## Tuesday, November 26, 2013

### BDCs as the New REITs

By Tim Husson, PhD

Brendan Conway at Barrons had an interesting piece back in September about business development companies (BDCs) and their similarities to real estate investment trusts (REITs).  His story highlighted that BDCs in some sense resemble REITs in the 1990s, in that they are considered "previously exotic areas that went mainstream."  Indeed, we are seeing more and more coverage of BDCs in the mainstream media, along with the troubling development of non-traded BDCs, just as we have seen non-traded REITs.

We discussed the similarities between non-traded BDCs and non-traded REITs back in February 2012.  Essentially, both BDCs and REITs are unique types of companies that are required by the IRS to distribute the vast majority of their earnings as dividends each year.  REITs invest in real estate, while BDCs invest in privately owned companies.  There are a number of traded REITs and BDCs on the New York Stock Exchange, which in turn are held by REIT or BDC mutual funds and exchange-traded funds.

But there are also a growing number of non-traded BDCs.  Non-traded BDCs, like non-traded REITs, are not traded on a public exchange, but are sold to retail investors through brokers who receive very large sales commissions.  The total upfront fees for non-traded BDCs are very high; for example, the most recent prospectus for Corporate Capital Trust notes upfront sales loads of 10%.  In addition, non-traded BDCs also charge '2-and-20' management fees:  2% of total assets plus 20% of profits.  This fee structure is characteristic of hedge funds--where it is widely criticized--but not of retail investments.

So just as we warned investors that non-traded REITs are not the same as traded REITs, we also want investors to appreciate the difference between traded and non-traded BDCs.  But this issue raises a larger question.  Given that there are traded BDCs and REITs, which can be bought and sold as cheaply as any other stock, are high-cost non-traded BDCs and REITs ever appropriate?  After all, they are in the same market for properties or private companies.  Is there any reason to believe that non-traded REITs or BDCs would be able to pick better investments than than their publicly listed counterparts?  We think the answer is no.

## Monday, November 25, 2013

### Monte Carlo Simulation, Explained

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Valuing products with exotic derivatives can be difficult since these products typically have complex payoff formulas.  One of the most flexible methods for valuing such products is called Monte Carlo simulation.  At SLCG, we use Monte Carlo simulation in a lot of our work, so we thought it would be helpful to explain a bit about it and show how it can be used to estimate the future returns of an asset.

The basic idea behind Monte Carlo simulation is to determine the statistical properties (e.g., mean and standard deviation) of the underlying security's returns, then to randomly pick returns that have those characteristics.  If you do this many times, you will generate many 'paths' of the underlying asset.  Then you can apply the payoff formula of the product to each path and average the result to determine the value of the product.

This might sound a little complicated.  We've created a simple tool that lets you simulate possible asset values based on log-normally distributed returns (which are commonly assumed for financial assets). Change any of the sliders to see their effect on the projected returns.

 Number of Years: Number of Simulations: Mean Return: Volatility:

For a given average (mean) return and volatility, Monte Carlo simulation let us draw many possible price paths and average the results. With enough simulations, the resulting returns are distributed log-normally.  These returns could be those of the S&P 500, the spot price of a commodity, a foreign exchange rate, or any other asset (though the log-normal assumption may not always be appropriate).

The graphs above plot many possible price paths (grey lines) for the asset and the average of all paths (black line). You can change the number of years to simulate, the number of simulations, the mean annual return, and the volatility using the sliders. We also plot the distribution of final returns in the lower panel, as well as the theoretical log-normal distribution implied by the chosen mean return and volatility.

This type of simulation is used to value options embedded in structured products and many other financial products that depend on the future value of an asset.  The flexibility of  the Monte Carlo framework allows practitioners to include the effect of, for example, mortality risk when valuing annuities, which is very difficult to value using any other method.  As products become ever more complex, Monte Carlo simulation is likely to become more and more important to both practitioners and investors.

## Friday, November 22, 2013

### SEC Litigation Releases: Week in Review

Court Enters Final Judgment by Consent Against SEC Defendant Corey Ribotsky, November 21, 2013, (Litigation Release No. 22873)

A final judgment was entered against Corey Ribotsky who, along with The NIR Group, LLC, allegedly made "false statements to investors regarding the poor performance and trading strategy of the various AJW Funds he managed" during the financial crisis. Ribotsky also allegedly "misappropriated client assets and misled investors about the decision to form the AJW Master Fund." The final judgment permanently enjoins Ribotsky from future violations of the securities laws and orders him to pay $14.5 million in disgorgement, prejudgment interest, and penalties. The SEC has also barred Ribotsky from "association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, with the right to reapply after four years." Claims against NIR have been dropped "because that entity is defunct and has no assets." Former Rochdale Securities Broker Sentenced to 30 Months' Imprisonment for Rogue Trades, November 21, 2013, (Litigation Release No. 22872) David Miller was sentenced to "30 months imprisonment, followed by three years of supervised release, for his role in a fraudulent scheme to place a series of unauthorized purchases of more than 1.6 million shares of Apple, Inc. stock on October 25, 2012 while employed as an institutional sales trader for Rochdale Securities LLC." His scheme caused Rochdale to suffer a loss "of$5,292,202.50 and [cease] all business operations." Chatigny has also been ordered to make full restitution to Rochdale. Based on the SEC's action, Miller had previously been permanently enjoined from violating the federal securities laws and barred from "association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, and...from participating in any offering of penny stock."

SEC Files Subpoena Enforcement Action Against Edward M. Daspin for Failure to Testify in Offering Fraud Investigation, November 18, 2013, (Litigation Release No. 22871)

Last Friday, the SEC filed an enforcement subpoena action against "Edward Michael Daspin, also known as 'Edward Michael' and 'Ed Michael,'" which calls for Daspin's "testimony in an ongoing investigation into...potential fraud in the offer and sale of securities of three related companies, Worldwide Mixed Martial Arts Sports, Inc., WMMA Distribution, Inc. and WMMA Holdings, Inc."

