Recently I attended a board meeting of a group. (I am not a member of the investment committee of this particular board.) The distinguished chairman of the committee announced that were currently holding over 20% in cash and short term paper because nothing appealed to the committee. In only one of the accounts that we manage, we have a similar out-of-the market position, while we are researching for the right combination of micro and small cap investments. The eventual spending needs of both organizations requires us to become more productively invested. Most institutional investors recognize this need, many individual private investors do not. Until very recently the flows into equity mutual funds have been largely institutional in nature with very little from retail investors except through their automated 401(k) investments.
There are lots of reasons to be uncertain about the future. Globally, the fear of ever-expanding government interference in the private economy, the unprofitability of adding to the workforce, rumblings of sharply increased tariffs, plus over-leveraged governments, companies, and individuals are just a few of the worries. Indicative of these concerns are uncertain tax rates, interest rates, inflation levels, and the value of currencies. Some may share my increasing concern with the ability of the Chinese government to manage population flows. Wouldn’t it be nice if we could divine the answers to some of these challenges?
As investors, the real trick is to get the answers ahead of others and to find prices that reflect the market uncertainty and not our superior knowledge and insight into the future. Dream on.
The plain truth is that prices represent the equilibrium point between buyers and sellers who are driven by their own needs plus some views as to the future. By nature, their views of the future are speculative. However if enough transactions are driven by similar thoughts, a recognized trend is quickly established. Thus, market prices imperfectly discount a series of future scenarios. As views of the future are by nature speculative (because the “knowns” are not known), prices will move ahead of the facts. The best prices will occur before the facts arrive.
Today the general level of stock prices assumes an accelerating recovery in the face of some additional layoffs and small sales increases that are not inventory rebuilding. In order for me to be comfortable with buying and owning equities today, I need to believe in two successive good fortunes. These pieces of good fortune include institutions who have long term spending needs and in addition will invest in their future by buying stocks or their equivalents. These purchases push prices up enough to create a trend that the public buys into in a major way. Will this happen? I have some confidence that it will happen, but I don’t know when the parade that can turn into a stampede will begin.
When I left active duty in the US Marine Corps one of the things I announced to myself is that I would not stand on line again. Foolish thought for anyone who commutes, particularly today at airports! Thus, I have become reconciled to standing on line waiting for something to happen. Therefore, I am willing to be as close to fully invested as my clients need and wait for something to happen. I recognize that some bad things are undoubtedly likely to happen, but I am betting on balance more good for investors than not will occur during this period of low level optimism. (By the way, I think we are well past the period of maximum pessimism which occurred just about a year ago. That was the time to invest.)
Bottom line, at the moment, I prefer to speculate about the future than to wait for the arrival of favorable facts.
For those who must invest to meet future spending needs, how are you investing now?
Sunday, January 31, 2010
Sunday, January 24, 2010
The Super Bowl and Fund Selection II
One of the more popular of my blogs in 2009 was my comparison of fund selection and picking the winner of the Super Bowl. This year, the Lords of Football have been very successful in building excitement in anticipation of the annual event. The two conference play-off games match storied teams with a great deal of interest on the part of the press and the fans. As I will be traveling during the broadcast of the games, I will not know the results, but I am guessing that the winners will be compared to each other during the next two weeks in great detail. Almost as much detail as one should use in selecting mutual funds and other investment managers. Thus, at popular request I am repeating last year’s blog on the Super bowl and fund selection.
While I believe that you can use the thinking demonstrated in the 2009 Super Bowl blog, you should not expect to do so for the 2011 games. Both professional football and the investment community are on the cusp of significant change having to do with the attractiveness of the investment of time and emotion in the games of selection and the profitability of the exercise.
On the football side, this Super Bowl will be the last played under the collective bargaining agreement that is scheduled to expire on March 31st. What we do not know is what changes will occur and how these changes will impact the compensation for existing and future players. These unknown changes could well affect the make up of the teams. I believe the spat between Fox and Time-Warner Cable is also emblematic of the changing economics of all electronic distribution in the future. How much revenue will be produced, and how it will be divided, will evolve over the next several years, which in turn will have an impact on the money that will be available to the teams and their players. There is at least one other uncertainty. In response to health and other concerns, the Competition Committee will make changes, subtle or great for all NFL games. Starting next year, but becoming more pronounced in future years, each of these changes are likely to be game changers. These changes may well downgrade the value of past performance in selecting the winner of future Super Bowls and the point spreads.
On the investment side we had already identified a number of changes before the White House thundered forth on special taxes on bank liabilities, prohibition of proprietary trading and other attempts to prevent the prospect of a very large institution failing financially and putting others at risk. I have already commented on my concerns regarding the way the central marketplaces have been replaced by a system of fractured electronic communication systems, where price, volume, and identity of counterparties become opaque. Combine these structural changes with various accounting changes which make comparative operating earnings more difficult to determine and it is much more challenging to use valuation techniques based on earnings. Lastly, as hinted in last week’s blog, I am increasingly concerned that rumors about China can stampede other markets around the world, including our own.
Bottom line: you should enjoy this year’s Super Bowl and perhaps this year’s market, but do not expect them to be too much help in the future. As they used to say in ancient Rome, “Let the games begin.”
_____________________________________________
The Super Bowl and Fund Selection
For many of us, this is the season of selecting which team will win the forthcoming Super Bowl. This year is a bit different for me because of this blog.
One reader recently asked me about fund selection, and the analyst in me forced me to list selection criteria topics that could apply to each selection task. I stopped when I had listed 25 items. To reduce mental strain on your reading, and writing efforts on me, I will only briefly discuss 14 of the items. For other analysts and exacting types who would like to read the entire list, please send me an email, aml@lipperadvising.com, and I will send you the list.
Before I begin, I should disclose that for the last 15 years I have worked with the NFL and its Players Association on their various retirement plans. I have been watching and thinking about the Super Bowl for many years before my professional responsibilities began.
SELECTION BRIEFS - For each selection point below, my Super Bowl observations are first, in bold. The related fund selection comments are second in italics, and my comments last, in plain type.
1. Compare the simple Won and Lost record compared with all other teams.
Compare Fund Performance Rank against all other funds.
