Sunday, January 8, 2017

Re-Risking with Bonds, China Near-Term


I have learned that one of the most risky periods to trade is when the market is open. Without the regular flow of transaction prices, one doesn't know if one is winning or losing. Thus, during all trading hours one is at risk to a significant price adjustment. Or to the contrary: opportunities to recognize investment profits. But some periods have been more prone than others to substantial price moves. We may be in such a period after a light volume expansion which appears to have topped out, and at the same time little in the way of successful shorting  and low volatility.

Re-Risking with Bonds

After 35 years of substantial gains, bond prices for high-quality paper experienced some falls. By year end it appears that the declines have just about slowed to a gentle fall, at least temporarily. Bond trading has attracted hedge funds and other speculative players. Many of these have taken losses as markets have signaled higher interest rates. These losses were  relatively small for un-leveraged portfolios, many portfolio managers feel that they have been insulted by "Mr. Market." They plan to get even with the market by re-risking their portfolios utilizing below-investment grade paper,  be it floating rate paper, loans, or high yield bonds. One can be concerned that they are creating the next large bubble. We should pay attention to that great portfolio manager William Shakespeare when he wrote the following words for the witches in Macbeth:

"Double, double, toil and trouble, fire burn, cauldron bubble...."

The re-risking has already begun with high yield bonds gaining +17.18% and floating rate paper +10.57% compared to 5.98% for the bonds issued by the S&P 500 participants. For a number of mutual fund management companies the appeal of this paper hopefully will add to their dominant bond funds which could be very useful to the groups, but particularly Eaton Vance*, Franklin Resources*, and T Rowe Price* among others. The flows are presumed to come from new shareholders who wish to participate in the rising interest rate phenomena. One sign of the popularity of intermediate quality bonds is that their average yield for the week fell 23 basis points vs. a fall of only 7 basis points for the previous week, according to Barron's. If interest and inflation rates grow slowly, and stay below a pre-determined yield point, many bond investors will not focus on the decline in the price of their bonds.

 At this point that breakaway yield is probably about 4%. Another concern is the likely default rate that is expected on this paper. Moody's* believes that currently the bid/ask spread on speculative issues is 60 basis points too narrow or phrased another way, Moody's expects greater default rate than the market does.
* Personally owned  or through a private financial services fund that I manage.

Must be in the China Funds Business

On the fifth of January two of the global fund industry’s leading groups announced long term commitments to the Chinese mutual fund business. Fidelity was given permission to establish a wholly owned fund management subsidiary in China. On the very same day it was announced that two arms of the Power Corporation of Canada* would become the second largest owners of the largest mutual fund company in China. Both of these two groups are long-term strategic thinkers that have successfully entered markets beyond their home and appear to the locals that they are local themselves. (Fidelity is one of the largest fund providers in the UK, Hong Kong, and Japan among others. Power Corp. has big positions in Great West Life both in Canada and US as well as Putnam and substantial investments within Europe.) While I don't know whether these Chinese ventures plan to offer domestic and international funds in China, I am impressed with the commitment these two giants have to their long-term expansion plans. Each has benefitted from multiple generations of their senior management families who have worked their way up to their current command positions. On the basis of my respect for these families and their companies, I feel in the future one can not afford to disregard China and the Chinese investors as even more portent powers in the fund business globally.


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Monday, January 2, 2017

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 29th) 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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Monday, December 26, 2016

Will ETFs (Factor Investing) Lose Popularity: Scientific Revolutions and Humility


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