stuff

I have no idea why the seasonal mutual fund-induced S&P 500 selloff hasn’t happened (so far, at least) this year.  Could be this is just an instance of the adage that the market tends to make the greatest fools out of the largest number of people–namely, me.   But even the best portfolio managers are wrong at least 40% of the time.  Not a profession for people who desperately need to be right about everything.

By the way, another curiosity about the annual mutual fund dividend is that holders strongly desire to have a dividend, even though this means paying income tax on it–but almost no one actually receives the payout.  Virtually everyone elects to have the dividend automatically reinvested in the fund.  In my experience, only holders of 2% -3% of shares actually take the money.  So there’s no need for the portfolio manager to raise cash.

This means the annual selloff is an occasion to do portfolio housecleaning plus optics for shareholders.

 

I heard an interesting radio interview of a prominent fixed income strategist the other day.  He said that the reason gradual money tightening by the Fed in the US has made no impact on the bond market is that central bankers in the EU and Japan are still creating new money like there’s no tomorrow.  That liquidity is offsetting what the US is doing so far to drain the punch bowl.  By next spring, however, both the EU and Japan will be at least no longer manufacturing new liquidity and may be joining the US in tapering down the excess money stimulus.  Once that’s occurring, we’ll see a bond bear market.  At the very least, I think, that would put a cap on stock market gains.  Until then, however…

 

September S&P 500 performance:

–I’ll post details for one month, the third quarter and year-to-date later in the week

–the biggest winners for September were:  Energy +9.8%, Finance +5.1%, IT +4.5%.  Losers:  Staples -1.1%, Real Estate -1.9%, Utilities -3.0%.  S&P 500 +1.9%.

ytd:  IT +24.4%; S&P +12.5%; Energy -8.6%.

why September is usually a bad month for US stocks

It has to do with taxes on mutual funds and ETFs, whose tax years normally end in October.

That wasn’t always true.  Up until the late 1980s, the tax year for mutual funds typically ended on December 31st.  That, however, gave the funds no time to close their books and send out the required taxable distributions (basically, all of the income plus realized gains) to shareholders before the end of the calendar year.  Often, preliminary distributions were made in December and supplementary ones in January.  This was expensive   …and the late distributions meant that part of the money owed to the IRS was pushed into the next tax year.

So the rules were changed in the Eighties.  Mutual funds were strongly encouraged to end their tax years in October, and virtually every existing fund made the change.  New ones followed suit.  That gave funds two months to get their accounts in order and send out distributions to shareholders before their customers’ tax year ends.

getting ready to distribute

How do funds–and now ETFs–prepare for yearend distributions?

Although it doesn’t make much economic sense, shareholders like to receive distributions.  They appear to view them as like dividends on stocks, a sign of good management.  They don’t, on the other hand, like distributions that are eitherminiscule or are larger than, say, 5% of the assets.

When September rolls around, management firms begin to look closely at the level of net gains/losses realized so far in the year (the best firms monitor this all the time).  In my experience, the early September figure is rarely at the desired target of 3% or so.  If the number is too high, funds will scour the portfolio to find stocks with losses to sell.  If the number is too low, funds will look for stocks with large gains that can be realized.

In either case, this means selling.

Some years, the selling begins right after Labor Day.  In others, it’s the middle of the month.  The one constant, however, is that the selling dries up in mid-October.  That’s because the funds’ accountants will ask that, if possible,  managers not trade in the last week or so of the year.  They point out that their job is simpler–and their fees smaller–if they do not have to carry unsettled trades into the new tax year.  Although the manager’s job is to make money for clients, not make the accountants happy, my experience is that there’s at least some institutional pressure to abide by their wishes.

Most often, the September-October selling pressure sets the market up for a bounceback rally in November-December.

 

 

 

actively managed ETFs begin to attract investors

About 2 1/2 years ago, I first wrote about actively managed ETFs.

As I mentioned in greater detail then, for buy-and-hold investors ETFs can be substantially cheaper than mutual funds.  That’s because mutual funds maintain their own high-cost distribution and recordkeeping networks, while ETFs use the much larger, and cheaper, infrastructure maintained by Wall Street brokerage firms.  To pluck a number out of the air, the added value of the ETF route could be 50 basis points (0.5%) in annual return.

