“All NAVs are opinions.” ― Richard Jacobs
While March was one of the most turbulent months on record for the S&P 500, with real-estate and oil sectors acutely affected, investors in fixed-income also experienced a rough ride. Funds reaching for yield were hardest hit, especially those employing leverage. There are plenty such funds, driven by a seemingly never-ending period of zero-interest-rate policy.
Warnings of the trouble in fixed-income came in early March, as was well as reported by Bloomberg’s Eric Balchunas and Lisa Abramowicz. Prices of exchange traded funds (ETFs) for even the most liquid and desirable assets, like US T-Bills and investment grade corporate bonds (e.g., tickers TLT and LQD) started trading at discounts to their NAV, the so-called Net Asset Value. Eric believes this behavior in ETFs acts like “a canary in a coal mine” … signaling broader issues, like illiquidity or front-running.
A fund’s NAV is defined as the value of assets held in a portfolio, less all liabilities, divided by the total number of shares outstanding. For open-ended funds, where most assets in US funds are held, the NAV is calculated at the close of business and those funds trade at NAV.
For ETFs, NAVs are computed periodically throughout the day, but because ETFs can be traded at any time the market is open, investors can end up paying a premium or a discount price to the NAV. The process is endearingly named: “price discovery.” Normally, these “dislocations” are very small, but in early March, they were not. The dislocations were even larger for non-investment grade bonds, so-called “junk” bonds (e.g., ticker JNK and HYD).
Large discounts can be a sign of illiquidity in the market. Basically, as the news of the potential impact of CV-19 spread (e.g., “Worst recession since the Great Depression.”) many investors panicked, CFO’s were fearful, and everybody wanted cash. Unfortunately, there were no buyers, so price dislocated from NAV. When the Fed announced in mid-March that it would be buying bonds, including junk bonds (a real shocker), prices recovered and closed back to their NAVs, or even above.
At month’s end, there remained about $25T in assets in US funds. Had the Fed not stepped-in to stabilize the markets, I suspect that number would be substantially lower. Only history will tell whether that stability is just temporary and what the long-term impact will be.
For investors, especially after an 11-year bull market that included periods of extremely low volatility, March was a wake-up call. Black swan events can and do happen. Risks can be secular and not just idiosyncratic. For investors in even the most stable assets, like core bond funds, there is a non-zero chance that they can lose substantially. (We’ll keep cash equivalents as “risk-free.” Let’s hope that never changes.)
Credit Quality and Duration Breakouts
Before the Fed announced it was also going to be “buyer of last resort” for junk bonds, I was worried that pensions, endowments, and funds that have an investment-grade only mandate would be forced to sell assets in anticipation of a wave of company down-grades, likely at large discounts.
While a bit less worried today, knowing how much junk or near junk (e.g., S&P “BBB” quality) your fixed income funds hold should be first and foremost on your mind. So, MultiSearch users on our MFO Premium site will now find that breakout under Bond Info.
Lipper defines the Core Bond category as follows:
“Funds that invest at least 85% in domestic investment-grade debt issues (rated in the top four grades) with any remaining investment in non-benchmark sectors such as high-yield, global and emerging market debt. These funds maintain dollar-weighted average maturities of five to ten years.”
There are currently 219 funds in this category, including ETFs. Here’s a breakout of the average quality held in these funds:
And here is the quality breakout of the five top core bond funds by AUM, which shows the long-time MFO Great Owl Dodge & Cox Income (DODIX) holding largest amount of junk and “near junk”:
While most core bond funds recovered nicely by month end, thanks again to Fed action, the intra-month drawdown of nearly 10% in funds like DODIX spooked investors. Core bond funds generally suffered large redemptions, $61B, or about 5%.
Similar to bond quality breakout, MultiSearch now also includes bond duration breakout. The former is a measure of credit risk while the latter helps assess interest rate risk. While no one expects rates to rise soon, it’s good to know just how much of your fund is in long duration bonds. Do you know?
