Tag Archives: outlook

One Investment… Three Ways To Profit

$150 billion is a lot of money. And due to some planned changes the makers of S&P and MSCI indexes are making, that’s the amount of money that is likely to flow into shares of real estate investment trusts (REITs) over the next few months. You see, up until now, REITs have been considered “financials” for the purposes of sector weighting. Well, that’s just crazy. A landlord that owns a portfolio of rental properties really has little in common with a bank or an insurance company. Yet, that’s where REITs have historically been lumped. But now that the index creators are fixing their mistake, there are going to be a lot of mutual fund managers and other institutional investors who will be pretty dramatically out of balance. According to recent research by Jefferies, that $150 billion is how much would need to be reallocated to REITs so that mutual fund managers can meet their benchmark weightings. I expect that the real number will be a decent bit lower than that. A lot of managers will be content to be underweight REITs relative to their benchmark. But even if it ends up being half that amount, that’s a big enough inflow to seriously buoy REIT prices. The entire sector is only worth about $800 billion. I’m telling you this now because we’ve been mentioning REITs in Boom & Bust of late, and so far, the results have been solid. But what I want to mention today is potentially even better. If you believe in the REIT story and expect REIT prices to go higher, and someone told you that you could buy a portfolio of REITs for 90 cents on the dollar, wouldn’t you jump at the opportunity? Well, that’s exactly the situation today in the world of closed-end funds. And in Peak Income , the new newsletter I write with Rodney Johnson, I recently recommended a closed-end REIT fund trading for about 90% of net asset value. Out of fairness to the readers who pay for that information, I can’t share the specific stock with you. But I can definitely tell you how I chose this fund and what you should look for when evaluating closed-end funds on your own. With most mutual funds, you can really only make money one way: the stocks in the portfolio must rise in value. Sure, dividends might chip in a couple extra percent. But for the most part, you only make money if the stocks the manager buys go up. That’s not the case with closed-end funds. In fact, you can make good money in three ways with this particular investment vehicle: #1 – Current dividend is generally a large component of returns. Unlike traditional mutual funds, closed-end funds are specifically designed with an income focus in mind, so they tend to have some of the highest current yields of anything traded on the stock market. This is partially due to leverage. Closed-end funds are able to borrow cheaply and use the proceeds to buy higher-yielding investments. This has the effect of juicing yields for you. #2 – Returns delivered via portfolio appreciation. Just as with any mutual fund, you make money when the stocks your fund owns rise in value. #3 – You have the potential for shrinkage of the discount or an increase in the premium to net asset value. That sounds complicated, so I’ll explain. Because closed-end bond funds have a fixed number of shares that trade on the stock market like a stock, the share price can deviate from its fundamentals just like any stock can. Sometimes, you can effectively buy a good portfolio of stocks, bonds or other assets for 80 or 90 cents on the dollar … or even less from time to time. But often, that same dollar’s worth of portfolio assets might be trading for $1.10 or higher on the market. Well, I’m not a big fan of paying a dollar and 10 cents for just a dollar’s worth of assets… no matter how much I might like those assets. But I do rather like getting that same dollar’s worth at a temporary discount. And when that discount closes, your returns outpace those of the underlying portfolio. The ideal closed-end fund investment should have solid potential from all three factors. It will pay a high current dividend, will have a portfolio poised to rise in value, and will be trading at a deep discount to net asset value. Be sure to look for those three things when you research closed-end funds. This article first appeared on Sizemore Insights as One Investment… Three Ways to Profit . Disclaimer: This article is for informational purposes only and should not be considered specific investment advice or as a solicitation to buy or sell any securities. Sizemore Capital personnel and clients will often have an interest in the securities mentioned. There is risk in any investment in traded securities, and all Sizemore Capital investment strategies have the possibility of loss. Past performance is no guarantee of future results. Original Post

Sentiment Vs. Liquidity