SEC Charges Former Level Global Investment Banker with Insider Trading, November 14, 2013, (Litigation Release No. 22870)

According to the complaint (PDF), Mark Megalli, "a former investment banker at Level Global Investors, L.P.," caused Level Global to trade on insider information in Carter's Inc. securities. This insider trading caused Level Global to allegedly profit and avoid losses "in excess of $3 million dollars." The SEC has charged Megalli with violating the securities laws and seeks a permanent injunction, disgorgement, prejudgment interest, and civil monetary penalties. ## Tuesday, November 19, 2013 ### Variable Annuity Fees Linked to the VIX -- Part II By Tim Dulaney, PhD, FRM and Tim Husson, PhD In our last post, we discussed a whitepaper that proposed linking the fees in a variable annuity to the CBOE Volatility Index (VIX). That paper ran a simple backtest of a variable annuity fee tied to the VIX over the period from 1990-2012, assuming certain parameters, and then compared the result to a fixed fee annuity over the same period. We have replicated their approach between January 1990 and January 2013 and found that not only are the fees and ending account values comparable, but so are the aggregate amount of withdrawals. We confirmed that a multiplier of approximately 5 results in a comparable average daily fee between the VIX-based variable fee account and the fixed fee account. This example illustrates some properties of a VIX-linked fee, but is a bit simplistic. We found an actual variable annuity that uses this type of fee structure: the SunAmerica Polaris line of variable annuities (see the Appendix in each prospectus). What they use is a bit more complicated. The annualized fee for the SunAmerica products is fixed for the first year (at 1.10%) but in later years fluctuates based on the value of the VIX, similar to the whitepaper's example. However, the VIX-based fee is subject to a minimum (0.60%) and a maximum (2.20%), and cannot decrease or increase by more than 0.25% per quarter. The formula for the annualized quarterly fee is: Initial Annual Fee Rate + [0.05% * (Average Value of the VIX - 20)] subject to the above constraints. The average is calculated based on the daily market close on all days during the relevant quarter (we assume they mean the close on any trading day). Because of these additional constraints, the VIX-based fee on the Polaris product is less sensitive to VIX movements than the simple example in the CBOE whitepaper. However, it is still negatively correlated with the S&P 500, and does fluctuate a great deal: Interestingly, if the provision that the fee cannot increase by more than 0.25% per quarter is relaxed, the fee would have hit the maximum level during the recent financial crisis and, in the absence of the cap, would have exceeded the cap. In the following figure, we plot the fees that would have been applied in the absence of the constraints (cap, floor and maximum increment) along with the applied fees for the variable account above. This unconstrained alternative is similar to the simplistic approach used in the CBOE white paper.** It is clear that the constraints make little difference except during the financial crisis of the late 2000's. While this calculation is described in the prospectus, there is no discussion of the VIX itself, most notably its negative correlation with the S&P 500. In fact, the only description of the VIX states simply that it is "an index of market volatility reported by the Chicago Board Options Exchange," and that if the market is in a period of high volatility the fee will increase and if in a period of low volatility it will decrease. The product brochures do not mention the VIX at all. Unsophisticated investors may not realize that this means their fee is likely to grow when their account values are declining, unlike traditional variable annuities. ______________________________________________ ** The simplistic approach of the CBOE white paper does not explicitly mention averaging the VIX levels, but we averaged for the sake of comparability. ## Monday, November 18, 2013 ### Variable Annuity Fees Linked to the VIX -- Part I By Tim Dulaney, PhD, FRM and Tim Husson, PhD We've discussed the CBOE Volatility Index -- known as the VIX -- many times before. Essentially, the VIX is a very complex calculation of the expected future variance of the S&P 500 (see full calculation methodology here), and is popularly known as the 'investor fear gauge'. The VIX is not a tradeable asset, but there are VIX options and futures contracts, and those contracts serve as the basis for several VIX-related exchange-traded products (TVIX, XIV, VXX to name a few). The VIX is very often misunderstood and we think that investments linked to the VIX are almost always too complex and risky for retail investors. We've also talked about variable annuities, which are investments that have been the subject of regulatory scrutiny over the past few years due to their complexity and potentially insufficient disclosures of fees. Given that context, we were surprised to see that the CBOE has a white paper (PDF) that describes linking variable annuity fees to the VIX. The authors note that the insurance giant AIG has a patent application pending for this design. Before we get into the details of that paper, the most obvious concern about this proposition is how such a fee could be fairly disclosed to potential annuity purchasers. Variable annuity fees can be complex to begin with, and understanding the VIX requires serious study and some quantitative background. For example, one critical feature of the VIX is that it tends to be negatively correlated to the S&P 500. Therefore, investors should at the very least understand what negative correlation is, what it means, and how it comes about, which is a subject of academic research including our own (PDFs). We think it's worth asking how retail investors could be expected to understand the implications of the VIX on their variable annuity fees, when the VIX itself is so complex. But there are other concerns as well. Linking fees (an outflow) to the VIX is, from the investors' point of view, similar to a short position on the VIX. Because VIX returns are negatively correlated with S&P 500 returns, that means that the fees will likely spike when the S&P 500 crashes. Therefore, an investor in an S&P 500 linked variable annuity will be paying lower fees when the S&P 500 is rising and more in fees when the value of that annuity is declining. This would also be difficult to explain to most retail investors. The paper contains an illustrative example that compares a fixed fee of 1% to a VIX-linked fee. The authors find that the variable VIX-linked fee is roughly equivalent to the 1% fixed fee if the variable fee, in basis points, is approximately 4.8 times the VIX level.