Wednesday, December 17, 2014

Oil Prices


So, a simple question is what do we now do with cheap oil?  What to sell?  What to buy? 

I would suggest buying gasoline but only if the needle on your dashboard gets close to E. 

The widows and orphans portfolio that was posted on this blog a couple of years ago included Exxon and/or Chevron.  The logic behind holding them is that the dividends would be superior to what one could get in a savings account and would grow faster than inflation or rising interest rates.  The logic still holds.  So, someone who owned the widows and orphans portfolio would not do a thing.  On the other hand, if someone were constructing a portfolio, the current price of Exxon and/or Chevron would present a good entry point. 


As commentators have pointed out, the Saudi's might continue supplying enough oil to keep prices down, what they refer to as “a big sweat.” They have done it before in order to drive out higher cost producers.  If they do, Exxon and Chevron's stock could go down more, but their current prices looks good.  Exxon and Chevron will not be the producers that the Saudi's drive out of business.  It is very unlikely that the Saudi's will even be able to force them to cut dividends.  For a very good analysis of the issue of the dividend safety of various oil companies I'd recommend “Which Big Oil Dividends Are Safe?” published today on seekingalpha.com.


There is one wrinkle.  US is now the second-largest oil producer.  A fair share of the high cost production the Saudi's are targeting is in the US.  Today General Electric outlined the effect of lower energy prices on its energy divisions.  We should anticipate more of those secondary effects on firm supplying the energy industry. 
ECONOMIST magazine had an interesting cover two weeks ago.  The title was "Sheikh vs shale."  It showed a picture of a sheikh and a roughneck standing back-to-back with their gas pumps drawn.  It is an interesting concept.  Shale producers are in many respects the swing supply.  However, unlike the high-cost producers of the past, shale production does not require a huge upfront fixed cost to develop the field.  In addition, although shale may be the swing production, it is not necessarily the highest cost production.  Consequently, shale production can gear up and down fairly easily.  Highly leverage producers may go under and have to sell their fields to that less leverage producers during periods when the industry is gearing back.  But, if prices go back up, those less leverage producers will quickly restore production.

If prices stay down long enough to reduce the drilling activity in shale fields, it may also cause extreme duress for other higher cost producers.  The Canadian tar sands are clearly vulnerable especially given the one-two of the Saudi's unwillingness to support prices and environmentalists success at delaying increases in efficiency of the transportation sector that would allow their production to reach global markets.  However, the greatest risk to the global economy may result from governments that own or have strong links to producers.  That affect is already shifting foreign exchange rates.  The Russian ruble has been an early casualty, but the risk to Venezuela, Nigeria, and to a lesser extent Brazil and Mexico are very real. 

The foreign exchange markets are so big that a major dislocation there can have all sorts of unanticipated consequences.  Today PIMCO’s emerging-market fund is showing the stress caused by significant holdings of Russian bonds.  We should expect more of that.  In fact, a default by one of the government's that has nationalized its oil resources, and thus the risks associated with energy production, is not out of the question.  It is worth keeping in mind that the vast majority of oil reserves are owned by governments.

There will also be many winners and losers among European companies that export to Russia.  For US investors in US corporations, exports to Brazil and Mexico may be more important than Russia or Venezuela.  However, the major risk is not from slower exports.  One should keep in mind that financial institutions make markets in both currencies and foreign bonds.  If a major financial institution gets caught with excess inventory of the wrong currencies or bonds, dislocation to the financial system could be significant.  That is a far greater risk for European banks than US banks.  However, some US banks, such as Citi, are so global, and the banking system of the developed economies are so linked, that financial dislocation is not out of the question.

Tuesday, March 11, 2014

Does Algorithmic Trading Make Sense for Small Investors?

Should the small investor play Wall Street's game?

Jason Zwieg’s column, The Intelligent Investor, is always interesting.  His book YOUR MONEY AND YOUR BRAIN is a delightful read, both interesting and informative.  The column in the March 8 WALL STREET JOURNAL entitled “The Incredible Shrinking Management Fee” was a good report on a new type of asset management company.  However, it left much to be desired if it was intended as a presentation of the phenomena for potential investors. 

First, the subtitle, “If a new company has its way, the cost of portfolio management could be zero,” reflects the problem.  The article discusses the number of companies, including WiseBanyan, Betterment, and Wealthfront that bill themselves not as portfolio management, but as investment advisers.  One thing to note is that Wealthfront does not seem to be a fiduciary.  The article contains no reference to whether Betterment or WiseBanyan are fiduciaries.  In other words, they do not have a legal obligation to act in the investor’s interest. 

They have a business obligation to do so, but not a legal obligation.  That is true of most investment companies like mutual fund companies, but it is unusual for someone who is taking financial management responsibility not to be a fiduciary.  Turning over asset allocation decisions to a financial manager who is not a fiduciary should make an investor uncomfortable.  However, there are some mutual funds that retain some asset allocation control, and The Hedged Economist has invested in and has recommended some of them when they were appropriate for an individual investor.   They were, however, well-established companies with a track record.  Further, they are explicit about limitations on the variability of the asset allocation.

