Closed-End Funds – Better Than Open-End Funds?
Scott Burns writing for the Houston Chronicle makes a past performance case for closed-ends funds, mutual funds that issue a set amount of shares, which trade on an exchange like shares of a stock:
Here's an interesting factoid. Over the three years ending May 30, the average mutual fund that invested in domestic equities has provided an annual return of 13.30 percent.
Rather nice.
Until you compare it with another return. The average closed-end fund, mutual funds that has returned 17.03 percent annually over the same period."
Now before you run out and buy a closed-end fund, let’s think about a few issues specific to closed-end funds that may have played a role in this recent streak of outperformance:
1) Leverage. Most closed-end funds leverage their portfolios with borrowed money. And why not? They get paid a management fee based on total assets, including borrowed money. That can prove to be one heck of an incentive to borrow. How has this juiced returns? Through much of the last three years borrowing was very cheap. More important, stock markets have been very hot. A fund manager throwing darts at the stock page and investing in the ones he hits in a leveraged portfolio is going to beat an unleveraged portfolio if stocks in general are going up more than the cost of borrowing.
2) Discount Erosion. Closed-end funds can trade at a premium or discount to NAV, or net asset value. This means that when closed-end funds are out of favor (say when reporters are not writing about their streaks of outperformance…) they can trade at ninety cents on the dollar. After strong runs in stocks, investors may bid up these discounts away completely.
Why is this important? Imagine two S&P 500 index funds, one a regular open-end fund, the other a closed-end fund trading at a 10% discount to NAV. If the S&P 500 index climbs 10% one year and the closed-end fund discount goes from 10% to 5%, the closed end fund will be up over 16% compared to the 10% return of the open-end index fund. Add in leverage and the gap would grow even more.
Now that closed-end discounts are much lower, interest rates are higher, and stock markets are more expensive, what are the odds that a leveraged closed-end stock fund will beat a traditional open end fund over the next three years? What if stocks get weak and the wide discounts to NAV return, and the fund managers of closed-end funds keep the leverage (and therefore management fees) up?
There are other reasons closed-end funds can be decent investments – in fact we’ve picked some in our past MAXadvisor Powerfund Portfolios HotSheets. These include smaller portfolios sizes, more experienced managers, and no hot money (in and outflows of money that hurt open-end fund returns).
You can track these important variables for open-end funds right here at MAXfunds. And remember to look forward as well as backward when picking funds.
Is Your Bond Fund a Ticking Sub-Prime Time Bomb?
Investors buy bond funds because of their safety, but if your bond fund manager has taken significant positions in sketchy sub-prime bonds (the kind backed by questionable mortgage loans), your bond fund could be anything but. Worst case: as these sub-prime bonds continue to be downgraded by rating agencies, fund managers could be forced to unload them - which could lead to the bond fund equivalent of a good old-fashioned bank run:
Some funds have rules that require them to invest only in relatively safe bonds. So if bond credit rating firms lower ratings, pensions and mutual funds might have to sell large quantities of bonds. That can set off a dangerous spiral for mutual funds, (Morningstar bond analyst Lawrence Jones) said. If there is a rush to sell any security, the price can fall. And if mutual funds sell a large portion of their portfolio, the fund can take a loss. If investors then become jittery and want to bail out, the fund manager needs to come up with cash for investors. If the fund manager sells good securities to generate cash, more losses can occur."
The problem is it is very difficult to determine if your fund has significant sub-prime exposure until after the performance damage has been done. You can call the fund and ask, but they aren't required to reveal portfolio holding details, even to current investors.
Perhaps the best way to determine if something is fishy – as the article notes – is to check its performance during a rough patch for higher risk debt, like this past June. If your bond fund fell significantly more than a total bond index fund, figure out why (it could simply be a longer duration bond fund or an ordinary high yield bond fund) or throw in the towel.
Another Hedge Fund Wrist Slap
If you get caught walking out of a Wal-Mart with a carton of smokes that you didn’t pay for, it’s unlikely that you would be allowed to refuse to admit or deny the wrongdoing, simply return the cigarettes to their rightful owner along with the interest on their value, and pay a fine of about $10. This is a good thing. Otherwise, the price of cigarettes would surely rise to compensate for the increase in thefts.
Fortunately for investors in London-based hedge fund giant GLG Partners, the punishment just doled out by the SEC was pretty toothless.
The crime was "multiple violations of Rule 105 of Regulation M of the Securities Exchange Act of 1934. Rule 105, designed to prevent manipulative short selling, prohibits covering certain short sales with securities obtained in a public offering."
