ETF and mutual fund problems last week

Both types of fund, exchange-traded and mutual, had issues throughout last week in calculating their per share net asset values .

For fund management firms, the lack of end-of-day mutual fund pricing was a real pain.  For us as investors, however, the ETF consequences were far worse.

mutual funds

The best feature of mutual funds, in my view, is the guarantee that under all but the most extreme circumstances owners can buy in or cash out every trading day after the close at net asset value.   Last week, because of the computer failure at BNY Mellon, the funds that it prices didn’t have NAV information.  So they had to estimate NAV to do daily transactions.

Once they have precise NAV information, they can adjust the number of shares that buyers from last week actually have.  For people who have cashed out, though, it’s not so easy.  If a fund paid too little in a redemption, it must forward the extra to the seller once it finds out.  If, however, it pays out too much in redemptions, most sellers won’t voluntarily return the excess.  The fund may not even ask, either because it doesn’t want embarrassing publicity or because it knows the cost of suing the seller to get the money back will doubtless exceed the potential return.  The fund will presumably try to get BNY Mellon to make good any losses. Failing that, the fund management company has to pony up.


ETFs are basically mutual funds that let designated brokerage firms handle the buying and selling for them.  This makes ETF expenses noticeably lower than those of a traditional mutual fund.  It also allows the ETF to trade all day, rather than once after the close.  These are the main ETF pluses.  The offset is that potential buyers and sellers have no assurance that brokers will be willing to transact at any given time and in the amounts they wish to.  We also have no guarantee that transactions will be at, or even near, NAV.  For those of us who are long-term holders or who place limit orders, neither shortcoming should be a big worry.

Then there was last week.

Last week, the ETFs normally priced by BNY Mellon had no current NAVs, only guesstimates.  This had two related consequences for investors:

–Brokers became reluctant to trade, since they couldn’t be 100% sure any bid-asked spread they made would be profitable on both sides (for most ETFs, they had to have had a reasonable idea, I think).

–And they widened the market they made from, say, + / – 0.5% around NAV to a lot more.  On Monday, for example, I decided to throw a long-time clunker in my portfolio overboard and replace it with an ETF.  I soon found that I could only buy at NAV +3%.  And even a small transaction at that price took half an hour to complete.

A lot orse than that happened, however.

The Wall Street Journal offers this account of ETFs during trading early Monday of last week:

“…the $2.5 billion Vanguard Consumer Staples Index ETF …plunged 32% within the opening minutes of trading. The Vanguard Consumer Staples ETF was halted six times over the course of 37 minutes early in the day, according to trading records.

The declines…were notable in that they exceeded the declines in the prices of their underlying holdings. In the case of the Vanguard Consumer Staples ETF, the value of the underlying holdings in the fund fell only 9%, according to FactSet. (my emphasis)”

Yes, Monday was a bad day.  But it wasn’t a terrible, horrible, no good, very bad day, of the type that occurs occasionally in a bear market.  This characteristic of ETFs–that market makers swing the bid price waaay down in times of stress–is one that all of us as investors should be aware of.  As far as I can see, it’s also something the ETF industry has deliberately de-emphasized.  I don’t think it’s a reason not to own ETFs in the first place.  But there will surely be times in the future like last Monday where the price for cashing out is 20%+ of the value of your holding.  So I think most people shouldn’t be holding only ETFs.  Trying to sell them in a market downdraft should only be a last resort.





acting in repsonse to last week’s market gyrations

Everybody’s first reaction to a period of falling markets is to pretend that nothing unusual is happening and not look at his/her portfolio.   My experience is that “everybody” includes the majority of professional investors.  There are, however, two measures we can take to strengthen our portfolios if we have the courage to analyse what has happened to our holdings during a volatile period like the past six trading days.

We can:

–gather information, and

–act to modify our portfolio structure.

gathering information

Professionals have performance attribution software, which will calculate performance vs. an index plus a holding’s contribution to overall outperformers/underperformance for any/all of their stocks/funds over any period.  I do the stock by stock performance calculation by hand and then rank the outperformers/underperformers by their impact on the portfolio,  rather than trying to figure out exact performance contribution.  I find that’s good enough.

