In the future, however, Bookstaber says he believes Dodd-Frank will improve the landscape: “The legislation will restrict the ability of banks to create complex derivatives just for the sake of doing it,” he said. Central clearing will also “pull derivatives back from the edge” and eliminate what has become an “informational asymmetry between the banks that make derivatives and the investors that buy them.” Reduced complexity and increased standardization will eliminate the information “game” said Bookstaber and that will reduce innovation for the better in this space. Click on the image to watch the entire video.

The morphing of ETFs has caused some trepidation among regulators and market participants. In the U.S., a subcommitttee of the Senate Banking Committee held hearings in October last year to examine whether ETFs have departed so much from their traditional moorings as to become a snare for the unsuspecting.

Eileen Rominger, Director, Division of Investment Management at the U.S. Securities and Exchange Commission notes that ETFs account for $1 trillion in assets, or one-tenth of total mutual fund industry assets. They have a substantial market share and are growing. The problem is mostly how they are growing.

The worry is less with ETFs that hold the underlying shares of the indexes they track. It’s more with ETFs that mostly use over-the-counter swaps to replicate or synthesize exposure to the futures or commodities markets. As a result, the SEC has stopped giving exemptive relief to ETFs that rely heavily on derivative or swaps. As Rominger explains:

“For example, some [exchange-traded products], in the form of commodity-based trust-issued receipts, seek to track an index of futures on volatility of a portfolio of stocks, such as the S&P 500. Futures on volatility have added another dimension to the calculation to express future or expected volatility.  In addition, the Commission has witnessed an increase in the past few years in the variety of actively managed ETFs introduced by sponsors.  For example, while an assortment of actively managed ETFs based on fixed-income portfolios is listed and trading in the marketplace, there have been an increasing number of actively managed ETFs that seek to primarily invest in instruments that raise concerns with respect to liquidity and transparency, including emerging market debt securities, high-yield debt securities, and other instruments.”

Despite the concern, such synthetic pools are a small proportion of U.S. ETF/ETP market, she notes: only 3%. By contrast, they have a 10% share in Europe.

Then again, the concern is very real.  “[B]ecause ETF share prices are dynamically linked to the prices of their underlying holdings, the trading and other characteristics of the underlying portfolio investments, such as certain illiquid types of securities and particular over-the-counter or ‘OTC’ derivatives, may impact the arbitrage process necessary to closely align the ETF share price with its NAV. In certain circumstances, temporary imbalances in supply and demand might result in the price of the ETF decoupling from the value of the ETF’s underlying instruments as the ETF starts to behave more like a stand-alone product whose price responds solely to whatever liquidity is immediately available in that product, regardless of the value of the underlying investments. Under these circumstances, the ETF can begin to trade at a significant premium or discount to the NAV of its assets.”

That’s a theme close to the heart of Harold Bradley, Chief Investment Officer of the Ewing Marion Kauffman Foundation.

“We believe that these instruments may now be undermining the fundamental role of equities markets in pricing securities to ensure that capital is efficiently allocated to growing businesses.  When individual common stocks increasingly behave as if they are derivatives of frequently traded and interlinked ETF baskets, then it is trading in the ETFs that is driving the prices of the underlying stocks rather than the other way around. This tendency is especially pronounced for ETFs that are comprised of small cap stocks or stocks of newly listed companies, that generally are thinly traded.”

In his view, this leads to ever more reliance on untransparently priced derivatives.

“High co-movement of securities is not new, often occurring when markets reflect crowd panic or euphoria. What is new, however, is how ETFs decrease diversification benefits, with stocks and sectors worldwide moving together, even when there is no panic. Stocks move together today more than at any time in modern market history with recent data indicating that individual common stock prices that make up the S&P 500 index now move with the index 86% of the time. … Consequently, market makers can often only match their positions against futures, options or other ETFs, or they must employ derivatives and synthetic securities.”

