Tag Archives: mutual funds

current equity market money flows

April 2, 2013 By in Current Market Thoughts, ETFs Vs. Mutual Funds, index funds, Industry Analysis, Investment firms, securities markets, stock market Tags: , , , , , , , , 1 Comment

There’s been a lot of press recently about investors suddenly waking up after four years of strong market gains and deciding to take their money out of “safe” fixed income investments and put it into stocks.

What’s implied in many of these articles is that this flow is what’s putting the recent zip into the S&P 500.  What’s also implied, and sometimes stated, is that this is the “dumb money” whose arrival on stage is a signal that we’re entering the closing act of the current bull market.

Both implications might have some truth to them.  But neither is anything like the full story.   Most people are a lot smarter than that.  Money flows are a lot more complex.

This is what I see:

1. Any money going into stock market mutual funds or ETFs is not coming out of bonds.  Bond funds have had large inflows every month since January 2009, except for tiny outflows in December 2010 and August 2011.

Money coming into bond mutual funds accelerated in 2012, to around $25 billion a month, according to the Investment Company Institute, the mutual fund trade organization.

2.  Bond inflows have been matched by steady though smaller, outflows from stock mutual funds.  The lost stock mutual fund money may be feeding part of the bond buying binge.  But there are also two important trends within the equity world.

–There’s a big multi-year shift away from actively managed equity mutual funds toward index ETFs.  Two reasons:  better performance, and lower costs.  ETF flows are clearly much healthier than equity mutual funds’.

–Virtually all the net equity mutual fund outflows have been coming from US-only funds.  Global, international and emerging market mutual funds have been at least treading water.  Similar ETFs are seeing large inflows.  Again, this has been happening for years.

3.  So far in 2013 over $60 billion in net new money has come into equity mutual funds, breaking an almost two-year stretch of outflows.  Two-thirds of that has gone, as usual, into global etc. funds.

Much more interesting, to my mind, but almost completely unnoticed, is the HUGE outflow of over $112 billion from equity funds that occurred last year, from August through December.

Why this rush to the door?  My guess is that this is the final shoe dropping from the stock market collapse of the Great Recession. In my experience, some investors will panic and sell at the bottom.  Others will nurse their wounds and refuse to sell until they get back to breakeven.  Then nothing on heaven or earth can persuade them not to take their money and run.  I’ve turned around two woefully underperforming global funds for two different organizations.  In both cases, this sort of almost inexplicable outflow was the last step in the healing process.

If that’s what happened during the second half of 2012, it’s a significant bullish sign for stocks.

Morgan Keegan, fund directors and fair value pricing: and SEC action to keep tabs on

March 27, 2013 By in ETFs Vs. Mutual Funds, fair value pricing, Getting financial advice, index funds, Investment firms Tags: , , , , , Leave a comment

Morgan Keegan, now a part of Raymond James, was a regional brokerage firm with a strong fixed income emphasis.  It was severely wounded by large losses in fixed income mutual funds during the housing meltdown, and by subsequent SEC legal actions.  The regulator accused the firm of misrepresenting the risk character of some mutual fund offerings to potential clients and of systematically mispricing funds over extended periods of time.  As part of a settlement, the portfolio manager who ran a number of these funds agreed to a fine of $500,000 and a lifetime ban from the securities industry.

“So, what’s new?” you may ask.

What’s unusual about this case is that late last year the SEC sued the boards of directors of some of these funds for what it says was their failure to ensure that the funds were priced correctly.   Although directors are, legally speaking, the highest-ranking officials in any mutual fund and are therefore directly responsible for the conduct of the fund’s officers and staff, the SEC has until now only held the investment professionals and support staffs of wayward funds accountable for their actions–and left the directors alone.

my thoughts

1.  The returns cited by the Wall Street Journal  for one of these funds in reporting on this case are really ugly.  It lost 30% of its value in 2008 vs. a return of +6.8% by the fund’s performance benchmark.  In 2008, the fund was down by 73.2% vs. a benchmark return of +4.0%.

2.  Fair value pricing–meaning having third-party experts estimate a price for a security if there are no trades for it on a given day–is an important issue.  Typically a rogue manager or a rogue firm will want to assign securities a price that’s too high, to disguise a fund’s underperformance.

The problem:  shareholders who sense the problem early and cash in their shares get more than their share of the fund assets, leaving loyal/trusting shareholders with a large hole in their fund NAV once the fraud is uncovered.

