Individual Investors Should Worry Professionals

Introduction

When I became a professional securities analyst in the 1960s there was a trend to have two separate research and marketing efforts of brokerage firms. A traditional effort to serve individual investors was joined by a second, and higher paid effort to serve institutional investors. Around the cyclical movements of the stock market, individuals and institutions invested differently and each fed off the other's transactions. Institutions were able to buy what they thought were cheap stocks from supposedly unsophisticated individual owners and sell into them when individuals were not well enough informed. Interesting this dichotomy did not work to the disadvantage of the individual investors as much as it may have seemed. Individual investors were not only net buyers, but for the most part long-term investors that often facilitated the more rapid turnover of the so-called professional investors.

This relationship is no longer the case. Because of the decision of the US government to introduce price competition in brokerage commissions (which led to a price war) the profitability of directly serving the individual long-term investor declined meaningfully. Today try to get a “full service” retail brokerage representative to be interested in opening an account to handle the sporadic purchase of a hundred shares of a NYSE traded securities. If the broker can’t get the customer to open a margin account, buy new issues, trade over-the -counter securities or place decision making judgment in a managed account or a packaged product or possibly an automated relationship with a call center, chances are he/she will not be interested in the relationship with the perspective customer. Only the alternatives just suggested are profitable for the firm and the individual broker. Thus relatively few individuals are directly active in today’s stock market. They are investors through their employers’ defined contribution plans, land stock purchase plans, and or mutual funds/variable annuities or in some cases stock options.

The plain truth on most days, particularly in the summer months, almost all the transactions come through various institutional channels. The market has become largely a game of professionals competing against each other for research and trades. In some respects the market has become more susceptible to sudden volatility within the trading day as the professionals in this interconnected world react to each incremental research element and price change. Thus, a different sort of market analysis is required to avoid being at a competitive disadvantage.

The Players

Exchange-Traded Funds (ETFs), and Exchange Traded Notes (ETNs), while relative small in terms of assets as compared with other institutions,  are selectively quite large in the intra-day markets. While the regulators believed that when they permitted the creation of these vehicles in the US and a number of other markets, that individual investors would benefit from their low cost and trading efficiency, they really created trading vehicles for fast trading professional investors including hedge funds, market makers, managed accounts of investment advisors, central banks (Tokyo), and other institutional players.

In many weeks the aggregate net transactions in ETFs is larger than those of conventional mutual funds, even though their assets are less than half of the assets of mutual funds. While there are thousands of ETF transactions in a given week, the vast majority of transactions are in a couple of products that professionals are using to invest or hedge with or without margin type leverage. According to my old firm, Lipper, Inc., for the week ending Wednesday there was $6.7 Billion in net purchases of equity ETFs; $4.4 Billion went into PowerShares QQQ Trust EFI, invested in the 100 largest NASDAQ stocks, and $1.2 Billion into the iShares Core MSCI EAFE Index fund or about 5.65% of that fund’s total net assets. This left approximately $100 million for net purchases of all other equity ETFs.

A similar pattern was present on the taxable fixed income side which had total net purchases in the week of $1.2 Billion, with $1.1 Billion into two funds, iShares 20+Year Treasury Bond ETF, and iShares Core Total U.S. Bond Market ETF.

All four of these funds could be used to fulfill the short-term trading needs of institutions. To get a feel as to how important the trading is in these products, one should look at the extreme volatility of the major stock and bond indices in the last ten minutes of a trading day as the Authorized Participants (APs) try to even up their trading books. On some days in the last few minutes the stock indices can move close to 1/3 of the daily price moves for the whole day up to 3:30. Sometimes some of the transactions in ETFs are on the short side. In October of 2016 the size of the short interest was at a record level on the SPDR S&P500 ETF. Currently it is at the lowest level in more than a year. Obviously some trading institutions were shorting due to their views on the US Election. They may have viewed this as a hedge against some long positions or it could have not been paired against other holdings.

Mutual Funds are Evolving

There is also something happening in conventional mutual fund transactions. Despite a current period of relatively good fund performance, funds are experiencing net redemptions. A careful analysis will reveal that this is not a signal of disappointment. Most of the redemptions are coming out of the Large Cap Growth and Growth and Income funds that were the major receivers of decades of inflows driven by commissioned sales people. The basic investment pitch to potential owners of funds was to provide retirement capital and to a lesser degree educational funding. On an actuarial basis a good bit of these redemptions are completions fulfilling their intended purposes. In prior decades we would not have seen net redemptions because the normal completions would have been offset by new sales of funds, except selling funds to individuals is far less profitable than it has been in part because the sale freezes the money in place for a number of years due to anti-churning rules and commissions on funds are no longer the highest level available to the salesperson.

