By David Snowball

Dear friends,

Spring is a time when we celebrate the small and uncertain signs of hope. Weighed down by the exhaustion of war and politics, pandemic and winter, we look happily at the first crocus to spring which shoulders its way through the autumnal leaf mold. We’re reluctant to invest too much in it, knowing that winter has not yet suffered its final defeat. (Here, anyway. Last Wednesday’s upper 60s was followed by Thursday’s measurable snow.)

And still, it’s in our nature to hope. That’s what makes the prospect of tomorrow bearable. And so I hope that the 1.7 million new jobs created so far this year, and the fall in unemployment to 3.6%, is a signal of sustainable economic vitality.

I hope that the Ukrainian people prevail quickly. Their fortitude in the face of heartbreaking losses heartens many. The suffering now is immense and the rebuilding will consume decades, but that’s an argument to act rather than to despair. Consider donating, as we’ve done on several occasions in the past month, to the UN Commission for Refugees or one of the groups vetted by Charity Navigator. There are small children who will remember the conflict for the rest of their lives; I’m hopeful that they have cause to remember the unstinting kindness of strangers as well.

In this issue …

My colleagues engage in a sort of wide-ranging conversation while inviting you along.

Devesh Shah takes a long look at Peter Lynch’s claim that Fidelity’s active funds crush their passive counterparts. I suspect Devesh’s response might be fairly summarized as, “not so much, really. And you certainly can’t count on it continuing.” Devesh’s own portfolio, he notes, holds nary an active fund, though he allows that he’s still examining the evidence.

Mark Freeland weighs in with a long and careful piece about what indexes – the driver of index funds – actually are, and aren’t, and how they come to be.

David Snowball shares his side of the conversation, walking through his take on the limits of passive investing and a strategy for constructing a more actively managed portfolio that gets you where you want to go.

Lynn Bolin offers a really solid analysis of which resources are best buffered against the effects of inflation (or, indeed, capable of profiting from it) and highlights the sectors and funds to favor when investing in the face of inflation.

Charles Boccadoro takes on the conventional wisdom: high inflation means high-interest rates means long-term bond funds crash means … run away!!! While recognizing the challenge, he offers reason to have a bit more faith in the long-term funds.

Speaking of inflation, we share an Elevator Talk with Jessica Jouning, one of the managers of the First Sentier American Listed Infrastructure fund. “Infrastructure” is all that stuff that makes our version of civilization possible: power grids, cell towers, solar farms, roads, railroads, waste treatment plants, and all. Some infrastructure is the responsibility of governments, some is funded by private investors, and others by corporations listed on US exchanges. First Sentier invests in the latter and seems to be the only infrastructure fund that targets only resources in the US.

The Shadow catches us up with the comings and goings in the fund industry, including one instructive fund liquidation, small wins, and new funds.

We hope you enjoy it and connect with the folks who produce it for you. We’re all linked in the articles we write!

Two thumbs up

Thumbs up: There are 2600 taxable bond and allocation funds. Only 75 of them are above water as of March 30, 2022. Those include four of the five CrossingBridge and RiverPark funds advised or sub-advised by David Sherman and the team at Cohanzick, as well as their Pre-Merger SPAC ETF. Their remaining fund, Responsible Credit, is down just 0.3% which places it in the top 3% of its peer group. With 84% of its funds and ETFs in the black, no other sponsor is close.

Thumbs up: Morningstar just downgraded Cathie Wood’s ARK Innovation ETF to an analyst rating of “negative.” The fund is down 58% since its peak in February 2021. Morningstar astutely notes that there are “few signs of improving its risk management or ability to successfully navigate the challenging territory it explores” (Robby Greengold, 3/29/2022). Good call, guys! Even before its epic collapse, Mr. Greengold warned that “its lone portfolio manager, inexperienced team, and lax risk controls make it ill-prepared to grapple with a major plot twist” (3/30/2021). MFO issued similar warnings while most of the financial media fawned over Ms. Woods’ genius, posting daily expositions of her latest moves. That should serve as both a warning (of the value of relying on unvetted sources whose qualifications come down to publishing a blog with a dramatic name) and a celebration (of people who have some principle greater than “more clicks”).

In Memoriam

We note, with sadness, the passing of two monumental figures.

Edward “Ned” Johnson III (1930-2022) died on March 23, 2022. Mr. Johnson was CEO of Fidelity Investments, a firm started by his father Edward (1947) and now led by his daughter Abigail, for 37 years. He also managed Fidelity Magellan before surrendering those responsibilities in 1977 to some guy named Lynch.

Fidelity was started as a sort of glorified family office to manage the family’s considerable investments. (The Johnsons have been in Boston since 1635 and made a fortune in the department store business.) Ned utterly transformed the firm, driving it into prominence in the 1960s with aggressive stock funds, and in the 1970s and 80s with star manager funds. At the same time, he was an early champion of money market mutual funds to offer investors better-than-bank returns with effectively no downside risk. During his tenure as CEO (1977-2014), Fidelity’s assets grew from $4 billion to $7 trillion. (Put more starkly, from four billion to seven thousand billion.) At his death, Fidelity had nearly $12 trillion in assets under management and his family owned half of the spectacularly profitable business. He was, very quietly, a champion of the arts and an incredibly generous philanthropist.

Mr. Johnson is survived by his wife of 62 years, three children, seven grandchildren, and several million shareholders.

Michael F. Price (1951-2022) died on March 14 after a lengthy illness. As an investor, Mr. Price was the antithesis of Ned Johnson. Mr. Johnson’s family was fabulously wealthy; Mr. Price’s ran a clothing shop. Mr. Johnson’s mantra was something like “go (or go-go) for the growth.” Mr. Price sought profit elsewhere, by investing in distressed businesses whose management might be pressured to unlock the value that was already present. He explained that “Max taught me that if you really wanted to find value, you had to dig through stuff no one else wanted to look at.” Seth Klarman, himself a famous value investor and founder of the Baupost Growth hedge fund, observed that watching Price taught him that “the more obscure and murky the security sounds, the higher the chance it will be interesting.” Mr. Price’s most famous coup was forcing Chase Manhattan Bank to “sell divisions or take other actions” to raise the stock price; with the firm’s purchase by Chemical Bank, Price’s investors realized a 70% return.

In 1974, he accepted a job as a research assistant to Max Heine, of Heine Securities. He and Mr. Heine managed three value funds, the Mutual Series, and did so brilliantly. Together they tended to end up on lists with the likes of Warren Buffett, Peter Lynch, T. Rowe Price (the guy, not the company), John Templeton, and Benjamin Graham.  In 1982, he became a full partner and, in 1988, with Mr. Heine’s passing, bought the firm and became the president and chairman. He grew the firm’s assets from $600 million to $16 billion and, in 1996, he sold the Mutual Series to Franklin Templeton Investments. He stepped down as manager two years later. In 2001, five years after the sale, he left entirely and launched his own company, MFP Partners, LP.

Inherent in his investment style was the need to confront recalcitrant corporate leaders on behalf of their shareholders. In disrupting the clubby world of corporate leadership, he was awarded the sobriquet “the scariest SOB on Wall Street” (Fortune cover, 12/1996).

Hedda Nadler, president of Mount & Nadler which provides public relations for financial services firms, knew Mr. Price for decades and disagrees with the label.

We had the privilege of being PR counsel to Mutual Series Funds, working with Max Heine and Michael Price since 1980. That relationship continued until 1996 when Michael sold to Franklin Templeton.

