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Investments Matter More than their Form

by David Merkel

  • Open-end Mutual Funds, including index funds
  • Closed-end Mutual Funds
  • Exchange Traded Funds, including index funds
  • Separately Managed Accounts
  • Unit Investment Trusts
  • Hedge Funds
  • Private Equity
  • Other Limited Partnerships [LPs], including MLPs
  • Variable Annuities (and Life Insurance)
  • Equity-Indexed Annuities (and Life Insurance)

What do all of the above have in common?  The first one is the easiest — they are all investments.  The second one is harder — they are all ways of investing in the ownership interests of corporations.

Think of the underlying investments within these investment forms when analyzing the forms as investments.  Now the forms aren’t entirely neutral:

  • Index funds don’t take a lot of fees.
  • Hedge Funds, Private Equity, and Insurance Products do take a lot of fees.
  • Insurance Products are tax favored.  LPs, MLPs and Private Equity have some tax advantages.  Separately managed accounts can have tax advantages, if managed right.  If you make the right investment, buying and holding has tax advantages, especially if you take it to the grave.

Thus, you should look at the manager, to try to analyze if he has skill.  You should look at the fees to see what you are giving up.  You should look at the tax advantages.

You should also think about the sensitivity of the investments to the overall risk cycle.  I don’t like the concept of beta, because it is not a stable concept, but in broad hedge funds have low beta, and private equity has high beta, relative to an S&P 500 index fund.  But neither in aggregate have much outperformance, after adjusting for the beta.

There are many clever investors scouring the world of investments looking for underpriced assets.  At a time like now, there aren’t a lot of underpriced assets.  I might find 2-4 per quarter, but they are only relatively underpriced, not absolutely underpriced (I.e. at this price, you should buy it regardless the the economic environment).

Every now and then, the market falls apart.  At such a time, two things happen.

1) Because some sector of the economy had too much debt, prices for the stocks and corporate bonds (or trade claims) fall, and the market as a whole falls along with them, though to a lesser extent.

2) During the crisis, many assets get oversold, and those with better knowledge can profit from the overselling.  The best example I can think of all of the hedge funds that bought non-agency mortgage-backed securities, when they were thrown out the window indiscriminately in 2008, and many of those securities have returned to par.

The ability to achieve alpha (outperformance) increases after a crisis.  Some who prepare for that, like Seth Klarman and Warren Buffett, create their own outperformance by taking more risk when other investors are running away in panic.

As my boss asked me in 2007, “Why have you not done so well for us the last few years, when you did so well 2003-5?  I answered, “When I came to you, the market was like an apple cart  that had fallen over and I picked up the undamaged apples.  Today, the market is rational, and there are not a lot of easy pickings to be had.  That is the difference between the bust and the boom.  It is much easier for a fundamental investor to act during the bust.

Thus I would encourage the following:

  • Pay attention to fees
  • Pay attention to tax advantages.
  • The time at which you invest matters  a great deal: try to invest when opportunities are the greatest (and others are scared stiff)
  • Ignore the form of investing, but invest with skilled managers (if you can find them, otherwise index funds).

Think of Seth Klarman who hands back money to his clients when markets are not promising.  Few professionals have the intelligence to do that.   Fewer have the ethics and courage to do so.

For my equity clients, I have reduced exposure, and I am close to my maximum cash level of 20%.  I am watching the market, and am willing to add to my positions, 10%, 20%, and 30% lower.  I own good companies.  As has been true in the past, I get close to zero cash as the market bottoms.  The market is somewhat high now — I think of it as the 80th percentile.  But it is not at nosebleed levels.

Analyze your investments, and sense the skill of managers, and lack thereof, and the degree of sensitivity to the market as a whole, which is likely higher than you expect.

Then adjust as you see fit.  Every situation is different, except for the parts that are the same.

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