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Portfolio Management Securities Law ValuationThe Rise and Fall of Apple-linked Structured Products
Geng Deng, Tim Dulaney, Craig McCann, and Mike Yan2013-01-25
investors but cap the upside at somewhat more than corporate bond yields. Issuers use individual stocks like Apple as the reference obligations for reverse convertible structured products because investors underestimate the risk of suffering losses when the individual stock's price falls.
The decline in Apple’s stock price from over $700 in September 2012 to $450 in January 2013 has resulted in over one hundred million dollars of losses in Apple-linked structured products. In this paper, we summarize our published reports on over 650 Apple-linked structured products and identify the impact of Apple's recent stock price decline on investors in these structured products. [read more]
The decline in Apple’s stock price from over $700 in September 2012 to $450 in January 2013 has resulted in over one hundred million dollars of losses in Apple-linked structured products. In this paper, we summarize our published reports on over 650 Apple-linked structured products and identify the impact of Apple's recent stock price decline on investors in these structured products. [read more]
What is a TIC Worth?
Tim Husson, Craig McCann, and Carmen Taveras2013-01-04
offering documents. Using a stylized TIC cash flow projection based on our review of these materials, we show that TICs use aggressive assumptions to inflate the apparent returns to investors.
Projected cash flows must be discounted to determine whether a TIC investment is reasonably priced or not. A TIC's projected cash flows should be subject to sensitivity analysis to determine the risk of unrealistic projections. This traditional risk-return analysis, as part of a reasonable basis suitability analysis, would have determined that TICs had expected returns which were insufficient to compensate for the risk of their leveraged investments in undiversified real estate and that the claimed tax deferral benefits were small compared to the mispricing in TIC offerings. [read more]
Projected cash flows must be discounted to determine whether a TIC investment is reasonably priced or not. A TIC's projected cash flows should be subject to sensitivity analysis to determine the risk of unrealistic projections. This traditional risk-return analysis, as part of a reasonable basis suitability analysis, would have determined that TICs had expected returns which were insufficient to compensate for the risk of their leveraged investments in undiversified real estate and that the claimed tax deferral benefits were small compared to the mispricing in TIC offerings. [read more]
Crooked Volatility Smiles: Evidence from Leveraged and Inverse ETF Options
Geng Deng, Tim Dulaney, Craig McCann, and Mike Yan2013-01-04
values following the method of Lipton (2001). We study a sextet of leveraged and inverse ETFs based on the S&P 500. We show that the Heston model can reproduce the crooked smiles observed in the market price of options on leveraged and inverse leveraged exchange traded funds. By analyzing the asymptotic behavior for the implied variances at extreme strikes, we observe an approximate symmetry between pairs of LETF smiles empirically consistent with the predictions of the Heston model. [read more]
Dual Directional Structured Products
Geng Deng, Tim Dulaney, Tim Husson, and Craig McCann2013-01-03
(ARBNs);
however, DD's lack principal protection and have different embedded options positions, which
have yet to be described in the literature. We find that DDs can be broadly organized into
two categories: single observation dual directionals (SODDs) and knock-out dual directionals
(KODDs). We determine the appropriate option decomposition for these categories and
provide analytical formulas for their valuation. We confirm our analytic results using Monte
Carlo simulation and use both techniques to value a large sample of DDs registered with the
Securities and Exchange Commission up to December 2012. Our results indicate that like
many types of structured products, DDs tend to be priced at a significant premium to present
value across issuers and underlying securities and that the present value of the decomposition
is smaller than the face value net of commissions. We find that DDs with embedded leverage
or a single observation feature tend to be worth less than products either without leverage
or with a knock-out option. [read more]
Robust Portfolio Optimization with VaR Adjusted Sharpe Ratio
Geng Deng, Tim Dulaney, Craig McCann, and Olivia Wang2012-11-29
tios ignores this uncertainty in parameter estimation from historical data and is therefore not robust. In this paper, we propose a robust portfolio optimization framework that selects the portfolio with the largest worse-case-scenario Sharpe ratios. We show that this framework is equivalent to maximizing the Sharpe ratio reduced by the VaR of the Sharpe ratio and highlight the relationship between the VaR-adjusted Sharpe ratios and other modi ed Sharpe ratios proposed in the literature. In addition, we present both numerical and empirical results comparing optimal portfolios generated by the approach advocated here and those generated by alternative optimization approaches. [read more]
Are VIX Futures ETPs Effective Hedges?
Geng Deng, Craig McCann, and Olivia Wang2012-06-27
Published in The Journal of Index Investing, Winter 2012, Vol. 3, No. 3, pp. 35-48.
500 Volatility Index (VIX) have grown in volume and assets under management in recent years, in part because of their perceived potential to hedge against stock market losses.