Michael was always loyal and caring about the people around him, including us. He was especially devoted to his mentor Max and had a big portrait of him hanging in his office.

We continued to have lunch together every several months which was only interrupted by the pandemic. He’d regale me with stories about undervalued stocks he found and Mutual Series alums.

While a Fortune cover called him ‘the meanest SOB on Wall Street’, the Michael we knew was kind, generous, and a mensch. He was low key, a devoted family man, and very loyal.

The world is a lesser place without Michael.

Price was married and has four children.

Thanks, as ever …

To Charles, Devesh, Mark, Lynn, and Bill, who are doing some really remarkable work for MFO. Reach out to them if something they’ve written strikes you and let them know.

Thanks especially to The Few, The Proud, The Regulars: Greg, William, another William, Brian, David, Wilson (thank you, sir!), and Doug. And we’d never forget our new contributors, Jonathan, Joseph, and Trev.

Wishing you all a joyful month, and looking forward to celebrating our 11^th anniversary with you in May,

 

By Mark Freeland

Step One: Find the right recipe.

Indexes are recipes. By that, I mean they’re really precise sets of instructions that direct you in what ingredients, in what amounts, need to be treated, in what way to achieve a particular, predictable outcome. In investing, as in cooking, recipes are relatively recent inventions. Once upon a time, both activities were dominated by the notion that “experienced old guys do their thing, the rest of us watch in awe.”

Take luce or tench or fresh haddock, & boil them & fry them in olive oil. And then take vinegar and the third part sugar & onions minced small, & boil all together, & mace & cloves & cubeb. And lay the fish in dishes & pour the sauce above & serve it forth.

How much luce or tench or haddock, boiled and fried (?) for how long? With cubeb? Uhhh … The problem was clear: it required a lot of trust, failed often, and couldn’t be explained even when it succeeded. Recipes explained how a particular dish was prepared, though that didn’t automatically make the dish good. Just predictable. Peanut butter and jelly macaroni? It is a thing. Easy to make. And not good.

A cold Salty Dog? Easy to make, quite good.

And so, cooks began experimenting, codifying, and testing. The goal was predictably, consistently good results – sacrificing the occasional bit of genius to avoid the more than occasional “well, it sounded like a good idea at the time” moments.

Investing, likewise. Indexes are created by recipe and offer predictability in lieu of accidents, happy or not.

I had these recipes that say do this, do that. Who MAKES these rules? Emeril Lagasse

MSCI, mostly, Emeril. MSCI calculates around 160,000 investable indexes. Each is a set of instructions for enacting a different investment recipe, though many of the recipes are variations.

Soon after Russia invaded Ukraine, and it closed its stock market, a question was raised about how index funds would handle Russian stocks. The short answer was that index funds track indexes, so it depends on what the index does. That is why this piece is about indexes as opposed to index funds.

Below, I will describe what indexes are and how they’ve changed. That will be followed by a discussion of what goes into an index. Next is a brief example of how markets are segmented. No section does more than touch the surface. The intent is to provide a sense of what indexes are and the underlying complexity of what, at first blush, seems very simple. The bottom line is that understanding the objective and construction of indexes can help in choosing which index in a given space best matches your perspective and meets your needs.

1. A description of indexes

There doesn’t seem to be an official or universally accepted definition of an index. Instead of putting a stake in the ground, we can take a brief look at how the meaning or use of indexes has changed.

1a. Basic role of indexes

Traditionally, an index is a measurement or calculation of an average or typical “something.” That something could be an attribute of the environment, like the temperature-humidity index (THI). Or it could be something that affects our pocketbook, like the consumer price index (CPI). Or what is most important for readers here, it could be the performance of an investment market.

Such indexes are largely indicators, not necessarily precise figures. When the government reports that the CPI has risen 7.9% in the past year, it is not saying that everyone has seen their expenses go up by that amount. It’s a typical figure, determined by averaging the types of items that people purchase, and at average prices.

That’s what Charles Dow did in the late 1800s when he constructed the first indexes, the Dow Jones Railroad Average (now the Dow Jones Transport Average) and the Dow Jones Industrial Average. He selected representative stocks that could be used to gauge the overall performance of the economy.

This was more a window into financial markets than into the economy, which is viewed only indirectly. These days we have better indicators for the economy, such as GDP and employment figures. As the stock market and economy grew in the 20^th century, the sampling size of his indexes was increased, first from twelve to twenty by 1916 and to its current thirty in 1928.

An obvious question is what amount of sampling is necessary to give a good indication of the stock market as a whole? Enter other indexes. Standard & Poor’s (then Standard Statistics Company) introduced its first stock index with 233 stocks in 1923. That gradually grew into the better-known S&P 500 Composite Index. Back when the S&P 500 started in 1957, it covered 90% of the value of NYSE-traded stocks. So it could serve as a reasonable index for the whole market. Even now, S&P writes that “The S&P 500 is highly regarded as a proxy for the U.S. equity market”. Though today it is better taken as a proxy for the large-cap segment of the market.

It’s not just the size of the sample that matters, but what is being sampled. Taking a broad sample is why the S&P 1500, the Russell 3000, and the Wilshire 5000 can all serve as reasonable indicators for the whole U.S. market, though each misses various small corners of the market.

1b. Indexes as benchmarks for funds

For a long time, there wasn’t much difference between defining the market as the total value of all stock companies and defining the market as the total value of stock one could actually buy on the open market. (This is commonly referred to as free float.)Two factors came together to change this.

One was the increasing use of the market by dot.com companies in the 1990s. They would sell only small portions of their stock in IPOs. High demand for these stocks could, and did, distort prices. Some of that demand came from index funds. Originally small when created in the 1970s, index-tracking investments grew to the point where they could affect small companies that were selling only a small percentage of their stocks.

Index providers responded by changing how they weighted companies. They moved away from the more economy-oriented practice of weighting companies by their total value and toward the more investment-oriented practice of weighting companies by the amount of investible stock they had outstanding. First, FTSE (1999), then MSCI (2000), and S&P (2004), these providers and others changed over to indexing investible markets.

What one sometimes reads is that the change in market definition to investible market was because investors want to know how they can expect their investments to perform. So they only want to know about the shares they can invest in. This has some superficial appeal but may ultimately strike one as unsatisfying. The impact of a company on the economy (harkening back to an original purpose of indexing) depends on the size of the company, not the percentage of its stock in circulation.

Weighting by investible stock value rather than outstanding stock value has its own potential for distortions. A CEO with restricted stock could at some point dump those shares and suddenly, substantially increase the number of investible shares in the market. While I accept the wisdom of the entire industry shifting over to free float, that does not come without its own set of issues.

Right before S&P converted to free float for its domestic indexes, it put out a paper explaining why it was hesitant to do so. It addressed the liquidity issue – difficulty in indexes tracking companies with low float percentages – by noting that it already excluded low liquidity companies from its indexes. It also made mention of how indexes are supposed to be barometers of an entire market, not just the investible portion. Call it confirmation bias, but it was nice to run across this piece.

Another change that index providers made to accommodate index funds was the introduction of buffers. If one wanted to construct a large-cap index, originally, one would just include all companies larger than a given size and exclude all smaller companies. While that’s a solid, clean approach, it has the potential for creating churn in index funds. A company sitting on the boundary might be included in an index for one period but then excluded in the next. This could go on repeatedly with multiple companies.

