Mutual Funds for Users and Competitors

Introduction

I have devoted my career to the study and use of mutual funds for my clients and family. Almost everyone that has been exposed to the media discussing investing has an idea about mutual funds. Just about every professional investor regardless of investment vehicle competes with mutual funds for talent, securities, and cash flow. Unfortunately be they the media, academics, regulators, general investors and even many mutual fund investors they have an incomplete and often flawed view of mutual funds. This is understandable as mutual funds start as a legal entity, not a group of people trying to accomplish an investment goal. The language of lawyers is designed to protect their paying clients, not to communicate users and bystanders.

Vehicles

We regularly use various types of vehicles to transport ourselves or other desirable objects such as water and freight. Staying with the vehicle analogy, your personal car, Uber or taxi ride, takes you to a specific planned location. A mutual fund is more like a bus. The bus takes a group of people, often strangers, from one planned location to another. Along the way passengers enter and leave to fulfill their private needs. The announced elements of the implied contract include expected times of departure and arrival, cost, and to be governed by more restrictive rules as to presumed safety. In a similar way mutual funds have a generalized statement of investment objective, a published price structure covering fees and expenses, regular reporting procedures, and more restrictive sets of rules usually promulgated by various regulators (SEC, IRS, DOL, various states, etc.) In my opinion these rules are more about what lawyers believe should be disclosed than about actual safety elements. Nevertheless they provide some useful information that are not provided to the same degree by other investment advisors or institutional investors.

Advantages of Mutual Funds

Mutual funds are the single most regulated investment vehicle and make both their performance and portfolios available for public disclosure. Many mutual fund management groups also advise pension and profit sharing plans, endowments, and separate accounts for wealthy individuals and families, plus in some cases hedge funds. Most often the media uses mutual fund reports as a clue what the institutional community is doing.

Thus, an element of misunderstanding occurs as mutual funds were originally designed for long-term investing not short-term trading. Mutual funds should be reviewed over long periods of falling and rising markets. Over these longer periods, it is rare for a fund to be a financial  failure; i.e., bankrupt. The reason for their longevity is they are often quite diversified in their portfolios. Just as diversified as the different types of people on the bus as distinct from a sole driver or a very small group of passengers who have more in common than those on the bus. This is one of the reasons that it is a bit foolish to compare the performance of an individual stock with most mutual funds. (More on this later when discussing funds vs. indices.)

Often investors in mutual funds do not appreciate for what they are paying. For many fund holders their monthly, quarterly, and annual statements represent a record of not only their performance but their ownership for tax and estate purposes. Further, funds use their best judgments in voting the funds’ securities particularly in complex transactions. Fund owners are paying for a somewhat independent review of all of the fund’s activities including fees, expenses, and other elements of potential conflicts of interest. This independent review is not found in separate accounts including various types of retirement accounts.

Perhaps for some or all of the reasons mentioned, institutions which because of their size and presumed experience also choose to invest in mutual funds. According to the latest data from the US fund trade association, 13.46% of fund assets are held by institutional investors utilizing equity, fixed income, and money market funds.

Understanding Fund Flows

Various studies focusing on how our brains make decisions, (including financial decisions) indicate that external forces, often other people, cause us to choose various decisions that perhaps seem on the surface to be irrational. Thus it has often been said that mutual funds are not bought but sold. The sales person may be a human or electronic as well as an image that has been created through paid media or public relations.

Reasons Why a Human Advisor is Necessary

One of the disadvantages of owning funds without a human investment advisor consulting with the fund owner is that when personal or investment conditions change the owner does not have the cautionary warning as to the shifting of spending, investment strategy, or redeeming too early. Investors purchase funds to meet various goals and when they think their goals are being met their instinctive reaction is to redeem their fund shares. Thus I look at most redemptions of long-term funds as planned completions. In recent years the combination of forced early retirements, rising college tuition support, and gyrating home prices has, in my opinion, accelerated the rate of gross redemptions somewhat higher than what prior actuarial trends would have suggested.

Mutual Fund Macro-Economics

Because of the growing wealth of the US, particularly through population growth combined with rising real wages, the dollar value of new fund sales were larger than the redemptions, leading to an industry of growing net sales. This has not been true for the last several years, as the old growth model has flattened, but also for another reason. There is a change in the economics of selling funds. Many distributors; i.e., brokerage firms, have materially reduced their efforts of selling funds. (Charles Schwab^*  has just announced that it is no longer going to sell load funds.)

