Investor Brain

Sunday, June 01, 2008

Progressing From Bear to Where?

THE BEAR MARKET HAS GIVEN WAY TO AN UNCERTAIN MARKET, according to recent surveys from three online brokers who put their information-gathering skills to much different purposes.

At TradeKing, rising market volatility means trimmer household budgets and more options trading. For Schwab, heightened uncertainty underscores the need for investor education. And over at E*Trade, the slide in stock prices last summer and this past winter argues for more investment in bonds.

TradeKing’s late-April online survey (http://www.tradeking.com) of 3,000 equities and options traders showed bearish sentiment receding. Just 23.9% said they were either “bearish” or “very bearish,” down from 48.3% in January. At the same time, 46% of those surveyed had a “neutral/not sure” outlook for the next three months, the highest uncertainty level in four quarters.

TradeKing’s active-investing respondents said they are reacting to market volatility by adjusting investment strategies and considering more foreign plays, as well as reducing their personal energy costs and household budgets. Those who expect to receive the economic-stimulus tax rebate said they’ll use it to pay down debt (credit card, mortgage, student loans and such), or invest further.

Shortly after releasing the survey results, TradeKing reported it would be among the first online brokers to allow customers to trade fixed-return options, which allow an investor to bet on whether a stock’s price will be above or below a set level on the date the option expires. TradeKing offers two types of FROs—Finish High and Finish Low—on 20 stocks and exchange-traded funds, with plans to add more. The fixed return is $100 per contract; your total return depends on how much you paid for the contract. Because they’re thinly traded at present, the bid/ask spreads are very wide.

If you buy a Finish High FRO, you’re hoping it will have a higher price on the date of expiration than the strike price. Let’s say you buy a Finish High FRO for Intel (ticker: INTC), with a July strike price of $25. You’ll get $100 per contract if Intel’s volume-weighted average price for trades placed on the date of expiration is $25.01 or higher. (You don’t get anything extra if the stock goes beyond $25.01—to $50, for instance.) If the average price is $25 or less, you get nothing, and lose the premium paid. On a Finish Low FRO, you’re betting that the price will be $24.99 or less.

FROs settle differently from regular options. If you’re in the money on the expiration date, you have $100 per contract, cash, deposited in your account. There’s no physical settlement. Background info, quotes, and educational material are available at http://www.amex.com. On the menu bar on the left side of the screen, click on Options, then Product Information, and finally, Fixed Return Options.

IN SCHWAB’S (http://www.schwab.com) survey of active traders, released in mid-May, 76% of the 500 respondents said they expect the Standard & Poor’s 500 to rise or trade sideways in the next six months. Four out of 10 said they now trade options regularly. Of that group, 95% expect to maintain or increase their options trading in the next six months.

Because of the growing popularity of options, trader education—especially about complex multi-leg strategies—has become more important. Some 75% of those using options said they do so to generate income or hedge risk. Speculation was cited by a minority as the leading reason to trade options.

E*TRADE (http://www.etrade.com) used the opportunity of a revamped bond platform to ask clients about fixed income. Most (58%) said they think fixed income is more important in volatile times. Yet they also betrayed ambivalence about bonds. Only two-thirds of respondents actually own them. (Like eating more fiber, it’s nice in theory, but not much fun in practice.)

Bond pricing isn’t easy to understand. A majority of E*Trade’s survey respondents preferred agency pricing, which is a per-bond fee similar to a per-transaction commission for stocks and options. The usual method of trading bonds now involves principal pricing, in which the bond’s price includes a dealer’s mark-up, which is not immediately obvious to the buyer. (Fidelity has switched to agency pricing.)

E*Trade’s revised bond center, with inventory supplied by BondDesk, has a clean layout and includes a lot of key tools on the initial page. You can search among about 30,000 corporates, munis, Treasuries, agency bonds, certificates of deposit, and program notes (bonds available directly from a corporate issuer at par) using the Quick Search, which sorts by maturity date. Advanced Search sorts by yield, price or other criteria.

Treasuries trade without a commission, while other bonds incur a $1-per-transaction fee. Because of differing availability and other factors, it can be tough to compare a bond from one broker with a similar one from another. But the prices displayed in E*Trade’s bond center don’t seem out of line with other brokers’. The upgrade is a welcome addition.

