Tuesday, October 26, 2010
ETF's are the new rage in investor circles. Correspondingly, a plethora of websites have sprung up to serve this growing interest. Which sites are worthwhile and which ones are a waste of time? I took a close look at 8 of the top sites based on traffic. The following are my findings.
8 ETF internet sites have been identified as the most popular ones.
The sites that will be evaluated are, in no particular order:
Here is a review of the basic background of each of the sites.
MorningStar.com: Founded in 1983 by Joe Mansueto, as an independent investment research company. The firm has grown to provide data on 300,000 investment products including ETFs. They provide several proprietary tools to help investors understand their investments.
Yahoo Finance: A sub site of the Yahoo brand launched in 1983. They are considered to be the top financial and research website in the United States. The site serves over 18 million visitors per month with financial news, quotes, company reports, ETF information, message boards, and a few hosted tools for personal financial management. They also provide aggregated information from dozens of partner sites keeping the content timely
Marketwatch.com: A large market news site owned by Dow Jones. Dow Jones is the leading provider of market news in the world. They own the Wall Street Journal, Barrons and various index names, among many other financial properties. The site contains a massive amount of up to date business and market news to over 6 million monthly visitors.
ETF Database.com: This site is published by a news media site called Accelerize News Media Inc. The parent companies goal is to provide users with comprehensive on line media solutions to reach specific audiences. News served with a side of education is the sites tagline. September was the latest news story posted on the home page. This site appears to be purely a news aggregation website with an ETF theme.
Index Universe.com: A news and research site containing up to date news, opinion and original research. Originally founded by proprietary trading pioneer, Steven Schoenfeld and Jim Wiandt, the site has expanded to a worldwide informational source. It focuses on index funds, ETFs, index derivatives, and passive strategies using these tools. This site provides a deep resource of study for those who want to delve into the inner workings of index products.
ETF Trends.com: This site was founded by author and asset manager, Tom Lydon in 2005. It contains up to date news stories mostly bylined by Mr.Lydon, educational material and an ETF analyzer. The ETF analyzer is a graph showing the past performance of each ETF and basic technical levels. It is always up to date and provides Mr.Lydon’s insights into the world of ETFs.
Trading Markets.com: Founded by Larry Connors, this site provides news, opinion and strategies targeted at the individual investor. Its home page is updated multiple times daily with actionable and current news and strategies. There is a deep resource of educational material from the very simple to that geared toward the sophisticated investor. What separates Trading Markets is their daily specific trade calls and actionable material. The contributors to the site are all market professionals with most being very active traders. This assures that the opinions and ideas provided by the contributors are current and up to date. It is geared toward the active investor with a tag line, “Making Great Traders”.
ETF Guide.com: Founded in 2003, this site contains up to date market news, a little education content and a subscription based ETF portfolio.
When evaluating any informational source, the first thing needed to be asked is how long have they been in business? The internet is full of sites with dubious value. Particularly, in the investment field, it’s important to know that an informational source has weathered several market cycles without closing their doors. Of the 8 leading ETF sites, only Morningstar, MarketWatch, Yahoo Finance and TradingMarkets have been in business longer than 7 years. In fact, startups ETF Database and ETF Trends have only been around a little over 2 and 5 years respectively. Although it’s important to note that older isn’t necessarily better. However, longevity in the internet business is a clear sign of doing something right.
All of the sites provide articles about ETFs. The question becomes is the information something that can be used to help make investment decisions? While most of the leading sites contain excellent data points and facts about ETFs, when it comes to current, up to date and actionable information they usually fail to deliver.
How to evaluate the value of the article content comes down to the investors goals. Is the reader just looking to increase knowledge? If this is the case, then any of the sites will serve the purpose. However, if the investor is seeking actionable, up to date information that teaches how, where, when and why to trade ETFs, the choices slim down considerably.
One must consider if the site actively operates a model portfolio. This is critical because it clearly reveals if the site actually has experience in the real world of trading and investments. While a model portfolio is far removed from an actual cash based investment portfolio. It can and will determine if the philosophy and tactics espoused by the site actually work in real life. Two of the leading ETF sites provide a model portfolio proving that the proprietors are more than simple internet entrepreneurs trying to catch the latest trend.
Another question to ask is does the site maintain a historic record of its recommended trades? This is critical in order to determine if the content is purely theoretical or actually work in real life. In the financial world there are many armchair investors and traders, some of whom appear highly learned. However, when put to the test of the real market, these untested theories often fail. Only a proven, well documented and complete historic record can separate the ETF dreamers from the actual practioners.
Backtesting is a major concept in professional investing circles. Backtesting is the proving of investment ideas over the long term via historical data. Backtesting determines if the theory has real world relevance over time. While a successful backtest will not guarantee success going forward with real money, it can and does clearly show what doesn’t and will not work. A successful back test is often the first step in evaluating trading strategies. It’s important that the backtest include enough historic data to determine the strategies viability across most market conditions. It is often referred to as quantification in academically minded groups. Only one of these sites provides a historic, backtested record of its suggested trades.
Backtesting means little if the site does not share the historic record with the users. This allows the investor to observe how the strategies develop overtime. It should show the good, bad and ugly of the winning and losing strategies. As can be guessed, the only site that provides backtesting also has a clear historic record of the results.
The most important point for many investors, does the site provide actual ETF entry signals? In other words, does the site provide real life, actionable, specific trade calls? The symbol and price level must be provided so that the investor can follow along with the trade in a real or practice portfolio. Without providing this critical information, trade recommendations are vague and easily tweaked to appear successful regardless of actual results. Once again, only one of the 8 sites is willing to put its reputation on the line by providing actual, clearly defined entry signals
As any investor knows, selling the investment is how profits are made real. Trading and investing is far more than simply buying and holding without selling. In fact, trillions of dollars are made but never realized as investors often hold when price drops back from the highs. Selling is the critical factor that determines how much an investment will make or even often if it will make a profit at all. To be actionable, selling recommendations must include specific price or technical level so the investor knows when to take profits or cut losses. Only one of the listed 8 most popular ETF sites provide when to sell information. As can be guessed, it’s the same site that provides specific entry criteria.
An important distinction is whether or not a service is based on the concept of trend following. Trend following often looks good in hindsight showing theoretical profits while the real life execution of such a strategy remains nebulous. Statisticians call this the hindsight bias. Trend following is a feel good method that looks great until it is actually placed into action. Trend followers often miss moves in reality that their theoretical models indicate were caught. This is dangerous ground for a trader/investor often resulting in getting enough multiple small losses to quickly deplete your investment capital. The site that provides entry and exit signals is the same one whose methods are not built upon the shaky, feel good ground of trend following. This sites methods are built upon long term, statistically valid tests and actual real life practice.
Who uses each of the services is another due diligence question to ask prior to trusting the information. Do professional money managers, proprietary traders, and full time investors use the information contained within the site when making decisions? Is the site more geared to weekend hobbyists playing with their lunch money? While it’s difficult to say as an absolute, we know that out of the 8 sites, 3 have a proven and active professional audience. These sites are Morningstar, Yahoo Finance, and TradingMarkets.
The last thing to be determined is there ongoing support from the site? Many of these sites are set up to basically run by themselves providing very little additional help for the investor than what is apparent. Does the site offer ongoing educational and actionable courses/materials that keep up to date with the ever changing world of ETF’s? Several of these sites look stale without much updating or refreshing of the material. Only one of the listed sites appears to be constantly updated with actionable suggestions while on the cutting edge of ETFs evolution.
Posted by marketsurfer at 8:11 AM
Monday, October 25, 2010
originally published on "realworldtrading.com" in 2004
The following is a chat I had with one of Bright Trading's top traders. Enjoy!
Dave: I am joined by professional trader Darren Clifford. Darren came to us with very high recommendations from expert trader and industry icon, Don Bright. Don explains that Darren is on the cutting edge of daytrading methods and techniques. Let's get started. How are you today, Darren?
Darren: I'm doing great, thank you for having me Dave.
Dave: Why don't we start out by learning a bit about yourself and what started you in the market. Your basic evolution as a trader to where you are now.
Darren: Sure, it would be my pleasure. I started in the market about two and half years ago. I graduated with a masters degree in economics. I specialized in financial mathematical modelling.. I didn't even know that this career existed and that you can be a professional trader. On the recommendation of a friend, I went to check out what they were doing over at Bright Trading . Once I saw it, I called them up and began my career. I had to start like a lot of traders, by borrowing money from family to get involved with trading. I started with $5000 as a sponsored trader. I lost that couple of times before I became consistent and successful.