To reduce the churn, index providers introduced the concept of buffers. A buffer is a region encompassing stocks from both sides of a dividing line. For example, if the dividing line between mid and large caps were $15 billion, then a buffer zone might range from $13 billion to $17 billion.

One way of using this buffer zone (as described by Gus Sauter) would be to leave a mid-cap company in the mid-cap index until it grew completely out of the buffer, i.e., attaining a market cap of $17 billion. An effect of this approach is that the classification of a company becomes path-dependent. It matters how the company got to where it is. Two companies with the same market cap could appear in different indexes. Engineers and physicists might recall hysteresis (effectively, lag).

Another way to use a buffer would be to gradually reduce the weight of a company in one index and increase it in another as it moves through the buffer. So our mid-cap company would have 100% weight in the mid-cap index until it grew to $13 billion in size. Between $13 billion and $17 billion, its weight would be prorated between the two indexes. Finally, at $17 billion, it would be weighted completely in the large-cap index. In actual practice, this type of buffering is generally used in dividing companies between growth and value, not between market cap categories.

2. Index components

Index providers use a large variety of factors to decide whether a company is eligible for indexing, in which market(s) it belongs, whether it is actually used in calculating an index value, and if so, what weight it is given. A few factors have already been introduced, including market capitalization, free float, liquidity, and growth/value.

2a. Eligibility for index inclusion

Eligibility only defines the market or universe that the index is measuring. When deciding which index one wants to track, how a provider defines stock eligibility may be an important factor to consider.

The providers often use the same criteria but with different values. For example, S&P requires a company to have at least 10% of its stock publicly available (free float) to be eligible for inclusion in its small-cap index (S&P 600). In comparison, Russell has just a 5% free float eligibility requirement for inclusion in the Russell 2000 index.

In addition, some providers may add criteria that some other providers don’t use.S&P requires companies included in the S&P 1500 (and by extension, the S&P 500, 400, and 600) to be “financially viable.” That is, the companies must have had positive GAAP earnings over the past quarter and over the past year. This tends to give S&P indexes a bit of a quality bias, especially in small caps where a greater percentage of companies may not be profitable. (S&P has no viability requirement for its total market index.)

2b. Actual inclusion in an index

Most index providers specify rigid rules for including companies in one of their indexes. For example, the Russell 3000E index contains the 4,000 largest eligible companies in the US., or all, if fewer than 4,000 companies are eligible. The Russell 3,000 is then the top 3,000 of these; the Russell 2,000 consists of companies 1,001-3,000, and so on.

Mechanical rules like these are unambiguous but can be subject to biases. Some sectors may tend to have smaller companies than others and thus get underrepresented this way. For example, in VRRTX (Vanguard’s Russell 3,000 index), only 2.17% of its portfolio is invested in basic materials, while in the total market, using VTI (Vanguard Total Stock Market ETF) as a proxy, basic materials represent 2.48% of the market.

Another approach is that taken by Standard and Poor’s. Regarding indexes as market indicators, it tries to select securities for inclusion that accurately represent the market as a whole. It has a committee of human beings to review index components and may remove a component for “lack of representation.” On the positive side, this can result in a better “barometer” of the market. In the S&P 1500, using SPTM (SPDR S&P 1500 ETF) as a proxy, basic materials represent 2.61% of the portfolio. This is a bit closer than the Russell 3000 allocation to the “true” value of 2.48%.

The downside of the human approach is that it may make wrong decisions. In December 2000, S&P decided that it needed to add “new economy” stocks to the S&P 500 and remove “old economy” stocks. Many people remember what happened next. Over the next twelve months after being replaced in the index in 2000, the deleted stocks returned 16.55% (median) / 21.77% (mean), while the replacement stocks returned -22.62% (median) / -24.88% (mean).

3. Segmenting the whole market

Markets can be sliced and diced in various ways – by market capitalization, by style (growth/value), sector or theme, country or region. Then there are alternative weightings. For example, equal weighting may be rationalized by asserting that what is being measured is stock mispricing which is equally likely on all stocks. So to measure this, all stocks must be weighted equally. Then there are “smart beta” indexes. At some point, these become active strategies in sheep’s clothing—a subject for another day.

This section will be limited to just one way of segmenting the market. Since we began with the question of Russian stocks, we can look at how providers define developing market indexes. It is instructive to compare how FTSE and MSCI view emerging markets.

FTSE has three categories of emerging markets: Advanced Emerging, Secondary Emerging, and Frontier. Classification is based on six different criteria, some with subparts. It’s a complex matrix, with factors including per capita income, regulatory environment, advanced trading features, accessibility to foreign investors, efficient clearing. FTSE created a fine-grained set of standards so that it could closely track each country’s progress.

Based on per capita income and on the size and sophistication of the Korean market, FTSE classified Korea as a developed country in 2009. It did this while acknowledging that foreign investors still faced some difficulties in investing in the country.

Russia had been classified as Secondary Emerging while also on a watch list for potential reclassification as an Advanced Emerging country. After sanctions were imposed on March 2, FTSE removed Russia from all its indexes. Russian stocks were no longer being traded, so very simply, they were ineligible for inclusion in any FTSE index.

MSCI handles emerging markets a bit differently. It has just one bucket for them, Emerging Markets. It classifies a country as emerging based on the country’s per capita income, size of its market, and accessibility of that market to foreign investors. It is because of that last factor that MSCI, unlike other index providers, classifies Korea as an emerging market.

If a country is in some important way unique, MSCI puts it into its own standalone index. Certainly, Russia’s situation is unique. MSCI reclassified Russia as a standalone market, effective March 9.

4. Conclusion

Indexes are primarily indicators of how a market or market segment is performing. How those markets are defined and measured varies significantly from provider to provider. The better one understands these differences, the better one can choose an index and an index fund that performs as one expects.

 

 

By Devesh Shah

When I came across a quote by Peter Lynch on how passive fund investors were making a mistake, I had two choices: to sweep his comments under the rug or evaluate the validity of them. In the article below, we will look at:

• • Lynch’s argument
  • My researched reasons for preferring passive investing.
  • The role of confirmation bias and how it can hurt or help investors.
  • The results of a careful analysis of the performance of Mr. Lynch’s preferred funds
  • Finally, a few conclusions.

The takeaway: Outperforming MFs do exist but their taxable distributions are a larger drag than expected.

We’re inviting you to join the conversation by completing our first-ever poll: the MFO active/passive preference snapshot, which you’ll find below. We’ll post results after our first week and then again in our May issue.

Peter Lynch Interview

“The move to passive is a mistake,” said Peter Lynch, the legendary one-time manager of Fidelity’s Magellan Fund. According to an article by Tom Moroney and Joe Shortsleeve of Bloomberg Quint from December 7^th, 2021, Mr. Lynch also said in a radio interview, “Our active guys have beat the market for 10, 20, 30 years, and I think they’ll keep on doing it.” In reference, he cited three current Fidelity managers: Steve Wymer of the Growth Company fund, Will Danoff of the Contrafund, and Joel Tillinghast of the Low-Priced Stock Fund.

My Investment Portfolio and Aversion to Active Mutual Funds

Upon reading this article, I took a big swallow. A cursory glance at my investment portfolio confirmed what I already knew: I own no actively managed mutual funds.

