Will Fund Classification Hurt Your Fund Selection?

Introduction

I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases relative performance is very important. My concern is that most benchmarks be they securities or fund indices are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional  “gate keepers” or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the US. According to McGraw-Hill Financial’s survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies’ foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources.  As a matter of fact I found four which had foreign sales of over 75%. Since for many years sales outside of the US have been (in local currency terms) growing faster than in the US, I am willing to bet that a number of funds that are characterized domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher quality small cap funds had a relatively good third quarter performance (see many of the Royce^* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important on this Sunday when the Financial Times reported that the Brookings Institution announced that the global economy is coming back, being led by the richer countries. For the moment the classification of small cap appears to be working. Nevertheless, from a selector’s view point it is a flawed classification.

^* Owned by some of our accounts

Better Classifications

Originally funds were slotted into classifications solely on what the funds’ marketing people claimed they were. Over time this yielded to the language in the prospectus created by the firms’ lawyers. Increasingly their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards as to earnings growth, price to book value, yield, market capitalizations and other measures. The data sources for these were the unadjusted financial statement statistics.

As both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed.  I have already pointed out that higher quality Small Cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors.  Other such measures might have to do with the difference between turnover in dollars vs. turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float and there are others.  Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

Bottom line: Pure performance ranking numbers in one period are not an important selection device today.

What screening devices do you use?  Please let me know.

Readers’ Service

In last week’s post I mentioned that Colin Camerer, a Caltech professor that we supported with help for his post-doc students, had just won a MacArthur fellowship, often called a Genius Award.  He sent me his collaborative article in the Neuron magazine, entitled, “In the Mind of the Market: Theory of Mind Biases Value Computation During Financial Bubbles.”  The work shows that during a bubble, the “smart guys/gals” get caught up playing what we used to call “the bigger fool theory.”  Please let me know if you would like me to email the article to you.

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Should We Appreciate Bonds? Part II

Cocktail parties for charities often reveal more investment concerns than those expressed in an organization’s formal meetings with investment advisers or investment committee members. In this age of unusually high fixed income yields and low total returns from common stocks, taking advantage of spreads for capital appreciation, not primarily income and capital preservation, can be unnerving. The question of whether this new approach is a sound one for a fiduciary has been expressed by members of several charity boards and committees.

As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.

Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.

A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.

Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.

While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.

At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)

The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.

(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)