Monthly Archives: September 2015

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.

 

what liquidity is to the SEC

September 29, 2015 By in liquidity Tags: , , , Leave a comment

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.

liquidity

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.

subjectivity

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.

skill

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.

bonds

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

September 28, 2015 By in Uncategorized Leave a comment

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

September 25, 2015 By in China, Current Market Thoughts, Portfolio management Tags: , , , , Leave a comment

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

September 24, 2015 By in Bond Environment, bond market, junk bonds, Portfolio management, securities markets, Strategy Tags: , , , , Leave a comment

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.