Insights from Mutual Funds in 2016 and Their Influences in 2017

Mutual Funds are Important to all Investors

First, funds are an important part of many publicly traded markets around the world. On a global basis they hold more than $44 Trillion dollars today.

Second, funds provide more relevant disclosure than probably any other financial sector.

Third, much of the less well disclosed institutional investments are managed by people who received their early training in the mutual fund business. Large financial institutions often manage mutual funds in addition to their other accounts.

Fourth,  in most countries mutual fund boards include independent directors and in most cases those independent directors represent the majority of the directors. In the US the annual investment contracts must be approved by the independent directors. These directors  have civil liability for their actions (or the lack of action).

Fifth, most mutual funds are managed by privately owned management companies or are part of large multi-product organizations such as banks and insurance companies. However, in a number of global markets there are publicly traded mutual fund management companies. Their disclosures reveal important trends as to the profitability of money management and related information. From time to time we have found these companies to be worthwhile investments.

Sixth, with the world's growing retirement capital deficit, it is important to recognize that mutual funds are a major gatherer of retirement capital. Of the $16 Trillion invested in US mutual funds, $7.5 Trillion were in identified retirement accounts about equally divided between employer-sponsored Defined Contribution Plans and Individual Retirement Accounts (IRAs). Upon exiting from employer plans, investors often place money into IRAs. 

The total US retirement market is $25 Trillion with the Defined Benefit Pension market flat and expected to decline as employers choose to shed the accompanying fixed and growing liability.  There is ample scope for Defined Contribution plans to grow and could lead to an increase in the size of the mutual fund share of the market. The average individual mutual fund is currently held between four and five years, more than twice the holding period for Exchange Traded Funds. Due to the lengthening of people's retirement period it is reasonable to expect that IRAs will remain open for at least twice to possibly four times the non-retirement money in mutual funds.  

Insights from 2016

1.   In the US market there was more money entering the fund business than leaving. From first glance, most of the net gain went into Money Market funds. However this gain occurred during a time when the number of funds declined. Due to changes in regulation most of the decline occurred in the Prime Retail Money Market funds arena. Considering the emotional turmoil caused by the US election and rising interest rates, it is not surprising that money flowed into Money Market funds. While a portion of the money in these funds will never enter the long-term mutual funds arena, some will.

2.   Due to automatic reinvestment of income and capital gains, distribution funds have another source of inflows other than net sales. For the first eleven months of 2016, reinvested dividends of about $42 Billion came in from this source to Long-Term funds which meant for the eleven months the flow into Long-Term funds was positive.  

3.   Appropriately in November there were net redemptions in bond funds for the first time. The redemption rate slowed for equity funds, particularly for World Equity funds.

4.   In the shortened time horizon that many advisors and brokers are using with their accounts, they are relying on the correlation among mutual funds and ETFs.  But these are not currently working. In the performance reports issued by my old firm, Lipper, Inc, now owned by Thomson Reuters, there are twelve investment objective averages of compound performance for the last five years (through December 29^th) between +11.83% and +13.80% . Nine of the thirteen were clustered at the 13% level. A nice tight group. These are funds grouped first by the size of market capitalizations within their portfolios. These include Large, Multi-Cap, Middle-Cap and Small-Cap. They are further sub divided by investment objectives into large, core and growth.

In 2016 the close correlations exploded. The Large-Cap Growth funds averaged a gain of +2.49% and the Large-Cap Value funds gained +14.93%. Hardly a tight correlation. Thus the fund selection criteria became critically important. Market capitalization did not help meaningfully in terms of the Large Cap. Actually if one ranked performance within this subset of 12 investment objectives, Large Caps where most of the money is, came in fourth behind in rising order, Multi Caps, Middle Caps and the winner was Small Caps.

Within the market cap segments, the choice of investment objective was even more meaningful. In each case the Value funds did better than the Core funds which beat out the Growth funds. Thus in the 12 fund categories analyzed, the best was the Small Cap Value funds which averaged +27.25%, compared with the previously mentioned +2.49% Large Cap Growth.

The real lesson in owning the best performing funds in 2016 was selection not correlation.

Looking Forward to 2017

1.   Though we are in a period of annual forecasts, in many respects it should be called the period of extrapolation. Most people including analysts and other pundits  draw on what they call the use of the brains, but their real pattern is elongating some past trends into the future without limit. This is natural and is discussed in a book entitled Seeking Wisdom from Darwin to Munger which was sent to me by Charlie Munger. The book ties in with the work that I have seen from Caltech; that the brain is essentially a memory device of personal experiences. Really bright people are not limited by their own experiences, they seek to learn from others' experiences current and past. That is why I say that if you slice a vein in a good analyst, an historian will bleed. Many of the published forecasts that I have seen as of today either extend the 2016 trends or one from November 9th. In my mind neither group has learned the lessons of 2016 which could be summarized as follows:

• Search for what is not in the data.
• Events can change perceptions.
• Many people are not forthcoming as to their plans.
• There is a need to learn from others with different backgrounds.
• Doubt much you have been taught.

