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?  

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Two Reversible Negatives

Introduction

For some time I have been worried about a market top in stocks. In a classic sense, a major decline is less likely today for structural reasons than I had previously thought. Two obstacles to higher stock prices are Politicians and Commodities.  Both of  these drawbacks are reversible, but could cause the “once in a generation fall” of my fears.

The Enemy = Politicians

All politicians, as distinct from statesmen or stateswomen, wish to avoid being tagged with unpopular political decisions. The very nature of human and animal life is one of periodic successes and failures. A student of financial history recognizes peaks and valleys. The current crop of political leaders recognize that job preservation and job creation are critical to their reelection. To deliver on these goals they have adopted a policy of bailing out large employers who have sufficiently poor financial conditions that there is fear of substantial job losses. Such bailouts ignore the historical fact that it is natural for businesses to expand and contract, and in many cases particularly good for their customers. When a significantly large number of voters in key areas are employed by a company that is in distress, the modern reaction is to bailout the troubled company or industry with taxpayer money.

The recognized problems of late 2007 and 2008 in the US led to massive bailouts of both major auto makers and very large financial institutions. The public was revolted by this use of its hard earned money in the face of needs for spending on infrastructure, education, and defense. To avoid future bailouts and to protect themselves, the politicians came up with the doctrine of preventing large corporations from becoming “too big to fail” so that the government would be politically forced to bail them out. From the standpoint of protecting the politicians, the various “reforms” such as the Dodd Frank legislation appear to be doing a good job currently, as we have not had a major failure since the financial crisis.

The Price

To fund the bailouts, the Federal Reserve bought almost all of the debt the federal government put out and in so doing increased money supply which led to materially lower interest rates, particularly hurting the retired population, living on fixed income returns from their savings and pensions.

As harmful as that policy was to an important part of the population, a much bigger price was paid by the retail investor. Over the five years that the Dodd Frank bill has been operating there has been a withdrawal from individuals buying individual stocks. This has been caused by two simultaneous elements. The first by making the investment community seem to be the sole source of the financial crisis without regard for the contributions of government policies, labor unions, and inappropriate education.  By demonizing the financial community many otherwise rational investors voted with their feet. In the past, this kind of withdrawal would have brought a response from the financial community.

Because of greatly increased regulation on large financial institutions they needed to add highly paid compliance people and capital buffers that made the cost of serving the middle income public sky-rocket.

For many brokerage firms, the retail cash agency business has become unprofitable. This in turn has led to a change in the nature of the sales force serving the public. They have shifted into selling packaged products that have higher margins and often include borrowing (leverage). This shift has led to a number of the older and more trusted sales people leaving to become fee-paid advisors, replaced with younger sales people with increased sales quotas (this did not sit well with established clients or younger would be-investors). The net result is that far too many investors did not benefit from the doubling of market prices over the last five years. Their absence is being felt today by their lack of enthusiasm for investing to meet long term retirement needs.

Despite various politicians’ beliefs, human nature has not been repealed. Eventually the animal instincts will drive greed over fears and we will get enthusiasm for risk taking. While it is likely to be more muted than what we have seen in China, it will become a force that will override the damage to investors’ psyche caused by the Dodd Frank bill.  (Retail investors own 80% of the small Chinese market often with substantial margin debt. The Asian institutional market is a heavy user of equity derivatives which did not help in the last couple of weeks.)

Commodities, the Second Reversible

I have not owned any commodity future for more than thirty years. Nevertheless, whenever I see the media coverage of a major decline with the expressed view that it will continue, my investment instinct is to look for exhaustion on the part of the late sellers which will create a bottom. To most investors, commodities and particularly futures are of little importance in developing longer term investment policies. With high quality interest rates being manipulated by the central banks, I wonder whether the fixed income market will continue to serve its historic role of alerting the equity market of on-coming problems. If that is the case I am beginning to examine whether there is useful information in commodity prices.

According to Calafia Beach Pundit, while commodity prices are down they are still substantially up from their bottom. For example, Copper, often called Dr. Copper because of its economic ties, is down 40% from it peak but still 290% above its 2001 bottom. The price of commodities is a function of perceived and actual scarcity. One of the students of commodities recognized that in truth, the only scarcity of mankind is “human ingenuity.” Over time technology has eaten away at the use of any commodity through improved mining and manufacturing techniques plus growing substitution of less expensive elements. Also history reminds us that higher prices bring out more supply including new discoveries.