By Jeffrey P. Snider On January 16, 2009, the FOMC gathered telephonically for an emergency conference call to discuss a deal that had been struck between Bank of America (NYSE: BAC ) and the FDIC, Federal Reserve, and U.S. Treasury Department. There was an enormous concern, quite well-founded, that had nothing been done the news of that day might have led to a place nobody wanted to go. In specific terms of BofA, that had already been the case as Merrill Lynch had been shepherded into a “cold fusion” whereby BofA’s supposedly superior resources and standing would be able to absorb all the impending trouble lurking still on ML’s balance sheet. What they were now considering was having bailed out the ML’s of the world, the large but mostly shadow/wholesale banks, might they have to go further and do the same with the true behemoths? Merrill was likely going to be a casualty of those tumultuous weeks in September 2008, starting when the GSE’s were taken into “conservatorship” and the next week when Lehman ran aground of illiquidity. The last Friday that Lehman was in business, Merrill was already in talks to be sold to BofA; an announcement of those talks was made that crucial Sunday, September 14. The merger would close on January 1, 2009, but already there was big trouble. The FOMC’s General Counsel Scott Alvarez actually led off the conference call (after being introduced, as is custom, by the Chairman’s opening) which already suggested unusual conditions. News of the financial (bailout) arrangement between the various government agencies and BofA had already leaked before the Committee had any chance to comment or voice any objections. The speed of events was necessary because of the scale of the losses announced by BofA, including greater than expected from its own operations pre-merger. The real hammer, however, was Merrill Lynch’s huge crater, which Mr. Alvarez characterized as, “in the mid-20s pretax.” It is extremely difficult to lose that much in any single quarter and only a few institutions, notably Citi (NYSE: C ), managed to do it. The government was afraid that such a massive writedown (and any cash considerations that would come of it) would shake any confidence left in BofA, especially since the merger was barely a few weeks in place and that BofA was already shaky to begin with, “one of the more thinly capitalized banking organizations, so losses for them are taken pretty seriously.” The timing of this discussion was perhaps the most meaningful, and it was not lost on Chairman Bernanke. This was not supposed to happen , not after everything that had been done especially after Lehman which was at that point already four months in the rear-view. Bernanke was simply befuddled, admitting, “But for whatever reason, our system is not working the way it should in order to address the crisis in a quick and timely way.” In other words, nothing the Fed did had any sustained, relevant effect. In the specific case of Merrill Lynch, the Chairman described to the Committee the frightening pace of the deterioration for BofA, “this whole situation was stimulated by a call from Ken Lewis just a few weeks ago to the effect that the losses that Merrill Lynch was going to report at the end of the fourth quarter had risen on the order of $10 billion or $15 billion in just a couple of weeks, in terms of what they were reporting to Bank of America.” The Fed had committed to QE in late November, voted for ZIRP on December 16, 2008, along with a further statement directed at the “markets” that the Fed was already considering expanding QE1 in agency and MBS securities, as well as adding the purchase of longer-term UST’s. How could Merrill Lynch’s losses accelerate under those promises of “money printing?” Bank of America in its earnings statement bluntly specified that ML’s losses were, “driven by severe capital market dislocations” especially late in the quarter. Under the terms of FAS 157 as they existed at the time, ML was marking asset prices based on any observable inputs no matter how bad; meaning illiquid pricing was still wreaking havoc (it must have been disastrously so, given that the loss projections increased $10 or $15 billion in only a few weeks even after ZIRP) deep within the bowels of the wholesale financial system. On the outside, markets were far more encouraged by the “money printing.” Stocks had suffered in October and then again in November, but had largely stabilized through the rest of the year as monetary promises only got larger. Junk bonds, which had been sold to an unbelievable extreme, were bid especially strong especially on the double news of December 16. In many ways, this wasn’t surprising since distressed debt is by far the best performing asset class (historically) after any crisis or crash – it is all high risk, high reward. Click to enlarge Click to enlarge The timing of the bargain hunting seemed quite rational given both the “money printing” commitment of the Fed and the fact that the economy at the time (in the mainstream view) seemed to be weathering the financial storm reasonably well. The NBER didn’t actually declare recession until December 1, 2008, and even a few weeks later when the FOMC gathered to discuss ZIRP there was (somehow) still quite a bit of optimism that it wouldn’t be as bad as some feared (denial is very powerful, especially when coupled with recency bias). For junk bonds in particular, it seemed the perfect buy signal. It all went wrong again starting January 7, 2009, ironically the day that the minutes from the December 16 FOMC meeting were released. In other words, the results of that meeting were highly encouraging (especially to junk bonds) but the discussions that led to the decisions were crushing. Maybe that should have been apparent all along, as at some point you would think even speculators would consider why the FOMC at that moment chose to “go all the way” rather