Different Forts: Misconceptions on Risk-less Investing + 3 Reasons for Equity Mutual Fund Redemptions - Weekly Blog # 497

Introduction

Attorneys in court often arrange “the facts” to support a conclusion. Economists and Professors of Finance suffer from “physics envy” of immutable laws. Politicians and pundits speak in sound bites. Investors, like other good judges, look at all of the information found in hard and soft data. Most importantly, investors should avoid accepting any proposition on the face of what is presented. Wise investors have learned to probe for a more complete understanding of what is on offer. 

Is Risk a Number?

Pity the poor professor introducing investments to a class. He or she finds it easy to introduce the concept of gains. It is essentially one of addition or in some cases multiplication. The problem is to introduce the concept of losing which is similar to subtraction. The real issue is to come up with a way to measure potential rewards vs. potential losses to get to a conclusion as to the risk of an investment. In the search for a mathematical answer rather than a deeper understanding of the different kinds of risks facing different investors, academia came up with the movements of US Treasury bond prices.  They measure the price pattern of the desired investment versus the volatility of Treasury prices. Thus, the idea of a “risk-less” rate of return was born. Investment sales forces deducted this so-called risk-less rate from the actual performance of a stock (and more frequently a fund or other portfolio) to create a comparison of favored investments, adjusting for risk.

While it is true that often the movement of treasury prices captures a reasonable amount of the general volatility in the stock market, for investors risk is the penalty for being wrong that causes changes in spending plans. It is these risks that cause pain to investors and their beneficiaries plus create “career risk” for hired professionals.

The use of Treasury prices presumes that there is no fundamental changes in the future of the Treasury market. Because of the changing market structure I believe that there will be periodic changes in the Treasury markets. In this weekend’s Financial Times John Authers has a column that is headed “Liquidity looms as the real challenge facing new Fed Chair Powell.” While he doesn’t spell out the problem, it is clear in the future he is properly worried that the various central banks led by the Federal Reserve will be cutting off credit through the banks to the fixed income market. While the Dodd Frank Act curtailed the commercial banks and large investment banks in their market-making efforts in securities, it did not really address the banks’ extension of credit to the few remaining market-makers. These credits are much larger than the banks’ own securities positions. There is already a shortage of repurchase agreements or repos at present. One sign of structural disequilibrium is that for ten year Government bonds, the US is paying 100 basis points more than the UK pays for its bonds and 200 basis points more than the German bonds. This suggests that the US paper is worth more. Why? I believe the reason is that it is the best collateral for loans that support borrowings for the purchase of derivatives and currencies which can be extremely volatile. Since most loans are immediately callable, there is the sort of risk that started the problems that led to the 1987 and Lehman crises.

  

Thus the ownership of a 4% yielding common stock or fund with a payout ratio of 40% or less and a price/earnings growth rate in the single digits versus a holding in US treasuries may be more dangerous in terms of risk to the investor and career risk to the professional. But these are unconventional thoughts.

Investors Rejecting Equity Mutual Funds

The constant drumbeat that retail investors are deserting mutual funds in favor of ETFs needs much deeper analysis than the pundits are giving it. For a number of months industry headlines have been screaming about the net redemptions of equity funds and this week is no different. Except they are missing the motivation behind the redemptions and its significance. The largest amount of redemptions is coming out of the Large Cap Growth funds. I do not believe that it is performance-related. On a year to date basis through November 2^nd,  my former firm, Lipper Inc., reports that Large Cap Growth funds, on average, have gained 26.03%.  No other non-leveraged, General Equity fund category has done as well this year or even in the last five years. The only other domestic funds that have done better are the Science & Tech funds. Some International funds have done better in part due to foreign exchange considerations.

Why are there so many redemptions?  There are three answers. The first is simple, the second is structural and the third has to do with the changes in the brokerage market.

The simple answer is that the Large Cap Growth funds have more assets than any other investment objective. Thus, logically over time it will have more redemptions. 

The structural answer is that investors put money into funds to meet future needs. The very day that someone invests in a fund, a future redemption is set up in the indefinite future. Because of the way many estates are settled, usually liquid investments are sold to distribute as much cash as quickly as possible so funds are not often directly inherited.

The third cause of redemptions relates to the fact that a large portion of investors in mutual funds was sold by commissioned-paid brokers. At the time of many of these transactions the commissions of mutual fund sales were among the highest rewards to the sales force. Currently many of these salespeople have morphed either into registered investment advisors or have changed firms for understandable reasons. In their new shops they are no longer motivated by commission sales but by investment advisory fees. As their books of business mature, there is little attempt to replace stock mutual funds in their aging accounts. These investors are converting their investments into either fixed income funds (whose sales are booming in spite of the likelihood of higher interest rates/lower bond prices), or into Exchange Traded Funds. In the latter case the investment adviser will charge an annual fee that within a few years will more than compensate for the loss of mutual funds sales commissions.

Hints For the Future

At some point before the current market suffers a major decline, there will be a more general recognition as to the risks in the fixed income market with higher yields driving fixed income prices down. The credit cycle in high quality paper will contract. It is likely that we may be surprised by the levels of domestic and international bankruptcies which won’t be isolated events.

On the equity side grudgingly we are seeing enthusiasm growing. In the last two weeks sentiment has become more bullish as measured by the American Association of Individual Investors (AAII). It will have to be sustained for a considerable period of time to fulfill a bear market indicator. In addition to Large Cap Growth funds and stocks doing well, industrial metals commodity prices are also ahead, showing a year to date gain of 25.11%. One of my senior analyst friends describes his current portfolio as a 1950s one. As many of the relatively newly minted investment advisors don’t have the historic perspective for the type of market we appear to be entering, they will disappoint some of their customers leading to a positive surge in equity mutual fund sales. (As an owner of a number of domestic and international mutual fund management company stocks both in my private financial services fund and personally, I hope so.)

