Friday, March 30, 2012

TVIX Explodes...Then Implodes

By Tim Husson, PhD and Olivia Wang, PhD

The Wall Street Journal has an article about the rollercoaster ride that TVIX, a volatility-related ETN, has been on recently.  [UPDATE 3/31/12:  there is now a second WSJ article]

TVIX is a leveraged ETN issued by VelocityShares, which is Credit Suisse's ETF/ETN brand.  Contrary to popular belief, TVIX and other volatility products do not track the CBOE S&P 500 Volatility Index (the VIX); instead, TVIX tracks a daily rolling portfolio of first and second month VIX futures with an average maturity of one month, leveraged to 200%. Therefore, it is susceptible to both the contango effect which erodes VXX's value as well as the compounding effects which trouble leveraged ETFs.

The interesting thing about TVIX is that there's really only one reason to hold it: speculation on market sentiment. The reason most volatility derivatives were created was as a hedge for equities, since the VIX (and to a lesser extent VIX futures) are negatively correlated to the S&P, especially on particularly bad days--hence they're sometimes called 'catastrophe insurance'. TVIX, however, is highly volatile itself and exposed to both contango and leverage effects, so holding it beyond a single day could lead to significant deviation from expected performance. Bill Luby, one of the most respected voices on volatility derivatives, calls it "day trading rocket fuel." And so it is.

Even more interesting is that a little over a month ago TVIX exploded in popularity. For most of its life TVIX was well behind VXX in terms of assets and volume, but for reasons that aren't at all clear yet, TVIX all of a sudden took off and become more widely traded than VXX and started approaching it in terms of assets. Credit Suisse, for similarly unknown reasons, decided to stop creation of new shares on Feb 21, saying that the explosion in interest violated "internal limits on the size of the ETNs" (see press release here). After that, TVIX started trading at a huge premium to net asset value--even beyond 80%--as continued demand was not met by new share issuances. On March 22, they announced they would issue new shares again "on a limited basis" (see here), at which point the premium disappeared and the share price dropped about 50% in 48 hours, back to NAV.

Recent Performance of TVIX

TVIX investors have obviously been in for a wild ride. The WSJ article highlights one investor, who purchased TVIX as "a way to hedge if the market took a big drop and offset my losses in other securities."  While many volatility derivatives claim to be effective for this type of hedging strategy (at least for very short periods of time), of all the available volatility products, TVIX is unlikely to be useful for this purpose.   Indeed, TVIX is one of the most complex and unpredictable exchange-traded products a retail investor could buy.

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

SEC Obtains Preliminary Injunction in New York Investment Adviser Case, March 28, 2012, (Litigation Release No. 22311)

The US District Court for the Eastern District of New York issued a preliminary injunction against Brian Raymond Callahan and his advisory firms Horizon Global Advisors, Ltd. and Horizon Global Advisors, LLC.  This preliminary injunction stems from the charges filed by the SEC alleging Callahan "defrauded investors in five offshore funds and used some of their money to buy himself a multi-million dollar beach resort property on Long Island."  The court continues to freeze Callahan's assets and requires him to repatriate assets located outside the US.

SEC Obtains Summary Judgment against Serial Fraudster Matthew J. Gagnon, March 27, 2012, (Litigation Release No. 22310)

The US District Court for the Eastern District of Michigan granted summary judgment and final judgment against Matthew J. Gagnon concerning the charges outlined in the May 2010 litigation release (Litigation Release No. 21532).  The SEC alleged that between January 2006 and August 2007, Gagnon "helped orchestrate a massive Ponzi scheme conducted by Gregory N. McKnight and his company, Legisi Holdings, LLC [...]".  In a separated scheme beginning in August 2007, Gagnon allegedly raised nearly $400,000 from 21 investors promising a 200% return in 14 months in an investment that was "risk-free and 'SEC Compliant'".  In yet another unrelated scheme in April 2009, Gagnon allegedly "[...] promot[ed] a fraudulent offering of interests in a purported Forex trading venture."  The final judgment orders Gagnon to pay over $4 million in disgorgement and prejudgment interest and a civil penalty of $100,000.

SEC Files Settled Charges Against Former Bank Executive who Misled Auditors, March 27, 2012, (Litigation Release No. 22309)

Earlier this week, the SEC charged John Cinderey -- a former executive VP at United Commercial Bank -- with misleading independent auditors concerning the risks of outstanding loans.  Cinderey allegedly "altered memoranda prepared for the independent auditors" and "circumvented accounting controls and policies that required the bank to accurately assess the risks associated with loans".  Because Cinderey has settled a related administrative action brought by the FDIC and due to his continued assistance in the investigation of this matter, Cinderey will not be required to pay a civil penalty relating to the SEC action.

SEC Obtains Final Judgment on Consent Against Winifred Jiau, March 27, 2012, (Litigation Release No. 22308)

According to the February 2011 SEC complaint, Winifred Jiau disseminated material, nonpublic information concerning the earnings of Marvell Technology Group Ltd. to two individuals who then traded on the information and realized nearly $900,000 of illicit profits.  Jiau allegedly obtained this information while serving as a consultant associated with Primary Global Research LLC.  In order to settle parallel criminal charges against her, Jiau was ordered to pay over $3 million and was sentenced to four years in prison.

SEC Charges Operator of Gold Coin Firm with Conducting Fraudulent Securities Offering, March 26, 2012, (Litigation Release No. 22307)

The SEC recently filed a civil injunctive action against David L. Marion and International Rarities Holdings, Inc. (IR Holdings) "accusing them of conducting a fraudulent, unregistered offer and sale of approximately $1 million in securities."  According to the litigation release, Marion allegedly raised the funds by offering shares in the worthless shell company IR Holdings falsely representing to investors that IR Holdings was the parent company and 100% owner of International Rarities Corporation.   Rather than expanding IR Holdings business, Marion allegedly used the funds to finance personal expenses and casino gambling.

SEC Charges Medical Device Company Biomet with Foreign Bribery, March 26, 2012, (Litigation Release No. 22306)

Earlier this week, the SEC filed charges against Biomet, Inc. -- a seller of medical devices to orthopedic surgeons based in Indiana -- alleging its subsidiaries and agents took part in an international bribery scheme wherein public doctors would receive kickbacks (sometimes as high as 15% to 20%) for buying their products.    The alleged bribery continued for the better part of a decade and took place in Argentina, Brazil and China.  Biomet has agreed to pay nearly $6 million to settle the SEC's charges and an additional $17 million to settle the parallel criminal charges from the US Department of Justice.

SEC Files Subpoena Enforcement Action Against Wells Fargo for Failure to Produce Documents in Mortgage-Backed Securities Investigation, March 23, 2012, (Litigation Release No. 22305)

Last week, the SEC filed a subpoena enforcement action against Wells Fargo & Company in connection with an SEC investigation into the possible fraudulent sale "of nearly $60 billion in residential mortgage-backed securities to investors."  Although documents have been subpoenaed, and Wells Fargo has agreed to produce, the company has yet to produce the documents.  In connection with the securitization of the loans, the SEC alleges that Wells Fargo only performed their due diligence on a sample of loans within a pool and did not take any steps to address deficiencies that may remain within the pool but outside the sample.  The SEC is investigating whether Wells Fargo "misrepresented to investors that the loans being securitized complied with the bank’s loan underwriting standards."

Thursday, March 29, 2012

Junk ETFs

By Tim Dulaney, PhD

The Wall Street Journal ran a great piece earlier this month concerning Junk ETFs.  For another recent prospective, see the recent blog post by Michael Aneiro.  We have discussed exchange traded funds (ETFs) a great deal on this blog, but we haven't yet addressed the issue of Junk ETFs.  A Junk ETF is an ETF that invests in high-yield bonds in an effort to garner high returns.  Of course high-yield is just an industry euphemism for low-quality (or high-risk) since, generally speaking, investors demand higher yields on fixed-income securities when the quality is low.  For a list of Junk ETFs, see here.

