Sunday, 20 April 2014

Flash Boys Provides Useful Reality Check

Michael Lewis new book, Flash Boys, has focussed mainstream attention on the benefits and costs of High Frequency Trading. HFT has transformed global equity markets over the past decade. Despite its critics, the book is a must read for anyone who has a significant stake in the equity market, either directly through a personal equity portfolio, or indirectly through mutual funds, ETFs or pension funds.

Lewis' claim on CBS "60 Minutes" that HFT firms have "rigged" the stock market at the expense of individual investors certainly attracted widespread attention.  It will be unfortunate, however, if the headlines about the book only succeed in eroding further already weak public confidence in financial markets. If, on the other hand, investors (and the mutual funds, pension funds and bank owned brokers who act on their behalf) read the book, do their own research, and demand protection from predatory HFT practices and those stock exchanges that encourage them, then the result can be increased confidence in the fairness and stability of equity markets.

Flash Boys is a well-told story that provides compelling reading and valuable education on how HFT developed and how, in some cases, it has been misused. It recounts how stock trading has been transformed, in the wake of the 1987 crash and the bursting of the Tech Bubble, from markets anchored by human market makers into a markets operated by high speed computers.
  • It explains why it made sense for Spread Networks to spend $300 million to lay fibre optic cable in as straight a line as possible to shave 3 milliseconds off the communication time between Chicago's equity futures market and New York's stock market. 
  • It explains how bank-owned brokers may use their own HFT dark pools to trade against their own customers or sell that opportunity to faster, predatory HFT firms.
  • It explains why stock exchanges can sell at high prices the right to co-locate the servers of HFT firms within close proximity to the computer "matching engines" of the exchange, thereby creating a speed and information advantage over non-HFT investors.
  • It explains why a simple system of market orders and limit orders that sufficed for decades has been supplanted by a system with over 30 different types of orders, some expressly designed to enable HFT to front run trades of non-HFT investors. 
  • It explains why increased HFT's increased share of total trading can actually reduce liquidity and increase intraday volatility of the stock market.
Defenders of HFT claim that the proliferation of private stock exchanges and HFT firms has reduced trading costs and increased liquidity of equity markets. But Flash Boys casts serious doubt on these claims. The advent of electronic trading and decimalization of stock prices are probably responsible for the lion's share of the the reduction in trading costs over the past decade. The explosion of HFT seems to have merely increased the frequency of partial fills on larger orders and unnecessary price movement that benefits high speed predators.

From my perspective, the most fascinating insight drawn from Flash Boys, is that investors, even large pension funds and mutual funds, cannot compel their bank-owned brokers to direct their trades to the stock exchange of their choice. Once the non-HFT investor pushes the buy or sell button for a market order, he/she loses control over where and how the trade is executed and permits the broker to sell the information contained within the order to HFT firms.

It's not just Michael Lewis and the Flash Boys cast of characters who are asking questions about HFT. Two years ago, the Investment Industry Regulatory Organization of Canada (IIROC) was already investigating these questions:
  • Is displayed order flow by HFT too fleeting?
  • Is the liquidity provided by HFT illusory?
  • Does HFT exacerbate volatility?
  • Does HFT seek informational advantages over other investors - retail and institutional - through their trading strategies?
After reading Flash Boys, it seems obvious that the answer to all of these questions is yes. What seems wrong with the system is that a set of rules and incentives has been allowed to develop by the brokers, exchanges and regulators that both permits and encourages predatory trading behaviour by HFTs.

Canada appears to be a bit further ahead in curbing predatory HFT than is the case in the United States and some other jurisdictions. In 2012, IIROC implemented tougher rules on HFT within dark pools in Canada. Since then, HFT firms share of Canadian equity trading has shrunk. With the publication of Flash Boys, pressure on brokers, exchanges and regulators to level the playing field for investors will likely increase. That would be good for investor confidence in the stock market.   

Tuesday, 1 April 2014

Canadian ETF Portfolios: Q1 Review and Outlook

The first quarter of 2014 proved to be choppy and surprising one for global investors. The beginning of the year consensus provided little guidance.

