Sunday, June 30, 2013

Money Flows: Good, Bad & Ugly

Unrealistically most investment discussions focus largely on purchase decisions and almost all the rest of the time on when to sell. In contrast, as both an investment manager and a member of numerous investment committees, our most frequent interaction with an investment account deals with flows; money coming in or going out.

In a normal (or worse, “new normal”) period, the median performance as a percent of the assets committed is relatively small, often in single digits. Most outflows are discreet amounts of money dealing with meeting legal, tax, or other requirements. In an account that wishes to stay in business, outflows should on average represent 3-5% of the corpus, or better yet, an average of 20 quarters. Offsetting the outflows are inflows of new contributions and income from the investment portfolio. In most years inflows represent a significant part of the annual performance.

The good

Whenever we are required to send money out of an account, be it a mandatory redemption requirement for an IRA,  a transfer out of a corporate retirement plan or funding a grant, I use the event as an opportunity to review the account. Rarely in a single account do we receive significant inflows at the same time as the outflows. Nevertheless, we take the same opportunity with new money to review the account for the best allocation at the moment. Further in some regimented accounts, market price movement may require addressing the need to rebalance the list to the closet limit allocation.

At the time of the flows, we rapidly decide what is best for the account looking forward to its normal investment time horizon. Notice that this review focuses on the perceived future not the immediate results within the portfolio. This might well be a wonderful opportunity with new inflows to start an investment in a new security or fund.

Somewhat strange for me of all people to say, is that we do not let past performance dictate future actions. In effect, we make the use of flows an investment moment.

The bad

There are strict guidelines for account (administrative) managers in terms of flows, particularly in large financial institutions. They usually follow one of three procedures:

The first is to divide up the flow so that proportionately the flows do not change the present structure of the account.

The second approach, followed by some short-term performance driven funds, particularly hedge funds, is to put the bulk of the flows in the best short-term performing holdings.

The third approach, favored by value-focused investors, is to put new money in the currently worst performing holdings and if the flows of the account are outgoing, take some off the top performing and/or largest holdings.

Why are these bad approaches? These are mechanical reactions and foreclose the opportunity to have an investment input. I have found that these periods of inputs can lead me to rethink the portfolio now, rather than wait for a normal receipt of documents for my review or major market move. While many portfolio managers want to make dramatic moves, there are times that an initial gradual set of moves (and more importantly, evolving thinking) produce good results.

I guess I would rather think of myself and hopefully others think of me as an investment artist, not just an investment mechanic.

The ugly

The ugly comes in two categories: the first is an immediate reaction and the second is misinterpretation of a repeating phenomenon. 

A good example of the first was the stock market action late last week. On Thursday, June 27th, the Dow Jones Industrial Average was up 114.35 points.  On a normal summer Friday, particularly coming into a holiday-shortened week, most short-term traders do not want to carry additional holdings over the weekend. During the day on Friday the 28th, the DJIA was aimless. However, all of a sudden in the last few minutes of the trading session, the DJIA plunged -114.89.

Almost all of the weekend news media pontificated as to the meaning of this decline, relating to the views regarding the size of the Fed’s reduction of its bond buying program. The day before the same pundits took a more favorable view of the expected actions by the Fed. Only a few noted something that I knew for over a year. On the last trading day of June each year the Russell Indexes are officially reconstituted. Index funds, mutual fund or ETF, closet indexers, and other passive funds need to own the new list before the opening on Monday. My guess what happened is that it was relatively easy to deduce which IPOs and spinoffs would be added to the relevant indexes. Once that number is ascertained on the basis of present market capitalization, one can make a very good guess as to the number of stocks that had to leave the index to make room for the incomers. These had to be sold quickly so that capital can go into the new names.

Thus, I do not attach much significance to Friday’s afternoon performance. I know of one instance many years ago when there was a disproportionate mark-up during the last hour of the last day of the calendar year when the auditors threw out prices for statement purposes after 2:30. (The market closed at 3:30 those days.) In terms of quality of numbers I have been always cautious of believing results of last days of June and December.