^* Held in the private financial services fund account that I manage.

To avoid being accused of churning their accounts, brokers and to a degree investment advisers have kept fund positions with average ownership turnover rates dropping well below the historic norm of five years. Some funds are experiencing turnover periods of two years or less. When capital is freed from funds it is redirected into more currently profitable products for the intermediary, including sales of private equity, various other underwriting, real estate related, and margined securities. Numerous fund groups have interviewed redeeming fund shareholders, perhaps the they are being too polite, but they do not detect a large amount of dissatisfaction with funds during these interviews. Thus, I have come to believe that what we are witnessing is part of the economic cycle as well as a change in industry economics that is evolving.

Funds Should Be Compared with Funds Not Securities Indices

One of the reasons my old firm was successful in convincing the independent directors of funds is that they recognized that the funds that they responsible for operated under different constraints than indices as shown below:

Index	Funds
Find Central Tendency	A legal creation to comply with SEC, IRS, Treasury, Federal Reserve,  FINRA, and regulations of various US states
No prudential requirements	Court-overseen limits as to portfolio composition
No tax implications.	Tax influenced decisions
Accept last price	Unrepresentative prices can be discarded
Not audited	Audited and examined
No diversification limits	5% and 10% rules for most funds
No cash	Cash required to meet redemptions and opportunities
“All Weather”	Time span and market conditions oriented

If I am being too cryptic please contact me for further explanation.

In our managed accounts we use index or passive funds along with active funds when we are seeking winners. There are a number of reasons to use passive accounts including the following:

•        Greater liquidity to meet sudden cash needs in periods of turmoil.
•        To lower the weighted average cost of the account when using higher fee active managers.
•        At times and in some investment objectives greater diversification is needed.
•        At perceived bottoms when active funds have too much cash.

Active funds have a place in our client accounts for the following reasons:

•        There are times that a portfolio of growing operating earnings that uses excess cash for acquisitions of under-used properties or activities is wise.
•        When we are seeking extreme concentration.      
•        When we are looking at undervalued voting interests.
•        When we want to bet on successful managers who need to prove that they can recover their winning ways.
•        When we are reviewing cyclical companies and asset classes in anticipation of near-term turnaround.
•       When passive vehicles won’t do the job.

As one can see, our management does not key off of near-term performance, but rather properly positioned portfolios and research capability for future (not present) markets.

In my personal account I mix both active and passive funds along with individual securities, mainly in the financial services businesses.

_________________

P.S.  I have been asked about my reaction to the winner of the Kentucky Derby. Regular readers know that much of my investment thinking began at the race track. I was out of the country and did not see this year’s Derby, thus I will briefly focus on betting the next race for an undefeated colt using my standard mutual fund  performance  analysis approach.  The next race, presumably, The Preakness, will send the colt off at very short, probably prohibitive odds.

 
Racing as with investing always is subject to unknown and unknowable factors. Thus  I would not place a bet on the Kentucky Derby winner, but look for a longer odds horse to place or come in the first two spot

_________________

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, please subscribe using the email or RSS feed buttons in the left column of MikeLipper.Blogspot.com 

Copyright © 2008 - 2016

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Selling, Risk, and Liquidity

Introduction

“Drive for show, but putt for dough” is an old expression on how to win at golf. The vast majority of investment advice is about buying securities that are expected to go up in price. However, the terminal value of investing is the final conversion of paper wealth to spendable cash.

While investors in individual securities can benefit from my thoughts, my comments are directed at institutional and high net worth investors that have one or more portfolios of mutual funds. Those that own multiple portfolios of mutual funds should modify these comments due to the different expected timespans for each portfolio. (These can be discussed privately, if you would like.)

Drive for show

When a competitive golfer addresses his or her tee shot at a crowded first tee almost all the comments will be on the distance and direction of the first shot. However, the first shot is only positioning for the follow-on shots and in the end the key is how many shots it takes to complete the hole. Thus to some extent the first shot is like relative performance versus peers or benchmarks. If all you know is how good the drive off the first tee is, you really won’t know about the ultimate success of the player. Therefore, what the investor wants to capture is the cash conversion from the ultimate sale as one can not spend relative performance.

