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Survival Skill: Distancing Yourself From Counterparty Risks

In a recent article entitled, Whatever You Do, Avoid Major Mistakes , I suggested that investors study-up on the subject of counterparty risk. Under a constructionist definition , the term equates to default risk as defined by the inability of a party to live up to its contractual obligations. The failure of a debtor to meet its obligations under a credit arrangement is a counterparty risk as is failure to perform under a swap or option agreement. A Broader Definition Needed However, for investors, a broader definition of the term is more appropriate to reflect that: a) counterparty risk arises when a major player(s) in a firm’s value-chain fails to perform whether contractually or not, b) the mere thought or mention of default gives rise to counterparty risk, and c) counterparty risk reverberates out from the source of the problem such that it can involve not just two, but multiple parties serially / simultaneously. This more encompassing definition explains a lot of what is going today: China’s faltering economy has seriously disrupted supply chain relationships beginning, notably, with miners as close as Australia and as far away as South America. For example, questions have been raised about Rio Tinto (NYSE: RIO ), Glencore ( OTCPK:GLCNF ) and Freeport-McMoRan (NYSE: FCX ) three of the largest mining companies in the world. The collapse in oil prices has now reverberated well away from drillers to servicing, pipeline, storage and tanker companies, landlords and hoteliers housing field personnel, banks, municipalities, states, and even countries. Take, for example, Kinder Morgan (NYSE: KMP ), the Royal Bank of Canada (NYSE: RY ), or Statoil (NYSE: STO ) / Norway. The gadget business that is over-saturated with products amid slackening demand has created problems along the value-chain including between the likes of Samsung ( OTC:SSNLF ) and Qualcomm (NASDAQ: QCOM ). Bricks retailers such as The Gap (NYSE: GPS ) and Aeropostale (NYSE: ARO ) are beating their brains out over fashion style and space utilization resulting in downstream impact to shopping center REIT’s as in the case of CBL & Associates (NYSE: CBL ). Distancing Yourself from Counterparty Risks It’s therefore understandable that some investors are scared. Stocks and bonds that they thought were fairly valued and perfectly safe are tanking. Moreover, fears are being whipped up by the likes of hedge fund managers who actually have lost their a$$ and are looking down the barrel at significant redemptions. Some would have us believe that the world is going to hell. It’s not. I personally see no reason to sell everything and to blow up an income stream in order to protect principle in these extremely volatile markets. BUT, if you haven’t already, the time is rapidly passing to put more distance between your portfolio and counterparty risks. This begins in one of two ways: a) By stepping back to consider macro changes that are developing / underway and how they may affect your holdings, or b) By taking a micro perspective and ‘looking back through’ your portfolio to ‘see’ what negative consequences may be coming at you from interrelated sectors. The idea is to get away, as quickly as possible, from ground zero. On my end, earlier this year, I took three actions to put more distance between our portfolio and counterparty risks: 1) I sold Corning (NYSE: GLW ) not because I don’t like the company – I really do – but because of concerns about the weakening gadget business, 2) I divested our positions in Chevron (NYSE: CVX ) and Royal Dutch Shell (NYSE: RDS.B ) even though as integrated companies they have fared a lot better than ‘pure plays’ in the oil production business, and 3) I bailed on JPMorgan Chase (NYSE: JPM ) believing that they have not been completely forthright about their exposures to oil and related sectors. In other words, I have concerns that, like other financial institutions, JPM may not have a handle on their counterparty risks. At the same time, I am sitting tight with positions in industries / companies that are more insulated from counterparty risks and whose demand for their products and services is relatively inelastic – military defense contractors, water management firms, and pharmaceutical companies. Also, I continue to make investments in what I feel will be growth areas such as in the fight against migrating tropical diseases. Two Directions to Alpha Like everyone else, I have suffered losses so far this year. However, by moving away from counterparty risks, my losses have been 3 to 4% less than comparable indices. Remember, just as alpha-level performance is doing better than the market when it is up, it is also doing less bad when the market is down. 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. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

