Investing In Bear Markets – A Conversation

The author of one of my favourite blogs (Thicken My Wallet) and I had another conversation – this time about “investing in bear markets, high-dividend yield stocks and all matters investing in these uncertain times.” Instead of both parts appearing on his blog, this time we are splitting the hosting duties and he has published Part 1 on his blog (to be published at 5:00am on April 10th) and this is Part 2. As before, his comments appear in italics…

PPNs and ETF’s

Let’s talk about two popular investing products: principal protected notes (PPN’s) and exchange traded funds (ETF). We seem to have creeping fees in both products which is pretty mind-boggling for PPN’s given how high fees are already. Even ETF MER’s are creeping up to above 0.50%. Is the market getting its grubby little hands on these products and making a bad product worse and a good product mediocre?

I think PPN sales are increasing even though the industry (and investors) are starting to react to the negative press surrounding them (mostly in the name of said high fees). More assets will flow into these notes given the recent market turmoil. As you can imagine, guaranteed products tend to pick up steam during times like these.

It would seem that they are building in self levering mechanisms to make them more appealing (beyond the traditional levering mechanisms). While I believe that built in levering with principal protection can look good – you still have to keep an eye out for what you are paying for that levering on top of what the fees are for the structure of the note itself.

All in all, while most PPNs use the CPPI structure (constantly proportionate portfolio insurance), you can build your own PPN that mimics the zero-coupon structure by purchasing a strip bond for 80 cents on the dollar, and using the left over 20 cents to go crazy – I suppose you could buy an option on HXU. That’s a call option on an ETF that is already 200% self levered – in other words two layers of leverage. If the option expires worthless, you still have your principal. If the TSX/60 goes up, you have massive gains on 20% of your original investment. I wrote a post about creating your own principal protected note here, but given that over 7-10 years a developed market has very little chance of losing money anyways, what’s the point?

In the end, PPNs (or creating your own) are for those who need to pay for the peace of mind and don’t mind doing so.

I guess I haven’t directly answered your question yet. I think the fees on PPNs are still high, but the notes are actually getting better. There’s still lots of room for improvement though. I would even venture to say that the fact that PPNs are so proliferative is a testament to the poor job the industry has done with respect to investor education if the investor is willing to pay extra for insurance they don’t need for the most part.

With respect to ETFs there are a number of reasons for the higher fees. While MERs on ETFs tend to increase the farther from home you are, that can be mostly explained by increased brokerage costs in the foreign markets. The newer ETFs you are talking about have two other factors to consider. Firstly, we have an explosion of ETFs that have included strategy and quant ETFs and self-levering ETFs. Secondly, the mutual fund gravy train is slowing and the industry sees it. The first actively managed ETF was launched a few weeks ago (by Bear Stearns no less) and Proshares has a slate of actively managed ETFs waiting for final approval. Surely you’ll agree that the industry is taking advantage of the explosion and media attention of ETFs in this case.

No argument here. The investment industry is just like sports. Figure out what the champion did and then be a copy-cat. I am sure if the Patriots won the Super Bowl, everyone would have encouraged their quarterback to date a Brazilian supermodel. Well… no prompting would be required for that. If the industry is shifting gears from mutual funds to ETF’s, we know that fee inflation will occur. In what instances are higher than average fee ETF’s justified?

I’ll be the first to say that I am a fan of some of the ETFs that provide double the daily exposure to certain indices because in this case, while the fees are very high for an ETF, the value is justified in my mind for a few certain funds. For example, some ETFs that provide double the daily performance on an index are capped at 2.00% MERs. If you believe a certain index will indeed go up over time, this gives you a moderately safer way to leverage into that market for the long haul and enhance your returns.

You better explain double the daily exposure comment to me.

Sure thing: These ETFs employ self-levering through derivative products with the specific goal of returning 200% of the performance (or -200% of the inverse performance for the inverse ETFs) of the underlying index. This doesn’t mean that you just double the returns for an index to figure out your final return – and this is explicitly why they include the words “of the DAILY performance” as the derivatives are unwound at the end of each day. Here’s an example of why you wouldn’t just double all the performance statistics of the underlying indices:

Let’s say your levered ETF’s underlying index goes from 100 to 150 in one day. The index is up 50%, so your ETF is up 100% (100 to 200). The next day, let’s say the index goes right back to 100 from 150. The index lost 33.3%, but the ETF lost 66.6% (200 to 67). So to recap: the underlying index was net flat over the two days, but your levered ETF started at 100 and ended up down 33%. (Note I wrote specifically about this yesterday.)

