From Frontwater Capital’s Options Desk:

In a matter of weeks, Apple (AAPL) stock has fallen 25% from its September 2012 high of $704. Investors are now questioning if Apple has lost its magic touch. Just what has changed in only a few months.

Has Apple Lost Its Magic Touch?

Apple is no longer the underdog, the contender; they are now the company to beat – the ones with the target on their back. And while Apple continues to be known for its excellence, innovation and quality, life at the top is much more rigorous, and pressure bound than being second in command.

Factories are demanding higher wages and better working conditions that are putting pressure on margins. Competitors like Samsung are constantly improving their own phones, tablets and computers. Furthermore, we are starting to see limited sales of the iPhone 5 due to supply chain issues. And finally, the newly released mini Ipad was only warmly received by analysts who noted marginal, insignificant upgrades with the mini.

That said, Apple’s stock looks to be in bargain basement territory. Even with competitive pressures Apple’s gross margin remains above 40%. Most important is that Apple has an ecosystem that few others can rival. Apple users link and connect their Mac laptops, iPhone, and iPad so that, for example, a library of itunes can be automatically distributed to each gadget. This convenience factor makes it extremely difficult for users to switch to a new platform.

Finally, much of the sell off in Apple stock can be explained by the approaching ‘fiscal cliff’. Investors who have held Apple stock for some time are likely sitting on large capital gains and are wishing to realize their capital gains in 2012 prior to potential tax hikes in 2013. This is creating downward pressure on the stock. Yet the company remains intact.

Here are some different ways to play Apple in today’s sell off:

1. Go Long!

Apple has been the trade of the year and up until recently, momentum and speculation had taken the price sky high. Now, with the momentum going against Apple, we think it is an attractive entry point. Even if we forget about ANY growth, this company seems like a bargain — valued at 12.5 times earnings; with more than $120B in the bank; and zero debt.

2. Sell a Put

The panic in Apple today has created a great opportunity if you are willing to take on exposure to Apple if it continues to drop. The options market will pay you $19 between now and December if the stock were to drop below $525 and you sold a put. Your downside risk here is that you own Apple with an effective price of $506. On the other hand, if Apple stock trades above $525, you effectively pocket $19 in option premium.

3. Buy a Collar

If you were willing to take the on additional Apple shares with an effective cost of $506 from the above example, you could turn around and purchase a March 605 Call using the $19 dollars that you received from selling the put. This will give you upside on Apple and enable you to profit in the event that Apple’s stock rises above $605.

Bottom line is that if you believe in the company’s long term value, there are a bunch of different and creative ways to play Apple using option

The flaws in Canada’s financial adviser system

Barrie Mckenna

OTTAWA— From Saturday’s Globe and Mail
Published Friday, Feb. 17, 2012 6:42PM EST
Last updated Tuesday, Feb. 28, 2012 7:22PM EST

http://www.theglobeandmail.com/globe-investor/the-flaws-in-canadas-financial-adviser-system/article2342799/page3/

In the investing industry, the line between what’s best for the client and what’s good for the adviser is easily blurred.

Advisers want their clients to enjoy high returns, but they need to make money, and the potential for large rewards is tempting.

That creates an inherent conflict of interest in many client-adviser relationships, critics say, and too many investors are left in the dark about the fees they’re paying to advisers and the effect those fees have on returns.

Many investors assume financial advisers have a duty to act in their best interests. But that’s not the standard regulators currently demand. The requirement in Ontario, for example, is to act “fairly, honestly and in good faith” – the duty-of-care model. That’s a long way from explicitly mandating that financial advisers’ first obligation is to the client – a so-called fiduciary duty – such as exists for lawyers, accountants and portfolio managers.

Canadian regulators are examining steps that would follow the lead of Britain and Australia, both of which are pushing ahead with legislation to regulate adviser fees and clarify the duty of advisers to serve their clients. The Ontario Securities Commission, under new chairman Howard Wetston, has pledged to build “confidence in the investment process” by exploring the pros and cons of mandating a fiduciary duty. The commission is expected to release a discussion paper on the issue this spring.

“The adviser-client relationship … is an area of focus for the Commission because of its importance to retail investors,” said OSC spokeswoman Carolyn Shaw-Rimmington.