In this paper we study whether VIX-related ETPs can effectively hedge a portfolio of stocks. We find that while the VIX increases when large stock market losses occur, ETPs which track short term VIX futures indices are not effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs. ETPs which track medium term VIX futures indices suffer less from negative roll yield and thus appear somewhat better hedges for stock portfolios. Our findings cast doubt on the potential diversification benefit from holding ETPs linked to VIX futures contracts.
We also study the effectiveness of VIX ETPs in hedging Leveraged ETFs (LETFs) in which rebalancing effects lead to significant losses for buy-and-hold investors during periods of high volatility. We find that VIX futures ETPs are usually not effective hedges for LETFs. [read more]
500 Volatility Index (VIX) have grown in volume and assets under management in recent years, in part because of their perceived potential to hedge against stock market losses.
In this paper we study whether VIX-related ETPs can effectively hedge a portfolio of stocks. We find that while the VIX increases when large stock market losses occur, ETPs which track short term VIX futures indices are not effective hedges for stock portfolios because of the negative roll yield accumulated by such futures-based ETPs. ETPs which track medium term VIX futures indices suffer less from negative roll yield and thus appear somewhat better hedges for stock portfolios. Our findings cast doubt on the potential diversification benefit from holding ETPs linked to VIX futures contracts.
We also study the effectiveness of VIX ETPs in hedging Leveraged ETFs (LETFs) in which rebalancing effects lead to significant losses for buy-and-hold investors during periods of high volatility. We find that VIX futures ETPs are usually not effective hedges for LETFs. [read more]
Isolating the Effect of Day-Count Conventions
Geng Deng, Tim Dulaney, Tim Husson, and Craig McCann2012-05-01
conventions, and many investors may not be aware of the effects of this choice on their future cash flows. Here, we show that the choice of day-count convention can have a surprisingly large effect on the market value of swap agreements. We highlight the importance of matching day-count conventions on obligations and accompanying swap agreements, and demonstrate various factors which influence the magnitude of day-count convention effects. As interest rate swaps are very common amongst municipal and other institutional investors, we urge investors to thoroughly understand these and other `fine print' terms in any potential agreements. In particular, we highlight the ability of financial intermediaries to effectively increase their fees substantially through their choice of day-count conventions. [read more]
Structured Product Based Variable Annuities
Geng Deng, Tim Husson, and Craig McCann2012-04-10
structured products are popular in the over-the-counter derivatives market, embedding a structured product into a variable annuity introduces substantial complexity into an investment typically considered conservative. In this note, we analyze structured product based variable annuities (spVAs) and demonstrate the effects of various product parameters on expected returns. We find that that SP VAs are substantially different from traditional variable annuities and that investors should carefully consider whether the returns of the structured product-like crediting formula are preferable over traditional, diversified bond/stock funds. [read more]
Optimizing Portfolio Liquidation Under Risk-Based Margin Requirements
Geng Deng, Tim Dulaney, and Craig McCann2012-04-06
by first generalizing the usual risk-based haircuts methodology of determining the portfolio margin requirement given the current positions of a portfolio. We derive first and second-order analytic estimates for the margin requirements given the positions. Given this generalization, we determine the liquidation strategy that minimizes the total positions liquidated and meets the margin requirement. We implement the strategy on example portfolios and show advantages over traditional piece-wise liquidation approaches. The analytic approach outlined here is more general than the margin context discussed. Our approach is applicable whenever an investor is attempting to maximize the impact of their capital subject to leverage limits and so has obviously applications to the hedge fund industry. [read more]
A Primer on Non-Traded REITs and other Alternative Real Estate Investments
Tim Husson, Craig McCann, and Carmen Taveras2012-03-07
Estate Investment Trusts (REITs), private REITs, and Tenants-in-Common (TICs), which are often sold to but may be unsuitable for most retail investors. Some common problems of alternative real estate investments are: 1) their illiquid nature allows them to give investors an illusory sense of low price volatility, 2) their high fees and significant conflicts of interests may lead to a loss of shareholder value, and 3) their reliance on leverage to fund current dividend payments may hide their inability to pay future dividends. Limitations on publicly-available data oblige us to concentrate much of our discussion on non-traded REITs. Our analysis is relevant for the even less transparent private placement REIT and TIC market. [read more]
Valuation of Reverse Convertibles in the VG Economy
Geng Deng, Tim Dulaney, and Craig McCann2012-02-01
down-and-in put options and offer investors relatively high coupon payments in exchange for bearing some of the downside risk of the equity underlying the note. Reverse convertibles are among the most popular structured products on the market today, but their path-dependent payoff have not yet been valued analytically within a stochastic volatility framework. Therefore, the magnitude of their overpricing in the offerings has not been precisely measured.
