closed-end funds

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.


what liquidity is to the SEC

As I mentioned in my Windows 10-plagued post yesterday, the SEC is considering new procedural and disclosure rules for ETFs and mutual funds about the liquidity of their positions.  The most controversial, as well as, to my mind, the most reasonable, is the idea of allowing funds to assess a premium to net asset value during times of unusually high purchases and apply a discount when redemptions are running high.


Liquidity itself, on the other hand, is not as straightforward a concept as it appears on the surface.  That’s not a reason for having no disclosure.  But it raises the question of how extensive the disclosure should be.


The definition the SEC appears to be using is how many days it would take for a given fund to sell its entire position in a certain security without having an impact on the security price.  Let’s refine that a bit by saying that having no impact would mean that the stock moves in line with its market over the selling period (as opposed to just doesn’t go down).

Let’s take Exxon (XOM) as an example.  It has 4.2 billion shares outstanding and has been recently trading 17+ million shares daily.

For you and me, selling is a piece of cake.  Our 100 or 200 shares is a miniscule portion of the daily trading volume.  Also, no one on Wall Street knows–or cares–what we’re doing.

Suppose, on the other hand, that we own 1% of the company, or 42 million shares, which amounts to three days’ total trading volume.  What happens then?

Subjectivity and skill/deception come into play.


How much of the daily trading volume can we be before a broker notices that we’re doing unusual selling?  (Once that happens, he/she looks up our position size on a trading machine (mutual fund positions are disclosed quarterly in public filings at the SEC) and assumes we’re selling the whole thing.  The trader then calls his own proprietary trading desk, and all the traders at other firms that he/she’s friendly with.  Then the price moves sharply against us.)

In my working career, I mostly dealt with positions in the $50 – $100 million range, although some of my stocks have been more illiquid than that position size would suggest.  I always thought that I could be 25% – 30% of daily volume without moving the price.  In the XOM example, that would mean my position would take 9 -12 days to sell and would be classified, according to the SEC proposal, as sort of liquid.  A larger or perhaps more cautious manager might think the percentage of daily volume should be capped at 10%.  In this case, the same position would take 30 trading days(six calendar weeks) to unload and would be highly illiquid.


The norm in the US is to separate trading sharply from portfolio management.  I’ve been lucky to have worked mostly with very talented traders, who could conceal their presence in the market.  I can remember one trader, however, that I inherited at a new firm who was almost inconceivably “loud.” Using him, every stock was illiquid (luckily for me a hapless rival headhunted him away after months of ugly trading results).

Organization size, not just portfolio size,  also comes into play.

organization size

Suppose I’m alone as a manager at my firm in having a 1% position in XOM.  That’s one situation. On the other hand, I might be one of five managers with similar-sized portfolios, each with a 1% position.  If we all decide to sell at the same time–perhaps influenced by internal research or by the most senior PM–the firm’s liquidity position in XOM is far different.  The stock is now very, very illiquid.  With conservative daily volume limits, it could take half a year to unload and ostensibly mega-cap liquid stock.


This is a whole other story, one that I don’t know particularly well.  However, corporate bonds, especially low quality bonds, can be extremely hard to sell.

It will be interesting to see what the SEC comes up with.


SEC on mutual fund and ETF liquidity

Last week the SEC proposed a new set of guidelines for mutual funds and ETFs about disclosure of the liquidity of their holdings.  This is  as banks.part of its continuing effort, being resisted by the fund industry, to establish tighter risk controls over mutual fund and ETF products.

There are several parts to the guidelines”

-funds should set aside a specific percentage of assets to be held either in cash or cash-like securities that could be turned into cash within three trading days,

–funds should rank and disclose holdings in groups by how long it would take the liquidate the entire position without market impact:  1 trading day, 2-3 days, 4-7 days, 8-15 days…

–funds would be allowed to establish and disclose a “swing factor” that would be added to NAV on days of high sales and subtracted from NAV on days of high redemptions, in order to compensate existing shareholders for the additional liquidity risk taken on by the fund in committing to buy or sell large portions of its portfolio

Why do this?

  1.  The fund industry is much larger than it used to be.  The SEC is worried that giant fund complexes are actually “too big to fail” financial institutions, but not subject to the same close supervision.
  2. The “load” industry, where clients had to call a financial advisor to buy and sell, has yielded the field to “no-load” funds, where panicky shareholders can transact without a calming influence and at any hour, day or night.
  3. The fund industry has recently developed many less liquid products.
  4. Fund buyers have recently allocated away from stock funds toward bonds, which are generally less liquid.
  5. Some individual funds have become extremely large, raising questions about the possibility of unusual problems coming with size.


