Friday, October 30, 2009

Picking the right ETF: Liquidity

Lack of liquidity is treacherous for everyone.

Catastrophe in capital markets is always characterized by a lack of liquidity. Significant imbalances between buyers and sellers (widened bid-ask spreads) can create market “gaps”. Occasionally this happens to the upside but predominately it occurs on the downside. Examples: October 1987, September 2001, Q4 2008. Liquidity is important for investors, but a lack of liquidity is treacherous for everyone.

Liquidity of underlying securities

Since the 1990 launch of the first exchange-traded fund (ETF), the Toronto Index Participation Securities (TIPS), liquidity has been important. Originally developed for retail investors, TIPS became popular among institutional investors seeking broad market access in part because of the liquidity of the 35 stocks underlying TIPS. It follows that ETFs with illiquid holdings should be watched carefully. Fixed income ETFs can fall into this category.

Theoretically, trading volume and liquidity for today’s ETFs is not a problem with the creation/redemption mechanism. This structure authorizes designated brokers to create additional units if demand exceeds supply, and conversely, remove units when supply exceeds demand. But there are differences in bid-ask spreads impacting every investor’s bottom line that require explanation.

Timing and volume

“An ETF manager may be doing a terrific job of tracking an index,” says Ioulia Tretiakova, Director of Quantitative Strategies for PŮR Investing, “but the retail investor may still be impacted by liquidity costs, paying a hefty price in the form of wide bid-ask spreads or volatile premiums/discounts to net asset value (NAV), all resulting in less than stellar market liquidity.

“Transacting before a holiday or at other times when volume is expected to be low, can be expensive and should be avoided. For example the closing bid-ask spread for actively traded iShares CDN S&P/TSX 60 (XIU), as of Friday, October 9, 2009 (Thanksgiving weekend) was $17.08-17.10 or 11.7 bps (normally about 5.8 bps) and for less actively traded Claymore Canadian Fundamental Index ETF (CRQ), was $10.85-10.99 or 129 bps (normally about 28 bps). Bid-ask spreads are generally correlated with trading volume and tend to be tighter for ETFs with more assets under management as the examples above demonstrate. 3 month average trading volume: XIU 17.6 million shares vs. CRQ 35,632 shares. The chart below demonstrates that trading volume and bid-ask spreads are correlated. This is not a surprise. More activity reflects popularity which suggests better arbitrage opportunities to keep spreads narrow and ETF values close to NAV.

“Poor liquidity can cost investors money. Most ETF prices oscillate around their NAV. The absolute level of premium/discount and its standard deviation, a measure of how far, on average, the market price of an ETF tends to deviate from the NAV, warrants scrutiny. Some ETFs, primarily fixed income, trade mostly at a premium. For these ETFs, the magnitude of the average premium depends on the liquidity of the underlying assets, a good example being iShares Canadian Real Return Bond ETF, (XRB). Due to the limited depth of the Canadian real return bond market, this ETF tends to trade at a premium to NAV, closing at $20 on October 9, 2009 with a NAV of only $19.75, or a 1.27% premium.”

The daily historical premium/discount to NAV for the XRB is shown below.


The overall measure of ETF liquidity is a combination of factors; bid-ask spreads, fund assets, trading volume, premium-discount and last, but not least, the liquidity of the underlying assets. Imbalances can lead to tracking error that can distort strategies (to be covered in a future article).

If investors intend to hold positions for longer than 6 months, liquidity may be less of an issue, but larger spreads can be costly over time to frequent traders. A rule of thumb for liquidity is that if the securities underlying the ETF are popular, the ETF’s construction is transparent, and trading is active, liquidity should be pretty good.

PŮR Investing Inc. offers a free ETF screener on their website that includes liquidity:

Picking the right ETF: Diversification

PICKING THE RIGHT ETF: Diversification

First of a series of articles exploring how to sort and evaluate exchange traded funds.

The need

Exchange-trade funds (ETFs) have had the most profound impact on personal investing since the introduction of the modern mutual fund in 1924. To the advantages that drove mutual fund growth; diversification, professional management, and shared expenses, ETFs have added low costs, transparency, market access throughout the trading day and tax efficiency.

Institutions lead the use of ETFs for effective acquisition and hedging of portfolio positions. In 2008, the ability to short financial ETFs while shorting individual financial company shares was banned is only one example of the value of these instruments.

With over 100 ETFs trading in Canada, over 800 in the U.S., and over 500 more in registration, this rapidly expanding universe demands better selection tools.

These articles will explore key factors for evaluating ETFs beyond simple categorization and screening. Diversification, liquidity, cost, tax efficiency and tracking error will be examined for their impact on portfolio construction.



Diversification is a method to control risk by limiting exposure to any one holding. Institutions typically diversify by:

 asset class (stocks, bonds, cash, real estate, commodities, currency)
 region (domestic, foreign, emerging markets)
 style (value, growth, core)
 size (large cap, mid-cap, small cap)
 sector (financials, materials, technology, energy)

All of these are available via ETFs. Individual investors no longer need millions of dollars to get broad exposure.

How to measure it

The quantitative way to measure diversification is by measuring the specific (idiosyncratic) risk in a portfolio. The less specific risk there is, the better the diversification. Specific risk is the risk "specific" to a security, not explained by systematic market factors (such as energy prices, interest rates, etc).

Specific risk is a metric routinely calculated by risk models. Investors without access to risk models can use PŮR’s “rule of thumb” approach:

 total number of securities (PŮR recommends at least 50),
 weight represented by the top 10 holdings (PŮR recommends under 30%)
 weight of maximum individual holdings (PŮR recommends 10%).

