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Monday, November 20, 2017

This is Not good For Investors


A Tax Provision That Would Exempt Mutual-Fund Firms but Not Individuals

Mutual funds now exempted from proposal changing tax rules for some share sales

The provision would prevent investors from minimizing taxes, when they sell part of a position, by choosing the specific shares being sold. Instead, investors would have to sell their oldest shares first.
As first proposed, the change would have applied to fund companies as well as individuals.
But senators exempted fund firms after some of the largest ones, including Vanguard Group and Eaton Vance Corp. EV 0.56% protested by saying the proposed change would tie their portfolio managers’ hands, make markets less efficient, and raise taxes on investors. 
If the change is enacted for individual investors, “it will take tax planning out of the hands of investors and advisers,

Interestingly it will take a big hole out of the marketing proposition of the robo advisors who make their tax loss harvesting a major part of their sell:

It would also affect firms like Parametric Portfolio Associates, a unit of Eaton Vance, and online financial advisers Betterment LLC, and Wealthfront Inc. These firms offer computerized tax-efficient investing strategies to individuals that typically use sales of specific groups of shares, or lots, to help boost after-tax returns.
It's rather amazing to me that the fund companies would lobby in their own interest but not in the interest of their clients. Could it be that they care more about juicing their returns and attacting assets rather than their clients after tax returns. Also this exemption will almost exclusively affect active fund managers since they do so much trading and would be keeping track of tax lots. I am not sure even this would apply to ETFs and even if it did , since they do little of such trading the impact would be minimal.
An explanation from the WSJ
Although the change would no longer affect securities sold by managers of active or passive mutual funds and exchange-traded funds, it would affect individuals who sell part of their investment in such funds.
Here’s how. Say an investor owns two lots of a sector fund bought at different prices, and they are in a taxable account rather than a tax-deferred retirement account. If the fund is trading at $90 per share now, each one acquired five years ago for $65 would have a $25 taxable gain.
But each share bought two years ago for $110 would have a $20 loss.
Under current law, investors can choose which fund shares to part with. So selling the ones that cost $110 would produce a loss to offset other gains, while selling the ones that cost $65 would produce a taxable gain.
If the provision is enacted, the first shares sold would be assumed to have a cost of $65 each, and the investor couldn’t sell the $110 shares until the $65 shares were gone.

Saturday, November 18, 2017

"Shooting Stars"

I have written several times about "shooting star" stocks. Small cap stocks. usually producing a very popular consumer product.Investors assume that because "everyone is buying/wearing the product: the stock is a good investment. In a classic behavioral finance flaw, investors extrapolate the performance into the future making the valuation very high and any earnings disappointment likely to trigger a sharp decline.

Some classic examples of this have been crocs:

Deckers, the manufacturer of UGG boots (remember those), The chat is 50% below its high.

Right now the classic example is Underarmour.(UA) They had much success with some niche products in football equipment and football shoes, But those products contained no technology that could be easily copied.which it was and when Nikes marketing machine gor behind their competing product Underarmour couldn't keep up. The company ventured into other types of atheletic/leisrue shoes against the "big boys", Addidas and Nike it was left in the dust.

Another stock I would call at this point a "mini shooting star" is Lululemon (Lulu) with its premium priced yoga wear sold exclusively through its own stores. Their formula has already been copied by Athleta and its efforts in men's products have had little success.

So far it recovered from a mega selloff but is still 30% below its high. And the 50% selloff in 2014 followed by the huge runup shows how sensitive the stock is to earnings disappointments.

Will LULU experience a fate similar to UA. I certainly don't know. But I do know that the big guns of NIKE are aimed right at lulumenon's target market. (BLOOMBERG)

Nike Coming for Lululemon, Sharpens Focus on Women's Wear

  • Company is also refocusing on innovating in women’s gear
Nike Inc. is increasing investments in yoga pants and sports bras as part of a quest to revive growth, intensifying its battle with Lululemon Athletica Inc. for women.
Nike will open pant studios in 5,000 stores on Nov. 1 to highlight new styles for workouts and leisure, the company said in supplemental documents to an investor presentation on Wednesday. A presence in thousands of stores would dwarf the footprint of Lululemon, which helped turn yoga and fitness gear into everyday attire. It has 421 locations, mostly in the U.S. and Canada. Even after the drop LULU is at a p/e of  32. well above the p/e just below 26.

Regardless of what happens to LULU in the future the takeaway is clear. Stocks that have a high public presence because "everyone is buying it" or there is always a line probably don't make a good investment. Of all the categories of stocks across the style box (large cap growth, large value, small growth and small value). Small growth the "sexiest category" have the worst risk/return.

