Some reading for the weekend.

Anyone who still believes that markets are ultra-rational got yet another rude awakening this week, when a huge sell-off in commodities sent prices for everything from silver to oil tumbling.

In a superb column for Reuters, John Kemp writes:

Front-month Brent crude futures sank almost $12 per barrel (well over 9%) in a series of vertiginous declines that took the market down from over $120 at the start of the day to under $110.

The price change was more than 4 standard deviations — which is something that should be seen on average only once in every 63 years — if the market was well-behaved and changes followed a normal or Gaussian distribution.

At times the move has approached 5 standard deviations — which should only occur once every 7,000 years.

Yet again, the markets are proving academic theories about Gaussian returns absolutely wrong. This is why you must read The Black Swan even though the book has become a trite buzzword, and is far less easy on the eye then the bonkers Portman movie of the same name.

Once every 7,000 years – either investors of 20,000AD are going to find the markets a millpond, or the theories are absolutely bunk.

However, realizing that markets are not rational is not the same thing as being able to profit from it. In fact, most market timers lose money, as academic studies have shown. The difficulty, basically, is that the bubble of tomorrow is the rational re-valuation of today.

Call time on market folly too soon, and you risk missing the gains that make investing profitable over the long-term. Or, even more commonly, you fail to get back in again because you expect more falls to come.

On that score, it’s worth noting that Goldman Sachs expects this fall in oil to be temporary. Central bankers will hope the squid is wrong, given how lower oil prices would take the edge off inflation, as Stephanie Flanders points out:

If the global price of oil averages, say $110 a barrel over the next year or two, and not the $120 forecasters had been pencilling in, that could take about 0.2 percentage points off the rate of inflation in 2011 and 2012, relative to what was previously thought. If you’re the ECB or the Bank of England, or the Federal Reserve, every little helps.

The perma-bullish investors in oil companies who plague the bulletin boards (and the boardrooms of hedge funds!) will be backing Sachs over Stephanie, of course. They’ve been doing so all year, to the chagrin of those of us invested in companies that dare to do something other than dig stuff up:

(Via Business Insider).

I am not going to predict the bursting of the commodity bubble, even if silver’s 30% price fall in a week looks suspiciously like the top (and confounds those who say the price of precious metals is driven by fundamentals).

But I think it’s worth heeding these thoughts from Larry Swedroe:

There are two […] reasons to be cautious and to avoid being caught up in the speculative hype:

• The prices of both gold and silver are now way above the marginal cost of production. When that happens, you get new supply (though it may take some time for production to come on line).

• Unlike oil, which is a depleting asset, all the gold and silver ever mined is still around and is available to be sold. That means supply can quickly swamp demand as those family heirlooms that have been sitting in attics become prime material for melting down.

Having some money in commodities as part of diversification is very sensible, if you can find a way that fits into your overall investing strategy.

[continue reading…]

Early on in the life of Monevator, I wrote a series of posts explaining how to pick high yielding shares for long term diversified dividend income, and why you might want to do so.

The series culminated with a example portfolio, which I reviewed for the last time in April 2011.

As promised, I am now going to create a new high yield portfolio (HYP). What’s more, I’m going to do the sensible thing this time, and track the dividend income.

Income is, after all, the entire point of a HYP. And while I’m fairly pleased with how well the capital value of that last HYP withstood the carnage of the credit crunch, I haven’t really got a Scooby as to how the income fared. This time I want to be sure.

Having weighed up various tools to enable me to track both the portfolio and its income – and taking into account the entire Monevator research department seems to have absconded, together with all our interns AND the hapless but dependable jobsworth who might otherwise have been lumbered with tracking the portfolio – I’ve decided to simply buy the shares in real-life to do it.

Yes, I am investing my own hard-earned money to buy and track this HYP here on Monevator.

As a fan of Airfix in my childhood, I can’t really resist having another mini-model portfolio to play with. More importantly, this way is guaranteed to be correct, if rather expensive, unlike the online tools which all have downsides. Also, buying and holding the shares will give us a better idea of how much faff it takes to run even a largely hands-off portfolio, as companies are acquired, go bust, do an Enron, and so on.

I’ll give the exact details, such as prices paid and initial costs next week. For the rest of this post, I’ll tell you what shares I’ve chosen and why.

Important: I’m not recommending you buy these shares, and take no responsibility if you do so. I’m just a private investor, not your personal adviser nor Warren Buffett. Also, if you’re going to hold shares directly, you need to learn about, choose and follow your own shares, not just blindly copy someone else’s picks. There’s no shame in going for an index tracker instead!

Let’s do it like we did last year

There’s no point in repeating what I’ve previously written about selecting shares for a HYP. Please follow the various links in the first paragraph of this article for the specifics (or else see this archive of all my HYP posts).

