Mutual Fundosaurus

The following financial market commentary was written by Matt Malick and Ben Atwater. Matt and Ben recently started their own firm, Atwater Malick LLC. Matt was a student of mine and has a really insightful take on what's happening in the market. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers.

For many years, stocks have been a common method of building financial wealth. When purchased at a fair price and sold at a full valuation, stocks can produce stellar returns. In fact, even after the recent equity bear market, the S&P 500 has returned 7.41% annually over the past 20 years ended March 31, 2009 with dividends reinvested in the index.


Because of strong potential returns, stocks have gained ever greater popularity over the years, and the financial services industry has responded by devising clever ways for the “average” investor to participate in the stock market. These include common trust funds, mutual funds, variable annuities, exchange traded funds (ETF’s) and hedge funds. Along the way, the industry created countless other financial products as well. Some have stood the test of time and others have not.


As the famous investor Barton Biggs reminded us in a November 11, 2008 Fortune article, “there is no asset class too much money can't spoil.” While he was referring to hedge funds, we think this adage also applies to mutual funds. The first mutual fund was organized in 1924 as a method of pooling investors’ assets together to purchase a diversified portfolio of individual stocks. Early mutual funds allowed “small” investors to own a diversified basket of equities at a time when it was not yet cost-effective for everyday folks to directly purchase and monitor individual stocks. In exchange for limited transparency and control, mutual fund clients gained diversification and professional oversight of their portfolios.


Over the years, there have been dramatic changes in both the mutual fund industry and the options available to individual investors. The charts below show the explosion of mutual funds and of mutual fund assets in the United States.

Source: 2008 Investment Company Institute Fact Book


While the mutual fund industry has grown exponentially, technology and the Internet have expanded the options available to individual investors. Through the advent of discount online brokerage sites, retail investors are now able to purchase individual stocks for modest commissions. And thanks to the free flow of information through the Internet, investors and independent investment advisors can more easily access vast amounts of pertinent data about publicly-traded companies, including all Securities and Exchange Commission regulatory filings. Therefore, the opportunity now exists for individual investors to directly own interests in the companies that mutual funds are frequently trading.


So why are mutual funds still so widely used? We think a clue lies in the flow of mutual fund assets. As you can see from the charts above, total assets invested in mutual funds at the end of 2007 were roughly $12 trillion. But according to data from the 2008 Investment Company Institute Fact Book, total sales of mutual funds throughout 2007 were $24 trillion – almost twice the level of assets. Now that is salesmanship.


You can partially attribute this to the natural ebb and flow of money in the economy. Fortunes are accumulated and spent, funds are redeemed to pay for financial goals, and new millionaires are made each day. But in our view, the vast majority of this phenomenon can be attributed to (1) the transactional incentives built into the financial services industry and (2) performance chasing.


As you know, mutual funds are the tool of choice for most financial salespeople. These funds often carry hefty expense ratios and sales loads and can therefore be highly profitable when the salesperson closes a deal. Unfortunately, the profitability of a transaction sometimes ranks higher on the priority list than simplicity, transparency, and prudent advice.


According to a study called the Quantitative Analysis of Investor Behavior by financial research firm Dalbar, from January 1, 1988 through December 31, 2007, the average equity fund investor earned an annualized return of only 4.5%, while the S&P 500 returned 11.8%. We think this is attributable to “performance chasing,” a common reason investors churn mutual funds. This occurs when an investor sells a poorly performing fund in favor of the hottest performing fund. Reversion to the mean and Murphy’s Law dictate that the purchase of this “best of breed” fund will happen at exactly the wrong time, right before the fund starts to underperform.

Cell Phones for the Poor

Following discussions about social insurance programs in my Public Finance course, a student emailed me a news item about a government program to provide cell phones for the poor. I had never heard of such a program but after a simple Google search, I found Safelinkwireless.com.

During my search to find out more, I came across many negative comments about how this is just another wasteful government program. Many were concerned about how much it would cost taxpayers and some seemed to already know that the phones would be going to the same people who cheat and defraud other welfare and income security programs. I also read many statements saying that having a cell phone is a luxury and not a right. Some of my students shared these same sentiments.

