Saturday, June 25, 2011

Your Investments Right Now:
Hold or Fold?

One of the techniques a former Director of Research of a major firm used in interviewing a candidate for hiring or promotion was to play poker with him/her. How the player handled him/herself, he believed, told him a lot about the person’s analytical abilities, risk-reward sensitivities, and to some extent, their integrity. In the modern era, poker has become both a casino and an electronic game. Regardless of how the game has evolved, there comes a point when each player has to decide to hold his or her position in the game by at least matching the last bet, or declining to do so by folding.

The investing game

While investing should be, and is for most people, a serious activity, some of the thinking that permits players to walk away from the table with their (hopefully augmented) chips, is useful. At every minute in the trading day the investor has the choice to stay in the game and accept today’s risks or to fold, perhaps to play on another day.

Okay coach, what do I do now?

As long as you don’t tell anyone, I will admit I do not know which way the market will go. I join both Peter Lynch and the late Sir John Templeton, who professed not to know (or to particularly care) about short-term movements in the market.

The rest of this post is in response to some members of this blog community who feel under pressure to do something.

The stock markets have been declining throughout the second quarter, which is about to end. The quarterly reports will attempt to focus on the first half results, which will be for the most part positive. Nevertheless, a lot of pessimistic comments are being generated by the single digit losses in the second quarter, and constant focus in the press on bad news. Uncertainty is a word that will be used by various political and economic commentators. Some may believe that there will not be sufficient clarity until after next year’s US elections for the Senate and President. (I placed the Senate first because in my mind it is more important in the long run as to the structure of the US, and to a lesser degree, international political and economic structure.) Some may feel that too much can and will go wrong, and want to exit or fold on some of their investments now. A good coach wants to win the current particular contest, but a great one wants his players to achieve long term success.

Don’t do “It” now

By definition, the optimal time to sell is when something is priced at an unsustainable level. With the exception of a limited number of new issues and some commodity plays, we are a long way from prior peaks or future valuations based on “normal growth and conditions.” Some with large unrealized profits may be concerned about the end of current capital gains tax rates. (If that were to happen, it would be in 2013.) For the ultra high net worth among us that are building inheritance and trusts for future beneficiaries, there is the after-tax risk of timing the re-entry into the market. Most of my clients are more concerned about the long-term future of their capital than the current size of their piles of poker chips.

I need to sell; what do I do?

The following is a series of thought patterns to guide the current seller:

  1. If you believe that we have rolled over into a bear market, examine the history of your fund or securities in the last couple of bad markets. We have recently done that on a list of funds of interest to a particular client. While we did find some funds that were in the lowest quintile in the last two bear markets (2000-2003 and 2007-2009), the reason they were on the list of funds of interest is that they had spectacular bull market performance. Thus, if you believe we are much closer to a bear market that might last until after the elections, one might choose to exit these funds. Be careful, getting the timing right near a bottom is very difficult. Most people come in to a subsequent rise late, after the easy money has been made in the early part of a recovery.

  2. If you believe that the current market recovery is getting old, you may want to look at your portfolios for your best performers. Have they done so much better than other investments to make their stock prices vulnerable? For some time small market capitalization stocks have done better than large-cap stocks. On average, Small-cap Growth funds are up +6.02% year-to-date through last Thursday, June 23rd, compared with the average Large-cap Growth fund being up +1.88%.

  3. Popular investments experience a crowd effect, with many of the well known pundits in or out of the media calling attention to particularly good results and/or intriguing personalities. People join the crowd late and usually take the pundits’ word that the touted security is a good investment. As expectations are not met quickly, the crowd dissipates, perhaps causing a redemption run. So if you must sell, look at the former media darlings.

  4. If you invest in sector oriented funds, keep in mind they can move much faster in both directions; and if you want to reduce your downsides you could cut back on these leaders, e.g., Gold and Silver oriented securities. At this point, one of the underperforming sectors is the Science & Technology group. Currently, there is much happening that may change the nature of competition among these companies, which creates both outsized risk and rewards; thus extreme selectivity is warranted. The worst performing sector in the US (and elsewhere) is the financial sector, with the average Financial Service funds down -5.27% year-to-date. As a manager and investor in a private financial services fund, I have mixed emotions. I am unhappy with the performance of the sector, but I can understand it, as can my long-term clients. On the other hand, any additional massive selling of the sector is likely to create bargain prices that we have not seen in many years.