Why it is important

According to capital market theory, specific risk is not rewarded. That's why minimizing exposure to this risk by increasing diversification makes sense. Better diversification can mean less variability in a portfolio’s value. Professionals call this “risk management”, investors call it “sleeping at night”.

How it works

The principle is based on the idea that prices of selected assets can move independently from one another (uncorrelated). Good diversification means lots of different risks not lots of different assets, as many investors often forget. ETFs’ risk is more reliable than that of individual securities because it is dampened by the variety and number of their holdings. The result offers a more effective approach to portfolio construction.

What are you trying to do?

Are you an investor or a trader? This will impact how you choose ETFs.

Investor: Your investing horizon is 5 years plus and you’re looking to overweight areas of the economy that will outperform. You need to manage risk, so diversification is important. Selecting the more diversified ETFs from different asset classes, regions, styles, sizes and sectors is a good way to succeed.

Trader: Your investing horizon is lunchtime tomorrow (maybe up to one year). All you need to predict price movements is in price, volume and trading statistics. You gain by exploiting volatility and you trade frequently. Ironically, ETFs dampen volatility! Nevertheless, it may be easier to make a call on a sector (like financials) rather than a single security (like TD Bank ). Diversification is a two-edged sword for you, but is useful in assessing broad or specific exposure to underlying indices.


An ETF’s diversification is a function of the number, concentration and nature of its holdings.

iShares CDN Large Cap 60 Index Fund (Symbol: XIU) with 60 holdings vs. iShares CDN Composite Index Fund (Symbol: XIC), with 220 holdings, illustrates similar ETFs with different diversification. While similar, the XIC is somewhat better. This doesn’t necessarily mean that XIC is the better choice however. As we will see in a future article, cost is a very important factor.

The iShares CDN Tech Sector Index Fund (Symbol: XIT) with only 5 holdings is a very concentrated ETF that would score low on diversification but may be interest traders.

Single commodity-based ETFs represent pure systematic risk. They are asset classes by themselves. Some U.S. ETFs track commodity indices that have different sector concentrations. Look before leaping.


Diversification is one the most important factors in ETF evaluation. It is central to portfolio construction and an important reason for ETF popularity today. In the next issue, we will discuss liquidity, important for when the $%^t hits the fan as it did in 2008.

PŮR Investing Inc. is a registered portfolio manager specializing in risk managment using exchange traded funds. PŮR’s free ETF screener is available at:

Wednesday, July 8, 2009

Goals-based asset allocation: Part B

Using the right tool for the job is fundamental in many disciplines. To drive a nail one needs a hammer, to insert a screw, a screwdriver, to screw unsuspecting investors , Goldman Sachs ( But I digress! Actually, from the viewpoint of many investors, all advisors, not just the ones at GS were guilty last year.

"If your only tool is a hammer, every problem looks like a nail." I love that phrase and it applies well to the investment business. Investment advisors too often believe that making as much money as possible is everyone's goal all of the time. Is that equally the case for a 26 year old investment banker and a 68 year old retired school teacher? Maybe, but not likely. So why do advisors push similar solutions for each client?

Whoa! You may argue that giving the retiree a conservative balanced or all fixed income portfolio and the banker an all equities or emerging markets portfolio is providing different solutions. But neither solution was likely constructed based upon that investor's needs only their perceived risk tolerance. What's the difference? Sometimes not much, but usually quite a bit!

If you ask a prospective investor to mentally divide their pool of investment capital into three buckets:
1. Basic needs: food clothing and shelter
2. Enhanced lifestyle: cottage, vacations, French rather than Chilean wine
3. Legacy: grandchildren's education, philanthropy.
a typical split may be 1.(60%) 2.(25%) 3.(15%).

Now assign risks to each bucket.
Bucket 1 is pretty important so you can't take much risk with that one. Perhaps you buy all bonds with this portion.
Bucket 2 gives you more flexibility. Perhaps a 60% equity 40% bond portfolio will address this need.
Bucket three is a long time horizon goal so perhaps 80% equities and 20% bonds works for this piece.

Now you have addressed client goals but investing time horizon needs to be accommodated. More on this in the next installment.

Thursday, July 2, 2009

Goals-based asset allocation: Part A

There is not much new in the world of asset allocation despite the drubbing portfolios sustained last year. The best and the brightest minds and the most researched and supported techniques failed to save Humpty Dumpty from shattering on impact as he fell from that wall.

The Harvard and Yale Endowments, and in Canada, the Ontario Teachers' Pension Plan and le Caisse de depot et placements with extensive risk budgeting tools and an enviable record of success, succumbed to the same gap in the system that eliminated 30-40% of the value of stock portfolios globally. Capital markets went into "rectal lock" and values plummeted in the ensuing vacuum.

What were the goals of these institutions? Did they achieve what they set out to achieve? What could have been done differently? All these questions are being asked and the industry, its observers and consultants have been offering opinions. The "finger pointing" has been extraordinary. The only question that is meaningful for most of us is: what can investors and investment professionals learn from this experience?

Asset allocation describes the strategy investors follow to divide their money between different assets like stocks, bonds and cash. The underlying principle is that the prices of different assets move in different (uncorrelated) ways leading to the idea that "diversification" protects against risk, as defined as volatility.

The obvious problem is that this approach says little about the objectives of the investor. Volatility is an abstract concept for most retail investors. After the extreme volatility of capital markets last year, I suspect it is a more distant concept for many professionals also.

