Labels Poorly Reported and Understood Could Hurt Performance - Weekly Blog # 485

Introduction

Most brains require some semblance of order often to make judgments. The first thing we do when we are exposed to a set of conditions or facts is to compare it to others in our memory banks. Our memories are in effect filing systems based on some preordained classification system which are labeled internally. Because we prefer fast, if not instant, decisions, we use labels as the main filters to evaluate the new set of facts or conditions.

In most cases we pay little attention to the labeled comparator. We don’t know who and why the label was created. We don’t know the boundaries to the classification, we don’t know the sorting process used to create the universe within the classification, we don’t know the range within the label and the correlations and dispersions within the classifications that serve as labels. Perhaps most importantly we aren’t familiar with who makes the decisions in including or excluding components  and their profit motivations.

What I believe are faulty conclusions due to labeling and their comparisons are found in a number of topics which we read about as highlighted below:

Mutual Funds and Other Portfolios

Often portfolios are compared on the basis of their investment objectives no matter where their geographical focus is. Each week I look at the results published by my old firm. They break the universe of SEC registered mutual funds and their performance into close to 100 different investment objectives. In numerous cases they use the same generic investment objective names for largely domestically oriented funds, global funds and international funds. Global funds have to have some significant portion devoted to the US as well as other legal domiciles and  international funds don’t invest in the US.

Comparing Large-Cap Growth Funds average performance does appear to be similar in their results year-to-date through August 17^th; Domestic +17.41%, Global +17.24% and International +18.10%. This makes sense as almost all Large-Cap companies around the world are multinationals  and are used by large financial institutions in both their home and foreign markets.  Most differences in performance can be attributed to the way the managers address the fluctuating value of the dollar as reported to dollar based investors.

Quite a different set of conclusions should be derived when reviewing Multi-Cap Core funds. These are typically equity oriented funds that can invest without constraints, often called “Go-Anywhere Funds.” The domestic version average was +7.76%, Global +12.44% and International +16.29%. When a change in geographical focus of companies’ legal domiciles leads to an international performance double the domestic average, the different opportunity set results suggest a faulty comparison under the banner of Multi-Cap Core.

Comparisons within industrial sectors can be even more skewed. While both are losing money this year through last Thursday, the domestic oriented Natural Resources funds on average were down -20.34% and the global natural resource funds only -5.90%. As global commodity prices are not that geographically sensitive and are usually priced in US Dollars, the difference appears to be in the opportunity set.

A similar but positive performance spread can be seen in the average Financial Services fund. The domestic oriented funds on average gained +3.30% whereas the Global Financial Services funds averaged +12.96%. The difference may be due to the level and direction of interest rates and possibly changing regulations. (More on this below.)

Is it any wonder that for some time when US mutual fund investors have completed their needs for domestic funding of their objectives that a portion of them have been investing beyond their borders? They got it right whereas those that lumped narrowly defined investment objectives based on where their legal domiciles are, got it wrong and are misleading themselves and some of their investors as to where the current action is.

Fixed Income Returns

I among others, but not the average mutual fund investor have had an overly cautious attitude toward fixed income funds. Using the same data source as used for equity funds, I failed to appreciate that there are seven different fixed income objectives with average gains in the 4% level, and five above 4%, with total return gains from +5.66% up to +11.70% for Emerging Market Local Currency Debt Funds. On an annualized basis alone currently these funds meet most pension funds’ payout requirements. Things are better than they seem.

Stock Comparisons

We have been barraged by stories as to the FANG (Facebook, Apple, Netflix, and Google/Alphabet as well as Amazon) stocks have been driving the S&P 500 performance with their gains. Few except Kopin Tan in Barron’s mention that a Chinese quartet labeled JBAT (JD.com, Bandung, Alibaba, and Tencent) are up more than double the leaders in the US. While there are great global companies in the US included in the FANG cluster, what is happening is a global phenomenon with some leaders outside the US growing faster. What this suggests is that if we want to invest in leaders we need to look beyond the constraints as to where a company’s corporate headquarters is, where it was incorporated, or even the stock exchange that is its main market.

Government Analysis

Part of the reason seasoned politicians around the world have been wrong on their expectations of what voters will do I suspect is the combination of inaccurate data, but more importantly wrong or meaningless classifications. Due to the short attention span of people within and beyond the political sphere, labels become short-cuts that can mislead. For example, as pointed out by the talented Randall Forsyth in Barron’s, the current US Administration is quite accomplished in getting to its goals. Each new or changed federal regulation needs to be recorded in the Federal Register. On an annualized basis the current Administration is responsible for 61,330 pages, whereas the former Administration in 2016 produced 97,000 pages. Not the 2 for 1 promised but a good start. The media has spent all its time on the legislative action, whereas both the current and former Administrations ruled primarily by executive actions. Thus the comparisons with legislative actions alone are misleading.

Question of the Week:

What other labels and classifications do you think are misleading to sound investment decisions?

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A. Michael Lipper, CFA

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