Category Archives: ETFs Vs. Mutual Funds

mutual funds/ETFs in time of stress

July 11, 2016 By in ETFs Vs. Mutual Funds, stock market, Uncategorized Tags: , , , , Leave a comment

As I mentioned last week, since the Brexit vote some property-based mutual funds trading in the UK have had to suspend redemptions while they attempt to raise the needed cash through asset sales.  This raises the question about how US mutual funds and ETFs might fare in a similar time of stress.

We have, of course, the large downturn of 2008-09 as a recent example.  The US survived that period of significant stress with scarcely any issues.  T

he worst experience of my working career, in terms of redemptions was in the aftermath of Black Monday in 1987, when the US stock market lost almost a quarter of its value in one day.  In the load fund I was running at the time, which also had a strong record, I lost about 5% of my assets under management over a few weeks.  Colleagues running no-load funds at other firms lost up to a third of theirs.  Again no very serious issues that would have required suspending redemptions.

The entire US stock market was closed for several days following 9/11.  But that was because US trade-clearing banks had their recordkeeping computers, including backups, all located in or around the World Trade Center; it took them several days to get back on their feet.  The banks have since established backup systems at more remote locations, so that presumably won’t be problem again.

It may be, then, that our potential worry is only about specialized funds that hold highly illiquid assets like property.

One significant source of regulatory worry has been the rapid growth since 2009 of passive products–ETFs and index mutual funds, which don’t have large staffs of portfolio managers and traders used to making lots of transactions.

Experience with ETFs has been, to my mind, surprisingly positive from a redemption point of view.  That’s because the theoretical idea that the brokerage houses that trade ETFs would move their bids to such a low price that all desire to panic-trade would evaporate, has so far worked every well in practice.

The only thing we as investors should note is that during several “flash crashes,”  the brokerage bid price for affected ETFs that I’ve seen has been as much as 15% below net asset value.  That’s a clear warning not to use market orders for these vehicles in bad times–or not to sell them at all.

To my mind, the one unanswered question is how liquid index funds might be in a future crisis.  The worst that happens, I think, is that big indexers do the same thing as the UK property funds and suspend redemptions for a time.  On the other hand, my entire working experience is that it’s institutions, not individuals, who panic during crises.  And these tend to cash in actively-managed products in times of stress, not index funds.  So maybe they’re not a big worry after all.

Something to think about and plan for, though.

redemption halts in UK-based property funds

July 7, 2016 By in Brexit, ETFs Vs. Mutual Funds, Property/housing, the UK, Uncategorized Tags: , , 1 Comment

Over the past week or so, the boards of a number of UK property mutual funds have exercised the ability their charters give them to suspend shareholder redemptions.

What’s this all about?

The central issue is, of course, the “Leave” result of the Brexit vote.  This has two negative consequences for UK property.  The first is that property is a domestic sector, where holders whose base currency is the US$ or the € have felt the full brunt of the subsequent fall in sterling against those currencies.  The second is that although suddenly 12% cheaper to foreigners, it’s questionable whether offices or other commercial properties will retain their allure once the UK is on the outside of the EU.  Also, the central bank is predicting the vote will cause a mild recession, always a bad thing for property.  So bargain hunters haven’t yet appeared as buyers.

On balance,  a lot of people want to cash their shares in.

The second problem is endemic to property.  It’s not a particularly liquid sector.  Not only would you get a horrible price in a forced quick sale, it’s probably impossible to get the paperwork processed and a check in hand inside, say, a month.  Property funds–in fact, all mutual funds–try to safeguard against being overwhelmed by redemptions by keeping a percentage of assets (maybe 2% or 3%) in cash.  Funds also have credit lines they can draw against if need be.  But for property funds if holders of 10% of the outstanding shares all want to redeem at once that won’t be enough.

Initial redemptions can also create a self-reinforcing cycle.  Shareholders who initially had no intention to redeem may join the queue simply because they fear continuing withdrawal pressure will depress net asset value further.

The result is that the funds in question have been unable to meet the redemptions they’re experiencing.  They’ve been forced to suspend redemptions while they raise cash in a orderly way.

I don’t think the redemption window will be opening any time soon, although I’d imagine enterprising brokers have already set up a market to transact in these suspended shares, at a substantial discount to NAV, no doubt.

 

Lessons for the US?  More tomorrow.

 

closed-end funds

September 30, 2015 By in closed-end vs open-end funds, ETFs Vs. Mutual Funds Tags: , , , , , Leave a comment

Investment companies in the US are a specialized form of corporation that is exempt from corporate income tax, a privilege they get in return for agreeing to restrict activities to investing in securities and to distribute to shareholders virtually all their realized profits (which become taxable income to recipients).

The predominant form of investment company is the mutual fund/exchange-traded fund, also called an open-ended fund.  What makes the fund “open-ended” is that the investment company itself regularly issues new shares to buyers and redeems them from holders who wish to sell.  Put another way, the number of shares of the company–and therefore the amount of money under management–is variable.  It typically ebbs and flows with market sentiment or with the track record of the professionals the company hires to manage the money.

 

A less common form of investment company is the closed-end fund.  In this format, the investment company raises initial capital in an IPO and trades its shares on an exchange.  It does not allow shareholders to purchase and redeem directly from the company (the reality is slightly more complicated, but nothing to worry about).  Instead, buyers and sellers find a counterparty on the exchange, just as if they were selling a regular stock or bond.

What makes closed-end funds interesting to you and me is that they almost always trade at discounts to net asset value.  There are some exceptions, like if they specialize in some exotic foreign market that’s hard to invest in directly and which happens to be flavor of the month, or if the managers have been shoot-out-the-lights successful in their investing (I can’t think of one in this second category).