Goals-based asset allocation attempts to match the volatility of a group of assets to the broad goals of an investor. I'll explore how to do this in future posts.

Tuesday, June 9, 2009

Leveraged and inverse ETFs

The controversy over ETFs that offer 2 or 3 times the daily price movement of an index (up or down) is rooted in the wonky returns from an unprecedented period of volatility in capital markets in 2008 and early 2009.

The Foundation for Advancement of Investor Rights (FAIR) executive director Ermanno Pascutto has been clear in criticizing these products as misleading. His statement in the May 15, 2009 Jonathan Chevreau Financial Post article "Investor group blasts makers of leveraged ETFs" could be, with respect for the goals of the organization, better informed.

"There's a lot of detailed disclosure in the prospectus about risk but nowhere does it bluntly tell you you could be completely right in your selection of an ETF and find out that despite being right, you lose money". He goes on to say "In several cases, no matter which way you bet over the past year, you would have lost money."

One of the examples cited is the case of the Horizon BetaPro Global Gold + ETF. The underlying index, the S&P/TSX Gold Mining Index was up 0.9% for the year ending March 31, 2009 while the Bull + (2X) ETF was down 46.4% and the Bear + (-2X) was down 86.7%. At first glance this doesn't seem right. The fact is that each ETF delivered pretty much what they said they would, 2X the daily price movement of the index. The issue is the difference between arithmetic daily returns and geometric compounded returns.

It doesn't take much volatility to get these two different returns out of alignment. When volatility is as wild as it was for the 12 months ending March 31, 2009, the extreme results mentioned earlier are possible.

A way to estimate the impact of volatility on the returns of leveraged ETFs is as follows:

daily geometric return = daily arithmetic return - (0.50 X SD^2)

In the case of the S&P/TSX Gold Mining Index, the daily volatility was 5% and that of the HBP Bull and Bear + ETFs was 10%! Working through the above formula one derives an estimate of 0.50% per day. This translate into 72% per annum of volatility drag. In other words, assuming zero index movement for a year, an investor could expect a -72% return from volatility in this ETF. The investment strategy is very clear, if an investor expects a high level of volatility to persist; short the ETF.

If FAIR wanted to help the broadest base of individual investors, they would be doing better to demand that Canadian mutual fund prospectuses display costs on the front page in a type size that everyone can read so that Canadian investors would know that they are being charged the highest mutual fund fees in the world.

Friday, June 5, 2009

Canada Cup of Investment Management 2009

This two day event, held in Toronto, has just ended. It was a subdued gathering compared to similar events several years ago when capital markets were more sanguine. The bloodied financial system and subsequent economic consternation has left investment professionals bewildered and chastened. This is quite significant when considering few stadiums could accommodate their collective egos in better times.

The presentations were good. Even mine, I am told! But most surprising was the attention attendees paid to the messages from sessions titled: Critical issues facing pension funds for the next year/Global economic crisis and its impacts on investment and risk management decisions. In better times, one can't tell portfolio managers anything. They are gods in bull markets! Today, gods in training.

The double barreled kick off speakers were Dwight Duncan, Finance Minister, Ontario followed by Iris Evans, Finance Minister, Alberta. We were reminded why we all should live in Alberta. One could conclude from this small sample of two people that there seems to be some intelligent life among politicians in that province.

Big public sector pension money was represented. Ontario and Alberta Teachers Pension funds, Hospitals of Ontario Pension Plan, OMERS, OPSEU, and others. Folks were in shock that their well constructed portfolios designed for diversification all took a bath. "Correlations all rose" they complained. The tools failed, VaR failed, alternatives failed, leveraged and inverse ETFs disappointed and the only way back is if the markets float funds into solvency. In other words, their is no resolution.

Everyone shuffled through the sessions looking for answers finding solace only in group commiseration.

The best hope for salvation was mentioned several times but usually out of context. It was as if nobody wanted to admit they were spooked by volatility and that it was too early after the disaster to face the perpetrator. Consultants failed to boost spirits with predictions of a long and uncertain road back. (Check this space in the future for more about the "answer").

The only bright event was the announcement that the Bank of Montreal had listed four exchange traded funds on the TSX Thursday. Their first. This is important because it marks a validation of this lower cost alternative to mutual funds. The mutual fund industry was only muddling along in Canada until 1990 when the banks entered the market that they now dominate, and validated that product. How many other banks will follow suit by January 2010?

Sunday, April 19, 2009

“Are we there yet?”: the dynamic risk glide path approach to target date fund construction.

Today’s “target date funds” offer tremendous potential for self-directed pension schemes and employer-sponsored defined contribution plans in particular. Reducing the decision-making burden for investors and streamlining administration are worthy goals indeed, but at what cost to investment outcomes?

Shortly after takeoff from Heathrow, the pilot’s voice crackles through the cabin.

“We will be flying at an altitude of 35,000 feet and our flight time to New York City will be 7 hours 56 minutes. Stronger than expected head winds are possible in which case we may be landing up to 1200 miles short of the airport. Nevertheless, we are pleased to offer you another ‘on time’ arrival!”

Such is the case with today’s fleet of “target date” funds that change their asset mix on a predetermined “glide path” towards a specified future date. The problem is, as with our pilot above, that adverse market head winds promise to ditch unit-holders and passengers in the ocean, short of their destination.

Executive summary

Having a flight plan at take off is essential. But making no adjustments for developments along the route seems irresponsible at best and negligent at worst.

