“Cynicism is an unpleasant way of saying the truth.”

Lillian Hellman

Current Events:

While we may be where we are, it is worth a few moments to talk about how we got here. In recent months the dichotomy between the news agendas of the U.S. financial press and the international press has become increasingly obvious. At the beginning of August, a headline on the front page of the Financial Times read, “One Trillion Dollars in Capital Flees Emerging Markets.” I looked in vain for a similar story in The Wall Street Journal or The New York Times. There were many stories about the next Federal Reserve meeting and whether they would raise rates, stories about Hillary Clinton’s email server, and stories about Apple’s new products to come, but nothing about that capital flight from the emerging markets.

We then had the Chinese currency devaluation with varying interpretations on the motivation. Let me run a theme by you that was making the rounds of institutional investors outside of the U.S. and was reported at that time. In July there was a meeting of the International Monetary Fund in Europe. One of the issues to be considered was whether or not China’s currency, the renminbi, would be included in the basket of currencies against which countries could have special drawing (borrowing) rights. This would effectively have given the Chinese currency the status of a reserve currency by the IMF. The IMF’s staff, whose response sounded like it could have been drafted by the U.S. Treasury, argued against including the renminbi. While the issue is not yet settled, the Executive Directors accepted the staff report and will recommend extending the lifespan of the current basket, now set to expire December 31, until at least September 2016. At the least, that would lock out the renminbi for another year. The story I heard about what happened next is curious but telling. The Chinese representative at the meeting is alleged to have said something like, “You won’t like what we are going to do next as a result of this.” Two weeks after the conclusion of the IMF meeting, we then had the devaluation of China’s currency, which in the minds of some triggered the increased volatility and market sell-offs that we have seen since then.

I know many of you are saying, “Pshaw, the Chinese would never do anything as irrational as that for such silly reasons.” And if you think that dear reader, you have yet to understand the concept of “Face” and the importance that it plays in the Asian world. You also do not understand the Chinese view of self – that they are a Great People and a Great Nation. And, that we disrespect them at our own peril. If you factor in a definition of long-term, measured in centuries, events become much more understandable.

One must read the world financial press regularly to truly get a picture of global events. I suggest the Financial Times as one easily accessible source. What is reported and considered front page news overseas is very different from what is reported here. It seems on occasion that the bobble-heads who used to write for Pravda have gotten jobs in public relations and journalism in Washington and Wall Street.

One example – this week the Financial Times reported the story that many of the sovereign wealth funds (those funds established by countries such as Kuwait, Norway, and Singapore to invest in stocks, bonds, and other assets, for pension, infrastructure or healthcare, among other things), have been liquidating investments. And in particular, they have been liquidating stocks, not bonds. Another story making the rounds in Europe is that the various “Quantitative Easing” programs that we have seen in the U.S., Europe, and Japan, are, surprise, having the effect of being deflationary. And in the United States, we have recently seen the three month U.S. Treasury Bill trading at negative yields, the ultimate deflationary sign. Another story that is making the rounds – the Chinese have been selling their U.S. Treasury holdings and at a fairly rapid clip. This may cause an unscripted rate rise not intended or dictated by the Federal Reserve, but rather caused by market forces as the U.S. Treasury continues to come to market with refinancing issues.

The collapse in commodity prices, especially oil, will sooner or later cause corporate bodies to float to the surface, especially in the energy sector. Counter-party (the other side of a trade) risk in hedging and lending will be a factor again, as banks start shrinking or pulling lines of credit. Liquidity, which was an issue long before this in the stock and bond markets (especially high yield), will be an even greater problem now.

The SEC, in response to warnings from the IMF and the Federal Reserve, has unanimously (which does not often happen) called for rules to prevent investors’ demands for redemptions in a market crisis from causing mutual funds to be driven out of business. Translation: don’t expect to get your money as quickly as you thought. I refer you to the SEC’s Proposal on Liquidity Risk Management Programs.

I mention that for the better of those who think that my repeated discussions of liquidity risk is “crying wolf.”

“It’s a Fine Kettle of Fish You’ve Gotten Us in, Ollie.”

I have a friend who is a retired partner from Wellington in Boston (actually I have a number of friends who are retired partners from there). Wellington is not unique in that, like Fidelity, it is very unusual for an analyst or money manager to

stay much beyond the age of fifty-five. So I asked him one day how he had his retirement investments structured, hoping I might get some perspective into thinking on the East Coast, as well as perhaps some insights into Vanguard’s products, given the close relationship between Vanguard and Wellington. His answer surprised me – “I have it all in index funds.” I asked if there were any particular index funds. Again the answer surprised me. “No bond funds, and actually only one index fund – the Vanguard S&P 500 Index Fund.” And when I asked for further color on that, the answer I got was that he was not in the business full time anymore, looking at markets and security valuations every day, so this was the best way to manage his retirement portfolio for the long-term at the lowest cost. Did he know that there were managers, that 10% or so, who consistently (or at least for a while, consistently) outperform the index? Yes, he was aware that such managers were out there. But at this juncture in his life he did not think that he either (a) had the time, interest, and energy to devote to researching and in effect “trading managers” by trading funds and (b) did not think he had any special skill set or insights that would add value in that process that would justify the time, the one resource he could not replace. Rather, he knew what equity exposure he wanted over the next twenty or thirty years (and he recognized that life expectancies keep lengthening). The index fund over that period of time would probably compound at 8% a year as it had historically with minimal transaction costs and minimal tax consequences. He could meet his needs for a diversified portfolio of equities at an expense ratio of five basis points. The rest of his assets would be in cash or cash equivalents (again, not bonds but rather insured certificates of deposit).

I have talked in the past about the need to focus on asset allocation as one gets older, and how index funds are the low cost way to achieve asset diversification. I have also talked about how your significant other may not have the same interest or ability in managing investments (trading funds) after you go on to your just reward. But I have not talked about the intangible benefits from investing in an index fund. They lessen or eliminate the danger of portfolio manager or analyst hubris blowing up a fund portfolio with a torpedo stock. They also eliminate the divergence of interests between the investment firm and investors that arises when the primary focus is running the investment business (gathering assets).

What goes into the index is determined not by the entity running the fund (although they can choose to create their own index, as some of the European banks have done, and charge fees close to 2.00%). There is no line drawn in the sand because a portfolio manager has staked his public reputation on his or her genius in investing in a particular entity. There is also no danger in an analyst recommending sale of an issue to lock in a bonus. There is no danger of an analyst recommending an investment to please someone in management with a different agenda. There is no danger of having a truncated universe of opportunities to invest in because the portfolio manager has a bias against investing in companies that have women chief executive officers. There is no danger of stock selection being tainted because a firm has changed its process by adding an undisclosed subjective screening mechanism before new ideas may be even considered. While firm insiders may know these things, it is a very difficult thing to learn them from the outside.

Is there a real life example here? I go back to the lunch I had at the time of the Morningstar Conference in June with the father-son team running a value fund out of Seattle. As is often the case, a subject that came up (not raised by me) was Washington Mutual (WaMu, a bank holding company that collapsed in 2008, trashing a bunch of mutual funds when it did). They opined how, by being in Seattle (a big small town), they had been able to observe up close and personally how the roll-up (which was what Washington Mutual was) had worked until it didn’t. Their observation was that the Old Guard, who had been at the firm from the beginning with the chair of the board/CEO had been able to remind him that he put his pants on one leg at a time. When that Old Guard retired over time, there was no one left who had the guts to perform that function, and ultimately the firm got too big relative to what had driven past success. Their assumption was that their Seattle presence gave them an edge in seeing that. Sadly, that was not necessarily the case. In the case of many an investment firm, Washington Mutual became their Stalingrad. Generally, less is more in investing. If it takes more than a few simple declarative sentences to explain why you are investing in a business, you probably should not be doing it. And when the rationale for investing changes and lengthens over time, it should serve as a warning.

