Monthly Archives: September 2010

large realized losses (II): how to find out

September 13, 2010 By in Accounting, book value, Constructing a Portfolio, Current Market Thoughts, ETFs Vs. Mutual Funds, Industry Analysis, Investment firms, Portfolio management, Stock ideas, Strategy, Trading Tags: , , , , , , , , , Leave a comment

don’t look in marketing materials

There are two ways for a mutual fund or ETF to have amassed large realized investment losses:

–they’ve had a very weak or very unlucky portfolio manager in charge of a fund, with the result that it has made losses in a benign investment environment, or

–the fund has simply existed during a period of great euphoria, when all the money flowed in, and a subsequent panic, when that money flowed back out at a loss.

The past several years have been such a period and have, by and large, produced the situation funds and ETFs are now in.

No one is going to advertise “Great news!!  We’ve lost billions since 2007, so you have a built-in tax shelter for future gains.  It’s so big your gains will be tax free for years.”

Quite the contrary.  A fund management company will provide this important information only when forced–that is to say, only in its official reports to shareholders and to the SEC.  You have to dig it out.

get the annual/semi-annual report

You can usually get the official reports on a fund company website.  You don’t want a summary report, or an abbreviated “fact sheet.”  That won’t have what you’re looking for.

Or you can go to the SEC’s EDGAR website.  Here’s the link.

On the Filings and Forms page, select the red “Search for Company Filings” link.  That will bring you to the search page.

Click on the red “company or fund name…” link.  That will bring you to an “Enter your search information” box, where you can enter either the fund name or its ticker symbol.  (This is the same search function you’d use for any publicly listed company.)

Clicking the “find companies” button will take you to a list of the fund’s SEC filings.

Look for the Certified Shareholder Report, form N-CSR, or semi-annual report, form N-CSRS.  That’s what you want.

inside the report

Go to the financial statements.  Note the date of the report, since all figures will be as of that date.

Statement of Assets and Liabilities

Find the “Statement of Assets and Liabilities.”

It will have three sections:  Assets, Liabilities and Net Assets.  Net Assets is the one you want.

There are two lines you should be interested in:

–“Accumulated undistributed net realized gain (loss) on investments and foreign exchange transactions.”  This is the figure you want! If it’s a loss, it will be in parentheses, like (2,345,678).  No parentheses if it’s a gain.

–“Net unrealized appreciation (depreciation) on investments and assets and liabilities in foreign currencies.”  This will show you whether the fund has an aggregate gain or loss stored up in the securities it still holds and has not yet sold.  This is a nice-to-know number, but it needs further refinement (see below).

schedules/tax footnote

There are two more pieces of information you should have.  There’s no standard place to find them, so you may have to do some poking around for yourself.  They are most likely either in a schedule immediately after the Statement of Assets and Liabilities or in a tax footnote.

The first item is when the tax losses expire.  This must be disclosed if it’s relevant, but need not be if it isn’t.  What I mean by relevant is, say, that the fund has unrealized gains of $250 million and accumulated losses of $2 billion that expire in December 2010.  In this case, the tax losses will likely expire unused.

The second is the gross unrealized gains and gross unrealized losses.  A fund may have $250 million in net unrealized gains, but that may be composed of $500 million in unrealized gains and $250 million in unrealized losses.  The gross unrealized gains show the real ability of the fund to generate gains that will use up the realized losses.

how to use this information

The first, and obvious, comment is that the foremost criteria for selecting a fund are its suitability for you, given your goals, risk tolerance and financial situation.  Tax benefits are nice to have, but they’re a second- or third-order consideration.  Better to have a fund run by a skilled manager inside a firm with strong dedication to good performance, with no tax losses, than one with tons of tax benefits but a weak manager and a deficient corporate culture.

In most cases, the losses funds have today have been caused by the market action of the past few years.  It’s possible, though, that in some cases losses have been generated by bad management (I know. I’ve been hired more than once to clean up a mess someone else has made).  These turnaround situations can have, I think, great profit potential.  But with so many funds with strong management being in a loss position that has significant value, I see no reason to take the extra risk.

