When we buy an equity or a bond we buy a claim on a business but with differing payoffs, rights and obligations. The rational investor would first decide if the business in question was something they wanted to own before deciding on whether to own it through the equity or the debt. If indeed the business was attractive then the analysis would progress to which claim to buy, an analysis which would take into account the prospects for the business, the riskiness of the business and the available claims. The assessment would be made on a risk adjusted basis and not on the absolute attractiveness of the claim. I say this because if it was decided that the most senior claim was the right one, leverage could be used to scale the investment to the right size. If for example equity was the right claim but the investor was targeting a low risk, then a deleveraged position could be taken (that is pairing the position with cash).

We apply this methodology with the prices before us. Its really the best we can do. The methodology may well drive us to hold lots of cash for example if equity was the more attractive claim, yet our desired volatility was lower than the unlevered cash equity. In this case we would hold a deleveraged position, meaning a portfolio of positive cash and positive equity.

Current valuations are quite balanced. Looking at aggregates, equities are cheap compared with government bonds but they are fairly priced on a historical basis when compared with corporate bonds. The spread of investment grade corporates to treasuries is moderately attractive and at this point at least, a comparison of high yield to investment grade yields is equivocal.

The investment problem is that government bond yields are too depressed. Valuations made against government bonds are a risky practice since yields are likely to rise and could render reasonably priced assets expensive quite quickly.

It was low interest rates in 2003/2004 of 1% in the US, now a princely level, which saw the reach for yield in that decade which was sated by ratings arbitrage, necessary because institutional investors were constrained by ratings requirements. The ratings arbitrage resulted in clever constructs like CLOs and CDOs. Demand for yield drove demand for CLO origination which in turn drove demand for ABS and in particular RMBS origination to the point that the banks were more willing to lend than the homeowner was to borrow. This was the tipping point.

As we reach for yield today we should be aware of the balance of enthusiasm between lenders and borrowers. When lenders are more motivated to lend than borrowers are to borrow it is usually a sign of a credit bubble.

The behavior of the EUR may have been confusing. If we look at the daily volatility since the Greek situation began its crescendo we have seen the EUR weaken on good news (of a deal) and strengthen when there was bad news (of no deal.)

This is not so irrational. Notwithstanding any plan for retaining Greece within the Euro, Greece’s business model is not working. Current plans for reorganization from both creditors and debtor do not present Greece as a going concern. Therefore, retaining Greece in the Euro must be negative for the EUR and lead to weakness, while a Greek exit would remove a source of uncertainty, inefficiency and cost from the Eurozone which is positive for the EUR.

How rational are markets? We often expect markets to react to bad news badly, regardless of the underlying logic. Could this be a case where the market is being remarkably rational?

Analgesics are addictive. Since interest rates were deployed to manage the economic cycle we have seen the Fed Funds Target Rate decline, making lower lows and lower highs (1980, 1984, 1989, 1995, 2000, 2007) as the Fed has been repeatedly enlisted in the bailout of asset markets and the economy.

Now that a new policy tool has been invented it will doubtless be counted upon to support further crises and excesses. This is the nature of moral hazard. We cannot un-discover QE.

With Fed Funds at 0.25% there is no room for cutting it any further. We will be fortunate when the Fed finds itself in a position to reset its policy tool higher but should another crisis or recession occur, with Fed funds at these low levels, the Fed’s balance sheet can and will be deployed. While the balance sheet may shrink in the next 7 to 8 years, one can reasonably expect it to expand over a longer time frame.

If you were careful, responsible and diligent and didn’t overextend yourself buying that big apartment in the prime central area and the second apartment to rent out, but maintained a reasonable debt to income and debt to equity ratio, you did OK but you certainly didn’t do as well as the guy who bought bigger than he could afford, was less than candid on his loan application for his buy-to-let in prime central, levered himself to his eyeballs and got bailed out when central banks the world over cut rates and did whatever they possibly could to ensure that a free market selection process for weeding out imprudent risk takers was confounded and conservative and responsible investors were disadvantaged.

The interventions and bailouts were entirely unfair. The bailouts were sold to us by the governments that the investment banks had the world over a barrel and that Wall Street had Main Street as hostages and human shields.

And now we are told (in a Bloomberg article Jun 18, 2015) that As the Rich Bounce Back, the Middle Class Stays Stagnant.

When income and wealth inequality are moderate, there is less motivation to challenge the status quo. However, at some level of inequality, when the bottom half of the population by wealth ask themselves what the probability is that they and their children might progress to the top half through diligence and effort, and the answer is pretty low, then change may come.

 

 

 

Some Issues In Mutual Fund Investing.

 

1. One of the problems in mutual fund investing is how they are sold to investors.

 

a. High front end commissions. Mutual funds typically charge a commission to invest in them. This commission is paid to the distributor of the mutual fund, such as a bank or an independent financial adviser. Just like any other product marketing has a cost. Mutual funds can charge up to 5%, sometimes more, in commissions. Distributors receive these fees ostensibly for providing advice. Perhaps, but if so, why are the fees charged by the funds and rebated to the distributors and not paid directly by clients to their bank. By accepting payment from the fund manager instead of the investor, distributors work for the fund manager, not the investor. How about sophisticated investors who do not require advice but are faced with subscription commissions wherever they turn? In a low yield environment even a 1% commission can eat up 3 months’ worth of gross returns.