More tomorrow. (I’m on the road and Windows 10 is acting up.  Sorry)

Janet Yellen, this week and last

Fridays are strange days on Wall Street.  That’s because, unless they’re super-confident, short-term traders don’t like to hold a large inventory of securities over a weekend.  Too much time for bad stuff to happen.  So they sell enthusiastically on Friday afternoons.

There’s certain sense to this behavior.  For them two days+ may be a long holding period.  Also, companies and people, particularly sneaky ones, like to save bad news up for late Friday afternoon or the weekend, when they think no one is paying attention.  This lessens the pain, they think.  Often, it has the opposite effect, however, since anyone who’s been around for a while knows what a late-Friday press release invariably contains.


So in one sense it’s not a great surprise that the huge effort–enough to send her staggering off the stage–Janet Yellen put out yesterday to explain that, yes, the US economy is in great shape and, yes, the Fed is going to take the first baby steps to get the country out of interest rate intensive care (IRIC (?)–although it may be too late for this acronym) before New Year’s eve had no lasting positive effect on stock prices today.

The reason is that, aside from robots designed to react to newsfeeds, everyone knew that already.  In fact, her announcement on Thursday the 15th that the Fed Funds rate would stay at zero for now wasn’t a shock, either.  Futures markets had been putting the odds of a rate hike in September at less than one in three.

Yet the stock market took something Ms. Yellen said last week the wrong way.  If it wasn’t the interest rate announcement, what was it?

Actually, I think there are two things, one said and one not.

The first, and more important, in my view, is the unspoken but strongly held belief by the nation’s finest economists that if we have to depend on the White House and Congress for economic support, we’re doomed.  That’s because monetary possibilities to plug up a hole in the bottom of the boat are all used up.  The federal arsenal now contains only fiscal policy—changes in government regulation of business, or in spending priorities or in taxes.  The Fed knows it isn’t going to get bailed out by Washington if it raises rates too soon–something that has gotten many nations into trouble in the past.  Therefore, it has to err on the side of caution, even if that’s unhealthy to do.

We all sot of know this, but it’s not a plus to be reminded that as a nation we’re stuck in at best second gear as long as Washington dysfunctions its way through life.

The second, the one said, is that developments in China have the potential to hurt US growth enough to tip us over the edge.  I don’t think the effect on the stock market is so much about the details.  It’s the headline that matters–that the US is no longer so large that we’re impervious to what may happen in any other single country.  It conjures up thoughts of the post-WWI, when the UK passed the mantle of world economic leadership to the US, except that we’re now in the role of the UK.

Again, everyone sort of knew this was happening.  But having it confirmed by our foremost economists is another thing.

To put this in stock market terms, I don’t think Ms. Yellen is calling into question the market’s ideas about current earnings as about the multiple those earnings are worth.




actively managed bond funds in a rising interest rate environment

During my working career as an equity portfolio manager, I experienced the US bear markets of 1980-82, 1987, 1990-91 and 2000-2002. Because I spent the majority of my career as a global manager, I also lived through the collapse of the Japanese stock market (then by far the largest in the world) in 1989 and the currency-triggered bear market in many smaller Asian countries in the late 1990s. I started writing this blog as a way of helping myself think about the bear market of 2007-09 and what would follow.

In other words, for equity managers there have been lots of bad times to help us along with the painful process of being able to, as they say, make the critical distinction between brains and a bull market.

Also, the bad periods themselves have been long enough to force us to recognize that different investment styles (growth or value) work best in different economic circumstances.  We certainly won’t change our overall philosophies.  However, successful equity managers all realize that for them there are some times to be in fifth gear with the gas pedal to the floor and others to be in second gear and tapping on the brakes.


Looking at the bond world from the outside, it seems to me that little of this has been the case for bonds and bond managers since the early 1980s.  Yes, junk bonds or emerging markets debt may have gotten ugly now and again.  Nevertheless, the continual decline in interest rates from the early Volcker years to the present has made for a remarkably smooth, and consistently bullish, ride for bond investors and managers.

The amazing part is not a long bullish period–after all, equities in the US had that for most of the 1990s–but the fact that the benign environment lasted over thirty years.  To have experienced an ugly time for bonds comparable to what happens to stocks every business cycle, you would have to have been a bond manager in the 1970s!

This is my main concern for actively managed bond funds.