Dave: Did you start out as a discretionary trader, or did you follow Bright guidelines at the beginning.
Darren: I was very fortunate to start in the office in Langley, British Columbia. Rob Friesen, the office manager, a great experienced trader himself does a lot of trading with a specific trading strategy called, Pair Trading. I was able to sit, learning from him to soak up his knowledge,in my first couple of months on the job. That really helped, so I wasn't necessarily on my own. From there I have gone on to be more established and take in more trading strategies that they teach at Bright. Bob Bright is now my mentor, a person whom I trust and keep in contact with in my trading.
Dave: I know Bob has quite a reputation on the street. He is known as being one of the smartest guys out there in the business of daytrading. You mentioned Pair Trading. What exactly is Pair Trading?
Darren: Pair Trading is when you are trading from a hedged position. I would be looking at two correlated stocks like Coke (NYSE:KO - News) and Pepsi NYSE:PEP. I may buy one, and short the other to play the price differential between the two. This allows the trade to be a lot more stable and a lot more predictable. There are a lot of old school traders who crave and love volatility and they just wish the markets would move again. As a professional trader, I don't care a bit about volatility, I care about predictability. Even if something is highly predictable in small patterns, I can trade it in a lot bigger size to make my money out of it. If something is moving all over the place, yet I can't predict where it is moving, it is going to be trouble and I can be losing a lot of money.
Dave: What do you look for when you are setting up a pair trade?
Darren: The first place I will look is intuition. You can go through the NYSE and you may see two companies like Citibank and Harley Davidson. They are both highly correlated with each other. Statistically this may be true, but intuitively give me a justification why Citibank and Harley Davidson are correlated.
Dave: Would there be a justification? To me there wouldn't be any at all. Perhaps when people are happy they buy Harley's and charge up their Citibank credit cards. Other than that, I can see no correlation.
Darren: They are both stocks on the NYSE. They both react to the market but that is where the correlation ends. Because of that, intuitive reason is not there. It is something I would say. Though statistically you may be able to come up with a great model for these two stocks to trade against each other. Intuitively it does not work. The place that we really look would be for Citibank is JP Morgan, Bank One, maybe Bank of America., for Coke, Pepsi.
Dave: Let's take the Coke and Pepsi example. What is the next step after you find a pair that is intuitively correct.
Darren: So now you come up with a pair that is intuitive and it makes common sense. The next step is looking at exactly how they trade with each other. Traditionally, when you have a sector like Coke and Pepsi, there isn't anyone else. There really is only two of them. What you see is that some companies like this don't trade as correlated as you expect. This is due to the money that may flow out of one company is actually flowing into the other one. Yes, we may like the soft drink industry, but right now we favor Pepsi more than we favor Coke;or now we favor Coke more than Pepsi. You can actually see anti-correlated movement even though they are in the same sector. After we have gone through the intuitive basis we take a look at statistically and historically how they traded.
Dave: You do this using technical analysis? You put the pair on a chart?
Darren: Absolutely, we put them on charts and take a look at the correlation between the two stocks. We see if they have traded within a range or some sort of pattern with each other. The big test is when you see news events happened with one of your stocks, and how the stock behaves. For example, you are looking for something that says, 'Coke moved up $4 this morning, did Pepsi move too?" " Did Pepsi move at least $2?" You are looking for a real sign that you have a knowledge based industry, meaning that company sympathy is actually going to occur. When people see coke rally they figure they should buy Pepsi.
Dave: Now specifically, when you set up the chart, is it a daily chart?
Darren: Well, as professional trader you have to appreciate that I trade every time frame. From short,short term to longer term.
Dave: When you say short term do you mean a tick chart?
Darren: Everything from a tick chart, a one minute bar chart, all the way up to a daily, or even a weekly chart. As a professional, I take advantage of every edge that is available to me. This means I may be holding a smaller position for a long time trying to get $5-6, as an investment out of it, or I may be taking a larger position for a shorter amount, trying to take 5-6 cents out of it. For each one of those trades I need to have a justification for my entrance, and I need to make sure I am looking at the appropriate time frame that I am analyzing for actually making that trade.
Dave: Let's talk about the difference between trading and analysis. When you are performing the analysis on a stock pair, is there a specific time frame that you use?
Darren: I will look at everything from the last 1000 days that it has traded on down. You are almost talking about 5 years there, anywhere down to the last couple of minutes. I prefer to take a look at, on the technical aspect of it, most of my trades intra day, then the last 20 days of data.
Dave: What type of chart do you use?
Darren: Generally a candlestick chart with a moving average and some Bollinger bands.
Dave: I know you trade with a theory that trys to develop each pair as an individual business model. Please elaborate a little on this idea.
Darren: This is something that should apply to all trading strategies regardless of if you are pair trading, momentum trading or something else. Every time you approach the market, you are an independent business person. This is your job, this is your company, you are a trader. As you know, every company before it starts has a business plan.
Dave: Ok, so this is what you mean when you treat each pair as an individual business? The trade itself has its own plan.
Darren: Absolutely, even the small scalp have a plan. They are just like micro-buisiness. This is the place where I take profits, this is where I exit, this is where I take a loss. Everything has a known entry and exit before I even begin. This way I am trying to take the emotion out of it.
Dave: Is this a written plan, or is it something you do mentally?
Darren: For my new traders, absolutely it is written. Even their small trades I have them write down where they are planning to enter and exit. For the shorter term trades, the less likely I am to write it down. But for the longer term trades, everything is written down.
Dave: The other word for pair trading is statistical arbitrage. Does that refer to a reversion to the mean type strategy?
Darren: Well, within a pair, you have to appreciate that there is actually a reversion that should occur. The natural way that free market economics works is that you should have a leader in every sector who has all the technologies, then these technologies being adopted by the secondary companies in the sector. You constantly see one company taking advantage of new technology, and taking a lead with their stock price.The other companies within that sector adapt to the new technology and catch up with the leader.
Dave: Like a follow the leader idea?
Darren: Absolutely, it's free market economics at work. You get a new technology that assists them, then it comes back to equilibrium, or at least starts reverting back. This is something that does not actually occur within the individual stocks. Mathematical modeling of the stock market as a whole, is said to be a random walk. While there is an upward drift to it. The idea is that we are going to go up in time but there is no reason that since the market rallied up 1000 points in the Dow that we should actually see it come back down. Within a pair, there is a reason that says when one company rallies $20 ahead of another company they will go back into line. Here is one reason why, the other company is going to take a look at what their peer is doing, adopt the successful technologies to catch up.
Dave: Let's say we are following a pair that has had very strong correlation within the last 20 days, I am just using this as an example. That all of a sudden they veer off. Lets say Coke starts going up, and Pepsi starts going down. In a situation like that would you then short the stock that is going up and buy the stock that is going down, betting that they are going to come back into correlation? Or does it all depend?
Darren: There are exceptions to every rule, but on average my trading strategy tends to be . I am fading moves so I'll take the opposite side in this case. If Coke pulls back like it has, which has happened in the last couple of months, I am buying Coke and selling Pepsi. I am expecting it to revert back to a mean between the two companies.
Dave: You guys take pair trading to what seems to be the next level. You go beyond the simple pair into 3, 4 and even 6 way trades. Can you explain?
Darren: One of the most profitable strategies we have is trading one company against a second company. Going into a sector like oil where there are an assortment of similar companies that do similar things. Then you start looking at them and ranking them fundamentally, and technically. I then get myself a list of these companies I want to buy, and those companies that I want to short.. What this allows me to do is take a position in a basket going long and take a position in a basket going short. Say you have maybe $500,000 in capital, as a new trader. Then be able to transfer the risk based on which one is actually performing well and which one is not. It allows you to move in and out of the different stocks between all six of them. You can capture within the basis of the relationship the predictability that is there, but you are getting more volatility to capture bigger moves and more of the moves.
Dave: Ok I see, you are limited to your capital as to how many stocks you can do this with across a sector?
Dave: How many different stocks have you ever traded at one time, using this method? Have you gone as far as almost creating a small index?
Darren: Probably the biggest I have done is a 5-way pair. Two companies long, two companies short, and one company as neutral as the middle, where I either long or short it. It allows you to play all five against one another. If one really rallies, you are able to sell another and buy more of that and are able to hedge it. It really works out well for me.