Both sound bites are useful if the competition is in the past.
2. Analyze the success or failure in “Red Zones,” within 20 yards of the goal line.
Analyze the general price level of securities high vs. low.
Most of the time the game is played in mid-field or within normal price levels, but the big dollars are earned in extreme places both for the offense and the defense.
3. Examine the heroes, usually the quarterback and one or two backs or line backs.
Examine the Portfolio Managers or lead managers.
Unfortunately, little or no recognition is given to the offense or defensive lines (or analysts and traders). In many cases they make the guy up front look good while they do the hard work.
4. Understand that the Offensive Line protects the backs, creates the holes in the opposing lines and confuses the opposition.
Analysts, both within and outside a fund organization, see what others don’t or see it faster.
5. A Defensive Line breaks up the offense’s plays and protects their goal lines.
The contrarians look for weaknesses in momentum and uncover the big users of Cash.
In items 4 & 5, we see the importance of the supporting roles contributing to the success of the team and the fund.
6. In terms of compensation, both groups use financial incentives to motivate their teams. In professional football, the players have well-defined contracts.
In the investment world, most serve as “at will” employees, but often the bulk of their compensation is paid as a bonus.
Too often the bonus emphasizes current year performance and very little, if any, based on team-building and leadership.
7. A vital factor is the football team’s Front Office, who provides the financial and real estate resources to build the franchise.
In fund organizations, the business management often has similar responsibilities, including reporting to shareholders (both inside and outside), as well Holding Companies, particularly those of banks, insurance companies, and brokers.
Fund stakeholders usually have different (longer) satisfaction time thresholds.
8. Penalty-prone teams may try too hard, generating loss of yardage on the field, and fines off the field.
Similarly, a fund could wander or purposefully enter the “information gray zone.”
This straying action could negatively impact a fund’s performance.
9. Fan Support can be very encouraging at both open practices and game time, and may give some teams a big home field advantage.
Retail investors who buy with a broker’s assistance and 401(k) investors tend to be more patient than some institutional investors or pure no load investors who only focus on near-term performance or momentum.
The NFL team front office and a fund’s business management both understand the long term cost of losing their base.
10. The “Hail Mary Pass” is an extremely long pass thrown at the end of a game to attempt to reverse a losing score.
Similarly, a fund may have an out-sized position, often in a relatively, thinly traded stock during the last quarter of the year.
Both approaches have produced winners, but not as often as tried. Desperation does not produce comfort for investors nor fans.
11. A running game focuses on backs going through or around the defensive line, mostly resulting in short yardage that occasionally leads to big yardage and a score.
A fund, trading for small advantage in short periods often produces more highly taxed gains.
The tax orientation of the manager is often a good clue to who should own the fund.
12. The fact that any team in the league can win on any given day is particularly true in the last three games, especially after the teams that do not make the playoffs are eliminated.
A fund’s “season” is its performance, annual period. It is unlikely that a bottom performing fund can become a top performer late in the period, but it can happen. The winners are likely among the current performance leaders, or among those showing momentum. This is particularly true in a tightly defined peer group.
Do not despair for this year’s laggards. Often a particular period is being used to develop a winner over a longer time period, particularly when, or if, market conditions change.
13. What about a “Winners Curse?” To the best of my memory there has never been a winner of four consecutive Super Bowls.
The same can be said for funds. Except in the case of a long market, rarely do winners repeat three years in a row and even twice is difficult.
The winners become celebrities and at least become more expensive, if not more difficult to manage. The winners attract fair weather friends and fans who are more demanding than those who were steady company in the dark days.
14. Dynasties are extremely difficult to sustain. Start with the Winners Curse and the absolute fact that each year humans get older and more prone to the trials of the flesh. Among these mortal groups are team scouts, who may miss insights or talent opportunities.
In the investment world there is no business-wide compensation cap, and only 100% of equity that conceivably could be redistributed and most of the time much, much less.
So after all this analysis what are my choices for 2009? You will understand that I can not make a public prediction as to the winner of the Super Bowl as all the participants are clients. However, going through the thought drill of the above items, I do not see that any single team has an overwhelming advantage. My guess is that the two finalists will be a surprise to most of us, and particularly one of them. The key question is whether the game will be close, which is a function of luck and the Zebras (the officials). So I root, as I do each game, for the Zebras. May they call a good game!
In terms of fund selection, I will go just a little further out on a limb for the non-paying crowd. First, I do not expect a repeat of this year’s winners. I expect the winners to be more diverse than this year’s Dedicated Short Biased funds. The winners will be based on their individual security selection skills, which can be found in equities, fixed income and international securities. A top down approach will not be effective enough.
A number of winning portfolio managers will come back from long-forgotten victories, while other winners may be inexperienced investors who did not see the same risks that their colleagues feared.
Let the Games begin...
While I believe that you can use the thinking demonstrated in the 2009 Super Bowl blog, you should not expect to do so for the 2011 games. Both professional football and the investment community are on the cusp of significant change having to do with the attractiveness of the investment of time and emotion in the games of selection and the profitability of the exercise.
On the football side, this Super Bowl will be the last played under the collective bargaining agreement that is scheduled to expire on March 31st. What we do not know is what changes will occur and how these changes will impact the compensation for existing and future players. These unknown changes could well affect the make up of the teams. I believe the spat between Fox and Time-Warner Cable is also emblematic of the changing economics of all electronic distribution in the future. How much revenue will be produced, and how it will be divided, will evolve over the next several years, which in turn will have an impact on the money that will be available to the teams and their players. There is at least one other uncertainty. In response to health and other concerns, the Competition Committee will make changes, subtle or great for all NFL games. Starting next year, but becoming more pronounced in future years, each of these changes are likely to be game changers. These changes may well downgrade the value of past performance in selecting the winner of future Super Bowls and the point spreads.