It is not surprising that investors are turning to junk bonds -- or funds that invest in junk bonds --  as a result of the low interest rate environment in which we find ourselves.  Investors are searching for yield any way they can find it and as a result are taking on more risk by investing in these lower-quality bonds.  In fact, the WSJ article reports that
[s]o far this year, mutual funds and exchange-traded funds investing in high-yield, or "junk," bonds have taken in more than $17 billion in new money. Roughly 15 cents of every dollar flowing into all stock and bond funds combined has gone into junk alone.
Of course, investors should realize that as demand for these high-yield bonds increases, the prices on the bonds go up and therefore the yield on the bonds decreases.  Junk ETFs are also much more liquid than the high-yield bonds the Junk ETFs hold.  As a result, Junk ETF investors pay "[...] around a 0.6% premium to the value of their assets [...]".   This liquidity premium is only one of the issues investors should consider before investing in Junk ETFs.

Another issue outlined in the article is that the prices of the underlying securities are inflated by approximately 0.6% relative to similar high-yield debt basically as a result of the ETF's investment in those securities.  The pricing premium, liquidity premium and fees can significantly decrease the realizable yield of Junk ETFs.

Of course, Junk ETFs also have some benefits that investors should consider.  Investing in a Junk ETF could be less risky than investing in a single high-yield bond since the ETF invests in many high-yield bonds and therefore realizes a diversification benefit in their return volatility.   Similar to many other types of ETFs, Junk ETFs also offer retail investors a way to gain exposure to high-yield debt when direct investment might be unfeasible.  The stock-like characteristics of Junk ETFs also offer investors an easier way to decrease exposure to high-yield debt than would an analogous direct investment in junk bonds.

Obviously every investor should consider their own needs, goals and expectations for the future before making any investment decision.  We hope this short post has shed a little light on this segment of the ETF market.

Wednesday, March 28, 2012

Regulating the Derivatives Markets

By Tim Husson, PhD and Olivia Wang, PhD

The New York Times had an excellent editorial last week titled “A Long Road to Regulating Derivatives,” which discusses the progress made in regulating the types of complex securities which have been implicated in the recent financial crisis.  We at SLCG feel that investors should pay close attention to the changes taking place in securities regulation as they could have a significant impact on the entire market.

Traditionally, derivatives were regulated relatively lightly, especially over-the-counter (OTC) derivatives.  The Dodd-Frank law included provisions for improving the transparency and safety of these markets, and specifically tasked the Commodity Futures Trading Commission (CFTC) and the SEC with drafting new rules governing their sales and reporting. While Dodd-Frank was signed into law almost two years ago, many feel that these agencies have not made sufficient progress in reining in the market for complex derivatives, which have begun to spring up again as the fallout from the crisis fades.

According to the editorial, although the CFTC has proposed an electronic trading system which would make price information accessible to the public, some lawmakers have proposed legislation to backtrack rules on regulating derivative markets under the “fear” that such open trading system might “hurt banks’ flexibility.”  As our own work has shown, the lack of publicly available price information for complex securities has led to numerous instances of misrepresentation and even fraud, and as long as this information remains beyond the reach of investors the opportunity for misconduct will not go away.

In essence, there is an enormous information asymmetry between banks and investors--especially retail investors--and a major goal for derivatives regulation would be to close that gap such that investors can make informed decisions.

Tuesday, March 27, 2012

A Primer on Investment Companies

By Carmen Taveras, PhD

Investment companies are entities that issue securities and whose primary business is investing in securities. We have written about investment companies in several of our posts (See here and here). This post provides a quick introduction to investment companies and the securities they issue. The three main types of investment companies according to federal securities regulation are: closed-end funds, unit investment trusts, and open-end funds.

Some of the main characteristics of investment companies refer to the timing and venue in which their securities are sold. While closed-end funds and unit investment trusts sell a fixed number of shares at their Initial Public Offering after which investors buy shares from the secondary market, open-end funds which are also commonly referred to as mutual funds sell shares daily. Other defining characteristics are the price after the securities’ initial public offering and the possibility of redemption from the issuer. While open-end funds and unit investment trusts trade and are redeemable at their Net Asset Value (NAV), closed-end funds may trade at a price that is different from NAV and are generally not redeemable. Investment companies differ in their management of their assets. While the portfolios of closed-end funds and open-end funds are actively managed by registered investment advisors, the portfolios of unit investment trusts are not actively managed and the securities are held until they mature or until each trust’s Termination Date. The different types of investment companies also have differing rules relating to permissible leverage. The table below summarizes the main characteristics of investment companies.

Characteristics of the Three Basic Types of Investment Companies According to Federal Securities Laws:

Some investment companies are Exchange-Traded Funds (ETFs). ETFs are investment companies that are most often legally classified as open-end funds, although some may be classified as unit investment trusts. ETFs sell large blocks of shares (generally 25,000 to 200,000 shares) called “creation units,” which are typically purchased by large institutional investors, such as broker-dealers. The “creation units” are typically purchased with a set of securities that mimic the ETF’s portfolio. Institutional investors, which are often called “authorized participants” may choose to hold the ETF shares or sell them on a stock exchange, allowing retail investors to obtain exposure to ETFs through their brokerage firms. Authorized participants may sell creation units back to the ETF in exchange for a representative sample of the securities in the ETFs portfolio. Retail investors wishing to dispose of their investment in an ETF may sell their shares in the secondary market at anytime throughout the day. (See here for more information on investment companies in general).

By the end of 2010, investment companies held $13 trillion in total net assets according to the Investment Company FactBook (See more information here). Over 90% of these funds were held by open-end funds.

Fraction of Net Assets Held by Type of Investment Company (2010):

Monday, March 26, 2012

$85 million and Counting: What Price Will Citigroup Ultimately Pay for Its MAT/ASTA Deception?

By Geng Deng, PhD and Mike Yan, PhD

On March 13, 2012, Bloomberg published Citigroup Ex-Manager Islam Has No Regrets After Funds Crash.  Then on March 21, 2012 USA Today published Investor hedge fund claims cost Citigroup $85M and counting.  These two stories deal with MAT/ASTA hedge funds Citigroup sold to retail clients which suffered staggering losses in early 2008. Both recent stories discuss the $54.1 million award in Hosier et al v Citigroup covered in the WSJ, Citigroup Loses Muni Case in April 2011.

Craig McCann has testified in virtually all of the FINRA arbitrations involving the type of hedge fund mentioned in the Bloomberg and USA Today stories as well as others against Citigroup: Hosier, PuglisiBarnett, Beard, Berghorst, Abramson, Coleman, Silk, Miller, Selan and Bach. In addition, Craig has testified in cases involving other funds such as First Republic’s TW Tax Advantaged, Aravali, 1861 and Stone & Youngberg’s Municipal Advantage Fund.  We've discussed these funds in previous blog posts and in a working paper.

Marketed as an arbitrage strategy, the MAT/ASTA and other similar funds were simply high-cost, highly-leveraged bets on interest rate, liquidity and credit risk in municipal bonds. Brokerage firms, including Citigroup, misrepresented the strategy by comparing the yields on callable municipal bonds with the yields on non-callable Treasury securities without adjusting the yields on municipal bonds for their embedded call features and by ignoring 30 years of published literature which demonstrates the remaining difference in after-tax yields is compensation for liquidity and credit risk. The losses suffered by investors were suffered during a period of relatively routine interest rates and not during an unprecedented interest rate environment.

