Correlations, Diversification, and Value - Weekly Blog # 521

Introduction

The words correlation, diversification and value are often used to describe purported solutions to avoid losing money. Yet rarely are these tools or concepts in and of themselves fully understood. Currently, many investors with substantial amounts of their investment portfolio invested in stocks and fixed income securities appear to be more worried than usual. This week’s blog post will examine some of my thoughts on these three words. I will be happy to discuss them with you to apply to your own specific portfolio needs.

Correlations

Correlation and its opposite, dispersion, are terms that come from the scientific realm that describe how members of a collection relate to one another. In concept, if there is a group of individual people or securities, they must have some common characteristics. Our psychological need for reaffirmation tends to view correlation as supporting us in our decisions.

In the last week ending Thursday night, the net asset values or prices of mutual funds fell. Eighty nine out of ninety six equity type mutual fund investment objective categories declined. Twenty five out of twenty seven taxable fixed income fund investment objectives also fell, according to my old firm Lipper Analytical Services, now a part of Thomson Reuters. (Money market funds and tax-exempt funds were excluded.)

On the surface it appears that geo-political and interest rate concerns caused the small number of transactors to slightly sell more than they bought.  I suggest that a greater motivation was that after a prolonged period of unrealized gains in their stock and bond portfolios they were worrying about committing the biggest sin of investing - roundtripping.

My racetrack betting experience saw it differently. I saw investor confusion as to the smart bet. At the track this usually leads to many horses with relatively low payoffs if they happen to win. Thus, to me current prices/and price momentum are not particularly useful tools in making investment decisions. I will rely on my continuing analysis as to the long-term imbalance between buyers and sellers and other fundamental investment principles.

Diversification

In discussing investments with a highly respected analyst of fifty plus years of experience, he suggested that in his portfolio it was important to build it in such a way as to be able to sleep well. As I have given up sleeping well years ago in favor of occasional short naps, I didn’t know how to do what he wanted. I countered that sleeping well should not be confused with being asleep for long periods of no intellectual involvement. The sleeper is frozen into position until they wake up. As a US Marine I avoid being frozen into place.

My investment policy rests on the thesis that not only do I not have the skill to predict the future with complete accuracy, but the future will be made up of periods of rotating leadership. I execute this strategy for my accounts and personally through the extensive use of mutual funds. I look to the individual funds’ managements to make smart, occasionally successful tactical moves within their sets of capabilities and mandates. I reserve to myself and my associates the proper mix to meet specific needs and the timing of changes.

Changes should be based on specifics within a fund, such as to tactics and policies, including key personnel, but not performance. Performance is the consequence of prior changes, explicit or implicit. As all human activity tends to be cyclical, periods of poor performance are likely to be followed by good performance.

The key to this portfolio strategy is diversification. I get nervous when all of my investments are doing well at the same time. Thus I am afraid of too much correlation as I won’t have some investments going up, or at worst going down slowly, when others are falling. For the last several years low and declining interest rates have reduced the temporal value of cash or near cash.  The search for yield has reduced the level of cash in many formerly sound portfolios.

We should collectively consider rebuilding our cash commitment as ballast to our investment voyage. As a practical matter, unless cash is above 25% of a portfolio it won’t likely keep the market value of a portfolio positive; what a smaller amount of cash will do is two-fold. First it will allow for the payment of current needs without having to liquidate good investments in a declining market, as would be provided by the Operational sub-portfolio in a Lipper TIMESPAN Portfolio®.  But probably more important than taking care of current needs is a focus on buying bargains. The great fortunes are made by buying bargains near a bottom. As a practical matter better risk diversification can be achieved in less crowded markets, which often means investing in smaller caps and smaller countries.

Value

Investors should not want to buy fairly valued securities. While not completely accurate, Benjamin Graham is viewed as the father of value investing, with Warren Buffett as his leading disciple. As a proud winner of The Benjamin Graham Award for Service to the New York Society of Securities Analysts, which Graham helped found, I am conscious that his fame rests on his writing of the seminal book for analysts labeled Securities Analysis with Professor David Dodd.

