Jun. 07, 2011
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What Our Members' Discussions Have Covered (May 2011)

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“A banker MUST make money out of clients no matter what he thinks is best for them”

Discusison

Last month our group members shared their thoughts and experiences on various topics. What follows are a few highlights of these discussions, such as inside knowledge on a banker’s conflicts of interest, strategies to reduce portfolios’ currency risks and a detailed posting on the benefits, risks and tax implications of security lending for an ETF investor.

Member Discussion: Which is more important; the banker or the bank?

Our member Obersee1 came up with one very sensible question that’s often overlooked when choosing a wealth manager. The response of our long-term member Buffet2 was very clear:

“At the end of the day it is the bank - because they pay the banker and therefore he has more interest in pleasing his employee than his client. That does not mean that the banker doesn’t try to do the best for you, BUT only within the limits set by his bank. ..Consequently either start to look for a completely independent adviser, ideally fee-only or check first the compensation/investment policies of the bank before deciding on the adviser.”

We also got a great insiders perspective from Boerse100 that our members found very helpful.

“I am working in a bank and can tell you how it is: There are clear targets on how much revenue should be generated from each client each year. These are considerably higher than the fees a client pays. So what has a banker to do, even if he does not like it, believe in it or want it? Because the bank forces him he has to generate the extra revenue from each client by selling products that pay kickbacks or have other hidden costs and/or push for a lot of transactions to increase fees. Bankers want to keep their job and pay their bills so I do not think one can blame them. Consider this fact of life when talking about bank v. banker. A banker MUST make money out of clients no matter what he thinks is best for the clients.”

Member Discussion: Asset allocation is important

Our member orchid broached the question about the right choice of assets by taking into account the allocation of currency exposure A very good question given the high volatility in the forex markets:

“I wonder if re-balancing also applies to the share of various currencies in my portfolio. I am talking about a portfolio of stocks and bonds denominated in USD, euro, SGD, Yen, Korean won and not a trading portfolio for currencies. How do others handle it? Buy protection and hedges or e.g. sell assets in a currency that appreciated a lot and therefore has a higher share in the portfolio than was aimed for?"

Alexarnback provided excellent and knowledgeable feedback:

"You have to rebalance, but should not take on currency risk for bonds. Here is what academic research tells us. Over time, currencies have a return of 0 and a rather high volatility as you know. Should you take risks for a return of 0? Probably not. However, implications are different for stocks and bonds. 1)For equities, currency tend to reduce volatility if your stocks are diversified enough (global equity), so you should not hedge currency. 2) for bonds, since the purpose is to protect your capital, you should not accept any currency risk. I.e. if you live and spend in HongKong, you should only have bonds in HKD. For how to approach the bond part, answers can be found in goal based asset allocation techniques."

Member Discussion: Security Lending Issues

In our group on ETFs an, at a first glance very technical discussion on security lending developed, which in fact very is a important concern for every ETF investor and we recommend that everybody should become familiar with the small-print of these sections of most ETF factsheets or even have a look at the prospectus. We found the postings by blacksmith and, again, Alexarnback very helpful and would like to present them in full. Because in this case detail matters to ensure that investors do not have a bad awakening by investing in ETFs. blacksmith kicked off the discussion by an careful analysis of the benefits, risks and tax implications of security lending for an investor

“Securities lending, from an ETF or other fund structures, can produce incremental income, but does involve risks. The borrower will have to post collateral but this may not always fully cover the exposure and risk of default and needs to be carefully managed in terms of monitoring both quantity and quality on a daily basis. Another sensitive issue is the costs of managing the securities lending program.

"iShares typically split the revenue from securities lending 50/50 with half going to the ETF and the lending program manager taking the remainder. Note the lending program manager may be an associate company of iShares manager Blackrock, highlighting a potential conflict of interest. Vanguard, another major operator of index funds and ETF's, more generously attributes all securities lending income to the fund, deducting only the actual costs of managing the securities lending program. Other fund managers do not even disclose such fee splitting arrangements.