   Major global equity markets sold off in January, rebounded in February, see-sawed in March and the MSCI World index finished Q1 with a modest 1.4% gain in local currency terms. 
   Global bonds, which were supposed to underperform as the Fed proceeded with tapering, turned in a surprisingly strong performance. 
   Emerging Market assets were under pressure early in the quarter as growth disappointments, political turmoil, fed tapering and worries about China's credit bubble took a toll. But in March, as Putin effectively annexed Crimea and China saw the beginnings of what could become a string of corporate defaults, EM assets, in contrarian fashion, regained some lost ground. 
   Gold, after a horrible 2013, had a stellar Q1, while copper and iron ore, more closely linked to China's slowing growth and credit problems, sold off sharply.
   Energy prices rallied on frigid North American weather and geopolitical risk, as the WTI futures price rose to $103/bbl by February 28 and finished March at $101/bbl.
   Global growth forecasts have edged down and global inflation has continued to disappoint on the downside, keeping the risk of deflationary outcomes on the table, thereby boosting bond performance.

This may all seem confusing, but the common thread may be rising uncertainty, which helped gold and safe-haven assets, but hurt the relative performance of EM assets, equities and inflation-linked bonds. Markets seem to believe that the Fed will continue to taper its QE program but, despite an apparent stumble by Fed Chair Janet Yellen suggesting that the Fed could begin tightening in early 2015, the timing of actual Fed rates hikes has become more uncertain. Even members of the FOMC seem widely divided on how soon and how much the policy rate should be raised.

The good news for Canadian investors in global ETF's was that whatever the Fed eventually does, the Bank of Canada continues to send signals that it is in no hurry to raise its policy rate and might even contemplate cutting it. The body language of BoC Governor Poloz clearly seems to be more relaxed about tightening than does that of his Fed counterpart. The result was a further 3.9% depreciation of the Canadian dollar relative to the USD and this tended to make Q1 quite profitable for Canadian ETF investors. 

Global Market ETFs

Monthly Performance for March

The S&P500 closed March at 1872, up from 1859 at the end of February, 1783 at the end of January and 1842 at the end of December. Global equity ETFs posted mixed returns in March. The C$ was virtually unchanged in March, so there was virtually no difference between returns local currency and CAD terms. The strongest returns were in Emerging Markets (EEM), which returned 3.7% in CAD terms. Other equity markets posted less stellar returns, as Eurozone (FEZ) returned 0.6%, Canada (XIU) +0.3%, and US (SPY) +0.2%. Japan (EWJ) significantly under-performed other markets, returning -2.6% in CAD terms. US small caps (IWM) returned -1.2%, underperforming US large caps.

Commodity ETFs lost ground in March. The Gold ETF (GLD) returned -3.3% in CAD terms, while the GSCI commodity ETF (GSG) returned -0.2% as copper and iron ore prices suffered from weakness in Chinese industrial production.

Global Bonds ETFs also turned in mixed performances in March. EM bonds rebounded to outperform DM bonds. Emerging Market Local Currency bonds (EMLC) were surprisingly the best performers, returning 1.9% in CAD terms. USD-denominated bonds (EMB) returned +0.7%. Among DM government bond ETFs, non-US global government bonds (BWX) were the best performers with a 0.0% return, while US long bonds (TLH) returned -0.3% and Canadian long bonds (XLB), returned -1.0%. 

Inflation-linked bonds (ILBs) posted mixed returns in March. Canadian RRBs (XRB) returned +0.4%, US TIPs (TIP) returned -0.7% in CAD terms, and non-US ILBs (WIP) returned +1.1%.

Corporate bonds posted negative returns in March as US investment grade (LQD) and high yield (HYG) bonds returned -0.5% and -0.7% respectively. Canadian corporate bonds (XCB) returned -0.2%.

Quarterly Performance for Q1

In Q1, with the Canadian dollar depreciating 3.9% against the US dollar, the best global ETF returns for Canadian investors were in Gold and US long bonds. The worst returns were in Japanese equities.

In global equities, the Canadian equity ETF (XIU) performed well, returning 5.6%. The S&P500 ETF (SPY) returned 5.2% in CAD terms and the Eurozone equity ETF (FEZ) returned +5.0%, Emerging Market equities (EEM) underperformed, suffering from Fed tapering, political turmoil, and China’s growth slowdown, and returned 1.9% in CAD terms. The Japan equity ETF (EWJ), suffering from Yen strength and slowing Asian growth, returned -3.1%. US small caps (IWM) returned 4.8%, under performing large caps (SPY).

Commodity ETFs turned in strong performance in Q1, aided by the weakness of the C$. The Gold ETF (GLD) returned 10.6% in CAD terms, while the iShares GSCI commodity ETF (GSG) returned 6.4%.  