What I look for:

Aggressive stocks will typically outperform on up days and underperform on down days.  Defensive stocks should do the opposite.  Performing in line with their character is no news.  But stocks that outperform on both up and down days are.  So, too, are dogs that underperform no matter what the daily market direction. I think there’s inevitably a message that the market is sending through such stocks.  It’s well worth trying to figure out what that must be.

Time permitting, we should also look at representative stocks not in our portfolios to figure out the same thing.  (Professionals also have this comparative information, for all the stocks in the index they’re competing against, available at the push of a button.)

Note:  results for ETFs may be problematic, since a computer failure at BNY Mellon, which prices many ETFs for others, made NAV quotes for many unavailable last week.

The S&P 500 was down by 2.3% over the past six days.  Although this is a short time, arguably a defensive portfolio should have done better than this, an aggressive one worse.  If I think I’ve built a defensive structure and my portfolio is down by 6%, I should probably rethink what I’m doing.  If my “aggressive” portfolio is down by 1%, I should be thanking my lucky stars–but also trying to figure out whether this is due to excellent stock picking or to poor construction.  If I’ve accidentally assembled a collection of stocks that acts contrary to what I intended, I’ve probably got to at least ponder how to change it.

Early last week I tossed one long-term clunker in my portfolio overboard and replaced it with what I consider a better stock.  For trades like this, I also ask myself how that’s turned out so far.  Admittedly, a week is a very short period of time.  But this will give me an idea whether I have a good feel for current market action or not.


I’ve often begun the process of analysis and reconstruction thinking that I should make my overall holdings either more aggressive or more defensive.  Almost always, I end up making changes–but they’re virtually never the global ones I’ve intended.  Instead of altering the direction of the ship, I find myself patching holes in the bottom of the boat instead.  This usually improves the portfolio, and it prevents me from dong something crazy wrong during a period of stress.

My alterations tend to be one of two types:

–I trade out of stocks that are underperforming on both up and down days and into ones in the same general industry or thematic area that are performing in a healthier way, and

–I find that chronic clunkers become more visible to my eye in volatile times.  (In my view, everyone’s portfolio has at least a few of these.)  Because they’ve never gone up, they tend to have less downside than stars, whose owners have much more profit to take when they’re nervous.  I find a time like this ideal to switch from the former to the latter.  This ends up being most of what I do.


For me, the most difficult market transition to read in advance is the shift from a generally upward trend to a bear market, the garden variety of which can last for the better part of a year, and entail losses of, say, 20% in the S&P 500.

Typically, what induces a bear market is recession.  I don’t think we’re in that market/economy situation today.  If it were, patching leaks in the hull wouldn’t be enough.  A change to a more defensive direction would be warranted.







analyzing the past week in stocks

a roller coaster ride

The past five or six days of stock market trading around the globe have been very unusual, to put it mildly.  To recap quickly, the S&P 500 (which will be my main focus here) peaked on July 31st at a value of 2114.  On Thursday August 21st, the index closed at 2026.  Then…

—on Friday the 21st, the S&P fell by 3.2%

–on Monday the 24th, the S&P opened down 5.2%–with major stocks falling by as much as 20%.  The index rallied back to breakeven before fading late in the day to close down 4%.

–on Tuesday the 25th, the index opened up slightly, added 2.5% to the initial print and then turned around to close 1.5% lower.

–on Wednesday, the index gained 4%+.

–on Thursday the S&P opened up slightly, rose steadily to gain a total of 2.5%, reversed course to lose almost all of that  …before reversing course again to end the day at +2.4%.

All this occurred on 2x -3x normal volume each day.

To add to the fun, the computers at Bank of NY-Mellon, which prices a good number of ETFs, failed over last weekend and still aren’t functioning normally.  So for days, traders of ETFs lost the NAV anchor on which to base their actions.  This may be a reason for my impression that bid-asked spreads for ETFs were wider than normal earlier this week.

