May 2017 IssueLong scroll reading

The Fifty Year Reich

By Edward A. Studzinski


“It is dangerous to be sincere unless you are also stupid.”

  George Bernard Shaw

Some thirty-odd years after its founding, the transformation of Morningstar is complete. From a firm that got its start providing tools and research to assist the individual investor, we now see a firm that exists to offer tools, support, and research to financial advisors or intermediaries. To a large extent, that evolution was necessary given the changes in the marketplace for mutual funds, as well as the changes in the regulatory environment. And once Morningstar became a public company, it would have been incumbent upon its employees and management to focus on maximizing the profitability of the corporation and the returns to shareholders. Credit is due them for effecting that transformation in a fairly transparent and top-shelf manner.

I mention all of this as this past week saw three days of the annual Morningstar conference in Chicago, moved up from its historic June date to now coming in April, also highlighting a shift in priorities. My colleague Charles will perhaps say more on this, but one of the more interesting presentations was a speech by John Bogle, of Vanguard fame, about the state of the mutual fund world today (especially as Vanguard continues to grow exponentially). Apparently one of Mr. Bogle’s comments was that the absentee owner fund complexes should focus on running a “cash cow” model to maximize their own returns in the business. Indeed that appears to be what we are seeing executed as a strategy in four or five firms in Chicago, struggling to counter the effects of asset outflows to passive vehicles. Expenses are cut and reinvestment in the business is curtailed, often in ways that are not readily apparent to outsiders or, for that matter, the absent parent and/or fund trustees.

We have for instance, heard a story about one large institutional firm that now allegedly executes most of its equity trades through “dark pools” rather than the 40-50% often referenced as a high-water benchmark at other institutions. This lack of transparency makes it difficult to gauge whether best execution is being obtained for the firm’s clients, whether they be individuals or funds. It also begs the question of whether the appearance of a conflict of interest should be sufficient to keep funds from putting all of their trading through those vehicles, since they may end up with the brokerage firm’s proprietary traders taking advantage of them (and they will never know it).

What’s New and Not

David will have a number of fund manager interviews in this issue, hoping to find the un-discovered gem. Myself, I have pretty much soured on those avenues proving to be fruitful. There is a wonderful book I would recommend called Concentrated Investing by Allen Benello, Michael Van Biema, and Tobias Carlisle. The premise of the book and most of the people profiled in it (none of whom were or are mutual fund managers, so crocodile tears from my former colleagues) is their belief that concentration (fewer than 20 stocks and low turnover) is the way to add value (the positive alpha) differentiated from the market averages. Alternatively, the average investor, such as my friends Mr. and Mrs. Moon Pies and Cola, is better off to be invested in lowest-cost index funds such as those offered by Vanguard. And the investment should be in index funds rather than Exchange Traded Funds. Even though the ETF’s may be cheaper in terms of fees, there will be a temptation to trade in and out of them. As Warren Buffett put it, “By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals.”

The second point the book makes is the advantage of permanent capital. Given that there are few long-term investors out there, especially in the retail marketplace, permanent capital is a key differentiator. Or as Kristian Siem put it, “ … the fund management business, by nature, is short term. Financial investors come in and out. They can push a button any day and get out.” That is the advantage that the Buffetts, Mungers, and Simpsons of the world have. They have permanent capital that is not subject to being withdrawn, forcing liquidations of investments at exactly the wrong time. The 1940 Act mutual fund, of infinite duration and daily liquidity, is not a permanent capital vehicle. The only way you might approximate it with a mutual fund is with a fund that is closed to new investors, or alternatively, where most of those invested are not able to withdraw easily (and one example of this would be Longleaf Partners Fund employees, who are not permitted any other investments but their own funds, and who are the largest investors in their own funds).

The Thousand Year Storm

One of the reasons I am beating a number of horses into the ground is that I feel that ETF’s in both fixed income and equities present a degree of systemic market risk of a type that we have not seen before. They are in effect a new form of leverage. There will come a point where there is an event. I don’t know when or what will trigger it, but it will cause many investors to panic and attempt to liquidate. They will try to get through a door that will slam shut in their faces, with permanent loss of capital.

The first quarter 2017 Market Commentary from Horizon Kinetics makes the point in its usual elegant fashion. If you look at the p/e ratio of the S&P 500 using prices relative to the average earnings of the prior five or ten years (for smoothing), the S&P 500 now trades at 29X earnings, a valuation level higher than all but two over the past 130 odd years. Another point made is that the return of the S&P 500 index over the last ten years may have averaged 7% a year, but the average investor’s return per dollar invested was less than 4%. That follows the tendency of people to put money into the market and funds (as the proxy) when the market is rising. They take it out when the market declines.

This disparity in returns between indices and real investors is of course not limited to index funds. The same applies to people committing funds to actively managed funds on the basis of returns that look backwards. There is always the hot money tendency, to put money into the top-performing fund. This is regardless of the fact that those returns look back, and are not predictive of the future. How many of you think going forward returns will equal or surpass the historic returns? Realistically, people should be pulling money out of the best performing investments, and putting it into the underperforming ones, that is, rebalancing their asset allocations.

Horizon Kinetics raises two more compelling points. The iShares S&P 500 Value ETF has 353 holdings. The iShares S&P 500 Growth ETC has 321 names in it. Does one need a Solomon to divide the S&P 500 by price to book value and still end up with 674 S&P issues? Sadly, two things become apparent. One, style drift, a no-no for active managers, appears to be permissible in ETF’s. Two, it really all comes back to AUM and competitive pricing in the ETF world (and who really can beat Vanguard’s pricing). If an index product is a commodity product, it is all a matter of price. And how does an advisor make money on a nearly zero-fee product? It cannot be done. Mr. Bogle proposed a solution to the above problem. Financial advisors, rather than charging fees tied to assets under management, should charge hourly rates for time and services performed, as do attorneys and accountants. Good luck with that.

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.