Billionaire Klarman Claims Risks of Collapse Dwarf All Other Factors

At times, analogies between the world of investing and the world of literature become so obvious that they cannot be ignored. Consider the parallel between this recent quote from Seth Klarman (cofounder of the 7^th largest U.S. hedge fund (Baupost Group) at the start of 2012, with almost $30 billion assets-under-management (AUM); he was mentored over 30 years ago by the legendary Michael Price):

“Investing today may well be harder than it has been at any time in our three decades of existence, not because markets are falling but because they are rising; not because governments have failed to act but because they chronically overreact; not because we lack acumen or analytical tools, but because the range of possible outcomes remains enormously wide; and not because there are no opportunities, but because the underpinnings of our economy and financial system are so precarious that the unabating risks of collapse dwarf all other factors.”

with this famous Charles Dickens’ prose at the very start of his A Tale of Two Cities:

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness…”.

Both quotes reference an era characterized by sharp contrasts and transitions – a description that surely fits the first six months of 2013.   What I offer you in this article is the following:

1)    CONTEXT: A “macro” look at the first six months of 2013, with the intent that you will –

a.   Gain the context needed to tie the above quotes to the recently widely swinging markets;
b.   Gather some perspective regarding the markets – looking at the steadiness of “the forest” instead of being paralyzed by “the trees” regularly blown here and there by the storms.

2)    INVESTMENT TIP: Consider a long-term approach to income investing that may help some of you – illustrating the impact of rate and economic fluctuations on one’s investments over time.

I know that many of you treasure (as I do) “context”. I also know that many others would rather “cut to the chase” and skip ahead to the (so-called) “tip”. I encourage you to do whatever you find most helpful.

Here is the “Context” that ties our market action with the insight of Mr. Klarman and the prose of Dickens:

1)   GOVERNMENT OVERREACTION (“foolishness”):

a.   We began the year with a dysfunctional Congress failing to meet its own deadline to spare the U.S. from the much dreaded “Fiscal Cliff” (feared to spark a downward spiral in the economy and markets);
b.   Congress extended its deadline two days and agreed upon a “deal” that postponed fiscal pain by creating a new draconian incentive (“Sequester”) meant to spur it to fiscal sustainability before summer’s arrival (which failed again);
c.   In part to compensate for fiscal stress, the Federal Reserve maintained its mega-doses of monetary stimulus, and projected its continuation into 2015, causing some overly smug “experts” to refer to it as the “Bernanke Put” (implying a “ceiling” for interest rates and a “floor” for stock prices).

2)   MARKETS RISING (“best”):

a.   Despite harrowing “Fiscal Cliff” fears, here is a summary of how U.S. markets responded between January 1st and May 21^st:
i.   S&P 500 Index                                                         UP      14.14%
ii.   Benchmark U.S. Treasury 10 Year Rate             UP      10.5 basis points
iii.   Barclays U.S. Aggregate Bond Index (LAG)       DOWN  0.9%
iv.   NOTE: Until May 2^nd, the U.S. Treasury Note rate was DOWN 30.8 basis points       and the U.S. Aggregate Bond Index was                         UP 0.27%

Then once again, the

3)   GOVERNMENT OVERREACTED (“foolishness”):

a.   On May 22^nd, during Congressional testimony, Fed Chair Benjamin Bernanke quite awkwardly broached the topic of “future tapering” of Federal Reserve bond purchases.
b.   During an even more uneven and awkward press conference on June 19th, during which Bernanke seemed more detached than in prior months, his attempts to clarify “tapering” and reign in market overreaction to the downside largely fell on deaf ears.

GRAPH: The graph to the left shows the price action in LAG (reflecting the U.S. Aggregate Bond Index) during the 12 months ended June 30, 2013. Not including distributions, the price fell over 3%!

4)   MARKETS FALLING (“worst”):

a.   Shadowing the overreaction of government, the markets overreacted to “tapering” talk, neglecting assurances that the record low Fed Funds Rate will continue indefinitely.
b.   Between their respective “peak” in May and their low in late June, here is what happened in U.S. markets:
i.    S&P 500 Index                                                         DOWN 5.76%
ii.   U.S. Treasury 10 Year Interest Rate                     UP 95.8 basis points
(or almost 59%)
iii.   Barclay U.S. Aggregate Bond Index                     DOWN 4.32%

These first six months also marked a tectonic shift within the fixed-income sphere.  As of June 31, 2013, the U.S. bond market experienced its first 12-month loss in seven years! On a total return basis, the Vanguard Total Bond Market Index was down 0.95% for the prior twelve months. Intriguingly, the last time that occurred was during June of 2006, when the Federal Reserve was midway through a long, extended ratcheting of its Fed Funds Rate (from 1.00% to 5.25%). This data point could imply that this year’s reaction was a bit overblown and/or to illustrate that a move upward from a 0.25% rate is much more traumatic than a move from 1.00%.