Let’s talk about value in ETF fees if the general trend is towards MER inflation. Jeremy Siegel talks about the next generation of ETF’s being fundamentally weighted indexes but they have higher MER’s. Is a fundamentally weighted index worth more fees than capitalization weighted indexation (note to reader: each stock in the latter is weighed by market value whereas each stock in the former is weighted by generally profits. Thus, in theory anyways, a fundamentally weighted index will not overweight itself in a particular high flying stock)

I feel I should mention (only to make people jealous!) that I will be meeting Jeremy Siegel in May. I will ask him if the higher fees are warranted – I don’t know if they are seeing as how the same computer programs that are responsible for keeping index funds aligned with the underlying indices just need to be fed different data for their programmed trading algorithms. In the meantime, we’ll have to put up with the higher fees nonetheless.

The value of quantitative ETFs like the ones that apply a fundamentally based weighting strategy on an index are not so cut and dry. Personally, I believe that the less efficient a market is, the more value a fundamental strategy can provide. I also provide my clients with the option of using a fundamental screen on even the efficient markets however. As an example, those who tell me that the problem with ETFs is that they don’t provide downside protection are prime candidates for presenting fundamental screening on even the most efficient of markets.

For example, the FTSE RAFI screen on the TSX: back in January of 2001 when Nortel was over 25% of the index, it was less than 9% of the FTSE RAFI Canadian index. When the bubble popped, the market-cap weighted index tanked and the FTSE RAFI did not. Also, since the FTSE RAFI places emphasis on the fundamentals of a company for weighting purposes, when the markets take a downturn and investors start pouring money back into blue chips and other “quality” stocks it’s what is called a “flight to quality” which keeps dividend payers and the like more resistant to market drops.

There has been an outperformance of fundamental screens over market-cap weighted indices for the last few decades, but the outperformance increases dramatically as we look at less efficient markets. By screening based on fundamentals, you are indeed taking a pseudo-active approach however, and therefore you must recognize that the outperformance may not always persist.

I do use fundamental indexing ETFs, levered ETFs and “plain-vanilla” ETFs in my practice. The third line on the graph that is close to the index line is an ETF that tracks the index – the ever so slight lag is the effect of tracking error and the small MER.

What are your thoughts on all these specific ETF’s that narrow down geography to say, India, or industries to, for example, only infrastructure stocks. Doesn’t this defeat one of the primary purposes of a ETF which is to give you the widest exposure to as many stocks as possible?

It’s getting a bit crazy to be sure and I would agree that for the purpose of broad diversification, it is defeating one of the advantages of indexing. However, for the purpose of strategic asset allocation it is welcomed. I use very broad index ETFs for the core of a portfolio and then can use the more specific ETFs for the satellite portion of a portfolio on a client by client basis (or stocks or bonds or funds, etc). For example, I have an Indian client who insists on getting some fun money into India specifically – the new India ETF allows me to do this more precisely than a BRIC ETF or Emerging Markets ETF. So they have their places, but I prefer sticking to the broader indices for the most part.

Fun Investing

Let’s talk about some fun investing. Many advisors and planners suggest to their clients that, if they really wanted to get their ya-ya’s out, to take up to 5% of their portfolio and invest it anyway they want- however crazy; typically called “fun money.” Suppose you had 5% of your portfolio to do some “fun investing”- invest in a stock that may be a ten bagger (a stock which increases 10 times) and you couldn’t care less if you lost the money. What would you do?

I have a couple of clients who have dedicated a certain percentage of their portfolio for something similar. It’s not exactly viewed as crazy risk taking, but rather a combination of jumping on opportunities as they present themselves and then making a play. They rely on me to call up and provide ideas when I see opportunities for quick gains or good entry points. It’s fun for them and fun for me, and I’ve been very, very lucky so far. With them, we’ve initiated trading positions on certain stocks that have netted us some double digit gains in the matter of days or weeks. And some of these stocks you see over and over again bouncing up and down. To be clear, I don’t call people up every day with a new idea, maybe once a month or two. For example, when the markets sunk like a stone on January 21^st, I called a few people to see if they wanted to buy HXU (200% exposure to the TSX/60) – it made 20% in a few weeks. My rationale on something like that is, for the risk takers, if they think the Canadian markets generally go up, we were 15% better off buying that day than we were 6 months ago. Trade ideas like that are generally made with the intent that if the trade goes sour, we would be happy holding for the long term anyways. And like I said, I’ve been lucky so far – I won’t fool myself into thinking that such an approach should be applied to the bulk of a portfolio no matter how smart a particular trade might have looked in hindsight.

If I had 5% to invest in anything without consequence, my ten bagger would be some junior oil play in Africa. When the U.S. Navy is budgeting for $300 barrel of oil in five years, you might as well take a chance on relatively unexplored oil fields – damn the political instability, dodgy drilling results and lack of refineries!

LOL – yeah, in retrospect my risk taking is tame in my eyes compared to that! J

Thanks for your time. Maybe do this again in the early summer?

Sure thing – but it’s my turn to do the interviewing! :)

You’re on.