mutual fund and ETF fund flows

away from active management…

There’s a long-term movement by investors of all stripes away from actively managed mutual funds into index funds and ETFs.  As Morningstar has recently reported, such switching has reached 2008-era levels in recent months.  Surges like this have been the norm during periods of uncertainty.

The mantra of index proponents has long been that investors can’t control performance, but they can control costs.  Therefore, all other things being more or less equal, investors should look for, and buy, the lowest-cost alternative in each category they’re interested in.  That’s virtually always an index fund or an ETF.

Active managers haven’t helped themselves by generally underperforming index products before their (higher) fees.

…but net stock inflows

What I find interesting and encouraging is that stock products overall are receiving net inflows–meaning that the inflows to passive products are higher than the outflows from active ones.

why today is different

Having been an active manager and having generally outperformed, neither of these negative factors for active managers bothered me particularly during my investing career.  One thing has changed in the current environment, though, to the detriment of all active management.

It’s something no one is talking about that I’m aware of.  But it’s a crucial part of the argument in favor of passive investing, in my opinion.

what is an acceptable net return?

It’s the change in investor expectations about what constitutes an acceptable net return.

If we go back to early 2000, the 10-year Treasury bond yield was about 6.5%, and a one-year CD yielded 5.5%.  US stocks had just concluded a second decade of double-digit average annual returns.  So whether your annual net return from bonds was 5.5% or 5.0%, or whether your net return from stocks was 12% or 11%, may not have made that much difference to you.  So you wouldn’t look at costs so critically.

Today, however, the epic decline in interest rates/inflation that fueled a good portion of that strong investment performance is over.  The 10-year Treasury now yields 1.6%.  Expectations for annual stock market returns probably exceed 5%, but are certainly below 10%.  The actual returns on stocks over the past two years have totalled around 12%, or 6% each year.

rising focus on cost control

In the current environment, cost control is a much bigger deal.  If I could have gotten a net return of 6% on an S&P 500 ETF in 2014 and 2015, for example, but have a 4% net from an actively managed mutual fund (half the shortfall due to fees, half to underperformance) that’s a third of my potential return gone.

It seems to me that so long as inflation remains contained–and I can see no reason to think otherwise–we’ll be in the current situation.  Unless/until active managers reduce fees substantially, switching to passive products will likely continue unabated.  And in an environment of falling fees and shrinking assets under management making needed improvements in investment performance will be that much more difficult.

 

takeovers and market price indications: Softbank/Arm Holdings

Softbank is bidding £17 per share for ARM, an offer that management of the chip design company has quickly accepted.  ARM closed in London at £16.61 yesterday, after trading as high as £17.52 in the initial moments of Monday trading–the first time the London market was open after the bid announcement.

What is the price of ARM telling us?

Let’s make the (reasonable, in my opinion) assumption that the price of ARM is now being determined by the activity of merger and acquisition specialists, many of whom work in companies mainly, or wholly, devoted to this sort of analysis.

These specialists will consider three factors in figuring out what they’re willing to pay for ARM:

–the time they think it will take until the takeover is completed (let’s say, three months),

–the cost of borrowing money to buy ARM shares (2% per year?) and

–the return they expect to make from holding the shares and delivering them to Softbank.

They’ll buy if the return is high enough.  They’ll stay on the sidelines otherwise.

Suppose they think that without any doubt the Softbank bid for ARM is going to succeed–that no other bidder is going to emerge and that the takeover is going to encounter no regulatory problems (either delays or outright vetoing the combination).  In this case, the calculation is straightforward.  The only real question is the return the arbitrageur is willing to accept.

I haven’t been closely involved in this business for years.  Although I know the chain of reasoning that goes into determining a potential buy point, I no longer know the minimum an arbitrageur considers an acceptable.  If it were me, 10% would be the least I’d accept if I thought there were any risk;  5% might be my lower limit even if I saw clear sailing ahead.  If nothing else, I’m tying up borrowing power that I might be able to use more profitably elsewhere.

Let’s now look at the ARM price.

At £16.61, ARM is trading at a 2.3% discount to the offer price.  An arbitrageur who can borrow at 0.5% for three months stands to make a 1.8% return by buying ARM now.  Ugh!  The only way to make an acceptable return, if the assumptions I’ve outlined above are correct, is to leverage yourself to the sky.

 

From this analysis, I conclude two things:

–the market is not worrying about any regulatory impediments to the speedy conclusion of the union.  Quite the opposite.  Otherwise, someone would be shorting ARM.

–buyers seem to me to be speculating in a very mild way that a higher bid will emerge.  If they had strong confidence in another suitor coming forward, the stock would be trading above £17.  If they were 100% convinced that there would be no new offer, I think the stock would be trading closer to £16.25, a point which would represent an annualized 20% return to a purchaser using borrowed money.

 

 

 

Softbank and Arm Holdings (ARM)

My thoughts:

–the price Softbank is offering for ARM seems very high to me.  That’s partly intentional on Softbank’s part, not wanting to get into a bidding war.  It’s also based on Softbank’s non-consensus belief that the development of the Internet of Things will be a much bigger plus for ARM than the consensus understands.

–I’m rereading the resignation of Nikesh Arora as a sign of his disapproval of the acquisition, not of Masayoshi Son’s remaining at the helm of Softbank

–ARM seems to be content to be bought.  And why not?  Holders of ARM stock and options will get a big payday.  Softbank has no semiconductor design expertise, so ARM will likely run autonomously under the Son roof.  Softbank is also apparently promising to keep the company headquarters in the UK as well as to substantially increase the research staff.