Nearly two years ago in a 2010 WSJ story, Dr. McCann was quoted as saying that Citigroup would end up having to pay out tens of millions of dollars to investors in the MAT/ASTA funds. With the $85 million Citigroup has paid so far with no end in sight, the total tally for Citigroup’s folly is likely to be much higher. In addition, ongoing regulatory investigations into the sales of the MAT/ASTA funds dogs Citigroup four years after the funds failed.

Perhaps far more costly for Citigroup is the harm to its franchise. As this Yahoo Finance graph illustrates, Citigroup’s shareholders have suffered terrible losses as the firm provided disservice to its clients.

Friday, March 23, 2012

SEC Litigation Releases: Week in Review (Part II)

By Tim Dulaney, PhD

Due to the high volume of litigation releases from the Securities and Exchange Commission over the past week, we're spreading this week's review over two posts. This is the second of the two posts.

SEC Settles Litigation with Former Veritas Software Corporation Head of Sales, March 22, 2012, (Litigation Release No. 22304)

The US District Court for the Northern District of California entered a settled final judgment against Paul A. Sallaberry -- former head of sales of Veritas Software Corporation.  According to the July 2007 complaint (Litigation Release No. 20178), Sallaberry participated "in a fraudulent scheme by artificially inflating Veritas' publicly reported revenues and earnings through an improper round-trip transaction with America Online, Inc. and by lying to Veritas' independent auditors."  The financial results reported in 2000 through 2002 contained the distortions.  Sallaberry has consented, without admitting or denying the allegations against him, to the final judgment ordering him to pay disgorgement, prejudgment interest and civil penalties amounting to $100,000.

Andrew Franz Allegedly Misappropriates over $1 Million from Ruby Corporation Clients, March 22, 2012, (Litigation Release No. 22303)

The SEC filed a complaint yesterday alleging Andrew Franz orchestrated a fraudulent scheme wherein he misappropriated nearly $900,000 from clients -- who are mostly family members -- of Ruby Corporation through forgery and other fraudulent means.  In addition, the SEC alleges that Franz misappropriated an additional $172,000 by stealing fees payable to Ruby.  Franz subsequently returned the majority of the misappropriated funds "to Ruby disguised as client fees to conceal the firm’s dwindling client base and revenues."  The US District Court of the Northern District of Ohio has frozen all assets under Franz's control and the SEC's investigation is ongoing.

Court Orders Purported Hedge Fund Manager and Principal to Pay Over $7.5 Million, March 22, 2012, (Litigation Release No. 22302)

The US District Court for the District of Massachusetts entered final judgments by default against Andrey C. Hicks and Locust Offshore Management, LLC as a result of an October 2011 SEC complaint (Litigation Release No. 22141).  Locust and Hicks allegedly mislead investors concerning information that includes Hicks' background, education, the fund's auditor, custodian and location of incorporation and "divert[ed] over $2.7 million of investor money to Hicks’ personal bank accounts."  Hicks and Locust are jointly and severally liable for fines and penalties amounting to over $2.5 million and individual civil penalties for each amounting to over $2.5 million.

SEC Charges Bay Area Investment Adviser for Defrauding Investors with Bogus Audit Report, March 21, 2012, (Litigation Release No. 22301)

Earlier this month, the SEC charged James Michael Murray with defrauding investors by distributing a phony audit report.  Beginning in 2008, Murray raised more than $4.5 million from investors in funds including Market Neutral Trading, LLC (MNT).  Murray allegedly provided investors with an audit report prepared by a supposedly independent firm: Jones, Moore & Associates (JMA).  The firm turned out to be a shell company created and controlled by Murray with several employees (including the two named principals) completely fabricated.  Murray allegedly went so far as to call brokerage firms "firms falsely claiming to be the principal identified on most JMA documents."  The JMA audit report allegedly overstated MNT's gains, income, member capital and total assets.

Federal Jury Convicts Brian Hollnagel and BCI Aircraft Leasing, Inc. on Seven Criminal Counts, March 20, 2012, (Litigation Release No. 22300)

In August 2007, the SEC filed a civil injunctive action alleging that between 1998 and 2007, Brian Hollnagel and BCI Aircraft Leasing, Inc. orchestrated a fraudulent scheme wherein they raised more than $82 million from over 100 investors.  The defendants allegedly "commingled investor funds, used investor funds to pay other investors, and failed to use investor funds as represented."  Both Hollnagel -- owner, president and CEO of BCI Aircraft Leasing, Inc. -- and BCI "were each convicted of six counts of wire fraud and one count of obstruction of justice."

SEC Litigation Releases: Week in Review (Part I)

By Tim Dulaney, PhD

Due to the high volume of litigation releases from the Securities and Exchange Commission over the past week, we're spreading this week's review over two posts. This is the first of the two posts.

Defendant Michael Kimelman Settles SEC Insider Trading Charges, March 20, 2012, (Litigation Release No. 22299)

Michael Kimelman -- formerly a trader a Lighthouse Financial Group, LLC -- received material nonpublic information from an attorney concerning the acquisition of 3Com Corp. and allegedly traded on this information in September 2007.  Using this insider information, Kimelman was allegedly able to realize "illicit profits of approximately $270,000 in two personal trading accounts."  Kimelman consented to the entry of final judgment entered by the US District Court for the Southern District of New York ordering him to pay disgorgement of illicit profits and over $50,000 in prejudgment interest.  

SEC Credits Former AXA Rosenberg Executive for Substantial Cooperation during Investigation, March 19, 2012, (Litigation Release No. 22298)

In this litigation release, the SEC "provide[s] guidance regarding the circumstances under which individuals may receive credit as part of the SEC’s Cooperation Initiative."  The SEC uses the assistance of a former AXA Rosenberg Group, LLC senior executive in "the agency’s investigation into the nondisclosure of a coding error in the firm’s quantitative investment process" as an example for how the initiative works in practice.   In this example, through the timely and complete cooperation of the executive, the SEC was able to return all of the over $200 million in losses and imposed additional penalties reaching nearly $30 million.

Lanexa Management, LLC Agrees Disgorge $746,797 in Insider Trading Profits, March 19, 2012, (Litigation Release No. 22297)

The US District Court for the Southern District of New York entered a final judgment against Lanexa Management, LLC as a result of a November 2010 SEC complaint (Litigation Release No. 21741).  The SEC alleged in their complaint that Thomas C. Hardin -- a former managing director at Lanexa Management, LLC -- traded on material nonpublic information on behalf of a Lanexa hedge fund "resulting in approximately $640,000 in illicit profits."  According to the amended complaint, two attorneys distributed information concerning the acquisition of 3Com Corp. in exchange for kickbacks.  The information eventually found its way into Hardin's hands and Hardin then allegedly used the information to trade in 3Com securities ahead of the public announcement of the acquisition.  Lanexa has been ordered to pay nearly $750,000 in disgorgement and prejudgment interest.

SEC Charges Senior Executives at California-Based Firm in Stock Lending Scheme, March 16, 2012, (Litigation Release No. 22296)

Last week, the SEC charged James T. Miceli and Douglas A. McClain, Jr. -- senior executives of Argyll Investements, LLC -- with defrauding investors using their "purported stock-collateralized loan business."  Miceli and McClain allegedly induced several corporate officers into offering publicly traded stock as collateral for loans.  Miceli and McClain allegedly represented that the collateral would not be sold unless the borrower defaulted on the loan.  Miceli and McClain subsequently sold the equity at market value, using the proceeds from selling the collateral to fund the loans in some cases and to accumulate "more than $8 million in unlawful gains that Miceli and McClain used in part toward their personal expenses."

SEC Charges Former Executive at CKE Restaurants with Insider Trading, March 16, 2012, (Litigation Release No. 22295)

Earlier this month, the SEC charged Noah J. Griggs Jr. -- a former executive VP of CKE Restaurants, Inc., the parent company of Carl's Jr. and Hardee's -- with insider trading.  Griggs allegedly purchased 50,000 shares of CKE stock after learned about a potential acquisition in a monthly strategic planning meeting.  Using this material and nonpublic information, the SEC alleges that Griggs was able to realize a profit of nearly $150,000.    Without admitting or denying the allegations against him, the defendant has agreed to pay over $250,000 in disgorgement, penalties and prejudgment interest.  

