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 dot.com 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).

Cheers!

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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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!

The “Total Return” Shell Game

No “Interest Rate Sensitive” Security is an Island…

Just what is this “total return” thing that income portfolio managers like to talk about, and that Wall Street uses as the performance hoop that all investment managers have to jump through? Why is it mostly just smoke and mirrors?

Here’s the formula:

  • Total Income + (or -) Change in Market Value – Expenses = Total Return — and this is supposed to be the ultimate test for any investment portfolio, income or equity.

Applied to Fixed Income Investment Portfolios, it is useless nonsense designed to confuse and to annoy investors.

How many of you remember John Q. Retiree? He was that guy with his chest all puffed up one year, bragging about the 12% “Total Return” on his bond portfolio while he secretly wondered why he only had about 3% in actual spending money.

The next year he’s scratching his head wondering how he’s ever going to make ends meet with a total return that’s quickly approaching zero. Do you think he realizes that his actual spending money may be higher? What’s wrong with this thinking? How would the media compare mutual fund managers without it?

Wall Street doesn’t much care because investor’s have been brainwashed into thinking that income investing and equity investing can be measured with the same ruler. They just can’t, and the “total return” ruler itself would be thrown out with a lot of other investment trash if it were more widely understood.

  • If you want to use a ruler that applies equally well to both classes of investment security, you have to change just one piece of the formula and give the new concept a name that focuses in on what certainly is the most important thing about income investing — the actual spending money.

We’ll identify this new way of looking at things as part of “The Working Capital Model” and the new and improved formulae are:

  • For Fixed Income Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!
  • For Equity Securities: Total Cash Income + Net Realized Capital Gains – Expenses = Total Spending Money!

Yes, they are the same! The difference is what the investor elects to do with the spending money after it has become available. So if John Q’s Investment pro had taken profits on the bonds held in year one, he could have sent out some bigger income payments and/or taken advantage of the rise in interest rates that happened in year two.

Better for John Q, sure, but the lowered “total return” number could have gotten him fired. What we’ve done is taken those troublesome paper profits and losses out of the equation entirely. “Unrealized” is “un-relevant” in an investment portfolio that is diversified properly and comprised only of investment grade, income producing securities.

Most of you know who Bill Gross is. He’s the fixed Income equivalent of Warren Buffett, and he just happens to manage the world’s largest “open ended” bond mutual fund. How was he investing his own money during other interest rate cycles?

Well, according to an article by Jonathan Fuerbringer in the Money and Business Section of January 11, 2004 New York Times, he’s removed it from the Total Return Mutual Fund he manages and moved it into: Closed End Municipal Bond Funds where he could “realize” 7.0% tax free.

(Must have read “The Brainwashing of the American Investor”.)

He doesn’t mention the taxable variety of Closed End Fund (CEF), now yielding a point or two more than the tax free variety, but they certainly demand a presence in the income security bucket of tax-qualified portfolios (IRAs, 401k(s), etc.).

Similarly, the article explains, Mr. Gross advises against the use of the non investment grade securities (junk bonds, for example) that many open-end bond fund managers are sneaking into their portfolios.

But true to form, and forgive the blasphemy if you will, Mr. Gross is as “Total Return” Brainwashed as the rest of the Wall Street institutional community — totally. He is still giving lip service validity to speculations in commodity futures, foreign currencies, derivatives, and TIPS (Treasury Inflation Protected Securities).

TIPs may be “safer”, but the yields are far too dismal. Inflation is a measure of total buying power, and the only sure way to beat it is with higher income levels, not lower ones. If TIPS rise to 5%, REITS will yield 12%, and preferred stocks 9%, etc.

No interest rate sensitive security is an Island!

As long as the financial community remains mesmerized with their “total return” statistical shell game, investors will be the losers.

  • Total Return goes down when yields on individual securities go up, and vice versa. This is a good thing.
  • Total Return analysis is used to engineer switching decisions between fixed income and equity investment allocations, simply on the basis of statements such as: “The total return on equities is likely to be greater than that on income securities during this period of rising interest rates.”

You have to both understand and commit to the premise that the primary purpose of income securities is income production. You have to focus on the “Income Received” number on your monthly statement and ignore the others… especially NAV.

If you don’t agree with the next three sentences; if they don’t make complete sense: you need to learn more about Income Investing:

  • Higher interest rates are the income investor’s best friend. They produce higher levels of spending money.
  • Lower interest rates are the income investor’s best friend. They provide the opportunity to add realized capital gains to both the total spending money and total working capital numbers.
  • Changes in the market value of investment grade income securities, Yogi says, are totally and completely irrelevant, 97% of the time.

Wall Street’s Even Dirtier Little Secret

As of Close of Business May 8th, no less than 57 multi-year experienced, Taxable Income, Closed End Funds (CEFs) were paying 7% or more in 401k and IRA eligible income to their shareholders.

31 issues (54%) paid 8% or above, and the average for the Heinz-like group was 8.56%. All of these portfolios are professionally managed by this long list of well respected, long experienced, investment companies… their purpose is dependable income production.

