Talented Managers Are Now Good Investments:A Contrarian View

Introduction

A contrarian is always alert to the chances that a popular view is exaggerated. I believe that the generally accepted view that passive investing will become the dominant type of fund management suffers from exaggerated extrapolation of net flow trends. This is particularly true when relying on passive Exchange Traded Funds (ETFs) as the main or exclusive component to a long-term investment portfolio.

The Weaknesses in ETFs

There are four structural weaknesses in passive ETFs as follows:

1. Each passive ETF at the time of inception picks a particular portfolio in which it must invest and in a specified allocation. (An earlier version of today's ETFs were the Unit Investment Trusts which had fixed portfolios.)  One of UIT’s drawbacks was when a security was no longer available to be purchased because it was acquired or went bankrupt, the UIT could not substitute another issue so it was a portfolio that was always looking backwards. In 2016 through the third quarter very few of the stocks in the S&P500 were rising and a small minority of the stocks were causing the institutional index to appreciate. In periods of large successful IPOs they may not get into various ETFs until after they have their initial surge.

2. Actively managed funds almost always have some cash to meet inopportune redemptions and as a reserve for new names to be added. (If in a sudden sharp decline the cash can be used immediately to meet redemptions and not hit panic level prices and/or buy some bargains. On the way up cash is a drag on performance, but it has proven to be a benefit  to many portfolios.)

3.  In the US only Authorized Participants can purchase or redeem shares in an ETF. (These are self-identified competing market makers who have bought a $250,000 creation unit in the ETF. To the vast majority of ETF players, they do not know who these "APs" are, or their capital and in what other activities they are engaged. In many big trades the other side of the trade will be a professional trading organization which temporarily stretches the AP's capital to a breaking point. It hasn't happened yet, but it could.)

4.   The biggest single risk for many investors is the person making the investment decisions in terms of specific ETFs, size of investment, and timing of the transaction.  (While the fees charged for passive funds are usually quite small compared to active funds with all their fees, expenses, and sales charges included, the portfolio manager of an ETF managed account is outside of its stated cost.) Also the commission charged by the broker supplying the trade to the AP is extra as well as the spread between the transaction price and the current net asset value is not revealed. However, the biggest weakness is that many of those who are managing ETF accounts are not as highly trained as the professional portfolio managers of most actively traded mutual funds in terms of choosing sectors, selecting securities, placement and timing of transactions and intelligent proxy maneuvers. At this point no one is tracking the long-term performance of these ETF Managed Account Managers.

Examining an Active Portfolio Manager as an Investment

An Important Caution

The manager that I will use as an example of how to look at this type of actively managed investment is one that is in the private financial services fund that I manage as well in my personal accounts. Further our investment advisory accounts own numerous of its mutual funds. I am not suggesting that you should buy shares in the manager or use their funds or accounts. Those decisions need to fit your particular situation and other investments.

 Why Focus on T Rowe Price?

This weekend when I started to do my note-taking for this post I saw two things that caught my eye. The first was that so far in 2017 many of the funds that were performing well were International funds with a heavy emphasis on Asia. The leader in this particular computer screen I was examining was T Rowe Price New Asia, which was doing well after laboring through most of last year. This reminded me that the management company is opening a series of international sales offices. As many of our readers have learned, I believe that there is a global shortage of retirement capital. In many, particularly Asian, countries there is a strong savings ethic, but not a fully developed mutual fund market.

The second thing that I noted was on Thursday the stock of the management company opened down by 3% and continued to fall the rest of the week. At the low on Friday it had declined 9% from its Wednesday high and now trades a full ten point decline from its 52 week high. The cause for the decline was the release of T Rowe Price’s calendar year earnings report. Unlike most of the financial stocks, the company does not hold earnings conference calls, but issues quite complete releases that you would expect from a firm with an army of analysts and significant employee ownership.

As is often the case it wasn't the announced fourth quarter earnings which were slightly above the average analysts' estimate, it was the "Other Events" three paragraphs that evidently shook out some holders.

