Investoid

Some traders look for ‘high probability’ trades, based on mathematical assumptions about how stocks behave. Others look for arbitrage opportunities or other systematic deficiencies that can lead to a guaranteed (or nearly guaranteed) profit. One of the opportunities I find that presents a high probability and highly profitable trade is index changes.

Once in awhile, major indices will change the complement of stocks in their basket. Sometimes this is due to some companies going private, other times it is because a company has outgrown an index’s stated target (eg. a small cap index). In yet other instances a company is failing to meet listing requirements or is otherwise being halted from trading. Whatever the reason, when a company is added or dropped to an index it is a good trading opportunity.

Why? Because in today’s passive investing world, there are trillions of dollars dedicated to tracking various indices. This means that when a company is added to an index, index fund managers are obligated to purchase the stock reasonably quickly, or else their fund’s performance will begin to materially deviate from the underlying index. Furthermore, many actively managed funds are closet index funds, meaning they want to ensure they typically purchase the companies in an index to ensure they do not underperform their benchmarks.

This adds up to a lot of buyers chasing a relatively small amount of sellers. The Vanguard S&P 500 Index alone has $175 billion under management. Even if a new company takes up only 1/2000th of that index, that means the fund must purchase $87.5 million worth of stock in a company that probably has a market cap of about $10 billion, which represents nearly 1% of the company’s total shares outstanding. And that’s just for one fund, albeit the biggest. The opposite effect is true for companies that are dropped from indices. The larger the index (and the more followed it is), the greater the effect.

As a result, you typically see a sustained run in a company’s stock for anywhere from a few days to a few weeks. It is especially astute when the announcement occurs prior to the actual change: despite the fact that the stock will jump on the news, the true increase in price will only occur once the change happens and fund managers begin to buy the stock.

One recent example of this phenomena is Expedia (EXPE: Nasdaq). It was announced on Sept 24 that the stock would be added to the S&P 500 on Oct 1. The stock jumped about 5% on the news, but settled around that figure for the next several days. Since Sept 28 (the last trading day before Oct 1), the stock is up another 9.9%.

I played this news by buying a slightly in the money call option. I purchased the Nov $30 call option on Sept 26 for $3.20, and sold it on Oct 2 for $3.90, yielding a 22% gain (not including commissions). While I could have held on for hopes of higher gains (the option is now worth $4.90), but I had hit my target profit and needed to follow my strategy rules.

I have yet to find a specific site or news source that will let me know of upcoming changes to indices, so if anyone out there knows, feel free to leave a comment.

As I’ve mentioned before, when you trade options you are working with a product whose value will change in a non-linear manner with respect to the underlying. When you are working with out of the money options, this means that you will experience very high percentage changes to the option value for every dollar change in the underlying asset. However, the farther along the option chain you go into the in the money options, the closer the change resembles the movement in the underlying asset.

Take for instance a ‘deep in the money’ (DITM) option. Let’s say you have a stock worth $50 and you buy a call option with a strike price of $40. That means that right now, the option is worth $10 + some time value (which depends on its expiry date). If the stock declined to $49 in one day, in theory the option value would decrease to $9 + time value. If the option has a far away expiry (at least 4 months, preferably 8-12), then it is likely the option value would only go down $1 since the daily time decay on such options is very small. Similarly, if the stock rose to $51 then the option is now worth $11 + time value. In option terms, the option’s delta is very close to 1.0.

Since these options behave very closely to the underlying, if you hold a DITM option you essentially have a long (or short) position in the underlying, until such a point that the stock has moved closer to the strike price (ie. against your position). When you’re buying a long term DITM option, you are making a leveraged buy or short decision against the stock. This leverage ratio can be greater than what your broker would provide you on margin, and does not have any interest to pay. It is an interesting strategy to use if you are bullish or bearish on a stock with liquid options.

Lenny Dykstra uses this strategy and chronicles his trades in his thestreet.com column. He has a pretty good track record when using this strategy, although as of yet it isn’t that long.

