Money Flows: Good, Bad & Ugly

Unrealistically most investment discussions focus largely on purchase decisions and almost all the rest of the time on when to sell. In contrast, as both an investment manager and a member of numerous investment committees, our most frequent interaction with an investment account deals with flows; money coming in or going out.

In a normal (or worse, “new normal”) period, the median performance as a percent of the assets committed is relatively small, often in single digits. Most outflows are discreet amounts of money dealing with meeting legal, tax, or other requirements. In an account that wishes to stay in business, outflows should on average represent 3-5% of the corpus, or better yet, an average of 20 quarters. Offsetting the outflows are inflows of new contributions and income from the investment portfolio. In most years inflows represent a significant part of the annual performance.

The good

Whenever we are required to send money out of an account, be it a mandatory redemption requirement for an IRA,  a transfer out of a corporate retirement plan or funding a grant, I use the event as an opportunity to review the account. Rarely in a single account do we receive significant inflows at the same time as the outflows. Nevertheless, we take the same opportunity with new money to review the account for the best allocation at the moment. Further in some regimented accounts, market price movement may require addressing the need to rebalance the list to the closet limit allocation.

At the time of the flows, we rapidly decide what is best for the account looking forward to its normal investment time horizon. Notice that this review focuses on the perceived future not the immediate results within the portfolio. This might well be a wonderful opportunity with new inflows to start an investment in a new security or fund.

Somewhat strange for me of all people to say, is that we do not let past performance dictate future actions. In effect, we make the use of flows an investment moment.

The bad

There are strict guidelines for account (administrative) managers in terms of flows, particularly in large financial institutions. They usually follow one of three procedures:

The first is to divide up the flow so that proportionately the flows do not change the present structure of the account.

The second approach, followed by some short-term performance driven funds, particularly hedge funds, is to put the bulk of the flows in the best short-term performing holdings.

The third approach, favored by value-focused investors, is to put new money in the currently worst performing holdings and if the flows of the account are outgoing, take some off the top performing and/or largest holdings.

Why are these bad approaches? These are mechanical reactions and foreclose the opportunity to have an investment input. I have found that these periods of inputs can lead me to rethink the portfolio now, rather than wait for a normal receipt of documents for my review or major market move. While many portfolio managers want to make dramatic moves, there are times that an initial gradual set of moves (and more importantly, evolving thinking) produce good results.

I guess I would rather think of myself and hopefully others think of me as an investment artist, not just an investment mechanic.

The ugly

The ugly comes in two categories: the first is an immediate reaction and the second is misinterpretation of a repeating phenomenon. 

A good example of the first was the stock market action late last week. On Thursday, June 27^th, the Dow Jones Industrial Average was up 114.35 points.  On a normal summer Friday, particularly coming into a holiday-shortened week, most short-term traders do not want to carry additional holdings over the weekend. During the day on Friday the 28^th, the DJIA was aimless. However, all of a sudden in the last few minutes of the trading session, the DJIA plunged -114.89.

Almost all of the weekend news media pontificated as to the meaning of this decline, relating to the views regarding the size of the Fed’s reduction of its bond buying program. The day before the same pundits took a more favorable view of the expected actions by the Fed. Only a few noted something that I knew for over a year. On the last trading day of June each year the Russell Indexes are officially reconstituted. Index funds, mutual fund or ETF, closet indexers, and other passive funds need to own the new list before the opening on Monday. My guess what happened is that it was relatively easy to deduce which IPOs and spinoffs would be added to the relevant indexes. Once that number is ascertained on the basis of present market capitalization, one can make a very good guess as to the number of stocks that had to leave the index to make room for the incomers. These had to be sold quickly so that capital can go into the new names.

Thus, I do not attach much significance to Friday’s afternoon performance. I know of one instance many years ago when there was a disproportionate mark-up during the last hour of the last day of the calendar year when the auditors threw out prices for statement purposes after 2:30. (The market closed at 3:30 those days.) In terms of quality of numbers I have been always cautious of believing results of last days of June and December.

Mutual fund flows misinterpreted

Over forty years ago the needs of the Wall Street trading community focused heavily on the net flows from mutual funds as a guide to very early trading directions the next day. Today, recognizing that mutual funds are the most transparent of all investment groups, people focus on net flows of funds to identify current and future investment attitude. Note that almost all of the focus is on net flows. Net flows are the mathematical sum of purchases, including reinvested distributions/dividends and redemptions without distinction of whether or not the redemption is a transfer to another fund in the same family.