I think the original strategy stood up fairly well last time, and steered me away from indebted disasters like Yell or from buying too many housebuilders or banks – even if it didn’t avoid banks altogether. (I did note yields on bank shares were high because of fears of a credit crunch, but I said it could go either way and so bought a couple of banks anyway!)

The importance put on diversification and avoiding excessive debt proved itself in the bear market, too.

All that said, my HYP thinking has evolved a little bit since 2007, in that I now think the sustainability of the yield is also worth an extra moment of guesswork thought.

It won’t pay to try to be too much smarter than the market here; let’s be honest, our 20-minute evaluation won’t beat a full-time analyst’s efforts. Our edge, if we have one, comes through buying a basket of higher yielders, not by second guessing the earnings forecasts for every company in the FTSE.

Put simply, I’d now pick a hugely dependable cash generator on a slightly lower yield like Unilever – which only just made my 2007 portfolio – over the average engineering firm or cyclical, unless its yield is stupidly low. (Still no room for ARM then).

The 2011 high yield portfolio

Again, please see my 2007 post for a step-by-step walkthrough of how you can pick your own portfolio of high yield shares using a combination of a screener, further research, and gut feel.

Needless to say, that old portfolio is wildly out of date. Yet I think reading the previous post is arguably more demonstrative than detailing every step today. Truth is, making pronouncements about share A versus share B as commentators and fund managers do gives an illusion of exactitude. By looking at that four year old post, you can see the warts and all, in the harsh light of what happened next.

Here’s my final chosen portfolio for this year, followed by a few brief notes on what’s in it and why:

Company	Size (m)	Sector	Cover	Yield
Aviva	£12,440	Life assurance	2.2	6.0%
BAE Systems	£11,065	Aerospace	2.2	5.6%
AstraZeneca	£42,670	Drugs	2.5	5.6%
Scottish & Southern Energy	£12,461	Utilities	1.5	5.5%
GlaxoSmithKline	£67,632	Drugs	1.7	5.3%
Vodafone	£87,075	Telecoms	1.9	5.2%
Admiral	£4,468	Insurance	1.1	4.7%
Centrica	£16,181	Gas supplier	1.8	4.7%
Royal Dutch Shell	£60,467	Oil	1.8	4.6%
British Land	£5,253	Property	1.1	4.3%
Balfour Beatty	£2,231	Construction	2.7	4.1%
HSBC	£115,135	Banking	2.2	4.0%
Tesco	£32,857	Retail	2.3	3.9%
Tate & Lyle	£2,831	Food	1.8	3.9%
Unilever	£25,561	Household	1.8	3.8%
Aberdeen Asset Management	£2,661	Funds	2.0	3.5%
Pearson	£9,149	Media	1.9	3.5%
Diageo	£30,787	Beverages	1.9	3.4%
Halma	£1,383	Engineering	2.2	2.5%
BHP Billiton	£51,522	Mining	4.3	2.4%
				———
Overall yield				4.3%

Note: The forward yield is rounded to one decimal place.

While I’m not going to run through every company I’ve picked – or indeed the ones that got away or were pushed overboard – a few points are worth noting.

First off, I’ve not included British American Tobacco. I’ve never bought tobacco shares – it’s a mental weakness of mine but I just can’t bear to profit from a habit I loathe, especially given how such companies’ future growth is predicated on selling cigarettes to less well-educated parts of the world.

If you’re made of sterner stuff, then grab the diversity and swap them in for either Glaxo or AstraZeneca. Doubling up on healthcare instead of cigarettes is my idea of share humour, but it’s also a chance to buy an out-of-favour sector that finally looks cheap.

I’ve included two utilities, both of which have a fair bit of debt. As I explained in the original series, utilities always come with debt, which is considered sustainable due to their long-term pricing arrangements.

Vodafone’s debt is horrible, too, but it’s a monster utility-like company. BAE’s pension deficit isn’t great, but it’s debt looks sustainable, provided the US military’s recent coup doesn’t mean the end of defense spending.

Aviva’s high yield is a bit of a mystery. I suspect it’s because it holds a lot of European government bonds. I’m sanguine, given the 6% reward for the risk.

Admiral and British Land both have lower dividend cover than the strategy looks for, but they’re special cases. Admiral has a superb record of paying out nearly all its income as a dividend, but that does make for low cover (and the potential for some lean years in the future). British Land is a REIT, which means it has to pass through most of its income, by law. It’s also got a fair bit of debt, albeit it backed by a great portfolio of commercial property.

The two lowest yielding shares at the end are in for diversification. Halma has one of the very best dividend records on the London market. I first bought it years ago on a near-4% yield, and I don’t deny it looks pricey now, but it’s a super business. As for BHP Billiton, I’m not comfortable setting up a long-term portfolio without a mining company in it, and BLT is as good as it gets today. Again, I can remember a 5%+ yield less than a decade ago on this share.