3.  Fair value pricing isn’t a new issue.  It was a big problem during the collapse of the junk bond market in the late 1980s.  It was also the centerpiece of Eliot Spitzer’s expose of shady practices by international funds in the mid-1990s.  Apparently the SEC again called mutual fund boards’ attention to possible fair value pricing issues with funds holding mortgage-backed bonds in 2007.

4.  The SEC must think that its warnings were being ignored by mutual fund boards and that it had to make an example of someone.

5.  If so, the agency appears to have chosen its target well.  Morgan Keegan isn’t a large, deep-pocketed, politically powerful investment banker like Goldman Sachs or Morgan Stanley.  The Morgan Keegan name no longer exists.  The firm has recently been sold to Raymond James, whose executives presumably have no personal ties with the accused directors and no interest in prolonged or expensive litigation which would only keep any past Morgan Keegan misdeeds in the public eye.

Yes, the directors doubtless have liability insurance against possible lawsuit.  But my guess is that the insurer in question may assert that coverage doesn’t extend to instances like this.

This case has the potential to change the way mutual fund directors are selected, what qualifications they should have, how they carry out their duties and how much they’re paid.  It’s worth keeping an eye on.

why September’s such a bad month for stocks

September 7, 2011 By in Cash position, Portfolio management, Recent Market Action, Securities regulation, yearly distributions Tags: , , , , , , , , 1 Comment

welcome to September 2011

This year, September has opened to a mini-swoon in world stock markets caused by a poor jobs report in the US, worries about the government suing banks over past sub-prime mortgage sins, and general panic about Greece (the EU political “plan,” if you’d call it that, appears to be to let the situation deteriorate to the point that voters will be grateful for even a painful rescue and not kick out the politicians who caused the problem in the first place).

the annual September equity decline

Who knows how long this downdraft will last–as I’m writing this, global equities appear to be rallying a bit, but this isn’t the normal seasonal decline in stocks.

It’s really not just September when stocks go down, either.  There’s a several-week period of selling that typically starts each year in mid-September and ends in mid-October.  But there’s usually a rally toward the end of October, so the early-month decline is less obvious.

This decline has nothing to do with the macroeconomy or stock valuation.  It’s all about mutual fund taxes.

here’s why

Mutual funds in the US (ETFs, too) are a special type of corporation.  Their activities are limited to investing, and they’re required to distribute to shareholders virtually all of their net realized profits soon after the end of each tax year.  In return for these restrictions, they’re exempt from corporate tax on their gains.  Only shareholders pay.

The tax year for virtually all mutual funds, which determines how much they must distribute, ends on October 31st.

adjusting the distribution

Shareholders like to get a distribution, which they take to be a sign that things are going well.  This makes no sense to me–better to “ride your winners” and let gains compound without paying tax–but that’s what the customers want.

On the other hand, people don’t like to pay taxes, so they don’t want a gigantic distribution (over 5% of the fund’s assets), either.

So mutual fund managers start to adjust the size of their potential distributions sometime in September.

This involves a lot of selling. 

If the required distribution is too big, a manager will scour his portfolio for stocks where he has a loss that he can sell.  If there’s no distribution, or if the payout will be too small, he hunts around for positions where he can justify taking a partial profit. 

It’s not about actually sending money to shareholders,

as I’ve heard “experts” on finance talk shows say.  An overwhelming majority of mutual fund shares, say, 95%+, sign up for automatic reinvestment of distributions.  So if the yearend gains add up to 5% of the fund assets, the amount of money that actually leaves the fund is .05 x .05 = .0025, or .25% of the assets.  That’s far less than the frictional cash a manager needs to have on hand to ensure smooth settlement of trades.  So the transfer of funds is not a big deal.

this tax planning is healthy, in my view

It gives a reason for a manager to step back and take a hard look at all the fund’s positions.  It also gives him a psychological excuse to dump out stocks where he’s hoping against hope that they’ll work out (trust me, even the top managers have one or two of them).

one caveat

If a fund has unused tax losses left over from prior years–and many still have them as scars from panic redemptions by shareholders in late 2008-early 2009–it can’t make a distribution until those losses are gone.  Either the fund makes offsetting gains (which won’t be subject to tax–a good thing) or the losses expire.

In either case, there’s no need to take part in the yearly September-October tax selling ritual.

this year?