Dave: I know you said earlier that volatility doesn't really matter to you, but is there any way you can play these pairs as a momentum trader would?
Darren: Well you can always trend trade a pair. You can setup your pair just like you would an individual stock. The type of thing you are looking for is higher highs and lower lows, buying on pullbacks. You can even do traditional technical analysis, things like MACD, and RSI, put them on the pair themselves. Now with doing this you can actually look at everything a regular trend trader would be looking for. I want my long stock to have increased volume on its up days, buying that to continue more of the trend, and hedging that off with some other stock that you want to go in short that is not showing momentum characteristics.
Dave: Okay, lets get off of pair trading and get onto another one of your strategies. I know Don is really big on a strategy called "opening orders". Do you guys utilize this method?
Darren: Absolutely, but I do have to revert back to pair trading here. One of the things that we do on our open is we use them within a pair trading context. For example, if I see an extreme open on one stock, I'll take a look at its peers to see what its peers are doing. If I see Coke is gapping down $1, not only will I be buying Coke, but I am going to sell Pepsi against it.
Dave: For our members that may not know anything about "opening orders" Please give me a brief tutorial and explain the concept.
Darren: Basically, you are fading opening gaps on the expected price on the stocks open. You are looking at a stock like General Electric. It generally is a market performing stock and it behaves correlated to the S&P 500. You watch the futures contract of the S&P 500 in the morning to see if the futures contract is up .5%, you expect GE to be up .5%. Now if GE opens up 1.5% you are going to short it. You are going to fade that extreme open of General Electric. If GE opens down .5% you would buy it. You would say it opened below where you would expect it to in comparison to the S&P 500.
Dave: You are placing multiple orders above and below the price? So you are basically enveloping the price?
Darren: Basically enveloping the expected opening price. Taking a look at the morning, and we have automated programs that do it, all the way up to about one minute before the opening bell. I will look at if the S&P futures contracts have moved, and the E-minis right now, where I expect the market to open. Using that information I make an estimate of where I think my stock should open, and that is where I envelope.
Dave: Once the order executed, do you just take it for a couple of ticks or do you take it for as long as it will go?
Darren: To do the entry is actually a very easy thing for an experienced trader, once you get into the habit of it. The entry side is always the place where traders have difficulty. This is what being an experienced trader really means. When you do get in to a position, how you manage getting out. There are times where you just take it for a couple ticks, there are times where you pair it off, there are times where you turn around and just take a loss as soon as you can. It all depends what you see on the tape.
Dave: How many opening orders do you throw out in the morning?
Darren: On any given morning I may have 600 open orders out there.
Dave: Wow, obviously this is something that is computerized?
Darren: It all depends on the approach you are taking. Some people who just like focusing on the broad market, and focus the strategy on five different pairs and only five pairs. Everyday they do the same stocks over and over again. But they become very familiar with their stocks.While I am putting an order quite away from the expected opening price, they may be looking at putting it five cents from the expected opening price, and not get in. They become a lot more aggressive to get more fills.
Dave: Let me see if I understand you. You place your order five cents away from the opening price and if you get filled you are betting the momentum would carry that price forward resulting in profits?
Darren: No, not exactly, let's say you are looking at a stock that closed at $40. You expect it to open at $40.50 the next morning because the S&P is up quite a ways. Then what I am doing is taking a price like $41, and I am shorting. At a price like $39.50 I am buying.If I get the $41 short then I expect it to come back down to that expected open price of $40.50. So in that case I have faded the gap open.
Dave: Man, it looks to me, if you have 600 orders out there, often, when you try to fade a gap, the stock will just keep ripping. Is this the case?
Darren: It happens more often than I would like it to happen. That is when the advantage of being an experienced trader comes in. If I see an opening price of $41 where I have sold it and I notice that, first off, going through that open is an indicator to me that it wasn't as good as I thought it was. It should be that the opening is quite often the extreme for the day for a lot of stocks. So that should be a great trade, I should see some instant gratification there to it and if I don't see some resistance building on that opening price and others aren't coming in and saying 'Wow, I missed the plane, I need to get it up here at this price,' then it is probably better off getting out. If I do get into a position where it is running hard against me, I'll find another stock that is sympathetic to it and I'll buy twice as much to balance out the position and turn a profit.
Dave: Buying the stock that is sympathetic to the one that is ripping against you. Do you have software or some sort of program to instantly locate these candidates?
Darren: I have a quote window on my screen that tells me what all the pairs in a sector are doing. If I do hit something like Citibank, and I am struggling with that open, I can just glance at my screen. If Citibank is up a dollar, JP Morgan is up 50 cents, Bank of America is flat. Well maybe JP Morgan is moving much more sympathetically to Citibank.
Dave: I know that you guys have software that specializes in finding gaps. Tell me a little about your gap system.
Darren: Absolutely. If you take this strategy of enveloping that we have been doing at the open, and carry it forward into the middle of the day. In this case, what you are looking at is gaps. Traders are paid on the NYSE in one of two ways: 1. Finding inefficiency, something that is undervalued or overvalued that shouldn't be. 2. We are trying to take on the roll of a market maker which is to provide liquidity. This is a service to the market, and over the long term you should get paid for it. What we are doing is putting envelope orders out around the last print of the stock, so that if it gaps 20 cents or 25 cents, you are providing liquidity for that gap. This strategy is something that, especially if you go back to the late 90s, early 2000 period, the way that the market was behaving, was probably one of the most successful strategies that was there for our traders. They were able to provide liquidity in situations that were trading, and if things did not work they had the other side to sympathetically use to make sure they were not getting overly hurt.
Dave: This has been a very insightful conversation. Is there anything you would like to leave us with?
Darren: We do offer some mentoring and training up here with our company. You can look at our website . There is a group of us, so feel free to look us up. We are always looking to improve what we are doing and to help the trading community.
Dave: Do you have remote traders?
Darren: Absolutely, we have traders all across North America and some internationally.
Dave: To trade in Canada, do you need to have a series 7?
Darren: Yes, you do need to have a series 7. Currently the only province we have license to trade in Canada is British Columbia and that is because we all trade through Bright. That is the province Bright is licensed to trade in. We do have a number of traders here. Our Langley office is actually our second largest office.
Dave: What is the minimum capital contribution from a trader?
Darren: A mentor trader through us is $10,000 as a minimum capitol contribution. You do come spend two months time with us in British Columbia
Posted by marketsurfer at 10:21 AM
Thursday, October 21, 2010
At 9:00 PM EST this evening CNN will air Almighty Debt. "Fighting Debt From The Pulpit" A Black in America special documentary. The pastor featured akins debt to being worse than slavery. While there are certainly correlations between being a slave to debt and real slavery, one must never forget that one was voluntary and one was forced. Comparing the two is ridiculous and only serves to demean those who actually have suffered under true slavery. There is a huge difference, CNN. While debt can be debilatating to many, debt is due to personal choice regardless of your race or education level. It is disturbing to see people blame everyone but themselves for their predictiment. The American legal system has a tool known as bankruptcy that is designed to help those who got in over their head. America believes in second even third chances, too bad the media insists on wallowing in the negative. Wonder what their true agenda is? See the trailer here: http://www.cnn.com/video/#/video/us/2010/09/23/inam.trailer.almighty.debt.cnn
Posted by marketsurfer at 2:07 PM
Tuesday, October 19, 2010
Reading the attached insider memo from Wells Fargo sent a chill up my spine. It appears they are preparing an aggressive and vicious counter attack against underwater home owners who are challenging the legality and validity of their mortgage contract. While they are certainly legally permitted to challenge challenges to their paperwork, some of the things listed are clearly out of line. An example is the appraisal reevaluation. At the time of the note, the bank trusted and used an outside appraisal company. Now it appears they will be determining the past value based on inside analysts to search for appraisal fraud. Property appraisal is an art not a science--- going down this road will only give the banks the power to twist things anyway they wish. This is simply just one example of the viciousness of the memo against the public. Politicians and banks need to think long and hard before allowing or implementing draconian measures against an already stressed public. "All your homes are belong to us", says Wells Fargo regardless of legality it seems. This is how rebellions and revolutions happen. Don't say you were not warned.
Wells Fargo Funding
Repurchase and Rescission Process Overview
This information is for use by mortgage professionals only and should not be distributed to or used by
consumers or other third-parties. Information is accurate as of date of printing and is subject to change
without notice. © 2010 Wells Fargo Bank, N.A. All Rights Reserved.
