Sunday, March 27, 2011

Combining Core & Periphery Portfolio

  • Learning about the Markets Through Classical Music
  • The Center vs. Selective Peripheries
  • A Reasonable Approach

My wife Ruth and I heard a wonderful concert Saturday night by the New Jersey Symphony Orchestra performing four pieces at the New Jersey Center for the Performing Arts in Newark. I attend these concerts first because I enjoy them and second because Ruth is the NJSO’s co-chair. While listening however, I cannot turn off my investor’s mind. The middle two pieces of the concert were composed in the Viennese/Germanic tradition (Mozart and Strauss) and the bookend pieces were composed by Nielsen (Danish) and Sibelius (Finnish). I recognize that much more great classical music was produced from the center of Europe than the periphery. This essential truth also reflects today’s currency constellation, with the euro as the dominant central European currency.

A quick view of the foreign exchange tables for Europe however shows that most of Scandinavia, Eastern Europe, Russia and the UK are outside the central Europe I refer to above. A number of European region, SEC registered mutual funds have largely a euro focus or perhaps a GDP weighted portfolio. Just as we enjoyed the music composed by the non-Central European composers Sibelius and Nielsen, I wonder whether a greater focus on non-euro based portfolios would give the investor larger gains in selected time periods.

The Center VS. The Selected Periphery

There are many institutional investors and some high net worth individual investors that define investment success relative to the market. Advisers can therefore hug the middle with index or closet index funds and in theory reduce their personal career risk. According to the tables in Sunday’s New York Times:

  • Within the fifteen largest mutual funds, of the five best performers’ year-to-date, three were Vanguard index funds (*).

  • The single best was Dodge & Cox Stock (*)

  • The second best for this short period was American Funds Washington Mutual Investors Fund (*).

The last two funds are large cap actively managed, holding fewer securities than the index funds and with somewhat higher expense ratios. Over the same period, the Times showed the performance of the twenty largest stocks, eight of the twenty gained more than the best of the largest mutual funds. The eight in order were Chevron, Pfizer, Exxon, IBM, Apple (*), GE, JP Morgan (*) and Berkshire Hathaway (*) The big difference between the two lists is that the five leading large mutual funds had gains of 5.2-4.9% and the leading stocks had gains from 17.0-6.2%. I believe this very small sample of performers and a very limited period of time demonstrates that even in the large cap world, narrower focused securities can at times perform better than “the market.”

A Reasonable Approach

For many of our institutional accounts we try to address both the needs of searching for outstanding performers as well as participating in the central market tendency. Where and when possible, we will often have a core of funds that are close to the market (be they be active or passively managed) combined with highly selected, narrow focused funds. The ratio between the two segments is a market judgment. This approach is appropriate for long term accounts, but will not work as well as those that are short term performance oriented.

Thus my portfolio tastes, at times, reflect my musical preference of strong classics combined with quality representatives from a number of regions.

How do you divide your portfolios between the central tendency funds and those who march to a different drummer? Please fill out the following table that shows the focus of your accounts:

Core/index funds or securities ____________%
Narrow based funds/securities ____________%
Any clarifying comments?___________________________________________ .

Please send to Email Mike Lipper's Blog. All replies will be treated confidentially.

(*) These funds and securities are owned either by accounts we manage or me personally or both.

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Sunday, March 20, 2011

Do We Have to Stay in the Fixed Income Trap?

Many institutional investors and wealthy individual investors are constrained by asset allocation policies that were appropriate when high quality yields of 5% or more were available. That is not now the case and instead of adapting this policy, we place capital at risk that we should not.