One more in the shooting star category in the restaurant category. Chipotle (remember the rapid expansion and lines out the door at that one ?)

And a possible shooting star: Shake Shack which went public in December of 2017 and last I saw in NY and  Los Angeles had lines out the door and is still adding locations rapidly. One thing for sure it has been a roller coaster since the ipo. I'm not sure many investors would have had the resilience to hang on as the stock fell close to 50%  Shake Shack trades at at p/e of a 65.

Bottom line: not a good idea to pick stocks based on 'there's always a line out the door' or "everyone is wearing them".

Wednesday, November 15, 2017

No End to Things Like This I Can Find


Are High-Yield Bonds the Canary in the Coal Mine?

Junk-bond indexes have hit a rough patch, even as the U.S. stocks are at record highs

WSJ  November 14

High-Yield Canary Isn’t Singing About Markets Doom

The selloff, mainly confined to telecoms and lower-rated bonds, should be put into perspective, investors say

CNBC November 15

Closing Bell Exchange: High-yield the canary in the coal mine?

Discussing the current state of the markets with Beth Lilly, Crocus Hill Partners; Keith Bliss, Cuttone & Co.; and CNBC’s Rick Santelli.

Saturday, November 11, 2017

Hard to See Why Anyone Would Buy This Fund

Seems that only a few years after their launch the robo advisors who advocated simple long term investing with stable portfolios managed with tax harvesting and rebalancing are doing exactly what they preached that investors not do..abandon the long term strategy and move into something else.

Betterment has launched its "indexing 2.0" which uses a proprietary model (no clear data presented) making use of smart beta strategy that it claims will deliver better than market risk adjusted returns. Seems that "hope springs eternal" and Betterment perhaps looking at the short term performance of their portfolios felt the need to offer something else. As I noted even if one were to incorporate a smart beta element to portfolios there are less expensive and more transparent ways to do it.

Wealthfront has gone even further announcing a mutual fund that is anything but a simple asset class low cost allocation From  Financial Planning

The firm filed with the SEC Wednesday for what it calls the Wealthfront Risk Parity Fund. The derivatives fund would invest in global developed and emerging market equities, global developed and emerging markets fixed income, real estate investment trusts and commodities.

It is true that the fund only has a management fee of .51% vs. the more common fees of hedge funds that use such strategies which are in the area of 2% management fee and 2% of the profits....

But even taking into account those fees, hedge funds have been terrible at beating simple index portfolios. Given Wealthfront's short tenure as a firm and zero experience in managing's not clear to me whether the fact that the strategy is now available to investors with not minimum is a good thing. More likely they should take advantage of the price wars in ETFs where a straightforward well allocated portfolio can be constructed for less than .10%

Financial Planning adds:

The SEC filing notes that “the fund is not suitable for all investors,” but instead only for those “who (a) understand the risks associated with the use of derivatives, (b) are willing to assume a high degree of risk, and (c) intend to actively monitor and manage their investments in the fund.”

In other words after offering plain and simple as the best path to investors Wealthfront offers a mutual fund with no minimums that is anything but simple.

Thursday, November 9, 2017

An Expensive Year for Holders of Actively Managed Mutual Funds

It is a well known fact that actively managed mutual funds can be painful for individual investors since they pass on any capital gains to the fundholder..regardless of how much of that gain occurred when the investor held the fund. If the fund has a 50% gain on a stock that it has held for 5 years and sells it you owe tax on the capital gain of the fund even if you have only owned the fund for 5 months. And actively managed funds move in and out of individual stocks and need to sell stocks to raise cash for redemptions if they dont have cash on hand. An index fund does few trades and the situation for ETFs with regards to meeting shareholder inflows or outflows are totally different . As explained here :

A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment. In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying structure. 

The net effect is that the return of a fund you own (or whose performance you see listed) is significantly higher than the after tax return for someone that owns the fund,

This year has been a particularly painful one for owners of actively managed mutual funds, As the WSJ notes this has been a very good year for stocks..but it also has been a very big one for investors "getting the message" and moving from actively managed funds to ETFs and index funds. Those outflows mean the fund manager must sell stock to meet the cash needs...and those sales generate taxable gains passed on to the individual investor...and some of those may even be short term capital gains taxed at the same rate as ordinary income. And it seems active managers are no better than individuals in deciding what to seems they sell winners and hold on to losers...hoping the losers will "come back" and in the process generating a greater tax bill than if they had sold losers or at least made an attempt to match sales of winners to sales of losers to reduce the tax bill (and rebalance their portfolios at the same time.