This is not going to become a “gold letter” for I believe that there are a different set of constraints on gold than on other commodities. Nevertheless, the price of gold hugged the CRB Raw Industrials Index in lock-step from 2001 to about 2007-2008. At that point the industrial commodities declined in sympathy to the then economic slowdown. Gold continued to rise until 2011. One might suggest it is when those that view gold not primarily as a commodity but a hedge against the decline in the value of currency became the dominant buyer as the US entered various phases of “quantitative easing.” Since that peak the price of the metal has had a parallel decline to the industrial materials. Gold bullion may have suffered the ultimate substitution by the increase use of “paper gold” in the form of futures and Exchange Traded Funds (ETFs) which absorbed some of the demand for currency safety.

China has become the pivot for commodity prices including grains. The command society shift from manufactured exports and internal infrastructure to consummation of goods and services has changed the global demand for industrial commodities. At some point this shift will meet its logical end and we will see growth in commodity imports into China. In the meantime the other developing economies will need to import commodities to fill the needs of their growing populations.

I do not know when commodity prices will turn upward, but as a student of history, I believe they will. If that happens at the same time as the lust to own securities deemed in short supply, we could have one enormous market rise which we will need before we have a generational type of decline.

Question of the week: Where are you seeing signs of growing demand? (The Mall at Short Hills was crowded on a warm and clear Sunday, today.) 

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All Rights Reserved.
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More Cautionary Signals for Investors

Introduction

The mission of a good investment analyst is to think about the impossible thoughts or at least the ones that seem improbable to most. The job of a prudent portfolio manager is to anticipate problems in the face of increasing momentum.

In last week’s post I raised concerns about a forthcoming peak or top of the global stock markets. This week I see more signs beyond the increase in margin debt I highlighted last week. I doubt that I (or anyone for that matter) can call the top with any precision. Nevertheless, I am concerned that we are much closer to a peak than a five year-old bottom and increased caution is warranted.

My concerns are outlined below. I would be happy to discuss these items with members of this blog community.

Black Friday: Traditional research could be failing

Long-term readers of these posts are used to my shoe-leather research of going to the near-by “The Mall at Short Hills” on Black Friday. This year my wife Ruth, my niece Alisa and I went to the glitzy, largely high-end mall Friday afternoon. Parking was less difficult than on other Black Fridays. With exceptions, both the shoppers and the stores were tight with their money. Relatively few people were carrying four shopping bags at once. As a matter of fact, this year there were many mall “walkers” and some in lounge seats without any bags at all.

I only noticed one shop advertising for additional help. The only two stores that seemed to have any frenzy around them were the Apple and Verizon outlets, both sellers of Apple products. (One should be careful, even analysts and portfolio managers see what they want to see. I am a long-term owner of Apple^* stock and we buy these products through the Verizon store.) In past years these perambulations gave me a good clue as to how overall Christmas sales were going. I now question this approach as there is some chance that on an overall basis there will be more sales over the Internet than in the physical stores in 2013; if not now then surely next year. We should have an easier time finding a parking place next year.

Mutual fund signals

One should expect because of my history and portfolio that I would pay attention to what is happening in the mutual fund business. In October investors added a net $21 billion to Equity funds as compared with a net redemption of $16 billion in October of 2012. For the ten months the net flow was $134 billion compared to a net redemption of $99 billion in the same period last year. This money probably came from a $221 billion smaller net contribution into Taxable Bond funds and a net swing into redemption from net sales in Municipal Bond funds of $91 billion. What has me concerned is that the biggest increase both percentage-wise and dollar impact was the $115 billion increase in World Equity funds followed by $104 billion increase in total sales by the Capital Appreciation funds. Both of these groups typically assume that the fund owner will be able to redeem quickly from these more volatile type funds. Only $67 billion was added this year into the less volatile and more likely retirement money of Total Return funds. Adding to these concerns was that most fund channels showed increases in October over September, except the institutional channel and the proprietary bank channel. I am concerned that the lower sales in October in these two channels could have to do with the restructuring of the marketplace in anticipation of the so-called Volcker rule restricting proprietary activities of banks.

In addition, Variable Annuities are seeing net redemptions across the board except for the Hybrid and High-Yield investment objectives, which suggest that even in this supposedly long-term arena for retirement, investors are looking for performance in some risky places. (All of the numbers quoted are sourced from the Investment Company Institute.)