Lipper U.S. Fund Flows-February 3, 2016

By Tom Roseen Did we just see mutual fund investors turn on a dime? After yanking nearly $5 billion from their accounts the previous week, this past week’s data show estimated net flows of $2.1 billion into equity mutual funds-for their first positive flows week this year. Although the benchmark Dow Jones Industrial Average was up for the week, the scant 392 points probably wasn’t as important as a rising sentiment that 16,000 is as good a floor as any we’ll find in this market. But count equity exchange-traded funds’ (ETFs’) authorized participants among the unconvinced: they withdrew about $8.5 billion (net), backing out of the SPDR S&P 500 Trust ETF ( SPY , -$3.2 billion ) and the iShares Russell 2000 ETF ( IWM , -$1.2 billion ) , but they made modest contributions to the SPDR Gold Trust ETF ( GLD , +$758 million ) . Taxable bond mutual funds suffered their thirteenth weekly net outflows (-$523 million), but the week’s magnitude was the lightest yet. The Loan Participation Funds classification (-$333 million) notched its twenty-eighth consecutive week of outflows from mutual fund investors and High Yield Funds suffered outflows of $108 million as investors kept a wary eye on the junk sector. On the other hand, bond ETFs collected $671 million of inflows as the week’s biggest individual bond ETF inflows belonged to the iShares 7-10 Treasury Bond ETF ( IEF , +$412 million ) , while the iShares iBoxx $ Investment Grade Corporate Bond ETF ( LQD , -$423 million ) led the outflows list. Municipal bond mutual fund investors added $585 million to their accounts while the muni market gained 0.48% for the week-after the previous week’s little tumble. Money market funds saw outflows of $3.8 billion this past week, of which institutional investors pulled $4.2 billion and retail investors redeemed $400 million.

3 Key Questions To Ask When Considering An ETF

Thinking about investing in exchange-traded funds (ETFs)? Be sure you can answer these questions before you do. Choosing investments for your portfolio is a complex-and sometimes emotional-process. It requires research, a clear understanding of your financial goals and time horizon, and, of course, money. And it can be overwhelming: should you go with stocks, bonds or mutual funds? How about gold? One security that has seen a surge in popularity over the past few years is the exchange-traded fund (ETF) . An ETF is an investment vehicle composed of pooled funds that owns shares of an asset, such as stocks, bonds or commodities, and trades on an exchange, just like a stock. In some cases, an ETF will track an index (the S&P 500, for example), which means it tries to match the index’s performance rather than beat it. According to a 2015 Charles Schwab Investor Study , millennial portfolios have the largest share of ETFs of any investing generation: on average, 40% of a millennial’s investments will be in ETFs. In fact, millennials dig ETFs so much that 61% of millennial investors surveyed said they would increase their ETF holdings in 2016. ETFs appeal to investors for several reasons. First, there’s the price tag. The minimum investment for a mutual fund can range from $500 to $3000 ; the minimum investment for an ETF is the fund’s market price, which can be as low as a couple of dollars. Then there’s the risk factor. Due to their composition, ETFs have more potential to mitigate losses in the event of a downturn than an investment concentrated in a single stock . ETFs also tend to be more tax-efficient than mutual funds because their structure minimizes the opportunity for taxable events-selling holdings, for instance-which can incur capital gains. Considering that there are over 1,500 ETFs available on the market, how do you go about choosing the right one? The following three questions are key when it comes to the ETF selection process. What is the underlying index? Some ETFs track easily recognizable indexes such as the S&P 500 or the Nasdaq 100. Others, such as the Global X Millennial Generation ETF , track new indexes that investors know very little about. Because ETFs usually track an index, it’s often quite easy to find out what their holdings are. Pay attention to what stocks and bonds are included in an ETF, as well as the weight assigned to the holdings. This will allow you to determine which ETFs offer the asset allocation you want. What are the true costs? Each ETF has an expense ratio. This number, which is expressed as a percentage, is a fund’s annual expenses divided by its average assets for the year. The expense ratio lowers your returns, and it isn’t the only cost associated with ETF investing. Given that ETFs trade like stocks, every purchase and sale incurs brokerage commission fees. Do the math and figure out which ETFs seem best positioned to give you the biggest bang for your buck. How liquid is it? The ease with which you can buy or sell shares of an ETF matters a lot: it’s the difference between making money and losing it. When an ETF has low liquidity, it becomes more difficult for an investor to sell their shares and make a profit. So what affects an ETF’s liquidity? Holdings, the holdings’ trading volume, the ETF’s trading volume and the market climate all play a role. Take a look at these factors to get a sense of how liquid or illiquid an ETF is. Keep in mind: the more the underlying holdings are traded, the more liquid they are, which, in turn, makes the ETF more liquid. Like any investment, there are pros and cons associated with investing in ETFs, but if you want to add some to your portfolio, be sure to ask the aforementioned questions. Doing so will help you choose the best ETFs for your investment needs.