Let's look at this public assistance program using positive economic analysis (objective and scientific).

What's the estimated cost? In Tennessee, one of the states offering the program, there are 800,000 estimated eligible people. The phone can be bought in most grocery stores for $20 and then there is the cost of the 42 minutes per month. Even if we assume the government is paying retail for the phone, I'm going to guess that 500 minutes per year would cost no more than $50. So for $70 per person per year or $56 million for all of the eligible people in Tennessee (assuming they all sign up), the people already qualifying for some level of government assistance would have a free cell phone.

So the questions are, what are the benefits and is there a potential net gain to society?

I beleive that if you really try to estimate the productivity and cost saving benefits that you have personally experienced using your own cell phone and then multiply that by hundreds of thousands, you might agree that there are significant potential benefits from a program like this. Take a look at this paper: http://www.newmillenniumresearch.org/archive/Sullivan_Report_032608.pdf

Will there be people getting a cell phone in this program who are not deserving? Sure, that's a predictable and quantifiable cost of any government assistance program but we cannot get caught up in the relatively small number of individuals who try to game the system - it's just another cost. We should always try to minimize fraud and abuse (again if benefits outweigh costs), but if the benefits still outweigh the costs, then the program generates a net gain and both the size of the economic pie and the distribution of the pie are arguably better than before.

Could It Be?

The following financial market commentary was written by Matt Malick and Ben Atwater. Matt and Ben recently started their own firm, Atwater Malick LLC. Matt was a student of mine and has a really insightful take on what's happening in the market. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers.

Could It Be?

As investors, we are constantly asking ourselves tough questions. Lately we have been grappling with the unthinkable.

Could it be that the major credit rating agencies will continue their abysmal predictive record?

Standard & Poor’s, Moody’s and Fitch are the three primary bond rating agencies and have enormous influence over Wall Street. The highest rating they bestow is Triple-A. As enablers of the great financial crisis that we are now facing, these agencies rated sub-prime mortgage-backed securities and collateralized debt obligations as Triple-A based on the ridiculous models that their firms created.

These firms once rated The American International Group (AIG) as a Triple-A credit, all the while AIG piled on mind-boggling obligations through credit default swaps (CDS), which last quarter led to the largest loss in American corporate history - $61.7 billion.

Without these colossal errors, our economy would be in a much better position. But, Standard & Poor’s, Moody’s and Fitch are not new to overlooking the elephant in the room. Remember Enron and WorldCom? Enron was rated an investment grade credit right up until the day it declared bankruptcy. WorldCom maintained its investment grade rating until three months before its bankruptcy.

Now these rating agencies are on a downgrading spree, cutting the ratings of vast amounts of mortgage-backed securities, many insurance companies and many banks. In fact, they recently downgraded the debt of both General Electric and Warren Buffet’s Berkshire Hathaway. If their track record holds, then they are likely to be wrong once again.

Could it be true that bears make money, bulls make money and pigs get slaughtered?

Wall Street banks, the rating agencies and the regulators all embraced the concept that thousands of bad mortgages bundled together as one security were transformed into a good security; after all, it was “diversified.” In an already overleveraged economy, faith in the all-encompassing power of broad diversification pushed us over the edge as the Wall Street banks leveraged their balance sheets thirty-to-one and bet the farm on these bogus mortgage-backed securities. Much of this was based on the misguided belief that housing prices could not decline.

Just as speculators participated on the way up to unsustainable heights, we now have others trying to push us down to new lows. The latest game in town is to drive fear about the prospects of certain companies by manipulating the credit default swap market. Credit default swaps are unregulated insurance that will theoretically pay if a company’s bonds default. The higher the premium on a credit default swap, the higher the implied risk that a company will fail. However, the market for these instruments is just small enough that unscrupulous players can create fear. Traders are shorting certain stocks (betting the stock’s price will fall) and then bidding up credit default swaps in an effort to fool the market into thinking that these companies are in irreparable trouble and then profiting handsomely from their short positions.

