Tag Archives: alternative

The Market Vectors Russia ETF – Low Oil Is An Existential Threat, The Worst Is Yet To Come

Summary Low oil prices have important implications for Russian economy and RSX holdings. These implications go beyond the direct damage. I explain my views on this topic, as well as on the Central Bank’s policy and the ruble exchange rate. In my latest article titled ” RSX: Ready For December Wipeout ” on the Market Vectors Russia ETF (NYSE: RSX ), I discussed the recent developments including the weakness of oil and the relative strength of the Russian ruble. In this article, I will focus on the role of the ruble exchange rate for the economy, the Russian Central Bank’s policy and its implications for RSX. Why the ruble is so important? First, I would like to address the role of the Russian ruble exchange rate for the country’s economy. In my view, failure to acknowledge the governing role of the exchange rate for the Russian economy will lead to wrong assumptions and wrong conclusions about the state of the economy, the state of individual firms and, ultimately, the direction of RSX. One of the first comments on my preceding article stated that Russia, perhaps, was relying on champagne from France, and could live without it. This is very far from truth. For years, the Russian ruble suffered from the so-called Dutch disease – it was very strong. The combination of high oil prices and a strong ruble made production in Russia not viable in many cases. Why produce something, risk capital and wait for years for return on this capital when you can just buy what you need with the funds from energy and materials exports? This tactic was also politically convenient, as it brought immediate results that anyone can feel through increased consumption levels. However, there was a major flaw in the whole system that everyone knew but did not want to address. The whole system was (and still is) heavily dependent on just one variable – the price of oil. Back in 2009, Russia was lucky and oil rebounded fast. This time, luck is over. From the comments that I read here on SA I see that many people think that low oil prices just make life for the Russian economy harder through lower oil income. However, the damage spreads wider. Low oil prices are an existential threat to the current economic system, and it will take time to develop a real response to challenges. When people think about Russian imports, they typically imagine something like clothes, pork or the abovementioned champagne. Yes, these could be internally substituted. The price will be high, the quality will likely be so-so, but a substitute can be made. However, when we think about capital goods like tools and machines, the situation starts to look dire. Here’s a snapshot of top Russian imports. Source: www. worldrichestcountries.com As you can see, Russia imports things that are necessary to produce other things. This means that it will take long time before the country can internally source the means of production. Below is the graph of Russian industrial production this year. (click to enlarge) Source: tradingeconomics.com The devaluation of the ruble failed to improve situation on this front. Also, please note that quality is not included in such calculations. What do you think about the quality of internally produced tools and machines when the country chose the easy way and just bought them for 15 years in a row? The Central Bank’s dilemma This puts the Russian Central Bank in an unpleasant situation. If the ruble is too strong, the budget suffers. If the ruble becomes weaker, you immediately get inflation and producers cannot afford to buy the means of production – and you get negative industrial production growth numbers. So far, the Russian energy sector was immune from such problems. However, if oil prices stay at low levels for a longer time, the companies will have to invest in production or face production declines. Yes, I’m talking about production declines while Russia pumps record amounts of oil. This is a short-term reaction which was anticipated. In the longer run, if oil stays lower for longer, the absence of investment will inevitably lead to the decline in production. Recently, the Central Bank stated ( Google translate link ) that it was targeting lower inflation. It looks like it is doing so through keeping the ruble stronger in the short-term. As I’m writing this, the ruble-denominated price of oil is 2670, further down from 2693 that I mentioned in my previous article. I restate my view that this cannot last forever, as it hurts both the Russian budget and the majority of RSX holdings – energy and basic materials companies. When the next year starts, the Central Bank will face a tough choice between targeting inflation and filling the budget. My bet is that “filling the budget” will win, sending ruble and RSX lower. The longer oil stays around current levels, the lower RSX will fall. The Russian economy and Russian companies have previously shown that they were able to sustain low oil prices for a short period of time. This time is different, and the economy is facing a prolonged period of low oil prices. I believe that this is an existential threat to the current economic model. At the same time, I see no changes in policy that would have signaled a shift from the current economic model to something different. When I look at RSX chart, I believe that investors are too optimistic about Russian companies and Russian economy in general. As oil prices stay lower for longer, the numbers will show the continuing contraction and early optimists will likely run for cover. I remain bearish on RSX.

Vanguard’s Total Bond Market ETF Is A Great Fund For Investors Seeking Higher Quality