Blackrock, Nuveen, Pimco, Putnam, Invesco, Alliance-Bernstein, MFS, Calamos, Eaton Vance, Deutsche, Pioneer, Western Asset Management, Wells Fargo, Flaherty & Crumrine, 1st Trust, Brookfield, John Hancock, KKR, Babson Capital, Allianz Global, Neuberger-Berman, & Cohen & Steers

The investment portfolios include all forms of Bonds, Preferred Stocks, Mortgages, Senior Loans, etc, domestic and global, high yield and normal…

How difficult could it be to put together a well diversified, retirement income portfolio? If you only knew…

Most of these funds have paid steady, dependable, income for more than fifteen years, even through the financial crisis… several have been around since the ’90s

Yet your financial advisor has probably never mentioned them to you as a viable alternative to low yielding income Mutual Funds or stock market dependant funds and ETFs… she probably isn’t familiar with them either.

The DOL (and other retirement plan “specialists”) have effectively banned these programs from 401k Plans, and it’s likely that you have never heard them advertised or even mentioned in the most popular financial newsletters…

One could conclude that Wall Street (even the CEF providers themselves) would prefer that you didn’t even know that they exist.

Now here’s “the rest of the story”: 

A May 15th data search at cefconnect.com reveals that nearly 90% of all Taxable/Tax Deferred Closed End Funds (CEFs) were selling below their net asset values (NAVs), and of those, 63% were available to all (yes, IRA and 401k investors, too) at discounts above 8%.

Income Mutual Funds (I believe) are never available at discounts from NAV, and how many discounted securities has your advisor suggested to you since 2012 or earlier? ETF prices, I understand, are manipulated by their creators to present within pennies of their NAV.

But tax-deferred/taxable CEFs historically sell at discounts as often as not, and this morning, nearly 62% of them were available to MCIM taxable, IRA, and self-directed 401k account investors at discounts of 7% and higher.

SO, WHY THE WALL STREET COVER-UP? 

And, why aren’t you asking for more information?

Wall Street’s Dirtiest Little Secret

As of Close of Business May 8th, no less than 53 multi-year experienced, Tax Free Income, Closed End Funds (CEFs) were paying 6% or more in federally tax free income to their shareholders.

18 issues (34%) paid 6.4% or above, and the average for the group was 6.35%. All portfolios are professionally managed by this dozen, well respected, long experienced investment companies.

Blackrock, Nuveen, Pimco. Putnam, Invesco, Alliance-Bernstein, MFS, Dreyfus, Eaton Vance, Deutsche, Pioneer, & Delaware Investors.

How difficult could it be to put together a well diversified, retirement income portfolio?

Most of these funds have paid steady, dependable, income for more than fifteen years, even through the financial crisis… several have been around since the ’90s

Yet your financial advisor has never mentioned them to you; you have never heard them advertised or reviewed in the financial press… Wall Street, it seems, would prefer that you didn’t know they exist.

But there’s even more to this story. These readily-available and much-higher-than-you’ve-been-led-to-believe-even-exist tax free yields can be purchased at bold discounts to their Net Asset Value, or NAV in Mutual Fund Terms.

A May 15th data search at cefconnect.com reveals that 85% of all Municipal Bond Closed End Funds (CEFs) were selling below their net asset values (NAVs), and of those, 20% were available to all investors at discounts above 10%.

Mutual Funds (I believe) are never available at discounts from NAV, and how many discounted munis has your advisor suggested to you since 2012 or earlier?

Municipal CEFs regularly sell at discounts, and this morning, nearly 60% were available to MCIM taxable account investors at discounts of 5% or more.

WHY THE WALL STREET COVER-UP?

Why aren’t you asking for more information?

Interest Rates Rising – the sequel

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

No doubt you’ve noticed about half the industry pundits cautioning that the US Federal Reserve is closer to ‘tightening’ monetary policy.  What this implies for us regular folk is that they will introduce monetary measures that will allow interest rates to rise.  We have enjoyed a very long period of inflation and interest rate stability following the financial crisis (a crisis almost forgotten by many).  Despite a recent slowdown in come economic indicators, efforts by governments around to world to jumpstart an economic recovery did bear some fruit.  The rebound in profitability, employment and growth has been particularly robust in the United States.  Both Europe and China are now making efforts to replicate this success by bolstering liquidity in their financial systems as the US did.

So what’s to worry about?  Savvy investors will have already noticed that interest rates in the world’s strongest economy have already begun to rise, even before the FED has taken any action.  This is what markets do – they anticipate rather than react.  Some forecasters predict that although interest rates are bound to trend upward eventually, there’s no need to panic just yet.  They suggest that there’s enough uncertainty (financial distress in Europe, fallout from falling energy prices, Russia’s military ambitions, slow growth in China) to postpone the threat of rising rates far into the future.