Published in Barron’s, May 26, 2008

Saturday, May 17, 2008

New Tools for New Cost-Basis Reports

IT WON’T BE LONG BEFORE CONGRESS MANDATES THAT YOUR BROKER tell the Internal Revenue Service the exact cost basis of securities you’ve sold. The move, designed to help pay for new federal programs—such as those aimed at the housing crisis—will not only increase scrutiny on investors, but likely sharpen a budding competition between two software companies that make tax-aware portfolio-management software.

The House Ways & Means Committee recently passed the Housing Assistance Tax Act, which includes a cost-basis reporting measure that could bring in $8 billion in tax revenues annually. “You do things to help housing, and you have to pay for part of it with cost-basis reporting,” says Stevie Conlon, tax director at investment-software specialist GainsKeeper. Ways & Means’ passing a bill with that provision puts it on “an express train to passage.”

If passed, the law would require tighter cost-basis reporting for positions that are closed in 2009. The compliance dates would be Jan. 1, 2010, for stock, Jan. 1, 2011, for mutual funds, and Jan. 1, 2012, for debt and other instruments. Investors are supposed to report the cost basis for their sales now, but the new measures would tighten scrutiny and impose penalties for mistakes.

Given all the headlines about subprime mortgages, Conlon thinks there’s a high likelihood the measure will become law.

Cost-basis reporting was also a funding mechanism in the farm bill that has a May 16 deadline for passage. Only one bill can legislate it, so the existence of two makes new, stricter rules that much more likely.

Conlon says, “There is likely to be pressure from different groups in the financial industry to make some changes, especially from mutual funds.” For instance, she expects that effective dates could change, as well as what kinds of holdings—for example, stocks, commodities, derivatives—the new reporting requirement will cover.

WHATEVER ITS EVENTUAL SHAPE, the measure will further stir a new rivalry. For years, the only game in town was Conlon’s employer, GainsKeeper, published by Wolters Kluwer. It comes in several versions. Earlier this year, upstart Maxit was rolled out by publisher Scivantage. Intriguingly, a cofounder of GainsKeeper, Cameron Routh, was hired away by Scivantage last year, leading to a fierce marketing war and behind-the-scenes legal kerfuffles.

GainsKeeper was first offered as a Web destination. Customers signed up for an account, then imported their brokerage transactions. Now the firm offers an enterprise application to brokers that integrates with their Websites, allowing clients to use GainsKeeper while logged into their accounts.

GainsKeeper is integrated into online brokers like TDAmeritrade, Scottrade, E*Trade Platinum and ShareBuilder, where customers get it for free. OptionsXpress clients can set up a GainsKeeper account for $24.95 per year, while at Zecco, it costs $24.99 every six months. This summer, Firstrade is expected to offer it, too.

Other firms offer a link to the retail version of GainsKeeper. These include Schwab, Fidelity, thinkorswim, Siebert, Interactive Brokers, AB Watley, ChoiceTrade and E*Trade (for customers who don’t qualify for the Platinum level of service). Using the retail version requires a customer to export transactions to a file that’s then imported into GainsKeeper.

Maxit doesn’t have a consumer version, although its enterprise application is integrated into several newer brokerages. It’s now offered free to customers of TradeKing and Just2Trade. Options- House is in the process of making Maxit available; it expects to roll it out over the summer. Other brokers are expected.

Why does any of this matter to brokerage clients? With the potential for hefty penalties, filing a correct tax return is more important than ever. And GainsKeeper’s and Maxit’s tools help traders reduce taxes, and calculate statistics such as return on investment. It’s also important for frequent traders to correctly identify and report wash sales. Their ability to track ticker-symbol changes and stock splits, is helpful, too.

A company that chose Maxit says it was impressed with how its system reads database files, making portfolio updates in close to real time; GainsKeeper’s methodology involves converting several files, sometimes leading to a reporting delay.

The nitty-gritty of how the two programs deal with the transaction files is most important to the brokers. One executive said that the overall cost (purchase plus operating expenses), ease of integration, and functionality were important to his firm, which opted for Maxit. But GainsKeeper still has more brokers. And their rivalry should aid traders as well as brokers.

