Dear friends,

I walked along today, kicking leaves, marveling at the maples, crunching through my last Golden Russet apple and wondering at the tension between local delight and global despair. Things are good in my life. My classes are full and my students are … hmmm, fascinating in a “bright but so very different from what I recall” way. My son just earned his driver’s license and I bought him a respectable used car. I harvested my first-ever potato crop and the last of my carrots and onions, so roasted root veggies are on the menu this week. I’m happy.

The world beyond mine is less happy. Weather forecasters report that Halloween temperatures in much of the country are at mid-summer level, the eastern US – from the Gulf Coast to New England – is trapped in drought, a condition which climatologists think might linger in California for several decades. While we’re distracted by the most dispiriting presidential campaign since, perhaps, the Civil War, several diminutive dictators are exploiting our preoccupation by raising global tensions, unchallenged. And perhaps a third of our brethren are so discouraged about their children’s future that they see a prancing, prattling mountebank as their last, best hope.

And yet, hope endures. More amazing people are putting more thought and energy in the questions of environmental sustainability than ever before. Some of what they’ve found, from sidewalks that convert sunlight to power to the first breakthroughs in carbon capture, is startling. Nations did join together to ban one incredibly powerful greenhouse gas, and to boot Russia out of the U.N. human rights agency. Finding ways to talk with, rather than shout about, those with whom we disagree, is rising on the post-election agenda. It’s certainly on my academic department’s agenda as we imagine the new curriculum we’ll create as Augustana moves to semesters. And I’m hopeful that November 9^th feels a lot better than November 7^th.

Mea culpa. Mea maxima culpa.

Apologies to the folks at Grandeur Peak and their shareholders for a needlessly worrisome snippet. Last month I reported on a couple changes to the Grandeur Peak prospectuses which seemed to imply a somewhat-tighter close. Wrong! Eric Huefner, GP’s president, explains the reality of the change:

The Global Micro Cap Fund remains hard closed (it was closed the day it opened on 10/20/15, and was officially hard closed as of 12/31/15).  Under the hard closure, there has been an exception for just those shareholders who hold the Fund directly through Grandeur Peak Funds to be able to purchase additional shares of up to $6000/year, during each calendar year.  As of 9/1/16 we made one very minor change to this, which was to increase the annual limit from $6000/year to now be $6500/year (simply to match the IRA annual Catch-Up limit for those who are investing in this Fund in their IRA).

Thanks to Eric for the clarification. Apologies to all of you for any miscommunication.

Good stuff in the Observer this month!

Leigh Walzer of Trapezoid LLC continues offering sharp, quantitative analyses. This month’s focus is on, well, focus. Our colleague Charles Boccadoro lifts the hood on the Vanguard Quantitative Equity Group. Ed Studzinski surveys the swirling mess around us and recommends caution: avoid conventional wisdom, appreciate cash, ease away from bonds and hold on.

With the return of capital gains season, we’ve also returned to capital gains distribution coverage. Mark Wilson, proprietor of The Cap Gains Valet, offers some preliminary observations on the evolving capital gains season and word on changes at his site. The ever-faithful folks on MFO’s Discussion Board have begun compiling their annual list of announced distributions. Thanks to The Shadow for coordinating it and all of the folks on the board for keeping it current.

There’s more, all of it now easily accessible from our new table of contents page.

In response to several reader requests, Chip and Andrew have added two cool new features for you. First, it’s easier than ever to get back to seeing our traditional layout, which we call “the long scroll.” It turns out that the scroll is helpful to folks who rely on vision augmentation technology and really comfortable to others who’ve become accustomed to it over the past 15 years or so. Second, it’s easier than ever to print and save individual articles. We’ve adapted our stylesheet to accommodate a print layout and added a printer icon to every story. We hope you like the changes.

Thanks for your support of the Observer

MFO Premium launched a year ago as a way of thanking folks for their financial support of the Observer and of providing access to risk and risk-return metrics that are almost impossible to find elsewhere. Readers who choose to make a tax-deductible contribution of $100 or more to the Observer help make the entire enterprise possible; in thanks, we offer a year’s access to MFO Premium. If you were one of the folks in that first wave of subscribers, please do consider contributing again. (We’ll send an email reminder soon.) If you weren’t in the first wave or you’ve been meaning to contribute but haven’t, now’s a great time to do so. It’s simple: Go to mfopremium.com and create an account by clicking on LOGIN tab.