2.   As one who is often described as a contrarian, I need to warn that after accruing the benefits of being a contrarian in 2016, there will be some times when the apparent majority will be right. (For a while and to a limited extent.)

3.   Unless you are primarily trading, looking at new highs is not often productive of big winners. My investment strategist son suggests one should look at the new low list which could be a better hunting ground for research. He is also more focused on industries rather than large segments of the market. For me, I focus on individual management of businesses that Charlie Munger and Warren Buffett would find of interest.

4.   Many Frontier market securities and some Emerging Market stocks have been beaten up pretty hard. In selected cases their prices have much less risk within them than before.

5.   The only two fixed income categories showing double digit gains for 2016 were High Yield funds +13.25% and Emerging Market Hard Currency Debt funds +10.75%. Be careful in 2017, these are taking on equity type risks without enough equity type gains.

6.   One possible way to gauge the level of excess enthusiasm is the cost to hedge against continued growth. It has been pointed out that the cost of hedging the enthusiasm for Small Caps is that the cost to hedge the Russell 2000 is very low. Options to protect against a decline in the iShares Russell 2000 ETF  haven't been this cheap since August 2015. While there could well be technical reasons for this, one should be on guard anytime it is too cheap to hedge.

7.    One of the lessons from the election campaign is that many in the middle class and the working rich feel that the economic future is limited. In the past many of these people would have been mutual fund buyers. It is their absence from the marketplace, not disappointment with results, which has impacted fund sales. To the extent that their post-election elation is real if they come back into the market, the bears on mutual fund management companies will once again be proven wrong.  

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A. Michael Lipper, C.F.A.,
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Will ETFs (Factor Investing) Lose Popularity: Scientific Revolutions and Humility

Introduction

Contrarians should always be looking for what is not present or expected. Exchange Traded Products or Funds are modern applications of traditional analytical screens. The established, top-down approach to selecting what to research in order to achieve investment success is a five step process:

1.   Economic/Political Overlay to Market Belief

2.   Segment Identification

3.   Security Selection

4.   Trading Requirements

5.   Timing of Purchase and Probable Sale

ETFs invest entirely in a segment. This can be a narrow segment such as an industry or a broad segment such as the components of a stock or bond index. Importantly, there is little to no additional cash to meet withdrawals or to provide flexibility. Components are selected by rigid prescribed rules.

The big advantage to this type of investing is that for many investment advisors, traders, and individual investors who believe them to be sophisticated, the choice is simple and takes far less time than what we do in a multi-step selection process. The brevity and decision speed makes these products attractive to individuals and organizations that can instead spend their time raising money or other worthwhile activities. In a number of global markets (largely stock markets), the gross inflows into these products is in the same range as the traditional long-only mutual funds. (Not all the purchases of ETFs are intended as a single, long-term investment. I believe a good bit of the reported net flow volume comes from trading elements as part of a complex strategy of being long or short other instruments, using ETFs as a hedging device.) 

With rare exception the use of ETFs has proven worthwhile as long as the various brokers and investment advisors’ selection, weighting of portfolios and timing has been reasonably good. I suspect that this has not universally been the case.

Real World Selection Processes

Many of us are happy with our marriage and other partners. Most of us are choosing to live in homes that were not selected solely by statistics. In many cases throughout our business careers we did not always pick the highest compensation offered. In each of these critically important choices either consciously or subconsciously we used a multi-step decision tree not too different to the five steps outlined above. I prefer to think that a multiple step process would lead to a more comfortable result than just buying the S&P500 Index fund, Financial Services fund, or a Single Country Developing Market fund.

Natural Law and Scientific Revolution

Over the Christmas holiday I had a deep discussion with our long-term family friend Mark Massa, SJ. This Jesuit Priest is working on a new book that is focused on the development of natural law relative to the evolution of scientific revolutions. Because I am a non-alumni trustee of Caltech, he asked me to read a section of the book which discusses Thomas Kuhn, an historian of science in a best seller, "The Structure of Scientific Revolutions."  Remembering discussions in my ancient school as well as Caltech about how “The Scientific Method” really worked, with most of the gains coming from "mistakes," I became sympathetic to Professor Kuhn's work. Normal science appears to rest on an agreement reached by a majority of scientists of a particular discipline, while the majority agrees there were always some contrarians. Instead of nice neat solutions, there were always some parts of the physical universe that were out of place in the picture painted by the accepted scientific law. These laws were meant to be universally predictive. Exceptions inevitably appeared so that the once the unthinkable  suddenly became thinkable.

