I want very short duration, and therefore minimal interest rate sensitivity. Capital preservation is important.

But I worry about the expense ratio (0.91%), and the average credit quality (B), which puts it in junk bond territory.

OSTIX has credit risk which you need to think about when you say capital preservation is important to you.
Mona

The small funds in my portfolio are not performing. I would like to replace them, even though there will be a tax hit on the gains. I might do it over a couple of years instead of one big dose of gains.
My present holdings are:
Heartland Value Plus (HRVIX)
Perkins Small Cap Value (JSCVX)
Fido Small Cap (FCPVX)
I intend to add a little to FCPVX and replace HRVIX and JSCVX with VB etf.
Any input will be helpful,
Thanks
Matt.

I'm watching the effect of interest rate angst on my bond funds, and wondering about making a change. I have significant positions in 3 Vanguard funds: GNMA, intermediate tax-free (muni), and short-term corporate. The GNMA fund has lost -3.4% ytd. Duration is 4.36 years, according to Morningstar. I love the expense ratio, 0.11%.
One alternative I'm considering is Osterweis Strategic Income. If you own it, could you comment on how you like this fund? It has a short duration (2 years) and has done well (ytd=3.4%). But I worry about the expense ratio (0.91%), and the average credit quality (B), which puts it in junk bond territory.
I think I'll hold the muni fund long-term, and also the short-term fund, which has been hit only minimally so far.
Other funds I'm considering are: FFRHX (fidelity floating rate high income), PONDX (pimco income), ATOIX (alpine ultra-short tax-optimized income), but so far OSTIX is the frontrunner.
I want very short duration, and therefore minimal interest rate sensitivity. Capital preservation is important.

I found Mr. Ely's comments to be a weak description of the issue, and points to a rather lackluster effort at reporting by Andrew Osterland .
From the Fairholme website:
“Fannie Mae and Freddie Mac are rapidly repaying the Government,” said Bruce R. Berkowitz, Managing Member and Chief Investment Officer of Fairholme Capital Management. “Their success should surprise no one given the value of Fannie and Freddie. Once the Government has recouped its investment, The Fairholme Fund – on behalf of our shareholders who are predominantly individual Americans with an average investment in the Fund of $43,000 – is owed a contractually specified, non-cumulative dividend for its investment in these companies. As solvent, highly profitable companies, Fannie and Freddie should honor all outstanding obligations to their investors.”
Fairholme’s actions do not challenge the 2008 emergency investments by the Government in Fannie and Freddie. Instead, Fairholme is contesting the August 2012 “Net Worth Sweep” that attempted to change the rules of priority. “Fairholme’s objective is quite simple,” continued Berkowitz. “The Government set the terms of their 2008 investments and should be held to their original deal.”
http://www.fairholmefunds.com/show_pdf.php?file=http://www.fairholmefunds.com/sites/default/files/FCM-Press-Release-on-FNMA-and-FMCC-Litigation1.pdf
Of course, as should be quite clear, I am a big FAIRX shareholder. If B. Berkowitz is rolling the dice, I am at the rail betting with the shooter.

Hello,
I used a strategy similar to the one described in the article in the management of my late parents investments to provide an additional income stream to their social security and pension benefits. I basically, took a sum equal to 1.25% as a withdrawal from the portfolio’s quarter ending value and accrued this in their savings accounts for future use. When I got into a situation that required additional cash requirements over and above their normal income stream then this sum was drawn from their savings accounts. This worked well and the value of their portfolios continued to grow over time along with the income distribution form their portfolios as the portfolio’s valuation grew.
This is, in part, the way I came up with my recent idea to build cash within my own portfolio plus put some spiff in my pocket. When the year started the S&P 500 Index was trading at 1426. At every 25 point increase I’d take a one percent sum from my equity area leaving the other (0.6% to 0.7%) as growth for the equity area. Today my equity area has a greater value by about six percent from where I started the year; and, I took the other ten percent (withdrawn) and split it between myself and the cash area of my portfolio.
Hey, with this, I grew both the equity and cash areas of my portfolio and put some good spiff in my pocket. This kept my equity allocation within the parameters I desired and kept it from ballooning.
Indeed, if one thinks, there are ways where an income stream can come from more than just interest, dividends and capital gain distributions in a bull market run. Take it from Mr. Market.
I wish all … “Good Investing.”
Skeeter

