Are Mutual Funds Worth It?

“If you don’t like the idea that most of the money spent on lottery tickets supports government programs, you should know that most of the earnings from mutual funds support investment advisors’ and mutual fund managers’ retirement.” – Robert Kiyosaki


Written by Steve Nyvik, BBA, MBA, CIM, CFP, R.F.P.
Financial Planner and Portfolio Manager, Lycos Asset Management Inc.

What is a Mutual Fund?

A mutual fund is a type of investment fund where investors buy units directly from the fund and the proceeds are invested by a professional investment manager in a variety of securities according to the fund’s stated investment objectives.  Such investments may include stocks, bonds, and money market instruments.

The mutual fund is known as an open-end investment fund as it can raise an unlimited amount of investment capital by continuously issuing new units.  The units don’t trade on a stock exchange, rather investors buy or redeem (sell) their units directly from the fund at the fund’s Net Asset Value Per Share (NAVPS) plus any applicable sales charges.

All income, expenses, gains and losses of the fund are shared amongst the unitholders based on their percentage ownership of the fund.

The main advantage of a mutual fund is that it may represent a cost effective way to gain access to a particular professional investment manager.  And for small amounts of money, which can be as low as $250, it is invested in a diversified portfolio rather than concentrated in one or a small number of investments.

The main disadvantages of a mutual fund include:

  • potentially high sales charges – Front-end load or Deferred Sales Charges (DSC);
  • fund expenses (which include legal fees for putting together the prospectus, accounting fees, marketing and advertising expenses, investment management fees to pay the fund manager and investment trailer fees that are paid to the salesperson who sells you the fund) which cut into returns;
  • professional management is not infallible;
  • the fund manager may be forced to sell assets at depressed prices when unitholders choose to redeem units;
  • the manager does not customize the investments according to your particular situation or preferences as the manager may be dealing with thousands of fund holders;
  • you have no input as to how it will be managed or what it will own;
  • you normally won’t be able to view the fund’s holdings other than when it publishes them periodically – typically on a semi-annual basis; and
  • you normally don’t have access to the fund manager to freely call him or her to enquire about the fund. The fund manager normally won’t know who you are.

When it is Worth Having a Fund Manager

The key issue is whether the fund manager is able to add value.  Is the manager skilled and able to generate returns, net of costs, in excess of a comparable market index or generate similar returns to the market index but do so with less risk.

Determining this is not an easy task.  When outperformance in term of superior net returns or in terms of better risk adjusted returns occurs, we need to have some idea of whether that was due to skill or luck.  We want to know this to gain confidence of whether such added value is likely to be repeated in the future years.

Identifying Skill

A skillful investment manager might be identified:

  • where the manager utilizes an investment strategy that is sensible, the variables screened for are materially significant and directly relate to financial performance, and enough securities are selected to generate the strategy returns to reduce the effect of randomness;
  • by learning the manager’s investment philosophy on constructing and managing a portfolio in terms of both risk and return;
  • by examining the manager’s background, education, experience and character including:
    • relevant investment education;
    • investment experience and experience managing portfolios;
    • age;
    • intelligence;
    • rational temperament;
    • self-confidence, independent thinking and creativity;
    • patience;
    • competitiveness; and
    • a passion for investing
  • by examining through time the manager’s performance net of fees compared to the comparable market index. A consistent history of outperformance can be indicative of skill.

But at What Price?

Robert Kiyosaki’s quote may be a little exaggerated but does highlight the issue of costs.  Consider a mutual fund with an all-inclusive management expense ratio of 2.3%.  This fund comprises of a fund manager fee of 1.0%, the trailer fee of 1.0% to the investment adviser and 0.30% for expenses.  On top of this would be any sales charges.

If you have more than $100,000, you can do better.  You can instead hire a portfolio manager that also customizes your portfolio according to your cash needs, risk tolerance and investment preferences.  Some of these portfolio managers can also offer you financial planning advice and service.  And this portfolio manager knows you and you deal direct with him or her.  Your cost could be cut in half putting more money in your pocket.  Now how’s that for building a better mouse trap?

Index and Sector ETFs: Mutual Funds: Speculation X3

How many of you remember the immortal words of P. T. Barnum? On Wall Street, the incubation period for new product scams may be measured in years instead of minutes, but the end result is always a greed-driven rush to financial disaster.

The meltdown spawned index mutual funds, and their dismal failure gave life to “enhanced” index funds, a wide variety of speculative hedge funds, and a rapidly growing assortment of Index ETFs. Deja Vu all over again, with the popular ishare variety of ETF leading the lemmings to the cliffs.

How far will we allow Wall Street to move us away from the basic building blocks of investing? Whatever happened to stocks and bonds? The Investment Gods are appalled.

A market or sector index is a statistical measuring device that tracks prices in securities selected to represent a portion of the overall market. ETF creators:

  • select a sampling of the market that they expect to be representative of the whole,
  • purchase the securities, and then
  • issue the ishares, SPDRS, CUBEs, etc. that speculators then trade on the exchanges just like equities.

Unlike ordinary index funds, ETF shares are not handled directly by the fund. As a result, they can move either up or down from the value of the securities in the fund, which, in turn, may or may not mirror the index they were selected to track. Confused? There’s more — these things are designed for manipulation.