The result is greater volatility. Are there solutions? Noel Archard, Managing Director at iShares, the biggest provider of ETFs (now owned by BlackRock) draws a line in the sand:

“While the first ETFs were straightforward, tracking relatively broad benchmarks such as the S&P 500 or individual country indexes, today some sponsors have introduced new products of increased complexity that carry greater risk and may not be appropriate for retail ‘buy and hold’ investors. Products which raise such concerns include so-called leveraged and inverse funds … products that are backed principally by derivatives rather than physical holdings.  These products require a greater  deal of disclosure and up-front work with clients for them to understand investment and structural risks and BlackRock believes that they should not be labeled ETFs.”

The gauntlet has been thrown. Next post: a perspective from Europe, where synthetic ETFs have a much larger market share.

CalPERS 2011 returns at a glance:

Public equities returned -12.3% compared to a -12.21% custom benchmark;

Fixed income returned 12.38%, compared to a custom benchmark of 13.91%.

Absolute-return strategies returned -2.29%, compared to a custom benchmark return of 5.6%.

Private equity returned 12.37%, compared to the custom benchmark’s 1.38%.

Thus Occupy Wall Street protestors decried banks that had been bailed out, yet still handed out lavish bonuses to their own employees. This, for them, was evidence of neo-liberalism and financialisation, which guts the truly productive economy in favour of speculation.

More latterly, the Tea Party has warmed up to the theme: private equity makes money by firing workers. At least that’s what one might assume from a recent political video disparaging Republican candidate Mitt Romney, once a prominent leveraged buyout specialist, now the Snidely Whiplash-like  King of Bain.

Which leads to an obvious question: do financial services create value? Certainly the academic wisdom has come under fire. In the two decades leading to the Great Recession, academics had mostly converged on Schumpeter’s view that well-developed financial systems play a crucial role in stimulating economic growth. … In fact, the body of empirical evidence linking causally and positively the depth of financial markets to growth was growing so rapidly that in 2003, in a discussion of a survey on the subject, one author was prompted to conclude that “…In 1993 many people doubted that there was a relation between finance and growth; now very few do.”

That’s from a paper, “On the tradeoff between growth and stability: The role of financial markets,” written for the VoxEu website by Alexander Popov and Frank Smets at the European Central Bank. It’s one of a series of papers VoxEu has published.

The absence of financial intermediation certainly has an impact and is, perhaps, key in the prolongation  of the slump.

“At this stage of a normal recession, output would be about 5% above its pre-crisis level. Today, in the UK, it remains about 3.5% below. So this much is clear: Starved of the services of the financial sector, the real economy cannot recuperate quickly,” note Andrew G. Haldane and Vasileios Madouros at the Bank of England.

“But that does not answer the question of what positive contribution finance makes in normal, non-recessionary states. This is an altogether murkier picture. Even in concept, there is little clarity about the services that banks provide to customers, much less whether statisticians are correctly measuring those services.2 As currently measured, however, it seems likely that the value of financial intermediation services is significantly overstated in the national accounts …”

Explains Christina Wang, an economist at the Federal Reserve Bank of Boston:  “In particular, how much of the income received by financial institutions is compensation for actual services provided to their customers and how much is merely for taking on risk, such as funding risky loans with short-term borrowing?”

The former is valuable; the latter a passive activity whose profits stem from leverage. But, she says, it is hard to separate the two activities.

“This is primarily because they often do not charge explicitly for services. Instead, they earn a spread between the interest rates received and the rates paid, as well as fees for writing derivatives contracts such as options and swaps. But earning interest is not in and of itself a productive activity that contributes to GDP. This is obviously sensible in the case of passive investors who buy market securities and then merely receive interest or dividends without producing new goods or services.”

Instead, she argues that ‘[t]he basic logic of the method for inferring the value added of bank services is intuitive. First, consider cases where a bank performs a transaction that earns it interest or fees, such as making a loan or underwriting a derivatives contract. We can ascertain what the bank would have to pay (in terms of either interest or fees) to purchase in the market a financial instrument of the same risk characteristics. Subtracting the value of, or interest on, the comparable market security from total income allows one to infer the implicit revenue the bank earns for services above and beyond investing passively in market securities. An analogous adjustment applies for transactions on which banks pay rather than receive interest or fees, such as those related to depositors.”