Thanks, in particular, to David from Beaver Dams, NY, Donald from Indiana and to our now three (!) regular subscribers, Greg, Deb and Jonathan. We couldn’t do it without you.

As the holiday shopping season approaches, please do consider using the Observer’s link to Amazon.com when you can. It costs you nothing and earns the Observer 6-7% of the value of your purchases.

As ever,

Technically, 10,315,656 miles high.

The IMF reported in October that global debt, government, corporate and individual, is now $152 trillion. (That’s $152 followed by 000,000,000,000.) That’s historically high, both in absolute terms and relative to global GDP. And it’s not limited to slow-growing developed economies; increasingly emerging markets are issuing debt at a record pace.

Folks at the Endowment for Human Development, who have either spiffy calculators or too much free time, calculate that a stack of $152 trillion one-dollar bills would stand ten million miles high. Laid end-of-end, they’d stretch 14.4 billion miles. That is, to Pluto.

And most of the way back.

That wasn’t supposed to happen. The watchword after the global financial crisis was “deleveraging.” In simple terms, paying down your debts. Debt-driven spending set the stage for the 2007-09 crisis and, in its aftermath, people were supposed to get prudent, pay off their credit cards, balance their national budgets, and finance corporate operations from free cash flows. Prudence would, in the short term, depress global growth by depressing demand. But, in the long term, it would better position us for strong, sustained growth.

Good luck with that.

Instead of deleveraging, we’ve added $50 trillion in debt since the start of the crisis, raising the global total from $102 trillion to $152 trillion. Why? Central bankers were terrified of the prospect of a global depression, perhaps a new dark age.

They first drove rates toward zero, then to zero, then below zero. There are now $10 trillion in negative interest rate bonds in circulation, primarily in Europe.

People responded rationally by borrowing more because savings didn’t pay (the five-year return on Vanguard Prime Money Market VMMXX is 0.10%) and lenders were pretty much giving money away. Investors, professional and otherwise, started buying riskier assets (dividend-paying stocks, for example) to try to earn enough income to cover their obligations. And governments rushed to capitalize. Belgium and Ireland have now issued their first 100-year bonds. Austria is selling 70-year bonds. Italy, Spain, France and Belgium all sold 50-year bonds this year. Those bonds are paying less than 1.2%.

That makes sense only if you think inflation will average under one percent annually for the rest of this century (perhaps because of the aforementioned dark age). If inflation exceeds 1.2%, you lose money. And if interest rates go up, you lose a lot of money.

Corporations have issued vast amounts of debt in response to the offer of free money and have badly misused the proceeds. J.W. Mason, economist at the liberal Republican Roosevelt Institute, found that only 10% of borrowed money goes into productive use. Much of the rest is used to buy back stock and underwrite dividends. An October 2016 FactSet Research report shows that companies now routinely payout more than they earn. Goldman Sachs concluded that the stock market’s entire return in 2015 was attributable to dividends.

Issuing 10-year debt that produces a one-year “pop” in your stock price makes a world of sense if you’re an exec who’ll be retired or snatched up by another firm in the next three years. It makes rather less sense for those left holding the bag.

If interest rates rise 1%, debtors are going to need to find $1.52 trillion dollars to cover the additional interest payments to their creditors. Bondholders, meanwhile, are going to see the market value of their existing bonds – that is, the amount they could get if they tried to sell them to somebody else – drop precipitously. It’s hard to imagine that this is going to go smoothly. The IMF put it mildly: “financial crises tend to be associated with excessive private debt levels.” On October16, Washington Post economics columnist Robert J. Samuelson allowed that it might “possibly trigger a major financial crisis … [though] whether or how this might become a full-blown crisis is uncertain.”

Traditionally, the stock market’s best period runs from November through early spring. Our collective insistence on electing either The Regular Crazy One or The Catastrophically Crazy One and the temper tantrum likely to follow either outcome, is not helpful. The Fed has reportedly been holding back on a rate increase until after the presidential election, for fear of influencing its outcome. Economists now guess there’s a 70% chance of a rate hike in December. The best argument that stocks aren’t crazy expensive is that they’re still a better value than bonds paying zero. If bonds cease paying zero, that argument is weakened.

What’s an investor to do?

Excellent question! Damned if I know the answer.