The second thing to be aware of is that these companies are venture-capital financed.  The Hedged Economist has nothing against startups and has invested in over half a dozen at various times and currently has positions in three.   They have been the subject of a number of postings addressing topics ranging from the important roll they can play in diversification to how they are affected by regulation.  (The most recent posting on the topic was entitled “Angels and friends. When it rains, it pours.”  It provides links to most of the other postings on startups.)

The important thing to remember about startups is that the majority of them will not survive.  Some will go bust, some will just return investors’ money, some will be ho-hum investments, but it is the return on the remaining ones that justifies the investments.  If one in 10 is very successful that is good because they are owned directly by the investor.  So, the one in 10 can return enough to offset all the others. 

Investing through a startup as opposed to investing in a startup is a different story.  There is no potential for that really big payoff if the company is successful because the investor does not have an ownership stake in the company.  At the same time, if these startups do not succeed, that could have implications.  These companies are entering a very competitive industry.  So, it is important to be extremely confident about the success of the business model and the individual company which the investor chooses to have manage the money.  The implications of the failure of one of these businesses would require a lot of research to understand.  That, in-and-of-itself should be a powerful deterrent for some small investors.

Third, whenever one turns money over to someone else to manage, it is very important that the investor trust the money manager.  Since the companies seem to be exclusively web-based, there is less of a basis for establishing a judgment about their honesty.  Plus, because these are new companies, there are no track records on which to base judgments. Not surprisingly, the senior executives at some of the companies have venture-capital backgrounds.  Perhaps, information about whether they made money for investors in their venture-capital firms would be relevant, but even that is only indirectly indicative and would have to be interpreted very carefully.  It should be a concern to investors even though it is more than likely that the senior executives are honest, hard-working individuals. 

The point is that trust is a judgment the investor has to make.  In the case of these companies, there is very little information on which to base the judgment.  One cannot count on anyone else making that judgment.  For example, the Securities Exchange Commission completely missed Bernie Madoff‘s fraud.  Similarly, one cannot rely on the Financial Industry Regulatory Authority, a self-regulatory body commonly called FINRA.  A recent WALL STREET JOURNAL article had the telling subtitle “Analysis Shows More Than 1,600 Stockbrokers Have Bankruptcies or Criminal Charges in Their Past That Weren't Reported.” 

Fourth, given the companies’ descriptions of their investment approaches, the investment will probably work well under normal circumstances.  However, how well it works for an individual investor depends upon the quality of the analysis of the investor’ risk tolerance.  The firms probably have a questionnaire to determine one’s risk tolerance.  What they are trying to do is apply Modern Portfolio Theory (MPT) to the asset allocation based upon the results of the questionnaire.  They use trading algorithms to try to maintain the risk-return level continuously. 

As was discussed in a previous posting entitled “A Core of Mutual Funds: Part 1,” modern portfolio theory has been around since the 50s.  It is a very good theory if one assumes that individuals’ risk tolerances are easily measured and consistent over time.  However, there is considerable evidence that individuals do not have stable risk tolerances.  Jason Zwieg’s book and many of his articles, especially those reporting on the research of behavioral economists, have pointed out that risk tolerance is neither stable nor independent of investment performance.  Consequently, it is a bit surprising that he does not point out this problem with the approach that the companies are using.

One could reasonably argue that the principal advantage of an algorithm over a human adviser is that the algorithm has no emotions.  The problem is when the algorithm, which has no emotions, interfaces with the investor who does.  There is no reason to believe that investors would not systematically move in and out of this investment with detrimental timing.  Investors have shown that they do that with other investments.  That is a problem that no investment vehicle can overcome.  However, ignoring the issues related to measuring risk tolerance is only the tip of the iceberg.

Fifth, there is a basis for suspecting that algorithmic trading encourages an incorrect assessment of risk.  The Hedged Economist has occasionally made reference to an article written by The Numbers Guy in the WALL STREET JOURNAL.  The article entitled “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees, professional researchers and even editors of scientific journals, can be too easily impressed by math.  Since that is the case, it is likely that the investor and the companies offering the service do not understand the limitations of their approach.  Thus, it is unlikely they correctly assess the risk.

Sixth, the marketing pitch that is quoted in the Zwieg article: "Investment management can be more expertly done by an algorithm than by a human adviser," should be cause for concern.  It could illustrate overconfidence and hubris on the part of those developing the services.  It also might represent a cynical willingness to use the tendency for people to be overly impressed with math.  Finally, as discussed below, it represents an incredible level of naiveté on the part of the developers.

Seventh, anyone who works with models is aware that they are models.  They have limitations and are based on assumptions.  The algorithm is simply a model of how the market functions.  All algorithms that stress diversification across asset types are applications of Modern Portfolio Theory.  Modern Portfolio Theory is an excellent theoretical framework for making asset allocation decisions.  It has been referenced frequently in The Hedged Economist and much of the financial literature to justify asset allocation decisions.  It is an excellent theory, but that is all it is.