As a result she concludes that, “[m]aking conservative assumptions, we show that the current official method overestimates the service output of the commercial banking industry by at least 21% (amounting to $116.8 billion in 2007:Q4 for example) and GDP by 0.3% ($52.9 billion in 2007:Q4 for example) between 1997 and 2007.”

Outside the U.S., Haldane and Madouros come to a similar conclusion.

“The headline national accounts numbers point to a significant contribution of the financial sector to the economy. For the US, the value-added of financial intermediaries was about $1.2 trillion in 2010 – equivalent to 8% of total GDP. In the UK, the value-added of finance was around 10% of GDP in 2009. The trends over time are even more striking. For example, they suggest that the contribution of the financial sector to GDP in the US has increased almost fourfold since the Second World War. At face value, these trends would be consistent with large productivity gains in finance.”

In fact, however, the productivity gains seem illusory.

“But crisis experience has challenged this narrative. High pre-crisis returns in the financial sector proved temporary. The return on tangible equity in UK banking fell from levels of 25%+ in 2006 to – 29% in 2008. Many financial institutions around the world found themselves calling on the authorities, in enormous size, to help manage their solvency and liquidity risk. That fall from grace, and the resulting ballooning of risk, sits uneasily with a pre-crisis story of a shift in the technological frontier of banks’ risk management.

“In fact, high pre-crisis returns to banking had a much more mundane explanation. They reflected simply increased risk-taking across the sector. This was not an outward shift in the portfolio possibility set of finance.”

More intriguingly, adds Thomas Phillippon, a professor at the Stern School of Business in New York:

“The cost of intermediation in the US is between 1.3% and 2.3% over 130 years. However, the finance cost index has been trending upward, especially since the 1970s. This is counter-intuitive. If anything, the technological development of the past 40 years – in IT in particular – should have disproportionately increased efficiency in the finance industry. How is it possible for today’s finance industry not to be significantly more efficient than the finance industry of John Pierpont Morgan?”

His answer: excessive trading, as a result of which “the finance industry’s share of GDP is about 2 percentage points higher than it needs to be and this would represent an annual misallocation of resources of about $280 billion for the US alone. “

The survey also revealed that 26% of institutional investors said their top challenge in hedge fund investing is meeting performance expectations. In fact, this concern outranked all others by a healthy margin. With that in mind, institutions also reported lower average returns over the year. According to the survey, respondents earned an average annualized return of 6.2% in 2011 versus 9.2% in 2010 and a median annualized return of 5.0% versus 8.1% in the previous year.

Download the survey.

As institutional investors grapple with volatility, managers are launching more and more low volatility products to meet their needs. At least half a dozen appeared last year and more are planned for launch in 2012. With bond yields at all time lows, investors are being forced to take a defensive approach to equity in an effort to tame their portfolios in choppy markets. It’s a trend many see continuing this year, as more and more investors seek low volatility products to help them achieve their return targets in tough times.

Reuters – The downgrade of much of Europe’s credit ratings demonstrates in perhaps the bluntest terms so far the collapse of any lingering — if lazy — assumptions that developed states are somehow “safer” than emerging counterparts. In the years to come, investors may make much harder-nosed assessments of how much to lend Western nations and how cheaply to do it, scrutinizing their economics, demographics and particularly politics much more sharply.

The long-term financial and geopolitical implications may be massive, making it harder for the world’s richest states to find the funds to bail out other countries or their own banks — or to meet the ever growing cost of an ageing population.

“The point here is that developed market countries are decreasingly creditworthy — and the higher pension burden… suggest this will only get worse in coming decades,” wrote Charles Robertson, chief economist of Renaissance Capital. “Emerging markets meanwhile (are) in a far healthier position and most emerging market countries seem on an upward direction over the long term.”

That growing belief itself, he says, accelerates the process. With ever more pension funds and other investors allocating more to emerging market debt and less to the developed world, it could move ever faster.

On Friday, ratings agency Standard and Poor’s cut its ratings of nine euro zone countries, stripping France and Austria of their coveted AAA status, downgrading Italy to the same BBB + level as Kazakhstan. Portugal followed Greece in being relegated to “junk” status — its BB rating the now same as that of the Philippines and Turkey — although it remains well above Athens’ dire CC, the worst of any rated state.