A fund example: I was looking at a mutual fund the other day as I was preparing for these posts that had roughly the following characteristics:

Assets:  $2 billion

Accumulated realized losses:  ($1.8 billion)

Unrealized net gains:  $700 million, consisting of $1 billion in gross unrealized gains and $300 million in gross unrealized losses.

A rough calculation of the value of these losses:

Assuming a federal tax rate of 15% on capital gains and (in my case) a state tax of 10%, the ability of (my share of) $1.8 billion in losses to shelter realized gains from being distributed to me as taxable income would be worth (my share of) $1.8 billion x .25 = (my share of) $450 million, or 22.5% of (my share of) the net assets of the fund.  That’s a lot.

This raises two other points:  don’t forget to include state taxes in your calculation; at this point it looks as if capital gains taxes will be going up for individuals with more than $250,000 in yearly income.  That would make a fund like I describe more valuable to the wealthy.

what can go wrong?

The worst problems would come from selecting a fund with poor management.  Let’s exclude this issue.  There are still potential pitfalls.

1.  The stock market stays in the doldrums.  As a result, it remains difficult for any manager to make gains to use up the tax losses before they expire.

2.  The fund manager doesn’t “get” the value of the tax losses.  Normally a manager sensitive to tax efficiency tries to avoid short-term trading.  When you have a big loss position, a somewhat greater trading orientation–provided you have the temperament and skills–is appropriate.

3.  Investors pour tons of new money into the fund you select, either because they realize the value of the tax losses or for some other reason.  The issue is this:  in the example above, the net assets of the fund are $2 billion.  If I put even $1 million into the fund, that represents only .05% of the fund assets, so portion of the tax losses that existing shareholders are entitled to is basically unchanged.  But if another $2 billion in new money comes in, then the entitlement of each existing share is cut in half.

How likely is this “unfavorable” outcome?  It’s hard to tell.  In my experience, only one thing will attract new shareholders–sharp price gains.  But that will also trigger outflows from existing shareholders who have decided to hold on to underwater shares until they’re back at breakeven.

4.  Your fund is merged into another one.  Fund companies will many times merge funds that are perceived to have weak records, or which can’t seem to attract new money, into other “healthier” funds.  The rules on what happens to tax losses in this case are complex, but the basic idea is that the ability of the successor fund to use the losses is severely restricted.  So not only do you have to share the losses with the holders of the other fund, but their present value is diminished.  It’s of course possible that the fund you’re merged into will have a bigger tax loss position that yours, but I wouldn’t count on it.

As a practical matter, I think #4 is the biggest risk.  Fund boards may have no understanding of the value of the tax losses.  And they generally tend to go along with the wishes of the fund management company.

On the other hand, if you have a choice between two roughly equivalent funds, one with large realized tax losses and one without them, I think the decision is a no-brainer.



large realized losses (I): the position of many ETFs and actively managed US mutual funds today

September 12, 2010 By in Absolute vs. relative performance, Constructing a Portfolio, ETFs Vs. Mutual Funds, Portfolio management, Stock ideas, Strategy, Uncategorized Tags: , , , , , , , , Leave a comment

I’m going to do this topic in two posts, today and tomorrow.

The bottom line is that many equity mutual funds and ETFs have large accumulated recognized losses.  These are akin to operating loss carryforwards that operating companies may have.  This was bad news for shareholders during the time the losses were racked up.  But it can be valuable good news for current or new shareholders.

How so?

They don’t appear in the net asset value calculation, so you don’t pay for them.  Nevertheless, they can be the single biggest asset a fund has.  Their value is that they offset the taxable distributions you would otherwise get when the fund sells stocks at a gain.  In other words, you get to keep the entire amount of the gain (inside the fund) rather than having to pay tax on the gain at either short-term or long-term capital gains rates.  Skillfully used by the fund management company, this ability could be worth 10% or more of the NAV of the fund.

Neither brokers nor fund companies talk about this topic.  This is mostly because doing so would highlight again the fund’s loss-making past that its marketing people hope everyone has forgotten about.

As it turns out, I’ve been hired more than once in my career to turn around a poorly performing fund that contained very large tax losses.  So I’ve seen the value of this asset first hand.  Along the way, I’ve been cited by Forbes a number of times for running very tax efficient portfolios.  I know this is an odd topic, but it can be a profitable one.