We extend the current literature to include analytical valuation formulas within a model of stochastic volatility − the Variance Gamma (VG) model. We show that these complex notes are even more overpriced than previously estimated when stochastic volatility is taken into account. As a result of their complex payoffs and the lack of a secondary market to correct the mispricing, reverse convertible notes continue to be sold at prices substantially in excess of their fair market value. [read more]
We extend the current literature to include analytical valuation formulas within a model of stochastic volatility − the Variance Gamma (VG) model. We show that these complex notes are even more overpriced than previously estimated when stochastic volatility is taken into account. As a result of their complex payoffs and the lack of a secondary market to correct the mispricing, reverse convertible notes continue to be sold at prices substantially in excess of their fair market value. [read more]
CLOs, Warehousing, and Banc of America's Undisclosed Losses
Tim Husson, Craig McCann, and Olivia Wang2012-01-31
securitization prior to the issuance of a CLO through a practice known as 'warehousing.' Warehousing appears to have resulted in some CLO trusts issuing securities without disclosing to investors that the securities had lost almost all their value because the CLO trust was committed to paying substantially more than the market value of the warehoused loans.
We provide two examples of such problematic CLO offerings in which Banc of America appears to have transferred at least $35 million of losses to investors in July 2007 and which ultimately led to approximately $150 million in losses in just these two CLOs. $35 million of those $150 million in losses occurred before Banc of America sold the securities to investors and only $115 million occurred after investors bought the CLO securities. The problem we identify is more widespread than Banc of America and broader than CLOs.
The Private Placement Memoranda for the products mentioned in the paper: Bryn Mawr II PPM, LCM VII PPM, and Symphony IV PPM. The LCM VII Marketing Deck is available here and the LCM Trustee Reports which document the decline in the value of the LCM VII loans before July 31, 2007 is available here.
News Article
- American Banker - B of A Subpoenaed by Massachusetts Over CLOs by Allison Bisbey
- The New York Times, February 5, 2012 - A Wipeout That Didn't Have to Happen
Recent Award
- Hayes v Banc of America Securities - $1.4 million CLO Award [read more]
We provide two examples of such problematic CLO offerings in which Banc of America appears to have transferred at least $35 million of losses to investors in July 2007 and which ultimately led to approximately $150 million in losses in just these two CLOs. $35 million of those $150 million in losses occurred before Banc of America sold the securities to investors and only $115 million occurred after investors bought the CLO securities. The problem we identify is more widespread than Banc of America and broader than CLOs.
The Private Placement Memoranda for the products mentioned in the paper: Bryn Mawr II PPM, LCM VII PPM, and Symphony IV PPM. The LCM VII Marketing Deck is available here and the LCM Trustee Reports which document the decline in the value of the LCM VII loans before July 31, 2007 is available here.
News Article
- American Banker - B of A Subpoenaed by Massachusetts Over CLOs by Allison Bisbey
- The New York Times, February 5, 2012 - A Wipeout That Didn't Have to Happen
Recent Award
- Hayes v Banc of America Securities - $1.4 million CLO Award [read more]
Valuing Partial Interests in Trusts
Geng Deng, Tim Husson, and Craig McCann2011-12-15
decisions, and sometimes under circumstances in which the settlor's expectations regarding investments and distributions as set forth in the trust document are unclear. Traditional methods for valuing partial interests in trusts offer insufficient guidance to courts in assessing the prudent investor standard, as they often disregard many of the important factors which go into investment decisions--notably, the allocations to different asset classes.
In this paper, we develop a valuation methodology based on Monte Carlo Simulation techniques which allows for economically feasible ex ante valuation of partial interests in trusts. The MCS technique is widely used in modern finance and economics, and is especially useful for valuing partial interests because it can incorporate mortality risk, portfolio asset allocation, varying distributions and the discretionary sale of the trust's assets to fund distributions. We explain how the MCS method can incorporate a variety of assumptions about the income beneficiary's mortality and the trustee's decisions, and show how these factors affect the valuation of partial interests. [read more]
In this paper, we develop a valuation methodology based on Monte Carlo Simulation techniques which allows for economically feasible ex ante valuation of partial interests in trusts. The MCS technique is widely used in modern finance and economics, and is especially useful for valuing partial interests because it can incorporate mortality risk, portfolio asset allocation, varying distributions and the discretionary sale of the trust's assets to fund distributions. We explain how the MCS method can incorporate a variety of assumptions about the income beneficiary's mortality and the trustee's decisions, and show how these factors affect the valuation of partial interests. [read more]
Rethinking the Comparable Companies Valuation Method
Paul Godek, Craig McCann, Dan Simundza, and Carmen Taveras2011-11-01
valuations can be significantly improved using regression analysis. Regression analysis is superior to the comparable companies method because, by using more of the available data and imposing fewer unreasonable assumptions, it is more accurate and can value more firms. [read more]
The Properties of Short Term Investing in Leveraged ETFs
Geng Deng and Craig McCann2011-07-26
Published in the Journal of Financial Transformation, Fall 2012, Journal 35.
