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The Specter Of Risk In The Derivatives Of Bond Mutual Funds

By Fabio Cortes, Economist in the IMF’s Monetary and Capital Markets Department Current regulations only require U.S. and European bond mutual funds to disclose a limited amount of information about the risks they have taken using financial instruments called derivatives. This leaves investors and policymakers in the dark on a key issue for financial stability. Our new research in the October 2015 Global Financial Stability Report looks at just how much is at stake. A number of large bond mutual funds use derivatives-contracts that permit investors to bet on the future direction of interest rates. However, unlike bonds, most derivatives only require a small deposit to make the investment, which amplifies their potential gains through leverage, or borrowed money. For this reason, leveraged investments are potentially more profitable, as the gains on invested capital can be larger. For the same reason, losses can be much larger. Derivatives offer mutual fund managers a flexible and less capital intensive alternative to bonds when managing their portfolios. When used to insure against potential changes in interest rates, they are a useful tool. When used to speculate, they can be bad news given the potential for big losses when bets go wrong. Strong growth in the assets of bond mutual funds active in derivatives The assets of large bond mutual funds that use derivatives have increased significantly since the global financial crisis. As you can see below in Chart 1, we now estimate they amount to more than $900 billion, or about 13 percent of the world’s bond mutual fund sector. While existing regulations in the United States and the European Union on mutual funds impose clear limits on cash borrowing levels, the amount of leverage that can be achieved through derivatives exposure is potentially large, often multiples of the market value of their portfolios. This may explain why mutual funds accounting for about 2/3 of the assets in our sample disclose derivatives leverage ranging from 100 percent to 1000 percent of net asset value in their annual reports. This range may be also conservative as these are the notional exposures of derivatives adjusted for hedging and netting at the fund manager’s discretion. What makes them sensitive to higher rates and volatile financial markets Although these leveraged bond mutual funds have not performed differently to benchmarks over the past three years, their relative performance has occurred in a period of both low interest rates and low volatility, which may mask the risks of leverage. This is because the market value of a number of speculative derivatives positions could have been unaffected by the relatively small changes in the price of fixed income assets. In addition, limited investor withdrawals from leveraged bond mutual funds may have also masked the risks of fund managers having to sell-off illiquid derivatives to pay for investor redemptions. In our analysis we find that a portion of leveraged bond mutual funds exhibit both relatively high leverage and sensitivity to the returns of U.S. fixed-income benchmarks, depicted in Chart 2 below. This combination raises a risk that losses from highly leveraged derivatives could accelerate in a scenario where market volatility and U.S. bond yields suddenly rise. Investors in leveraged bond mutual funds, when faced with a rapid deterioration in the value of their investments, may rush to cash in, particularly if this results in greater than expected losses relative to benchmarks (and the historical performance of their investments). This could then reinforce a vicious cycle of fire sales by mutual fund managers, further investor losses and redemptions, and more volatility. Improve disclosure: regulators need to act Making a comprehensive assessment of these risks is problematic due to insufficient data; lack of oversight by regulators compounds the risks. The latest proposals by the U.S. Securities and Exchange Commission to enhance regulations and improve disclosure on the derivatives of mutual funds is a welcome step. There is currently no requirement for disclosing leverage data in the United States (and only on a selected basis in some European Union countries). Implementing detailed and globally consistent reporting standards across the asset management industry would give regulators the data necessary to locate and measure the extent of leverage risks. Reporting standards should include enough leverage information (level of cash, assets, and derivatives) to show mutual funds’ sensitivity to large market moves-for example, bond funds should report their sensitivity to rate and credit market moves-and to facilitate meaningful analysis of risks across the financial sector.