Having been involved in the market for many decades and also having talked to friends who have invested in stock for far longer, I have formed strong biases. I believe a very limited set of investors have an edge in stock picking, and that these investors tend to work at hedge funds because of the superior compensation payouts. I also have a great degree of difficulty in predicting which MF will do well in the next market cycle because few funds have outperformed in all types of market cycles.

Furthermore, I rationalized my biases by backing them up with market research:

1. 1. Active MFs have higher fees compared to index funds.
   2. Active MF performance lags the index over the long term. The SPIVA reports show that 8 out of 10 Equity Mutual Funds underperform the US Equity Index benchmarks when the observation window is stretched out to a 10-year period. For the year 2021, 8 out of 10 actively managed equity funds underperformed the US index.
   3. Individual fund success does not last.  An academic research paper by Prof. James Choi and his graduate student, Kevin Zhao, “Did Mutual Fund Return Persistence Persist?” (2020) finds that “significant performance persistence does not exist in the 1994-2018 period.” Also, this NY Times article for a quick read.
   4. Poor tax management is common: Annual taxable distributions and dividends by actively managed MF are significant. For those with MF investment assets in taxable brokerage accounts, taxes on distributions are a significant drag on performance. Michael Lane, Head of iShares U.S. Wealth Advisory, reports:

      for the 10 years ending in 2019, taxes on distributions reduced returns on the average annual performance of actively managed U.S. Large Cap Blend mutual funds by 1.79 percentage points. Over the same period, the average expense ratio of that category was 0.89%. In other words, while investors are increasingly focused on fund fees – as they should be – the average impact of taxes has been nearly double that of the expense ratio. (“Don’t let taxes drag you down,” BlackRock Advisor Center, 5/26/21)

   5. Opportunity Cost: While periods of outperformance do not last, periods of serious underperformance are common and last for long. Overlooking this opportunity cost requires a certain level of faith in the investment manager.
      (When I read David Snowball’s commentaries of selected funds, I can see his meaningful conversations with certain fund managers have allowed space for his faith to grow. This is perhaps an important reason for active MF managers to make themselves more available.)
   6. Active bond funds didn’t protect in down markets: I owned a lot of active bond managers. Low-interest rates for a decade seduced me to invest with them. Their source of higher carry was mostly driven by credit risk and illiquidity. For some reason, I expected them to skirt an equity market crash. When in March 2020, I saw my bond funds down 15-20%, I was disappointed. I didn’t sell out of those funds into stocks as I was hoping to. Realizing I was the greater fool to expect a free lunch, I eventually exited those active bond funds. (In the 2022 market sell-off, the active bond funds seem to be predictably suffering. There is little outperformance adjusted for the duration.)
   7. Flow of Funds and the Sage of Omaha’s future widow’s portfolio: The amount of money flowing into passive investing from active over the last ten years must be a few trillion dollars. Warren Buffett has said that when he dies, he would like his widow’s assets to be invested 90% in the S&P 500 Index and 10% in T-Bills. Cumulatively, the high fees and underperformance of most actively managed equity MF have been quite clear for all to see.

   None of this is to say that active fund management does not work; only that I could not make it work for me. Others might have a different and more promising story. My aversion to active MF investing makes me a strange bedfellow in the Mutual Fund Observer community. But it also allows me an opportunity to learn from others who have faith.

   Confirmation Bias

   Peter Lynch’s contradictory comments about my biases and research came unannounced and forced me to think: “What is his incentive to call the passive crowd wrong?” I wondered. “Is this an advisor to Fidelity talking or is there genuine merit in his argument?”

   I peered inside my own mind. By ignoring Mr. Lynch’s message and looking only for research that supported my existing bias and thesis, I would be engaging in the behavioral shortfall known as Confirmation Bias.

   Here is Daniel Kahneman, author of Thinking Fast and Slow, as quoted in an article by Drake Bear in The Cut: “Where does confirmation bias come from? Confirmation bias comes from when you have an interpretation, and you adopt it, and then, top-down, you force everything to fit that interpretation.”

   Confirmation Bias makes us seek out like-minded people, who share our opinions, our views on the world, and on investments. Confirmation Bias means I look up and down for facts that will make me feel better about my already established investment thesis. It means overlooking every contradictory fact because it would be inconvenient to my way of thinking. All investors are susceptible to Confirmation Bias because there is a fine line between deeply believing something and questioning that belief by putting it to the test. Most people find it difficult to learn and invest well.

   For example, there are believers and non-believers in cryptocurrency. Whichever side one is influenced by, that’s the “correct” side. Every dialogue has the feel of pushing people deeper into their established biases.

   Precisely, therefore, in the field of investing, talking to people who see things dramatically differently from us can often bring us the greatest benefit. It can save us from our biases and self-selected group think. To avoid Confirmation Bias, if I am truly bullish on a stock or an investment idea, I find the biggest bear and listen to his/her arguments.

   I have learnt that I usually learn from these conversations and temper my bullish or bearish enthusiasm. And on rare occasions, I have strengthened my own convictions and bet bigger, because I know the opposite thesis is weaker.

   I will admit that it’s hard to undergo this ego-crushing exercise. It’s far easier to block out the other voice. It is so much more comfortable to just see my version of the world as correct and every other version wrong.

   Taking President George W. Bush’s “You are either with us, or against us” may work in geopolitics, but it is a disaster recipe for an investor. Being open-minded is more lucrative.

   As inconvenient as it was, I knew that Mr. Lynch was a legend, his words were counter to the music in my own head, and that I ought to go find out if he was correct. I might change my mind and learn something.

   The Analysis

   Using the MFO Premium search engine, I analyzed the three aforementioned Fidelity funds. For good measure, I added the Vanguard 500 Index Fund, and also Berkshire Hathaway A shares (my proxy for a well-run actively managed investment). The detailed results table is highlighted at the end of the article along with some technical explanations. Here is a quick analysis:

   1. 1. The Fidelity Growth Company: Mr. Lynch was correct. This fund has absolutely crushed the market benchmark and even Berkshire Hathaway over the last 20-30 years. Unfortunately, the Fund is closed to New Investors as of April 2006.
      2. The Fidelity Low Stock Fund: This fund did very well in the 90s but NOT since then. It is not one of the funds that have beat the market over the last 10 and 20 years. Mr. Lynch was wrong here.
      3. The Fidelity ContraFund: Mixed results.
         1. 1. The fund is Open and has generally beaten the Market Indices.
            2. This outperformance has been driven by significant active movement within the portfolio.
            3. The distributions from the active trading have tax consequences.
            4. Adjusted for taxes, the fund’s outperformance has disappeared against the market.
            5. This active fund might work for tax-deferred accounts.
      4. Berkshire Hathaway: Many investors are critical of Warren Buffett for not paying a dividend or distribution. But thanks to NOT paying a distribution, adjusted for taxes, this stock has started outperforming. This, despite the generally noted inability of Berkshire to use its large cash pile for suitable elephant investments.

   Conclusion

   Have I answered the question I started with on active vs passive? Has the analysis affirmed my existing biases or made me change my opinion about anything?

