Options Licensed Advisors Are Rare

Posted by Preet on Apr 5, 2010 | 8 comments

How many financial advisors are in Canada?

To give you a rough idea as to the number of financial advisors in Canada as a whole, there are about 75,000 MFDA advisors (mutual fund sales reps), 125,000 Life-Licensed advisors (insurance agents) and 25,000 IIROC advisors (licensed to sell individual stocks). Those are rough numbers for a few reasons: I’m going by memory (which may be flawed) for the life-licensed advisor number, and there are many advisors who are dual-licensed (MFDA + Life License or IIROC + Life License). Further, not all life-licensed advisors sell investments (for them, this would be segregated funds and annuities for the most part).

So let’s call it about 125,000 to 150,000 financial advisors in Canada who are giving investment advice to investors.

How many advisors are licensed to use options?

In order to buy, sell or advise on options (puts and calls) you not only have to pass additional licensing exams, it is only available to IIROC advisors which we have seen is a pool of about 25,000 advisors. I don’t know the exact number of options licenses there are out there, but going from experience I would say that perhaps 1 in 5 IIROC advisors were options licensed and of those that were licensed maybe 1 in 4 actually engaged in any option related activity.

That leaves us at about 1,250 advisors (give or take, and based on unconfirmed estimates by yours truly) who are using any kind of option strategies with clients. That’s about 1% of the total advisor population.

Now, this post is not intended to persuade everyone to trade options, but I do believe that option strategies can play very important roles in portfolios. There were actually invented to reduce risk, but have become associated with risk taking for laypeople.

Portfolio Insurance as just one example

A simplistic strategy would be the purchase of put options to protect the value of a portfolio from black swan events such as the credit crisis. Purchasing a put option essentially means that you buy the option to force someone to buy your investments at a certain price for a certain period of time. Think of it as portfolio insurance (indeed some people promote the strategy as such). For a cost of a few percent of your total portfolio value per year you could limit the possible decline in value for that year. Again, this is a simple strategy being described here, but for people who were a few years from retirement and therefore in that “retirement risk zone” you could have selectively insured your portfolio for a few years, trading off the annual “premiums” for guarantees against catastrophic loss when you most needed that protection/assurance.

There are plenty of other option strategies, and again this isn’t meant to be an endorsement of this particular strategy for everyone but if more people had been asked or informed of these strategies I think that would’ve been a good thing (for clients and advisors).

Index Fund Tracking Error Sources

Posted by Preet on Mar 24, 2010 | 2 comments

NOTE: I’m scrambling to write this before I get on a plane and my laptop battery is near death, so pardon any typos for the time being – I’ll edit it tomorrow, and may even re-write it! It’s good to be my own editor…. :)

Not all index funds are created equal. Some actually track their indices pretty well, and some do a poor job. Most people think that tracking an index would be a relatively simple thing but you know what they say, “in theory, theory and practice are the same but in practice they are not.”

Some sources of index fund tracking errors:

1. Resampling (Or Optimization)

If an index has 500 constituents, then it is impractical to replicate all the holdings when the fund has a small amount of assets. For example when an index fund first starts trading, it may only buy another manufacturer’s ETF to get market Beta until there are enough assets in the fund to actually go out and buy some or all the holdings itself. The index fund manager may also choose to hold a portion of the 500 holdings until the fund gets really big (to minimize transaction costs). How do they pick which stocks to hold and which they don’t? It’s up to them, but one method is to pick a combination of stocks that allow them to replicate the GICS sector allocations in the index (Global Industry Classification Standard). That means that if financials are 20% of the index and consumer discretionaries are 20% and so on, they will pick the combination of stocks that allow them to match those numbers – in this case they are seeking to match sector Betas.

2. Cash Flow timing

When money is added to a fund it must then be deployed into the holdings. In the case of ETFs, if not enough money is added to a fund to buy a creation unit, it might sit in cash until the next day. If the underlying stocks move between the positive cash flow and the cash deployment, this could affect the index fund’s performance. In the case of a mutual fund, the portfolio manager (yes, index funds have them too actually!) might get a small cash flow and not be able to deploy it into all the underlying constituents – they may choose to buy an ETF for market or sector beta, or buy a portion of the underlying constituents and make up the difference the next trading day when new money comes in, or if money leaves the fund for a redemption.

3. Proxies

Some index funds (with foreign exposure) may buy the foreign holdings on foreign exchanges, and some may buy ADRs or GDRs (American Depositary Receipts or Global Depositary Receipts). ADRs trade in the US but may trade at a premium or discount to the actual underlying stock.

4. Market Access

Again, index funds with foreign exposure may have stocks that trade in markets that are closed when domestic markets are open and vice-versa. If the index fund buys the direct stocks, someone has to deploy the cash overnight – it can be the fund custodian who sub-contracts out to a foreign prime broker, or the fund might have an office in that market. But if the fund operates in a different market, they can only receive the money during their hours of operation, so the underlying stocks can change in value between the time the cash comes to the fund and when it gets deployed.

If the fund buys ADRs then you still have the issue of the ADR lagging the movement of the underlying stock since money gets deployed right away, but in a security (the ADR) that can itself be moved by supply-demand issues on the market it trades even though the underlying security is not being traded. Again, this can introduce tracking error.

