Ishrc � Discussion Threads

[kiwi2007] 13/3/2009 01:06

Sorry, the following is rather long, but pertinent .
Unfortunately I can't find a link to go direct to it on ftalphaville:

The curious case of ETF NAV deviations
Posted by Izabella Kaminska on Mar 12 15:34. 5 comments.

It would probably be fair to say that since launching in the 1990s, exchange-traded funds - hailed as among the most innovative and attractive retail investment products of recent times - have caught the investing public's imagination.

It's easy to see why. They're cheaper and more flexible than mutual funds. And because of the number and variety of funds on offer they can seriously empower an enthusiastic amateur's ability to manage his own money. Meanwhile, because they trade just like stocks, they're open-ended and can be exited at any time.

Of course, essential for the ETF model to work, are the funds' methodologies which depend on Net Asset Values (NAV) of individual units correlating closely with the price of the exchange-traded units themselves. To achieve this ETFs depend on 'authorised participants' and arbitrage incentives, created via the process of in-kind 'redemption and creation' - a sort of incentivised market manager independent of the issuing house.

However, post last autumn's financial stroke, could this ETF arbitrage mechanism be failing?

Morningstar's Bradley Kay asked the question in a recent article, noting that the iShares Barclays Aggregate Bond, Vanguard Total Bond Market ETF and SPDR Barclays Capital Aggregate Bond have all been selling for a premium of between 1-3 per cent over their quoted net asset values since the beginning of the year. (At this point it's important to remember the idea of ETFs trading at a persistent discount or premium to their NAV was something we were told by ETF developers would never happen.)

As Kay explains, it all rests on the arbitrage opportunity :

Essentially, the fund must publish, every 15 seconds, an up-to-date version of its portfolio, including the vast majority of securities it holds and the amount of cash necessary to buy the rest. The fund also publishes an estimated cash value of those holdings, known as an Intraday Indicative Value, based upon the most recent prices of the securities in its basket. At any point in the trading day, major banks and trading desks known as authorized participants can come to the fund with a basket of the underlying securities given in the published holdings, which the fund will exchange for a creation unit consisting of a set number of shares in the ETF (typically 50,000).

Similarly, the APs could also buy up shares in the ETF on the market, then exchange them with the fund in return for the published basket of underlying holdings. So if the market price for the ETF starts to rise too far above the price of its underlying stocks or bonds, the APs will buy the underlying holdings, exchange them for shares in the ETF, and sell enough of those shares to drive the price back down to net asset value. Similarly, APs will buy up any shares of the ETF trading at a discount so that they can turn in large blocks of shares for the more expensive underlying securities. This drives prices for the ETFs close to the prices for the underlying stocks and bonds and produces some of the incredible tax benefits of ETFs to boot.

But as Kay also points out, this arbitrage works only if APs can trade the funds' underlying stocks and bonds. When panic strikes, liquidity dries up. This can compromise the arbitrage mechanism, seeing market prices for index funds deviating substantially from the calculated value of their underlying holdings.

As a fund researcher, Morningstar is in a good position to note the frequency and degree of such deviations. Kay says the first time they noted such moves on a major scale was in October 2008. As he says:

With this sudden spike in uncertainty over the future of corporate America, corporate-bond markets froze by Oct. 10. No one knew what would happen to default rates or interest rates in the future (remember how we went from an inflation scare to the threat of deflation in about two months?) and prices had already fallen substantially, so market participants simply refused to buy any more.

Because there's no exchange publishing prices, the corporate-bond market also depends heavily on major broker-dealers who keep a large inventory of bonds on their books for any potential buyer. After the collapse of Lehman Brothers, those broker-dealers were trying to reduce the size and risk of their assets at the same time institutions and investors were trying to sell out of corporate bonds, so the market had no major buyers and no ways for the few willing smaller investors to publicize their buy prices on the myriad corporate bonds available.

However, there were now bond ETFs trading on the stock exchanges. Investors and institutions eager to sell their risky corporate bonds had to settle for hedging their exposure by instead selling the still-liquid basket of bonds on the market. This drove down the market price for the ETFs while the net asset value stood still due to the lack of new prices on the underlying securities. The APs who would normally jump at discounts of 5%-10% refused to take on more corporate-bond exposure by purchasing the millions of dollars of shares necessary to redeem for the underlying portfolio, and they couldn't find any buyers for the underlying bonds anyway.

