Dear friends,
What a weird summer.
I began the summer with a short reflection on the conventional wisdom, "sell in May and go away." At the start of June I wrote: "We enter summer with less certainty than at any time in the recent past" and quoted Steve Leuthold’s prediction of an "institutional underinvested panic."
And, indeed, it was an unusual summer in the market. But not in a way I would have predicted. By every measure I can find, the rally was driven by the "wrong" investments. Mark Hulbert reports that the lowest quality stocks have returned an average of 141.8% since the beginning of the March rally, while the highest-quality stocks rose "just" 44.3%, or one-third as much (Hulbert, "Speculative Fever," 8/28/09). Over the summer, Morningstar’s highest-quality stocks – the Wide Moat 100 – rose a respectable 12.2% (through 8/28), which put it behind the returns of 14 out of 15 style groups (small, small value, small core, small growth, midcap, midcap value, and so on).
On the fund front, 85 five-star funds have utterly sucked this summer: Mutual Global Discovery, Oakmark Equity & Income, Royce Special, Sextant International, First Eagle Overseas, FPA Crescent, Amana Growth, Sequoia . . . all trailed 90-99% of their peers this summer. Less than a third as many five-star funds – and those mostly bond funds – had top 10% relative returns. Only one five-star fund (CGM Realty) has posted a great summer for absolute (30% or more) and relative (top 10% of its peer group) returns. Of the 43 funds which have earned more than 30% this summer, only three have earned ratings of three stars or above. Ten funds, almost all weak long-term performers, returned 90% or more just in the month of August. That’s of course dwarfed by the 143 stocks – including 137 microcaps plus deadsters AIG, Fannie Mae and Freddie Mac – which returned between 250 – 8000% in August.
I was listening to an ardent airbag (sorry, didn’t catch his name and the transcript is not yet available) on CNN’s Your Money program who opined that 2010 will make 2008 look like "a picnic in the park." I dismiss most such rhetoric as mere marketing noise: some guy wants to generate "buzz" so he can suck in assets. I take Mark Hulbert’s admonishment much more seriously:
. . . one of the distinguishing characteristics of bear-market rallies is their speculative nature ("Speculative Fever," 8/28/09).
If it isn’t time to run for the hills (for better and worse, I never run for the hills), it might be time to examine the possibility that the last place you want to be entering what are traditionally the worst two months of the year for stocks, is in "exciting" investments. "In dullness," a very good – somewhat dull – college debater once noted, "there is strength."
Barron’s misreads RiverNorth Core
The month’s oddest article was "Chasing This Year’s Fund Stars Could Be Risky: Cases of ‘Buyer Beware’" (Barron’s, 8/10/2009). In it, writer J.R. Brandstrader placed
RiverNorth Core Opportunity (RNCOX) in the company of Direxion Daily Technology Bull 3X Shares (TYH) as too risky for amateur investors. The case for being scared of the Direxion fund, which has returned 130% YTD, is pretty straightforward: it triples the daily returns or losses of the tech sector. It’s designed for folks with a holding period measured in hours. For anyone holding longer than that, the prospect of catastrophic losses looms. How catastrophic? Its sibling Bear 3X fund is down 78% YTD, which will be the fate of any Bull investors holding the fund when the market turns.As a quick recap, RiverNorth Core constructs its portfolio in two steps: first, it makes tactical asset allocation decisions ("put 5% in tech") then it chooses the securities to execute the allocation. The manager chooses between closed-end funds (CEFs), ETFs or – more rarely – stocks. Here’s the fund’s unique advantage: if there are closed-end funds trading at irrational discounts to their net asset values, he’ll use those funds to execute the asset allocation. That offers his investors two independent sources of profit: one is the investment in the tech sector, the other is the return generated when the CEF’s excessive discount regresses to the mean. If there are no irrationally-priced CEFs available, he uses low-cost ETFs instead.
So how has RNCOX drawn Brandstrader’s ire? It seems that the combination of making money (the fund is up 36% YTD) and confusing her did the trick. She has three beefs with the fund:
Objections #2 and #3 strike me as completely irrelevant. Why do I care that closed-end fund analysts aren’t following this open-end fund? Patrick Galley, the manager, compares it to saying that, since "analysts that cover GE don’t cover the mutual funds that invest in GE," you need to avoid investing in such funds. That wouldn’t be a good argument even if Morningstar wasn’t covering the fund. But they are: the manager tells me, Morningstar is going to initiate coverage because of RNCOX’s "uniqueness and interesting strategy." Why do I care that TrimTabs, or whoever, isn’t monitoring RiverNorth’s asset base? The short answer: I don’t.