As I’m writing this early Friday afternoon, the S&P is flattish.  Volume is about half – two-thirds of what it was earlier in the week.


If the question is why a sharp decline now rather than, say, two weeks ago, there’s never a good answer.

If the question is what forces caused the big fall–and equally sharp rebound–that’s almost as difficult.  We might view this week as the panic-filled culmination of an equity slide that began on the first trading day of August and which is based, I think, mostly on extended valuation.  The decline in the oil price below $40 a barrel can’t have helped sentiment.  Nor would spirits have been perked up by the weakness of Chinese stocks as speculative excess continues to be washed out of that market.

Of course, battling computer trading algorithms could have been the driving force.  That would at least explain how quickly everything moved.

For my money, though, a technical correction in a pricey market is a good enough story.


A more important question for us as investors is whether the selling, however motivated, is over.  The optimistic part of me (which is virtually my entire body) says that the rebound from the opening lows on Monday is an important positive psychological sign.  However, I think volumes have to return to normal, time has to pass, and the market has to begin to drift upward before I’ll be completely convinced.

Let’s say, just for the sake of argument, that this week has seen the establishment of an important resistance level for the S&P.  Remember, I’m not yet willing to bet that this is the case.  But if it is, three considerations are important:

–the market often rises for a while, but then returns to visit the prior low before bouncing up again off it.  This action forms the so-called “double bottom,”–which technicians take as a very bullish sign

–in a major reversal of direction, market leadership often changes, meaning some star groups become clunkers going forward and some clunkers regain the market limelight.  Although I’d scarcely call this past week a major event, we should still look carefully for hints of leadership change

–we’re fast approaching the yearend selling season for mutual funds (most mutual funds have a fiscal year that ends on Halloween), which typically extends from mid-September to mid-October.  The prospect of such selling could keep a lid on stocks over the next weeks, and would be the vehicle for retesting Monday’s lows.

what to do?

That’s my topic for Monday.



what’s going on in stock markets?


From the intraday high of 2132 on July 20th, the S&P 500 has fallen by almost 12.5% to its intraday low of 1867 yesterday.

For fans of support and resistance, 1867 is within hailing distance of the 1820 intraday low for the index in mid-October 2014.  The closing lows at that October bottom were 1867 on both October 15th and 16th.

That all adds up to a severe correction by the experience of the past few years, but still one that might be called “garden variety.”

opposing signals

What’s unusual about this decline is that virtually the entire fall happened in a panic-filled two-day period–last Friday and yesterday.

So this all gives us two opposing market signals.  On the one hand, in the normal two-steps-forward-one-step-backward rhythm of stock markets, we’ve finally made a significant backward step over a suitably long period of time.  One might conclude that we’re done with that phase and are ready for the next up move.

On the other hand, the past two trading days have been fear-filled.  On Friday, the S&P was down by 3%+ and closed on its lows.  Yes, it was a Friday, so brokerage houses flattened their books going into the weekend (translation:  dumped inventory into the market near the close).  Even so, closing on the lows sends shivers down traders’ spines.  Then the market opened on Monday down by about 6%, another stomach acid inducer.  Pundits rushed in to “explain” the goings on to retail investors as a sign that the Chinese economy (the largest, or second-largest, depending on how you count, economy in the world) was imploding–with dire consequences for the rest of the globe.  That increased the fear quotient.

My point here is that emotions are much more powerful that we usually recognize–and they linger.  Maybe the market had been fearful for close to a month and purged that fear over the past two trading days.  But I don’t have the sense that anyone was afraid before fireworks erupted on Friday.  That’s my main hesitation about saying Monday represents a selling climax that clears the way for upward progress.

China not the cause

I think that China is the trigger for what’s happening in markets now, not the cause.

I’m torn between two viewpoints on China as an economy.  I think the hedge funds proclaiming that the selloff in oil and metals is due to economic weakness in China that Beijing is covering up–and that we are due for a protracted bout of global economic weakness–are completely wrong.  On the other hand, either they or their brethren spouted similar nonsense about hyperinflation being induced by Fed action five years or so ago.  Everyone now knows that was totally wrong–yet this craziness struck a responsive chord and influenced stock trading for an extended period of time.