from the WSJ

There are two forces at work here: The S&P 500 index has gained more than 17% this year, and some sectors are up even more—the type of performance that tends to lead many fund managers to cash in winning stocks to lock in gains. At the same time, as investors continue to shift out of actively managed funds and into passively managed index funds in droves, they made net withdrawals of nearly $240 billion from active U.S. equity funds in the 12 months through Sept. 30, according to Morningstar Inc., causing managers of those funds to sell winners to meet redemption requests.,,,

As of Nov. 5, more than 249 mutual funds are anticipating making capital-gains payouts to shareholders of more than 10% of their net asset values, says Mark Wilson, president of MILE Wealth Management in Irvine, Calif., who tracks mutual funds’ estimates of their capital-gains payouts and posts them on his website, Just 114 funds made distributions of more than 10% in all of last year, he says.

Not only are the numbers for some distributions eye popping some of the results are ironic

Some surprises
Among the surprise distributions this year are payouts anticipated by the JPMorgan Tax Aware Equity fund (JPEAX) and the PNC S&P 500 Index fund (PIIAX). The Tax Aware Equity fund estimates a payout of 8.9% this year, which is surprising since the fund is supposed to manage its portfolio to reduce capital-gains payouts, says Ms. Benz. J.P. Morgan Asset Management declined to comment.
The PNC S&P 500 Index fund is estimating a payout of more than 22%, according to PNC Funds’ website. It’s “an unusual dynamic” to see index funds make such a hefty distribution, says Mr. Wilson, because their holdings typically don’t change often. A spokeswoman for PNC Financial Services Group Inc. declined to comment
The explanation I could see for the latter fund is that some investors realized that paying a .45% management fee for an S+P 500 index instrument when it can be for basically zero elsewhere was a good reason to sell. This meant the fund needed to sell assets...and generate capital gains distributions

Tuesday, October 31, 2017

Morningstar vs. The Wall Street Journal...Does It Really Matter ? Not in My Opinion

The WSJ recently had a lengthy article critical of Morningstar and the use of its star ratings. It found the lack of persistency in the star ratings, the use by some advisors of the star ratings as a shortcut in justifying fund recommendations to clients, and the use of fund ratings by mutual fund companies to tout their funds.

This sparked a series of fevered responses by Morningstar here and here and here
For instance one argument by Morningstar's CEO is
  • The Journal sees little predictive value in the star rating, but the results show that investors were far likelier to succeed with 4- and 5-star funds over subsequent periods and much more likely to fail with 1- and 2-star funds, on average.
Morningstar also stresses that the ratings "should be used as a starting point" for research.

I could go though and analyze all the back and forth between Morningstar and the WSJ over the star system. But in fact with regards to actually choosing an investment strategy the star system is irrelevant...because it is fundamentally a rating system among actively managed funds (usually how well they do against the relevant index) and actively managed funds should be eschewed in favor of index funds or ETFs.

In the WSJ vs. Morningstar "smackdown They are simply debating a syatem that ranks a a group of investments that should be avoided.

In fact to be fair to Morningstar if you dig down Morningstar often  has some pretty good things to say about indexing and authors that recommend portfolios often make heavy use of index funds. And if you dig even further you will find Morningstar authors stating that the best predictor of future fund performance is the level of fees (not those star ratings). The message is somewhat buried of course because Morningstar's core business is ranking actively managed funds. Telling everyone to forget 90%+ of the funds they rank and just index wouldn't be very good for business.

One author that constantly shows a bias towards indexing is John Rekenthaler who writes on the morningstar advisor website aimed at professionals. In fact in his most recent column he writes
Two weeks back, Barry Ritholtz of Ritholtz Asset Management and Nir Kaissar, a Bloomberg columnist, discussed the merits of active versus passive investing. The debate's outcome was a foregone conclusion; these days, few if any investment writers wholeheartedly support active management. They either recommend passive investing fully or they advocate blending the two approaches, typically by starting with a core of passive investments and then adding active funds as desired.

But Rekenthaller was also on the warpath with the WSJ on the main consumer website with no mention of the indexing alternative and plenty of arguments on how to evaluate the star rating system. The article was enttled Statistical illusions But there is one set of statistics most important to investors that are not an illusion..they should avoid actively managed mutual funds...period/

Just as there is little or no persistency in the star ratings for the actively managed funds it should not be surprising  there is no persistency of returns in actively managed funds vs their relevant index. In fact the only reliable statement that can be made about actively managed funds is that the vast majority of them will fail to outperform their relevant indices.