There is another important trend that takes mutual fund dollars out of the US marketplace. While domestic funds in the week had net redemptions of $4.6 Billion, non- domestic funds had net sales of $2.6 Billion. This is understandable on two levels. The Financial Times data shows that there are eighteen national stock markets it tracks. Eight had gains of between twenty and twenty-six percent and only one of these (NASDAQ) was in the US. The IMF is forecasting only India and China will have GDP gains of more than 5%.

Chart Readers

All three of the major US stock market indices, Dow Jones Industrial Average, Standard & Poor's 500, and the NASDAQ composite started last week with a price upward gap. Often price gaps get filled before a major move occurs. In addition the NASDAQ composite daily price chart shows a reversal pattern called a “Head & Shoulders” which might be predicting a decline. As part of the market’s function to promote humility, this index is now rising near its former peak. The technical market analysts at Merrill Lynch stated that if the index breaks out on the upside it would be a failed Head & Shoulder pattern that is quite bullish. As usual there is an “on the other side” market research team at Charles Schwab that suggests that we should be prepared for a summer pull back.

Investment Conclusions

One of the reasons I came up with the TIMESPAN Lipper Portfolios® is to address this kind of situation, The second of the two portfolios, the Replenishment Portfolio, has a function of replenishing the Operating Portfolio which is designed to meet payment needs near term, or about  two years. The Replenishment Portfolio expects that over a market cycle it will be called to replenish the operating funds. This assumes that over a cycle (which typically takes four to seven years) there will be at least one down market. With this in mind Replenishment Portfolios should be examining their liquidity positions . This will be easier if they are in open end mutual funds that are not expected to “gate” or temporarily restrict redemptions in cash. In some cases large redemptions will be met with in-kind transfers. In most cases the transferred securities will be relatively easily sold.

The other two portfolios, Endowment and Legacy should not be disturbed. However if there was a serious decline one might want to switch. My data and consulting client, the late and great Sir John Templeton instructed to switch into better bargains when available.

__________

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.

Reputational Risks Await Big Money

Investment management literature usually covers portfolio manager career risks gently. This is the risk of a managed portfolio in a current time frame under-performing an index, or for the more advanced managements, underperforming peers either by accepted asset classes or better yet, by well-chosen funds. As a natural defense against career risk, too many active managers dwell on short-term variations to the index and often hide out with a somewhat closet index portfolio. From a career standpoint this strategy works when correlations between securities are close.

Reputational risks are not a composite of career risks

Many large institutional accounts have an investment committee or a board to which portfolio managers report. My British friends who I expect to visit in October call these groups a collection of the “worthies.” Generally these worthy gentlemen and gentle ladies are retired from the investment, financial, and marketing fields. Somewhat naturally these people think of long-term as a period up to their retirement from these boards/committees. This is the first risk to the underlying institution:  that the relative light hand of this governance is shorter and often very much shorter than the institution’s planned life. For endowments and other immortal bodies, their investment life is way beyond that of the current portfolio manager and their team.

The risk of comfort

Many of the members of these investment committees are no longer in the business of finding new and different major investments. Much of their focus is on the macro concerns facing the world. Numerous members have had instant favorable reaction to the latest announced moves by the ECB to permit central banks to buy bonds with maturities of three years or less. If they dig into the matter they will see that this is a way for the governments to recapitalize the banks so they can write off the government and commercial loans to the countries and companies on the periphery of “Euroland.” Similarly the committees believe they know which way the German Constitutional Court will decide, the size and shape of the soft landing in China, and the results of key elections around the world, as well as knowing the impacts of these events on short and longer-term stock prices. The broader the subject, the greater comfort they have in setting policy. I find this point of view to be frightening.

Many of the brightest minds in the hedge fund world manage “Macro Funds.” A study of these hedge funds (which have little in the way of constraints) shows how few of them have a consistent long-term record of success. In various investment committees, too much time is spent on macro judgments, which in my opinion have little chance of being meaningfully correct.