5. Dividend Drag

This really falls into the cash flow management arena, but instead of the cash flows being due to investors adding or subtracting money from the fund, with dividend drag it is due to the receipt of dividends earned on the underlying stocks being held. The fund receives cash which has to wait to be deployed.

6. Securities Lending Income

Same principle as with dividend drag, except the positive cash flow is due to the income generated from loaning out stocks in the fund to short sellers.

7. Brokerage commissions

The fund itself has to pay commissions to buy and sell stocks, so this will create a drag on returns too.

8. MER

Ah yes, can’t forget this one! The Management Expense Ratio is made up of the Management Fee and Operating Expenses, and of course these will drag down performance of the fund as well.

Conclusion

These are some of the areas which can introduce tracking error and I haven’t even talked about currency concerns. Different index companies tracking the same indices can have dramatically different tracking errors and its certainly something that doesn’t get enough attention. Note that some of these factors may generate positive or negative tracking errors and some (i.e. fees) can only generate negative tracking error. In its purest form, tracking error is the absolute magnitude of the deviation from the index and is not normally referred to as being positive or negative, but breaking it down this way is helpful.

Can you Diversify too much?

Posted by Preet on Jul 31, 2007 | 0 comments

This is a tricky topic to talk about.  So please read the caveat at the bottom of this post!

The wealthiest people in the world have, on average, made their fortunes on ONE stock… and that is usually the stock of the company they themselves founded and ran in the form of a small business that just kept expanding.  But of course for every small business that becomes the next GOOGLE, there are countless more that fail and go under. This is the ultimate example of why you won’t get rich quickly by diversifying AND how you could lose everything quickly by NOT diversifying.

Understanding this debate is understanding the trade off that you want to make between risk and reward. You take on an astronomical amount of risk by buying only one company’s stock, but if that company is indeed the next GOOGLE well then it was worth it, wasn’t it? :)

Similarly, a lot of successful investors advocate buying only a handful of stocks (maybe 10-20) that they KNOW and BELIEVE in and expect will grow faster than the rest of the economies in which they are domiciled.  They understand it will be a rockier ride than holding every stock in the world, but expect to be rewarded over the long term for the increased amount of risk they expose themselves to.

By properly diversifying, you virtually guarantee you will never get rich overnight, but you also virtually guarantee you won’t lose your shirt either. Conversely, by under-diversifying you open up the possibility of making a lot money very fast… or losing it!

For new investors – you will want to diversify as much as possible, and across multiple levels of diversification as well – see “What is Diversification?”. (At least until you get your feet wet and experience a full market cycle.)

Risk: Systematic Risk vs Non-Systematic Risk

Posted by Preet on Jul 26, 2007 | 0 comments

This is an advanced level topic – you may want to skip this post if you are just finding your feet with respect to finances! It assumes a basic understanding of portfolio diversification…

With respect to any given stock market there are two types of risk (which is another word for variance according to Modern Portfolio Theory): 1) Systematic Risk and 2) Non-Systematic Risk. Systematic risk is the general ebb and flow of the market – kind of like the tendency for all stocks to get dragged down or move up in tandem at the same time to a certain degree.  For example, the 1987 market decline was a Systematic event in that it really didn’t matter what you owned, it probably went down.  Is it warranted? Yes and no, but a main thing to consider is that nothing probably happened to any one stock to make it lose value in and of itself that day, but rather there was a general expectation or fear of a downturn in the economy linked to the market that caused everything to move. SYSTEMATIC RISK CANNOT BE DIVERSIFIED AWAY.

Non-Systematic risk CAN be diversified away. The best way to describe it is to build an analogy. Let’s say you owned one stock – if that company went bankrupt you will have lost 100% of your portfolio. If you owned 100 stocks, and 1 comany went bankrupt you would have lost 1% of your portfolio. On the flip side, what if that one company doubled in value? You either doubled your money or only gained a measley 1% if you held 1 stock or 100, respectively.  So this analogy builds a case against diversifying too much, but making sure you diversify a little. Non-Systematic risk is like the individual risk associated with the company linked to the stock – if it goes bankrupt – that is non-systematic risk and has nothing to do with the general ebb and flow of the market overall.

So, I mentioned that non-sytematic risk can be diversified away. It is generally debated as to how many securities you need to hold to get rid of non-systematic risk. You see, just as one company might go bankrupt, one company in your portfolio might double in value.  And one company might increase by 25% and one might decrease by 25%. So most recent research papers tend to think that 15-20 securities is enough to get rid of non-systematic risk. They suggest that trying to diversify by adding more securities than that is pointless as you may be adding stocks that do not have as rosy a prospect as the initial 15 or 20.  They further argue that for those that over-diversify by having 100 securities from the same market have bought alot of garbage for the sake of diversifying and will not reap the same long term returns as someone who has been more picky with their money.

Since it is agreed that non-systematic risk can be diversified away, and systematic risk cannot – it is plain to see that the goal for a rational investor is to do just that.  So the debate is really how many securities do you need to eliminate non-systematic risk? For now, I would tend to agree that 15-20 is optimal within any given market to eliminate non-systematic risk.  Anything beyond that and you are buying ”filler” and reducing your long term rate of return – truly an irrational goal! :)