2 posts tagged “mutual funds”

The reason for some institution's refusal to sell their positions that have appreciated dramatically (and that are most vulnerable to decline) can be deeper than the impression desired by publishing the positions. Management's compensation is usually a set percentage of the market value of the assets managed. If a profitable position is sold, the gain may be subject to taxation and paid out to clientele as a capital gains distribution. This effectively reduces the amount of money being managed and the associated fees.

The problems associated with selling positions that have profited most can be particularly acute in small mutual growth funds that have followed the practice of "taking losses and letting profits ride" for an extended period. The result is that their portfolio consists of only a few issues. By having locked themselves into holding a few profitable stocks, the fund's value becomes a function of the value of the rigid holdings and has nothing to do with the overall ability of management.

Keep in mind that money managers are human beings with basic needs such as food and shelter, which require employment. Also recognize that, especially in the larger institutions, clientele are not aware of the identity of the individual analyst making the investment decisions. This anonymity is often strictly enforced and a prerequisite for employment.

In this environment, the individual analyst (whether a genius or an idiot) is under pressure to conform to the crowd. To be too good or too bad relative to one's peers involves risks of criticism or resentment with the associated occupational hazards. This effect is obvious to anyone familiar with the financial media. When an analyst (usually independent) becomes popular because of accurate forecasting and then stumbles, the mistake (even though the overall return over time has been far superior) is pounced on. On the other hand, a spokesperson for a large institutional analytical service that has consistently been wrong, but that is one of the crowd, attracts media attention when making forecasts without criticism of past mistakes.

Understanding the structural aspects of institutional investing practices and employment pressures, you would logically conclude that the average institution would underperform the market, with the underperformance magnified by the fees involved. Yup.

External

Aside from the difficulties associated with internal structure and characteristics, institutions have the added problem of dealing with their clientele. Discretionary clientele who do not properly understand the stock market, although they have entrusted their investment decisions to someone else, often have a tendency to self-destruct. This is particularly evident in mutual funds, whose investors are continually adding or withdrawing (redemptions) money. People tend to add money when the market is highand the mood optimistic. Redemptions tend to dominate when the marketis low and the mood pessimistic.

The institutions are forced to invest the money—that is what they arebeing paid to do. Therefore, with more money coming in when the market is high, the institutions so affected are forced to buy at relatively high levels. Conversely, when redemptions dominate and the market is low, the institutions are forced to sell at depressed prices to fulfill the investor'sdemand for cash.

From the professional standpoint, the process is marvelous. We knowwe have buyers at high prices and sellers at low prices because of the demands of discretionary clientele creating a supply/demand imbalance. When they are doing their forced buying, it creates underlying buying demand and we can raise our prices. When they are forced to sell, we know there is "overhanging supply," and we can lower our purchase prices.

This buy-high/sell-low behavior (required to fulfill clientele's wishes) is not limited to mutual funds. It can affect any funds that can redeem or add capital according to their client's emotions: bank trust departments, pension funds, and the like. An important exception is closed-end mutual funds where the capital base is fixed and the investor must buy/sell shares in the open market rather than affecting the funds' specific holdings.

The market is a business. The purpose of the business is to acquire the monies of others through the process of buying low and selling high. Because of the anonymous nature of trading structure, it is very difficultto specifically identify the individual to whom you are selling or from whom you are buying. Consequently, physical coercion to create losingbehavior among fellow market participants cannot be applied. People do not enter the market to lose. However, they must be placed in a situation in which they will willingly part with their money. The only way to elicit losing behavior is psychological pressure. The most effective tool for applying the pressure is a change in market price. Faced with "paper" losses, those vulnerable to the emotion associated with "apparent" losses will capitulate, accepting the loss in the form of cash to relieve thepsychological strain.

The discretionary manager is subjected to the same emotional pressuresas all other market participants. It is not uncommon for discretionary managers to buckle under the pressure and sell low in direct conflict with historical or statistical precedent to alleviate pressures both self- and clientele-imposed. Conversely, when prices are too high, the emotionallure of greed can stimulate buying when prices are most vulnerable to severe decline. Those who conduct themselves professionally are acutelyaware of the psychological effects of price on institutional managers and take advantage. Such advantage is possible only by strict adherence to a methodology that prevents being lured into the irrational (emotional) behavior of the crowd. This is easily accomplished by having predetermi_ned buy/sell points dependent upon market condition, not price in itself.