That sure sounds complex and boring. No wonder the recent articles about this fine avoid explaining the scheme in depth. If only Paris Hilton crime coverage was so shallow. Here goes:
GLG Partners may sound shady, but they are actually a good hedge fund. Good hedge funds make risk-free or nearly risk-free trades. This is what investors are really paying 2% per year, plus 20% (or more) of their profits, for. If you want predictions, trading, stock picks, and market gyrations, watch CNBC or buy a mutual fund that charges 1% a year (with no cut of profits).
Truly bad hedge funds, which are a fast-growing population, charge GLG Partner-grade fees, but aren’t quite so clever in delivering low-risk returns. They just charge a lot more for their guesses and are open to just about anybody.
Most publicly traded corporations have a few large investors who own big swaths of the stocks – some are founders of the company. When these big fish want to sell a few million shares here or there, they often seek professional help. Rather than selling shares on the open market through their E*TRADE account, they enlist Goldman Sachs to put together a "secondary offering" of stock. This is sort of like an IPO, but the company whose stock is being sold doesn’t get any money – the selling shareholders do.
In 2003, electronics giant Philips decided to sell 100 million shares (American Depositary Shares or ADSs) in Taiwan Semiconductor Manufacturing Company (Ticker TSM) – about a billion dollars worth. For a few million bucks, Goldman and Merrill Lynch helped with the sale.
Normally, these investment banks would have to drum up demand for the stock. It has been frowned upon for an investment bank to issue favorable recommendations for stocks that they are selling ever since the 2000 bubble crash, so this would mean a lot of pavement pounding, which slows down deals.
Instead, the investment bankers apparently found some hedge funds to take big chunks of the stock off their hands. But why would a hedge fund want to speculate on the day-to-day gyrations of a tech stock?
They wouldn’t, which is why the hedge fund shorts the stock in the days before they buy the stock in the offering. ‘Shorting a stock’ means borrowing shares from other investors (probably clients of Goldman Sachs and Merrill Lynch), and then selling them with the hopes of buying the shares back at a lower price.
It’s the Wimpy from Popeye trade: I’ll gladly give you your shares back Tuesday if you give them to me today, and it has risks – big risks. If the stock takes off, the short seller loses money. The short sellers can even lose more money than they earned selling the stock because, although a stock can only fall to zero, it can also triple in price.
But what if a hedge fund knew they could get, say, 7 million shares in the TSM offering at the guaranteed price of $10.77 per share? Well then, selling some shares short at $11.50 two days before you buy the shares for $10.77 from Goldman isn’t so risky after all…they just hand off the $10.77 shares to the person they borrowed them from to cover the short, so to speak.
What about the poor saps who bought TSM shares at $11.50 from the hedge fund, not knowing the offering price was going to be at $10.77 in the very near future? Maybe they should quit whining and start paying the high hedge fund fees to join the "in" crowd.
The securities rule in question is sort of a vague catch-all to try to weed out these sorts of tricks, but it doesn’t really do the job, hence the lame settlements. Frankly, being effectively both short and long, any one stock (directly or through various derivatives or contractual pre-sales) is questionable and is likely a tax avoidance scheme at best and flat-out securities fraud at worst.
But what’s so bad about a hedge fund essentially acting as a stock underwriter anyway? If GLG was genuinely taking on risk by shorting the stock, and if they had no pre-arranged deal to find out what price they were getting the stock at and to thereby cover the short, then no muss no fuss. In reality, somewhere between a 100% risk-free trade and a normal trade took place. Arbitraging the price gap between the outsider and insider price can be as questionable as insider trading.
What’s so bad about a risk-free trade? Nothing, for GLG investors. Remember the great mutual fund timing scandal? The result of hedge funds skimming near risk-free profits from ordinary mutual funds was lower rewards for mutual fund investors.
Risk-free trades effectively skim profits off the market – leaving the same risk but lower returns for everybody else. The market as a whole only has so much profit. This profit comes at a cost, and that cost is risk. Skimming the profit while leaving the risk means less reward for everybody else.
It’s like ordering a $25 porterhouse steak at a restaurant, noticing that the filet mignon part was missing, and being informed by the waiter that a hedge fund patron cut it off your steak on its way from the kitchen.
We’ll leave you with one funny line from the secondary stock offering documents, "...we are not aware of any plans by any major shareholders to dispose of significant numbers of common shares…"
Of course not, they disposed of them before the offering.
The Bigger The CEO’s House, The Smaller The Shareholder’s Returns
A new study on executive stock sales and ensuing stock performance, summarized on Marc Andreessen’s blog, has discovered that the more house an executive buys with the proceeds of selling company stock, the crummier the future company stock returns:
When a CEO buys real estate, future company performance is inversely related to the CEO’s liquidation of company shares and options for financing the transaction. We also find that, regardless of the source of finance, future company performance deteriorates when CEOs acquire extremely large or costly mansions and estates. ...