I suspect many of you feel that the investment world is not this way in reality. For those who are willing to consider whether they should rein in their animal spirits, I commend to you an article entitled “Journey into the Whirlwind: Graham-and-Doddsville Revisited” by Louis Lowenstein (2006) and published by The Center for Law and Economic Studies at Columbia Law School. (Lowenstein, father of Roger Lowenstein, looks at the antics of large growth managers and conclude, “Having attracted, not investors, but speculators trying to catch the next new thing, management got the shareholders they deserved.” Snowball). When I look at the investment management profession today, as well as its lobbying efforts to prevent the imposition of stricter fiduciary standards, I question whether what they really feel in their hearts is that the sin of Madoff was getting caught.

The End

Is there anything I am going to say this month that may be useful to the long-term investor? There is at present much fear abroad in the land about investing in emerging and frontier markets today, driven by what has happened in China

and the attendant ripple effect. The question I will pose for your consideration is this. What if five years from now it becomes compellingly obvious that China has become the dominant economic force in the world? Since economic power ultimately leads to political and military power, China wins. How should one be investing a slice of one’s assets (actively-managed of course) today if one even thinks that this is a remotely possible outcome? Should you be looking for a long-term oriented, China-centric fund?

There is one other investment suggestion I will make that may be useful to the long-term investor. David has raised it once already, and that is dedicating some assets into the micro-cap stock area. Focus on those investments that are in effect too small and extraordinarily illiquid in market capitalization for the big firms (or sovereign wealth funds) to invest in and distort the prices, both coming and going. Micro-cap investing is an area where it is possible to add value by active management, especially where the manager is prepared to cap the assets that it will take under management. Look for managers or funds where the strategy cannot be replicated or imitated by an exchange traded fund. Always remember, when the elephants start to dance, it is generally not pleasant for those who are not elephants.

Edward A. Studzinski

P.S. – Where Eagles Dare

The fearless financial writer for the New York Times, Gretchen Morgenson, wrote a piece in the Sunday Times (9/27/2015) about the asset management company First Eagle Investment Management. The article covered an action brought by the SEC for allegedly questionable marketing practices under the firm’s mutual funds’ 12b-1 Plan. Without confirming or denying the allegations, First Eagle settled the matter by paying $27M in disgorgement and interest, and $12.5M in fines. With approximately $100B in assets generating an estimated $900+M in revenues annually, one does not need to hold a Tag Day for the family-controlled firm. Others have written and will write more about this event than I will.

Of more interest is the fact that Blackstone Management Partners is reportedly purchasing a 25% stake in First Eagle that is being sold by T/A Associates of Boston, another private equity firm. As we have seen with Matthews in San Francisco, investments in investment management firms by private equity firms have generally not inured to the benefit of individual investors. It remains to be seen what the purpose is of this investment for Blackstone. Blackstone had had a right-time, right-strategy investment operation with its two previously-owned closed-end funds, The Asia Tigers Fund and The India Fund, both run by experienced teams. The funds were sold to Aberdeen Asset Management, ostensibly so Blackstone could concentrate on asset management in alternatives and private equity. With this action, they appear to be rethinking that.

Other private equity firms, like Oaktree, have recently launched their own specialist mutual funds. I would note however that while the First Eagle Funds have distinguished long-term records, they were generated by individuals now absent from the firm. There is also the question of asset bloat. One has to wonder if the investment strategy and methodology could not be replicated by a much lower cost (to investors) vehicle as the funds become more commodity-like.

Which leaves us with the issue of distribution – is a load-based product, going through a network of financial intermediaries, viable, especially given how the Millennials appear to make their financial decisions? It remains to be seen. I suggest an analogy worth considering is the problem of agency-driven insurance firms like Allstate. Allstate would clearly like to not have an agency distribution system, and would make the switch overnight if it could without losing business. It can’t, because too much of the book of business would leave. And yet, when one looks at the success of GEICO and Progressive in going the on-line or 1-800 route, one can see the competitive disadvantage, especially in automobile insurance, which is the far more profitable business to capture. It remains to be seen how distribution will evolve in the investment management world, especially as pertains to funds. As fiduciary requirements change, there is the danger of the entire industry model also changing.

“I prefer the company of peasants because they have not been educated sufficiently to reason incorrectly.”

               Michel de Montaigne

At this point in time, rather than focus on the “if only” questions that tend to freeze people in their tracks in these periods of market volatility, I think we should consider what is important. For most of us, indeed, the vast majority of us, the world did not end in August and it is unlikely to end in September.  Indeed, for most Americans and therefore by definition most of us, the vagaries of the stock market are not that important.

What then is important? A Chicago Tribune columnist, Mary Schmich, recently interviewed Edward Stuart, an economics professor at Northeastern Illinois University as a follow-up to his appearance on a panel on Chicago Public Television’s “Chicago Tonight” show. Stuart had pointed out that the ownership of stock (and by implication, mutual funds) in the United States is quite unequal. He noted that while the stock market has done very well in recent years, the standard of living of the average American citizen has not done as well. Stuart thinks that the real median income for a household size of four is about $40,000 …. and that number has not changed since the late 70’s. My spin on this is rather simple – the move up the economic ladder that we used to see for various demographic groups – has stopped.

If you think about it, the evidence is before us. How many of us have friends whose children went to college, got their degrees, and returned home to live with their parents while they hunted for a job in their chosen field, which they often could not find? When one drives around city and suburban streets, how many vacancies do we see in commercial properties?  How many middle class families that used to bootstrap themselves up by investing in and owning apartment buildings or strip malls don’t now?  What is needed is a growing economy that offers real job prospects that pay real wages. Stuart also pointed out that student debt is one of the few kinds of debt that one cannot expunge with bankruptcy.

As I read that piece of Ms. Schmick’s and reflected on it, I was reminded of another column I had read a few months back that talked about where we had gone off the rails collectively. The piece was entitled “Battle for the Boardroom” by Joe Nocera and was in the NY Times on May 9, 2015. Nocera was discussing the concept of “activist investors” and “shareholder value” specifically as it pertained to Nelson Peltz, Trian Investments, and a proxy fight with the management and board of DuPont.  And Nocera pointed out that Trian, by all accounts, had a good record and was often a constructive force once it got a board seat or two.

Nocera’s concern, which he raised in a fashion that went straight for the jugular, was simple. Have we really reached the point where the activist investor gets to call the tune, no matter how well run the company? What is shareholder value, especially in a company like DuPont? Trian’s argument was that DuPont was not getting a return on its spending on research and development? Yet R&D spending is what made DuPont, given the years it takes to often produce from scientific research a commercial product. Take away the R&D spending argued Nocera, and you have not just a poorer DuPont, but also a poorer United States. He closed by talking with and quoting Martin Lipton, a corporate attorney who has made a career out of disparaging corporate activists. Lipton said, “Activism has caused companies to cut R&D, capital investment, and, most significantly, employment,” he said. “It forces companies to lay off employees to meet quarterly earnings.”

“It is,” he concluded, “a disaster for the country.”

This brings me to my final set of ruminations. Some years ago, my wife and I were guests at a small dinner party at the home of a former ambassador (and patriot) living in Santa Fe.  There were a total of six of us at that dinner. One of the other guests raised the question as to whether any of us ever thought about what things would have been like for the country if Al Gore, rather than George W. Bush, had won the presidential election. My immediate response was that I didn’t think about such things as it was just far too painful to contemplate.

In like vein, having recently read Ron Suskind’s book Confidence Men, I have been forced to contemplate what it would have meant for the country if President-elect Barack Obama had actually followed through with the recommendations of his transition advisors and appointed his “A” Economic Team. Think about it – Paul Volcker as Secretary of the Treasury, the resurrection of Glass-Steagall, the break-up of the big investment banks – it too is just too painful to contemplate.  Or as the line from T.H. White’s Once and Future King goes, “I dream things that never were, and ask why not?”