A New Reality for Repurchase and Rescission Requests
In today’s mortgage market, repurchase and rescission requests from investors and mortgage insurance companies (MI companies) have become commonplace. This has been driven by the increase in delinquent borrower accounts, as well as the liquidation of foreclosed properties. These macro-economic changes have prompted increased investigation into potential breaches of representations and warranties.
Wells Fargo is committed – just like you are - to honoring contractual obligations with investors and mortgage insurance (MI) companies*. We want to ensure that the resolution process for Repurchase and Rescissions is as smooth and swift as possible.
Some demands can be rectified simply by obtaining missing documents. But more often, as you know, the demand process is more complex. Demands are generally received in connection with misrepresentation of income, occupancy, employment, or regarding undisclosed debt or mortgages, and valuation concerns.
Improvements to the Process
Because of the complexity of each demand, the numerous ways to resolve them, and the seriousness of these issues to both of our businesses, Wells Fargo is taking steps to improve the demand process.
Here are some changes and tools we’re implementing to improve the process:
Enhancing communication and collaboration with our clients by:
o Engaging you as early as possible.
o Working closely with you to clear deficiencies discovered on the loan during investor audits.
Repurchase and Rescission Scenarios Exhibit – This document provides insight on how Wells Fargo approaches many of the most common demand issues.
Improving our demand process (outlined below), effective October 18, 2010
*In this communication, investors and MI companies are collectively referred to as “investors” and reference will be made to both repurchase demands and MI rescissions jointly as “demands”.
Overview of Wells Fargo’s Demand Process – Effective October 18, 2010
Wells Fargo receives a deficiency notice or demand from the investor. Typically, Wells Fargo has 60 days to resolve the issue.
Wells Fargo notifies the Seller and provides supporting documentation when available. At this time, the Seller is given twenty-one calendar days to provide an explanation, facts or documentation to demonstrate that the mortgage loan complies with the requirements. If the Seller does not respond within 14 days of the initial notice, Wells Fargo will follow up with the Seller.
(Continued on page 2)
Wells Fargo Funding
Repurchase and Rescission Process Overview
This information is for use by mortgage professionals only and should not be distributed to or used by
consumers or other third-parties. Information is accurate as of date of printing and is subject to change
without notice. © 2010 Wells Fargo Bank, N.A. All Rights Reserved.
Overview of Wells Fargo’s Demand Process (Continued)
Wells Fargo will begin internal research (concurrently with Step 2) to resolve the loan issues. During this process, Wells Fargo will determine if there is a missing document and if the document can be located.
For all other issues, Wells Fargo will perform research to determine if there is evidence that proves or disproves the validity of the issue. For example, if the investor provided a review appraisal indicating a value deviation, Wells Fargo will order an independent appraisal review of the origination appraisal and the investor’s review appraisal from a third party vendor.
The Seller responds to Wells Fargo’s request and either agrees with the investor’s findings or provides an explanation, missing documents or information for Wells Fargo to utilize in drafting an appeal to the demand or MI rescission notification.
If an appeal is not practical, based on all the information collected, Wells Fargo will notify the Seller, allowing them a final opportunity to provide additional documentation.
If an appeal is submitted to an investor, the Seller will be notified of the result of the appeal. If the Seller provided a response that specifically addressed the investor's issues and the investor deems the information to be insufficient to rescind the repurchase demand or MI rescission, the Seller will be given seven (7) calendar days to provide new documentation to support a second appeal. (Please note: Even if documents are provided by the Seller, the appeal may not be successful).
If attempts to refute the demand or MI rescission are unsuccessful, Wells Fargo will be obligated to repurchase the loan from the investor or accept the MI rescission. Likewise, Wells Fargo will issue a demand to the Seller for the repurchase of the mortgage loan pursuant to the provisions of the Loan Purchase Agreement or reimbursement for costs and expenses, if applicable.
• Send repurchase letter questions to our mailbox at IRMRepurchaseResponses@wellsfargo.com. The mailbox is monitored daily with replies to inquiries completed within 3 business days, or
• You may contact a member of your regional sales team.
Shared Vision, Shared SuccessSM. Together, we can achieve long-term industry success. Learn more today.
Wells Fargo Funding
Repurchase and Rescission Scenarios Exhibit
Page 1 of 6
When an MI rescission or repurchase demand is received by our Wells Fargo Repurchase Operations team, Wells Fargo will research the issues to determine if there was a breach of a representation or warranty, or non-compliance with a term of the Mortgage Insurance policy.
If there is no breach, the analyst will appeal the repurchase demand or MI company decision.
If there is a breach, the analyst will recommend the loan for repurchase. If the loan is recommended for repurchase, the recommendation is escalated for a second level review. The final determination to repurchase or appeal the demand is made in the second level review.
The matrix on the following pages provides insight into how Wells Fargo analysts review each demand to help determine if there is a breach of a representation and warranty. Examples provided in the matrix are not all inclusive, but represent some of the more common and complicated types of MI rescissions or repurchase demands.
Note: This information is provided as general guidance only and does not change, alter or modify any contractual obligations between Wells Fargo and the Correspondent Seller. Individual cases may vary. Information provided below is subject to change at any time and without notice.
Action/test performed by Wells Fargo
How you can help
Definition: The borrower has additional debt that was obtained prior to the closing of the subject loan, but it is not reflected on the origination credit report or application. It is not included in the qualifying ratios for the subject loan.
Was debt included in the original underwriting calculations?
What date was the debt opened? If it was opened in the same month as the loan closing date, the exact date must be verified to ensure that the debt was opened prior to closing.
Does the new DTI, including the undisclosed debt, exceed the allowable DTI for the program?
Provide evidence that the debt was included in the qualifying debt ratio.
Provide documentation that the debt was opened after the subject loan closing date.
Provide debt ratio calculations documenting that the debt ratio would have remained at an acceptable level.
Provide documentation that the debt or a portion of the debt was eligible for exclusion from the debt ratio (e.g. provide lease if the property was a rental).
Wells Fargo Funding
Repurchase and Rescission Scenarios Exhibit
Page 2 of 6
Action/test performed by Wells Fargo
How you can help
Definition: The occupancy of the subject property is misrepresented in an effort to obtain more favorable financing options.
The decision to repurchase for this breach is based on an evaluation or weighting of the evidence presented. As a general principle, Wells Fargo considers occupancy misrepresentation documented if the answer is “yes” to at least two of the following:
1. Does the appraisal indicate that the property is tenant-occupied?
2. Is the homeowner’s declaration page reflecting a landlord policy?
3. For a refinance - is the documentation provided to verify income and/or assets reflecting a different address for the borrower?
4. Is the distance between the subject property and the borrower’s employment unreasonable for commuting?
5. Is the property tax statement for the borrower reflecting a different mailing address?
6. Did the borrower change their mailing address for servicing communication?
7. Does a reverse directory search of the borrower’s home phone reflect a different home address?
8. Is there documented verification that the utilities are not and have not been in the borrower’s name?
9. Are there public records (driver’s license, voter registration, homestead exemption) that indicate the borrower never moved into the property?
10. Do the bankruptcy discharge papers indicate a different home address for the borrower for the timeframe following closing?
11. Is there documented communication between the borrower and a third party investigator indicating the borrower never occupied the subject property?
Provide documentation that proves that the borrower occupied/ occupies the subject property.
If the borrower intended to occupy the property, but did not, provide an explanation for the extenuating circumstances that prohibited the borrower from moving into the property.
Offer an explanation and documentation to refute the evidence provided (e.g. the address that the borrower is utilizing for servicing correspondence and property tax records is actually their business address).
Wells Fargo Funding
Repurchase and Rescission Scenarios Exhibit
Page 3 of 6
Action/test performed by Wells Fargo
How you can help:
Definition: The income information and/or documentation that were provided at origination were either altered or falsified.
Does the new income documentation provided reflect the same time period as the 1003 application?
Is the new income documentation re-verifiable? If re-verification is not possible, is the investor’s documentation clear and complete?
Was the original documentation altered or falsified?
Does the DTI utilizing the new income exceed an allowable DTI for the program?
Provide documentation that the verification provided does not represent the same time period as the 1003 application.
Provide new documentation (verbal or written) that supports the original income documentation.
Definition: The employment status (self employed vs. W-2; Full time vs. Part time), dates or job title are misrepresented on the loan application and supporting documentation.