We look first at whether the CEO sells shares of company stock to finance the home purchase. Although buying a house appears to offer a prima facie personal liquidity reason for CEOs to sell their own shares, most are wealthy enough to acquire homes with other sources of finance."
This should be expected. If a top exec already owns stock in their company, it’s not illegal to hang on if they know next year’s earnings are looking pretty good. Therefore, why would a rational executive cash out of a near-sure thing to buy a historically ho-hum investment with high maintenance costs?
Don't Do That
The Wall Street Journal's Jonathan Clements lists four pieces of financial advice 20-somethings SHOULDN'T take:
1. DON'T build an emergency fund equal to six months of living expenses:
Let's be honest: This is dull, unrealistic and -- I would argue -- not all that sensible. Even if you regularly sock away 10% of your after-tax income, it might take four years or so to amass six months of living expenses. At that juncture, you are supposed to leave this money in low-risk investments, where it will earn modest returns for the rest of your life."
2. DON'T buy a bigger house than you can afford:
Borrowing a huge sum to purchase an unnecessarily large house is financial foolishness. You will saddle yourself with hefty monthly mortgage payments and a lifetime of large utility bills, maintenance costs, property-tax payments and home-insurance premiums. Rather, when buying that first home, you should strive to purchase a place that's the right size for you and your family -- and that you can see living in for a good long time."
3. DON'T buy life insurance:
Don't do it. To be sure, under the right circumstances and with the right policy from the right company, cash-value life insurance can be a decent investment. But for those in their 20s, these policies are unlikely to make sense.
Remember, the principal reason to buy life insurance is to protect your family -- and you may not even have a spouse, let alone kids. And if you are married with young kids, you no doubt need a heap of coverage. The cheapest way to get that coverage is with term life insurance, which offers a death benefit and nothing more."
4. DON'T invest as aggressively as possible:
You don't want to invest heavily in stocks and then panic and sell during the next market plunge. Yet that's a real danger if you are new to the market and you have never lived through a market decline.
My suggestion: Start with 60% stocks and 40% bonds. If you find yourself unperturbed by market swings, move your stock allocation up to 85% or 90% after a year or two."
Good stuff all around. What financial advice had I wished I had listened to when I was 20? That's an easy one: 1) Avoid credit card debt like the plague. 2) Invest a little each month in a low cost mutual fund (a great option for younger investors is Vanguard LifeStrategy Growth Fund [VASGX]) via an automatic investment plan.
See also:
Ask MAX: Can I build a fund portfolio with just $17,000?
Ask MAX: Where do I start?
Ask MAX: Investing $20 a month?
The Future for Stocks and Bonds? Like The Past. Only Not Nearly As Good
Investment pros at Morningstar’s recent annual investment conference seem to be in agreement on one thing: future returns for investors will be a mere fraction of the golden era of the last two decades or so.
'If we are to rely on history as a predictor of future returns, we are likely to be intensely disappointed. Because the future is simply unlikely to be anywhere near the recent or even historical past,' Ranji Nagaswami, chief investment officer of AllianceBernstein Investments, told the conference.
'Bonds are not likely to have returns in double digits. And relative to their long-term history, equities, too, are likely to return a lot less,' she said. AllianceBernstein estimated that in the past two decades, equities returned a compounded 12.5 percent in U.S. dollar terms."
While here at MAXfunds we also have tepid estimates on future stock and bond returns, some of these fund managers motives for setting shareholders expectations so low are suspect. Many of these managers have seen billions of new money hit their hot funds. This makes their job harder, because they have to find more and more compelling investments in which to invest all that cash. The lower the expectations of investors are, the better these managers look when they exceed them – and the less likely those investors are to look for better returns elsewhere. None of these managers, of course, recommended going with a low fee, near zero risk money market fund, of course.
401(k) Not Ok?
No time to read a half-dozen articles about retirement plans before the fireworks tonight? Well today is your lucky day. MAXfunds co-founder Jonas Ferris tells you all you need to know about your 401(k) in this handy dandy video from the Fox News Channel. If you have old-fashioned dial-up internet access you'll may want to wait until you're back at work to watch.
ETFs Aplenty
The Boston Globe reports on the ridiculous number of new exchange traded funds being launched this year:
Exchange traded funds, or ETFs, have attracted hundreds of billions of dollars as an alternative to mutual fund investments in recent years. Mutual funds still pull in much more client money than exchange traded funds, but ETFs have established themselves this decade as competitive products that appeal to many investors. Their assets, just $130 billion at the end of 2003, had grown to $480 billion by May.