Past Performance is Not Predictive 

While I made a reasonable living being the guardian of mutual fund performance records, I totally believed that past performance was not totally predictive of future results. Yet those advocating the use of constrained exchange traded portfolios are relying almost exclusively on their past records. To me the construction of market indices, (I created many) is a backward looking device. Most of these vehicles were created by publishers not active portfolio managers. Further, based on technological and legal/accounting evolution, narrow industry definitions change. I remember when analyzing steel companies, the steel company in Chicago was worth more than those in Pennsylvania, as Chicago was in a steel deficit region. Due to the cost of transportation, the Chicago steel producer could get premium prices and margins. Over time that advantage disappeared. Often just looking at financial statements one would miss a critical change such as at one point the profitability of color television tubes was the key to the profitability of TV set manufacturers.

Possible changes to the deductibility of expenses and different levels of tariffs, bring into question the predictability based on the past. In some cases, changes of reported earnings could be substantial because of changes in accounting and court settlements. An investment advisor who does not consider these and other changes is not only putting his client in a potentially risky situation, but also possibly his or his/her company's practice.

How Little We Know

In addition to the normal cautions about survivability, is the less mentioned historic truism: that the only guaranteed product of investment is humility.  Marathon Global Investment Review has a useful quote from Daniel Kahneman, "We have very little idea of how little we know." One of my concerns for high reliance on the use of ETFs is that there is no built-in flexibility to be able to change the portfolio. Actually the only thing that I promise my accounts is that I will make mistakes, but hopefully recognize them quickly and begin corrective actions soon.

Too Much of a Good Thing
 

I worry about “too much of good thing.” The current level of market enthusiasm is too high and suggests very little can go wrong. Many professionals have been trained to view the VIX measure from the CBOE as a fear gauge. The peak reading was 80, and averages about 20, and on December 22nd it dropped to about half of the average. Just on general principle, when others are not worried, I am concerned.

To my readers, their friends and family, I wish a Merry Christmas and a Happy New Year.  This next year may prove to be quite different from what we have experienced.

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Short and Long-Term Unseen Implications

Introduction

Being solely a contrarian is insufficient to be a competitive investor. There are instances when the majority is correct. To improve the contrarian's odds the search for seeing elements that others don't is essential.

Since the presidential election there has been a dramatic blast of enthusiasm for US stocks and a disdain for high quality bonds and emerging market securities. While the positive effects of rising interest rates have been present for a number of months, the equity acceleration began almost immediately after the election. One might be accurate in believing that all those who were so wrong about the outcome of the elections at every level were attempting to play catch-up by doubling down their bets. In both cases their views were narrow and lacked fundamental knowledge.

Early Contrarian Training

In the 1960s I was a journeyman electronics analyst. The technology to produce color television had been known since the 1940s if not before, but the projected retail cost for a set was over $1000. My analyst peers focused their time on getting up to date on all the technological advances in components for the set. Unlike them I spent time with the marketing research people of the major set producers. In turn, they were very focused on how middle market consumers were spending their money. By the mid to late 1960s, the portion of consumers’ budget devoted to auto purchases had peaked as the post WWII replacement surge had peaked.  Thus they were ready to buy their first color television at prices over $600, and some up to $1000. That perception allowed me to be early in recommending color set producers and some of their component suppliers before my more technologically-oriented competitors were waiting on new breakthroughs.

There are Two Important Elements the Enthusiasts are Missing

The people that were so wrong about the Republican surge in the election are making the same mistake again. They are taking what Donald Trump has been saying as a concrete plan for his and the party's actions, just as they misread the polls for two generations wanting an outsider to have someone to listen to them. It didn't matter whether they were on the right or the left of the political spectrum. To some extent Mr. Trump's fellow elected Republicans have not fully accepted the implications of the recent elections.

The issues for the Republicans comes down to how they will vote and how will they manage their attempts to "drain the swamp." I believe (somewhat naïvely) that the investment bulls believed explicitly in the words of the candidate and President-elect in terms of both corporate and personal taxes. One needs to remember how tax proposals become laws and regulations. The House Ways & Means committee, after what will be strenuous debate, will eventually report out a bill to the full House where there will be further debate.