On the investment side we had already identified a number of changes before the White House thundered forth on special taxes on bank liabilities, prohibition of proprietary trading and other attempts to prevent the prospect of a very large institution failing financially and putting others at risk. I have already commented on my concerns regarding the way the central marketplaces have been replaced by a system of fractured electronic communication systems, where price, volume, and identity of counterparties become opaque. Combine these structural changes with various accounting changes which make comparative operating earnings more difficult to determine and it is much more challenging to use valuation techniques based on earnings. Lastly, as hinted in last week’s blog, I am increasingly concerned that rumors about China can stampede other markets around the world, including our own.
Bottom line: you should enjoy this year’s Super Bowl and perhaps this year’s market, but do not expect them to be too much help in the future. As they used to say in ancient Rome, “Let the games begin.”
_____________________________________________
The Super Bowl and Fund Selection
For many of us, this is the season of selecting which team will win the forthcoming Super Bowl. This year is a bit different for me because of this blog.
One reader recently asked me about fund selection, and the analyst in me forced me to list selection criteria topics that could apply to each selection task. I stopped when I had listed 25 items. To reduce mental strain on your reading, and writing efforts on me, I will only briefly discuss 14 of the items. For other analysts and exacting types who would like to read the entire list, please send me an email, aml@lipperadvising.com, and I will send you the list.
Before I begin, I should disclose that for the last 15 years I have worked with the NFL and its Players Association on their various retirement plans. I have been watching and thinking about the Super Bowl for many years before my professional responsibilities began.
SELECTION BRIEFS - For each selection point below, my Super Bowl observations are first, in bold. The related fund selection comments are second in italics, and my comments last, in plain type.
1. Compare the simple Won and Lost record compared with all other teams.
Compare Fund Performance Rank against all other funds.
Both sound bites are useful if the competition is in the past.
2. Analyze the success or failure in “Red Zones,” within 20 yards of the goal line.
Analyze the general price level of securities high vs. low.
Most of the time the game is played in mid-field or within normal price levels, but the big dollars are earned in extreme places both for the offense and the defense.
3. Examine the heroes, usually the quarterback and one or two backs or line backs.
Examine the Portfolio Managers or lead managers.
Unfortunately, little or no recognition is given to the offense or defensive lines (or analysts and traders). In many cases they make the guy up front look good while they do the hard work.
4. Understand that the Offensive Line protects the backs, creates the holes in the opposing lines and confuses the opposition.
Analysts, both within and outside a fund organization, see what others don’t or see it faster.
5. A Defensive Line breaks up the offense’s plays and protects their goal lines.
The contrarians look for weaknesses in momentum and uncover the big users of Cash.
In items 4 & 5, we see the importance of the supporting roles contributing to the success of the team and the fund.
6. In terms of compensation, both groups use financial incentives to motivate their teams. In professional football, the players have well-defined contracts.
In the investment world, most serve as “at will” employees, but often the bulk of their compensation is paid as a bonus.
Too often the bonus emphasizes current year performance and very little, if any, based on team-building and leadership.
7. A vital factor is the football team’s Front Office, who provides the financial and real estate resources to build the franchise.
In fund organizations, the business management often has similar responsibilities, including reporting to shareholders (both inside and outside), as well Holding Companies, particularly those of banks, insurance companies, and brokers.
Fund stakeholders usually have different (longer) satisfaction time thresholds.
8. Penalty-prone teams may try too hard, generating loss of yardage on the field, and fines off the field.
Similarly, a fund could wander or purposefully enter the “information gray zone.”
This straying action could negatively impact a fund’s performance.
9. Fan Support can be very encouraging at both open practices and game time, and may give some teams a big home field advantage.
Retail investors who buy with a broker’s assistance and 401(k) investors tend to be more patient than some institutional investors or pure no load investors who only focus on near-term performance or momentum.
The NFL team front office and a fund’s business management both understand the long term cost of losing their base.
10. The “Hail Mary Pass” is an extremely long pass thrown at the end of a game to attempt to reverse a losing score.
Similarly, a fund may have an out-sized position, often in a relatively, thinly traded stock during the last quarter of the year.
Both approaches have produced winners, but not as often as tried. Desperation does not produce comfort for investors nor fans.
11. A running game focuses on backs going through or around the defensive line, mostly resulting in short yardage that occasionally leads to big yardage and a score.
A fund, trading for small advantage in short periods often produces more highly taxed gains.
The tax orientation of the manager is often a good clue to who should own the fund.
12. The fact that any team in the league can win on any given day is particularly true in the last three games, especially after the teams that do not make the playoffs are eliminated.
A fund’s “season” is its performance, annual period. It is unlikely that a bottom performing fund can become a top performer late in the period, but it can happen. The winners are likely among the current performance leaders, or among those showing momentum. This is particularly true in a tightly defined peer group.
Do not despair for this year’s laggards. Often a particular period is being used to develop a winner over a longer time period, particularly when, or if, market conditions change.
13. What about a “Winners Curse?” To the best of my memory there has never been a winner of four consecutive Super Bowls.
The same can be said for funds. Except in the case of a long market, rarely do winners repeat three years in a row and even twice is difficult.
The winners become celebrities and at least become more expensive, if not more difficult to manage. The winners attract fair weather friends and fans who are more demanding than those who were steady company in the dark days.
14. Dynasties are extremely difficult to sustain. Start with the Winners Curse and the absolute fact that each year humans get older and more prone to the trials of the flesh. Among these mortal groups are team scouts, who may miss insights or talent opportunities.
In the investment world there is no business-wide compensation cap, and only 100% of equity that conceivably could be redistributed and most of the time much, much less.
So after all this analysis what are my choices for 2009? You will understand that I can not make a public prediction as to the winner of the Super Bowl as all the participants are clients. However, going through the thought drill of the above items, I do not see that any single team has an overwhelming advantage. My guess is that the two finalists will be a surprise to most of us, and particularly one of them. The key question is whether the game will be close, which is a function of luck and the Zebras (the officials). So I root, as I do each game, for the Zebras. May they call a good game!
In terms of fund selection, I will go just a little further out on a limb for the non-paying crowd. First, I do not expect a repeat of this year’s winners. I expect the winners to be more diverse than this year’s Dedicated Short Biased funds. The winners will be based on their individual security selection skills, which can be found in equities, fixed income and international securities. A top down approach will not be effective enough.