Let’s get started.

background

funds as corporations

Mutual funds and ETFs are, as legal entities, are a special type of corporation.  They are exempt from taxation of income at the corporate level in return for restricting their activities to portfolio investing and distributing virtually all their income and realized capital gains to shareholders (who are liable for paying income tax on the distributions).

individuals tend to buy high and sell low

The old brokers’ joke is that Wall Street is the only marketplace in the world where customers run out of the store when a 30% off sign is placed in the window.  It is a characteristic of the behavior of many individual investors that they tend to act in a highly emotional fashion.  This leads them to buy when prices have already been rising for a considerable time and the market is very enthusiastic and to sell after sharp drops and everyone is scared.

in the Great Recession

In the most recent instance of such behavior, according to the Investment Company Institute, equity mutual funds in the US had net outflows of about $150 billion between October 2008 and March 2009.  During this time the S&P 500 ranged from the high 600s to the high 800s–or 30% or more below today’s level.

In contrast, net inflows to equity mutual funds during the first half of 2007, when the S&P was above 1400–25% higher than now, were about $85 billion.

US funds vs. international

We can disaggregate these flows to see the behavior of investors toward US-oriented funds and their international/global counterparts.

US funds had virtually no net inflows during the first half of 2007 and about $100 billion in redemptions at the bottom–outflows equivalent to most of the money invested in them (at levels above 1200) since 2004.  (there’s a clear shift by investors away from domestic funds to ETFs during this period but that’s another story.)

Global/international funds, in contrast, captured just about all the $85 billion in inflows at the top and had “only” $50 billion in outflows at the bottom.

concentrating on US funds

If we assume that the $100 billion in redemptions occurred when the S&P was at 800 and that the stocks were bought on average when the S&P was at 1300, we can get a rough idea of the magnitude of the losses that this “sell low” trade engendered.  The two index levels imply that the stocks sold for $100 billion had a cost basis of about $165 billion–therefore that the selling funds created an aggregate loss of about $65 billion, much of which is still on the books of mutual funds.

Why still on the books?  For many funds, their share of this number dwarfs the unrealized gains they have on positions they still hold.  Given the (rare) occurrence of two bad bear markets during the last decade–the aftermath of the Internet bubble + the financial meltdown–a fund would likely have to have either bought stocks recently or held them since some time in the Nineties to have unrealized gains.

caveats

Not every fund has accumulated losses.  Not every fund has a skilled manager or a management philosophy that will allow them to use this asset effectively.  Although most funds are in a loss position because the past few years have been the worst for stocks since WWII, some have added to their woes because they’re not good investors.  This latter type is one to identify and avoid.

ETFs

Many equity ETFs are passive entities.  They may have very large losses, but unrealized ones, because they became popular and received large inflows in 2006 and 2007.  Today those purchases are probably deeply under water.  To the extent that these funds are run by computers, not humans, it’s unclear how they’ll be able to realize and use these losses.

That’s it for today.   Tomorrow I’ll write about how to find and evaluate the loss position for any given mutual fund.  You’ll find the numbers buried in the fund balance sheet and accompanying footnotes.


mutual fund investors and their investment advisors

September 10, 2010 By in Current Market Thoughts, Getting financial advice, mutual fund holders and financial advisors, Surveying Tags: , , , , , , , , Leave a comment

the ICI survey

I was looking on the Investment Company Institute (the trade organization for the fund management industry) website for aggregate data on the size of tax losses held inside mutual funds and ETFs–the topic of Sunday’s post–when I found a report on a survey of mutual fund investors and their investment advisors.  This was supplemented by a later survey that elaborates on the types of financial advisors used.  I thought the information was interesting, and certainly not what I had expected even though I marketed my products to financial advisors for twenty years.  Here are the survey results:

preliminaries

The survey was done by phone in 2006, before the financial meltdown.  1003 households were interviewed by a third-party professional surveying company.  The report didn’t contain either the survey questionnaire or the raw survey data.

Two characteristics of phone surveys to keep in mind:

–they almost never use cellphone numbers because laws in most states prevent machine dialing of cells, so surveys that include them are more expensive.  This distorts the twenty-something demographic, which probably isn’t so important in this case.