than just blindly believe it would work enough for the economy to continue to escape the worst cases. What the minutes showed was that even the FOMC, long a bastion of that mainstream optimism, turned to expanding QE and ZIRP not as means to avoid those worst cases but rather with an aim to manage getting through them . In short, it was no longer “if.” They [the Committee] agreed that maintaining a low level of short-term interest rates and relying on the use of balance sheet policies and communications about monetary policy would be effective and appropriate in light of the sharp deterioration of the economic outlook and the appreciable easing of inflationary pressures. Maintaining that level of the federal funds rate implied a substantial further reduction in the target federal funds rate. Even with the additional use of nontraditional policies, the economic outlook would remain weak for a time and the downside risks to economic activity would be substantial . [emphasis added] The minutes record that some members further expressed what amounted to surrender on the economic question, as current (not future) circumstances justified further inclusion in the policy statement, “that weak economic conditions were likely to warrant exceptionally low levels of the federal funds rate for some time.” Everything sold off from there, not reaching the ultimate end of the systemic liquidation for another two months of devastation. The problem was twofold, both factors of which were in many ways self-reinforcing. Though markets had been devastated already, there was far too much unrealistic sanguinity that it just could never get that bad because it hadn’t at least since the Great Depression (recency bias). The second factor was liquidity; it never responded positively to anything the Fed did, including the very fact of the panic in the first place . As the sharp trajectory of ML’s losses even after ZIRP demonstrated, “better” is not the same as “fixed.” We can see this disparity in the 30-year swap spread: Though it had bottomed out on November 21, 2008 (the same as stocks), volatility remained extreme and the spread (and the entire swap curve, for that matter) highly compressed even though it had managed a return to positivity on December 22. Liquidations are the combination of illiquidity and selling sentiment; liquidity remained highly impaired and though the Fed seemingly gave “markets” positive sentiment on December 16 they then justified severe reversal on January 7. The result was that last leg of the panic/liquidations and the further, shocking economic damage that went with it. Liquidity is an extremely important factor, which is why I spend so much time and effort analyzing and trying to figure out its actual state (subscription required) beyond the cursory sweep of the most apparent market prices. Liquidity in systemic terms is the ability of the system to reasonably absorb any shift in sentiment toward more sustained selling, to take on an increase in margin (and collateral) calls such that they do not snowball into the avalanche. That function is all the more important in periods where great fundamental uncertainty abounds, because during those times sentiment can shift seemingly in the blink of an eye. In reality, sentimental usually shifts back and forth just that quickly, only those times never seem to matter or cause global disruption – until they meet in the perfect storm of uncertainty and illiquidity.

Are Buy-Write Funds Good Buys?

This article first appeared in the May issue of Wealth Management Magazine and online at WealthManagement.com Equity markets stalled in 2015 after a relentless six-year rise from the depths of the Great Recession. Last year’s stagnant market, even with its bearish tilt, was a perfect set-up for buy-write plays. A buy-write is an option strategy featuring a stock purchase (that’s the “buy” part) along with the sale (a “write”) of a related option. Typically, these are call options. Deemed “covered calls,” they offset the otherwise unlimited liability associated with selling options through ownership of the underlying stock. The object of the strategy is income production. The premium earned for selling the options is retained if the contracts remain unexercised-a likely occurrence in a flat-to-bearish market. That’s not to say there’s no risk. If the market value of the stock spikes, pushing the options into the money, shares may be called away at the strike price, leaving the writer with just the premium and perhaps a bit more. What’s at risk is the upside potential of the stock, a sort of opportunity cost. Should the value of the underlying stock decline instead, the call premium provides a modicum of downside protection. A number of exchange traded funds engage exclusively in buy-writes. Most use call options. A couple, though, feature puts. Selling puts rewards investors in a stagnant or rising market if the underlying stock’s market price exceeds the put’s strike price; a downtrending market is anathema to this particular variation on the strategy. It’s worth a look at these ETFs to see how successful they’ve been in providing income and limiting risk. The PowerShares S&P 500 BuyWrite Portfolio (NYSEARCA: PBP ) writes at-the-money calls on its portfolio of S&P 500 securities. Launched in 2007, PBP is well established with $308 million in assets and an average