Does the documentation provided reflect the same time period as the 1003?
Are the differences in employment substantial? E.g. was the verified profession essentially the same as the stated profession (supervisor vs. manager).
Is the documentation re-verifiable? If re-verification is not possible, is the investor’s documentation clear and complete?
Provide documentation that the verification provided does not represent the same time period as the application.
Provide new documentation that supports the original verification.
Wells Fargo Funding
Repurchase and Rescission Scenarios Exhibit
Page 4 of 6
Action/test performed by Wells Fargo
How you can help:
Definition: The original appraiser did not follow USPAP or FIRREA standards when developing the origination appraisal.
Wells Fargo will order an independent third party review of the origination appraisal and the review appraisal from a vendor (at Wells Fargo expense).
As part of the review process, the vendor will:
Obtain a property detail report for the subject property that contains an aerial photo of the subject property and additional sales,
Verify the sale date, price and history for all sales referenced within any of the appraisal reports provided,
Verify the appraiser’s licensure,
Ensure that the appraiser was appropriately licensed as of the effective date of the appraisal and make note if the license had been revoked at any time,
Analyze market conditions as of the effective date of the appraisal and pull additional market trend data if necessary,
Summarize all items of note, in the form of an e-mail, to be addressed by the original appraiser. MLS sheets for the sales that have been utilized will also be requested, in addition to any other additional local market support that is available. Items of note will include, but are not limited to:
o Concerns or discrepancies noted by the local market review,
o Concerns noted within the MI Rescission letter or Demand Request,
o Reviewer concerns not noted by the local market review or rescission letter.
After a response is received from the original appraiser, the vendor makes a determination about whether or not the value was supported as of the effective date of the appraisal.
The Wells Fargo analyst will determine the following:
Does the review support the original value?
Does the reviewer state that the original appraisal contains USPAP or FIRREA violations?
Encourage the origination appraiser to provide the Wells Fargo vendor with all requested documentation.
Provide an independent review appraisal that supports the original appraisal.
Wells Fargo Funding
Repurchase and Rescission Scenarios Exhibit
Page 5 of 6
Action/test performed by Wells Fargo
How you can help:
Definition: One or more required documents were not delivered to the investor.
Was the document applicable or required?
Can the document be located on the Wells Fargo imaging system?
Can the document be retrieved by contacting the original provider (e.g. missing title policy)?
Provide the document that is being requested.
Provide evidence that the document was not required or applicable.
Can the document be retrieved by contacting the original provider or a third party vendor (e.g. missing title policy)?
Definition: Investor determines that the loan did not meet State, Federal or Agency guidelines or regulations.
Wells Fargo’s Compliance Department will conduct a compliance review specific to the compliance issue raised by the investor.
Their review includes:
A determination as to whether the cited regulation applies to the loan,
Testing the loan according to the appropriate regulations.
Wells Fargo determines the following:
Did the loan pass the compliance test?
If the loan did not pass, do the specified regulations provide for a curing of the issue?
Provide the original compliance testing calculations and results indicating a pass for the issue identified by the investor.
Provide evidence that the regulation is not applicable to the loan.
Provide proof that the issue was cured prior to delivery, if allowable and applicable.
Provide documentation to prove that
Posted by marketsurfer at 8:16 AM
Saturday, October 16, 2010
Dave: Let's start off by getting a bit of history about yourself. I know you have had tons of experience in and around the option markets. What first got you interested in options?
Charles: I was an accountant. I use to track the transactions of my clients and I got very interested in the workings of options. I then had the opportunity to visit a friend who was trading on the floor. This was an amazing new world that I never even knew existed, even though my office was just down the street for years. I worked at a family accounting firm during the summers. At this point, I was a year out of college and I visited the floor. Several of my friends were starting to trade futures. Futures did not attract me, but options seemed intriguing. It seemed like you really could control the risk. I went to a free seminar and came back to the office and said "I'm giving a years notice to this family business of 65 years." Then I went down to become a trader.
Dave: Wow, that took some nerve leaving the security of the family office. We are talking about Chicago and the CBOE?
Dave: What was your evolution on the floor? Did you start out as a clerk or did you step right into trading?
Charles: I stepped right into trading. I read a few books and figured I didn't have to go that route. The market told me differently, because 6 months later I lost all my money. I just didn't understand things. I thought when the customers were buying I could just take the other side and bet against them. I had no idea on how to take on an inventory of options. The other guys in the pits seemed to be so emotionless about every single trade they made. I was riding on every single contract that I had. I was basically hoping, praying and doing all the wrong things.
Dave: What was the path between being a losing trader and the thinkorswim brokerage launch?
Charles: There was a lot of in between. I went back to trading and I was a clerk for a while. I latched onto a fellow who was leaving his job. He was a Spread Hunter for some market makers on the floor. He wanted to become a market maker and needed to replace himself. I got the nod that he would train me. This is about the time that I was offered a job by someone who would eventually back the owners of thinkorswim. I turned that down because I was on a mission to learn everything that there was to know about options. I let Tom Sosnoff get the job, he now runs thinkorswim. We have had a very long friendship. At that point I went down to the Board of Trade to trade. I traded for many years and then Tony Saliba started The International Trading Institute and I wanted to take a breather in the late 80s, I decided to gallivant around Europe and when the new electronic exchanges were sprouting up, I started teaching market making in Europe. I wrote all the course material for The International Trading Institute and delivered all the content to the banks in Germany, Spain, Austria, and Denmark. That was about a five year tour of duty for me. Two of the years were in Europe, then I was in Madrid for four or five months, spent four or five months in Sweden and just had wonderful time. I learned a lot about electronic trading.
Dave: Is that the impetus for your book, Options---Perception and Deception and Coulda Woulda, Shoulda? Which by the way, I consider the best options book ever written.
Charles: Thank you. Yes, and for thinkorswim. I dreamt up the concept of thinkorswim after that whole journey, Tom came up with the name. I called Tom with the idea after waiting to hear from companies like E*Trade concerning my concept. Tom said, "Hey we can do that." But he was not anxious to build spreading into the platform. I insisted to build the spreading technology if he wanted me to come on board. I still have the email from 1999,about a year before we even started the business, saying "Though I am inclined to believe and agree with you that spreading is the way to go, the CBOE is going to have their one-year anniversary for the last time they had a spread. They are going to have that party next week."
Dave: I hope he was joking. Tom can be a character!
Charles: Yes, It was a funny joke. However, I insisted and he said that we would build it. When we built it, we had built it before even I could accept an order. So the day they opened their doors electronically, we were firing spreads into the exchange! Today about 90% of thinkorswim business is spread orders.
Dave: Earlier you mentioned the term, Spread Hunter, can you explain to our members what this is?
Charles: Well, before all these computers that had software that scans the market to hunt down certain spread criteria, we had to manually pull them up to see if there were any good spreads in the market.
Dave: So you were actually looking for spreads to put on, not searching for existing spreads to knock out.
Dave: Many traders are scared of options, do you have any words of advice to someone just starting in options and learning the options language?
Charles: I agree with you. It is a scary thing, especially if someone doesn't learn it properly. That is why in the first paragraph of both of my books it says, "Stay away from options." Then in the second paragraph it says, "Oh, you are still here? You better educate yourself because there are a lot of things that can blindside you." In my book there is more about losing money than there is about making money. The way that I go about teaching it is by a market makers standpoint. I found through revamping Options: Perception and Deception was a book for market makers into a retail product that we gave as the Think or Swim guide to options which is now available for download atwww.riskdoctor.com at no cost. If you jump right into the last chapter of it, which in the new version is the first chapter, you will see an email dialogue for two months with somebody. A lot of the jargon and nomenclature addressed there in the normal conversation of email back and forth as I help this fellow manage his first electronic trade. To support that, the first chapter is called "Picking Up Where The Rest Leave Off: Synthetics." It dives right into using synTools and boxTools. These synthetics are where the market makers can turn around the way they look at the position and understand it a whole lot better. For example, one of the first examples in the book is the covered write which is a very popular thing. You ask the same person who is excited about doing covered writes, "Would you sell naked puts?" The answer is 'No.' But you can prove to them, using these market-maker tools that I have assembled that have been used on the floor for decades, they see that it is exactly the same thing as a short put, penny for penny.
Dave: What exactly do you mean when you say 'synthetic?'