Any brave investors who bought the major aggregate-bond ETFs issued by iShares, Vanguard, or SPDRs may have bought at a large discount on paper, but they were likely paying a fair price for the basket of bonds due to the sheer uncertainty about future values and the liquidity they were providing. During the few days when panic sweeps over a market like it did in October 2008, net asset values mean very little due to the lack of fresh prices, and frequently traded ETFs provide a better estimate of their holdings' true value than any estimate based on the old prices.

And while discounts on the major bond ETFs persisted through October and into November, when governments began to prop up the bank lending and commercial paper markets, a new trend started, according to Kay. The bond indices started to trade at a premium to their net asset values. As Kay explains:
Once again, this was less a fault of the ETFs than a result of the liquidity in the market for the underlying securities. At the end of 2008, bond markets were calmer as the large spreads on corporate debt seemed to offer sufficient compensation for the newly higher risk of defaults. However, the major banks and trading desks that provide liquidity to the corporate-bond market were still trying to reduce their exposure to risky assets, which entailed lower bond inventories, wider bid-ask spreads, and less trading.

In the environment, however, investors wanting to pick up bonds would still have had a hard time assembling portfolios in a short period. Buying liquid fixed-income ETFs was therefore much easier. Plus, there was the fact that ETFs had proved just how useful they were in October and November when things turned bad for bond investors - unlike traditional bond investors, ETF investors could easily get out of their positions if they needed to.

Of course, the added flexibility hasn't come for free, says Kay. The APs' incentive to arb between units and underlying has disappeared, and so they have begun to ignore price differences between NAV and market value which previously they would have 'swiftly arbitraged'. As Kay surmises:

Although newly created ETF shares would be fairly easy to sell at a premium, these major trading desks would take a while to accumulate the large bond portfolio necessary to create those shares in the thinly traded bond market. During that time, they would have to carry a larger inventory of corporate bonds and the corresponding risk of another sudden market collapse. With the higher risks persisting today and the longer holding periods necessary to build up and sell off the bond stake, APs demand a larger premium before they will perform the arbitrage. Throughout the early part of this year, iShares Barclays Aggregate Bond, Vanguard Total Bond Market ETF and SPDR Barclays Capital Aggregate Bond all sold for a premium of 1%-3% over their quoted net asset values.

The above is particularly interesting in light of the issues affecting 'the United States Oil Fund' ETF of late. In the USO's case, because the derivative oil industry is so much smaller than the fixed-income world, its own recent accumulation in size has created distortions in the very market it tracks.

On a side note, the build-up in the fund's size was curious in itself given the fact the market was in super contango - a highly unprofitable time to be investing in an oil ETF that tracks the front-month contract as the fund's returns routinely falter every month at rollover. Fund specialists nevertheless attributed the growth to a rush of interest from retail investors seeking oil exposure on the idea it was cheap and ripe for a rally - and most likely unaware of the contango effect.

While that's all very possible, energy analyst Olivier Jakob at Petromatrix pointed out recently that by far the largest investors in the USO were and are institutional and professional parties, not retail investors. What's more, these parties should have known how the fund's growing size would negatively impact the efficiency of the roll - because a predictable and sizeable player in the market can theoretically be front-run by other market participants.

Meanwhile, at FT Alphaville we speculated whether there was some sort of manipulation going on that focused on heightening or exploiting the deviation between the NAV and market price of units - so as to encourage the fund to take on new underlying WTI contracts at a non-opportune time for itself. The idea being it could potentially create a profitable trading opportunity for authorised participants or other players who were also invested in oil securities.

Indeed, the fund itself explains in its prospectus the AP's particular unique ability to benefit from their position if also invested in oil securities.

Certain Authorized Purchasers are expected to have the facility to participate directly in the physical crude oil market and the crude oil futures market. In some cases, an Authorized Purchaser or its affiliates may from time to time acquire crude oil or sell crude oil and may profit in these instances. The General Partner believes that the size and operation of the crude oil market make it unlikely that an Authorized Purchaser's direct activities in the crude oil or securities markets will impact the price of crude oil, Oil Futures Contracts, or the price of the units.

As can be seen, the fund relied on the fact that the oil market was too big to manipulate by the AP itself, especially for its own profit and to the disadvantage of the USO. However, they may not have accounted for experiencing so many negative factors all at once: super contango, massive position build-up, NAV/market price deviation.

As they themselves state:

The more assets the General Partner manages, the more difficult it may be for it to trade profitably because of the difficulty of trading larger positions without adversely affecting prices and performance and of managing risk associated with larger positions.

It could be said, therefore, that the fund's growing size became an additional Achilles heel in an already negative contango scenario - as well as having to pay a premium as it rolled, it was having to add positions which only heightened its losses. It is all these factors combined that could possibly have also presented some sort of profit-making opportunity for APs or other market participants.

