Tag Archives: mutual-fund

3 Income Funds You Should Hold In 2016

Summary If 2015 has taught us anything it’s that there is a high degree of risk in individual high yield sectors such as master limited partnerships and junk bonds. My top income themes for 2016 are centered around large, diversified, and proven investment vehicles that circumvent the hit-or-miss proposition of individual sectors. I think you will find these actively managed mutual funds and low-cost ETFs offer attractive characteristics as core holdings for nearly every style of income investor. Forecasting where the market will end up in 2016 is a very difficult task, as innumerable variables will intercede over the course of the next twelve months. The actions of the Federal Reserve in particular are going to be a heavy influence on income investors as they seek to position their portfolios for capital preservation and dependable dividend streams. If 2015 has taught us anything it’s that there is a high degree of risk in individual high yield sectors such as master limited partnerships and junk bonds. These groups have erased years of accumulated gains in a manner of months as credit headwinds weigh on investors’ minds. In addition, the trendless direction of interest rates will likely lead to above-average volatility in high quality fixed-income holdings as well. My top income themes for 2016 are centered around large, diversified, and proven investment vehicles that circumvent the hit-or-miss proposition of individual sectors. That may seem boring to those who like to tempt fate with the glory of a turnaround story or make assumptions in continued strength of momentum names. Nevertheless, I think you will find these actively managed mutual funds and low-cost ETFs offer attractive characteristics as core holdings for nearly every style of income investor. Vanguard High Dividend Yield ETF (NYSEARCA: VYM ) If you are looking for an essential equity income fund to own in 2016, then VYM should near the top of your list. This exchange-traded fund houses 435 U.S. stocks with characteristics of consistently high dividend yields. Top holdings include well-known names such as Microsoft Corp (NASDAQ: MSFT ), Exxon Mobil Corp (NYSE: XOM ), and General Electric Co (NYSE: GE ). VYM has exposure to virtually every sector of the stock market, which means that it is a highly diversified and transparent investment vehicle. I like to think of this fund as the “S&P 500 of dividend stocks” because of its market-cap weighted structure and broad index construction methodology. Currently VYM has a 30-day SEC yield of 3.25% and income is paid quarterly to shareholders. The embedded expense ratio of this fund is just 0.10% and it has over $11 billion in total assets. I have owned this ETF as a core holding in my Strategic Income Portfolio for several years and expect that it will continue to add value in 2016 as well. It’s simply difficult to find a better investment vehicle for those that crave a low-cost, dividend-focused stock fund. PIMCO Income Fund (MUTF: PONDX ) Most bond investors have their core holdings in passive indexes such as the Vanguard Total Bond Market ETF (NYSEARCA: BND ). However, in my opinion, an over allocation to a passive fixed-income basket may lead to weak performance over the course of the next several years. One of my favorite actively managed bond funds to supplement or replace existing passive strategies is PONDX. This portfolio is governed by Daniel Ivascyn and Alfred Murata of PIMCO, who were named MorningStar’s 2013 U.S. Fixed-Income Managers Of The Year. The PONDX strategy is built on the foundation of a flexible, multi-sector approach with the goal of income and long-term capital appreciation. It takes a global slant by incorporating themes from overseas markets and has been known to use hedges to control risk and limit interest rate sensitivity as well. The effective duration of PONDX is just 3.09 years and it has a current 30-day SEC yield of 3.03%. This fund has an admittedly higher expense ratio than a comparable ETF at 0.79%. However, the performance over the last several years has well compensated investors for the superior security selection and risk management techniques. PONDX has gained 2.81% versus 0.81% in BND on a year-to-date basis in 2015. Over the last three years, PONDX has returned 17.02% versus just 4.02% in BND. The fund is rated 5-stars by Morningstar and has been consistently ensconced in the top of its peer group over the last 3 and 5-years. I own this fund in my own account alongside my clients and feel that the managers’ expertise navigating credit and interest rate volatility will make for a solid bond holding in 2016. Note: Larger investors or those working with an advisor may benefit from the institutional share class PIMIX, which charges an expense ratio of 0.45%. Vanguard Wellesley Income Fund Admiral