three-whirlpools-sequence

Thanks to the SEC’s efforts, investors now understand the perils of parking money in leveraged ETFs.

Such products defy market wisdom because they buy high and sell low. When the market rises, the fund’s equity rises faster than the underlying price, so the fund must buy more of the underlying at the increased price to re-establish its leverage. When the market declines, the opposite holds true and the fund sells at the lower price. A highly volatile market results in losses to the investor—often overwhelming any gains that might have been expected from correctly projecting the overall market trend.

Sequence-of-returns risk

This effect is another example of the sequence-of-returns risk popularized by William Bernstein and Dr. Moshe Milevsky: in the presence of cash flows, it is not simply the total return over an entire planning horizon that affects the ending value of the portfolio. The order in which sub-period returns are experienced is also important, as is the volatility of these sub-period returns.

Let’s say we have a planning horizon of two years and intend to make cash withdrawals at the end of each year. If these withdrawals are not covered by portfolio income, you’ll have to sell securities to raise cash at the end of the first year. If the market has declined, you’ll have to sell a greater number than anticipated to raise the same amount of cash.

Those sold securities will not participate in a market recovery, even if the total return for the underlying portfolio for the two years exactly matches the initial projection.

This fits with the observation of volatility effects in leveraged ETFs, when you consider cash flows rather than market prices, to drive the funds’ purchases or sales. And, in the case of these funds, the Sequence of Returns is actually guaranteed to generate the worst possible result for the security holder.

These effects of sequence-of-returns risk are intimately related to the credit quality of preferred shares issued by Split Share Corporations (SSCs). Such a corporation is very similar to a mutual fund—in fact, they are legally described as “mutual fund corporations” and are subject to the provisions of National Instrument 81-106, among others.

The difference is, SSCs issue two classes of investment: capital units and preferred shares. Potential buyers of the preferred shares are offered preferential dividends and preferential repayment of principal when the company is wound up on a set date; capital unitholders get whatever is left over and have a de facto leveraged investment in the underlying portfolio.

In most cases, the corporation’s promised cash distribution greatly exceeds the cash income derived from the underlying portfolio. The prospectus for Financial 15 Split Corp. (FTN) states the investment objectives are to distribute $0.525 p.a. to preferred shareholders and $1.20 p.a. to capital unitholders, for a total of $1.725 per whole unit—with the whole units initially sold for $25.

This implies that, even in the absence of fees, the underlying portfolio had to return 6.9% annually to meet the fund objectives; once fees are included, that required return rises to an average of 8.58%. That could be considered aggressive, but not completely unreasonable by the standards of the time. The gigantic CalPERS pension fund was using 8.25% at the time FTN came to market.

But the dividend yield of the underlying portfolio was less than half this figure, implying a cash drag. While the company engages in covered-call writing to generate cash income and reduce this cash drag, neither it nor any other SSC I know has ever published figures demonstrating this strategy works.

In fact, the company’s total return from the commencement of investment operation (November 2003) to the most recent annual financial report date of November 2011 has been only 0.80% p.a. Plus, the NAV has suffered; the total NAV on May 15, 2012 was only $13.60. It should be clear the company’s promise to repay $10 to the preferred shareholders on windup is less credible now. DBRS has gradually downgraded the credit rating of the preferreds from Pfd-2 at time of issue to their current Pfd-4(high).

What’s a default?

However, DBRS, like all other rating agencies, considers only the potential for default in assigning a primary credit rating. If the company should find it can only pay $9.99 to preferred shareholders on the scheduled December 2015 termination date, this will be considered a default—but these shareholders, having received only a penny less than promised, will doubtless consider the default a mere peccadillo.