Wednesday, October 31, 2012

Leveraged Exposure to the Mortgage REIT Sector

By Tim Dulaney, PhD and Tim Husson, PhD

Michael Aneiro over at Barron's pointed out an interesting recent SEC 424(b)2 filing from ETRACS for their Monthly Pay 2x Leveraged Mortgage REIT ETN (MORL).  According to the prospectus, the ETNs will "provide a monthly compounded two times leveraged long exposure to the performance of the [Market Vectors Global Mortgage REITs Index], reduced by the Accrued Fees."  This ETN is essentially a leveraged version of Market Vectors Mortgage REIT ETF (MORT) which tracks the same underlying index.

The index tracks a portfolio of traded mortgage REITs.  For example, the largest component is Annaly Capital Management Inc -- with almost 19% of the index's value -- which is "the largest mortgage REIT on the New York Stock Exchange."  Interestingly, there appear to be only 24 components to the index, which could indicate a lack of diversification and higher volatility than a more broad-based index.  That would be important to a levered ETN tracking that index because higher volatility can lead to higher holding period return deviations due to rebalancing.

An interesting and relatively uncommon feature of this particular ETN is the use of monthly rebalancing as opposed to the daily rebalancing of leveraged and inverse leveraged exchange traded products that we've talked about so frequently.  This essentially means that an investor holding this ETN from the beginning of one month through the end of the month will have a holding period return of approximately twice that of the Market Vectors Global Mortgage REITs Index gross of fees.

We backtested this strategy from January 2005 to October 2012 by studying a net investment of $10,000 in the Market Vectors Global Mortgage REITs Index (MVMORT) leveraged by 200%.  In other words, we borrow $10,000 and put $20,000 in the index.


During this period, the unleveraged investment lost approximately 65% of it's value while the leveraged investment lost nearly 95%.  As should be expected, the leveraged investment outperforms the unleveraged investment when the index is increasing.  Below we plot the effective daily leverage for the leveraged investment over time, which can differ widely from 2x.

While the real estate market in the late 2000s saw heavy losses, these backtests do not look particularly promising for the new ETN.  Leveraged ETNs are typically considered for day-trading purposes, while real estate is often considered a diversifying asset class for long-term investors.  It is not clear how these two seemingly different approaches will mesh together in this new ETN--but it appears that we will find out.



Details of the backtesting procedure:

We assume the tracking fee is paid at the end of each day and that the short account accrues interest daily at three-month LIBOR plus the contractual 80 basis point financing spread.  We compare this to a direct investment in the index with a 40 basis point fee (comparable to that paid by MORT investors).  Since investors can invest in the ETNs at any point in the month, the actual exposure the investor experiences is dependent upon the index performance through that point in the month.  The average daily leverage is about 2.02 with a standard deviation of about 0.15.  The effective daily leverage varied between 1.68 and 4.36 during this period.

Monday, October 29, 2012

The Effects of ETF Turnover

By Tim Husson, PhD and Tim Dulaney, PhD

Lately there has been a lot of turnover in exchange-traded funds (ETFs), as we noted back in August.  InvestmentNews has a great summary of what has happened this year, with 86 funds having closed so far in 2012.  They note the important consequences of an ETF closing for investors and advisers:
Even though they are more routine, ETF closings still can create ripple effects that reach financial advisers and their clients. “For an adviser, the worst thing that can happen is, you recommend an ETF to a client that ends up shutting down," [Matt Hougan, president of IndexUniverse LLC] said. “That makes you look dumb to your clients.” 
For the ETF investor, the biggest downside would be holding the fund after the announced closing to the point where it is fully liquidated. 
“If you hold on till the very last day when the fund closes and rolls down the portfolio, you're taking on some performance risk, and it will also generate some capital gains as it sell all the positions,” Mr. Hougan said.
They also note that the ETF market is highly competitive, and there is a large first mover advantage, such that older funds with established flows tend to crowd out new funds with similar objectives.  It's also not necessarily the case that the largest funds are the cheapest--new funds often try to undercut competition, such as Schwab's new fund family, but still may not attract a sustainable amount of investment.

This may lead ETF issues to try to differentiate their funds by tweaking exposure.  For example, while VXX remains the largest exchange-traded volatility product, newer products that are linked to short-term VIX futures like VQT or XVZ have components that try to hedge against certain risks.  But there is a tradeoff here:  the more specific a product's exposure, the smaller the base of potential investors for whom the product would be suitable.

Friday, October 26, 2012

SEC Litigation Releases: Week in Review

Former Silicon Valley Executive to Pay $1.75 Million to Settle Insider Trading Charges, October 26, 2012, (Litigation Release No. 22523)

The SEC charged Kris Chellam, former senior executive of Xilinx Inc., with illegally tipping "hedge fund manager Raj Rajaratnam with nonpublic information that allowed the Galleon hedge funds to make nearly $1 million in illicit profits." Chellam allegedly tipped Rajaratnam on December 5, 2006 that Xilinx Inc. "would fall short of revenue projections it had previously made." According to the charges, Rajaratnam then short sold more than 650,000 shares over the following two days. Chellam had over $1 million "invested in one of the Galleon hedge funds" and in May 2007, "Chellam became the co-managing partner of the Galleon Special Opportunities Fund." Chellam worked at Galleon until April 2009 and during this time frame he allegedly continued to pass along confidential information about Xilinx's financial performance to Galleon colleagues. Chellam has agreed to pay over $1.75 million in disgorgement, prejudgment interest, and penalties, as well as  a five year officer and director bar.

SEC Charges Denver-Based Insurance Executive with Insider Trading, October 26, 2012, (Litigation Release No. 22522)

The SEC has charged Michael Van Gilder, CEO of Van Gilder Insurance Company, with insider trading involving Tracinda's acquisition of a 35 percent stake in Delta Petroleum. According to the SEC, Van Gilder received the inside information from someone within the Delta Petroleum Corporation in November and December 2007. After receiving the information, Van Gilder allegedly tipped his broker, a co-worker, and relatives. In all, "Van Gilder and his tippees made more than $161,000 in illegal trading profits." Van Gilder has been charged with violating sections of the Exchange Act.