"Regulators please take note. Swaps-based ETFs promise lower tracking errors but involve other risks. Firstly, the collateral may be assets totally unrelated to the underlying investment, and although the bank underwriting the swap absorbs that risk, the investor is exposed to residual risk of default by the bank on its obligations if there is any shortfall. Secondly, swaps-based ETFs do not benefit from securities lending revenues since that is all internalised by the bank writing the swap. Finally, another hidden risk in swaps-based ETFs is that the promised performance benchmark may include embedded deductions for dividend withholding taxes at higher levels than a direct investor or holder of replication ETF or index funds would pay. In effect the bank is then able to pocket the arbitraged gains from a lower rate of withholding tax(WHT). For example the benchmark may assume 30% withholding tax on dividends but the bank may actually pay 15% or less, potentially pocketing around 30 basis points (0.30%) annually. For all these reasons, comparing differing fund structures is far from straightforward, and certainly involves more than a simple comparison of published expense ratios.

"For replication based ETFs, any difference between the actual withholding tax paid by the ETF and the rate assumed in the benchmark will be reflected in the overall performance against the benchmark, i.e. the tracking error. However, one technique for mitigating the impact of WHT is to lend out the relevant shares for dividend collection by a more favoured investor, which again raises the issue of fee splitting. Another hidden cost not mentioned earlier is internal portfolio turnover costs when shares are bought and sold due to index changes or corporate actions. For replication based ETFs these costs are borne by the fund. A swaps based ETF does not incur such costs but the issuing bank may levy a portfolio replication cost in addition to the annual management fee."

Alexarnback added his personal experience and ranked the providers:

"I have been investing passively since 2005 now and my ranking of the providers are 1)DFA 2)Vanguard 3)Pictet & IShares. Only that Pictet has a very limited offer and DFA is reserved for institutions and approved fee only advisors. A point I would like to stress is that the choice of the ETF/fund provider is only a part of the challenge. Another part that is at least as important is to know how to mix and use the different products to produce best results and lowest risk. For instance if you do market timing with ETFs, research suggests your risks of getting hurt are almost as high as with an actively managed fund."

Excellent discussions of high importance for every wealth management client. We would like to thank our members for sharing the insights. Keep up with the good postings!
 

My Private Banking



What Our Members' Discussions Have Covered (May 2011)

“A banker MUST make money out of clients no matter what he thinks is best for them”

  Jun. 07, 2011

Discusison

Last month our group members shared their thoughts and experiences on various topics. What follows are a few highlights of these discussions, such as inside knowledge on a banker’s conflicts of interest, strategies to reduce portfolios’ currency risks and a detailed posting on the benefits, risks and tax implications of security lending for an ETF investor.

Member Discussion: Which is more important; the banker or the bank?

Our member Obersee1 came up with one very sensible question that’s often overlooked when choosing a wealth manager. The response of our long-term member Buffet2 was very clear:

“At the end of the day it is the bank - because they pay the banker and therefore he has more interest in pleasing his employee than his client. That does not mean that the banker doesn’t try to do the best for you, BUT only within the limits set by his bank. ..Consequently either start to look for a completely independent adviser, ideally fee-only or check first the compensation/investment policies of the bank before deciding on the adviser.”

We also got a great insiders perspective from Boerse100 that our members found very helpful.

“I am working in a bank and can tell you how it is: There are clear targets on how much revenue should be generated from each client each year. These are considerably higher than the fees a client pays. So what has a banker to do, even if he does not like it, believe in it or want it? Because the bank forces him he has to generate the extra revenue from each client by selling products that pay kickbacks or have other hidden costs and/or push for a lot of transactions to increase fees. Bankers want to keep their job and pay their bills so I do not think one can blame them. Consider this fact of life when talking about bank v. banker. A banker MUST make money out of clients no matter what he thinks is best for the clients.”

Member Discussion: Asset allocation is important

Our member orchid broached the question about the right choice of assets by taking into account the allocation of currency exposure A very good question given the high volatility in the forex markets:

“I wonder if re-balancing also applies to the share of various currencies in my portfolio. I am talking about a portfolio of stocks and bonds denominated in USD, euro, SGD, Yen, Korean won and not a trading portfolio for currencies. How do others handle it? Buy protection and hedges or e.g. sell assets in a currency that appreciated a lot and therefore has a higher share in the portfolio than was aimed for?"