My concern about market restructuring can be gleaned from information re-published by John Mauldin on the number of pages of major financial laws. The list is arrayed chronologically and also inversely as to their lasting importance: Remember the more pages, the less effective the legislation becomes.

• Federal Reserve Act (1913) 31 pages
• Glass Steagall Act (1933) 37 pages
• Graham-Leach-Bliley Act (1999) 143 pages
• Dodd-Frank (2010) 2319 pages

All of these bills created hurdles in the end and at great expense defeated the fundamental purpose of each legislation, but made a lot of money for lawyers, including those who had service on Capitol Hill.

Portfolio managers cherish their investment records as well as having concerns for the long-term benefits to their shareholders. The obvious fear on their part after a number of years of good to great performance is concern about a less good if not an outright nasty future. In some cases of over 40% gains this year, certain Small Company funds are closing their doors to new money or new accounts. The latest one to announce this softly is T Rowe Price^* New Horizons fund who has executed this move a number of times in its long and distinguished history. Other Small Company funds have built up their cash holdings to over 40% and in one case, it is reported, to 65%. We are increasingly finding it difficult to find growth-oriented funds, particularly Small Company funds that meet my standards of research and prudence for our fiduciary accounts. As the market rises on more enthusiasm, it will be more difficult to pick long term winners.

Two-handed economists and portfolio managers needed

While a former US President once sought a one-handed economist, an economist that shows the proper degree of balance is actually more worthwhile. The control of the leading Central Banks of the world is now in the hands of those who believe that no mess is quite so bad that official intervention won’t make it worse, asserted the UK's Daily Telegraph. In this era of multiple quantitative easing (QE), some academically driven measures can work. Over the weekend Moody’s^* upgraded the Greek Government Bond rating from “C” to “Caa3” with a published view that after six years of the economy contracting that in 2014 there will be some growth and by 2015 the Greek economy will be rushing ahead at a 1% growth rate.

Two missing important caveats should be added. First there is no measure of the long-term impact of exporting brains and labor to be employed elsewhere with little probability that they will return. The second point:  to a market observer the Moody’s announcement is not a surprise as both the markets for Greek bonds and shares have been rising for some time.

The lead/lag effect between the markets and the economy needs some explanation to many who are not deeply involved with the market. I will share with you a synopsis of two conversations about this dichotomy I had in a 24 hour period. The first was with a confused cousin who is a graduate of a well-known university who also has a locally obtained master’s degree. She was confused as to how the US market (where she has some investments) could go up, and the economy be so bad that her sales of a professional product were not up to expectations. I asked her whether she had two left hands. She said she had a right and a left. I asked if there are there times each hand is doing something different. My comment was that the market and the economy were like her two hands each performing different tasks. This apparently made some sense to her. 

Saturday night at a reception for donors to the New Jersey Symphony Orchestra (an organization lucky enough to have my wife as its Co-Chairman), I was talking with a senior staff member who had a similar question. I suggested that we would not want our Concertmaster who is a world renowned violinist switching places with an equally professional timpanist for an important piece of music. He got it that in terms of harmony one needs both, but they play different roles. That seemed to satisfy him.

Buy, Sell or Hold 

Howard Marks, the CEO of Oaktree Capital, a very successful investment management firm, and a friend for 30-plus years believes that markets are forever cyclical and those who do not expect future cyclicality are at risk. At the moment, while cautious, he is not calling a top. I am also cautious, particularly because my private financial services fund last week had a gross year to date gain of 34% which is high for a quality-biased conservative portfolio.

Nevertheless for clients I am responsible for making decisions or at least suggestions. Thus, I have to make Buy, Sell, and Hold decisions. As mentioned in previous posts I array my decisions along the different time horizons. I am, for the most part, reserving my buying to stocks that appear to have substantially more long-term upside than shorter term downside.

My Selling is largely driven by cash funding needs, rebalancing within agreed-to guidelines and in anticipation of some current holdings enjoying upward momentum, but which have a history of significant drops when the markets turn nasty as they always do. For long-term oriented endowments and my own family I favor Holding, as I believe the underfunding of global retirement capital will lead long-term capital flows into the markets that will produce good results for long-term, prudent investors.

*Disclosure: Either owned personally or in my private financial services fund.

Please share your thoughts with me on these topics.

_______________________

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.