When I took his course, Professor Dodd instructed us to recast published financial statements to determine the real value of the company, which was its liquidating value or as some call it “net-net” value. Graham and Dodd published their initial work in the real depression of the 1930s. They were primarily focused on defaulted bonds, which were many. They viewed them as future equities. Their approach, as implemented in their leveraged closed-end fund, was to use a substantial discount from the net-net value as their entry point into the reconstruction of the defaulted entity’s new equity, with the old equity either completely or largely written off. There were a handful of others playing this game, but Graham & Dodd were the only ones writing about this approach.

What brought this to mind was the Barron’s cover story this week, entitled “Are Value Stocks about to Grow Again?” The article focuses on book value compared to current price as the measure of value, and mentions Ben Graham and Warren Buffett.  The concept may be right but the tool can be very misleading. What most of the time drives up the price of so-called value stocks is an above market bid.

In general there are two types of acquirers, financial and strategic buyers. I have been involved with both. The financial buyer is essentially a liquidator, the faster the better. Often the financial buyer is using borrowed money to execute the raid, so they do not have time to get maximum value out of real estate or unfinished inventory. The quicker they can shed people the better. The strategic buyer sees a bigger value in the acquisition than the present management is producing. The acquirer values the customers, the intellectual property, and often the people.

Since most companies are not about to be acquired, they sell at a discount to their acquisition value. Roughly speaking, I start with a belief that many stocks are selling at a 25% discount to a potential acquisition price, which won’t be realized in the foreseeable future because a financial buyer’s net-net calculation is close to an extended book value calculation. Strategic buyers don’t see what they can do quickly with the targeted acquisition to make the return on the new investment.

Liz Ann Sonders from Charles Schwab suggests that value stocks will rise. I agree selectively. A number of companies are capacity limited, with long lead times to bring on new capacity. As customers for their products and services find bottlenecks causing delays, corporations may either buy new capacity by buying a company or will tolerate higher prices. These are capacity plays not book value plays.

A New Constraint

The Department of Labor is questioning the value of recognizing the “ESG” attraction in selecting securities for employee 401(k) plans. A number of foundations and endowments are devoting a portion of their investment pools for similar purposes. They may be challenged by the DoL’s view as to the investment merit of ESG, no matter how laudatory the objectives. It would be difficult to include ESG elements in the calculation of value for many investors. 

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Moves For 8 Months and 8+ Years - Weekly Blog # 520

Introduction

Probably the single most common investment mistake is to have a single portfolio to meet multiple needs. My suggested cure for this malady that has to leave investors not fully addressing needs is to divide the single portfolio into sub portfolios to focus on specific timespans and their funding needs. Thus, when I look at investing my first focus is on the desired cash flow to meet beneficiary needs in specific timespans, (Lipper Timespan Portfolios^® ).

Today I am focusing on the probabilities for the rest of this calendar year or about eight months. I am also looking at a period of recovery in stock prices after the next recession, which the strong odds will come about over the next eight or so years. Finally, I am looking to the period beyond my personal control or influence on various investment committees in terms of replacing very successful investment managers after a long period of successful and faithful performance.

The Remainder of 2018

As of today the only thing that will come out of the 2018 US mid-term elections is more words about the implications for the 2020 elections and some legislation in 2018 which will probably be wrong. Thus stock prices at the end of the year will probably reflect largely what is known today. One of the advantages of learning security analysis at the racetrack is first to identify the most probable result of a future race. This leads to picking the favorite (which almost always is confirmed by the lowest payoff if correct).

My nomination for 2018 is that we have seen both the high and the low for the year in the first quarter. This would result in a gain or loss of somewhere close to half of 2017’s gain. In this case I suggest that there is a 50% chance that we have seen the high and low for the year already. The remaining fifty percent could be divided in half again with a 25% chance that we go through the last top of the market and/or we retrace the gains of 2017. If one combines the most likely 50% with a new high or 25%, this would produce a 75% chance of a satisfactory return for most investors completing ten rising years.