Mutual fund flows misinterpreted

Over forty years ago the needs of the Wall Street trading community focused heavily on the net flows from mutual funds as a guide to very early trading directions the next day. Today, recognizing that mutual funds are the most transparent of all investment groups, people focus on net flows of funds to identify current and future investment attitude. Note that almost all of the focus is on net flows. Net flows are the mathematical sum of purchases, including reinvested distributions/dividends and redemptions without distinction of whether or not the redemption is a transfer to another fund in the same family.

The math treats that buying and selling have the same motivations or purposes. I believe that this is often inaccurate. Most redemptions, in my opinion,  are completions in that the original purpose of the investment has been met. Payments are necessary to meet tuition, medical, or housing needs as well as planned or unintended retirement. A switch from a stock portfolio to a Money Market fund or an Intermediate or Short Government Bond fund probably has more to do with the near-term need of investors than a view as to how attractive the equity market is currently.

As difficult as it is to fathom redemptions, purchases are more difficult particularly if they are the result of a commission-oriented adviser or broker. Due to competitive pressure egged on by the SEC, the sale of mutual funds (particularly to individuals) has become less profitable to both the individual sales person and his/her house. The sale of private placements, real estate, and hedge funds are more profitable for the intermediaries than selling funds whose results can be tracked every business day after the initial transaction.

Until the stock market goes higher and more speculative, I believe in many periods it will be difficult for equity funds to show more dollars of sales than the actuarially-driven redemptions of Money Market and high quality Short to Intermediate Bond funds. Thus, I would not use the headline numbers of mutual fund net flows. However, I will continue to analyze the net flows within various categories of equity funds and at a greater delay the relative flows among various funds with the same objectives.

Please share with me how you use flows.

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Sunday, June 23, 2013

Losses Lead to Profits, but Will the Fed Learn?

Losses are inevitable in all of life, including your investment portfolio. As a matter of fact, the only thing I promise to those whose portfolios I manage is that I will make mistakes for them, but hopefully they will be relatively small and quick, and that we learn from them.

There are four kinds of losses. The first is that the selection failed to deliver the expected result because the choice was fundamentally flawed. The second is a faulty understanding of how the particular investment actually works. The third is the right idea, but the wrong timing. The fourth and the most dangerous to the future of the people involved is not to learn from the losses. One of the few things I did not learn from my experiences in the US Marine Corps is my motto of “Blunder Forth,” but the key is to learn from past blunders and not to repeat them.

Diversification losses

Since few, if any of us know with certainty what either the markets or the economy are going to do, it is traditionally wise to hedge our bets. (This is why at the racetrack an occasional bet on second place or even third makes more sense than only betting to win, particularly in each race.) There are two active ways to hedge our bets. One is to sell something short. The second is to buy something which is likely to move in the opposite direction than the bulk of the portfolio is expected to go.

Many institutional and individual investors are hesitant to sell short because to be successful one needs to get one’s timing right. Too few have a good history of this skill. Many more investors look for contrary plays. Two of these are gold and TIPS (Treasury Inflation Protected Securities). The owners of these are betting that the current manipulation by the major central banks of the world will produce a decline in the value of major currencies or create a large bout of inflation. In the first half of 2013 neither of these calamities have occurred, therefore these bets are considered by many to be losers. In most institutionally managed portfolios the actual or paper gold (futures or gold mining shares), the gold holding is less than 10% and in many cases below 5%. The purpose of the holding is to act as a ‘canary in a mineto signal an abrupt change of conditions which has not yet happened. TIPS are typically held in a portfolio that also owns other bonds or bond funds. The combination of the bond holdings is meant to insure that when the bonds mature they will produce dollars that are equal in spending power to the level of the dollars invested initially. For most of this year TIPS have not been returning a real (inflation adjusted) return.

Are the investment in gold and TIPS losers? I would say no. Because of some investment in TIPS, a number of investors were able to have enough courage to own much larger investment positions that had a more positive outlook than if they had not owned TIPS.  I would go further by saying that a well-balanced portfolio could well be at its maximum risk of large losses when all of its investments are showing significantly positive results. It is unprepared for abrupt changes which have been known to happen.