Target date or lifecycle funds (TDFs) attempt to simplify decision making for individual investors by automatically shifting to more conservative asset mixes (“soft landing”) as the “target” date approaches. Investors pick a fund with a terminal date closely corresponding with their retirement date and are spared rebalancing and asset mix shift decisions. This approach is increasingly popular among defined contribution (DC) pension and other self-directed schemes.

Predetermined asset mix changes vary somewhat from manager to manager, but each has a “glide path” that shifts from primarily equities in long dated funds to mainly fixed income and cash equivalents later on. Funds with near targets (like 2010), caught with 40%-60% in equities, have been severely damaged by the 2008 market downdraft, with little prospect for meaningful recovery given the increasingly conservative trajectory of their asset mixes. Disappointment, consternation, and questions are understandable.

We argue that the real objective of retirement schemes should be adequate replacement income in retirement, not “maximizing returns” within a fixed risk structure. We revisit TDF tactics and, using passive strategies, suggest that a dynamic risk glide path based upon actual return experience relative to a predetermined dollar target (safety net) and constant volatility rebalancing increases the probability of meeting capital accumulation targets compared with fixed trajectory funds that dominate the market today.

Defined contribution and other self-directed pension schemes

A massive unfunded defined benefit pension liability (perhaps $257 billion for S&P 500 companies at the end of 2008 for an aggregate funding level of 82.1%1) in part explains the shift to defined contribution as a dominant form of pension growth globally. Globalization itself has forced corporations to lower costs to stay competitive. Only 367 of S&P 500 companies had defined benefit (DB) plans at the end of 2007 and fewer are expected to have them after 20081. DC plans are the primary retirement plan for 64% of private sector employees in the U.S. (2007). The number of active participants in private DC pension plans surpassed those in DB plans in 19842. Corporations and governments look to control and reduce liabilities by shifting more responsibility to employees. This trend has been in place for over two decades but only within the last year have U.S. DC and Individual Retirement Account (IRA) assets exceeded private DB, Government pension plan and retirement annuity assets.3

Self-directed pension plans’ problems include participants’ failure to save adequately or to start early enough to build sufficient assets for retirement. Mandatory participation and portability are addressing the first issue, but current economic challenges threaten the latter as corporations trim matching contributions, and immediate participant needs supersede retirement goals.

Shifting investment decision-making responsibility to employees has also been a challenge for plan sponsors addressing varying participant ages, aptitudes, inclinations, and resources. More investment choice, once believed the best way to limit liability, has given way to simpler solutions that encourage fewer decisions with less investment expertise.

In summary, a competitive global business environment has led to a shifting of inadequate pension funding from corporations to individuals. DC plan sponsors are now responsible for offering participants inexpensive but effective solutions.

Target date funds

Self-directed pension plan growth is likely to persist. Plan sponsors must respond with simpler but more effective solutions at a fair price. They must, furthermore, eliminate conflicts of interest and provide full disclosure or face consequences that may include lawsuits.

Investors may prefer a simple one-decision approach to investing. Indeed, 90% of DC scheme members in the UK make no choice, ending up with a default portfolio.4 Potentially, TDFs address this need well. However, poor plan participation rates, lacklustre involvement in educational sessions and disappointing investment results from higher costs, poor diversification5, and neglect has meant that both plan sponsor and investor experience has often been less than happy.

Conceptually, TDFs are a simple and effective solution for the average investor or DC plan participant. The investor need only know their retirement date, although even this information is not clear in the new economic reality that sees changes to mandatory retirement age as a response to inadequate pensions and challenged social welfare systems in many countries.

That TDFs have varying asset mixes for the same target date from one supplier to another suggests that the goal for these products is not always clear. Not surprisingly, different parties have different objectives.

Objectives of target date funds

Plan participants want adequate and reliable replacement income in retirement. TDF investors are no different, yet this objective is not always explicitly incorporated into TDF investment strategy. Is it sufficient to provide a declining risk level over time? Should the current funding status be considered when determining a target risk level?

In common TDF schemes, the portfolio is rebalanced to progressively more conservative asset mixes ignoring the realized market experience of fund participants. Over-funded plans following a roaring bull market and under-funded plans in the wake of a bear market are treated to identical glide paths. The shortcoming of this deterministic approach has been observed by others.6

Misalignment of interests explains part of the problem. Investment managers want to win mandates. Demonstrating better historical performance than their competition is one way to do this (although everyone knows that past results are no indication of future performance). These higher returns usually come with higher risk over time (usually via higher equity exposure). Plan sponsors fall into the trap of chasing historical returns for DB schemes all the time. However, the passage of time has a real impact on self-directed plans. Individual portfolios lack homogeneity and have rapidly shortening time horizons compared with DB plans that often have younger workers replacing older retirees, thus maintaining a more stable investing horizon.

When the recent bear market materialized, many TDFs found themselves irreparably under water. Static-predetermined glide paths failed to consider actual market experience and changing risk levels. The results have been tragic for many about to retire.


We test the hypothesis that dynamic risk glide paths can increase the probability of providing sufficient retirement funds by:

 establishing a return floor;
 directing asset mix shifts driven by progress towards that return floor;
 enhancing lifestyle by systematically growing assets over the return floor;
 using constant volatility rebalancing to maintain consistent portfolio risk.


According to Maslow’s hierarchy of needs7, individuals seek first to satisfy basic needs by addressing physiological and safety requirements. We call this the “safety net”. For simplicity, the safety net is represented by an annuity purchased at age 65 sufficient to cover basic needs (assumption used in these simulations is $20,000 a year). Purchase of an annuity is not being specifically recommended, but is used as a conservative estimate of the required size of retirement savings to achieve this objective.