Asset allocation can be made to sound complicated.  However, it is actually a lot simpler than advocates of Modern Portfolio Theory make it sound.  It is just asset diversification.  The problem with algorithmic application of Modern Portfolio Theory is that it is based upon the correlations and covariances between all asset classes.  It assumes they are stable.  Nothing demonstrated the fact that they are not stable better than the recent financial crisis.  (Technically one might argue that they do not have to be stable.  They just have to be measurable and forecastable.  However, the combination of discontinuities and the tendency for nonlinear models to be unstable – – one has to forecast the derivative; in some cases the second derivative – – which necessitates adding even iffier assumptions than stability in the correlation matrix).

So, the theory works well under normal circumstances, and it results in a theoretical improvement in returns for any given level of risk.  When put into practice, any improvement in return is very, very slight.  Consequently, frequently professional managers try to take advantage of the slight improvement by increasing the leverage.  That, of course, creates its own risk.  However, the most common problem with the approach is that, as the saying goes, “it works as long as it works and then it doesn't work.”

There is an eighth point that was missed in the article. Algorithmic trading is much the rage with many on Wall Street.  What is not clear is whether there is any return to continuous, algorithmic trading in-and-of itself.  The largest firms involved in the activity also are accessing information not available to the general public or only available to the general public with a delay.  Research that separates the returns due to the information advantage from the return due to their trading algorithm is sorely needed. 

Further, and this should be a major concern, if these new firms serving the small investor are trading with an algorithm that is similar to those used by one of the larger firms but only receives the information on which the trades are based after it has been available to the larger firms, there may be no advantage regardless of how rational the algorithm is.  In fact, the trading by these firms may only enhance the returns of the larger firms which have better information.

Ultimately, most individual investors will do better by just avoiding continuous trading as a method of reducing volatility.  Volatility between the beginning date and the ending date of a trade is actually quite irrelevant to the return from the trade.  It is important in Modern Portfolio Theory, but only matters to the individual investor if he or she is willing to accept short-run volatility as the definition of risk. 

Continuous trading strips individual investors of one of their strongest advantages over professional traders.  The individual knows how long he or she intends to hold the asset whereas the professional investor has to continuously worry about the mark-to-market value of their assets.  For the individual investor giving up that advantage in order to conform to the tenants of Modern Portfolio Theory seems like a foolish choice.



Saturday, March 8, 2014

A Different Approach for a Different Objective.

What if it is the stock not the portfolio?

In a previous posting entitled “The Widows’ and Orphans’ Portfolio and US Banks” the composition and objectives of the portfolio were used to identify a particular reinvestment plan for 2014.  However, the portfolio objectives outlined in the article include the diversification of risk to the capital (management of the size of the holdings) and diversification of the income streams they generate through dividends.  They are not the only potential portfolio objectives.

An equally acceptable alternative objective would be growth in the total portfolio based on combined capital gains and dividends.  That approach is particularly appropriate for an investor in the accumulation phase.  Individuals in the accumulation phase are usually younger and may be willing to take a little more concentration risk.  This second approach necessitates more attention to the price of individual stocks and the timing of individual stock purchases.  That will be the topic of this posting.

Verizon
The portfolio holds a significant position in Verizon (VZ).  While the dividend represents an appropriate portion of the portfolio, the amount of Verizon stock held in the portfolio could be increased without undermining the portfolio’s design.  An investor who is just building the portfolio might want to begin accumulating Verizon now.  The same might be true of any investor with different portfolio weights. 

The portfolio’s design is for all the stocks to be potential long-term holdings.  However, as has been discussed in this blog, the market will occasionally provide an investor with an opportunity to purchase long-term holdings at a discount.  The first thing is to determine whether there is any reason to believe that such an opportunity currently exists in Verizon stock.

After the financial crisis, there was a deluge of books and articles about the investment mistakes made by many of the larger money managers.  Back in April of 2010, The Hedged Economist included a number of postings analyzing some of those mistakes (e.g., “Sometimes Wall Street provides more entertainment than Hollywood: PART1 the winners” and “PART 2 the losers”). Looking at these mistakes was an extremely useful exercise.  It is always more fun to try to learn from other people's mistakes instead of making them yourself.

One thing that was particularly interesting was how often investors were burned because they failed to analyze the motives of their counterparty.  (If they were buying, they forgot to look at why their counterparty was selling, or vice versa).  An analysis of counterparties’ motives has become a frequent and often very useful supplement to the traditional financial and technical analysis.

In the case of Verizon, such an analysis is possible.  One knows that the Vodafone acquisition resulted in the distribution of Verizon shares into the hands of a number of individuals and financial institutions that never explicitly chose to purchase the shares.  More importantly, some of the institutional investors may be operating under portfolio guidelines or institutional charters that require them not to own foreign stocks.  Consequently, it is reasonable to assume that there are sellers of the shares who are not expressing a judgment about the future of the company.  The phenomenon described is sometimes referred to as “post-acquisition blowback.”  If that line of reasoning is correct, the recent decline in Verizon's stock is an opportunity to purchase at a discount.