The math treats that buying and selling have the same motivations or purposes. I believe that this is often inaccurate. Most redemptions, in my opinion,  are completions in that the original purpose of the investment has been met. Payments are necessary to meet tuition, medical, or housing needs as well as planned or unintended retirement. A switch from a stock portfolio to a Money Market fund or an Intermediate or Short Government Bond fund probably has more to do with the near-term need of investors than a view as to how attractive the equity market is currently.

As difficult as it is to fathom redemptions, purchases are more difficult particularly if they are the result of a commission-oriented adviser or broker. Due to competitive pressure egged on by the SEC, the sale of mutual funds (particularly to individuals) has become less profitable to both the individual sales person and his/her house. The sale of private placements, real estate, and hedge funds are more profitable for the intermediaries than selling funds whose results can be tracked every business day after the initial transaction.

Until the stock market goes higher and more speculative, I believe in many periods it will be difficult for equity funds to show more dollars of sales than the actuarially-driven redemptions of Money Market and high quality Short to Intermediate Bond funds. Thus, I would not use the headline numbers of mutual fund net flows. However, I will continue to analyze the net flows within various categories of equity funds and at a greater delay the relative flows among various funds with the same objectives.

Please share with me how you use flows.

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Manager Selection in a World With Uncertain Forward-Looking Statements

The Sleeping Pill

One potential cure for the sleep deprived and a somewhat required reading for serious analysts is reading the SEC Form 10-Q of companies of interest. This is a disclosure document that details the past quarter and other periods of a publicly traded company. To make the document more useful to shareholders and/or perspective investors, the SEC requires a section called “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” This narrative gives the management a chance to explain in words what the numbers show or do not show. In order to dampen too much reliance on what is printed, there is a required additional (actually very long) statement entitled “Factors which could cause changes in the expectations or assumptions on which forward-looking statements are based include, but are not limited to.” At every investor meeting or analyst conference call reference is made to this disclosure.

Perhaps I read these turgid documents to repent for my sins as an avid follower of the mutual fund industry and a portfolio manager of a small private financial services fund.

The Nightmares

State Street Corporation is at the center of the mutual fund universe as the largest fund custodian in the world, the second largest manager of exchange traded funds (ETFs), a major provider of passive portfolio management and other services. With its impressive client base it should have a good view of the future for the investment business as well as itself. However, it lists 22 separate bullet points under its “Cautions as to Forward-Looking Statements.” In my opinion, 15 of these points are importantly under State Street’s control or at least heavily influenced by the bank. The seven that are not under State Street’s control or influence raise concerns as to the predictability of the future. I will briefly summarize them below:

1. The financial health (viability) of its counterparties as impacted by changes of law or regulation.
   
   
2. Financial market or economic disruption beyond “normal.” (To some this may be the “Black Swan” or “Fat Tail” risks.)
   
   
3. Not only the maintenance of high credit ratings, but also the level of credibility of credit agency ratings. (I believe a world without some informed credit ratings is a scary concern for all. Our fund is a long term holder of Moody’s stock.)
   
   
4. The level of redemptions and withdrawals from State Street’s collateral pools and other collective products.
   
   
5. The potential for new products and services that could cause the bank to be at operational risk and exposed to higher unreimbursed expenses.
   
   
6. Changes in accounting standards and practices. As we attempt to have a single global set of accounting standards, the accommodations to foreign issuers could cause harmful results to domestic issuers.
   
   
7. Changes in tax legislation, the interpretation of existing tax laws and the affect as to when tax payments are due.
   

The Implications

Perhaps it is very strange for me, who made money by analyzing and selling past fund performance data, to now consider State Street’s precaution that the past is even a worse guide to the future than it was in the past. The conservative management of State Street is suggesting that we should be warned that we are entering a new investment world. What this means to me is that reliance on past historic patterns could be dangerous to our wealth. Carrying this thought out, we should question the utility of various individual securities indexes like the multiple Dow Jones, Russell and Standard & Poor’s benchmarks. By definition many ETFs can become suspect of not capturing the new forces that operate within the markets.

The Exploiters

Many portfolio managers spend their entire investment life investing in the same securities. Some of these have good long term records, but that may not be of much comfort going forward if the pace of disruption accelerates. I would suggest that early general stock market investors who purchased Apple (which I own personally by historic accident) and Google after the flipping of the IPO phase ended, recognized change. Similarly, those global or international funds that were early in China showed the kind of sensitivity needed to ride the future waves.

How do you find these managers? I would suggest that it will be worthwhile to look at the new purchases shown in the interim reports. New names to the portfolio and perhaps new names for you are of great interest. Of course they have to go up in time to be very valuable. However, the willingness to buy into the unfamiliar can be a good trait, if on balance it leads to success.

A Search for New Names

If members of this blog community wish to suggest new names to me, I will be happy to publish a list with or without attribution and further comment in a future issue of this blog.


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