Published in Barron’s, May 11, 2008.

Saturday, April 12, 2008

A Bond, A Bear and a Bind

LOOKING FOR MUNIS TO ADD TO YOUR PORTFOLIO? Fidelity Investments has teamed with the electronic bond-trading outfit TheMuniCenter to increase the mutual-fund giant’s municipal-bond offerings by about 40%. Fidelity’s Open Bond Market service, available to customers online at http://www.fidelity.com, contains educational material as well as screeners and other tools designed to make trading of all sorts of bonds more accessible and understandable.

Fidelity’s customers also can now trade Treasury Inflation Protected Securities (TIPS) online at Fidelity.com; previously they could only trade TIPS through Fidelity’s phone representatives or in person at an investor center.

Launched in 2004, the Open Bond Market offers U.S. Treasuries and CDs (certificates of deposit), as well as corporate, municipal, government agency and principal-protected notes. The fees were lowered last year to $1 per bond (subject to $8 minimum); Treasuries can be traded at no cost.

IN THE WAKE OF BEAR STEARNS’ RECENT COLLAPSE, industry analysts worried about the financial stability of the Customer Assets Protection Company, which carries the brokerage firm’s coverage beyond that of the mandatory Securities Investor Protection Corp., or SIPC, coverage. Capco is backed by a consortium of brokers and SIPC is funded by member-brokers. SIPC covers individual accounts up to $500,000, and firms like Capco cover amounts in excess of that. (See “Are You Covered If Your Broker Fails?,” Dec. 17, 2007, and “If Your Broker Goes Belly Up, Part II,” Dec. 31, 2007 for more.) A Bear unit is a major securities-clearing firm and therefore handles transactions for lots of regional banks and brokers. The concern is that any failure would jeopardize these trades.

Standard & Poor’s issued a bulletin on March 19 in which it said that Capco is maintaining its A+/Stable rating, in spite of the claims that may ensue in a post-Bear Stearns universe. Of interest is the rating agency’s assertion that “In the event of an excess SIPC claim related to Bear Stearns, Capco should benefit from a guarantee provided by JPMorgan Chase for Bear Stearns’ obligations. In addition, clients withdrawing funds from their personal accounts actually reduces CAPCO’s potential maximum loss.” (Sentence Italicized by Barron’s.)

As the S&P bulletin spells out, SIPC, and excess coverage like that of Capco, is aimed at restoring missing, lost or stolen accounts. They don’t cover a decline in the market value of a client’s investments.

We’re looking at a problem of market value, which was adversely affected by management choices that turned out to be inappropriate, rather than outright theft. Alas, there’s no insurance against poor judgment.

A BARRON’S READER WHO’S A CUSTOMER OF A MAJOR online brokerage and lives outside the U.S. described an interesting situation via e-mail recently:

“I am a long-time investor who generally purchases shares of undervalued micro-caps that are often thinly traded, which I usually hold for periods of over a year. In recent months, my broker is refusing to allow Internet purchases for many of these companies, requiring me to phone a broker. They are vague about why they are doing this; for legal and security reasons, they say. This requirement has even been in place when I wanted to add to a holding that I originally purchased in an Internet trade, and when I tried to adjust the price of an open order by a few pennies.”

My theory, verified by the broker in question, is that the trading pattern—even though it’s completely above board—resembles that of a crooked pump-and-dump scheme that usually involves stealing an online trader’s identity and then redirecting his account to buy securities at huge premiums that benefit the thief. The broker, in my view, is being appropriately cautious, particularly since this is a ploy often used by overseas scamsters. It may be really inconvenient for an honest trader, which is a terrible drag, but it’s just part of the current reality.

The writer’s broker verified that it monitors securities for suspicious activities and will, from time to time, restrict those transactions until the client phones a broker so that the firm can verify that he or she is in fact a client and not an identity thief. “It is for the protection of our clients that we make these decisions, and while we realize that it can be an inconvenience to them, it is done with their best interests in mind,” says the broker.

More patience—or a change in investing strategy—may be needed.

Published in Barron’s, April 7, 2008