Probable Causes for 2018 - Gains

Frequently I have referred to the weekly survey conducted by the American Association of Individual Investors (AAII) which is very volatile in part because its sample size is small. In the latest week 37.8% were bullish for the next six months, 33% were neutral, and 29.2% were bearish, as opposed to 42.8% being bearish two weeks ago. Stock markets don’t go higher when all the available money is already committed. A major brokerage/wealth management firm is suggesting its clients should sell into any rise.

Another source of cash is investors adding to their account into a rising market and the market is rising. Each of the three major stock market indices have the very same looking chart of a narrow rising channel starting from the February low points. If upside price momentum starts heating up, the old highs could be challenged. (While my clients and I would enjoy these gains, in a contrarian view breaking out of the old high could suck in all or most of the available cash and that would eventually lead to a major decline.)

Probable Causes for 2018 - Losses 

A couple of weeks ago the Masters Golf Tournament concluded with a new young champion, Patrick Reed. His win verified the old expression, “You drive for show, but you putt for dough.” In a similar fashion, stock price movements are what gets the crowd’s attention, but in the fixed income marketplace winning is achieved by avoiding losses. 

Traditionally fixed income is a seemingly dull game for the professionals. While individuals may buy bonds they often hold them to eventual maturity. They don’t trade them. Also they rarely pay attention to credit instruments such as loans and mortgages. Not only is the total fixed income market larger than the stock market in most countries, it is the source of financing of governments and large corporations.

Compared to equity returns, most fixed income instruments trade off their promise of periodic payments of interest and principal return versus lower average total returns on stocks. However, various trading organizations have leveraged their fixed income investments with borrowed money, usually from banks or the credit markets. Whenever leverage is used a small price decline can shrink the value of an investment to a leveraged owner.

Most brokerage firms, bank trading desks, and some hedge funds use leverage to support their fixed income investments. The origin of most stock market declines is a reaction to traders having their loans immediately called and their collateral holder immediately liquidating the collateral without regard for price. That is one risk. Other risks have been created by the central banks of the world that have manipulated interest rates down so much that investors have become desperate to find satisfactory yields. This has led to an expansion of the use of credit instruments beyond bonds. This has led to a situation, according to Moody’s *,  for the first time in recent memory outstanding high-leverage loans now exceed the outstanding amount of high-yield bonds.  In effect, leveraged credit investors are trading off their safety for yield. That won’t always work.

*An equity in our private financial services firm

In Europe and some parts of Asia, gold is a normal part of many conservative investors’ portfolio. This is not true for most US portfolios.  From my standpoint it doesn’t matter whether one owns gold or not, but what matters is what others are doing. A current buyer of gold sees trouble ahead. Each of us can probably create a list of future troubles. That doesn’t matter in terms of one’s own beliefs, what matters is when more people believe it. The way I follow it is represented in a chart that in the recent past depicted a high was established in September of 2017. Since January of 2018 there have been three attempts to meaningfully to supplant it. The chartists tell me that gold is in a rising triangle from a December bottom and could go through the 2017 peak on the way to challenging earlier higher peaks. If this were to happen I would be concerned as to equity and debt values.

Concerns of Jamie Dimon, Warren Buffett and Charlie Munger

Jamie Dimon at JP Morgan Chase plus Warren Buffett and Charlie Munger at Berkshire Hathaway have spent considerable time and thought about short/emergency and long-term succession. I am struggling to do so as well. I have sat on a number of non-profit boards who when faced with the need to relatively quickly replace a retiring CEO look for someone that possesses a skill set that the older CEO did not have and that seems to be more important than continuing the good attributes of the retiring CEO.

Since my professional responsibilities as well as family requirements have to do with the replacement of investment managers, largely of mutual funds, it appears easy to replace funds that are deemed to become poorly managed in their execution of their process, which is much more important than periodic poor investment results. What is difficult to do is to replace a successful manager such as the three gentlemen mentioned. No two people are exactly alike and future periods are going to be somewhat or completely different than the successful periods that we have enjoyed in the past. Do we search for a copy of the successful manager? Do we look for some one quite different? What are the missing skills that will be needed in the future that are not needed presently? How do we assess success? How long a trial period is reasonable, particularly if we enter difficult times? I would be greatly in your debt if you could send me an email or even a snail mail with some of your views to these questions.