* An important point though is that this fee was determined ex post--in other words, after the fact. An insurer would likely charge a different fee based upon different expectations of the VIX during the term of a variable annuity since the fee needs to be determined at the inception of the contract (ex ante). Again, it would be difficult for an investor to determine if such a multiplier fairly priced his or her annuity. The reason variable annuity issuers might be interested in this approach is that the VIX also indirectly measures the cost of the hedging position most variable annuity issuers use (a rolling call option strategy). By linking the fees to the VIX, the issuers could charge higher fees when their hedge is more expensive to obtain. While that may help solve a problem for the issuers, it is unclear what benefit that would have to investors, especially at the cost of greatly increased complexity. In our next post, we'll dive a little deeper into just how this VIX-based variable annuity fee works and how it might actually be implemented in a real annuity contract. Stay tuned! __________________________________________ * This multiplier shouldn't be a surprise since the average VIX level was around 20.5 for the period considered by the authors (1990 to 2012). So if we want the average daily fee to be equal to the average daily fee in the fixed account (100 basis points), then we would need a multiplier of about 4.88. ## Friday, November 15, 2013 ### SEC Litigation Releases: Week in Review Court Orders Charles T. Lawrence to Comply with Commission Subpoena, November 13, 2013, (Litigation Release No. 22869) This week, the Court ordered Charles T. Lawrence to "to comply with an investigative subpoena previously served on him and relating to his formerly registered investment adviser, Chasson Group." According to a previous litigation release, the SEC's application (PDF) alleges that in April of this year, "the SEC issued a Formal Order Directing Private Investigation entitled In the Matter of Chasson Group, Inc." Lawrence has allegedly failed to comply with the "subpoena for documents and testimony relating to this investigation, which involves, among other things, possible (i) misappropriation of client funds, (ii) false or misleading statements in forms Chasson Group filed with the Commission, and (iii) acting as an unregistered broker-dealer." Commission Files Subpoena Enforcement Action Against Bobby Jones, Raymon Chadwick, Terry Johnson, Innovative Group, Redwater Funding Group, LLC and Expectrum, LLC, November 13, 2013, (Litigation Release No. 22868) Last week, the SEC filed an application to enforce "investigative subpoenas served on" Bobby Jones, Raymon, Terry Johnson, Innovative Group, Redwater Funding Group, LLC, and Expectrum, LLC. In June, the SEC issued a "Formal Order of Private Investigation entitled In the Matter of Janus Spectrum that authorized its staff to investigate, among other things, whether Janus Spectrum LLC or its affiliates may be involved in the possible offer or sale of unregistered securities, or other violations of the securities laws." The respondents allegedly refused to comply with the subpoenas "based on several objections, including objections under the First, Fourth, Fifth, and Fourteenth Amendments." ## Thursday, November 14, 2013 ### How Does VolDex Stack Up to the VIX? By Tim Dulaney, PhD, FRM and Tim Husson, PhD We've talked a lot about the idea of using volatility to hedge equity exposure. The basic finding, from our research work and that of others, is that the CBOE Volatility Index (VIX) hedges the S&P 500 fairly well. Unfortunately, the VIX is not investable, but is a complicated calculation based on a large strip of options contracts -- i.e., contracts of varying moneyness. Proxies for the VIX, such as rolling VIX futures strategies, are much worse hedges and have a number of problems that make them extremely unattractive investments.* NationsShares, an index provider that specializes in options-based indexes, is now providing a new volatility index called the Nations VolDex Index (ticker: VOLI). Instead of using a broad strip of options contracts, VolDex only looks at "the implied volatility of a precisely at-the-money option due to expire in precisely 30 days" linked to SPY, the largest S&P 500 exchange-traded fund (ETF). NationsShares claims that not only is this SPY option more liquid than the VIX's SPX options, but that by calculating implied volatility of a single option means that their index can be replicated relatively simply. While the differences between the VIX and VolDex might seem technical, they are actually very significant. The CBOE has responded to some of the claims made by NationsShares in a recent Risk.net piece, specifically noting that the VIX does not measure implied volatility (a point we have made numerous times ourselves), but prices future S&P 500 variance. In fact, when the VIX was first issued in the early 1990s, it did use implied volatilities, but revised its methods in 2003 to bring it more in line with the academic literature (PDF) on variance swaps. The CBOE also clarifies a few misconceptions that NationsShares seems to be encouraging through the marketing of their index. One major difference between the VIX and VolDex that the CBOE does not discuss is exposure to volatility skew. Volatility skew is the empirical observation that the implied volatility of options contracts tends to vary with different strike prices, such that out-of-the-money and in-the-money options have markedly different implied volatilities. For some background, you can check out our paper (PDF) on volatility skew in leveraged and inverse leveraged ETF options. VOLI will not incorporate any information about volatility skew because it only looks at one strike price -- the 'at-the-money' option. On the other hand, the VIX includes many in- and out-of-the-money options in its calculation. Nations claims that this skew effect is "statistical noise", and has even created a separate index -- the Nations SkewDex Index (PDF) -- to measure it. It has been noted before that the VIX does tend to overestimate actual volatility; however, the academic literature notes that volatility skew is important to accurately pricing variance swaps, which is why it is incorporated into the VIX methodology. Furthermore, VolDex uses a proprietary algorithm for calculating implied volatility from observed options prices. The VIX methodology is highly complex, but fully disclosed in the CBOE's white paper. The International Securities Exchange has entered into a licensing agreement to list cash-settled European options linked to VolDex, and may also offer options, futures, or exchange-traded products linked to the index as well, meaning that retail investors may soon be able to purchase access to this index. However, unless NationsShares publishes the full methodology, investors will not be able to fully understand what their underlying exposure actually is. It will be interesting to see if VolDex is adopted by traders and analysts, as well as how it responds relative to the VIX during spikes in volatility. It will also be interesting to look at its ability to hedge equity portfolios, as so many other products have tried to do using VIX derivatives. However, there are many reasons to believe that its relationship to S&P 500 volatility will be less clear than the current standard. _________________________________________ * For related research, see our paper "Are VIX Futures ETPs Effective Hedges?" (PDF) which appeared in the Journal of Index Investing in winter 2012 (Vol. 3, No. 3, pp. 35-48). ## Wednesday, November 13, 2013 ### Athlete-Backed Securities and Credit Risk By Tim Dulaney, PhD, FRM and Tim Husson, PhD The financial media has been abuzz about Fantex, a brokerage firm that is offering investments linked to the earnings of professional athletes. Their first offering was linked to 20% of the future earnings of Houston Texans running back Arian Foster, and the second was for a 10% interest in the future earnings of San Francisco 49ers tight end Vernon Davis.* At first, the plan was met with some skepticism (and some ridicule), which was only magnified when last Sunday both Foster and Davis sustained injuries, including a season-ending back injury to Foster. The IPO of the Foster-linked shares have since been postponed. Now, we don't know a lot about sports (we're more the nerdy type). But we do know a bit about esoteric, highly risky securities, so we thought we'd take a peak under the hood of this one. According to the prospectus for the Foster series, the value of such an investment is determined by the potential future earnings Arian Foster might earn on, or off, the field. Foster is giving up 20% of his future earnings in exchange for an upfront payment of about$10 million.  If the initial public offering of the shares generates sufficient interest, the shares would trade on an exchange operated by Fantex.  The transaction costs associated with buying and selling the shares on the Fantex exchange "are expected to be up to 1% of the total amount of the purchase or sale."

