Is 2% the Investment Solution?

Introduction

Friday saw the popular US securities industry fall between 2 and 3%. In the week through Thursday over half of the equity-oriented mutual fund averages gained over 1% and over 12% of the performance averages were up over 3%. It was also a week where there were discussions by institutional investors as to the appropriateness of management fees between 1 and 2%.

Every Model is Flawed

As a “card-carrying” securities analyst I have never seen a statistic that I didn’t like. But also I have never seen a statistic that I didn’t ask for more as well - as in more understanding of what was behind “the number.” During the week I was at a presentation by an academic who based his pitch on statistics. I almost believed him because he admitted to what I believe, in that every model is flawed.

The difference between a reporter reporting ‘the facts” and a real analyst is that the analyst attempts to get behind the proclaimed number and more importantly put this particular insight into the constellation of factors leading to a tentative conclusion. The tentativeness of the conclusion is that there are always more “facts” which are revealed and sentiments change.

The Classic Definition of a Market Top

One of the best comments I read this week was that risk aversion is not a constant. The perception of risk of loss of capital and reputation is cyclical. Actually it is contra-cyclical. The definition of a market top is when risk aversion is low, when it should be high and the reverse at the bottom. At the moment unless there is a great follow-through of Friday’s drop, risk aversion appears to me to be in the mid range.

Unless Friday triggers massive selling in the weeks and months ahead, investors appear to me too petrified to grossly change their allocations to equities and fixed income securities. The classic definition of a market top is when there is no more cash that can be “sucked” into the market. 

In my judgment there is still a lot of potential money that could come into the equity market. Some of this is in portfolios that have an unnaturally large commitment to fixed income. After all, in 2015 one of the best places to have money was in long-term US Government bond funds. Nevertheless market history suggests that a temporary decline in stock prices could be on the order of 10%. Further I recognize that at least once every ten years there can be an equity decline of about 25%. Without more risk aversion disappearing and becoming enthusiasm, I am not worried about a once in a generation drop of 50%. However, my accounts invested in mutual funds would have better liquidity exits than many stock and bond portfolios.

Examining Friday’s Stock Market Numbers

The array of one-day performance of the popular market indices is instructive as shown below:

Dow Jones Industrial Average	-2.13 %
S&P 500	-2.45 %
NASDAQ	-2.54 %
S&P 400 (Midcap)	-2.92 %
S&P 600 (Small cap)	-2.97 %
Financials	-1.85 %
Banks	-1.01 %

On a market capitalization weighted basis the Dow Jones has less of the growth oriented company stocks than the S&P 500. The latter have much bigger derivative and ETF drivers than the old DJIA. The NASDAQ marketplace is more lively than the old exchange-oriented markets as can be seen on the NYSE on Friday: only 5.5% of the stocks rose in price whereas 13.6% of the stocks rose on the NASDAQ. The greater declines suffered by the Midcaps and Small Caps were due, in my opinion to much smaller capital commitment by the dealers making markets in those stocks.

The smaller decline in the financials in general and specifically in the larger banks is due to the fact that their prices are still being penalized for perceived sins of the financial crisis. (Strangely, we don’t penalize the Congress and the GSEs!)

I am particularly sensitive to the financial sector as I manage a private financial services fund.

Mutual Fund Performance Ending Thursday

There are 96 equity related mutual fund investment objectives tracked by my old firm Lipper, Inc. a subsidiary of ThomsonReuters. Last week, 55 of the peer group averages were up over 1%, most of the gains in sector and world equity groups (22 categories) gained over 2% and 12 were over 3%. The latter group was mostly natural resource and commodity based. With the exception of the High Yield Bond funds, none of the fixed income categories were up 1% or more.

