Tag Archives: etfs

Over-Rated: Do Fund Asset Classifications Tell The Whole Liquidity Story?

By Hamlin Lovell, CFA Suspensions of dealing by the credit mutual funds Third Avenue and Stone Lion have prompted various knee-jerk requests for a simple rule of thumb to help avoid recurrence: Beware Level 3 assets. It is reported that Third Avenue owned 18% in Level 3 assets. Many credit funds have zero or less than 1% of their assets in this category. Behavioral finance teaches us that we are susceptible to messages that simplify the complex. Unfortunately, financial market liquidity may not be amenable to such simple rules. Level 3 assets are assets for which a fair value can’t be determined by observable measures such as models or market prices. Though they are commonly dubbed mark-to-model, any unobservable input applied to modify a market price can also lead assets to be classified as Level 3 despite their valuation not being entirely model driven. Furthermore, relying on the Level 1/2/3 breakdown as a proxy for liquidity can result in both false positives and false negatives. Let’s start with the false negatives. Absent or insufficient market prices or dealer quotes can be reasons for Level 3 classifications, but they are not the only reasons. For instance, derivatives with non-standard maturities may be valued by interpolating between broker quotes on those derivatives with standard maturities. So a six-week currency option might be valued roughly halfway between a one-month and a two-month quote, but if the fund in question offers quarterly dealing, there need not be grounds for concern about asset/liability mismatches. But Level 3 is a broad range. At the other end of the spectrum, Level 3 could include private equity that might never be monetized, leading to an immortal “zombie” fund. Many assets might fall between these negative extremes; structured credit, for example, can be self-liquidating if cash flows from underlying assets accrue to various tranches according to the predetermined schedule. Some short-dated structured credit assets could generate cash flows faster than, say, zero coupon or payment-in-kind (PIK) bonds, where there may be indicative broker quotes – but you’d only find out if the borrower could repay (or refinance) at the maturity date! So using Level 3 categorizations to avoid illiquids is a crude tool. Of course, for those investors not worried about missing some adequately liquid assets falling under the Level 3 umbrella, a “Level 3 is bad” rule should still avoid many of the least liquid and completely illiquid assets. Less discussed and of greater concern are the false positives that can arise from assuming Level 1 and Level 2 must be liquid. That assets have an exchange price or some form of counterparty quote does not mean they can be traded in unlimited amounts, as the price or quote may only be good up to certain volume levels. Indeed, Third Avenue claimed it cannot liquidate “at rational prices,” which may imply they could sell at discounted prices. Any asset’s liquidity needs to be seen in the context of the fund’s position size, and I have seen funds take months or years to exit some Level 1 or Level 2 securities when they are holding a substantial multiple of volumes. The bottom line is that valuation methods should not be used to draw inferences about liquidity. Credit Ratings Third Avenue owned significant amounts of assets with a CCC credit rating, which may be deemed extremely speculative. The impulsive response here is to suggest that funds with higher credit ratings are more liquid, or less risky, or both, than those with lower (or no) credit ratings. Let us remind ourselves that some asset-backed security vehicles stamped AAA and backed by subprime mortgages ended up worthless and illiquid during and after the 2008 crisis, to the chagrin of institutional investors ranging from Norwegian pension funds to German municipal banks. Some money market funds that were perceived as super-safe cash substitutes also had to suspend dealing in 2008, and they were, broadly speaking, required by Rule 2a-7 to hold assets bearing the highest two short-term credit ratings. Since September 2015, money market funds are no longer bound by this constraint , as Dodd-Frank requires them to ensure assets meet a range of appropriate criteria. “Unrated” Assets When an asset is unrated, it generally means that the issuer has declined to pay for a credit rating rather than that the ratings agency has declined to provide one. The amount of C-rated issuance seen in the United States and Europe over the past two years shows that agencies are perfectly willing to provide some of the lowest credit ratings to companies that may be stressed or distressed. Convertible debt is often not rated, but this does not necessarily mean it is less liquid. I recall convertible bond funds largely comprising unrated names in 2008 paying out plenty of redemptions on time. In any case, credit ratings are not necessarily a reliable proxy for liquidity. Some credit assets reportedly see higher volumes after they get downgraded or default, partly because some holders become forced sellers and specialist distressed investors then become interested in the higher potential returns on offer. So, neither valuation hierarchies nor credit ratings can necessarily guarantee fund liquidity. Nor can regulation – both US mutual funds and US money market funds are now allowed to suspend dealing, and the SEC has approved Third Avenue’s suspension. Investors and advisers need to broaden and deepen their levels of analysis to get a better handle on liquidity risks. Quantifying fund liquidity is not only nuanced but also fluid, particularly as there can be seasonal variations, with calendar year-end reportedly a less liquid time. Investors and asset management companies may be drawn to the apparent certainty of putting funds into a small number of boxes, buckets, or categories, but this may prove to be a false comfort. Exact estimates of fund liquidity could prove to be spuriously precise, so the concept needs to be presented in broad brush terms that allow plenty of margin for error. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

Are ETFs Made Up Of CEFs Worth Owning?