Few, if any, people will be able to accurately predict the future earnings potential of a professional athlete.  NYU professor and valuation expert Aswath Damodaran gave it a shot, pegging the Foster shares at only 61% of the offering price.  But as he notes, that involved a number of assumptions.  One of those assumptions was that Foster would play until he is 36 years old -- another nine years -- and another was that there would be a 5% chance of a career-ending injury each year.

In finance, the analogy is to credit risk, or the risk that an entity will default on its obligations.  Credit risk is notoriously difficult to measure (at least without liquid credit default swap spread data), and numerous models exist for single-issue credit risk as well as portfolio credit risk.  The Foster shares are essentially undiversified, which maximized their injury risk.

Indeed, running backs have the highest injury rate of all NFL positions.  Jason Lisk has a great series of posts about injury risk to running backs, which varies by workload (number of carries) and even the closeness of games.  Arian Foster certainly got a lot of work in the past two seasons, and his injury risk might have been particularly high.  As any fantasy football player likely appreciates, injury risk is very significant in the NFL and a team's success is in no small way determined by its portfolio 'credit' (or injury) risk.**

Thus Fantax's (perhaps brief) experiment with athlete-backed securities has highlighted one of the most important lessons in investing:  diversification.  Individual entities, whether they be the debt of Fortune 500 companies or shares of a pro athlete's future earnings, have idiosyncratic risk that is difficult to predict.  Often the best bet is to invest in a very broad portfolio of many different types of securities, such that the risk of any one default is relatively small.

Since this was not really possible with the Foster or Davis shares, it's unclear whether such securities would be suitable for any retail investor.  Time will tell if any other similar products ever...wait for it...make it to the big leagues.
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Interestingly, investors in the Foster or Davis series are actually investing in the Fantex business model.  Importantly, Fantex has structured the offerings such that the shares can be converted into "Shares of [Fantex] Platform Common Stock" at any time under the direction of Fantex's board of directors -- not the investor.   Although the value of the Foster series may be linked to the performance of Arian Foster, in the end "[w]hat you are investing in is Fantex the brokerage."

** You could get some injury diversification by buying shares in a whole team rather than just a player.  Unfortunately, there is only one pro sports team that is publicly traded:  the Green Bay Packers.

### FINRA Announces Enhanced BrokerCheck System

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Yesterday the Financial Industry Regulatory Authority announced an enhanced version of their BrokerCheck system.  We regularly suggest that investors consult FINRA's BrokerCheck since these records contain important information about complaints and specific actions about individual brokers and firms.  According the FINRA Executive Vice President Derek Linden, investors "using BrokerCheck will encounter a more user-friendly interface that allows them to quickly find information that can help them decide if an investment professional is right for them."

The new incarnation of BrokerCheck has a more intuitive feel and presents investors with a graphical timeline of a broker's experience.  This timeline shows the employment history with prior registrations and includes disclosure events.  The timing of these disclosure events can be particularly enlightening when the broker changes firms following around the time of such an event.

## Tuesday, November 12, 2013

### Study Finds that the Average PE Investor Just Breaks Even

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Brendan Conway over at Barron's pointed out an interesting new study (PDF) from the National Bureau of Economic Research entitled: Valuing Private Equity.  Private Equity (PE) investments -- typically called limited partnerships (LPs) -- are long-term, illiquid securities representing (perhaps not surprisingly) an equity interest in a private company.  Investors are typically referred to as limited partners.  The study notes that while private equity returns tend to be high, "it remains controversial whether this outperformance is sufficient to compensate investors (LPs) for the costs of risks and long-term illiquidity."

Typically, a PE equity firm manages the investment and serves as a general partner (GP) -- collecting annual management fees of 1%-2% as well as incentive fees of around 20% of the profits.1  In principle, such incentive fees are meant to increase the returns investors will realize, but with increasing returns comes increasing risk.

The authors of Valuing Private Equity argue that the GP "must generate sufficient risk-adjusted excess return" to compensate the LP for bearing the liquidity risk and performance fees.  The authors find that the illiquidity of PE investments is as large of a cost to LPs as total GP compensation.   In particular, the study finds that "LPs may just break even, net of management fees, carry, risk, and costs of illiquidity."  PE investments carry significant risk for potential LPs and any investor considering such an investment should fully weigh the cost of illiquidity and GP compensation.