Now, a few thoughts about the carnage and how to deal with it.  Have a plan and stick to it. Do not panic, for inevitably all panic does is lead to self-inflicted wounds. Think about fees, but from the perspective of correlated investments. That is, if five large (over $10B in assets) balanced funds are all positively correlated in terms of their portfolios, does it really make sense not to own the one with the lowest expense ratio (and depending on where it is held, taxes may come into play)? Think about doing things where other people’s panic does not impact you, e.g., is there a place for closed end funds in a long-term investment portfolio? And avoid investments where the bugs have not been worked out, as the glitches in pricing and execution of trades for ETF’s have shown us over the last few weeks.

There is a wonderful Dilbert cartoon where the CEO says “Asok, you can beat market averages by doing your own stock research. Asok then says, “So … You believe every investor can beat the average by reading the same information? “Yes” says the CEO. Asok then says, “Makes you wonder why more people don’t do it.” The CEO closes saying, “Just lazy, I guess.”

Edward A. Studzinski

Some men are born mediocre, some men achieve mediocrity, and some men have mediocrity thrust upon them.

       Joseph Heller

We are now at the seven month mark. All would not appear to be well in the investing world. But before I head off on that tangent, there are some housekeeping matters to address.

First, at the beginning of the year I suggested that the average family unit should own no more than ten mutual funds, which would cover both individual and retirement assets. When my long-suffering spouse read that, the question she asked was how many we had. I stopped counting when I got to twenty-five, and told her the results of my search. I was then told that if I was going to tell others they should have ten or less per family unit, we should follow suit. I am happy to report that the number is now down to seventeen (exclusive of money market funds), and I am aiming to hit that ten number by year-end.

Obviously, tax consequences play a big role in this process of consolidation. One, there are tax consequences you can control, in terms of whether your ownership is long-term or short-term, and when to sell. Two, there are tax consequences you can’t control, which are tied in an actively-managed fund, to the decision by the portfolio manager to take some gains and losses in an effort to manage the fund in a tax-efficient manner. At least that is what I hope they are doing. There are other tax consequences you cannot control when the fund in question’s performance is bad, leading to a wave of redemptions. The wave of redemptions then leads to forced selling of equity positions, either en masse or on a pro rata basis, which then triggers tax issues (hopefully gains but sometimes not). The problem with these unintended or unplanned for tax consequences, is that in non-retirement accounts, you are often faced with a tax bill that you have not planned for at filing time, and need to come up with a check to pay the taxes due. A very different way to control the tax consequences, especially if you are of a certain age, is to own passive index funds, whose portfolios won’t change except for those issues going into or leaving the index. Turnover and hence capital gains distributions, tend to be minimized. And since they do tend to own everything as it were, you will pick up some of the benefit of merger and acquisition activity. However, index funds are not immune to an investor panic, which leads to forced selling which again triggers tax consequences.

In this consolidation process, one of the issues I am wrestling with is what to do with money market funds, given that later this year unless something changes again, they will be allowed to “break the buck” or no longer have a constant $1 share price. My inclination is to say that cash reserves for individuals should go back into bank certificates of deposit, up to the maximum amounts of the FDIC insurance. That will work until or unless, like Europe, the government through the banks decides to start charging a negative interest rate on bank deposits. The other issue I am wrestling with is the category of balanced funds, where I am increasingly concerned that the three usual asset classes of equities, fixed income, and cash, will not necessarily work in a complementary manner to reduce risk. The counter argument to that of course, is that most people investing in a balanced (or equity fund for that matter) investment, do not have a sufficiently long time horizon, ten years perhaps being the minimum commitment. If you look at recent history, it is extraordinary how many ten year returns both for equity funds and balanced funds, tend to cluster around the 8% annualized mark.

Morningstar, revisited:

One of the more interesting lunch meetings I had around the Morningstar conference that I did not attend, was with a Seattle-based father-son team with an outstanding record to date in their fund. One of the major research tools used was, shock of shock, the Value Line. But that should not surprise people. Many of Buffet’s own personal investments were, as he relates it, arrived at by thumbing through things like a handbook of Korean stocks. I have used a similar handbook to look at Japanese stocks. One needs to understand that in many respects, the purpose of hordes of analysts, producing detailed models and exhaustive reports is to provide the cover of the appearance of adequate due diligence. Years ago, when I was back in the trust investment world, I used to have various services for sale by the big trust banks (think New York and Philadelphia) presented to me as necessary. Not necessary to arrive at good investment decisions, but necessary to have as file drawer stuffers when the regulators came to examine why a particular equity issue had been added to the approved list. Now of course with Regulation FD, rather than individual access to managements and the danger of selective disclosure of material information, we have big and medium sized companies putting on analyst days, where all investors – buy side, sell side, and retail, get access to the same information at the same time, and what they make of it is up to them.

So how does one improve the decision making process, or rather, get an investment edge? The answer is, it depends on the industry and what you are defining as your circle of competency. Let’s assume for the moment it is property and casualty reinsurance. I would submit that one would want to make a point of attending the industry meetings, held annually, in Monte Carlo and Baden-Baden. If you have even the most rudimentary of social skills, you will come away from those events with a good idea as to how pricing (rate on line) is going to be set for categories of business and renewals. You will get an idea as to whose underwriting is conservative and whose is not. And you will get an idea as to who is under-reserved for prior events and who is not. You will also get a sense as to how a particular executive is perceived.

Is this the basis for an investment decision alone? No, but in the insurance business, which is a business of estimates to begin with, the two most critical variables are the intelligence and integrity of management (which comes down from the top). What about those wonderfully complex models, forecasting interest rates, pricing, catastrophic events leading to loss ratios and the like? It strikes me that fewer and fewer people have taken sciences in high school or college, where they have learned about the Law of Significant Numbers. Or put another way, perhaps appropriately cynical, garbage in/garbage out.

Now, many of you are sitting there thinking that it really cannot be this simple. And I will tell you that the finest investment analyst I have ever met, a contemporary of mine, when he was acting as an analyst, used to do up his research ideas by hand, on one or one and a half sheets of 8 ½ by 11 paper.

There would be a one or two sentence description of the company and lines of business, a simple income statement going out maybe two years beyond this year, several bullet points as to what the investment case was, with what could go right (and sometimes what could go wrong), and that was generally it, except for perhaps a concluding “Reasons to Own. AND HIS RETURNS WERE SPECTACULAR FOR HIS IDEAS! People often disbelieve me when I tell them that, so luckily I have saved one of those write-ups. My point is this – the best ideas are often the simplest ideas, capable of being presented and explained in one or two declarative sentences.

What’s coming?

And finally, for a drop of my usual enthusiasm for the glass half empty. There is a lot of strange stuff going on in the world at the moment, much of it not going according to plan, for governments, central banks, and corporations as one expected in January. Commodity prices are collapsing. Interest rates look to go up in this country, perhaps sooner rather than later. China may or may not have lost control of its markets, which would not augur well for the rest of us. I will leave you with something else to ponder. The “dot.com” crash in 2000 and the financial crisis of 2007-2008-2009 were water-torture events. Most of the people running money now were around for them, and it represents their experiential reference point. The October 1987 crash was a very different animal – you came in one day, and things just headed down and did not stop. Derivatives did not work, portfolio insurance did not work, and there was no liquidity as everyone panicked and tried to go through the door at once. Very few people who went through that experience are still actively running money. I bring this up, because I worry that the next event (and there will be one), will not necessarily be like the last two, where one had time to get out in orderly fashion. That is why I keep emphasizing – do not put at risk more than you can afford to lose without impacting your standard of living. Investors, whether professional or individual, need to guard mentally against always being prepared to fight the last war.

Edward A. Studzinski

By Edward Studzinski

“A sign of celebrity is that his name is often worth more than his services.”