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The Golden Calf for Investors - Weekly Blog # 519

Introduction

According to human experience as recorded in The Old Testament, in a period of great uncertainty many people look for certainty when faced with a tricky period ahead. Today’s investors are in a similar quandary. In their search for a defined future, there is great appeal in simple tangible answers. Today, many investors have conflicting views as to the future direction of their investments. We are now facing a tricky market and there is great appeal in simple declarations of faith or the lack of faith.

The one thing I am totally convinced of is that there are no good simple answers, despite what future market historians will condense for an impatient audience.


The Known Knowns

Without putting dates or timespans on when these conditions will become dominant and for how long, based on human experience there are two knowns.

1. Due to excessive expansions of capacity and credit there will be future recessions. These could start soon or after various coincident changes. The base causes are what they have always been; imprudent expansion based on excessive enthusiasm. The coincident events or actions will not be the base causes for a period of unhappiness, but will supply a label to those looking to others for an explanation and not to themselves, in order to not get caught up in the tidal wave. Perhaps as an equity owner for clients and my family I don’t see a high level of an immediate risk. As long as the latest survey of the American Association of Individual Investors (AAII) shows that 42.8% of respondents to their weekly poll are bearish for the next six months compared to 26.1% bullish and 31.2% neutral, I am not too worried. Further, a major US-domiciled brokerage and wealth management firm is on record stating that investors should use rises in stock prices as an opportunity to sell. I would agree that it is an opportunity…for the firm to free up investors’ capital, often held with large unrealized gains, which might lead to future investments, often in packaged products with favorable economics for the intermediary. (There is always a risk for all contrarians that a popular view will be accurate. This is a lesson that gets reinforced at the racetrack.)

2.  The second “known” is the human survival instinct. Greed and fear drive all of us. Our primary driver is greed to obtain at least minimum subsistence and beyond to higher and higher levels of security. Fear is the worry that we and our loved ones will not survive without the appropriate levels of financial, intellectual, and health resources. The solution to both primal drives is to secure sufficient resources beyond our subsistence levels. The excess beyond consumption is savings, including debt reduction, and investments for longer term needs.

Unlike the first known which is periodically important, the second is a global constant in all of our lives. For the moment it appears that aggregate corporate and personal revenues will be growing beyond the AAII six month focused period and way beyond for those of us who believe that we will grow on a secular basis. (Note I did not mention corporate earnings, which will discussed shortly.)

One of the long-term reasons to be bullish on the future level of global investment is China. As of May1st (May Day) China will for the first time permit the commercial sale and operation of pension plans. Contributions to the plans will be tax incentivized and open to foreign insurance companies which the Chinese government has authorized. In most of Asia, beneath the level of stocks owned by International Index funds, the valuations appear to be cheaper than those found in the US. However, a detailed accounting and operational comparison is needed to show that they are more valuable to own, although we tend to think so.


Near Term Debt Worries

Because of the insistent drive for current yield, almost every financial institution or intermediary is selling a credit focused product which will hold direct loans rather than tradeable bonds. Three quotes from the Financial Times on the views of S&P sum up our concerns:

• “S&P warns of risks in leveraged loan sector as private equity deals surge.”
• “We’ve already seen weaker (covenant) terms deteriorating over the last couple of years.”
• History shows us that the worst debt transactions are done at the best of times.”

Another long article published in the weekend issue of the FT is entitled “The volatility virus tells the history of turning volatility into an investable product.” The article mentions that today there are at least forty exchange traded products (ETPs), funds and notes that alone trade VIX elements.  This comes to the heart of a concern of mine. Too many of the media pundits treat ETFs and ETNs as retail alternatives to conventional mutual funds, when in reality they have become cheap trading vehicles for professional speculators. The available ETPs have replaced the more expensive futures as the derivative of choice. Not only are they cheaper to transact but they are more easily marginable or borrowed against. I suspect that a significant portion of the trading, particularly near the close of the days’ trading, is to facilitate short sales in “pair” like trading, which entails being long another index derivative or an individual stock or bond.