There is a second reason to believe that a purchase now is appropriate for the long-term investor.  This blog often makes reference to a posting entitled “Wall Street doesn’t run the world.”   The reason is that the posting makes the important point that Wall Street is largely composed of investors with very short-run horizons.  It is not at all difficult for an investor to take advantage of any difference between his or her investment horizon and the typical investment horizon of Wall Street.

It is easy to see how that may apply to Verizon.  With its earnings release, Verizon ruled out stock buybacks for at least two or three years as it aims to slash that debt.  Impatient investors do not like that sort of behavior.  They had bid up Verizon stock based upon the increased earnings expected from their purchase of Vodafone.  Verizon's announcement of what it was going to do with those earnings was accompanied by selling of the stock.

Wall Street's time horizon makes that response totally understandable.  If Verizon used the increased earnings to purchase shares that they issued in connection with the acquisition, it would increase earnings per share.  The increased earnings per share would occur at the time the purchases were made.  It is a reasonable strategy, but not a long-run strategy.

If Verizon purchased back shares it would be influencing per share earnings before interest, taxes and amortization.  However, the interest paid per share would increase.  By reducing debt instead, Verizon does not directly influence earnings before interest, taxes and amortization per share.  Rather, by paying down debt, it decreases the interest expense.  Thus, earnings after interest, taxes and amortization will increase “other things being equal.” Ultimately, in the long run, it is earnings after expenses that the investor should be seeking.  Consequently, foregoing the short-run increase in earnings before interest, taxes and amortization should result in a greater return after interest, taxes and amortization, but it may be a slower process.

Thus, there are at least two reasons to think that Verizon stock may temporarily represent an opportunity: post-acquisition blowback and Wall Street impatience.  The next step in determining whether the stock represents such an opportunity is traditional financial analysis.  Using traditional measures, there is no compelling case for adding Verizon right now.  It is worth noting, however, that acquisitions sometimes create a situation where traditional analysis looks ambiguous.  As already mentioned, Verizon's stock has underperformed.  The Hedged Economist is not an expert in technical analysis.  However, the underperformance could represent an opportunity.  It is an opportunity that could continue to exist or even become more inviting.

Stepping back and analyzing the business, there are both pros and cons.  Verizon operates in increasingly competitive markets.  That is true of the cell phone business and FiOS.  However, Verizon has a long history of being able to flourish in competitive markets.  In addition, the reason the markets are competitive is that they are attractive and growing.  It has been many years since Verizon made any major strategic mistakes in approaching the markets, although future mistakes are always possible.  From a strategic perspective, Verizon made a couple of very forward-looking decisions a number of years ago.  If Verizon can continue to anticipate consumer and technical trends, its business should prosper.

A reasonable conclusion would be that the current period of underperformance represents an opportunity to accumulate the stock.  However, that conclusion is highly dependent upon the investor’s timeframe.  There is no need to do it all at once, and it may best be done by selling cash-covered puts at lower strike prices.

Exxon.
The situation at Exxon (XOM) is, in some respects, analogous to the impact of Verizon's statement in connection with its earnings release.  Exxon’s problem does not relate to debt, but like Verizon’s, it involves details about the company’s use of capital.  Exxon announced that it would be lowering its capital expenditures.   Since Exxon has not been growing reserves, this decision has caused concern, and it resulted in a selloff of the stock.

Given that Exxon is one of the largest companies in America, the decision to reduce capital expenditures received considerable attention.  For a summary of the details and illustrations of the attention it has garnered, see “Are ExxonMobil's Reduced Capital Expenditures Cause for Concern?” or “Is Exxon Mobil Heading for an Inflection Point in 2014?”  Those two articles provide excellent background on the issue while “Exxon Performance, Spending Cuts Rattle Investors' Nerves” is an excellent description of why investors were concerned. 

The bottom line is that the cut in capital expenditures was very minor when compared to capital expenditures over a long-term period of time.  Interestingly enough, the increased capital expenditures in past years brought on an equal number of concerns among investors and selling pressure.  The long-term investor might be very tempted to dismiss both as simply management decisions made in the course of doing business in an area that requires large, long-term investments.  That, in fact, seems like a very reasonable conclusion at this point.  Thus, the current selloff presents an opportunity.

However, a recent article on Seeking Alpha entitled “Exxon Mobil Needs A Big Dividend Hike This Year” touched off a stream of very interesting comments.  As many of the comments on this thread make clear, if Exxon does not raise its dividend, there are large numbers of investors who may sell and present an investor with an even better opportunity to purchase the stock. That could be a wonderful thing. Imagine being on the same side of the market as one of the most capitalized companies in the world, as well as with investors like Warren Buffett.