A number of winning portfolio managers will come back from long-forgotten victories, while other winners may be inexperienced investors who did not see the same risks that their colleagues feared.
Let the Games begin...
Sunday, January 17, 2010
Enjoy a Laugh on My 10 Year Investment Plan
There is an old expression, “Man plans and God laughs.” Bear in mind, with absolute certainty, my ten year investment plan will give you a laugh or a cry. In last week’s blog I outlined how ten typical investment personalities would react to the publishing of fund performance results for various periods ending on December 31st. I promised that I would then provide how I personally reacted to the same data input. Please note that this is an idealized reaction, and does not completely represent how I am currently invested or how I will invest. Among the reasons that the following plan is “What I say” versus “What I do,” are inertia, taxes, expenses and not finding a comfortable fund manager for each component. In some cases I will be sorry that I do not follow my own advice,
First, I set my time horizon for a minimum of ten years, which allows for at least one, if not two, normal investment cycles. In terms of our own money and those of us charged with fiduciary responsibilities, almost all of us should consider longer periods. You should think in terms of the life of a new roof, not the patched one for which we too often opt.
Second, one of the bitter lessons for an equity investor is to look to the performance of fixed income funds as a guide to investment thinking. While 2009 produced double digit returns for longer maturity funds, an examination of their two to twenty year total reinvested return results are, for the most part, in the middle single digits. Recognizing that these are open-end funds which have inflows and outflows that need to be managed, the average returns are not a great deal different than the coupon on their underlying bonds, plus the benefit of interest on the interest income caused by the reinvestment function. In contrast, there was a considerable increment caused by price appreciation in 2009, as bond prices rose significantly. As a contrarian, I look for a reversal of this phenomenon in the years ahead. Until the current yields and the yields to maturity on US Treasuries reach 8%, I do not want to count on bonds to represent a strategic part of my portfolio, other than as a tactical reserve to dampen the volatility for the sole benefit of my nerves.
What is magic about 8%? In the Weekend edition of The Wall Street Journal, Jason Zweig stresses the need to take into consideration investment expenses (to pay wretches like me), taxes for some, and inflation for all. He suggests that using equity market data going back to 1926, the average stock earned 9.8% annually, but after deducting expenses, less than 4% would be produced net. I find it very difficult to get investment committees that I sit on to get their spending rate as low as 4%. In recognition that I will suffer some poor investment choices and that expenses of individual and institutional heirs will creep up, I would be happier with a 3% spending rate. (In one of the attacks of the government against accumulated capital, the government requires foundations, on average, to spend 5% of their capital yearly. So far this does not force families to consume their capital in this way.)
Third, if I desire, (I almost said need), at least an 8% compound annual growth rate on my capital to retain it, can I ask equity funds provide it? The answer is a classic half empty/half full glass of water. For most people that are alive today, the last ten years have been the worst ten years for equity performance. Only in the 1930’s were the results worse. On the other hand, there has never been a twenty year period of this kind of performance. Comparing +1.13% for the average US Diversified Equity mutual fund in 2009, with longer term periods, we note an average gain of 7.66% for 15 years, 9.73% for 25 years, 10.37% for 30 years and 11.74% for 35 years. These results are biased upwards due to dropping out the funds that ceased to exist. On the other hand, these performance averages are not weighted by assets. Almost by definition, larger funds over long periods of time do better than smaller funds, as they compound their performance with fresh capital and have lower average expenses, at least in the US.
Fourth, I look at the old question as to whether active (stock picking) produces better results than passive investing (indexing). In each of the periods ending in 2009, active, diversified managers produced better results even though they charge higher fees. When one reaches back to the 25 and 30 year records, S&P 500 funds beat the average US Diversified Equity fund. On the basis of these records, a contrarian would suggest that as money starts to flow out of S&P 500 funds, it is the time to consider adding index funds to an active fund mix. For me this makes good sense, as I am, for the most part, attracted to highly concentrated funds managed by skilled researchers and managers. The skilled researchers are the key to my selection. From my educational days at the race track, I learned, on balance, that it does not pay to bet against the house. Yes, occasionally some combination of trainer, jockey, or perhaps more accurately, some jockey’s agent, can successfully see a way a particular horse, (read stock), has an advantage over the others if things pan out as they expect and others don’t. In the fund world, these moments of advantage go to the funds that develop, at least for the moment, a research advantage.
Fifth, flowing from the fourth, I seek out relatively unpopular fields where the general lack of research gives a fund more insight than what is believed to be in the market. I find these opportunities often in smaller companies, difficult to understand companies and/or ones with poor near-term results and little or no public market image. In the past, I have found these in brokerage firm and money management stocks. At one point there were legal restrictions on the part of mutual funds owning brokerage firm stocks. This is far less true today.
Sixth, I plead guilty in the past to the trend of comparing funds within investment objective and size classifications as a way to sell my former fund ranking services. Today, I do not see much advantage using these as primary research selection filters. With some maturity on my part, I am now much more interested in research skills and portfolio management artistry than classification ranking. Thus I do not look at my own money in terms of growth vs. value, or large vs. mid vs. small. Further, for my purposes, I am not impressed with purity of style and/or size. I want my funds to own winning positions. (This is a view not shared by a number of the accounts that we manage, who believe that classification results are an important part of their fiduciary responsibilities. I do concede to them that classification comparisons are of significance to their communication responsibilities to their beneficiaries.)
Seventh, sometimes it is more important to be absent than to directly participate in one or more of the performance-leading categories. While they are legitimate options, there are three in particular that I would not currently add to an account that I could not redeem quickly. The three are the three best performing groups of 2009: Latin America 113.09%. Emerging Markets 75.74% and China 69.27%. I normally have an allergy to “hot” areas because rapid cash flow coming into a small area gets exploded when the almost inevitable large waves of redemptions occur. There is a tie that links these three geographically separated areas. Many of the companies held in these fund categories, as well as many US companies, are becoming increasingly dependent upon the growth of Chinese demand. There is the rising demand within China for consumer goods. China is now the largest car market in the world. The demand for selected raw materials to feed their industries to produce for domestic and foreign markets is becoming crucial to the valuation of stocks, and to a lesser degree bonds, around the world. Any slowdown in the creation of urban jobs in China can create extreme political problems. There are reports of factories being closed and people returning to their farm communities. Having sounded the caution, I believe it is still prudent to hold some emerging market funds as a hedge against our own domestic slow growth economy.