Critics say changes are needed in part because there’s a side to the investment business many Canadians don’t see.

Take the so-called cash payout grid, industry parlance for the mechanism that determines the pay of many brokers. The more investments they sell, the greater the share of the fees they get to keep – sometimes in excess of 50 per cent.

Fail to meet minimum revenue targets at the bottom of the grid and a young broker can soon be looking for a new career.

“The grid is the enemy of savings,” says Donald Ross, a former Vancouver-based mutual fund wholesaler for a major bank-owned investment dealer. “It creates an incredible amount of pressure to generate volume.”

Throw volatile equity markets and near-zero interest rates into the mix and what your broker earns can be the difference between you making money or owning a shrinking nest egg.

John Tak, 57, of Vancouver, and his wife say they’ve endured a decade of frustration over embedded fees and subpar returns. They’re now on their third financial adviser.

“I can’t think of another field where you don’t get a clear bill and you don’t know exactly what you’re paying for,” said Mr. Tak, an executive at a health products manufacturer. “I don’t think they’re dishonest or trying to trick me. It’s the nature of the industry.”

The standard risk profile that clients sign becomes a way for advisers to duck their responsibility to generate better returns for investors, Mr. Tak said. “They’re making money, whether we’re losing money or making money,” he complained.

A nationwide survey by Genesis Public Opinion Research for The Globe and Mail found that most Canadians generally trust their financial advisers (52 per cent gave their advisers marks of 9 or 10 on a 0-10 scale).

But they’re also deeply dissatisfied with the returns they’re getting, disillusioned with the stock market in general and wary of their own investment ability. And less than half of respondents give their brokers top marks on such critical measures as recommending investments that suit their financial goals and selling products clients fully understand.

The data suggest many investors don’t have the necessary tools to assess the quality of the advice they’re getting.

“Many retail investors don’t know any better,” said Genesis pollster Dave Crapper.

Experts say too many Canadians don’t understand what’s behind the investment advice they’re getting, and more importantly, how much they’re paying for it. In many cases, the financial advice investors get is coloured by the adviser’s needs, including a desire to keep their job. Buying, selling and just holding on to mutual funds, many with high fees, for example, is a common way for advisers to earn a living.

“A lot of people don’t understand what they’re paying for. They think the advice is free,” said Ilana Singer, deputy director of the Canadian Foundation for the Advancement of Investor Rights.

“Their own knowledge is so low they don’t know how to assess the value of the advice they’re getting … If you think you’re getting free advice, your opinion of that advice will be higher.” Ms. Singer said many investors are unaware that the cost of the advice they’re getting is often buried in the mutual funds they’re buying, through trailer fees and management expense ratios.

Mr. Ross, the former mutual fund wholesaler, said brokers sometimes face pressure to dump the perfectly good funds already in a client’s account in order to buy new ones, simply to generate fees needed to make their pay “grid.” He said the mutual fund industry helps feed this thirst for income with a steady stream of new closed-end funds, which pay the broker up-front fees and may be sold at an initial discount to their book value to drive sales.

“The public doesn’t have any idea what goes on,” added Mr. Ross, who now works in real estate. “They don’t have a clue.”

Just to break even, investors typically must generate annual returns of 5 to 8 per cent to cover fees, commissions, trading costs and inflation, estimates Victor Therrien, a mutual fund industry veteran and former executive vice-president of Brandes Investment Partners.

“Investing is a zero-sum game, right out of the gate,” said Mr. Therrien, who left the industry in 2008, disillusioned at the way investors were being treated.

“Investors don’t understand. If you have commissions, it makes that mountain you have to overcome so much more acute.”

Clarity around an adviser’s fiduciary duty would be a step forward. But the OSC isn’t making any promises. Ms. Shaw-Rimmington said the issue is complex and the OSC wants to review the implications of imposing a “best interests” or fiduciary standard before moving forward.

Early next week, the OSC-funded Investor Education Fund is releasing new research on adviser relationships and investor decision-making.

There’s also interest in Ottawa. Ursula Menke, commissioner of the Financial Consumer Agency of Canada, agrees that imposing a fiduciary duty for advisers would clearly be good for investors.