For the first 3 days of the week the average volume was slightly below 1.5 million shares, on Thursday it was five times that at 7.6 million shares and 4.6 million on Friday. The essence of the three paragraph note was that in the fourth quarter there were outflows of $1.9 Billion from the Target Date funds and $6.3 Billion in net inflows for the year.

With about 2/3rds of the firm's assets in retirement accounts depending on conditions in the market, there can be a significant amount of exchanges between retirement accounts and the Target Date funds. In examining these flows/exchanges with various accounts and Target Date funds, it was determined that the fourth quarter outflow was $63 Million and an inflow for the year of $8.1 Billion. These disclosures did not  change the overall outflows of T Rowe Price funds for the 4^th quarter of $2.8 Billion and $5.0 Billion for the year 2016. The firm noted that net cash outflows were largely caused by institutional and intermediary clients reallocating to passive investments.

The Way a Contrarian Sees the Situation

As someone who has served on various institutional investment committees, I have experienced the pains of under-perceived trend performance and understand the strong desire to go passive and get the performance bug off one's back. Unfortunately much of this tendency is based on conformation bias. On a casual basis up to the election, which should not have been a surprise to good data analysts, the various market indices were out-performing most institutional accounts. Too few investors recognized the positive effects of gradually rising interest rates from last summer. When investment committees move they often do it slowly and often wait until the later part of the year. Thus the shift in the fourth quarter is not surprising. What I find disheartening is the ETF discussion above. A somewhat similar set of issues are involved with other passive techniques.

Relative to other large mutual fund complexes T Rowe Price has the best long-term record of out-performance of peer funds. As previously mentioned it is expanding its global sales efforts and is increasing investment into internal technology along with some other leaders.

As regular readers know, I believe in dividing an investment portfolio into various TimeSpan slices or portfolios which I have named TIMESPAN L Portfolios®. I have placed the stock of T Rowe Price in the long-term endowment portfolio as a good representative of the expected growth of global retirement capital. With the current decline in its stock,  TRP is now yielding over 3% compared with the yield on the market averages of about 2%. Further, the yield over time is likely to rise if T Rowe Price continues to buy back stock in excess of  internal needs.

Implications

You can use a similar or even better approaches to investing in a contrary way. Good Luck.   

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Difficult Symbols, Equity Opportunities and Bond Worries

Introduction

One of the college textbooks that I vaguely remember made a big thing of people being either inner or outer directed. In truth, I suspect that each of us are in different ratios at different times and conditions. Over the last six to eight weeks there have been many trumpet calls trying to lead us into new and/or strong beliefs in answering our needs for outer-direction. Being a skeptic by nature I am recoiling from these attempts to lead me and others.

Different Inputs for Trading and Investing

As we can not avoid being influenced by some outside influences, I try to be selective. I regularly quote  Jason Zweig, one of the better students of investment behavior. In his latest column in the weekend edition of The Wall Street Journal, he cautions about the influence of others on investment decisions. He acknowledges that many want the comfort of going along with the popular mood of the time. One of the ways I control my investment urges is to identify what it is I am trying to accomplish. If near-term success is important, other's opinions that support the current momentum can become dominant. If I am focusing on building a long-term oriented portfolio of securities and funds, I am much more likely to search for counter trends.

You can do a little bit of both if you segregate your money and your actions. In our four sub-portfolio approach, TIMESPAN L Portfolios^®, we are very conscious of both momentum and counter trend investing. The Operational Portfolio to pay bills in the next one or two years needs to be cautiously sensitive to momentum. The Replacement Portfolio is very much oriented in replacing the capital that has been used to pay current bills along with the almost certainty of some market reversals. The Endowment Portfolio is designed to generate capital for those that are currently alive. This portfolio accepts periodic down markets, but essentially is focused on investing wisely for the long-term. The Legacy Portfolio needs to recognize much of what is expected won't happen as intended. Thus the Legacy Portfolio will include investments that are part of the disruptions that regularly occur. In this way one can use your outer directed and inner directed instincts.