The forced behavior of institutions provides one of the most important profit centers for the true professional.

What really roils me is that so many Americans have their necks overexposed to the risks of common stocks to start with. By that I do not mean that stocks are generically too risky, although I do recommend staving out of the overpriced U.S. stock market and dollar-denominated stocks. Stocks that are selected conservatively and pay high cash dividends are, in fact, my favorite investment alternative, especially where there is the prospect of currency profits, as I'm going to discuss later in detail.

But Wall Street has led the American public to think stocks have the safety of bonds. There's a huge difference, of course. Stocks carry all the risks inherent in business ownership Bonds are contractual loan obligations that must be paid before owners get anything. Because stockholders have all that risk, they should naturally expect a higher rate of return than bondholders. But Wall Street has fostered a myth that because shareholders enjoy unlimited upside (capital gain) potential, they Should settle for a dividend return that, if it exists at all, is often far lower than the interest rate on comparable bonds.

I also feel Wall Street puts an unhealthy value on potential Capital gains. Just look at the widely used formula for setting up an individual's investment program. You take 100 and subtract the investor's age. That determines the basic asset allocation. If the customer is 20 years old, you recommend 80 percent stocks and 20 percent bonds, and then adjust the proportions as the investor gets older on the reasoning that youth justifies risk and advancing age requires safety and income.

My problem with that kind of thinking is that it assumes stocks rise in value as a function of time, that they are always a good buy regardless of valuation, and that there's always going to be a pool of people that you can sell out to so you can buy bonds and retire on the interest. As we'll see, though, the market has a well-earned reputation for perversity and there have been long periods when prices remained flat or declined.

Call me old-school, but I've seen enough of self-serving corporate management to make me want cash on the barrelhead. I want stocks that pay cash dividends and provide a higher yield than bonds do.

Wall Street has also muddled the distinction between investing and speculating. The argument that growth stocks of companies that plow all their net earnings back into the bussness reward shareholders with future capital gains assumes that the objectives of corporate managers and shareholders are the same that the two interests are in alignment, to use more elegant language. Now I'll grant that there have been many companies over the years where this has been true, and where investors profited handsomely from capital gains that, until recently, were taxed at a more favorable rate than dividends.

But to overpay for stocks that don't produce income and derive their attractiveness from the promise of future capital gains that may or may not materialize to my mind smacks more of speculation than investment Some stocks will gain, of course, but only at the expense of other companies, whose earnings shrink. If the market is trading at a given multiple, there have to be stocks whose earnings go up and stocks whose earnings go down. They can't all be winners.

Conflicts of interest are rampant on Wall Street and in corporate America, and the victim is the little guy. I started out as a broker with one of the big investment banks, and know from firsthand experience how Wall Street's symbiotic relationship with corporate America has operated to the disadvantage of retail investors. Year in and year out, the risks of common stocks are played down by firms that make their real money from advisory or underwriting services performed for client corporations.

Brokers are paid extra commissions to push certain stocks as favors to corporate clients or to move positions held by their firms acting as dealers. "Suitability rules" designed to protect investors from undue risk are treated perfunctorily as brokers pass spoon-fed recommendations off to trusting customers who think they're getting thoughtful advice.

On the research side, although stricter regulation has resulted from recent scandals, analysts are under pressure to favor existing , or potential corporate clients by assigning higher ratings than their shares warrant or failing to assign negative ratings to inferior stocks that retail investors might otherwise avoid.

Lately, the interests of corporate executives and shareholders have diverged to a point bordering on or actually constituting scandal. The most infamous example, of course, was Enron, where shareholders walked away with nothing after criminal _activities by top executives that were so complex and extensive they are being analyzed to this day. Here’s the point, though, and it’s a big one: if Enron had been forced to pay cash dividends, it could never have pulled that paper off!

There were so many other examples of corporate skullduggery at the expense of shareholders-WorldCom, Global Crossing, Adelphia, et al.-in the early 2000s that it really serves no purpose to go into them.

