Fundmastery Blog

Kurt Brouwer October 15th, 2009

Some of the mutual funds that suffered most in the financial panic and bear market of 2008 have had excellent results in 2009.  Yet, nervous investors who took the hit in 2008 may not have been on board those funds in 2009.  In fact, there is solid evidence that investors often do not reap the rewards of being in volatile funds because they tend to buy in when the funds are hot and dump them when the funds turn cold.

This solid, yet oddly-titled, report from Morningstar gives us an example of how investors can get scalded when they buy a hot fund [emphasis added]:

How Some Investors Ruin a Great Fund (Morningstar, October 13, 2009, Russel Kinnel)

The stock market’s powerful rally since early March has been a blessing for patient investors. Many of the funds that suffered the most during the bear market have experienced the biggest rebounds. But a lot of investors didn’t stick around for the comeback. And who could blame them? It’s hard to hang tough when your fund has sunk 50% or more. Yet fleeing short-term laggards or jumping to the hot fund du jour often undermines investors’ returns.

This point is very important.  Hot funds can and do turn cold and t is excruciatingly difficult to stick around when that happens.  The financial panic of 2008 and early 2009 took down volatile funds, but even steadier performers (Longleaf Partners comes to mind–llpfx) fell to an extent that surprised many professional investors.  Staying the course when investments move against us is very difficult.

This next information is quite startling as Kinnel fleshes out how investors in volatile funds can and do snatch defeat from the jaws of victory.  Morningstar continues:

We at Morningstar have a way of capturing the true costs of fund hopping. In addition to a fund’s total return, we calculate what an average investor in the fund really earned. Investor returns adjust the officially reported returns based on cash flows into and out of funds. The gap between the figures essentially tells you how well or how poorly investors did at timing.

…CGM Focus (cgmfx) and T. Rowe Price Equity Income (prfdx) illustrate how volatility affects investor behavior. Both are run by excellent managers (Ken Heebner and Brian Rogers, respectively) who have beaten their peers over the long term. Focus’ 10-year annualized return of 19.6% thumps Equity Income’s 3.7% yearly return through the end of September 2009–as it should, because Heebner takes much bigger risks than Rogers. Heebner makes huge sector bets, holds only about 20 stocks, and even sells short stocks that he thinks are primed for a fall. Rogers aims for a steady ride by focusing on reasonably priced, dividend-paying stocks.

But consider what investors actually earned. Rogers’ clients have kept nearly all of the fund’s meager gains, earning an average of 3% annualized over the past 10 years. Heebner’s have somehow turned their fund’s terrific reported results into an annualized loss of 14%. They managed that feat by piling into CGM Focus after its extraordinary 80% gain in 2007, only to get pummeled when Focus plunged 48% in 2008…

Buying high and selling low

Anyone who has invested in mutual funds for a while has heard of Ken Heebner.  His funds are legendary for volatility, but also for stunningly high returns at times.  Despite the excellent average annual returns, this Morningstar data indicates that investors have actually had poor results due to buying in after the fund had a very hot year in 2007 and then dumping the fund when it turned cold in 2008.

If you want to own funds like CGM Focus, then you need to have lots of patience.   An incremental approach wouldn’t hurt either. That is, buy a modest amount of a volatile fund’s shares and then, assuming you can handle the volatility, when the fund hits a rough patch, buy a bit more.  Also, make sure you have plenty of diversification in the rest of your portfolio such that you own funds that are less volatile.

Whatever your investment strategy is, you need to stick with it.  If you like high octane mutual funds such as CGM Focus, then make sure you have a strategy in place to deal with the bad times.   Alternatively, if you do not want all that volatility, then you could invest in lower return/lower risk funds that make it easier for you to ride out the market’s inevitably downturn.  Either way is OK as long as you match your portfolio to your own personality and willingness take risks.

Full Disclosure:  Kurt Brouwer owns Longleaf Partners Fund (llpfx)

• ETF , Investing , Mutual Funds , Personal Finance
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Kurt Brouwer October 13th, 2009

So far, 2009 has been a great year for bonds and an even better year for stocks.  However, the long-term numbers are quite different.  For the past 20 years, bonds have done better than stocks on average.

This chart from Steve Leuthold illustrates this fact and also points to an interesting historical comparison.  First, let’s check out the chart:

Source: Leuthold Group

The top line (black) is the S&P 500 and the lower line (blue) shows time periods when stocks are outperforming bonds (above the 0% line) or underperforming bonds (below the 0% line).

Right now is a very rare time period in which bonds have outperformed stocks on average for 20 years.  As you can see from the chart, stocks have generally done very well after one of these periods in which stocks struggled.

• ETF , Investing , Mutual Funds , Personal Finance , debt
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Kurt Brouwer October 13th, 2009

Exchange traded funds (ETFs) have many of the built-in advantages that mutual funds have, but there are also differences.  In my view, the biggest difference is not the fact that ETFs trade throughout the day or even how ETF pricing works, but rather that ETFs have a very short operating history.

We use both mutual funds and ETFs so I am not at all negative about exchange traded funds, but I am aware that there will be growing pains as the ETF industry matures.