For example, according to a Merrill Lynch report issued on Friday, March 6^th, the credit default swap market was indicating that Warren Buffett’s Berkshire Hathaway had a greater risk of default that the country of Vietnam and that General Electric was at greater risk of default than Russia (a country that actually did default on its debt in 1998).

If the track record of outrageous greed holds, then these scare tactics should ultimately fail. Just this week, many of the stocks that have been victims of this strategy have rebounded strongly. Let us hope that this is a sustainable stock market rally.

Could it be that individual investors are as wrong as ever?

The American Association of Individual Investors released its most recent survey of investor confidence. The survey is the most negative in its twenty-two year history, with 70% of the respondents bearish about the market’s prospects. The last time that 70% of the respondents agreed on something, it was in January of 2000, near the top of the technology stock bubble. At that time, 70% of respondents were bullish on the market’s prospects. Again, let’s hope their track record holds.

Could it be that there are two tiers of financial institutions, the awful and the OK?

The assumption before this week was that every financial institution was fatally flawed. Perhaps this is an overstatement. Of the Wall Street banks, we have thus far found that Bear Stearns, Lehman Brothers and Merrill Lynch were among the awful, but it appears that Morgan Stanley and certainly Goldman Sachs are among the OK. In terms of the super-banks, we know that Citigroup is awful, that Bank of America is perhaps somewhere between awful and OK, but it is increasingly appearing that perhaps Wells Fargo and J.P. Morgan are OK.

If our country truly has a large contingent of OK, i.e. well managed financial institutions, then there will be the opportunity for many positive surprises in the weeks and months ahead, much like we’ve seen this week.

Could it be that stocks are priced appropriately for a bear market bottom?

According to a recent Goldman Sachs study that analyzed the twelve previous bear markets beginning in 1929, assuming a March 2009 end to the present bear market, we are at very normal levels for a bottom. The historical average peak-to-trough price decline was 38%. We reached 56%. The average peak price-to-earnings ratio was 25.6. We reached 22.4 back in October of 2007. And finally, the historical average trough price-to-earnings ratio was 13.9. We reached 13.4.

Only time will tell, but there are numerous questions worth considering. The counter punch is that our economy and our markets are weakening at unprecedented rates with much of the rest of the world in even worse shape. Is this time different?

View our previous market commentaries at www.atwatermalick.com.

Foreign Holders of US Government Debt

I've heard too many misquoted figures lately regarding how much US government debt China currently owns. I've also heard correct figures but without any context. Here are the figures from the end of 2008.

China is the largest foreign owner of US government debt however as a percentage of total outstanding debt, China's stake is relatively small, too small to have any significant effect on the US economy or interest rates.

For an up to date accounting of all foreign holders of US government debt, visit the Treasury's website: http://www.treas.gov/tic/mfh.txt and for a breakdown of the entire national debt visit: http://www.treasurydirect.gov/govt/reports/pd/mspd/mspd.htm

The Fuel for the Financial Crisis Fire

Many of the people I've talked to about the financial crisis like to suggest that the cause for the financial crisis was the change in lending practices of Fannie Mae during the Clinton Administration (1999). Although these changes did increase the risk on the balance sheet of the largest mortgage lender in the US, I don't feel this played a significant role in getting us to where we are now.

The reason, because in 1999 and until April 2004, the amount of capital that could be leveraged by investment banks was capped. However, this rule changed on April 24, 2004 for any investment bank over $5 billion in market capitalization. Banks who qualified were now allowed to almost double the amount of leverage. Who qualified under this little known rule change? Just 5 companies.... maybe you remember them: Bear Sterns, Lehman Brothers, Merrill Lynch, Mogan Stanley, and Goldman Sachs.

So before the rule change, the fuel that could be put on the fire was at least known and limited, after the rule change, the fuel [read potential disaster] almost doubled.

This is a slideshow by the NY Times. What's great about this is the actual audio from the meeting when this rule change was debated and passed.

"The Day the SEC Changed the Game"

http://www.nytimes.com/interactive/2008/09/28/business/20080928-SEC-multimedia/index.html