Introduction
“Drive for show, but
putt for dough” is an old expression on how to win at golf. The vast majority
of investment advice is about buying securities that are expected to go up in
price. However, the terminal value of investing is the final conversion of
paper wealth to spendable cash.
While investors in
individual securities can benefit from my thoughts, my comments are directed at
institutional and high net worth investors that have one or more portfolios of
mutual funds. Those that own multiple portfolios of mutual funds should modify
these comments due to the different expected timespans for each portfolio.
(These can be discussed privately, if you would like.)
Drive
for show
When a competitive
golfer addresses his or her tee shot at a crowded first tee almost all the
comments will be on the distance and direction of the first shot. However, the
first shot is only positioning for the follow-on shots and in the end the key
is how many shots it takes to complete the hole. Thus to some extent the first
shot is like relative performance versus peers or benchmarks. If all you know
is how good the drive off the first tee is, you really won’t know about the
ultimate success of the player. Therefore, what the investor wants to capture
is the cash conversion from the ultimate sale as one can not spend relative
performance.
The more professional
golf observer would pay attention to the form of the golfer, the particular
club that was used, the amount of power the player used in hitting the ball,
and the tactical position of where the first shot landed. If I knew these
things I would be in a much better position to judge whether I wanted to bet on
the success of the player rather than just remark that he/she hit a nice first
shot. Applying this to the fund selection puzzle, I am much more interested in
the process and procedures followed by the manager of a fund than their current
relative performance.
Relative performance is
a rearward looking device. We get paid to make future judgments and thus I am
much more interested in the way managers
addresses their task, such as:
a) What
tools are likely going to be used?
b) The
time spent on studying the opportunities
c) What
comparisons with other opportunities in the present or past time periods?
d) Compensation
pressures, which might impact decisions?
e) What
does one know about the competitors that are playing in the game?
f) And
finally, what is the pattern of flows going into and out of the fund?
Since our major
investments occur after several visits or points of contact, any changes in
these processes or procedures need to be understood. We expect there to be
changes as we live in a dynamically changing investment world. If there were no
changes there is an increase of being blindsided. Each of the items listed above can have an
impact on future performance beyond general changes in the market. Our
objective is to use process and procedure changes as early warning signals to
begin to exit a meaningful position. To quote Sir John Templeton, “Progress
requires change. Focus on where you want to go, instead of where you have
been.”
Three
reasons to sell
The first reason to
sell is an actual or expected change in the nature of the account. This is
particularly true if the account requires a higher than expected conversion to
cash for operational spending needs.
The second reason to
sell is actually to buy; the late Sir John said “the reason to sell is to buy a
better bargain.” (We have had the honor and pleasure of supplying special
data reports to him and also being called down to Nassau to consult with him
and his colleagues.)
The third reason to
sell is if some important deterioration in the process being used or fundamental
change in the longer-term outlook for the investment occurs.
What
to sell
Anytime one needs to
add or subtract from a portfolio, the whole account should be reviewed. The
change is an opportunity to partially redirect the course of the portfolio.
Thus, the first pass should be to see whether the various components of the
portfolio are properly balanced in today’s environment and future focus. This
could be the ideal time to reduce a position that has gotten to be way out of
balance. Depending on the nature of the account the natural barriers might be
10%, 20%, and 25% for an individual sector. In terms of a balanced account, the
fixed income range should be between 25% and 60% with equities between 40% and
75% in most cases. If one is not hurried, changes should be averaged in or out
over at least three time periods which can be days, weeks, months, or quarters.
The
role of risk
If
the account is all of the money of an institution or an individual without any
expected new money coming into the account, a prudent investor needs to weigh
the impact of a loss of capital on future spending needs. In the same light the
investor needs to understand that the risk of not growing capital and therefore
income can be a bigger risk than some downside diminution particularly after
taxes and likely high inflation. While I am very conscious that various studies
have shown that individuals feel a loss 2 ½ times more than a similar amount of
gain, nevertheless for most tax-exempt institutional accounts whose demands go
up on a countercyclical basis when economic times are poor, the risk to the
organization of not growing the capital base is worse. A less than optimum
capital base puts extreme pressure on earned income and fund raising in
difficult times.
The role of liquidity
Another
former client, Howard Marks, of Oaktree Capital Management wrote about
liquidity in this week’s Barron’s.
He said that liquidity is not important until it becomes vitally important.
Further he characterizes liquidity as transient and paradoxical. Liquidity is
the ability to get the last published price in a transaction, particularly when
one is selling in troubled times. Normally mutual fund investors are not
concerned about liquidity because when they place their redemption order they
know it will be executed at the price (net asset value) calculated for the next
close of the market. However, some fund investors may be surprised by the gap
between one day’s price and the next one.
Some
SEC commissioners and certain members of the US Congress are concerned about
the potential evaporating liquidity in the bond market including US government
issued debt. The professional investors (hedge funds) invested in various debt
and equity Exchange Traded Funds (ETFs) could overwhelm the marketplace with a
wall of redemptions, which will probably be met by the market makers
immediately selling the heavily weighted securities in the ETFs which will put
more price pressure on the final net asset value for the ETF and the companion
mutual fund.
As
a student of the market for over fifty years I would urge fund holders not to
panic during troubled periods and add to the forced sales. Well designed
investment portfolios of mutual funds should survive the decline and could be
very well positioned for a subsequent rise.
Question of
the week: For your accounts is there more risk
on the upside of not generating enough future capital than on the downside of
avoiding forced losses?
__________
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Copyright © 2008 - 2015
A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.
All Rights Reserved.
Contact author for limited redistribution permission.
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