Once the amount is reached and the “floor” for retirement is secured, the safety net amount is invested in lower risk inflation-linked vehicles. Remaining funds are invested to improve life style in retirement with the peace of mind that basic needs are secured.

There are two key considerations:

 risk allocation is not equivalent to asset allocation. Over time, the risk of asset classes change in a more predictable and manageable manner than returns;

 incorporating the realized experience of the fund in setting asset allocation significantly increases the probability of achieving retirement objectives.

Risk allocation
In our experience, rebalancing to a constant volatility yielded 3%-4% per annum higher returns than rebalancing to a fixed asset mix (using back-tested data over the last ten years ending December 2007). While actual returns may differ, this is a meaningful difference worthy of every investor’s consideration.
Risk changes over time, and so should a portfolio’s asset mix. We are not suggesting chasing performance or timing markets. But adjusting downward the proportion of asset classes that are becoming more volatile, whether in a bull or bear market, can help to preserve capital. Conversely, increasing risk during quiet markets increases opportunities. Simply, time the risk, rather than the return.
This is possible because risk is persistent. If markets were volatile in the previous month, they will likely be volatile in the following month and vice versa. One measure of persistence is autocorrelation. The autocorrelation for monthly volatility of the S&P 500 is around 60%; the autocorrelation for monthly returns is close to 0%. Translation: risk is persistent, return is not. The persistence of volatility is the raison d'être for the whole risk modeling industry, an increasingly important part of professional investment management.
Ideally, investors should employ asset allocation with the help of a regularly updated risk model, putting overall portfolio risk in the context of each individual investor’s risk tolerance. Do-it-yourself investors, without access to a risk model and the expertise necessary to use it, could look to the CBOE Volatility Index [VIX] which measures the implied volatility of S&P 500 index options. The chart below shows the 252 day (one year) rolling average of the annualized standard deviation of the S&P 500 Index. Persistently higher levels for this index suggest rebalancing to a more conservative asset mix. Persistently low levels may suggest that an increase in equity weight is indicated.

Maintaining a consistent level of risk in the portfolio makes more sense than subjecting clients to often wild swings in volatility. 2008 has shown how dramatic volatility can be!

Dynamic risk glide path

In devising a glide path, several observations are made that will be quantified into a few simple and intuitive investment rules.

Assets are moved to a conservative mix once the safety net amount is achieved (or gets close). Gains are locked in and earned capital is preserved. Conversely, if the fund is short of the goal, more risk would be assumed. Hence, the level of risk assumed by the fund is inversely proportionate to the funding status. To test this hypothesis, Monte Carlo simulations are run making some basic assumptions about salary levels and growth rates (U.S. Census Bureau), inflation rate, contribution rates and annuity quotes as a proxy for the security net lump sum (see Appendix). The resulting glide path is dynamic. It depends on plan funding status and realized market experience. Results are compared to prevailing predetermined glide path returns.


A successful design should improve the probability of securing the safety net. Table 1, below, summarizes results of the Monte Carlo simulations. While the static predetermined path gives us a probability of secure retirement that is virtually the same as a flip of a coin (45%), the dynamic risk path results in a comfortable 91% probability. Furthermore, the worst 10th percentile of dynamic risk glide path outcomes is almost twice as good as for the predetermined glide path example.

Fund Value at Retirement (table 1)

Predetermined Glide Path Dynamic Glide Path
Mean $802,159 $961,233
Median $708,821 $968,967
Standard Deviation $405,868 $223,690
Probability of achieving target 45% 91%
10th percentile (low outcomes) $407,196 $781,514

The impact of the adjustable glide path can also be seen in the changed shape of the return distribution. The dynamic distribution is more compact, substituting low probability positive extreme returns for an improved chance of securing the security net.


Plan participants want adequate and reliable replacement income in retirement. Reliable cash flow after retirement is best afforded by an annuity from a reliable carrier. A balanced self-directed portfolio may provide similar cash flow at lower cost. Nevertheless, there are advantages to targeting a fixed dollar amount at retirement:

a) purchasing an annuity to provide a reliable income stream remains an option;
b) restructuring the portfolio to address post-retirement investment needs is also an option;
c) if projected rates of return are insufficient to provide required replacement income (or risk is too high), plan participants can be better motivated to save more and to start earlier;
d) interest rate changes over the accumulation phase can lead to adjustments to the target goal so that savings and/or risk profile can be modified as required;
e) funding a post-retirement income stream addresses one of the advantages of DB plans.

While the dynamic glide path approach is a form of actively managing the course of the portfolio towards a target destination, it is not active management. By maintaining a consistent level of risk that is appropriate for the investor, the portfolio is simply optimizing the opportunities and avoiding the high volatility that markets present over time. This is a prudent approach that should be considered regardless of the mandate.


The distance between Heathrow and JFK is 5,560 kms with an approximate flying time of 8 hours. Flying for exactly 8 hours and landing or putting down after precisely 5,560 kms without accounting for conditions along the way or where you happened to be en route would be silly. Yet today’s target date funds would have investors sign on for just such a journey.

Self-directed investment schemes dominate the global pension space and target date funds are increasingly popular. Target date funds’ appeal is simplicity. Disinterested plan participants are asked to make important investment decisions about a distant abstract event (retirement) that is low on their list of priorities. Target date funds ask a question that most can answer, “When do I retire?”. The logical appeal of an increasingly conservative set of predetermined asset mixes is not borne out in theory and the practical example of funds maturing within the next several years is equally discouraging.

