The Critical Assumption

The European Convergence Bet
In 1988, the mutual fund industry introduced a new type of bond fund called short-term multimarket income. The funds were as complex as the name suggested. They were long in the cash and bonds of some currencies and short in other currencies. Their portfolios were difficult to decipher as they consisted mostly of derivatives. The early performance of the funds was strong, with the funds posting very high yields even for the day, with minimal price fluctuations. 

The Golden Fleece in the mutual fund business is high yield plus low volatility, so the funds gathered much attention--and suspicion. What was the catch, buyers asked? They were told there was no catch. Short-term multimarket income funds were long in higher-yielding currencies and short in lower-yielding currencies. Their profits would be the differential in yield between the two buckets of currencies, plus the rate on risk-free securities, minus fund expenses. Yes, currencies do fluctuate in value, thereby causing some modest volatility, but, as these were mostly European currencies and the European market was increasingly trading in sync, these movements would pretty much even out over time.

Left unsaid was the true investment proposition: The entire scheme was a play on the convergence of European currencies. A system titled the European Exchange Rate Mechanism had been created to keep European currencies within a certain band and to bring them together over time so that the euro could be created in 1999. The funds were a bet that the ERM would function as planned. If the ERM broke, so would the funds. That was the true risk assumed by the funds--the reason that their lunch was not free--and that the funds would crack if the ERM failed was the critical risk to know. It should have been stated directly in fund prospectuses, in shareholder reports, and by fund managers. It was not.

You can guess the punch line. In September 1992, the ERM did indeed break down, as England was forced to withdraw the pound sterling from the arrangement, which had the effect of devaluing the pound and causing losses to the short-term multimarket funds, which universally were long the pound. (The story behind the withdrawal is quite entertaining. Effectively, it was a battle of staying power between hedge fund managers and currency traders betting that the United Kingdom could not withstand intense selling pressure on the pound and The Bank of England desperately trying to support the pound. The Treasury lost. George Soros' Quantum Fund alone pocketed $2 billion from the trade.) In response, several other high-yielding currencies relaxed their bands, leading to additional devaluations and further fund losses. Within two years, all short-term multimarket funds had either folded or changed their charters. The category was extinct.

Similarly, the key item to know about the process of creating so-called optimized portfolios by finding the efficient frontier is that the results depend heavily on the return assumptions for the asset classes. Much has been made of the fact that optimization routines create extreme portfolios--that is, portfolios that tend to be heavy on certain asset classes and light on others. Various work has been done to modify that extremity. One recent paper on the subject, by Santa Clara professor Meir Statman and practitioner Joni Clark, addresses the issue by arguing that the process should take into account investor preferences and not try to land exactly on the line of the efficient frontier. The authors prefer the notion of an "efficient range" to an efficient frontier. This is all well and good, but the bigger problem remains: What if the underlying estimates are wrong?

One example would be in 1999, when I was presented with a different approach for smoothing the results of the optimization process. The speaker showed a group of stocks with estimates for their future expected returns, standard deviations, and correlations, as required for optimization. When he ran the standard optimization routine, the result was to put 18% of the entire portfolio into AOL. He ran the smoothing routine and, sure enough, the AOL position was reduced, to 10%. I was left thinking, "But do you want to own AOL at all?" As it turned out, he didn't. AOL's stock price was $72 shortly thereafter in January 2000 when it acquired Time Warner; by 2003, it was languishing at $15.

I think about this as I ponder "risk parity." Currently fashionable in institutional investment circles, risk parity is a different approach for asset allocation. Rather than allocate assets by dollars--as represented by the traditional pie chart--risk parity allocates according to volatility, with the idea being that all portfolio assets should contribute equally to the portfolio's overall risk. (Risk parity can dramatically lower a portfolio's position in stocks.) I haven't yet figured out what to make of risk parity, but the framework I am using is as I have outlined. What is the unsaid weakness? If I can determine that, then I can write something useful. Until then, I had better stay mum.

Decommissioned
Monday's column on financial advice moving from being based on commissions to fees on assets under management was, shall we say, not universally appreciated. I will rephrase. 

There's no question that ongoing fund commissions (that is, 12b-1 fees) need to go. The 12b-1 fee has been an abject failure. It was sold to the American public on the promise that it would reduce fund costs, the theory being that while 12b-1 fees were an additional expense, this extra cost would be more than recouped by economies of scale as funds gathered assets and were able to cut operating expenses. That did not happen. Some funds didn't gain assets. And those that did rarely (if ever) passed along enough savings to investors to overcome the addition of the 12b-1 fee. It was a lie. It was a Great Lie. That 30 years later the SEC permits the 12b-1 fee to exist, although it clearly and obviously failed at its stated mission, is a joke.

Front-end commissions are another matter. For the long-term, buy-and-hold investor, paying the upfront charge of a traditional A share (particularly the old-school A shares that had no 12b-1 fees whatsoever) is much cheaper than paying an ongoing advisory fee. As one financial advisor wrote to me, "I do have older clients holding Templeton or Franklin funds purchased in the late '60s-early '70s. No fee other than what the fund charges. If wrapped at 1% the annual fee would be close to the original purchase price!" (That last comment indicates that the clients made fairly large purchases of the funds, thereby qualifying for volume discounts on the front-end load.)

The fund industry, and the financial advisory community, can and should come up with a cost-effective solution for the low-activity, long-term investor. The traditional A share was such a solution. If the A share is disappearing, where is the replacement? 

That is the argument. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.