Wednesday, March 21, 2012

Problems Surrounding the Complexity of Annuity Products

By Tim Husson, PhD and Tim Dulaney, PhD

On Sunday, The Wall Street Journal reported the felony-theft conviction of Glenn Neasham who had sold a complex annuity to an elderly woman.   The conviction -- which comes with a 90-day sentence -- was handed down by a state-court jury in Lake County, CA.  From the article:
The case underlines authorities' continuing discomfort with "indexed" annuities, savings products that pay interest tied to the performance of stock- and bond-market indexes. Insurers guarantee that buyers won't lose any of their principal but in return charge sometimes-steep penalties if investors withdraw their money early, for periods that can stretch beyond a decade.
Indexed annuities are attractive to agents because of the high commissions they receive from insurers, which can be 12% or more of the invested amount.
It is our position that deferred annuities -- those annuities that have a long deferral period before distributions begin -- are unsuitable for the elderly since the deferral period can extend beyond their actuarial lifetime.

Also this weekend, Investment News reported on the complexity annuities add to divorce proceedings.  In particular, the division of annuities among the parties in the divorce often results in a significant decrease in realizable value due to the illiquidity of the products as enforced by high surrender charges and penalties.  From the article:
With nearly one in two marriages ending in divorce, financial advisers who deal with divorcing couples often face complex problems connected with untangling annuities that are in the pool of shared assets.  
With divorce attorneys typically unaware of the nuances of annuity contracts and the various ways insurers treat contracts in the context of divorce, and with advisers typically out of the loop when settlements are hammered out, the problem lands in the lap of advisers.
Speaking directly to the issuer of the annuity for more information or options in this situation might be a good starting step for annuity holders, but there is an inherent conflict of interest here and one should not rely solely upon the advice of the issuer.  Financially sound annuity valuations are possible, but often require very complex simulations to incorporate their extraordinarily complicated payout structures.  This analysis would typically be beyond the means of most investment advisers -- and certainly could not be expected from unsophisticated investors.

Tuesday, March 20, 2012

Abuse of Municipal Finance in Wisconsin

By Tim Husson, PhD and Tim Dulaney, PhD

The Wall Street Journal is reporting that Stifel Financial has settled with five Wisconsin school districts on charges that they misled these municipal investors with their sale of several complex CDOs.  This is just another example of the situation outlined in a previous post wherein a municipality or institutional investor was taken advantage of through the sale of inappropriate investments.  The settlement involves $22.5 million in cash, plus $154 million in debt forgiveness.  SLCG has been involved with this litigation from the beginning, including valuing the CDOs at issue.

The SEC has also filed complaints regarding these same CDOs against RBC, who structured the deals, and Stifel, who allegedly sold them knowing they were unsuitable for the school districts.

As outlined by the article (and by an older post from Zero Hedge), the representations made to the school districts showed a gross misunderstanding of the risks embedded in these products.  Unfortunately, it is common for unknowing or unscrupulous brokers to target municipalities and rural institutional investors for the sale of highly complex and highly risky investments such as swaps and CDOs.  The complex structure of these deals makes them hard for unsophisticated investors to adequately value and therefore easy for financial intermediaries to structure the deals in their own favor.

The combination of relatively unsophisticated investors -- often school administrators and other local officials -- and large investment portfolios (often backed by future tax revenue), can lead to unbalanced deals which saddle the community with debt for decades.  Clearly more oversight and impartial advice is required in the municipal finance arena, but we are happy that the SEC and other regulatory bodies are fighting the good fight.

Kudos to the WSJ for drawing attention to this grossly underreported issue.

Monday, March 19, 2012

UK Financial Regulators Probe Interest Rate Swaps

By Olivia Wang, PhD and Tim Dulaney, PhD

The Financial Times reported yesterday that the Financial Services Authority -- the counterpart of the SEC in the UK -- will investigate the possible mis-selling of interest rate swaps by banks, including Barclays. The regulator decided to look into the issue after The Telegraph provided detailed information about the potential misconduct of banks when selling interest rate swaps to small businesses.

In one of its reports, the Telegraph details a situation in which a manufacturing company owner was caught up in an interest rate swap sold by Barclays.
“It was stipulated that I had to take out cover for the period of the loan, which was for three years. What they sold me was a 10-year swap deal,” he said. “I am a young entrepreneurial person taking my first step into this and trusted the bank.” Mr Hawkes said no one from Barclays Capital, the investment banking division, sat down with him to explain the implications of taking out the swap.
Despite the bank’s emphasis in its presentation that “interest rates had 'never' fallen below 3.5pc,” when the base rate dropped below the floor-rate structured into the interest rate swap Mr Hawkes ended up paying much more than he expected. Naturally, Mr Hawkes wanted to exit his position in the swap, until he was told that he faced a termination fee of £160,000. “I saw it just like a house mortgage where I fixed the rate. I did not understand there would be such a large break fee,” said Mr Hawkes. Stories like these raise the question of whether banks should sell such products to unsophisticated retail investors.

We have worked on several cases involving the mis-selling of interest rate swaps by banks here at SLCG. Swaps can be very useful and powerful instruments that can help hedge interest rate exposure; however, interest rate swaps can also cause great harm when sold with complex or unclear terms. Investors should be very careful when entering into any such agreement, and should consult with experts in interest rate swaps to ensure the terms of the deal are fair and adequately meet their financial objectives.

Friday, March 16, 2012

SEC Litigation Releases: Week in Review (Part II)

By Tim Husson, PhD

Due to the high volume of litigation releases from the Securities and Exchange Commission over the past week, we're spreading this week's review over two posts. This is the second of the two posts.

SEC Charges Five with Insider Trading on Confidential Merger Negotiations Between Philadelphia Company and Japanese Firm, March 14, 2012 (Litigation Release No. 22288)

The SEC charged Timothy J. McGee, Michael W. Zirinsky, Robert Zirinsky, and Hong Kong residents Paulo Lam and Marianna sze wan Ho with insider trading. Lam and Ho have each agreed to settle the SEC’s charges and pay approximately $1.2 million and $140,000 respectively. The SEC alleges that McGee and Michael Zirinsky, both registered representatives, traded on nonpublic information about an impending merger between Philadelphia Consolidated Holding Corp.'s (PHLY) and Tokio Marine Holdings. According to the complaint, McGee obtained knowledge of the merger from a PHLY senior executive "who was confiding in him through their relationship at Alcoholics Anonymous (AA) about pressures he was confronting at work," and made a $292,128 profit when the stock price jumped 64 percent on July 23, 2008. He also traded on this information in the accounts of several family members, and passed the information to Michael Zirinsky, who in turn tipped off Lam, who in turn tipped off Ho.

SEC Charges Three Executives At Noble Corporation With Bribing Customs Officials In Nigeria, March 14, 2012, (Litigation Release No. 22290)

The SEC claims the executives, James J. Ruehlen and Noble CEO Mark A. Jackson, violated the Foreign Corrupt Practices Act (FCPA) "by participating in a bribery scheme to obtain illicit permits for oil rigs in Nigeria in order to retain business under lucrative drilling contracts." The SEC also alleges that Thomas F. O’Rourke, who was a former controller and head of internal audit at Noble, helped approve and cover up the bribe payments. O’Rourke settled the charges by paying an undisclosed penalty.