Yield Curves 2015-05-02_15-28-30

What they are ignoring is that the bond markets will anticipate the future, and indeed bond investors out there have already begun to create rising interest rates for longer term fixed-income securities.  The graph illustrates that U.S. yield curves have shifted upward.  The curve shows market yields for US Treasury bonds for various maturities back in February compared to rates more recently.  So what’s the issue?  If investors hang on to their bonds while rates are rising, the market value of those bonds declines.  This often comes as a surprise to people who own bonds to avoid risk.  But professional bond traders and portfolio managers are acutely aware of this phenomenon.  So they begin to sell their bonds (the longer term-to-maturity bonds pose the most risk of declining in value) in order to protect themselves against a future rise in the general level of interest rates.  More sellers than buyers of the bonds pushes down the market price of the bonds, which causes the yields on those same bonds to increase.

Many money managers (including me) have learned  that despite how dramatically the world seems to change, in many respects history does repeat itself.  For example, while writing my CFA exams back in the mid-1980’s, I was provided with sample exams for studying, but they were from the most recent years.  I figured it was unlikely that questions on these sample exams would be used again so soon, and managed to do some digging in order to find much older previous exams.  I reasoned there are only so many questions they could ask, and perhaps older exam questions might be recycled.  I was right! In fact several of the questions on the exam I finally wrote were exactly the same as the ones I’d studied from the old examination papers.

In my experience recent history is not useful at all when devising investment strategy or trying to anticipate the future, but often a consideration of historical events further back in time – especially if trends in important economic drivers are similar – can be very helpful indeed.

The consensus is that interest rates will rise eventually.  But it is human nature to stubbornly hang on to the status quo, and only reluctantly (and belatedly) make adjustments to change.  What if what’s in store for us looks like this:  Consistently increasing interest rates and inflation over the next decade?  This has happened many times before (see graph of rising 10-year Treasury bond yields from 1960-1970).

US Treasury Yields 1960 - 1970

Before you rant that things today are nothing like they were then (and I do agree for the most part) consider the following: Is the boy band One Direction so different today compared to The Monkeys then?  And wasn’t the Cold War simply Russia testing the fortitudes of Europe and America just like the country is doing today?  Weren’t nuclear capabilities (today it’s Iran and North Korea) always in the news?

Yes there have been quantum leaps in applied technology, brand new industry leaders in brand new industries.  China’s influence economically was a small fraction of what it is today.  So where is the commonality? The potential for rising interest rates coming out of a recession.  The US government began raising rates in 1959, which caused a recession that lasted about 10 months from 1960 – 1961.  From that point until 1969 the US economy did well despite rising interest rates and international crises.  But which asset classes did well in the environment?

Growth of $100 - 1960 to 1970

Could the disappointing 1st quarter economic data be hinting that we might also be entering a similar transitioning period?  Inflation is bad only for those unable to pass higher prices along to customers.  If the economy is strong and growing then real estate and stock markets provide better returns.  Since the cumulative rate of inflation between 1960 and 1970 was about 31%, investors essentially lost money in constant dollars (returns below the rate of price inflation) by being invested in the bond market.  They would have done better by simply rolling over short-term T-Bills.  An average house in the US cost about $12,700 in 1960 and by 1970 cost $23,450 – beating inflation handsomely.

Do I believe we will see a repeat of the 60’s in terms of financial developments?  Yes and no!  There will be important similarities – especially in terms of stock markets likely performing well enough and the poor prospects for the bond market. There will be differences too.  The outlook for real estate is clouded by the high level of indebtedness that has been encouraged by extremely depressed interest rates over the past few years.  Higher rates mean higher mortgage payments which might serve to put a lid on real estate pricing, or cause prices to fall significantly for a period of time before recovering.

Companies that have substantially financed their acquisition binges with low-cost debt will soon find that unless they can pass along inflation to their customers their profit margins will be squeezed.  Who will benefit?  Commodity producers have had to significantly reduce their indebtedness – commodity prices tend to stagnate when inflation is low, and even decline when economies are growing slowly.  In a global context, these companies have had a rough time of it.  It is quite possible that their fortunes are about to improve.  If Europe and China begin to enjoy a rebound then demand will grow and producers will have more pricing power – perhaps even enjoying price increases above the rate of inflation.

Do I believe any of this retrospection will prove useful?  I hope so.  The first signs that a different environment is emerging are usually evident pretty quickly.  If there were a zero chance of inflation creeping back then why are some key commodity prices showing signs of strength now?

recent aluminum price recent copper price data

If we begin to see inflationary pressures in the US before Europe and Asia, then the $US will depreciate relative to their currencies.  In other words, what might or might not be different this time is which countries benefit and which countries struggle. Globalization has indeed made the world economy much more difficult to come to grips with.  Nevertheless, there are some trends that seem to be recurring over the years.

There will be recessions and growth spurts.  In recessions and periods of slower growth, some formerly stronger industries and companies begin to lose steam as a paradigm shift takes place, but then other industries and companies gather momentum if the new reality is helping their cause.  This is why I’ve biased my own TFSA with commodity-biased mutual funds (resource industries, including energy) and a European tilt.  You guessed it – no bonds.

Any success I enjoyed while I was a money manager in terms of performance was because exercises like this one help me avoid following the mainstream (buying into things that have already done well) and identifying things that will do well.