Boston
Many of you remember our early years as a family owned business. The first person you'd come into contact with, whether by phone or in person, was Kathy, my wife. Besides handling everything office-wise, Kathy also expertly put me in my place whenever I began feeling a little full of myself and just as easily also gave me a "pick-me-up" when it was needed.
While she still has the duty of putting me in my place, during her days she has taken on a new and far more important role: helping children. When our youngest daughter graduated from high school in 1997 and set her sights on college, Kathy decided it was also a good time for her to make a change and pursue a dream. The two went off to college: one for the first time, and the other for a new start. After seven years including an additional year as an intern, Kathy entered the health care field as a School Psychologist for the Fort Mill SC School District. Many of us quickly claim to be "overworked and underpaid," but I can tell you first hand that this phrase accurately applies to Kathy. For her, twelve hour days are more the norm than the exception.
Of course, there are many benefits that come with her job, and one of these is the annual spring break. This year Kathy, one of her friends (also a School Psychologist), and her friend's daughter headed north for an adventure, making their first stop in Boston, the heart of New England. While those of us in South Carolina are proud of our history and the service of our ancestors in the American's fight for freedom, it was Boston and its citizens who started the ball rolling. Kathy's co-worker was born and raised in New Hampshire and graduated from The University of Massachusetts, and so was the tour guide for the trip. The trio took some time to visit Amherst, Portland, Maine, Mystic, Connecticut, Newport, Rhode Island and Salem, all of which are special places with wonderful histories and ample sight-seeing opportunities.
I was happy to hear that Kathy enjoyed the trip. She even said Boston was a city she could see herself living in, which brought back memories for me. In the days of slide rules, before Financial Engineering, the IVY League B-School Buddy System, and the great bull market of the late 80's and 90's, Boston had come very close to being our home. In those earlier years, a young and energetic Chartered Financial Analyst had limited opportunities for practicing his skills. He could take a job crunching numbers with a brokerage firm, a bank trust company, or an insurance company. He could also take a job in the much smaller mutual fund industry, with hopes that his skills would elevate him to the premier job of Portfolio Manager.
The very first modern era mutual fund, the Massachusetts Investors Trust, was established in 1924 in Boston. Boston continues to be home to many of the world's largest fund companies. Given this history, it should be of no surprise to you that offers to move to this city were tempting. However, I overcame that temptation and settled down to help raise our family in Rock Hill instead. Given what has happened with the mutual fund industry from those years, I believe that someone must have been watching over me.
MUTUAL FUNDS
As a firm, we purchase data from Morningstar Inc. ® that provides information on mutual funds in a single standard format. As of December 31, 2008, the database covered 26,565 mutual funds. It is amazing that during one of the worst years in decades for the markets, this number has increased, as it was 25,195 on December 31, 2007. In very simple terms, this means over 5 net new mutual funds a day were being offered to you and every other soul in the country. Often people ask "Why so many funds?"
I'll try to give you the simplest explanation of why so many funds are created. The average cash flow paid to the fund companies in 2008 (this is the cost of these funds- and the average cost is paid by the mutual fund investor), was 3.15% of the value of the funds' assets. That's not all: the average front end load is 0.78% a year, the average deferred Load is equal to 0.57% a year, and the average 12b-1 Fee is 0.34%. For many of us, these figures aren't as clear as thinking in terms of cold hard cash, so I'll give an example. If your portfolio value at the end of 2007 was $200,000 and you were the proud owner of a traditional open end mutual fund paying the average, then your "fee" would have been $6,980.00 before you paid your salesman a dime. Of course, a mutual fund salesman can be paid in different ways, varying from an annual fee just like the fund's management company or via the more traditional single upfront commission. Don't kid yourself: the salesman is getting paid, and the investor is doing the paying. Worst of all, the amount paid is hidden in page upon page of disclosures and is never shown as a single sum.
With revenues like this, it's no wonder that an army of mutual fund salespeople have emerged. It's also no wonder that the bank teller wants you to buy a mutual fund, the insurance agent wants you to buy a mutual fund, and just about every financial advisor, financial planner (including the stock broker), employers, etc. also want you to buy a mutual fund. Not only do they want you to buy a fund from them, but they want you to believe that they have the knowledge and expertise to pick the best fund out of these 26,565 different funds despite the fact that they have never met the manager of the fund, they have no idea what securities the fund holds today or held yesterday, nor do they have any idea of what securities the fund will hold tomorrow. Let's look at the odds of the salesman being accurate by using the help of a little math: 1(best fund)/26565(total number of funds) = .0000376435. This is the probability that someone has chosen the "best fund". Do you still think the salesman is right?