Unlike managed Closed-End Funds (CEFs), ETF shares can be created or redeemed by market specialists, and Institutional Investors can redeem 50,000 share lots (in kind) if there is a gap between the net-asset-value and the market price of the fund.

These activities create artificial demand in an attempt to minimize the gap between NAV and market price. Clearly, arbitrage activities provide profit-making opportunities to the fund sponsors that are not available to the shareholders. Perhaps that is why the fund expenses are so low — and why there are now thousands of the things to choose from.

Two other ETF idiosyncrasies need to be appreciated:

a) performance return statistics for index funds may not include expenses, but it should be obvious that none will ever outperform their market, and

b) index funds may publish P/E numbers that only include the profitable companies in the portfolio.

So, in addition to the normal risks associated with investing, we add: speculating in narrowly focused sectors, guessing on the prospects of unproven small cap companies, experimenting with securities in single countries, rolling the dice on commodities, and hoping for the eventual success of new technologies.

We then call this hodge-podge of speculation a diversified, passively managed, inexpensive approach to Modern Asset Management — based solely on the mathematical hocus pocus of Modern Portfolio Theory (MPT).

Once upon a time, but not so long ago, there were high yield junk bond funds that the financial community insisted were appropriate investments because of their diversification. Does diversified junk become un-junk? Isn’t passive management as much of an oxymoron as variable annuity? Who are they kidding?

But let’s not dwell upon the three or more levels of speculation that are the very foundation of all index and sector funds. Let’s move on to the two basic ideas that led to the development of plain vanilla Mutual Funds in the first place: diversification and professional management.

Mutual Funds were a monumental breakthrough that changed the investment world. Hands-on investing became possible for everyone. Self-directed retirement programs and cheap to administer employee benefit programs became doable.

The investment markets, once the domain of the wealthy, became the savings accounts of choice for the employed masses — because the “separate accounts” were both trusteed and professionally managed. When security self-direction came along, professional management was gone forever. Mutual fund management was delegated to the financially uneducated masses.

ETFs are not the antidote for the mob-managed & dismal long term performance of open end Mutual Funds, where professionals are always forced to sell low and to buy high. ETFs are the vehicles of choice for Wall Street to ram MPT mumbo jumbo down the throats of busy, inexperienced investors… and the regulators who love them because they are cheap.

Mutual fund performance is bad (long term, again) because managers have to do what the mob tells them to do — so Wall Street sells “passive products” with controlled content that they can manipulate more cheaply.

Here’s a thumbnail sketch of how well passive ETFs may have performed from the turn of the century through 2013: the DJIA growth rate was about 0% per year, the S & P 500 was negative; the NASDAQ Composite has just recently regained its 2000 value.

How many positive sectors, technologies, commodities, or capitalization categories could there have been?

Now subtract the fees… hmmmm. Again, how would those ETFs have fared? Hey, when you buy cheap and easy, it’s usually worth it. Now if you want performance, I suggest you try real management, as opposed to Mutual Fund management… but you need to take the time to understand the process.

If you can’t understand or accept the strategy, don’t hire the manager. Mutual Funds and ETFs cannot “beat the market” (not a well thought out investment objective anyway) because both are effectively managed by investor/speculators… not by professionals.

Sure, you might find some temporary smiles in your ETFs, but only if you take your profits will the smiles last. There may be times when it makes sense to use these products to hedge against a specific risk. But stop kidding yourself every time Wall Street comes up with a new short cut to investment success.

There is no reason why all of you can’t either run your own investment portfolio, or instruct someone as to how you want it done. Every guess, every estimate, every hedge, every sector bet, and every shortcut increases portfolio risk.

Products and gimmicks are never the answer. ETFs, a combination of the two, don’t even address the question properly — AND their rising popularity has raised the risk level throughout the Stock Market. How’s that, you ask?

The demand for the individual stocks included in ETFs is raising their prices without having anything to do with company fundamentals.

What’s in your portfolio?

How will ETFs and Mutual Funds fare in the next correction?

Are YOU ready.

Brave Old World: Market Cycle Investment Management

The Market Cycle Investment Management (MCIM) methodology is the sum of all the strategies, procedures, controls, and guidelines explained and illustrated in the “The Brainwashing of the American Investor” — the Greatest Investment Story Never Told.

Most investors, and many investment professionals, choose their securities, run their portfolios, and base their decisions on the emotional energy they pick up on the Internet, in media sound bytes, and through the product offerings of Wall Street institutions. They move cyclically from fear to greed and back again, most often gyrating in precisely the wrong direction, at or near precisely the wrong time.

MCIM combines risk minimization, asset allocation, equity trading, investment grade value stock investing, and “base income” generation in an environment which recognizes and embraces the reality of cycles. It attempts to take advantage of both “fear and greed” decision-making by others, using a disciplined, patient, and common sense process.

This methodology thrives on the cyclical nature of markets, interest rates, and economies — and the political, social, and natural events that trigger changes in cyclical direction. Little weight is given to the short-term movement of market indices and averages, or to the idea that the calendar year is the playing field for the investment “game”.

