Monday, September 15, 2008

Risk Arbitrage

Merrill Lynch just signed a deal with Bank of America to be purchased for 0.8595 shares of BAC for every share of MER. Markets are down on the news, but some hedge funds will be profiting.

Arbitrage involves simultaneously buying low and selling high the same commodity or investment in different markets. Risk arbitrage is a very close cousin.

MER is currently priced at about 21.17, and BAC is priced at about 28.36. Since each share of MER is worth about 86% of BAC, the truer price based on BAC's valuation should be about $24.

To take advantage of this price differential and to remove market correlation, a hedge fund manager would simultaneously short BAC while going long MER. As the prices of the shares reach the correct ratio, the manager should realize a profit of around 14% that is not correlated to the rest of the market. That is, the market can move up or down, and the manager would get his 14% either way.

The risk involved is if the deal falls through. If that's the case, as of now, MER shares will plummet, and BAC shares will shoot up, losing the manager money on each position.

If the manager is strongly opinionated about the direction of the market in the near term, he might choose to take only one side of the transaction, assuming the other side will be the losing end. That is, if he is bullish, he should buy Merrill. If bearish, short BAC.

I'm personally not taking action on this. In this market, anything could happen. The deal could collapse. MER might get an even stronger offer, making the position a wash. The terms could be restated. If I was running a hedge fund, I'd be doing it right now, because that would be my job description.

Saturday, August 16, 2008

Only a sucker pays full retail

I've noticed a lot of resentment of full service brokers in a forum I frequent. I don't really understand it. I'd never go to a auto dealership and pay full sticker price on a new vehicle, but I don't resent those guys who are selling them. They are providing a service to people that they should be compensated for.

I had a friend in college (a PhD finance student) that went to a full service broker at his bank, and got upset when the broker didn't recommend a no-load index fund. When he informed the broker he was a finance PhD student, the broker looked at him in amazement and asked him, "Then why are you here?"

With discount brokers like Fidelity, Vanguard, and Scottrade, why do full service brokers and advisors exist? They exist for same reason that the new auto dealerships exist: convenience, professional help, and assistance buying - they supply the market demand.

If you're the financial advisor to your family, be sure to continue to educate them continuously, better than a full-service broker would, and help them set up their accounts and buy their investments, if they need the help. Know when you don't know the answer, and where to find it.

If they pay full price, only blame yourself for not doing the above, don't blame the distribution network, because as expensive as it is, it supplies the demands of the market.

As an ex-full service broker, I had to offer load funds, commissions as a percent of the stock purchase (three to one percent depending on the size of the purchase), annuities, and life insurance because that was how I paid for my salary. As a current investment advisor, I use no-load funds and annuities, ETFs, CEFs, and other low expense investments, and I bill the accounts directly (1.5% of the account). As I accumulate more clients, I'll probably reduce my fees, unless I'm providing a great deal of Alpha (outsized risk adjusted performance) in which case I may even increase my fees. Why? This is my job and profession. I want to help people, but I have to provide for my family, and I'm in business for myself. I do a lot of pro-bono work, but I do a great job for my paying clients, who without an advisor would invest themselves into the poorhouse (or at least not even come close to what appears to be an efficient frontier.)

In conclusion, only a sucker pays full retail. But don't hate the retailer, some people need or want them.

Aaron

Thursday, August 14, 2008

Equity Indexed Annuities, an interesting strategy...

Equity indexed annuities work like traditional deferred annuities in that they guarantee your principal every year and credit a certain amount of growth in the contract every year. The difference lies in how they determine growth. If the index they are marked to increases, they credit an amount relative to the increase. If the index decreases, remember these are still fixed annuities, so they don't lose value (though they may not gain value).

This is usually attractive to the purchasers of these contracts because they can participate in market upturns and stay out of market downturns. However, many people choose not to buy them because of long lockup periods (up to 20 years), surrender charges (up to 20%), caps on returns, and IRS treatment because they are essentially retirement accounts that shouldn't be accessed until age 59.5.

Is it possible to replicate the attractive features of Indexed Annuities without the negative drawbacks? Actually, yes.

For example, if you bought a zero coupon bond that would be worth $100 in one year for say $97, and bought a call option on the chosen index at the money at $100 for the remaining $3, you have replicated the positive features of the equity indexed annuity. This example assumes a lot regarding interest rates and option prices. The annuity companies get around these assumptions by creating floors that the index must achieve before crediting begins, and caps on crediting as well, sometimes limiting performance participation to 6% or less. After overcoming any difficulties in buying the options or getting the interest income on the majority of the principal, the annuity company pockets the difference.

If you can do it yourself, you can pocket the difference yourself as well.

Good luck!

Aaron

Tuesday, August 5, 2008

Are Bonds a good buy right now? What if I need income?

Never buy long term bonds for short term income (meaning you need 100% of your principal back in a couple of years).