Suppliers and plan sponsors need to revisit the investment construction process to assure more than just a disciplined asset mix procedure is in place. A dynamic risk glide path is only one way to tailor the plan to the real needs of investors, but making shifts to reflect consistent volatility rather than fixed asset mix is a promising approach. The simple trading rules pursuant to funding status are:

 once the safety net amount is achieved (or gets close), move assets to a conservative mix;
 if the fund falls short of its goal, assume risk inversely proportionate to the funded status.

The diversification possibilities afforded by risk dampening index and exchange traded funds (ETFs) can help fine tune and target risk in these portfolios although the use of futures and proxies for groups of securities may be more applicable to pools.

Establishing a return floor that addresses the investors’ key goal of reliable replacement income is a good way for plan sponsors to engage participants in a discussion of the most powerful retirement options: saving more and starting sooner.

Plan sponsors choosing to remain with the existing crop of target date funds may be well advised to issue flotation devices to participants for those “on time” landings that fall short of their mark.

Ioulia Tretiakova, Director of Quantitative Strategies, PŮR Investing Inc., M.Sc. in Mathematics, University of Toronto, C.F.A, the C.F.A. Institute, Financial Risk Manager (F.R.M.), Global Association of Risk Professionals. Ioulia specializes in portfolio engineering using statistics, econometrics, and behavioural finance.

Mark Yamada, President and Chief Executive Officer, PŮR Investing Inc., B.A., University of Toronto, founder of PŮR Investing Inc. (PŮR), an investment management company providing tailored private-client portfolio solutions for banks, brokerage firms, investment advisors and individuals. PŮR offers web-based mass-customized ETF portfolios on a multi-currency/multilingual ready platform.



3.43%, the long term average inflation rate (U.S.) is used for inflation:

Monte Carlo simulations (10,000 iterations):

• The portfolio’s value is simulated for a representative employee starting at age 30 through retirement (age 65) resulting in a 35-year investment period.

• A target safety net amount is estimated using the cost of an annuity as a proxy. The annuity quote is obtained from for a 65-year-old male and $20,000 annual income amounting to $230,696. The cost of the annuity is then adjusted for inflation of 3.43% over 35 years resulting in a target “safety net” estimate of $751,048.

• Using target levels of risk, expected returns are determined using standard deviation as a departure point assuming a risk-free rate of 4% and a Sharpe ratio of 0.30. For example, for a target risk of 10%, the expected return is 4% + 0.30*10% = 7%. Returns are assumed to be normally distributed.

• Employee income levels and growth rates, are estimated using the U.S. Census Bureau Current Population Survey (CPS) 2007 data. The staring salary value is taken as $30,127, according to the CPS, and the annual growth rate is calculated as the percentage difference in income between age groups linearly interpolated for annual values. This approximates the salary growth rate due to experience. The second component is an inflation adjustment accounted for as the inflation rate (3.43%) added to the growth rate above.

• The plan’s contribution rate is assumed to be 8%.


1 “Funding Woes”, Jennifer Byrd, Pension & Investments, December 2008.
2 Department of Labor Form 5500, Pension Plan Bulletins, 1998-2001.
3 “U.S. Retirement Market, First Quarter 2008”, Investment Company Institute, October 2008, Vol.17, No.3-Q3.
4 “Pensioners at risk in ‘defined contribution’ pensions environment”, David Blake, Cass School of Business; Debbie Harrison, Visiting Fellow, April 2007.
5 “Patience is a Virtue, Asset Allocation Patterns in DB and DC Plans”, Boive and Almeida, Issue Brief July 2008, National Institute on Retirement Security.
6 “Dynamic Lifestyle Strategies for Target Date Retirement Funds”, Anup Basu, Queensland University of Technology, Alistair Byrne, University of Edinburgh, Michael Drew, Griffith University, 2008.
7 “A Theory of Human Motivation”, A.H. Maslow, Psychological Review, 1943.

Monday, April 6, 2009

Tribalism on the Board

Whether boards of directors are responsible to shareholders or not can be debated. More clear, is director responsibility to the best interests of the corporation. When bad decisions are made, or lead to negative consequences, we all understand that nobody is perfect, but we hold boards to a high standard. This is fair because, in theory, an assemblage of smart people decreases the likelihood of poor choices.

In this spirit, directors of public companies should have their voting records made available to the public or at least to registered shareholders on issues of substance like executive and director compensation, mergers and acquisitions, non-standard accounting practices and anything else that might be considered worthy of shareholder note. Perhaps any item that requires a note to the financial statements could be included. If shareholders are to select board members, we must be given the tools to assess and evaluate directors effectively.

That governance is lacking in boardrooms is obvious. The current financial crisis is a direct result of U.S., UK, and European bank boards who did not understand the most important duty they have; the safeguarding of their corporations. Directors may argue that their voting records should be kept secret either because board solidarity is important (hogwash) or that the CEO may be constrained by such disclosure (also hogwash). As shareholders, we hope that dissent and discussion will keep management's feet to the fire and forge the right balance between short term needs and long term goals. If we don't see evidence of this discussion, how can we properly vote for a slate of directors based only on reputation. Boards continue to rely too much on the old boys network.

Tribalism is no excuse for bad governance.

Monday, March 23, 2009

U.S. Treasury Bailout

The Treasury's plan to isolate toxic assets appears to be thoughtful. Its strength is the reliance on private sector valuation of assets, the weakness may be having the private sector administer the assets under FDIC guarantee.