Active ETFs have never really taken off, though.  That’s partly because start-up active ETFs can be illiquid, and therefore difficult to trade.  And, again because of their small initial size, expense ratios can appear to be very high.  In addition, large mutual fund groups have been reticent to launch active ETF clones of their mutual funds.  Most firms don’t want to be pioneers.  But also, if an associated ETF begins to trigger redemptions of a mutual fund, the fund’s expense ratio will begin to rise–presumably creating more momentum to redeem.  That’s because the costs of distribution will be spread over fewer shares.

This may all be beginning to change.

As Factset reports, actively managed ETFs had large inflows for the first time ever in May.

Two things caught my eye:

–the Principal Financial Group launched an actively-managed, dividend-focused global ETF last month that took in $424 million, and

–ARK Investment Management, a small firm focused on “disruptive innovation”  received $37.3 million in new money in its flagship ARK Innovation ETF (ARKK) + the ARK Industrial Innovation ETF (ARKQ)  (Note:  I’ve owned ARKW, the firm’s internet fund, for a long time).  ARKK and ARKQ together had assets of $53.4 million at the end of April.

My first thought about the strong ARK showing was the attraction could be that the firm has been an early investor in the Bitcoin Investment Trust (GBTC).  But ARKQ doesn’t hold it.

It’s noteworthy, too, that Principal should want to cannibalize its mutual funds–although it’s always better to cannibalize yourself than to have other firms do it.

 

We may be at a positive inflection point in the development of active ETFs.  Good for innovation, if so.  Bad for stodgy mutual fund complexes, at the same time.

 

August-October in mutual fund/ETF-land

 August has traditionally been a slow month in financial markets, for two reasons:

–Europe, including European factories and stock markets, pretty much closes up for the month and everyone goes on vacation

–on this side of the Atlantic, high-level Wall Streeters head for the Hamptons, leaving behind cellphone numbers and assistants who have less authority to make independent decisions–and who certainly don’t execute changes in strategy.

Yes, in today’s world the EU is much less significant than it used to be and Industrials as a group are a mere shadow of their former selves.  But the vacation effect is still a powerful soporific.

 

In September, mutual fund/ETF minds turn toward the end of the fiscal year, which occurs on Halloween.

Mutual funds/ETFs are special-purpose corporations.  Their activities are restricted to investing; they’re required to distribute to shareholders as dividends each year virtually all of the profits they recognize.  (In return for these limitations, they’re exempt from corporate income tax on their gains.)

About thirty years ago, with government encouragement, the industry moved up the end of its fiscal year from December to October.  This gave funds two months post-yearend to put their books in order and get checks in the mail in December, so the IRS could collect income tax from holders on those distributions in the current year.

Because of this, fund/ETF preparation for the October 31st yearend typically begins in early or mid-September.  It invariably involves selling.

How so?

For reasons that completely escape me, mutual fund holders like to receive distributions. They regard it as a mark of success.  And they seem to like a payout of around 2% -3% of asset value.

For most of the year, the tax consequences of their decisions are not in the forefront of portfolio managers’ minds (strong industry belief is that taxes are tail that shouldn’t be allowed to wag the portfolio dog).  As a result, distribution levels most often require fine-tuning.  This means either selling to realize an additional gain, or selling to realize an additional loss.  Either way, it means selling.

At the same time, this occurs close enough to the end of the calendar year that PMs often use the opportunity to begin to make major portfolio revisions in anticipation of what they think will play out in the following calendar year.  This means more selling.

 

October often sees the beginning of a rally that lasts into December, as the fiscal yearend selling pressure abates.  Accountants play a role here, as well.  Every organization I’ve been in requests that PMs avoid trading, if possible, during the last two weeks of the fiscal year.  That’s to avoid the possibility that a trade has settlement problems and isn’t completed until the beginning of the following fiscal year.  PMs mostly play only lip service to requests like this, but it does ensure that purely tax-related selling is over by mid-month.

 

a(n important) footnote

Like any other corporation, if a mutual fund/ETF has net losses, it carries them forward for use in subsequent years.  Virtually every fund/ETF has been saddled for years with large tax loss carryforwards generated by large panic redemptions at the bottom of the market in 2008-09.  These had to be offset by realized gains before a distribution would be possible.

Last year was the first time that enough funds/ETFs had used up losses and were able to make distributions.  During the second half of last September, the S&P 500 fell by about 5%, before rallying from  early October through late November.

 

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.

 

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.