Charles: Well, it's something that is equivalent to something else. You have a package of two different items that emulate or impersonate another one. For example, a long stock and a short call behave the same way as a short put. So if you have the long stock and the short call, and I had a short put, you and I would have the same future. We would have the same profit and loss outcome.
Dave: You are creating something by combining two or more things, mirroring the result. Am I understanding?
Charles: Yes, that is exactly right.
Dave: Let's go a little deeper and look at several different market conditions and discuss which option strategy would work best for each condition.
Charles: That is the idea behind thinkorswim. The idea where you had to teach people about spreading because back then in the late 90s and early 2000, in that era, premiums were so high that you can only sell premium if you wanted to make money. But selling naked premium was prohibited from a risk and margin standpoint. The only thing else was to buy the option. Well, buying the option was prohibitive because it was too costly. So what's left, Spreading. Limited risk, short premium is a very good way to consistently make money, but you have to have in your arsenal of tools that are able to take advantage of any market. Buying long premium, one usually has to be really right. It's probably best to use a vertical in most situations.
Dave: Long premium is just betting on the stock going up with a call?
Charles: Well, that is one way, but you can also buy put premium. You can also buy straddle or strangle premium which is buying for both directions. You are buying a call and a put so you can take advantage of a move in either direction.
Dave: Many people reading may not know what you mean by 'vertical.' Please explain what you mean by this term.
Charles: Sure. A vertical is an option position composed of either all calls or all puts with long options and short options at two different strikes. The options are all on the same stock and of the same expiration, with the quantity of long options and quantity of short options netting to zero.
Dave: Would one use a vertical if they are bullish--or bearish on the stock?
Charles: Both. There are long call verticals.
Posted by marketsurfer at 12:08 PM
Thursday, October 07, 2010
One often hears the term "killer app" in the high tech world. It refers to any program or application that becomes a necessary part of the platform. In other words, the system just isn't the same with out this application.
Developing the killer app is the goal for most programmers. Everyone now seems focused on the next killer app for Apple's iPhone platform. Traders are also constantly on the search for the next Holy Grail indicator or killer app that will place the odds of success solidly on their side.
In an earlier article, I talked about how the 2-period Relative Strength Index (RSI(2)) is an excellent short term indicator for stock trading (if you missed it, read it here). Our research has taken the basic building blocks of the RSI(2) concept to build a true killer app technical analysis tool.
This tweaked usage of the RSI(2) concept is known as the Cumulative RSIs Strategy. It's a very simple method that has proven itself over extensive testing to be a true killer app in the world of indicators.
Cumulative RSIs are a running daily total of RSI(2) readings. Basically, one adds up the daily RSI(2) figures to get the cumulative reading. The strategy was tested on the SPY from inception to December, 31 2007. The results were impressive. Using a 2-day Cumulative RSI(2) reading of less than 35, 88% of the trading signals proved correct.
In fact, after tweaking the parameters a little, the system nailed almost all of the SPY gains over these 15 years but was only exposed to the market less than 20 % of the time.
You can find further details of these tests in Larry Connors' book "Short Term Trading Strategies That Work".
Does this system work for stocks or is it simply an index based method? We discovered that if you would lower the Cumulative RSI(2) to 10, 69% of the stocks tested showed profits.
Posted by marketsurfer at 1:18 PM
Tuesday, October 05, 2010
One of the most popular and widely quoted technical analysis tools is called Market Breadth. Barely a day goes by without the financial media mentioning this indicator. Market Breadth measures the number of stocks advancing over the number of stocks declining during each session. The Market Breadth theory states that the market is believed to be healthy if advancers outnumber decliners. The wider this spread becomes, the more likely the market is to continuing advancing per the traditional theory. The opposite is also an accepted tenant of Wall Street. When declining issues outnumber advancing issues, the market is believed to be weak thus due for decline. This Market Breadth theory is well entrenched in the minds of most financial professionals as well as retail investors. A cursory internet search reveals that it is by far the dominant idea regarding Market Breadth.
We decided to take this well accepted theory, that seems to make perfect sense, and put it through vigorous, statistically valid tests. What we discovered is quite surprising. Not only is the accepted idea wrong, the opposite proved to be true. An 8 year period was tested revealing that the traditional wisdom could not be more wrong. We tested advancing issues being greater than declining issues for multiple days in a row, as well as, sessions that advancing issues outnumbered declining issues by a 2 to 1 and 3 to 1 margin. The results of the tests left no ambiguity, traditional wisdom is completely wrong. Here is what was found out.
Consecutive days of declining issues greater than advancing issues on the NYSE has led to higher prices short term. We considered one week to be short term for purposes of the testing. The testing also discovered that significant underperformance occurs when advancing issues outnumber declining issues when the market is trading under its 200 day Simple Moving Average. Another finding that flies in the face of conventional wisdom is that weak breadth days outperform strong breadth days over the short term.
It makes so much more sense to trade on the side of statistics and solid testing than to merely accept Wall Street’s often wrong wisdom.
Posted by marketsurfer at 3:23 PM
Sunday, October 03, 2010
Inspired by Vanity Fair's recent piece on how to be a hedge fund honcho, thought I would republish my interview with hedge fund lawyer, Hannah Terhune
Traders and money managers often dream about one day running their own hedge fund, managing large sums of money, and competing head to head with the world’s top traders. For many, this dream remains an unfulfilled desire since they really don’t know where to begin. My guest this week will answer your questions, simplify this often complex subject, and point you in the right direction.
Hannah Terhune is chief attorney and member manager of Capital Management Services Group.com, Inc. Get ready for a tours de force education!
Dave: Greetings Hannah, Thank you for joining me today. Let’s start right at the beginning. Exactly what is a hedge fund?
Hannah: Although there is no universally accepted definition of the term hedge fund,” the term generally is used to refer to an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which are not registered as an investment company under the Investment Company Act. Alfred Winslow Jones is credited with establishing one of the first hedge funds as a private partnership in 1949. That hedge fund invested in equities and used leverage and short selling to “hedge” the portfolio’s exposure to movements of the corporate equity markets. Over time, hedge funds began to diversify their investment portfolios to include other financial instruments and engage in a wider variety of investment strategies. Today, in addition to trading equities, hedge funds may trade fixed income securities, convertible securities, currencies, exchange-traded futures, over-the-counter derivatives, futures contracts, commodity options and other non-securities investments. Furthermore, hedge funds today may or may not utilize the hedging and arbitrage strategies that hedge funds historically employed, and many engage in relatively traditional, long-only equity strategies. In short, the term generally identifies an entity that holds a pool of securities and perhaps other assets that does not register its securities offerings under the Securities Act and which is not registered as an investment company under the Investment Company Act. Hedge funds are also characterized by their fee structure, which compensates the adviser based upon a percentage of the hedge fund’s capital gains and capital appreciation. Hedge fund advisory personnel often invest significant amounts of their own money into the hedge funds that they manage. As discussed in the Report, although similar to hedge funds, there are other unregistered pools of investments, including venture capital funds, private equity funds and commodity pools that generally are not categorized as hedge funds. Hedge funds are often compared to registered investment companies. In addition, unregistered investment pools, such as venture capital funds, private equity funds and commodity pools, are sometimes referred to as hedge funds. Although all of these investment vehicles are similar in that they accept investors’ money and generally invest it on a collective basis, they also have characteristics that distinguish them from hedge funds.
Dave: When did this concept originate? Briefly, what’s the history?
Hannah: Hedge funds, while representing a relatively small portion of the U.S. financial markets, have grown significantly in size and influence in recent years. The SEC recognized over 30 years ago that hedge fund trading raises special concerns with respect to their impact on the securities markets. The growth in hedge funds has been fueled primarily by the increased interest of institutional investors such as pension plans, endowments and foundations seeking to diversify their portfolios with investments in vehicles that feature absolute return strategies – flexible investment strategies which hedge fund advisers use to pursue positive returns in both declining and rising securities markets, while generally attempting to protect investment principal. In addition, funds of hedge funds (“FOHF”), which invest substantially all of their assets in other hedge funds, have also fueled this growth.
Dave: What are the parts of a hedge fund?