   1. 1. The Fidelity Growth Company’s massive outperformance is a good wake-up call for me. I learnt that superb and consistent outperformance exists in a Mutual Fund, even in today’s benchmark-driven passive market.
      2. The Contrafund is interesting because it both outperforms and underperforms the market benchmark fund at the same time. Its outperformance is from Danoff’s investment acumen, and the underperformance from the high taxes on distribution the fund pays. On a related note, Morningstar just downgraded Contrafund (3/22/22) in recognition of the enormous constraints imposed on a manager whose strategy (which covers Contrafund, clones, and related accounts) has grown to $250 billion.
      3. David Snowball had an interesting take on the Contrafund. Danoff has trained a lot of analysts. How come none of them have performed as well outside of the Contrafund? Maybe Danoff is Betting on the Contrafund means hoping Danoff sticks around.
      4. I am now open to the idea that there is a select number of fund families (Primecap, Fidelity, Wasatch, Grandeur Peak to name a few) where the investor has a higher shot than the average actively managed mutual fund. I am open to reading and learning more about successful MF managers so I can form faith.
      5. For most of my investment assets, I still feel comfortable in the warm blanket of passively managed index funds. Only after I have substantial faith in a fund management team would I consider moving my assets, and I would be in no rush to do this.

   Remember: join the conversation by completing our quick, easy and anonymous MFO active/passive preference snapshot

   For readers who enjoy looking at the detailed data behind my arguments, I’ve reproduced the results of a side-by-side comparison of the short- and long-term performance of Mr. Lynch’s favorite funds. And because taxes sting, I’ve also included their tax-adjusted performance. For each metric, the fund with the single highest performance is flagged with a green box.

   Detailed performance record: three Fidelity stars, the S&P 500 and Mr. Buffett

   What is APR: It is the Annual Percentage Return of a fund including the Price and Dividend Return, as well as the fees paid.

   1. 1. APR 1yr %: Total fund Return over the last 12 calendar months (March 2021-Feb 2022).
      2. APR 3yr %/yr.: The total returns are taken for the last 36-months and then recalculated to form an average compounded annual return for the period. This has the effect of averaging the good years with the bad years to give us an approximate number the fund delivered to its investors over the 3-year period. This same calculation is done for the APR 5, 10, 15, 20, 25, 30 in the MFO search engine (or in most financial websites).
      3. 10-yr APR Present %/yr: The fund’s 10-year total return when annualized on average from Mar-2012 to Feb-2022.
      4. 10-yr APR 10 Years Ago %/yr: The fund’s 10-year total return when annualized on average from Mar-2002 to Feb-2012.
      5. 10-yr APR 20 Years Ago %/yr: The fund’s 10-year total return when annualized on average from Mar-1992 to Feb-2002.
      6. APR After Tax Pre 5yr: The fund’s 5yr APR %/yr is adjusted down to account for the taxable distributions made by the fund. The assumption is the investor is holding the fund in the taxable account and is taxed at the highest marginal ordinary income tax rate at the federal level. No tax is subtracted at the State and Local level.
         The After-Tax APR numbers are reported by the funds to the SEC since the early 2000s. This measure was added recently to MFO Premium. Existing fund holders of actively managed mutual funds receive distributions in a tax year when:
         1. 1. A fund’s stock holdings pay dividends
            2. A fund liquidates positions with short-term and long-term capital gains
            3. Other fund holders exit their fund investment and force the fund to liquidate positions.
   1. 1. Fund holders in the Contrafund have been receiving such distributions and it’s been eating into their total returns.

   

By David Snowball

Devesh and I have an ongoing conversation about the value of active managers. He thoughtfully runs through the arguments – from consistency to tax efficiency – that led him to conclude, “not much value there.” Cool and sensible.

If you want to join the conversation but start with somewhat greater sympathy for the role of active managers, you might consider five arguments.

1. Measuring an investment by whether it “beats the market” is irrational. It is, nonetheless, the starting point for all criticisms of active management. And, to be clear, those criticisms can get a bit heated. One financial planner wrote to ask whether a piece I’d contributed to on mid-cap funds more reflected the fact that I was “bought off or just stupid.” (Having checked my modest savings account, I concluded that “bought off” couldn’t explain it.)

   I’ll repeat the argument I made in “Bright Guys Saying Dumb Things” (2019):

   There is no stupider or more destructive obsession in the investing world than this: so how often does your guy beat the market? This is the fantasy football version of investing: we win not by winning but by adding together a bunch of random, unconnected data points and declaring that the person with the biggest piles o’ points won.

   Earth to Investors: Fantasy Football is Fantasy. It’s not a model for managing your money. In personal finance, you win if and only if the sum of your resources is equal to or greater than the sum of your needs.

   If you beat the market ten years in a row and the sum of your resources is less than the sum of your needs, you lose.

   If you trail the market ten years in a row and the sum of your resources is greater than the sum of your needs, you win.

   Our guess is that winning requires investments that you understand and can stick with in the long term, ideally calibrated to a calculation of your long-term needs. In my case, for example, I win if my retirement portfolio returns 6% per year. If my 6% returns “trail the market,” I still win. If I “beat the market” but make less than 6%, I lose.

2. You are much more destructive to your portfolio than your managers are. We panic; we get greedy. We lose focus; we hyper-focus. We pretend we have special insights and, worse yet, act on those delusions. You know all those weird little cloud computing / AI and robotics / disruptive fintech / hemp and pot / obese America / vegan funds and ETFs that have been launched in the last five years? Morningstar “research shows that options for thematic funds—ranging from artificial intelligence to cannabis—have seen a surge in recent years, with $806 billion in assets under management as of the end of 2021” (Morningstar, 3/22). Morningstar tracks the impact of our delusions in their annual “Mind the Gap” studies. The average investor underperforms the funds they’re invested in – active or passive – by 1.75% annually through our ill-timed impulses. The gap is greatest in the sexy sectors and alternative funds (about 4% per year lost) and smallest in boring old allocation funds (0.7% lost).

3. There is no such thing as “passive investing.” The only truly passive approach to investing would be to assign every person, preferably at birth, fractional ownership of all of the world’s equity, debt, and commodity market. We could call it The One Fund. The total global equity market is about $100 trillion, global debt is $130 trillion and $250 trillion is in real assets.

   There would be no other options and you’d sell none of it until you reached your “decumulation date.”

   A truly passive portfolio would be 9% US equities, 12.5% international equities, 18% government debt, 9% corporate debt, and 51% real assets.

   Just 9% US equities!! Twice as much in God-forsaken foreign stocks? Tons of bonds in a 30-year-old’s portfolio? A toll road in Nepal? (WTF!) You wouldn’t like that, would you? That’s understandable.

   Welcome to active management. As an investor, you (or your representative) actively manage your strategic asset allocation (that is, your long-term exposure to stocks, bonds, and so on), your tactical asset allocation (your exposure to them right now, which might vary based on your position on the greed-fear spectrum), and your security selection (Fund A, ETF B, call option C, Stock D). Each of those decisions represents an active bet on your part that one set of options will be more satisfying than another.

   And, contrary to the general perception, index funds are not passive portfolios. They represent a series of complex and active decisions, bets, if you will, made by their portfolio managers. The difference is that the portfolio managers reside at MSCI or Standard & Poor’s rather than in the offices of your fund or ETF provider.

   By one tally, MSCI calculates 3.5 million potential investible indexes. There are 652 distinct index funds, with expense ratios ranging from 0.0 – 2.01%, tracking US equities alone. They have reported portfolio turnover rates ranging from 0 – 4700%.