Curiously, after the CFTC's announcement in late February that it was investigating the USO's influence on the WTI futures market, the fund actually began reducing positions almost as quickly as it had built them up. This still appears to be the case as of Thursday. More bizarrely still, the reduction comes just as the contango is in decline and people are becoming increasingly convinced of an impending if modest rally to come - not quite the sentiment three months ago. This surely makes now a far more logical time to invest in an oil tracking ETF than back in November when, which ironically is when the fund began to grow in size.
As for the NAV/market price deviation - the USO's market price on Wednesday was trading at a premium of some 1 per cent to the NAV. That's a much steeper deviation than the fund's historical average. As the following data from Morningstar shows, the market return from USO units in 2009 (as far as February) was -18.28 per cent, versus returns on the NAV of -20.20 per cent. This means the NAV markedly underperformed the units by as much as 1.92 per cent over the first two months of 2009. The opposite is true of 2008 where the NAV outperformed the market price by 1.57 per cent. Going back to 2007 (the more normal market years), the NAV outperformance was merely 0.67 per cent - much more in line.

USO performance history - Morningstar

If you look at the deviation-specific data from Morningstar, however, the evidence is even more telling. Note in October 2008 - just when the fund began to balloon in size - how the deviation also ballooned to as much as a 4.5 per cent of the NAV to the market price.

That said, a comparative deviation also occurred across other oil-invested funds like the PowerShares DB Oil fund, and the USL (the USO's sister fund) - the peak deviation averaging about 4 per cent in and around November/December 2008. That, by the way, is almost double the fixed income funds' deviation referred to by Kay. Of course, the USO was the only one of those funds to simultaneously mushroom in size at the time. Meanwhile, other fund classes - like stocks-trackers –remained firmly within their historical deviation trends throughout the period.

USO deviation - Morningstar

Whatever the reasoning for the above moves, the takeaway is that ETFs - often billed as rock-solid investment vehicles - are clearly not always going to act as expected. And with that in mind, retail investors in particular should take heed.

[jeddah jo] 11/3/2009 19:59

Reminds me of the time during oil shock in 1970s Idi Amin offered to send the UK some bannanas as aid while we were calling in the IMF :)

[miata] 11/3/2009 11:21

To me it still looks too early for growth stocks. Long term treasuries still have mileage for a few months, index-linked gilts even longer.

The Governor of the Central Bank of Zimbabwe is delighted that the UK is now following his lead and hopes that the UK will now recognise that Zimbabwe have led the world in printing money and nominate him for a Nobel prize in Economics.

[simon gordon] 11/3/2009 11:19

It still looks too early for Corporate Bonds. Growth stocks look the best bet if you can handle the volatility:

[erpetao] 11/3/2009 11:05

What about today's huge drop in NAV? Any news?

[kiwi2007] 09/3/2009 22:18

SLXX Continuing to price in Armageddon !!

From FTAlphaville

HSBC: underweight equities and overweight credit
Posted by Stacy-Marie Ishmael on Mar 09 18:29. 1 comment.

Corporate credit might be the the pachydermic herd in the room, but it's a better buy than equities, according to HSBC's Richard Cookson.

In a note published on Friday, Mr Cookson argues that "it's unclear why we'd be anything other than underweight equities and overweight credit." More...

Corporate credit might be the the pachydermic herd in the room, but it's a better buy than equities, according to HSBC's Richard Cookson.

In a note published on Friday, Mr Cookson argues that "it's unclear why we'd be anything other than underweight equities and overweight credit."

He argues, emphasis ours:
...corporate debt is just about as cheap as it's ever been compared with corporate equity. Over the next few years it's likely to become a lot more expensive, both because spreads fall and because equity valuations fall a lot, much as happened in the late 1930s.

The big problem for now is that dividend yields are under huge pressure from plunging corporate profits and dividends that are being slashed left and right. In the medium term, then, the only way in which relative valuations can improve is if spreads fall a lot or equity prices adjust downward. In English, if corporate spreads don't collapse, then there's a big risk that equity prices will collapse even more than the 60% they've already fallen.

US equities would look reasonable value compared with investment-grade credit were spreads to fall to 220bps and look cheap were spreads to fall to 150bps. If spreads fall by only 150bps from present levels, nominal growth in GDP is a percentage point less than our strategists assume in their equity-risk premium calculation and dividends are cut by 20% from present levels – none of which seem especially heroic assumption – then the S&P500 would be reasonable value at, er, 200.