Symbols

Political and religious leaders going back to Biblical times used concrete symbols to convey the abstract, unseen  power. Remember the Golden Calf, the grandeur of Rome, staged events in Nazi Germany. To some extent various inaugurals and marches serve the same purpose, that of a symbolic message to convey outer-direction to the masses. As with most symbolic promises, the deliveries will be different. This is particularly true today when new interpretations will change the more current views of symbols. Bottom line: enjoy the massive pageantry, but expect severe modification.

Upsides for Stocks Possible

Though we have had a long, but mild expansion, is there room for more economic expansion in the US and elsewhere before historic limits lead to a bear market for stocks? Without predicting it, a look at the data says it is possible. According to government sources we are currently operating at about 75% of industrial capacity when other booms topped out at close to 83%. Also only 57% of working age population is actively working when recently close to 60% were working.  However, if one looks deeper, there are a number of doubts. Most importantly we are no longer a heavily weighted goods producer dependent on domestic industrial capacity to turn out these goods. Further, I suspect that we are actually using a significantly higher percentage of modern capacity. Where there is scope for substantial expansion is in vastly improving our transportation capacity of airports, roads, rails, harbors, etc. These will require long lead time efforts and probably will depend directly or indirectly on private financing.

Actually one of the retarding factors to increased production is finding qualified, honest, high energy workers with appropriate skills. Thus there is a need for a massive infrastructure investment into schooling at all levels with the hope that it will lead to useful human education. This is a huge necessity throughout the developed world. We need smart, reliable workers' earnings to pay for our expanding healthcare costs as well as the need for protection domestically and internationally. The US could be a leader on this front, but we will have to move fast.

Much of the future will need to serve two new unaccounted for masters. The first are the growing number and money of the consumers. While management and labor are often represented in some of the halls of power, the consumer is not. We need to respect and serve the consumers. The second growing power who is critically involved with effectively serving the consumer is the corporate state. While their first loyalty will be to their customer bases, they will also serve their multinational owners and lenders. The consumers will increasingly buy what they feel is good for them and not where it is produced. The consumers and the owners will focus on what is good for them and use governments to help or at least not hinder them.

At the moment the symbols for this new world are not apparent to me.

Stocks’  Biggest Worry is Bonds

If you are a regular consumer of the financial media, you would believe that stocks are bigger and more important than fixed income securities. Any careful reading of financial history will disabuse of this thought. Most financial crashes occur because a fixed income relationship is or has failed. For example most of the blame for the collapse that centered around 2008 was due to improper mortgages and their derivatives. The strain coming out of the collapse put banks and leveraged brokerage firms under extreme pressure. Congress, various Administrations and most mutual fund shops escaped blame, despite having some culpability. This was just latest chapter of runs on banks in many countries due to imprudent bank loans.

Because of this history, as primarily an investor in equity funds and individual stocks I keep an eye on any indicators of potential trouble in the fixed income world. Often the litmus paper test of some problems is that yields rise as inducements to accept some troubled paper. As previously written about in past posts coming out of the US election, there was a desire by some institutional investors to "re-risk" their portfolios. In the last week we saw two examples of this. The yields needed to move a number of European Sovereigns rose. Second, each week I look at what Barron's calls yields on best bonds, which I assume means of highest quality. In the last weeks their yields rose to 3.50% from 3.41% the week before. (Remember bond prices go down when yields go up.) The nine basis point gain compares with only three basis point increase yield for intermediate quality paper. I have not included yields on high yield bonds who are bought by those who can tolerate risk in some cases similar to stock risk.

Summary

We  are becoming more cautious, but not yet bearish. We will need to pick our spots and time the purchase of stock funds with any excess cash.

Question of the week: What would cause you to change your current investment policy?      

