QE3 Fixed Income Aftermath

So what happens to fixed income after QE3? I thought it would be interesting to look at the max drawdowns versus the current 30-day SEC yields for a select cross-section of the fixed income ETF space for the past 52-weeks. All yields are quite compressed as is expected. Yields are so compressed that only MBB (US agency-based mortgage bonds) has a 30-day SEC yield exceeding the max drawdown. TIPs have negative yield as was true for quite a while now. It seems the contagion of return-free risk has spread to most of the fixed income ETF universe at this point.

Bid-Ask Spread

One reason for preferring highly liquid versus illiquid products is the bid-ask spread. This is a cost built into a trade when the trade is a market order. This spread also happens to be the market maker's profit for providing liquidity, whether it be a traditional specialist or a high-frequency trader taking the other side of your trade. Though I usually trade using limit orders to cut down on the spread I pay, for illiquid issues, it is really difficult to get the spread down by much if I want any timely execution.

One case I stumbled on is that of specialized ETFs. With so many specialized ETFs on the market, slicing, dicing, and grafting all different kinds of securities, some of them are bound to be too exotic to gain the trading volume of a typical S&P 500 stock. Moreover, ETF share creation and redemption mechanisms usually work to minimize costs, but this is not always the case. A case in point are the ETFs issued by brokers specifically for their own customers. Whereas SPDRS, Vanguard, and iShares ETFs trade millions of shares a day, some of these broker-tied ETFs only trade tens of thousands. These ETFs can be traded by anybody via any broker, but the customers of the issuing broker receive incentives such as commission-free trading. The price, however, is greatly reduced liquidity and large bid-ask spreads. I frequently see spreads of 0.5%+ for some of these products. For a large number of trades and a good amount (> $2000), paying the spread quickly becomes more expensive than paying a hefty commission. Large bid-ask spreads certainly aren't restricted to certain low volume equity-like products. Spreads in forex are quite lucrative for forex brokers, some of whom do not charge commission at all in favor of profiting for spreads. For currency-pairs such as the New Zealand Dollar (NZD), large spreads are quite common. In contrast, EUR-USD and JPY-USD usually maintain 1-2 pip spreads. However, during major events and announcements, even these high-volume instruments may see spreads widen considerably.

Market Indexing

Fundamental indexing, an idea promulgated by Rob Arnott and his firm, caused quite a stir when it was introduced in 2004 with many questioning the whole idea. It has since given rise to a number of ETFs. The original is PRF, an ETF launched in December 2005. According to PowerShares' site, they are benchmarking PRF against the Russell 1000. Powershares followed on this product with 5 more, covering the developed markets ex-US (PXF), Asia Pacific ex-Japan (PAF), emerging markets (PXH), developed ex-US small cap (PDN), and US small-mid cap (PRFZ).

Buybacks and Dividend Growth

There is a lively discussion on one of the front-page stories on SeekingAlpha about whether buybacks destroy value. As in my previous posts, I am on the fence regarding this one. It really varies on a case to case basis depending on where the money is coming from (some buybacks are highly leveraged and some special dividends come from debt issuance) and where it could have gone instead. It was surprising to see at least one investigation seemingly indicating that Buyback Achievers trump Dividend Achievers by a considerable margin. In terms of the intersection between PKW (PowerShare Buyback Achievers ) and PFM (PowerShares Dividend Achievers), it is only 12 companies: IBM, TGT, WAG, CB, FDO, WMT, GWW, CTAS, TJX, SFG, CASY, LOW. This group outperformed both PKW and PFM over a 1 year time frame. So, anecdotally, a combination of buybacks and dividends coincide with outperformance. Of course, there may be a number of confounding factors that may affect this.

Share Buybacks, Part 4

Taking a sampling of the 41 PKW Buyback Achievers I could find XBRL annual reports on, there are a number of interesting points. The mean buyback rate for 2010 was 7.3% of common stock shares outstanding (DEI). Given this data point, IBM's rate of buyback seems only a middling one. I would caution generalization from a single year's worth of data, but it does provide a little perspective. A particular high or low buyback rate does not mean much by itself. One has to consider where the money for the buybacks is coming from and how is the rest of the business doing.