Shares (MUTF: VWIAX ) For those seeking a conservative multi-asset income fund with a solid track record and low fees, look no further than VWIAX. This fund is one of the few actively managed offering from Vanguard that has been in existence for over 40 years. Yet true to the Vanguard approach of minimal cost, the expense ratio of VWIAX is only 0.18%. The fund invests in a mix of income generating assets that fluctuate between 35-40% stocks and 60-65% bonds. The stock allocation consists of 59 large-cap names such as Wells Fargo Inc (NYSE: WFC ) and Merck & Co (NYSE: MRK ) to name a few. The bond sleeve consists of high quality corporate and government securities with an average maturity of 6.5 years. VWIAX has a current 30-day SEC yield of 2.83% and dividends are paid quarterly to shareholders. In a world filled with aggressive income strategies trying to position themselves as high yield standouts, this stalwart mutual fund aims for a quality and dependable asset allocation mix that has survived the test of time. This helps keep volatility low and risks in an acceptable range that retirees or other capital preservation-focused investors can appreciate. Furthermore, it has been rated 5-stars by Morningstar over 3, 5, and 10-year time horizons. The bottom line is that these three income funds offer solid value in 2016 by sticking with investment themes that have historically provided dependable results. They can also be supplemented with tactical or alternative investment themes to enhance the overall yield of your portfolio or capitalize on a relative value opportunity.

Third Avenue Focused Credit Fund – Designed To Implode

Summary Third Avenue Focused Credit Fund has been placed in liquidation by its board of trustees. The cause was the illiquidity of its portfolio of deep value high yield securities. The board could not continue to run an open-end mutual fund with such a high concentration of illiquid securities. Will there be contagion for other high yield bond funds? Yes, if they have a high proportion of illiquid securities in their portfolios. On December 10, Third Avenue Focused Credit Fund (MUTF: TFCIX ) announced that it was going into liquidation rather than redeeming any additional securities. It is in all the newspapers. Liquidation is a highly unusual move for an open-end mutual fund to make, but it appears to have been the only rational course of action open to the fund’s board of trustees in the circumstances. The fund, started in 2009, had an unusual, possibly unique investment style. It invested in deep value high-yield bonds – the sort that would not blush when called “junk” – often with the lowest ratings. Third Avenue Management, the fund’s manager, and its chairman, Martin Whitman, are highly regarded value investors. It is not a fly-by-night operation. Indeed, when the Focused Credit Fund opened in 2009, I was an early investor – though I redeemed my shares after about a year because I thought the fund was taking greater risks than I had understood when I invested. The fund had over $2 billion of assets at the beginning of 2015, but due to portfolio losses and redemptions, it was down to $789 million at December 10. Illiquidity of the Portfolio Assets of a mutual fund have two pricing mandates: (1) a mandate under the Investment Company Act that, although detailed in overall methodology, is relatively general regarding specific securities, and (2) a process under Generally Accepted Accounting Principles, which, by dividing valuation into three methodologies, is somewhat more specific. By reason of its specificity, the GAAP definition tends to prevail in the valuation of individual securities. The last SEC-filed report on the valuation of the Focused Credit Fund’s portfolio securities, as of 7/31/15, shows that of the fund’s $1,953 million of assets, $171 million was priced in accordance with level 1 methodology, $1,399 million in accordance with level 2 methodology, and $382 million under level 3 standards. By the standards of most mutual funds, only level 1 assets are deemed to be liquid – that is, capable of being sold at a price near their valuation in a reasonable period of time. The Third Avenue Focused Credit Fund had over half its assets in level 2 and almost 20% in level 3, which sometimes is called “mark to myth.” These figures stand out starkly against the SEC’s general rule that open-end funds are to limit their holdings of illiquid securities to 15% of assets or less. Strategic Illiquidity Looking at Focused Credit Fund’s holdings, it appears that the deep value methodology that the fund adopted almost necessarily led to endemic illiquidity because securities of that type trade infrequently. Looked at in that light, the fund was almost bound to implode if the lowest-rated part of the high yield market declined significantly. And that is just what happened in 2015: The lowest