Fund Choices: Questions are Better than Rules

Introduction

This post is being composed during the long weekend of deliberation on spending and taxes in the US. These endless, and in many ways pointless discussions and the resulting actions taken, will have some short-term impacts and will set up further imponderables for the future. All of this is of interest, but our clients pay us to provide long-term solutions to their needs. Thus, I need to focus on finding good investment choices of funds and separate account managers.

Citywire Global, an informative website and magazine for international fund selectors, asked its audience, “What are the rules you use in your selection process?” This approach is similar to those used by consultants and "gate-keepers" in the US. This “rules based approach” also works well in many manufacturing activities. Rules provide particular comfort to large organizations and those who like being within a crowd.

Wise investment decisions are an art form

While there is a great deal of math within investments, I believe that making wise investment decisions is an art form. I have held this view for many years after my failure to find absolute investment rules. This belief was reinforced this weekend when my wife Ruth and I attended the wonderful Aspen Music Festival. We heard Mahler's 4th Symphony and will hear his 5th on Sunday. This year is the 100th anniversary of Gustav Mahler's death. His track record includes ten symphonies, which many believe was essentially one continuous probing of the meaning of life and death. Many orchestras around the world, including the Sydney Symphony, the Berlin Philharmonic, the London Symphony Orchestra as well as the New Jersey Symphony and the New York Philharmonic noted the anniversary of his death by playing his music this year.

I believe the collective experience of these concerts has a direct bearing on the reliance of the past performance of great investment managers. For instance:

• Many, if not most of the anniversary concerts played particular interpretations of Mahler’s music. Many investment strategies have the same notes from a previous genius (EPS & other facts), but will get different results.
  
  
• Concert performance differences can be caused by the size of the orchestra. The results of a fund or portfolio is shaped by the size of the universe of available investments.
  
  
• Affecting the overall music are the individual talents within the orchestra. The varying abilities of supporting securities analysts similarly contribute to invesment returns.
  
  
• The availability of good soloists is critical to a performance. External research/intelligence sources are essential to successful investing.
  
  
• The acoustics within the hall affect every performance. Location-dependent results, e.g., different currencies, market caps, the use of external brokerage, etc., greatly affect investment results.
  
  
• The talent and personality of the conductor is constantly on view. The investment manager brings his/her own attitudes to help shape a portfolio.

After 100 years, experts still have different interpretations from the same inputs.

Critical elements missing

Critics and others in the media focus on the total results without adjusting or commenting on critical elements. For example, for many years the late and great Sir John Templeton was celebrated for his fund's great performance in the early 1960s. Few noted that most of the superior performance was due to large investments in Japan, not repeated in the rest of his long and distinguished investment career. Other high-profile fund leaders were celebrated, with little or no comment about the portions of their portfolios that seriously underperformed. A number of the portfolio managers (PMs) named, by others, as the “Manager of the Year” (or Decade), had the humbling situation of producing poor results right after being overwhelmed by receiving media accolades.

What are some of the questions for today?

The first series of questions for past good performers revolves around the changing structures of trading. With the locations of trading fragmented and no real central marketplace recording prices and total volumes, how do PMs know what is happening beneath the surface of the reported prices? Further, how have the practices of quantitative trading (algorithms), changed their ability to accomplish large trades in a turbulent market?

One of the things that happens to successful managers is that materially-increased cash flow moves into their funds, some from short-term investors. How are they dealing with this flow? Often as investment organizations grow, leading PMs are required to manage an increasing number of accounts. Further, they become responsible for more people and functions as they add executive responsibilities. How are these changes impacting the time available for investment decisions? Is the amount of money and available choices within their target asset classes changing substantially, and how will that impact their efforts? Has the nature and strength of the competition changed? Will this impact their organization?

An interesting question that came up at dinner Saturday night with a very well known and respected PM who has been “retired” for more than five years, is how much of his extraordinary results originated from working with selective industrialist clients on their private investments in non-public companies? The greater understanding of the economics and the personalities involved aided the PM in his selection of public companies. There are a number of other examples of these special insights. What happens to the performance of the PMs when they are no longer having these conversations?

We have come to expect something different every time we hear a great symphony play a popular piece of classical music, just as we now expect a somewhat different result from a great portfolio manager in an ever changing marketplace. Our analytical strength is in the questions we ask, not finding good past records.