In this piece from the Wall Street Journal [registration may be required], we see problems arising in bond ETFs.  Namely, that it is hard to price some of the underlying bonds in the various ETF portfolios accurately.  Or, it may be difficult for a given ETF to replicate a bond index exactly because the index may hold some bonds that are not traded frequently.

Eleanor Laise at the WSJ spells out some of the issues [emphasis added]:

Bond ETFs Are Popular But Pricing Is a Problem (Wall Street Journal, October 6, 2009, Eleanore Laise)

…Share prices of many bond ETFs are drifting far from the value of their underlying holdings, which can create big trading costs for investors. Some of the funds are straying from their benchmarks, meaning investors aren’t getting the returns they expected.

…ETFs, typically cheap, straightforward products designed to act like index funds, generally track the performance of a benchmark for stocks, bonds or commodities. But they differ from traditional mutual funds because they trade throughout the day on an exchange.

Keeping ETF returns in line with the indexes has proven to be tough in the murky bond market…

…State Street Corp.’s SPDR Barclays Capital High Yield Bond ETF fell nearly 1% in the 12 months ending Aug. 31, even while its benchmark gained 6%…

…The iShares iBoxx $ High Yield Corporate Bond ETF, for example, traded at a 7% premium at one point in April, and traded within 0.5% of its NAV on only five days in the third quarter…

Such wide gaps aren’t generally supposed to appear in ETFs. Big investors can typically buy up the fund’s underlying holdings and swap them for ETF shares, arbitraging away any significant gaps between the ETF share price and NAV.

But bonds can be so tough to trade that large investors become reluctant to perform this function for fixed-income ETFs. Even when they do make the trades, they incur big trading costs that get factored into the price of the ETF shares…

In another WSJ piece, Tom Lauricella adds a bit of detail to this problem:

Bond ETFs Are Usually Priced Higher Than What They’re Worth (Wall Street Journal, October 5, 2009, Tom Lauricella)

On Sept. 30, 39% of U.S.-bond ETFs traded at a premium of greater than 0.5% to NAV, according to Morningstar Inc. To a large degree, these pricing issues reflect the challenge faced by all bond investors. Most bonds don’t trade on exchanges. And the gap between the “offer” price at which you can buy a particular bond and the lower “bid” price at which you can sell it is typically much wider than on stocks.

The headline for Tom Lauricella’s piece is a bit exaggerated, as headlines often are.  And, I’m well aware that the reporter does not generally get to write the headline, so I won’t give Tom a hard time for it.  I would have written, Bond ETFs Often Trade at Slight Premiums or Discounts.  It’s not as exciting though.  The WSJ continues:

Bond ETFs set the NAV based on estimates of the prices they would get if they sold their holdings. Meanwhile, most bond ETFs are bringing in new money now, so the dealers responsible for creating ETF shares need to constantly buy new securities. That takes place at the higher “offer” side. To compensate, dealers will price the ETF shares higher than NAV, resulting in the bias toward a premium.

If it’s a matter of buying and selling at inflated prices, it’s a wash. But sometimes, investors who bought at a premium end up selling at a discount. “If everybody is selling, it’s also a time where there may not be much liquidity in the bond market, and…funds will be trading at NAV or at a discount to NAV,” says Kenneth Volpert, a principal at Vanguard Group.

In fact, when investors fled corporate bonds last fall, many bond ETFs traded at meaningful discounts. This year, some $25 billion has gone into bond ETFs, a good portion of which is chasing big returns in high-yield bonds, which are notoriously difficult to trade in tough times. How would ETF prices handle that money being pulled out in a flash?…

So far, the discrepancies between a given ETF’s share price and its net asset value (NAV) seem to be manageable.  As anyone who has ever purchased bonds knows, bond traders do a good job of exacting their pound of flesh, particularly for thinly-traded securities.  So, the cost of putting together a portfolio that matches a given index would be very difficult and costly.

This last point is a good one though.  If all the investors in a given ETF want to get out at the same time, raising cash may be an issue.  And, if a given ETF has to raise a lot of cash quickly, it will probably get dinged a bit on those securities that it sells.

• ETF , Investing , Mutual Funds
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Kurt Brouwer October 6th, 2009

Municipal bonds are coming back into favor again.  In fact, according to this Bloomberg piece [emphasis added], September 24th was close to a record day for new bond being issued.  And, California played a major part in the big day:

Source: Bloomberg

California Tries to Save Municipal Market Itself (Bloomberg, October 6, 2009, Joe Mysak)

For one day, it was like old times in the municipal market. Can lightning strike twice?

The CHART OF THE DAY shows trading in municipal bonds jumped to an 18-month high on Sept. 24, after California sold $8.8 billion in short-term notes. At $34.9 billion, the par value of state and local securities traded that day was the highest since March 7, 2008, when it was $35.1 billion, according to Municipal Securities Rulemaking Board data.

…Fewer banks, the loss of major arbitrage accounts and a reduction in dealer appetite for risk have all combined to curb trading, Fischer said.

