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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Going Global is No Escape from Investment Problems

• Too Much Correlation
  
• Four Letter Word: Jobs
  
• Fragmented Markets = Less Liquidity
  
• SEC’s Other Unintended Consequences
  
• A Father’s Day Focus For Wealthy Investors
  

Too Much Correlation

You would think after suffering through 2008, when almost all investments went down, we would pick equity investments that were not extremely correlated. Many US investors, particularly those who have had long term exposures to the economy and the stock markets, are unhappy with the current situation of a lackluster economy combined with an excessive US government intervention/manipulation into the financial structures of the economy. There are two fears at work; first there are growing signs of stagflation. (A flat economy with an increase in recognized inflation.) The second fear is the uncertainty of the structure and rates of various taxes. To escape these increasingly perceived problems, many investors are opting to go global.

The ever adaptive mutual fund business has generated a large number of Global funds to fill the needs of investors. These funds, unlike International funds, allow the portfolio managers to select the best available investments whether they are traded in the US or elsewhere. The problem is that this enlarged hunting ground has not produced materially better results. As a matter of fact, the list of fund indexes of various global fund categories has produced somewhat poorer results in the first five months of 2011 than the domestic funds. (Some domestic funds can invest up to 25% in international securities and there is no limit to their investment in multinational companies.)

Out of a larger list, I selected six pairs of fund indices to compare. The first index listed is the global group, comparing with the second group, a similarly focused domestic fund index:

• Global Multi-Cap Growth = 6.30% vs. Multi-Cap Growth = 8.61%
  
• Global Multi-Cap Value = 6.28% vs. Multi-Cap Value = 8.23%
  
• Global Multi-Cap Core = 6.71% vs. Multi-Cap Core = 7.98%
  
• Global Health/Biotech = 16.54% vs. Health/Biotech = 17.90%
  
• Global Sci. & Tech = 7.93% vs. Sci. & Tech = 8.56%
  
• Global Real Estate = 8.35% vs. Real Estate = 12.75%

Source: Lipper, Inc.

Four Letter Word: Jobs

One of the main reasons that “going global” is not working is that in most developed countries, and in a great many developing countries, there is widespread unemployment (as well as underemployment in the US). Globalization has worked too well. Capital has poured into companies and industries that could improve their productivity through the increased use of global technology. Thus we are producing more with fewer people. An important global issue is that we are not creating jobs. The way both China and Brazil are addressing these pressing problems is by raising wage levels, particularly at the entry levels. They are, in effect, inducing inflation that will create later problems for many and opportunities for some. Over-population is not a new problem. Historically, one answer was to wage wars on neighbors, particularly for their land, and in some cases their women. Also life expectancy was limited until the impact of modern medicine and modern agricultural processes became widespread. There is one crying need for vastly under-funded investment in almost every country: infrastructure. Once again China is in the clear lead here. Infrastructure funding historically comes with three problems. The first is the displacement of people from their homes and farms without adequate replacement. The second is that succeeding governments use cutting infrastructure spending as a way to avoid raising taxes. The third is that the very nature of infrastructure spending is that, at some level, it is a cash business which makes it more susceptible to corrupt practices (particularly with low level local politicians). Despite these real drawbacks, if various societies are going to prosper in the future, our global infrastructure needs must be met. At this point I would prefer not to invest in various infrastructure funds, but in more broadly based funds that can move into and out of infrastructure investments as price and circumstances dictate.

Fragmented Markets = Less Liquidity

One of the reasons that the global markets have become much more correlated is that with the exception of some Asian markets and to a lesser extent the UK market, the main driving forces in the marketplace are institutional investors. Many of these are managed by people who have been educated and/or had training in a limited number of universities or major firms. This somewhat limited exposure has produced generally accepted ways of thinking aided by instant global communications. In the search for meaningful competitive advantage, the players have to find more restrictive card games (markets) where only a few serious (big money) players are at the table. This has led to the creation of numerous places to trade. In effect, this move destroyed the knowledge capital of the formerly central marketplace. As no one knows for sure what transactions are currently occurring, there is a reluctance to provide liquidity to the marketplace. In turn, the lack of identifiable liquidity leads to increased volatility. Increased volatility scares many retail investors, so they retire from the marketplace. In the past, at the time of investment, individual investors were looking to the long term for their gains. The focus of too many institutional investors was defending against career risk, i.e., they needed superior performance in the present quarter. Markets work best when investors with different time horizons meet. Thus, one investor could be focused primarily on today’s price and another on some future price. That way both could be right. The absence of longer term-oriented investors in the marketplace hurts finding equilibrium prices, which promote future investment.