Here are our Top Ten recommendations:

1. Don’t be stupid. This is not the time to rush into a fully invested, market cap weighted ETF, index fund or closet index. By their nature, they accelerate as we approach cliffs then fall fast and hard when the market goes over them.
2. Don’t be stupid. Don’t try to protect yourself by investing in strategies that you can’t explain or, worse, which the manager can’t explain to you.
3. Don’t be stupid. Don’t invest with a manager who still has training wheels on; there are a lot of funds being launched that try to escape the all-ETF-all-the-time temptation by offering tricky strategies that have only worked in computerized back-tests but not in the real world. Let them practice with somebody else’s money.
4. Don’t be stupid. Don’t wait until you’re in a panic, personal or otherwise, to make a financial plan. Talk it through now. Write it down. Write the paragraph on a piece of paper: “I don’t care what the stock market does when it’s panicked. I won’t let other people’s panic force me into making mistakes. I promise myself and my family that I will not sell anything for the next 12 months.” Then explain it to your family and stick it on the refrigerator door. The inimitable Jason Zweig goes a step further. Keynes was a good investor not because he was always right but because he was always resolute. Drawing on that lesson, Mr. Zweig advises you to “write a bind contract with yourself, witnessed by a friend or family member, committed you to buy more stocks when they fall 25%, 50% or more.” The refrigerator still works as a bulletin board for it!
5. Really, resist the temptation to be stupid.
6. If the past predicts the future, you could try to ride the dividend-stock wave. Timothy McIntosh argues, in The Snowball Effect (2016) that during the four great bear markets in the past 110 years, “The only reliable way to make positive returns during secular bear market periods is to invest in dividend-paying stocks.” I’m skeptical because dividend-paying (and low volatility) stocks have been dramatically bid up, but I could be wrong.
7. Tilt toward what’s cheapest. The Leuthold Group argues that valuations in the emerging markets are downright cheap and that they are, in developed markets outside the US, no higher than “neutral.” That’s led a number of global stock fund managers to lighten their US exposure, if not flee.
8. When there’s nothing good to buy, don’t buy anything. That is, hold cash and wait. In the past 12 months, Vanguard Total Stock Market Index (VTSMX) is up 3.5%. Unless you believe things are fundamentally better now, that’s a proxy for the cost of lightening up on your investments; you might miss out on a two or three percent gain. As Jason Zweig observes, “with stocks still not far from their record highs, sitting on some cash is a better idea than ever” (WSJ, 10/14/16).
9. Trust your money to the people who have earned your trust. In May 2016, we profiled the Dry Powder Gang, the small handful of fund managers who refuse to put your money needlessly at risk. They are resolute when you are wavering and they have, over time, richly rewarded investors who didn’t get greedy and bolt. This month we’ve tracked down the 25 funds that had the best risk-adjusted returns in the 2007-09 market crisis and identified those which have continued to perform exceptionally during the relentless bull that followed. (See Counting The Winners.)
10. Celebrate life. You used to do that more than you do now. You should get back to it. Here’s a start: go out to dinner with your family and intentionally leave your cell phones at home! Eeeeeeeeeee! You can tell that I wrote that suggestion on Halloween. It’s scarier than the headless horseman!

Halloween is the time of year to start thinking about the impact of capital gains distributions from your mutual funds and ETFs. At CapGainsValet.com, we’ve spent the last month updating our site and building our Free and Pro databases. We’ve already made two passes through over 250 fund firm websites looking for 2016 distribution estimates.

As I think about how this year compares to previous years, I have a house full of high schoolers dressed up for a Halloween party. Some of their costumes match my initial comments for the year:

• Einstein – Educate yourself. Misunderstanding the impact of capital gains distributions can cost hundreds or thousands of dollars in extra taxes. The Articles section of the CGV website has several short pieces that explain beginner distribution concepts as well as more advanced tax saving strategies.
• Wonder Woman – Heroic firms have already posted 2016 estimates. Investor friendly firms make their shareholders’ lives easier by posting capital gains information (estimated amounts and distribution dates) early. We’ve already found this information for nearly 90 firms. We will continue to cycle through mutual fund firms and post estimates as they become available.
• Chihuahua – Our doghouse will probably be smaller than usual. Our annual “In the Doghouse” list compiles funds with estimated distributions over 20% of NAV. At this time last season, we already found 28 funds with these huge distributions. This year, we have only eight. It’s early in the year so the list will continue to grow.
• Ostrich – Do not bury your head in the sand. While I’m expecting this to be a less dramatic season for capital gains distributions, ignoring them is not a good plan. We’ve already found over 60 funds that are expecting distributions in the 10-20% range and we’ve seen countless distributions in the 5-10% range. Planning around (even small) distributions still makes good sense.