Investment management companies have responded to that kind of demand by burying investors in new products. A total of 150 new ETFs were created in the first five months of this year, according to research by the industry's two largest competitors. That's almost exactly the number of all the new ETFs created during the entire year in 2006, and three times the number formed in 2005. About half of all ETFs on the market today have arrived in the past 12 months."
This plague of ETFs brings to mind an important point about fund companies: they don't launch investment vehicles because they think those vehicles are particularly likely to perform well. In fact, we'd wager that most of the funds started by fund companies are not expected by their managers to be top performers. That's because fund companies are interested less in their funds posting big returns as they are with getting investors to buy them.
Fund investors usually make investment decisions based on recent past performance. Most of the time the new mutual funds and ETFs that are the most saleable are not the ones that are set to post big gains in the near future but those that are in the hottest categories. So what if study after study shows that funds that are top performers rarely remain so? As long a performance chasing investors are buying, the fund companies will be selling.
Why World’s 3rd Richest Person Is In A Lower Tax Bracket Than You
Warren Buffett in the Washington Post confirms what I’ve suspected for quite some time: he is in a lower tax bracket than me.
Warren E. Buffett was his usual folksy self Tuesday night at a fundraiser for Sen. Hillary Rodham Clinton (D-N.Y.) as he slammed a system that allows the very rich to pay taxes at a lower rate than the middle class.
Buffett cited himself, the third-richest person in the world, as an example. Last year, Buffett said, he was taxed at 17.7 percent on his taxable income of more than $46 million. His receptionist was taxed at about 30 percent."
But how could he be? My income was significantly less than Buffet’s last year (and every other year for that matter).
The answer is because while all men may be created equal, all income is not. Relatively recent changes to the tax code have created even more favorable classes of income.
A dollar earned is taxed as income – at the local, state, and federal level. Income tax rates go up with higher level of incomes because we have progressive taxes – meaning you pay a higher rate the more you earn. Worse, social security and other payroll taxes are a huge percentage of your total taxable income if you earn a normal wage, but because they are largely capped these taxes become a very small percentage of your taxes if you earn $9 million.
But that only explains why many people are in such a high tax bracket. Why is Buffett in such a low bracket? A dollar passively earned is rarely taxed as income. Start a company and sell it for a billion dollars, and that billion dollars is long term capital gains, not income. Stock dividends are now taxed at lower rates than a clock watcher’s salary. And of course, social security and other payroll taxes don’t apply to passive income. Income from your checking account (0.50% interest rate…) is still taxed as income. As is CD, savings account, and bond income.
Unfortunately the money in our 401ks and IRAs will be taxed as income someday, not long-term capital gains or dividends. Hopefully our country’s financial situation won’t be so screwy that Congress will have to raise income taxes right when we need our retirement income.
While low taxes on passive investment income is good, most non-billionaires and those not partners in private equity outfits and venture capital firms would probably prefer a lower tax rate on income and a higher tax rate on investments – a simpler tax where income is income and there are no favorable ways to earn it.
Perhaps no tax on the first $25,000 and a 25% tax bracket on all income over $25,000 – no matter how it comes in. That way Buffett wouldn’t be in a lower tax bracket than his Secretary.
Fund Investors To Blame For Poor Returns, Ray of Hope Shines
Fund investors have a nasty habit of buying high and selling low. We have been noting this phenomenon since 1999 and invented a measure of real fund shareholder returns to capture the gap between how well a typical fund investors does compared to the funds they invest in.
A Wall Street Journal article covering a report issued by Dalbar Inc. once again highlights how poorly fund investors perform compared to the market.
The 2007 report found that while the past 20 years have been a boon to the mutual-fund industry, the average investor has earned only a fraction of the market's results. That's because mutual-fund performance is based on an investment held throughout a specific time period -- one, three, five, 10 years, etc. -- but investors frequently don't hold the funds for the entire period. Instead, they pour in cash as markets rise and start a selling frenzy after a decline. In addition, new funds, funds that surge in popularity and funds that close, may cause investors to switch or withdraw their money, which can lower returns, depending on when they occur."
Shockingly, "The average equity fund investor's 20-year annualized return jumped to 4.3% from 3.9% in 2006". In other words, because of bad timing, fund investors may have done better in a low risk and low fee money market fund.
One possible salvation discussed in the article is asset allocation funds – funds that own a mix of stocks, bonds and cash. These funds tend to be boring for most investors as they never show up on top performance lists. However, less volatile returns means performance chasing fund investors are less likely to make ill-timed buys and sells.
While buying a low fee asset allocation fund and falling asleep at the wheel is generally superior to chasing hot funds and fund categories, the good people of MAXfunds feel a more active fund investor can increase their returns by essentially doing the opposite of the fund investing herd – buying good funds in fund categories others avoid, increasing allocations to stock funds in general when other investors are scared, and cutting back on stock funds when optimism is high.