“The compensation model, by its very nature, creates a conflict of interest,” she said in an interview.

Dumping the current duty-of-care model in favour of something more stringent is likely to face stiff resistance from the industry, which maintains that Canadians have ample legal protections now.

But Ms. Singer, the investor advocate, said imposing a fiduciary duty is the right thing to do, particularly at a time when governments and employers are gradually shifting the burden of providing for retirement onto the shoulders of individuals.

“This kind of duty is important to the fabric of the country,” she argued.

“Canadians have to rely more on their own savings to get them through their retirement years. And if your savings are placed with a financial adviser, it is even more important now that greater responsibility is placed on the shoulders of the people providing the advice.”

The grid: Many advisers are paid according to what’s known as the grid, typically a one-page table that spells out how gross fees are shared between the adviser and their brokerage firm. The more fees the adviser brings in, the more of that cash they keep. An adviser generating fee and commission revenue of $200,000 a year might get to keep, say, 25 per cent. One earning $400,000 would get 35 per cent. Some brokers impose a minimum amount the adviser is expected to generate.

Fees: Some brokers charge an all-inclusive flat fee, typically in the range of 1 to 1.5 per cent, based on the size of your portfolio. A broker may also operate on a fee-for-service basis, either by the hour or based on the specific services they provide. Many other advisers offer what appears to “free” service, when in fact they are compensated via a vast array of fees on the investment products they put in your account. Many of these fees are not readily apparent to the investor.

Front-end sales or load commissions: You buy $10,000 of a mutual fund, and your adviser gets 2 per cent or $200. So your net purchase is actually $9,800.

Back-end or deferred fees: You buy a $10,000 mutual fund, $10,000 goes into your account and the adviser gets a commission. But sell that investment before a set period and you will be charged a fee.

Redemption fees: Paid by the investor to the fund when you sell units in a mutual fund.

Switch fees: Fee charged to investors when they switch funds within a family of funds.

Trailer fees: Annual fee the mutual fund pays your adviser and his or her firm to keep you in a particular fund. Rates are typically in the range of 0.25 per cent to 1 per cent a year.

Management Expense Ratios: This is the percentage of a mutual fund’s assets that are deducted annually to cover operating costs, trailer fees, marketing, and fund manager salaries. MERs range from less than 1 per cent to 3 per cent or more. This comes right out of your return. So if a fund’s investments generate a 5-per-cent return and the MER is 3 per cent, your return is about 2 per cent. Published returns are after fees are deducted.

McKenna, Barrie. “The Globe and Mail.” Home. Globe and Mail, 17 Feb. 2012. Web. 01 Mar. 2012.

Jeff buckstein
Globe and Mail Update
Published Saturday, Feb. 25, 2012 6:00AM EST
Last updated Tuesday, Feb. 28, 2012 8:24AM EST

Canadians who own registered retirement savings plans recognize the critical importance of building and maintaining value within their RRSPs. But comparatively few think about the need to protect their RRSP against potential creditors, or understand the degree to which they are covered could depend on the jurisdiction in which they reside.

Those most at risk are likely “self-employed people, owners of corporations, and professionals who might be subject to unlimited liability. Even those professionals who are incorporated are still subject to personal liability,” warns chartered accountant Robert Snowdon, who runs a CA firm in Kanata, Ont.

Cognizant of that reality, and recognizing the prudence of planning ahead for unforeseen events, Mr. Snowdon protected his own RRSP assets in the past by putting them into a segregated fund as part of a 10-year life insurance contract.

RRSP and registered retirement income fund (RRIF) proceeds held under any life insurance contract are generally fully protected from creditors, provided the proceeds have not been deposited fraudulently to avoid paying creditors, and so long as the insurance policy names a beneficiary.

Certain RRSP and RRIF holdings are also protected from creditors under a provision of Canada’s federal Bankruptcy and Insolvency Act, which came into force in July of 2008. This act provides protection under specific circumstances involving bankruptcy.

It covers situations where “a trustee takes over an individual’s financial affairs once they have been petitioned into bankruptcy by their creditors, or the individual makes a voluntary assignment in bankruptcy because they can’t pay all their creditors,” explains Jack Courtney, assistant vice-president of advanced financial planning with Investors Group Inc. in Winnipeg.