What about Objection #1? Here’s Brandstrader’s critique at length:
Frankly, pricing can seem completely irrational at times, with funds selling for far less or more than their liquidation value. These funds, which are much older investment vehicles than mutual funds, rarely trade at net asset value. Instead, they usually trade in the secondary market at either a premium or a discount to net asset value.
Uncertain market conditions during the past year or so created discounts so wide that these funds have provided eye-popping yields for intrepid investors. However, some buyers were shocked to learn that dividends could be suspended when investor paralysis causes the price of a fund to plunge. Others discovered, to their surprise, that some closed-end funds used auction-rate preferred securities to gain leverage as this market seized up last year.
Let me summarize the argument: "an unwary investor can get completely screwed by the huge, irrational swings in a CEF’s discount or premium."
Which is true. But it’s also the argument for investing in RiverNorth Core, not against it. These price swings are huge and irrational but they’re also predictable, which creates the opportunity for substantial arbitrage gains. Mr. Gallery explains it this way:
. . . funds where dividends were suspended last year. . . were trading at very attractive discount levels. For retail investor[s it] was a shock that their fund postponed the dividend. What they didn’t realize is the [Investment Company Act of 1940] requires closed-end funds to maintain certain asset coverage limits of at least 2:1 ($2 of assets for every dollar of preferred securities issued) . . .. An investor only needed to do a simple check; what is the asset level (based off of current NAV) vs. the debt issued (including preferred securities). When the asset coverage was violated, the 1940 act requires them to postpone dividends until they are back into compliance with the coverage test. Most funds needed to sell assets and deleverage.
This entire episode gave RNCOX fantastic trading opportunities that we only can pray will happen again. In this situation, the funds that postponed their dividends traded at deep discounts. RNCOX picked them up in many cases for $0.75 on the dollar (25% discount to NAV) knowing that there were only two possible outcomes, 1) the fund would need to deleverage and turn the dividend back on, or 2) the fund would have to liquidate and shareholders would get NAV. The first situation was the winner and when the funds turned their dividend back on, the discount immediately narrowed (which we profited from). In sum, we were able to avoid the selloff and capitalize on the new opportunity due to the irrational selling by doing a little research into the funds.
As an investor, I surely agree with Brandstrater’s injunction, "Make sure you really understand what you're buying first." As a sometime-writer, I agree as strongly with the logical corollary to it: "Make sure you really understand what you're writing about first."
Briefly noted:
The Falcons of Aplington-Parkersburg (IA) High School took a 30-0 lead into the fourth quarter before beating the scrappy Dike-New Hartford Wolverines, 30-14. It was their first game after the murder of their beloved coach, Ed Thomas. The Falcons – including the younger brother of Thomas’s murderer – ran onto the field through a tunnel formed by 200 of the team’s former players, including the gunman’s father. It all had a very Iowa feel to it. If you don’t know why an investor might care, you really need to read some of my archived stories.
This month I sold my shares of Baron Partners (BPTRX) and used the proceeds to start positions in
Matthews Asian Growth & Income (MACSX) and FPA Crescent (FPACX). Why sell Baron? I bought the fund when it first opened because I was attracted to its advertised ability to hedge its equity exposure. I sold the fund because, so far as I could tell, it refused to use that ability. On the contrary, in the face of a market collapse it maintained a leveraged position (since unwound) to maximize its exposure to the market’s movements. I bought the recently-reopened MACSX because it’s been on my watch list (and in a retirement portfolio) for years. FPACX appears to actually do the things I’d hoped for from Baron. A nice side effect is that I’ll drop my portfolio expenses by about 15-20 basis points.Speaking of MACSX, I want to note that the correct name of the fund’s adviser is the Matthews Asia Funds. On several occasions, I’ve incorrectly added an "n" to the word "Asia." The "n" is correct, however, in the names of individual funds, such as Asian Growth & Income. Victoria Odinotska, the firm’s PR person, kindly shared word of my goof.
And speaking of the Baron funds, a series of actively-managed ETFs managed by Baron alumni (or "escapees," depending on your perspective) are set for launch this month. The RP Growth, Technology and Financials ETFs open on September 10. Mitchell Rubin helped manage Baron iOpporunity and Baron Growth while Morty Schaja was the firm’s president and chief operating officer. A fourth fund, RP Focused Large Cap Growth, will be sub-advised by Wedgewood Partners. Expenses will be 0.89% plus whatever your brokerage charges are.
Metzler/Payden closed its international real estate fund earlier this year and so we’ve removed its profile from the archive.
MainStay ICAP has announced the merger of their Mid Cap Value and Value funds into Select Equity, a very fine fund. Similarly, RS Smaller Company Growth will soon be absorbed by RS Small Cap Growth.
In closing . . .