The Risk Reduction Concept of Asset Allocation

The original format for managing other people’s money and endowment was to have elements of the portfolio rising in value at the same time as other portions were going down. This concept worked well when interest rates rose, because the demand for funds sent down bond prices of issues already trading at the same time as the spiked demand increased the likelihood that prices would rise. Thus, Balanced funds of stocks and bonds were the first type of popular mutual fund in the US in the 1920s. From this practice, Balanced funds’ investment allocations were codified in their prospectuses to 60% in stocks and 40% in bonds within a 10% range of these midpoints. Over the last ninety years trustees looked to bonds first as a strategic reserve element that could recapitalize the stock portion of the portfolio when stock prices lowered the equity commitment to below 50%. Thus, the portfolio would have the ability to actually buy low at depressed prices. In subsequent years the bond portion was able to supply most, if not all, the current income needs to the family or endowment beneficiaries. This worked particularly well in high, by today’s standards, interest periods where there was need to pay out 5% of the principal. (One believes the 5% requirement instigated by the IRS on charitable funds was a subtle attempt to end the immortality of these funds.) In today’s world of high inflation, the expected spending rate should be no higher than 4% on average over an investment cycle. For tax-paying accounts, like wealthy families, the long term payout ratio should be 3%. I will be happy to discuss these views privately with both the receivers and givers of these funds.

Today’s Reality

With the interest rate on high quality bonds (for sake of argument, US Treasuries) historically low today and likely to rise due to inflation, the outlook for bond prices of the high quality nature is dim. Inflation is expected to rise in the near term due to the government and central banks’ manipulation through quantitative easing and similar measures, including this week’s currency intervention. Notice when the government does these things, it is called intervention; the same moves in the private/commercial world would be called manipulation. The second and more natural cause for increased inflation expectation is the cyclical recovery of many of the world’s economies, as demand comes up against short term supply capacity constraints.

Thus, I believe there is significant price risk to bonds larger than their annual coupon. The professionals call this interest rate risk, to identify when interest rates go up, forcing the prices of existing bonds to decline.

Current Practice

I sit on a number of non-profit investment committees who have evolved an asset allocation strategy of roughly 60% equities (split between so-called domestic and foreign stocks), 30% in bonds and 10% in short term cash instruments. The reason for the last 10% is to assure the recipients of a 5% spending rate that, even if the investment world would collapse and the other assets would be wiped out, they would receive payments for two years.

The Dilemma

We cannot produce a cash income equal to the desired long term spending rates from today’s portfolios. None of the allocations are producing current cash returns to meet the assigned needs. The last several years have demonstrated that while stocks in the long run produce superior results, the variability of their returns do not meet the annual needs each and every year. In today’s environment there are four methods of dealing with this problem:

  1. Accept some capital risk and use lower quality (high yield) paper, usually bonds or very high dividend paying stocks.

  2. Use an averaging technique in setting the spending rate on the basis of the average of a certain number of years. The most popular period advocated by many consultants (for their own business reasons) is three years. There is much history to indicate that one can get three year movements in one direction, unlikely then to be repeated in the immediate future. Four years works better in the US, perhaps due to the presidential cycle. My personal preference is five years, as it often links well with the strategies of many corporate CEOs.

  3. Accept long term defeat by accepting a limit to the institution’s or family’s mortality by recognizing that the asset pool will shrink into eventual oblivion.

  4. Adjust the current spending practices to today’s reality.

I have dealt with all four approaches and each can be appropriate depending upon the situation. My preferred approach is to turn my back on fixed income, keep a short strategic reserve for capital opportunities and adjust the spending rate to a long term average. To the extent that bonds are required, we have recently reduced our commitment to Intermediate US Treasuries in favor TIPS. There is a substantial give up in income, approximately 240 basis points at the ten year level. However, since the end of 2010, a TIPS fund has gained 2.88% compared with 1.04% for an Intermediate Treasury fund, roughly making up ¾ of the yield gap.

The Vacuum Will Be Filled

Among the most creative members of the financial community are the investment bankers focused on fixed income. I fully expect that the minds that created securitization of mortgages, credit card asset backed securities and other asset types are at work to fill the vacuum created by asset allocation requirements. This time, let us hope that they produce sounder products for investors. The other solution is that the courts will decide that including fixed income in asset allocation is not necessarily prudent. One has difficulty thinking of many large fortunes made through investing in bonds, but there are a number that have been diminished.