Court Enters Order Amending Final Judgment Against Agile Group Founded and Head Portfolio Manager Neal R. Greenberg, March 14, 2012, (Litigation Release No. 22291)

The SEC claimed in September 2010 (PDF) that Greenberg "negligently misrepresented the safety, suitability, and diversification of several hedge funds to clients, in many cases conservative investors in or near retirement" and alleged provided several inadequate disclosures, account statements, and compliance and supervision policies and procedures. Greenberg was the majority owner of Tactical Allocation Services LLC, and was the head portfolio manager of the funds at issue: the Agile Safety Fund, the Agile Safety Fund International, and the Agile Safety Variable Fund. Under the amended Final Judgment, Greenberg is liable for almost $4 million in disgorgment plus post-judgment interest.

SEC Brings Charges in Connection with Secondary Market Trading of Private Company Shares, March 14, 2012, (Litigation Release No. 22292)

The SEC alleges that Frank Mazzola and his firms Felix Investments, LLC, and Facie Libre Management Associates, LLC, misled investors and reaped undisclosed commissions in connection with several funds ostensibly created to acquire shares of Facebook, Twitter, Zynga, and related technology companies. The Commission also alleged that SharesPost, Inc., an online platform that facilitated certain secondary market transactions, and its CEO, Greg Brogger, effected securities transactions without registering as a broker-dealer. SharesPost and Brogger agreed to penalties of $80,000 and $20,000, respectively.

SEC Charges a Chicago-Based Management Consultant with Insider Trading, March 15, 2012, (Litigation Release No. 22293)

The SEC claims that Sherif Mityas, a partner and vice-president at a global management consulting firm, was retained by the Carlyle Group in May 2010 in regards to Carlyle's potential acquisition of NBTY Inc., a Long Island-based vitamin company. "That same month, Mityas purchased NBTY stock and subsequently tipped a relative who also bought NBTY shares. After Carlyle publicly announced its acquisition of NBTY, Mityas and his relative sold their NBTY stock for a combined profit of nearly $38,000." Mityas has agreed to pay more than $78,000 to settle the SEC’s charges.

Court Orders Former Broker to Pay over $500,000 for Defrauding 9/11 Widow, March 15, 2012, (Litigation Release No. 22294)

A federal judge in Massachusetts entered a final judgment ordering James J. Konaxis, formerly a registered representative at Sentinel Securities, Inc., to pay $514,954 in interest, penalties, and disgorgment related to "commissions earned over a two-year period by defrauding a former customer who was left widowed by the September 11, 2001 terrorist attacks." The judge found that Konaxis “misled the victim into thinking her investments were safe, while churning (e.g., excessively trading) her funds in a manner contrary to her interests[.]” The accounts were initially funded with payments from the September 11th Victim Compensation Fund.

SEC Litigation Releases: Week in Review (Part I)

By Tim Dulaney, PhD

Due to the high volume of litigation releases from the Securities and Exchange Commission over the past week, we're spreading this week's review over two posts.  This is the first of the two posts.

SEC Files Civil Injunctive Action Against Senior Management of Thornburg Mortgage, Inc. for Alleged Fraudulent Overstatement of Thornburg’s Income, March 13, 2012 (Litigation Release No. 22287)

Ealier this week, the SEC charged that Larry Goldstone, Clarence Simmons and Jane Starrett (former executives of Thornburg Mortgage, Inc.) had  "materially misrepresent[ed] the financial condition and liquidity of Thornburg."  The defendants allegedly overstated quarterly income in Thornburg's 2007 annual report by over $420 million changing the loss actually experienced by Thornburg into a false profit.  Immediately preceding the 2007 annual report, Thornburg received over $300 million in margin calls that could not be met on a timely basis which "severely drained its liquidity." For more information about this complaint, see here (link opens PDF).

Court Orders Two Officers of United American Ventures to Pay $1 Million Penalties and $8.5 Million in Disgorgement in SEC Case, March 13, 2012 (Litigation Release No. 22286)

In 2010, the SEC charged Eric J. Hollowell, Philip Lee David Jack Thomas, Matthew A. Dies, Anthony J. Oliva and United American Ventures, LLC with securities fraud steming from United American Ventures' alleged "rais[ing of] $10 million from at least 100 investors through the unregistered and fraudulent sale of convertible bonds."  A federal judge in New Mexico assessed fines and penalties against Hollowell and Thomas amounting to more than $10 million.  The judge also assessed disgorgement and penalties amounting to  over $400,000 for Oliva (jointly with Integra Investment Group, LLC) and over $100,000 for Dies.

Former StarMedia Executive Agrees to Settlement in SEC Litigation, March 13, 2012 (Litigation Release No. 22285)

Earlier this week, the US District Court for the Southern District of New York entered a final judgement against Adriana J. Kampfner of the non-defunct StarMedia Network, Inc.  This final judgement stems from a 2006 SEC civil injunctive (Litigation Release No. 19627) action that alleged StarMedia had "made materially false disclosures and financial statements in its annual Report on Form 10-K for its fiscal year 2000 and its quarterly Reports on Form 10-Q for the first two quarters of 2001."  According to the original litigation release, StarMedia allegedly inflated revenues by nearly $20 million to meet projections and in order to obtain additional financing.

SEC Settles With Former Wall Street Professional for Insider Trading Relating to the Acquisition of Jamdat Mobile, Inc., March 12, 2012 (Litigation Release No. 22284)

Ealier this month, the US District Court in Manhattan entered a final judgement against Alissa Joelle Kueng.  In October 2009 (Litigation Release No. 21249), the SEC alleged that Kueng dispensed material non-public information concerning the acquisition of Jambat Mobile, Inc. by Electronic Arts, Inc. including the acquisition price prior to the public announcement of the acquisition.  The four other defendants in this action had previously settled the charges against them.  The final judgement ordered Kueng to pay a civil penalty of $25,000.

SEC Charges Two Operators of Home Maintenance Company with Conducting Fraudulent Securities Offering, March 9, 2012 (Litigation Release No. 22281)

The SEC filed a civil injunctive action earlier this month in the US District Court for the Eastern District of Pennsylvania against Edward V. Ellis and Jennifer L. Seidel alleging the two had conducted an unregistered offering of Sederon, Inc. stock.  Sederon was a company that provided home maintenance services to residential home owners.  Although Sederon was "never profitable [...] and often failed to generate enough revenue to meet payroll and other expenses", the defendants allegedly raised more than $500,000 by claiming the company was highly profitable and that investors could potentially realize a 900-1300% profit when the company went public.  The SEC is seeking nearly $600,000 in disgorgement and prejudgment interest.

SEC Charges Former Executive at Coca-Cola Bottling Company with Insider Trading, March 9, 2012 (Litigation Release No. 22280)

In a complaint (link opens PDF) filed earlier this month, the SEC alleged that Steven Harrold traded on material non-public information in his wife's brokerage account.  Steven Harrold was a VP at Coca Cola Enterprises Inc. (CCE) and alleged knew that his company planned "to acquire The Coca-Cola Company's [(KO)] bottling operations in Norway and Sweden."  Harrold allegedly traded CCE during the blackout period before the public announcement of the acquisition and allegedly realized an illicit profit of nearly $90,000.

Thursday, March 15, 2012

SPIVA Scorecard Year-End 2011

By Tim Dulaney, PhD

S&P recently released their semiannual report comparing the performance of actively managed mutual funds against their appropriate benchmark indices (the PDF can be found here).  The S&P Indices Versus Active Funds (SPIVA) Scorecard contains information the mutual fund industry would likely prefer to be kept quiet.

The Year-End 2011 SPIVA Scorecard reports that "over a five-year horizon[...] a majority of active equity and bond managers in most categories lag comparable benchmark indices."  Actively managed mutual funds are shown to empirically exhibit lower returns nearly independent of style, asset class or market.