However, this act also contains an important timing proviso. A trustee can claw back, or seize, RRSP or RRIF proceeds contributed within 12 months of the date of bankruptcy.

Somewhat complicating the matter is the existence of provincial legislation in jurisdictions such as British Columbia, Alberta, Saskatchewan, Manitoba, Prince Edward Island, and Newfoundland and Labrador that also specifies RRSP and RRIF assets are generally protected from creditors. Other jurisdictions might provide protection under certain circumstances. However, most of these provincial laws do not contain a time provision exempting certain deposits (B.C. is an exception, mirroring the 12-month federal period).

“In most provinces that exempt RRSPs from seizure, the clawback will not apply. So if you’re in a province that always exempted RRSPs, the fact that federal law in bankruptcy has now changed does not alter the status of the injection of RRSP money in those provinces in the previous 12 months,” Toronto lawyer Fred Tayar explains.

When Mr. Snowdon’s segregated-fund insurance contract expired, after the Bankruptcy and Insolvency Act was in force, he decided against establishing a new insurance contract to cover his RRSP proceeds, electing instead to transfer the full amount to a new self-administered RRSP.

There were a couple of other things he wanted to change. Within the insurance contract, Mr. Snowdon felt his management fees for transactions were higher than those of other RRSPs, as a result of guaranteeing at least 75 per cent of the value in the segregated fund. He also felt restricted to a selection of only five or six mutual funds.

There is a trade-off for the added protection, experts say.

“The more guarantee you buy, the more expensive the underlying fee associated with the product will be,” Mr. Courtney explains. “You can buy segregated fund products that have very minimal guarantees where the pricing is very comparable to mutual funds, and many of them will almost mimic an underlying mutual fund in their investment mandate and the way they are managed,” he says.

Those who do elect to put their funds into an insurance product have all the same flexibilities built in as they would in an RRSP held with any other financial institution. Plan holders can take out money for an emergency. At age 71, they can also make the same choices available to RRSP holders with a bank or elsewhere; convert their RRSP proceeds into their choice of a RRIF (if they want to continue managing their funds with a similar degree of autonomy and risk, with the same investment portfolio), or convert the proceeds into the certainty of a fixed income annuity.

“A segregated fund will typically have a maturity date within the contract. That’s going to be at the end of the year that you’re 71, but the investment is open ended until that time. They really are designed as lifetime arrangements, and [they are] liquid at any time,” says Ron Sanderson, the Toronto-based director of policy holder taxation and pensions for the Canadian Life and Health Insurance Association Inc.

Why bonds are risky right now for your portfolio

Tara Perkins
Globe and Mail Update
Published Friday, Feb. 24, 2012 6:00AM EST
Last updated Friday, Feb. 24, 2012 6:41AM EST

With a greater concern for preserving their wealth rather than building more, high-net-worth individuals confronting volatility tend to look for lower-risk investments. But the Catch-22 these days is that traditionally lower-risk vehicles may present higher risk in the long run.

One way to deal with volatility is to find an equities comfort zone, experts say. That way investors can take some risk off the table at peaks and add some in valleys.

The first step is determining your financial goals. Second, create a basic plan with a financial adviser that has flexibility built into it for those moments when you are feeling a bit more positive or, conversely, a bit more risk averse.

Laura Wallace, vice-president and portfolio manager in Bank of Nova Scotia’s private client group, tells clients to figure out what rough mix of stocks and bonds is likely to meet their needs over the long run, and then establish a range of exposures to equities.

“It might be a 40- to 60-per-cent equity range, for example,” she says. “What we find is that making a pre-established range when times are calm allows you to make the right decision when times are crazy.”

Ideally, you would be at the bottom end of the range and buying stocks at a time like the fall of 2008, when markets imploded. And you would be at the top end of the range and selling stocks during a euphoric period, such as the peak of the Internet bubble in 2000.

What about right now? Ms. Wallace suggests being at the mid-point of your range.

This is due to two factors, she explains. Due to low interest rates, fixed income securities are offering only tiny returns at best, especially once you factor in taxes and inflation. Also, stocks may be cheap, but most experts don’t expect them to rise in the near term.

