Black Swans - Moses - Myths & Mutual Funds

Black Swans - Moses - Myths & Mutual Funds  (Printer Friendly Version)

Kendall Anderson, CFA May 5, 2008

"Before the discovery of Australia, people in the Old World were convinced that all swans were white, an unassailable belief as it seemed completely confirmed by empirical evidence. The sighting of the first black swan might have been an interesting surprise for a few ornithologists (and others extremely concerned with the coloring of birds), but that is not where the significance of the story lies. It illustrates a severe limitation to our learning from observation or experience and the fragility of our knowledge."

Nassim Nicholas Taleb

Moses

On April 5^th, 2008 Charlton Heston made his way to his creator. I wonder what Moses said to him? I wonder if they looked alike? Growing up in Iowa I attended a Catholic elementary school. Of course, the Catholic school included a daily one-hour religion class. When it came to Moses, no matter what the discussion, I immediately envisioned Charlton Heston. In fact, without this image I would not have been able to remember much about the lesson taught. This of course placed Mr. Heston (at least my image of him) above the normal man, someone who is not like the rest of us, but superior in all aspects. At that young age, I had a belief that some people where in a league of their own, a true group of white swans.

So with that in mind I wanted to share with you my one and only encounter with Moses and the impact it had on my life. It was in July 1983. My family and myself had moved to Rock Hill just one month earlier. Without knowing a soul, and with three hungry kids I had to get out and meet people in a hurry in hopes that one or two would hire me. My chosen course to do this was to walk in unannounced to businesses and introduce myself, along with the services I could provide. Although Rock Hill had ample businesses to visit, for whatever reason on a bright sunny day I chose to drive about twenty miles south to the little town of Chester. Prior to July of 1983 Chester's biggest claim to fame was a simple event that happened in 1806, when Aaron Burr, the winner of a duel with Alexander Hamilton and a deep desire to build a new kingdom in the West was being led back to Virginia to stand trial as a traitor. It seems that when in Chester, he jumped from his horse, announced his identity and pleaded with the locals to liberate him. They did nothing and he was led out of town. Not much, but enough for Chester until 1983. That's when the town was chosen to be the location for the filming of the mini-series Chief's, starring Mr. Heston.

I remember it was late in the afternoon, and I just walked into a local business to say hello. When I was leaving I noticed Moses looking at some items near the entrance. Granted, for anyone else, seeing Moses in a store probably deserves a trip to the local doctor, but in my case it was a rare opportunity to meet someone who I believed was different and above the rest of us in society. The conversation lasted about thirty minutes and covered the topics as diverse as the Moral Majority, our families and of course the markets. This encounter was very brief and truly unexpected, yet it had a very deep impact on my thinking. I never again thought of Charlton Heston as Moses, but simply a man who happened to be very good at his chosen profession. It was the beginning of my quest to understand behavior and the impact that it has on investing. There are white swans that we take as fact without question, yet it is the unexpected, the black swans, that actually produce the vast majority of our investment returns.

April - Relief or a Suckers Rally?

April was the first month since last October where the Standard & Poors 500 (as well as all other domestic indices) produced positive rates of return. The benchmark index for American stocks rose 4.8% in April, the best one month showing since December of 2003.   For most this is a relief from some of the agony created by the markets' showing in the first three months of the year. But for others, especially our friends in the media, good news is not worthy of print. The Economist (yes I know I pick on this magazine more than others) headlined their reaction with "Too Soon to Relax" and went on to remind us all that we are still in "A sea of trouble".   Today's Bloomberg.com produced this headline "Suckers Rally Signaled After S&P 500 April Surge" and quoted Jean-Marie Eveillard, who runs the First Eagle Global Fund, with this comment; "Investors want to believe. But if I'm right, then there's truth to the argument that this is the worst financial crisis since the end of World War II." And one more from CNNMoney.com "Wall Street: Sell what in May and go away?" saying, "April was a strong end to an otherwise wretched six months in which the Dow Industrials lost 8%. That's the worst ‘best six months' performance for stocks since 1973, when the Dow fell 12.5% between Nov. 1 and April 30, amid an OPEC oil embargo, according to the Stock Trader's Almanac." The Stock Trader's Almanac is the source for most of the "Sell in May and Go Away" strategy used by many market timers and a number of brokers whose purpose is highly questionable. It's easy for us as individuals (myself included) to make our media pundits into white swans, other than just a person doing a job. What is worse though, is that the media is in the business of selling advertisements but unlike Mr. Heston, who freely admitted that he is just an actor, they do not want you to believe they are just a reporter. They want you to believe they are investment experts.

