Sunday, September 11, 2016

Is 2% the Investment Solution?


Friday saw the popular US securities industry fall between 2 and 3%. In the week through Thursday over half of the equity-oriented mutual fund averages gained over 1% and over 12% of the performance averages were up over 3%. It was also a week where there were discussions by institutional investors as to the appropriateness of management fees between 1 and 2%.

Every Model is Flawed

As a “card-carrying” securities analyst I have never seen a statistic that I didn’t like. But also I have never seen a statistic that I didn’t ask for more as well - as in more understanding of what was behind “the number.” During the week I was at a presentation by an academic who based his pitch on statistics. I almost believed him because he admitted to what I believe, in that every model is flawed.

The difference between a reporter reporting ‘the facts” and a real analyst is that the analyst attempts to get behind the proclaimed number and more importantly put this particular insight into the constellation of factors leading to a tentative conclusion. The tentativeness of the conclusion is that there are always more “facts” which are revealed and sentiments change.

The Classic Definition of a Market Top

One of the best comments I read this week was that risk aversion is not a constant. The perception of risk of loss of capital and reputation is cyclical. Actually it is contra-cyclical. The definition of a market top is when risk aversion is low, when it should be high and the reverse at the bottom. At the moment unless there is a great follow-through of Friday’s drop, risk aversion appears to me to be in the mid range.

Unless Friday triggers massive selling in the weeks and months ahead, investors appear to me too petrified to grossly change their allocations to equities and fixed income securities. The classic definition of a market top is when there is no more cash that can be “sucked” into the market. 

In my judgment there is still a lot of potential money that could come into the equity market. Some of this is in portfolios that have an unnaturally large commitment to fixed income. After all, in 2015 one of the best places to have money was in long-term US Government bond funds. Nevertheless market history suggests that a temporary decline in stock prices could be on the order of 10%. Further I recognize that at least once every ten years there can be an equity decline of about 25%. Without more risk aversion disappearing and becoming enthusiasm, I am not worried about a once in a generation drop of 50%. However, my accounts invested in mutual funds would have better liquidity exits than many stock and bond portfolios.

Examining Friday’s Stock Market Numbers

The array of one-day performance of the popular market indices is instructive as shown below:

Dow Jones Industrial Average
-2.13 %
S&P 500   
-2.45 %
-2.54 %
S&P 400 (Midcap)
-2.92 %
S&P 600 (Small cap)
-2.97 %
-1.85 %
-1.01 %

On a market capitalization weighted basis the Dow Jones has less of the growth oriented company stocks than the S&P 500. The latter have much bigger derivative and ETF drivers than the old DJIA. The NASDAQ marketplace is more lively than the old exchange-oriented markets as can be seen on the NYSE on Friday: only 5.5% of the stocks rose in price whereas 13.6% of the stocks rose on the NASDAQ. The greater declines suffered by the Midcaps and Small Caps were due, in my opinion to much smaller capital commitment by the dealers making markets in those stocks.

The smaller decline in the financials in general and specifically in the larger banks is due to the fact that their prices are still being penalized for perceived sins of the financial crisis. (Strangely, we don’t penalize the Congress and the GSEs!)

I am particularly sensitive to the financial sector as I manage a private financial services fund.

Mutual Fund Performance Ending Thursday

There are 96 equity related mutual fund investment objectives tracked by my old firm Lipper, Inc. a subsidiary of ThomsonReuters. Last week, 55 of the peer group averages were up over 1%, most of the gains in sector and world equity groups (22 categories) gained over 2% and 12 were over 3%. The latter group was mostly natural resource and commodity based. With the exception of the High Yield Bond funds, none of the fixed income categories were up 1% or more.

I suspect most of the buyers of equity-related mutual funds already assumed that both interest rates would rise and the central banks would be forced to recognize that their collective monetary experiments weren’t working. Further, that a rise in rates to meet commercial and savers’ demands was a positive development. One should expect narrowly based sector funds to be more volatile than Diversified funds. The increase in volatility that is expected by some may scare more money into the Diversified funds than the Sector funds. We should watch both broad groups in terms of performance and flows.

Putting Management Fees into Perspective

While various pundits stress the importance of fees in investment selection, management fee is a number like any other number and should be put into proper perspective. Friday’s decline was greater or equal to many investment advisor management fees. However, the performance of most equity funds and many separately managed accounts in just the two months of July and August were greater than their annual fees. In most cases these equity accounts are showing positive results for the year.

There is much enthusiasm for Index funds on the basis of their fees being lower than actively managed portfolios. As with any number it needs to be examined. I believe in many, if not most cases, the currently superior results of selected Index funds to certain actively managed portfolios has to do with other factors. Most importantly Index funds carry little in the way of cash in their portfolios where it is not unusual to see an active manager with 4-10% of the portfolio in cash and cash equivalents. The use of these reserves are to meet redemptions/grants and to be a tactical reserve for future purchases. Many Index funds are not worried about redemptions and will tolerate bad exit prices that active managers would not. Many market dealers offer Index funds with lower commissions/spreads than active funds as they treat an Index fund as an information-less trade. On the other hand the dealer is afraid that the active manager is ahead of the market’s realization as to dramatically changed information. Dealers want additional income on these trades to offset these risks. Many Index funds have positions above 5% of their portfolios, largely due to market appreciation. These big name stocks are the very ones that active traders will be dumping in an aggressive declines.

Buyer Beware

As long as Index fund buyers understand the risks that come with their lower fees they can celebrate their lower fees; but be careful of going to the lowest priced brain surgeon.

My own view is that the greater the proportion of the trades that are done by price-insensitive transactors, there is more room for bargain hunters who are the type of managers we favor.

Is 2% the Investment Solution?

Two percent is just a number like any other number, which needs to be evaluated.  Most importantly, 2% is a small number relative to the long-term expected movement of your money, and therefore we don’t think 2% an important element of an investment decision.  What do you think?

Question of the week: Did Friday’s price action cause you to materially change your asset allocation plans?
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