(LETFs) are a multiple of the daily returns of a reference index. Because LETFs rebalance their leverage daily, their holding period returns can deviate substantially from the returns of a leveraged investment. While about half of LETF investors hold their investments for less than a month, the standard analysis of these investments uses a continuous time framework that is not appropriate for analyzing short holding periods, so the true effect of this daily rebalancing has not been properly ascertained.
In this paper, we model tracking errors of LETFs compared to a leveraged investment in discrete time. For a period lasting a month or less, the continuous time model predicts tracking errors to be small. However, we find that in a discrete time model, daily portfolio rebalancing introduces tracking errors that are not captured in the continuous time framework. On average, portfolio rebalancing accounts for approximately 25% of the total tracking error, and in certain scenarios the rebalancing tracking error could rise to as high as 5% in 3 weeks and can dominate the total tracking error. Since investors in LETFs have short average holding periods and high average turnover ratios, the effects of portfolio rebalancing must be accurately accounted for in the analysis of LETF returns. [read more]
(LETFs) are a multiple of the daily returns of a reference index. Because LETFs rebalance their leverage daily, their holding period returns can deviate substantially from the returns of a leveraged investment. While about half of LETF investors hold their investments for less than a month, the standard analysis of these investments uses a continuous time framework that is not appropriate for analyzing short holding periods, so the true effect of this daily rebalancing has not been properly ascertained.
In this paper, we model tracking errors of LETFs compared to a leveraged investment in discrete time. For a period lasting a month or less, the continuous time model predicts tracking errors to be small. However, we find that in a discrete time model, daily portfolio rebalancing introduces tracking errors that are not captured in the continuous time framework. On average, portfolio rebalancing accounts for approximately 25% of the total tracking error, and in certain scenarios the rebalancing tracking error could rise to as high as 5% in 3 weeks and can dominate the total tracking error. Since investors in LETFs have short average holding periods and high average turnover ratios, the effects of portfolio rebalancing must be accurately accounted for in the analysis of LETF returns. [read more]
The VXX ETN and Volatility Exposure
Tim Husson and Craig McCann2011-06-16
Published in the PIABA Bar Journal, Vol. 18, No. 24, pp. 235-252.
in the form of futures and since 2006 in the form of options, but recently new exchange-traded products have offered retail investors an easier way to gain exposure to this popular measure of market sentiment. The most successful of these products so far has been Barclays's VXX ETN, which has grown to a market cap of just under $1.5 billion. However, the VXX ETN has lost more than 90% of its value since its introduction in 2009, compared to a decline of only 60% for the VIX index. This poor relative performance is because the VXX ETN tracks an index of VIX futures contracts that can incur negative roll yield. In this paper we review the VIX index and assess the opportunities and risks associated with investing in the VXX ETN. [read more]
in the form of futures and since 2006 in the form of options, but recently new exchange-traded products have offered retail investors an easier way to gain exposure to this popular measure of market sentiment. The most successful of these products so far has been Barclays's VXX ETN, which has grown to a market cap of just under $1.5 billion. However, the VXX ETN has lost more than 90% of its value since its introduction in 2009, compared to a decline of only 60% for the VIX index. This poor relative performance is because the VXX ETN tracks an index of VIX futures contracts that can incur negative roll yield. In this paper we review the VIX index and assess the opportunities and risks associated with investing in the VXX ETN. [read more]
Modeling Autocallable Structured Products
Geng Deng, Joshua Mallett, and Craig McCann2011-03-15
Published in the Journal of Derivatives & Hedge Funds 17, 326-340 (November 2011)
products in the U.S. has increased exponentially. The autocall feature immediately converts the product if the reference asset's value rises above a pre-specified call price. Because an autocallable structured product matures immediately if it is called, the autocall feature reduces the product's duration and expected maturity.
In this paper, we present a flexible Partial Differential Equation (PDE) framework to model autocallable structured products. Our framework allows for products with either discrete or continuous autocall dates. We value the autocallable structured products with discrete autocall dates using the finite difference method, and the products with continuous autocall dates using a closed-form solution. In addition, we estimate the probabilities of an autocallable structured-product being called on each call date. We demonstrate our models by valuing a popular autocallable product and quantify the cost to the investor of adding this feature to a structured product. [read more]
products in the U.S. has increased exponentially. The autocall feature immediately converts the product if the reference asset's value rises above a pre-specified call price. Because an autocallable structured product matures immediately if it is called, the autocall feature reduces the product's duration and expected maturity.
In this paper, we present a flexible Partial Differential Equation (PDE) framework to model autocallable structured products. Our framework allows for products with either discrete or continuous autocall dates. We value the autocallable structured products with discrete autocall dates using the finite difference method, and the products with continuous autocall dates using a closed-form solution. In addition, we estimate the probabilities of an autocallable structured-product being called on each call date. We demonstrate our models by valuing a popular autocallable product and quantify the cost to the investor of adding this feature to a structured product. [read more]
Futures-Based Commodities ETFs
Ilan Guedj, PhD, Guohua Li, PhD, and Craig McCann, PhD2011-01-28
Published in The Journal of Index Investing, Summer 2011, Vol. 2, No. 1: pp. 14-24.
since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodities ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodities ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging.