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Default Discussions Could be Good for Sound Investing

A few years ago there was a not too successful Broadway play with the title “I Love You, You’re Perfect, Now Change.” That is the way I am beginning to feel about the endless discussion about a possible default by the US government if it cannot borrow new money as of August 2nd.

First, let me say the obvious, that I do not know what political solution will accommodate the opposing forces of spending too much money and the unwillingness to pay for it. Having seen the professional negotiators for my clients (the National Football League and the former NFL Players Association) apparently come to agreement after a four month lock-out, I have great faith that some interim agreement is probable. Like with the football agreement, for those of us who care, God will be in the details. While both disagreements were foreseeable for at least the last two years, the players in Congress and the White House have not been in serious negotiations until perhaps a month ago, thus they lag the professional negotiators for the football collective bargaining agreement.

Second, the financial community has been of two minds, either there will or will not be a default. Separating all the chatter from market prices has a way of sharpening the focus. One of the more modern innovations to the bond market is the development of credit default swaps (CDS), in which the buyer wants to be assured that he/she will receive full payment of principal and interest when due, and the seller will insure that delivery. CDSs were initially used for high yield bonds (junk bonds), more recently a market has appeared for those who want insurance on sovereign debt of various countries. One of the ways the market gauges the chance of a downgrade is to rank the cost of CDSs on $10 million face value bonds. According to Saturday’s Wall Street Journal, “Currently, one-year protection against a U.S. default is roughly double that of other triple-A rated nations such as the U.K. and Germany….” The article also states that the cost is higher than for Indonesia with a credit rating of BB+. According to Markit, the cost for the 1-year CDSs and the annual five year cost is an identical 53,000 Euros or approximately $76,000. Further, the WSJ article states, “The annual cost of protection over five years, which more investors focus on, was also €53,000, but has risen by a smaller magnitude since January 2011 and remains well below its peak of €100,000 in early March 2009, at the height of the recent financial crisis.” These are small markets and do not represent the market judgments of hundreds of billions of dollars held by various institutions around the world. If that is not enough of a warning, I have been informed that the six leading insurance companies with an AAA rating may be facing an immediate down-grade because so much of their required reserves are held in US government paper.

Third, while up to this weekend the markets have not significantly reacted to the possibility of a failure to raise the debt limit, some have been thinking quietly about how to operate under such conditions. For example, I believe that there has been a group within the Federal Reserve developing plans as to what checks will be honored and when. I know that a number of government contractors including Caltech, which I have the privilege to serve as a trustee, have drawn up plans to deal with an uncertain stream of payments. If by the opening of markets on Monday there are others accelerating their contingency plans, interest rates will rise and fixed income prices will fall.

Fourth, the much maligned, but essential credit rating agencies’ warnings of a downgrade will be examined more closely. (Our financial services hedge fund has a position in Moody’s.) Unlike most other downgrades which are based on the odds that there is some insufficiency to meet debt obligations, these potential downgrades are based on the evidence of an unwillingness to meet our obligations.

The Good

How can any of these traumas be good? First, the situation forces recognition of the inevitable clash between our society’s apparent demands for goods and services from the central government and our willingness to pay for them concurrently. Similar clashes are observable in numerous European countries that have had socialist leanings for a long time. This battle of wills was a long time coming and it was naïve to ignore the issues as the markets have largely done. Whatever the outcomes of these struggles, we are entering a true-up phase which recognizes that deficits do count and cannot go on forever. Second, few of us fully recognize the multiple roles the government plays in our lives. For example, one can not travel by air, rail, boat, or by road and not be subject to governmental rules and regulations as well as the spending of taxpayers’ money that subsidizes our movements. In similar fashion, in the fields of energy and health care, we have become heavily influenced by government actions and direct as well as indirect payments. Clearly among the most dependent arenas of government influence are the financial markets (bonds, stocks, commodities, real estate and intellectual properties). Most often prices in these markets are directly or indirectly priced off of similar maturity Treasuries. The private sector’s retirement contributions are keyed off of the level of interest rates for many pension plans and the investment policies stated or unstated for defined contribution and other retirement plans. Note that in periods of turmoil, various investment policy statements and prospectuses permit a 100% commitment to Treasuries.

Why do I say that listing these dependencies on potentially downgraded government paper is good? The first step in helping a person with some form of behavior disorder is to recognize the problem and the levels of chemical or other dependencies on the source of the problem. Without this recognition, there will be little chance of a cure. I do not know what will be the various solutions used. But the genius of the American culture (also found elsewhere) is that we will find appropriate, if not elegant, solutions.