Days like yesterday and today ALMOST make me wish I was heavier into the USA Market. I'm happy with today's gains, though. Actually, my MAPOX was up yesterday, but down a tiny bit, today. A function of its bond holdings serving as a drag in those times when things are running hot? My MSCFX was up again, to a new all-time record. (The fund has been in existence only since August of 2011. Call it ALMOST 2 years. Glad I got in. My own MSCFX position is doing statistically better than the performance record posted by Morningstar.)
Elsewhere: it seems that I timed things fortuitously, without even trying, when I bought TRAMX in August, 2012. Morningstar's posted 1-year performance record for that fund beats my own, but the fund is at a 52-week high, and definitely out of its doldrums from 5 years ago. Over the past 5-year period TRAMX is still down by -6.12%.

CNBC discussing server farms located near govt buildings so that news releases can be sent to traders a couple of milliseconds before everyone else. The building they are discussing is owned by Coresite (COR is the symbol, it's a REIT.) You have a consistent trend of companies putting servers as close as possible to exchanges (from Coresite's website about their Chicago location: "CoreSite's Chicago data center adjacent to the Chicago Board of Trade brings together a well-developed customer ecosystem with over 80 customers including tier 1 carriers, financial trading firms, CDNs, cloud computing providers, and systems integrators") to get that extra fraction of a second advantage.
However, interesting to see that at least one of the data center REITs (and I'm guessing the others - such as Digital Realty Trust - DLR; do too) is focusing on this theme. One may think that there may be eventual regulation of this, but on second thought, nah probably not.
You have computers that can read headlines and act accordingly. Large money is absolutely trying to gain that advantage over competition - the only question is what is the cost of an imperfect tool looking to gain an extra millisecond?I think you saw that when Knight Capital happened.
How one bad algorithm cost traders $440m
http://www.theregister.co.uk/2012/08/03/bad_algorithm_lost_440_million_dollars/

Reply to @STB65: I love it. I've often thought the same thing and when I get chance will go ahead and analyze the data say as of 1Q2007. D&C darlings come to mind - they had carefully navigated the tech bubble, but were slammed in 2008.
Computing past returns is the easy part, all after-the-fact. The recent bond swoon is a reminder how quickly the world can go upside down. In 1Q2013 1 year ratings, AQRIX ranked 5 in performance...as of 2Q, it's 2.
Or, much worse, the 1998 bond market, as described in Roger Lowenstein's great read "When Genius Failed: The Rise and Fall of Long-Term Capital Management."
But I'll argue with you a bit on this point:

If several other ratios select the same funds as those favored by M/U, then we know why M/U isn't widely included in fund ratings.

My suspicion is that fund companies are inclined not to publish draw down performance, which is at the center of Martin ratio and Ulcer Index, because it can be the most frightening of metrics.
In any case, I think your good points lead to these key questions: Do funds that have previously limited draw down while delivering healthy returns (ie., high Martin) have tendency to do so in future? And, is this any better a predictor than say Sharpe?
I believe it is generally recognized that comparative volatility (or beta) tends to be remarkably stable over time, much more so than returns. But not always...as was painfully learned by folks at LTCM.
One thing I'm learning is that no matter what we show based past data, doubt will remain about about any predictor...and prudently so. That said, I'd still want to know how a fund has handled draw down in past compared to other funds, even if, like the ubiquitous qualifier says: "It is no guarantee of the future."
Thanks STB65. More soon.