“We think there’s going to be a fair amount of volatility over the next six months or so, and so the combination of those two things leaves us in the mid-point of our asset range mixes,” Ms. Wallace says.

In other words, since bonds are offering pitiful returns, they are actually a risk to a portfolio.

“I see 10-year treasuries, even Government of Canada bonds, as being one of the riskiest asset classes over the next 12 to 24 months,” says Scott Hall, a vice-president and portfolio manager at Canaccord Financial.

Even a whiff of higher interest rates could push bond returns broadly into negative territory.

But with markets up and down, potential economic crises and slow growth expected for the while, stocks are also risky.

Stocks will continue to be a risk for the next three to 10 years as the global debt super cycle works its way through the financial system, predicts Paul Taylor, chief investment officer at BMO Harris Private Banking.

“Because we accumulated too much debt, economic growth rates are going to be more modest for an extended period of time,” he says. “And therefore earnings in the stock market are going to be tight. Equity markets are just not going to be on this massive upward swing that we’ve been accustomed to in the past.”

And if a default of Greece or another European country sparks a liquidity crisis, all bets are off.

Still, many advisers lean to equities for the long haul, though they differ in their strategies. “Longer term, now probably more so than ever, equities offer better relative value than fixed income vehicles,” says BMO’s Mr. Taylor.

If volatility doesn’t scare you, you might want to kick it up a notch. Why own bonds that yield 2.5 per cent when you can own shares of BCE that yield more than 5 per cent? “If you can wait out the volatility, you’re going to be better off in the BCE stock,” says Scotiabank’s Ms. Wallace.

On the other hand, “with the markets having just rallied 23, 24 per cent off of the October lows, our advice at this point is to probably be looking to take some risk off the table and adopting a slightly more defensive posture, not putting new money to work,” says Canaccord’s Mr. Hall. “If anything, right now we are raising cash. Our expectation is that the markets will in all likelihood pull back, maybe as much as 5 to 10 per cent, after this 20- to 25-per-cent rally. At which point in time we would then look to deploy our cash.”

Mr. Taylor suggests, “Assemble a portfolio of very high-quality securities, some Government of Canada’s, some quality provincials, some blue chip corporate bonds. Hold some convertible debentures, hold some relatively juicy preferred shares, and hold some straight common shares in absolutely blue chip franchises.”

Ms. Wallace adds that she likes natural resources and Canadian financial institutions right now. Mr. Hall says that commodity trading accounts and managed future accounts are good ways to increase your return profile without excessive risk. He is a fan of emerging markets, particularly Brazil, and for high-net-worth clients with an appetite for some risk, he is making use of private equity investments, including smaller oil and gas firms.

Perkins, Tara. “The Globe and Mail.” Home. The Globe and Mail, 24 Feb. 2012. Web. 01 Mar. 2012.

February 22, 2012 By Robb Engen

Mortgage life insurance is marketed by the banks as a flexible, low-cost way to protect one of your largest financial obligations. If you face a terminal illness, or have a serious accident, mortgage life insurance can help you out. It will pay for such things as:

The outstanding mortgage principal amount, up to $500,000
Up to five years of accrued interest, and
Any debit balance in your tax account

The concept behind mortgage life insurance is a good one. It protects your family against unexpected illness, accident, or death.

Related: What happens when you miss mortgage payments?

However, I declined the bank’s insurance coverage when we purchased our new home and kept enough term life insurance to protect my family.

Here’s why:

Mortgage life insurance is the one financial product that goes down in value as you continue to pay, yet this is promoted as a benefit. The marketing material says: your premiums will not increase for the term of your mortgage, even as you get older. It’s comforting to know that this important coverage will remain affordable.

But that also means that relatively it costs more over time. As the mortgage principal decreases the cost stays the same. That’s called a declining benefit.

The monthly mortgage insurance costs for a 30-something couple with a $300,000 mortgage can range from $75 – $120. Four years into a 25-year mortgage with a four-and-a-half per cent interest rate, your outstanding mortgage balance will be reduced to $270,000, but you will continue to pay the same mortgage life insurance premium.

On the other hand, a $600,000 5-year term life insurance policy only costs about $50 per month for a 30-something non-smoker. You get twice the coverage with term life insurance for half the cost of mortgage life insurance.