If you are not aware, the MFO Discussion board has an impressive list of links of capital gains estimates. Between that posting and CapGainsValet, you should be able to get through the remainder of the year without any surprise scares.

Mark Wilson, APA, CFP®
Chief Valet, CapGainsValet

There’s a good chance that the next five years will be far more challenging for investors than the past five. It’s rare that a market delivers returns (12% annual returns) greater than its volatility (11% standard deviation). We’ve had five years of extraordinary monetary policy; if the next five years look more ordinary (say, 10 year rates back to their normal 3-4% range), there’s likely to be a “repricing” of assets, possibly dramatic, surely erratic. GMO’s asset class projections, which simply assume a return to normal levels of profits and earnings, say that almost all asset classes are set for negative real returns.

For folks looking for managers well-equipped to handle hostile markets, we used the fund screener at MFO Premium to identify the 25 domestic stock funds that posted the strongest risk-adjusted returns during the global market crisis of 2007-09 (the screener identifies that as Down Market Cycle 5).

Why the focus on risk-adjusted returns? Isn’t it all about beating the market? Well, no. The price of some returns is simply too high to bear. You might earn an 8% return over four years by gaining 2% annually or you might earn 10% by losing 30% in Year One, making 50% in Year Two, losing 30% again, then making 50% again. No rational person would choose Option 2 and if you’d inadvertently stumbled into it, you’d be unlikely to remain. That sort of performance is reflected in David Iben’s Kopernik Global All-Cap Fund (KGGAX ). Mr. Iben is a famously talented, aggressive investor who gained renown as manager of Nuveen Tradewinds Value Opportunities (NVOAX). He left Tradewinds to found Kopernik and his flagship fund has posted market beating returns since inception. Here’s a picture of what that looks like:

That trough in March 2016 represents a 40% loss for Mr. Iben’s investors, about four times what his peers suffered. His fund is up about 80% since then. That’s great. It’s also not worth it. You’d have been much better off with the mediocre little orange line funds that now trail Kopernik. By looking at risk-adjusted returns rather than raw market beating power, we’re trying to find funds you can actually live with.

Our next question was, how did they hold up during the subsequent bull market (called Up Market Cycle 5).

The results are laid out below. For the sake of simplicity, we consistently color-code “the best” results in blue. Those represent results in the top 20%. Green are still above average, yellow is average, orange and red are below. You’ll notice that “1” is sometimes blue and other times “5” is blue. Simple explanation: low risk (“1” on the risk scale) is good and high return (“5” on the return scale) is good.

I’ve simplified the screener’s output to look at just three variables: pure risk, which is measured by a fund’s downside deviation, pure return, measured by its annual percentage return, and then risk-adjusted returns measured by its Sharpe ratio. The premium screener adds a bunch of other risk and risk-return metrics, but these are a good start.

Ideally, you’d look for funds that were blue (best) and green (second best) across the board. Three qualify

Brown Capital Management Small Company (BCSIX), which is closed to new investors.

Eaton Vance Atlanta Capital SMID-Cap (EISMX), which is closed to new investors.

Yacktman Focused (YAFFX), a freakishly excellent fund whose namesake manager, Donald Yacktman, retired on May 1, 2016. His son and long-time co-manager, Stephen, remains. Whether Stephen can match his father’s performance remains to be seen.

Why so few winners (three of 25?). Part of the answer is column 5, pure returns during the bull market. In seven cases, funds posted strong risk-adjusted returns while posting average to weak raw returns. That is, these funds went up a little less than the market but exposed you to a lot less risk. They are:

Champlain Small Company (CIPSX), which is closed to new investors.

Copley (COPLX), which has been run by Irving Levine since 1978. He came to investment management after a 20 year career that started, in 1946, in handbag manufacturing. Ed would really want to sit down as a quiet club with this guy.

FMI Common Stock (FMIMX), an exceptionally solid fund from a family of exceptionally solid funds.

Hancock Horizon Burkenroad Small Cap (HHBUX), a $700 million small-core fund that’s completely off my radar, in part because it’s larger than we normally target but also because the “Hancock” name threw me off. It looks like an interesting little fund complex headquartered in New Orleans.

Intrepid Disciplined Value (ICMCX), a sort of all-cap version of Intrepid Endurance which, like Endurance, is willing to hold cash when opportunities are scarce. It’s about 50% cash at the moment.