These findings are particularly interesting given that several new retail investments are targeting private equity or private equity-like allocations.  Brendan's article mentions the PowerShares Global Listed Private Equity Portfolio (PSP) exchange-traded fund, but non-traded business development companies (BDCs) also invest in high risk ventures, such as emerging or distressed companies.  Retail investors should therefore familiarize themselves with the risks of private equity investing before considering such strategies.
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1Incentive fees are sometimes referred to as "carried interest" in PE.

## Monday, November 11, 2013

### Structured Product Fees and Credit Risk

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Kevin Dugan noted in the April edition of Bloomberg's Structured Notes Brief that "Citigroup collected the highest average fees in the first quarter [of 2013] among the 10 biggest underwriters of U.S. structured notes."  This got us wondering, is there any relationship between the credit quality of the underwriter and the fees the underwriter collects?  If investors truly understood credit risk, issuers with higher credit risk would presumably have to structure products with lower fees to entice investors.  All else equal, as credit risk increases, the fee should decrease.1

To explore this question, we obtained the rates on one-year credit default swap (CDS) contracts for nine of the ten underwriters -- data was unavailable for Royal Bank of Canada.  The rate on a CDS contract reflects the perceived likelihood that an issuer will be unable to pay their obligations as they become due.  Essentially the higher the CDS rate, the higher the probability of default.

We averaged the daily observations of the CDS rates over the first quarter 2013 and plotted them against the results of Kevin's study on structured note fees (CDS rates are quoted in basis points with 100 basis points = 1%):

This analysis shows that higher fees don't necessarily mean the underwriter is of higher credit quality -- lower CDS rate.  Morgan Stanley and Barclays had the highest perceived risk of default in the first quarter 2013, but still charged fees higher than the average for this group of nine.  On the other hand, Citigroup charged the highest fees and was the median underwriter with respect to perceived risk of default.

Investors considering structured notes should remember that these products are often short term and carry high fees (both explicitly stated and implicit in their structuring).  In addition, investors are exposed to the credit risk of the issuer.  This is sometimes forgotten in the complex structure, but a structured note is still basically single-name corporate debt from a financial company.

In a perfectly liquid market, in which all investors understood and appreciated credit risk, we might expect that riskier issuers would have to compensate investors with lower fees or better terms on the notes.  At least in regards to fees, that does not appear to be the case in the real world.
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1 This analysis assumes, for simplicity, that issuers would not change the features of the products (cap levels, etc.) to compensate investors for credit risk.

## Friday, November 8, 2013

### SEC Litigation Releases: Week in Review

SEC Charges Royal Bank of Scotland Subsidiary with Misleading Investors in Subprime RMBS Offering, November 7, 2013, (Litigation Release No. 22866)

According to the complaint (PDF), RBS Securities Inc. (a subsidiary of the Royal Bank of Scotland plc) misled investors "in a 2007 subprime residential mortgage-backed security (RMBS) offering" by stating that the "loans backing the offering 'generally' met the lender's underwriting guidelines." According to the SEC, nearly 30 percent of the loans "fell so short of the guidelines that RBS should have excluded them from the offering entirely." RBS has agreed to a final judgment that orders it to pay over $150 million in disgorgement, prejudgment interest, and civil penalties. SEC Obtains Final Judgment Against Defendants Charged with Perpetrating$35 Million International Boiler Room Scheme, November 7, 2013, (Litigation Release No. 22865)

A final judgment was entered against Nicholas Louis Geranio, The Good One, Inc., and Kaleidoscope Real Estate, Inc. "for their roles in a $35 million scheme to manipulate the market and to profit from the issuance and sale of certain U.S. companies' stock through offshore boiler rooms." According to the SEC, from 2007 to 2009, Geranio organized eight companies: Green Energy Live, Inc., Spectrum Acquisition Holdings, Inc., United States Oil & Gas Corp., Mundus Group, Inc., Blu Vu Deep Oil & Gas Exploration, Inc., Wyncrest Group, Inc., Microresearch Corp., and Power Nanotech, Inc. Geranio then "installed management, and entered into consulting agreements with them through his alter-ego entities The Good One and Kaleidoscope." Geranio then allegedly used boiler rooms to raise money and direct "traders to engage in matched orders and manipulative trades to establish artificially high prices for at least five of the Issuers' stock." The final judgment permanently enjoins the defendants from future violations of the securities laws, orders them to pay over$3 million in disgorgement, prejudgment interest, and penalties, places a penny stock bar against them and places an officer-and-direct bar against Geranio. The judgment also "order[s] relief defendant BWRE Hawaii, LLC to pay, jointly and severally with Geranio, The Good One, and Kaleidoscope, an additional $240,000 in disgorgement plus prejudgment interest thereon of$55,295."

The Commission Dismisses Its Claims for Disgorgement and Prejudgment Interest Against Charles O. Morgan, Jr., as Personal Representative of the Estate of Frederick J. Kunen, November 7, 2013, (Litigation Release No. 22864)

The SEC has dismissed its claims "for disgorgement and prejudgment interest against Charles O. Morgan, Jr.,  in his capacity as personal representative of the probate estate of Frederick J. Kunen, because Kunen's Estate was placed under Receivership."

SEC Files Subpoena Enforcement Action Against Anthony Coronati for Failure to Produce Documents and Appear for Testimony in Investigation of Solicitations Relating to Pre-IPO Securities, November 5, 2013, (Litigation Release No. 22863)

The SEC has filed a subpoena enforcement action (PDF) against Anthony Coronati. The Court then entered "an order directing Coronati to show cause (PDF) why he should not be ordered to comply with the subpoenas." According to the SEC, "Coronati and others have violated or are violating registration, anti-fraud, or other provisions of the federal securities laws in connection with a business known as Bidtoask.com." Coronati has allegedly ignored the subpoenas by "never produc[ing] any documents, appear[ing] for testimony, or otherwise respond[ing] to the subpoenas." The SEC's application seeks an order that compels "Coronati to comply fully with the subpoenas."