 

b. High management fees. Mutual funds charge different clients different fees. Institutional clients pay half of what retail clients pay, sometimes even less. The primary reason for the difference is that retail funds’ fees have to be shared with distributors such as banks and IFAs in what are called trailer fees. A fund charging 1.5% per annum will pay its distributor 0.75% per annum on the assets raised. Fortunately there are some banks who eschew this practice and either invest their clients’ money in institutional share classes, which incur much lower fees, or rebate any trailer fees they get on to their clients. In certain markets like the UK, it has become illegal to pay trailer fees to distributors. In Asia trailer fees are the norm.

 

c. Opaque fee structures and conflicts of interest of distributors. The payment of trailer fees to distributors creates a conflict of interest. Distributors have a strong incentive to sell funds with high trailer fees or commissions. Whereas fund distributors claim to represent the interests of their investors they are in fact being paid by the fund managers. Low volatility funds often also have low expected returns and fund managers scale their management fees accordingly. Since trailer fees are usually a cut of management fees distributors prefer to sell investors high risk, high returning funds which charge high fees to low volatility funds. Investors are allowed to believe that their banks are working for them when in fact they are working for the fund managers as their distributors.

 

2. Underperformance of benchmarks is addressed below under “When ETFs are more effective.”

 

3. Mutual funds are aggregation vehicles when it comes to market systemic risk. As more capital comes to be controlled by fewer independent decision makers, systemic risks are raised. CLOs and CDOs dominated the demand for loans and bonds in the years prior to the 2008 crisis.

 

a. The size of a fund should be seen in the context of its market. A fund which represents too large a proportion of total trading or total holdings in a particular market is risky from a liquidity aspect.

 

b. The aggregate size of mutual funds as a percentage of total market size is another risk factor since mutual fund managers and their investors are likely to behave similarly.

 

 

There are a number of reasons for investors to invest in investment funds.

 

1. They are a practical and convenient tool and component to deploy a diversified global portfolio. Regional, country, sector and asset class funds allow the investor to construct a portfolio to their own requirements.

2. Investment funds offer a diversified portfolio within a defined investment objective. Funds diversify the idiosyncratic risk while retaining the thematic risk so a single security or issuer cannot derail a sound thematic investment strategy.

3. Outsource investment strategy to experts in their particular fields. Funds allow investors to delegate investment strategy to professionals of a particular focus and specialization.

4. Related to point 2 abov
e is divisibility. Some securities can only be traded in large values. If an investor’s portfolio is too small it may be impossible to invest in such securities or to invest in such securities with sufficient diversification.

5. Access. Certain instruments and markets are not easily accessed by retail investors. Catastrophe bonds, asset backed securities, structured credit, freight futures, commodity derivatives, etc are examples of instruments which are traded by institutional investors and not retail investors but which can be accessed through funds.

 

 

When Exchange Traded Funds Are More Effective.

 

1. One of the criticisms of mutual funds is costs. Mutual fund managers charge annual management fees, and some even charge performance fees. In order for a manager to return the same as their benchmark on a net basis, they must outperform their benchmarks by the quantum of their fees on a gross basis. Empirical evidence suggests that on average, mutual fund managers are unable to compensate for the fee drag. An exchange traded fund or ETF may be the solution to the fee problem. Due to scale and the mechanical nature of the portfolio construction ETFs charge very low fees. In some cases, the index replication strategies are sufficiently clever that they even recoup the little transaction, administration and custody expenses incurred by the fund.

 

2. Highly efficient markets are difficult to outperform. The US equity market is a good example where very few active managers outperform the index. In such markets, an ETF is more efficient.

 

3. Highly liquid and efficient markets are easier to replicate in an ETF. In illiquid markets.

 

4. ETFs can be traded at any time during the trading day. Mutual funds are typically traded at the NAV at the close of the day. Some mutual funds have poorer redemption liquidity which may be weekly or monthly.

 

5. The cost in trading ETFs is normal trading commissions which have seen significant compression over the years. Mutual funds can and often do involve paying a hefty up front commission to the distributor of the funds. Commissions can be as high as 5% or higher in certain markets.

 

 

When Mutual Funds Are More Effective.

 

1. There are some markets which are simply not tracked by indices or ETFs. An example is the non-agency MBS market. While there are a number of large and well known MBS (mortgage backed security) ETFs these invest entirely in agency mortgages. The non-agency MBS market is simply not represented by any ETF.

 

2. There are some funds which have a theme or strategy that is not represented by any index or ETF. Hedge Fund Research, an index compilation company has compiled investable indices called HFRX so that even hedge fund strategies are replicable and can be accessed through an ETF but there remain some areas which ETFs have not reached. ETF providers are, however, trying to complete their shelf and are constantly evolving new strategies.

 

3. On average, by definition, mutual funds make a gross return equal to their benchmarks, which after fees and expenses, is below the benchmark. There are, however, mutual funds whose managers consistently outperform their benchmarks. The incidence of these managers is in part determined by the efficiency of the market. More efficient markets like US equities, are more difficult to outperform. Less liquid and less efficient markets enable active management and outperformance. They also enable underperformance.

 

 

Bottom Line:

 

1. As with all things investors should know the product at least as well, if not better than, their advisors.

 

2. Regulators should address the conflicts of interest in how mutual funds are offered to end investors. Regulation in the UK for example has been enacted to address the trailer fee issue.

 

3. Investors should be aware not just of the fees, costs and expenses in fund investing but of who are the beneficiaries of these fees, costs and expenses so that a judgment can be made as to the quality of advice they obtain from the various parties.

 

4. There are circumstances under which actively managed mutual funds can be used and circumstances under which ETFs should be used. One is not always and everywhere superior to the other.