Share Buybacks, Part 3

Following my previous discussions of share buybacks here and here, let's look into the distribution of the share counts for the PKW (Share Buyback Achievers ETF) components. The components of the Share Buyback Achievers exhibit significant diversity in outstanding shares. For this study, I used the outstanding share information from Yahoo Finance which appears to be a rough undiluted number. The mean, median, and standard deviation of share count are 242M, 81M, and 430M respectively. The component with the minimum number of shares outstanding in this fund is homebuilder NVR with a mere 4.98M shares out. Mega-retailer WMT has the most with 3.44B shares.

Crude Oil and Oil Stocks

One would logically expect oil stocks to track with crude oil prices. For the most part, this is true. Below are the correlation coefficients between a select number of oil services, drillers, refiners, integrated conglomerates, an oil sector ETF (XLE), and an ETF for accessing crude prices (USO), imperfect as it may be due to futures roll. Though most companies track with USO, there are a couple of exceptions. Transocean (RIG) exhibits low correlation with other sector companies and even a negative correlation coefficient with the commodity itself. Halliburton (HAL) has also been exhibiting very low correlation coefficient (0.16).

Share Buybacks, Part 2

In my last post on share buybacks, I started by breaking down the components of the Powershares Share Buyback Achievers ETF PKW. The fund PKW sports an average PE of 13, a yield of 0.78%, and a beta of 0.98. Over several periods, PKW outperformed SPY (with a bout of slight underperformance recently):

Share Buybacks, Part 1

I recently read an interesting article on SeekingAlpha about IBM's share buyback record. The article says that over the past 16 years, IBM has been able to half its outstanding share count, which Warren Buffett claims as one reason why he bought $10B worth. That got me thinking, there is at least one ETF focused on share buybacks, PKW PowerShares Buyback Achievers. The fund has 139 components. What is IBM's performance relative to the rest of these? The fund has only been around since 12/2006, but presumably the index (Mergent DRB) has been around a while longer. Some of the components include TGT, DTV, TWX, TJX, COH, AZO, and GPS at 4.77%, 13.4%, 4.99%, 4.82%, 9.11%, 10.62%, and 10.35% decrease in common stock shares outstanding from FY 2010 to FY 2011 respectively. From the SeekingAlpha article, IBM has bought back anywhere from 0.01% to 8.73% of shares in a single year. Stay tuned for more information on the share buyback data point.

This is the first post in a series. The next post is here.

ETF Performance

Comparing ETF performance is actually somewhat tricky, though the issue isn't particular to ETFs. Though the CFA material has whole sections to deal with presentation of performance, there remains many variables. Returns can be annualized (though generally only performance terms 1 year or more should be annualized) or cumulative. The prices used could be bid-ask midpoints at closing (which is the preferred method by ETF issuers) or last trade price (which is the data available to us mere mortals). The performance can be total return (including any distributions such as dividends and capital distributions) or market price return. The cumulative return could end on today or the last business day of the preceding month. Then there is market and NAV performance. All these factors can make a significant difference in the calculated performance numbers, especially over longer periods. For illiquid issues, the bid-ask midpoints and last trade may differ considerably. Yesterday, I collected cumulative returns for IYY (iShares Dow US Broad Index ETF) from a few places:

Schwab Cumulative

Period	Mkt	NAV
1 mo	11.3	11.3
3 mo	-3.3	-3.2
6 mo	-8.0	-8.0
1 yr	-7.8	-7.8

Yahoo "Trailing Returns"

Period	Mkt	NAV
1 mo	11.30	11.33
3 mo	-3.26	-3.17
1 yr	7.76	7.84

iShares Cumulative

Period	Mkt	Total
1 mo	11.31	11.33
3 mo	-3.15	-3.16
6 mo	-7.96	-7.99
1 yr	7.83	7.87

Though the Schwab and Yahoo data are agreement, notice how the iShares reported performances diverges starting from the 3 mos point. In a low yield environment, the difference between -3.26% and -3.15% cumulative market returns is huge. I have not been able to reconcile this discrepancy exactly. It is not merely the $0.262 dividend distribution during the 3-mo period. I think the moral of the story is threefold:

1. take nothing for granted
2. always read the fine print on how performance is calculated
3. try to obtain performance data from multiple sources