http://news.morningstar.com/articlenet/article.aspx?id=602427
* Vanguard Suffers Its First Firmwide Outflow Since 1994
* Fairholme Suing U.S. Government Over Fannie, Freddie Shares
* Munder Capital Management Up for Sale
* Former Columbia Manager Takes Lead at Vanguard Muni Funds
* Columbia Hires Former Putnam Value-Equity Manager
* Aberdeen PM, Relationship Manager Die in Cycling Accident in England

A relatively low-cost way to get into Dimensional Funds is available through AssetBuilder (see http://assetbuilder.com), the investment house started by Scott Burns. You do not get to choose from the Dimensional Funds menu a la carte, but instead have to choose one of the predefined AssetBuilder portfolios. The funds are held by you at Schwab, with AssetBuilder authorized to do transactions on your behalf in your Schwab account. Assetbuilder management fees and trading costs at Schwab inevitably reduce returns a modest amount.
I have used one of the AssetBuilder portfolios as one "sleeve" of an income-generating, capital preservation type of portfolio. It turns out that over the past couple of years, the actively managed sleeves have done better. But I do not expect the active sleeves (using funds like VWIAX, FPACX, EXDAX) to have a permanent advantage.

This week's Barron's has an article on star managers who choose to strike out on their own and launch fund firms ("Introducing the New Guard," July 8, L17-19). They focus on four firms about which, you might have noticed, I have considerable enthusiasm:
Vulcan Value Partners, whose Vulcan Value Small Cap Fund we profiled.

Highlights: C.T. Fitzpatrick - one of the few managers whose funds I've profiled but with whom I've never spoken - distinguishes Vulcan's approach from the Longleaf (his former employer) approach because "we place as much emphasis on business quality as we do on the discount." He also thinks that his location in Birmingham is a plus since it's easier to stand back from the Wall Street consensus if you're 960 (point eight!) miles away from it. He also thinks that it makes recruiting staff easier since, delightful as New York City is, a livable, affordable smaller city with good schools is a remarkable draw.

Seafarer Capital Partners, whose Seafarer Overseas Growth & Income is in my own portfolio.

Highlight: Andrew Foster spends about a third of this time running the business. Rather than a distraction, he thinks it's making him a better investor by giving him a perspective he never before had. He frets about investors headlong rush into the more volatile pieces of an intrinsically volatile sector. He argues in this piece for slow-and-steady growers and notes that "People often forget that when you invest in emerging markets, you're investing in something that is flawed but that you believe can eventually improve."

Grandeur Peak Global Advisors, whose Grandeur Peak Global Opportunities was profiled in February 2012 and whose new Global Research fund is the subject of an upcoming profile.

Highlight: Robert Gardiner and Eric Heufner both began working for Wasatch as teenagers? (Nuts. I worked at a public library for $1.60/hour and doing landscaping for less.) They reject the domestic/international split when it comes to doing security analysis and - I've really got to follow up on this - Gardiner is "intent on keeping Grandeur Peak, which is now on the small side, just shy of $1 billion under management." Uhhh ... International and Global already have $825M and if you allow for asset growth there, this implies a tiny capacity for Global Reach. Time to call Eric.
Okay, mostly right. They got the name of the fund wrong, the photo caption wrong and the quote wrong. Apparently Mr. Heufner said Grandeur Peak currently had a bit under a billion, that their strategies' collective capacity was $3 billion but they're apt to close once they hit $2 billion to give them room for growth.

RiverPark Advisors, five of whose funds we've profiled, two more of which we've pointed to and one of which is in my personal portfolio (and chip's).

Highlight: Mitch Rubin's reflection on the failure of their first venture, a hedge fund "Our mistake, we realized, was tryig to create strategies we thought investors wanted to buy rather than structuring the portfolios around how we wanted to invest" and Mitch Rubin's vitally important note, "Managers often think of themselves as the talent. But the ability to run these business well takes real talent." Ding, ding, ding, ding! Exactly. There are only a handful of firms, including Artisan, RiverPark and Seafarer, where I think the qualit y of the business operation is consistently outstanding. Lots of small firms handicap themselves by making the operations part of the business an afterthought. Half of the failure of Marx's thought was his inability to grasp the vital and difficult role of organizing and managing your resources.