Mutual funds did not start out to take money from individual investors for themselves. Their beginnings were humble and honorable. In the five years following the 1924 creation of the Massachusetts Investors Trust, eighteen other funds were created with some well known names. State Street Investor's Trust was one, and one of the managers, Richard Saltonstall, later went to Scudder Stevens and Clark, the first no-load fund in 1928. The Wellington Fund and the Pioneer fund were both established in 1928. It took until the early 1950's for the 19 funds available in 1929 to grow to 100 funds. By 1960 this number reached 150. It was during these first 36 years that mutual funds were conservatively managed. I believe it was the decade of the 60's that forever changed the focus of mutual funds from that of honorable stewardship of others' money to that of salesmanship and risk-seeking for the benefit of the company and its sales force rather than for the mutual fund investor.
The funds in the fifties were for the most part run by investment committees who were more risk-aversive than risk-seeking. The majority of funds were invested in a diversified portfolio of blue chip companies and the highest quality bonds available. The typical fund believed in the long-term ownership of growing, financially sound, dividend paying companies. They held their average stock for more than six years. The average cost to manage the funds was 0.77% a year. The returns were market-like. It was during these years that mutual funds, their managers, and their companies met the mission that they started out to accomplish: managing a portfolio of stocks and bonds as a fiduciary for the small investor who did not have the funds or the expertise to manage a portfolio for him or her self. Today there are still a few funds whose objectives and mandates are structured for the benefit of the conservative investor. You hear very little about them simply because they are not "exciting," just "consistent," and who wants to sell that?!
During the sixties, the world changed with the advent of star managers, momentum investing, and go-go funds. The industry found that the average individual investor would chase performance and throw all they have into the "hot fund". Bernie Cornfield used this knowledge to mastermind a wonderful confidence game that ultimately ruined individuals and many US and European Banks. His sales pitch was "Do you sincerely want to be rich?"
John C. Bogel, the founder of the Vanguard Mutual Fund Group, sums up the changes to the industry in his book, Enough, as follows:
"The combination of asset growth, truncated investment focus, counterproductive investor behavior, real-time portfolio management process, hair-trigger investment strategies, soaring cost, conglomerate ownership, and product proliferation (inevitably followed by deproliferation) has constituted a serious disservice to fund investor.
Simply put, we, the trustees of the investment dollars of American families-pension funds, mutual funds, and other financial institutions-have failed to live up to the faith investors have placed in us. We have become blind to our excessive intermediation costs; deaf to the fact that given the level of those costs, investment managers as a group are destined to fail at the task of providing adequate returns; and insensitive and unforthcoming to the multitudinous ways in which we as an industry fail our clients".
At one time, I thought the mutual fund industry and the even larger financial services community would change for the benefit of investors. However, the one-sided incentives are so great, the savings complex of 401K's, IRA's and other retirement plans are so entrenched, and the level of investment knowledge of the average financial advisor is so limited, that the only hope for this change is for it to come from our elected officials. The easiest way for this to be accomplished would be if all advisors fell under the same fiduciary rules currently in place for all Registered Investment Advisors. The majority of financial advisors, financial planners, stock brokers, and insurance agents who sell securities and bank financial salesmen only have to abide by the suitability rules, which don't require the salesman to "hold the client's interest above its own in all matters including full disclosure of any and all conflicts of interest." Congress, at the direction of the Securities and Exchange Commission, is currently working on a proposal to make this change a reality. For obvious reasons, the investment community is up in arms, and because of the huge amount of money this community controls, I doubt that any changes will be made, which is too bad for the American Investor.
Cap and Trade
Speaking of legislation... Over the years there have been multiple pieces of legislation targeting the reduction of pollutants with an economic incentive, normally in the form of taxes or fines. This approach has worked well when the pollutant is local and can be controlled without needing your neighbor to participate. Most of you are familiar with the cost of disposal for tires, batteries and used motor oil. This can also work on a larger scale as it has with the levels of acid rain and ozone depleting CFCs. The current Cap and Trade proposals before us are related to the reduction in CO2 and other greenhouse gas emissions. The concept is pretty simple: those who produce a higher level of CO2 than allowed (the Cap) will have to buy credits (the Trade) from a producer who emits less than allowed. Of course, in that the public owns the sky, the government as the initial owner of the credits will set the terms of the credits (number of credits available and the expiration terms of the credits) and receive the proceeds from the initial sale of the credits at auction.
Most of us have no opposition to effective pollution regulations. In fact, most of these types of regulations have an economic impact that is not necessarily measured in terms of cost. Knowing that our water, food, gasoline, fabrics, etc. are safe to use allows us to live our life much more simply. We know we can take a trip without having to take a chemical test kit with us. We know we can buy a product online without having to worry that we are going to receive a product which was made with toxic materials. These are controllable and effective ways to reduce pollution and increase our own safety.
However, the controversy over Cap and Trade resolves around the cost, including the direct cost to producers and the economic impact on the American Economy, and the effectiveness of the rules (i.e. will these rules have a material impact on the reduction of CO2 and other greenhouse gases?). The direct cost has already been estimated by our President's team of advisors at $646 billion. This is the tax (revenue from the sale of credits) over the years 2012 to 2019. The second layer of cost, the economic impact, has to be viewed from our second area of controversy, the effectiveness.