daily volume of 109,000 shares. Over the past two years, PBP’s maximum drawdown was significantly less than the biggest hit taken by the SPDR S&P 500 ETF (NYSEARCA: SPY ) , a proxy for the blue chip index. Drawdowns represent peak-to-trough losses sustained before new price peaks are attained (see Table 1). Another metric of downside risk, Value at Risk (VaR), typifies the expected loss within a given timeframe. Essentially, VaR depicts a worst-case scenario. Based on the past two years’ returns and within a 95 percent confidence level, PBP can be expected to lose 1.12 percent on a bad day. Compared to SPY, with a daily VaR of 1.44 percent, PBP appears less risky than holding the index portfolio outright. A final comparative metric, M-squared (M 2 ), depicts the fund’s risk-adjusted return. Simply put, M-squared estimates what the fund would return if it took on the same level of risk as its SPY benchmark. PBP would have earned 3.82 percent-86 basis points more than its actual total return-if it was as volatile as SPY. If the M-squared return was lower than the fund’s actual return, the PBP portfolio would be more risky than the benchmark. So what about income? PBP boasts a dividend yield more than twice as high as SPY’s. Still, the buy-write fund’s total return is just a third of the level of the index fund-testimony to the effect of having assets called away as the market rose prior to leveling off. Click to enlarge Another ETF based on the S&P 500, the Horizons S&P 500 Covered Call ETF (NYSEARCA: HSPX ) , pursues a more aggressive call-writing strategy. HSPX sells out-of-the-money options, which, all else equal, typically produce less income. The fund, however, writes more calls than PBP-up to 100 percent of each stock position. This affords more equity upside. But there’s a trade-off for this-namely bigger drawdowns and a higher VaR compared to PBP. Despite the risk disparity, both funds earned the same M-squared return over the past two years. Chart 1 depicts the day-to-day performance of the buy-writes versus the SPY benchmark. Click to enlarge First Trust Advisors runs two actively managed buy-write portfolios, one geared to maximize income, the other designed to minimize volatility. The First Trust High Income ETF (NASDAQ: FTHI ) relies on a universe of large-cap stocks paying high dividends to underlie its call writing and rewards its investors with an attractive total return and dividend yield. The cost for this is higher risk, reflected in all three metrics: drawdown, VaR and M-squared. A sibling fund, the First Trust Low Beta ETF (NASDAQ: FTLB ) writes calls on the same portfolio as FTHI, but also buys put options to reduce volatility. The put premiums create a drag on performance, reducing both total return and dividend yield, but pay off with lower drawdowns and VaR compared to FTHI. Yet another actively managed portfolio, the AdvisorShares STAR Global Buy-Write ETF (NYSEARCA: VEGA ) , is even more expansive. A fund of funds, VEGA is presently made up of equity sector ETFs and bond ETFs in addition to broad-based ETFs like SPY and the iShares MSCI EAFE ETF (NYSEARCA: EFA ). The extensive call-writing base hasn’t produced capacious returns or dividend yields, though. A fund [1] that writes puts rather than calls is a standout, but not in a good way. The ALPS US Equity High Volatility Put Write ETF (NYSEARCA: HVPW ) selectively sells out-of-the-money puts on high-volatility large-cap stocks, aiming to maximize income. HVPW succeeds on that front. Its dividend yield is high, but volatility torpedoes the fund on a total return basis. HVPW, in fact, is the only ETF surveyed that produced a negative total return over the past two years. One other ETF requires special attention. Rather than being focused on the large-cap stocks populating the S&P 500, the Recon Capital NASDAQ 100 Covered Call ETF (NASDAQ: QYLD ) buys the stocks populating the Nasdaq-100 Index, a compendium of the largest nonfinancial issues listed on the Nasdaq marketplace. As you can see in Table 2 and Chart 2, QYLD shows the dramatic trade-off between total return and dividend yield. Compared to the PowerShares QQQ ETF (NASDAQ: QQQ ) , a portfolio that tracks the Nasdaq-100, QYLD produces a much bigger dividend yield, but a significantly lower total return. The risk metrics of the QYLD fund show the benefit derived from call writing. Click to enlarge Click to enlarge The Bottom Line Call-writing funds more often than not compensate for their relatively low returns with high dividends, making up for losses incurred over the past two years. Most of the funds, too, mute market volatility, providing higher risk-adjusted returns. Put writing, though, has been a vexation. The hefty premiums received for put sales just couldn’t cover the capital losses incurred as the options were assigned. Investors looking for high levels of current income and hedged exposure to the equity market might very well find call writing funds attractive alternatives in a flat-to-slightly bearish market. If, however, an investor or advisor believes stocks are poised for another sustained upward surge, less costly and mechanically simpler exposures are more suitable. [1] Another ETF, the ALPS Enhanced Put Write Strategy ETF (NYSEARCA: PUTX ) also pursues a put-write strategy, but was only launched in 2015, making it too young to include in our two-year study.