Interestingly, the cycles themselves prove the irrelevance of calendar year analysis, and a little extra volatility throws Modern Portfolio Theory into a tailspin. No market index or average can reflect the content of YOUR unique portfolio of securities.

The MCIM methodology is not a market timing device, but its disciplines will force managers to add equities during corrections and to take profits enthusiastically during rallies. As a natural (and planned) affect, equity bucket “smart cash” levels will increase during upward cycles, and decrease as buying opportunities increase during downward cycles.

MCIM managers make no attempt to pick market bottoms or tops, and strict rules apply to both buying and selling disciplines.

NOTE: All of these rules are covered in detail in “The Brainwashing of the American Investor” .

Managing an MCIM portfolio requires disciplined attention to rules that minimize the risks of investing. Stocks are selected from a universe of Investment Grade Value Stocks… under 400 that are mostly large cap, multi-national, profitable, dividend paying, NYSE companies.

LIVE INTERVIEW – Investment Management expert Steve Selengut Discusses MCIM Strategies – LIVE INTERVIEW

Income securities (at least 30% of portfolios), include actively managed, closed-end funds (CEFs), investing in corporate, federal, and municipal fixed income securities, income paying real estate, energy royalties, tax exempt securities, etc. Multi level, and speculation heavy funds are avoided, and most have long term distribution histories.

No open end Mutual Funds, index derivatives, hedge funds, or futures betting mechanisms are allowed inside any MCIM portfolio.

All securities must generate regular income to qualify, and no security is ever permitted to become too large of a holding. Diversification is a major concern on an industry, or sector, level, but global diversification is a given with IGVSI companies.

Risk Minimization, The Essence of Market Cycle Investment Management

Risk is compounded by ignorance, multiplied by gimmickry, and exacerbated by emotion. It is halved with education, ameliorated with cost-based asset allocation, and managed with disciplined: selection quality, diversification, and income rules— The QDI. (Read that again… often.)

Risk minimization requires the identification of what’s inside a portfolio. Risk control requires daily decision-making. Risk management requires security selection from a universe of securities that meet a known set of qualitative standards.

The Market Cycle Investment Management methodology helps to minimize financial risk:

  • It creates an intellectual “fire wall” that precludes you from investing in excessively speculative products and processes.
  • It focuses your decision making with clear rules for security selection, purchase price criteria, and profit-taking guidelines.
  • Cost based asset allocation keeps you goal focused while constantly increasing your base income.
  • It keeps poor diversification from creeping into your portfolio and eliminates unproductive assets in a rational manner.

Strategic Investment Mixology – Creating The Holy Grail Cocktail

So what do your Investment Manager and your neighborhood bartender have in common, other than the probability that you spend more time with the latter during market corrections?

Antoine Tedesco, in his “The History of Cocktails“, lists three things that mixologists consider important to understand when making a cocktail: 1) the base spirit, which gives the drink its main flavor; 2) the mixer or modifier, which blends well with the main spirit but does not overpower it; and 3) the flavoring, which brings it all together.

Similarly, your Investment Manager needs to: 1) put together a portfolio that is based on your financial situation, goals, and plans, providing both a sense of direction and a framework for decision making; 2) use a well defined and consistent investment methodology that fits well with the plan without leading it in tangential directions; and 3) exercise experienced judgment in the day-to-day decision making that brings the whole thing together and makes it grow.

Tedesco explains that: new cocktails are the result of experimentation and curiosity; they reflect the moods of society; and they change rapidly as both bartenders and their customers seek out new and different concoctions to popularize. The popularity of most newbies is fleeting; the reign of the old stalwarts is history — with the exception, perhaps, of “Goat’s Delight” and “Hoptoad”. But, rest assured, the “Old Tom Martini” is here to stay!

It’s likely that many of the products, derivatives, funds, and fairy tales that emanate from Modern Portfolio Theory (MPT) were thrown together over “ti many martunies” at Bobby Van’s or Cipriani’s, and just like alcohol, the addictive products created in lower Manhattan have led many a Hummer load of speculators down the Holland tubes.

The financial products of the day are themselves, created by the mood of society. The “Wizards” experiment tirelessly; the customers’ search for the Holy Grail cocktail is never ending. Curiosity kills too many retirement “cats”.

Investment portfolio mixology doesn’t take place in the smiley faced environment that brought us the Cosmo and the Kamikaze, but putting an investment cocktail together without the risk of addictive speculations, or bad after- tastes, is a valuable talent worth finding or developing for yourself. The starting point should be a trip to portfolio-tending school, where the following courses of study are included in the Investment Mixology Program:

Understanding Investment Securities: Investment securities can be divided into two major classes that make the planning exercise called asset allocation relatively straightforward. The purpose of the equity class is to generate profits in the form of capital gains. Income securities are expected to produce a predictable and stable cash flow in the form of dividends, interest, royalties, rents, etc.

All investment securities involve both financial and market risk, but risk can be minimized with appropriate diversification disciplines and sensible selection criteria. Still, regardless of your skills in selection and diversification, all securities will fluctuate in market price and should be expected to do so with semi-predictable, cyclical regularity.

Planning Securities Decisions: There are three basic decision processes that require guideline development and procedural disciplines: what to buy and when; when to sell and what; and what to hold on to and why.