SEC’s Other Unintended Consequences

The fragmentation of the US market is a direct consequence of the SEC’s belief that “better” prices could be achieved through competing marketplaces which would aid the individual investor. As is often the case with government intervention, the unintended and unanticipated consequences have led to harming the very people who the changes were meant to help. I am not attempting to change these market structures through this blog community. I am just suggesting that the impact of what was designed to help investors, I believe hurt them. Another example tied to the fund index data shown above is the term global. The SEC cannot directly dictate a fund’s investment objective, but it can dictate as to its name under the concept of Truth in Advertising. At an earlier time, when US investors were pouring money into funds, the commission was concerned that investors could wind up in a non-diversified fund in terms of exposure to various foreign markets. That is why they insisted that for a fund to be called “global” it had to be invested in at least three different countries. In truth many of these funds invested in many countries and from my standpoint, too many countries. (When I used to counsel new funds, I suggested that they should not put a geographical or investment term in their name.) One of the reasons for the closeness of the performance data shown above is that too many of these funds are too broadly diversified, thus they will hug the middle of the market and not attempt to do extremely well. When examining a fund, investors should look at the fund’s portfolio to get their own view as to what the fund holds, and therefore how it should be measured to meet their own needs. If an investor cannot, or chooses not to perform this analysis, then the use of a competent investment adviser is warranted.

A Fathers’ Day Focus For Wealthy Investors

This blog was written on a day that is celebrated as Father’s Day in several countries of the world. For many, this was a day of family gatherings, exchanging cards/electronic messages, and gifts. When thinking about the upsurge in communicating with one’s family, there is a natural tendency to think about both the past as well as the future. Anyone who has children is wealthy beyond any commercial successes derived. Thinking back to one’s own father and grandfather, there has to be recognition that in many cases they are no longer with us. Turning to the future, we need to absorb the fact that at some point in the future our children will probably be looking back to a father or grandfather who is not with them on some future Father’s Day. All fathers (and mothers) try to pass on to their children their values and perhaps their talents. If you can do this, you are indeed wealthy.

For those who have financial assets, particularly sizeable assets, there is an added task, which is to pass on to children, grandchildren and great grandchildren not only financial assets, but the moral and investment values that have the best chances to make them happy and productive people. There are many models and devices to accomplish these goals, however there is no single plan for each and every beneficiary. When we lived in a much simpler world where our main asset was a farm or a local business, often the heirs had to share in the ownership and management of the family asset. There was very little one could do wisely for one heir compared to another except in terms of decision making. Today most wealth is, or can be, converted into liquid form. In many cases the assets of the heirs can and should be handled differently. One way to start the process, while you can change it, is to create separate portfolios with different rules for each of the heirs. Working with your accountant and trust/estates lawyer in the early stage of this process, I would use mutual funds because of their relative transparency and flexibility. Once policy portfolios feel right, then they can easily be memorialized in wills and trusts. To start the process, give some thought to the use of investing outside of your home country. In all likelihood one should start small, and as experience and confidence grow, take bigger steps. Don’t you wish your parents or grand-parents did this for you? This effort can be a gift to your children and grandchildren in addition to passing them your values and talents.

Perhaps we can help a limited number of fathers and mothers out there.

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How to Send Your Investment Dollars Overseas

More and more money is leaving home. The flight is caused by unhappiness at what is happening in this country, if not outright fear as to the long term value of our hard earned capital. What many Americans fail to realize is that there is hardly a truly popular government any place. To some this desire to obtain capital escape is a new urge, but the truth is that wealthy individuals and families have been exporting their investment capital for centuries. The earliest investors to send their money across borders were the wealthy from small, often but not always, wealthy countries. The two leading countries that were slow to export an important part of their wealth were the Americans and the Japanese. In our case there was some foreign investment in the late 19th and early 20th centuries, (I believe that my grandfather’s brokerage firm had not only foreign customers, but some US investors investing overseas through his facilities). From the time I was a trainee in the vault of a New York bank counting foreign stock certificates that backed the American Depository Receipts some 50 years ago, I was interested in investing in foreign securities. While I have owned individual foreign stocks in the UK, Canada, Australia, Netherlands, and France, I found a sounder way to invest. With total bias, the better way to invest is through internationally-oriented mutual funds.