This is particularly true in times of stress.

If the discount to NAV becomes too great, or persists for too long a time, predators may try to take control of the fund and liquidate it–which, of course, makes the discount disappear as well as the fund.

 

Why am I writing this today?   …because I’ve been reading that closed-end bond funds are trading at unusually high discounts to NAV at present.  I presume that this is in anticipation of higher interest rates.

I’m by no means an expert on these funds.  And I can’t imagine rushing out to buy bonds today.  But these may be a class of securities to begin to learn about and keep an eye on.

 

bond funds when interest rates are rising (ii)

September 22, 2015 By in ETFs Vs. Mutual Funds, Portfolio management Tags: , , , , , , Leave a comment

Yesterday I referenced an article in the Wall Street Journal that talked about possible liquidity problems with junk bond funds as rates begin to rise. Based on information provided by Barclays, a huge provider of ETFs, the reporter, Jason Zweig, concluded that junk bond ETFs are a safer alternative to traditional mutual funds.

My comment from yesterday, boiled down perhaps to the length it should have been, was that since the first junk bond crisis in the late 1980s, junk bond funds have adopted very rigorous pricing mechanisms, so the chances a junk bond fund is badly mispriced are very small.  On top of that, mutual fund companies have lots of tools available to deal with high levels of redemptions.

 

As to ETFs, while as a practical matter it may be that these vehicles themselves may not be subject to the same selling pressures as traditional mutual funds, the way that ETFs insulate themselves can be an issue for you and me.

In the case of traditional mutual funds, we buy and sell directly with the fund, once daily, after the close, at NAV.

ETFs are considerably more complicated.   We deal with broker intermediaries who make a continuous market throughout normal trading hours, though with no guarantee about how closely the bid-asked spread they set will match up to net asset value.  (Authorized participants, who typically deal in minimum blocks of 50,000 shares are the only ones who transact directly with ETFs.)

The tendency of ETF market makers in times of market stress is to widen the bid-asked spread.  This does two good things for the broker.  He gets a higher return for transacting at a risky time.  And the wider spread discourages people from trading.  Translation:  liquidity for you and me dries up.

How bad can it get?  I don’t know.  Several years ago I tried to collect data on the performance of stock ETFs at the market bottom in early 2009.  The only information available then was a comparison of the last trade on  given day with the NAV calculated after the NY close.  In one case, for a foreign stock ETF, the last trade was at a 12% discount to NAV.  The discount may have been considerably wider during the day.  At that time, ETF companies told me they just didn’t know.

I haven’t checked since. I haven’t done this for bond funds.  And one might argue that the 12% discount is an outlier. But the horrible problems ETFs had during the last week of August suggest to me that the situation hasn’t changed for the better.

My experience is that trying to trade during highly emotionally charged times is usually not a good idea.  But it also seems to me that the potential risks inherent in trading in mutual funds at times like this to you and me, not to the fund company, pale in comparison to those involved with ETFs.

 

This has gotten much longer than I intended.  More tomorrow.

 

 

 

correction or bear market: where are we now?

September 4, 2015 By in correction vs. bear market, stock market, yearly distributions Tags: , , , , , , , Leave a comment

correction vs. bear market

The financial media, in a deceptively over-precise way, has come to define a correction as a 10% fall in price of a given index during an ongoing bull market.  The same source defines a bear market as a fall of 20% or more.  There is some sense to making the distinction in this way, at least in that it’s unlikely that a market can fall by 20% and still be said to be retaining its fundamentally upward direction.  Other than that, I don’t find the 10%/20% distinction useful.

two worries:  price and earnings

To my mind, the key difference between the two–correction and bear market–is whether the favorable environment of expanding economies and resulting rising earnings per share which supports a bull market remains intact.

In a correction, stock prices have run ahead of the fundamentals and become too pricey.  We can no longer envision, say, achieving a 10% return from holding stocks for the coming 12 months.  Therefore, stocks have to fall to a level where buyers will anticipate a suitable return and reenter the market.  Buyers are concerned about price, not about earnings.

A bear market has very little to do with the 20% number.  What creates a bear market, simply put, is anticipation of recession, and the decline in corporate earnings that goes along with it.  Buyers don’t reenter the market after an initial fall, because they no longer believe that earnings will be rising.  They either continually withdraw funds from the  market or simply hold on to what they have and wait.  They look for some sign that the economic downturn the stock market has been forecasting has emerged—and reached its low point.  Historically, the turning point has been when the monetary authority begins to adopt a more accommodative stance.  Occasionally, it’s the legislature that acts.  Sometimes, it’s less action than investor perception that the assets of publicly traded companies are at bargain basement prices regardless of the near-term economic situation.

timeline

A correction runs its course in a matter of weeks;  a garden-variety bear market lasts nine to twelve months.

Where are we now?

For the mining industry–metals and oil–the picture has deteriorated dramatically over the past year.  This isn’t because the overall macro environment has weakened.  It’s because of overcapacity that the industry, in its typical shoot-yourself-in-the-foot fashion, has itself created.  This unfavorable situation will take a turn for the better only when substantial capacity is taken off the market.  Last time this happened for metals, in the early 1980s, the downturn lasted a decade.

Mining, and mining-dependent economies, apart, I don’t see any signs of actual GDP decline.  Yes, China may be growing at 5% instead of 7%.  Maybe it’s even 2%.  But it’s still growing.

So my vote is for correction.

One caveat:  as I’ve mentioned before, early September is the time when mutual funds in the US begin to sell to adjust the level of the yearend profit distribution they are required by law to make to shareholders.  Some of this selling may have been preempted by August’s market decline.  But until we see what the mutual fund situation is this year, I don’t think there’ll be much market desire to push prices higher.