SEC Halts Ponzi Scheme Involving New Zealand Companies, November 5, 2013, (Litigation Release No. 22862)

According to the complaint (PDF), Christopher A.T. Pedras misled his initial investors into believing they were investing in a profitable trading platform, "Maxum Gold Small Cap Trade Program, in which Pedras's company Maxum Gold purportedly serves as the intermediary between banks that can't legally trade with each other directly." When Pedras and his companies "encountered difficulty paying the promised 4 to 8 percent monthly returns," they began steering investors to invest in a "New Zealand company called FMP Medical Services Limited that would" supposedly "be publicly traded and operate kidney dialysis clinics in New Zealand." According to the SEC, both of these investment "opportunities" were part of a Ponzi scheme that "paid investors more than $2.4 million in 'returns' using new investor money." Pedras allegedly stole over$2 million from investors through the scheme.

The complaint charges Pedras, Sylvester M. Gray II (his business partner), Alicia Bryan (a lead sales representative), Maxum Gold Bnk Holdings Limited, Maxum Gold Bnk Holdings LLC, FMP Medical Services Limited, and FMP Medical Services LLC with violating the Securities Act and Exchange Act. The complaint also names Comptroller 2013 as a relief defendant. A temporary asset freeze has been placed against the defendants and a hearing has been scheduled for November 20th.

## Thursday, November 7, 2013

By Tim Husson, PhD

Issuers of new exchange traded funds (ETFs) have a problem:  how to attract enough investment to keep the fund alive.  ETFs have a relatively high turnover rate, and many of the funds that fail simply never gained significant assets under management.  Also, if the fund is not traded frequently, it is likely to have a wide bid-ask spread, further reducing investor interest.

One solution that a few ETF issuers have recently adopted involves building ETFs with a particular customer in mind.  Back in April, iShares launched three ETFs that were developed in collaboration with the Arizona State Retirement System -- with each receiving initial investments of $100 million. Those funds were designed to track aspects of an MSCI equity index. Recently, this idea has been taken even further. Earlier this month, a new nonprofit ETF issuer, Vident Financial, issued its first ETF, the Vident International Equity ETF (VIDI). According to IndexUniverse, both the fund and the issuer were developed in conjunction with investment advisory firm Ronald Blue & Co., who is reportedly responsible for most of the fund's initial assets under management. The fund invests in international equities based on a highly customized, "principles-based" selection strategy. This approach "identifies countries outside the United States that promote human productivity, as measured by dozens of research metrics" and allocates "among developed and emerging markets in countries that exhibit an adherence to these principles." Investors should perhaps be cautious about ETFs developed in this fashion. If an issuer develops a fund with a particular client in mind, and that client invests an overwhelming majority of initial assets, then that client may have a disproportional influence on the fund either through its relationship with management or through its large trading capacity. For example, if that client were to liquidate its shares, the ETF itself might liquidate or have significantly reduced trading volume. Also, this approach might not solve the liquidity problem faced by many new ETFs. While having a large client lined up might solve the problem of attracting sufficient assets under management to make the ETF profitable, it does not necessarily ensure that the fund will trade at a small bid-ask spread. In all, the benefits of securing a large investor are mostly for the issuer, while the potential downsides might fall more on the fund's other investors. It will be interesting to see if more ETF issuers adopt this approach. If so, this might be another risk factor for ETF investors to be aware of. ## Wednesday, November 6, 2013 ### SEC Charges Municipal Issuer with Misleading Investors By Tim Dulaney, PhD, FRM and Tim Husson, PhD Yesterday, the Securities and Exchange Commission (SEC) charged the Greater Wenatchee Regional Events Center Public Facilities District, a group of nine cities and counties in Washington state, with misleading investors in connection with a bond offering meant to finance the construction of an event center. According to the press release, this is " the first time that the SEC has assessed a financial penalty against a municipal issuer." In 2008, the municipal issuer issued nearly$42 million in municipal bonds to finance the Town Toyota Center in Wenatchee, WA.  In the official statement (PDF), the issuer claimed that the financial projections had not been "examined by any financial adviser or by any accounting or other firm in order to verify [...] the reasonableness of the assumptions". The municipality failed to disclose that an independent consultant had twice provided financial projections for the event center that were pessimistic about the center's economic viability. Rather than disclosing these projections, the issuer relied upon "optimistic assurances [of] civic leaders".  The events center ended up underperforming the optimistic projections in the offering documents.

In addition, the SEC alleges that the issuer mislead investors by omitting information about the limited debt capacity of the city.  This limited debt capacity constrained the city's ability to repay the 2008 bonds when they matured in 2011.  As a result, Greater Wenatchee Regional Events Center Public Facilities District defaulted on payment of principal on the notes in December 2011.  The municipal issuer has been ordered to pay a $20,000 penalty for its transgressions related to the 2008 bonds. In addition, the bond's underwriter, Piper Jaffray & Co., was censured and fined$325,000 for "fail[ing] to develop a reasonable basis for believing the accuracy of key representations made in the official statement."  Piper Jaffray must also "retain an independent consultant to conduct a review of the firm’s municipal underwriting due diligence policies and procedures as well as its supervisory policies and procedures relating to municipal underwriting due diligence."  For more information, see the SEC's order (PDF).