The fallout from these extremes during the first half of 2013 has claimed countless “victims” – from the “generic” investor to such long-established bond “masters” as Bill Gross, who had accumulated $1.8 trillion AUM through the end of the first quarter. (Yes, that is “trillion”!)  However, Bernanke caught Gross a bit “flat-footed” in May and June.  Approximately 70% of Gross’ funds and ETFs are reported (by the New York Times) to have underperformed respective benchmarks during June. Adding to Gross’ discomfort, 75% of his ETFs experienced asset “outflows” during June (two lost almost 40% of assets). Finally, his flagship fund (Pimco Total Return (PTRAX) suffered an outflow of almost $10 billion in June – setting an all-time record for the fund.

However, Gross was by no means the only bond manager who endured a dreadful May/June period. Investment research company, TrimTabs, has reported that U.S. listed bond funds and ETFs endured an aggregate exit of almost $62 billion during June. Even more astounding, that huge number was nearly 50% higher than the prior record outflow – which occurred in the depths of the financial crisis in October 2008!!

Here is one final “context” about which I would be remiss if I failed to highlight it. Mr. Klarman elegantly expressed the magnitude of current risk in the markets when he offered an explanation for the extraordinary variability in potential investment returns:  “because the underpinnings of our economy and financial system are so precarious that the unabating risks of collapse dwarf all other factors.”  (Italics are inserted by me, not by Klarman). Multiple markets are currently uncomfortably suspended between slow growth and recession, inflation and deflation, barely serviceable deficits and unprecedented debt – while being unnaturally sustained through a seemingly bottomless pool of fiat sovereign monetary injections (many unpleasant corollaries come springing to mind).

It is in this context that I offer this “Investment Tip” for longer-term fixed income allocations. I ran across the following illustration in the May edition of “The Independent Adviser” [1]. Research chief Jeff DeMaso crafted an insightful narrative comparing two (hypothetical) income investors initiating a significant allocation to fixed-income in April of 2007.  For the sake of comparison, let’s categorize Investor A as someone very focused on current income, while Investor B is a person looking for total return. I am sure we can all agree that each of these approaches is extremely common and widely practiced.

Investor A chose to invest in a very liquid ETF (was recently one of the 30largest) named iShares Preferred Stock (PFF). Its dividends have “priority” over dividends due to common stock shareholders, and preferred stock is a favorite of many “income” investors. Investor A chose to withdraw all dividend and capital gain distributions made by PFF (maximizing current “income”).

Investor B also made a logical and popular choice – investing the exact same amount in the Vanguard Total Bond Market ETF (BND). He also chose to withdraw all income/capital gain distributions from the fund.

Here is where DeMaso’s study manifests its genius and provides us with an outstanding insight. Through the first year, it was no surprise that the distributions from PFF totaled more than those from BND.  Therefore, during every month in which A received more income than B – Investor B sold enough shares in BND to make up the difference.

These two investors then stuck through and endured the harrowing Mortgage Crisis.  How did they fare between April 2007 and April 2013?  Review the unusual graph (below) prepared by Mr. DeMaso.  Note that the axis on the left charts the “principal value” of each fund, while the axis on the right displays the “monthly income” from each fund (remember that Investor B then equalized his income by selling shares, as stated above):

At least a couple of key points jump out at us:

1)    Notice that by the start of 2009, PFF had lost almost 60% of its value;
2)    A corollary to 1) is that PFF experienced a good deal more volatility. If you like roller coasters, you’d have loved PFF!
3)    Despite redeeming enough shares in BND each month to garner the same amount of monthly income as provided by PFF, the total value of Investor B’s allocation was extremely steady!

So my “tip” is, don’t become so focused on “current income” from your fixed income allocations that you risk suffering the same unpleasant “roller coaster” endured by Investor A!  Remember this dramatic illustration…. remember this graph… and if need be, remember the old fable of the “tortoise and the hare”.   The rabbit moved out of the gate in impressive fashion, but the tortoise came out way ahead by the end!

If you abide by this “tip”, you’ll likely “even out” the “best of times and the worst of times”!!

DISCLOSURE: The author does not own LAG, PFF, BND, PTRAX… and regularly intones his own advice to himself, since the “human condition” is such that one often does that which one knows should not be done, and does not do that which one knows should be done!

Submitted by Thomas Petty MBA CFP

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