A purchaser could skip these last two and take the yield up to 4.5%; I’d rather have their proven prowess in the portfolio.

Incidentally, the ability to focus on whatever sector is down in the dumps and thus get higher yields is an advantage of buying your HYP over a period of years, instead of all in one go like this. If you’ve got the cash and you need to buy an income now, it’s better to get the diversification and lose some yield, I say.

I’m happier with the quality of shares in this portfolio than the 2007 version. True, the starting yield is lower, but the quality of companies seems overall higher. Of course, that might just be because we haven’t had the car crashes yet!

This HYP versus cash, trusts, and annuity

Our final yield of 4.3% is much higher than the FTSE All-Share’s yield of roughly 3%. It’s also much higher than cash.

But the HYP yield only just matches the current forward yield on my favourite income investment trust, City of London, which is slightly disappointing. The latter is trading on a 2% premium, but owning it (or better a basket of such income trusts) will be a lot less hassle for most investors. I’ll probably use the trust as a benchmark comparison against this HYP in the years to come.

HYPs were originally conceived as an alternative to an annuity, and the income compares well here, only a little below the £4,583 starting level a 65-year old man might get from the best single life annuity with 3% escalation and a 5-year guarantee. It’s much lower than the £6,491 he’d start with if he skipped the 3% escalation and the guarantee, though. (These quotes come via the Hargreaves Lansdown best buy table).

Of course, a HYP has a big advantage over an annuity in that you don’t lose it just because you’ve done the indecent thing and died. A portfolio of shares can be left to your heirs.

The other key advantage is that both the income and the capital value of our shares will, hopefully, grow ahead of inflation in perpetuity.

The downside of the HYP route – aside from the extra work in buying and monitoring a portfolio – is that either through poor share picking or a market meltdown, your income is hit and you get less than the guaranteed payment of an annuity. I’m decades away from retiring, but if I was I’d probably split a pension pot 50/50 between shares and annuity, to hedge against this risk.

In terms of expectations, I don’t expect fireworks from my mini-portfolio. A HYP shouldn’t beat the wider market, according to the boffins, as that higher starting yield will be paid for by lower capital growth. Over 20 years or so, a FTSE tracker’s income might well have overtaken it, too, due to faster dividend growth. But a HYP is about a higher income now, not some day in the future – a pensioner hasn’t got 20 years to wait!

While it may not beat the market, I’d certainly hope the income will rise ahead of inflation, though, and it’d be nice if the capital value does, too.

We’ll see.

There’ll be more details of the benchmarks I’ll be tracking this HYP against in next week’s post, so if you’ve not done so already please subscribe to make sure you get it.

The risks of Exchange Traded Fund (ETF) investing have been brought into stark relief by a volley of warning shots from the G20’s Financial Stability Board (FSB), The International Monetary Fund (IMF), and the Bank for International Settlements (BIS).

While much of the alarm has centred around exotic synthetic ETFs, physical ETF risks could also be storing up a shock for the financial system, according to the FSB and IMF.

Often described as plain, vanilla funds, physical ETFs are so-called because they physically own the bulk of the securities of the index they aim to track.

The problem is what they do with those securities next.

Many physical ETFs run security lending programmes, renting out securities to hedge funds et al, who like to make short-selling mischief with them.

Securities are lent for a fee which, if we’re lucky, is split between the ETF manager and the fund shareholders (you and me).

ETF risk alert

The short-sellers get a ready supply of securities to bet against the markets and the ETF makes some easy money that can offset its tracking error.

Everybody’s happy? Everybody except the FSB which warns:

Thin margins on plain-vanilla physical ETFs create incentives for providers to engage in extensive securities lending in order to boost returns… Securities lending… may create similar counterparty and collateral risks to [those incurred by] synthetic ETFs. In addition, it could make the liquidity position of the ETF fragile, by challenging the ability of ETF providers to meet unexpected liquidity demands from investors, particularly if outflows from ETFs become significant under severe stress.

So supposedly simple, original flavour ETFs potentially expose investors to the same unpalatable dangers as those tutti frutti synthetic ETFs. Specifically:

Counterparty risk – In this case the chance that you’ll never see your borrowed security again, because the borrower goes under before they give it back.

Collateral risk – The danger that the collateral the borrower posted to lend your security (to cover the counterparty risk) turns out to be worth a lot less than the value of the original security. Alternatively, perhaps you can’t get your hands on the collateral at all, due to a bankruptcy bunfight with the counterparty’s administrators.

The nightmare scenario envisaged by the BIS and FSB is that – in the midst of a market panic – doubts about counterparty viability and collateral value trigger a run on the ETF. (I explored that chain reaction more fully in last week’s synthetic ETF piece).

Don’t touch physical ETFs with a bargepole?

