Sunday, March 24, 2013

Are We Entering The Most Risky Phase?

Apparently this quarter’s surge in net flows into equity funds has been identified as sourced from idle cash, not from in my opinion the most risky asset class, bonds.  I would suggest that two other factors need to be considered to get a fuller picture. The first factor was the January surge, led by stock investments from defined contribution plans; i.e., 401(k), 403(b), and 457 plans in addition to bonuses. In some of these cases the employer’s contributions and the bonus money are once a year events. Further, I suspect the level of gross redemptions in 2013 are down somewhat relative to 2012, which would magnify the impact of one of the highest January inflows on record.  
There is no denying that many investors both institutional and individuals have turned more positive to equities, almost on the basis of ‘what doesn’t kill you, makes you stronger.’  With a few exceptions, major stock markets gained in 2012, rather than going down in early 2012 as many had thought. This result is in contrast to 13 years of equities generally going nowhere. Total reinvested return calculations for the last ten years of equity mutual funds does show a 10% compound growth rate mainly through reinvesting distributions into more shares at lower prices. Those that spent their distributions did not get this benefit.

Whatever the reason, we are being asked to become more aggressive with client portfolios. We manage each account for its own needs. In almost all cases we produced double digit returns for 2012 and in some cases were ahead of the equity averages (even though the accounts had somewhat of a balanced nature). In one case our gross performance was above the 20% level. Nevertheless some accounts are asking for even better returns which we would also like to deliver, but the increase in the potential level of risk is uncomfortable.     

The nature of risk

Risk is not what is taught in various schools by academics which should be more accurately described as the variability of returns. Risk is not the volatility of prices from short-term period to period, which may describe the comfortableness of a ride along a trend line compared with some other price series.  Essentially risk is the penalty for being wrong to the extent that it causes the investor or his/her beneficiary to change permanently one of life’s essential goals. For you or I, risk is a potential loss of serious magnitude. For you as an institutional investor, a million dollar decline in your portfolio is a bit distressing but your beneficiaries are not really hurt until the loss may be in eight or nine figures. For others personally, a loss equal the cost of a new car or one or two annual college tuition bills would be painful.        

When to expect large losses?

In typical capital preservation-oriented accounts that are well diversified in uncorrelated assets, large risk of large capital losses come from two sources.

The first is that there is greater correlation of price movements than expected, which is what happened in 2008 where practically everything except Treasuries and a handful of other assets fell, with many funds dropping  20-40% or more.  The other way is to become unbalanced through the exceptional success of a single investment, think of Apple* or Berkshire Hathaway* for early investors. Instead of representing say 5% of a portfolio and because of relative appreciation, one position now represents over half of the value of the portfolio. Assume that Apple at the top represented 60% of the portfolio and with the current slide of approximately 40% from the top, the portfolio could be down 24% ($60x.40%= 24%). How could this happen?  Allow me to quote from the esteemed Howard Marks, president of Oaktree Capital: “Things get riskier as they become more highly respected (and thus appreciate). There can be more risk in thinking you know something than in accepting that you don’t.” He further states: “the better returns have been, the less likely they are-all other things being equal to be good in the future.” 
* Owned positions in personal or managed accounts

Nevertheless, we have often heard the advice to sell your losers and let your gains run. To do the opposite has been the curse that has fallen on US and UK managers of funds sold into the Japanese retail market where many Japanese measure risk only by seeing how much the price or net asset value has gone up and then they redeem relatively quickly. This view may be aided by their brokers who are interesting in recycling their money into newer investments. In my opinion, both extremes of holding forever (for which I can be accused), or quickly selling after a sharp rise, can be wrong. The key is that every day one should evaluate both the upside potential and the downside risk of permanent loss. 

What are the increased risks today?

If we choose we can buy into the belief that while this year may be economically challenging, like the IMF we can choose to believe that 2014 will be better than 2013 not only for the US but importantly for Europe. This “happy talk” is increasingly being accepted despite the strong odds that France will join the deteriorating countries who won’t come to grips politically with their problems. The potentially sizeable problems of France could well be too much for the German taxpayers’ willingness to carry. Further, I suspect that any significant solutions to the US deficit problems unless solved in the next six months won’t be meaningfully addressed until after the 2014 congressional elections, when the fundamental composition of both houses could change and the White House will completely focus on its legacy.     

The current Federal Reserve Board believes that they are largely in control of the both the level of interest rates and the relative value of the dollar. I believe that the Fed can be surprised by non-monetary events. For example a pandemic of SARS or similar life-threatening waves that can affect the US directly or indirectly. This weekend’s issues around Cyprus could produce symptoms of much bigger problems. For example, if the Cypriot banks can tax depositors on their euro accounts, won’t other governments under pressure to raise tax revenues at least consider doing the same thing? Possibly the regulated banks will be considered less secure than they were a few weeks ago. The skeptic in me always looks for something below the surface to actions of governments. In this case perhaps one should look beneath the surface literally. Off Cyprus to the north there is believed to be a large undersea gas field that Turkey wants to develop. To the south there are possibly two potential offshore oil/gas fields which people from Cyprus and Israel want to develop, and the Russians would like an Eastern Mediterranean port for five of their ships. (Remember this would not be the first time that these types of issues have driven geopolitics both within and beyond the Middle East. The British government sponsored what was, in effect, British Petroleum’s takeover of the Suez Canal from a failing French firm.) Other potential offshore gas and oil deposits could also produce conflicts and disabling price movements in terms of the disputed Chinese/Japanese islands and possibly a significant discovery off Vietnam. One only needs to look at the deep-water find off Brazil and the opening up of Mexican oil exploration as examples of how ‘surprises’ can cause disruption to the Fed’s neat playbook. 

A small but potentially new player is on the scene: Irrevocable Trusts.

In the aftermath of the year-end changes on US estate taxes, I believe a significant number of new irrevocable trusts were created out of former estate plans to lower the size of the estate taxes. Many of these trusts used the maximum allowed of $5 million per grantor. In many cases these trusts are designed for children/grandchildren, personal foundations or other charities. Since these are non-returnable gifts, quite probably their investment character should change. As long as the money was in the planned estate corpus it may have been invested for capital preservation to make sure that the grantor and spouse will have enough capital and income to meet their expressed needs. As the money is permanently set aside and could have a materially longer if not eternal (dynasty) horizon, some or all of this portfolio will be more aggressively invested in a capital generation mode as distinct from the same dollars in the past invested for capital preservations. 

The buyers who could drive the stock market

The following is pure speculation, perhaps informed speculation. As indicated, investment advisors are being asked to produce higher returns particularly at present low interest rates. Money from the sidelines appears to be coming in. The continuing flow from salary reduction savings plans is augmented by employer contributions, particularly as more defined benefit plans are being tapped in favor of new defined contribution plans. Foreign investors who are becoming increasingly nervous about unfriendly home governments may also, at least temporarily, want to shift money into US traded equities, And finally some of the money comes from new irrevocable trusts.         

My dilemma is that I believe we have entered a phase of heightened risk. When these flows do come in, by definition they will have the effect of increasing risk to our markets. Jumping out of the stock market too soon may cause professional managers to lose their jobs. Waiting too long to reduce positions could lead to substantial loss of capital or real risk. Exit timing is the most difficult part of the investment art.   

How are you going to time some of your exits?
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