There are a couple of things you need to watch out for when using this strategy:

• Don’t buy these options at the ask price. Longer term options are relatively illiquid and will have bid/ask spreads of at least 20 cents. Place a limit order at a price you like and make sure you adjust it if the underlying moves significantly.
• Determine your stop loss and profit limits for these trades. Since you are highly leveraged, a small move in the underlying can make a big difference in your return. I haven’t used this strategy yet, but I’d be looking for a max risk of about 15% with similar upside (ie. risk reward ratio of 1).
• Look for options whose time value seems reasonable, meaning that implied volatility isn’t too high. Compare prices across expiry dates as well as strikes, to find a reasonable entry point.

I am thinking about using this play on a short basis against the US Real Estate Industry, via Dec 07 or Jan 08 put options on the iShares ETF IYR. Today the index was higher but gave up its gains. If another rally occurs without any material change in the fundamentals of the space, I’ll be looking to make an entry.

Volatility plays an important part in the long term performance of our portfolio. At times, I find that volatility is erroneously considered as ‘downside risk’ or ‘value at risk’, which are quite different. Volatility is simply the standard deviation of returns, typically in an annualized format. In of itself, volatility is a neutral measure. It does not mean that stocks are more likely to go up or down, but rather how much they go up and down. Skewness (the third moment of deviation of returns), is what measures whether period returns tend to be more positive than negative.

On an individual stock basis, volatility can be a good thing. Value investors actually like some volatility, or else they would never be able to find a stock that was undervalued. Short term investors are looking for stocks which can appreciate quickly, and thus they are looking for volatile stocks as well. But when it comes to portfolios, volatility is a bad thing.

You don’t want your portfolio to be bouncing around for one simple reason: it hurts your long term performance. One of the co-founders in my last company put it this way (he’s a math guy):

“A squared (A^2) is more than (A+B)*(A-B)”

This is simple to check: (A+B)*(A-B) = A^2 - B^2. In every possible value for A and B, A^2 >= (A+B)*(A-B). Furthermore, (A+B1)*(A-B1) > (A+B2)*(A-B2) when B1 < B2.

So if B is your portfolio's volatility, the lower it is the higher your compounded returns are. It may seem great if you make 20% one year and 10% the next, but you would have been better off earning 15% annually.

What does this mean? Look for uncorrelated assets to fit into your portfolio to minimize volatility. I talked a bit about some assets uncorrelated to the overall market in my inflation post. Larry MacDonald also discusses what big pension funds are using to minimize volatility.

Maximizing your retirement portfolio is all about steady, stable growth. It is definitely not the assets you want to be chasing the hot stock or sector de jour with. By keeping an eye on the long term, you will ensure that your retirement portfolio reaches its potential.

Thicken My Wallet has mused about the increasing popularity in infrastructure firms. He indicates that companies like RBC are investing in the sector now and that it may become the new fad sector.

I think the infrastructure sector has a lot going for it at the moment. The continuing development of the BRIC countries as well as Eastern Europe has lead to increased demand for new capital projects to meet the needs of the increasingly wealthy populations of these nations. As a result the sector is in a cyclical growth period, one that will probably last for several years, if not a couple of decades, since most of these projects take many years to build.

One way to play this sector is to look at infrastructure services firms. I believe these companies will also benefit from this cycle, but are better value since they typically have higher margins than the actual bricks & mortar developers and/or operators. Much like oil services firms, they benefit greatly from the rush of new development, but will also be faced with reduced revenue earlier in the cycle than the actual developers.

One holding I have in this area right now is IBI Income Fund (TSX: IBG.UN). The fund owns 50% of the IBI Group, which provides consulting, planning, design, implementation and analysis for urban land, facilities, transportation and systems projects. They have done everything from designing Alberta’s SuperNet to venue planning for the 2010 Olympics. The other part of IBI Group is owned by a management partnership, whose payouts are tied directly to the payouts IBG makes to unitholders.