SEC v. Michael Johnson, October 26, 2012, (Litigation Release No. 22520)

According to the complaint (opens to PDF), Michael Johnson, "a divisional merchandise manager at Kohl's," assisted Joseph Elles, former Executive Vice President of Sales at Carter's, Inc., with financial fraud. In a previous case, the SEC charged Joseph Elles with manipulating "the amount of discounts that Carter's granted Kohl's" from 2004 to 2009. Allegedly, "Elles persuaded Johnson, who handled the Carter's account at Kohl's, to sign a false confirmation that misrepresented to Carter's accounting personnel the time and amount of those discounts." The SEC has charged Johnson with violating sections of the Exchange Act and seeks permanent injunctive relief as well as financial penalties against Johnson.

SEC Charges Former J. Crew Executive with Insider Trading, October 25, 2012, (Litigation Release No. 22519)

According to the complaint (opens to PDF), Frank A. LoBue, former Director of Store Operations at J. Crew Group, used "material, nonpublic information about sales and expenses of the company's stores to purchase J. Crew common stock in advance of earnings announcements in May and August 2009." LoBue allegedly made more than $60,000 in illiegal profits. In February 2010, J. Crew terminated LoBue's employment. LoBue has agreed to permanent enjoinment from violating the Exchange act and to pay over $128,000 in disgorgement, prejudgment interest, and penalties.

SEC Charges Two in Michigan-based Fraudulent Securities Offering, October 23, 2012, (Litigation Release No. 22518)

According to the complaint (opens to PDF), brothers James Mulholland and Thomas Mulholland conducted "a fraudulent, unregistered offer and sale of approximately $2 million in securities." The brothers, who operated a real estate business, "raised money from individual investors...through the offer and sale of securities in the form of demand notes" to finance their business. According to the complaint, when the Mulhollands' real estate business began to experience financial difficulties in January 2009, they continued to raise funds from investors on the false and misleading premises that their business "was profitable, [the investors] would earn 7% per year on investments, the returns would be generated by profits of the real estate business, and that the investors could get their money back upon 30 days' written notice." Furthermore, the brothers "never told investors that they were experiencing financial hardship, that they were having difficulty meeting financial obligations..., or that they were contemplating filing for bankruptcy." The SEC is seeking a permanent injunction, disgorgement with prejudgment interest and civil monetary penalties.
SEC v. Joseph Pacifico, October 19, 2012, (Litigation Release No. 22517)

According to the complaint (opens to PDF), Joseph Pacifico, former President of Carter's, Inc., "caused Carter's to materially misstate its net income and expenses in several financial reporting periods between 2004 and 2009" by engaging in financial fraud. According to the complaint, Joseph Elles, Carter's Executive Vice President of Sales, "fraudulently manipulated the amount of discounts that Carter's granted to [Kohl's]." According to the SEC, Elles "then concealed his conduct by persuading [Kohl's] to defer subtracting the discounts from payments until later periods and creating and signing false documents misrepresenting the timing and amount of those discounts to Carter's accounting personnel." Allegedly, when Pacifico discovered Elles's scheme, he signed "a false certification to Carter's accounting personnel that understated the amount [of] discounts that Carter's owed to the customer." Additionally, Pacifico allegedly "signed false internal forms that also misstated that discounts to be paid to the customer related to sales in 2009 when, in fact, the discounts related to prior financial periods." 

SEC v. Irwin Boock, et al., October 19, 2012, (Litigation Release No. 22516)

On October 17, 2012, the SEC filed an amended complaint naming Alena Dubinsky as a relief defendant in an action that involves "the hijacking of defunct or inactive publicly-traded companies and the unregistered offer and sale of securities." According to the amended complaint, Dubinsky "opened bank and brokerage accounts...at the behest of certain defendants through which were effected unregistered sales of securities and the deposit of at least $1 million in illicit proceeds." The SEC seeks disgorgement.

Hong Kong Firm to Pay $14 Million to Settle Insider Trading Charges, October 19, 2012, (Litigation Release No. 22515)

Well Advantage Limited agreed to pay over $14 million in disgorgement and penalties to settle charges of insider trading involving CNOOC Ltd.'s acquisition of Nexen Inc. Well Advantage has also been permanently enjoined from violating various section of the Securities Act and Exchange Act.

Thursday, October 25, 2012

SEC Under Pressure Regarding JOBS Act Provisions

By Tim Husson, PhD

According to InvestmentNews, the SEC is being asked to abandon their new rules allowing hedge funds and other private placements to actively advertise to investors.  We've discussed these issues before, as we think this could mark a significant change in how the public views this highly opaque and unregulated market.  From the article:
Critics assert that the SEC proposed rule on private-fund advertising was too vague and would hurt investors by allowing them to be lured in by slick sales pitches for opaque and volatile investments. 
“Lifting the advertising ban on these highly risky, illiquid offerings without requiring appropriate safeguards will create chaos in the market and expose investors to an even greater risk of fraud and abuse,” Heath Abshure, Arkansas' securities commissioner and president of the North American Securities Administrators Association Inc., said during a conference call with the media.
While we agree with the concerns expressed by these groups, it is not clear that the SEC has any choice in the matter.  Their proposed rule change is simply an implementation of provisions of the JOBS Act signed into law earlier this year, and Congress has already accused the SEC of dragging its feet on this issue. So it is not clear how much room the SEC has to investigate potential erosion of investor protections, even if they are significant.

Tuesday, October 23, 2012

Do ETF Flows Move the Market?

By Tim Husson, PhD and Tim Dulaney, PhD

As exchange-traded fund (ETF) flows have grown over the past few years, the question of whether those fund flows influence the prices of ETF holdings has become a perennial issue.  Matt Jarzemsky and Chris Dieterich of the Wall Street Journal recently posted what is perhaps the highest profile discussion of this issue to date, in which they provide interesting evidence that the ETF 'tail' might be wagging the market 'dog.'

