Sunday, July 5, 2015

Watching Investment Paint Dry


For many mutual fund investors owning domestic stock and bond funds, the first half of 2015 while volatile on a week to week basis, for the six months performance was as exciting as watching paint dry. For these investors the net result was minor gains or losses in an essentially flat period. (We will discuss the positive results for international investments below.)

Different Speeds Create the Gap

Ever since the bottom of the last economic cycle, the domestic stock and bond markets have been producing worthwhile capital appreciation. The markets have been so much better than the economy that a valuation gap may have been created. One can say that some or the entire gap was formed by the combination with the Federal Reserve’s manipulated-low interest policy that there were insufficient returns in savings vehicles, thus money went into investing. At the very same time the main vehicles for investing in stocks have been shrinking. The combination of buy-backs and cash paid for mergers has reduced the number of shares available. The net result is that we have had a shortage of satisfactory investment vehicles. Shortages are cured by either new supply, higher prices, or both. Valuations rose in the face of shortages of investments at reasonable prices in spite of only pedestrian growth.

Closing the Gap

Often when a valuation gap appears it leads to a price correction. As noted by many, we have not had a domestic market correction which is normally translated as a 10% drop since the 2009 bottom.  There is a second way the gap can close, which is that over time the earnings production grows within a flat price environment. In addition to a sharp increase of new equity underwritings including IPOs, supply is increasing. Thus the gap is structurally closing.  Perhaps, flat is good for awhile.

Double Digit International Returns

As this post is being written the final performance returns for funds during the first half are not yet available. Nevertheless, I do have fund performance data through June 25th which shows a substantial number of International funds producing double digit returns. The best returns were coming from China and Japan. Undoubtedly some of the gains were given back since then, particularly for domestic Chinese portfolios.

This phenomenon has been understood by mutual fund investors who have been adding to their non-domestic holdings practically every week this year while redeeming their domestic stock funds. Is this just performance chasing?  All too often this is a practice of unsophisticated investors in a bull market which is often labeled momentum investing. Only a few can execute a withdrawal from momentum investing successfully.

Another Possible Explanation

We have seen a similar pattern in just about every mutual fund arena around the world. More and more people globally have noticed that their governments and central banks are in effect devaluing their local purchasing powers. While this pattern is global in nature, for many investors it is wise to invest some of their wealth, perhaps 25-50% beyond their home countries, as a form of diversification. In the case of US investors, there are some relatively bargain priced securities available outside of the US. If this trend becomes too strong it could be another example of the smart locals offloading their own securities onto the gullible foreigners, so caution is urged.

Implications of the Greek Vote

Now that the population of Greece has voted “No,” there is an improved chance that the euro will last longer than had the vote been reversed. There are increased odds that agreements having to do with the level of deficits will be kept. Thus those that remain within a smaller central currency will have a stronger currency to deal with the dollar and yuan.

The Meaning of Fund Redemptions

With every purchase of mutual fund shares, redemption is set up. What is purchased must be sold eventually to capture the full value of the investment. Historically it is a mistake to view gross redemptions as a sign of dissatisfaction. Post-redemption surveys indicate that for the most part investors are cashing out of various funds which have met their needs. Investors need the money for retirement or other needs where aggressive investing may be unsuitable.  Sometimes they switch to lower volatile funds to meet their new needs.

Most fund sales people and many investors focus on relatively near‑term past performance. They do not wish to buy into past poor performance, ignoring the principle of buying low and selling high. Thus there is relatively little in the way of fund purchases to meet normal, often actuarial based, redemptions. We are currently seeing this pattern increasing in importance due to changes in market structures, particularly by relatively inexperienced investors.

Unprofitable Investors’ Mechanistic Solutions

Frequently it has been said that mutual funds and some other investments are not bought, but are sold. The reason behind this statement is that investing is complex and difficult to do well. Earlier I alluded to momentum investing which is essentially jumping on a speeding train. The basic view is that gains of yesterday will be repeated tomorrow ad infinitum.  If this always works, almost any upward sloping mechanical strategy would work. Many are available through the wonders of the Internet world.

Increasingly, fees and commissions for investment products and services are controlled by regulatory bodies. In their minds, by definition, lower fees are better than higher fees without regard to quality of service and lifetime support. This view has led to little to no upfront charges and various ingenious ways to generate other revenues for the distribution and management entities. Thus, the number of full time mutual fund salespeople making a living providing services to investors has declined. Some of their efforts have been redirected to other packaged products, including unregistered offerings. Thus, with the number of peddlers down, the sales of open-end funds is not what it used to be.

There is some Help

Today’s younger investors are not facing their investment future alone.  Many of them are employees of companies, government bodies, schools and universities that offer salary reduction programs to supplement or replace defined benefit pension plans. As an investment advisor to some of these, where appropriate, I created a series of portfolios of funds. When I began with these I was concerned that the employees would pick out one of the better performing funds in the mix for their own after-tax account. To counteract such an undiversified approach, I captioned our reports with a cautionary label that individual funds used in the plans were not necessarily a good personal investment, or similar words. 

Even though one of the plans that we were the advisor to was judged to be the best large 401(k) plan for the past two years in a row, I saw no large scale use of the particular funds in the plan in the personal accounts, except by some of the people administering the plan. Evidently the high income participants separated their retirement money from their personal, and I presume more aggressive money. Thus in this case they did achieve reasonable diversification which should help them in the long run. In industry statistics the 401(k) and similar plans are considered institutions because of how they are sold, serviced, and priced, even though their ultimate beneficiaries are individual people who, over time, would have their own redemption patterns.

Question of the Week:
When you close out an investment, do you enter a similar investment or readjust your portfolio with the proceeds?
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A. Michael Lipper, C.F.A.,
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