Financial Analysis

IBI has been growing steadily over the past few years, through a mixture of organic growth and acquisitions. The company has been buying up small, mature firms with a solid client base around the world as they increase their global presence. While the company still has a heavy reliance on North American revenue, they have been making inroads in China and other emerging markets.

In the most recent quarter, revenues were up 17.4% Y/Y, with organic growth of 13.8%. Their net margin has been increasing as well, although their cash flow decreased slightly due to one-time capital improvements.

For an income fund, distribution cash and payout ratios are of utmost importance. The payout ratio is currently around 80%, which is quite a bit higher than last year. The company has increased distributions twice in the past year, which partially accounts for the higher payout ratio (the capital project costs is also a factor).

Stock Analysis

The company’s float is rather illiquid – the bid/ask spread can be as much as $0.90 at times and the daily volume is quite low. Despite these facts the stock has had a pretty solid appreciation in the past year, mainly due to the increasing distribution.

The company still yields over 8%, which is fairly solid for an income trust with strong growth potential, high cash flows and a good payout ratio. IBI is a relatively small firm (only $144M Cdn market cap), and is only covered by one analyst. This is a company that’s pretty much under the radar, which is part of the reason I like it. In order to reap substantial capital gains on top of the income distribution, its profile will have to be increased. See my comments on investing locally for more details on what I think about under the radar firms.

While the eventual taxation changes to the firm will diminish its income potential in 2011, IBI will still reap a pretty good yield in the future. I think this is a solid medium term holding if you can set a bid at a price you like and be patient for it to be filled.

As I mentioned at the beginning, I think that services firms are a great way to play the infrastructure sector. They typically have better margins and generally do not face cost overrun issues that could materially affect profits. But their performance will lead the sector, since most of their work is done prior to actual development. Thus it’s important to keep an eye on the announcement of future projects and assess when the cycle it nearing its peak.

In order to get into short term investing, you need to understand what human traits causes people to act irrationally. The field of behavioural finance is dedicated to this topic. In this straightforward introduction to the subject, Jay Ritter provides us with the common faults that human investors/traders make. While there are many failings highlighted, the ones that I find most influential are:

• Overconfidence: people tend to overestimate their abilities (for instance, ask them if they are better than the average driver), while underestimating what they are up against. This can lead to under-diversification as well as continuing to employ a losing strategy.
• Representativeness: people tend to underweight long term behaviour and averages in favour of near term trends. This is one of the main factors behind asset price bubbles, as people only see the upside and forget about the eventual reversion to the mean.
• Disposition effect: people are known to take profit too early and hang onto losing positions for far too long. This is because people think about paper gains/losses differently than realized gains/losses. As a result volume is typically higher during bull markets than bear markets. Ken Fischer calls this effect ‘mental liquidity’.

This paper indicates that most short-term deviations in asset value away from the theoretical ‘fair value’ are hard to capitalize on due to a lack of short-term mean reversion, while more systemic and/or long term deviations (eg. tech bull market, 1987 market crash) can be taken advantage of.

I don’t necessarily agree with this conclusion, since most stocks have a pretty wide 52 week range that does not coincide with material changes in their underlying value (eg. earnings, dividends, etc.). As Joel Greenblat observes, do most companies report 100% changes in earnings each year? If not, then why do their prices behave as such? Earnings and financial performance have only a partial influence on a stock price.

My theory behind such volatility is the continual change in assumptions as to what the stock price will be in the future. Other informational influences such as economic news, rumors, buyout activity, etc. all play a part in the daily variation of stock prices.

Knowing what basic human characteristics inhibit your success in the markets is quite important. I plan on keeping a list of all the potential pitfalls I could fall into close at hand and review them every week to ensure that I am managing my positions appropriately.

Over the past few weeks, I’ve decided to try and gain some expertise in short-term trading. I define short-term trading as a security holding period between 1 day and 6 months (more or less), and can include buying or shorting a stock as well as holding options on a stock or futures on a commodity or index.