Any reductions in the net tax realization of revenues will increase the size of the deficit unless one accepts dynamic scoring that suggests that tax reduction will expand tax revenues through growth. The political problem facing the Administration's desires is in the House where there are a significant number of Republican deficit hawks who probably feel that they can not get re-elected if they vote in favor of an increased deficit. It is quite possible before a tax bill can pass the full house some Democrats will need to be in favor of it. Traditionally this support is purchased with some very specific policies favored by the Democrats which the Administration would have to signal approval. Subsequently the Senate will pass it's own bill setting up a joint congressional committee to work out the differences so that both Houses can approve the legislation. Both houses' majority leaderships will appoint members to the conference committee from both parties. These will likely be their most senior tax aware members. Eventually a compromise bill will be agreed to in the small hours in the morning between as few two members and a small number of their staffs. Due to their exhaustion and some lack of familiarity of the wording of tax regulations, the committee will get help from selected lobbyists from the deepest part of the swamp  will suggest the actual language to be used.

At this point hopefully the majorities in both houses will vote to pass the tax bills on to the President for enactment. For the investment bulls to believe that they can guess both the timing and the actual impact of the legislation on specific corporations and individuals is naïve. 

In many ways the easiest part of the governing process will be the passed legislation. Particularly for the incoming Republican cabinet the much more difficult process will be the actual administration of the ensuing regulations that the multi-generational government workers will write and administer. Just look at how almost every government body is actually managed by career people from "the swamp." Good luck without substantial help from "K Street" lobbyists to guess the actual implications for various taxpayers.

The chattering classes are assuming that by a swipe of the pen the President can in the long run effectively change regulations through executive action. Regulations were initially put into place because of perceived problems; some valid problems will need to be addressed for the protection of certain groups. The tradition in government is that even when totally free market people are put in place they will drift to the bureaucratic tendencies of command and control policies. In all likelihood those that will be actually administering the regulations at the local level will believe in the command and control philosophies.

The Second Misreading

The general rise in stock prices in many markets is being taken as the public' s affirmation of the results of the election. I believe that far too many people are not looking carefully at the underlying data and drawing, at the moment, the wrong conclusions. Most of those that wanted to be labeled "the smart money" were totally convinced that the US would have its first female president. Recognizing that probably meant at best a continuation of slow growth in a market that was close to being fully priced on election eve. They were short the market or  at least a number of stocks. When they woke Wednesday morning these "investors" became traders and quickly attempted to cover their shorts in a relatively thin market at higher prices. Soon thereafter to make up for their losses they went long the stock market and short the bond market.

The faulty analysis of the US stock market, at least in part, was due to the headlines that mutual funds received substantial inflows and therefore would be heavy buyers. As usual people should carefully examine the underlying data. The quoted numbers combined traditional mutual funds with Exchange Traded Funds (ETFs). Utilizing the data from my old firm, one could see that for the month of November traditional US Diversified Equity funds had net redemptions of $+38.6 Billion  up from $+22.3 Billion in October. On the other hand for the same types of equity portfolios,  ETFs had net sales of $+33.2 Billion up from $+11.2 Billion on October. Perhaps, even more significant ETFs investing in specific sectors had net inflows of $+13.4 Billion up from net outflows in October of $-1.3 Billion.  

The significance of these divergent trend is that due to the length of time many traditional mutual fund holders have owned their funds they are approaching a period of their lives that are choosing to either becoming more conceived conservative with their money and/or their need for cash has been rising. Judging by the volatility of ETFs transactions most of the transactions are from trading entities often hedge funds or professional traders. Some of their transactions are part of "pair" trades where they take a position long or short on a specific issue, but also hedge either general market or a sector against their primary choice to reduce general market risk. Thus, the main motivations of the owners of traditional mutual funds and ETFs are in terms of likely timespans of their holdings are different. Mutual fund holders own their shares for more than four years, often for twenty, where as the ETF holder is probably focused on the month's or quarter's performance.

Thus, I do not believe that there is a general affirmation of the policies of the incoming administration at this point.

Short Term Views

It is quite possible that this last week was something of a mild turning point in the market. Each week I look at the mutual fund performance of our clients' fund positions. I compare their quintile rankings versus their perceived peers. In most periods for most funds there is relatively little movement. However, among the many funds we follow, in this week, eleven of our funds (after doing among the best in the four weeks ending December 8^th) did relatively poorly in the week ending on the 15th. On the other hand we had four funds that materially beat their four week average. What this pattern suggests is not that there were materially changes in the funds' portfolios, but that the market is questioning the very recent strength.

In a piece on the views of ten well-known investment strategists picking their favored industrial segments, eight picked financials which clearly have been doing well. As a portfolio manager of a private financial services fund, this near unanimity of opinion makes me nervous. Bob Farrell, one of the all time great market analysts was quoted in Barron’s saying, “When all the experts agree, something else is going to happen.”

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Copyright © 2008 - 2016

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