–phone respondents tend to portray themselves in what they consider a more favorable, or more conventionally acceptable, light than they would in an internet survey.

The survey wanted to find out about financial assets held outside workplace retirement plans.

The survey defined a financial advisor as “someone who makes a living by providing investment advice and services.”  This includes not just traditional “full service” brokers, but also independent financial planners, bank and financial institution investment representatives, insurance agents and accountants.

the customer base

1.  Almost all the respondents (82%) had access to professional financial advice.

–Almost half (49%) bought mutual funds exclusively through financial advisors.

–A third bought both through advisors and on their own (through discount brokers or directly from fund companies).  No explanation for this behavior, although I think many customers try to control the fees they pay to financial professionals by maintaining two accounts.  One will be  wrap-fee account with a financial advisor;  the second will be a no-fee discount broker “clone” of the first.

–14% bought exclusively on their own.

–4% had no clue where the funds came from.

A total of 60% of the assets were held through financial advisors.

why customers seek advice

For most customers, there’s an event that triggers the search for a financial advisor.

For people in their twenties or fifty-plus, the event is usually receipt of a large lump sum, either an inheritance or payout of a work-related investment account.

For thirty- or forty-somethings, the event is lifestyle-related, usually marriage or the birth of a child.

what they need

The top four things customers want from a financial advisor are:

1.  help with asset allocation

2.  an explanation of the characteristics of the financial instruments they can buy

3.  help in understanding their overall financial situation

4.  assurance that they’re saving enough to meet their financial goals

Although a large minority(about 40%) of respondents seem to want to turn their money over to an advisor and forget about it, most regard their advisor (correctly, I think) as a consultant rather than a money manager and want to play an active part in making the decisions that define their portfolios.

demographics of advice seekers

The predominant characteristic of people with ongoing relationships with financial advisors is that they don’t use the internet to get financial information.  This group is twice as likely to have a financial advisor as those who do use the internet for financial data.  Here the survey really seems to break down, because it doesn’t say whether these customers don’t use the internet to get any information (my guess) or whether it’s just financial information they get elsewhere–if they get any at all.

What’s also interesting is that this (Luddite) behavior is not characteristic of mutual fund holders as a whole.  Other ICI research from around the same time shows that mutual fund owners tend to be intensive users of the internet, with financial information a particular area of interest.  Apparently, this latter–probably younger and more affluent–group doesn’t use financial advisors.

The other ICI research also suggests that the third of respondents who had some advisor-related funds and some not were predominantly in the latter camp.  The fact that 60% of the assets were bought through financial advisors suggests that the non-internet users are substantially wealthier, and probably older, than internet savvy respondents to the financial advisor survey.

Female decision maker households are 50% more likely than average to have an ongoing financial advisory relationship, as are families with over $250,000 in household assets (remember, this is pre-crisis).

The fourth defining characteristic is age. Respondents who were 55+ were 40% more likely than average to have a financial advisor.

who doesn’t want a financial advisor?

This group, a small minority according to the survey, has three defining attributes:

–they want control of their own investments, a desire that increases in intensity with age

—they (think they)know enough and have access to all the resources they need to make intelligent decisions on their own.  Sixty-somethings and older hold this conviction the most strongly, followed by the under 45 set.  Those in the 45-59 bracket think so too, but have more doubts.

—they don’t like advisors. They think they’re too expensive and that they put their own interests ahead of their clients’.

One in seven respondents, under 45 more often than not, said that they don’t need professional advice because they get it for free from a friend or family member.  Other than my children–who get excellent, if aggressive, investment advice, this group seems to be one fated to live on public assistance later in life.

my thoughts

I wonder if a survey conducted today would get the same results?

Despite long-term planning and all that, many individual investors seem to have sold their equities at the bottom and put the money into bonds, missing the subsequent equity rebound.  According to ICI data, they continue to allocate assets away from stocks and into bonds, despite the fact that bonds haven’t been so expensive vs. stocks in almost sixty years.  Is this conservative move spurred on by financial advisors?  Probably not.

I remember a story that ran in the Wall Street Journal just after the stock market collapse of 1987.  It was about a prescient retail broker in Connecticut who called up all his clients in late summer of 1987, just before the crash, and convinced them to sell all their stocks–which they did.  He called them back in November, at the market bottom, to advise them to buy again.  No one returned his calls.  He packed up and left for Oregon to try to rebuild his business there.