I decided to get into this space for a few reasons:

• I am fully invested in my long term holdings right now, and I have found it difficult maintain interest in finding long term buys beyond periodically evaluating my current holdings.
• I currently believe that the overall market is fairly or slightly overvalued, based on the stagnant economic conditions in the US and the spectre of inflation around the globe, along with a rising interest rate environment. As a result, I am finding it hard to find stocks I think have good growth potential as well as solid dividend stocks at a reasonable yield, beyond my existing holdings.
• There are opportunities in short-term trading for profits regardless of the market cycle, and outsize returns at that.
• I believe the market is less efficient on a shorter time scale, due to the human factor involved in short-term predicitions. Thus I believe there are greater opportunities for skilled agents in short-term trades over long term investing, which reflects my long term portfolio index-oriented core.
• I am looking for a challenge, and being consistently successful in short-term trading is one of the biggest challenges that anyone can face in the finance world.

I am aware that with the large potential rewards by doing short-term trading comes with it outsize risks. Indeed, on a risk/reward basis the potential returns may not justify the chances I will be taking with my hard earned assets. Nonetheless, I am interested to see if I can apply a combination of mathematical and behavioural analysis to this space. I am planning on giving this area a lot of my investing attention over the next 6-12 months and see how I fare. I will only be taking my risk capital (10% of my portfolio) for this venture/experiment.

I am only in the early stages of my short-term trading education, and have started to read as much as possible on the subject. I am planning on picking up a couple of books that look at the behaviour of short-term traders, rather than the “Here’s how to make big bucks day/options trading” type of literature. I am also looking at some academic papers on the subject as well, and will post some thoughts on what I read. So far, I’ve come across some interesting conjectures:

• Most amateur speculators are poor predictors and get their bets wrong. Thus, if you can determine what they’re doing, do the opposite.
• Irregular options volume can be a predictor of stock performance in the near term
• Large jumps in stock prices based on news results typically overshoot the ‘true’ revaluation price, and thus will correct somewhat in the following days/weeks (my take: there’s no true value to correct to, but some profit taking occurs on large movements which swings the momentum in the other direction).

I’ve set up a personal trading journal to record my thoughts, analysis and trades that I make. As I mature in this area, I’ll start to post some of those entries here as well.

If any readers have experience in this area (good or bad), I’d like to hear what you think.

Larry MacDonald from Canadian Business has wrote an article on “Lazy Active Portfolios”. I appreciate the mention of my article on the subject and the use of the term I coined a couple of months back. I suggest you take a look at the article, as it’s full of good information on how to construct market-beating active portfolios based on the efforts of the best in the business. He also mentions on his blog how Stockpickr is an excellent resource for evaluating US-listed companies.

I have one additional comment to Larry’s article - be aware of the quality and how up to date the information you’re gleaning from the pros is. Typically most pros are in a regulatory environment where they have to provide public updates quarterly, but for some funds and private investors, the period can be longer or even non-existent. So it’s important to know where the source of the information is coming from, be it EDGAR, news reports or elsewhere. If the information is from published public reports, determine reliable news sources that you can use to track what movements the pros are making in between reporting periods. You don’t want to be stuck with the best investment Buffet had last year.

A couple of months ago Claymore announced that it would be releasing ‘fund of funds‘ ETFs. These three funds, Claymore Global Balanced Growth, Claymore Global Balanced and Claymore Global Balanced Income, are designed to provide a mixture of equities, bonds, sectors, and geographic diversification all in one product. These ETFs are still ostensibly ‘index funds’, since they track custom indices created by Sabrient Systems.

The CEO of Claymore Investments, Som Seif, was on BNN’s Market Call yesterday and indicated that these products would contain “about 13 ETFs” within them. Claymore will be marketing these products as low cost, all-in-one investment products that can make up a significant portion of your portfolio.