Alexarnback provided excellent and knowledgeable feedback:

"You have to rebalance, but should not take on currency risk for bonds. Here is what academic research tells us. Over time, currencies have a return of 0 and a rather high volatility as you know. Should you take risks for a return of 0? Probably not. However, implications are different for stocks and bonds. 1)For equities, currency tend to reduce volatility if your stocks are diversified enough (global equity), so you should not hedge currency. 2) for bonds, since the purpose is to protect your capital, you should not accept any currency risk. I.e. if you live and spend in HongKong, you should only have bonds in HKD. For how to approach the bond part, answers can be found in goal based asset allocation techniques."

Member Discussion: Security Lending Issues

In our group on ETFs an, at a first glance very technical discussion on security lending developed, which in fact very is a important concern for every ETF investor and we recommend that everybody should become familiar with the small-print of these sections of most ETF factsheets or even have a look at the prospectus. We found the postings by blacksmith and, again, Alexarnback very helpful and would like to present them in full. Because in this case detail matters to ensure that investors do not have a bad awakening by investing in ETFs. blacksmith kicked off the discussion by an careful analysis of the benefits, risks and tax implications of security lending for an investor

“Securities lending, from an ETF or other fund structures, can produce incremental income, but does involve risks. The borrower will have to post collateral but this may not always fully cover the exposure and risk of default and needs to be carefully managed in terms of monitoring both quantity and quality on a daily basis. Another sensitive issue is the costs of managing the securities lending program.

"iShares typically split the revenue from securities lending 50/50 with half going to the ETF and the lending program manager taking the remainder. Note the lending program manager may be an associate company of iShares manager Blackrock, highlighting a potential conflict of interest. Vanguard, another major operator of index funds and ETF's, more generously attributes all securities lending income to the fund, deducting only the actual costs of managing the securities lending program. Other fund managers do not even disclose such fee splitting arrangements.

"Regulators please take note. Swaps-based ETFs promise lower tracking errors but involve other risks. Firstly, the collateral may be assets totally unrelated to the underlying investment, and although the bank underwriting the swap absorbs that risk, the investor is exposed to residual risk of default by the bank on its obligations if there is any shortfall. Secondly, swaps-based ETFs do not benefit from securities lending revenues since that is all internalised by the bank writing the swap. Finally, another hidden risk in swaps-based ETFs is that the promised performance benchmark may include embedded deductions for dividend withholding taxes at higher levels than a direct investor or holder of replication ETF or index funds would pay. In effect the bank is then able to pocket the arbitraged gains from a lower rate of withholding tax(WHT). For example the benchmark may assume 30% withholding tax on dividends but the bank may actually pay 15% or less, potentially pocketing around 30 basis points (0.30%) annually. For all these reasons, comparing differing fund structures is far from straightforward, and certainly involves more than a simple comparison of published expense ratios.

"For replication based ETFs, any difference between the actual withholding tax paid by the ETF and the rate assumed in the benchmark will be reflected in the overall performance against the benchmark, i.e. the tracking error. However, one technique for mitigating the impact of WHT is to lend out the relevant shares for dividend collection by a more favoured investor, which again raises the issue of fee splitting. Another hidden cost not mentioned earlier is internal portfolio turnover costs when shares are bought and sold due to index changes or corporate actions. For replication based ETFs these costs are borne by the fund. A swaps based ETF does not incur such costs but the issuing bank may levy a portfolio replication cost in addition to the annual management fee."

Alexarnback added his personal experience and ranked the providers:

"I have been investing passively since 2005 now and my ranking of the providers are 1)DFA 2)Vanguard 3)Pictet & IShares. Only that Pictet has a very limited offer and DFA is reserved for institutions and approved fee only advisors. A point I would like to stress is that the choice of the ETF/fund provider is only a part of the challenge. Another part that is at least as important is to know how to mix and use the different products to produce best results and lowest risk. For instance if you do market timing with ETFs, research suggests your risks of getting hurt are almost as high as with an actively managed fund."

Excellent discussions of high importance for every wealth management client. We would like to thank our members for sharing the insights. Keep up with the good postings!