Market Cycle Investment Management: Most portfolio market values are influenced by the semi-predictable movements of several inter-related cycles: interest rates, the IGVSI, the US economy, and the world economy. The cycles themselves will be influenced by Mother Nature, politics, and other short-term concerns and disruptions.

Performance Evaluation: Historically, Peak-to-Peak analysis was most popular for judging the performance of individual and mutual fund growth in market value because it could be separately applied to the long-term cyclical movement of both classes of investment security. More recently, short-term fluctuations in the DJIA and S & P 500 are being used as performance benchmarks to fan the emotional fear and greed of most market participants.

Information Filtering: It’s important to limit information inputs, and to develop filters and synthesizers that simplify decision-making. What to listen to, and what to allow into the decision making process is part of the experienced manager’s skill set. There is too much information out there, mostly self-motivated, to deal with in the time allowed.

Wall Street investment mixologists promote a cocktail that has broad popular appeal but which typically creates an unpleasant aftertaste in the form of bursting bubbles, market crashes, and shareholder lawsuits. Many of the most creative financial nightclubs have been fined by regulators and beaten up by angry mobs with terminal pocketbook cramps.

The problem is that mass produced concoctions include mixers that overwhelm and obscure the base spirits of the investment portfolio: quality, diversification, and income.

There are four conceptual ingredients that you need to siphon out of your investment cocktail, and one that must be replaced with something less “modern-portfolio-theoryesque”:

1) Considering market value alone when analyzing performance ignores the cyclical nature of the securities markets and the world economy.

2) Using indices and averages as benchmarks for evaluating your performance ignores both the asset allocation of your portfolio and the purpose of the securities you’ve selected.

3) Using the calendar year as a measuring device reduces the investment process to short-term speculation, ignores financial cycles, increases emotional volatility in markets, and guarantees that you will be unhappy with whatever strategy or methodology you employ —most of the time.

4) Buying any type or class of security, commodity, index, or contract at historically high prices and selling high quality companies or debt obligations for losses during cyclical corrections eventually causes hair loss and shortness of breath.

And the one ingredient to replace: Modern Portfolio Theory (the heartbeat of ETF cocktails) with the much more realistic Working Capital Model (operating system of Market Cycle Investment Management).


Stock Market Corrections Are Beautiful… When

A correction is a beautiful thing, simply the flip side of a rally, big or small. Theoretically, even technically I’m told, corrections adjust equity prices to their actual value or “support levels”. In reality, it’s much easier than that.

Prices go down because of speculator reactions to expectations of news, speculator reactions to actual news, and investor profit taking. The two former “becauses” are more potent than ever before because there is more self-directed money out there than ever before. And therein lies the core of correctional beauty!

Mutual Fund unit holders rarely take profits but often take losses. Additionally, the new breed of Index Fund Speculators over-react to news of any kind because that’s what speculators do. Thus, if any brief little market hiccup becomes considerably more serious, new investment opportunities will become abundant!

Here’s a list of ten things to think about doing, or to avoid doing, during corrections of any magnitude:

1. Your present Asset Allocation should be tuned in to your long-term goals and objectives. Resist the urge to decrease your Equity allocation because you expect a further fall in stock prices. That would be an attempt to time the market, which is (rather obviously) impossible. Asset Allocation decisions should have nothing to do with stock market expectations.

2. Take a look at the past. There has never been a correction that has not proven to be a buying opportunity, so start collecting a diverse group of high quality, dividend paying, NYSE companies as they move lower in price— Investment Grade Value Stocks. I start shopping at 20% below the 52-week high water mark— the bargain bins are filling.

3. Don’t hoard that “smart cash” you accumulated during the last rally, and don’t look back and get yourself agitated because you might buy some issues too soon. There are no crystal balls, and no place for hindsight in an investment strategy. Buying too soon, in the right portfolio percentage, is nearly as important to long-term investment success as selling too soon is during rallies.

4. Take a look at the future. Nope, you can’t tell when the rally will resume or how long it will last. If you are buying quality equities now (as you certainly could be) you will be able to love the rally even more than you did the last time— as you take yet another round of profits. Smiles broaden with each new realized gain, especially when most Wall Streeters are still just scratchin’ their heads.

5. As (or if) the correction continues, buy more slowly as opposed to more quickly, and establish new positions incompletely. Hope for a short and steep decline, but prepare for a long one. There’s more to Shop at The Gap than meets the eye, and if you are doing it properly, you’ll run out of cash well before the new rally begins.

6. Your understanding and use of the Smart Cash concept has proven the wisdom of The Investor’s Creed (look it up). You should be out of cash while the market is still correcting— it gets less scary each time. As long your cash flow continues unabated, the change in market value is merely a perceptual issue.

7. Note that your Working Capital is still growing, in spite of falling prices, and examine your holdings for opportunities to average down on cost per share or to increase yield (on fixed income securities). Examine both fundamentals and price, lean hard on your experience, and don’t force the issue.