Summary BND offers a very low expense ratio that allows the interest to reach shareholders. The biggest risk factor for the fund is the diverging interest rate policies in the U.S. and Europe leading to potentially higher levels of volatility in rates. The exposure to MBS is unfortunate given the options investors have for using mREITs to acquire MBS at a discount to book value. Vanguard Total Bond Market ETF (NYSEARCA: BND ) is a solid bond fund. As I’ve been searching for appealing bond funds, I’ve found some of my favorites are from Vanguard. Given my distaste for high expense ratios, it should be no surprise that the Vanguard products would be appealing. Some funds are able to offer low expense ratios and mitigate their risks by strictly dealing in the most liquid bonds where pricing is most likely to be efficient and relying on the market to ensure that the risk/return profile is appropriate. Generally I favor ETFs that have low expense ratios and strictly deal in highly liquid bonds where the pricing will be more efficient. The expense ratio for BND is a .07%. This is one of the funds that falls into my desired strategy of using highly liquid securities and a very low expense ratio to rely on the efficient market to assist in creating fair values for the bonds. Yield The yield is 2.45%. The desire for a higher yield should be fairly easy for investors to understand. Bond funds that offer a higher yield are offering more income to the investor. Unfortunately, returns are generally compensating for risk so higher yield funds will usually require an investor either take on duration risk or credit risk. In many situations, an investor will take on a mix of the two. Junk bond funds generally carry a high degree of credit risk but low duration risk while longer duration AAA corporate funds have only slight to moderate credit risk combined with a significant amount of duration risk. Theoretically treasuries have zero credit risk and long duration treasuries would have their risk solely based on the interest rate risk. The yield for BND is coming primarily from the interest rate risk on the fund. The average duration is 5.8 years and the average effective maturity is 8 years. Fluctuations in the interest rate environment will be a major source of changes in the fair value of the fund. Duration The following chart demonstrates the sector exposure for this bond fund: At the present time I’m concerned about taking on duration risk in early December because of the pending FOMC (Federal Open Market Committee) meeting. I believe it is more likely than not that we will see the first rate hike in December. I think a substantial portion of that probability has already been priced into bonds, so investors willing to take the risk prior to the meeting could see significant gains if the Federal Reserve does not act. The very interesting thing we are seeing in the interest rate environment today is a divergence in policy between the domestic interest rates and the interest rates in Europe established by the ECB (European Central Bank). The ECB has announced another decrease in their short term rates to negative .30% while the Federal Reserve is planning to increase short term rates. That disconnect is going to make bond markets very interesting over the next few years. Credit Risk The following chart demonstrates the credit exposure for this bond fund: High quality corporate debt may often show significant correlation to treasuries but it offers higher yields. The biggest weakness for a high quality corporate debt fund is the fact that some bonds may still fall into lower credit quality and eventually default. Even if the fund sells the bonds before they default, they will receive a much lower fair value for those bonds when the market assess that the bond is riskier. I find high credit quality corporate debt to be a fairly attractive space for bond investing because it offers higher yields than treasuries but is unlikely to suffer from high default levels. By combining high credit quality corporate debt with treasury positions BND is able to create a higher yield than the fund would otherwise have while maintaining exceptionally high credit quality overall. The one notable concern I have in this regard is that over 20% of their “U.S. Government” debt is coming through the form of mortgages, and investors have access to mREITs that are trading at enormous discounts to book value. Conclusion I’m not a fan of holding the MBS at book value, but other than that I find the fund to be a solid choice for bond investors. It offers a reasonable yield for the very low credit risk on the fund and a very low expense ratio so the interest from the securities is actually reaching the shareholders. The biggest risk here, in my opinion, is the challenges we may see in the interest rate environment as the United States and Europe intentionally move in the opposite directions.

Third Avenue Focused Credit’s Investor Freeze Re-Affirms Advantage Of Closed End Funds

Third Avenue Focused Credit shutting the gate on redemptions. A reminder that traditional open-end mutual funds can suffer “runs on the bank” if they hold illiquid assets during nervous market periods. Reminds us that closed end funds are the safer vehicle to hold high yield and other more illiquid asset classes. Third Avenue Focused Credit Fund ( TFCIX , TFCVX ) just dropped the bombshell that they are freezing the fund and barring investor withdrawals as it seeks an orderly liquidation. TFCIX, as a sort of “vulture fund,” operates at the lowest end of the high-yield bond spectrum, specializing in bankruptcies, turnarounds and other bottom-of-the-barrel opportunities. I had personally been quite enamored of the fund when it was launched in 2009 as a vehicle to take advantage of post-crash credit market bargains. In that sense I saw it as a vehicle for retail investors to get in on the opportunities typically only available to hedge fund and other institutional investors. The fund’s “Achilles Heel” turned out to be its status as a traditional “open end” mutual fund, where investors could liquidate their positions on a daily basis. In fact, in recent years it was the only open-end mutual fund I had continued to hold, feeling personally more comfortable with closed end funds where, if other investors want to bail out, they have to sell their fund on the open market, and cannot demand the funds’ portfolio managers cash them out at NAV by selling fund assets. That is a much safer vehicle for holding potentially illiquid assets, as high yielding assets like junk bonds, MLPs, BDCs, etc. have turned out to be recently. I started selling out my TFCIX a few months ago (as I explained in an article in early November), not because I was worried about the fund freezing its assets (I wasn’t that smart), but rather because I saw a unique opportunity, since it was an open-end fund offering cash back at full NAV value, to take advantage of that and put the funds back into the market via closed end funds at 10% discounts (or more.) So that’s what I did, completing my exit later in the month. By way of post mortem, I ran the numbers on my total investment in TFCIX over the past six years. I collected back 34% of the total investment in dividends over the holding period, about 8% per annum, accounting for the timing of the investment (i.e. it wasn’t all outstanding the entire period). Then I gave back about 25% of the total investment in capital loss. That means I only made about 9% in total on my money, spread over 6 years. An opportunity cost, for sure, and a waste of earning power, since if invested better it would have been earning 6-7%. But – fortunately – not a disaster. To me this reinforces: · The attractiveness of closed end funds as the vehicle of choice for holding high-yielding illiquid assets, since you have the option of sitting out periods of market volatility while clipping your coupons and waiting for the storm to pass; and · The advantages of holding high yielding assets (equity and fixed income) in general, as a hedge against market losses, since the cash flow acts as a buffer over time to offset market depreciation.