Daniel J. Boorstin

So the annual Morningstar Conference has come and gone again, with fifteen thousand attendees in town hoping to receive the benefit of some bit of investment or business wisdom. The theme of this year’s conference appears to have been that the world of investors now increasingly is populated by and belongs to “Gen X’ers” and “Millennials.” Baby Boomers such as yours truly, are a thing of the past in terms of influence as well as a group from whom assets are to be gathered. Indeed, according to my colleagues, advisors should be focused not on the current decision maker in a client family but rather the spouse (who statistically should outlive) or the children. And their process of decision making will most likely be very different than that of the patriarch. We can see that now, in terms of how they desire to communicate, which is increasingly less by the written word or in face to face meetings.

In year’s past, the conference had the flavor of being an investment conference. Now it has taken on the appearance of a marketing and asset allocation advice event. Many a person told me that they do not come to attend the conference and hear the speakers. Rather, they come because they have conveniently assembled in one place a large number of individuals that they have been interested either in meeting or catching up with. My friend Charles’ observation was that it was a conference of “suits” and “skirts” in the Exhibitors’ Hall. Unfortunately I have the benefit of these observations only second and third hand, as for the first part of the week I was in Massachusetts and did not get back to Chicago until late Wednesday evening. And while I could have made my way to events on Thursday afternoon and Friday morning, I have found it increasingly difficult to take the whole thing seriously as an investment information event (although it is obviously a tremendous cash cow for Morningstar). Given the tremendous success of the conference year in and year out, one increasingly wonders what the correct valuation metric is to be applied to Morningstar equity. Is it the Google of the investment and financial services world? Nonetheless, given the focus of many of the attendees on the highest margin opportunities in the investment business and the way to sustain an investment management franchise, I wonder if, notwithstanding how she said it, whether Senator Elizabeth Warren is correct when she says that “the game is rigged.”

Friday apparently saw two value-oriented investors in a small panel presenting and taking Q&A. One of those manages a fund with $20 Billion in assets, which is a larger amount of money than he historically has managed. Charging a 1% fee on that $20B, his firm is picking up $200 Million in revenue from that one fund alone, notwithstanding that they have other funds. Historically he has been more of a small-midcap manager, with a lot of special situations but not to worry, he’s finding lots of things to invest in, albeit with 40% or so in cash or cash equivalents. The other domestic manager runs two domestic funds as the lead manager, with slightly more than $24 Billion in assets, and for simplicity’s sake, let’s call it a blended rate of 90 basis points in fees. His firm is seeing than somewhat in excess of $216 Million in revenue from the two funds. Now let me point out that unless the assets collapse, these fees are recurring, so in five years, there has been a billion dollars in revenue generated at each firm, more than enough to purchase several yachts. The problem I have with this is it is not a serious discussion of the world we are in at present. Valuation metrics for stocks and bonds are at levels approaching if not beyond the two standard deviation warning bells. I suppose some of this is to be expected, as if is a rare manager who is going to tell you to keep your money. However, I would be hard pressed at this time if running a fund, to have it open. I am actually reminded of the situation where a friend sent me to her family’s restaurant in suburban Chicago, and her mother rattled off the specials of the evening, one of which was Bohemian style duck. I asked her to go ask the chef how the duck looked that night, and after a minute she came back and said, “Chef says the duck looks real good tonight.” At that point, one of the regulars at the bar started laughing and said, “What do you think? The chef’s going to say, oh, the duck looks like crap tonight?”

Now, if I could make a suggestion in Senator Warren’s ear, it would be that hearings should be held about what kind of compensation in the investment management field is excessive. When the dispersion between the lowest paid employee and the highest results in the highest compensated being paid two hundred times more than the lowest, it seems extreme. I suppose we will hear that not all of the compensation is compensation, but rather some reflects ownership and management responsibilities. The rub is that many times the so-called ownership interests are artificial or phantom.

It just strikes that this is an area ripe for reform, for something in the nature of an excess profits tax to be proposed. After all, nothing is really being created here that redounds to the benefit of the U.S. economy, or is creating jobs (and yes Virginia, carried interest for hedge funds as a tax advantage should also be eliminated).

We now face a world where the can increasingly looks like it cannot be kicked down the road financially for either Greece or Puerto Rico. And that doesn’t even consider the states like Illinois and Rhode Island that have serious underfunded pension issues, as well as crumbling infrastructures. So, I say again, there is a great deal of risk in the global financial system at present. One should focus, as an investor, in not putting any more at risk than one could afford to write off without compromising one’s standard of living. Low interest rates have done more harm than good, for both the U.S. economy and the global economy. And liquidity is increasingly a problem, especially in the fixed income markets but also in stocks. Be warned! Don’t be one of the investors who has caught the disease known as FOMO or “Fear of Missing Out.”

“Moon in a barrel: you never know just when the bottom will fall out.”

 Mabutsu

So as David Snowball mentioned in his May commentary, I have been thinking about the potential consequences of illiquidity in the fixed income market. Obviously, if you have a portfolio in U.S. Treasury issues, you assume you can turn it into cash overnight. If you can’t, that’s a potential problem. That appears to be a problem now – selling $10 or $20 million in Treasuries without moving the market is difficult. Part of the problem is there are not a lot of natural buyers, especially at these rates and prices. QE has given the Federal Reserve their fill of them. Banks have to hold them as part of the Dodd-Frank capital requirements, but are adding to their holdings only when growing their assets. And those people who always act in the best interests of the United States, namely the Chinese, have been liquidating their U.S. Treasury portfolio. Why? As they cut rates to stimulate their economy, they are trying to sterilize their currency from the effects of those rate cuts by selling our bonds, part of their foreign reserve holdings. Remember, the goal of China is to supplant, with their own currency, the dollar as a reserve currency, especially in Asia and the developing world. And our Russian friends have similarly been selling their Treasury holdings, but in that instance using the proceeds to purchase gold bullion to add to their reserves.

Who is there to buy bonds today? Bond funds? Not likely. If you are a fund manager and thought a Treasury bond was a cash equivalent, it is not. But if there are redemptions from your fund, there is a line of credit to use until you can sell securities to cover the redemptions, right? And it is a committed line of credit, so the bank has to lend on it, no worries! In the face of a full blown market panic, with the same half dozen banks in the business of providing lines of credit to the fund industry, where will your fund firm fall in the pecking order of mutual fund holding companies, all of whom have committed lines of credit? It now becomes more understandable why the mutual fund firms with a number of grey hairs still around, have been raising cash in their funds, not just because they are running out of things to invest in that meet their parameters. It also gives you a sense as to who understands their obligations to their shareholder investors.

We also saw this week, through an article in The Wall Street Journal, that there is a liquidity problem in the equity markets as well. There are trading volumes at the open. There are trading volumes, usually quite heavy, at the end of the day. The rest of the time – there is no volume and no liquidity. So if you thought you had protected yourself from another tsunami by having no position in your fund composed of more than three days average volume of a large or mega cap stock, surprise – you have again fought the last war. And heaven help you if you decide to still sell a position when the liquidity is limited and you trigger one or more parameters for the program and quant traders.

As Lenin asked, “What is to be done?” Jason Zweig, whom I regard as the Zen Philosopher King of financial columnists, wrote a piece in the WSJ on May 23, 2015 entitled “Lessons From A Buffett Believer.” It is a discussion about the annual meeting of Markel Corporation and the presentation given by its Chief Investment Officer, Tom Gayner. Gayner, an active manager, has compiled a wonderful long-term investment record. However, he also has a huge competitive advantage. Markel is a property and casualty company that consistently underwrites at a profitable combined ratio. Gayner is always (monthly) receiving additional capital to invest. He does not appear to trade his portfolio. So the investors in Markel have gotten a double compounding effect both at the level of the investment portfolio and at the corporation (book value growth). And it has happened in a tax-efficient manner and with an expense ratio in investing that Vanguard would be proud of in its index funds.

I recently was speaking with a friend in Japan, Alex Kinmont, who has compiled a very strong record as a deep value investor in the Japanese market, in particular the small cap end of the market. We were discussing the viability of a global value fund and whether it could successfully exist with an open-ended mutual fund as its vehicle. Alex reminded me of something that I know but have on occasion forgotten in semi-retirement, which is that our style of value can be out of favor for years. Given the increased fickleness today of mutual fund investors, the style may not fit the vehicle. Robert Sanborn used to say the same thing about those occasions when value was out of favor (think dot.com insanity). But Robert was an investment manager who was always willing to put the interests of his investors above the interests of the business.

