Sunday, March 18, 2012

Misunderstanding Mutual Funds, Spain and Goldman Sachs

As an analyst for more than fifty years, I have learned that I will never have enough information to be completely secure in my investment judgments. On average, I receive over one hundred business or investment related emails daily, and in addition, I read numerous trade and general circulation publications. I must admit one of these publications is the New York Times which every now and then gets something right, and almost always has impact on some investors.

The mutual fund myth

Many people, including some who would call themselves sophisticated, knowledgeable investors have an image that the bulk of mutual fund investors are na├»ve and will buy any fund that has good performance and then jump to the next fund that has better performance. In the Sunday Business section of the New York Times, a statistical table of the fifteen largest mutual funds is published. I find this data particularly instructive, compared to the often exaggerated image of mutual fund buyers as “Ma and Pa Kettle.” First, none of the fifteen largest funds has total expense ratios over 1%, thus a large number of investors own some of the least expensive funds. In the long run, the low expenses provide a performance advantage over the average fund. What is even more instructive is the fund management families that make up the roster of the fifteen largest. Seven are managed by the American Funds group that relies on salespersons to raise assets. The next largest group is the four Vanguard funds, followed by two from Dodge & Cox and one each from Franklin Resource and Fidelity. Six of the funds have no sales charges and two have share classes that have different sales charges. I believe that at least half of the combined assets of these funds are from institutional investors and probably over half represent retirement money. For the most part, the shareholders in these funds maintain their ownership for longer than average holding periods (even though a number of these large funds have not produced “top of the charts” performance for many years). Yet, they fill the needs of their holders. In many cases they have normal redemption rates, as voluntary or involuntary retirements and health issues require funding. New sales are now probably largely sourced from various retirement plans. For some time, more dollars have been leaving than arriving in these coffers. This imbalance may be about to change.

In February, my old firm, Lipper Inc., estimated that $1 billion came into Large-Capitalization Growth funds, and another $700 million came into Multi-Cap Growth funds. (Multi-Cap is a classification for a fund that has assets in different levels of market capitalization. Often Large-Cap is the largest commitment, but not the dominant market-cap.) During February the more speculative group of investors often including hedge funds, put $6.9 billion in Sector Exchange Traded Funds (ETFs) and $5.1 billion in World Equity ETFs. If these speculators prove to be correct, I expect it will ignite the interest in Large-Cap funds.

A survey of international asset managers compared expectations for the US market in January compared to their expectations in December. In January, 62 managers expected a rise versus 53 in December. Only nine were looking for a decline.

Disclosures: Both my private financial services fund and I personally own shares in most mutual fund management company stocks, including one mentioned above. We own a large number of these management company stocks within the US, Canada and the UK as a way to understand our primary investments for clients in their underlying funds. A number of the funds in the largest funds table are owned in our client accounts. I have been annually advising one of these funds as to the appropriateness of the advisory fees since the late 1970s. I believe my multiple involvements with mutual funds and their managers make me a more informed and better analyst. The prices of mutual fund management stocks are leveraged to the market’s expectation as to their growth in assets, which normally leads to increased profit margins.

Other tea leaves

JP Morgan Private Bank has noted that the US Consumer Spending is the largest source of consumer sales in the world by region. However, the US is behind both Europe and Asia in terms of the level of gross investment, and is the only major region that is a net importer. Brazil, Japan and other countries are fighting what they see as competitive devaluations through QE or other interest rate repressions. Until the fears of induced inflation increase and the exhaustion of the excess corporate capital hoard occurs, we are not likely to see meaningfully higher interest rates. As US taxpayers, we should hope that rates remain low for the next ten years as the US is facing the largest single refinancing need of any country or region.

Sam Eisenstadt, the long-time statistical genius behind Value Line is once again expressing a precise bullish view as to the market into August, where he believes the S&P 500 will reach 1520. Market Hulbert translates this in MarketWatch to a DJIA of 14360.

Spain, and its somewhat kissing cousin California, are in deeper trouble than they appear to be on the surface. Both have more complex conditions than are initially apparent. Officially, Spanish sovereign debt is listed as $732 billion and 68.5% of GDP. However, if you add in the bank and other guaranteed debt plus the regional government debt, the total indebtedness rises to $1.1 trillion or 103 % of GDP. What makes this difficult to swallow on the part of the task masters in Germany, is that it is too similar to Ireland, where the biggest part of its debt was the Irish government’s assuming the local banks' real estate debt. The Spanish banks' commercial real estate loans are larger than similarly combined loans in Germany and the UK. (Just as we went to Asia to get a better understanding of China earlier this year, we are trying to plan a visit to Spain to get a view on the ground.)

The connection with California (which has a long tradition of Spanish investment) is that as the EU was being formed, I was urged to invest in Spain as it was ironically touted as the “New California,” providing low cost labor for Europe’s manufacturing needs. Spain would be home for a real estate explosion as the Europeans from less favorable climates would want to vacation and retire there. For awhile it worked, until the production of debts rose faster than income, similar to, you guessed it, California. To bring the parallel up to date, in the annual period ending in February 2012, California tax revenue fell 22.5% due to sharp declines in retail sales as well as use taxes and personal income taxes. A sunny climate is not sufficient to produce prosperity.

Goldman Sachs

Last week was “The Week that Was” for the firm. Too much has been written about the reactions to a disgruntled employee. Much of this verbiage is in the so-called “popular press,” as distinct from the professional or trade press. I do not want to add to the collection other than to make two points. First, many amateurs do not understand the concept of agency where an agent is working exclusively at the time for a client. On the other hand, a principal is involved on the opposite side of the trade. A couple of generations ago there were separate brokers (agents) and dealers. Over time, driven by economics, these two functions were combined in the same firm. Most of the time people, (whether they recognize it or not) deal with Goldman as a dealer not as an agent. Clearly both some clients and a small number of employees of the firm do not appreciate the distinction. The popular press does not. The second point I feel compelled to disclose is that we are no longer clearing through an affiliate of the firm, as we did not provide sufficient revenue to them, but this has no effect as to our long-term holding of Goldman Sachs.

Investment conclusion

Read as many tea leaves as you can. Look for deeper implications from factoids because they are often visible before the full picture becomes clear. As many of these thoughts are not without controversy I would like to hear from you.

Did you miss Mike Lipper’s Blog last week? Click here to read.

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