The historical trap

Investors in general and most investment committees present their views in the context of historical performance. A given number is larger or smaller than another number and that defines good or bad. As someone who for many years sold relative performance to fund groups and their directors around the world, I have often stated that performance analysis did not supply answers, but was a good place to start a dialog of questions. Many committees treat poor performance as the reason to fire a manager, without any understanding as to what caused the variation. Every good manager with a long-term record has had an uncomfortable number of periods with sub-par performance. I attempt to understand the nature of investment mistakes. Often such errors are result of making poor personality judgments on managements. Other times it is a premature or faulty choice on new product/services, sometimes it is getting out of step with a major macro change, and at times it is sloppy financial analysis. Good managers learn from their mistakes and don’t often repeat them. If one studies the cyclicality of performance, one of the best times to buy into a manager is after a period of poor results. Thus firing a manager with “poor performance” as the only explanation is probably an early sign of institutional reputational risk. 

The biggest risk is extrapolation

Most committees have become captured by immediate past history. They are like many general staffs for the military. The generals and admirals plan to fight the last war better this time. History suggests that the early success of an aggressor is based on not just tactical surprise but some believed technological or political advantage. (America does not seem to learn from this history in that once again we are shrinking our global and to some degree our technological capabilities which will likely invite a new attack for which we are not prepared. So believes this proud member of the US Marine Corps.)  In the investment world the equivalent to the generals refighting the past war is to believe that all of the conditions that are now present in the marketplace will be the same during the life of the institution. There is no awareness of a Christopher Columbus effect or the invention of the semiconductor, let alone the impact of the fall of the Berlin Wall.

Today most committees are looking to protect their image as “worthies” in preserving their assets. To me this is the biggest single reputational risk to the long-term health and respect for any institution dependent upon its investments. Currently we are in an extended period of a flat equity market and a rising fixed-income market. I don’t know when things will change; 2012, 2013, 2016, 2020 or some other initiation of a major equity market and a crumbling of fixed-income prices. I firmly believe that this will happen soon enough that an institution that is not prepared for this change will miss out on substantial amounts of easy money.

These beliefs have led me to exit a more conventional thinking investment committee after many years of service.

How to get ready?

First, reduce exposure to fixed-income, particularly high quality and do not expect high yield paper to do particularly well as spreads versus treasuries narrow as the market (with or without additional quantitative easing) will recognize the risks in the low yielding treasuries. Next recognize that each day technology marches on in almost every field of human endeavor, from new building techniques, retail shopping in person and on the Internet, the encashment needs around the world, the delivery of improved medical products and services and a need to eventually rebuild our global defense establishments. Equities should be viewed on a global basis. Dodge & Cox International fund noted that on the surface it had 40.7% invested in Europe (using the custodian’s balance sheet standards). However, management points out that 70% of its “European” investment is in companies that have 60% or more of their sales outside of Europe. Analytically this suggests that when we look at this portfolio some 17% of its sales are outside of Europe, so its exposure to the problems of a narrowly defined Europe is not what it seems. Further, one of the fund’s small positions, 1.3%, is invested in a bank that has half its market value covered by its minority investments in fast growing banks in Poland and Turkey. Whether they are counted as US or European, I believe many of our holdings in other funds have similar sound investment exposures. These views are ahead of market indexes and the ETF crowd. For the first six months this fund gained 3.3% after expenses vs. the MSCI EAFE gain of 3.0%. There are other funds being led by active managers who are also aware of these developments. As the game changes I want to be with some funds that slightly anticipate the changes rather than wait for the committee of the “worthies” to catch on to the change.

Holding cash

Should a nimble account raise cash? My studies suggest a major cash commitment, (e.g., 25% of the total value) will retard a sudden decline, but won’t produce a positive result. For many, the biggest problem with cash is that it is too comfortable and therefore difficult for many to get the courage to reinvest until the market is higher.

Our own investment committee

Even as individual investors we have an informal investment committee of people whose judgment we trust. You know who they are even if they have not been formally identified. In many ways your working investment committee is like that of an institution. You have the same problem of getting them up to speed with your own investment needs and that of your family and heirs.

Please share with me how you are refreshing your own personal and institutional investment committees.

________________________

Did you miss Mike Lipper’s Blog last week?  Click here to read.
http://mikelipper.blogspot.com/2012/09/our-arrogance-hurts-our-investments.html

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. 