  5. I believe the biggest risk to many portfolios is their high quality and short-term fixed income holdings. Except for TIPS (Treasury Inflation Protected Securities), the risk to your purchasing power is high and going higher in the other securities. At this point in the cycle I would suggest that there is more credit risk than current prices can accommodate. If you are cutting back on your equity exposures, I suggest you cut back on their “kissing cousins,” high yield securities and funds. The higher the current yield, the bigger the risk according to the market.

Twin Conclusions

Long-term oriented investors should hold on; this particular period of uncertainty will be over relatively soon. For those who feel they must exit some of their portfolio, do it wisely. Be willing to cut back on some of your outsized winnings.

As a paranoid spectator, I wonder whether there is any long-term significance in the fact that the plane crash earlier this week in Russia had five nuclear scientists from Iran who were purported to be working on the peaceful use of an Iranian reactor.


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Sunday, June 19, 2011

Going Global is No Escape from Investment Problems

  • Too Much Correlation
  • Four Letter Word: Jobs
  • Fragmented Markets = Less Liquidity
  • SEC’s Other Unintended Consequences
  • A Father’s Day Focus For Wealthy Investors

Too Much Correlation

You would think after suffering through 2008, when almost all investments went down, we would pick equity investments that were not extremely correlated. Many US investors, particularly those who have had long term exposures to the economy and the stock markets, are unhappy with the current situation of a lackluster economy combined with an excessive US government intervention/manipulation into the financial structures of the economy. There are two fears at work; first there are growing signs of stagflation. (A flat economy with an increase in recognized inflation.) The second fear is the uncertainty of the structure and rates of various taxes. To escape these increasingly perceived problems, many investors are opting to go global.

The ever adaptive mutual fund business has generated a large number of Global funds to fill the needs of investors. These funds, unlike International funds, allow the portfolio managers to select the best available investments whether they are traded in the US or elsewhere. The problem is that this enlarged hunting ground has not produced materially better results. As a matter of fact, the list of fund indexes of various global fund categories has produced somewhat poorer results in the first five months of 2011 than the domestic funds. (Some domestic funds can invest up to 25% in international securities and there is no limit to their investment in multinational companies.)

Out of a larger list, I selected six pairs of fund indices to compare. The first index listed is the global group, comparing with the second group, a similarly focused domestic fund index:

  • Global Multi-Cap Growth = 6.30% vs. Multi-Cap Growth = 8.61%
  • Global Multi-Cap Value = 6.28% vs. Multi-Cap Value = 8.23%
  • Global Multi-Cap Core = 6.71% vs. Multi-Cap Core = 7.98%
  • Global Health/Biotech = 16.54% vs. Health/Biotech = 17.90%
  • Global Sci. & Tech = 7.93% vs. Sci. & Tech = 8.56%
  • Global Real Estate = 8.35% vs. Real Estate = 12.75%

Source: Lipper, Inc.

Four Letter Word: Jobs

One of the main reasons that “going global” is not working is that in most developed countries, and in a great many developing countries, there is widespread unemployment (as well as underemployment in the US). Globalization has worked too well. Capital has poured into companies and industries that could improve their productivity through the increased use of global technology. Thus we are producing more with fewer people. An important global issue is that we are not creating jobs. The way both China and Brazil are addressing these pressing problems is by raising wage levels, particularly at the entry levels. They are, in effect, inducing inflation that will create later problems for many and opportunities for some. Over-population is not a new problem. Historically, one answer was to wage wars on neighbors, particularly for their land, and in some cases their women. Also life expectancy was limited until the impact of modern medicine and modern agricultural processes became widespread. There is one crying need for vastly under-funded investment in almost every country: infrastructure. Once again China is in the clear lead here. Infrastructure funding historically comes with three problems. The first is the displacement of people from their homes and farms without adequate replacement. The second is that succeeding governments use cutting infrastructure spending as a way to avoid raising taxes. The third is that the very nature of infrastructure spending is that, at some level, it is a cash business which makes it more susceptible to corrupt practices (particularly with low level local politicians). Despite these real drawbacks, if various societies are going to prosper in the future, our global infrastructure needs must be met. At this point I would prefer not to invest in various infrastructure funds, but in more broadly based funds that can move into and out of infrastructure investments as price and circumstances dictate.