Ignoring a tactical bounce, always a possibility, the real question for equity investors is whether they are now paid sufficiently to take equity risk in an environment where the global economy is collapsing faster than one of Navigator's cheese soufflés (yes, he's a man of hidden shallows). Probably not, is our answer, unless credit spreads fall an awful lot.

And:

when it comes to relative valuations and likely future performance, corporate debt is, quite simply, hugely more attractive than corporate equity. Even though the latter market has now fallen almost 60% from its high, there's still a lot of downside risk. Strategically, over the next few years we would strongly expect a huge revaluation of corporate debt compared with corporate equity. That's likely to mean spreads come in a lot in coming years, as they did in the 1930s after spiking up hugely at first, but there's a risk, too, that equity valuations will adjust lower via the simple expedient of prices falling further.

You get the picture.

[sicall] 03/3/2009 10:22

Some very good points there Alun RM. I agree that i dont think the yield justifies the risks especially with such a large holding in financials.

If you compare this ETF with some of the American Bond ETF`s i dont consider this one compares too favourably.

Check out AGG, BND, CFT, HYG, IEF, JNK and LAG.

I think the best option is spread your money in corporate bonds around several open end funds and ETFs and remember High yield = Higher Risk.

[hazelton] 22/2/2009 18:33

I accept these arguments and as I see it capital movements usually dwarf the dividend payout. Waiting for bonds to rise may be a good idea.

[boozer99] 22/2/2009 07:59

Alun,

For what it's worth I agree with your actions and some of the reasoning. I put these (and the BB) on my watch list 3 months ago. I didn't buy bought them for 2 main reasons.
The universe of investments from which the fund can choose is limited to too few instruments: compared to an equity index fund, that is too small a subsector.
Secondly, the financial overweighting. I don't (and have never) owned banks because they are too opaque.

Lastly, though not the governing factor, is that there is too much hype over corporate bond funds for PIs.

p.s. I like the fact that you sold at a loss. Good discipline, although repeating it too many times is not conducive to good returns ;)

p.p.s. I have not yet bought gold, so it probably has further to rise. I have bought baked beans and ammo though.

[alun rm] 20/2/2009 12:09

Well, I finally gave up on SLXX today and accepted a loss (average in was £112 and I got one dividend) so the loss isn't tragic, but still annoying. The reason for selling is as follows:

1) The economic reality is going from bad to worse and I don't doubt that we are going to see record numbers of buinsesses going under over the next 2 to 3 years as the spare capacity built up to supply to debt based spending has to be cut away. As firms go under, so corporate bonds will have to price in rising defaults (we are already seeing this, hence the recent falls). I am affraid that the price of SLXX does not yet fully reflect the troubles ahead.

2) Even as SLXX is being purchased in huge amounts, the value keeps dropping. I suspect that this shows that as the retail investors are buying into the stories of 'once in a lifetime opportunity to lock in yield on triple A bonds', the professionals are selling bonds like crazy in the background. You have to ask yourself, who knows better what is going on. the pros or us?

3) SLXX is over exposed to financials, and I am becoming more and more persuaded that many of the banks in the UK, US and Eurozone are effectively insolvent. More and more commentators are argueing for complete nationalisation, and I am now of the opinion that this is the best solution. We need a 'Swedish style' solution to give the whole economy a fresh start. Gordon Brown has shown that he is capable of moving in which ever way the wind blows (try new classical to Keynesian in a weekend!). I don't doubt that he will nationalise the moment he thinks that it may give him a better chance of surviving in office.


Clearly, I can't hold bank debt if I believe that the banks need to be nationalised. If this scenario plays out, then SLXX will get slaughtered (£80?). It will probably come back, as debt gets swapped for equity, etc. But I don't want to go through that experience as a holder.

I fell for the idea that the banks were backstopped by the government and that the yield on bank bonds was high for a 'quasi gilt'. The reality is that the yield reflects the risk (as it always does) and for me the risk is too high at this time.

I wish all holders well. I am now 100% cash and plan to sit back and watch 2009 happen from a neutral position. I am buying physical gold and silver coins, slowly each month, just incase the whole system implodes and I need something other than paper!

Good luck,

Alun

[borderbill] 20/2/2009 09:18

kiwi

that is interesting, I guess you are saying the income is 'franked', as I hold my investments in a ltd company that woudl be better from a tax perspective than slxx, bill

[borderbill] 18/2/2009 12:46

Kiwi

I will look at NCYF also, thanks, bill

[kiwi2007] 18/2/2009 11:41

I also hold NCYF which, unfortunately, has even underperformed SLXX :o(



From their pdf out today concerning corporate bonds etc.:

The latest Moody's monthly default report has forecast a jump in the US and European issuer-weighted default rate to
15.5% and 18.3% respectively. The peak in 1990/91 was 11.9%. High yield markets currently are discounting in excess
of 50% default rates over the next 5 years, compared to 45% in the Great Depression.