Alex made another point which is more telling, which is that Warren Buffett has been able to do what is sensible in investing successfully because he has permanent capital. Not for him the fear of redemptions. Not for him the need to appear at noon on the Gong Show on cable to flog his investment in Bank America as a stroke of genius. Not for him the need to pander to colleagues or holding company managers more worried about their bonuses than their fiduciary obligations. Gayner at Markel has the same huge competitive advantage. Both of them can focus on the underlying business value of their investments over the long term without having to worry about short-term market pricing volatility.

What does this mean for the average fund investor? You have to be very careful, because what you think you are investing in is not always what you are getting. You can see the whole transformation of a fund organization if you look carefully at what Third Avenue was and how it invested ten years ago. And now look at what its portfolios are invested in with the departure of most of the old hands.

The annual Morningstar Conference happens in a few weeks here in Chicago. Steve Romick of FPA Advisors and the manager of FPA Crescent will be a speaker, both at Morningstar and at an Investment Analysts Society of Chicago event. Steve now has more than $20B in assets in Crescent. If I were in a position to ask questions, one of them would be to inquire about the consequences of style drift given the size of the fund. Another would be about fees, where the fee breakpoints are, and will they be adjusted as assets continue to be sought after.

 I believe in 2010, Steve’s colleague Bob Rodriguez did a well-deserved victory lap as a keynote speaker at Morningstar and also as well at another Investment Analysts Society of Chicago meeting. And what I heard then, both in the presentation and in the q&a by myself and others then has made me wonder, “What’s changed?” Of course, this was just before Bob was going on a year’s sabbatical, leaving the business in the hands of others. But, he said we should not expect to see FPA doing conference calls, or having a large marketing effort. And since all of their funds at that time, with the exception of Crescent, were load funds I asked him why they kept them as load funds? Bob said that that distribution channel had been loyal to them and they needed to be loyal to it, especially since it encouraged the investors to be long term. Now all the FPA Funds are no load, and they have marketing events and conference calls up the wazoo. What I suspect you are seeing is the kind of generational shift that occurs at organizations when the founders die or leave, and the children or adopted children want to make it seem like the success of the organization and the investment brilliance is solely due to them. For those of us familiar with the history of Source Capital and FPA, and the involvement of Charlie Munger, Jim Gipson, and George Michaelis, this is to say the least, disappointing.

“Life is an unbroken succession of false situations.”

                                     Thornton Wilder

Given my predilection to make reference to scenes from various movies, some of you may conclude I am a frustrated film critic. Since much that is being produced these days appears to be of questionable artistic merit, all I would say is that there would be lifetime employment (or the standards that exist for commercial success have declined). That said, an unusual Clint Eastwood movie came out in 1970. One of the more notable characters in the movie was Sergeant “Oddball” the tanker, played by Canadian actor Donald Sutherland. And one of the more memorable scenes and lines from that movie has the “Oddball” character saying  “Always with the negative waves Moriarty, always with the negative waves.”

Over the last several months, my comments could probably be viewed as taking a pessimistic view of the world and markets. Those who are familiar with my writings and thoughts over the years would not have been surprised by this, as I have always tended to be a “glass half-empty” person. As my former colleague Clyde McGregor once said of me, the glass was not only half-empty but broken and on the floor in little pieces. Some of this is a reflection of innate conservatism. Some of it is driven by having seen too many things “behind the curtain” over the years. In the world of the Mutual Fund Observer, there is a different set of rules by which we have to play, when comments are made “off the record” or a story cannot be verified from more than one source. So what may be seen as negativism or an excess of caution is driven by a journalistic inability to allow those of you would so desire, to paraphrase the New Testament, to “put your hands into the wounds.”  Underlying it all of course, as someone who finds himself firmly rooted in the camp of “value investor” is the need for a “margin of safety” in investments and adherence to Warren Buffett’s Rules Numbers One and Two for Investing. Rule Number One of course is “Don’t lose money.” Rule Number Two is “Don’t forget Rule Number One.”

So where does this leave us now? It is safe to say that it is not easy to find investments with a margin of safety currently, at least in the U.S. domestic markets. Stocks on various metrics do not seem especially undervalued. A number of commentators would argue that as a whole the U.S. market ranges from fully valued to over-valued. The domestic bond market, on historic measures does not look cheap either. Only when one looks at fixed income on a global basis does U.S. fixed income stand out when one has negative yields throughout much of Europe and parts of Asia starting to move in that direction. All of course is driven by central banks’ increasing fear of deflation. 

Thus, global capital is flowing into U.S. fixed income markets as they seem relatively attractive, assuming the strengthening U.S. currency is not an issue.  Overhanging that is the fear that later this year the Federal Reserve will begin raising rates, causing bond prices to tumble.  Unfortunately, the message from the Fed seems to be clearly mixed.  Will it be a while before rates really are increased in the U.S. , or,  will they start to raise rates in the second half of this year?  No one knows, nor should they.

As one who built portfolios on a stock by stock basis, rather than paying attention to index weightings, does this mean I could not put together a portfolio of undervalued stocks today?   I probably could but it would be a portfolio that would have a lot of energy-related and commodity-like issues in it.  And I would be looking for long-term investors who really meant it (were willing to lock up their money) for at least a five-year time horizon.  Since mutual funds can’t do that, it explains why many of the value-oriented investors are carrying a far greater amount of cash than they would like or is usual.  As an aside, let me say that in the last month, I have had more than one investment manager tell me that for the first time in their investing careers, they really were unsure as to how to deal with the current environment.

What I will leave you with are questions to ponder.  Over the years, Mr. Buffett and Mr. Munger have indicated that they would prefer to buy very good businesses at fair prices. And those businesses have traditionally been tilted towards those that did not require a lot of capital expenditures but rather threw off lots of cash with minimal capital investment requirements, and provided very high returns on invested capital. Or they had a built-in margin of safety, such as property and casualty insurance businesses where you were in effect buying a bond portfolio at a discount to book, had the benefit of investing the premium float, had a necessary product (automobile insurance) and again did not need a lot of capital investment. But now we see, with the Burlington Northern and utility company investments a different kettle of fish. These are businesses that will require continued capital investment going forward, albeit in oligopoly-like businesses with returns that may be fairly certain (in an uncertain world). Those investments will however not leave as much excess capital to be diverted into new portfolio investments as has historically been the case. There will be in effect required capital calls to sustain the returns from the current portfolio of businesses.  And, we see investments being made as joint ventures (Kraft, Heinz) with private equity managers (3G) with a very different mindset than U.S. private equity or investment banking firms. That is, 3G acquires companies to fix, improve, and run for the long term. This is not like your typical private equity firm here, which buys a company to put into a limited life fund which they will sell or take public again later.

So here are your questions to ponder?  Does this mean that the expectation for equity returns in the U.S. for the foreseeable future is at best in the low single digit range?  Are the days of the high single digit domestic long-term equity returns a thing of the past?   And, given how Buffett and Munger have positioned Berkshire now, what does this say about the investing environment?  And in a world of increased volatility (which value investors like as it presents opportunities) what does it say about the mutual fund model, with the requirement for daily pricing and liquidity?

By Edward Studzinski

“We do not have to visit a madhouse to find disordered minds; our planet is the mental institution of the universe.”          Goethe

For students of the stock market, one of the better reads is John Brooks’, The Go-Go Years.   It did a wonderful job of describing the rather manic era of the 60’s and 70’s (pre-1973). One of the arguments made then was that the older generation of money managers was out of touch with both technology and new investment ideas. This resulted in a youth movement on Wall Street, especially in the investment management firms. You needed to have a “kid” as a portfolio manager, which was taken to its logical conclusion in a cartoon which showed an approximately ten-year old sitting behind a desk, looking at a Quotron machine. Around 2000, a similar youth movement came along during the dot.com craze, where once again investment managers, especially value managers, were told that their era was over, that they didn’t understand the new way and new wave of investing. Each of those two eras ended badly for those who had entrusted their assets to what was in vogue at the time.