An argument frequently made by investment companies is that indexing is appropriate for large-cap markets while actively managed funds are appropriate for small-cap markets (due to liquidity concerns, etc.).  Contrary to this assertion, the Year-End 2011 SPIVA Scorecard notes "indexing works as well for U.S. small-caps as it does for U.S. large-caps."

Another argument frequently presented by proponents of active managers is that the managers earn their keep when markets begin to go south.  They argue that talented managers are able to time the market and produce a more defensive portfolio in these situations.  According to the Year-End 2011 SPIVA Scorecard, the data in no way supports this contention.  "In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks."  Anyone who says they can consistently time the market is probably not telling the whole truth.

Fee minimization is an important component of investing.  Actively managed mutual funds generally command higher fees and as such would need to exhibit higher returns for investors to realize even comparable net returns to lower-fee alternatives.  Of course, with higher returns comes higher risk.   As we showed in a previous blog post, even within the category of indexed mutual funds and ETFs, the fees can vary dramatically.

Investors must weigh the benefits of low-fee indexed mutual funds (and ETFs!) against the supposed benefits of actively managed mutual funds.  Investors should determine the exposure they require and then minimize the fees they are willing to pay for that exposure.

Wednesday, March 14, 2012

Which Would You Rather Have?

By Tim Husson, PhD and Olivia Wang, PhD

Last month we had a blog post introducing the FINRA Mutual Fund Expense Analyzer tool. In this post we apply it to the 25 largest mutual funds and ETFs measured by net asset value using data from Morningstar. We assumed for this calculation an initial investment of $1,000 held for five years, and plot the total fees and sales charges over that period against the historical 5 year annualized total return of the fund:

There is no clear linear relationship between returns and fees as depicted in the graph; however, it is interesting to point out the cluster of funds with high fees between $80 and $100 and returns around 1-2% return are all from a single issuer, American Funds, as shown in the red circle. And the cluster of funds with low fees but similar returns, shown in the green circle, are all from Vanguard with the only exception of the SPDR S&P 500 ETF (ticker: SPY). The table below shows the list of funds in the green circle (marked as green) and those in the red circle (marked as red) together with their tickers.
VMMXX Vanguard Prime MM;Inv
VTSMX Vanguard T StMk Idx;Inv
VINIX Vanguard Instl Indx;Inst
VFIAX Vanguard 500 Index;Adm
VTSAX Vanguard T StMk Idx;Adm
VWO Vanguard MSCI Em Mkt ETF
AGTHX American Funds Gro;A
CAIBX American Funds CIB;A
AMECX American Funds Inc;A
CWGIX American Funds CWGI;A
AIVSX American Funds ICA;A
AWSHX American Funds Wash;A

Greg Smith Leaves Wall Street

By Carmen Taveras, PhD and Paul Meyer, MA

The New York Times published an op-ed by Greg Smith, a Goldman Sachs’ Executive Director who is resigning from his job after almost 12 years with the firm because, as he puts it, the firm’s culture has veered far from what it was when he first joined the firm. He says in spite of the firm’s recent scandals “the interests of the client continue to be sidelined in the way the firm operates and thinks about making money.” At SLCG, we have come across many examples of the issues raised by Mr. Smith. We think that the marketing of investments aimed at maximizing financial firms’ profits without regard to their clients’ investment objectives or bottom lines transcends any single firm and is a common characteristic of many financial firms.

Mr. Smith lists three ways to become a leader in today’s Goldman Sachs. We have come across examples of these same three practices.

The first way to become a leader according to Mr. Smith is to persuade clients to buy products your firm wants to unload. Until 2007, big brokerage firms occasionally placed bids on ARS (which we discuss here and here) to prevent auctions from failing. In late 2007, as demand for ARS declined and banks’ ARS inventories increased considerably, brokers aggressively marketed ARS to small investors in an effort to reduce their inventories, according to a Congressional Research Service Report (available here). Court documents describe how, for example, UBS management discussed withdrawing their support from bids, allowing auctions to fail, while at the same time encouraging its brokers to market ARS to UBS’s clients (see Summons and Complaint, Cuomo v. UBS Securities LLC, available here). By mid-February many auctions failed leaving investors with illiquid, devalued securities.

According to Mr. Smith, the second way to become a leader is to push securities that produce the highest profits to the financial advisor’s employer. For example, we’ve blogged about non-traded REITs here and distributed a significant research paper here. Traditional mutual funds and ETFs provide exposure to real estate with transparent pricing, ready liquidity, and low fees yet non-traded and private REITs are often marketed to investors even though their expected returns do not compensate for their risk and their illiquidity. It is doubly hard to justify such investment recommendations considering the high fees advisors and dealer managers are able to collect, which may be as high as 15% of the investment.

The third way of becoming a leader according to Mr. Smith is to trade “any illiquid, opaque product with a three-letter acronym.” Bank of America’s LCM VII CLO is a spectacular example of such a product (see here). In July 2007 Banc of America Securities transferred $35 million of previous losses to unsuspecting investors in its LCM VII and Bryn Mawr II CLO offerings. Investors ultimately lost nearly $150 million in October 2008 when these two CLOs backed by leveraged loans were liquidated. After we issued our report, Gretchen Morgenson of the NY Times wrote an article about LCM VII and William Galvin, Secretary of the Commonwealth of Massachusetts, subpoenaed Bank of America over these two CLOs (see here).

Our casework can sometimes provide a pessimistic view of modern finance. Regulatory reform and changes in enforcement policy alone will not eliminate the problem. We think Mr. Smith has part of the story right when he appeals to corporate culture and the “moral fiber” of financial firms as a way to turn the tide. We would add that another key ingredient is investor education, which is the main purpose of this blog.

Friday, March 9, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD

District Judge Approves SEC Settlement with Koss Corporation and Michael J. Koss, its former CEO and CFO, March 9, 2012 (Litigation Release No. 22279)

In the SEC's October 2011 complaint (Litigation Release No. 22138), the SEC alleged that the Milwaukee, Wisconsin based Koss Corporation had prepared materially inaccurate financial statements from FY 2005-2009.  The complaint alleged that, during this period, Sujata Sachdeva (Koss Corporation's former Principal Accounting Officer and Vice President of Finance) had embezzled more than $30 million and covered up the embezzlement with the help of Julie Mulvaney (Koss Corporation's former Senior Accountant).  Due to the lack of adequate internal controls, Sachdeva was allegedly able to steal approximately half of the retained earnings in FY 2009.  The proposed settlement required Michael J. Koss to reimburse Koss Corporation with his incentive bonuses from FYs 2008-2010.  The SEC announced in the current litigation release that the US District Court for the Eastern District of Wisconsin has approved the proposed settlement.

SEC Charges Prime Star Group, Inc., with Violations of Antifraud, Registration and Reporting Provisions, March 7, 2012 (Litigation Release No. 22278)

According to the SEC complaint, Prime Star Group, Inc., and Roger Mohlman allegedly issued "18 million purportedly unrestricted Rule 144 shares pursuant to backdated consulting agreements or forged attorney opinion letters" to consultants Danny Colon, Marysol Morera, Felix Rivera, DC International Consulting, LLC., Kevin Carson, The Stone Financial Group, Inc., and Joshua Konigsberg.  The consultants alleged then "liquidated Prime Star stock and either kept a portion of the sales proceeds or forwarded proceeds to promoters to tout Prime Star". The SEC alleges these actions constituted a pump and dump scheme.

Judge Order Brookstreet CEO to Pay $10 Million Penalty in SEC Case, March 6, 2012 (Litigation Release No. 22277)

In December 2009, the SEC filed a civil injunctive action against Brookstreet Securities Corporation and Stanley C. Brooks (Brookstreet's former CEO) alleging that Brookstreet and Brooks developed a program in which registered representatives would sell particularly risky and illiquid types of Collateralized Mortgage Obligations (CMOs) to investors for which the investments were unsuitable.  These investors allegedly included seniors and retirees.   As a result of this program, the investors realized severe losses and Brookstreet Securities eventually collapsed.  Stanley C. Brooks was ordered by a federal judge last week to pay a $10 million penalty.