Question of the Week:

For your own account how are you defining risk?  

__________

Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe using the email or RSS feed buttons in the left margin of Mikelipper.Blogspot.com

Copyright ©  2008 - 2017

A. Michael Lipper, CFA

All rights reserved

Contact author for limited redistribution permission.

A Contrarian’s Long-Term Outlook

In last week’s blog I described the market measures and representative sectors that comprise the foundation for my long-term outlook. My contrarianism is in contrast to many analysts and pundits, though I am sobered by the fact that of the 90 stocks I track every day, only 7 were up for the five-year period.

Recovery, or More of the Same? Why?

A knowledgeable reader emailed me to ask why I believe a recovery may be in the making. Because there has always been a recovery is not a sufficient foundation for me. In part because of my exposure to Caltech and a background of examining various funds seeking good investments, I am optimistic. Similar to the New York Yankees solving their business problems (as I mentioned last week), the American society comes up with solutions to many of its problems. Some of the products and services that we produce will not only address our problems but will also be in demand beyond our borders. The iPad, Boeing Aircraft (to economically replace aging plane fleets), Deal Making (we lead the world in those skills), wheat( in a period of growing excess demand), social media (Facebook, etc), US movies and televisions shows (with greater international revenues than domestic) and new drugs and other life-altering medical devices. I will be the first to admit that these products and services, with rare exception, are not massively labor intensive. But they are factors that may help us. For example, the vast majority of immigrants (legal or otherwise) come here to make money. They are strivers and in the long term may be more productive than many of our other residents.

In the future some of our military dollars may be shifted to much needed infrastructure expenditure. In the long run I am confident that we will continue to be a nation of problem solvers.

Four Low Hurdles Before the Outlook

There are four brief periods that we will pass through before most investors will be comfortable enough to look at the long term future. Each of these periods is likely to produce higher than normal volatility as the headlines will scare us one way or another depending on our own biases. The first is the period between now and the general election when the control of Congress, particularly the House of Representatives, will be determined. The next and to me the most worrisome, is the post-election session. A significant number of the members in both Houses will be incumbents who will not likely face voters again. These people are prime candidates for government appointments or key lobbying positions. Watching this sausage machine won’t be pretty. The third period will begin with the new Congress, when there will be jockeying for various committee assignments and chairmanships. Not all of these will be in favor of pro-investment legislation. The final period will be after the President’s budget message. That message will give the Congress the choice of bargaining with the White House or just ignoring the Administration’s wishes. There is likely to be some progress, but the execution of the legislation will still leave a lot to be desired in terms of logical clarity.

Contrarian Outlooks for the Long Term

1. The S&P 500 will likely gain at least 200% (JP Morgan points out that historically when a market recovery takes place, gains of 250% can be expected.
   
   
2. The S&P 500 is likely to somewhat outperform most managers, unlike what it has done over the last ten years.
   
   
3. One would be better off betting on the lagging groups, particularly the Science & Technology funds than the Emerging Markets and Resource focused funds. The real winners are likely to be the companies that use technology to disrupt the ways others do business.
   
   
4. For some time bond yields will rise with the stock market
   
   
5. The US will not default on our debts, our assets are too valuable.
   
   
6. The lost generation of investors will return to the marketplace.
   
   
7. At a low enough price level, the housing market will recover. Often prices will reflect intelligent replacement costs.
   

Bottom Line

Our stock market has not been capital productive for ten years. Is this a long enough period of base building to support a market expansion? That depends on whether one sees the ten years as a correction and correction for what. If we are correcting primarily for too high equity valuation, we probably have already done that. Well covered yields on many stocks are now higher than Treasury bonds. If we are correcting from an overvalued currency, that has been happening in fits and starts at least for 20 years. What we have not corrected for is lending practices at the consumer, business and governmental levels. The current approach of just requiring more capital to cushion the bad loans does not irradiate the bad loans, as a matter of fact it probably causes more risky loans, as they produce more profits than safer loans, (the potential profits are greater than the additional capital requirements). We still have the need to correct for the bad loan policies and this could delay our recovery. Another correction we may have to make is that of our use of inflation. Governments have been users of inflation to reduce the purchasing power of their debt repayments. Businesses, when faced with assured but flat demand have often elected to raise prices to increase revenues rather lower prices to increase demand. If we need to correct for our inflation biases, it may take along time. For most of our lives we have lived in an inflating society. Any correction may have to represent something on the order of 1/3rd to 1/2 a normal lifetime. I do not know which correction phase we are in. My guess: for a significant portion of your money, you should invest in the future; it will be better than not over the next ten years.

One clue as to whether the correction phase is ending and the next expansion is beginning, is to look to the mutual funds that are characterized as large cap growth funds. With rare exception it has been very difficult for large capitalization growth companies to make significant progress. While there have been some exceptions (for example Apple and Google), to date there have not been a minimum of twenty of these to drive a reasonably sized growth fund portfolio forward. As a contrarian I would suggest a minor investment in this category might alert you when such a move may begin.

The turn could be sooner than we think. On a rainy Sunday with the New York Giants playing locally, the Short Hills Mall was full of people with shopping bags. These were adults not participating in back to school shopping.

____________________________________________
To Members of Mike Lipper's Blog Community:

For readers who would like to stay current on my uncommon perspectives regarding investing and world markets, join the community by subscribing, at no monetary cost, just your time and interest as well as occasional responses. Simply click the "To Receive Blog via Email" box on the left-side of the screen.

For those already receiving my blog by email, if you would like to recommend this blog to a relative, friend or colleague, the sign-up is located on the left-hand portion of the screen at www.MikeLipper.blogspot.com.