In 2008, we had a period of over-valuation in the markets that was pretty clear in terms of equities. We also had what appears in retrospect to have been the deliberate misrepresentation and marketing of certain categories of fixed income investments to those who should have known better and did not. This resulted in a market meltdown that caused substantial drawdowns in value for many equity mutual funds, in a range of forty to sixty per cent, causing many small investors to panic and suffer a permanent loss of capital which many of them could not afford nor replace. The argument of many fund managers who had invested in their own funds (and as David has often written about, many do not), was that they too had skin in the game, and suffered the losses alongside of their investors.

Let’s run some simple math. Assume a fund management firm that at 2/27/2015 has $100 billion in assets under management. Assets are equities, a mix of international and domestic, the international with fees and expenses of 1.30% and the domestic with fees and expenses of 0.90%. Let’s assume a 50/50 international/domestic split of assets, so $50 billion at 0.90% and $50 billion at 1.30%. This results in $1.1billion in fees and expenses to the management company. Assuming $300 million goes in expenses to non-investment personnel, overhead, and the other expenses that you read about in the prospectus, you could have $800 million to be divided amongst the equity owners of the management firm. In a world of Marxian simplicity, each partner is getting $40 million dollars a year. But, things are often not simple if we take the PIMCO example. Allianz as owners of the firm, having funded through their acquisitions the buy-out of the founders, may take 50% of profits or revenues off the top. So, each equal-weighted equity owner may only be getting paid $20 million a year. Assets under management may go down with the market sell-off so that fees going forward go down. But it should be obvious that average mutual fund investors are not at parity with the fund managers in risk exposure or tolerance.

Why am I beating this horse into the ground again? U.S. economic growth for the final quarter was revised down from the first reported estimate of 2.6% to 2.2%. More than 440 of the companies in the S&P 500 index had reported Q4 numbers by the end of last week showed revenue growth of 1.5% versus 4.1% in the previous quarter. Earnings increased at an annual rate that had slowed to 5.9% from 10.4% in the previous quarter. Earnings downgrades have become more frequent. 

Why then has the market been rising – faith in the Federal Reserve’s QE policy of bond repurchases (now ended) and their policy of keeping rates low. Things on the economic front are not as good as we are being told. But my real concern is that we have become detached from thinking about the value of individual investments, the margin of safety or lack thereof, and our respective time horizons and risk tolerances. And I will not go into at this time, how much deflation and slowing economies are of concern in the rest of the world.

Look at the energy sector, where the price of oil has come down more than 50% since the 2014 high. Each time we see a movement in the price of oil, as well as in the futures, we see swings in the equity prices of energy companies. Should the valuations of those companies be moving in sync with energy prices, and are the balance sheets of each of those companies equal? No, what you are seeing is the algorithmic trading programs kicking in, with large institutional investors and hedge funds trying to grind out profits from the increased volatility. Most of the readers of this publication are not playing the same game. Indeed they are unable to play that game. 

So I say again, focus upon your time horizons and risk tolerance. If your investment pool represents the accumulation of your life’s work and retirement savings, your focus should be not on how much you can make but rather how much you can afford to lose. As the U.S. equity market has continued to hit one record high after another,  recognize that it is getting close to trading at nearly thirty times long-term, inflation-adjusted earnings. In 2014, the S&P 500 did not fall for more than three consecutive days.

We are in la-la land, and there is little margin for error in most investment opportunities. On January 15, 2015, when the Swiss National Bank eliminated its currency’s Euro-peg, the value of that currency moved 30% in minutes, wiping out many currency traders in what were thought to be low-risk arbitrage-like investments. 

What should this mean for readers of this publication? We at MFO have been looking for absolute value investors. I can tell you that they are in short supply. Charlie Munger had some good advice recently, which others have quoted and I will paraphrase. Focus on doing the easy things. Investment decisions or choices that are complex, and by that I mean things that include shorting stocks, futures, and the like – leave that to others. One of the more brilliant value investors and a contemporary of Benjamin Graham, Irving Kahn, passed away last week. He did very well with 50% of his assets in cash and 50% of his assets in equities. For most of us, the cash serves as a buffer and as a reserve for when the real, once in a lifetime, opportunities arise. I will close now, as is my wont, with a quote from a book, The Last Supper, by one of the great, under-appreciated American authors, Charles McCarry. “Do you know what makes a man a genius? The ability to see the obvious. Practically nobody can do that.”

Imagine the Creator as a low comedian, and at once the world becomes explicable.     H.L. Mencken

January 2015 has perhaps not begun in the fashion for which most investors would have hoped. Instead of continuing on from last year where things seemed to be in their proper order, we have started with recurrent volatility, political incompetence, an increase in terrorist incidents around the world, currency instability in both the developed and developing markets, and more than a faint scent of deflation creeping into the nostrils and minds of central bankers. Through the end of January, the Dow, the S&P 500, and the NASDAQ are all in negative territory. Consumers, rather than following the lead of the mass market media who were telling them that the fall in energy prices presented a tax cut for them to spend, have elected to save for a rainy day. Perhaps the most unappreciated or underappreciated set of changed circumstances for most investors to deal with is the rising specter of currency wars.

So, what is a currency war? With thanks to author Adam Chan, who has written thoughtfully on this subject in the January 29, 2015 issue of The Institutional Strategist, a currency war is usually thought of as an effort by a country’s central bank to deliberately devalue their currency in an effort to stimulate exports. The most recent example of this is the announcement a few weeks ago by the European Central Bank that they would be undertaking another quantitative easing or QE in shorthand. More than a trillion Euros will be spent over the next eighteen months repurchasing government bonds. This has had the immediate effect of producing negative yields on the market prices of most European government bonds in the stronger economies there such as Germany. Add to this the compound effect of another sixty billion Yen a month of QE by the Bank of Japan going forward. Against the U.S. dollar, those two currencies have depreciated respectively 20% and 15% over the last year.

We have started to see the effects of this in earnings season this quarter, where multinational U.S. companies that report in dollars but earn various streams of revenues overseas, have started to miss estimates and guide towards lower numbers going forward. The strong dollar makes their goods and services less competitive around the world. But it ignores another dynamic going on, seen in the collapse of energy and other commodity prices, as well as loss of competitiveness in manufacturing.

Countries such as the BRIC emerging market countries (Brazil, Russia, India, China) but especially China and Russia, resent a situation where the developed countries of the world print money to sustain their economies (and keep the politicians in office) by purchasing hard assets such as oil, minerals, and manufactured goods for essentially nothing. For them, it makes no sense to allow this to continue.

The end result is the presence in the room of another six hundred pound gorilla, gold. I am not talking about gold as a commodity, but rather gold as a currency. Note that over the last year, the price of gold has stayed fairly flat while a well-known commodity index, the CRB, is down more than 25% in value. Reportedly, former Federal Reserve Chairman Alan Greenspan supported this view last November when he said, “Gold is still a currency. “ He went on to refer to it as the “premier currency.” In that vein, for a multitude of reasons, we are seeing some rather interesting actions taking place around the world recently by central banks, most of which have not attracted a great deal of notice in this country.

In January of this year, the Bundesbank announced that in 2014 it repatriated 120 tons of its gold reserves back to Germany, 85 tons from New York and the balance from Paris. Of more interest, IN TOTAL SECRECY, the central bank of the Netherlands repatriated 122 tons of its gold from the New York Federal Reserve, which it announced in November of 2014. The Dutch rationale was explained as part of a currency “Plan B” in the event the Netherlands left the Euro. But it still begs the question as to why two of the strongest economies in Europe would no longer want to leave some of their gold reserves on deposit/storage in New York. And why are Austria and Belgium now considering a similar repatriation of their gold assets from New York?