Jury Returns Verdict of Liability on all Claims against Two Former CFOs of infoUSA, Inc., Rajnish K. Das and Stormy L. Dean, March 6, 2012 (Litigation Release No. 22276)

The SEC announced earlier this week that an Omaha jury found former CFOs of infoUSA, Inc., Rajnish K. Das and Stormy L. Dean liable for their assistance in the looting of company funds to pay for former CEO Vinod Gupta's personal expenses.  In particular, the SEC alleged that Das and Dean "signed and certified [infoUSA]’s false public filings which underreported Gupta’s executive compensation and related party transactions."

SEC Charges New York Investment Adviser with Defrauding Investors and Obtains Emergency Relief, March 6, 2012 (Litigation Release No. 22275)

Early this week, the SEC alleged that Brian Raymond Callahan -- a New York Investment advisor associated with Horizon Global Advisors, Ltd., and Hortizon Global Advisors, LLC. -- defrauded at least a dozen investors by raising more than $74 million, promising to invest in liquid assets but instead investing in unsecured, illiquid promisory notes.  Furthermore, Callahan allegedly overstated the amount invested in a real estate project in order to collect inflated (by 800% or more) management fees.  Callahan and his advisory firms assets have now been frozen by the courts and the SEC is "seeking preliminary and permanent injunctions against Callahan and his firms, return of ill-gotten gains, with interest, and civil penalties."

SEC Sues California Insurance Broker and Pennsylvania Tax Manager for Insider Trading, March 5, 2012 (Litigation Release No. 22274)

Earlier this week, the SEC alleged that William F. Duncan -- a California-based insurance broker -- and John M. Williams -- a Pennsylvania-based tax manager -- traded securities of Hi-Shear Technology Corporation on material non-public information concerning a proposed acquisition of Hi-Shear Technology Corportation by Chemring Group, PLC.  Duncan and Williams settled the Commission's charges without admitting or denying the allegations against them by paying over $175,000 and almost $15,000, respectively.

Wednesday, March 7, 2012

SLCG Research: Non-Traded REITs

By Tim Husson, PhD and Carmen Taveras, PhD

We've posted a new working paper on our website that brings together much of our research related to non-traded Real Estate Investment Trusts (REITs).  In it, we discuss the history and structure of non-traded REITs as well as differences between non-traded REITs and other avenues for gaining exposure to real estate.  We highlight the dizzying array of fees and conflicts of interest embedded in these companies.  We demonstrate that non-traded REITs are often misleadingly valued, heavily leveraged, and financially unsustainable.

Real estate investments now come in a wide variety of forms, and retail brokers and investors may be surprised to learn that the differences between real estate mutual funds, ETFs, REITs, Tenants in Common (TICs), and other investments can be substantial and subject investors to unnecessary risks.  We will continue to develop research products that better illuminate these differences and help bring transparency to this often misunderstood market.

Hedge Fund Correlation with Broad-Based Indexes Increases Dramatically

By Olivia Wang, PhD and Tim Dulaney, PhD

As Bank of America-Merrill Lynch Global Research's Mary Ann Bartels showed last year, the correlation of hedge fund monthly returns with broad based stock market indexes has recently hit historic highs.  We decided to look into this phenomenon and determine whether or not it is persisting.

In the following plot, we show the monthly returns for the S&P 500 index as well as the Dow Jones Credit Suisse Core Hedge Fund Index (representing an aggregation of several hedge fund investment strategies).

This figure indicates that the volatility of hedge fund returns is smaller than the volatility of broad-based index returns; however, this result is misleading for several reasons.  Since the CORHI Index represents an aggregation across hedge fund strategies, the idiosyncratic characteristics of individual hedge funds are lost in the analysis.  Furthermore, hedge funds self-report their returns.  This leads to artificially low-volatility since hedge funds are able to smooth reported returns over several months (resulting from a phenomenon known in the literature as "stale prices").  A related reason for the observed low volatility of returns could be the so-called "incubation bias".   As a hedge fund begins to report returns, the presentation of historical returns might not be precisely reported (again leading to a smoothing of returns).

In the following figure, we plot the trailing twelve month correlation between the returns of the given hedge fund indexes and the S&P index.  The indexes in this figure are the Dow Jones Credit Suisse Core Hedge Fund Index (CORHI), Dow Jones Credit Suisse Core Convertible Arbitrage Hedge Fund Index (CORHICA) Dow Jones Credit Suisse Emerging Markets Hedge Fund Index (CORHIEM)and Dow Jones Credit Suisse Long/Short Hedge Fund Index (CORHILS).

In the following figure, we plot the trailing twelve month correlation between the returns of the given hedge fund indexes and the S&P index.  The indexes in this figure are the Dow Jones Credit Suisse Core Hedge Fund Index (CORHI), Dow Jones Credit Suisse Core Fixed Income Arbitrage Hedge Fund Index (CORHIFI), Dow Jones Credit Suisse Global Macro Hedge Fund Index (CORHIGM) and Dow Jones Credit Suisse Event Driven Hedge Fund Index (CORHIED).

These two figures indicate several interesting characteristics about hedge fund strategies.  Firstly, almost all hedge fund strategies currently exhibit a large (>0.5) positive correlation and have been exhibiting this level of correlation for the better part of the past two years.  This high degree of positive correlation indicates that the diversification benefits of hedge fund investing, at least when aggregated across several hedge funds within the same strategy, are limited in our current climate.  Secondly, the degree of correlation with the S&P 500 has remained relatively stable for several of the strategies over time. Third, different hedge fund strategies have historically behaved quite differently when compared to broad-based indexes, but recently all hedge fund strategies seem very closely tied to the behavior of the overall hedge fund index in terms of the correlation with the broad market (CORHI Index).

We hope, in future blog posts, to address the returns exhibited by the hedge fund industry at a more micro-level; however, this post will hopefully give our readers an introduction to the general trend in the hedge fund industry.

Tuesday, March 6, 2012

WSJ on Innovation in Commodity ETFs

By Tim Husson, PhD

Yesterday the Wall Street Journal ran an article about recent innovation in the commodity ETF space.  Our work on commodity ETFs has focused on their use of constant-maturity rolling futures strategies, which incur a roll yield depending on conditions in the futures markets.  Now, according to the WSJ, many ETF issuers are choosing more complex strategies to try to mitigate these and other effects in commodities markets:
Some of these new products use complex formulas to identify commodities with the most promising returns. Others place bets that pay off if prices fall as well as rise, a major departure. And in one of the most significant breaks with the past, some funds give managers wider discretion about which materials to invest in than traditional commodity indexes allow...
"You might say it's not indexing," says Matt Hougan, president of ETF analytics at, which tracks funds. "It may be that traditional indexing isn't the best idea in the commodities space."
The funds they mention have a variety of complex features.  For example, the PowerShares DB Commodity Index Fund (DBC) uses longer-dated futures contracts to try to reduce negative roll yield.  Pimco CommoditiesPLUS Short Strategy (PCCAX) takes short positions, betting that the value of commodities will decline.  Some funds, such as Invesco Balanced-Risk Commodity Strategy (BRCAX), and Highbridge Dynamic Commodities Strategy (HDSAX), allow managers to purchase or short a variety of commodities, as well as non-commodity assets such as currencies and swaps.

Some of these strategies, such as the long/short strategies used by the Forward Commodity Long/Short Strategy (FCOMX) and the Rydex SGI Long/Short Commodities Strategy (RYLBX), are commonly employed by hedge funds and options traders, and involve different risks and very specific outlooks as compared to buy-and-hold investments--all the more reason why retail investors should be extra cautious with these and other types of complex ETFs.

