Avoiding Many Mistakes - Weekly Blog # 834

 

         

Mike Lipper’s Monday Morning Musings

 

Avoiding Many Mistakes

 

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018

   

       

Numbers Are Not the Answer, Questions Are

This is the season of the year when investment managers are often chosen. This is particularly true now, with US stock market leadership evolving. There is a debate between the short-term attraction of growth and fundamental long-term concerns over the global economy and political structure. We may have entered the early stage of replacing current leadership in business and in Washington. Because the future appears uncertain, group decisions through committee are more likely. (A historic lesson from military and political history is the larger the group, the less dynamic the decision.)

 

The first step in making an investment discussion is often to gather the easily available numbers. The first problem with gathering numbers is the motivation of the sources. In the investment arena, the major providers are groups who wish to publish data for direct or indirect sale and/or profit. Another source is regulators who wish to provide standards leading to evidence for lawsuits. Neither of these sources try to help others make wise investment decisions.

 

At this point in my professional life and practice, I am trying to make informed and correct investment decisions for specific users, including my family and myself. The following discussion are some of the indicia I use to ask some of the right questions.

 

Critical Questions in Search for Profitable Investments

1. Rarely the first question and more likely the last, is understanding the motivation of important individuals involved on a personal and group basis. Different answers should be expected depending on whether the mindset is one of a publicly traded investor or a sole ownership, and all gradations in between.
2. Obtain quarterly performance since inception for at least ten years, or shorter if there was a significant change of individuals or operating philosophy.
3. Understand the choice of perceived peers and their performance for the period where their critical philosophy and personnel were in place.
4. Get the percentage of time the investment occupies in each quintile. If potential investors are satisfied with mid-quintile performance, eliminate all candidates who don’t have 75% of their results in the 3^rd quintile. If the account is a significant turnaround buyer, focus on managers with 25-50% in the 4^th and 5^th quintile. (This is based on the reaction of many investors to the pain of losing, which is felt twice as much as gaining an equal amount. If the pain multiple is higher e.g. 4x, the loss tolerance level will be lower, perhaps as low as 13% or in the range of only five quarters out of 50.) If the buyer insists on avoiding problems, screen for a manager that has performance primarily in the second quintile, but no more than 25% in top quintile.)
5. Voting members of the committee, are they making choices or reaffirming choices made?
6. How important are inputs from marketing/sales and trading? Who are the top 10 brokers and top 10 marketers for the organization?
7. Recalculate the published turnover of the portfolio to include the greater of sales & purchases. (The SEC mandated measure is based on the smaller, because of their concern for “churning”. Identify the major sources of inflow and withdrawals? From the portfolio perspective, how much of sales is replacement of positions and how much stems from disappointments?
8. What are the management responsibilities of the portfolio manager and who does he/she report to? Can he describe his personal and major family portfolios?

 

Items of Interest you may have missed.

1. Daniel Henninger wrote a column in Thursday’s WSJ titled “The Counter-Revolt Begins”. He lists a number of instances where decidedly left leaning communities have passed local regulations and laws to bring back some safety to their cities and states. These include San Francisco, Los Angeles, the District of Columbia, and the states of Oregon and New York. Wealthy university donors are also insisting on changes.
2. The global financial community is consolidating as intra-industry acquisitions occur. Computershare is buying BNY Trust Company of Canada. Several top financial advisors at JP Morgan also left in a single day.
3. PGIM of Prudential is following the trend and has applied to the SEC for a new class of Exchange Traded Fund shares for their mutual funds. They are following DFA, Morgan Stanley, and Fidelity. (This may bring more money into the ETF industry. It answers one of my concerns for redeeming ETFs in thin markets.  A surge in bond and small-cap redemptions on a crisis day can be helped by accessing the open-end fund’s resources. Until Vanguard’s patent protection expired, it was the only fund group that could do this.
4. All 32 global equity market indices rose this week.
5. AAII publishes bullish, bearish, and neutral indices from a sample survey of their members market views six-months out. They show rare confusion in the retail market this week, where all three numbers were in the 32-33 range.
6. Also, Copper prices are often referred to as Dr Copper because the metal is used in so many products. Copper has been used as a type of currency in some countries with limited or expensive markets for dollars. This week’s copper prices were near an all-time high.

 

As always, I am searching for good thoughts from bright people such as you.   

 

 

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

Mike Lipper's Blog: News & Reactions - Weekly Blog # 833

Mike Lipper's Blog: Better Investment Thinking - Weekly Blog # 832

Mike Lipper's Blog: Preparing for the Future - Weekly Blog # 831

 

 

Did someone forward you this blog?

To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

 

Copyright © 2008 – 2024

A. Michael Lipper, CFA

 

All rights reserved.

 

Contact author for limited redistribution permission.          