   But the S&P 500 is …! It’s an actively managed, low turnover fund. The active management occurs at Standard and Poor’s, which updates the fund’s portfolio quarterly. The S&P500 is not a collection of America’s 500 largest stocks. It’s 500 stocks that a committee at S&P has chosen to represent the US market, constrained by a combination of liquidity, profitability, American-ness, and trading rules (which kept Berkshire Hathaway out of the index for decades) and human judgment. Their selection process is opaque and answerable to none. Motley Fool (2019) published a nice walk-through of the process. About 25 stocks per year are booted from the S&P 500, though it’s been as high as 60.

4. The charm of the best passive funds is that they make predictable mistakes cheaply. The S&P 500 is, predictably and by design, a momentum-driven portfolio. If everyone is rushing to buy Tesla (or, this year, Occidental Petroleum) regardless of the health of its business model or the valuation of its stock, the S&P 500 will rush to buy Tesla. If everyone is dumping Moderna, the S&P 500 will rush to sell Moderna. But, really, that’s about the only sort of mistake the fund will make; it doesn’t pretend to have special insights that other, lesser beings lack. (See, by contrast, Sequoia Fund and their decision to bet 36% of their portfolio on Valeant Pharmaceuticals or Third Avenue Value Fund’s commitment of 40% of their assets around 2010 to Hong Kong property stocks.)

   Sensible investors can access an S&P 500 portfolio for between 0 – 61 basis points.

5. 80% of active funds could be liquidated with no loss to anyone except possibly their managers. That’s actually a founding principle of MFO and a carryover from our predecessor, FundAlarm.

   Funds can be justified as an investment imperative or a business necessity. By “investment imperative,” I mean that the strategy is really useful, innovative, and rewarding. By “business imperative,” I mean that the fund was launched because the adviser needed a fund like it to “offer a complete suite of investment options” and, hence, to keep investors from taking their money elsewhere. Assuming that an S&P 500 Index fund is a good idea – an assumption I’m happily willing to make – the world needs about three S&P 500 funds. That would be enough to produce a useful downward pressure on expenses. But it has 38 S&P 500 funds, with some offering seven distinct share classes. Thirty-five of those funds, in over 100 share classes, could be liquidated with no loss except to the companies who need them to “keep assets in-house.”

   The situation is a lot worse in the realm of active funds. For example, there are 186 separate active funds (some with 16 share classes) investing in US large-cap core stocks, few of which even pretend to add any value for their investors. The five largest active large-cap core funds have correlations to the S&P 500 index of 0.95-0.99. That’s intentional because these funds are business necessities: their imperative is to keep assets in-house, not to do something interesting or distinctive. Put simply, a lot of jobs – and a lot of corporate bonuses – depend on the ability of the managers to hold onto assets. The simplest way to hold onto assets is to avoid getting noticed: never get out-of-step with the index, never act boldly, never take chances. So, they don’t.

So why cheer at all for active funds? At base, I rely on active managers to make prudent risk adjustments on my behalf. There was a time when I thought that checking my investments daily and tweaking them frequently was a good use of my time. I no longer do and, quite likely, I should never have. There are simply too many other things demanding my available brain space – mental bandwidth, so to speak – for me to consistently monitor and adjust market exposure.

Risk management works in the long-term and across market cycles

None of the 50 domestic equity funds and ETFs with the highest 25-year Sharpe ratio are passive products. Of the top 100, only four are passive products. (There are 113 index funds that have been around for more than a quarter-century.)

Shift to a 15-year period, when passive funds and ETFs were much more common and included the major market disruptions of 2007-09, only 14 of the top 50 domestic equity funds and ETFs measured by risk-adjusted returns, were passive. Of the top 100, 17 were passive.

Shift to the Period of the Party, the last ten years in which the most accommodative Fed policy in history created “the market on opioids,” and you still get only 24 passive funds in the top 50 by risk-adjusted returns.

In selecting funds, I’ve looked for several characteristics that allow me to get comfortable with my portfolio and leave it alone, with funds typically remaining there for decades rather than months. Among the characteristics:

1. A strategy that I understand well, in preference to algorithms and black boxes.
2. A clearly articulated understanding of the manager’s role in controlling risks, in preference to managers who have “pedal to the metal” as their mantra.
3. A track record for the manager, rather than just the particular fund, that spans multiple market cycles, in preference to strategies that have proven they work when markets are rising.
4. An independent streak, which allows managers to explain why I wouldn’t be better off in a low-cost index fund.
5. The ability to invest in more than one asset class, rather than being locked into 80% of the portfolio always in the asset class in the name. That’s a “give them the latitude to zig from time to time” preference.
6. Substantial, widespread, and consistent insider investment – by the managers surely, but also by their families, staff, and boards of trustees ideally. One manager admitted, “I hate losing my own money, but it’s deadly if I lose my mother-in-law’s.”

Bottom line

You need to understand what it’s going to take for you to win. That means starting with the “sum of your resources greater than the sum of your needs” calculation, rather than a “beating the market and brag to my brother-in-law” one. (Tools like T. Rowe Price’s Retirement Income Calculator do a phenomenal job of letting you estimate your options and prospects.)  From there, determine the long-term strategic allocation you need; how much of your portfolio needs to be exposed to market risks in order for you to have a decent chance of winning? (Our various articles on the stock-light portfolio are a decent part to start.)

Mr. Buffett famously announced that he thinks his wife’s portfolio, as he’s gone, should be 90% Vanguard 500 Index and 10% short-term Treasuries. Uhhh … does anyone else wonder why Warren Buffett’s wife should have any money invested in the stock market? Astrid Menks was born in 1946; she and Mr. Buffett were wed in 2006. At the point of his departure from this realm, she’ll be in her late 70s or 80s and will have … oh, a couple billion in her savings account. One wonders how much capital appreciation she will need in order to comfortably meet her needs.

Think about who, if anyone, is going to try to “tilt” the portfolio to deal with short-term traumas. Then, finally, pick the securities that make it all work. For Devesh, the right answer is a series of indexed products spread across complementary asset classes, and cheers to him for it! For me, it’s a stock-light portfolio of actively managed boutique funds whose managers have a bit of flexibility. For you, it’s quite likely something different from – and, for you, better than – the choices we’ve made. The key is not being trendy, popular or market-beating. The key is reaching the finish line, perhaps bruised but with arms raised in triumph.

By Charles Lynn Bolin

I have expressed my intention to retire in the next few months with the specter of stagflation looming. I have studied the 1960s to 1970s stagflation period since I lived through these times and know that they are secular. Federal Reserve Chairman Jerome Powell recently described the potential for inflation to last for an extended period of time:

…the risk is rising that an extended period of high inflation could push longer-term expectations uncomfortably higher, which underscores the need for the Committee to move expeditiously as I have described. (Powell Says ‘Inflation Is Much Too High’ And The Fed Will Take ‘Necessary Steps’ To Address,” CNBC, 3/21/2022)

This article describes how conservative investors may prepare for this evolution in the investment environment. I’ll walk through five sets of ideas.

1. 1. Evaluating Similar Time-Periods (for what worked then)
   2. Financial Physics (low and volatile returns ahead)
   3. Hard or Soft Landing? (can the Fed perform magic?)
   4. Categories and Funds Favored to Outperform (real assets, steady demand, cash)
   5. Conclusion

I would like to give a hat tip to Charles Boccadoro for developing the new graphical analytical tools which I used in this article. Thank you.

1. Evaluating Similar Time Periods

Key Point: During similar time periods of inflation, rising rates, and/or quantitative tightening, commodities, global natural resources, precious metals, real return, inflation-protected bonds, global infrastructure, utilities, consumer staples, and value have performed relatively well.