We’re (already) in a period in which interest rates are not going to decline.  They may fluctuate for a while, even a long while, but the new main trend is going to be for rates to rise.  And we haven’t had circumstances that have forced bond managers to cope with a situation like this for decades.

Instead, the recipe for success over the past thirty-five years has been to throw caution to the winds and bet as heavily as possible on continuously declining rates.  The most successful managers would have been the most aggressive, the ones willing to double down on any bet gone wrong and to stack their portfolios full of risk.  Brash, bold, stubborn, no sense of nuance, not the brightest crayon but tenacious.  Think Jon Corzine and what happened to him.


Will bond fund managers be able to adjust to the changing trend?  I don’t know.

Bill Gross is another interesting case in point.  He became the “bond king” by betting aggressively on lower interest rates.  My reading of his results for his last several years at Pimco is that he tried to keep his performance numbers up by layering on extra amounts of risk to the main bet that had stopped providing results.  That didn’t work so well, in my view.  Since leaving for Janus, where he could express his ideas in his portfolio without an outside sanity check (outside interference?), he’s done poorly.

This is not about old dogs and new tricks in the sense of age but only in having the temperament and mental flexibility to adjust to changing circumstances.


vendor financing and Carly Fiorina


The leaders in the race for the Republican presidential nomination are both deeply flawed business people.   Both are brilliant marketers.  Both are, paradoxically, running–successfully–on their “records” in business, something that alternately bemuses and appalls the financial community.

The Trump case is complex: excessive use of leverage that all but destroyed the family real estate business in the late 1980s, followed by a successful decades-long struggle to rebuild what was lost.

The Fiorina record is less so:  her tenure at Hewlett-Packard is best summed up by the fact Fortune magazine points out that HPQ stock gained almost $3 billion in market value the day she was fired.

As her poll numbers continue to rise, however, attention is beginning to shift to Fiorina’s tenure at Lucent, a spinoff from ATT that included Bell Labs and ATT’s telecom infrastructure business.  Lucent was a stock market darling in the late 1990s, but collapsed in the early 2000s under an accounting scandal surrounding vendor financing.  Fiorina, who became CEPO of HPQ in 1999, was long gone by then.  But the question is beginning to surface as to what role she played in promoting vendor finance at reckless levels before she left.

So I figured I’d write about what vendor financing is.

vendor financing

I’ve found that a good way of gauging competitive strength is by looking at how quickly a company gets paid for its goods or services.   On the positive end of the conceptual spectrum is the firm that gets paid in full before it makes or delivers stuff.  On the far negative side is the outfit that either gives its products/services away or pays you to take them.

Vendor financing falls much nearer to the negative pole.  It isn’t simply giving customers 180 days to pay.  Vendor financing is long-term loans given to customers by a firm to induce the purchase of that company’s very expensive capital equipment.  In Lucent’s case, vendor financing involved multi-billion dollar deals for telecom infrastructure equipment.

At first blush, there’s nothing wrong with this.

The company providing vendor financing may have a lower borrowing cost than a customer.  So one could argue that this is a relatively harmless way of providing a product discount.  In addition, the fact that a customer doesn’t have to line up bank financing makes it easier for a super salesman to close deals–and lock up clients–in a very short time.  In the land rush to stake out territory in the fast-growing mobile phone infrastructure, it became a staple of dong business in Europe and emerging markets in the 1990s.

Even in its most benign form, however, vendor financing has issues.

It makes company profits look better than they otherwise would be.  Let’s say, for example, my list price is 100, on which I earn an operating profit of 50.  If my customer asks for a discount of 10 to seal the deal, my sale would be 90 and my profit 40.  If I counter with 100 plus cheap long-term financing, then I still show sales of 100 and a profit of 50, even though I’m giving a discount.  The loan I provide simply sits on the balance sheet and has no effect on profits.  So I’ve hidden the discount and inflated my profits.

Like most financial things, vendor financing didn’t remain in its benign form for long.

Telecom vendors soon began offering financing to firms that wouldn’t be able to arrange commercial bank loans.  Then they began to offer loans that would be impossible for customers to repay  …and/or for more equipment than they could ever possibly use.

Lucent was eventually charged by the SEC with accounting fraud.


In an extremely carefully written article on the front page of the New York Times yesterday, Andrew Ross Sorkin reports that Fiorina was involved with a multi-billion dollar Lucent vendor loan to a company called PathNet that had less than $1.6 million in annual revenue (shades of Solyndra)–something that came up in her unsuccessful Senate run in California.

bond funds when interest rates are rising (ii)

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.