More significant than the laundry list of major scandals are practices we read about every day. Executive stock options that are timed and structured in ways that give managers incentives to make corporate planning decisions designed to maximize their personal profits at the expense of shareholder values are now commonplace. Just the salaries of top corporate executives have become so outsized as to penalize shareholder returns. Stock repurchase plans are often timed to create capital gains to benefit managers.

As this is written, a scandal seems to be breaking that involved the back-dating of executive stock options to capitalize on favorable stock price movements.

Wall Street has conditioned the public to think about stocks simply in terms of their prices. According to Wall Street, prices can only go up if one simply holds them for the long term. Most investors regard low-priced stocks as being cheap and high-priced ones as being expensive. The real fundamental value of the business those shares represent seldom comes up. This general misconception concerning stocks is evident even among my own clients. Whenever I call one to recommend a stock, the first question that I am usually asked is "What's its price?" My typical response is "What difference does price make?"

By itself, the share price confers no real information about the underlying value of the stock. Price is meaningful only when related to other factors, such as earnings, sales, book value, and shares outstanding. When such factors are considered, a stock selling for $5 per share can be expensive while another selling for $100 per share can be cheap.

That's why the public is so confused about stock splits, where a stock's perceived value is enhanced simply by reducing its price, with investors ignoring the increased number of shares outstanding. Stock splits originated because under the old system of trading and commissions odd lots (increments under 100 shares) were expensive to trade, so splits made it easier for small investors to trade in round lots.

For similar and equally foolish reasons, investors believe that it is easier for a stock selling at a low share price to double than for one selling at a high price. However, price is meaningless, as a company's earnings would have to double for the real value of its shares to double, which of course has nothing to do with price. If it were really easier for low-priced shares to rise, perpetual stock splits would rule the day.

The only reason low-priced stocks tend to move faster is that most are less liquid and often manipulated. If it were true that low prices meant faster appreciation, all high-priced shares would split, not at $50 or $100, but at $10, $5, or even a dollar. In most Asian markets, share prices below $1 are the norm, even for billion-dollar companies. However, their prices appreciate no faster as a result of prices being lower.

Wall Street's failure of responsibility is glaring even where clear conflict of interest isn't the issue. I strongly believe Wall Street deserves much more opprobrium than it got for its failure to discourage in a proactive way the naive investor behwior that drove the dot-com bubble. Sure, brokers were only giving customers what they wanted, but I strongly feel they had an implicit fiduciary responsibility to make investors aware of the insanity they knew they were witnessing.

At the risk of sounding unctuous, I don't mind saying that I personally sleep at night with a clear conscience. When other brokers were riding the tech-stock wave, 1 spent many hours persuading my clients to avoid the foolish risk of buying stocks without earnings. "But it's a long-term investment," I'd hear. "Sure, in a company that will not even be around in the long term," 1'd tell them, and more often than not I was right. At Euro Pacific Capital, I do no investment banking. I don't make markets or act as a dealer. I am purely a retail broker specializing in stocks that pay cash dividends, and I plan to keep it that way.

But Wall Street, I'll say again, is rigged against the little guy and I see no signs of that changing, either.

Mutual funds are an overrated investment heavily promoted by Wall Street. During the latter 1990s, as I was still cold-calling prospective clients, a typical question I would ask those who professed to be invested in mutual funds was "What is the yield you are earning?" Of course it was a loaded question, as dividend yields at that time were next to nothing, if not zero itself. Even if the stocks that the funds owned paid some minimal dividend, they were not high enough to offset the fees charged by the funds. However, the typical answer to my question was "My funds are yielding about 20 percent per year." What my prospects were doing, of course, was confusing yield with past performance. How much a fund's share price had risen over the years has nothing to do with its dividend yield.

However, shareholders typically confused illusory price appreciation with actual dividend yield.

Another major problem with mutual funds, and one rarely understood or seldom discussed, is the concept of relative versus absolute performance. Investors of course should be concerned with the latter; however, managers are far more concerned about the former. That often overlooked conflict of interest is vitally important and is the principal reason that most mutual funds will underperform the market in the long run.

This conflict arises from the way fund managers are paid and the way funds themselves are marketed. It's all about short-term quarterly performance, relative to either a benchmark or competitive funds with similar objectives. Therefore, no manager wants to underperform and no fund wants its recent performance to compare unfavorably to the performances of its competitors. This reinforces speculative behavior and causes fund managers to chase performance by buying overvalued stocks, the prices of which keep rising as more funds buy.