They note that in early October, mid-cap indexes saw uncharacteristically poor returns relative to large- and small-cap indexes.  According to the article, "it was just the fifth session in the past five years when the S&P's large- and small-cap indexes have risen while the midcap benchmark fell, according to FactSet. The last time that occurred was Jan. 20."  Interestingly, the losses in the mid-cap indexes seemed to track two large ETFs who "sold off on heavy volume throughout the day, with each setting a record for the number of shares traded in one session."

This question has been hotly debated in the world of futures-based ETFs, especially volatility-linked products.  In those markets, the volume of futures contracts 'rolled' each day by the ETF can amount to a large percentage of the total volume in the futures market.  There has been vigorous debate about whether there in fact is a pricing effect or if traders can front-run those purchases and sales and thus distort market prices.  Some sources have suggested position limits in those futures markets to prevent ETF flows from having too large an effect.

However, such market distortions are difficult to prove conclusively.  ETFs provide a creation and redemption process that allows certain dealers the ability to arbitrage away any discrepancy between the ETF and the value of its underlying assets, meaning the value of ETF shares should quickly counteract any tracking error if markets are working normally.  It's also not clear what exactly caused the sell-off in the two mid-cap ETFs mentioned in the WSJ story -- the iShares S&P 400 MidCap Index Fund (IJH) and the ProShares Ultra MidCap 400 (MVV).

So while the exact price impact of ETF fund flows on their underlying assets remains undetermined, it is clear that ETFs have become a dominating force in many markets, and that further pricing anomalies will be closely watched by analysts and market participants.

Monday, October 22, 2012

FINRA Fines and Suspends David Lerner for Apple REIT Ten Misrepresentations

By Tim Husson, PhD

Today, FINRA fined David Lerner Associates $14 million, including $12 million in restitution to investors, for charging excessive markups and misleading investors in a non-traded real estate investment trust (REIT) known as Apple REIT Ten.  They also suspended David Lerner himself for one year from the securities industry and for two more years from acting as principal for a securities firm.  From the news release:
As the sole distributor of the Apple REITs, DLA solicited thousands of customers, targeting unsophisticated investors and the elderly, selling the illiquid REIT without performing adequate due diligence to determine whether it was suitable for investors. To sell Apple REIT Ten, DLA also used misleading marketing materials that presented performance results for the closed Apple REITs without disclosing to customers that income from those REITs was insufficient to support the distributions to unit owners. FINRA also fined DLA more than $2.3 million for charging unfair prices on municipal bonds and collateralized mortgage obligations (CMOs) it sold over a 30 month period, and for related supervisory violations.
As we've covered before, non-traded REITs have recently drawn significant attention from regulatory authorities.  FINRA's complaint against David Lerner, first filed in May 2011, drew significant attention to the problems in the non-traded REIT industry generally.  Our own research on non-traded REITs and other alternative real estate investments suggests that the very high commissions and fees on non-traded REITs make them relatively unattractive investments relative to traded REITs, especially given their lack of liquidity and analyst coverage.

The misrepresentations made by David Lerner regarding Apple REIT Ten may not be unique to that firm or to that REIT.  Many other broker-dealers for non-traded REITs have sold these relatively long-term illiquid products to elderly and other unsuitable investors, and may misrepresent the largely constant sale prices of non-traded REITs as 'low volatility' market values.  Such practices have been the subject of both FINRA and SEC (pdf) warnings to investors.  What is unique about the David Lerner case is that DLA was the sole distributor of the Apple REITs, whereas other non-traded REITs use more than one distributor.

FINRA's action today may be a sign of things to come as regulators begin to crack down in earnest on the non-traded REIT market.

[UPDATE October 23]  The story has been picked up by the New York Times and Bloomberg.  The NYT story notes that David Lerner will continue to work with the Spirit of America Mutual funds and that "those funds, sold by David Lerner Associates, have a total of more than $600 million in assets, and are characterized by high fees, according to Morningstar."

Friday, October 19, 2012

SEC Litigation Releases: Week in Review

SEC Charges Three Individuals for Their Roles in a $5.77 Million Investment Scheme, October 18, 2012, (Litigation Release No. 22514)

According to the complaint (opens to PDF), from February 2010 to February 2011 Geoffrey H. Lunn, Darlene A. Bishop, and Vincent G. Curry raised $5.77 million in an "investment scheme [through] Dresdner Financial, a fictitious financial services company." Lunn allegedly attracted investors by posing as the vice-president of Dresdner and telling investors that "Dresdner's principals had connections to Dresdner Bank." According to the SEC, Bishop and Curry acted as marketers for the scheme and lured investors in by promising "100% guaranteed rates of return." Lunn allegedly did not invest any of the investors' funds, but instead used them for personal expenses including paying "at least $848,500 to Las Vegas call girls," paying "over $1.3 million to marketers," and paying $1 million to Dresdner's creator, "a one-eyed man who used the alias "Robert Perello.'" Lunn, Bishop, and Curry have been charged with violating sections of the Securities Act and the Exchange Act. The SEC is seeking permanent injunctions, disgorgement with prejudgment interest, and civil penalties. 

