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.

 

 

 

seeking outperforming funds

Earlier this morning I ws reading a Wall Street Journal article on the Janus fund group.  What  especially caught my eye was the part on the performance of Janus bond funds.

Over the past one and three years, only 9% and 15% of Janus bond fund assets ranked in the top half of their Morningstar categories.  The corresponding figures from twelve months ago are 75% and 100%.

This home-run-or-strikeout approach to fund management is what I saw when I was competing against Janus equity products ten or twenty years ago.  The idea, which I think is never successful over long periods, is to run portfolios that are built for large deviations from their benchmark indices, in the hope of achieving eye-popping relative returns that will result in large asset inflows.

One problem with this approach is that it’s extremely hard to be very right in a big way on a consistent basis. A second is that, while the freedom to make big bets may be emotionally satisfying for portfolio managers, clients don’t necessarily want the resulting large relative ups and downs.  As one of my former bosses (often, as it turns out) put it, “The pain of underperformance lasts long after the warm glow of outperformance has disappeared.”

That is also, in a nutshell, the basic appeal of index funds:  while there are no sugar highs, there are no heart-attack lows that force the holder to periodically evaluate whether the fund manager knows what he’s doing.   Since there’s really no easy way of knowing, staying with an underperforming fund requires a leap of faith most investors are leery of making.  Better to avoid being put in this position in the first place.

 

This is probably also the gound-level reason Janus is selling itself to Henderson.  It will be interesting to see whether Janus changes its stripes under new ownership.  By the way, achieving such a cultural change is easier than one might think–just change the bonus structure to strongly emphasize batting average and defense instead of Dave Kingman-like power.

where’s the tax selling?

Pretty much all mutual funds and ETFs in the US have tax years that end on October 31st.  They are required by law to distribute virtually all the dividend/interest income and realized capital gains collected during the fiscal year to shareholders by calendar yearend (so that the IRS can collect income tax from holders).

Invariably, funds adjust the size of these distributions during September – October.  Whether this means making them larger or smaller, it involves selling.  This means a seasonal market correction between September 1st and October 15th.  The only exception I’ve seen in over thirty years has been in times directly following a major market selloff like that in 2000 or in 2008-09, when funds are working off massive realized losses–and have no taxable income to distribute.

Last year, for example, the selloff in the S&P was about 7.5% and went from mid-August through late September.  2014’s was 6%+ and lasted from September 19th through October 17th.

This year September has delivered about a 1% loss so far, which would be an extremely small seasonal dip.

 

Where’s the selling?  I don’t know.  Maybe the lack of downward market pressure comes from the fact that the S&P is flat during the current fiscal year.  In any event, if selling doesn’t emerge in the next, say, week, it’s unlikely to develop.

If it doesn’t, we’ll have missed an annual buying opportunity and will have to press ahead with annual portfolio adjustment plans without this advantage.

Odd.

 

12b-1 fees: what they are

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 Sequoia Fund (ii)

large position sizes

At the end of June 2015, the Sequoia Fund had assets of $8.7 billion, of which 28.7% was in shares of Valeant Pharmaceuticals (VRX) and another 10.6% in Berkshire Hathaway.

How did these positions get so large?

a.  The portfolio managers chose to have nearly 40% of their fund in two names.  In fact, as VRX began to decline in the second half of last year, the managers bought more.

Don’t ask me why.  To my mind, following Bernard Baruch’s dictum to have all one’s eggs in one basket may have been ok for the renowned speculator way back when, but it makes no business or economic sense for mutual funds today.  According to the Wall Street Journaltwo members of the board of directors of the fund resigned last year because they disagreed so strongly with the strategy.

b.  SEC diversification rules permit this.  The pertinent regulation has two parts:

  1.  The fund can’t make a purchase of a security if doing so would make its total holding in the security more than 5.0% of fund assets.  At the 5% threshold, the manager can allow the existing position to grow; he just can’t buy more.  Growth can come because the security is outperforming and/or because the total asset size is shrinking.
  2. 25% of the fund’s assets are exempt from rule 1.

The second provision is much less well-known than the first.  I’m not sure why the SEC wrote the rules the way it did (my guess would be lobbying from the fund management industry), but I can’t recall an instance where having a whopping position like Sequoia has with VRX didn’t end in tears.  And I can only recall two other cases, one involving a junk bond fund, another a Pacific Basin fund, where managers took such large bets with shareholder money.

More tomorrow.

 

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.

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.