Life insurance also protects more than just your mortgage, which is just one expense your family will face if you die. Other family needs can include funeral expenses, your children’s education, and income replacement.

Life insurance gives your surviving spouse or beneficiary the option of paying off the mortgage or using the payout for other purposes. With mortgage life insurance, the bank is the beneficiary and only the mortgage will be paid off.

Mortgage life insurance is not a requirement to qualify for a mortgage and term life insurance is much cheaper and offers greater protection than the mortgage life insurance offered by your bank. That makes it my choice.

As an options trader and as a specialist in risk management, I often get annoyed when I read about risk mitigation strategies in any number of business newspapers and magazines. Rare is the case where I read an insightful article on the use of options strategies, particularly the protective put, to manage volatility within one’s portfolio.

All too often, authors focus on asset allocation as the primary mechanism for managing risk. In order to preserve capital, low risk investors should overweight fixed income products like GICs, government bonds, investment grade bonds, and underweight equities.

To further this argument, authors often display historical chart information to graphically illustrate the steadiness and consistent returns from bonds over the last twenty, even thirty years.

Problems With Relying On Asset Allocation

There are a number of problems I have in relying on asset allocation as a risk mitigation tool. First, only two years ago, we laid witness to the fact that all asset classes were hit hard. It did not matter if you held investment grade bonds, junk bonds, small cap stocks, preferred shares, or blue chip stocks in your portfolio, everything took a beating. Asset allocation did not turn out to be the safe haven that many thought and counted on.

Is Fixed Income Really A Safer Haven?

The second issue that I find bothersome is the assumption that fixed income is a steady eddy asset class over the long run. Many investors are oblivious to the fact that we have been in a declining interest rate environment for the last thirty years. Interest rates have dropped from twenty percent to one or two percent. So is it any wonder that bonds have done so well – it is simply a function of falling interest rates — as interest rates go down, bond prices go up.

On that note, one has to question a historical bond chart, even one with thirty years of history, if it is statistically representative.
Now that interest rates are slowly creeping up from their all-time lows, it could get very ugly, very quickly for bond holders. Unfortunately, I foresee a lot of seniors taking it on the chin once this bond bear market kicks in — especially those seniors being advised by their bank mutual fund salesperson to buy into bond mutual funds.

Capital Preservation At The Risk of Inflation

Finally, the third issue I have with the ‘bond safe haven’ argument is that few advisors make mention of the risk of inflation. And in today’s high commodity price environment, I fear too many investors are exposed to inflation risk – specifically the loss of purchasing power.

It does an investor little good to earn 3 percent on a long term government bond if inflation is running at 4 percent. True, the investor is almost certain to see his initial cash outlay returned as the bond matures, but the investor will have lost in real purchasing power. Unfortunately, too many investors associate capital preservation with the likelihood that cash is returned all the while ignoring the risk of inflation.

Problem With Laddered Bond Strategies:

That brings us to the next type of business news article which discusses the benefits of a laddered bond strategy. In a laddered bond strategy, an investor owns a number of different bonds, each with various maturities. Some bonds mature earlier and some mature later. Presumably, if interest rates rise, the bonds that mature earlier can be re-invested in potentially higher yielding bonds. Thus the exposure to inflation and higher interest rates is diminished.

On paper, the strategy sounds great. One problem though: in this low interest rate environment, the returns from this strategy are lousy.

The Protective Put

All of which brings me to the protective put strategy.

The concept of an index put is very simple. It is very much like insurance with the added benefit that it trades on an exchange. Unlike ‘asset allocation’ which did little to shelter portfolios against an outright collapse in the financial markets, puts most certainly protect investors against extreme market events.

Furthermore, puts give conservative investors much more leeway in bumping up the equity portion of their portfolios. Generally, it would be unheard of for a conservative investor to assign more than 65% of his portfolio towards equities. But with put protection in place, an investor has the flexibility to increase the equity portion towards even 80% with the knowledge that an effective hedge is in place should the market collapse.