I’m looking forward to the fall, despite the prospect of watching the market eat my modest gains. There are a slug of interesting newer funds to write about – Madison Mosaic Small/Mid-Cap (MADMX – seriously? MadMax?), Scout International Discovery (UMBDX), Manning & Napier Dividend Focus (MNDFX), Walthausen Small Cap Value (WSCVX) – are all clamoring for your attention. Veteran manager Michael Fasciano will return to the fray. And some very small Royce funds continue racking up peer-beating gains.
And then there’s the story of Harvard. They may not teach their students much in the classroom, but their ability to lose $10 billion or so in a year – and their inability to maintain any sort of discipline in the face of good fortune – may teach us an awful lot. But that’s a story for next month.
As ever,
David
| NEW Discussed this month: | ||
|---|---|---|
| Wasatch Heritage Value (WAHVX): An outstanding small cap value manager has taken on the task of bringing his (and Wasatch’s) distinctive "value plus momentum" discipline to the universe of larger-cap, higher-quality firms. To date, the results are promising. | ||
First Trust NASDAQ Clean Edge Smart Grid Infrastructure Index Fund (GRID) will invest in the grid and electric energy infrastructure sector. That includes companies that are primarily engaged and involved in electric grid, electric meters and devices, networks, energy storage and management, and enabling software used by the smart grid infrastructure sector. Trés trendy. The expenses ratio will be 0.70% after waivers. Geneva Advisors All Cap Growth Fund will seek long-term capital appreciation, mostly by investing in domestic stocks though it can hold up to 30% foreign. It’s managed by a team of guys who are former William Blair managers. (For those who don’t know, that’s a good thing.) The minimum initial investment is $1,000 and the expense ratio is 1.52%. iShares S&P India Nifty 50 Index will invest in the top 50 companies by market capitalization that trade in the Indian market. Those companies account for about two-thirds of the market capitalization of the National Stock Exchange, one of India’s two nationwide exchanges. The Fund may or may not hold all of the securities in the index. Fees not yet announced. Likewise, rationale for naming your fund after an investment disaster (the "nifty fifty" craze of the late 1960s) not yet announced. Keeley Small Cap Dividend Value Fund will seek capital appreciation by investing in companies with market caps of $3.5 billion or less. They can hold stocks which appreciate past the $3.5 billion cut-off. The fund has the option of investing in "other equity type securities (including preferred stock, convertible debt securities and warrants)" issued by small cap companies. The managers see dividends as both stabilizers and signs of on-going growth, so they’ll seek them out while reserving the right to invest with companies " that pay no dividend, but may initiate a dividend." Robert Becker is the Portfolio Manager, Brian P. Leonard and Brian R. Keeley will assist. PIMCO Enhanced Short Maturity Strategy, Government Limited Maturity Strategy, Prime Limited Maturity Strategy Fund, Short Term Municipal Bond Strategy and Intermediate Municipal Bond Strategy will be a series of actively-managed ETFs. With one exception, John Cummings, the managers have not yet been announced nor have the expense ratios. More on this story as it becomes available. PIMCO Tax Managed Real Return Fund will seek to provide after-tax inflation-protected return by investing in investment grade municipal bonds and inflation-indexed securities. The fund will seek to minimize taxes by minimizing the sale of securities with large unrealized gain, holding securities long enough to avoid short-term capital gains taxes, selling securities with a higher cost basis first and offsetting capital gains realized in one security by selling another security at a capital loss. Unfortunately, the most-accessible share class for small investors ("D") is limited to tax-advantaged accounts where all of this hard work is for nought. Managed by John Cummings, a PIMCO veteran, and Gang Hu, PhD, who has been working in this field for Deutsche Bank. Expenses not announced, minimums vary by share class. ProShares Short 20+ Year Treasury (TBF) seeks daily investment results that correspond to the inverse (opposite) of the daily performance an index of publicly issued, U.S. Treasury securities that have a remaining maturity greater than 20 years (except for TIPs and a few other classes). Expenses after waivers of 0.95%. Third Avenue Focused Credit Fund (TFCVX) will seek long-term total return by investing in bonds and other types of credit instruments, primarily those that are rated below investment grade. Credit instruments include junk bonds, bank debt, convertible bonds or preferred stock, loans made to bankrupt companies and loans made to refinance distressed companies. The manager may sometimes use derivatives for hedging. The manager will be Jeffrey Gary, who has more than 20 years of investment experience in high-yield, long/short credit and distressed investment strategies, including the last twelve years as a senior portfolio manager. Early in his career he was "a distressed portfolio manager at AIG." Minimum initial investment is $2,500. Expenses capped at 1.4%. |
| NEW Discussed this month: | ||
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| Sextant International (SSIFX): How does "the best international fund that you’ve never heard of" strike you? | ||