I believe Cap and Trade would be effective if and only if the rest of the world joined in and played by the same rules. Unfortunately, we do not control the world's supply of carbon, nor do we have the ability to control the world's use of carbon. The two major stores of carbon on our planet are oil and coal. Of course, the burning of these stores of carbon creates the emissions that we are trying to reduce. They are also the primary source used to create the worlds' electricity, which provides heat to the people of the world in the winter cool air to the people of the world in summer. It also is the source which transports the majority of the world's people for work, vacation, etc. Therefore, to be effective, the use of these two sources of energy would need to be reduced on a world-wide basis. Without this cooperation, the effectiveness of Cap and Trade would be non-existent. If the rest of the world did not participate, the cost to the American Citizen would not only be measured in direct out of pocket expense, but would impose a huge competitive burden to all U.S. based manufacturers who have almost zero impact on the worlds' CO2 output.
There are ten countries in the world who openly voice their dislike of the American people and who also control 80% of the known oil reserves on our planet. The majority of these countries are covered in sand, with no other means to support themselves other than pumping oil from the ground. For Cap and Trade to be effective without excess cost to the American citizen, these ten countries will have to reduce their oil production.
Almost across the board, the poorest countries in the world are sitting on the biggest store of carbon on our planet: coal. This coal is estimated at over 1 trillion tons. It is cheap and can be accessed without a huge capital investment. These countries also control the third largest source of carbon: the great forests of the world. The population of these countries is about 5 billion of the total 6.5 billion in the world. These 5 billion people in total are the largest polluters in the world. China, the largest emitter, will be opening over 100 new coal fired power plants this year alone. To be effective, we would need to tell the poorest countries in the world to find another way to produce energy which they have no ability to pay for.
Of course, if our government took the revenue and used it to find a way to produce energy at a lower cost than oil or coal, there would still be hope. However, what we have heard is that wind and solar power are the choices. I am not sure how many of you have seen a power generating windmill, but it would be worth a trip if you haven't. They are huge, with some of the largest as high as a fifty story building. However, they only generate about 2 to 3 megawatts of power. It takes about 100 megawatts to get a jumbo jet off the ground. It would take a mere 50 windmills operating for 24 hours to lift one jumbo jet. On a larger scale, it would take 13,000 windmills with a constant level of wind to produce enough energy to keep New York City operating.
Currently, the largest solar farm in the U.S. is located in the desert on Nellis Air Force Base. The panels cover approximately 140 acres and produce approximately 14 megawatts. This simply means we would need about 1,000 acres of desert covered with solar panels to lift our jumbo jet. It would take over 300,000 acres to keep New York operating.
Some of you believe that Cap and Trade is the right way to go. Others will say it will create such a burden on American Manufactures that every plant in our country will be priced out of the market and will have to close. We will have to monitor the situation and take a non-philosophical view, weighing the cost and/or opportunities of any new legislation closely.
A Warning
Most of you stay pretty informed about the markets by following the performance of the Dow Jones Industrial Averages, the Standard and Poors 500, and your portfolio. Because of this you are fully aware that these markets have done quite well over the past month. At the same time, it looks as if real estate is stabilizing and consumer confidence is increasing. The financial system looks as if it may be over the worst of the problems, and our Federal Reserve Board is telling us that our economic recession may be over by the end of this year. These facts are having an impact on all of us. The first is an increased portfolio value which is always welcomed. The second is some comfort from the turmoil of the past two years. But with that comes a warning! As times move from bad to good we often quickly forget the bad and rejoice in the good. We may even start believing that we are smarter than the markets and we can take on higher and higher levels of risk. The one thing that you need to remember is that economies go through periods of prosperity and periods of depression. The markets do the same. For our part, we will try as hard as we can to be your stabilizer, reminding you that when things are bad, they will not be bad forever, and when they are good, they will at some point cease to be as good.
Until next time,
Kendall J. Anderson, CFA
Anderson Griggs & Company, Inc., doing business as Anderson Griggs Portfolio Management is a registered investment adviser with the US Securities & Exchange Commission. Pursuant to laws and regulations Anderson Griggs also maintains notice filing with several individuals state regulators including North and South Carolina. Anderson Griggs only conducts business in states and locations where it is properly registered or meets state requirements for advisors. This commentary is for information purposes only and is not an offer of investment advice. We will only render advice after we deliver our Form ADV Part II to a client in an authorized jurisdiction and receive a properly executed investment Management Agreement. Any reference to performance is historical in nature and no assumption about future performance should be made based on the past performance of any Anderson Griggs Investment Objective, individual account, or index. The authors of publication are expressing general opinions and commentary. They are not attempting to provide legal, accounting, or specific advice to any individual concerning their personal situation. Anderson Griggs Portfolio Management's office is located at 113 E. Main St., Suite 310, Rock Hill, SC 29730. The local phone number is 803-324-5044 and nationally can be reached via its toll-free number 800-254-0874.