Eighth, I am avoiding the double and triple leveraged ETF and ETN funds that are individual fund leaders for many weeks throughout the year, as these highly volatile funds can have difficulty in extreme market conditions. At this point, we do not need leverage to meet our goals.
First, I set my time horizon for a minimum of ten years, which allows for at least one, if not two, normal investment cycles. In terms of our own money and those of us charged with fiduciary responsibilities, almost all of us should consider longer periods. You should think in terms of the life of a new roof, not the patched one for which we too often opt.
Second, one of the bitter lessons for an equity investor is to look to the performance of fixed income funds as a guide to investment thinking. While 2009 produced double digit returns for longer maturity funds, an examination of their two to twenty year total reinvested return results are, for the most part, in the middle single digits. Recognizing that these are open-end funds which have inflows and outflows that need to be managed, the average returns are not a great deal different than the coupon on their underlying bonds, plus the benefit of interest on the interest income caused by the reinvestment function. In contrast, there was a considerable increment caused by price appreciation in 2009, as bond prices rose significantly. As a contrarian, I look for a reversal of this phenomenon in the years ahead. Until the current yields and the yields to maturity on US Treasuries reach 8%, I do not want to count on bonds to represent a strategic part of my portfolio, other than as a tactical reserve to dampen the volatility for the sole benefit of my nerves.
What is magic about 8%? In the Weekend edition of The Wall Street Journal, Jason Zweig stresses the need to take into consideration investment expenses (to pay wretches like me), taxes for some, and inflation for all. He suggests that using equity market data going back to 1926, the average stock earned 9.8% annually, but after deducting expenses, less than 4% would be produced net. I find it very difficult to get investment committees that I sit on to get their spending rate as low as 4%. In recognition that I will suffer some poor investment choices and that expenses of individual and institutional heirs will creep up, I would be happier with a 3% spending rate. (In one of the attacks of the government against accumulated capital, the government requires foundations, on average, to spend 5% of their capital yearly. So far this does not force families to consume their capital in this way.)
Third, if I desire, (I almost said need), at least an 8% compound annual growth rate on my capital to retain it, can I ask equity funds provide it? The answer is a classic half empty/half full glass of water. For most people that are alive today, the last ten years have been the worst ten years for equity performance. Only in the 1930’s were the results worse. On the other hand, there has never been a twenty year period of this kind of performance. Comparing +1.13% for the average US Diversified Equity mutual fund in 2009, with longer term periods, we note an average gain of 7.66% for 15 years, 9.73% for 25 years, 10.37% for 30 years and 11.74% for 35 years. These results are biased upwards due to dropping out the funds that ceased to exist. On the other hand, these performance averages are not weighted by assets. Almost by definition, larger funds over long periods of time do better than smaller funds, as they compound their performance with fresh capital and have lower average expenses, at least in the US.
Fourth, I look at the old question as to whether active (stock picking) produces better results than passive investing (indexing). In each of the periods ending in 2009, active, diversified managers produced better results even though they charge higher fees. When one reaches back to the 25 and 30 year records, S&P 500 funds beat the average US Diversified Equity fund. On the basis of these records, a contrarian would suggest that as money starts to flow out of S&P 500 funds, it is the time to consider adding index funds to an active fund mix. For me this makes good sense, as I am, for the most part, attracted to highly concentrated funds managed by skilled researchers and managers. The skilled researchers are the key to my selection. From my educational days at the race track, I learned, on balance, that it does not pay to bet against the house. Yes, occasionally some combination of trainer, jockey, or perhaps more accurately, some jockey’s agent, can successfully see a way a particular horse, (read stock), has an advantage over the others if things pan out as they expect and others don’t. In the fund world, these moments of advantage go to the funds that develop, at least for the moment, a research advantage.
Fifth, flowing from the fourth, I seek out relatively unpopular fields where the general lack of research gives a fund more insight than what is believed to be in the market. I find these opportunities often in smaller companies, difficult to understand companies and/or ones with poor near-term results and little or no public market image. In the past, I have found these in brokerage firm and money management stocks. At one point there were legal restrictions on the part of mutual funds owning brokerage firm stocks. This is far less true today.
Sixth, I plead guilty in the past to the trend of comparing funds within investment objective and size classifications as a way to sell my former fund ranking services. Today, I do not see much advantage using these as primary research selection filters. With some maturity on my part, I am now much more interested in research skills and portfolio management artistry than classification ranking. Thus I do not look at my own money in terms of growth vs. value, or large vs. mid vs. small. Further, for my purposes, I am not impressed with purity of style and/or size. I want my funds to own winning positions. (This is a view not shared by a number of the accounts that we manage, who believe that classification results are an important part of their fiduciary responsibilities. I do concede to them that classification comparisons are of significance to their communication responsibilities to their beneficiaries.)
Seventh, sometimes it is more important to be absent than to directly participate in one or more of the performance-leading categories. While they are legitimate options, there are three in particular that I would not currently add to an account that I could not redeem quickly. The three are the three best performing groups of 2009: Latin America 113.09%. Emerging Markets 75.74% and China 69.27%. I normally have an allergy to “hot” areas because rapid cash flow coming into a small area gets exploded when the almost inevitable large waves of redemptions occur. There is a tie that links these three geographically separated areas. Many of the companies held in these fund categories, as well as many US companies, are becoming increasingly dependent upon the growth of Chinese demand. There is the rising demand within China for consumer goods. China is now the largest car market in the world. The demand for selected raw materials to feed their industries to produce for domestic and foreign markets is becoming crucial to the valuation of stocks, and to a lesser degree bonds, around the world. Any slowdown in the creation of urban jobs in China can create extreme political problems. There are reports of factories being closed and people returning to their farm communities. Having sounded the caution, I believe it is still prudent to hold some emerging market funds as a hedge against our own domestic slow growth economy.