The article's most curious claims surround the economics of starting a firm. One claim is that it takes about a million in start-up capital. The other comes from Frank Strauss, of Beacon Consulting Group: "Depending on the type of fund and cost structure, you need $100 million to $200 million in assets before a fund can start making a profit." That's an awfully big "depending on," since most managers place breakeven at or below $50 million.
More soon,
David

Reply to @andrei
Hi Andrei, in response to your comments:
1) The appropriate comparison is WABIX. The A-share has an ER nearly 50bp higher. WARDX is the admin class with an ER in between I & A shares. WABIX is the institutional share.
2) A fund cannot use a track record that doesn’t reflect the same strategy as the new fund. They can’t make this stuff up like an unregulated private.
3) Past performance of any fund tells you nothing about the future.
4) If you look at YTD performance you will see that the difference in performance is actually less than 30bp. I did not check since inception, but if a difference exists I would assume it might be attributable to fund flows. The fund grew rapidly in a rising market. That could account for any difference that might exist. You cannot extrapolate over 10 years and infer anything about future incremental costs.
5) Tax efficiency will be a function of the future allocation. Funds must distribute their income and gains to maintain their tax status. GMO generally only makes a handful of changes in a year. Past tax information is virtually useless in determining what to expect from the future. That will float with time.
6) GMO believes this strategy can generate returns of CPI + 5 after expenses. They might officially state a lower number to control expectations. We will see if they can pull it off, but I at least like their chances.
Hope this helps. There is no doubt that this is my favorite fund and has the highest allocation of my portfolio.
Happy fourth to all!

Most of the 2008 relative failure occurred in the first three weeks of the fund's existence. Here's Mr. Smead's discussion of that period:

Our first year of managing the Smead Value Fund could not have been more difficult. The fund began trading on Jan. 2nd with an over-weighted position in financials and by three weeks into the year had fallen behind the S&P 500 Index significantly. For the year ended Nov. 30 the fund fell -43.72%, versus a decline in the S&P 500 Index of -36.76%, as we made up some of the relative performance ground from April through May by not losing as fast as the index.
Most of our poorest performers were financial companies which we got out of on the way down like Washington Mutual, AIG and Wachovia Bank.

Absent those first three weeks, the fund dropped around 37% through the rest of the year and the S&P dropped around 35%. The fund also trailed the S&P for four consecutive quarters from 2Q2010 - 1Q2011. Here's his take on, and reaction to, those markets:

At the end of November, 2010 we explained that there were two big risks in the US stock market. We were concerned about how an improving economy might ultimately hurt bond investments and felt that this would be the year that China’s economy would slow dramatically. Therefore, we have rescreened our portfolio to eliminate our exposure to China’s slowdown. We have removed any energy and industrial holdings to help mitigate these risks.
We want to make all the money for you in common stocks that we can while trying to shield you as much as possible from what we perceive are the biggest risks going forward. We have been faithful to that call and fully expect that approach should help us to outperform in the long term. Most folks don’t realize that all the gains in the stock market since the 2009 lows have come while both institutional and individual investors have been net sellers of Large-Cap US stocks.
Performance for the Investor Class shares of the Smead Value Fund for the six month period ended May 31, 2011 was +11.15%. We underperformed our benchmark, the Russell 1000 Value Index, which returned +16.67%. Our best performing stocks in the last six months have been Accenture, Pfizer and Walgreens. Our pharmaceutical stocks have shown relative strength in the last 90 days, but our financial stocks have weakened as some additional worries about getting past the last big slug of foreclosures in the US housing market has attracted great fanfare and attention. We feel the pessimism is overdone. Both financial and consumer discretionary stocks offer significant upside potential.
The Positive Case Which Nobody Makes
We have a much brighter vision of the next 5 to 10 years than do most other money managers. The US has done a great job of adjusting to the deep recession of 2008-09 by recapitalizing its banking system, and US households have quickly crawled back inside their incomes and worked toward cleaning up their balance sheets. Our savings rate has risen to 6% in the US. The massive cleansing of our economy could soon put us in a position similar to 1982 and 1992 where dour news precluded people from seeing upcoming extended periods of prosperity.