Estimated Inflows and Outflows
As mentioned earlier, with liquid and stable markets, price and NAV tend to be pretty close with ETFs. But in unstable markets, they dislocate. And that may be an early indication that the NAV in your open ended fund may be about to change, perhaps drastically, as it did for many holding lightly traded assets, like non-agency rating mortgage backed securities. Such occurrences highlight the problem of stale or unchallenged NAV pricing, which is brilliantly addressed in the near prescient article by Jon Seed, entitled “Price, ETFs, and Bond Market Liquidity,” published in February of this year.
At the end of the day for open-ended funds, both literally and figuratively, it’s about managing liquidity. Or, as PIMCO’s Dan Ivascyn said in a 2019 Morningstar Interview: “So, that’s the most important thing that a mutual fund manager needs to focus on, liquidity management.”
To help provide a bit more insight, estimated current month inflow and outflow, both in terms of $M and % of the portfolio, are now included in MultiSearch. While monthly updates may be too infrequent to protect against a “run of the fund,” I find it helpful to know what funds are seeing the most inflow and outflows and how their performance responds.
Price/NAV Premiums and Discounts
Closed-end funds (CEFs) are another way to help investors manage liquidity risk in that fund managers are not forced to sell underlining assets (likely at discount) to meet redemptions, like they do with open ended funds. Similar to ETFs, CEFs trade like stocks and are subject to large premiums and discounts, even during stable markets, sometimes perpetually. To get insight into how large those differences can be, MultiSearch now displays Premium/Discount (PremDisc) Highs/Lows, as well as high and low NAVs, associated dates, and NAV update frequency for all ETFs and CEFs in the database.
(Gentle reminder: When purchasing ETFs and CEFs, like when purchasing stocks, use limit orders.)
Alpha, Beta, and Information Ratio
As with many features in MultiSearch, a new group of screening metrics called “Alpha, Beta, and Information Ratio” are now available, thanks to a request from a subscriber, known as MikeW, on our discussion board.
Mike wrote:
Also, wanted to ask you if you thought it would be possible to add “Information Ratio” as a measurement to MFO. I find this to be a really good gauge for measuring fund performance in the context of how much risk the fund takes in straying from the benchmark. I have a good friend who works at [a fund company] and this is one of the primary ways they benchmark themselves against other mutual funds.
Users can now screen absolute values or ratings in alpha (versus benchmark defined by Lipper), tracking error and Information Ratio. Screening for best Information Ratio in the large cap value category over the last (presumptive) full and bull markets? The winner: PIMCO RAE Plus (PIXAX). And that’s with a high tracking error! RAE stands for Research Affiliates (Rob Arnott) Equity.
Past Performance To Determine Consistency and Beware of Asset Size
One of the first books I read on investing was John Bogle’s Common Sense on Mutual Funds. While he urged investors to commit to all-index funds, he offered the following eight basic rules for any investment program:
- Select Low-Cost Funds
- Consider Carefully The Added Costs of Advice
- Do Not Overrate Past Fund Performance
- Use Past Performance To Determine Consistency and Risk
- Beware of Stars
- Beware of Asset Size
- Don’t Own Too Many Funds
- Buy Your Fund Portfolio – And Hold It
Through the years, I’ve tried to follow these rules with varying degrees of success. Many of the screening tools and metrics in MFO Premium emphasize risk (volatility), risk adjusted returns, correlation, asset size, cost, and consistency. Ferguson Metrics are especially good at assessing relative outperformance and consistency.
This month we’ve added some graphics that help shed more insight into Bogle’s Rules 4 and 6. He cites that “good” funds will consistently outperform their peers on a yearly basis while “bad” funds will do the opposite. He also used the same visualization to assess whether a fund’s performance is deteriorating with asset size growth. I’ll venture to say that competition from lower cost ETFs may play the same role today.
Here’s an example of the new Yearly Return Ratings display in the MultiSearch results table. I believe Bogle would say it includes a few “good” funds for consideration (5 Blue = Top Quintile Absolute Return, 1 Red = Bottom Quintile):