District Court Orders More Than $3 Million in Remedies, Grants Motions for Disgorgement, Civil Penalties and Officer-and-Director Bars Against Timothy Huff, Lawrence Lynch, Joseph J. Monterosso, Luis Vargas, October 18, 2012, (Litigation Release No. 22513)

This Thursday the Court granted the SEC's "motions for disgorgement, civil penalties, and officer-and-director bars against" Timothy Huff, Lawrence Lynch, Joseph J. Monterosso, and Luis Vargas for their involvement in a scheme involving GlobeTel Communications Corp. (now World Surveillance Group Inc.) from 2002 to 2006. According to the original complaint, "GlobeTel reported millions of dollars in telecommunications revenue...that was fake." Huff and former GlobeTel chief financial officer, Thomas Jimenez, were sentenced to prison in parallel criminal prosecutions: U.S. v. Huff and U.S. v. Jimenez. Huff allegedly created the scheme that made it look from 2002 to 2004 that GlobeTel "bought and sold telecom 'minutes' with other companies in Mexico, Brazil and the Philippines." However, the complaint claims that in reality there were no transactions and Huff and Jimenez "created false invoices and technical documents and lied to auditors" to support their claims. Monterosso and Vargas also allegedly  created "hundreds of false invoices from 2004 to 2006 that made it appear that GlobeTel's three wholly-owned subsidiaries, Centerline Communications, LLC, Volta Communications, LLC, and Lonestar Communications, LLC bought and sold telecom 'minutes' with other wholesale telecom companies." According to the SEC, in reality there were no transactions. Volta and Lonestar allegedly "did no business." The reported millions of dollars in business between Centerline and "Monterosso's and Vargas' own private company, Carrier Services Inc." allegedly did not occur as well. Lynch, who was aware that Monterosso and Vargus had submitted fake invoices, allegedly "made and approved journal entries in GlobeTel's financial records to record revenue and concealed that GlobeTel and its supposed counter-parties were not paying their bills." 

In earlier judgments, Lynch received an officer and director bar for five years and Huff received a permanent officer and director bar. In Thursday's ruling, Huff was ordered to pay over $2.71 million in penalties and disgorgement, plus prejudgment interest; Lynch was ordered to pay a $780,000 civil penalty; Monterosso was ordered to pay (jointly and severally with Vargus) $975,000 in penalties and disgorgement plus prejudgment interest; and Vargas was ordered to pay (jointly and severally with Monterosso) $825,000 in penalties and disgorgement plus prejudgment interest. Monterosso and Vargus also received a ten year officer and director bar.

Defendant in SEC Action Charged by United States Attorney's Office for the District of Massachusetts, October 18, 2012, (Litigation Release No. 22512)

This Thursday the United States Attorney's Office for the District of Massachusetts charged Arnett L. Waters (who is also a defendant in an action filed by the SEC this past May) with "multiple schemes to defraud investors and business clients, as well as with obstruction of justice." Specfically, Waters has been charged with "sixteen counts of securities fraud, mail fraud, money laundering, and obstruction of justice." From 2007 through 2012, Waters allegedly raised at least $839,000 "using fictitious investment-related partnerships to draw in investors," including his church which gave him $500,000 in March 2012. In another scheme, Water allegedly defrauded clients "out of as much as $7.8 million" of his rare coins business "using interstate commerce and the mails." Furthermore, Waters also allegedly "engaged in money laundering through two transactions totaling $77,000." The criminal information claims that Waters "made mutliple misrepresentations to Commission staff...to conceal...that investor money was misappropraited in a fraudulent scheme." In August, the Attorney's office filed a separate criminal information charging Waters with two counts of criminal contempt due to an undisclosed bank account to which Waters allegedly transferred funds.

SEC Charges Arizona Man with Acting as an Unregistered Broker and Unlawful Touting, October 17, 2012, (Litigation Release No. 22511)

According to the complaint (opens to PDF), from 2007 to 2011 Michael J. Southworth and his entity, The Investors Registry, LLC, (TIR) violated the broker-dealer registration provisions of the federal securities laws. In addition, Southworth also allegedly violated the anti-touting provisions. During this time frame, Southworth allegedly acted as an unregistered broker through TIR in regards "to the profiling of five issuers by soliciting TIR members to invest" in these "pre-IPO" issuers, and by "negotiating with the issuers regarding certain terms of their offering to TIR members." Additionally, "Southworth touted the same five issuers without adequate disclosure of the consideration that he received from them." Southworth and TIR have agreed to permanent enjoinments as well has a three year penny stock bar and to over $200,000 in disgorgement plus prejudgment interest. However, a waiver of payment of all but $100,000 has been given due to Southworth's financial condition. 

SEC Charges Hedge Fund Adviser and Two Executives with Fraud, October 17, 2012, (Litigation Release No. 22510)

According to the complaint (opens to PDF), Yorkville Advisers LLC, its founder and president Mark Angelo, and its chief financial officer Edward Schinik used false information to entice "pension funds and other investors to invest in their [two] hedge funds" YA Global Investments (US) LP and YA Offshore Global Investments Ltd. They allegedly misrepresented the safety and liquidity of the investments made by the hedge funds, and charged at least "$10 million in excess fees based on the inflated values of Yorkville's assets under management." In addition, the SEC charges that the defendants "failed to adhere to Yorkville's stated valuation policies, ignored negative information about certain investments by the funds, withheld adverse information about fund investments from Yorkville's auditor [...and] misled investors about the [...] collateral underlying the investments and Yorkville's use of a third-party valuation firm." The complaint charges the defendants with violating sections of the Securities Act, Exchange Act, and Investment Advisers Act.

SEC v. James B. Catledge et al., October 15, 2012, (Litigation Release No. 22509a)

According to the May 24, 2012 complaint (opens to PDF), James B. Catledge, Derek F. C. Elliott, EMI Resorts Inc., EMI Sun Village, Inc. and Sun Village Juan Dolio made "material misrepresentations to investors in connection with the unregistered sale of interest in two resorts in the Dominican Republican." A final judgment has been entered against Elliott which "waives disgorgement and authorizes the Commission to seek a civil penalty of not more than $250,000 by subsequent motion." 

Wednesday, October 17, 2012

Vanguard Abandons MSCI and MSCI's Share Price Crashes

By Tim Dulaney, PhD and Tim Husson, PhD

 A few weeks ago, the Wall Street Journal reported that Vanguard is replacing the benchmarks on nearly two dozen of its index funds currently provided by MSCI and replacing them with benchmarks provided by either FTSE or the Center For Research In Security Prices (CRSP) at the University of Chicago.  For the press release dated October 2, 2012, see here.