8. Identify new buying opportunities using a consistent set of rules, rally or correction. That way you will always know which of the two you are dealing with in spite of what the Wall Street propaganda mill spits out. Focus on Investment Grade Value Stocks; it’s just easier, as well as being less risky, and better for your peace of mind. Just think where you would be today had you heeded this advice years ago—

9. Examine your portfolio’s performance: with your asset allocation and investment objectives clearly in focus; in terms of market and interest rate cycles as opposed to calendar Quarters (never do that) and Years; and only with the use of the Working Capital Model (look this up also), because it is based upon your personal asset allocation. Remember, there is really no single index number to use for comparison purposes with a properly designed portfolio.

Unfortunately, only Self Directed 401k and IRA programs are able to use Market Cycle Investment Management.

10. So long as everything is down, there is nothing to worry about. Downgraded (or simply lazy) portfolio holdings should not be discarded during general or group specific weakness. Unless of course, you don’t have the courage to get rid of them during rallies— also general or sector specifical (sic).

Corrections (of all types) will vary in depth and duration, and both characteristics are clearly visible only in institutional grade rear view mirrors. The short and deep ones are most lovable (kind of like men, I’m told); the long and slow ones are more difficult to deal with. Short ones (those that last a few days, weeks, or months) are nearly impossible to deal with using Mutual Funds.

So if you overthink the environment or overcook the research, you’ll miss the party. Unlike many things in life, Stock Market realities need to be dealt with quickly, decisively, and with zero hindsight.

Because amid all of the uncertainty, there is one indisputable fact that reads equally well in either market direction: there has never been a correction/rally that has not succumbed to the next rally/correction—

Think cycle instead of year, and smile more often.

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A Preemptive, Timeless, Portfolio Protection Strategy

A participant in the morning Market Cycle Investment Management (MCIM) workshop observed: I’ve noticed that my account balances are near all time high levels. People are talking down the economy and the dollar. Is there any preemptive action I need to take?

An afternoon workshop attendee spoke of a similar predicament, but cautioned that a repeat of the June 2007 through early March 2009 correction must be avoided — a portfolio protection plan is essential!

What were they missing?

These investors were taking pretty much for granted the fact that their investment portfolios had more than merely survived the most severe correction in financial market history. They had recouped all of their market value, and maintained their cash flow to boot. The market averages seemed afraid to move higher.

Their preemptive portfolio protection plan was already in place — and it worked amazingly well, as it certainly should for anyone who follows the general principles and disciplined strategies of the MCIM.

But instead of patting themselves on the back for their proper preparation and positioning, here they were, lamenting the possibility of the next dip in securities’ prices. Corrections, big and small, are a simple fact of investment life whose origination point can only be identified using rear view mirrors.

Investors constantly focus on the event instead of the opportunity that the event represents. Being retrospective instead of hindsightful helps us learn from our experiences. The length, depth, and scope of the financial crisis correction were unknowns in mid-2007. The parameters of the recent advance are just as much of a mystery now.

MCIM forces us to prepare for cyclical oscillations by requiring that: a) we take reasonable profits quickly whenever they are available, b) we maintain our “cost-based” asset allocation formula using long-term (retirement, etc.) goals, and c) we slowly move into new opportunities only after downturns that the “conventional wisdom” identifies as correction level— i. e., twenty percent.

  • So, a better question, concern, or observation during an unusually long rally, given the extraordinary performance scenario that these investors acknowledge, would be: What can I do to take advantage of the market cycle even more effectively — the next time?

The answer is as practically simple as it is emotionally difficult. You need to add to portfolios during precipitous or long term market downturns to take advantage of lower prices — just as you would do in every other aspect of your life. You need first to establish new positions, and then to add to old ones that continue to live up to WCM (Working Capital Model) quality standards.

You need to maintain your asset allocation by adding to income positions properly, and monitor cost based diversification levels closely. You need to apply cyclical patience and understanding to your thinking and hang on to the safety bar until the climb back up the hill makes you smile. Repeat the process. Repeat the process. Repeat the process.

The retrospective?

The MCIM methodology was nearly fifteen years old when the robust 1987 rally became the dreaded “Black Monday”, (computer loop?) correction of October 19th. Sudden and sharp, that 50% or so correction proved the applicability of a methodology that had fared well in earlier minor downturns.

According to the guidelines, portfolio “smart cash” was building through August; new buying overtook profit taking early in September, and continued well into 1988.

Ten years later, there was a slightly less disastrous correction, followed by clear sailing until 9/11. There was one major difference: the government didn’t kill any companies or undo market safeguards that had been in place since the Great Depression.

Dot-Com Bubble! What Dot-Com Bubble?

Working Capital Model buying rules prohibit the type of rampant speculation that became Wall Street vogue during that era. The WCM credo after the bursting was: “no NASDAQ, no Mutual Funds, no IPOs, no Problem.” Investment Grade Value Stocks (IGVSI stocks) regained their luster as the no-value-no-profits securities slip-slided away into the Hudson.

Embarrassed Wall Street investment firms used their influence to ban the “Brainwashing of the American Investor” book and sent the authorities in to stifle the free speech of WCM users — just a rumor, really.

Once again, through the “Financial Crisis”, for the umpteenth time in the forty years since its development, Working Capital Model operating systems have proven that they are an outstanding Market Cycle Investment Management Methodology.