Do you really want to Sell in May and Go Away?

Some of the most enduring investment myths are those based on a seasonal theme. Sell in May and Go Away is one of those best known. The basis for this myth is rooted in economic history. In the 19^th and early 20^th century, when our economy was based on agriculture, the non-agricultural business community experienced slow downs during the summer months. Our farmers only had cash when they sold their crops in the fall. The last half of the 20^th Century, as our economy turned into a manufacturing based economy, the summer time was devoted to vacations and the need to re-tool our manufacturing plants for the next year's models. These factors also contributed to a slowdown in business activity.   This myth has had a good run. For the seven years from 2001 through 2007 you would have hit a home run simply by selling in May and buying back in September.    And of course a good run is easily accepted as fact, after all the pundits will tell us, just look at the facts, it has to be true. Look at the following table:

Source: Standard & Poors

On May 1^st 2007 an article appeared in Market Watch written by Jim Lowell who said "while most adages have some grounding in reality, this Sell in May saw has investment teeth." He goes on to add, "The adage and all studies focus on the large-cap group of stocks found in the Standard & Poor's 500 index; what happens if you sold whatever S&P device suits yours fancy (i.e. an index fund or an ETF like the SPDR Trust at the end of April and stayed away until the beginning of November, and then bought back again and hung on through the end of the next April, ad infinitum. The result of doing so: over the past 6 years, you would have made 35.0% vs. 27.2% for those that bought and held throughout the time period."

I wonder what studies Mr. Lowell was looking at? If someone actually did a little homework you would know that this short-term mentality was simply data mining and urging the buying and selling of securities. Lets look at the real facts. We have information on the S&P 500 index back through 1925. The summer returns vs. the whole returns for the entire time frame are as follows:

Source: Standard & Poors

Salesmen want to believe the Sell in May and Go Away myth has teeth. After all if you are paid by generating transactions, maybe these short-term results will convince you enough to continue making additional trades. Looking at the complete data set negates this myth. The June through August returns have averaged 1.53% per month while the whole year average has been just 1.01% per month. Lets go one step further and look at month-by-month returns for 80 years ending in 2005 (the additional data from 2006 & 2007 will not change the monthly figures in a meaningful way)

Source: Global Financial Date

What you notice almost immediately is that September is the only month with negative average returns, with every other month averaging positive returns. This simply indicates that the market on average is more positive than negative. Given today's anemic interest rates, the average monthly return for May through August looks pretty attractive.

Beware of Data Mining

Sell in May and Go Away is a very simple application of data mining. Data mining can be very useful in certain applications. It is simply the process of analyzing data to find useful information. Technically it is finding correlations or patterns among dozens of fields in large relational databases. If you were managing Wal Mart, if you knew what, when and where something is purchased, you could stock the shelves with the products needed to meet the demand of your customers. What is not useful is trying to predict future stock market returns based on correlations or patterns. Why? First and foremost is that the stock market is constantly evolving. Data mining is used by more of my peers (Chartered Financial Analysts) than those who could actually benefit, such as Wal Mart. The basic belief is that the past can be predictive of the future, if we only have enough data to crunch. This belief is promoted by most of us in the investment community. Our approach has always recognized that science has its place, but financial forecasting is not based on a mechanical model. As Roman Frydman and Michael D. Goldberg, the authors of "Imperfect Knowledge Economics", states; "Good forecasting is much like good entrepreneurship-it relies on personal knowledge and intuition, as well as luck in spotting profit opportunities".