Fragmented Markets = Less Liquidity

One of the reasons that the global markets have become much more correlated is that with the exception of some Asian markets and to a lesser extent the UK market, the main driving forces in the marketplace are institutional investors. Many of these are managed by people who have been educated and/or had training in a limited number of universities or major firms. This somewhat limited exposure has produced generally accepted ways of thinking aided by instant global communications. In the search for meaningful competitive advantage, the players have to find more restrictive card games (markets) where only a few serious (big money) players are at the table. This has led to the creation of numerous places to trade. In effect, this move destroyed the knowledge capital of the formerly central marketplace. As no one knows for sure what transactions are currently occurring, there is a reluctance to provide liquidity to the marketplace. In turn, the lack of identifiable liquidity leads to increased volatility. Increased volatility scares many retail investors, so they retire from the marketplace. In the past, at the time of investment, individual investors were looking to the long term for their gains. The focus of too many institutional investors was defending against career risk, i.e., they needed superior performance in the present quarter. Markets work best when investors with different time horizons meet. Thus, one investor could be focused primarily on today’s price and another on some future price. That way both could be right. The absence of longer term-oriented investors in the marketplace hurts finding equilibrium prices, which promote future investment.

SEC’s Other Unintended Consequences

The fragmentation of the US market is a direct consequence of the SEC’s belief that “better” prices could be achieved through competing marketplaces which would aid the individual investor. As is often the case with government intervention, the unintended and unanticipated consequences have led to harming the very people who the changes were meant to help. I am not attempting to change these market structures through this blog community. I am just suggesting that the impact of what was designed to help investors, I believe hurt them. Another example tied to the fund index data shown above is the term global. The SEC cannot directly dictate a fund’s investment objective, but it can dictate as to its name under the concept of Truth in Advertising. At an earlier time, when US investors were pouring money into funds, the commission was concerned that investors could wind up in a non-diversified fund in terms of exposure to various foreign markets. That is why they insisted that for a fund to be called “global” it had to be invested in at least three different countries. In truth many of these funds invested in many countries and from my standpoint, too many countries. (When I used to counsel new funds, I suggested that they should not put a geographical or investment term in their name.) One of the reasons for the closeness of the performance data shown above is that too many of these funds are too broadly diversified, thus they will hug the middle of the market and not attempt to do extremely well. When examining a fund, investors should look at the fund’s portfolio to get their own view as to what the fund holds, and therefore how it should be measured to meet their own needs. If an investor cannot, or chooses not to perform this analysis, then the use of a competent investment adviser is warranted.

A Fathers’ Day Focus For Wealthy Investors

This blog was written on a day that is celebrated as Father’s Day in several countries of the world. For many, this was a day of family gatherings, exchanging cards/electronic messages, and gifts. When thinking about the upsurge in communicating with one’s family, there is a natural tendency to think about both the past as well as the future. Anyone who has children is wealthy beyond any commercial successes derived. Thinking back to one’s own father and grandfather, there has to be recognition that in many cases they are no longer with us. Turning to the future, we need to absorb the fact that at some point in the future our children will probably be looking back to a father or grandfather who is not with them on some future Father’s Day. All fathers (and mothers) try to pass on to their children their values and perhaps their talents. If you can do this, you are indeed wealthy.

For those who have financial assets, particularly sizeable assets, there is an added task, which is to pass on to children, grandchildren and great grandchildren not only financial assets, but the moral and investment values that have the best chances to make them happy and productive people. There are many models and devices to accomplish these goals, however there is no single plan for each and every beneficiary. When we lived in a much simpler world where our main asset was a farm or a local business, often the heirs had to share in the ownership and management of the family asset. There was very little one could do wisely for one heir compared to another except in terms of decision making. Today most wealth is, or can be, converted into liquid form. In many cases the assets of the heirs can and should be handled differently. One way to start the process, while you can change it, is to create separate portfolios with different rules for each of the heirs. Working with your accountant and trust/estates lawyer in the early stage of this process, I would use mutual funds because of their relative transparency and flexibility. Once policy portfolios feel right, then they can easily be memorialized in wills and trusts. To start the process, give some thought to the use of investing outside of your home country. In all likelihood one should start small, and as experience and confidence grow, take bigger steps. Don’t you wish your parents or grand-parents did this for you? This effort can be a gift to your children and grandchildren in addition to passing them your values and talents.

Perhaps we can help a limited number of fathers and mothers out there.


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Sunday, June 12, 2011

Handicapping Mutual Funds the “Belmont Way”

As many of our blog community members and readers of my book, MONEYWISE already know, I credit the US Marine Corps and the racetrack as my two great educational experiences; as distinct from Columbia University, from which I graduated. What little I know about security analysis and mutual fund selection is based on what I learned at the race track.

For those who have a detail orientation and are comfortable with basic arithmetic, the task of analyzing races is a great challenge and a pleasure. Just some of the items to take into consideration are the track records of the horses, their parents, the trainers and the jockeys. These factors are vital in terms of the winning results, but more importantly, the conditions under which the records were produced. The objective of all this study is to pick net winning bets, (winning more dollars than losing). Note by setting this goal I am accepting the reality that a number of the bets will be losers. I do not expect to win with every bet. I carry this expectation into my investing in funds and individual securities.