This is clearly great news for FTSE since this index change by Vanguard makes them the "third-largest equity exchange traded product index benchmark provider globally, with more than $124 billion in ETF assets benchmarked to FTSE indices."

MSCI, on the other hand, is having sort of a bad month as a result of this news.  As the Wall Street Journal reports, MSCI's stock price was hovering around $36 for the month of September, but has dropped to about $27 as a result of this news even though "S&P pegged Vanguard's contribution at under 3%".


An interesting side note to the story is that a fairly significant insider sale occurred less than a month before this event.  The insider was Mr. C.D. Baer Pettit and, according to his Form 4 filed with the SEC, he was MSCI's Head of Index Business as of the September 7, 2012 transaction date.  (An earlier dated Form 4 from February 2012 states his position as Head of Client Coverage).  Pettit sold over 72,000 shares of MSCI -- or more than 38% of his ownership -- as of the transaction date. The average price received was $36.61 since the transaction "was executed in multiple trades at prices ranging from $36.52 to $36.69."  Clearly this is almost a full $10 more than what Pettit would have received if he had waited just a few weeks to sell these shares. 

MSCI's closing price on October 1, 2012 was $35.82 and the closing price on October 2, 2012 was $26.21.  The shares Baer Pettit sold on September 7, 2012 would have lost over $694,572. The intraday price graph is included below with the price dropping right around the time of the announcement by Vanguard.

 

According to MarketBrief's News Feed on this transaction, this single transaction accounted for (coincidentally) over 38% of the shares of MSCI sold by insiders during the twelve months preceding this transaction.  Furthermore, insiders at MSCI have been net sellers over the same period with over 186,000 shares sold and only 10,000 shares bought. 

Monday, October 15, 2012

Mutual Funds Holding Leveraged and Inverse Leveraged ETFs

By Tim Dulaney, PhD

While looking through recent SEC filings, an updated prospectus happened to catch our eye.  The prospectus offers updated information concerning the investment strategy and details of two mutual funds: USFS Funds Limited Duration Government Fund (USLDX) and USFS Funds Tactical Asset Allocation Fund (USFSX).

The fund management company -- Pennant Management, Inc. -- states in this prospectus that "[USFSX] may invest up to 33% of its assets in leveraged ETFs and inverse ETFs, up to 10% of its assets in options, and up to 5% of its assets in futures."  An earlier version of the prospectus stated that the fund would "invest extensively" in leveraged and inverse leveraged ETFs, but didn't specify an upper bound on this allocation.  According to the fund's fact sheet, the fund had total net assets of about $17 million as of June 2012 and has underperformed the S&P 500 since the fund's inception in November of 2009.

We were curious how much disclosure such a large allocation to leveraged and inverse leveraged ETFs is given concerning the suitability of this allocation for retail investors -- which we've written extensively about on this blog. The prospectus has the following disclosure concerning daily rebalancing in leveraged and inverse leveraged ETFs
Such ETFs often “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Due to the effect of compounding, their performance over longer periods of time can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect may be enhanced during the periods of increased market volatility. Consequently, leveraged ETFs may not be suitable as long-term investments.
The prospectus also indicates that USFSX may "buy and sell investments frequently" possibly leading to higher expenses and increases in taxable short-term capitals gains.  If a high-turnover fund invests in leveraged ETFs, this effect could be magnified because leveraged ETFs often have higher turnover rates due to their daily rebalancing (see, for example, the prospectus for the Direxion Shares ETF Trust).

The current asset allocation indicates that this mutual fund has no allocation to leveraged and inverse ETFs, but that's not really the point.  Mutual funds that might allocate such a large portion of their assets to such ETFs should make a more concerted effort to educate potential investors as to the risks involved in the underlying investments.

Friday, October 12, 2012

SEC Litigation Releases: Week in Review

SEC Brings New Charges in Insider Trading Case Against Chinese Citizens, October, 12, 2012, (Litigation Release No. 22508)

In December 2011, the SEC charged several Chinese citizens and Chinese-based entity, All Know Holdings Ltd., with insider trading concerning the merger between Pearson plc and Global Education and Technology Group, Ltd. The SEC filed an amended complaint (PDF) on October 4, 2012, naming Jie Meng as a new defendant. According to the complaint, Meng received information regarding the merger from friend Angela Yang (a.k.a. Yang Yan), who was an employee of Pearson. Meng used money from Yang as well as money from relief defendant Song Li's bank account to purchase over 24,000 shares of Global Education securities in Li's brokerage account. Allegedly, Meng made nearly $150,000 in illicit profits. Due to an asset freeze on Li's account, however, Meng was unable to liquidate Li's account. Meng has agreed to pay, jointly and severally with Li, nearly $150,000 in disgorgement and prejudgment interest. Meng has also been ordered to pay a $71,000 civil penalty. In regards to the other defendants, Lili Wang has been ordered to pay almost $400,000 in disgorgement, prejudgment interest, and civil penalties.

Defendant James L. Douglas A/K/A James L. Cooper Held in Civil Contempt after Failing to Comply with Judgment, October, 12, 2012, (Litigation Release No. 22507)

The SEC announced that James L. Douglas (a.k.a James L. Cooper) was found to be in civil contempt for not paying in full a judgment entered against him in 1983. This judgment (which resulted from a SEC complaint alleging Douglas raised over $7.5 million by "offering and selling unregistered oil and gas partnerships") ordered Douglas "to disgorge $200,000 within three years." Douglas only paid a little over $120,000, leaving an unpaid balance of over $78,000. In 1988, Douglas was found to be in contempt based on the non-payment and a warrant was issued for his arrest. However, Douglas's location was unknown to U.S. Marshals until 2010 when he had returned to the U.S. to file a suit "on behalf of his deceased wife's estate." On August 20, 2012, the Court again held Douglas in contempt. This time, the Court ruled that Douglas "must pay post-judgment interest at the statutory rate of 10.74% from the 'date of the entry of the judgment' in 1983." According to the SEC's calculation, this post-judgment interest "now exceeds $1.7 million."