My guess is that tax selling season will be relatively mild.  The S&P 500 is showing about a 1% loss since last Halloween.   So unless a manager made very large adjustments to his portfolio positioning a few months ago, when stocks were considerably higher, the gains generated in day-to-day portfolio activity shouldn’t be large.  Also, at least some funds will continue to be in a net loss position, so they won’t be able to make distributions no matter what.

 

 

are South Korea and Taiwan emerging markets?: implications for index mutual funds/ETFs

June 12, 2011 By in Current Market Thoughts, emerging markets, ETFs Vs. Mutual Funds, Purchasing power parity (PPP) Tags: , , , , , , Leave a comment

Korea and Taiwan aren’t emerging economies…

Korea has been a member of the Organization for Economic Co-operation and Development, the association of developed nations, since 1996.  Taiwan would presumably be a member, too, if it were not for China’s insistence that Taiwan is not a separate country, but a prodigal province of the mainland.

On a GDP per capita basis, Korea and Taiwan rank #33 and #37 in the world, respectively, just above the Czech Republic, which is also an OECD member.  On a Purchasing Power Parity basis, the two rank #25 and #20 by their per capita GDP–around the same level as the UK, France and Japan.

Looking at their place in world trade, neither is an exporter of raw materials or agricultural products in the way Australia or New Zealand (both classified by index compiler MSCI as developed countries) are.  Instead, both sell advanced technology and machinery products, like computers and smartphones.

…but their stock markets aren’t well-developed.

My experience is that company financial statements aren’t reliable in either country.  Neither governments nor company managements in either country care to have foreigners as shareholders, and treat them poorly.  There’s also a significant amount of intrusion into market workings by politically powerful entities in both.  The fact of this interference isn’t the issue; that happens everywhere.  It’s the extent–and maybe my lack of familiarity with the local rules–that bothers me.  In this regard, both Taiwan and Korea seem to me like Japan, only on steroids.

Every one of these factors is characteristic of emerging markets, not developed ones.

is MSCI about to reclassify both stock markets as developed?

There’s nothing new about what I’ve written above.  It’s been the situation for at least a decade (in stock market terms, it was worse before).

What is new, however, is that both the Wall Street Journal and the Financial Times have published recent feature articles suggesting that the MSCI will reclassify both Korea and Taiwan as developed markets later this month.

that might be an issue for holders of emerging markets index funds/ETFs

I’m most familiar with these entities in the US, but I think what I’m saying holds true for EU funds/ETFs as well:

Mutual funds/ETFs are both instances of a special type of corporation that is exempt from corporate tax.  It gains this exemption by, among other things, distributing all income (net of expenses) and realized capital gains to shareholders–who must pay tax on them.  Typically, distributions are made once annually, shortly after the tax year for the fund/ETF ends.

Together, Taiwan and Korea make up about a quarter of the MSCI Emerging Markets stock index (the largest other index constituents are China and Brazil).  If both countries are reclassified, index funds/ETFs will be required by their charters to sell all their Taiwanese and Korean holdings and reinvest the proceeds back into the revised Emerging Markets index.  That will presumably generate a large capital gain to be distributed to shareholders.

four quirks about a possible distribution

1.  It’s a fact of life about funds/ETFs that the holder who pays tax on a fund’s capital gain is the person who receives the distribution–not necessarily the person who enjoyed the rise in price of the stock that’s been sold.  If you buy a fund/ETF share today and receive a massive capital gains distribution tomorrow, you’re on the hook for any tax due, not the holder of the share while the capital gain was being amassed.

2.  Any distributions are net of any accumulated realized losses.  In the case of the Vanguard emerging markets index fund, which I hold, it had unrealized gains of $7.5 billion on April 30, 2011, the date of the most recent semi-annual report, but accumulated losses of $2.4 billion.

3.  Distributions are usually made at the same time every year.  For US funds, which typically have an October tax year, distributions come most often in late November or early December.  But a distribution can be made earlier–and often is, if the fund manager fears shareholders intend to sell their holdings to avoid receiving a large taxable distribution.  In other words, a Taiwan/Korea-related distribution could come as early as in July.

4.  Virtually everyone who buys a fund/ETF signs up for automatic reinvestment of distributions, so that the distribution itself results in almost no outflows. Only anticipatory sales, made to avoid a distribution, do that.

fund groups aren’t talking

I called up Vanguard the other day to ask about this issue.  My own back-of-the-envelope reckoning is that a distribution from the Vanguard emerging markets fund, if any, will be small (25% of the accumulated unrealized gains of $7.5 billion would be $1.9 billion, less than the $2.4 billion in accumulated losses).  And I own my fund shares in an IRA, so a distribution doesn’t affect me, in any event.  But I was curious.