rated high-yield securities performed far worse than the rest of the market. In that circumstance, a high level of redemptions was predictable, and an inability to sell the portfolio’s securities at reasonable prices in reasonable amounts of time also was predictable. Under and Over Valuations – Risks either Way In a way, I am surprised that the Board of Trustees waited so long to put the fund into liquidation because the responsibility for valuing level 2 and level 3 assets falls on the board itself, including its independent members. Although the board usually defers to management and often has a subcommittee that deals with valuations, the board as a whole is responsible. Thus, for a long period of time, the board has been blessing portfolio valuations that are hard to defend, even if they were done in the best of faith. Moreover, those who cashed out and those who held on had conflicting interests. Those who cashed out benefited from higher valuations; those who held on benefited from lower valuations. The board therefore has been or will be sued every which way. Liquidation is the only way to avoid further litigation risk for valuations. It appears from reading press reports that the officers of Third Avenue Management are concerned that they may have overvalued some portfolio securities. That surprised me because looked at from the point of view of a lawyer representing the independent trustees, a role I played often over a 30-year period, and the valuations should be conservative – on the low side. But it appears that the Third Avenue people are concerned about over-valuations. However, I now see that an investment manager has incentives to place valuations of the high side because that will keep the NAV up, which will tend to fewer redemptions and higher management fees. If the valuations were high, then stockholders that did not redeem may have been injured because stockholders that redeemed got more than they should have. In all likelihood, the remaining stockholders have a good class action. The board finally decided it had to liquidate the fund because no matter what valuation methodology it used, it would be subject second-guessing in court. Definition of Liquid Security Over the last year, I have written about the need for a better definition of liquid security. The definition, I have argued, is too loose; therefore, it is likely to lead to some funds holding far greater proportions of illiquid securities than the SEC thought safe – or than I thought safe. The industry has fought a redefinition because it has made money from the old definition. The liabilities that are likely to flow from this event may soften that opposition, and the events will strengthen the forces of reform. Here is what I said on this subject at NexChange.com about six months ago: The genius of the form is that forward pricing at net asset value prevents investors from gaming the system. Whether the market is going up or down, NAV is NAV. (Yes, there are issues with trading in different time zones, but those issues have been minor in most cases.) But the genius of NAV depends on two things: One, that it be a reliable source of true value; and two, that the underlying securities be, for the most part, liquid in substantially all markets. Many open-end bond funds have significant percentages of assets that are liquid under the SEC’s definition of “liquid” but that in a crisis would not be liquid-that is, they could not be sold except at a price far lower than their intrinsic value. If, due to redemptions, some funds were forced to sell such assets, the NAV of all similar funds would fall more precipitously than the intrinsic value of their underlying assets would warrant. This illiquidity problem could be solved by the SEC changing its definition of “liquid asset” to make it more stringent. Open-end bond funds then would have to avoid smaller issues that would likely be thinly traded and have practically no market in a crisis. But that will not happen because the fund industry is making too much money on their bond fund products. Besides, the problem is not likely to have a systemic impact because the illiquid issues are not due immediately and the losses that investors suffer will not, for the most part, be leveraged.” The liquidation of Third Avenue Focused Fund is evidence that my fears were well founded. In the same series of articles at NexChange, I discussed the difference between interest rate risk-based valuation issues and credit quality-based valuation issues. Here is what I said. It is applicable to the Focused Credit Fund style and experience. There is a big difference between wondering whether the interest rate on a particular bond is appropriate in the current market and wondering whether the bond will be repaid. The interest rate question an investor can quantify. At any given rate (the current risk free rate is