Thursday, October 11, 2012

Exchange Traded Interest Rate Swap Futures

By Tim Dulaney, PhD

We've talked briefly about interest rate swaps in the past, but I wanted to write about a recent development in the securities industry that relates to these conventionally over-the-counter (OTC) instruments.

Back in the summer of 2010, the Dodd–Frank Wall Street Reform and Consumer Protection Act (PDF) was signed into law and as a result many OTC products have began the process of standardization in preparation for exchange trading.  The idea is essentially that exchange traded products offer a level of transparency and liquidity that are hard to find in the individualized and (sometimes) illiquid OTC market. 

Concurrent with this legislation, several Chicago financial institutions organized to form a new exchange (Eris Exchange, LLC) hoping to capitalize on the standardization of one of the most common types of OTC instruments: interest rate swaps (or, simply, swaps).  These bilateral agreements are used by nearly every segment of the investing population -- from individuals to banks, from school districts to hedge funds -- to alter the exposure of a portfolio to interest rates. 

In October 2011, the Commodity Futures Trading Commission (CFTC) designated "Eris Exchange, LLC [...] as a contract market." The Delaware limited liability corporation gained additional momentum recently through a highly-publicized investment by "State Street Corp. and Devonshire Investors, the private-equity arm of Fidelity Investments."

Eris offers a product comparison between OTC swaps and their exchange traded interest rate swap futures contracts.  In particular, their website notes that changes in the net present value of future cash flows are more quickly realized within the margin accounts of buyers and sellers.  As a result, investors can withdraw funds if their contract is overcollateralized, freeing funds for alternative investments. Furthermore, customers can realize up to 95% margin offsets through the mitigation of exposure with different futures contracts. 

For this exchange, clearing services are provided exclusively by the CME Group.  The initial margin levels are based on notional value of the underlying interest rate swap.  The exchange fees are per ($1MM notional) contract, charged to both the buyer and the seller, and depend on the tenor of the swap.

We here at SLCG are advocates of transparency and the establishment of this exchange could be a step in the right direction.  Although trading volume and open interest seems low now the CFTC recently said "over-the-counter trading in swaps and other derivatives, including about $465 trillion in notional worldwide interest-rate market activity, would be required to move to the public trading and clearing platforms by 2013." Only time will tell whether or not the Eris Exchange is "The Future of Swaps."

Wednesday, October 10, 2012

Variable Prepaid Forwards Cost JP Morgan at least $18 million

By Craig J. McCann, PhD, CFA

Yesterday, the Oklahoma District Court in Tulsa, OK ordered JP Morgan Chase Bank to pay the Burford Trust over $18 million.  In addition to this payment, JP Morgan is responsible for attorneys’ fees and punitive damages to compensate the trust for the diminution in value resulting from a series of 11 variable prepaid forward contracts (VPFs) JP Morgan entered into with the Trust starting in May 2000.  The news of this decision has been picked up by Bloomberg, the New York Times as well as Reuters.

VPFs are complex securities containing embedded put and call option contracts on a stock position as well as a loan secured by the stock and option positions.  VPFs can partially hedge concentrated stock positions and raise funds to make additional investments.  At initiation of a VPF, the investor receives proceeds in exchange for a commitment to return these proceeds plus an implied interest.  At maturity, VPFs can be settled by delivering shares of stock or with cash.  Sometimes, as in this case, the cash settlement of a VPF is funded with the proceeds from entering into a subsequent “roll over” VPF.

The proceeds received when a VPF is entered into are typically invested in other assets.  The net effect of the VPF and the other investments is to place a collar on a stock position using derivative contracts plus a leveraged investment made on margin.  If the proceeds are invested in assets which earn exactly the same return as the interest charged in the VPF, the contract reduces to a collar.

The 11 VPFs JP Morgan sold to the Trust transferred over $2 million from the Trust to JP Morgan on the dates they were executed according to expert testimony provided by SLCG in this case.  Incurring these costs neither fully diversified the Exxon-Mobil shares covered by the VPFs nor dealt with the embedded capital gains tax liability.

Some of the loan proceeds from the VPFs were used to fund bond investments.  The bonds provided no diversification of the firm-specific risk in the Exxon-Mobil stock and had much lower expected returns than the implied interest charges on the loan portion of the VPFs.  Moreover, the interest earned on the municipal bonds was paid out to the income beneficiary and so, predictably, the VPFs covered more and more of the Exxon-Mobil stock as they were rolled over. Once all the stock was covered, further roll overs were likely to require stock sales.  The VPFs converted Exxon-Mobil stock into distributable income effectively circumventing the settlor’s intentions.

The VPFs JP Morgan sold to the Trust violated the Prudent Man Rule because they caused the Trust to incur unnecessary costs, enter into derivatives contracts, make additional investments on margin and needlessly dissipate a portion of the Trust’s assets.  For additional information on the Prudent Investor Rule, see here (PDF) and here (DOC).  The court found in particular that JP Morgan's "failure to adequately investigate and inform the beneficiaries of the risks and costs associated with VPF contracts was a breach of the duty of prudence." 

Tuesday, October 9, 2012

Two New Exotic Products from the CBOE

By Tim Husson, PhD

The CBOE has begun the offering process on two new and highly innovative volatility-related products that could have broad implications for the exchange traded products market and index investing in general.

The new S&P 500 Variance Futures are futures contracts on the realized variance of the S&P 500 index. This is in contrast with VIX futures, which trade on the implied volatility of the S&P 500; however, according to a CBOE press release, the ability to combine the two may have motivated their creation:
The S&P 500 Variance futures contract, like over-the-counter (OTC) variance swaps, allows users to trade the difference between the implied and realized variance of the S&P 500 Index. CFE's futures contract will offer the same quoting conventions and economic performance of OTC variance swaps, while providing the advantages of exchange-traded contracts -- transparency, price discovery and counterparty clearing guarantees.
Implied volatility, such as that calculated by the VIX index, measures forward-looking expectations for the movement of an index or asset price (is the volatility 'implied' by options prices).  Realized variance, however, is the degree actual fluctuations in an asset's value as they have occurred over a period of time.  The difference, often referred to as 'volatility arbitrage', has been of interest to investors and practitioners and has been calculated by the CBOE index VTY.  The payout formula for the new variance futures is enormously complex, but may serve as a useful technical indicator for sophisticated market analysts.