The Fed’s current policy trajectory is likely to lead to stagflation, with average unemployment and inflation both averaging over 5 percent over the next few years — and ultimately to a major recession. (Larry Summers’ new warning: Fed heading for ‘stagflation and recession’,” MSN, 3/16/2022)

Figure #1 shows the Consumer Price Index (purple), Federal Funds rate (green line), Federal Reserve Assets rising with quantitative easing (blue), and the behavior of the S&P 500 (red line) for the past twenty years. We begin a new period with the Federal Reserve raising rates, and tapering its balance sheet to slow the economy in response to inflation. Expect higher volatility.

Figure #1: Inflation vs Fed Funds Rate and Federal Reserve Assets (QE)

Table #1 shows the similarities and dissimilarities between the current environment and five other periods. The grey areas show similarities to the current economy and market. The red font indicates areas of concern. Yes, this time is different! There are several points to highlight:

• • Valuations are high relative to inflationary periods.
  • Short term rates are being increased from a low base.
  • Total Public Debt to GDP has quadrupled since the 1970s to 125 percent of GDP.
  • The Budget Deficit has increased from less than 2% of GDP to 12%.
  • Stocks only outperformed inflation by less than 2% during the 1970s.
  • Dividends were a larger share of the returns than the paltry dividend yield today.
  • Net imports are a much larger percent of GDP than during the 1970s.
  • Commodities slightly outperformed large cap stocks during the 1970’s, and are doing well this year.

Table #1: Metrics During Selected Time Periods

Table #2 contains the average performance of Lipper Categories during the selected time periods with the exception of the two most recent periods which are based on the two hundred funds that I track. They are color-coded by the highest (blue) and lowest (red) performers. The Category is shaded by the ones that I expect to hold up well over the remainder of the late stage.

Table #2: Category Performance During Selected Time Periods

2. Financial Physics

Key Point: Conditions favor higher inflation, and valuations are probably going to compress. Returns from stocks are likely to be low and volatile over the next decade.

The economic and financial impact of the Russian invasion of Ukraine represents a stagflationary shock for the global economy… Stagflation, an economic environment of stagnant growth and rising inflation, was once a long-tail risk, but now appears to be a real possibility…

Failing to see an easy off-ramp for the crisis [in Ukraine], the disruptions to energy markets may prove longer than initially anticipated, raising the uncertainty in the fight to rein in inflation and likely extending its duration.” (Jeffrey Rosenberg and Tom Parker, “A Stagflationary Shock,” BlackRock, Systematic Fixed Income Market Outlook, Spring 2022)

Ed Easterling, the founder of Crestmont Research, distinguishes between markets and the economy in what he calls Financial Physics. Mr. Easterling wrote Probable Outcomes and Unexpected Returns: Understanding Secular Stock Market Cycles, both great books that describe secular bull and bear markets and the role of inflation. Figure #2 shows the Financial Physics concept which he explains as:

Since Real GDP has been relatively constant over extended periods of time and all other factors are driven by inflation, a primary driver of the stock market is inflation — as it trends toward or away from price stability. Given the current state of low inflation and the likelihood of it either rising (inflation) or declining (deflation), P/E ratios are expected to decline, in general, for a number of years. As P/E ratios decline and EPS grows, the result will be another relatively nondirectional secular bear market. (Financial Physics, 2022 update)

Figure #2: Financial Physics

Commodity prices tend to rise as production approaches capacity as shown in Figure #3. The velocity of money is also shown and is basically the rate at which money changes hands. In spite of massive stimulus, the velocity of money has continued to slow until after the 2020 recession and since then has flattened as the money starts to circulate more which coincides with inflation rising.

Figure #3: Inflation vs Capacity and Money Velocity

Martin Pring, chief investment strategist at Pring Turner Capital Group, a California advisory with $183M in AUM, and author of Investing in the Second Lost Decade: A Survival Guide for Keeping Your Profits Up When the Market Is Down (2012) wrote Impending Super Cycle Commodity Signal Argues Against Transitory Inflation in October 2021 where he laid the potential for a secular bull market in commodities as shown in Figure #4.

Commodity prices look poised to signal a new secular bull market, which would likely broaden out to result in the highest more generalized inflation rates since the 1970’s… If that proves to be the case, the implications for stock investors would be tremendous. One obvious effect would be an improvement in relative performance by earnings driven sectors, especially commodity sensitive ones. More importantly, history shows, that as secular commodity bull markets mature, their consequential economic distortions trigger secular bear markets for stocks in general.

Figure #4: Commodity Secular Markets

Figure #5 from Stocks to Commodities Ratio shows an interesting comparison of the S&P 500 and the Producer Price Index by Commodity: All Commodities (PPIACO). Commodities tend to perform well relative to stocks during periods of higher inflation.

Figure #5: Stocks to Commodity Ratio

COVID has wreaked havoc on the production of commodities for the past two years, and the effects are still detrimental. Most commodity production is capital intensive and requires long lead times. After a decade of low inflation and relatively low commodity prices, it will take time for new production to ramp up. Rhiannon Hoyle, who writes about mining and commodities from The Wall Street Journal’s Australia-New Zealand bureau, observed:

Underscoring the constraints facing miners in responding to shortages, the International Energy Agency estimates that it takes more than 16 years on average from the discovery of a potential mine site through to first production. (“Ukraine War Threatens Commodities Supply and Miners Can’t React,” WSJ, 3/23/22).

Russia is a major exporter of the following commodities. While this production may not be entirely removed from the markets there will be a major shift in global supply chains as new sources are developed.

1. 1. Mineral fuels including oil: US$211.5 billion (43% of total exports)
   2. Gems, precious metals: $31.6 billion (6.4%)
   3. Iron, steel: $28.9 billion (5.9%)
   4. Fertilizers: $12.5 billion (2.5%)
   5. Wood: $11.7 billion (2.4%)
   6. Machinery including computers: $10.7 billion (2.2%)
   7. Cereals: $9.1 billion (1.9%)
   8. Aluminum: $8.8 billion (1.8%)
   9. Ores, slag, ash: $7.4 billion (1.5%)
   10. Plastics, plastic articles: $6.2 billion (1.3%)

– Russia’s Top 10 Exports

3. Hard or Soft Landing?

Key Point: The yield curve has been flattening showing an increased risk of a recession over the next few years.