Puts: The Concept Of Insurance

As mentioned, puts are equivalent to insurance. Like insurance, there is a cost to a put. A buyer of a put pays cash to the seller in what is known as the option premium. What is kind of neat is that the put premium is liquid and trades on an exchange. Investors can buy and sell put premiums exactly in the same manner that they buy stocks (eg. enter a ticker symbol, enter a price, and click ‘buy’ or ‘sell’)

Like many types of insurance, there is an expiration date associated with a put. After the expiration date, the put no longer trades and is considered terminated.

Put premiums appreciate in value when the market drops and decrease when the market goes up. But, put premiums cannot go below zero. Upon expiration, the put will be “in-the-money” and have monetary value, or it will be worthless.  Keep in mind, that the maximum amount that a buyer can lose is the put premium. The buyer cannot lose more than what he paid for the premium.

One More Feature: The Strike Price

In addition to an expiration date, puts are described by a strike price. The strike price enables investors to further customize the level of protection.

For example, if the TSX is trading at 14,000, an investor may choose a put with a strike price of 14,000. That particular put protects the investors against a market drop below 14,000.  Another investor, however, may choose to insure his equity portfolio at a lower strike price, say 13,000. Here, the investor has protection but only if the index falls below 13,000.

Why would an investor choose a strike price of 13,000 versus 14,000, one might ask?  The answer is cost. A put with a lower strike price costs less than one with a higher strike.

Having the ability to buy insurance at various strike prices gives investors a tremendous amount of flexibility in tailoring a risk strategy.  Some investors may be fine with a marginal drop in the market but want protection to kick in only in the event of a catastrophic event. Those investors are more likely to choose a strike price below current market levels – say 13,000. Other investors may want a higher amount of protection and choose a higher strike price that is more in line with the current market – say 14,000.

Volatility and Put Premiums

While both expiration dates and strike prices affect put premiums, volatility is the most important factor in determining relative value.  This is why many option traders track a volatility index called the VIX in order to assess the relative value of options.
When volatility is low, option traders know the cost of the put premium is relatively cheap. Likewise, the reverse is true. If volatility is high, put premiums become relatively more expensive.

Intuitively, this makes sense. Investors are more fearful in highly volatile markets and are therefore willing to pay more for insurance in order to protect their portfolios.

With investor sentiment bullish and the VIX trading at near lows in Jan & Feb 2011, Frontwater loaded up on 2012 protective put options on the TSX, DJIA, and S&P 500. This week we were rewarded. As stocks dropped, the index puts that we bought increased in value and our portfolios only suffered marginal paper losses. With insurance in place, not only were we able to avoid knee jerk reactions but we were positioned to take advantage of the first weekly drop in several months and added to our equity positions at depressed levels.

Admittedly, we bought the puts from a purely risk management perspective and not because we had a crystal ball that could possibly forecast the political unrest that would break out in the Middle East or that a terrible natural disaster would hit Japan.

That said, we complement ourselves for recognizing the most cost efficient way of managing risk at the time was through the use of put options. The protective puts offered great value, enabled us to comfortably maintain a higher level of equity allocation (close to 80%), and then positioned us to further take advantage of a market drop.

Option strategies can be a powerful risk management tool within one’s portfolio. All too often they get dismissed as being ‘too sophisticated’ for the average investor which draws my ire. True there are many complex option strategies but buying a put is a very simple investment strategy and insurance policy at the same time.

Jeff Kaminker

President, Frontwater Capital

Do you know what your investments cost? You would think that the collapse of worldwide markets would have provided a wake-up call to both governments and investors, but that’s not the case.

As a Portfolio Manager for private wealth individuals in Canada, I come across many intelligent and sophisticated individuals who have little, if any clue as to their all-in management fees with their current adviser. Truth be told, you’d probably need a forensic accountant to discover how much your investment adviser really earns from managing your money.

The problem is that all-in fee structures are just not transparent, and the Canadian government (unlike other governments in the UK, U.S, Australia) has shown little interest in forcing the industry to simplify its communication of management fees.

The reality is that very few Canadians realize just how much degradation occurs within their investment portfolios as a result of profits being siphoned out via “management”, “trading”, and “trailer” fees into the hands of financial advisers and the financial institutions that they work for.

The biggest culprit of portfolio degradation is the Canadian mutual fund industry itself. Mutual funds became popular in the 60’s and 70’s as investors realized that they could access and tap into professional portfolio managers via a pooled set of funds.