Although the stocks of Verizon and Exxon presented opportunities, those opportunities should be viewed in the context of the total portfolio and the investors’ objectives for the portfolio.  If the issue were simply to pick the stock that will appreciate the most over the next six months to a year, neither company would probably be the winning candidate.  As discussed in “What is to be learned for 2014 planning?” one would probably want to focus on PPG.  However, current developments in both companies’ stocks present opportunities to those focused on constructing a long-term portfolio.




Wednesday, March 5, 2014

The Widows’ and Orphans’ Portfolio and US Banks

Regulatory Risk.

The “widows’ and orphans’ portfolio” introduced in the January 9, 2011 posting entitled “Investing PART 9: One version of the ‘Unfinished symphony” is intended to be a long-term investment portfolio.  The type of adjustments that one would expect were summarized in the January 24, 2014 posting entitled “What is to be learned about stock acquisition?”  Generally, they should be adjustments in portfolio weights.  However, as mentioned in the January 26, 2014 posting entitled “What is to be learned for 2014 planning?” when a portfolio objective cannot be achieved by adjusting portfolio weights, there is always the possibility of adding a new holding.

The possibility of not being able to achieve portfolio objectives by adjusting weights was made in connection with a restatement of the portfolio objective:  “Stability, simplicity, profitability, and low risk are not the only objectives of the portfolio.  As the name widows’ and orphans’ implies, dividends are an important consideration in the design and objectives of the portfolio.  Dividends interact with stability and low risk, but the more important point is that, for this portfolio, they are an objective in-and-of-themselves.”
“…one would want to … increase the average yield of the portfolio....  Hopefully, that can be done within the portfolio.  If that is not possible, some additional companies could be added to the portfolio.”

Currently, the objectives of stability, low risk, and dividend yield necessitate a significant change in the portfolio.  As the title of this posting implies, it concerns the US bank held as a part of the portfolio.  When the portfolio was initially introduced, the Bank of New York Mellon (BK) was identified as a core holding.  As explained below, that posture is no longer sustainable.

One should not misinterpret this shift in the portfolio.  As was stated in an earlier posting “…the Bank of New York Mellon is particularly well situated going into 2014.”  However, as it also has been noted, “…it has one of the lower yields of the portfolio holdings.”  Consequently, from the perspective of portfolio management, “…one would have to be very confident that it will be able to increase its dividend in order to justify anything more than just automatic dividend reinvestment.” 

It is with respect to increasing its dividend that the problem with holding Bank of New York Mellon as a core holding first surfaces.  However, the problem is broader than just the dividend.  As the subtitle, “regulatory risk,” implies, the US government has introduced a new dynamic into planning any investment in a US bank. 

First, just from the perspective of dividend increases, Bank of New York Mellon is not going to be able to increase its dividend based upon its own assessment of its business.  That is a problem in the short run and totally unacceptable over the long run.

In April it will undergo a round of stress testing supervised by the government.  Based on how pleased the government is with the results, the regulators will determine how much the Bank of New York Mellon dividend can be increased.  A good guess is that the government will allow the Bank of New York Mellon to increase its dividend (or stock buybacks) by somewhere around 20%. A 20% dividend increase is not to be dismissed lightly.  But even with a 50% increase, Bank of New York Mellon would still have one of the lower dividends yields in the portfolio.  Thus, in the short run, the Bank of New York Mellon cannot achieve the dividend yield appropriate for the portfolio.

Over a longer period of time, the dividend will increase, but it will be based upon political considerations to an unacceptable extent for the widows’ and orphans’ portfolio.  The Hedged Economist has worked with regulators and banks for much of his career.  That experience makes one thing very clear: regulators are no better at forecasting and scenario analysis than banks.  What is even more concerning is that the current administration seems to be regulating by whim.  It is unlikely that regulators are sufficiently independent to avoid being drawn into the process of regulation by whim.  The widows’ and orphans’ portfolio should be made up of financial investments, not a political bets.

With respect to the dividend, both the process by which the dividend will increase and the amount of the increase justify looking for an alternative bank investment.  If the dividend were the only issue, supplementing the Bank of New York Mellon holdings with another bank would be a viable strategy (e.g., Wells Fargo—WFC-- was mentioned when the widows’ and orphans’ portfolio was first introduced). 
Second, dividends are only a part of the objectives of the portfolio.  Stability and low risk are also important considerations.  The Bank of New York Mellon had traditionally been a relatively stable bank because of its dependence upon fee-based services like trust management.  Those fee-based services tended to make the earnings and the stock price relatively stable.  In the current environment, that is no longer the case. 

An administration that acts upon whims does not facilitate the stability or low risk sought for the widows’ and orphans’ portfolio.  The Bank of New York Mellon has become a high beta stocks relative to the rest of the portfolio.  In fact, by some measures it is the most volatile stock in the widows’ and orphans’ portfolio, and although its stock may appreciate, on a risk-return basis it cannot justified as a portfolio holding.