This paper examines the sources of the deviation between futures-based commodities ETF returns and the changes in commodity prices using crude oil ETFs. We show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. We conclude that only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs. [read more]
since first introduced in 2004. These funds offer investors a simple way to gain exposure to commodities, which are thought of as an asset class suitable for diversification in investment portfolios and as a hedge against economic downturns. However, returns of futures-based commodities ETFs have deviated significantly from the changes in the prices of their underlying commodities. The pervasive underperformance of futures-based commodities ETFs compared to changes in commodity prices calls into question the usefulness of these ETFs for diversification or hedging.
This paper examines the sources of the deviation between futures-based commodities ETF returns and the changes in commodity prices using crude oil ETFs. We show that the deviation in returns is serially correlated and that a significant portion of this deviation can be predicted by the term structure of the oil futures market. We conclude that only investors sophisticated enough to understand and actively monitor commodities futures market conditions should use these ETFs. [read more]
Leveraged Municipal Bond Arbitrage: What Went Wrong?
Geng Deng and Craig McCann2010-10-25
Published in The Journal of Alternative Investments, Spring 2012, Vol. 14, No. 4: pp. 69-78.
the leveraged municipal bond strategy was simply an opaque high-cost, highly leveraged bet on the value of call options, interest rates and liquidity and credit risk. Brokerage firms misrepresented the strategy by comparing the yields on callable municipal bonds with the yields on non-callable Treasury securities without adjusting the yields on municipal bonds for their embedded call features and by ignoring 30 years of published literature which demonstrates the remaining difference in after-tax yields is compensation for liquidity and credit risk. We also show that much of the losses suffered by investors were suffered during a period of relatively routine interest rates and not during an unprecedented interest rate environment.
Recent Awards
- Puglisi v Citigroup - $750,000 MAT Five Award
- Young v Deutsche Park Securities - $1 million Aravali Fund Award
- Hosier et al v Citigroup - $54.1 million MAT Finance, MAT Two, MAT Three, MAT Five Award
- Coleman v Citigroup - $230,667 ASTA Five Award
- Beard v Citigroup - $336,000 ASTA Five Award
- Barnett et al v Citigroup - $2,428,000 MAT Five Award
[read more]
the leveraged municipal bond strategy was simply an opaque high-cost, highly leveraged bet on the value of call options, interest rates and liquidity and credit risk. Brokerage firms misrepresented the strategy by comparing the yields on callable municipal bonds with the yields on non-callable Treasury securities without adjusting the yields on municipal bonds for their embedded call features and by ignoring 30 years of published literature which demonstrates the remaining difference in after-tax yields is compensation for liquidity and credit risk. We also show that much of the losses suffered by investors were suffered during a period of relatively routine interest rates and not during an unprecedented interest rate environment.
Recent Awards
- Puglisi v Citigroup - $750,000 MAT Five Award
- Young v Deutsche Park Securities - $1 million Aravali Fund Award
- Hosier et al v Citigroup - $54.1 million MAT Finance, MAT Two, MAT Three, MAT Five Award
- Coleman v Citigroup - $230,667 ASTA Five Award
- Beard v Citigroup - $336,000 ASTA Five Award
- Barnett et al v Citigroup - $2,428,000 MAT Five Award
[read more]
Auction Rate Securities
Craig McCann and Edward O'Neal2010-10-22
short-term investments were entirely dependent on the presence of sufficient orders to buy outstanding ARS at periodic auctions in which they were bought and sold subject to a contractual ceiling on the interest rate the issuer would have to pay. If the demand for an ARS was too low to clear the market, broker dealers sponsoring the auction could place bids just below the maximum interest rate to clear the auction. The lower the public demand for an issue, the larger the quantity broker dealers had to buy to avoid a failed auction.
Participating broker dealers had better information than public investors about the creditworthiness of the ARS issuers and were the only parties with information about the broker dealers' holdings and inclination to abandon their support of the auctions. This severe asymmetry of information made public investors in ARS vulnerable to the brokerage firms' strategic behavior. In this paper, we explain what auction rate securities were, how they evolved, how their auctions worked, and why their flaws caused them to become illiquid securities. [read more]
Participating broker dealers had better information than public investors about the creditworthiness of the ARS issuers and were the only parties with information about the broker dealers' holdings and inclination to abandon their support of the auctions. This severe asymmetry of information made public investors in ARS vulnerable to the brokerage firms' strategic behavior. In this paper, we explain what auction rate securities were, how they evolved, how their auctions worked, and why their flaws caused them to become illiquid securities. [read more]
Leveraged ETFs, Holding Periods and Investment Shortfalls
Ilan Guedj, Guohua Li, and Craig McCann2010-08-09
Published in the Journal of Index Investing, Winter 2010, Vol. 1, No. 3: pp. 45-57.
of the daily returns of an index. Several papers have established that investors who hold these investments for periods longer than a day expose themselves to substantial risk as the holding period returns will deviate from the returns to a leveraged or inverse investment in the index. It is possible for an investor in a leveraged ETF to experience negative returns even when the underlying index has positive returns. This paper estimates the distributions of holding periods for investors in leveraged and inverse ETFs.