The High Yield market therefore has priced in a lot of "downside" in the global economy and hence could have a
reasonable performance in 2009. Add to this the technical point that Moody's credit rating models use current spreads
as a large input which may "overclub" the figures and be less of a lead indicator as to the actual state of the credit
market, and more an indicator of a current less liquid and somewhat dysfunctional market.

[borderbill] 18/2/2009 11:35

gilts up SLXX sideways or down, slxx gross redemtion yield 8.5% with average term 18 years, gross redemption yield on 18 year gilt 4.25 2027 = 4.25% - double the yield, but double the worry ! tempted to give up on this with a 4% loss on my average price oc c£111, but then you get 2% divi this month - what to do ? suggestions anyone ? bill

[spacecake] 16/2/2009 19:35

Skyship: Follow the link for a list.

[skyship] 16/2/2009 13:37

I just don't understand this one. Decided to make an allocation into corp bonds 3 months ago. Considered SLXX, but actually bt 3 bonds with 2011/12 redemption dates - Compass, J. Lewis and Marks&Spencer. Have now sold all three as they delivered an average gain of 6.5% in 3months. In that time SLXX has slipped 3%!!

Think I'll stick to stock-picking. Recently bt back into the Aviva Prefs yielding 8.75%. (AV.A & AV.B)

Anyone got any other high-yielding recommendations?

[simon gordon] 16/2/2009 13:04

Bloomberg - 17/2/09:

Lloyds Leads Drop in Bank Bonds to Record Low on Rescue Concern

[kiwi2007] 16/2/2009 10:00

Quarterly dividend does vary! According to the site Flat Yield = 7.33%
and Gross Redemption Yield = 8.30%

[erpetao] 16/2/2009 08:12

RNS Number : 3291N iShares GBP Corporate Bond 16 February 2009 iShares Dividend Declaration 4th Distribution for the accounting year ending 28th February 2009
Announcement Date: 16th February 2009
Ex Date: 25th February 2009
Record Date: 27th February 2009
Payment Date: 25th March 2009


Fund Currency Rates


iShares £ Corporate Bond GBP 1.9085


That's around 1.9085/107.4*4*100 = 7.10% yield at current price.

[lbo] 09/2/2009 21:19

Corporate bonds – a compelling opportunity

[flyfisher] 06/2/2009 20:37

LONDON -(Dow Jones)- The Bank of England said Friday it intends to buy small amounts of a wide range of sterling-denominated U.K. corporate bonds and commercial papers.

In a notice to participants in the fixed income markets, the BOE said the GBP50-billion Asset Purchase Facility announced by the government on Jan. 19 will be "operational" from Feb. 13, but it's not clear that purchases of commercial paper will be made from that date.

The APF is intended to improve liquidity in the markets for debt securities issued by companies that "make a material contribution to economic activity in the U.K."

The government and the BOE believe that will cut the cost of borrowing for companies, giving them an alternative to bank loans, which have become particularly difficult to find since September of last year.

The BOE said the securities it will purchase will be of "high credit-quality," but they can include bonds that are one ratings notch above junk, and therefore relatively likely to be subject to a default.

The notice to participants in the bond markets makes it clear that much of the fine detail of the facility has yet to be finalized, and it lists eight key issues on which it is "seeking feedback."

But if buying corporate bonds seems likely to happen some time after Feb. 13, the purchase of bank bonds that carry a government guarantee, asset-backed securities, and syndicated loans seems even further off.

The BOE was given all three options under the Jan. 19 announcement. But in the market notice, the BOE would only say that it "could in principle" set up a facility to buy bank bonds.

"The bank is keen to engage on these issues, and in due course on detailed operational requirements," the BOE said of possible purchases of asset backed securities and syndicated loans.

The BOE said it will buy commercial paper with a maturity of at least three months, and rated at least A-3, P-3, or F-3 by the three main credit rating agencies.

The BOE said it won't disclose the names of the issuers of the paper, but will publish a weekly account of the total volume of its purchases.

It said it will restrict its purchases of corporate bonds to conventional, senior unsecured debt, thus excluding convertible or exchangeable instruments. The bonds must be rated at least BBB-/Baa3 by two of the three agencies, but will be excluded if they carry a junk rating from one of the agencies.

Bonds at the lower rating limit that are on negative credit review will also be excluded.