Global Bond ETFs, contrary to consensus expectations at the beginning of the year, performed well. Foreign bond ETFs benefited from currency strength relative to the Canadian dollar and long duration bonds benefited from a combination of weaker than expected economic data and safe haven demand. The US long bond ETF (TLH) returned +4.3% in USD terms, and with the weakening of the C$, this translated into a +8.3% return in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of +3.8%. Non-US global government bonds (BWX) fared better, posting a return of +6.8% in CAD terms. Emerging Market local currency bonds (EMLC) suffered from the same problems as EM equities, but still returned 3.9% in CAD terms. USD-denominated EM bonds (EMB) returned +7.0%.

Inflation-linked bonds (ILBs) rebounded in Q1 after a disastrous performance in 2013. Non-US ILBs (WIP) fared best, returning +6.8% in CAD terms, while US TIPs (TIP) returned +6.0%. The Canadian real return bond ETF (XRB), benefiting from its long duration, returned 5.7%.

Among corporate bond ETFs, the US investment grade bond ETF (LQD) returned 6.4% in CAD terms, while the US high yield bond ETF (HYG) posted a return of 5.6% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned of +2.1%.

Global ETF Portfolio Performance for March and Q1

In March, the Canadian ETF portfolios tracked in this blog posted only small positive returns, but for Q1, all of the portfolios turned in solid performances.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 34 basis points in March to be up 4.2% year-to-date (ytd). A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 28 bps in March to be up 3.7% ytd.

Risk balanced portfolios performed well in January, added to their gains in February and were little changed in March. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 1 bp in March, but finished Q1 with a stellar year-to date gain of 8.9%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, returned 17 bps in March to be up 5.4%ytd.

Outlook for April

March turned out to be a volatile but relatively flat month for most Canadian dollar portfolios. As a result, the solid year-to-date returns achieved by the end of February remained intact.

Key developments that markets will be watching in April will include:

  • Developments in Ukraine, including Russia’s de facto annexation of Crimea, added volatility, but did little damage to major equity markets. Bond and Gold ETFs benefited from their safe haven attraction. The situation remains a source of uncertainty and a continuing geopolitical risk to markets.
  • The Bank of Canada, with its policy rate decision in March and a subsequent speech by Governor Poloz, confirmed that the direction of the next rate move will depend on growth and inflation developments. The weather-battered economy contracted 0.5% in December and managed to rebound 0.5% in January, leaving output unchanged from its November level. This slow start to the year will result in a downgrade to the BoC’s growth projection in the April 16 Monetary Policy Report. Core inflation remains stuck at just over 1% and the BoC remains puzzled about the causes of the weakness of inflation. There is little reason to expect a near term change in the BoC’s thinking.
  • In Q1, global economic data was weaker than expected, but much of the weakness was shrugged off by markets as weather related and, therefore, temporary. In April, this assumption will be tested. If the economic data fails to reaccelerate, the resilience in equity markets will be tested. If data do suggest a strong reacceleration, bond markets will be at risk.
  • Concerns about falling global inflation continue. Recent weak inflation readings in the Eurozone and China support ongoing concerns about global disinflation.
  • Emerging markets remain a focus. China has increased the flexibility of its exchange rate setting as it gingerly attempts to let some air out of its credit bubble without seriously damaging growth. Russia’s economy is likely to suffer from G7 sanctions and private sector capital outflows and is vulnerable to a drop in crude oil prices. Political uncertainty remains high in Turkey and Brazil.

In a mid-January post on Inflation and Deflation Scenarios, I pointed to Russell Napier’s advice to watch inflation expectations (measured by US 5-year TIPs break-evens), copper prices and credit spreads. In Q1, these indicators, especially copper prices, continued to move, although not yet decisively, toward the outcomes consistent with the deflation scenario.

Last month, I concluded that, “Until we have more clarity on geopolitical risks and the trend of global growth and until disinflationary pressures show signs of abating, the direction of markets in 2014 remains highly uncertain. Having ample cash in the portfolio remains a good strategy, as opportunities to buy either equities or bonds at significantly lower levels later this year still seems like a good bet.”

As it turned out, major equity and bond markets drifted sideways in March as global uncertainties failed to abate. This may be a pause the refreshes and gives way to better news on growth and less evidence of disinflation in April. That would go some distance toward validating current high equity market valuations, but would likely cause some reversal of the surprising bond market rally of Q1. Having ample cash in the portfolio remains a good strategy; April is likely to send important signals about the best way to deploy that cash.