The fund has outperformed the S&P in each of the past nine quarters, starting in April 2011 and including the two quarters with negative market returns. It's performance against its large blend peer group has been stronger than its performance against the unmanaged benchmark. It has outperformed them (and the S&P) since inception and in four of its six calendar years (including 2013 YTD).
For what it's worth,
David

Reply to @Hrux: When I was considering investing in WARAX, I found that WARDX is going to lag the GBMFX by more than 1%, rather than by 30bp. Indeed you can easily check using M* that since inception on 03/01/2012 $10 invested in WARAX would grow up to $10.713, whereas in GBMFX they would grow to $10.893. The difference, during a bit more than a year, is %1.8, which is a lot! During 10 years you are going to lose more than %15 as compared to GBMAX. And that is ignoring the load.
But my main worry is that the past performance of GBMFX does not tell you almost anything about the future. As I said, read the fine print of the prospectus. As for the tax inefficiency, at the time when GBMFX was functioning successfully, as an internal fund, its share price DID NOT GROW AT ALL. Which means that ALL gains were distributed to the shareholders. After this fund was reorganized, it suddenly became tax efficient, but this may be just another side of the same medal: It is a different animal now, so one cannot use his historical performance to look into the future.
I would be happy to be proven wrong. I was absolutely planning to invest in it, and they I decided against it.

Reply to @Skeeter: About a year ago, I considered investing in WARAX/WARDX. It is a clone of the GMO Benchmark-Free Allocation III GBMFX managed by Inker, which has a wonderful 10 years long history of performance. However, you pay an extra layer on fees while investing in WARAX. Also, when I looked at the history of GBMFX, I found that for a long period of time it was a small internal GMO fund, not a mutual fund (please read their prospectus and correct me if I am wrong). It was trading all the time, and it was 100% tax inefficient, i.e. all gains were distributed every year. Once it was reorganized as a mutual fund, its turnover became rather small, perhaps in part because of the rapid growth of assets. As a result, I doubt that its early history can serve as a guide to its future performance. Its close cousin, Wells Fargo Advantage Asset Alloc Adm EAIFX, is a clone of another GMO fund managed by Inker, and it regularly underperforms its GMO brother. I decided not to invest there. I could mis-evaluate WARAX, but I suggest anybody interested in it to download the prospectus of GBMFX and read the fine print.

Hi Charles and others,
I recently reopend my investment cash sleeve within the cash area of my portfolio with the purchase of a 24 month cd, Bank of Commerce, that has a yield of 0.85% along with the option of two step ups (my choosing). This is nothing to really write about ... but, it is where I have started to stash some of my cash in the rebuiling of my cd ladder. At one time, I had a sixteen position CD Ladder with cds maturing every 90 days over a four year span. It had an average yield in the 4.5% range.
I don't plan to sell assets in the rebuilding of my cd ladder; however, I do plan, in good time, to split my cash with 10% being in the demand cash sleeve and 10% bing in the investment cash sleeve all of which will be time deposits (CDs).
In the near term I will continue to make special "spiff" investment positions form time-to-time thus making some of my demand cash productive through utilizing some short term investment strategies. I am awaiting a retreat of S&P 500 Index to the 1565/1575 range before opening any new "spiff" positions. I recently saw a report, that my broker provided form S&P Capital IQ, that currently targets the Index towards 1800 by year end. Indeed good news if this comes to be.
Within, the fixed income sleeve of my portfolio I continue to operate with three short term fixed income funds LALDX (yield 3.46%), THIFX (yield 2.46%), and ITAAX (yield 2.82%) along with two multi sector income funds NEFZX (yield 4.96%) and LBNDX (yield 5.20%). I plan to add a third income fund in the near term. I currently have under review two multi sector income funds TSIAX and EVBAX along with a high yield fund FAHDX all which hold a limited amount equity exposure.
When interest rates normalize, I most likely will swap out the short term fixed funds for intermediate income and/or long term income funds.
Thus far this year all twelve of my investment sleeves within my portfolio have produced positive returns.
I wish all ... "Good Investing."
Skeeter