Completely avoiding physical ETFs would be an over reaction, to say the least.

Firstly, we’re compensated for the risk through the securities lending income returned to the ETF, in much the same way that we’re compensated for the heightened risk of investing in emerging markets by the expectation of greater returns.

The key question is are we’re compensated enough? You can only answer that question by knowing how much of the bunce is going into your pocket. I’ll return to this in a sec.

Also, securities lending isn’t unique to ETFs. Almost everyone is at it. Index funds, active funds, pension funds – securities lending has been going on for decades without major disaster.

Neither do these reports suggest that their apocalyptic visions will come to pass. The authors stress that they are highlighting concerns over the unintended consequences of rampant ETF growth, the mutation of the product, and possible interactions with contemporary trading developments.

By highlighting these physical ETF risks, they’re pointing out potential weaknesses and flashpoints in the system. Flaws to be addressed now by regulators, investors and the industry, rather than by blackened survivors raking through the rubble.

It is the work of regulators keen not to be caught napping again quite so soon after the credit crunch.

What should happen next?

If the security lenders have us surrounded, then we need to know what they’re up to. And we need to be able to compare those activities in a meaningful way: Apples with apples – rotten or otherwise.

The ETF industry has barely moved a muscle on the issue so far. A fund’s factsheet and website page should contain the following information, in my view:

1. Does the ETF actually lend securities?

Not all do. You can check which iShares ETFs lend out securities on the individual fund’s page in the latest annual report (but not the interims). If no securities lending income is reported then you’re in the clear. Although that doesn’t mean that fund can’t lend in the future.

Credit Suisse’s latest semi-annual report says they didn’t indulge in any securities lending, although they’re perfectly entitled to according to their prospectus.

If you’re in any doubt about the position then contact your ETF’s provider and ask them.

2. Are we being well rewarded for the risk?

iShares split securities lending income 60:40 in favour of the investor. They dine out on 40% of the income. The other 60% takes the edge off an ETF’s costs.

What I’d like to know is would anyone else give me a 70:30 deal, or better, to compensate me for the risk that is all mine, not iShares.

Investors certainly aren’t getting any love from HSBC’s growing range of physical ETFs. Their latest annual report baldly states:

The Investment Manager is entitled to retain any fee received for such [stock-lending] services for its own benefit and not for the benefit of the relevant Sub-Fund.

As we’ve seen, Credit Suisse’s ETF securities lending programme is on hold. They don’t mention what the revenue split would be if they cranked it up.

3. How much income is being generated?

I’d like to see securities lending income presented as a clear benefit to the investor. For example, what percentage did it knock off the TER?

iShares is the only provider I know of that coughs up details on security lending income for individual ETFs. As mentioned, you can find the info buried deep in the annual report (though not the interims) which reveals:

• Lending income generated in pounds.

• The value of securities each ETF has on loan.

• How much collateral is covering the loan.

You can compare these figures with the ETF’s Net Asset Value (NAV) to work out how exposed the fund is.

It would be much more investor-friendly if iShares (and everyone else) provided the information for every ETF as per this snapshot (choose the institutional settings to view) of selected funds:

This info gives you an instant gut-feel for how hawked around the ETF is as the loans are presented as a percentage of the fund’s NAV. The average on-loan percentage is crucial, too.

We passive investors don’t want to fritter away our lives checking this stuff daily.

4. Basket case

There’s been plenty of woolly calls for more ‘transparency’ regarding the actual collateral basket holdings of ETFs. The idea is that a rummage in the basket enables investors to perform ‘due diligence’ on their collateral risk exposure.

That’s all very well, but the information has got to be readily useable by retail investors. Too often transparency or disclosure means a provider pumping out a spreadsheet containing hundreds of listings that defy analysis by the average punter.

I’d like to see a simple rating system devised that would enable the collateral basket and the credit worthiness of counterparties to be easily assessed. Perhaps using the rating agency methodology of AAA and so on down the food chain.

No doubt this would be proclaimed expensive, but it’s not as if the ETF providers’ risk managers don’t already know what they’re getting themselves into. (I hope!)

These reporting requirements should be consistently presented for ease of comparison across providers. They should also apply equally to other UCITS funds marketed to retail investors, too. Why single out ETFs when my pension fund is merrily renting out my shares too?

Where’s my risk analysis department?

My biggest fear is not that physical ETFs have suddenly become radioactive and I’ve lost my asbestos gloves. Risk abounds, so I just need to know what I’m getting myself into.

My biggest fear is that the reports prompt a raft of new regulation, or the ETF industry makes pre-emptive moves to put their house in order, but in such a way that the little guy is still left none-the-wiser.

Given that we’re all increasingly thrown onto our own mettle to provide for our future, we need the risks of investable vehicles, including physical ETF risks, to be fully understood by the average Joe.

Take it steady,

The Accumulator