Tag Archives: money

mutual fund and ETF fund flows

July 21, 2016 By in ETFs Vs. Mutual Funds, mutual fund holders and financial advisors, Portfolio management, Uncategorized Tags: , , , , , , 2 Comments

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.

 

12b-1 fees: what they are

April 25, 2016 By in 12b-1 fees, Getting financial advice, How your broker gets paid, securities markets Tags: , , , , Leave a comment

fiduciary

The recent Labor Department determination that all financial advisors making recommendations for individuals’ retirement savings must act as fiduciaries is reviving interest in the topic of mutual fund/ETF fees and expenses.

Being a fiduciary means that the advisor has to place the client’s interest ahead of his own.  It isn’t permissible, for example, for a fiduciary to recommend an investment that is likely to return 5% per year, for selling which he gets a large commission, over a virtually identical one that will return 8%, but which pays a small commission.  For a non-fiduciary, which is what brokers/financial planners are when dealing with non-retirement assets, pushing the low return/high commission alternative is still ok legally.

Personally, I don’t like it that the fiduciary standard doesn’t apply to non-retirement investments.  I also don’t understand why individual investors don’t appear to be worked up about this.  I do understand why the big banks are opposed to fiduciariness, since applying the fiduciary standard to all advice to individuals strikes at the heart of the profits of the traditional “full service” brokerage industry.

12b-1 fees

The 12b-1 part refers to the section of the Investment Company Act of 1940 that governs how an open end mutual fund is allowed to pay for fund distribution and servicing.  It covers things like advertising, sending materials to prospective shareholders or having a call center to answer questions about the fund.

The general idea is that a fund benefits from retaining existing shareholders and adding new ones, so it’s a legitimate use of shareholder money to promote both objectives.

But the most common use of funds under the 12b-1 rule–and the least well understood, in my view–is periodic payments to financial advisors by a fund while clients continue to hold shares.   In the industry, these payments are called “trailing commissions,” or “trailers.”

The SEC doesn’t limit the amount of this fee, although FINRA (the Financial Industry Regulatory Authority, the investment industry trade group) rules set an effective  cap of 1.0% of fund assets yearly.  My sense is that the most common fee percentage for an equity fund is 0.25% – 0.50%.  The best hard data I can find come from the ICI (Investment Company Institute, a mutual fund trade group), and are from 2003.  At that time, aggregate 12b-1 fees amounted to just under half the total administrative expenses, at 0.43% of assets annually.  The rest were old-fashioned (more clearly understood by customers) sales charges.

why is 12b-1 a current issue?

Historically, disclosure of these fees has been exactly crystal clear.  Try finding information about them on the ICI website, if you don’t believe me.  In fact, I can’t recall having met anyone not involved in selling mutual funds who was aware these fees exist.

So, does a broker/financial planner who advises a client on retirement investments in mutual funds have to make sure the customer understands that 12b-1 fees are being subtracted from NAV on a regular basis?  Once he gets that, does the customer put two and two together and realize he’s subject to these fees on non-retirement investments, too–and has been from day one?

How does he react?

The difficulty I’ve experienced in gathering factual data for this post tells me that fund companies think the reaction will be strongly negative.

 

the jobs report and last Friday’s trading

October 5, 2015 By in Current Market Thoughts, employment, Employment Situation report, securities markets, stock market, Trading Tags: , , , , , , , 1 Comment

I had decided last week to write today about what happens in an overall market when one or two significant sectors are performing poorly and have weak future prospects.  Is the rest of the market indifferent to the laggards?   or do the weak sectors work to sap the strength of sectors where business is good and the outlook favorable?  This is potentially important, given the miserable performance of the Energy, Materials and Industrials sectors–and the likelihood of no positive news for these areas of the stock market for a considerable time to come.

After I saw the sharp negative reaction of the market to the so-so Employment Situation report released Friday morning, I decided to push that post back until tomorrow and write about Friday’s market action instead.

 

There’s been  lot of discussion recently about the role of computerized trading in influencing the day-to-day, or hour-to-hour, direction of stocks on Wall Street.  Understanding what effect this trading is having on stocks is the first step in the stock market’s judo-like process of beginning to use the momentum of such trading against itself.  For investors like us with long holding periods in mind, one might argue that day-to-day volatility has little significance.  Even so, it seems to me it’s important to be able to read the signals the market is sending    …alao, understanding the rhythms of daily trading can be some help in determining the timing purchases and sales we may be thinking about for strategic reasons.

 

Last Friday, stock index futures fell immediately on the Labor Department release of the monthly ES report.  Stocks fell sharply at the open, an hour later.  Equities remained depressed for about an hour, before beginning a steady ascent through the rest of the day.  The S&P 500 closed on its high.  This is a particularly positive sign, since professional traders tend not to want to hold positions over the weekend if they have even the slightest worries.

On the surface, the ES report isn’t encouraging reading.  The economy gained 142,000 jobs last month.  That was substantially below the average gain for the past year, and it was much less that the 200,000 new positions that economists had estimated.  More than that, the two previous months’ estimated job gains were both revised down.  All of this was emphasized in media reports that were available a minute or two after the 8:30am edt release of the information.