Intrepid Endurance (ICMAX), which we’ve profiled and in which I invest. Endurance tends to invest in small cap value stocks and is one of the few funds still willing to hold cash, 70% currently, when opportunities are scarce.

Symons Value (SAVIX), a nominally institutional LCV fund with the same manager since inception and a $5,000 investment minimum. (The guy earned a B.A. in three years from Williams College and started off as a financial software developer. Cool!) It has earned a Great Owl Fund designation for top-tier risk-adjusted returns in every trailing measurement period.

The handful of funds that have posted disappointing results in both absolute and risk adjusted returns seem to fall into three camps: funds whose lead managers left five or six years ago (Westwood’s founding managers, headlined by Susan Byrne, had all departed around 2011; likewise, the managers for Invesco Exchange and Needham Aggressive left in 2010), freaks (well, Nysa) and the Royce funds (the whole complex suffered for overexpansion in the 2000s and seem to be staggering about a bit as they contemplate life after its founding generation of managers).

Bottom line: approach Yacktman cautiously (they have a new fund, Yacktman Fully Invested, about to launch) and the other six open candidates with curiosity and interest. If you meet Mr. Levine, pass along our respects and admiration. If you like funds in the SoGen / First Eagle tradition, be sure to check out Centerstone Investors (CETAX), run by First Eagle’s former lead manager, Abhay Despande.

In October, we offered a Launch Alert for RiverNorth’s latest fund, RMPLX. It’s a closed-end interval fund which offers institutional investors access to the quickly evolving marketplace lending sphere. The fund has a million dollar minimum initial investment and, structurally, has some similarities to a hedge fund.

In mid-November, RiverNorth will host a webcast helping investors understand the potential risks, returns and distinctive characteristics of this slice of the market. They’ve done good work with their webcasts before, so folks with the interest and wherewithal might want to join in.

Here are the details shared by RiverNorth:

Webcast Title: Incorporating Marketplace Lending Into an Institutional Portfolio

Thursday, November 17, 2016

3:15pm CT

Register for the webcast at www.rivernorth.com/events

Hosted by Ron Suber and Philip Bartow

• Prosper Marketplace President Ron Suber will present an overview of the marketplace lending (“MPL”) industry and provide his perspective on the future of the MPL space.
• Philip Bartow, Portfolio Manager of RiverNorth’s marketplace lending strategies, will discuss the primary investment characteristics of the MPL asset class and the opportunity for incorporating it into a portfolio.
• Philip will also provide an overview of RiverNorth Marketplace Lending Corporation (RMPLX)which launched September 2016.
• Q&A will follow the main discussion.

Questions can be submitted during the call via the webcast portal. Limited lines will be available for dial-in at 877.407.1869

In a February 2012 Wall Street Journal piece, I nominated MASNX as one of the three most-promising new funds released in 2011.  In normal times, investors might be looking at a moderate stock/bond hybrid for the core of their portfolio.  In extraordinary times, there was a strong argument for looking here as they consider the central building blocks for their strategy. Our profile of the fund that year argued

these really do represent the “A” team in the “alternatives without idiocy” space.  That is, these folks pursue sensible, comprehensible strategies that have worked over time.  Many of their competitors in the “multi-alternative” category pursue bizarre and opaque strategies (“hedge fund index replicant” strategies using derivatives) where the managers mostly say “trust us” and “pay us.”  On whole, this collection is far more reassuring.

Five years on, the fund’s performance has borne us out.

Here’s the quick translation. From inception through September 2016, MASNX incurs less risk than its Lipper peers (maximum drawdown is smaller, standard deviation and downside deviation is lower, performance in sharply falling periods is stronger and its Ulcer Index is lower), produces greater returns (measured by its annualized returns) and has a far better risk-adjusted return profile (reflected in the Sharpe, Sortino and Martin ratios).

The Observer designates MASNX as a Great Owl Fund for superior risk-adjusted performance in all trailing measurement periods.

In an invitation to a conference call with Jeff Gundlach, Litman writes:

Now, after reaching the five-year mark, we are proud to be the sole five-star, analyst recommended fund in the Morningstar multi-alternative category, and with the highest risk-adjusted return.

Which they supplement with a nice infographic:

Interested parties have been invited to join the Litman Gregory folks on November 10 at 1:00 p.m. Pacific for the Alternative Strategies Fund 5-Year Webinar with DoubleLine’s Jeffrey Gundlach. If you click the link, you’ll be taken to a registration page so you can get an access code. If you’d like to read more before committing, check out their Q&A page.