Better

If that is what I label as good, can you stand what I label “better”? Coming out of these economic traumas we normally look to change our risk exposure to past problems. The standard prescription would be diversifying beyond the all-powerful US dollar. That is going to be difficult to do. Almost all global assets have their prices impacted by US activities. Ideally we should look at public and private investments in countries that have relatively small populations but with sufficient internal capital to develop large resources for the benefit of the present and future generations of a striving population, e.g., Canada, Australia, Singapore and Mongolia. These were some of the main characteristics that have made the US an attractive place for both domestic and foreign investment in the past. We are on a search for the next investment horizon. We are not alone; many of the international portfolio managers that I speak with are on the same search either directly or through the companies that they put into their portfolios. Whether they recognize it or not, most institutional portfolios of endowments and mutual funds are also deep into the difficult process of finding different, and hopefully better places for investment.

The ultimate irony of both the debt/expense problems and the search for new investments is that it is possible, perhaps unlikely, that the American public will take its bitter medicine so that the children and grandchildren of the US will once again live in a society that is an attractive investment home. That truly would be best.

Do you have any long-term solutions or portfolio construction suggestions?

____________________________________________

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More unconventional thoughts while waiting for the Metro

I am preparing this post on our drive back from a four-day birthday celebration in and around Washington, D.C. The location was picked first because it was convenient for four of the celebrants, and second that the Metro (DC's subway) made it easy for what could have been sixty people to meet for various activities. On Thursday, I was able to go from Pentagon City to the middle of the District for a business appointment in under 15 minutes. On Friday night the return trip took one hundred and five minutes. This “performance disparity" strikes at the efficiency of the government in Washington, albeit a local government responsible to the US Congress. In a related thought, I am fearful of what will be the middle-of-the-night debt ceiling compromise. I cannot predict the outcome, but what I can do is think about the inevitability of the conflict.

Unwritten elements in all constitutions

Whenever there is an unexpected crisis in a family, tribe or nation, a plaintive cry goes out to"do something." The leadership group fears that if they do not do something quickly, they will be replaced. One of the continual crises that governments attempt to address is the need for jobs. (Look to last week's blog addressing the need to focus on work, not jobs.)

The Bad Manual

Since the 1930s, almost all governments have been instructed in the writings of Lord John Maynard Keynes, a University of Cambridge scholar and British civil servant/speculator who advocated for governments to lower taxes and increase spending during poor economic times, and to raise taxes and cut spending in good times. Any realistic analysis will show that the first part has not worked most of the time. The second part (particularly reduced spending) has not been tried, thus rainy day surpluses have not been created in any sizable amounts. The theory is still widely taught and believed by economists. Economists like the theory because it places card-carrying economists in senior powerful government positions. The theory rests on the wisdom of the government elite to manipulate the economy for the benefit of the less fortunate who did not study under them in an ivy-covered hall. Early economists were professors of philosophy centered on ethics. Their thinking was based on the thought that rational humans would do the right thing if they were presented with all of the facts. The latter day economists and their political masters did not totally trust the populace to do the right thing and thus they manipulated the facts to force people to do what the politicians wanted.

Three clear examples of this current trend toward manipulation are first, the bailing out of those entities that were deemed too big to fail. Strangely, they did not realize that after every bankruptcy, the sun came up; new or different entities undertook many of the same functions at appropriate price/wage levels. The managements, equity holders and some debt holders became wiser as to the risks they were taking after experiencing their losses. The second current example is the Federal Reserve, buying treasuries to lower overall interest rates and thus stimulate lending. The result of quantitative easing was to make investment in emerging economies and commodities more attractive. Just as prior Fed manipulations created the dot-com and sub-prime bubbles, this time we may have created the biggest bubble yet in the form of significantly overpricing US Treasuries. The third manipulation was created by actions at both ends of Pennsylvania Avenue (the White House and the Halls of the Congress)for the last seventy years. The current impasse caused by the debt ceiling curiously comes as a surprise. The truth is that in deciding what is good not only for our own people, but many overseas, we have been bribing them with assets that that they couldn't afford.(Yet we treated these debts as good assets that would be repaid until periodic write-offs occurred.) We should have known that we had a government that we and the rest of the world could not afford.

What is going to happen now?