Please address your comments to: Email Mike Lipper's Blog.

Inducing a Recession, Opportunities?

Reading the general and financial media, be it print or on a screen, most of us see disappointment. In part because of our disappointments with political leaders around the world, we are taking away their firepower by inducing a recession. We are disappointed with the various politicians for their reluctance to solve the growing gulf between what we want to receive as a society, and what we are willing to pay for in the way of taxes and fees. Since political leaders wish to get elected, they are reluctant to force the narrowing of this gap.

As political leaders like spending as much as getting elected, we are pressing them to cut expenses, mostly by cutting the other person’s entitlements or benefits. This less spending without an offsetting increase in the private sector will shrink the size of the global economy. Since the expected general level of demand will be reduced thus creating a recession, many are already cutting back on expenditures and have a pessimistic attitude toward investment obligations to themselves and others.

Two extreme behaviors

The first extreme behavior assumes the worst is compounded into tragic levels. Since politicians won’t lead, in this scenario we will see the equivalent of the “Man on Horseback” taking charge and forcing a solution, usually by attacking one or more groups. The dastardly actions of various dictators of the 1930s who “solved” the crushing debts of their country are the source of some people’s paranoia. Following historical precedents, the group to be attacked are the wealthy people, who fear a pillaging of their assets. This fear is palpable today for some. In an investment group meeting last week, we were informed by a third generation dealer in gold bars and coins that sales of these items for personal delivery are skyrocketing. The announced intended purpose for this portable wealth is to pay bribes to cross a border. For some, this was experienced during their lives or their parents' lives in Europe and Asia. Others feel that their wealth is threatened by various left leaning governments, including the present gang in Washington. Their demand for physicals is such that new vaults specifically designed to hold gold, and to some degree silver, are being sold in London and elsewhere. Perhaps another example of this conversion of fiat currencies is that the highest priced real estate properties are selling very well.

The second extreme behavior is that some are buying in the face of plunging stock prices around the world. The buyers could well be traders who recognize, using the past metrics, that both the S&P 500 and the MSCI EAFE are oversold by a significant amount, at least as of Thursday’s close. The other possibility is that the buyers are really investors who know something. My brother points out that our grandfather, based on decades of Wall Street experience, told us that the person on the other side of a trade may know as much, if not more, than we do.

Asian Lessons

Perhaps the rumored flirtation of the Chinese for Italian debt was aborted by their analysis that the rating agencies would lower the credit rating on both the sovereign debt and two of the largest banks in Italy, which occurred last week. A more difficult factor to consider is the announcement last week that FedEx is significantly lowering its estimate of the growth in revenues of expected parcel traffic from Asia for the rest of the year. What requires more study is whether the projected drop in growth is due to an expected dip in the sales of Christmas items in the US. Historically, we have thought of Asia primarily as exporters to the US and Europe. However, our Asian portfolio managers point out that over half of Asian exports are now done within Asia. If the expected decline in the growth of air freight shipments is due to an expected weakness in the Christmas trade, that fits with the induced recession scenario. If on the other hand, the growth of consumer demand within Asia is softening, this could be much more serious. The continued growth in Asian consumer demand is critical to my long term investment philosophy, and to others as well.

What is happening in the “Real World?”

According to a survey done by JP Morgan Chase, 75% of small company CEOs are planning to add people in the coming six months. They may feel that they have a chance to fill a void left by their larger competitors who are pulling back. What appeals to me is that there is an abundance of high quality talent available, either already separated from their employers, or people who are available for the first time.

What should Investors Do Now?

We are reducing our fixed income exposure for our long term accounts who perceive that they have extended obligations to various beneficiaries. Soon the only high quality fixed income that we intend to own will have short maturities. Periodic, planned increases in equities make sense for many of our institutional and High Net Worth clients.

What are you doing with your portfolios?
-----------------------------------------------------------------------------------------------
Did you miss Mike Lipper’s blog last week? Click here to read.

Add to the Dialogue:

I invite you to be part of this Blog community by commenting on my blog posts or by adding your perspective to the topic. All comments or inquiries will be handled confidentially.

Please address your comments to: Email Mike Lipper's Blog .

To subscribe to this Blog, or to refer a colleague or family member, use the email box or RSS feed sign-up on the left side of MikeLipper'sBlog.Blogspot.com