Hannah: The parts of a hedge fund include the private placement memorandum, the subscription agreement, and the operating agreement for the fund. Hedge fund advisers typically provide information to investors during an investor’s initial due diligence review of the fund, although some, more proprietary, information may not be provided until after the investor has made a capital commitment to the fund, if at all. Most hedge funds provide written information to their investors in the form of a private offering memorandum or private placement memorandum (“PPM”). This reflects market practice and the expectations of the sophisticated investors who typically invest in hedge funds. It also reflects the realization of the sponsors and their attorneys that the exemptions from the registration and prospectus delivery provisions of Section 5 of the Securities Act available under Section 4(2) of the Securities Act and Rule 506 there under do not extend to the antifraud provisions of the federal securities laws. The disclosures furnished to investors serve as protection to the principals against liability under the antifraud provisions. Some of the information may be disclosed less formally in one-on-one conversations between investors and the hedge fund adviser. Hedge fund advisers may also provide information to hedge fund investors in the form of letters, conference calls and financial statements. In addition, some hedge fund advisers may provide prospective investors with access to their prime brokers and other service providers, such as administrators, both during the investor’s initial due diligence of the hedge fund and subsequently.
Hedge fund investors must often spend significant resources, frequently hiring a consultant or a private investigation firm, to discover or verify information about the background and reputation of a hedge fund adviser. In practice, even very large and sophisticated investors often have little leverage in setting terms of their investment and accessing information about hedge funds and their advisers. As a matter of practice, hedge funds generally provide investors with a PPM before an investment is made. As with any other offering solely to accredited investors, there are no specific disclosure requirements that pertain to the PPM under Section 4(2) or Rule 506. While we are not passing on the adequacy and content of PPM disclosure generally, we note that certain basic information about the hedge fund’s adviser and the hedge fund is typically disclosed. The information disclosed in PPMs varies from adviser to adviser, however, and often is general in scope. PPMs generally discuss in broad terms the fund’s investment strategies and practices. They also typically disclose that the hedge fund’s investment adviser may invest fund assets in illiquid, difficult-to-value securities and that the adviser reserves the discretion to value such securities as it believes appropriate under the circumstances. The PPM also may disclose that the adviser may exercise its discretion to invest fund assets outside the stated strategy or strategies. PPMs also generally discuss qualifications and procedures for a prospective investor to become a limited partner, as well as provide information about the hedge fund’s operations. For example, PPMs generally discuss fund expenses, allocations of gains and losses, tax aspects of investing in the fund and may incorporate the hedge fund’s financial statements. PPMs disclose any lock-up period that new investors must observe, as well as laying out the specifics for when investors will be able to redeem some or all of their investments out of the hedge fund. PPMs also may name frequently used service providers to the fund. PPMs may generally disclose potential conflicts of interest to investors, frequently under the heading of “risk factors.” A hedge fund’s PPM may note that the fund’s valuation practices give rise to an inherent conflict of interest because the level of fees that the investment adviser earns is based on the value of the fund’s portfolio holdings as determined by the fund’s adviser. PPMs also may discuss potential conflicts arising from the adviser’s “side-by-side management” of multiple accounts, including the hedge fund, private accounts, proprietary accounts and registered investment companies. A hedge fund’s PPM may also disclose the investment adviser’s conflicts in allocating its time and certain investment opportunities among its clients. Some PPMs spell out allocation policies with respect to limited investment opportunities in great detail, while others may list, and only briefly discuss, the factors on which such allocations will be decided. PPMs also often provide information concerning the use of affiliated services providers, including affiliated broker-dealers. Some PPMs also may note that the hedge fund may direct brokerage business to, and use other services of, firms that introduce investors to the fund. PPMs may disclose that the adviser may use soft dollars to pay for research and other services used by the adviser to benefit other accounts that it manages, and may further disclose that soft dollars.
Dave: Are these documents boiler plate or created individually for each fund?
Hannah: They are created individually for each client.
Dave: Does this paperwork need to be filed with the SEC or anyone?
Hannah: Form D is filed with the SEC and other forms may be required to be filed with each state where investors are located.
Dave: What is the definition of “accredited investor”?
Hannah: The safe harbor protection most often relied upon by hedge funds under Rule 506 exempts offerings that are made exclusively to “accredited investors.” Issuers are permitted under these provisions to sell securities to an unlimited number of “accredited investors.” In addition, if the offering is made only to accredited investors, no specific information is required to be provided to prospective investors. The term “accredited investors” is defined to include: Individuals who have a net worth, or joint worth with their spouse, above $1,000,000, or have income above $200,000 in the last two years (or joint income with their spouse above $300,000) and a reasonable expectation of reaching the same income level in the year of investment; or are directors, officers or general partners of the hedge fund or its general partner; and Certain institutional investors, including: banks; savings and loan associations; registered brokers, dealers and investment companies; licensed small business investment companies; corporations, partnerships, limited liability companies and business trusts with more than $5,000,000 in assets; and many, if not most, employee benefit plans and trusts with more than $5,000,000 in assets.
Dave: Does everyone who invests in a hedge fund need to be an “accredited investor” or high net worth individual?
Dave: I have several friends who would love to invest in a hedge fund, but don’t meet the above criteria. Is there anyway around the regulation?
Hannah: Yes, non accredited investors can invest in a hedge fund. It depends on the fund manager’s discretion.
Dave: Does the manager need to have a Series 7 or other licenses?
Hannah: No, a Series 7 is not relevant to this discussion.
Dave: How about registration? Does the manager need to register with the SEC?
Hannah: Yes, in certain cases, given recent law changes.
Dave: Does the manager need to register in the state the fund is domiciled in?
Hannah: Form D needs to filed with the SEC.
Dave: What about the funds trader (s). Do they need to register with anyone?
Hannah: Yes, in certain cases. This requires a state-by-state determination. A fund manager must sign up with their state as the investment adviser if they have less than $25 million under management. Between $25 million and under $30 million under management, the fund manager may choose the regulator—either the state or the SEC. If the fund manager has more than $30 million under management, the fund manager would need to register with the SEC as an investment adviser.
Dave: What if the investors are from different states? Does the manager need to register in every state an investor is from?
Hannah: Yes, usually a notice filing is required as long as they are registered in another state or with the SEC.
Dave: Is this in all cases? What about very small start up funds?
Hannah: It depends on the state and the structure the fund manager opts to use.
Dave: Is there anyway to legally avoid registration?
Hannah: You either have to register or you fall within an exemption.
Dave: If the manager is a CTA does he still need to register as a fund manager?
Hannah: The difference between a CPO and a CTA is that a CTA manages individual accounts, while a CPO manages only the hedge fund, or Pool. Few of our clients remain interested in the CTA option once they realize the administrative hassle associated with managing the separate accounts. No sponsor is needed to take the Series 3 exam. The Series 3 exam is given under the auspices of the NASD’s testing program. Two different testing services provide their services to the NASD.
Unlike a traditional hedge fund (where the SEC may end up being a regulator if enough money is under management), the government regulator that may associated with CPOs is the CFTC—the Commodity Futures Trading Commission.
The CFTC has allowed the National Futures Association (NFA) to become the primary regulator of futures and commodity products (as a Self-Regulatory Organization, similar to the NASD’s status with the SEC). It is my opinion that the NFA is a very effective and competent regulator.
Dave: How about if the manager has a series 7. Is registration still required?
Hannah: A Series 7 is of no particular value to either an RIA or a CPO. If someone has a current Series 7 (they’ve been registered within the past two years with a broker/dealer), they can choose to take the Series 66 instead of the Series 65. The Series 7 plus the Series 66 is always (in all states) equivalent to the Series 65. After two years of not being with a broker/dealer, all prior registrations (such as a Series 7) expire and are no longer valid. Similarly, if someone previously passed the Series 65 but has not had it registered with either a broker/dealer or an investment advisory firm, the exam has expired and will need to be taken again. Some states will not consider someone for investment advisory status unless they were previously registered as a Series 7 with a broker/dealer.
Dave: Ok, now that we have the basics out of the way. What’s the first step someone should take before launching a fund?
Dave: Is there a minimum capital amount that you feel is needed before launch?
Dave: What about someone who does not have any investors yet, who just wants to set up the fund structure for the future?
Set up an incubator fund? I know your firm runs some type of “hedge fund incubator” Can you explain what this is?
Hannah: It’s a start up process for a prospective fund manager to develop and document a track record that could be legally marketed to prospective investors when he or she is ready to open the fund to outside investors.
Dave: Do you actually do capital introductions?
Hannah: Yes, often, as a professional courtesy to our clients. We do not accept referral fees from non lawyers, as we are prohibited from accepting such fees by the rules governing the practice of law. We have an extensive network of contacts worldwide. We endeavor to set up our clients for success and look toward a long term relationship as well as build global relationships.