## Tuesday, November 5, 2013

### SLCG Research: Structured Product Indexes

By Tim Dulaney, PhD, FRM and Tim Husson, PhD

Most research on structured products focuses on what is known as initial date mispricing -- the difference between what a product costs and how much it is worth, as of the issue date.  If you look at any of our structured product reports (let's take this reverse convertible, for example), you can see that the product was issued at a price of $1,000, but that the present value of its resulting cashflows only comes out to$960.40.  The difference, $39.60 or 3.96%, represents an expected loss to the investor. We and others have documented issue-date mispricing on many types of structured products -- for example: reverse convertibles, dual directionals, absolute return barrier notes, etc. But you might be wondering, how have structured products actually performed? Have structured product investors actually fared well, or poorly? These are pretty tricky questions. In order to answer it for any given time period, you would have to look at how the value of all outstanding structured products changed on each day. But since structured products don't have liquid secondary market prices, you would have to actually value each structured product on each day, and aggregate the returns to see how structured products as a whole have performed. In our latest research paper, released today, we do exactly that. We use our sample of over 18,000 structured products and value every outstanding structured product in that sample every day, then weight each return by the face value of the note and combine those returns. The result is an index of ex post structured product returns, which we calculate over a period from 2007 to April 2013. We also calculate subindexes for four popular structured product types: reverse convertibles, single-observation reverse convertibles, autocallables, and tracking securities. These indexes show the ex post returns to large numbers of products over time. But to answer the question: structured product returns have been poor. Structured products as a whole have had lower returns than either bonds or stocks over this period, as have each of the four subtypes we have studied. In addition, structured product returns are highly correlated with the S&P 500, suggesting little diversification benefit. We have also studied the performance of individual structured products. We find that the majority of structured products underperformed stock and bond portfolios -- see Table 6 and Figure 8 (reproduced below). In the following figure, we plot how frequently stock and bond portfolios overperform structured products, measured by the difference between the returns on stock and bond portfolios and contemporaneous structured product returns. The black bar marks a 0% difference in returns. The fact that the majority of the weight in each of the above distributions is found to the right of the black bar indicates that stock and bond portfolios generally overperform contemporaneous structured products. To our knowledge, this is the first large-scale study of ex post US structured product returns. We encourage you to check out the paper for details on our methodology and results, which we think have import implications for structured product investors. ## Saturday, November 2, 2013 ### FINRA Investor Alert: Closed-End Fund Distributions By Tim Dulaney, PhD, FRM and Tim Husson, PhD The Financial Industry Regulatory Authority (FINRA) recently released an Investor Alert to draw investors attention to the subtle difference between distributions and returns in the context of closed-end funds. Closed-end funds are pooled investments like mutual funds (which are also known as 'open-end funds'), but have only a fixed number of shares. This distinction has a big impact on how the fund is analyzed. Distributions from closed-end funds are typically quoted as a rate (e.g. 6%). This rate is calculated by "annualizing the most recent amount paid to investors and dividing the resulting amount by either the market price or the fund's" net asset value (NAV). For example, if a closed-end fund with NAV of$10 per share paid $0.05 per share in the last monthly distribution, then the distribution rate would be$0.05*(12 months)/$10 = 6%. What makes closed-end fund distribution rates different from the yields quoted for typical mutual funds is that closed-end fund distributions might also include a return of principal. Returning principal to investors can, at least temporarily, inflate distribution rates and therefore give the false impression of strong performance. This was the case for many non-traded real estate investment trusts (REITs), business development companies (BDCs) and master limited partnerships (MLPs). The way to combat this confusion is to look at the closed-end fund's total return. The total return of a closed-end fund also includes the effect of changes in NAV and assumes that all distributions are reinvested into the fund. Let's take an extreme example of a fund that generates no income and pays out all of their NAV in twelve monthly payments to investors. The distribution rate for this fund will exceed 100% but the total return of the fund will be 0%! FINRA offers six questions investors should ask themselves before investing in a closed-end fund: 1. Does a closed-end fund fit into my investment objectives? 2. What is the closed-end fund's investment strategy? 3. How much of what I pay per share in an IPO will actually be invested? 4. What are the tax implications? 5. How is the distribution rate set? 6. Are the shares trading at a premium or discount to NAV? Closed-end fund investors would be in a much better place if they asked themselves these questions and were thoughtful about the consequences prior to investing in any closed-end fund. ## Friday, November 1, 2013 ### The Consequences and Implications of TIC Investments By Tim Husson, PhD and Carmen Taveras, PhD The research we have outlined all this week strongly suggests that TIC interests are exceptionally poor investments. We have focused our posts on what a thorough due diligence on the TICs should have revealed at the time of issuance. But you may be wondering, what happened to these TICs? What sort of returns did investors receive? To our knowledge, there is no retrospective study of TIC returns. But in our experience, the vast majority of TIC properties suffered significant impairments during the recent real estate market collapse. Many properties saw lower rental revenue and many faced increased vacancy rates, leading to reduced or suspended distributions to investors. Many TICs have gone into foreclosure as they have been unable to pay their debt obligations. Some TICs even required investors to pay more into the property for maintenance or other costs. Unlike diversified real estate mutual funds or even traded REITs, TIC investors directly own a proportional share of the property, and are responsible for any required tax or management fees, whenever TIC revenues fall short of covering expenses. Many TIC issuers have also gone under. Most notably, DBSI (who had 29 of the 194 TICs in our database) has gone bankrupt in the face of fraud and other charges. Many of the broker-dealers who sold them, such as Pacific West Securities, are also defunct, while others face significant litigation from outraged investors. Many of the issues that plague TICs are not present in liquid, diversified alternatives. However, those issues are present in many other private placement real estate funds. In our opinion, TICs are just an example of the highly speculative, illiquid, and potentially fraudulent offerings made in private placement format. We think investors should realize that private placements are often sold with limited disclosure of relevant information regarding potential conflicts of interest and the parameters underpinning projected cash flows. We suggest that the vast majority of investors would be better served by simple, traditional allocations to market-traded index funds. While such funds saw temporary losses during the real estate collapse, they fared far better than TICs. ### SEC Litigation Releases: Week in Review SEC Obtains Summary Judgment Against Defendants Charged with Defrauding Investors in Fictitious Offering, October 30, 2013, (Litigation Release No. 22861) A summary judgment was entered against the Estate of Frank L. Pavlico, Brynee K. Baylor, her law firm Baylor & Jackson, P.L.L.C., and their former “client” The Milan Group, Inc. for their involvement in "a prime bank investment scheme that defrauded at least 13 investors out of more than$2 million." According to the SEC, "Pavlico and Baylor operated a prime bank scheme, offering investors risk-free returns" on bank instruments and trading programs that "were entirely fictitious." Baylor and her law firm "acted as 'counsel' for Pavlico’s company Milan, vouching for Pavlico and acting as an escrow agent that in reality was merely receiving and diverting the majority of investor funds." During the scheme, Pavlico used a fictitious name, "Frank Lorenzo," " to conceal his 2008 money laundering conviction from investors." The final judgment enjoins the defendants from future violations of the securities laws and orders them to pay over $7.6 million in disgorgement, prejudgment interest, and penalties. The judgment also orders relief defendants, Patrick Lewis, GPH Holdings, LLC, The Julian Estate, Global Funding Systems, LLC, and Mia Baldassari to pay over$1.4 million combined in disgorgement and prejudgment interest. The court denied a judgment against relief defendant Brett Cooper.