As I have already indicated, I do not know, but I fear that the result will not be well thought-out and efficient in terms of our resources, taxes and debt capacity. What should be happening is to examine the implications of an eventual default. First, at some point the risks overseas will appear to moderate, and the flight into the "safe currency" of the US dollar (and therefore our Treasuries) will become less intense and could reverse as higher and perhaps sounder interest rates will become very competitive to US paper. We should not blame only the scared foreigners for forcing up the price and lowering the yields on Treasuries. A good bit of the demand is generated by sophisticated US investors. These investors are looking for both the combination of higher return and escaping the presumed forthcoming wave of inflation. These smart guys/gals are buying commodities and other assets on margin. Guess what? They are supplying treasuries as the collateral for their leverage bets. A default could crunch the value of their collateral which supports leverage multiples of 50 times or more. If temporarily the value of the collateral should decline, unless they have other uncommitted assets, they will be forced to sell. I am hardly the only analyst to see this connection, thus any dramatic fall in the price of commodities may not be a function of inflation but a need to reduce leveraged positions. Less exposed, but tied to the US credit, are the assurances of various government agencies, e.g., FDIC,FHA, FNMA, SBA, etc. The prices of their paper also might react violently if the market really believes in a long lasting default.

Why is this happening now?

Around the world people are turning on their ruling political leaders because what they did in their attempt to do something is clearly not working. They are not producing new jobs. People want all of the benefits "promised," but they want someone else to pay for it. Their ability to achieve the retirement of their dreams is in tatters. For some time now I have questioned whether there are any truly popular governments, better than the other party or parties. However, all ruling political leaders are, or should, feel threatened.

This brings us to the current UK headlines on hacking. I am certainly not a defender of violating the privacy of individuals (including disclosures of the illness of a former Prime Ministers’ child). While there has been some apparent breeches of non-political leaders’ privacy, the strident calls for the hackers' heads is coming from the politicians and in some cases politically-oriented entertainers. If all of these people were as pure as the driven snow, they would have nothing to fear of the disclosures about their public positions or indiscreet activities. Clearly, they are human just like you and me. They must have some private feelings and doings which they would choose not to share. Apparently, that is not what the hackers in general are seeking. They want to catch the "Big Man or Big Woman" in a compromising situation which could cause the exposed person to lose face, if not power. If the people in power were secure in their popularity, probably no disclosure could unseat them. The focus on hacking in some respects is good for the powerful, in that it diverts immediate attention away from the continuing fiscal imbalances, the desires for current/enhanced services, and the unwillingness to pay for them.

What to Do?

Having the above thoughts, I am questioning the next steps in terms of our clients’ portfolios. Perhaps some of you in this blog community will share your thoughts. In the meantime, I will be patrolling the periphery of the markets to try and catch a fundamentally changing trend.

____________________________________________

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Improve Your Investing with Unconventional Thinking

Though we think about the details of our investing almost all the time, rarely do we fully examine the foundations of our investment philosophy. If you will, they are treated as given. One of the standard analytical techniques is to contrast a particular viewpoint with something very different. Most often after the examination, we conclude that our basic premises are correct and if anything, believe in them even stronger as they survived being rigorously challenged. As part of this occasional exercise I look beyond the center of our beliefs, even beyond the periphery, to the fringe. In the following two sections I will briefly discuss two unconventional ideas in the spirit of providing contrast to conventional thinking. I have not concluded that these ideas are more correct than the conventional views or necessarily believe in the views expressed. (Just as I don’t believe in what I see in the bathroom mirror on some mornings.)

“Jobs” is an insufficient answer to global economic problems

“Jobs” is an insufficient answer to global economic problems. In numerous posts of my blog I have commented on the power of various four-letter words, some that can be used in polite society. Jobs is probably the single most used four letter word in today’s political world that can be printed in family newspapers. The lack of sufficient employment to create economic growth is a problem facing many, if not most, nations of the world. In the United States, the figures may show that if we include the unemployed, the under-employed, those who have officially dropped out of the work force, the young that never had a chance to find a paying job and the undocumented immigrants who are supporting families add up to perhaps 20% of the employed base. We know of hardly an extended family that does not have a member qualified to be included in this total. The conventional thinking is that government needs to indirectly cause employers to hire these people.