As with S&P’s August downgrade of the United States, the move had in many ways been long presaged by the markets.

Political risk

The two other major rating agencies, Fitch and Moody’s, have yet to follow S&P’s lead either on the United States or many of the major European countries. But a broader look across the past decade shows a general narrowing of the gap.

Turkey’s credit rating, Renaissance Capital analysis shows, has climbed 4 notches in the past decade whilst Spain has fallen four, Portugal nine and Greece 15 notches.

S&P’s BB rating might show Portugal and Turkey equal, but the market believes that stage has long passed. The cost of insuring Portugal’s sovereign debt in the credit default swaps market is more than three times higher than that of Turkey, 1,095 basis points against 322.

Whether Turkey can maintain that position, however, is heavily dependent on politics — particularly the ability of Prime Minister Recep Tayyip Erdogan not just to maintain control and stability but also to tackle their own growing deficit.

It’s the kind of assessment that could dominate sovereign debt markets for the next decade.

“Russia is up three notches on 10 years ago while Italy is down five notches,” writes Robertson. “Russia is still one notch below Italy. Over coming years, with low Russian debt, we’d assume Russia will rise above Italy.”

But Fitch clearly does not share that confidence. On Monday, it cut its outlook on Russia’s BBB rating from positive to stable — citing not just weak growth and growing dependency on higher oil prices but particularly rising political worries.

Prime Minister Vladimir Putin might have been seen as a guarantor of stability for more than a decade, but as he prepares to stand again in presidential elections this year worries grow that he may prove more of a liability.

It’s a similar picture in many other presumed rising emerging markets. In South Africa, India, Brazil, Argentina, Kenya, Ukraine, Kazakhstan and many others, politics will prove just as important as economics in shaping both their creditworthiness and broader fate in the years to come.

Finances in emerging economies are also deteriorating at the moment as a result of the European debt crises.

But the fact remains that until the recent moves, the only major emerging economy in Europe, the Middle East and Africa to see its rating fall over the past decade was Hungary — largely because of the actions of its relatively “unconventional” Fidesz government in recent years.

In West, wishful thinking is over

For Western economies, the main point is that the days when “political risk” was seen only to apply to emerging markets are a thing of the past.

Germany’s economy might be strong enough to preserve its AAA rating for the time being, but it is clear that whether or not the euro survives and its constituent nations remain creditworthy comes down to the bloc’s leadership.

Investors in euro zone assets might still study economic data or guidance, but as they focus on in-built problems ignored for years they know they are essentially making bets on political decisions as yet undertaken and at worst unachievable.

The only good news, some say, is that the recent downgrade means Europe and perhaps the wider West is finally confronting its true situation.

“The main effect… could be more honest dialogue about the real reasons for the crisis… and leave us better off as talk finally centers on reality rather than hope,” wrote Steen Jakobsen, chief economist at Saxo Bank.

“Effectively S&P did what it was supposed to do, it ignored the “PowerPoint presentation” from the EU and looked only at the accounts. The accounts speak clearly for themselves – no progress, no real plans.”

Whether the political systems that served western states in decades or longer of economic growth can deliver that is another question. As the euro zone struggles to act, in Washington DC the key danger may be that the system of constitutional “checks and balances” produces a deadlocked Congress and weakened executive that simply finds fiscal policy making impossible.

“We’re in the midst of a long-term deleveraging cycle in developed markets. Deleveraging cycles are protracted, they’re painful and typically, they have not been particularly friendly to either economic growth or equity markets,” says Stephen Harris, Head of Research at Macquarie Capital Markets. He was speaking at the Empire Club’s 18^th annual investment outlook in Toronto yesterday.

That’s one of five themes he highlights for the next year. Consumers are beset with falling house prices, which increases their leverage ratio, despite their efforts to pay down debt while financial institutions need to do more work to clean up their balance sheets. Then there’s government debt, which he doesn’t think has yet peaked. All the same,  “Every dollar used to reduce leverage is dollar that is not used for consumption,” Harris notes, and predicts the U.S. economy will grow at a sub-par 2% for the next several years.