I think this product will attract quite a few people in the marketplace, but I would caution about its use. These funds are actively managed, and will likely be at least partially based on actively managed ETFs as well. I’ve spoke about why passively managed index funds are typically a better choice in the past. Sabrient is a quantitative shop, meaning that likely all of the asset allocation decisions will be based solely on quantitative measures. While this may be an advantage and could provide above-market returns, the added risk that such methods will work over the long term is not typically justified (or necessary to achieve one’s goals) for long-term retirement portfolios.

Secondly, all of these funds have a relatively high proportion of equity holdings, making them less desirable for individuals closer to retirement. While these funds could provide a smart and relatively cheap way for investors to create their portfolios early in their life, I would not recommend that you hold these funds once you are within 10-15 years of retirement, as the equity positions will entail a great risk to your nest egg.

Claymore has really been leading in Canada with some innovative products (along with Horizons), and it will be interesting to see if any of the other ETF providers in Canada like iShares will respond.

Earlier today I mentioned that the S&P/TSX index is not very diversified, and that it’s severely under-represents sectors such as Health Care and Utilities. I mentioned some ETFs that can provide you with some sector diversification, but they were all US-listed ETFs.

In Canada, the breadth of ETFs has been increasing quite a bit in the past few months. For some global utilities exposure, you may want to look at the Claymore S&P Global Water ETF. The fund tracks a specialized index composed of companies who sell water from the utilities standpoint, or provide equipment and related services for water-related industries. It has an MER of 0.60%, which is relatively high. The US, France and Japan are the three biggest geographic holdings.

The fund just came out on June 4, and has had a big response. As a result it is trading over 2% above its Net Asset Value (NAV), meaning that you’re paying a premium to purchase it relative to the underlying value of the shares the fund holds. Over time, this premium will likely go away and should enable investors to acquire the ETF near it’s NAV.

While you’re still exposed to global currency fluctuations with this ETF, you do not have the additional risk (and poor exchange rate spread that brokers typically give you) of having to hold a US-listed fund. This ETF does not completely cover off the utilities sector, but it is an interesting one to watch for in the coming quarter.

The Globe had a good article on how the TSX is quite overweight in financial and commodity companies over the weeknd. Because the index is a market-cap weighted index, when certain sectors or companies have strong outperformance over a long period of time, they begin to take up an ever-increasing proportion of the index.

This has major implications for the average investor using a passive index strategy. If the index is supposed to be broad market but is not really representing all the sectors adequately, you are at a higher risk than you may think. For instance, if you’re an XIU holder, over 77% of the ETF’s funds are in financials, energy and materials companies. If the any of these sectors begins to fall precipitously, then you’re more likely to experience higher losses than if you were in a more diversified fund.

I personally hold XIC instead of XIU, since it caps the maximum weight each company can take in the fund, but that does not really address the sector overweighting that the index has. So, if you’re looking to gain some exposure to sectors that have little representation in the S&P/TSX index, and at the same time beef up your international exposure, here are some options:

• Vanguard Health Care ETF (VHT) represents a mixture of medical device suppliers and pharmaceutical/biotech companies in the US. As we all know, health care is in a long-term growth cycle in the developed world due to demographics, and is one that typically provides a lot of cash flow in the US. With an MER of only 0.25%, this is an excellent low-cost way to get exposure to the health care sector.
• iShares S&P Global Utilities ETF (JXI) has a broad base of utilities stocks from around the world. While it’s expense ratio is higher (0.48%) than a similar Vanguard product, its international exposure makes it a more compelling stock to own.
• SPDR Consumer Staples (XLP) is a collection of large cap companies specializing in the consumer retail sector. Most of these companies are US based but have a strong global presence, like Proctor & Gamble, WalMart and General Mills. The ETF has a small 1% dividend and an expense ratio of 0.24%.

All of these ETFs are listed on US exchanges, which means that you’ll be facing some currency risk if you invest in them. If you have a very long term investment horizon, I believe that you will have little to worry about since we are at historically high levels for the US/Cdn exchange rate. However, if you are looking to hold these funds for a 5-10 year time horizon, you may want to discuss some currency hedging strategies with your financial advisor.