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Keeping a lid on the fees you pay to financial intermediaries is like trying to eradicate bindweed. Chop off one plant’s head and two shoots take its place.

Yesterday Citywire reported that two UK-based fund of funds managers, Evercore and 7IM, both of which have been prominent advocates of ETFs, are under fire for neglecting to include ETFs’ total expense ratios in their own managed funds’ expense measures.

Factsheets for the Evercore PanDynamic funds, for example, available on the manager’s website, show the total expense ratios for the retail share class as 1.1% per annum. That’s 0.9% to the fund manager and 0.2% to cover administrative charges, the PanDynamic range’s prospectus makes clear.

However, Evercore’s PanDynamic funds invest exclusively in ETFs, which of course charge their own fees as well. The PanDynamic Growth fund had its three largest positions at the end of August (representing a collective 40% of the fund) in the iShares £ Corporate Bond ETF, the db x-trackers MSCI Emerging Markets ETF and the iShares MSCI Far East ex Japan ETF, which charge 0.2%, 0.65% and 0.74%, respectively.

Should Evercore be including these underlying fund charges in the overall expense figure it shows to clients? Undoubtedly, in my opinion.

Unfortunately, it’s easy to think of several other cases where fees are added to fees without the end result being advertised to the investor, even where notionally low-cost ETFs are concerned. db x-trackers’ hedge fund index ETF, for example, which claims a total expense ratio of 0.9%, tracks a basket of hedge funds on Deutsche Bank’s managed account platform, all of which will levy their own fees before the index return is calculated. Being hedge funds, those fees are not cheap – but an investor in the ETF gets no measure of the cumulative effect of the charges, even though he pays them.

Where another hedge fund product is concerned, the MW TOPS Global Alpha ETF website spells out a little more clearly that its fund fee of 0.25% is going to be levied over and above a 1.5% management fee and 20% performance fee on the underlying index components. Those charges will land the end-investor with a total bill of well over 2% per annum if the fund produces any respectable positive return, though (something the MW TOPS Global Alpha fund has so far failed to do).

Perhaps the average investor in a fund of funds does have some idea that he’s going to be charged twice – at the umbrella fund level and at the underlying funds level – and, after all, there’s nothing forcing the investor to buy such a structure. Usually, and especially using ETFs, you can put together a diversified portfolio yourself. If your umbrella fund operator adds value through asset allocation, fair enough: you're paying for it.

But fees are fees, they’re certain, and they detract from your ultimate return. If there are two (or more) levels facing the end-investor, then it’s misleading not to show the aggregate amount.

Unfortunately, umbrella fund double charging is perhaps the least difficult area when it comes to calculating real investor costs.

What about the cost of providing a swap for a swap-based ETF? If a fund pays a Libor-plus rate of interest to its swap counterparty, then those extra basis points above Libor will be reflected in an additional performance lag versus the fund’s benchmark, something that is not shown in the fund’s expense ratio at all, but which can only be measured after the fact. And if there is no Libor-plus charge, to what extent is the fund being given lower quality collateral in return for its swap contract? The “cost” of owning a sub-standard collateral basket is completely invisible in a fund’s tracking performance and might only appear in a bankruptcy event, but it’s there. Similar considerations of risk versus return arise when stock lending takes place. Is the fund bearing all the risk but gaining only part of the return? If so, that’s a cost too – but one that’s impossible to measure without greatly improved disclosure.

And what about setting a benchmark that’s too easy to beat because of the index’s dividend tax assumptions? If you then only match it, that’s also a cost to the end-investor, albeit one that’s completely invisible at first glance.

There’s almost no end to this. Clever fund designers will always try to generate more revenue for themselves from less, while those of us observing from outside (and the regulators) struggle to keep up. But weren’t ETFs supposed to be about transparency?

There’s no Great Recession in the world’s FX markets. But who’s making the money?

According to the Bank for International Settlements (BIS), quoted in today’s Financial Times, the global foreign exchange market now turns over US$4 trillion daily, up from US$3.3 trillion three years ago. So while equity volumes (and index levels) remain depressed when compared with the world as it was pre-Lehman, FX market traders must be breaking out the champagne.

My “football shirt sponsor” indicator hints at the money flow to FX trading concerns. International “retail forex broker” FxPro starts the 2010/11 English premier league season as sponsor on two teams’ shirts, those of Fulham and Aston Villa.

Talking of following the money, loan sharks Wonga – famous for their payday loans at 3000%-plus interest rates – are in the football shirt sponsorship business too (with Blackpool), as is a roster of online betting firms like 188BET, SBOBET and Sporting Bet (gambling and gaming sites sponsor five clubs’ shirts).

Cash-hungry football players and club owners, real-time online betting and multiple opportunities for match-fixing – it all sounds like a very unhealthy combination. Pakistani cricketers, anyone? (And English and Australian too, I should add.)

But perhaps the average football fan is happy to take out a £100 five-day loan at a 3253% interest rate to buy his match ticket and have a little left over to gamble online while at the game, even if some of the players may be trading on inside knowledge.