My Vanguard representative was aware of the issue, but said everything depended on what MSCI does later this month.  I asked for the April 30th tax situation for the fund, but she wasn’t able to find it.  I looked it up online after I hung up.

relevant tax data are easy to find

Look for the latest annual/semiannual/quarterly report for your fund/ETF.   It will have a list of holdings and their market value (but not their individual cost basis).  At the end of the list, there’ll be aggregate cost and market value data.  In a section following right after that, the fund will show its accumulated realized losses.

2008 is a key year

The emerging markets index lost over half its value that year.  Although there’s no way of being certain with any individual fund, twenty some years of managing this type of money tell me that all the redemptions that created Vanguard’s accumulated losses came at the bottom or shortly after–probably in large part from people who bought shares in 2007.

Any fund/ETF that’s large now but was just getting started in 2008 probably has little in the way of accumulated losses to offset realized capital gains.  Entities like this are where the risk of a large taxable distribution are highest, in my opinion.  We’ll know more on June 21st, when MSCI does its next revision of the index.

 

ICI mutual fund data: old habits resurface

April 29, 2011 By in Academic Theories, Current Market Thoughts, Industry Analysis, Investment firms, Recent Market Action, Strategy Tags: , , , , , , , , , Leave a comment

individuals’ fund buying patterns over the past four years

Perhaps the one constant in the behavior of individual investors in the US during the recession and subsequent bounceback has been their fervent embrace of bonds and equally ardent shunning of stocks. Within that overall orientation, it’s clear that individuals have preferred taxable bonds to municipal ones and foreign stocks to their domestic counterparts.

True, there were several months of pure panic after the Lehman collapse in September 2008.  At the fund-flow nadir, in October of that year, individuals withdrew over $128 billion from mutual funds and put the money into federally-insured bank deposits.  Less than a third of that amount, however, came from bond funds.

during the bull market

By June of 2009, investors were settling into the pattern that has marked their behavior through most of the entire spectacular rise in stocks of the past two years:   net investment of around $40 billion each month, $30 billion of that into bond funds, the rest into stocks–virtually all the equity money going into foreign securities.

late 2010

As 2010 was coming to an end, two significant departures from this norm emerged:

1.  As the big problems state and local governments are having with their finances became better known, individuals started a steady stream of withdrawals from tax-free bond funds, and reinvestment of that money in taxable fixed income.  That continues. to the present.

2.  January and February 2011 saw $32+ billion of new purchases of stock funds, the largest allocation of money to equities since early 2007.  At the same time, investors, quite uncharacteristically, put the lion’s share of their equity money into domestic securities.

At the time, I remember asking myself how to interpret the fact that an investor class that happily watched a near-doubling of stocks without showing a flicker of interest suddenly started piling in–and in a big way.

In this case, would it be unfair to characterize individuals as the “dumb money”?  …no.  Was it a good sign that they’re beginning to buy?  …not at all, since having the last bear capitulate is usually a sign of the top.  On the other hand, US stocks were still cheap then, in my view. (For what it’s worth, I think they remain so.)  My conclusion was to worry a little more, but not alter my pro-cyclical portfolio stance.

the past two months

In this context, the most recent data on individual investor actions from the Investment Company Institute are very interesting:

–municipal bond withdrawals continue

–taxable bond funds are receiving net additions of $3+ billion weekly

–money flowed out of equities in March, although April has seen modest inflows resume

–investor preference for foreign equities has returned.  In five of the past eight weeks, money has been withdrawn from domestic funds.  More than 100% of the net new equity money stock funds have received in March and April has gone to non-US funds.

In other words, we’re back to the pattern of equity avoidance that has characterized individual behavior during the best of the bull market.  Interestingly, the S&P has continued to go up in March-April, although at a more sedate pace than during January-February.

what to make of this

Theory says that as people get older and richer they become more risk-averse.  I think that’s true.  What I don’t get is why individuals, who are usually a shrewd lot, think at today’s prices and in today’s economic circumstances that bonds are a low-risk investment.

Exhibiting the perverse mindset that characterizes much of Wall Street’s thinking, I’m kind of relieved that individuals have lost interest in stocks.  That probably means that the S&P 500 still has legs.