Ramblings of a Portfolio Manager 12-28-2009

Ramblings of a Portfolio Manager, Predictions for a New Year.

“Daddy, what’s a stock?” was the question from my six year-old the other day. As the son of a portfolio manager he needed to know even if his eyes blurred and wandered toward the TV set showing Sponge Bob during the excessively lengthy answer. After he had returned to the travails of Squidward and Patrick, I got to thinking how I might have answered the same question had he asked it 20 years hence. In a similar vein, would I have even been mad at him if he were 20 years older and asked the same question now?

There used to be an urban legend on Wall Street that there were more mutual funds than common stocks traded on US exchanges. According to the Investment Company Institute, however, there were 8,022 open-ended mutual funds as of the end of 2008 compared to approximately 9,800 common stocks (our count excluding closed-end funds) traded on the NYSE, AMEX, NASDAQ, OTCBB and Pink Sheets combined. As you can see that the old saw was indeed just legend…but it was close. Wall Street, branded as a horde of greed heads and “fat cats” by our loving government, is, in reality, just a big marketing machine. We now have mutual funds that seek to emulate just about any asset class, market, strategy, sector, industry, philosophy, stock price or you-name-it sub-segment of an asset class you can imagine. And the list is growing.

Each year at this time we hear from a raft of portfolio managers calling out their investment predictions for the upcoming year. By and large, these predictions are self-serving—bond managers tell us that fixed income will outperform, equity managers tell us that stocks will be the place to be, etc. The prediction that always tickles us is the annual forecast by equity managers that “next year will be a stock picker’s market,” meaning that active managers will outperform the passive market indices. We hear that one every year. Our favorite is the catch phrase “it will be a market of stocks rather than a stock market.” Dang if we know what that means, but we do observe that every year, equity managers as a collective group underperform the major market indexes. The reason for this phenomenon is well known and simple: fees, commissions and trading friction from cash flows create a huge hurdle for the individual manager targeting a market index and, collectively, equity managers are the market. So the result is easy to predict.

In the “if you can’t beat them seek to emulate them” approach, Wall Street has created a whole new class of investment vehicles, Exchange Traded Funds (ETFs), to address some of the shortcomings of mutual funds but further complicating investors’ choices. ETFs trade as individual listed securities and seek to do what sector or asset-class specific mutual funds do but with lower cost, fewer capital gains, better tracking and simpler investing. At last count there were approximately 925 ETFs traded on US exchanges and the number is growing so if you combine them with mutual funds, indeed there just about as many “funds” as there are common stocks. There are now ETFs which track equity indices at 1x, 2x or 3x the returns of the underlying index. There are ETFs which track fixed income, real estate and just about every other asset class and sub-seqment thereof. Just to keep things interesting there are now mutual funds of ETFs (we can’t envision why someone would pay a manager for that service). Recently, we witnessed the launch of several faith-based ETFs: the FaithShares Islamic, Catholic, Christian and Methodist ETFs. Arriving soon is the Lutheran ETF. The purpose of these is to allow investment in only companies with “values consistent with the targeted religion.” For the life of us we can’t fathom how the structure of the underlying portfolios of the last four will differ. As of this writing they all hold shares of Nike, a company who’s principal spokesman hardly lives up to the Christian ideal of family values. Perhaps the Lutheran ETF will distinguish itself by purchasing the old Davy and Goliath film library and selling it to Bill Gates at a profit…

With such choices, does anyone buy individual stocks anymore? It’s clear that Wall Street, despite last year’s setback and the stream of rancor emanating from the White House, hasn’t died as a marketing powerhouse but in our opinion the product innovation is starting to get excessive. Carrying the trend to its logical extreme conclusion, one can envision a market where the only trading in individual company stocks is the result of rebalancing among the passive indexes, ETFs and sector/asset-class specific funds. Such a scenario is admittedly extreme but at the margin declining interest in individual stocks isn’t good for both Wall Street and companies trying to raise capital in the equity markets—and ultimately bad for Main Street. So here’s our not-so-self-serving prediction for next year: The equity markets will rise, active managers will once again underperform the major market indices, more ETFs will be launched and more will be closed. Here’s our self-serving prediction: good managers will continue to outperform the indices, investors will grow to realize that they can’t yell at an ETF for losing them money and that ETFs don’t buy them lunch, give them tax and investing advice or hold their hands during rough markets. ETFs will prove themselves to be high maintenance (one still has to research and track them) so for individuals without too much time on their hands, choosing a good manager will be more rewarding than locating an fund that tracks their individual tastes, religion or political affiliation.

Happy New Year to All!