At the same time, we have seen Russia, with its currency under attack and not by its own doing or desire as a result of economic sanctions. Putin apparently believes this is a deliberate effort to stimulate unrest in Russia and force him from power (just because you are paranoid, it doesn’t mean you are wrong). As a counter to that, you see the Russian central bank being the largest central bank purchaser of gold, 55 tons, in Q314. Why? He is interested in breaking the petrodollar standard in which the U.S. currency is used as the currency to denominate energy purchases and trade. Russia converts its proceeds from the sale of oil into gold. They end up holding gold rather than U.S. Treasuries. If he is successful, there will be considerably less incentive for countries to own U.S. government securities and for the dollar to be the currency of global trade. Note that Russia has a positive balance of trade with most of its neighbors and trading partners.

Now, my point in writing about this is not to engender a discussion about the wisdom or lack thereof in investing in gold, in one fashion or another. The students of history among you will remember that at various points in time it has been illegal for U.S. citizens to own gold, and that on occasion a fixed price has been set when the U.S. government has called it in. My purpose is to point out that there have been some very strange doings in asset class prices this year and last. For most readers of this publication, since their liabilities are denominated in U.S. dollars, they should focus on trying to pay those liabilities without exposing themselves to the vagaries of currency fluctuations, which even professionals have trouble getting right. This is the announced reason, and a good one, as to why the Tweedy, Browne Value Fund and Global Value Fund hedge their investments in foreign securities back into U.S. dollars. It is also why the Wisdom Tree ETF’s which are hedged products have been so successful in attracting assets. What it means is you are going to have to pay considerably more attention this year to a fund’s prospectus and its discussion of hedging policies, especially if you invest in international and/or emerging market mutual funds, both equity and fixed income.

My final thoughts have to do with unintended consequences, diversification, and investment goals and objectives. The last one is most important, but especially this year. Know yourself as an investor! Look at the maximum drawdown numbers my colleague Charles puts out in his quantitative work on fund performance. Know what you can tolerate emotionally in terms of seeing a market value decline in the value of your investment, and what your time horizon is for needing to sell those assets. Warren Buffett used to speak about evaluating investments with the thought as to whether you would still be comfortable with the investment, reflecting ownership in a business, if the stock market were to close for a couple of years. I would argue that fund investments should be evaluated in similar fashion. Christopher Browne of Tweedy, Browne suggested that you should pay attention to the portfolio manager’s investment style and his or her record in the context of that style. Focus on whose record it is that you are looking at in a fund. Looking at Fidelity Magellan’s record after Peter Lynch left the fund was irrelevant, as the successor manager (or managers as is often the case) had a different investment management style. THERE IS A REASON WHY MORNINGSTAR HAS CHANGED THEIR METHODOLOGY FROM FOLLOWING AND EVALUATING FUNDS TO FOLLOWING AND EVALUATING MANAGERS.

Diversification is another key issue to consider. Outstanding Investor Digest, in Volume XV, Number 7, published a lecture and Q&A with Philip Fisher that he gave at Stanford Business School. If you don’t know who Philip Fisher was, you owe it to yourself to read some of his work. Fisher believed strongly that you had achieved most of the benefits of risk reduction from diversification with a portfolio of from seven to ten stocks. After that, the benefits became marginal. The quote worth remembering, “The last thing I want is a lot of good stocks. I want a very few outstanding ones.” I think the same discipline should apply to mutual fund portfolios. You are not building an investment ark, where you need two of everything.

Finally, I do expect this to be a year of unintended consequences, both for institutional and individual investors. It is a year (but the same applies every year) when predominant in your mind should not be, “How much money can I make with this investment?” which is often tied to bragging rights at having done better than your brother-in-law. The focus should be, “How much money could I lose?” And my friend Bruce would ask if you could stand the real loss, and what impact it might have on your standard of living? In 2007 and 2008, many people found that they had to change their standard of living and not for the better because their investments were too “risky” for them and they had inadequate cash reserves to carry them through several years rather than liquidate things in a depressed market.

Finally, I make two suggestions. One, the 2010 documentary on the financial crisis by Charles Ferguson entitled “Inside Job” is worth seeing and if you can’t find it, the interview of Mr. Ferguson by Charlie Rose, which is to be found on line, is quite good. As an aside, there are those who think many of the most important and least watched interviews in our society today are conducted by Mr. Rose, which I agree with and think says something about the state of our society. And for those who think history does not repeat itself, I would suggest reading volume I, With Fire and Sword of the great trilogy of Henryk Sienkiewicz about the Cossack wars of the Sixteenth Century set in present day Ukraine. I think of Sienkiewicz as the Walter Scott of Poland, and you have it all in these novels – revolution and uprising in Ukraine, conflict between the Polish-Lithuanian Commonwealth and Moscow – it’s all there, but many, many years ago. And much of what is happening today, has happened before.

I will leave you with a few sentences from the beginning pages of that novel.

It took an experienced ear to tell the difference between the ordinary baying of the wolves and the howl of vampires. Sometimes entire regiments of tormented souls were seen to drift across the moonlit Steppe so that sentries sounded the alarm and garrisons stood to arms. But such ghostly armies were seen only before a great war.

By Edward Studzinski

The Mountains are High, and the Emperor is Far, Far Away

Chinese Aphorism

Year-end 2014 presents investors with a number of interesting conundrums. For a U.S. dollar investor, the domestic market, as represented by the S&P 500, provided a total return of 13.6%, at least for those invested in it by the proxy of Vanguard’s S&P 500 Index Fund Admiral Shares. Just before Christmas, John Authers of the Financial Times, in a piece entitled “Investment: Loser’s Game” argued that this year, with more than 90% of active managers on track to underperform their benchmarks, a tipping point may have finally been reached. The exodus of money from actively managed funds has accelerated. Vanguard is on track to take in close to $200B (yes, billion) into its passive funds this year.

And yet, I have to ask if it really matters. As I watch the postings on the Mutual Fund Observer’s discussion board, I suspect that achieving better than average investment performance is not what motivates many of our readers. Rather, there is a Walter Mittyesque desire to live vicariously through their portfolios. And every bon mot that Bill (take your pick, there are a multitude of them) or Steve or Michael or Bob drops in a print or televised interview is latched on to as a reaffirmation the genius and insight to invest early on with one of The Anointed. The disease exists in a related form at the Berkshire Hathaway Annual Circus in Omaha. Sooner or later, in an elevator or restaurant, you will hear a discussion of when that person started investing with Warren and how much money they have made. The reality is usually less that we would like to know or admit, as my friend Charles has pointed out in his recent piece about the long-term performance of his investments.

Rather than continuing to curse the darkness, let me light a few candles.