Returning to forex, with firms like FxPro offering leverage of up to 500:1 to retail punters, it’s perhaps unsurprising that the BIS is seeing global currency turnover rise. However, the life expectancy of the average FxPro client must be extremely short. At that leverage ratio a 0.2% move in a spot rate will wipe you out.

By comparison with the mind-boggling riskiness of some of these ventures, currency exchange-traded products are utterly boring. There’s little or no leverage, simply an opportunity to move funds easily from one currency base to another (for example, with ETF Securities’ currency ETCs) or to invest in different currency strategies (via db x-trackers momentum, carry and valuation funds).

In currency ETCs, investors appear stubbornly bullish on the dollar against the euro and yen, as we reported three weeks ago. Meanwhile, db x-trackers currency valuation ETF has done the best over the two and a half years since its launch, adding nearly 30%, while the momentum ETF is up 14% and the carry ETF is down 14%. Currency carry strategies (which borrow in low interest rate currencies to invest in high ones) took a big hit in late 2008 after years of steady gains.

Remembering that gold is a currency too, it’s worth pointing out that gold ETCs have done better still. ETF Securities’ Physical Gold ETC (LSE: PHAU) is up 32% since the date of db x-trackers currency ETFs’ launch. Gold tracker assets also vastly outweigh those invested in other currency ETPs.

So while the world’s currency markets offer plenty of trading “opportunities” with the type of leverage and froth that suggest the credit bubble never happened, there’s also a respectable list of more sober FX investment products to choose from, ones that don’t promise to immediately part you from your money to enrich the provider.

If an exchange-traded product firm ever gets into the football shirt sponsorship business, it might be time to start worrying, though...

Since its launch in May, Lyxor’s ETF on Euro Stoxx 50 dividends has outperformed the Euro Stoxx 50 index itself. Could this continue?

In May Lyxor introduced an ETF offering exposure to the dividends paid out from the Euro Stoxx 50 index’s constituent stocks, rather than exposure to the stock prices themselves. The ETF does this by tracking an index representing a five-year “strip” of the dividend futures traded on Eurex, each of which represents the cumulative dividends to be paid out from the index’s 50 constituent companies in the relevant year.

Here’s IndexUniverse.eu’s report on the original fund and index launch, and a subsequent feature article examining the product in more detail.

Since the Euro Stoxx 50 dividends ETF was launched by Lyxor on 19 May, it has outperformed the Euro Stoxx 50 index itself by around 5%. In the chart below I’ve compared the performance of two Lyxor ETFs, one tracking the dividend index, the other the Euro Stoxx 50 net total return index. Both funds’ NAVs are rebased to 100 on 19 May.

Earlier this week James Montier of fund manager GMO released a piece of research in which he makes the same argument as Patrick Armstrong did in our June feature: that European dividend expectations look too pessimistic, and investing in them makes sense.

Montier starts by demonstrating that dividends contribute around 90% of an investor’s long-term total return from equity investing, then goes on to illustrate that European dividend expectations are already pricing in the equivalent of the US great depression (see the chart below). Since 2008 there has already been a sharp fall in dividend payouts in Europe, but the path of dividends to 2019 implied by Eurex’s futures suggests further falls, just as US dividends fell for a decade after 1930.

One can quibble about some of Montier’s assumptions: there’s no comparison of the starting level of dividends, nor of companies’ payout ratios. Both these measures could have a significant impact on subsequent distributions. And his argument that “even Japan has managed to grow its dividends by just over 2% annually during its two decades of post-bubble economic stagnation” sounds impressive at first glance, but on reflection doesn’t amount to so much if one considers that Japanese companies paid out almost nothing in dividends in 1989, whereas the Euro Stoxx 50’s starting point in 2008 was a 4-5% yield.

Also, 20% of the Euro Stoxx 50 index is in financial stocks, whose dividends are already under pressure as a result of demands for higher capital ratios. If the economic environment deteriorates further, there will be additional calls for banks to scrap payouts (although some investors, like Armstrong, argue that such an outcome is already largely priced into the dividend futures market).

Nevertheless, Montier makes some other interesting comments in support of investing in dividend futures. First, he points out, dividends offer a very effective long-term inflation hedge, so you might easily consider a product investing in them as a match for pension liabilities. Second, he adds, dividend products are one of the rare cases where you’re likely to benefit rather than suffer from index survivorship bias, since large, dividend-paying stocks are likely to get into the index, while dividend cutters get thrown out (and when investing in a “pure” dividend strategy you don’t suffer from the stock price deterioration that typically occurs as markets discount such an event). Finally, argues Montier, over time dividend swap- or futures-based products should show lower volatility than stock prices themselves (the chart of the performance of Lyxor’s two ETFs already hints at this).

Assets in Lyxor’s Euro Stoxx 50 dividends ETF are still tiny by comparison with those in the Euro Stoxx 50 ETF itself (€34 million as opposed to €4.9 billion). But the increased attention being paid to the dividends market by some of Europe’s most successful asset allocators suggests that the first figure should soon rise. Meanwhile, credible arguments that future dividend expectations are structurally depressed mean that the Euro Stoxx dividends ETF may indeed carry on outperforming the Euro Stoxx 50 ETF itself.