An unconventional approach would say that this is the wrong way of looking at the situation. As is usual we measure what is easy to measure, not necessarily what is important. Both for the employed and those who are beyond payroll status, what is important is the quality and quantity of the work being done. There are many unmet needs of our society that should be addressed. In almost every society there are at least three common deficits. When we look around us, up-close and at a distance, our physical infrastructure is approaching an unsafe condition. Our method and practice of education is producing children who are not prepared to get, hold and prosper in the jobs of today and tomorrow. The third major shortfall is that there is a crying need to modify people’s behavior in terms of what they eat, exercise, and how they use their precious time, etc. Today’s government cannot really address these issues and if it could, it would probably do a poor job. Private businesses are stretched to meet their own internal needs; thus some of the workload falls on the non-profit world. The problem is that these institutions and to some extent families, all manage their expenditures carefully and for the most part, extremely prudently. What they don’t do is measure the productivity gained through the changed lives of their various assisted clients.

These productivity measures (including the value of work and maintaining a home) are difficult to measure, but some attempts are needed. As someone who is involved with a large number of tax exempt organizations (usually regarding their investments and other financial considerations), I hear very little comments relating to the measurement of the productivity that is being created for the various users of the organizations’ services. What is the lifelong value of a healthy baby compared to a chronically sick one? Returning a worker to full employment is worth what? Educating a child to get and hold a job of the future has what benefit? Helping a family eat healthier has what value? As is often the case, any measure is better than none; and over time, with diligence, measurement gets better. My guess is that for our economy these aggregate improvements, if encouraged, could in a somewhat tangible value, equal our commercial production of goods and services. Remember those employed in the US and in many other countries are a minority of the total population.

OK with the thought, now what should be done about it?

There are many things that we should do. First, encourage volunteer activities for all who are not fully employed or in an organized sport or intellectual activity. Second, if we continue to have complex tax codes, recognize the value of these non-profit gifts to society through the tax code. Third, organize work parties to help with building the infrastructure in our schools and neighborhoods. Finally, track the benefits to the clients helped, to instill senses of pride and accomplishment for the individuals and their commitment. An interesting side benefit of this potential surge in volunteerism is that it may well be a very good training ground for future employment. So when you hear various political leaders talking about a jobs program, guide them to a work-oriented program both on the pay and volunteer level, but in all cases demand various measures of productivity.

Could there be some benefit if temporarily the US debt ceiling is not raised?

I am sitting here on a lovely sunny Sunday afternoon with the television on mute waiting to see if anything of substance comes out of the political conference between the White House and legislative leaders on the debt ceiling. I believe that all of us hope that they can agree on a series of sound decisions on expenditures and possible changes to the tax code. But what would happen if August 2nd came and there was no agreement? We have never experienced this exact situation before. Many are afraid that it would be cataclysmic. Some believe that while bad, that there can be some benefits. As required by law, all bonded debt with interest will be paid. This is important, as an increasing portion of our debt is owned by foreigners. However, since we have been operating at annual deficit for many years, there will not be an immediate source of income to pay our non-bonded debt, which is largely various government payrolls (and payrolls dependent upon federal funds) to many Americans. To meet most of these requirements, like the rest of us, the government will have to come to a difficult decision to prioritize its payments. A possible offset to fill a portion of this hole is the sale of some of the government assets. We don’t know the true situation, as no balance sheet with the estimated value of the US government’s assets has been published.

One of the legitimate concerns of some is that an internal payment lag would hurt the standing of the dollar in the world and in the marketplace. In a strange and convoluted way, the monetary value of the dollar could rise. First, one needs to recognize that almost all paper currencies are losing value to inflation and in many cases, increasing their debt load. Many international investors believe that the dollar is the best of a bad lot. The recent rise in the relative value of the dollar is perhaps due to the fact that it is safer than other currencies. This safety is not a function of a government balance sheet, for as noted, it does not exist. The safety is primarily based on the strength of our military and geographical location to avoid a rapid foreign take-over. (With the expected substantial cutback planned for our military forces, we need to be thankful to wide oceans and reasonably friendly neighbors.) Traditionally the value of our currency was based on the implied promise of our taxing power on our citizens. The current impasse questions the strength of this implied action. Out of this clash of too high expenditure and too low tax revenues will come, eventually, a new equilibrium. As the problems that caused this conflict have been building for many years, perhaps as far back as the 1930s, the economic value of the dollar based solely on domestic considerations should have been declining. This new equilibrium may well give the dollar a sounder base and could in turn lead to some appreciation.