The Importance of Turnover in Picking Managers

Most of my posts end with a question to our readers. I ask questions not only to promote a dialog, but more importantly to learn from some pretty smart people who regularly read these posts. Last week one of the long-term members of this community sent me a series of thoughtful questions. One of which was, “When you conduct your analysis of funds and manager(s), how important is portfolio turnover in your calculation?” In effect, he is asking, do turnover rates matter?

When an investment analyst is asked this type of question you should not be surprised that the answer is “yes and no with an explanation.”

 A compliance invention misused

The earliest use of the term turnover rate was by the US Securities and Exchange Commission (SEC) in required prospectus disclosure. (As I hope to be visiting our British friends shortly, I need to distinguish between the US use of the term and UK’s use of turnover as a synonym for sales.) The SEC’s prospectus requirement was not designed as a selection tool to pick funds. The purpose of the calculation was to spot excessive churning of a portfolio to generate, what used to be valuable brokerage commissions. This purpose will become clearer when one knows the methodology of the calculation which is take the smallest of aggregate purchase dollars or sales divided by the monthly average of total net assets. Now you have learned more than you ever wanted to know about turnover rates.

Turnover is a good place to start asking questions

Portfolio turnover is an important place to start, but perhaps more important is personnel turnover which I will discuss further below. In terms of portfolio turnover data, when I talk with portfolio managers the following questions are asked:

1.      On balance are they selling losers or winners?

2.      What is the average length of time before transacting?

3.      Is the average length of time different for the winners and losers?

4.      Do they do any post-transaction analysis to see in the succeeding six or twelve months whether the decision was a good one?

5.      In general, what did the transactions do to the portfolio?

6.      How does the current turnover rate compare with those in the past and does this have any particular significance?

There are other questions that are then asked about the research behind particular positions in the portfolio. However, if the Portfolio Manager (PM) does not have answers to most of the turnover questions above, I find it difficult to have the requisite confidence in the fund for it to be owned by my clients.

There is an important caveat about turnover rates that needs to be recognized. That is they seem to be rising; meaning that the weighted average in the portfolio is being held for a shorter period of time. One of the reasons for this is the consultants'/selectors' “Three Year Fallacy.”  Under normal conditions three years is only a portion of an investment cycle. Four years fits closer to the historical trends and normally contains a US Presidential cycle. Actually the command economies have favored a five year period for their planning. I personally prefer a ten year period which would give ample time for a recovery from a management mistake. Enough of the numerology, the real reason for the intermediaries to focus on three years is that it is the shortest period that they can earn a new fee for a search to replace a poorly performing manager. (Often there is a substantial relative performance recovery after a three year period. This could be caused by redemptions that are forcing the PM to sell and often he/she sells some positions that didn’t do as well as expected in the recovery.)

There is a second and more structurally dangerous factor causing turnover rates to rise. I have been on non-profit investment committees who are doing a good job meeting the twenty or more years need for funding. They invest for the long-term and review their performance intensively once a year and less so quarterly. Because of the long-term nature of their tasks they will put up with a number of underperforming periods before they switch investments. That period of disappointment might last five years or 20 quarters. Today we have the ability to get publicly traded portfolio performance monthly, weekly, daily and perhaps even hourly. If it took 20 observations for the long-term manager to finally terminate a fund, the same number of unhappy reports could occur in a month of twenty trading days or a year and eight months if monthly numbers are the trigger.

Hopefully owners of accounts in funds and/or individual securities will be mature enough not to be solely driven by performance numbers and will pay attention as to what is happening within the portfolio and within the investment organization.

The important turnover report: Personnel

In our meetings with various fund groups we are sensing many more portfolio managers being switched than what we have seen in the past.  The same trend is also being noted by Citywire outside of the US, where at the current rate by year-end over 1000 portfolio managers will be replaced. Several US organizations which have been remarkably stable for years are now experiencing portfolio manager turnover. Some of this may be due to financial or psychic compensation or in a number of instances, performance problems. In some cases these changes are not disclosed. What is definitely not disclosed is the turnover in analysts. Only at a recent face to face meeting with a PM did we learn about a reduction in the number of analysts in the office. (Interesting enough the PM believes that it could help improve the quality of investment research and decisions.) 

The turnover of senior officers in a firm is important to me. Recent turnover of CFOs has caught my attention as these are not just bookkeepers but play critical roles in developing and carrying out corporate strategies. Rarely do we see announcements of critical changes on the trading desks at institutions. For many funds that have a high portfolio turnover and/or invest in small or micro-caps, the traders can add great value. This also true in the fixed income and credit markets. 

Is turnover important?

Yes, the context of the turnover in the portfolio and in the organization is important, but the number itself can be misleading.

How do you view turnover?

Please let me know privately or publicly.

I am looking forward to seeing some of you in London in September.

______________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.



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

Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.