The more professional golf observer would pay attention to the form of the golfer, the particular club that was used, the amount of power the player used in hitting the ball, and the tactical position of where the first shot landed. If I knew these things I would be in a much better position to judge whether I wanted to bet on the success of the player rather than just remark that he/she hit a nice first shot. Applying this to the fund selection puzzle, I am much more interested in the process and procedures followed by the manager of a fund than their current relative performance.

Relative performance is a rearward looking device. We get paid to make future judgments and thus I am much more interested in the way  managers addresses their task, such as:

a)    What tools are likely going to be used?

b)   The time spent on studying the opportunities

c)    What comparisons with other opportunities in the present or past time periods?

d)   Compensation pressures, which might impact decisions?

e)    What does one know about the competitors that are playing in the game?

f)     And finally, what is the pattern of flows going into and out of the fund?

Since our major investments occur after several visits or points of contact, any changes in these processes or procedures need to be understood. We expect there to be changes as we live in a dynamically changing investment world. If there were no changes there is an increase of being blindsided.  Each of the items listed above can have an impact on future performance beyond general changes in the market. Our objective is to use process and procedure changes as early warning signals to begin to exit a meaningful position. To quote Sir John Templeton, “Progress requires change. Focus on where you want to go, instead of where you have been.”

Three reasons to sell

The first reason to sell is an actual or expected change in the nature of the account. This is particularly true if the account requires a higher than expected conversion to cash for operational spending needs.

The second reason to sell is actually to buy; the late Sir John said “the reason to sell is to buy a better bargain.” (We have had the honor and pleasure of supplying special data reports to him and also being called down to Nassau to consult with him and his colleagues.)

The third reason to sell is if some important deterioration in the process being used or fundamental change in the longer-term outlook for the investment occurs.

What to sell

Anytime one needs to add or subtract from a portfolio, the whole account should be reviewed. The change is an opportunity to partially redirect the course of the portfolio. Thus, the first pass should be to see whether the various components of the portfolio are properly balanced in today’s environment and future focus. This could be the ideal time to reduce a position that has gotten to be way out of balance. Depending on the nature of the account the natural barriers might be 10%, 20%, and 25% for an individual sector. In terms of a balanced account, the fixed income range should be between 25% and 60% with equities between 40% and 75% in most cases. If one is not hurried, changes should be averaged in or out over at least three time periods which can be days, weeks, months, or quarters.

The role of risk

If the account is all of the money of an institution or an individual without any expected new money coming into the account, a prudent investor needs to weigh the impact of a loss of capital on future spending needs. In the same light the investor needs to understand that the risk of not growing capital and therefore income can be a bigger risk than some downside diminution particularly after taxes and likely high inflation. While I am very conscious that various studies have shown that individuals feel a loss 2 ½ times more than a similar amount of gain, nevertheless for most tax-exempt institutional accounts whose demands go up on a countercyclical basis when economic times are poor, the risk to the organization of not growing the capital base is worse. A less than optimum capital base puts extreme pressure on earned income and fund raising in difficult times.

The role of liquidity

Another former client, Howard Marks, of Oaktree Capital Management wrote about liquidity in this week’s Barron’s. He said that liquidity is not important until it becomes vitally important. Further he characterizes liquidity as transient and paradoxical. Liquidity is the ability to get the last published price in a transaction, particularly when one is selling in troubled times. Normally mutual fund investors are not concerned about liquidity because when they place their redemption order they know it will be executed at the price (net asset value) calculated for the next close of the market. However, some fund investors may be surprised by the gap between one day’s price and the next one.

Some SEC commissioners and certain members of the US Congress are concerned about the potential evaporating liquidity in the bond market including US government issued debt. The professional investors (hedge funds) invested in various debt and equity Exchange Traded Funds (ETFs) could overwhelm the marketplace with a wall of redemptions, which will probably be met by the market makers immediately selling the heavily weighted securities in the ETFs which will put more price pressure on the final net asset value for the ETF and the companion mutual fund.

As a student of the market for over fifty years I would urge fund holders not to panic during troubled periods and add to the forced sales. Well designed investment portfolios of mutual funds should survive the decline and could be very well positioned for a subsequent rise.

Question of the week: For your accounts is there more risk on the upside of not generating enough future capital than on the downside of avoiding forced losses?  

__________    

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

Comment or email me a question to MikeLipper@Gmail.com .

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 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.