading in the U.S. equities market (2).

High-frequency trading uses computers to make trades at lightning speed. Firms that employ HFT say users are merely harnessing available technology to make trades, resulting in increased price efficiency (3). Some market observers also emphasize that high frequency trading is simply faster trading, and that many of the trading strategies used by HFTs are not new, therefore nothing has changed in the economics of the market (4).  Critics, however, say HFT leaves other investors at an unfair disadvantage and that it can be disruptive, with liquidity drying up suddenly when markets turn volatile and trading programs shut down (3). Furthermore, studies on low-latency activity – strategies that respond to market events within milliseconds – show that the algorithms involved are so fast that detect, analyze, and respond to a market event within 2-3 milliseconds (4).  These statistics question the relationship between the interplay of algorithms and market dynamics; how can human traders accurately recognize the current state of the market if the speeds of market interactions occur too fast for human comprehension?

As for flash orders, some critics describe it as a way for a firm – and exchange – to hack the system.  Technically, it is legal, and it barely makes it by the National Market System (NMS) regulations established by the SEC.  The rationale for flash orders: better me than you.  They allow a venue to execute marketable orders in-house when that market is not at the national best bid (NBBO) or offer instead of routing those orders to rival markets.  They do this by briefly displaying information about the order to the venue's participants and soliciting NBBO-priced responses.  If there are no responses, the order can be canceled or routed to the market with the best price (5).

I'm not entirely sure how to feel about this topic. It's new to me, and I feel like I have a lot more to learn before I can prove valuable to a discussion. My initial reaction was "heck, it's capitalism, right?" Technology and innovation has removed or significantly decreased the human factor in all industries. There are factory's run by some sort of sophisticated technology that make automobiles and package our food and prescription drugs. I suppose the true question is how much responsible do we want to put in the "hands" of a computer when it comes to our money? We feel safe about computers running the production plants that make our cars and package food, why is it different in finance?

Josh


References

(1) Lauricella, Tom (May 7, 2010). "Market Plunge Baffles Wall Street -Trading Glitch Suspected in 'Mayhem' as Dow Falls Nearly 1,000, Then Bounces". The Wall Street Journal. p. 1.
(2) http://online.wsj.com/news/articles/SB10001424052702304887104579302681366721324
(3) http://blogs.marketwatch.com/thetell/2014/01/15/europe-plans-crackdown-on-high-frequency-trading/
(4) Tarun Chordia, Amit Goyal, Bruce N. Lehmann, Gideon Saar, High-frequency trading, Journal of Financial Markets, Volume 16, Issue 4, November 2013, Pages 637-645, ISSN 1386-4181, http://dx.doi.org/10.1016/j.finmar.2013.06.004.
(5) http://www.highbeam.com/doc/1G1-203482971.html