known), the value, based solely on the interest rate, tenor and repayment options, is known. The spread between the implied market rate on the bond and the market rate on a similar duration Treasury reflects the market’s judgment as to credit risk. Traders will be quick to spot any anomalies and will take advantage of them, in effect stabilizing the interest rate side of the market. But when the issuer’s ability to repay comes into doubt, no one knows what the right price is, and the market may have no floor. That is what owners of sub-prime backed RMBS and their derivatives discovered on 2008. When credit quality is unknown, there may be no market price because there may be no market.” Contagion Will there be contagion for funds that look like Third Avenue Focused Credit Fund? Yes, if they really do look like it. But I expect there are not many of those. The unusual deep value nature of the fund’s strategy met up with that class of assets falling out of favor over the last year and seeing their value drop sharply. The bigger question is whether more ordinary high-yield open-end funds will suffer from contagion. First reactions, including that of the Wall Street Journal, appear to suggest there will be contagion throughout that class of funds. How far it will go remains to be seen. The tide has gone out. Now we will see who is swimming naked – that is, who really has a higher level of illiquid securities than they claim to have. That could be quite a few. According to research using the Schwab search engine, there are 82 high yield bond funds with over $500 million in assets, 28 with over $1 billion, and 3 with over $10 billion. That looks like maybe $48 billion of assets. That is a large number, but it does not seem like enough to be a systemic threat. (Yes, that’s what they said about the subprime mortgage market in 2007.) Two of the biggest are BlackRock High Yield Fund (MUTF: BHYAX ), and JPMorgan’s High Yield fund (MUTF: OHYFX ).

Jack Bogle Was Right – You Could Be Leaving 80% On The Table

The typical investor should accumulate $3.7 million at an 8% annual rate. But the cost of intermediation – 2.5% – reduces that return from 8% to 5.5%. Due to the “tyranny of compounding costs”, the investor surrenders 80% of final wealth. You’ve heard it before – the key to building long-term wealth is to tap into the power of compounding returns. It’s a concept that’s universally accepted by savers, investors, finance professors, and math geeks. But for most of us it still requires a leap of faith because the math can be a little tricky. Anyone willing to devote 5 minutes to this topic will understand just how powerful compounding is. Why is this important? Because the power of compounding is a double-edged sword. Compounding growth (especially in a tax-deferred account like an IRA or 401K) will turbo-charge your wealth, compounding costs are a real drag. It’s important to understand how both of these forces work, and how they impact your portfolio. If you are an experienced investor, or someone who is good at math, you might think you don’t need to go through this exercise. But when it comes to the compounding cost part, you might be surprised to learn just how much of a drag it really is. In his book, The Battle for the Soul of Capitalism, Vanguard founder Jack Bogle made a bold statement. He said that thanks to the “tyranny of compounding costs,” investors leave 80% of their wealth on the table. I was more than a little skeptical – not about the nature of Bogle’s claim, but about the magnitude. Could it be true that investors leave 80% on the table? How does that happen? More importantly, why would any investor allow it to happen? Everyone knows that brokers charge commissions and advisers charge fees, but how much can those costs come to? Maybe 1% or 2% per year? How can that end up taking 80% of an investor’s wealth? Although I have always had great respect for Mr. Bogle, I wondered whether he might have overstated the case. So I set about the task of trying to debunk this astonishing claim. Much to my surprise, the claim holds up to scrutiny. To arrive at the 80% figure, Bogle used a very long investment horizon – 65 years. At first I thought, a-ha! Nobody stays in the market for 65 years! But after thinking about it I realized that it’s not only possible, it’s actually very plausible. Here’s how he arrived at the 65-year time horizon: A 20-year-old investor, just starting out on a long career Works and contributes to savings for the next 45 years, until age 65 Then lives another 20 years in retirement (actuarial tables say this is realistic) And doesn’t liquidate his holdings during retirement, but lives off of the interest on his principal At 85, leaves his nest egg to his children, after a 65-year investing career. Although this timeline is unusual, it’s not unrealistic. When making an argument, it’s completely legit