I suspect most of the buyers of equity-related mutual funds already assumed that both interest rates would rise and the central banks would be forced to recognize that their collective monetary experiments weren’t working. Further, that a rise in rates to meet commercial and savers’ demands was a positive development. One should expect narrowly based sector funds to be more volatile than Diversified funds. The increase in volatility that is expected by some may scare more money into the Diversified funds than the Sector funds. We should watch both broad groups in terms of performance and flows.

Putting Management Fees into Perspective

While various pundits stress the importance of fees in investment selection, management fee is a number like any other number and should be put into proper perspective. Friday’s decline was greater or equal to many investment advisor management fees. However, the performance of most equity funds and many separately managed accounts in just the two months of July and August were greater than their annual fees. In most cases these equity accounts are showing positive results for the year.

There is much enthusiasm for Index funds on the basis of their fees being lower than actively managed portfolios. As with any number it needs to be examined. I believe in many, if not most cases, the currently superior results of selected Index funds to certain actively managed portfolios has to do with other factors. Most importantly Index funds carry little in the way of cash in their portfolios where it is not unusual to see an active manager with 4-10% of the portfolio in cash and cash equivalents. The use of these reserves are to meet redemptions/grants and to be a tactical reserve for future purchases. Many Index funds are not worried about redemptions and will tolerate bad exit prices that active managers would not. Many market dealers offer Index funds with lower commissions/spreads than active funds as they treat an Index fund as an information-less trade. On the other hand the dealer is afraid that the active manager is ahead of the market’s realization as to dramatically changed information. Dealers want additional income on these trades to offset these risks. Many Index funds have positions above 5% of their portfolios, largely due to market appreciation. These big name stocks are the very ones that active traders will be dumping in an aggressive declines.

Buyer Beware

As long as Index fund buyers understand the risks that come with their lower fees they can celebrate their lower fees; but be careful of going to the lowest priced brain surgeon.

My own view is that the greater the proportion of the trades that are done by price-insensitive transactors, there is more room for bargain hunters who are the type of managers we favor.

Is 2% the Investment Solution?

Two percent is just a number like any other number, which needs to be evaluated.  Most importantly, 2% is a small number relative to the long-term expected movement of your money, and therefore we don’t think 2% an important element of an investment decision.  What do you think?

Question of the week: Did Friday’s price action cause you to materially change your asset allocation plans?

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Copyright © 2008 - 2016

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

Investment Survival in a Disruptive Age

Introduction

The First Commandment for all investors is to play to survive.

In my discussion of the Legacy Portfolio part of the Timespan L Portfolios^®, I suggest including stocks and funds that focus on being disruptive to the established order. Thinking deeper about the attributes of disruption, I know we have entered a disruptive age.

If you are a keen observer you will see that almost every major activity is experiencing some form of disruption. In virtually all areas we are trained in some classical way of thinking derived from past successes and failures. The neuroeconomists at Caltech assure me that we make important judgments on the basis of our or others’ experiences. We like to follow patterns. The problem with this comfortable approach is that in many spheres there is disruption. Just look at Science (colliding black holes creating time warp evidence), Economics (experimental quantitative easing), Politics (populism usurping establishment roles), and even some money managers. Our instinctive reaction is at first to reject the disrupters and then fight them as they are threatening our classical way of thinking and operating. What we should be doing is examining the facts/data and trying to understand the power of their proponents. Whether the disrupters are right or not they may represent an opportunity. They may not be completely wrong, and without rigorous study we may not recognize when they are more right than our older models.

This is far too big of a series of subjects for me to thoroughly deal with now. Because I feel that I have some responsibility to those that have used various investment performance measures to select mutual funds and other managers based on their past records (which for a period of about a year have been underperforming) this set of disruptions deserves some attention. I am going to briefly review what is in the process of changing which may explain what is now happening and more importantly what may happen.

Sound Bites

Look at almost any front page of a newspaper or the first story on a so-called news broadcast. The strong odds are that it will be negative in terms of life, limb, and the pursuit of happiness or gain. We need to understand that the media has discovered that negative sells. The people who believe that principle the most are the politicians. In almost every country they are focusing on the problems as a way to attack the “they” who need to be replaced by a different set of politicians. Interesting that each day many if not most things in this world get a little bit better.