Third, lawsuits designed to extort money from the banking system seem to have become extremely stylish.  Led by the state and national regulators who find banks an easy mark, the legal profession has come to realize that all they need in order to make fat legal fees is someone to play the role of plaintiff.  The widows’ and orphans’ portfolio appreciates stylishness, but it missed the memo indicating that wearing a target was stylish.  Put differently, investing in a large US bank involves assuming considerable headline risk, a risk the portfolio does not need.

Fourth, regardless of how one feels about all or any specific regulations that have been enacted, one cannot deny that they have added complexity.  From the very start of this blog, The Hedged Economist has pointed out that complexity creates its own risk.  Thus, the regulations themselves are creating new risks.

At the Federal Reserve's annual policy conference in Jackson Hole, Wyoming on August 31, the Bank of England's Director of Financial Stability, Andrew Haldane, made a presentation entitled "The Dog and the Frisbee."  The speech and the supporting research provide evidence that as regulations become more complex, they also become less effective.  The research also points out that much of the reason large banks are so difficult for regulators to comprehend is because regulators themselves have created complicated metrics that cannot provide accurate measurements of a bank's health.  So, the additional regulations are not necessarily reducing risk.  At the same time, the regulations are making it harder to identify what risks do exist.

For a brief summary of the speech consult the WALL STREET JOURNAL of September 13, 2012.  The article was entitled “Complexity and Risk Management.”  For an updated discussion of the topic, consult the December 20 WALL STREET JOURNAL article entitled “Andrew Haldane: The Banker Who Cried 'Simplicity’.”  It is based on an interview of Mr. Haldane.  For a non-technical discussion of why the metrics developed by regulators are often counterproductive, consult the January 4, 2013 WALL STREET JOURNAL column by The Numbers Guy.  The article entitled  “Don't Let Math Pull the Wool Over Your Eyes” makes the case that many people, including holders of graduate degrees and professional researchers are too easily impressed by math.  Behavioral economists have been able to show that is true when applied to financial decisions.  However, their focus has been narrower than the generalized statement of the article. 


If one wants a fuller explanation and longer history of how regulation has created risk in the banking system, one might want to read FRAGILE BY DESIGN: THE POLITICAL ORIGINS OF BANKING CRISES AND SCARCE CREDIT by Charles W. Calomiris and Stephen H. Haber.  Despite the title, the thesis of the book is not that regulators intentionally design an unstable system.  Rather, they focus on the political motivations that lead to regulations that have unintended and largely unanticipated consequences.  If history is any guide, the regulators are creating risks that they do not understand.

The net effect of regulation by whim and the regulatory landslide that has occurred is that all US banks now contain a level of uncertainty totally unrelated to the economy or their operation.  A quote from the conclusion in a previous posting is appropriate: “… about the nature of the relationship between politicians and Wall Street. It isn’t always easy to tell who is using whom. That implies that avoiding situations with Washington-based headline risk is an effective risk reduction strategy for most investors.”

The unavoidable conclusion is that Bank of New York Mellon has to be replaced in the portfolio.  To summarize in terms of the objectives: 1) Dividend yield --The dividend yield is too low and the company's performance cannot be relied upon as a basis for increasing the dividend.  2) Stability-- The price of the stock has become far less stable and is exposed to considerable headline risk.  3) Low risk-- The Company is exposed to significant new risks, some of which are identifiable and others are not even known.

From a portfolio perspective, finding a suitable replacement is problematic.  While many of the arguments for dropping Bank of New York Mellon applied to any US bank, not all banks have experienced the effect to the same extent.  For example, Wells Fargo, mentioned when the widows’ and orphans’ portfolio was first introduced, has been more successful at maintaining its dividend, and the price of the stock has been more stable (e.g., it has a lower beta).  If it were used as the banking component of the portfolio, dividend reinvestment might be all that would be required.  However, that would still leave the portfolio exposed to regulatory risk.  Put differently, it is impossible to guess when our government or a group of trial lawyers will decide that Wells Fargo would be a nice target for extortion.

Fortunately, an investor does not have to be exposed to the types of risks that have been introduced into the US banking system.  Our northern neighbor, Canada, has a far more stable banking system than the US.  Thus, Canadian banks provide excellent candidates for substitution for the Bank of New York Mellon.  Further, many of the Canadian banks have US subsidiaries.  Consequently, the investor does not have to give up exposure to the US economy totally in order to reduce the exposure to regulatory whim and legal extortion.

One of the nice things about focusing on Canadian banks is that there are not too many of them.  One can fairly quickly narrow the field of consideration down to two or three banks.  The Hedged Economist’s screens narrowed the field to The Royal Bank Of Canada (RY) and Toronto Dominion (TD).  As stocks, both pay healthy dividends, have histories of raising the dividends, and have betas that are lower than Bank of New York Mellon.  Both have healthy financials and strong businesses.

For the widows’ and orphans’ portfolio, Toronto Dominion was selected.  Its dividend is slightly lower, but not significantly lower.  By contrast, its beta is significantly lower, and that is an important consideration for this portfolio.  Both are financially strong banks, but TD Bank seems to be more successful at building a strong brand around the “America's most convenient Bank” theme.

