Sunday, November 14, 2010

A More Insightful Way to Characterize Funds

Guilty As Charged

I plead guilty. I plead guilty for the crime of characterizing mutual funds and their kissing cousins, hedge funds by the types of securities in their portfolios. My enablers are the fund marketing people and the lawyers. At times we are all guilty of taking the easy way out. We choose to identify people by what they look like, not what they are, or more significantly how they think. I should have known better. I forgot my race track education of calculating my betting choices after examining the characteristics of the jockey, trainer, and breeding as well as the conditions of the race and the racetrack. Shame on me.

The Talents of the Trade

Each of us has a different collection of talents. I have made a living analyzing a mass of data, organizing the data for decision making, and using that data for making decisions applying the disciplines that I learned from my educational institutions, the US Marine Corps and the aforementioned racetracks. I should have looked at the primary thought patterns of the principal decision maker for each fund. Most of the time this is the portfolio manager, but it can be the most forcible member of the investment committee, a determined marketer, or extremely rarely, the fund’s board of directors. The following are some of the ways that I identify the dominant personality of a fund and how the fund can be used most effectively in a portfolio of funds. (I manage or advise on the use of funds in a multi-fund portfolio where each fund has a separate function in contributing to the whole over the long-term.)

The Discoverer

This portfolio is full of names that are not common to most other portfolios. More often than not these names are of smaller, often newer companies. Sometimes the names are from rarely explored foreign markets. Occasionally the names are different types of securities which more often than not come from the extremes of the fixed income world. All of these securities lack significant research coverage from the usual sources of research. As an analyst I used to delight in finding companies whose president has not talked to an analyst in years. As he or she explained the company to me, I explained how analysts like me operated. Some of the most rewarding investments were in companies that had a policy of not speaking to analysts. In almost all cases the names in a Discoverer’s portfolio are difficult to analyze. When these stocks move, it is usually not due to an asset class’s popularity or the general trend of the market. Most often a Discoverer will have more strike outs than home runs. The investment results will look more like those of a venture capital portfolio, but have the advantage of offering daily liquidity. In the hands of someone with a great deal of industrial experience and a proclivity in recognizing management’s abilities, this kind of investing can be rewarding for the truly long term investor. Wealthy individuals who have a multi-generational outlook or a structured endowment for long term horizons can find a Discoverer a non-political “fellow traveler” and a good strategic fit.

The Anticipator

I use to hear this term used more frequently than now. The term was applied to managers who felt they had well-defined skills at anticipating major interest rate moves. There is still at least one fund that invests either in very short term treasuries or thirty year treasury bonds. The Anticipator has a defined view of the future and is waiting for the rest of the investing community to catch up. The trick for a successful Anticipator is not to be the first Anticipator but near to the last, just before the take off of the expected trend. At times, Bill Gross and others at PIMCO are Anticipators. To some degree this a necessity, due to its size relative to the size of the available merchandise at an inflection point. This may be a requirement for PIMCO as the world’s largest bond fund manager. Some patience is required to be a successful holder of a fund that anticipates. One can appropriately call my faith in the benefits of technology as anticipatory and not often rewarded.

The Immediate Reactor

The financial press believes that the market is full of those traders/investors who immediately react to a bit of news. They are looking for the proverbial one-handed economist who has a singular view on an event. Even the rapid-fire “macro” hedge funds don’t put their money on a single roll of the dice. Most often a substantial buy is offset by a sale or short sale, perhaps through derivatives or ETFs. Nevertheless, the Immediate Reactor does make dramatic moves quickly. The closing of the liquidity pool around a security or currency is viewed as an opportunity to get in before the bulk of the move is underway. Funds that do react well have suburb trading skills and they know how to use their size to get the best advantage. In many ways these are trading artists. Outside of occasional outsized gains, these funds can be used as an early warning device, a canary in a mine if you will.

Trend Identifier

These managers are constantly searching for minor deviations from immediate past experiences; to be one of the earlier identifiers of a change in an investible trend. For example, these trends can focus on elements of consumer spending at various price points, the popularity of products ( e.g. Blackberries and iPads), or the daily movement of a currency. In the fund arena, the rate of inflows and redemptions can be interpreted as meaningful trends. Often large funds use identification of trends to shift a small amount of their portfolio in the direction of the trend on a daily basis and more as the trend becomes more pronounced.

Trend Follower

Some managers, particularly in the commodities world, are Trend Followers. They need to separate market volatility from important market trends. These stock, bond, and commodity managers focus on large aggregates in the market place. A more modern example of this age-old technique is the use of Exchange Traded Funds. Currently there are portfolios that only own ETFs or Exchange Traded Notes (ETNs), a fixed income equivalent. Increasingly these portfolios are being used for commodities like gold and silver. Trend Followers have more faith that the trend will continue for some period of time than recent history suggests. Also aggregate trends do not allow for the investment opportunity differences among various industries, sectors and other components of the aggregates. If one does not have much faith in individual selection skills and the direction of “the market” becomes all important, Trend Following is an attractive approach.

The Resurrection Believers in Recovering Prices

As all life seems to be cyclical in terms of up and down phases, hopefully around a recognizable trend, some managers look at investments that are currently priced well below their peak levels. Excluding from this universe those stocks that were substantially over-priced given their best expectations, the resulting list of large discounts from peak can be a happy hunting ground for some investors. These investors are different from value investors who believe that today’s price represents a good value relative to today’s reality. Those that believe in recoveries believe that conditions will change. Whatever caused the unfavorable conditions, e.g. commodity prices, unpopular styles or product failures, will change. The argument goes something like this: if oil was priced at either $150 or $36 a barrel, certain properties would be perceived to be more valuable. Another variant of this strategy is when the new production comes on line, such and such will happen that will significantly change the valuation of a security. This may be considered as betting on the return of the Black Swan from Australia. History is on the side of those who believe in cycles of prices and other forms of human behavior. What is more difficult is identifying which particular cycle will change the soonest. To some degree distressed securities buyers believe in a form of financial resurrection.

Final Note

To be a good investor, one needs to know more about the intellectual motivations behind various portfolios.

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