With government bonds yielding less than equities, is a buy signal approaching for stock markets? 

James Mackintosh, investment editor at the Financial Times, points out that government bond yields have moved below broad equity index dividend yields in several countries: Japan, many European countries, the UK and now even the US (if you use the Dow Jones Industrial Average as your benchmark). Isn’t this a buy signal for shares?

As Dian Chu of Economic Forecasts and Opinions put it last week, “Equities historically outperform bonds. And the current Dow 30 composition is probably the strongest on record. So, the strategy here is simple–get in on these blue chips when everyone else is still playing musical chairs over at the bond market. Then, sit tight knowing at least a portion of your portfolio will ride the Dow 30's nice dividend yield, and the price appreciation coming from their solid long term top line growth.”

Here, from the FT’s helpful video on the subject, is the chart of US equity and government bond yields in the year to date. The decline in bond yields has been dramatic, while the Dow’s dividend yield has drifted slowly upwards. Incidentally, the yield crossover has yet to occur for the broader S&P 500, and it hasn’t occurred – yet – if you use the 30-year, rather than 10-year bond yield.

However, as Mackintosh points out, the yield indicator doesn’t always work. In Japan, for example, when the equity dividend yield moved above Japanese government bond yields in late 1998 and early 2003, it was indeed a signal to switch from bonds to equities, and on both occasions equity investors more than doubled their money in the subsequent year or two. However, the most recent crossover, from 2008 onwards, has simply failed to work. Equities languish at 20-year lows, while bond yields have carried on down.  See the chart below.

As we argued a couple of weeks ago (“Equities for Income?”), yield relationships between bonds and equities looked a whole lot different before the 1950s. 

The “Fed model” of the interrelationship of bond yields and equity earnings yields, popularised in the 1990s by many Wall Street strategists and used to justify higher stock weightings when bond yields fall, has now completely broken down, for example.

A completely different model, explained by strategist Bob Bronson, posits a relationship between the bond and stock markets that switches polarity, depending on where we are in what he calls “supercycle economic seasons” – a concept similar to Kondratieff or long-wave cycles.

In the supercycle autumn, which prevailed for most of the 80s and 90s, according to Bronson, bond and equity yields could indeed move in the same direction. Now, he says, in the winter phase, bond yields are falling while equity yields move up – a complete reversal of the relationship of the previous two decades. Plus, he adds, there will be a generalised increase in risk aversion and a decline in P/E ratios, neither of which is bullish for equities.

So don’t place too much store in recent historical relationships from the asset markets – it can pay to cast your eye further back in time. And, if you are playing a possible equity recovery via ETFs, make sure you’re receiving the full dividend stream, or as much of it as possible. As we pointed out recently (“Those Leaky Dividends”), it’s easy to forfeit up to a third of your income from shares without really being aware of it.

While German and French bonds have been hitting record lows in yield, strains are intensifying elsewhere, threatening a stormy autumn.

The chart below, which comes from the Calculated Risk blog, shows how the bond yield spreads of Europe’s peripheral markets have widened again, after a brief respite earlier this summer.

The EU/IMF bailout of Greece in May helped the country’s 10-year bond yield spread over German bonds to halve from a peak of over 1000 basis points.  However, spreads have steadily increased since then, and are now almost back up to those May highs.

The introduction of Europe’s financial stability fund (EFSF) in June, a month after the Greek bailout, in an attempt to stop the contagion spreading elsewhere within the eurozone, has also had limited success, if one looks at the widening spreads of Ireland, Spain, Portugal and Italy over recent weeks.

Remember that the EFSF is a kind of CDO structure that uses overcollateralisation to try and enhance its overall creditworthiness:  the collective guarantees of the 19 participants are designed to add up to 20% more than the amount insured by the fund.

The problem with the structure – as with CDOs – is that all the apples in a basket tend to go bad at once.

As derivatives expert Satyajit Das calculates, “if 16.7 per cent of guarantors (20 per cent divided by 120 per cent) are unable to fund the EFSF, lenders to the structure will be exposed to losses. Coincidentally, Greece, Portugal, Spain and Ireland happen to represent around this proportion of the guaranteed amount. If a larger eurozone member, such as Italy, also encountered financial problems, then the viability of the EFSF would be in serious jeopardy.”

The Irish government, which earlier this year was being lauded – by contrast with those lackadaisical Greeks – for taking the harsh medicine of austerity, is now right back in trouble.

As an article in today’s Economist points out, the cost of Ireland’s bank bailout has soared, raising concerns that public debt is out of control.  Ireland faces a classic debt trap, with nominal GDP having shrunk by nearly 20% since the 2007 peak, causing the real debt burden to compound at an accelerated rate.

In Greece, servicing debt at double-digit interest rates while economic activity contracts by 4% this year, then 2.6% next, would be impossible were it not for the EU/IMF backstop.  Meanwhile, top-end property prices have already fallen by half.

If the credibility of that backstop is beginning to be questioned – and market developments suggest that it is coming under increased pressure – then European government bonds are heading for another crisis, with the euro likely to take the strain as well.