My conclusion:  this isn’t a time to bet heavily on whether the market is going up or down (it almost never is).

trading up

During periods like this, most investors, even professionals, tend to go on vacation.  They just don’t look at the daily ups and downs of prices.  For anyone who can stand the rocking of the boat, however, there’s useful portfolio work that can be done to upgrade holdings.

–clunkers that have never gone up usually don’t go down a lot in general market declines.   Strong stocks that have gone up a lot typically get pummeled.  So this is a great time to ditch the former and use the money to buy the latter.

–we’re in a time of significant structural economic change.  I think the prophets of doom are mistaking that for cyclical economic weakness.  Losers in a time like this are typically large and well-known; potential winners are typically smaller and more obscure.  For most of us, the appropriate switch is from old-line, status-quo stocks into ETFs that are focused on Millennials.


stock options and stock buybacks

I first became aware of the crucial relationship between stock option grants and stock buybacks in the late 1990s.

I was on a research trip to San Francisco, where I had dinner with the new CEO, a turnaround specialist, of a chip design and manufacturing company with a checkered history.

In the course of our conversation, he said that one of his objectives was to ensure he retained top talent.  He went on to mention, as if it were a matter of course, that he would do so by having his firm issue enough stock options to transfer ownership of 6% of the company each year to workers (I’m pretty sure 6% was the number, but it could have been 8%).

I was shocked.

My first thought was that after eight years (six years, if the 8% is correct), there’d potentially be 50% more shares out.  This would massively dilute the ownership interest of any shares I might buy for clients.

My second was that I would have to evaluate the potential for massive positive earnings surprises that would make the stock skyrocket if the turnaround were successful, against the steady erosion of my ownership interest through stock option issuance.  (I decided to bet on skyrocket, which ended up being the right thing to do).

My third was that eventually suppliers of equity capital like me would have to question whether the kind of ownership shift this CEO was presenting as normal tilted rewards too far in the direction of management.


After this experience, I began to look much more carefully at the share option schemes of companies that might potentially be in one of my portfolios.  I noticed that in many cases companies had stock buyback programs–pitched as a “return to shareholders” of profits, sort of like dividends–that almost exactly offset the dilution from the issuance of new stock to employees.

This isn’t the case for all companies, but my observation is that it is for many.  I don’t think this is a coincidence.

Part of the rational for buybacks, it seems to me, is simply to prevent dilution of earnings per share, which would arguably help no one.  But at the same time, for the casual observer who looks only at share count and at earnings vs. eps, it obscures how big the corporate stock option issuance plan is.  I don’t think this is an accident, either.  Yes, the information is all in the SEC filings, but the reality is that even many investment professionals don’t read them.

That’s what I find problematic about stock buybacks–that I feel they’re misleadingly described as a shareholder benefit, while their purpose is to play down the level of key employee compensation.



should corporate stock buybacks be banned?

This is becoming an election issue.

Elizabeth Warren, deeply suspicious of anything to do with finance, regards them as a form of stock manipulation.

Many more mainstream observers note that $7 trillion (according to the New York Times) spent on buybacks by S&P 500 companies has consumed a large chunk of their cash flow at a time when both wage growth and new investment in physical plant and equipment in the US have been paltry.  They argue, without further elaboration that might have the argument make some sense, that the latter are being caused by the former.  Therefore, they think, if only stock buybacks were eliminated, employment and wages would rise and the US would reemerge as a global manufacturing power.  I imagine the same people are saving their old calendars in case 1959 should come back.

There are instances where, in my view, stock buybacks are clearly the right thing to do.  Imagine a publicly traded company that has a profitable business that generates free cash flow, and that has no liabilities plus $1 billion in cash on the balance sheet.  Let’s say the firm’s total market capitalization is $500 million.  In this situation, which actually happened for a lot of companies in 1973, stock buybacks would accommodate shareholders who wanted to liquidate their holdings and create $2+ in value for remaining shareholders for every $1 spent.  I can’t see any reason to outlaw this.