to use best-case and worst-case scenarios in order to illustrate your point. So let’s stipulate that a 65-year horizon is acceptable for illustrative purposes. As you go through the charts and tables below, you can substitute your own likely time horizon for the 65 years that Bogle used. In constructing his argument in the book, Bogle states the following: “$1,000 invested at the outset of the period, earning an assumed annual return of, say, 8 percent would have a final value of $148,780 – the magic of compounding returns.” Here’s what that looks like in chart form. (You’ve undoubtedly seen this graph before, but bear with me – I’m establishing a baseline here.) (click to enlarge) Bogle then warns that this outcome is unlikely to be achieved. Why? Because the graph above excludes what he calls “intermediation costs.” And these costs also compound over time. Bogle’s argument is that the power of compounding returns is eventually overwhelmed by the tyranny of compounding costs – a concept that many investors fail to fully appreciate. Bogle continues… “Assuming an annual intermediation cost of only 2.5 percent, the 8 percent return would be reduced to 5.5 percent. At that rate, the same initial $1,000 would have a final value of only $32,465 – the tyranny of compounding costs. The triumph of tyranny over magic, then, is reflected in a stunning reduction of almost 80 percent in accumulated wealth for the investor… consumed… by our financial system.” Here’s what the tyranny of compounding costs looks like in chart form: (click to enlarge) As Bogle points out, financial intermediaries – the money managers, sellers of investment products and financial advisers – “put up zero percent of the capital and assume zero percent of the risk yet receive almost 80 percent of the return.” And it’s true – I ran the numbers six ways to Sunday and I came up with the same results every time. Now let’s take a look at the numbers from a different angle. Instead of using a static $1,000 deposit at the beginning of the period, I devised a more realistic scenario. The median household income in the U.S. today is $55,000. If we assume that this household sets aside 5% of that income each year, they will end up with a nest egg of roughly $800,000 when they retire after 45 years. And if they leave that money in their account for the next 20 years, only spending the interest on their principal, it will continue to grow, and their final account value will be roughly $3.7 million, using an 8% annual rate of return. That’s the power of compounding returns. Now let’s assume that the total cost of investing – what Bogle describes as financial intermediation – comes to 2.5% per year. This is a reasonable figure, based on many studies from academia and from the financial industry itself. When you combine the visible costs like mutual fund expense ratios, management fees, and account servicing charges, you get to 1.5%. When you add in the hidden costs, like the commissions that mutual funds pay to the brokers who execute their trades, trading impact costs, bid/ask spreads, capital gains taxes, and payment for order flow – you get to 2.5%. Now let’s see how much this typical household gives away to financial intermediaries – after 45 years, and after 65 years. (click to enlarge) After investing for 45 years, this household would – in theory – have accumulated a $798,000 nest egg. And if they kept their principal intact for the next 20 years of retirement, their nest egg would grow to $3.7 million. However, due to the tyranny of compounding costs, the financial intermediaries who “helped” them build this wealth would take 65% of their nest egg after 45 years, leaving them with just $278,000. At the end of the full 65 years, the financial intermediaries will have taken 78% of our household’s wealth, leaving them with $811,615. The true cost of financial intermediation is outrageous and unjustified. But most of these costs are hidden, which explains why so many investors aren’t aware of the destructive impact these costs have on their future wealth. In my next article on this topic, I’ll dig into the details of the costs to show you how they sneak up on us and overwhelm the power of compounding returns. In the meantime, I’ll leave you with a set of low-cost, high-quality mutual funds and ETFs that will help you cut down on the high cost of financial intermediation. I created this list using Morningstar’s fund screening tool. I screened for a combination of low expenses and high analyst ratings. It’s not a perfect list, and it doesn’t cover every asset class – but it’s a good place to start. If you own some funds that have high expenses, it might be worth your time to compare what you own to the funds shown below. Every dime you save on expenses gets moved from the intermediation side of the ledger to the wealth side. Think about it. (click to enlarge)