Eighth, I am avoiding the double and triple leveraged ETF and ETN funds that are individual fund leaders for many weeks throughout the year, as these highly volatile funds can have difficulty in extreme market conditions. At this point, we do not need leverage to meet our goals.
Monday, January 11, 2010
Investment Policies for Investment Personalities
INTRODUCTION
One of the basic tenets of my book MONEY WISE is that one's personality will shape how one invests. In Chapter 14, I briefly identified ten investment personalities as shown below:
* Absolute
* Confident
* Uncertain
* Relative
* Fiduciary
* “Star”
* Bored
* Guilty
* Financial Death Wish
* Paralytic
Actually each of us is likely to be some combination of these personalities and some of us will change personalities in the future due to life circumstance changes. Nevertheless, this framework is a good place to start to evolve one's investment policies. Most of my clients invest with us in various selected funds, but the same principles could be used with individual stocks and bonds as long as there is appropriate diversification.
At this time of the year the press is full of economic, financial, and market predictions. Most of these predictions are for the current period, meaning up to one year. For the most part, the fund investor leaves individual security selection and timing to the funds' managers, so they are not primarily focused on periods as short as one year. For the investors that we serve, our approach is to look to the longest term that the account will permit. For me, that is the rest of my life and to the extent that I am dealing with my heirs, both individual and charitable, to the rest of their lives. To put this into practice, I will focus at looking into the next ten years by reviewing the past ten. Bear in mind no one can truly foretell the future, and based upon the past, we have every reason to believe new discoveries, new industries, new laws and certainly new taxes, will impact us in this ever-changing geopolitical world.
The ten year data by my old firm (now known as Lipper, Inc.) is shown for groups of funds sliced into various categories. Depending on the availability of data, I use fund averages or established fund indexes.
Ten Year Compound Growth Rates
as of December 31st, 2009
FIXED INCOME FUNDS
Emerging Market Debt 11.09%
US TIPS 6.77%
General Bond 6.59%
US Treasuries 6.24%
Corporate Bonds BBB 6.11%
High Current Yield 4.80%
Balanced 2.79%
Money Market 2.60%
EQUITY FUNDS
Global Natural Resources 14.57%
Emerging Markets 9.40%
Small Company Value 8.73%
Global Flexible 5.63%
Small Company Core 5.24%
US Diversified 1.13%
Small Company Growth -0.63%
S&P 500 Index -1.19%
Growth -4.51%
CONCLUSIONS
In looking at these ten year results, one can reach a number of conclusions:
Being something of a contrarian, I am willing to bet that a number of these trends in the next ten years will not be as strong as they were in the last "lost" ten years, or will be reversed. In setting their investment policies in early 2010, different investment personalities will view both the past data and the odds of reversals differently. The following are my initial suggestions to the investment personalities listed above. These suggestions would be modified in individual discussions with each as accounts:
The Absolute Investor, with her fear of significant loss and willingness to accept more limited gain, might opt for some fixed-income laddering, but would be wise to include some TIPS.
The Confident Investor, believing that he has timing skills at least equal to the market, would be attracted to the global natural resources area as well as emerging markets, with heavy emphasis on the so-called "BRIC" countries.
The Uncertain Investor would feel less anxious with a portfolio of money market instruments, TIPS, as well as exposure to a global flexible fund.
The Fiduciary Investor would be similar to the Absolute Investor, but would add one or two index funds.
An investor who wants to boast about his current successes (the "Star" Investor), would be attracted to the narrowly-based exchange traded funds and similar products that are invested in specific industrial segments or specific emerging countries.
Regarding the Bored Investor: Boring is as boring does, with a combination of S&P 500 index funds and money market funds.
The Guilty Investor, who needs to be punished because of some unidentified sin, will load with larger growth funds because of their recent poor record and could well be punished most severely by having a very successful portfolio. Woe is me.
A cousin of the Guilty Investor, but who is more manic, is the Financial Death Wish Investor, who is likely to be attracted to what is currently doing spectacularly well due to leverage and will be attracted to funds investing in high current yield ("junk bonds").
The Paralytic Investor, often the result of a diverse investment committee, will diversify unhappily into index funds, money market funds and global flexible funds.
Next week I am inclined to describe what policies I would like to follow in some of my own accounts.
Further, I would welcome anyone's thoughts as to what I have suggested in this blog.
One of the basic tenets of my book MONEY WISE is that one's personality will shape how one invests. In Chapter 14, I briefly identified ten investment personalities as shown below:
* Absolute
* Confident
* Uncertain
* Relative
* Fiduciary
* “Star”
* Bored
* Guilty
* Financial Death Wish
* Paralytic
Actually each of us is likely to be some combination of these personalities and some of us will change personalities in the future due to life circumstance changes. Nevertheless, this framework is a good place to start to evolve one's investment policies. Most of my clients invest with us in various selected funds, but the same principles could be used with individual stocks and bonds as long as there is appropriate diversification.
At this time of the year the press is full of economic, financial, and market predictions. Most of these predictions are for the current period, meaning up to one year. For the most part, the fund investor leaves individual security selection and timing to the funds' managers, so they are not primarily focused on periods as short as one year. For the investors that we serve, our approach is to look to the longest term that the account will permit. For me, that is the rest of my life and to the extent that I am dealing with my heirs, both individual and charitable, to the rest of their lives. To put this into practice, I will focus at looking into the next ten years by reviewing the past ten. Bear in mind no one can truly foretell the future, and based upon the past, we have every reason to believe new discoveries, new industries, new laws and certainly new taxes, will impact us in this ever-changing geopolitical world.
The ten year data by my old firm (now known as Lipper, Inc.) is shown for groups of funds sliced into various categories. Depending on the availability of data, I use fund averages or established fund indexes.
Ten Year Compound Growth Rates
as of December 31st, 2009
FIXED INCOME FUNDS
Emerging Market Debt 11.09%
US TIPS 6.77%
General Bond 6.59%
US Treasuries 6.24%
Corporate Bonds BBB 6.11%
High Current Yield 4.80%
Balanced 2.79%
Money Market 2.60%
EQUITY FUNDS
Global Natural Resources 14.57%
Emerging Markets 9.40%
Small Company Value 8.73%
Global Flexible 5.63%
Small Company Core 5.24%
US Diversified 1.13%
Small Company Growth -0.63%
S&P 500 Index -1.19%
Growth -4.51%
CONCLUSIONS
In looking at these ten year results, one can reach a number of conclusions:
- Emerging market debt benefited from a material increase in the perception of its credit quality and in some cases an improved currency.