Investing in any company that operates in multiple countries involves some currency risk.  That is true of the TD investment.  It would also be true of an investment in the Royal Bank of Canada.  A totally domestic US bank would not involve currency risk to any appreciable extent.  However, any large bank whether US or Canadian embodies some currency risk because of the nature of the assets it holds.  Thus, it would be easy to overestimate the extent to which the purchase of TD Bank increases the portfolio’s currency risk.  When compared to the currency risk involved in the investments in the other multinationals held in the widows’ and orphans’ portfolio, the currency risk embedded in TD is acceptable.

In order to acquire the Toronto Dominion shares, all shares of Bank of New York Mellon were sold.  In addition, the small position in Newmont Mining, discussed in a previous posting as primarily held as an indicator, was also sold.  The combination of the two sources provided adequate funds to achieve a more desirable dividend yield for the portfolio (2.5%) and brought banking as a portion of the portfolio (4.9%) closer to the desired level.  At some future date, dividends from the portfolio will be used to bring both the dividend flow and portion of the portfolio completely up to the desired levels.

The effect of this trade is to bring the portfolio much closer to balance.  Only minor adjustments should be required for a fairly long time.  The stock portion of the portfolio is summarized in the table below.  The first column is the stock symbol.  The second column is the portion of the portfolio represented by that stock.  The third column is the dividend yield (i.e., the rate at which dividends are paid based on current prices).  The third column shows the portion of the total dividends derived from the specific stock identified in column 1.
PERCENT
PERCENT
NAME
OF VALUE
YIELD
OF YIELD
20.9%
1.3%
10.6%
10.2%
2.8%
11.3%
14.4%
2.2%
12.4%
8.6%
2.9%
9.8%
5.1%
4.6%
9.3%
13.1%
2.6%
13.4%
9.5%
2.7%
10.0%
4.5%
3.4%
6.0%
8.8%
3.0%
10.3%
4.9%
3.6%
7.0%

The price appreciation in PPG has brought it to a level that some investors view as an upper bound for a portfolio weight.  By contrast, PPG is not overly represented as a portion of the dividend yield.  The inverse situation is characteristic of Verizon (VZ).  As a portion of the portfolio, Verizon shares do not represent a very large portion of the holdings.  However, because of its higher dividend rate its contribution to dividends is about appropriate.  GE and TD Bank are the two portfolio holdings where both the portion of the portfolio and the contribution to dividends need to be enhanced.  Unless something unanticipated arises that will be a principal focus for the balance of the year.

A disclosure, as mentioned in “A Core of MutualFunds: Part 2,” a number of mutual funds are also held as a core portfolio.  Thus, the portion of the portfolio and the portion of dividends attributable to any individual stock are both allowed to fluctuate within fairly large bands.  However, in keeping with the idea that the portfolio is a source of income, the portion of dividends attributable to any individual stock is more tightly monitored than its portfolio weight. 

However, since some people prefer stocks and others prefer mutual funds, in The Hedged Economist’s postings, core portfolios of either are presented as standalones.  When that is not the case, it will be quite explicitly stated (e.g., “Funds for Asset Class Diversification”).  When the discussion is about acquiring or selling non-core holdings, there will be no reference to how they fit in a portfolio (e.g., “Without the Glitter, An Alternative to Trading Bonds”).  It should also be understood that references to a position as core or non-core should be viewed as relating to a portfolio.  A non-core holding referenced in a posting may be held for multiple years (e.g., the Kimberly-Clark stock purchased for reasons discussed in “Wall Street doesn’t run the world” has been held continuously since March of 2010) or it may be sold very shortly after acquisition (e.g., some of the alternatives to bonds mentioned in “AnAlternative to Trading Bonds”).












Monday, March 3, 2014

A Word of Explanation.

Pick a mutual fund for your purpose.

Last month's postings on mutual funds all referenced open-end funds (“The Three Fund Portfolios, A Core of Mutual Funds: Part 1 and Part 2, Funds for Asset Class Diversification”).  The use of open-end funds was consistent with the focus of the postings. 

Often, much is made of the distinction between closed-end versus open-end funds, open-end funds versus Exchange Traded Funds(ETFs), and index funds versus managed funds.  Each type of fund is appropriate for a particular investment objective. 

Most people have no problem understanding that when the decision is between a bond fund versus a stock fund.  By contrast, when they focus within the stock fund universe, both investors and financial commentators lose sight of the fact that each type of mutual fund has a purpose.  They often get absorbed by recent relative returns or short-run projected returns.  

The investor ultimately has to select a type of fund that is consistent with his or her objective for the fund investment.  For example, last month’s postings make quite clear that the selection between index funds and managed funds had nothing to do with short-run projected returns or historical relative returns.  The selection criteria were based on the portfolio objective.