There are still a lot of derivatives being used in fixed income, currencies, and commodity trading. These are global markets with individual country banking rules. All of these vehicles are used as collateral to support trading positions with call loans that can require immediate repayment of the supporting loans. Rarely are these loans repaid with existing cash, but are paid with securities that are not immediately price sensitive. These trading and lending activities are conducted by trading groups and banks that have to maintain given levels of capital. If there is a sudden fall in the level of collateral, other assets will often have to be sold without sensitivity to current prices. We have seen this occur in the past.

Equity Concerns

If one pays complete attention to the media prognosticators, the only thing in the end driving stock prices are earnings per share, or if you will the rejuvenation of the biblical Golden Calf. The followers, including a number of university professors, would have achieved losses on Friday. According to them, the market was going to be led by the earnings reported by three major US money center banks on Friday.

In each case their announcements stressed the favorable comparison to their reported earnings compared to those of the prior year. Thus the stock market should have gone up. It didn’t, which was not a surprise to me. Ruth, my good wife, asked me after I got off the first of the earnings calls what I thought. I replied that the announcement was quite positive, but I saw problems when I went through the detail of the announcement. By the end of the day the stocks of the banks and a good bit of the market was down 2-3%. It was not a case of buy on the rumor or expectation and sell on the news, which often happens.

My concerns were first that the market price assumed that the tax generated savings were a growth element rather than a onetime benefit, (the expected state and local tax increases plus higher sales and use fees one might expect a bigger tax rate going forward).  An operating concern was that the reported earnings benefitted from buybacks and the release of some credit reserves and similar adjustments.

Revenues were largely up but not spectacularly. Often these reports brag about relative investment performance vs. peers, which was missing, but not their selective inflow comments. Bottom line: the results did not trigger additional buying or selling in our long-term accounts. The level of operating pre-tax earnings was acceptable.
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A. Michael Lipper, CFA
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Critical Time for Critical Questions - Weekly Blog # 518

Introduction

Critical Time

For the US stock market, we may be at a critical time or juncture leading to materially higher or lower stock prices. Are we pausing in a correction or are we on the way to a full bear market of about twice the decline already experienced, or worse? Are we in the process of successfully testing the February bottom?

To me, as both an analyst/portfolio manager and a handicapper trained contrarian, I think the odds are good for the first, but not the second. To me, as an observer at the  race track, favorites typically win about a third of the time. I look at sentiment readings and the mainstream media for clues. Given three choices, bullish, bearish, and neutral, the latest weekly survey sample of the American Association of Individual Investors (AAII) has pushed the bearish button to being a slight leader. Normally, most investors are bullish most of the time. Their views are being reinforced or led by large elements of the coastal media who are proclaiming the market slide as confirmation of the supposed failures of President Trump.

Using my training as a racetrack handicapper, I suggest the odds we are experiencing a successful test is better than 60%. Those odds are in the same neighborhood as investors’ own various mutual funds which are 67.74% in equity funds. (Strange how the 2/3 to 1/3 split is similar to the standard attack format for successful battles won by the US Marines.)

As focused as most investors are on the next general direction for the market, the key is not the tactical direction, but the answers to long-term strategic questions. Just as at the track, the key to walking away a winner in dollars is how one handles the betting money. The key to being a winning investor is reasonably answering the following strategic questions.

Critical Questions

The single most important question (usually not answered) occurs when someone asks for a stock recommendation. Until a stock is no longer trading, history suggests that it will have a plus sign in terms of its performance for some period. Thus, it is not whether this stock will rise in price, but whether it will rise over a pre-designated time span. Just as it is a mistake to bet on every race during your day at the track, it is also a mistake to have a single portfolio that one believes will be a winner for the current, intermediate, and long-term. This is particularly true today, with half the stocks disappearing over the last twenty years or so.