And what was it that the workshop participants didn’t realize they had — a preemptive portfolio protection strategy for the entire market cycle. One that even a caveman can learn to use effectively.

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One Person’s Bond Crash is Another’s Income Opportunity

Today’s “Investment News” headline (from Bloomberg) is designed to make you shiver in your income portfolio boots:

“Big fixed income shop prepares for the worst”…

The Bond Portfolio “Window Dressing” sell-off has begun.

Bond funds in general are now holding 8% of assets in cash, the article reports…highest since the financial crisis, and 1999, even. Professional Bond Traders certainly have reason to worry; closed end fund income investors not so much.

The article is reporting fear of lower market values with respect to existing bonds, particularly the higher yield variety…. big players in the bond market are hoarding cash (even selling existing holdings at losses in the process).

Bond Traders and Fund Managers look foolish as inventory market values fall. The cash hoard is their way of preparing to buy similar paper at higher yields sometime in the future and/or to buy back “old” bonds after the fall in price.

In the meantime, they are holding zero interest rate cash in anticipation of the higher yields… and could care less about the negative impact this behavior has on portfolio yields.

This is the result of what I call “Total Return Crossover”… the absurd application of market value growth analysis, instead of income development criteria, to primarily income security portfolios. (An analytical atrocity that is reinforced and encouraged by retirement plan regulators.)

So bond and Income Mutual Fund managers choose to actually lose your money now to look less foolish than the competition later. This “panic selling” by professionals leads to irrational, “knee jerk” reactions in amateurs.

What I did not read in the Bloomberg “disaster scenario” (and this should calm all the frayed nerves) was any indication or expectation of default on the interest paid by the bond issuers. This is the key issue with income investing…

Bonds are corporate and government debt securities, people… so long as they pay the interest why worry about the market value?

Wall Street is always more concerned about appearances than it is about income generation. And the Masters of the Universe really do have a problem… OMG, what this could do to those year-end bonuses…

But we (the average investors out here) can simply reinvest our current CEF income in any number of portfolios of bonds, preferred stocks, loans, notes, etc., selling at discounts, not only from their maturity value, but also from their combined Net Asset Values. Read that again please.

Remember, Closed End Income Fund portfolios aren’t influenced directly by either the fear (or greed) of individual investors… they are under a “protective dome”, if you will, that is subject to all forms of volatility for a vast array of reasons.

But an Income CEF, for example, becomes the totally liquid trading vehicle for a portfolio that could contain hundreds of totally illiquid individual securities… do you believe in magic? Be it Magic, or genius, who cares. We, mere mortals that we are, can jump on the lower prices that chill the blood of Wall Street’s Master Class.

Closed End Fund investors are uniquely positioned to take advantage of both the lower prices and the higher yields that exist right now. Market Cycle Investment Management users have done it before, right?

Remember the fall in CEF prices from early 2007 (higher rates caused these) through early March 2009 (even in the face of the lowest interest rates ever)… and the ensuing rise through October 2011?

Well, do you really think that the anticipated one percentage point rise in interest rates over the next year or so will cause Financial Crisis #2?

Isn’t it great when Wall Street’s pain becomes fuel for the small investor’s gain…. but only if you take advantage of the lower price, higher yield scenario that is staring you in the face as you read this message..

Yes, YOU can be the Master of this Universe!

Income Investing: “Feed Your Head… Feed Your Head”

Jefferson Airplane has never, ever, been mistaken for a band of financial advisors, but the White Rabbit lyrics can be incredibly instructional to the generation of investors who experienced the classic first hand — as a description of their own college days’ lifestyle. If only they had heeded the dormouse’s call to “feed your head.” For the sake of your retirement sanity and security, you just have to make income investing an intellectual exercise — not an emotional one.

The Brainwashing of the American Investor has its own tale of an Alice whose “logic and proportion” had “fallen sloppy dead”. Many years ago, when interest rates soared into double digits, elderly Alice was well advised to invest her stash in a portfolio of Ginnie Maes. Broadly smiling, she bragged to her friends about the federally guaranteed 13% interest she was receiving in regular monthly intervals — much more than she needed to cover her living expenses.

But interest rates continued to move higher, and the decreasing market value of her Ginnie Maes was more than she could tolerate. “If rates continue to go up, I’ll have nothing left” she cried to her White Knight financial advisor who suggested patience and understanding. The very same pill that made her income grow larger was also making her market value become smaller.

Yet the income kept rolling in, higher yielding unit trusts were purchased with the excess, and major redemptions were nowhere to be seen. The income kept growing, the market value kept shrinking, and Alice was seeing red from seeing red on her account statements.

So Alice went to her local bank and traded in her absolutely government guaranteed 13 per centers for some laddered, non-negotiable, 8.5% CDs. “No more erosion of my nest egg”, she toasted proudly with the hookah smoking bank caterpillar who orchestrated her move to lower income levels. Within a few months, she was liquidating CDs to pay the bills that never seemed to be a problem with those terrible Ginnie Maes.

Don’t let such uniformed thinking sabotage your retirement program; don’t let the selfish advice of a product sharpshooter send you chasing rabbits when IRE (interest rate expectations) or other temporary market conditions shrink the market value of your income portfolio. Feed your head; feed—your—head.