1. When are index funds appropriate for an investment program? For most of middle America, I am hard pressed to think of when they are not. They are particularly important for those individuals who are not immortal. You may have constructed a wonderful portfolio of actively-managed funds. Unfortunately, if you pass away suddenly, your spouse or family may find that they have neither the time nor the interest to devote to those investments that you did. And that assumes a static environment (no personnel changes) in the funds you are invested in, and that the advisors you have selected, if any, will follow your lead. But surprise – if you are dead, often not at the time of your choice, you cannot control things from the hereafter. Sit in trust investment committee meetings as I did for many years, and what you will most likely hear is – “I don’t care what old George wanted – that fund is not on our approved list and to protect ourselves, we should sell it, regardless of its performance or the tax consequences.”
2. How many mutual funds should one own? The interplay here is diversification and taxes. I suspect this year will prove a watershed event as investors find that their actively-managed fund has generated a huge tax bill for them while not beating its respective benchmark, or perhaps even losing money. The goal should probably be to own fewer than ten in a family unit, including individual and retirement investments. The right question to ask is why you invested in a particular fund to begin with. If you can’t remember, or the reason no longer applies, move on. In particular, retirement and 401(k) assets should be consolidated down to a smaller number of funds as you get older. Ideally they should be low cost, low expense funds. This can be done relatively easily by use of trustee to trustee transfers. And forget target date funds – they are a marketing gimmick, predicated on life expectancies not changing.
3. Don’t actively managed funds make sense in some circumstances? Yes, but you really have to do a lot of due diligence, probably more than most investment firms will let you do. Just reading the Morningstar write-ups will not cut it. I think there will be a time when actively-managed value funds will be the place to be, but we need a massive flush-out of the industry to occur first, followed by fear overcoming greed in the investing public. At that point we will probably get more regulation (oh for the days of Franklin Roosevelt putting Joe Kennedy in charge of the SEC, figuring that sometimes it makes sense to have the fox guarding the hen house).
4. Passive funds are attractive because of low expenses, and the fact that you don’t need to worry about managers departing or becoming ill. What should one look for in actively-managed funds? The simple answer is redundancy. Dodge and Cox is an ideal example, with all of their funds managed by reasonably-sized committees of very experienced investment personnel. And while smaller shops can argue that they have back-up and succession planning, often that is marketing hype and illusion rather than reality. I still remember a fund manager more than ten years ago telling me of a situation where a co-manager had been named to a fund in his organization. The CIO told him that it was to make the Trustees happy, giving the appearance of succession planning. But the CIO went on to say that if something ever happened to lead manager X, co-manager Y would be off the fund by sundown since Y had no portfolio management experience. Since learning such things is difficult from the outside, stick to the organizations where process and redundancy are obvious. Tweedy, Browne strikes me as another organization that fits the bill. Those are not meant as recommendations but rather are intended to give you some idea of what to look for in kicking tires and asking questions.

A few final thoughts – a lot of hedge funds folded in 2014, mainly for reasons of performance. I expect that trend to spread to mutual funds in 2015, especially those that are at best marginally profitable. Some of this is a function of having the usual acquiring firms (or stooges, as one investment banker friend calls them) – the Europeans – absent from the merger and acquisition trail. Given the present relationship of the dollar and the Euro, I don’t expect that trend to change soon. But I also expect funds to close just because the difficulty of outperforming in a world where events, to paraphrase Senator Warren, are increasingly rigged, is almost impossible. In a world of instant gratification, that successful active management is as much an art as a science should be self-evident. There is something in the process of human interaction which I used to refer to as complementary organizational dysfunction that produces extraordinary results, not easily replicable. And it involves more than just investment selection on the basis of reversion to the mean.

One example of genius would be Thomas Jefferson, dining alone, or Warren Buffet, sitting in his office, reading annual reports.  A different example would be the 1927 Yankees or the Fidelity organization of the 1980’s. In retrospect what made them great is easy to see. My advice to people looking for great active management today – look for organizations without self-promotion, where individuals do not seek out to be the new “It Girl” and where the organizations focus on attracting curious people with inquiring but disciplined minds, so that there ends up being a creative, dynamic tension. Avoid organizations that emphasize collegiality and consensus. In closing, let me remind you of that wonderful scene where Orson Welles, playing Harry Lime in The Third Man says,

… in Italy for 30 years under the Borgias they had warfare, terror, murder, and bloodshed, but they produced Michelangelo, Leonardo da Vinci, and the Renaissance. In Switzerland they had brotherly love – they had 500 years of democracy and peace, and what did they produce? The cuckoo clock.

“The most costly of all follies is to believe passionately in the palpably not true.  It is the chief occupation of mankind.”

          H.L. Mencken

I will apologize in advance, for this may end up sounding like the anti-mutual fund essay. Why do people invest, and specifically, why do they invest in mutual funds?  The short answer is to make money. The longer answer is hopefully more complex and covers a multitude of rationales. Some invest for retirement to maintain a standard of living when one is no longer working full-time, expecting to achieve returns through diversified portfolios and professional management above and beyond what they could achieve by investing on their own. Others invest to meet a specific goal along the path of life – purchase a home, pay for college for the children, be able to retire early. Rarely does one hear that the goal of mutual fund investing is to become wealthy. In fact, I can’t think of any time I have ever had anyone tell me they were investing in mutual funds to become rich. Indeed if you want to become wealthy, your goal should be to manage a mutual fund rather than invest in one. 

How has most of the great wealth been created in this country? It has been created by people who started and built businesses, and poured themselves (and their assets) into a single-minded effort to make those businesses succeed, in many instances beyond anyone’s wildest expectations. And at some point, the wealth created became solidified as it were by either selling the business (as the great philanthropist Irving Harris did with his firm, Toni Home Permanents) or taking it public (think Bill Gates or Jeff Bezos with Microsoft and Amazon). And if one goes further back in time, the example of John D. Rockefeller with the various Standard Oil companies would loom large (and now of course, we have reunited two of those companies, Standard Oil Company of New Jersey aka Exxon and Standard Oil Company of New York aka Mobil as Exxon-Mobil, but I digress).

So, this begs the question, can one become wealthy by investing in a professionally-managed portfolio of securities, aka a mutual fund? The answer is – it depends. If one wants above-average returns and wealth creation, one usually has to concentrate one’s investments. In the mutual fund world you do this by investing in a concentrated or non-diversified fund. The conflict comes when the non-diversified fund grows beyond a certain size of assets under management and number of investments.  It then morphs from an opportunistic investment pool into a large or mega cap investment pool. The other problem arises with the unlimited duration of a mutual fund. Daily fund pricing and daily fund flows and redemptions do have a cost. For those looking for a real life example (I suspect I know the answer but I will defer to Charles to provide the numbers in next month’s MFO), contrast the performance over time of the closed-end fund, Source Capital (SOR) run by one of the best value investment firms, First Pacific Advisors with the performance over time of the mutual funds run by the same firm, some with the same portfolio managers and strategy. 

The point of this is that having a fixed capital structure lessens the number of issues with which an investment manager has to deal (focus on the investment, not what to do with new money or what to sell to meet redemptions). If you want a different real life example, take a look at the long-term performance of one of the best investment managers to come out of Harris Associates, whom most of you have never heard of, Peter B. Foreman, and his partnership Hesperus Partners, Ltd.

Now the point of this is not to say that you cannot make money by investing in a mutual fund or a pool of mutual funds. Rather, as you introduce more variables such as asset in-flows, out-flows, pools of analysts dedicated to an entire fund group rather than one investment product, and compensation incentives or disincentives, it becomes harder to generate consistent outperformance. And if you are an individual investor who keeps increasing the number of mutual funds that he or she has invested in (think Noah and the Ark School of Personal Investment), it becomes even more difficult

A few weeks ago it struck me that in the early 1980’s, when I figured out that I was a part of the sub-species of investor called value investor (not “value-oriented investor” which is a term invented by securities lawyers for securities lawyers), I made my first investment in Berkshire Hathaway, Warren Buffett’s company. That was a relatively easy decision to make back then. I recently asked my friend Greg Jackson if he could think of a handful of investments, stocks like Berkshire (which has in effect been a closed-end investment portfolio) that today one could invest in that were one-decision investments. Both of us are still thinking about the answer to that question. 

Has something changed in the world in investing in the last fifteen or twenty years? Yes, it is a different world, in terms of information flows, in terms of types of investments, in terms of derivatives, in terms of a variety of things. What it also is is a different world in terms of time horizons and patience.  There is a tremendous amount of slippage that can eat into investment returns today in terms of trading costs and taxes (even at capital gains rates). And as a professional investment manager you have lots of white noise to deal with – consultants, peer pressure both internal and external, and the overwhelming flow of information that streams by every second on the internet. Even sitting in Omaha, the net of modern communications still drops over everything. 

So, how does one improve the odds of superior long-term performance? One has to be prepared to step back and stand apart. And that is increasingly a difficult proposition. But the hardest thing to do as an investment manager, or in dealing with one’s own personal portfolio, is to sometimes just do nothing. And yes, Pascal the French philosopher was right when he said that most of men’s follies come from not being able to sit quietly in one room. Even more does that lesson apply to one’s investment portfolio. More in this vein at some future date, but those are the things that I am musing about now.