The SLCG study shows that a substantial percentage of investors may hold these short-term investments for periods longer than one or two days, even longer than a quarter. The study estimates the investment shortfall incurred by investors who hold leveraged and inverse compared to investing in a simple margin account to generate the same leveraged or short investment strategy.
The study finds that investors in leveraged and inverse ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%. [read more]
of the daily returns of an index. Several papers have established that investors who hold these investments for periods longer than a day expose themselves to substantial risk as the holding period returns will deviate from the returns to a leveraged or inverse investment in the index. It is possible for an investor in a leveraged ETF to experience negative returns even when the underlying index has positive returns. This paper estimates the distributions of holding periods for investors in leveraged and inverse ETFs.
The SLCG study shows that a substantial percentage of investors may hold these short-term investments for periods longer than one or two days, even longer than a quarter. The study estimates the investment shortfall incurred by investors who hold leveraged and inverse compared to investing in a simple margin account to generate the same leveraged or short investment strategy.
The study finds that investors in leveraged and inverse ETFs can lose 3% of their investment in less than 3 weeks, an annualized cost of 50%. [read more]
The Anatomy of Principal Protected Absolute Return Notes
Geng Deng, Ilan Guedj, Joshua Mallett, and Craig McCann2010-07-30
Published in the Journal of Derivatives, Vol. 19, No. 2, pp. 61-70, 2011
products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.
The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.
The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies. [read more]
products that guarantee to return the face value of the note at maturity and pay interest if the underlying security's price does not vary excessively.
The SLCG study derives four closed-form valuation approaches which are considered as representative methodologies on valuing structured products. The approaches are: 1) decomposing an ARBN's payoff into double-barrier linear segment options, 2) decomposing an ARBN's payoff into double-barrier call and put options, 3) transforming an ARBN's path-dependent payoff rule into a path-independent payoff rule which significantly simplifies the derivation of product value, and 4) using PDE (Partial Differential Equations) to model an ARBN's payoff and calculate its value. The study shows the four methodologies to value 214 publicly-listed ARBNs issued by six different investment banks. Most of the products are linked to indices such as the S&P 500 Index and the Russell 2000 Index.
The study finds that the ARBNs' fair price is approximately 4.5% below the actual issue price. Each of the ARBN's fair price is stable across all four valuation methodologies. [read more]
What TiVo and JP Morgan teach us about Reverse Convertibles
Geng Deng, Craig McCann, and Edward O'Neal2010-06-22
of the reference stock index declines substantially during the term of the note. The SLCG study finds that brokerage firms overcharge for reverse convertibles so significantly that the expected return on these complex investments is actually negative and that reverse convertibles continue to be sold at inflated prices only because investors do not fully understand these products.
The SLCG study reports that despite substantial overpricing in the offerings and the significant losses on the reverse convertible notes in 2008 and 2009, there have been a substantial number of new issues of these dubious investments by JP Morgan, Barclays and many others brokerage firms in 2010. The study illustrates its main themes with JP Morgan's May 14, 2010 TiVo-linked reverse convertible. [read more]
The SLCG study reports that despite substantial overpricing in the offerings and the significant losses on the reverse convertible notes in 2008 and 2009, there have been a substantial number of new issues of these dubious investments by JP Morgan, Barclays and many others brokerage firms in 2010. The study illustrates its main themes with JP Morgan's May 14, 2010 TiVo-linked reverse convertible. [read more]
The Risks of Preferred Stock Portfolios
Guohua Li, Craig McCann, and Edward O'Neal2010-06-02
and become more similar to equity when the company's financial condition deteriorates. We show that issuers of preferred stocks are heavily concentrated in the financial services industry, a fact that exposes investors who hold a portfolio concentrated in preferred stocks to further risk - industry concentration risk. We illustrate the features of preferred stocks using the Fannie Mae 2008 issuance as a case study.
Recent Award
- Jenkins v Crowell Weedon - $51,807 Preferred Stock Award
[read more]
Recent Award
- Jenkins v Crowell Weedon - $51,807 Preferred Stock Award
[read more]
Oppenheimer Champion Income Fund
Geng Deng and Craig McCann2010-05-14
return swaps (TRS). The Fund used CDS and TRS to leverage up the Fund's exposure to corporate debt and asset-backed securities, including Mortgage-Backed Securities and swap contracts linked to Residential and Commercial Mortgage-Backed Securities indices. [read more]
What Does a Mutual Fund's Term Tell Investors?