Then those funds buying such overpriced shares post impressive relative performance numbers, which results in increased inflows from performance-chasing investors. Those funds need to be invested in those same overvalued shares that goosed the performance in the first place, and it is a self-reinforcing cycle. When it ends, of course, the share prices collapse, and long-term investors lose big. However, the managers already earned their bonuses, and since all the funds collapse together, no one cares as no one's relative performance suffers.

Assume a diligent fund manager, with the good sense not to buy the overvalued shares, who instead invests in undervalued companies. The prices of such shares could languish for years before finally rising to reflect the true value of the companies they represent. While such a strategy is fine for investors, it Could be disastrous for fund managers, who would likely lose their jobs long before such investments paid off.

In the final analysis it does mutual fund investors no good to pay managers big-time fees for impressive short-term perfor malice when by the time investors need their money it's all gone. What is important to investors is absolute, long-term performance, which is the furthest thing from the minds of most fund managers.

If you think mutual funds aren't a flagrant enough example of conflict of interest, try hedge funds. Once relatively obscure bastions for the superrich, hedge funds, which are largely unregulated and exempt from disclosure requirements, have become the current rage, now numbering around 9,000 and holding over $1 trillion in assets. Their managers, the latest crop of gazillionaires, conventionally charge a 1 to 2 percent annual management fee plus 20 percent or more of the quarterly profits. You heard right: 20 percent or more of quarterly profits.

Since "hedge" means to protect against risk, it's ironic that the conflict of interest in hedge funds exists because of heightened risk taking, the very thing hedging was supposed to minimize.

Although, to be sure, the hedge fund universe has its share of exceptional managers, too many of the impressive returns boasted by the industry are produced not by outperforming investments, but by investments with ordinary returns that excessive leverage has turned into huge dollar windfalls on which managers base their 20 percent performance fees.

There's actually very little hedging being done. Most hedge funds would be more accurately termed "risk funds" or "ultra leveraged funds." For example, a yield of 8 percent might be achieved by buying junk bonds. But leverage it up 10 times by borrowing

money at 4 percent, and you magnify the return over fivefold.

In other words, simply by assuming additional risk, an 8 percent return is transformed into a 40-plus percent return through the magic of leverage. If a$1_ billion hedge fund specializing in junk bonds merely leverages up 10 times, an 8 percent return becomes a windfall of more than $400 million, That gives the manager a payday of $80 million.

Hedge fund investors, trusting the expertise of hedge fund managers, are accepting risks they would never assume on their own and giving away 20 percent into the bargain. The hedge fund managers are taking a ton of risk, but with other people's money, not their own. When the risks pay off, the manager gets 20 percent. If the risk goes bad, the manager doesn't lose anything; he just doesn't gain anything. The investors take the hit. Heads, the manager wins. Tails, the investor loses.

Sure, when losses occur the fund managers have to get back to the last high-water mark before they can start collecting performance fees again. But the effect of this is a moral hazard even greater than existed before the loss: Now they have an even stronger incentive to push the risk envelope.

So that 20 percent performance fee creates a powerful incentive to use leverage and, since hedge funds tend to pursue similar strategies, they create short-term market momentum in the direction money is flowing. This tends to increase the paper gains for funds already positioned in those strategies, creating a lot of performance fees in the process.

The problems will arise when everyone tries to get out. The big paper profits will quickly evaporate when the momentum reverses, but that's the investor's problem. While the managers were raking in their 20 percent of profits each quarter on the way up, it's not as though they'll have anything to lose on the way down. They will gain as long as there's a profit. Managers can press a trend until it ends. There's no need to get out early, because there's no way they can lose. They can have their cake and eat yours, too.

Take the recent example of Amaranth, the $10 billion hedge fund that blew up in September of 2006. It lost better than 60 percent of its capital in a few short weeks as some highly leveraged natural gas bets went south. As those bets were paying off the managers made millions, but when they finally blew up, it ",as their investors who got creamed.

Did the Amaranth managers really earn their fat incentive fees for strategies that ultimately caused their investors to lose lots of money? Do you think they're going to reach into their personal pockets to help cushion the blow for their shell shocked investors? Don't hold your breath.