The Belmont

Belmont Park is America’s longest dirt race track. Each year in June it conducts the Belmont Stakes, which is the so-called third crown of the Triple Crown for three year old colts and fillies. Linking the three races into an overall result is a public relations/media concoction and has very little to do with the development of racing and perhaps more importantly, breeding results. No single horse has won the three races since 1978. Out of the last twenty-three years there have been eighteen years (including this past Saturday) that neither the winners of the Kentucky Derby nor the Preakness Stakes have won the Belmont.

As a kid who grew up in New York City, I have always taken the attitude that the Belmont was the real test of champions. Further, as the race normally has the fewest horses and the longest distance, it is the truest race. (Most of the horses will not run again at a distance of a mile and a half in the US.)

The Analytical Bridge to Fund Selection

Picking winners at the track, called handicapping, involves a great deal of intensive research and analysis. With all of this effort, the odds are that I will come up with more losers than winners; but by limiting my wagers to selected races and appropriate odds, I will come out dollars ahead. Many of the same techniques that I use in the search for winning horses I use in selecting funds for my clients and myself. There are two big differences in investing in funds. The first is that a losing race ticket is worthless, but when a fund goes down all is not lost. The second is with a race the most important result is at the predetermined finish line. With investing it is a continuous race which ends when the investor chooses, except if it’s a forced sale due to external circumstances, e.g., better bargains, change of objective, a margin call or similar involuntary termination.

Belmont Lessons and Fund Selection Applications

I have spent almost my entire professional career of more than fifty years thinking about investment selection. I use many different inputs for my analyses. The purpose of the following exercise is to show the application of the lessons observed from this year’s running of the Belmont Stakes to fund selection as well as examining the use of specific past performances to correlate to future results. The objective of the exercise is to improve the odds of avoiding losers and picking some better than average results. The following list outlines the lessons from the Belmont Stakes, and their applications to fund selection as a point of departure for deeper analysis:

Belmont Lessons matched with Fund Selection Applications

  • The 2011 Belmont race was very slow by historical standards. Fund winners in a given year have had gains of 100%+, to losers of (-50%), with the norm of 8-12%.

  • Too many horses crowded the favorite from the gate. Too many investors plowing into the same names at the same time makes it difficult to get a distinctive advantage.

  • Racing luck=Derby winner losing early contact with its stirrup. Anything that distracts portfolio managers in their personal or professional lives could be a factor.

  • Change of equipment: first time use of blinkers by the winner. Some PMs need to focus more

  • Winning change in strategy from stalking to being near the lead. Adapting to change conditions

  • Performance records not useful. Managers of the year or decade can lose

Ten Past Bull Market Winners

Each week I look at lists of funds that are of interest to our clients. They either own these funds or are considering them. We compare the funds with their own specific peers and array them in quintiles. Recognizing that often fund performance fits into a bell-shaped curve, we include funds that are in the three highest performing quintiles. The following is a list of funds of interest for one of our clients. The list includes funds that performed in the top three quintiles in the rally between March 31, 2003 to September 30, 2007. Next to each fund name is its quintile performance in the current rally which started on March 9, 2009 and continued through June 2, 2011.


  • Mutual Global Discovery - Fifth quintile. Portfolio Management changed

  • Templeton Institutional Foreign Investment - Second quintile. Good in down markets

  • CGM Focus - Fifth quintile. Poor in down markets

  • Longleaf Partners - First quintile. Poor in down markets

  • T Rowe Price Growth - Second quintile. Third quintile in down markets

  • Dodge & Cox Stock - First quintile. Poor in down markets

  • Vanguard Mid-Cap Index - First quintile. Poor in down markets

  • Thornburg Value - Second quintile. Poor in down markets

  • Fairholme - Third quintile. Financials lag this rally

  • Vanguard Small-Cap Index - First quintile. Poor in down markets

The superior performance of the two Vanguard index funds suggests that the index funds are not structured or own the same securities as their actively managed peer funds.

One of the lessons from observing the Belmont Stakes is that some of the participating teams of horses, jockeys, and trainers change their equipment and strategies. Sometimes the changes are beneficial. Further, track records are a guide, e.g., in the Belmont, roughly 80% of the time the winner is neither the Kentucky Derby or the Preakness winner.

How do you pick winning investments? Please share.