“The worst thing we can do as investors is to look for that V-shaped recovery; it’s going to be more of the same as it has been in the last several years.”

Apart from that, there are sovereign risks – in Europe thanks to the debt crisis in the countries on the periphery and in the U.S. thanks to political gridlock. ”Sovereign risk limits the ability of governments to respond to economic weakness by using fiscal stimulus,” he says. Consequently, monetary policy will have to carry the burden – and low interest rates over a prolonged period will boost yield stocks.

Another theme is the growing gap between developed and developing economies. Developing economies – not facing deleveraging or sovereign risks — have a lot more policy room to foster growth, and are expected to account for 70% of future growth, which bolsters the outlook for commodities.

Still, and this is another theme, developing economies have had to contend with inflation; once they  master inflationary pressures, that gives them the freedom to cut interest rates more aggressively, leading to a synchronized global easing, what Harris calls “the sweet spot of the cycle, where policy will be seen to be effective.”

Against that backdrop of gloom, corporate profits outside the financial sector in the U.S. are at a 60-year high. Primarily, that’s the consequence of labour’s loss of pricing power, and as a result “for every incremental dollar of revenue corporations generate, a large portion can fall to the bottom line.”

Still, Harris predicts a climate of three steps forward and two steps back, with equity markets rising higher before pulling back modestly late in the year. He also foresees gold at $2500 an ounce, and higher prices for energy and base metals.

Nick Barisheff, president of Bullion Management Group Inc., thinks gold could go as high $10,000 an ounce. He sees a direct relationship between the rising price of gold and growing government debt, which he says debases the value of currency.

Debased currency, he thinks, is inevitable. Governments have four ways to pay down debt. One is to “grow out of it” though higher productivity and exports. Another is strict austerity, which reduces GDP and thus augments debt at least in the short term. A third is to default on debt. Finally, governments can issue more debt.

“Most politicians will select option 4. … Inevitably, they will choose postpone the problem and leave it for someone else to deal with in the future,” he argues, pointing to the repeated failure of  U.S. politicians to get its own debt under control, as well as the continuing Euro debacle.

Higher debt levels, he believes, will lead to global currency wars as governments devalue currencies to increase exports. One consequence is that currencies will lose much of their purchasing power. Already, he says, the U.S. dollar and the British pound have seen their purchasing power reduced by 80% over the past decade. Thus, he argues, “gold can rise as high as currencies fall.”

Some global institutions have taken note. Central banks are now net purchasers of gold. Barisheff thinks its only a matter of time before pension plans and insurance companies start holding gold, a situation that would be a “game-changer” as these institutions seek to offset their exposure to financial assets. But he argues for direct holdings of gold, rather than an ETF.

“In case of fire, would you rather have a real fire extinguisher, or a picture of one.”

Much of this is a matter of mood, argues Fred Sturm, executive vice-president at Mackenzie Financial Corporation. He thinks that the next year will bring “more certainty about how we will attack the problems.” That also means, for investors, “a positive bias … to anything that has limited supply growth.”

That could be gold, but it could also be wealth-generating companies.

Given current uncertainties, he advises “first cover off your basics” with “safety assets.” Then proceed up the ladder with fixed income, especially high-quality corporate debt and dividend stocks. Then there’s the wealth-generating companies that withstand recessions: companies like Apple, Master Card or McDonald’s.

People have probably written off equities at exactly the wrong time, he thinks, noting that every five years, the world adds another 350 million to its population. “Every five years you have to feed and clothe and  house another North America.”

People have a tendency, he says, to make short-term decisions for long-term needs. But, he adds, at current rates, it would take 350 years for an investment in T-bills to double.

There are a number of issues that have been overlooked and these may undermine the objectives of the proposed legislation. Before it is enacted, these should be considered. In this blog post, I discuss the major, unintended consequences of the PRPP legislation for Canada.