GLOBAL FUNDS OR INTERNATIONAL FUNDS?

For those who are novice investors the best choices are global funds that mix at their discretion, US and foreign holdings. In truth, today most large capitalization funds almost anywhere in the world are global funds. In many cases at least half of the earnings growth driving their performance is generated by foreign-based affiliates or exports. But for those of us who believe that we have the right mix of investment managers, a dedicated international fund is the right tool. For those of us who are more demanding, a number of different international funds are needed.

FOUR APPROACHES TO OVERSEAS INVESTING

Recently I was present when a large domestic investor was hearing the seductive call to invest overseas. Sitting through three presentations of separate account international managers, I realized that the analysis leading to their decision should have been similar as to what I do in selecting international funds for portfolios of largely domestic funds.

PARTICIPATE IN THE MARKET

The first approach entails asking the question, “What does the international investment bring to the account?" The simplest desire, and the one that can not be assured, is better performance than the existing portfolio. To me the first step is how the new investment integrates with the existing investments. Some portfolios are essentially participators in the general economic conditions. Most of the satisfactory investments for this need are index huggers, or if you prefer, closet indexers. Some prefer actual index funds trading off potentially advantageous stock selection for lower fees. In truth, the portfolio manager of this product can be located anyplace where there is electricity for his/her index modeling computer.

TILTING THE ALLOCATION

A second approach is a country and/or sector allocator. In this case there is a willingness to move away from the central tendency of the index. As practiced by the activists, there may be a willingness to eliminate some countries or sectors. Others have an operating rule to underweight or overweight a country or a sector by 50%. For the most part these managers use publicly known trends. Their skills of mixing and matching can be practiced from any location where air travel can easily bring in foreign salesman or commentators.

PICKING STYLE

The third approach is to have a global point of view. Often this is described in terms of growth (of earnings) or value (a discount from intrinsic value). Various studies show that from time to time either growth or value produce better results. As the investment game is now global, it is my point of view that growth or value leadership (or for that matter most sector leadership) follows a similar path in the domestic market as it does in various international markets. Therefore, we try to match the style inclinations of the international portfolio managers with those that dominate the domestic portfolio. As international investing is inherently more expensive, I reserve the domestic portfolios for minor style changes if I do not have the ability to meaningfully shift cash flows. In this third approach one is counting on the allocation skills of the portfolio manager. If one wants to participate in the leading edge and willing to be part of the “bleeding edge,” then the activist should be located in the flow of information. While today we can do a lot from a central location like my intergalactic world headquarters in Summit, New Jersey, there is a belief particularly by clients and some consultants, that closer to the action listening posts are better. (Notice that most of these are in cities with good restaurants.) There is some risk that the listeners are primarily getting their inputs from these restaurants, golf clubs, and in certain places, the American Clubs. The listeners may not have their ear really to the local ground. For example, in none of the recent manager presentations or six month reports did I hear anything about wide scale loss of faith in the European Union. On August 27, in my previously mentioned global world headquarters, I read that only 42% of Europeans say they trust the European Union, and this is down 6% in the last six months. In addition, “fewer than half of Europe’s citizens see their country’s membership in the EU as a positive thing….” as reported in EurActiv. I do not find this poll as a positive indicator unless I want to put on my contrarian hat. If I do this hat trick my investors should be warned.

STOCK SELECTION

The fourth approach and the one that I generally favor is one where individual stock selection is the critical talent of the portfolio manager. To my mind they have to know as much about the companies they invest in as the leaders in the various local communities. These managers should regularly attend important weddings and funerals; speak and understand the local dialects as well as be able to prepare local foods. In other words, they should have gone, or are, local. Having a string of offices around the world would help if they are offering investments beyond a single market. These should be primarily research offices not sales offices. There is a risk to this marriage with the locals similar to the risk of working with industry analysts. While from time to time they may advocate a sale, rarely will they advocate complete retreat and closing the office. Thus in this fourth approach there is a purchase bias which must be recognized.

We use all four approaches depending upon the needs of the account. Notice in no case did we focus on performance. My approach is that performance is at best an introduction to a manager and may well be poorly timed after a period of good performance.

As this blog is an instrument of a global community, I am curious whether you will share your thoughts on international fund and manager selection.

I hope next week to devote this blog to a view as to the direction of the domestic market that appears to be wallowing in fear and unhappiness. Any thoughts would be most welcome.

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