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Sunday, June 5, 2011

In the Hedge Fund Shadows

One of the ways that I try to give back to a society that has been very good to me and to my family is to volunteer at six non-profits. Often I sit on or chair investment and/or finance committees. In a few of these cases the committees have chosen to use hedge funds and separate accounts as well as mutual funds for their investing. During periods of volatility, often on the down side, there is considerable anxiety until the comprehensive monthly performance report is published.* There is fear that the results will be so poor that the committee will be criticized for not being on top of the portfolio deterioration that might have commanded some selling action. Most of the time one or more of the hedge funds is the last to disclose its performance, which holds up the report.

Back of the envelope

Trained as an analyst, I am often in the uncomfortable situation of not having complete and accurate inputs. What I attempt to do is to produce an educated guess as to the missing numbers. One approach, which goes back to being a scout or perhaps learned in physics or math class, was to measure shadows. In the classic experiment, if one could measure the size of a shadow and how far it was from the source of light, one could triangulate and determine the size of the object that was throwing the shadow. I use the same approach to guess the likely performance of a hedge fund.

This is not a commercial

My old firm, now known as Lipper, Inc, publishes daily, weekly and monthly performance records of almost all mutual funds in the world. While I have no financial relationship with the company, I am a user of its data for my commercial and volunteer investment advisory work. As a carry-over from when I was running the firm, it produces many investment objective indices of typically the 30 largest individual funds in each group. Since my sale of the operating assets of the firm to Reuters (now Thomson Reuters), there have been waves of “retail-ization” of hedge funds. To counteract some real and potentially large losses of mutual fund sales, various firms have produced funds that somewhat copy the techniques of hedge funds. At the moment, with new investment objectives tracking these funds, we must use their performance averages as substitutes for indices that do not exist. (For the purists in the community I would be happy to discuss the advantages of indices over averages).

What do the averages portray?

First there are four such new investment objectives that are titled: Absolute Return funds, Dedicated Short funds, Equity Leverage funds, and Equity Market Neutral funds. Second, in most cases, these are equity funds, and often their “shorting” is by selling short ETFs (Exchange Traded Funds). Third, their average expense ratios are between 1.52% and 1.73% before any performance fees, if earned. Fourth, they are somewhat constrained in their use of leverage by the Investment Company Act of 1940, as amended from time to time. This potential difference with the more unconstrained private hedge funds is one of the reasons that I use the mutual fund results only as an early indicator of what some hedge funds might produce. A tighter fit is possible by picking out specific mutual funds as a somewhat peer comparison with specific hedge funds.

The results

The average returns for the first 5 months of 2011 were:
  • Absolute Return mutual funds: gained +1.20%
  • Dedicated Short funds: lost -9.79%
  • Equity Leveraged funds: gained +6.51%, (the best of the four new objectives)
  • Equity Market Neutral funds: gained +1.02%

To put these results in perspective:
  • S&P500 Index funds: gained +5.00%
  • Multi-Cap Growth funds: gained +6.02%
  • Multi-Cap Value funds: gained +5.78%
  • Multi-Cap Core funds: gained +5.54%
  • Large-Cap funds, on average, produced returns in the +4.6 to +4.75 range

Working conclusions

When the hedge fund numbers come out they are likely to be behind the publicly available mutual fund results. However, I expect there will be some spectacularly good results. The winners will possess great selectivity skills and may have used the greater flexibility that hedge funds have to their distinct advantage. I believe that performance numbers do not provide the answers to selecting investments for the future. Performance numbers should promote questions not answers. For example, if a portfolio has significant investments in financial services stocks, one should take into consideration that the average Financial Services (domestic) fund was down -2.74% year-to-date. Around the world banks and non-life insurance companies have been the worst investment group thus far in 2011. Part of the problem for these institutions is that for regulatory capital requirements they are being forced to own too much of their own government paper in addition to holding prior bad loans to other governments. At the moment the investing public, outside of speculating on a few IPOs, is not actively participating in the market place. [Disclosure item: I manage a private financial services fund that is only appropriate for long-term oriented accredited investors who believe in looking for depressed securities.]

*My good friend Larry Goldman, the CEO of the NJ Center for the Performing Arts (NJPAC), was kind enough compliment me and the members of the Investment Committee in pointing out that the Chronicle of Philanthropy ranked the estimated yearly return of 19.6% for the NJPAC’s endowment as #11 of the 72 endowments with similar fiscal year periods.

Correction to last week’s blog

One of the best members of this blog community quite correctly noted that I slipped the decimal to the right when I indicated that a doubling in 100 years was the equivalent of a 0.1% gain per year. Actually on a simple divisor basis it is 1% p.a., and a compound basis 0.70%. We have corrected the original blog on its website, .


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