The document correctly identifies the lack of liquidity as the colonic blockage of the system and is on the right track in trying to arbitrage or bridge the time needed to find a more realistic balance between information and valuation. Inviting private investors is a good move to assure those with "skin in the game" are valuing these assets and not politicians! Nevertheless, only the details of the contracts will tell if terms sufficient to offset the risks inherent in the worst paper will attract speculators. There is not enough evidence that long term investors would be interested at this time because the banks are most likely to dump the worst quality paper into this program first and retain the better ones.

No bank wants to incur more massive write downs or have write downs already taken to be determined as having been insufficient. Already exhausted stockholders would muster another breathe to whip them anew in the marketplace.

While it will be in the best interest of the new equity owners of these assets to maximize their returns, with the 6 to 1 leverage, this may mean selling quickly or foreclosing rapidly to realize any value above the bid. This may not serve the public policy piece as the Administration may have hoped. Earlier foreclosures are a blessing and a curse. The blessing is the more direct resolution of poor loans, but the curse of exacerbating additional negative public sentiment does little to bolster consumer confidence.

On balance, getting bankers to lend again is an essential first step and providing greater clarity about their real capital levels is important. Nevertheless, it would have been nice to see some extra discipline implemented in the governance of the banks themselves when the opportunity is most ripe. Bank boards have not been held adequately responsible for their role in the financial "train wreck".

Perhaps we can look forward to additional measures in the future if this plan works. If it doesn't, I suppose no rules or discipline will matter very much at all.

Tuesday, March 17, 2009

AIG Bonus Issue

It looks bad, smells worse and feels slimy, but AIG executives have been asking for this day since they partied the night away to celebrate the first of many government injections of capital to keep the "too big to fail" organization alive.

What these "bozos" did is no worse than any of the Wall Street investment bankers have done in looking out for themselves first, their families second and their Porsche lease payments third. That the AIG transgressors speak with English accents (it was the London office that masterminded the fiasco) or with Connecticut clipped phrasing is not important. The disconnect from "Main Street" is laughably tragic.

The fact that the Government is least likely to succeed at managing a business of any kind is worrisome. They screwed up the management of the Mustang Ranch outside of Las Vegas when they assumed ownership after a tax issue. If they couldn't make a brothel that served booze make money, we all have to worry if they try to manage anything more complex than a lemonade stand in the desert.

The blame should be kept separate from the solution. The blame is Hank Paulson and the deregulating regulators. Andrew Cuomo as head of HUD under Clinton bears some responsibility also but Donaldson and Cox at an SEC that allowed for the abandonment of common sense need to be fingered for sure.

A solution is to arbitrage time. Taxpayers bridge the bad paper until it is worth something and be sure the bridge loans are properly valued and that the spread on the inevitable public offering that Goldman Sachs underwrites, reflects the fees paid to that organization to keep it alive. In fact the fees that GS makes on government offerings should be gratis even if Paulson coughs up his ill gotten $700 million that he picked up during the last few years at GS.

Wednesday, March 11, 2009

I can't take credit for this but it is pretty cute.

The Credit Crunch Explained

Heidi is the proprietor of a bar in Berlin. In order to increase sales, she decides to allow her loyal customers, most of whom are unemployed alcoholics, to drink now
but pay later. She keeps track of the drinks consumed on a ledger (thereby granting
the customers loans).

Word gets around and as a result increasing numbers of unemployed alcoholics
flood into Heidi's bar. Taking advantage of her customers' freedom from immediate payment constraints, Heidi increases her prices for wine and beer, the most popular drinks. Her sales volume increases massively.

A young and dynamic customer service consultant at the local bank recognizes these
customer debts as valuable future assets and increases Heidi's borrowing limit. He
sees no reason for undue concern since he has the debts of the alcoholics as

At the bank's corporate headquarters, expert bankers transform these customer
assets into DRINKBONDS, ALKBONDS and PUKEBONDS. These securities are
then traded on markets worldwide. No one really understands what these
abbreviations mean and how the securities are guaranteed. Nevertheless, as their
prices continuously climb, the securities become top-selling items because (insert
here the name of your financial advisor) recommended them as a good investment.
One day, although the prices are still climbing, a risk manager of the bank,
(subsequently of course fired due to his negativity), decides that the time has come to demand payment of the debts incurred by the drinkers at Heidi's bar. But of course
they cannot pay back the debts.

Heidi cannot fulfill her loan obligations and claims bankruptcy.DRINKBOND and ALKBOND drop in price by 95 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The suppliers of Heidi's bar, having granted her generous payment due dates, and having invested in the securities, are faced with a new situation.
Her wine supplier claims bankruptcy, her beer supplier is taken over by a

The bank is saved by the Government following dramatic round-the-clock consultations by leaders from the governing political parties. The funds required for this purpose are obtained by a tax levied on the non-drinkers.

Monday, March 2, 2009


From the Treasury statement:

Washington, DC The U.S. Treasury Department and the Federal Reserve Board today announced a restructuring of the government's assistance to AIG in order to stabilize this systemically important company in a manner that best protects the US taxpayer. Specifically, the government's restructuring is designed to enhance the company's capital and liquidity in order to facilitate the orderly completion of the company's global divestiture program.

The company continues to face significant challenges, driven by the rapid deterioration in certain financial markets in the last two months of the year and continued turbulence in the markets generally. The additional resources will help stabilize the company, and in doing so help to stabilize the financial system.

As significantly, the restructuring components of the government's assistance begin to separate the major non-core businesses of AIG, as well as strengthen the company's finances. The long-term solution for the company, its customers, the U.S. taxpayer, and the financial system is the orderly restructuring and refocusing of the firm. This will take time and possibly further government support, if markets do not stabilize and improve.