Unintended Consequences

Section 3 of the proposed legislation states the legislation will provide a framework for a plan accessible to “employees and self employed persons.” Employers already offering a DC or RRSP as a pension program may also participate in the PRPP and transfer an existing DC or RRSP to a PRPP  (i.e., the proposed legislation does not preclude an employer from transferring an existing Capital Accumulation Plan into a PRPP).

Under Section 22 the financial institution becomes the administrator and a trustee of the plan hence the sponsors’ current administrative and fiduciary role responsibilities will be transferred to a financial institution. The transfer of the administrative role and fiduciary role provides a significant legal, financial and competitive advantage: employers are relieved of the onerous and risky administrative, communication, education and fiduciary responsibilities to their employees.

From a corporate governance perspective, an employer would be remiss if it did not transfer its DC or RRSP pension programs to a PRPP to relieve owners and shareholders of the potential legal and financial risk associated with defined benefit or CAPs. Employers will also achieve cost savings given the administrative portion of the fees paid to the PRPP administrator will now be paid by the employee. This combination of factors represents a huge economic incentive for an employer to move their current pension programs to a PRPP.

Is this the real objective of PRPPs?

The inevitable switch to PRPP by employers will result in a significant change in the Canadian pension environment which should be brought to the public’s attention for before enacting the legislation.

“Low-cost” Retirement Savings

The government releases and financial industry lobbying emphasize that PRPPs will provide a low-cost retirement savings opportunity for PRPP members. Other than citing volume of investments, however there is little indication how this will be done or reason to believe it will be achievable.  Many large CAP sponsors have already negotiated fees that are significantly lower than those available to individuals using “retail” RRSPs but this appears to have been ignored.

A close look at the management fees charged in CAPs also reveals that the majority of fees paid by DC and sponsored RRSP members go to the  record-keeper (usually a financial institution) and to financial advisors: fees paid to the actual investment fund managers used in the pension programs generally do not make up the bulk “management fees” paid by members.  In addition, a significant portion of the investment fund management fee actually goes to the record-keeper. Achieving significant fee reductions in a PRPP therefore will not likely come from negotiating lower investment management fees as implied by the government and financial institutions.

Will financial institutions in fact significantly reduce the administration portion of the management fee paid by PRPP members to get fees down?

Section 22 of the proposed legislation states that the administrator  “must administer the PRPP and assets as a trustee for the members.”  What are implications of this?

The administrative, legal and fiduciary roles and responsibilities of the employer will be transferred to the financial instruction(s). The role of a trustee is already considered to be onerous: financial institutions and custodians are very reluctant to take on a trustee role for DB plans because of the inherent fiduciary and financial risks. If they do assume the role of a trustee it comes at a price. The responsibility and administration costs in a PRPP for providing communication, education, and decision-making tools will become a cost of the financial institutions(s). Since there will be several financial institutions providing PRPPs it is difficult to imagine they will individually be able to achieve the economies of scale needed to significantly reduce their administrative costs.

It is not a given that PRPPs will result in significantly lower fees for their members.

Conflict of Interest

Under section 22 and 23 of the proposed legislation, the administrator must act prudently and offer a diversity of investments to PRPP members. Many financial institutions have proprietary investment funds as part of their retail retirement program. These funds are often used in their asset allocation and/or target date products. These products are not necessarily the lowest cost or best performing nor do they necessarily provide optimal diversification. The risk of a financial institution using and promoting its proprietary funds is already acknowledged in the pension industry and will likely become a bigger issue with PRPPs.

To mitigate this area of potential conflict of interest the financial institutions should only be allowed to offer low-cost passive investments in a PRPP.

There are already a number of tax-assisted vehicles similar to the proposed PRPPs (i.e., DC plans, RRSPs, TFSAs available through financial institutions). Perhaps the lack of retirement savings for many Canadians is a shortage of discretionary income rather than a lack of tax-assisted retirement savings opportunities. A Segregated National Annuity Program (SNAP) that invests in federal, provincial and high quality corporate bonds may be more economically sound and a less complicated and less risky approach to providing Canadians with the type of savings approach they need.

A “ready shoot aim” approach often leads to serious and unintended consequences. The federal and provincial governments should take some time, step back and consider some of the potential unintended consequences of implementing the proposed PRPP legislation.