Geng Deng, Craig McCann, and Edward O'Neal2010-04-14
Published in the Journal of Investing, Summer 2011, Vol. 20, No 2: pp. 50-57.
statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds' reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds' risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.
Morningstar uses a fund-provided statistic - the average effective duration - to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds' unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds. [read more]
statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. In this article we address a similar problem with bond mutual funds' reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds' risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds.
Morningstar uses a fund-provided statistic - the average effective duration - to classify funds as ultra short, short, intermediate or long-term. Funds have figured out how to hold long-term bond portfolios yet be classified as ultra short-term and short-term bond funds. We show that extraordinary losses suffered by these funds in 2008 can be explained by the how much the bond funds' unadulterated weighted average maturity exceeded the maturities typically expected in short-term bond funds. [read more]
What Does a Mutual Fund's Average Credit Quality Tell Investors?
Geng Deng, Craig McCann, and Edward O'Neal2009-11-30
Published in the Journal of Investing, Winter 2010, Vol. 19, No. 4: pp. 58-65.
typically calculated by the mutual fund companies and by Morningstar significantly overstates bond mutual funds' true credit quality. This statistic is based on Standard & Poor's and Moody's assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds.
The study concludes that, for instance, funds that have the credit risk of a portfolio of BBB-rated bonds often report an Average Credit Quality of A or even AA and that given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk at all. Since bond fund managers compete for investors based on yield and risk, the authors find that fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios. [read more]
typically calculated by the mutual fund companies and by Morningstar significantly overstates bond mutual funds' true credit quality. This statistic is based on Standard & Poor's and Moody's assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds.
The study concludes that, for instance, funds that have the credit risk of a portfolio of BBB-rated bonds often report an Average Credit Quality of A or even AA and that given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their reported credit risk at all. Since bond fund managers compete for investors based on yield and risk, the authors find that fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios. [read more]
Structured Products in the Aftermath of Lehman Brothers
Geng Deng, Guohua Li, and Craig McCann2009-11-04
products' opaqueness obscured their true risks and costs and the high fees earned by underwriters and salespersons.
The current SLCG study presents a brief history of the structured products program at Lehman Brothers and illustrates many of its points with Lehman structured products examples including Principal Protected Notes, Enhanced Return Notes, Absolute Barrier Notes, Steepeners and Reverse Convertibles. The study reports that the spectacular failure of Lehman brothers in September 2008 left investors holding more than $8 billion face value $US-denominated structured products. Dr. Craig McCann, the study's principal author, explained that the Lehman experience is especially instructive of the opportunity for mischief presented by financial engineering; faced with increasing borrowing costs Lehman stepped up its issuance of structured products where its credit risk would not be priced into the debt. [read more]
The current SLCG study presents a brief history of the structured products program at Lehman Brothers and illustrates many of its points with Lehman structured products examples including Principal Protected Notes, Enhanced Return Notes, Absolute Barrier Notes, Steepeners and Reverse Convertibles. The study reports that the spectacular failure of Lehman brothers in September 2008 left investors holding more than $8 billion face value $US-denominated structured products. Dr. Craig McCann, the study's principal author, explained that the Lehman experience is especially instructive of the opportunity for mischief presented by financial engineering; faced with increasing borrowing costs Lehman stepped up its issuance of structured products where its credit risk would not be priced into the debt. [read more]
Charles Schwab YieldPlus Risk
Geng Deng, Edward O'Neal, and Craig McCann2009-07-20
that YieldPlus's extraordinary losses occurred because the fund held much larger amounts of securities backed by private-label mortgages than other ultra short bond funds. In doing so, Schwab's fund violated concentration and illiquidity limits stated in its prospectus. These private-label mortgage-backed securities holdings had given YieldPlus a slight advantage over its peers prior to 2007. Unfortunately, the extra yield was an order of magnitude smaller than the losses that followed when the value of structured finance securities - especially those backed by mortgages - dropped significantly.
SLCG also found that Schwab significantly inflated the value of YieldPlus's holdings and therefore its NAV in late 2007 and early 2008. By inflating the YieldPlus fund's NAV, Schwab provided existing investors incorrect information about the value of their investments and caused new investors to overpay for shares in YieldPlus. [read more]
SLCG also found that Schwab significantly inflated the value of YieldPlus's holdings and therefore its NAV in late 2007 and early 2008. By inflating the YieldPlus fund's NAV, Schwab provided existing investors incorrect information about the value of their investments and caused new investors to overpay for shares in YieldPlus. [read more]
Regions Morgan Keegan: The Abuse of Structured Finance
Craig McCann2009-01-20
An Economic Analysis of Equity-Indexed Annuities
Craig McCann2008-09-11
that:
- Existing equity-indexed annuities are too complex for investors to understand.
- This complexity is designed to allow the true costs to be hidden.
- The high hidden costs in equity-indexed annuities are sufficient to pay extraordinary commissions to a sales force that is not disciplined by sales practice abuse deterrents found in the market for regulated securities.