Thanks MJG! Much appreciated.
I too very much enjoyed David's commentary this month. Once again, rich with content. The man moves with ninja-like speed, always keeps it fun, and remains kind even in criticism.
Hmm. How does he do it?
I used to think "Chip" was mere mortal assistant, but starting to suspect this may be a cryptonym for Constant High Intensity Publication unit.
Until this month's commentary, I honestly could not get my head around long-short categorization. From now on, I will be examining such funds through David's ABS filter (alpha, beta, or structural).
I started laughing at the literate monkey picture! Crack me up =). I think I will adopt it for my avatar.

Versus Capital Multi-Manager Real Estate Income Fund...The fund’s retail, F-class shares carry an annual expense of 3.30% and a 2.00% redemption fee on shares held less than one year.

And I thought 5.75% load was bad.
Sad to read about Fidelity's decline or implication of decline. But sadder still to see investors hand over millions, correction billions, in high ER fees for gargantuan funds of mediocre strategies.
I signed up for the RiverNorth/OakTree call. These calls are always insightful.
RiverPark Structural Alpha (RSAFX) sounds intriguing. Ditto for David Sherman's upcoming RiverPark Strategic Income Fund. Yes, investors can gloat deservingly over just closed RiverPark Short Term High Yield (RPHYX)...nice performance graph...but try not to rub it in too hard to those of us suffering from recent fixed income declines, or as Hank puts it "Federal Open Mouth Committee" disease.
Honest healthy skepticism of Forward Income Builder (IAIAX). If the PMs don't believe enough in the fund to invest in it, how can we?
Mr. Smead is interesting. But 1.4% on assets of $363 million for his namesake Value Fund (SMVLX) does seem too high on a buy-and-hold forever fund. Stiff alternatives here with Berkshire Hathaway for zero fee, and as David points-out, ING Corp Leaders Trust Ser B (LEXCX) for 0.52 ER - an MFO Great Owl 20 year fund.
Dustbin was especially fun this month.

Stephen Leeb wrote The Coming Economic Collapse (2008). The economy didn’t, his fund did. Leeb Focus Fund (LCMFX) closed at the end of June, having parlayed Mr. Leeb’s insights into returns that trailed 98% of its peers since launch.

I love this business.

Reply to @Hrux: Hi Heather, I appreciate your well researched perspective. I accept that we do re-hash many of the same funds here at MFO so hearing new names is great. Thanks for moving from lurker to poster. You have a lot to add.
I've read and understand the permanent portfolio theory. I held PRPFX for many years but traded it for a dividend total return type fund, PGDPX. I understand the 2 funds are apples and oranges. I think PP is a great approach over long time periods and if you want a steady fund for 20-30 years you may not do much better. But my belief is there is a mean return for any approach and over the last 10-15 years PP has performed above it's expected average. Gold and treasuries have propelled this theory to over reaching returns and I believe the economic cycle will bring it back to the 5-7% average expected from a fund like PRPFX. My guess is PP will have some pretty low returns over the next 10 years to bring returns back to the mean.
In reading your thoughts both here and in your other posts, I think we are very much on the same investing page. I too invest with Arnott and Romick but also with flexible managed funds, FAAFX and MACSX. I also prefer funds managers that put capital preservation first and foremost with good upside downside capture ratios. Managers with funds like YAFFX, ARIVX, ODVYX.
Looking forward for more posts from you.

Thanks Max. I also own some Matthews funds and already have seen a nice bounce off the lows. I wonder how much of the previous selling was due to investors who got into EMs on advice or having read about the gains? At the first sign of volatility they sell. I think there was a lot of whiplash selling here.