Long term bonds are subject to interest rate risk, and change values based on changes in interest rates. As interest rates go down, long term bond values increase, and vice versa. The reason for this is that if you buy a new 20 year bond while interest rates are 5%, and rates on new bonds go down to 4%, your bond is more valuable than new bonds. You could attempt to calculate the Net Present Value of the bond by using the current interest rate to discount the future payments and the return of principle, but there will generally be some difference based on where investors expect interests rates to go.

So, if rates are currently 2% (and they are) and you reasonably expect interest rates to increase (which they will), would you buy a long term bond now? (I hope not...) What if you need 100% of your principal in a year? (I really hope you're not that self destructive...)

What if you already have high interest paying long term bonds right now? You'll get the biggest premium for them right now... so SELL!!!!

Good luck!

Aaron Hall

ETFs versus Mutual Funds

Instead of a side by side comparison, I'm just going to examine the criticisms I've heard of ETFs, and my response, since I fall on the side of ETFs.

Looking at ETFs, they have historically faced certain criticisms. Criticisms included:
  1. Price not tracking Net Asset Value (NAV)
  2. Bid/Offer Spreads
  3. Lack of liquidity from low volume
  4. Commissions charged for buying and selling
I personally think these criticisms are all bunk. The biggest issue for me would be the first, and the difference is usually only 1% or so. What debunks this one, is that the difference could be in your favor (buying at a discount, or selling at a premium).

The second is ridiculous to me, because I've never had trouble getting a limit order executed (and sometimes they get superior execution.) I have extensively used ETFs and never use market orders.

The third sounds big, but I don't buy or sell on a panic, so it's not important to me.

The fourth is easily overcome with a small enough commission relative to the size of the trade, and the usually smaller fees inside the ETF relative to the mutual fund.

In summary, ETFs make very good sense for most investors. The only way I'd recommend mutual funds, is if the investor is very conservative, and has a very small amount to invest (like less than $10,000.)

Have any questions? Feel free to ask!

Aaron Hall

The stock market, a more diversified play:

Ok, everyone knows the market is at a low (even after its short rally today) and I think most people expect it to be up from now over the next 6 months to a year. How can we make the most money off of this belief?

Here's a couple of ideas:

  1. Look at all your options, including index options (yes I love puns, but I generally restrain myself). Bullish option trades are buying calls, and writing (selling) puts. While writing puts may net you the most money, it can also lose you a disproportionate amount. Lucky for you, if you've got no business writing puts, most brokerages won't let you anyways. Buying calls on the other hand, only put at risk the amount you spend on the option. Buying a call on an index such as the S&P 500 could pay off greatly, but you also have a good chance of losing a good deal if not all of your investment.
  2. More conservatively, one could buy an index fund. I prefer ETFs (exchange traded funds) when buying index funds, because expenses range from half to 95% of traditional open ended funds, and I can name my price with a limit order and generally get same day execution. (When using regular mutual funds, I'd try to buy on a down day, which could mean several days or weeks before I'd buy...) A specific trade might be the heavily traded QQQQ which buys the Nasdaq 100, but if you want to buy the whole market, I'd recommend a broader approach. VTI attempts to buy the entire stock market (reading the fine print, it only buys 1300 of the largest stocks).
  3. There are also ETFs that call themselves "Intelligent" index funds, which use a standardized screening approach to attempt to outperform their related indexes. These screens generally take advantage of the long term outperformance of value bias related measures. Since value as a strategy is out favor at the moment, moving more towards a value based strategy would be likely to pay off as the economy turns around. This is my second favorite strategy here.
  4. Finally, my favorite strategy would be to focus on the stocks that have led this downturn: financial stocks. Not buying the individual stocks, like Merrill Lynch or Citi, but buying sector based ETFs. A volatile approach would be to buy UYG, which offers the financial sector at 50% leverage daily (twice the performance less expenses...). A more conservative approach would be DRF which sort of combines this approach with the previous in screening for high dividend paying international finance companies. The purest play is XLF, which actually has a higher yield because it's going to focus on only domestic financial corporations. So I'd go with UYG (if you can tolerate the volatility) or XLF (which is the pure investment.)

I hope this gives you some investing ideas, or the confidence to take the plunge if you've been on the sidelines.

Good luck!

Aaron

Why write this blog?

I want to help people.

I can't help it, I'm altruistic. I just want to help people with no expectation of compensation. I do have to eat, and I make money managing other people's money, so if you want me to help you hands on, I can, but that's not the purpose of this blog.

The purpose is to help people make smart decisions about their money. Whether it's selecting a good investment, or general ideas about retirement accounts, I expect to give timely and timeless recommendations. My qualifications? I have worked for 6 years as a financial planner and investment advisor, for both small and large companies (like Ameriprise and Merrill Lynch.) I've made and lost money in the markets. I'm working on my MBA, CFA, and CFP. I expect to have all of them within the next several years.

We are at an exciting point in the financial markets. There has been a small collapse in investment prices, and a small rally indicating a bottom. They say investing should be like watching grass grow, but I can't help being excited. This means we may see markets increase 30 to 50 percent in the next few years.

Look soon for blog posts that will discuss both the general nuts and bolts of investing as well as specific recommendations and ideas.

Aaron Hall