Last week I devoted most of my blog post to the annual letter from Warren Buffett as edited by Carol Loomis. I, and others, found the letter to contain reasons to be bullish in the long-run. In her letter this week to her largely retail audience, Liz Ann Sonders stressed a preference for what Mr. Buffett was saying rather than the politicians and their pleas of misfortunes if they are not elected. The statistical odds favor investing in US equities in the long-run.

The Cost of Regulation

Around the world banks and other members of the financial community were blamed almost exclusively for past financial crises. To prevent repeats without reforming the political leadership, the financial community and particularly the large banks were subjected to intense and costly regulation. Due to this additional regulation banks need to increase their capital at all levels. The higher the value placed by the market, the belief is the better the future results and the lower the cost of raising the required capital.

According to Standard & Poor’s the price/earnings ratio of the banks in its 500 index is 12.38 X where the P/E for the banks in S&P's small cap 600 Index is 18.51 X. Thus the smaller banks have to give up less of their equity to get capital than the larger ones. In a period of manipulated low interest rates banks will have difficulty making enough money to attract more capital to make more loans. One of the disruptive forces being unleashed are non-bank financials that are less regulated and often less transparent. Thus the portions of the economy that need loans will likely get their loans with less regulations but at higher interest rates. In Europe banks are often less well capitalized and in some cases have materially larger non-performing loans relative to their assets.

Most private businesses get their money from local banks. In the US, businesses approaching mid size have the option of publicly issued paper. This would be a new experience for many European companies which they may find disruptive in terms of disclosures, costs, and tax implications. On the other side of the coin, retired individual pensioners are not earning enough on their deposits to meet their living needs. So their senior lives have been disrupted.

Price of Oil Links

Disruption can be positive or negative in terms of direction and whether one is a natural buyer or seller. The more established participants are in the camps of lower prices for longer. Moody’s has just lowered the credit rating of many Gulf and African government bonds. T Rowe Price New Era Fund which maintains half of it portfolio in energy stocks views that the price can descend into the twenties from the current prices in the thirty dollar a barrel range, rebounding for a longer term target of $40-50. Sounds bearish, but in February the leading developed market broad market index performer was Canada +4.27% compared with S&P’s measure for the US of ‑0.28%. (For many years, I have hedged my investments in US domiciled mutual fund management company stocks with some of their cousins above the border.)

Another link to the disruptive changes in oil prices are many securities in the emerging and frontier markets. In general, as a group they have fallen in sympathy with the fall in imports into China. One of the reasons for the decline in energy prices is a cutback in its imports of oil and other raw materials. Based on their valuations close to the lows of the prior cycle, they appear to be “cheap.” They may be cheap, but not a bargain. In revamping the Chinese economy its import needs may be permanently altered which would certainly be disruptive to buyers of these stocks.

How to Invest In a Disruptive Period

During disruption, most of us mere mortals do not know how things will turnout. We do know that we are in a period of rapid change at many levels. While we may return to the pre-disruption stage, it won’t be really the same because in the back of our mind we know that there has been a disruption and others could come.

The standard investment strategy in dealing with risk is to diversify into different instruments. Most investors do that within various individual securities. What we do for clients is to offer a better way to diversify. We assemble a specific portfolio mostly of mutual funds from different managers who think differently about market conditions, risks and opportunities. All too often even those who are early recognizing a problem or opportunity only see a portion. Hopefully we can assemble a task team that can get a fuller picture and thus give us and our clients more confidence in dealing with disruptions.

I would be happy to discuss how to deal with the disruptions that you perceive.

Question of the Week: When was the last time before an important election you were correct as to what the newly elected leader was able to deliver?

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Comment or email me a question to MikeLipper@Gmail.com.

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Copyright © 2008 - 2016

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