Given the systemic risk AIG continues to pose and the fragility of markets today, the potential cost to the economy and the taxpayer of government inaction would be extremely high. AIG provides insurance protection to more than 100,000 entities, including small businesses, municipalities, 401(k) plans, and Fortune 500 companies who together employ over 100 million Americans. AIG has over 30 million policyholders in the U.S. and is a major source of retirement insurance for, among others, teachers and non-profit organizations. The company also is a significant counterparty to a number of major financial institutions.

AIG operates in over 130 countries with over 400 regulators and the company and its regulated and unregulated subsidiaries are subject to very different resolution frameworks across their broad and diverse operations without an overarching resolution mechanism. Within the options available, the restructuring plan offers a multi-part approach which brings forward the ultimate resolution of the company, has received support from key stakeholders and the rating agencies, and provides the best possible protection for taxpayers in connection with this commitment of resources.

The steps announced today provide tangible evidence of the U.S. government's commitment to the orderly restructuring of AIG over time in the face of continuing market dislocations and economic deterioration. Orderly restructuring is essential to AIG's repayment of the support it has received from U.S. taxpayers and to preserving financial stability. The U.S. government is committed to continuing to work with AIG to maintain its a bility to meet its obligations as they come due.

Treasury has stated that public ownership of financial institutions is not a policy goal and, to the extent public ownership is an outcome of Treasury actions, as it has been with AIG, it will work to replace government resources with those from the private sector to create a more focused, restructured and viable economic entity as rapidly as possible. This restructuring is aimed at accelerating this process. Key steps of the restructuring plan include:

Preferred Equity : The U.S. Treasury will exchange its existing $40 billion cumulative perpetual preferred shares for new preferred shares with revised terms that more closely resemble common equity and thus improve the quality of AIG's equity and its financial leverage. The new terms will provide for non-cumulative dividends and limit AIG's ability to redeem the preferred stock except with the proceeds from the issuance of equity capital.

Equity Capital Commitment : The Treasury Department will create a new equity capital facility, which allows AIG to draw down up to $30 billion as needed over time in exchange for non-cumulative preferred stock to the U.S. Treasury. This facility will further strengthen AIG's capital levels and improve its leverage.

Federal Reserve Revolving Credit Facility : The Federal Reserve will take several actions relating to the $60 billion Revolving Credit Facility for AIG established by the Federal Reserve Bank of New York (New York Fed) in September, 2008, to further the goals described above.


Thursday, February 26, 2009

Last bid in size: Anatomy of market meltdowns

Major market meltdowns share one critical factor: a liquidity vacuum. Liquidity vacuums occur when information is not available or is not trusted. Confidence deteriorates and markets go “no bid”. “No bid” means there is no participant willing to pay any price at that moment for any amount of a particular asset.
As investment professionals, these are surreal moments because we have come to believe in the market as the clearing house for all information, both good and bad. If a company disappoints, expectations adjust to a lower reality by reducing its quoted price. Participants rely on the market to reflect the discounted present value of “reality” and reality is the “last bid in size”. But when the market for an asset goes “no bid” as is the case for so-called toxic assets underpinned by sub-prime mortgages of unknown or questionable origin and solvency, it is theoretically saying that the asset is “worth” nothing.Even in the case of catastrophic events, there is usually some market participant willing to pay a deep discount, during an information black hole, to arbitrage the time between not knowing or trusting the facts and some future point when reality reconstitutes a value.
The current financial crisis is simply more complex than previous crises and it is so because the terms of arbitrage have been disrupted. Let’s start with an example.
If you list your house for sale and receive no offers for several months is it worth zero? Does it mean that the value of your property is zero until it was sold? The issue for some assets that are not liquid is that time is required before a market value can be established. If you bought another house before selling this one, there may be a cost to carrying or arbitraging the time until it can be sold. The same principle holds for most banks today. They must find a way to arbitrage their toxic assets to shore up their capital in the short run until the problem assets can be worked out or finally written off.
When Bear Stearns was forced to mark down the value of their mortgage portfolios to “market” was the “market” value realistic? Most market participants would say yes, because if nobody was willing to buy it at any higher price, that “marked down” price was its real “value”.If some mechanism existed to allow Bear to arbitrage the time until a work out were established, they would not be the historical footnote that they are today.
Today, bank and government officials from U.S. Treasury and the Federal Reserve Board are struggling to restore interbank confidence in the value of assets in a critical attempt to unblock the constipation in the banking system over unknown capital adequacy issues.
If banks take an immediate write down and amortize the notional loss over a reasonable period of time (say five years), there should be adequate time to restructure and/or establish better valuations in the absence of a liquidity freeze. They need a reliable mechanism to arbitrage time.Homeowners who have been caught in the crossfire of declining housing values may also need a mechanism to arbitrage time. This may be a reduction in monthly payments in exchange for longer amortization periods. It is difficult to have any sympathy for consumers who have "maxed out" their credit cards who will be seeking relief sometime later this year and perhaps only empathy for the sub-prime borrowers who were partly duped by unscrupulous mortgage originators particularly in the case of falsified mortgage applications. Nevertheless an arbitrage can be structured that creates realistic choices for those folks who feel they are "in over their heads". Losing a house is disruptive and disheartening but if the choices are food, clothing, shelter and education for the kids, vs. a 100 year mortgage (a la Japan pre-bust), perhaps more rational choices can be made.

The idea of closing ones eyes to the problems and hoping that they vanish when one awakes is obviously unsatisfactory. But in this case, arbitraging time while addressing systemic problems can buy valuable time for the banking and credit markets to do what needs to be done. What those things may be will be in a future post.