Income pays the bills, and if the income level is both steady and adequate, there is no need to change investments. Market value should be used to determine when to buy more (at lower prices) and when to take profits (at higher ones). It is almost never necessary to take a loss on a high quality (government guaranteed in Alice’s case) income security.

More recent experimenters in much more sophisticated potions have addressed the issue with similar results, reaching mind-numbing conclusions such as these:

  • I know the income hasn’t changed throughout the debacle in the financial sector but I don’t want to buy anymore of these securities until the prices go back above what I paid for them originally. Translation: I’d rather stick with my 4.5% tax-free yield than increase it by adding to my positions at lower prices.
  • Sure, I understand the relationship between IRE and the prices of income CEFs but individual bonds and Treasuries haven’t suffered nearly as much. That’s where we should have been. Translation: I would be much happier with a 3% than with an 8% rate of realized income.
  • I’m tired of seeing all the negative positions in my portfolio. Let’s keep all the income we receive in money market until we’re back in positive territory. Translation: I’d rather accept 0.5% or so, than reduce my cost basis and increase my yield by adding to my positions at lower prices.

Modern brokerage firm monthly statement “pills” were developed during the dot-com era, when Wall Street was trying to emphasize the brilliance of its speculative prescriptions by making us all feel ten feet tall, month after month after month.

But the geniuses on the institutional chessboard produced too many mushroom product varietals and the Red Queen of corrections lopped off many of their sacred heads. The papers that were designed to make our chests burst with pride have turned on us as a haunting reminder of the reality of markets and the cycles that push them in either direction.

It should be easy to navigate a quality income portfolio through whatever circumstances, cycles, and scandals come at you, but a clear head and a clearer understanding of what to expect is required. Most brokerage firm statements make it difficult to monitor asset allocation using any methodology, including the Working Capital Model, and I don’t think that it’s by chance.

Confusion breeds unhappiness, and unhappiness brings about change, and the masters of the universe encourage you to fritter around from mushroom to mushroom in perpetual motion. To whose benefit?

It would be wonderful if an investor’s monthly statement would organize his securities based on their class and purpose, but Wall Street doesn’t want such distinctions to be made easily. It would be great if the institutions would help investors formulate reasonable expectations about various types of securities under varying conditions, but that’s not likely to happen either.

It would be spectacular if the media would produce information and explanation instead of news bites and sensationalism, but you guessed it — not much chance of that.

Income investing can be easy. Ask your hookah-smoking caterpillar to give you the how?

Income Closed End Funds and Total Return Analysis

What are the two main reasons mere mortals invest in income purpose securities: one is their inherent safety compared to equities… a 50% income asset allocation is much safer and theoretically less volatile than a 100% equity exposure.

There is less risk of total loss in XYZ company bonds or preferred stock than there is in XYZ common stock… a major fact of investment life roundly ignored by most investors/speculators in overpriced stock markets.

Equally important (as retirement looms larger) is the income these securities produce, first for compounding and then for spending.

  • Compound interest/dividends/realized capital gains is the most powerful retirement income force known to mankind… neither total return nor market value can pay your bills, take you on vacation, or pay your grandkids tuition.

Unlike Tom Wolfe’s “Masters of the Universe”, most of us are not bond traders. If our income inventory shrinks in market value, we don’t have to sell our positions. Wall Street fixed income pros don’t care about income production… buying and selling inventory is their business model, and they set the market prices.

The “higher interest rates are coming panic” you are hearing about in the media is a real problem for MOTUs, but it may be an investment opportunity for the rest of us. If I buy an Exxon 4% debenture, a 3% 30 year municipal bond, or a 10 year treasury note, three things are inherently true:

If interest rates rise, their market values will go down and it will be difficult to add to my positions… BUT my income (and their safety vis-a-vis equities) will not change; MARKET VALUE CHANGE HAS NO IMPACT ON INCOME, in high quality securities.

It is this “Interest Rate Expectation (IRE) Sensitivity” that CEF Investors are uniquely well positioned to take advantage of. All income focus securities (and funds that contain them) are impacted by IRE:

“Market Value Varies Inversely With Interest Rate Expectations”

The Net Asset Value (NAV) of CEFs is the sum of the values of hundreds of securities, inside a virtual “protective dome”, where only the manager can trade them. BUT we can “trade” the dome itself, reducing our cost basis and increasing our yield as we choose… something totally unimaginable in any othe income investment medium.

So this is precisely what is going on “inside” income CEFs right now. Individual security prices are being forced down by the expectation of rising interest rates and a significant discount is available. Absolutely nothing has changed with respect to the quality of the securities or the income being produced “Under The Dome”. The price of the dome has been reduced, and its “IN YOUR POCKET” income is rising.

Yes, that observation is correct, we can now accelerate the growing power of our Compound Earnings Machine

No change in the securities, their quality, or contractual payments… only the price of the package has changed. So there they are, investors, opportunities just waiting for you to pad your retirement portfolio pocketbooks with income over 6.5% tax free and up to 8.0% taxable.

These sweet discounts are only available through the financial genius of CEFs. Only here can “mere mortals” turn Wall Street’s blood bath into an income portfolio worth bragging about. There has been no news that suggests there is anything wrong with the “securities under the dome”.