(Interestingly, banks have attempted to sell complex commodities strategies to retail investors before.  For example, Lehman Brothers sold structured products linked to their extraordinarily complex ComBATS dynamically-allocated commodity strategy just before their bankruptcy in 2008.)

Monday, March 5, 2012

Downloading Price Quotes from Yahoo! Finance: an Excel-Based Tool

By Geng Deng, PhD, FRM and Olivia Wang, PhD 

Yahoo! Finance is a useful tool to get the latest quotes on various financial products. Although it is very convenient to see the price movement of the security of your interest (for example, IBM Stock) on Yahoo! Finance, it is somewhat more difficult to download the data into your own Excel spread sheet. 

We recently designed an Excel template which allows users to directly download price data from Yahoo! Finance. You can download the tool from our website. To use the tool, simply call the macro function using the following syntax:

=GetPriceQuote(Ticker, Date) 

Here "Ticker" is the ticker of the security, and "Date" is the quote date.  The following screenshot shows the template in action (using IBM stock as an example):

If you have feedback for us while using this function, we would enjoy hearing from you.

Friday, March 2, 2012

SEC Litigation Releases: Week in Review

By Tim Dulaney, PhD and Tim Husson, PhD

Court Enters Summary Judgement Against Insider Trading Defendants John Jantzen and Wife, Marleen Jantzen, March 1, 2012 (Litigation Release No. 22273)

On Wednesday, United States District Judge James R. Nowlin of the Western District of Texas, Austin Division, entered summary judgment against Austin residents John and Marleen Jantzen on insider trading charges brought by the Commission in 2010. The Court found that both Jantzens insider traded in violation of the Exchange Act based on material nonpublic information obtained by Marleen, a former assistant to an executive at Dell, Inc, that Dell would soon acquire Perot Systems, Corp. in a tender offer. John was a licensed securities broker at the time and purchased call options and stock on the firms just before their public announcement of the deal. The Court ordered the couple to pay disgorgement of $26,920.50, representing profits gained as a result of the illegal insider trading, plus prejudgment interest.

Court Dismisses Remaining Claims Against Frank T. Noyes, February 28, 2012 (Litigation Release No. 22272)

The SEC had alleged (PDF) that Noyes manipulated revenue by backdating a contract in 2001. Noyes was a senior manager and then director of financial reporting at Qwest Communications International Inc., a Denver-based telecommunications company, between April 1999 and September 2000 and a senior director of finance in April 2001. The claims were dismissed upon motion by the SEC.

Court Enters Final Judgement Against Former CFO of Qwest Communications Int’l Robert S. Woodruff, February 28, 2012 (Litigation Release No. 22271)

The United States District Court for the District of Colorado entered a Final Judgment dated February 3, 2012, in a civil action against Robert S. Woodruff, the former chief financial officer of Qwest Communications International Inc., a Denver-based telecommunications company. The SEC claimed (PDF) that "from at least April 1, 1999 through March, 2001, Woodruff and others at Qwest engaged in a large-scale financial fraud that hid from the investing public the true source and nature of the company’s revenue and earnings growth," and that "Woodruff sold Qwest stock in violation of the insider trading prohibition of the securities laws." The Court found him liable for disgorgement of $1,731,048 (plus prejudgment interest of $640,427), imposed a civil penalty of $300,000, and prohibited him from acting as an officer or director of a public company for a period of five years.

SEC Obtains Final Judgments on Consent against Jason Pflaum and Walter Shimoon, February 24, 2012 (Litigation Release No. 22270)

The Securities and Exchange Commission alleged that between 2008 and 2010, Jason Pflaum (a former analyst at Barai Capital Managament) received material non-public information and caused others to trade upon this information. Similarly, Walter Shimoon (a former VP of Business Development at Flextronics International Ltd.) disseminated material non-public information about his company. Both Pflaum and Shimoon have plead guilty to their respective charges and were fined approximately $113,000 and $50,000, respectively.

Court Accepts Guilty Plea from Gregory McKnight in $72 Million Ponzi Scheme, February 24, 2012 (Litigation Release No. 22269)

In mid-February, the US District Court for the Eastern District of Michigan accepted Gregory N. McKnight's plea of guilty on the charges of wire fraud (one count) and his orchestration of a $72 million Ponzi scheme that ensnared over 3,000 investors. McKnight raised investor funds through his company Legisi Holdings, LLC and promised investors unrealistic returns (as high as 15%/month) by investing in "foreign currencies, commodity futures, stocks and real estate." McKnight allegedly only invested a fraction of investor funds and used new investor funds to pay for the supposed profits accumulated by old investors. In addition to the fines and penalties levied last summer totally approximately $6.5 million, McKnight faces the possibility of 20 years in a federal prison. For the previous litigation releases in this matter, see here and here.

Court Enters Judgements Against Defendants Magnum d’Or Resources, Inc., David Della Scuicca, Jr., and Dwight Flatt, February 24, 2012 (Litigation Release No. 22268)

In April 2011 (Litigation Release No. 21951), the SEC filed a complaint in the US District Court for the Southern District of Florida alleging Joseph J. Glusic and Magnum d'Or Resources, Inc. (where he was formerly the CEO and president) had committed antifraud and registration violations. In addition, Dwight Flatt, Shannon Allen and David Della Sciucca, Jr. were charged with registration violations. According to the litigation release, "Magnum issued stock pursuant to false Form S-8 registration statements, and used bogus consultants to funnel more than $7 million in illicit stock proceeds back into the company." Glusic and Allen have already consented to the entry of judgments against them, without admitting or denying the accusations. This latest release announces the results of the litigation which include nearly $9 million in fines and penalties for Magnum and permanent injunctions against Sciucca and Flatt.

Thursday, March 1, 2012

Time to Call for More Transparency in ETF Market

By Olivia Wang, PhD

Exchange-traded funds (ETFs) started as a “plain vanilla” product: a type of low-fee, tax-efficient mutual funds holding index-mimicking portfolios. The first ETF was formed by the Toronto Stock Exchange in the 1980s and has garnered spectacular popularity in recent years. According to a recent article in The Economist, the number of ETFs in America has almost tripled from its 2006 level of 343 to 1,098 in December 2011. This volume increase has been accompanied by substantial financial innovation beyond that found in a traditional index-mimicking ETF (leveraged ETFs, inverse ETFs and synthetic ETFs are all great examples of this innovation).

Last week we had a blog post introducing the basic properties of synthetic ETFs. A synthetic ETF attempts to generate returns of an index using derivatives instead of physically holding the underlying index portfolio. An unfunded synthetic ETF is based on a total return swap, while a funded synthetic ETF is essentially issuing equity-linked notes (ELNs) promising specified returns. Usually the counterparty of the total return swap or the provider of equity-linked notes is an affiliate of the ETF manager. Furthermore, banks typically have full discretion over the composition of the collateral portfolio. As a 2011 BIS working paper points out, this arrangement provides incentives (for example, reducing the bank’s regulatory capital requirements) for banks to post low credit quality and illiquid securities as collateral assets when they act as swap or ELN providers. This practice could lead to substantial losses for ETF investors when banks fail to deliver the promised returns.

That being said, physical ETFs are not completely without risk. Although in a less obvious way, physical ETFs also exhibit counterparty risk. Many physical ETFs routinely lend out securities to other investors to increase their returns, exposing ETF investors to the possibility of counterparty’s default. Also, as the territory of the indexes used by ETFs expands, the basket securities would unavoidably leave the liquid stock market and enter into more thinly traded asset markets, resulting in an increase in liquidity risk of the ETFs in the future.

The momentum of ETFs’ growth seems to be unstoppable at this moment. However, as ETFs evolve and the complexity of their operations increases, more transparency and proper disclosure should be required.