Since the beginning of the year, daily trading volume has averaged $12.2 billion. In 2008, it was $19 billion; in 2007, $25 billion.

Trading in tax-exempt or municipal securities has been way down for a couple of years and it appears that it is likely to stay down because traditional big investors in munis — banks and insurance companies — remain on the sidelines.  Individual investors and mutual funds investing in tax-exempt bonds seem to be the main investors now.

• Geopolitics , Investing , Mutual Funds
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Kurt Brouwer September 29th, 2009

Though inflation fears are popping up all over the place — particularly in ads for inflation-hedging investments such as gold — Pimco’s Bill Gross still believes economic activity is weak and he is warning of deflation ahead, not inflation.  This Bloomberg pieces gives his thoughts [emphasis added]. Be wary though of the headline because I believe it is incorrect as I point out below:

Pimco’s Gross Buys Treasuries Amid Deflation Concern (Bloomberg, September 29, 2009, Thomas R. Keene and Susanne Walker)

Bill Gross, who runs the world’s biggest bond fund at Pacific Investment Management Co., said he’s been buying longer maturity Treasuries in recent weeks as protection against deflation.

“There has been significant flattening on the long end of the [yield] curve,” Gross said in an interview from Newport Beach, California, with Bloomberg Radio. “This reflects the re-emergence of deflationary fears. The U.S. is at the center of de-levering as opposed to accelerating growth.”

...He boosted the $177.5 billion Total Return Fund’s investment in government-related bonds to 44 percent of assets, the most since August 2004, from 25 percent in July, according data released earlier this month on Pimco’s Web site. The fund cut mortgage debt to 38 percent from 47 percent…

This piece is a good example of why you should be wary of headlines and media reports in general.  The reporters were probably correct that Pimco bought a modest amount of Treasury securities opportunistically when rates hit an attractive level, but they gave the impression that a major move into Treasuries was underway.  And, the headline writer added to that erroneous (I believe) impression.

The piece got it right in the final paragraph above when it pointed out that Pimco is putting more emphasis on government-backed securities (such as Fannie Mae bonds or other government agency bonds) and interest rate swaps and other similar instruments tied to government-backed securities. Government agency bonds are guaranteed by the Treasury, but they are very different from Treasury bonds or notes.

Getting back to the main theme, like Gross, I too wonder and worry about deflation.  It’s not that I do not see a threat from inflation in the future because I do see inflation ahead.  But, inflation is not much of a factor right now whereas deflationary forces are still quite strong.  With the potential for deflation, we also have a higher likelihood of lower interest rates.  Whereas, in an inflationary environment, we would typically have higher interest rates for most fixed income securities.

What is inflation and what is deflation?

Inflation means that we are experiencing a general increase in the price of goods we buy.  Deflation is the opposite, that is, a general decline in the prices of various assets and the goods we buy. Inflation is very common in most developed countries, but deflation is rare.  The last time we had protracted deflation was in the Great Depression of the 1930s.  Now, the slumping economy has weakened demand enough that, at least, most goods and services are under some pricing pressure. Overall, the cost of living (Consumer Price Index) is still up a bit, but that is primarily due to recent increases in the cost of energy.

Why is general deflation so scary to our government?

Falling consumer prices are a good thing, but there are concerns about generalized falling prices, i.e. deflation.  A generalized state of deflation is viewed with fear and loathing by the government because it can be very disruptive.  Falling prices for goods and services mean companies struggle financially and are forced to cut spending and employment.  Falling prices for assets such as real estate means that homeowners see their equity vanish and that leads to lower levels of consumer spending.  As real estate prices fall, banks and mortgage holders also suffer.  This leads to a hoarding of capital and decreased lending activity.  And, as economic activity under a deflationary environment falls, more unemployment results, thus leading to yet further reductions in consumer spending.

In short, deflation can become a downward spiral and our government will use every tool it has to quickly root out deflation and prevent it from taking hold because, to paraphrase Sun Tzu from The Art of War:

If the deflation is protracted, the resources of the State will not bear the strain.

As Gross pointed out in his September Investment Outlook,

As of now, PIMCO observes that the highest probabilities favor the following strategic conclusions:

1. Global policy rates will remain low for extended periods of time.
2. The extent and duration of quantitative easing, term financing and fiscal stimulation efforts are keys to future investment returns across a multitude of asset categories, both domestically and globally.
3. Investors should continue to anticipate and, if necessary, shake hands with government policies, utilizing leverage and/or guarantees to their benefit.
4. Asia and Asian-connected economies (Australia, Brazil) will dominate future global growth.
5. The dollar is vulnerable on a long-term basis.

The Feds are fighting deflation very hard for the reasons noted above, but the deflationary pressures are such that we are not likely to see inflation for some time.  That’s good. Unfortunately, deflationary pressures also mean that we will probably have a modest, rather than robust, economic recovery in 2010.

See also:

Burgeoning Bond Funds

Economy Turning — slow growth ahead

Full Disclosure:  Kurt Brouwer owns Pimco Total Return (pttrx)

• Economy , Geopolitics , Investing , Mutual Funds , debt , deficit , inflation
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