Admittedly, the concept was a good one. The problem today is that financial institutions have bastardized the concept. Thanks to the large fees attached to most mutual funds, investors are almost guaranteed to under perform the market, while bearing most of the downside risk. Meanwhile the mutual fund companies rake in their profits regardless.

Mutual funds are not the only ones offering fees that are out of proportion to the value of services received.

Many high net worth investors turn to professional investment managers for tailor made, customized investment solutions. Under this scenario, investors will often pay an investment fee to the firm. One immediate tax advantage that private wealth firms have over mutual funds is that investment management fees are tax deductible whereas mutual fund management fees are not. The “tax deductible” feature enables high net worth individuals who use portfolio managers, to presumably get better quality and service at lower costs.

These are difficult times for private wealth management firms, more so with the larger ones, as they have high operating costs and large overhead to maintain. A sharp depreciation in the value of portfolios and a migration of assets from high-margin products to the safety of deposits, money market products and government bonds, has eroded profits for many of these large firms.

Leave it to the financial services industry though to figure out innovative ways to disguise higher fee structures and market ill conceived products.

At many large firms, an incentive exists for wealth managers to churn accounts in order to generate trading fees and commissions. These commissions often serve as a drag on the portfolio and directly convert client principal into fees and commissions for the broker and firm.

Higher trading commissions are often overlooked and downplayed by private wealth firms as simply small, immaterial costs within a ‘Buy and Hold’ portfolio. Make no mistake, high trading fees eat into profits over the long run. Furthermore, it compels portfolio managers to take a “Buy and Hold” philosophy even if the situation does not call for it. It is difficult enough for a portfolio manager to slim positions when the market is in free fall, but it’s that much tougher of a decision if he knows that the account will be further eroded by trading fees. Thus, clients are often left holding the bag much longer on poor performing stocks.

“Proprietary” or “Structured” products have become the next step in the evolution of financial offerings. Most of these are marketed by large financial institutions under the veil that an investor can somehow get the best of all worlds. In truth, these products represent one more way for financial institutions to surreptitiously filter money out of the hands of investors and into their pockets.

The Globe and Mail (”Why Investors Can’t Have It Both Ways” By John Heinzl) recently exposed one such structure product marketed by the Bank Of Montreal,called the BMO Blue Chip GIC. The bank marketed the GIC as a low risk investment with the potential for large rewards — basically, a “too good to be true” offer. In fact, by the time, you go through all the fine print, an investor, in all likelihood is guaranteed to generate very low returns. The probability of there being some significant upside was highly remote yet the marketing materials clearly focused on the absolute best case scenario.

Structured products have become so bad that the Securities Exchange Committee (SEC) in the U.S. has launched an investigation into financial institutions who have over charged individual investors for structured notes while failing to disclose fees, and potential conflicts of interest.

Unfortunately, we are unlikely to see a similar investigation here in Canada. If we have yet to tackle clear abuses within the mutual fund industry, it is apparent that there is little appetite by the government to pursue further misrepresentations within the marketplace.

When I walk into a casino, I know over time I am guaranteed to lose. Most Canadians know this too. What they don’t know is that the same applies to the Canadian financial industry.

Under the deal, RehabCare stockholders will receive $26 in cash and 0.471 Kindred shares for each of their shares. Kindred plans to issue about 12 million shares in connection with the transaction. The deal also includes the assumption of about $400 million in debt.

That will award Rehab shareholders a 37.4% premium to the company’s closing share price on Monday of $25.47. Rehab shares have traded as high as $31.93 and as low as $15.88 over the past year. Kindred will receive financing from J.P. Morgan Chase, Morgan Stanley and Citigroup Inc. and also assume $400 million in RehabCare debt.

The deal will create the largest “post-acute” health company in the country, with more than $6 billion in revenue and operations in 46 states.

RehabCare posted fourth-quarter earnings of $17.1 million, or 69 cents a share, up from $655,000 or 3 cents a share, a year earlier. The year-earlier period included $7.2 million in charges related to its 2009 acquisition of Triumph Healthcare. Revenue jumped 36% to $339.3 million. Analysts had predicted a per-share profit of 61 cents on $344 million in revenue.