Achieving 16.7% Returns With The Value Score

Summary What is the OSV Action Score? What is the OSV Value Score? How was the Value Score created? The Quality Score produces 16.8% CAGR in the tests that I’ve performed for the upcoming “Action Score” that I’m implementing into Old School Value. Next is the Value Score. Here is the full table of results again. stocks are bought at the beginning of the year held for one year rebalanced after 1 year commissions and fees are not included into these results If you followed this strategy, the 16.74% is the max return. After fees, it likely comes down to 13-14% range annualized. Here’s How I Created the Value Score When you create a ranking system (or even a screener) the higher the number of criteria, the worse the performance becomes. When picking individual stocks, making sure a stock passes lots of checks is a good strategy because you allocate based on your conviction. However, when you try to employ any sort of quantitative strategy, it is not a good idea to list 20 different criteria that must be passed. Of all the tests I’ve performed, a strategy with lots of checks consistently lose to the market by a wide margin. I mention this because people ask me whether I’ve tried combining several of the best performing value screeners on display. I have. And the results are pathetic. It severely handcuffs the number of stocks that pass and the screen ultimately fails. When you pick stocks individually, you have to be precise and picky. For anything quant based, it needs to be looser as you are buying a bunch. As I mentioned in the Quality Score article, instead of blindly coming up with metrics for each Q, V and G, I already had a list of metrics for each methodology based on previous research papers and proven results. Then the theory was tested and confirmed via backtesting. In its purest form, the Value Score is based on the following 3 factors: P/FCF – best range is less than P/FCF of 10 EV/EBIT – best range is less than 11 P/B ratio – preference for P/B to be less than 3 Here’s the initial backtest to confirm the theory for a 20 stock holding portfolio. Eliminating OTC stocks, financials, energy, mining or utilities and the results continue the outperformance. Great. Backtest works with the selected metrics. It now comes down to how well the same idea can be applied when creating a ranked database. To further clean up the results, additional weightings were applied to each of the above ratios. Then all the stocks are further ranked with the Piotroski score again to eliminate low quality stocks. P/FCF has the biggest impact on the results and receives the highest weighting EV/EBIT does a great job of identifying cheap stocks and receives the second highest weighting P/B acts as a “cleaning” filter to remove stocks where you overpay for assets. Also a way to remove bad stocks you wouldn’t want to own no matter how cheap it looks The Piotroski score is assigned a fairly high weighting so that the list removes “lotto” stocks and potential black swan stocks The Value Rank Results Even if I did follow this strategy, it’s not an easy one to follow. There is a LOT of volatility. If you can’t stomach big moves and have faith in the process, you are doomed. If you focus too much on beating the market each year instead of an absolute long term return, you are doomed. When buying and holding the top 20 ranked Value stocks each year for the entire universe of stocks, the scoring system achieves 16.74% CAGR. If you start with $10k, you’d end up with $138k after 16.5 years. Eliminate OTC, financials, miners, utilities and energy again and the results are shockingly great at 19.4% CAGR. $10k becomes $203.6K after 16.5 years. But what I don’t like about the Value Rank on its own is the lack of downside protection in 2008. Cheap stocks and growth stocks get hammered the most during severe bear years. But a -40% return is a huge blow and a can easily shatter your faith in the system and process. Something to think about. Top 20 Value Stocks from 2015 Here is the list of top 20 stocks that make up the Value Score portfolio starting from Jan 1, 2015 so that you get a sense of what type of stocks the Value Rating is selecting. Disclosure No positions in any stocks mentioned.

Is Now The Time To Look At Floating Rate Bonds?

Summary Now that the Fed has begun raising rates, investors should refocus on risk minimization over yield maximization. Investors reaching for yield in securities like MLPs and high yield bonds have been hurt badly since the beginning of 2014. The iShares Floating Rate Bond ETF focuses on short term investment grade floating rate notes and carries an effective duration of just 0.14 years. In light of the Federal Reserve’s persistent zero interest rate policy, many investors have traveled further down the risk/return spectrum in order to improve yields on their portfolios. Anybody that’s dabbled in MLPs or high yield bonds over the past two years probably knows very well the risks that come with reaching for yields. The ALPS Alerian MLP ETF (NYSEARCA: AMLP ) is 40% off of its recent high while the high yield bond index is down over 20%. AMLP Total Return Price data by YCharts Now that the Federal Reserve has finally begun moving away from its zero interest rate policy and rates are slowly on their way back up, it might be time to focus more on principal preservation instead of yield maximization. Staying on the short end of the yield curve can certainly help accomplish that task but floating rate bonds should also be a consideration. The iShares Floating Rate Bond ETF (NYSEARCA: FLOT ) is the biggest floating rate note ETF out there at nearly $3.5B in assets. Its current yield of 0.5% won’t necessarily get income investors excited right now but its risk mitigation characteristics will once rates begin moving significantly higher. This ETF is benchmarked to the Barclays US Floating Rate Note