The second result that may come out of this is a clearer understanding on the ability of a creditor to sue the US government. Historically, no suit is possible without its permission. This is why, in many respects, high quality corporate debt is more valuable than US government paper. Quite possibly coming out of a temporary delay in payment by the government, a new standing of its obligations will be confirmed by a competent court.

What do you do with these unconventional thoughts?

After some consideration, you should see if these views change your existing investment outlooks. Second, and much more importantly, you should review existing more conventional views to see whether you are prepared for some unexpected result to challenge your portfolio. A list of current somewhat conventional views is shown below:

1. Interest Rates will rise over the next several years.
   
   
2. We will see the price of oil at least at $150-200 a barrel sometime in the foreseeable future.
   
   
3. Past performance is a good way to screen for investment managers at all times.
   
   
4. In choosing an investment management firm an easily explainable investment process and discipline is required.
   
   
5. Only managers with a well-defined succession plan for their operating companies and investment managers should be considered.
   

What Do I Recommend?

Even though I very much value my US Marine Corps training, I do not want to be invested in a lockstep portfolio that is rapidly marching only in one direction. I believe in regularly examining some unconventional approaches and people, to combine with more conventional approaches. The value for my clients is that we provide individually selected portfolios of mutual funds that permit having a number of different views working for them. The visibility of their portfolios and other critical disclosure information is reassuring most of the time.

Please share your thoughts on conventional and unconventional thoughts and how they might impact your investing.
____________________________________________

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

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Independence Day: A Chance to Re-think Our Portfolio Structure

• Independence
  
• Interdependence and Insights
  
• Items of Interest

In the United States we celebrate July 4th as Independence Day. Many countries celebrate a Nation Day, observing the date when they became independent from an occupying power. The US appears to be an exception. We celebrate the date we published our Declaration of Independence (actually agreed to on July the 2nd). Thus, we are celebrating a document of principles that we hoped would separate us from what was our Mother country. At the time in 1776, the wish would not have been considered a good bet. The British had the best army and navy in the world, and we had thirteen colonies of very different backgrounds and policies. In at least three states the delegations to the Continental Congress were split and many of our people remained loyal to the Crown, fearing the disruption that would be caused by this new form of government. They were right to be afraid. A number of those successful men who signed the Declaration, who survived capture, torture and death in battle, died bankrupt because of their loss of property during the war. They could not agree among themselves how to govern, even if their independence was won. After twelve long years of debate, a compromised Constitution was passed. Viewing this arduous procedure from today’s vantage point, one of the key political decisions was to create a currency union by assuming all of the outstanding debts of the individual states, and agreeing to make payments in the discredited national currency of the US dollar. I am particularly proud that the driving force behind this and the other financial matters of the new government went to the same college as I did. Alexander Hamilton attended what is today Columbia University. (I need to assure the young in my family that we were not classmates.)

The currency union rested on the ability of the federal government both to raise taxes (largely through tariffs), and to muster a standing army that was under the President’s command. The current problem with the fiscal conditions in Greece, Portugal, Spain, Ireland and Italy are subject to the weak currency union of the Euro. One of the lessons from the American Revolution is that while ideals can flow across borders well, commands do not. I am not suggesting that our various mother countries follow the American experience, but they should use it as a base for their thinking as moderated by local conditions. We also need to apply some introspection to our own activities and thinking, including our investment portfolios, which is the focus of this blog.

Interdependence and Insights

While some early Americans may have thought that they could be independent of the “Old World,” we now know that our very existence and markets are dependent on what is happening both in the Old World of Europe, but even more importantly, China and other countries that we label, somewhat incorrectly, as “emerging.” Perhaps it is my intellectual inheritance from Alexander Hamilton, but I view the world through the prisms of financial lenses. Hamilton, first as the Secretary of Treasury, was very concerned in paying off the war debt of both the country and the assumed debt of the states. He was aided by the development of an active bond market. Only after he left the government did he become involved with the stock market, in part by founding the Bank of New York. (BONY was my first employer after leaving active duty with the US Marine Corps.) Even today investors should first be conscious as to what is happening with the various fixed income (debt) markets. These markets are much more sensitive to changes within the economy than the longer-term focused stock market. Too many stock investors today are not paying attention to the signals from the bond market which can be highlighted as follows:

1. The interest rate spread between US Treasury securities and Treasury Inflation Protected Securities (TIPS) is widening to 2.7%, indicating that market participants over the next ten years expect inflation to be 2.7% or possibly higher.
   