- Inflation while declining, had a real impact.
- Higher credit quality was not penalized.
- Being risk adverse still produced positive results.
- The world appears to be running short of natural resources at current costs of production.
- For the total period, bond investors did better than stock investors in the emerging markets.
- The willingness to combine bonds with stocks worked.
- US diversified equity funds' putrid returns were still better than the S&P 500 index funds.
- Smaller companies did better than large ones particularly of the growth variety.
Being something of a contrarian, I am willing to bet that a number of these trends in the next ten years will not be as strong as they were in the last "lost" ten years, or will be reversed. In setting their investment policies in early 2010, different investment personalities will view both the past data and the odds of reversals differently. The following are my initial suggestions to the investment personalities listed above. These suggestions would be modified in individual discussions with each as accounts:
The Absolute Investor, with her fear of significant loss and willingness to accept more limited gain, might opt for some fixed-income laddering, but would be wise to include some TIPS.
The Confident Investor, believing that he has timing skills at least equal to the market, would be attracted to the global natural resources area as well as emerging markets, with heavy emphasis on the so-called "BRIC" countries.
The Uncertain Investor would feel less anxious with a portfolio of money market instruments, TIPS, as well as exposure to a global flexible fund.
The Fiduciary Investor would be similar to the Absolute Investor, but would add one or two index funds.
An investor who wants to boast about his current successes (the "Star" Investor), would be attracted to the narrowly-based exchange traded funds and similar products that are invested in specific industrial segments or specific emerging countries.
Regarding the Bored Investor: Boring is as boring does, with a combination of S&P 500 index funds and money market funds.
The Guilty Investor, who needs to be punished because of some unidentified sin, will load with larger growth funds because of their recent poor record and could well be punished most severely by having a very successful portfolio. Woe is me.
A cousin of the Guilty Investor, but who is more manic, is the Financial Death Wish Investor, who is likely to be attracted to what is currently doing spectacularly well due to leverage and will be attracted to funds investing in high current yield ("junk bonds").
The Paralytic Investor, often the result of a diverse investment committee, will diversify unhappily into index funds, money market funds and global flexible funds.
Next week I am inclined to describe what policies I would like to follow in some of my own accounts.
Further, I would welcome anyone's thoughts as to what I have suggested in this blog.
Sunday, January 3, 2010
The “Fifth Season” for Investors
Introductions
As an analyst, I was always intrigued with the term that retailers used to describe the time that was spent marking-down their inventory after their financial year closed. For financial statement purposes, (read: borrowing requirements), they needed to adjust ending inventories to provable levels. This period was called the “fifth season.” As an analyst looking at electronics companies’ years ago and financial service companies more recently, I separate the inventory adjustments from the operating results of the fourth quarter. For publicly traded companies, we can make some guesses but we do not know the adjustments to compensation and after-the-close price adjustments, among other items. Only when I work on private companies and non-profit institutions do I regularly see the post-period adjustments. I am still waiting to see a fifth season financial statement.
Investors also have a fifth season that can aid in their own portfolio management. As with most things of value, these facts are hidden in plain sight. The facts hide in the Internal Revenue Services’ required calendar year-end statements. Most of these arrive in the first six weeks of the year. Those who are invested in various forms of partnerships must wait until they receive their K-1 forms. As these documents come in, there is a natural tendency to gather them up for tax preparation work by an accountant or other tax preparer. When reviewing these documents, the focus is almost exclusively on the identification of taxable income. While this is important, it is a lost opportunity to construct the investment section of a personal balance sheet. Those who have read my book MONEY WISE, will know that I believe a properly drawn personal balance sheet with all assets and liabilities, contingent and intellectual, is the key to sound investing. For those who do not want to deal with judgments required to build such a statement, one can still use the formats used in reported financial statements to guide one’s investments. Looking forward on the investment horizon, are your investments where you want them to be? Are your investments in the optimum tax and estate set-up? These are the questions that one should be asking in the “fifth season.”
With the New Year, 2010 offers tax differences that you may not have dealt with before. The most publicized and uncertain of these changes is the absence of the federal estate tax. As this is a moving target, I am not going discuss the longer-term implications of actions today on your personal financial balance sheet and those of your individual and charitable heirs. I am calling to your attention the removal of the income limit on converting a regular investment retirement account (IRA) to a Roth IRA.
Restructuring your Retirement and Estate Plans
Allow me to set the stage for a person who can get optimum benefit from converting their regular IRA to a Roth IRA from a portfolio management viewpoint. Prior to January 1st , 2010, those with income of $100,000 or over were barred from making this conversion, so I am addressing a relative small slice of the population, but numbering in the millions. Most sizeable IRAs are the result of converting a corporate-sponsored retirement program, either from a defined-contribution or defined-benefit plan. For some individuals, we are talking about accounts valued into eight figures. At the same time, many of these people have sizeable after-tax funded investment accounts from earned or inherited wealth. In the early years of IRA accounts there were no restrictions on individuals setting up accounts, even though they were covered by other retirement plans. Many who have shifted employers have multiple IRA accounts.
For example purposes, I am assuming we are dealing with an individual who has a personal after-tax account and a couple of IRAs. Prior to 2010, assume that the size of the personal account was reasonably close to the size of his or her largest IRA. From a tax and estate management point of view, the personal account should have been loaded with equities, where the gains would have been taxed at the more favorable capital gains level while the account holder was alive, and passed to heirs on a date of death basis. The IRA should have been loaded with high income-producing investments, typically bonds and big dividend paying stocks. The income derived would accrue tax-deferred until it was paid out to its owner or his or her heirs. From an overall portfolio management standpoint, the IRA was the reserve element that provided something of a safety net under the more risky, hopefully higher return, equity-oriented account. Note that there is nothing in this two part portfolio set-up to prevent the use of market judgment impacting some reserves in the equity account, and concerns for interest rates and inflation in the IRA.