The other new product, SPX Variance Strips (nicknamed 'V-Strips', ticker VSTRP), is even more complicated, but may have an enormous impact on equity investing.  Very briefly, V-Strips allow investors to trade "a large and complex portfolio of SPX options in a single transaction"--namely, the portfolio of options that make up the VIX index.  In fact, V-Strips are "intended to replicate S&P 500 implied variance exposure."

The reason why this product is so significant is that until recently, the only way to obtain exposure to implied volatility was through VIX futures contracts or exchange-traded products that track VIX futures portfolios.  These products have seen numerous problems, but have become popular because many investors either want to bet on the 'fear gauge' properties of the VIX or because the VIX may serve as a hedge on the S&P 500 itself (see our two research papers on the subject).  If V-Strips in fact allow direct trading on the VIX portfolio itself, traders may be able to use them to hedge equity exposure in a way that other volatility products have failed to achieve.

It is clear that these products are extremely complicated, and their underlying assets would not typically be suitable for retail investors.  In fact, the CBOE very explicitly describes both of these products as designed for "qualified professionals," namely over-the-counter (OTC) customers who may benefit from an open and transparent market.  However, if the market for these products takes off, we can expect exchange-traded notes or funds linked to these futures contracts spring up quickly, just as we have seen a proliferation of ETNs and ETFs on VIX futures.  In that case, these incredibly technical innovations may find their way into the portfolios of unsophisticated retail investors.

Friday, October 5, 2012

SEC Litigation Releases: Week in Review

SEC Charges Unlicensed Financial Advisor James S. Quay for Defrauding Investors in Atlanta Area, October 4, 2012, (Litigation Release No. 22506)

According to the complaint (opens to PDF), James S. Quay, along with his brother Jeffrey A. Quay, conducted a scheme in which they convinced two elderly women to invest $560,000 into a sham limited partnership called Trinity Charitable Solutions. Quay, who has a history of defrauding the elderly, claimed the funds would be used to operate the program, but the brothers allegedly misused at least $180,000 of the funds for "mortgage payments, lavish restaurant meals, and membership at a massage spa." According to the complaint, Quay never revealed to these women that he is a convicted felon and disbarred attorney and that in the past he received $1.4 million in illicit sales commissions from fraudulent activity. James Quay has agreed to a final judgment which orders him to pay over $2 million in disgorgement, prejudgment interest and penalties. He has also agreed to a penny stock bar and to be barred "from appearing or practicing before the SEC as an attorney or an accountant."  The investigation against Jeffrey Quay remains pending.

SEC Charges San Francisco Investment Adviser and Its Owner for Fraud, October 4, 2012, (Litigation Release No. 22505)

According to the complaint (opens to PDF), hedge fund manager Hausmann-Alain Banet stole $550,000 from a retired schoolteacher who "thought she was investing her retirement savings in Banet's hedge fund." Instead of investing the money, Banet allegedly used it to pay personal and business expenses "including his home mortgage, office rent, and staff salaries." Furthermore, Banet gave the woman phony account statements showing "non-existent investment gains and listing an independent administrator that performed no actual work for the fund." Banet and his firm, Lion Capital Management, have been charged with violating sections of the Securities Act, Exchange Act, and Advisers Act.  Criminal charges have also been announced against Banet.

SEC Charges Chicago-Based Investment Adviser and Its Owners for Fraud, October 3, 2012, (Litigation Release No. 22504)

According to the complaint (opens to PDF), investment adviser GEI Financial Services, Inc. and its owners, Norman Goldstein and Laurie Gatherum, defrauded their advisory clients--"including the GEI Health Care Fund 2001, L.P.--by taking at least $147,000 in excessive fees and capital withdrawals from the Fund since 2009." Goldstein and Gatherum never told investors that "their investment adviser removed performance hurdles...in order to draw additional fees." Furthermore, the complaint alleges that the defendants never told their clients that in 2011 Goldstein was barred from providing investment advisory services in Illinois. Even with this bar, Goldstein "continued to make all investment decisions for GEI Financial's clients and for clients of GEI Management, LLC--an affiliated unregistered adviser owned by Goldstein and Gatherum."

SEC Charges Repeat Violator in South Florida with Fraudulently Offering Investments Tied to Oil Drilling Projects, October 3, 2012, (Litigation Release No. 22503)

According to the complaint (opens to PDF), Joseph Hilton made "misrepresentations to investors while selling limited partnership units in two oil drilling projects through his firm Pacific Northwestern Energy LLC." According to the SEC, Hilton falsely told investors that "Pacific acquired its wells from Exxon Mobil Corp., and he overstated Pacific's experience in the oil and gas industry [as well as] the historical accomplishments of its drillers." Hilton raised nearly $800,000 from these investors and raised an additional $2.5 million from investors through New Horizon publishing Inc., another company he controlled. Hilton allegedly deceived these investors about "his identity, the anticipated returns on the investments, the amount of oil being produced by U.S. Energy's wells, and the existence of natural gas wells." Furthermore, Hilton also operated a "boiler room of sales representatives paid on a commission basis." Hilton changed his name last year from Joseph Yurkin following a final judgment of fraud against him for securities offerings he made through Homeland Communications Corp. The SEC has frozen the assets of Hilton, Pacific, and the two limited partnerships, Rock Castle Drilling Fund LP and Rock Castle Drilling Fund II LP. The SEC seeks disgorgement, prejudgment interest, "financial penalties, and permanent injunctions against Hilton and his entities."