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Sunday, March 13, 2011

Another Victim of FICC Groups

  • Where the Past Problems Generated Profits and Troubles
  • Seven Immutable Laws of Investing
  • The Currency Game
  • The Interactions of Man and God
  • Paper Money, Deficits and Hyperinflation
  • We Are All Players-The Best Defense is a Good Offense

Where the Past Problems Generated Profits and Troubles

In an earlier era there was, in theory, a sharp distinction between brokers who were meant to act as un-conflicted agents and investment bankers and other dealers who were viewed as principals using their capital to enrich themselves. This theoretical distinction disappeared years ago, and its disappearance was reinforced by the combining of commercial banking activities with those of underwriting and market making. Out of this stew came the last financial crisis, through the sale and securitization of mortgages and similar debt instruments. The groups within the large financial conglomerates are labeled “FICC,” which stands for fixed income, currencies and commodities. Past blog posts have mentioned the growing attraction of the commodities segment to “investors” (really speculators) and the firms that service them. My concern with this blog are the $4 trillion dollar a day currency markets.

Seven Immutable Laws of Investing

This weekend I read an excellent piece by James Montier of GMO which many of us knew as Grantham, Mayo, Van Otterloo & Co. The seven laws are the following:
  1. Always insist on a margin of safety
  2. This time is never different
  3. Be patient and wait for the fat pitch
  4. Be contrarian
  5. Risk is a permanent loss of capital, never a number
  6. Be leery of leverage
  7. Never invest in something you don’t understand

While we all should obey these seven laws all the time, for many of us this could lead to very little investing on our part. However, I urge all to apply these rules to their thinking when addressing the investment in currencies as an asset class.

Currencies can be traded by themselves in original form or through derivatives. This week, Barron’s published two articles that focused on currencies. The first piece focused on the growth of the market, some of the reasons for the growth and the use of ETFs to play the game. (An interesting point was made that it was better to short a currency ETF than to buy a bear-focused currency fund.) What the article did not stress was how much of the FX trade was leveraged by the use of various forms of derivatives or “margin” purchases. The second article was an interview with Ray Dalio of Bridgewater Associates, which has $90 billion under management. This interview focused on the difference between large deficit producing countries/currencies and those that have small deficits. Dalio favors the latter. I would suggest that unless you are in the FX markets everyday because you are hedging a stream of operating transactions, that currencies as a separate asset class fails the Seven Immutable Laws of Investing. Future exchange rates are not guaranteed or even have the same sense of reliability as do the maturity value of high quality bonds. Money has been traded around the world since the beginning of recorded time as noted in the Bible. Therefore, this time is not different.

One rarely sees a “fat pitch” (a perfect, or “too good to be true” pitch) that is advertised; note the FX dealer ads on the financial networks or popular press articles. The reason I mentioned shorting an ETF that is long a currency, is that is a contrarian move. From my own viewpoint, the short interest on the ETFs that hold Canadian and Australian dollars suggest that these may not be contrarian enough to be safe. Many of the academically trained participants in the market will look at the past movement of a currency and calculate the standard deviation around a 36 month trend line, and label this volatility as risk. Whereas risk is the permanent loss of capital, occurring when a government dramatically changes what its currency is tied to.

The second derivative of risk is not just the loss of capital, but the loss of the productive use of the capital. The problem with leverage, either through direct borrowing or through the use of derivatives, is that there is always a payment date that can be extremely inconvenient. Unless one clearly understands the real political pressures on the various central banks and how they in-turn apply pressure to their principal dealers, I would suggest that there is a lack of understanding that makes currency trading problematic.

The Interactions of Man and God

There are two old sayings that are worth remembering: “Man plans and God laughs” and “Man proposes and God disposes.” As long term investors, we try to think about the future, matching future streams of income with spending needs. In the past, many employers and their employees felt secure in terms of retirement on the basis of an average compound earnings rate on their capital of 8% or higher, with an inflation rate of 2%. That is not the world we live in today nor for the last several years. Not only were the forecasts very wrong, most investors did not have strategic reserves that could be applied to adjust the returns to meet some or most of their spending needs. The problem with reserves are that they don’t earn much money; effectively zero today, adjusting for published inflation. Even if we were smart enough to build strategic reserves, the removal of this capital from the higher earnings pools will reduce the overall return on the entire capital base and therefore a cut in spending plans will be required. That is an extremely difficult message for us to get accepted by various investment committees and wealthy families.