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Faulty Political Analysis May Lead to Investment Bubble

Introduction

When one finds oneself in a hole the prescription to get out is not to dig deeper! Many are digging deeper with the same shovel of faulty analytical techniques that led them to be wrong on the last three 2016 elections of BREXIT, the Colombian referendum, and the US elections. To compensate for being wrong, they have quickly become stock market Bulls by taking the Republican Presidential candidate’s every statement as a list of future accomplishments.

Insufficient Analysis Leads to Mistakes

Most of the time the side that either has deeper analysis or brings a superior way of thinking will have a distinct advantage.  In each of the three missed elections what started as a generally accepted expected outcome gradually lost polling support but still appeared to be dominant. There were four critical mistakes in accepting the presumed premise.

1.  Reports of trends are often behind the times, the reality is people do not freeze their views when polled. One of the most useful times I spent at the racetrack was after watching a race that did not turn out as expected. Sitting in the grandstand near a group of bettors I heard them explain how they picked the winner. Some of these lessons that I later applied to picking securities and funds include:

• Conditions are different than the past

• New talent vs. established players

• Signs of improvement or deterioration which could change present and future rankings

• Competitive mix now

• Better prepared than other entries

Any and all of these are also relevant to political forecasting.

2.  The dataset was incomplete, missing some intensive sub-groups, e.g., “The missing barking dog,” - as per Sherlock Holmes.

3.  “Check the box mentality” is efficient, cheap, and often wrong on controversial views. Only after physical conversations including body language does one get the deep seated feelings of an individual including levels of doubts.

4. The political classes use identity politics as all-encompassing motivational decision making. This mistake came from the liberal arts instructors in our scholastic system not understanding that the concept of identity came from their algebra class when two mathematical expressions, while different, are deemed to have the same value; x+y=a+b. While at the moment they may be equal that doesn't mean that for all time they will be. Further x,y,a, and b may not be completely interchangeable under all conditions, e.g.; working at all, at low pay, high pay, receive meaningful psychic income, near retirement, starting out with or without family, living in a good city, a dangerous city, small town, rural area, have deep or little religious belief, etc. 

From an investment standpoint this is the same mistake (using over-simplistic investment tools)  as many are making investing in Index funds and other relatively fixed portfolios as a way to invest in a dynamically changing investment world.

In terms of the US elections some saw the probability of a Republican sweep including key electoral votes.  According to Barron's, my old friend Bill Priest at the time of their Round Table meeting in 2016 believed that Trump would win. Having known Bill for about forty years I am not surprised with his judgment. He looks at data deeply seeing what is actually there and what is missing. (Those traits made him a good little league baseball coach for his and one of my sons.)  

Compounding the Error

To make up for the emotional loss of face to themselves and their clients as well as their media audiences, many needed to act. Thus, they invested whatever reserves they had as well as moving out of conservative holdings into high momentum stocks. These stocks were moving on the faulty analysis of using what the winning candidate said along the way. As with the reliance on misreading poling data particularly in terms of supposed identity politics, they created a view as to what the new US Administration and Congress would deliver. 

Any careful reader of political history going back to the Roman Republic, and to our own Founding Fathers, as well as Abraham Lincoln understands that little if any of the more controversial views get executed as planned. While we all revere "Honest Abe Lincoln" one can see a fine political mind at work. In 1858 he and Steven Douglas ran for the US Senate, the campaign included seven debates moving from the northern part of their home state of Illinois to the southern portion. 

While the Douglas rhetoric remained relatively consistent, our future President modified his as he moved closer to slave owners in nearby states. From a historical standpoint it is not important that Mr. Lincoln lost that election, but it helped to split the Democratic Party in 1860, which allowed Lincoln to be elected with about 40% of the vote. Despite his under-whelming electoral tally, he showed political skills that would be needed to manage a fiercely divided government. (I have paid particular attention to his political acumen as one of my distant ancestors wrote a book on when he was an elector for President Lincoln for his second term.) Bottom line: it is a mistake to view campaign speeches as a guide to elective political successes.