However, there is a risk which overtook investors in 2007-2009. The risk is that the protective diversification schedule was trashed by the correlations (particularly on the downside) among supposedly uncorrelated assets. I am not at all suggesting that one should abandon diversification as a practice, but to be aware that there will be times that supposedly uncorrelated prices will move together and only a reasonable amount of cash or very short-term treasuries will supply some ballast to a rapidly sinking portfolio.

Will the Fed learn?

The two losing diversification investments mentioned above were meant to be good diversifiers against the actions of the US Federal Reserve Board (the Fed) and a number of other national Central Banks in attempting to stimulate their economies by depressing the natural risk-oriented interest rate levels. Perhaps it is coincidence, but this week I have become conscious of four separate but different comments that suggest that we are approaching a time when the structure of the Fed may be changing. In order of their first appearance to me the four are as follows:

1.   As mentioned in last week’s post I chaired a panel presentation on the impact of the media on the nature of “bubbles” with Bill Cohan and Jason Zweig at the Columbia Club in New York. As is often the case in these public sessions, the audience was less interested in history and more interested in what to do now. One of the speakers who is a good historian stated that the Fed is not very good about predictions. They have not done a good job of predicting the economy and worse, they have been poor on predicting what they would do in the future.

2.   A “Hindsight” column in the  New York Times, included an article by Roger Lowenstein entitled “The Fed Framers Would Be Shocked.” Roger is someone who has written widely on the economy and the market, he is the independent chair of the Sequoia Fund, a sound fund that comes out of the heritage of Warren Buffett’s original hedge fund. He focuses on the concerns of many involved with the passage of the act that created the Fed; that it would become too powerful and would drive the economy. The authorization of the second Bank of the United States was allowed to lapse because many feared control of our economic interests by a powerful unelected body which would likely to be heavily vested by the ‘money trustbankers. In some ways this was a replay of the battle between local control and national control, a battle that is still raging in education, medicine, and other arenas that people care about.

3.   The Bank for International Settlements (BIS) functions as the central bank for the world’s central banks. In a report released over the weekend, they urged the central banks to withdraw from the stimulus business. The BIS felt that the proper function of the central banks was inflation control not to provide growth impetus for their economies, which is a function of the governments and their fiscal policies. An interesting article was published Sunday by the Telegraph, entitled:
BIS Fears Fresh Bank Crisis from Global Bond Spike.” 

4.   There is a bill in Congress which removes the double standard for the Fed by eliminating the responsibility to aid the growth in the economy other than by attempting to control inflation.

I found it interesting that all seem to be forgetting that the original purpose of the Fed was to substitute a public source of capital to troubled banks replacing JP Morgan’s policy of forced cooperation. (Morgan once locked the participants of a key meeting in his library to force agreement among the solvent banks to provide bailouts to the distressed banks.)

Quite possibly these and additional drumbeats may hasten changes in the proper use of the Fed. Others are learning from the recent past, it will be interesting to see whether the momentum for change will come from within the Fed or from external forces.

All of us, including the Fed can learn from our past losers or mistakes.

From what losers have you learned? Please share publicly or privately.       
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Sunday, June 16, 2013

Investment Stages Need Second Opinions

There are five stages through which many long term successful investors pass. They are titled past, present, future, retirement, and beyond. Many of us prudently seek qualified second professional opinions to review our options at each stage.

I urge all investors to look for multiple causers for past actions which should help in deciding how much weight to put on the perceived history to their investing for today and much more importantly for tomorrow.

US Marine Corps inputs

Ruth and I have concluded a reunion with my US Marine Corps Basic Officers Class.  My class was an unusually productive group producing five general officers including two four-star generals, one being our Commandant. We found our meetings and visits both worthwhile and thought provoking. A meeting like this recognizes our brethren who are no longer with us, some lost in defending our country. Our class leader and our former Commandant reminded us that we are all in the zone to join our departed brothers. In typical Marine optimism two thoughts were mentioned. The first was in planning future reunions, there was discussed the need to have a reunion when members will be 95 years old. The second item brought up was the Marines’ Hymn, which in its final verse provides the duty assignment, "If the Army and the Navy/ ever look on Heaven’s scenes; /They will find the streets are guarded/ By United States Marines.” 

After an evening such as this I cannot avoid thinking about our progress as investors and the missions ahead.  In the USMC spirit, a "Pass in Review" is the command issued to troops to pass and salute their reviewing officers. Reviews by others can also be very useful for our investment marches.