Paper Money, Deficits and Hyperinflation

One of the attractions of using currencies as an asset class is to escape too much reliance on any one currency, read US dollars. As most currencies today are not convertible into hard assets by their individual owners, the name of the game is to gravitate to those other paper currencies that have substantial excess earnings power that the issuing government is not spending. The current trends are not favorable either for the US or the UK, and many feel most of Europe, beyond Germany and Switzerland, is beyond hope. The US deficit is approaching the tipping point of 20% of federal government spending. Beyond 20% there is a very strong historic trend to go into hyperinflation, which will make most fixed income investments unsalable. (Thus, one can see why the FICC groups are building up their sales forces in the commodities and currency arenas.) If there is some chance of hyperinflation, one can see the investing public as reluctant to commit to what is probably a fairly priced, large capital equity market.

We Are All Players- The Best Defense is a Good Offense

In this blog, my intention is to cast doubt on adding to one’s present investments, suggesting the need for strategic reserves and altered planned spending. I further recognize that the earnings on today's strategic reserves don’t help the unavoidable spending needs. In response to these dilemmas, my training from the US Marine Corps makes me search for a good offense as a best defense. While I have some ideas to be shared at a later date with my clients first, I am not comfortable that these are the best or perhaps not even good moves on the offense.

I appeal to this blog community to suggest currently good long-term investments or sound strategic reserve elements that can be used for a narrow base of clients or shared with this entire blog community.

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Sunday, March 6, 2011

Discussing a Four Letter Word

  • “Jobs”
  • Creating new demand

When we hear that someone is using four letter words, we think of words that should not be used in polite society. Most of the time we don’t think of more positive words such as “Love” and “Like.” Rarely do we include a word on the tongues of some in the rioting crowds of the Mid East/North African (MENA) countries, “Hate.” I posit that the base disappointment of the crowds today is indeed a four letter word, “Jobs.”

Mobs and Jobs

Throughout history, demonstrating crowds have been made up either exclusively or mostly by young men who cannot find jobs. Without sufficient income, they do not marry and procreate. Thus in many respects, the intensity of their fervor is testosterone based.

Many so called developed countries, including the US, also have large scale unemployment of young people. My guess is that many of these youths have not had their first full time jobs and thus are unlikely to be counted in the unemployed numbers. Governments are not blind to the political crises caused by unemployment and underemployment. They react through their central banks, spending policies and tax preferences, funneling money to those activities that are already creating employment. The theory is that if they had more money to spend they would hire more people. However, it is not working, or not working fast enough to head off political disruption.

My friend Chip Dickson of Discern, in a very thoughtful set of PowerPoints, using data from the St. Louis Federal Reserve Bank’s website, tracks the last eleven recoveries from 1947. He concludes, “The key determinant of the ultimate strength of this expansion and stock market is employment. Private sector employment levels are more in line with an economy struggling to recover.” Bottom line: the old ways of throwing money at the problem are not working well enough to avoid trouble.

In the past there were two realities that helped “solve” unemployment. The first were the natural disasters of flood-induced food shortages and virulent diseases. The second was war in its fullest sense. At times, wars killed off as much as 25% of the able young men. Hopefully these techniques will no longer be a factor in closing the employment gap.

Is the problem structural?

I maintain that we have become too productive per unit of labor to vastly increase our use of human workers at the foreseeable levels of aggregate demand. Part of this picture is caused by too high wages and too little relevant education and job discipline. (Numerous employers have said that they would hire if they could find the right people.)

New product demand

As a global society, we need to create several large quantums of new demand for new products and services. Three examples are:

  • Think of five or ten times the ultimate demand for iPads and similar tablet communication devices.
  • Radically new wellness products and services.
  • Rebuilding our cities, requiring additional large mass transit investments and jobs.

Some of this new demand will be for new services as well as manufactured products, but too often services do not have labor leverage characteristics, thus are really just transfer payments.

Historically, politicians and governments follow the people in the private sector. Thus, I do not expect leadership will come from the central political forces. I do expect the more aware political leaders will be reasonably quick to jump on the new demand elements and start to throw taxpayer money on the accelerating train once it is underway, e.g. through large scale credit extensions, government purchases and tax incentives.

I suspect that somewhere along the delivery channel both technology and advertising will become important conduits. As investors, we should be watching the customers of both technology companies and advertising agencies to pick up the accelerating momentums relatively early. Investment in these two sectors may be worthwhile early identifiers of meaningful change as we find new and more productive ways to put well-meaning young men and women to work. In that fashion, jobs can become a positive word.

Please send me a comment with your suggestions.

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