We have been an advocate for dividing institutional and individual portfolios into separate time-span portfolios. Different securities are likely to dominate the short-term or Operational Portfolio, Intermediate or Replenishment Portfolio, longer term Endowment Portfolio and the beyond the control of the current investor Legacy Portfolio. I would be pleased to work with subscribers to construct these portfolios. The following are not recommendations but illustrations as to what we would be looking for in the candidates:

• Short term/operational Portfolio - mutual funds with a balance of short-term high quality fixed income and high quality liquid stocks
• Intermediate/replenishment Portfolio - medium price/earnings ratio stocks paying average dividends
• Longer-term/endowment Portfolio - mutual funds of established growth companies with high return on tangible assets and p/e no more than 150% of market
• Legacy Portfolio -  funds or companies that look to the next generation of leadership e.g. Berkshire Hathaway*

*Held in client and personal portfolios

One of the most difficult questions to deal with is the measurement of success. To the extent that a portfolio is meant to produce capital (principal, income or total return), the clearest measure is absolute return. If there is a competitive need to be fulfilled, then an external index or indices are needed. (University endowments are in competition to get the best faculty and foundations are in competition to get grants.) The critical key in choosing a measuring rod is how the index is constructed and changed, the rigor of measurement, data availability, and whether the proposed portfolio will be restricted to elements within the index. I have a bias in favor of using mutual fund indices and averages when they qualify. Some of the areas they cover include market capitalization, growth, value, and core, world equity and debt, sector funds, mixed asset funds, various types of bond and credit funds, and different types of money market vehicles.

Be very careful not to lump conventional mutual funds in with Exchange Traded Products (Funds and Notes). While both are registered under the Investment Company Act of 1940, they are designed and largely used differently than the larger universe of conventional mutual funds. Exchange Traded Products do not have cash to buffer market price changes and flows, they have relatively fixed portfolios and are primarily used to express specific long or short points of view. The bulk of their volatile flows come from trading organizations or advisors who trade their accounts. Recently, they have not been particularly good at handling these difficult markets. According to The Wall Street Journal which tracked the price performance of 72 stock indexes last week, including currencies, commodities and ETFs, there were no ETFs in the top 21 or bottom 27 slots. This suggests to me is that the market is reconstructing the winning and losing groups.

The purpose of comparing performances of various instruments is to create awareness of what is going on and to manage expectations. The result of measurement leads to an understanding as to what portion of one’s portfolio is for investment or speculative purposes. The answer is not always found in the nature of the instruments, but how and why the owner uses them. The market needs both investors and speculators as they often trade with each other to enlarge or reduce their universe. The changes in the value of investments and speculative vehicles are dependent on these trades. Market prices don’t generally move a lot unless investors are selling to speculators or the reverse. For example, during periods of high price momentum, with the exception of scale orders to enlarge or reduce the size of a position, wise investors should leave the action to the speculators.

Questions of the Week:

How many, if any, sub portfolios do you use?
What is the ratio in your own account of investments to speculations?
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Copyright © 2008 - 2018

A. Michael Lipper, CFA
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Contact author for limited redistribution permission.

“The Risk to Worry About” - Weekly Blog # 517.

Introduction

Recently I ran into an old friend at a cocktail party who is retired from being the managing editor of a trade newspaper. He expressed concern as to his own investments with the current volatility. I suggested that the time he should have been worrying about risk was during the fourteen months ending in January, after nine years of rising markets! He was much more comfortable with gradual gains and no declines greater than 3%. I said he should have been worried about risk when others were not, which is perhaps the best measure of the reciprocal level of certainty that a large number of pundits proclaim.

You never know about the future, but one can guess what you don’t know. While in the US Marines as an officer, we were instructed when planning for an operation to identify the essential elements of information (EEI). We quickly learned that it was rare to have as much as 70% of the EEI. Applying the same approach to handicapping at the racetrack, I was pleased to find 60% of the EEI. I feel the same today when selecting individual stocks and funds.