By Richard Gao:
Weekly Asia Update
June 28, 2013
Growing Pains: In China, a cash crunch forces the pace of financial reforms for the long run.
Short-Term Pain, Long-Term Gain
China’s economy has seen plenty of headwinds recently—weak exports numbers, slower growth in both services and manufacturing and a weak recovery of corporate earnings despite rapid credit growth. China’s equity markets have performed weakly too and have been extremely volatile. But much of the recent volatility has less to do with sagging growth and much more to do with a cash crunch and tight liquidity in China’s banking system. What is going on?
These developments are taking place amid major reform efforts in China's capital markets. There is now stronger demand for wealth management and savings and trust products in China. As a result, the actions of central government authorities should be seen not merely as a response to an uptick in credit growth but as steps toward reshaping its entire financial system, liberalizing its currency and creating international financial markets, centered around Shanghai.
China's cash crunch, which began in mid-June, came just before its three-day Dragonboat holiday. (Public holidays are typically times of high demand for cash.) At the same time, banks were scheduled for regulatory review and as such, typically require cash to close their quarter-end books. The Shanghai Interbank Offered Rate (SHIBOR) started to rise due to these high interbank borrowing demands. This has happened in the past toward quarter-end and, typically, the central bank has stepped in to help ease banking system liquidity and thus lower the SHIBOR rate. However, what surprised the market this time was that China’s central bank held back from pumping cash into the market. Instead, it allowed the SHIBOR to soar, at one point reaching as high as 13%. Expectations that the interbank interest rate hike might lead to widespread default among the system’s weaker banks—and spark a banking crisis—led to severe selling activity in the equity markets of China and Hong Kong.
Some analysts claimed that this was a crisis “self-created” by the central bank. True, the Chinese central bank can very easily defuse the crisis by injecting liquidity into the system. But the fact that the central bank did not intervene also sent a strong signal to the banks: They need to source their own liquidity and shed the assumption, particularly held by the country's smaller banks, that interbank interest rates will remain constantly low and liquidity typically abundant. China's banks should also not rely too heavily on low-cost interbank borrowing as their funding source to issue a variety of wealth management products. Banks need to own up to the consequences of a liquidity squeeze and not expect an automatic government bailout. In recent years, the amount and types of wealth management products issued by banks have grown quickly and become central to China’s risky shadow banking system. Wealth management products bear much higher interest rates and are not reflected in bank balance sheets.
So far this year, although China’s overall credit growth has been quite strong, it has not translated into higher economic growth. A big part of credit creation has taken the form of wealth management products, some of which have involved the country's somewhat unhealthy real estate market as well as local government-funded projects. This has posed significant risk to the financial system. Given the fast development and lack of transparency in China's shadow banking system, inappropriately managed wealth management products could significantly deteriorate a bank's asset quality and, ultimately, lead to further needs to recapitalize. China's banking sector liquidity crunch seems likely to have a significant impact on the behavior of financial institutions and could eventually slow the pace of growth in its shadow banking activity. At Matthews, we have tracked the evolution of China's banking sector cautiously. We believe that a widespread banking crisis seems unlikely for China, but we have nonetheless taken a cautious approach and typically are underweight in Chinese financials, especially banks, in our portfolios.
If the interbank interest rate remains high for an extended period, it could ultimately lead to higher financing costs for businesses, harming the growth of China’s already slowing economy. By leaving the SHIBOR rate high, the central bank is taking a risk. But this move also demonstrates its determination to reform its financial system and place it on a more sustainable long-term footing. One would assume that the central bank is aware of the risk in taking these steps and will ensure that it won’t go too far. At the time of this writing, the central bank has announced that it has provided some liquidity to support financial institutions “in prudent need.” As a result, the SHIBOR rate has lowered substantially. The relatively tight liquidity may still exist for some time, but it seems that its peak may be behind us.
Richard Gao
Portfolio Manager
Matthews Asia