I didn't even realize how terrible the record is until the always excellent blogger Ben Carlson posted this chart (click to enlarge)

In sum the debate over the efficacy of Morningstar ratings is a case of "looking for the keys under the lamplight". If you are looking for the best choices for your investments then active funds are not the place to look.

Does that mean Morningstar is useless ?...not really if you use their material correctly. Don't even look at the star ratings, don't even look at the actively managed funds. But Morningstar includes a wealth of data about ETFs which can be used for research.  With hundreds of ETFs including multiple ones in basic categories like small cap value Morningstar can offer a valuable tool. I do think the difference in long term performance among ETFs within as market sector can be relevant to an asset allocation. In addition the Morningstar analysis allows one to drill down on the holdings and methodology of the ETF. Very useful data on individual ETFs is also available at ETF,com. So the investor can do some very useful research on various index instruments within categories in Morningstar.

Morningstar has an additional very useful tool I believe in only its premium service. It is something called stock overlap. It is a tool that allows one to analyze an entire portfolio with regards to data such as geographic and industry distribution, p/e, market cap  and percentage of an individual stock in a portfolio. For example since Apple has a high weighting in the overall stock index, the momentum ETF Mtum and large cap growth ETFs like VUG the Morningstar tool is extremely useful in calculating the overall exposure to Apple in a portfolio holding these ETFs.

A very interesting article explaining another way of analyzing overall portfolios appeared at this case with "factors" It can be forund here..

So my conclusion about Morningstar: forget about the stars..and the WSJ/Morningstar debate over them. Forget about using actively managed funds. Make use of the Morningstar material on ETFs and Index instruments (as well as other data such as the excellent material at and construct a diversified portfolio of index instruments, rebalance and stay the course.

Tuesday, October 17, 2017

Richard Thaler and Your Investments

Richard Thaler's Nobel Prize is yet another sign of the growth of behavioral economics as a dominant part of the field of economics. Others behavioral economists that have won the Nobel Prize was Daniel Kahaneman (2002)Kahneman was actually a Psychologist and Thaler's mentor,, and Robert Schiller(2013). The fact that both Schiller and Thaler have been heads of the American Economists Association says much about the "mainstreaming" of behavioral economics.

Thaler put his findings susinctly "the only people that think humans are rational are economists" Or as I like to say "it ain't physics"Thaler's latestbook Misbehaving gives his intellectual biography and thus a history of the field. His previous book(written with Cass Sunstein Nudge showed how public policy and other decisions can influence behavior and was used in both the UK and US as an input to policy decisions. In my view it was the only case in which policies based on an academic economist were implemented and led to results which virtually everyone views as positive,

I would put the findings of Thaler into two categories of relevance to investors:

Forced savings: the most practical implementation of Thaler's theory was his success in getting 401k plans to incorporate automatic enrollment thus implementing automatic payroll deductions to go into a retirement account (of course people are free to opt out..but the overwhelming number do not do so). Based on a "rational economic man" expectation there would be no difference in the number of employees enrolling in such plans if there was a choice available or if the enrollment was the automatic/default selection. Of course if that wasn't the case and there was no open enrollment the theory would be proven wrong in 401k plans increased tremendously when the automatice deductions was implemented. Regulations regarding 401k plans were altered in 2006 to allow plans to have automatic enrollment and participation by employees has increased as a consequence.T

The implications for individual investors is clear the more one sets up an automatic transfer from checking/savings accounts into an individual investment account the better for building a retirement portfolio (rather than making decisions about each transaction. Also it makes sense to opt for the maximum possible 401k contribution (which is not the default option in automatic enrollment plans)

Investor behavior. 

Loss Aversion. In a 'rational world" an investor would always choose the possibility of a coin flip (investment) in which there was a 51% chance of a gain of $101 and a 49% chance of a loss of $100 (higher expect return for the former) but in fact the number at which investors would demand a gain far larger than the loss to make the rational (higher expected return) choice tolerate a potential loss in  is far far higher.  Investors feel more pain about a loss than pleasure at a gain, Not surprisingly one of the consequences for this that  the more often an investor checks his account value (more likely to find short term losses) the more often he will sell his investments.