Looking beyond the March meeting, we expect higher inflation and concerns about inflation expectations to continue to weigh more heavily on Fed officials than downside risks to growth in the coming months. As a result, our baseline forecast remains that there will be rate hikes at consecutive Fed meetings and a meaningful further tightening of policy throughout the year. This faster pace of tightening raises the risk of a hard landing further down the road and suggests a higher risk of a recession over the next 2 years. (PIMCO, Tug Of War: The Fed Begins A Rate‑Hiking Cycle As Inflation Trumps Uncertainty, 3/17/22, SA registration required)

Dr. Nouriel Roubini gave advance warning of the financial crisis and has been warning of stagflation for some time. He was a professor of economics at New York University’s Stern School of Business. He has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank. He is the author of Crisis Economics: A Crash Course in the Future of Finance (2010). He combines the effects of 1970s stagflation with the 2007 financial conditions to warn of a “Minsky Moment”:

We are thus left with the worst of both the stagflationary 1970s and the 2007-10 period. Debt ratios are much higher than in the 1970s, and a mix of loose economic policies and negative supply shocks threatens to fuel inflation rather than deflation, setting the stage for the mother of stagflationary debt crises over the next few years…

As matters stand, this slow-motion train wreck looks unavoidable. The Fed’s recent pivot from an ultra-dovish to a mostly dovish stance changes nothing. The Fed has been in a debt trap at least since December 2018, when a stock- and credit-market crash forced it to reverse its policy tightening a full year before Covid-19 struck. With inflation rising and stagflationary shocks looming, it is now even more ensnared. (Nouriel Roubini, “Conditions Are Ripe For Repeat Of 1970s Stagflation And 2008 Debt Crisis,” The Guardian, 7/2/21)

Wells Fargo economists argue that the probability of recession is low for this year but increases by the end of next year:

Today’s environment leads us to believe recession risks are unusually elevated; we put the odds of the U.S. economy contracting at some point between now and the end of 2023 at 30%. Our base case remains that the Fed tightens policy further over the next year or two without generating a recession… We see a significant likelihood that a technical recession is avoided, but growth slips below trend and the labor market treads water. That, however, may require living with above-target inflation somewhat longer if the FOMC re-weights its priorities as economic growth and the labor market look shakier. (Sarah House, et al., The Great Escape – Will the Fed Be Able to Wring Out Inflation Without a Recession?, 3/25/22)

4. Categories and Funds Favored to Do Well

Key Point: I favor commodities, commodity producers, real return funds, global infrastructure, value, utilities, and consumer staples in the current environment. Cash is not trash.

Historical analysis shows that value exposures have tended to outperform in a rising yield environment as it coincides with rising inflation… In a rising rate environment, traditional bonds can lose value, but investors should not write off fixed income exposure altogether… Exposure to broad commodities can provide diversification in a multi-asset portfolio and can potentially hedge against interest rate risk. (BlackRock, Maneuvering Through the Fed’s Hiking Cycle, 3/17/22, SA registration required)

The fantastic chart from Fidelity below shows how well sectors have performed in four different inflationary regimes. Energy and utilities are the most consistent winners followed by consumer staples. Health care and materials are inconsistent winners. The most consistent losers are consumer discretionary, financials, industrials, real estate, and technology.

Figure #6: Sector Performance During Inflation Regimes

Commodities can be volatile and I look for a diversified approach to protecting against inflation. Table #3 contains funds that have done well over the past two years which may help protect against inflation.

Table #3: MFO Metrics of Top Inflation Protection Funds – Two Years (Since March 2020)

Figure #7: Fund Performance of Top Performing Inflation Protection Funds

The following are strategies from funds shown as representative examples of differences in Lipper Categories. Commodity funds invest in commodity price futures while Global Natural Resources invest in companies that produce commodities. Real Return Funds are more diversified and often less volatile. I favor Flexible Portfolios where the fund manager has the discretion to improve risk adjusted returns by investing across diverse asset classes.

Flexible Portfolio: PIMCO Inflation Response Multi-Asset Fund (PZRMX)

The fund invests in a combination of Fixed Income Instruments of varying maturities, equity securities, affiliated and unaffiliated investment companies…, forwards and derivatives, such as options, futures contracts or swap agreements, of various asset classes in seeking to mitigate the negative effects of inflation. It may invest up to 25% of its total assets in equity-related investments.

Real Return: Fidelity Strategic Real Return Fund (FSRRX)

Allocating the fund’s assets among four general investment categories, using a neutral mix of approximately 25% inflation-protected debt securities, 25% floating-rate loans, 30% commodity-linked derivative instruments and related investments, and 20% REITs and other real estate related investments…

Commodities General: Parametric Commodity Strategy Fund (EAPCX)

The fund invests primarily in commodity-linked derivative instruments backed by a portfolio of fixed-income securities. The fund’s portfolio of fixed-income securities is generally comprised of U.S. Treasury securities and money market instruments…

Global Natural Resources: Fidelity Global Commodity Stock Fund (FFGCX)

Normally investing at least 80% of assets in stocks of companies principally engaged in the energy, metals, and agriculture group of industries.

VictoryShares US Equity Income Enhanced Volatility-Weighted Index ETF (CDC)

I include CDC because it is up 1.4% year to date as of March 17^th. It is currently invested (approximately 65%) in utilities, financials, and consumer staples.

The Fund seeks to achieve its investment objective by investing, under normal market conditions, at least 80% of its assets directly or indirectly in the securities included in the Nasdaq Victory US Large Cap 100 High Dividend Long/Cash Volatility Weighted Index…

The Index combines fundamental criteria with individual security risk control achieved through volatility weighting of individual securities. In accordance with a rules-based mathematical formula, the Index tactically reduces its exposure to the equity markets during periods of significant market decline and reallocates to stocks when market prices have further declined or rebounded. The term “Enhanced” in the Fund’s name refers to a feature of the Index that is designed to enhance risk-adjusted returns while attempting to minimize downside market risk through defensive positioning, as described below.

The Index follows a rules-based methodology to construct its constituent securities:

• • The Index universe begins with the stocks included in the Nasdaq Victory US Large Cap 500 Volatility Weighted Index, a volatility weighted index comprised of the 500 largest U.S. companies by market capitalization with positive earnings over the last twelve months.
  • The Index identifies the 100 highest dividend-yielding stocks in the Nasdaq Victory US Large Cap 500 Volatility Weighted Index.
  • The 100 stocks are weighted based on their daily standard deviation (volatility) of daily price changes over the last 180 trading days. Stocks with lower volatility receive a higher weighting and stocks with higher volatility receive a lower weighting.

Short-Term Inflation-Protected Bonds (VTIP, STIP, PBTP). These funds are up over 0.75% year to date as of March 17^th.

Table #4: Annual Inflation-Protected Bond Performance

Figure #8: Short-Term Inflation Protected Bond Performance

Closing

“Unfortunately, history isn’t on his [Fed Chairman Powell] side. Inflation is much further from the Fed’s objective, and the labor market, by many measures, is tighter than in previous soft landings. Yet the Fed starts real interest rates – nominal rates adjusted for inflation – much lower, in fact deeply negative. In other words, not only is the economy traveling above the speed limit, the Fed has the gas pedal pressed to the floor. The odds are that getting inflation back to the Fed’s 2% target will require much higher interest rates and greater risk of recession that the Fed or markets now anticipate. (“Odds Don’t Favor the Fed’s Soft Landing,” WSJ, Grep Ip, March 24, 2022)

My storyline remains that we are entering the late stage of the business cycle with valuations and inflation unusually high. Inflation will remain elevated for the next year or two at a minimum and the Federal Reserve will raise rates in response. A hard landing with a recession is more likely than a “soft landing”. I will casually reduce risky assets as indicators suggest doing so is prudent.

Investors should maintain diversified portfolios because the future is uncertain. I put 75% of portfolios in stable long-term funds, with 25% in a tactical sleeve, and limit categories to 5%. Commodities, equity of commodity producers, real return funds, utilities, and consumer staples are part of the tactical sleeve but will be scrutinized as a recession approaches.

Investing in commodities, real return funds, and utilities greatly reduced the volatility in my portfolio this year as the inflationary shock pushed prices up. This year, I have continued to rotate into inflation beneficiaries as I believe the trend will continue for some time. I have also reduced funds that are not responding well to rising rates as this trend will continue while there is high inflation. I have raised cash above normal levels to reduce risk and uncertainty as well as to take advantage of future opportunities.