- Unsophisticated investors will continue to be victimized by issuers of equity indexed annuities until truthful disclosure and the absence of sales practice abuses is assured. [read more]
- Existing equity-indexed annuities are too complex for investors to understand.
- This complexity is designed to allow the true costs to be hidden.
- The high hidden costs in equity-indexed annuities are sufficient to pay extraordinary commissions to a sales force that is not disciplined by sales practice abuse deterrents found in the market for regulated securities.
- Unsophisticated investors will continue to be victimized by issuers of equity indexed annuities until truthful disclosure and the absence of sales practice abuses is assured. [read more]
A CMO Primer: The Law of Conservation of Structured Securities Risk
Craig McCann2007-06-30
bond mutual funds to fall in value far more than expected. Today's CMO losses resulted from the relatively recent introduction of CMOs with substantial credit risk and the inadequate or misleading way in which that credit risk was disclosed. Dr. McCann provides a selective history and a brief description of CMOs. [read more]
Closed-end Fund IPOs
Eddie O'Neal2007-06-29
IPO is dominated by investments in seasoned mutual funds. This suggests that closed-end fund IPOs don't pass the NASD's 'reasonable basis' suitability test and recommendations to buy a closed-end fund at the IPO should therefore be per se unsuitable. [read more]
Corporate and Municipal Bonds
Michael Piwowar2007-06-28
for institutional-sized (large) bond trades. Dr. Piwowar summarizes key findings in the academic finance literature on bond market trading costs, including research on the effects of adding price transparency to the bond markets, and explains how bond trading costs can be hidden in realistic examples using simple numerical examples. [read more]
Mandatory Arbitration of Securities Disputes
Edward O'Neal and Dan Solin2007-06-13
amounts have declined significantly over time. Moreover, claimants fare more poorly in large cases and in cases against larger brokerage firms. Dr. O'Neal and Mr. Solin estimate that the expected recovery before legal fees and expenses in a large case against a top brokerage firm is only 12% of the amount claimed. [read more]
Are Structured Products Suitable for Retail Investors?
Craig McCann and Dengpan Luo2006-12-02
sold only to sophisticated investors, structured products are increasingly being sold to unsophisticated retail investors. Equity-linked notes are difficult to evaluate and monitor, have high hidden costs and are illiquid. They are therefore virtually never suitable for unsophisticated investors. [read more]
An Overview of Equity-Indexed Annuities
Craig McCann and Dengpan Luo2006-06-01
state insurance commissions, rather than by the SEC and the NASD. We estimate that between 15% and 20% of the premium paid by investors in equity-indexed annuities is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces and that the claimed benefits for EIAs can be had at a tiny fraction of the cost using stocks and Treasury securities. [read more]
Annuities
Craig McCann and Kaye A. Thomas2005-12-10
sold annuities will pay more taxes and have less wealth in retirement as a result of the tax treatment of investments within tax-deferred annuities. [read more]
Optimal Exercise of Employee Stock Options and Securities Arbitrations
Craig McCann and Kaye A. Thomas2005-06-01
options. [read more]
Concentrated Investments, Uncompensated Risk and Hedging Strategies
Craig McCann and Dengpan Luo2004-12-01
strategies. [read more]
The Use of Leveraged Investments to Diversify a Concentrated Position
Craig McCann and Dengpan Luo2004-06-01
opposite. [read more]
Mutual Fund Share Classes and Conflicts of Interest between Brokers and Investors
Eddie O'Neal2003-12-24
interests. [read more]
Churning - Revisited: Trading Cost and Control
Craig McCann and Dengpan Luo2003-09-01
accounts with turnover ratios of 2 indicate excessive trading in common stock portfolios. [read more]
Detecting Personal Trading Abuses
Craig McCann2003-06-01
in a simple, cost effective manner. [read more]
Securities Class Action Lawsuits
Craig McCann, Ph.D., CFA2002-12-01
economists assist fact finders in determining whether allegedly omitted or misrepresented information was truly important or 'material.' This is done with the use of event studies or by reference to published scientific literature. Financial economists help the parties reach settlements by estimating alleged damages. Alleged damages depend on the amount by which a company's stock price was allegedly inflated and the number of shares that were bought at fraudulently inflated prices. In these slides, SLCG outlines the major issues in estimating alleged damages in securities class action lawsuits. [read more]
The Suitability of Exercise and Hold
Craig McCann and Dengpan Luo2002-06-01
concentrated position. As such, the advice to exercise and hold can be evaluated within the familiar suitability framework. [read more]
Churning
Craig McCann2001-12-01
damages. [read more]
Bid-Ask Spread, Sales Credits and Brokers' Compensation
Craig McCann and Richard G. Himelrick2001-06-01
compensation. [read more]
McCann On Trading Models
Craig McCann2000-06-01
experts. [read more]
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