So don’t be concerned with the “OMG, bond prices are falling” headlines… that’s Wall Street’s problem. This is the biggest CEF sale since 2011, and… the “Call to the Mall” has sounded!

Income CEF Price Volatility… No Problem at All

Market Cycle Investment Management portfolios are different from any others you may be analyzing, and all investors analyze their portfolios most intently when their “bottom line” market values begin to crumble. This focus on market value is part of Wall Street’s Brainwashing of the American Investor.

MCIM investing is more realistic. It recognizes that investment markets (both equity and income) are cyclical. Rarely do portfolio market values trend upward as long as they have since March of 2009, and most equity investors have forgotten the five month, 22%, mini-correction that ran from May through September 2011. When will we experience the real deal?

MCIM focuses on “working capital”, a measure of the total cost basis of the securities and cash contained in an investment portfolio. Managed properly, this measure should grow in all market, economic, and interest rate environments, irrespective of changes in “market value”… really.

MCIM portfolios include 30% Income Purpose securities (based on Working Capital), and never own non Investment Grade Value Stock equities. This translates into portfolios of high quality securities, each contributing to higher realized base income than that contained in market averages and blended Mutual Funds.

Embracing the cycles, MCIM portfolios strive to grow both total Working Capital and portfolio “Base Income”steadily, regardless of what is going on in the investment markets, in either direction.

MCIM portfolio “Working Capital” will be higher now than on January 1st; and “base income” will have risen in all portfolios where cash flow has remained positive… in spite of lower CEF market values. Long term, this is the single most important of all portfolio management issues.

Income Closed End Fund (CEF) prices have been moving lower since November 2012; the decline accelerated in May — but with barely any change in total income generated. In November 2012, you’ll recall, many CEFs were selling at premiums to NAV. The premiums are now gone, taking a whole lot of market value with them… but, again, with little or no change in income.

Stock market numbers have also weakened recently, and this 2.5 year divergence between equity and income security prices is quite normal; accelerated weakness in income security prices often signals an upcoming stock market correction, as it did in 2007..

The vast majority of income CEFs are now selling at significant discounts to the Net Asset Value of the security portfolios inside. The vast majority of income CEFs are selling at significant discounts to the market value of the securities they contain. (repetition intended)

Wall Street wants you to believe that higher prices and lower yields are better… how does that make any sense with no change in the portfolio content?

A selection universe of about one hundred taxable income CEFs and seventy tax free income CEFs is used in constructing MCIM portfolios. In the six plus years since the depths of the financial crisis, and in spite of the lowest interest rate environment in history, the vast majority of these CEFs have maintained their regular payouts to shareholders.

Lower prices now are as much a result of FED tinkering as threatened rate hikes.

Historically, in more “normal” interest rate environments, income increases have been more prevalent than income reductions. Overall, income CEF managers coped well with the lowest interest rates ever…. how have they been dealing with the specter of higher rates? Keep in mind that no actual interest rate change has yet occurred.

After six years of artificially low interest rates, many have been forced to reduce their payouts… very few have made significant dividend cuts.

Now the interesting part: at current prices, the average dividend yield on 57 taxable CEFs paying over 7.0% is approximately 8.5%; the average on 53 tax free CEFs paying over 6% is about 6.7%

The vast majority of all CEFs made their regular scheduled distributions throughout the financial crisis; more actually raised their payouts than reduced them; after six years of close-to-zero rates, higher “coupons” will eventually increase CEF dividend payouts to normal, pre-financial crisis, levels.

The current yield on the MCIM CEF Universe is well above 6% for tax free income and above 8% for taxable. Why is this bad news? Only, yes only, because professional bond traders have to realize losses when they trade… income investors do not have to sell at all…. they can take advantage of “discounts” to increase their spending money.

What’s lnside the CEFs:

• Each CEF portfolio contains hundreds of individual issues with varying qualities, maturities, call provisions, etc. The average duration is between 7 and 8 years

• Managers use short term borrowing to purchase additional securities; nothing forces them to borrow at higher rates if they can’t still invest profitably

• Managers capitalize on profit-taking opportunities; and are not forced to sell at losses.

• CEF share prices are completely “uncoupled” from NAV; shareholders are investing in the investment company as opposed to owning a piece of the investment portfolio itself.

As I see it, and this is no prediction or recommendation of any specific course of action, CEFs provide investors with the opportunity to take advantage of irrational price dislocations in the income securities market — an opportunity that is difficult for the average investor to capitalize upon using individual securities.

By adding to existing CEF positions, investors increase overall portfolio yield, increase yield on specific holdings, and reduce per share cost basis.

Thus, even if some reduced payouts are experienced, the overall level of income is likely to be at least stable, and possibly higher. Right now, the expectation of higher interest rates is probably the main force driving Closed End Fund prices lower.

BUT, particularly if the stock market corrects, higher interest rates and higher demand for safety may cause investors to seek out higher yielding and safer investments.

Never forget, all companies must pay their bond, note, and preferred stock investors BEFORE a penny goes to their Equity investors… income CEFs contain no equities, even though your (purposely) confusing Wall Street account statement tells you that they are equities…. hmmm