What is the consequence of the above ? Investors systematically under allocate to stocks relative to bonds given the risk return characteristics of stocks and bonds. This is particularly the case if investors are presented with short term data as to past behavior of stocks and bonds (which of course show more down periods than long term data). This behavior could also explain "busts": sharp down moves in assets as investor show loss aversion. In my personal experience working with clients I have at least two take aways: when presenting allocation proposals to clients stress long term data and the commitment to have discipline and 2. the academic measure of rik "standard deviation over a one year period is and should be irrelevant to most investors. Since the investor should have a long term focus why should the one year fluctuations of an investment be an important input to their discussion (also long term investments dont fit a bell curve distribution...but that is another more academic discussion.

Loss Aversion does have another nuance: past outcomes influence current decisions.

House money effect: Investors tend to take more risks when playing with "house money" i.e. gambling with profits. Rationally the decision to invest aggressively/take more risk simply because there are already profits in the account is irrational there should be no difference where the new investment money comes from. But investors don't behave that way. That likely explains bubbles and momentum in markets.

By the way it  could explain why Thaler has stated that he is concerned about current market levels its continual rise  with low volatility yet markets go higher and it seems investors continue adding to their stock allocation.

Break Even effect: Investors are prone to take more risks when presented with the possibility to make back the money lost.

All of the above factors should not influence investor behavior if they were rational decision makers the "homer economicus" of classical economics...but they do.

Furthermore all of the above factors work against the investor making the proper allocation policy: rebalancing by selling some of their winning positions and buying more of the losers. Everything described above moves investors to buy high and sell low.

Smart Beta, Thaler, and Your Portfolio:

"Smart Beta"
is a hot term in finance although many of these factors have been known for quite awhile and have been available to investors through passive vehicles

The value factor:

 Data shows that over the long run value and particularly small cap value stocks outperform the overall market. The explanation for this is likely at least in part behavioral investors: overreact to losses and bad news which causes price declines and are drawn to stocks with recent high performance. and investors are drawn to "hot  stocks" that are in the news and have had recent large price gains --the exact opposite of  vale and small cap value stocksThis leaves "value" stocks based on measures like low price/book or p/e, particularly small cap value stocks   to have good long term performance...but likely periods of shorter term underperformance. Dimensionsal Fund Advisors was the first to offer passive/index vehicles weighted towards these factors. They are now available at very low cost through a number of value ETFs large cap and small cap using a variety of methodologies.


Another factor that has been clear in market data has been momentum:,the tendency of markets and asset classes to perform in trends. This factor has long been used in "technical analysis" which academics have dismissed as voodoo for many years. More systematic research has indeed shown a momentum effect leading even the most  stubborn of "efficient markets" advocates Nobel Prize winner Eugene Fama to admit he couldn't find a rational(risk/reward based) explanation for this behavior. It would seem that the house money effect is at least one of the factors at work here. The behavioral explanation is clear investors extrapolate expectations of future performance from recent short term performance..which in turns adds to the "herd effect" in markets. As the market rises and the investors have gains in their portfolios they are more willing to take risks and purchase additional stocks..even riskier ones.

Momentum ETFs which purchase individual stocks based on their short term momentum and sell them when the momentum ends attempt to take advantage of this anomaly. Momentum factor ETFs are a more recent phenomenon and can be accessed with an ETF like MTUM which carries a management fee of .15% Momentum shows its best performance in strong up markets thus it is not surprising that momentum has not only outperformed a market cap weighting but also the other smart beta factors..over the past 3 years by a significant margin (total return of 66.5% vs. 44.5% for the cap weighted index).

Low/Minimum Volatility This strategy tilts towards stocks with low volatility. Because these stocks offer the prospect of smaller gains and smaller losses they are ignored by investors who are attracted to "lottery tickets": stocks with a low prospect of very high returns despite the fact they also have a much higher likelihood of losses. This the effect caused by investors trying to "make back" their losses.
 In other words the higher expected return of the low volatility portfolio (high likelihood of small losses and small gains) is rejected in favor of the higher risk portfolio with a lower expected return but a perceived higher potential of a "big gain" to make back losses. This low/minimum volatility strategy can also be incorporated through low cost ETFs. This strategy has shown long term outperformance by showing smaller losses relative to a market cap weighted index during market downturns while underperforming in strong up markets. It represents a "free lunch" that efficient markets theorists say cannot exist: higher returns without an increase in risk.

If in the past the work of Nobel Prize winners seemed esoteric with little relationship to real world decisions we all make this is clearly not the case with regards to Thaler's work. This time around with academic work that doesnt include books full of equations the Nobel Prize winning work is accessible to all. Reading Thaler' very readable accessible and entertaining book Misbehaving is highy recommended...a rational choice of reading material.

One last anecdote: when asked how he would spend his Nobel prize money Thaler replied "as irrationally as possible".