A Bad Month for Mutual Funds

In the late 80's when I was pursing investment education by any means possible, I came across an article that mentioned a book title "The Aggressive Conservative Investor" written by Martin J. Whitman in 1979. In looking for a copy, I found out that it was not in print. Financial books have a limited shelf life and are labeled big sellers after about 100,000 copies sold. In this case the best course of action was for me to get on the phone and call the author, which I did. Mr. Whitman was a very interesting individual. Quickly I learned I was out of my league when it came to knowledge of the investment business. He is by far one of the most honest and intelligent individuals that I had spoken to up to that time. By the way, Mr. Whitman is a value investor and the founder of M.J. Whitman and the Third Avenue family of mutual funds. A few years later I met Mr. Whitman in person in Orlando Florida. He is a short man with a honest smile and a sparkle in his eyes. He is in his eighties today and working as hard as ever.

Mr. Whitman, along with managing his business, is also a Professor at the Yale School of Management. In 2004 Eli Rabinowich conducted an interview for publication in the Columbia Business School magazine (the whole interview is available here - http://www4.gsb.Columbia.edu/valueinvesting/schlossarchives/public) titled "The Bottom Line". This is a quote that should be shared to all mutual fund investors; "At the time I discovered what a license to steal the mutual fund business was - it was like having your own toll booth on a bridge. So in 1990 I started up the Third Avenue Fund and now we have a little bit over $8 billion" (This was in 2004, today, the Third Avenue Fund Complex manages approximately $19.5 Billion).

This is from an honest man who without question understands the economics of the mutual fund industry. It seems the "license to steal" has turned into reality. Fidelity paid an $8,000,000 fine to settle federal charges that its stock traders improperly received gifts from brokers seeking the firm's business, including weekends of partying on private jets to golf and gambling outings. What I found even more devastating was the fact that Peter Lynch, an individual who I believed to be an honest person and grew to admire when he ran the Fidelity Magellan Fund, received nearly $16,000 worth of free tickets to some pretty special events including the Ryder Cup golf match and a U2 concert. Fidelity acknowledged in this statement, "the seriousness of the misconduct found by the SEC", but noted the government made no finding that its shareholders or funds were harmed. I'll add, Yes they were!

The American Funds $5,000,000 fine was initially levied by the NASD (which since has merged with the regulatory functions of New York Stock Exchange to form FINRA the self regulatory agency overseeing the brokerage industry) and upheld under appeal for violations of mutual fund distribution rules by sending trading business to brokers as a reward for selling their funds. The appeals body of FINRA (Financial Industry Regulatory Authority) took a pretty tough stand saying that American Funds Distributors were intentional, not negligent in their violation of the rules. They went on to say, "Brokerage arrangements, like those employed by AFD tended to undermine the rules of fair competition envisioned by the rule". They also added "it doesn't appear that AFD's actions enriched the firm or harmed fund shareholders". Again I add, Yes it does!

Banc of America Investment Services, a unit of Bank of America and Columbia Management Advisors, the successor to Banc of America Capital Management agreed to pay $9,800,000 to settle charges it failed to disclose in its favored affiliated mutual funds. SEC enforcement director Linda Thomsen stated, "BASI's selection of mutual funds for wrap fee clients was compromised when it favored its own proprietary funds over non-affiliated funds." Neither Bank of America or their attorney gave a response.

The real problem with mutual funds is that all the relevant information that you need is hidden in legal documents that you or your advisor will never read. We conduct an annual cost analysis of mutual funds as a way to compare our fees. The process is fairly simple given the information that most fund companies provide to Morningstar.   The last study ended on December 31, 2007. With the assistance of Morningstar's Principia we averaged the management fee for 25,195 mutual funds. The following table shows the results:

Source: Morningstar Principia

Granted, these are averages and for each the range of cost is large. In almost all instances, when we ask the individual mutual fund owner what they are paying for the fund, most will say, "I don't know". In any case, if you own a mutual fund it's worth checking. Of course, if you need help, give us a call.

Doing My Best to Help the Economy

I'm doing my best to help our economy. I am on my way to pick up a new vehicle. All you need to know is that it's Italian, Red, has two wheels and will be purchased from an American dealer.

Kendall J. Anderson, CFA