How does the Roth conversion opportunity change the investments in these portfolios? First, nothing has to change. Second, a decision needs to be made on where the funds will come from to pay the income tax on the conversion. The money can come from either the personal account or the IRA. This decision allows the taxpayer the chance to rebalance the two accounts. Third, if there are more than one existing IRA account, there is no need to convert them all to a single Roth IRA. One might choose to delay moving some to reduce the amount of taxes due in one year, or if there is a belief that one would be in a much lower tax bracket in the near future.
Where to Invest in 2010 for the Future?
The investment results for 2009 were a sizeable after-shock to the earthquake that hit the investment world in 2008. Some investors may feel that these results are normal, cyclical behavior and we can go back to investing as before. Others may feel that we have gone through a seminal period which should lead us to re-examine our thinking and modify our policies.
Space constraints do not permit me to suggest how each of the eleven different investment personalities described in MONEY WISE should view last year’s results and develop plans for the future. Stay tuned for next week’s blog, but the impatient can contact me before next weekend by using the “Comment” button on the blog or by replying to the email version. I will gladly send you the excerpt.
____________________
If you would like to receive my blog automatically through your email system, please subscribe using the box on the left-hand portion of this screen. If you are not sure, use the box above to review past blogs that may interest you.
As an analyst, I was always intrigued with the term that retailers used to describe the time that was spent marking-down their inventory after their financial year closed. For financial statement purposes, (read: borrowing requirements), they needed to adjust ending inventories to provable levels. This period was called the “fifth season.” As an analyst looking at electronics companies’ years ago and financial service companies more recently, I separate the inventory adjustments from the operating results of the fourth quarter. For publicly traded companies, we can make some guesses but we do not know the adjustments to compensation and after-the-close price adjustments, among other items. Only when I work on private companies and non-profit institutions do I regularly see the post-period adjustments. I am still waiting to see a fifth season financial statement.
Investors also have a fifth season that can aid in their own portfolio management. As with most things of value, these facts are hidden in plain sight. The facts hide in the Internal Revenue Services’ required calendar year-end statements. Most of these arrive in the first six weeks of the year. Those who are invested in various forms of partnerships must wait until they receive their K-1 forms. As these documents come in, there is a natural tendency to gather them up for tax preparation work by an accountant or other tax preparer. When reviewing these documents, the focus is almost exclusively on the identification of taxable income. While this is important, it is a lost opportunity to construct the investment section of a personal balance sheet. Those who have read my book MONEY WISE, will know that I believe a properly drawn personal balance sheet with all assets and liabilities, contingent and intellectual, is the key to sound investing. For those who do not want to deal with judgments required to build such a statement, one can still use the formats used in reported financial statements to guide one’s investments. Looking forward on the investment horizon, are your investments where you want them to be? Are your investments in the optimum tax and estate set-up? These are the questions that one should be asking in the “fifth season.”
With the New Year, 2010 offers tax differences that you may not have dealt with before. The most publicized and uncertain of these changes is the absence of the federal estate tax. As this is a moving target, I am not going discuss the longer-term implications of actions today on your personal financial balance sheet and those of your individual and charitable heirs. I am calling to your attention the removal of the income limit on converting a regular investment retirement account (IRA) to a Roth IRA.
Restructuring your Retirement and Estate Plans
Allow me to set the stage for a person who can get optimum benefit from converting their regular IRA to a Roth IRA from a portfolio management viewpoint. Prior to January 1st , 2010, those with income of $100,000 or over were barred from making this conversion, so I am addressing a relative small slice of the population, but numbering in the millions. Most sizeable IRAs are the result of converting a corporate-sponsored retirement program, either from a defined-contribution or defined-benefit plan. For some individuals, we are talking about accounts valued into eight figures. At the same time, many of these people have sizeable after-tax funded investment accounts from earned or inherited wealth. In the early years of IRA accounts there were no restrictions on individuals setting up accounts, even though they were covered by other retirement plans. Many who have shifted employers have multiple IRA accounts.
For example purposes, I am assuming we are dealing with an individual who has a personal after-tax account and a couple of IRAs. Prior to 2010, assume that the size of the personal account was reasonably close to the size of his or her largest IRA. From a tax and estate management point of view, the personal account should have been loaded with equities, where the gains would have been taxed at the more favorable capital gains level while the account holder was alive, and passed to heirs on a date of death basis. The IRA should have been loaded with high income-producing investments, typically bonds and big dividend paying stocks. The income derived would accrue tax-deferred until it was paid out to its owner or his or her heirs. From an overall portfolio management standpoint, the IRA was the reserve element that provided something of a safety net under the more risky, hopefully higher return, equity-oriented account. Note that there is nothing in this two part portfolio set-up to prevent the use of market judgment impacting some reserves in the equity account, and concerns for interest rates and inflation in the IRA.
How does the Roth conversion opportunity change the investments in these portfolios? First, nothing has to change. Second, a decision needs to be made on where the funds will come from to pay the income tax on the conversion. The money can come from either the personal account or the IRA. This decision allows the taxpayer the chance to rebalance the two accounts. Third, if there are more than one existing IRA account, there is no need to convert them all to a single Roth IRA. One might choose to delay moving some to reduce the amount of taxes due in one year, or if there is a belief that one would be in a much lower tax bracket in the near future.
Where to Invest in 2010 for the Future?
The investment results for 2009 were a sizeable after-shock to the earthquake that hit the investment world in 2008. Some investors may feel that these results are normal, cyclical behavior and we can go back to investing as before. Others may feel that we have gone through a seminal period which should lead us to re-examine our thinking and modify our policies.
Space constraints do not permit me to suggest how each of the eleven different investment personalities described in MONEY WISE should view last year’s results and develop plans for the future. Stay tuned for next week’s blog, but the impatient can contact me before next weekend by using the “Comment” button on the blog or by replying to the email version. I will gladly send you the excerpt.
____________________
If you would like to receive my blog automatically through your email system, please subscribe using the box on the left-hand portion of this screen. If you are not sure, use the box above to review past blogs that may interest you.
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