While we are huge proponents of leveraging low cost and liquid ETFs for virtually every asset class ; ETFs that invest in closed-end funds (CEFS) are a different story altogether. The two funds that have garnered the most investor attention in this space are the PowerShares Closed End Fund Composite ETF (NYSEARCA: PCEF ) and the Yieldshares High Income ETF (NYSEARCA: YYY ) . Both contain a seemingly diverse array of underlying asset classes, sectors, and strategies. While both funds’ actual management expense ratio of 0.50% sounds reasonable, the issue is that you’re also paying for active management and leverage borrowing costs on an individual fund level. While that isn’t an immediate red flag, the largest issue I see with ETFs that purely invest in CEFs is that the index construction methodology doesn’t take into account the fundamental propensities of the underlying holdings. For example, these funds may have overlapping strategies spread across multiple managers, which also have varying fundamental views on portfolio strategy . Envision it this way, one manager may love a specific sector of the fixed-income market, such as emerging market bonds, another manager avoids them like the plague. So while one manager may be proven right, the other is wrong, and whatever benefit you would have received is sorely cancelled out. What’s worse is that you continue to pay both managers a fee regardless. When you sum up all the instances where that scenario happens in each individual CEF, all of the exotic portfolio management themes and talent is quickly stripped away. Meaning, your returns are doomed to plod along with the index and ultimately the mean average of the entire asset class. It’s a classic case of over-diversification. Oddly enough, that fact alone is the primary marketing tactic to attract investors to these funds; you remove individual fund risk. However, if an investor simply wants index returns from a complicated asset class they may not fully understand, CEFs are the last place I would suggest they invest in. There are multiple layers of complex derivatives, hedging, and active management strategies in play. On top of individual fund corporate actions, premium and discount analysis, and earnings reports. Lastly, probably the most dangerous element to CEF investing flies under the radar: leverage. Instead, it is my opinion that investors should equip themselves with basic knowledge on evaluating the attractiveness of a group of closed-end funds, and build a cohesive portfolio made of equities and fixed-income. They will have inherent diversification at the fund level, and probably build a better knowledge of how CEFs work in the process. They also stand the chance for better performance and paying lower fees overall. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Distinction Between Mutual Funds And Hedge Funds Is Eroding

The growth of liquid alternatives combined with an evolving regulatory framework is leading to a confluence between ’40 Act mutual funds and private hedge funds, according to Wulf A. Kaal, contributor to the forthcoming Elgar Handbook on Mutual Funds. In an expert from that guide, titled Confluence of Mutual Funds and Private Funds , Mr. Kaal makes the case that mutual funds are becoming more like hedge funds in terms of strategy, while hedge funds are becoming more like mutual funds in terms of regulation. In Mr. Kaal’s view, this calls into question the distinction between mutual funds and private funds. Eroding Distinctions While it’s true that mutual funds and hedge funds still occupy distinct segments of the market, employ some different strategies, serve largely different clients, and are subject to different legal rules, the gulf between the two types of funds is eroding. This is due to a combination of market forces, as retail investors seek out alternative strategies while institutions demand greater liquidity and transparency; and regulatory changes such as the Jumpstart Our Business Startups Act (the “JOBS Act”), which makes it easier for non-accredited investors to fund private, startup enterprises, including via crowdfunding. Alternative AUM Growth In terms of market forces, Mr. Kaal points out that, since 2005, alternative investments have grown twice as fast as traditional investments, in terms of assets under management (“AUM”). Although traditional investments, i.e. long-only stocks and bonds, have seen AUM grow from $37.1 trillion in 2005 to $56.7 trillion in 2013; in terms of percentages, the growth in alternative AUM from $3.2 trillion in 2005 to $7.2 trillion in 2013, is greater. While traditional investments’ AUM grew by a total of 52.8% during the period under review, alternative investments saw their AUM more than double. Rate of Growth Across Alternative Investments Mr. Kaal breaks down AUM growth across three alternative-investment structures: Alternative mutual funds Hedge funds Private equity He also lists the AUM growth for all mutual funds – i.e., mostly traditional assets – as a control group. His findings: While all four categories suffered AUM drawdowns in 2008, alternative mutual funds had by far the strongest growth in 2009, 2010, 2011, and 2012. Alternative mutual funds continued to grow in 2014, but at an abated pace. All three alternative categories showed positive AUM growth for all years, save 2008, while traditional mutual funds lost ground in 2011. Conclusion Market forces and regulatory changes are leading to a confluence between mutual and private hedge funds – but what are the implications of this confluence? Mr. Kaal lists several areas he expects will be impacted, ranging from mutual fund governance to the structure of federal securities law, and he opines that possible effects of this confluence could include “drastic immediate repercussions for market participants.” He concludes his paper by calling for continued monitoring, scholarly evaluation, and regulatory scrutiny of these developments. For more information, download the full report . Past performance does not necessarily predict future results. Jason Seagraves contributed to this article.