   
2. A number of the bond dealing desks of banks are shedding both people and capital invested in making markets. This is causing some lack of liquidity with prices becoming more volatile with reduced volume. A similar pattern is expected on the stock side of these dealers. To some degree the use of Exchange Traded Funds (ETFs) is providing additional liquidity for the stock market, on both the long and short sides of trades. Lack of liquidity, at times can lead to sudden, large price movements.
   
   
3. High Current Yield bonds and their bond funds are marching to a different drummer/different direction. While we do not just yet have the final numbers for the second quarter fixed income performance, my friends at Lipper, Inc., to which I am no longer connected, estimate that High Current Yield funds will show the only declines in the fixed income averages. These small declines should have been expected. Again, as estimated, these funds had net redemptions of $1.3 billion for the second quarter. The enthusiasm for these “junk bonds” reached a peak in March, when close to $16 billion was purchased at the time of significant issuance by corporations taking advantage of low interest rates. By May the gross flows into this category of funds had dropped to $6.4 billion, which was lower than 14 out of the last 16 months. One of the reasons for the enthusiasm for these bond funds is that in May, Moody’s* estimated that no more than 2.7% of rated bonds defaulted, and they expect by year end this number could be lower than 2%. I have two reactions to the above elements. First, I view high current yield paper as essentially equity with interest payments due and are really a form of stock investing. When these become less popular, I am concerned that stock investing in time will become less popular (which we may be seeing now). Stock markets have difficulty sustaining a big rise without increased volume. My second reaction is that I believe most things follow a cycle pattern. While Moody’s may be correct that we will be in an era of low bond defaults, I have my long-term doubts and would expect as interest rates rise and there are more high-priced deal financings, that the level of defaults, will unfortunately also rise.
   

*Moody’s is a position in our private financial services fund.

Items of Interest

One of the benefits of serving on important tax exempt institutions’ boards of directors/trustees is sharing different points of view. Recently, one particular board was asked about the outlook of the various organizations represented. The concerns of the management were first, that during poor times the needs for its services will rise. Second, fund raising is more difficult when the economy, particularly the local economy, is not expanding. Third, could the endowment be expected to raise its contribution to the operating funds? Much of the answers could be expected if one read the local newspaper. However, there were two expressed views that were interesting. The first was from an accounting firm that was increasing its hiring at the entry level. (Considering the training cycle for the firm, this was a bet that business was expected to be expanding in 2012 and beyond.) The other view held by a number of financial types, excluding me, was a bit dour focusing on this country’s debt problems. One could say that the view from these elements of the financial community was already expressed above, in the drying up of liquidity and smaller staffs on trading desks.

Those who know me would not be at all surprised that I had a different point of view. I expected that the near-term would be a period of increased volatility filled with opportunities. Some companies will do unexpected things that they never considered doing in the past. I believe that there is more proven executive talent available now than at any other time. I saw sufficient long-term growth ahead to warrant investment of reserves above the level of contingencies. A few days after the above-mentioned board meeting, I read a survey conducted for Chase Bank (JP Morgan Chase) indicating that 72% of the companies polled expected higher revenues, 62% expected higher earnings, and 50% said they would be hiring. The difference between the Chase survey and my board’s comments was that Chase’s was a national survey and the board was New York centric. The Chase survey did show some elements of concern. First, with revenues expected to grow but less than earnings, raises questions as to a margin squeeze. Second, with revenues expanding, the expansion of employment is less robust.

Two inside baseball statistics hit me as perhaps significant regarding the changing structure of the fund marketplace. First the net sales, (sales vs. redemptions) in the institutional channel was, in aggregate, greater than the combined net sales in the first five months of the direct marketing, sales force, and variable annuity channels. Most of the money recorded in the institutional channel comes from the institutional shares used by salary savings plans, e.g., 401k, 457, 403b, etc. The second and somewhat related statistic was that US Diversified Equity mutual funds had net redemptions of an estimated $4.9 billion in the first half vs. net sales by similar ETFs of $7.8 billion. The impression I draw from these factors, mirrored by slow volume at retail brokerage firms, is that the investing public is disengaged from the stock market, and is only investing involuntarily through employers’ savings plans. While this is very understandable in view of investors’ experiences over the last ten years and what they read/hear from the media, in ten or more years from now they will look back regretfully at what they could have bought.

With the second half beginning Tuesday what are your views?
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