There are also cases—IBM comes to mind–where continual buybacks make investors think that this is all the firm has left in the tank.  So though buybacks keep on generating increases in earnings per share, by shrinking the number of shares outstanding, they no longer support the stock price.  The generate selling pressure instead.  In theory, and provided management understands it can’t play with the big boys any more, the firm should liquidate and return funds to shareholders rather than to continue to destroy value.  Like that’s ever going to happen.  But investors will vote with their feet.  While maybe management conduct should be different, I can’t see how that could be legislated.

My big beef with stock buybacks is that the main purpose they serve is to disguise the gradual transfer in ownership for a company from shareholders to employees that happens in every growth company (more about this tomorrow).  This could be/ should be made clearer.

I also think managements should show more backbone when “forced” into buybacks to satisfy activist investors, in what is the 21st century equivalent of greenmail.

But the idea that barring stock buybacks will cause corporations to make massive capital investments in advanced manufacturing in a country that has a sky-high 35% corporate tax rate, a shortage of skilled labor and rules that bar a firm from bringing in needed technical and management employees from outside is loony.  It isn’t clear to me that removing legislative impediments to investment will be enough to roll back the clock and make the US a manufacturing power.  It isn’t clear, either, that we should want to return to an earlier stage of economic development.  But outlawing buybacks won’t achieve that goal.

capital raising by Tesla (TSLA)

the offering

Last Friday, TSLA filed a final prospectus with the SEC, indicating that it is selling up to 3.099 million new shares of common stock (including underwriters’ over-allotment) at $242 a share.   This will net the company close to three-quarters of a billion dollars, which it needs to fund ambitious expansion plans–the Gigafactory to make batteries the chief among them.

I presume the precipitous decline of TSLA shares over the past ten days or so was triggered by underwriters soliciting indications of interest in this offering from hedge funds and other institutional investors.  Two bullish signs:  the offering was initially pitched as being 2.1 million shares, but raised to 2.7 million on Friday (not counting the underwriters’ allotment, which will have been bumped up as well).  As I’m writing this prior to Monday’s open, TSLA shares are trading at around $255 each.

my thoughts, (somewhat) randomly presented

  1.  TSLA made what I consider a firm-transforming offering of $3 billion in convertible bonds (at a conversion price of $350 (!!!) a share) last year.  This says something about how professional fixed income investors feel about the attractiveness of straight bonds.  More important for TSLA, the successful offering took talk of building the Gigafactory out of the realm of fantasy and placed it solidly into reality.
  2. The automobile world has changed significantly over the past year, with the plunge in oil prices and the rise of ride-sharing services like Uber.  The former may mess up the economics of electic vehicles; the latter calls into question the highly operationally leveraged corporate structure of traditional car companies (translation into English:  if they need to run at, say, 80% of plant capacity to break even, will that be possible if Millennials en masse use Uber instead of buying a car themselves.  Will the car industry be a replay of the current commodities debacle).
  3. My guess is that these shifts: (i) increase TSLA’s attractiveness to stock market investors vs. conventional car companies, and (ii) make Teslas relatively more attractive abroad, where petroleum products are more expensive than in the US.
  4. It seemed clear to me from the outset that the 2014 bond offering didn’t totally solve TSLA’s need for capital.  Another offering had to happen in 2015.  I’d expected more bonds.  Why stock instead?  Market etiquette says that a new offering should be at a higher price–here meaning a higher conversion price–than previous ones (otherwise last year’s buyers look like idiots).  Also, potential lenders periodically want companies to prove that they still have enthusiastic equity backers.  This is a combination of lenders not wanting financial leverage to be too high, their not wanting to be the only ones holding the bag if things go sour, and their knowledge that bonds are going to be under pressure as interest rates begin to rise.
  5. Last year’s offering signaled a near-term top for TSLA shares.   My instinct is to think that this offering establishes a near-term bottom.  I own a small position in the stock, however, so I may have an interest in thinking this is the case.



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