Dave: How about hooking a fledging manager up with a prime broker?
Hannah: Yes, as a professional courtesy to our clients. We do not accept referral fees from non lawyers, as we are prohibited from accepting such fees by the rules governing the practice of law. We have an extensive network of contacts worldwide. We endeavor to set up our clients for success and look toward a long term relationship.
Dave: I see, your firm is really a “one stop shop”. Do you do the back office stuff too?
Hannah: Yes, of course.
Dave: While we are on this topic, what is a “back office”?
Hannah: Many clients are accustomed to being one-person businesses, trading from their home office. They are interested in trading for others to leverage their knowledge and make more money, but they don't want to change how they work. They don't want to have to hire accountants and secretaries, or rent an office or gain tons of paperwork. They don't want to spend their days with attorneys, accountants, consultants and business operation hassles. We provide a full service, virtual Web-based and e-commerce solution takes all the hassle out of entering the hedge fund business. Clients can continue working from home, without any of the above mentioned hassles. We handle all of the charges to your investors for the management fees and the performance allocations as well as prepares the statements for investors. Most of clients use our hedge fund accounting services on a monthly basis; others on a weekly, quarterly, annually basis, or whenever they like. The work product includes NAV, performance records, brokerage statement reconciliation, advisory fee billing, performance allocation, investor changes, and other related reports generated from the software programs.
Dave: When the fund grows, are there capital levels or partner numbers that need to be watched? What I mean is, is there additional regulation, registration, et al on a 100 million dollar fund than there is on a 250k startup?
Dave: Recently, I have noticed a proliferation of off shore funds. What exactly is an off shore fund? What reasons would a manager want to set up an off shore fund?
Hannah: The word “offshore” has a certain mystique to many. Offshore hedge funds are investment vehicles organized in offshore financial centers (“OFC”). OFCs are countries that cater to the establishment and administration of mutual and hedge funds (“funds”). Offshore funds offer securities primarily to non-U.S. investors and to U.S. tax-exempt investors (e.g., retirement plans, pension plans, universities, hospitals, etc.). U.S. money managers who have significant potential investors outside the United States and tax-exempt investors typically create offshore funds. In many OFCs, the low costs setting up a company along with a kind tax environment make them attractive to establishing funds. Offshore hedge funds are typically organized as corporations in countries such as the Cayman Islands, British Virgin Islands, the Bahamas, Panama, the Netherlands Antilles or Bermuda. Offshore funds generally attract investment of U.S. tax-exempt entities, such as pension funds, charitable trusts, foundations and endowments, as well as non-U.S. residents. U.S. tax-exempt investors favor investments in offshore hedge funds because they may be subject to taxation if they invest in domestic limited partnership hedge funds. Offshore hedge funds may be organized by foreign financial institutions or by U.S. financial institutions or their affiliates. Sales of interests in the United States in offshore hedge funds are subject to the registration and antifraud provisions of the federal securities laws. Offshore hedge funds typically contract with an investment adviser, which may employ a U.S. entity to serve as sub adviser. An offshore hedge fund often has an independent fund administrator, also located offshore, that may assist the hedge fund’s adviser to value securities and calculate the fund’s net asset value, maintain fund records, process investor transactions, handle fund accounting and perform other services. An offshore hedge fund sponsor typically appoints a board of directors to provide oversight activities for the fund. These funds, especially those formed more recently, may have directors who are independent of the investment adviser.
Dave: Sounds like a good way to avoid taxes. Does the manager of a fund domiciled off shore still need to pay capital gain taxes, etc?
Hannah: The Do’s and Don’t of offshore funds are can be summed up as follows:
Do: Consider setting up an offshore fund is you manage money for either foreign and/or U.S. tax-exempt individuals and businesses. Under U.S. income tax laws, a tax-exempt organization (such as an ERISA plan, a foundation or an endowment) engaging in an investment strategy that involves borrowing money is liable for a tax on “unrelated business taxable income” (“UBTI”), notwithstanding its tax-exempt status. The UBTI tax can be avoided by the tax-exempt entity by investing in non-U.S. corporate structures (i.e., offshore hedge funds).
Don’t: Go offshore to avoid U.S. taxation. This is the wrong reason to consider an offshore fund. In short, setting up an offshore fund is not a tax minimization strategy as U.S. citizens, resident aliens (e.g., green card holders) are taxable on their worldwide income. The U.S. tax results depend on the nationality and domicile of the fund manager and his or her management company.
Dave: Am I able to set up an off shore fund without ever even visiting the country?
Hannah: Yes, of course. Our firm liaisons with foreign legal counsel. Everything is handled on a turnkey basis. You don’t need to stop trading or take a break from the markets. Just call us as we will work around your trading schedule.
Dave: What countries are most hospitable to off shore funds?
Hannah: Investment fund managers typically create offshore funds in Caribbean OFCs, although a European offshore entity may be more appropriate if a significant number of European investors are involved. Funds legally domiciled in OFCs hold around half of the hedge fund assets reported by the TASS hedge fund data base, with the British Virgin Island and the Cayman Islands being the most popular location. It has been estimated that over half of the world’s funds are incorporated in the British Virgin Islands However, management of funds is often conducted in or near major international financial centers such as London and New York although the actual fund is registered in an OFC. Ask where a hedge fund is domiciled and you are likely to hear the name of a handful of places worldwide. In the United States, domestic hedge fund businesses tend to cluster in a few states, in particular California, Delaware, Connecticut, Illinois, New Jersey, New York and Texas. Each state has different tax and regulatory laws. Outside the United States, several centers in the Caribbean and Europe present different benefits and costs to fund managers. Regulatory burdens and expenses can be worth bearing, depending on the nature of the investment vehicle and its clients.
Dave: Is there anywhere you would avoid and why?
Hannah: Any country lacking monetary or political stability.
Dave: Moving onto the next structure. Master-Feeder funds. What are they?
Hannah: The corporate structure of a hedge fund depends primarily on whether the fund is organized under U.S. law (“domestic hedge fund”) or under foreign law and located outside of the United States (“offshore hedge fund”). The investment adviser of a domestic hedge fund often operates a related offshore hedge fund, either as a separate hedge fund or often by employing a “master-feeder” structure that allows for the unified management of multiple pools of assets for investors in different taxable categories. The master/feeder fund structure allows the investment manager to collectively manage money for varying types of investors in different investment vehicles without having to allocate trades and while producing similar performance returns for the same strategies. Feeder funds invest fund assets in a master fund that has the same investment strategy as the feeder fund. The master fund, structured as a partnership, engages in all trading activity. In today's trading environment, a master/feeder structure will includes a US limited partnership or limited liability company for US investors and a foreign corporation for foreign investors and US tax-exempt organizations. The typical investors in an offshore hedge fund structured as a corporation will be foreign investors, US tax-exempt entities, and offshore funds of funds. Although certain organizations, such as qualified retirement plans, generally are exempt from federal income tax, unrelated business taxable income (UBTI) passed through partnerships to tax-exempt partners is subject to that tax. UBTI is income from regularly carrying on a trade or business that is not substantially related to the organization's exempt purpose. UBTI excludes various types of income such as dividends, interest, royalties, rents from real property (and incidental rent from personal property), and gains from the disposition of capital assets, unless the income is from "debt-financed property," which is any property that is held to produce income with respect to which there is acquisition indebtedness (such as margin debt). As a fund's income attributable to debt-financed property allocable to tax-exempt partners may constitute UBTI to them, tax-exempt investors generally refrain from investing in offshore hedge funds classified as partnerships that expect to engage in leveraged trading strategies. As a result, fund sponsors organize separate offshore hedge funds for tax-exempt investors and have such corporate funds participate in the master-feeder fund structure. If US individual investors participate in an offshore hedge fund structured as a corporation, they may be exposed to onerous tax rules applicable to controlled foreign corporations, foreign personal holding companies, or a passive foreign investment companies (PFIC). To attract US individual investors, fund sponsors organize separate hedge funds that elect to be treated as partnerships for US tax purposes so that these investors receive favorable tax treatment. These funds participate in the master/feeder structure. Under the US entity classification (i.e., check-the-box) rules, an offshore hedge fund can elect to be treated as a partnership for US tax purposes by filing Form 8832, "Entity Classification Election," so long as the fund is not one of several enumerated entities that are required to be treated as corporations.
Posted by marketsurfer at 6:06 PM