Former IndyMac CEO Agrees to Settle in SEC Litigation, October 1, 2012, (Litigation Release No. 22502)

On September 28, 2012, the Court entered a settled final judgment against IndyMac Bancorp, Inc's former CEO and Chairman, Michael W. Perry. According to the SEC, in 2008 IndyMac and Perry "failed to disclose that IndyMac Bank had only been able to maintain its well-capitalized regulatory status by retroactively including in IndyMac's first quarter capital balance an $18 million capital contribution from IndyMac to IndyMac Bank." The final judgment permanently enjoins Perry from violations of the Securities Act and orders him to pay an $80,000 penalty.

SEC Charges Three for Their Roles in Manipulating the Market for Sunrise Solar Corporation Stock, October 1, 2012, (Litigation Release No. 22501)

According to the complaint (opens to PDF), between July 25, 2008 and May 26, 2009 Sunrise Solar Corporation along with its former CEO, Eddie D. Austin, Jr., and Austin's wife, Carolyn Austin, were involved in a "fraudulent market manipulation scheme." During this time period, Eddie D. Austin "drafted, reviewed, and approved numerous false and misleading press releases that portrayed Sunrise as a thriving business operating in the solar power industry." Additionally, Sunrise allegedly filed, and Austin certified, "two annual reports that failed to disclose Austin's recent bankruptcy filing." Furthermore, Carolyn Austin allegedly received over $170,000 in improper proceeds from receiving and selling "300,000 shares of Sunrise stock in transactions that should have been registered with the Commission." The SEC has charged Sunrise and Eddie D. Austin with violating sections of the Exchange Act and Carolyn Austin with violating sections of the Securities Act. Together, the Austins must pay over $230,000 in disgorgement, prejudgment interest, and penalties. 

SEC Charges Former CFO with Evading Internal Controls to Pay for Unauthorized Travel and Entertainment Expenses, September 28, 2012, (Litigation Release No. 22500)

According to the complaint (opens to PDF), former CFO of Digi International, Inc., Subramanian Krishnan, "engaged in conduct which resulted in the filing of inaccurate reports and accompanying certifications in Digi's annual quarterly reports from March 2005 through May 2010."  Through Krishnan's conduct, corporate funds were used to pay for unauthorized travel and entertainment expenses. The complaint charges Krishnan with "caus[ing] the Company to file inaccurate reports, fail[ing] to enforce Digi's internal controls, demonstrat[ing] a lack of management integrity, fail[ing] to act to reveal inaccurate reports, and wrongly certify[ing] that he evaluated the effectiveness of Digi's internal controls and disclosed they were effective." Krishan has consented to an officer and director bar and to pay a to-be-determined amount of disgorgement, prejudgment interest, and civil penalty.

SEC Obtains Judgments and $12.9 Million in Monetary Relief Against Three Defendants Involved in 23 Corporate Hijackings, September 28, 2012, (Litigation Release No. 22499)

On August 2, 2012, final judgments were entered against Irwin Boock, Jason C. Wong, and Stanton B.J. DeFreitas "for their involvement in hijacking 23 defunct or inactive publicly-traded companies and subsequently making unregistered offers and sales of billions of shares." On March 26, 2010, "the Court entered a default as to Boock and DeFreitas," and imposed permanent injunctions against future violations of the Securities Act and Exchange Act. The Court also imposed a penny stock bar against Boock and DeFreitas, as well as an officer and director bar against Boock. On August 25, 2011, a summary judgment was entered against Wong "finding that the evidence was sufficient to establish that Wong had violated the registration requirements in relation to 12 of the hijacked companies." The August 2nd judgments hold Boock, Wong, and DeFreitas jointly and severally liable to pay over $12.8 million combined in disgorgement, prejudgment interest, and civil penalties. 

Wednesday, October 3, 2012

Holding an ETF During the Day vs. Holding Overnight

By Tim Husson, PhD and Tim Dulaney, PhD

Lately we've been reading the interesting new book by Eric Falkenstein on risk premia and low volatility investing.  We are long time followers of Eric's blog, which has a variety of interesting analyses of equity markets.

Following one of the figures in his book, we decided to look at two different strategies of investing in a given ETF where the holding period is on average one trading day.  In particular, we looked at the pricing data of SPDR S&P 500 (SPY) since inception and constructed two investment strategies:
  • Buy Close/Sell Open: The trader initially invests $100,000 in SPY at the close of business on January 29, 1993 and sells at the opening price on the next trading day (February 1, 1993).  Near the close of business, the trader invests the remaining portfolio value in SPY once again and then sells it at the opening price on the next trading day (February 2, 1993), and so on.  
  • Buy Open/Sell Close: The trader initially invests $100,000 in SPY at the opening price on February 1, 1993 and sells at the closing price on the same day.  The following trading day, the trader invests the remaining portfolio value in SPY and sells it at the closing price on this day (February 2, 1993), and so on.  
The first strategy is not exposed to the price movements of SPY during the trading day while the second strategy is not exposed to the price movements between the close and subsequent opening of trading.  The following plot (basically a replication of Eric's figure) presents the value of these investments over time.

Account Values of Portfolios Investing in SPY by Buying at the Open (Close) and Selling at the Close (Open)
While one might have intuitively expected these two accounts to have roughly the same value over time, the difference in their exposure to SPY leads to vastly different results.  Although it could be argued that both incur significant transaction costs, these should be comparable between the two accounts since they both trade the entire portfolio daily.  For reference, a buy and hold investor with an initial investment in SPY at inception would have over $328,000 just with price appreciation.

To further analyze these surprising results, we looked at the distribution of returns for the two scenarios and produced a histogram of the results below.  

Histogram of Daily Log-Returns for Portfolios Investing in SPY by Buying at the Open (Close) and Selling at the Close (Open)
The distribution of daily returns for the strategy of buying at the close and selling at the open exhibits a mean daily return of about 1.4 basis points and a standard deviation of about 0.3% while the distribution for the alternative strategy exhibits a very small negative mean return and a standard deviation of about 0.5%.

We think that these results are both interesting and counter-intuitive, and will follow up with more analysis in the coming days and weeks.