I suggest that in each of our attempts to measure risk, the largest single risk is the unknown and it rises when the pundits are more certain.

Is the Public Smarter?

“Americans Hold Off on Spending Extra Tax Dollars” was a page 2 headline in The Wall Street Journal on Friday. In addition, February was the third month that overall retail sales were slightly off from prior months. Consumer spending was up +0.2% compared to a rise in wages of +0.4%. This was not what was expected. I cheered this announcement as it demonstrates consumers are acting rationally. In the end, the article did point out that a number of consumers were using their tax benefit dollars to reduce their high interest loans. (Economists would label this as savings or deferred spending.) 

Consumers should be fearful of increased state and local taxes as well as increased fees paid to government agencies, and for business sales/use taxes. They should be saving and investing to reduce their growing retirement capital deficit. I don’t know whether it has yet entered into the public’s psyche that there is a chance that the purchase prices of their items will bear the costs mentioned and possibly the impact of tariffs.

A Second Example of Consumer Smarts

For the last several years American investors have been net buyers of “non-domestic equity funds.” I am guessing that these buyers are not largely the same fund investors that have been redeeming older domestic equity funds. I believe the redeemers are completing their expected retirement, estate building, and large purchase needs. To the extent that older fund investors are adding foreign stock investments, they are hedging their domestic equity funds. For a number of years the US dollar has been weak compared with other currencies and deservedly so. Despite foreign investors buying US securities for refuge, it makes sense for US investors to invest overseas. Often there are lower valuations in local markets, which makes sense when considering they are also in less liquid markets. They are also unique investments not found within US borders.

Traders are also buying more overseas investments while redeeming domestic ones. Each week my old firm, now a part of Thomson Reuters, measures the net flows of both conventional mutual funds and Exchange Traded Funds and Exchange Traded Notes. For the last week, ending on Wednesday, ETFs had net redemptions of $11.5 Billion in domestic equity vehicles while conventional mutual funds had $2.5 Billion. (Remember the assets of ETFs are much smaller than conventional mutual funds.) It is worth noting that just two ETFs had combined net redemptions of $10.6 Billion in S&P 500 invested portfolios. This suggests to me that the redemptions came from a small group of trading desks and not the general public.

The fallacy of the “risk on/risk off” approach

The financial media has gotten into the habit of describing market movements as either “risk on” or “risk off.” This is simplistic but can be a binary switch for a quantitative portfolio. It assumes that the investor has identified the risks. Perhaps, this in and of itself is a big risk.  Many can produce a roster of risks. Few can weight them. Fewer still can set the time when their impact will be felt.

The fallacy of the “risk on/ risk off” approach is that it is one directional. At all times we should be looking at both the opportunity for risk and reward. In this case those that invest in mutual funds have an advantage over those that use only individual securities. Mutual funds have flows that many individual investments don’t have. Flows drive buy and sell reactions which cause the portfolio to change. (Often a fund in net redemption benefits from pruning the least attractive current holdings and has an additional opportunity to switch into new investments.) 

Regardless of how one’s portfolio is structured, you should always be looking to add opportunity.

Quotes from Berkshire Hathaway’s Annual Report*

While Warren Buffet lays out their thinking about acquisitions of companies, the principles can be applied to selected individual stocks.

•     good returns on net tangible assets and a sensible price

•   “We evaluate acquisitions on an all-equity basis.”

•  “Betting on people can sometimes be more certain than betting on       physical assets” (I would include shown financial assets.)

•  Berkshire’s goal is to substantially increase the earnings of the non-insurance group through a large acquisition.

•   Berkshire has suffered four short-term price declines of 59.1%, 37.1%, 48.9% and 50.7%.

•  “An unsettled mind will not make good decisions.”

• “Charlie and I will focus on investments and capital allocation.”

Perhaps the single most important clue to Berkshire Hathaway’s long-term thinking is the following statement:

• “The Yahoo broadcast of the meetings and interviews will be translated simultaneously into Mandarin.”

*Held in client and personal portfolios

Question of the Week: What are the risks to your portfolio that others don’t see?

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.