I will devote the rest of this blog to the different phases we have as investors. 


For most of us the sum total of our experiences are our main guides to our thinking and actions. This is the way we learn in school and from other authority figures. My fellow securities analysts (quoting our various professors or former bosses) rely heavily on perceived history. In an uncertain world, we like the certainty of history because it then becomes an easy task to extrapolate a trend;  such as projecting growth rates into the indefinite future. Economists are also fond of using history as laboratories for their pronouncements. The problem with relying on perceived history is that it may not be either accurate or relevant to the tasks ahead. We need to remember that history is largely written by the survivors and they are good, simple story tellers. There are many examples of deeply believed historical views that were inaccurate; e.g., the flat earth was the center of the universe or that slavery was the only cause of the US Civil War or the assassination of the Austrian Archduke was the cause for the first World War.  I urge all investors to look for multiple causers for past actions which should help in deciding how much weight to put on the perceived history to their investing for today and much more importantly, for tomorrow.

History is often seen through the eyes of good writers of history. Two of the best currently are my friend Jason Zweig of the Wall Street Journal and William Cohan, a Bloomberg contributor and the author of
The Last Tycoons: The Secret History of Lazard Frères andA House of Cards: A Tale of Hubris and Wretched Excess on Wall Street” his story of the last days of Bear Stearns. They will be on the panel that I will chair in New York this Wednesday night on financial bubbles. The discussion should be good fun as I may question nice neat declarative statements about our past bubbles and who contributed to the problems.


As much as some may like to live in the past because of its perceived certainty, we cannot. Others would prefer to live in the future where today's problems are solved satisfactorily, but we cannot dwell there either. We can only live in the present. The present is in truth confusing, particularly as Jason Zweig points out, we now live in a 24 hour, 7 day a week barrage of information and opinion. How will my portfolio react Monday to the election of an apparent moderate Iranian cleric as its president?  Will all global investments change dramatically on the 18th after the news conference by the chair of the Federal Reserve? Because of the increasing reach of the financial press plus the drumbeat of investment peddlers, one would think that your entire investment portfolio will permanently change in value with each news update.  I doubt it. I do not doubt that the activists will see reasons to trade and that volatility will rise in what should have been quieter markets. Based on the past I would not be surprised to see the initial violent action to some news to be reversed. Because of the absence of market structure stability forces, (floor specialists) we are likely to see wider intraday moves. This increase in intraday volatility is not likely to mean a perceived increase in changes of attitudes of risk of permanent loss of capital.

My attitude about the present that it is a minefield to be traversed until we can get to a future that is focused on solving longer-term problems. However, we need to be prepared and have our scouts out looking for opportunities to make money and avoid permanent losses.


There are two nice things about thinking about the future. The first is that it is an indefinite period which can cyclically turn out to be favorable to one's point of view. The second benefit of cogitating about the future is you can't be wrong until you get there. Nevertheless, as equity investors our rewards will come in the future. I cannot claim to know the future, but I can share with you thoughts about the elements that are likely to shape the future.

The first is the way people look at the future. Some expect the future to be largely like the past; these view themselves as pragmatic and rules based.  They tend to be value investors, buying securities at a discount from presently defined value. Another group is more optimistic and expects change to be in a more positive direction (“good things can and will happen”). These tend to be growth investors. For a considerable period of time the value investors have produced larger and more consistent results. Some have said that investors could either eat well (on current income) or sleep well (on perceived security). There is a third alternative, those that dream well. These are the risk assumers, or in many cases the entrepreneurs who follow the force of their driven dream. The mix of the leading personalities pointing towards value or growth will supply the multiple effect on whatever the current valuation metric is popular. Another example of an optimist who comes from a very value orientation is the current President of the New York Stock Exchange, who recently stated that the only surprises he perceived coming were on the upside.

Second is to appreciate how technological progress is changing our world; not only are we finding ways for people to live longer, but more comfortable and productive lives. Technology is a growing tool kit which can be used positively or negatively. A recent Bloomberg BusinessWeek article entitled "Balancing Security and Liberty in theAge of Big Data" described the impact of gathering huge quantities of personal "metadata" indicating there is enormous power in linking things or ideas. Our ability to predict the actions of people will have major predictive power both in the commercial world and the security world. 