–A competing bid is unlikely.  That’s mostly because of the price.  But ARM management knows it would never have the operating freedom as a subsidiary of Intel or Samsung (the most logical other suitors) that it would as part of Softbank.  When the company’s assets leave in the elevator every night, any unfriendly bid is inherently risky.  Doubly so when it threatens a really sweet deal.  No, I don’t think antitrust issues would be a deterrent to a bid.

–Will the UK allow the deal?  The Financial Times, which should be in a position to know, suggests that the UK might not.

How so?

ARM is basically the country’s only major technology company, so domestic ownership may be an issue of national prestige and pride.  There’s certain to be some opposition, I think.  And crazier things have happened.  For example, France disallowed Pepsi’s bid for Danone on the argument that the latter’s yogurt is a national treasure.  In the late 1970s, the US barred Fujitsu from buying Fairchild Semiconductor on grounds that foreign ownership presented national security risks   …and then allowed it to be sold to French oilfield services firm Schlumberger.  More recently, the US scuttled the sale of a ports management business that runs Newark and other US ports to the government of Dubai, an ally, on security grounds.  The would-be seller was also foreign, P&O of the UK.

This is the major risk I see.

the EU today: structural adjustment needed

Let’s assume that my description of the EU ex the UK is correct–that beneficiaries of the traditional order (the elites) are, and will continue to be, successful at thwarting structural change that would rock tradition but produce higher economic growth.

How should an equity investor proceed?

There are two schools of thought, not necessarily mutually incompatible:

–the first is that in an area where there is little growth, companies with strong fundamentals will stand out even more from the crowd.  This lucky few will therefore gain much of the local investor interest, plus the vast majority of foreign investor attention.  If so, in places like continental Europe or Japan one should look for fast-growing mid-cap companies with global sales potential for their products and services.  These will almost certainly outperform the market.

The more important question for an equity investor is whether they will do as well as similar companies domiciled and traded elsewhere.

–my personal observation is that the general malaise that affects stock markets in low-growth areas like Japan or the EU infects the fast growers as well.  The result is that they don’t do as well as similar companies elsewhere.  I haven’t tried to quantify the difference, but it’s what I’ve observed over the years.

It may be that the local market is offended by brash upstarts.  It may be that local portfolio managers deal only in book value and dividend yield as metrics.  It may simply be the fact that local laws prevent owners from eventually selling to the highest bidder, thereby damping down the ultimate upside for the stock.  One other effect of a situation like this is, of course, that entrepreneurs leave and set their companies up elsewhere.

 

The bottom line for a growth investor like me is that these areas become markets for the occasional special situation, not places where I want to be fully invested most of the time.  Because of this, and because of Brexit, the UK assumes greater importance for me.  So, too, Hong Kong, as an avenue into mainland China.  And to the degree I want to have direct international exposure–which means I want to avoid the US for whatever reason–emerging markets also come into play.

 

A final thought:  one could argue that the lack of investment appeal I perceive in Japan and continental Europe has nothing to do with political or cultural choices.  Both areas have relatively old populations.  If it’s simply demographics, signs of similar trouble should be appearing in the US within a decade.  I don’t think this is correct, but as investors we should all be attentive to possible signs.

 

internal and external economic adjustment

This is ultimately about the euro and the EU.  Today’s post is about creating a framework for thinking about this issue.

It’s a condensed version of a longer post I wrote six years ago on Balance of Payments (actually, a series, for anyone who’s interested).   Although a big simplification of what is actually going on in the world, it highlights what I believe is a central structural issue facing the EU and Japan today   …and potentially the US, at some point.

 

imports and exports

The residents of any given country typically don’t consume only items made in that country.  They buy imported goods as well.  In fact, the marginal propensity to consume imports is normally higher than the marginal propensity to consume, meaning that as spending increases imports rise at a faster rate.

paying for imports

The country as a whole gets the money to pay for imports in one of a number of ways:  it can make things to sell to foreigners, it can use accumulated savings, it can sell assets to foreigners or it can borrow.

imbalances

In an ideal world, every country would make and sell exactly enough goods and services through export to pay for the imports it purchases.  That’s seldom the case, however.

chronic deficit

Consider a country that, year after year, buys more from foreigners than it can pay for with the proceeds from what it sells.  To continue consuming foreign goods at the same rate, such a country has to either sell assets, like land or companies, or borrow from foreigners.  At some point, however, it will reach the limits either of what it has that others want to buy or the amount foreigners will lend.

This situation sets the stage for a potential foreign currency/trade/economic growth crisis.

internal/external adjustment

Here’s where we get to internal/external adjustment.

There are two ways of dealing with this issue:

internal

–the government can slow down overall consumption (essentially, create a recession) by raising interest rates/taxes by enough to decrease consumption of foreign goods and services

–domestic industries can voluntarily restructure themselves, with/without government help, to improve quality and lower prices so they make more things foreigners will want (unlikely to happen on a large scale)

–the government can erect tariff or regulatory barriers to imports, to try to redirect consumption to domestic goods (almost always a bad idea:  look at the US auto industry since the mid-Seventies)

None of these actions are likely to win unanimous applause from voters.  And if legislative action produces negative results, it will be completely clear who is to blame.  So politicians everywhere, and particularly in badly-run countries, tend to not to want to choose any one of them.  Instead, they most often opt for the external adjustment route.

external

–This means to encourage or embrace a decline in the local currency versus that of trading partners.  That simultaneously makes foreign goods more expensive for locals and local goods cheaper for foreigners.  Devaluation will encourage exports and inhibit imports, achieving the same end as rising interest rates, but without the sticky legislative fingerprints attached.  It’s those horrible foreign exchange markets instead.

 

More tomorrow.

 

 

 

 

 

 

mutual funds/ETFs in time of stress

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

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.

 

Follow

Get every new post delivered to your Inbox.

Join 425 other followers