Using the same mistaken identity politics as those investors trying to recover, many of them view all Republicans as fully on board with the new President. Some wiser souls have already recognized that Paul Ryan and his abilities are the keys to passage of critical legislation. I can almost guarantee the final bill presented to the President will not much look like one that could have been drafted from the campaign trail. Even if that would have been desirable one needs to take into consideration that the incoming President is a negotiator and may have announced his starting positions not his final ones. In Washington no piece of governing stands totally on its own, but rather as a negotiating item in a mix of deliverables.

The history of our Presidents is that the main items that command their attention are new events which modify past positions.

Faulty Political Analysis May Lead to Investment Bubble

Instead of looking at the tea-leaves, I urge you to concentrate on the tea-readers. Also, I seek to look at the entire dataset not the conclusions.

__________

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Re-Risking with Bonds, China Near-Term

Introduction

I have learned that one of the most risky periods to trade is when the market is open. Without the regular flow of transaction prices, one doesn't know if one is winning or losing. Thus, during all trading hours one is at risk to a significant price adjustment. Or to the contrary: opportunities to recognize investment profits. But some periods have been more prone than others to substantial price moves. We may be in such a period after a light volume expansion which appears to have topped out, and at the same time little in the way of successful shorting  and low volatility.

Re-Risking with Bonds

After 35 years of substantial gains, bond prices for high-quality paper experienced some falls. By year end it appears that the declines have just about slowed to a gentle fall, at least temporarily. Bond trading has attracted hedge funds and other speculative players. Many of these have taken losses as markets have signaled higher interest rates. These losses were  relatively small for un-leveraged portfolios, many portfolio managers feel that they have been insulted by "Mr. Market." They plan to get even with the market by re-risking their portfolios utilizing below-investment grade paper,  be it floating rate paper, loans, or high yield bonds. One can be concerned that they are creating the next large bubble. We should pay attention to that great portfolio manager William Shakespeare when he wrote the following words for the witches in Macbeth:

"Double, double, toil and trouble, fire burn, cauldron bubble...."

The re-risking has already begun with high yield bonds gaining +17.18% and floating rate paper +10.57% compared to 5.98% for the bonds issued by the S&P 500 participants. For a number of mutual fund management companies the appeal of this paper hopefully will add to their dominant bond funds which could be very useful to the groups, but particularly Eaton Vance^*, Franklin Resources^*, and T Rowe Price^* among others. The flows are presumed to come from new shareholders who wish to participate in the rising interest rate phenomena. One sign of the popularity of intermediate quality bonds is that their average yield for the week fell 23 basis points vs. a fall of only 7 basis points for the previous week, according to Barron's. If interest and inflation rates grow slowly, and stay below a pre-determined yield point, many bond investors will not focus on the decline in the price of their bonds.

 At this point that breakaway yield is probably about 4%. Another concern is the likely default rate that is expected on this paper. Moody's^* believes that currently the bid/ask spread on speculative issues is 60 basis points too narrow or phrased another way, Moody's expects greater default rate than the market does.

^* Personally owned  or through a private financial services fund that I manage.

Must be in the China Funds Business

On the fifth of January two of the global fund industry’s leading groups announced long term commitments to the Chinese mutual fund business. Fidelity was given permission to establish a wholly owned fund management subsidiary in China. On the very same day it was announced that two arms of the Power Corporation of Canada^* would become the second largest owners of the largest mutual fund company in China. Both of these two groups are long-term strategic thinkers that have successfully entered markets beyond their home and appear to the locals that they are local themselves. (Fidelity is one of the largest fund providers in the UK, Hong Kong, and Japan among others. Power Corp. has big positions in Great West Life both in Canada and US as well as Putnam and substantial investments within Europe.) While I don't know whether these Chinese ventures plan to offer domestic and international funds in China, I am impressed with the commitment these two giants have to their long-term expansion plans. Each has benefitted from multiple generations of their senior management families who have worked their way up to their current command positions. On the basis of my respect for these families and their companies, I feel in the future one can not afford to disregard China and the Chinese investors as even more portent powers in the fund business globally.

__________

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Copyright © 2008 - 2017

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.