Several important factors weren’t mentioned, however:

–economists’ estimates of +200,000 new jobs were, as usual, very close to the average monthly gain in jobs over the past year, leading me to conclude that getting this figure right is not their highest priority

–that’s understandable.  The Labor Department says that the monthly job figures from its Establishment survey are correct to within +/- 100,000, meaning a “miss” of 50,000 or so jobs contains no statistically significant information

–we’ve seen outlier months occasionally over the past several years.  In each case, job gains have soon returned to trend

–the latest JOLT (Job Openings and Labor Turnover) Survey from the Labor Department shows that the country has 5.7 million unfilled jobs at present, a figure 25% higher than at the previous economic peak in 2007.  This is also an all-time high for the JOLT tally, which makes it hard for me to believe that the September jobs report heralds a significant downshift in US economic activity.

How do I read Friday trading?

I think computers programmed to read news services pushed the market down, both in pre-market futures trading and in the first hour of actual stock trading, as well.  Human traders (smarter computers?) waited for the downward momentum to exhaust itself and, recognizing that this initial move was a mistake, then began buying.

Although I think my analysis is correct–Friday’s trading pattern was very unusual–I also find it very odd that someone (actually lots of someones) would be content to trade on a government report + questionable sentiment indicators.  But maybe that’s the world we’re in today.   If anything, it argues for higher day-today volatility.  It also suggests that there’s money to be made for those with better-than-newspaper knowledge, a trading temperament and time to watch the market closely.

 

 

 

 

vendor financing and Carly Fiorina

September 23, 2015 By in Uncategorized Tags: , , , , , , Leave a comment

prelude

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.

risk and volatility

September 14, 2015 By in risk = volatility, Uncategorized Tags: , , , , , 1 Comment

risk

I think that defining what risk is is the most difficult topic in finance/investing.

I’m not sure there’s one answer that fits everyone and everything.

We do know that individuals’ perception of what risk entails changes as they age or as their wealth increases; they become more conservative.  We also know that appearances can be deceiving.  A model with a perfectly proportioned body may be clumsy or a terrible athlete.  Experience counts for something, as well.  Situations that appear risky when a neophyte is in control, like in doing brain surgery, may in fact be relatively safe in the hands of an expert.  Information is important, too, like having enough data or experience to know who is the beginner and who is the well-trained seasoned pro.

risk as volatility

Academic finance, and following its lead, pension consultants and their pension fund clients, have all chosen to reduce this complexity to a single concept, risk = volatility.  In other words, the magnitude of day to day price changes in securities. This can be expressed either in absolute form or relative to some benchmark, and may be measured over differing time periods.

Defining risk as volatility has three big advantages:

–easy data availability

–quantitative form

–simplicity.

In a world where no one runs with scissors or texts while driving, or where there’s never a flood, a tornado or huge food items falling from the sky (like in Chewandswallow), that would be enough.

In practice, however, volatility isn’t such a hot measure.

On a very abstract level, there’s no recognition of the issue that philosophers have been pondering for the past two centuries or so–that groups may not be connected by every member having a single thing in common.  One alternative is the possibility of “family resemblances” popularized by Ludwig Wittgenstein over a half-century ago.  So maybe there isn’t one common factor that constitutes risk.

On a more practical level, in the real world not everyone has the same information.  History also shows that markets periodically become highly emotional, either wildly optimistic or deeply pessimistic.  My conclusion, based on decades of experience, is that the results of daily trading don’t constitute infallible indicators.  Quite the opposite–most often one should take the evidence of daily trading with a grain of salt.

…but does it trade?

To my mind, though, the most striking failure of volatility as a risk measure is that it doesn’t take liquidity into account.

An example of what I mean:

In the mid 1980s, I came across for the first time academic articles that touted real estate as the most attractive of major asset classes.

How so?

The argument was that since the end of WWII real estate had not only a higher annual rate of return than stocks or bonds, but it also had the lowest average price volatility of the three.  Not only did real estate deliver the highest absolute gains, but adjusting for its low “risk” property ownership looked even better.  This was an odd result, because one typically thinks that reward and risk are directly correlated, not inversely.  But no one questioned it.

real estate

Anyone who has owned a home over an extended period of time, to say nothing of owners of commercial or office real estate, knows this is loony.  In bad times, bank finance disappears and, along with this, so too transactions.  During 1981-83 in the US, when I experienced this phenomenon first-hand, houses could only be sold at extremely steep discounts to pre-recession prices–or to owners’ notions of fair value based on rental equivalents.  Potential buyers made very low-ball offers, prospective sellers took their homes off the market, and no transactions happened.  In the very narrow sense, therefore, volatility was low.  But that was because there were no sales to demonstrate how the market had deteriorated, prices were stable.  You just couldn’t sell.

junk bonds

The collapse of the junk bond market in the late 1980s demonstrated the same idea.  Junk bonds had been touted as having “all the rewards of stocks with all of the safety of bonds.”  The safety part proved an illusion.  The apparent stability of the net asset values of junk bond funds ended up resting in large part on the fact that the bonds they held seldom traded.  So every day the funds priced themselves using more or less the last trade, which might have been weeks ago–and which might not reflect current circumstances.  This idyll lasted until funds began to have net redemptions, forcing them to sell bonds at real market prices, which were often way below their carrying value on  fund books.