However, just stating what the portfolio objective is and pointing out funds that meet that objective does not automatically rule out alternatives.  Consequently, why other alternative types of funds were not appropriate for last month’s portfolio discussion is worth addressing.  One of the advantages of such a discussion is that it provides an opportunity to identify when those alternatives would be appropriate.

In last month’s discussion of mutual funds, the importance of low fees was pointed out.  Thus, a legitimate question is: Why were ETFs, which often have lower fees than open-end funds, not used instead of index funds?  The March 1, 2014 WALL STREET JOURNAL ran an article entitled “Do ETFs Turn Investors Into Market Timers?”  For those who did not already know, it documents how ETFs’ primary advantage, that they can be traded easily, is far from a blessing. 

The research cited in the article includes a Vanguard study that summarizes why ETFs were not mentioned in last month's postings: “The individuals owning ETFs were more than twice as likely to fall outside the "buy and hold" category than those who owned open-end share classes….”  Since the postings were about a buy-and-hold strategy, open-end funds seemed more appropriate. 

The fact that Vanguard’s ETF investors were not pursuing a buy-and-hold strategy does not mean an ETF could not be used in a buy-and-hold strategy.  Theoretically one could purchase an ETF and use it in exactly the same way as the postings recommended using open-end funds.  However, that does not seem to be what happens in practice.   The theoretical possibility is interesting, but what really matters is actual investor experience.  By applying a statistical model that relates frequency of trading to various investor characteristics, the Vanguard study hints at something more fundamental being at work.  People with the same investor characteristics seem to behave differently when they own ETFs instead of open-ended funds.

That impression is supported by data from the largest brokerages in Germany. The researchers found that performance deteriorated for the average investor after he or she began investing in "easy-to-trade index-linked securities" such as ETFs.  Further, the deterioration in performance was related to trading.  "Bad market timing" that the typical investor engaged in after investing in ETFs was identified as the source of lower returns.  While the Vanguard study used statistical techniques to isolate the impact of ETFs versus open-end funds, the study by the German brokerage firm looked at behavior over time.

Yet additional support for the impression comes from the experience of investment advisers.  A Hulbert Financial Digest study monitored 23 advisers who maintain both a model portfolio of ETFs as well as one focusing on open-end funds. The ETF portfolios over the past five years trailed their non-ETF fund portfolios by an average of 2.5 percentage points on an annualized basis.

The research is inconclusive, but in truth, one hardly needs the research results.  All one has to do is listen to the marketing pitch for ETFs: it is quite clear that trading convenience is their primary selling point.  Clearly, if one’s objective is to trade a particular asset class, an ETF may be appropriate vehicle.  By contrast, if one just wants to participate in the long-run performance of a particular asset class, an open-end mutual fund may be the more appropriate vehicle despite slightly higher expenses.

Similarly, closed-end mutual funds can be very useful investment vehicles.  However, the biggest return in closed-end mutual fund investing results from trading activity rather than a buy-and-hold strategy.  How successful one is at investing in closed-end mutual funds depends upon timing the trades. 

Successful closed-end fund traders are navigating two sets of timing variables as well as the basic issue of portfolio composition characteristic of any mutual fund.  First, those timing variables included cycles in the relationship between each fund’s price and its net asset value.  The second time variable involves cycles in the asset prices of the particular sector or country in which the closed-end fund invests.  Needless to say, those two timing variables interact.

There is a further complication with closed-end mutual funds: one cannot assume that selecting a good fund manager is the most important decision.  A truly good fund manager of a closed-end mutual fund will have an impact upon the relationship between the price of the mutual fund and its net asset value.  As a consequence, the fund manager’s ability to select the right investments may be totally offset by the fact that the fund has to be purchased at a premium; the premium being a price above the net asset value of the fund’s holdings.  Thus, the fund may hold the right assets, but the investor is overpaying for them.

One further consideration with closed-end funds is whether their charter allows them to take on leverage.  When it does, the leverage can be a major consideration.  Analyzing the leverage (how much, what duration, what rates, etc.) is not a trivial task.

As a consequence, closed-end mutual fund investing is a discipline in-and-of-itself.  People who are good at it can make a substantial trading profit.  It is a discipline quite different from portfolio management and long-term investing.  The Hedged Economist has generally found it easier to select individual stocks for a portfolio than to time purchases of closed-end funds.  Any diversification needed to supplement the stock portfolio can easily be purchased using open-end funds.  Achieving that additional diversification was the focus of last month's postings.

Both ETFs and closed-end funds are useful trading vehicles.  However, as such, they were inappropriate for last month's postings about buy-and-hold strategies.  Theoretically one could argue that the lower expenses of an ETF justify using it in a buy-and-hold strategy instead in an index fund.  The theory is nice,  but it is not what happens.  Similarly, one could argue that the closed-end fund if purchased when it trades significantly below its net asset value is a reasonable substitute for a managed open-end fund.  However, with a closed-end fund one cannot avoid the timing issue involved in determining an adequate discount to the net asset value.  One of the advantages of the strategies discussed last month is that for the long-term investor timing is irrelevant.