Sunday, May 8, 2016

Mutual Funds for Users and Competitors


I have devoted my career to the study and use of mutual funds for my clients and family. Almost everyone that has been exposed to the media discussing investing has an idea about mutual funds. Just about every professional investor regardless of investment vehicle competes with mutual funds for talent, securities, and cash flow. Unfortunately be they the media, academics, regulators, general investors and even many mutual fund investors they have an incomplete and often flawed view of mutual funds. This is understandable as mutual funds start as a legal entity, not a group of people trying to accomplish an investment goal. The language of lawyers is designed to protect their paying clients, not to communicate users and bystanders.


We regularly use various types of vehicles to transport ourselves or other desirable objects such as water and freight. Staying with the vehicle analogy, your personal car, Uber or taxi ride, takes you to a specific planned location. A mutual fund is more like a bus. The bus takes a group of people, often strangers, from one planned location to another. Along the way passengers enter and leave to fulfill their private needs. The announced elements of the implied contract include expected times of departure and arrival, cost, and to be governed by more restrictive rules as to presumed safety. In a similar way mutual funds have a generalized statement of investment objective, a published price structure covering fees and expenses, regular reporting procedures, and more restrictive sets of rules usually promulgated by various regulators (SEC, IRS, DOL, various states, etc.) In my opinion these rules are more about what lawyers believe should be disclosed than about actual safety elements. Nevertheless they provide some useful information that are not provided to the same degree by other investment advisors or institutional investors.

Advantages of Mutual Funds

Mutual funds are the single most regulated investment vehicle and make both their performance and portfolios available for public disclosure. Many mutual fund management groups also advise pension and profit sharing plans, endowments, and separate accounts for wealthy individuals and families, plus in some cases hedge funds. Most often the media uses mutual fund reports as a clue what the institutional community is doing.

Thus, an element of misunderstanding occurs as mutual funds were originally designed for long-term investing not short-term trading. Mutual funds should be reviewed over long periods of falling and rising markets. Over these longer periods, it is rare for a fund to be a financial  failure; i.e., bankrupt. The reason for their longevity is they are often quite diversified in their portfolios. Just as diversified as the different types of people on the bus as distinct from a sole driver or a very small group of passengers who have more in common than those on the bus. This is one of the reasons that it is a bit foolish to compare the performance of an individual stock with most mutual funds. (More on this later when discussing funds vs. indices.)

Often investors in mutual funds do not appreciate for what they are paying. For many fund holders their monthly, quarterly, and annual statements represent a record of not only their performance but their ownership for tax and estate purposes. Further, funds use their best judgments in voting the funds’ securities particularly in complex transactions. Fund owners are paying for a somewhat independent review of all of the fund’s activities including fees, expenses, and other elements of potential conflicts of interest. This independent review is not found in separate accounts including various types of retirement accounts.

Perhaps for some or all of the reasons mentioned, institutions which because of their size and presumed experience also choose to invest in mutual funds. According to the latest data from the US fund trade association, 13.46% of fund assets are held by institutional investors utilizing equity, fixed income, and money market funds.

Understanding Fund Flows

Various studies focusing on how our brains make decisions, (including financial decisions) indicate that external forces, often other people, cause us to choose various decisions that perhaps seem on the surface to be irrational. Thus it has often been said that mutual funds are not bought but sold. The sales person may be a human or electronic as well as an image that has been created through paid media or public relations.

Reasons Why a Human Advisor is Necessary

One of the disadvantages of owning funds without a human investment advisor consulting with the fund owner is that when personal or investment conditions change the owner does not have the cautionary warning as to the shifting of spending, investment strategy, or redeeming too early. Investors purchase funds to meet various goals and when they think their goals are being met their instinctive reaction is to redeem their fund shares. Thus I look at most redemptions of long-term funds as planned completions. In recent years the combination of forced early retirements, rising college tuition support, and gyrating home prices has, in my opinion, accelerated the rate of gross redemptions somewhat higher than what prior actuarial trends would have suggested.

Mutual Fund Macro-Economics

Because of the growing wealth of the US, particularly through population growth combined with rising real wages, the dollar value of new fund sales were larger than the redemptions, leading to an industry of growing net sales. This has not been true for the last several years, as the old growth model has flattened, but also for another reason. There is a change in the economics of selling funds. Many distributors; i.e., brokerage firms, have materially reduced their efforts of selling funds. (Charles Schwab*  has just announced that it is no longer going to sell load funds.)
* Held in the private financial services fund account that I manage.

To avoid being accused of churning their accounts, brokers and to a degree investment advisers have kept fund positions with average ownership turnover rates dropping well below the historic norm of five years. Some funds are experiencing turnover periods of two years or less. When capital is freed from funds it is redirected into more currently profitable products for the intermediary, including sales of private equity, various other underwriting, real estate related, and margined securities. Numerous fund groups have interviewed redeeming fund shareholders, perhaps the they are being too polite, but they do not detect a large amount of dissatisfaction with funds during these interviews. Thus, I have come to believe that what we are witnessing is part of the economic cycle as well as a change in industry economics that is evolving.

Funds Should Be Compared with Funds Not Securities Indices

One of the reasons my old firm was successful in convincing the independent directors of funds is that they recognized that the funds that they responsible for operated under different constraints than indices as shown below:
Find Central Tendency      
A legal creation to comply with SEC, IRS, Treasury, Federal Reserve,  FINRA, and regulations of various US states
No prudential requirements
Court-overseen limits as to portfolio composition
No tax implications.            
Tax influenced decisions
Accept last price
Unrepresentative prices can be discarded
Not audited
Audited and examined
No diversification limits
5% and 10% rules for most funds
No cash
Cash required to meet redemptions and opportunities
“All Weather”
Time span and market conditions oriented

If I am being too cryptic please contact me for further explanation.

In our managed accounts we use index or passive funds along with active funds when we are seeking winners. There are a number of reasons to use passive accounts including the following:

  •        Greater liquidity to meet sudden cash needs in periods of turmoil.
  •        To lower the weighted average cost of the account when using higher fee active managers.
  •        At times and in some investment objectives greater diversification is needed.
  •        At perceived bottoms when active funds have too much cash.

Active funds have a place in our client accounts for the following reasons:

  •        There are times that a portfolio of growing operating earnings that uses excess cash for acquisitions of under-used properties or activities is wise.
  •        When we are seeking extreme concentration.      
  •        When we are looking at undervalued voting interests.
  •        When we want to bet on successful managers who need to prove that they can recover their winning ways.
  •        When we are reviewing cyclical companies and asset classes in anticipation of near-term turnaround.
  •       When passive vehicles won’t do the job.

As one can see, our management does not key off of near-term performance, but rather properly positioned portfolios and research capability for future (not present) markets.

In my personal account I mix both active and passive funds along with individual securities, mainly in the financial services businesses.
P.S.  I have been asked about my reaction to the winner of the Kentucky Derby. Regular readers know that much of my investment thinking began at the race track. I was out of the country and did not see this year’s Derby, thus I will briefly focus on betting the next race for an undefeated colt using my standard mutual fund  performance  analysis approach.  The next race, presumably, The Preakness, will send the colt off at very short, probably prohibitive odds.
Racing as with investing always is subject to unknown and unknowable factors. Thus  I would not place a bet on the Kentucky Derby winner, but look for a longer odds horse to place or come in the first two spot
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A. Michael Lipper, C.F.A.,
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