The SEC previously settled with "relief defendant Dawn Jackson, Baylor’s law partner, and the court entered a final judgment against her" that ordered her to pay over $160,000 in disgorgement and prejudgment interest. Securities and Exchange Commission v. Andrew J. Franz, October 30, 2013, (Litigation Release No. 22860) Andrew J. Franz, who previously pled guilty to "mail fraud, securities fraud, investment adviser fraud, and income tax evasion," was sentenced to nearly five years imprisonment followed by three years supervised release. Additionally, Franz was ordered to pay over$357,000 in criminal restitution. The SEC previously filed an action against Franz, SEC v. Andrew J. Franz, based on the same charges in the criminal case. The SEC alleged that "Franz operated a fraudulent scheme in which, through forgery and other fraudulent means, he misappropriated approximately $865,969 from clients of Ruby Corporation, including$779,418 from family members and $86,551 from other clients." An emergency order was entered against Franz that permanently enjoins him from future violations of the Exchange Act and Advisers Act, as well as freezes "all assets under Franz’s control." Franz was also permanently barred from the securities industry. Securities and Exchange Commission v. Steven W. Salutric, October 30, 2013, (Litigation Release No. 22859) Steven W. Salutric was sentenced to eight years imprisonment followed by three years of supervised release and ordered to pay$3.89 million in criminal restitution. Salutric pled guilty to one count of wire fraud in 2012. In a 2010 action, the SEC charged Salutric with "misappropriat[ing] over $2 million from at least 17 clients to support businesses and entities linked to him and to make Ponzi-like payments to other clients." In one case, Salutric "misappropriated over$400,000 from a 96-year-old client who resided in a nursing home and suffered from dementia." In 2010, Salutric's assets were frozen and a receiver was appointed to "marshal all existing assets of Salutric." A final judgment was entered later that year that permanently enjoined Salutric from future violations of the Exchange Act and Advisers Act, and barred him from association with any investment adviser.

SEC Charges New York Investment Professional with Insider Trading, October 29, 2013, (Litigation Release No. 22858)

According to the complaint (PDF), "Rosenberg traded in the securities of Carter's Inc...on the basis of material non-public information provided by a former Carter's executive, and tipped two investment advisers about this information." Allegedly, "Rosenberg's total ill-gotten gains, losses avoided, and consulting fees...totaled approximately $500,000." A final judgment was entered against Rosenberg that permanently enjoins him from future violations of the Securities Act and Exchange Act and orders him to pay$608,000 in disgorgement and prejudgment interest.

Former Schottenfeld Trader Settles SEC Insider Trading Charges, October 29, 2013, (Litigation Release No. 22857)

A final judgment was entered against Joseph M. Mancuso in SEC v. Mancuso, who allegedly "used inside information he received from his good friend and colleague Zvi Goffer to trade ahead of the acquisitions of "Avaya, Inc., 3Com Corp., Axcan Pharma Inc., Hilton Hotels Corp. and Kronos Inc." According to the SEC, "certain of the tips originated from Arthur Cutillo and Brien Santarlas, attorneys at the law firm Ropes & Gray" while other information came from Gautham Shankar and "Thomas Hardin, a managing director at the hedge fund adviser Lanexa Management." Goffer, Cutillo, and Santarlas also used their mutual friend, Jason Goldfarb, as a conduit.

Mancuso has agreed to a final judgment that permanently enjoins him from future violations of the securities laws, orders him to pay over $460,000 in disgorgement and prejudgment interest, and bars him "from association with any broker, dealer, investment adviser, municipal securities dealer, municipal advisor, transfer agent, or nationally recognized statistical rating organization, and bar[s] him from participating in any offering of a penny stock." The payment obligations will be waived in light of Mancuso's financial condition. SEC Obtains Permanent Injunction and$100,000 Civil Penalty Against Cellular Telephone Company President for Role in Fraudulent Scheme, October 28, 2013, (Litigation Release No. 22856)

A final judgment was entered against Paul V. Greene, President of Americas Premiere Corporation (APC), a former vendor of now-bankrupt InPhonic, Inc., for his alleged participation in a scheme to artificially inflate InPhonic's financial results. Greene consented to the final judgment, which enjoins him from future violations of the Exchange Act and orders him to pay a \$100,000 civil penalty.