Our enhanced, but not perfect understanding of people may well have had a similar impact as the development of the printing press. However, we need to be aware that technological and other progress is built on mistakes or failures. For those who are interested in this aspect’s progress,  the new book “Brilliant Blunders” by Mario Livio is about the greatest scientists since the beginning of the scientific revolution.  One of the largest blunderers described by Livio was Albert Einstein, who contributed to the greatness of Caltech where I serve as a trustee.

China and Japan

The third element that will shape our future is not Europe where much of the US financial news media and numerous political leaders derive their views taking up most coverage of world economic affairs. After the US, China and Japan are the number two and three ranked national economies. Both of these countries have serious demographic challenges and both have been critical suppliers of imports and exports to this country, the rest of Asia-Pacific, Africa, and Latin America. A good bit of the recent nervousness in the US bond, stock, commodity and currency markets is due the accurate transition of the Chinese economy from an export/investment orientation to a consumer oriented society. This is probably a decade-long trend. What is creating greater short-term volatility is the Japanese government and central bank utilizing quantitative easing at a rate four times greater than the US relative to the size of its population. If Japan does not show a great deal of progress quickly there could be a real signal to investors globally as to the appropriateness of "QE". The widening spread between the yield on high yield (junk) paper and US Treasuries is an early sign that the suppressed rates may explode rather than rise in a gradual, gentle pattern. There already appears to be some indigestion in Japan. The bottom line is that much more of the future of the US market will be coming from the East.

Redistribution of retirement capital

I don't know how it happened that the meeting of this band of brothers, the young Second Lieutenants of fifty-six years ago, now includes some old men who are living on their stored retirement capital. While no longer at risk to bullets and other forms of destruction, they and their children are under fiscal attack by much larger forces. First the current low interest rate environment is similar to our former front line troops now discovering that they are running out of effective ammunition to save themselves in their retirement. The next sneak attack on these warriors is the first salvo of limiting the tax deferral privileges on the size of their 401k and IRAs. This redistribution ploy on our troops’ savings will hurt our replacements on the line to protect their heirs/families. With Medicare Means-testing, the ability to fund the most expensive part of our lives will become more limited, which again will penalize our heirs. As the retirees have less votes than those who pay little or none in the way of direct taxes, it will be difficult to defeat the redistribution efforts of some of our politicians.


For the lucky ones who will not outlive our retirement capital, there is the obligation to have our savings be used wisely for the true benefit of our heirs or good charities. To do this effectively four people need to be involved:

An attorney who can provide counsel and an accurate record to the giver/grantor.

A wise and currently up-to-date tax accountant who can recognize the tax application of various strategies and structures.

A flexible investment advisor who can structure investment portfolios that work well for the living grantor, multiple generations of human heirs as well as various different tax-exempt institutions of varying investment capabilities.

The fourth person is the most important, the grantor/student. The reason I used the term student is because the grantor needs to be aware of changing legal, tax and most importantly changes in the thinking and conditions of each of the main heirs.

Second opinion for Supreme Court Justices and others

Recently the press has ferreted out that potentially eight out of nine members of the US Supreme Court have personal assets of over $ 1 million. Further research shows all eight of these justices own mutual funds.  The poor man on the bench happens to have a son who has worked in our industry and I suspect that he has invested for at least himself if not members of his family in some sorts of funds.

Perhaps, it is due to visiting our imperial city this weekend, but I am moved to be helpful to these public servants.

This post has briefly recounted some of the more important aspects of assembling a portfolio. Suspecting that these very busy people did not personally assemble their investment portfolio of funds, I assume that they used good investment advisors to help them. Just as it is wise to seek a second qualified opinion on many of life's challenges, I am offering a free, no obligation review of each of the Justice’s portfolios.  These men and women may have potential conflicts of interest as well as other reasons they use mutual funds.  I am guessing that other readers have similar needs and portfolios, thus I will extend the same offer to them. For the first few readers with over $1 million accounts holding at least five funds,  I will offer a no cost/no obligation portfolio review. Please contact me, within the next two weeks.
Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.