Maybe the same has been happening today.

Another aspect to 1987.  I think the market decline marked a paradigm shift by individual investors.  Prior to that, people typically bought individual stocks through full-service brokers.  Post-crash, I think that many individuals, like those Connecticut customers, lost faith in brokers and turned to independent financial advisors and mutual funds.

Does the financial crisis mark another structural turning point?  Maybe.  If so, it’s probably away from mutual funds to ETFs and away from using financial advisors as consultants with specialized financial expertise to self-reliance.

Mike Mayo vs. Citigroup on deferred taxes: round III

September 8, 2010 By in Accounting, Banks, Current Market Thoughts, deferred taxes, Industry Analysis Tags: , , , , , , , , , Leave a comment

Mike Mayo’s writing about C’s deferred tax assets again.  They now amount to over $50 billion and Mr. Mayo thinks at least part should be written off and removed from C’s balance sheet.

Mr. Mayo, a respected Wall Street bank analyst now working at CLSA, has always spoken his mind, even when he knows it will arouse the ire of the major commercial banks he covers.  Banks–like any large-cap publicly listed companies–know how to play hardball.  They can, and have, cut off his access to top management, and they can deny his employer their securities underwriting, and other investment banking, business.  But that has never stopped Mr. Mayo–who (perhaps out of necessity) has worked for a variety of Wall Street firms over his career.

Last year, Mr. Mayo predicted that C would write off $10 billion in deferred tax assets from its balance sheet at yearend.  The company didn’t, explaining in its 10-K that if all else failed it would repatriate massive foreign accumulated profits to enable it to use the tax losses has accumulated on its balance sheet.

So, Mr. Mayo’s writing again.  Why?  –because C’s deferred tax account has continued to grow, reaching $50 billion at the end of the June quarter–or a third of the bank’s tangible equity.  The number is also very big relative to C’s market capitalization of $110 billion.  If they could all be used today, they would probably represent C’s single most important asset.

That’s the question, though.  They can’t all be used today.  In fact, C is generating more of them.  But can they all ever be used before they expire?  Mr. Mayo thinks not.  C says they will be.

My guess is that Mr. Mayo is technically correct, but that we won’t see a writedown for several years, if we ever do.  Two reasons:

–I don’t think the authorities see any percentage in portraying a major commercial bank as being in worse financial shape than its audited financials show it to be now.  At least a portion of the deferred tax assets are counted in the regulatory capital supporting C’s loan portfolio.  No one wants to mess with that at the moment.

Furthermore, C is not alone in having substantial deferred tax assets.  A C writedown might snowball into an investor demand for similar writedowns by other European and US banks.  That would be playing with fire, also.

–There’s a technical reason, as well.  It’s important to distinguish between a company’s financial reporting books, which it presents to investors, and its tax books, which it shows to the IRS.  A company may take a writedown of, say, $10 billion in US assets on its financial reporting books.

Let’s assume, to keep matters simple, that it has no other taxable US income.  If so, on its income statement, the company will show a pretax loss of $10 billion, a deferred tax benefit of $3.5 billion and an after-tax loss of $6.5 billion.  In the footnotes to its financials, it will show a tax carryforward of $3.5 billion.

What’s crucial is that it uses this accounting treatment whether it actually disposes of the assets or retains them at a nominal value on the balance sheet.  And it may not want to sell the assets right away.

Why not?  –because disposal of the assets is what starts the clock ticking on the limited time a company has to make use of the tax losses.  If you’re not making money now, it’s often better to hold off on disposal.  Doing so can extend the time you have to use the lax losses indefinitely.

In C’s case, we don’t know the details of what it has done.  Only C and its auditors know for sure.

Again, why am I writing about this? I think the C tax controversy is interesting, although I don’t own C and have no intention of buying any soon.  I also am intrigued by the idea that yesterday’s loss can be tomorrow’s asset value.  That can be a key issue in evaluating fallen angel bonds or turnaround stocks.  It also has important implications for mutual funds and ETFs, especially in times like these when the securities have big realized losses and are experiencing redemptions.  More on this last topic in a later post.