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Summer Journal 8/26: Problems with Mutual Funds/ETFs

yo….. yo…. YO!….. hit this shit man. We’ve got like… no more work to do

During my job this summer I kept a notebook and wrote about 3-5 pages of notes each day. The thing is about 200 pages front and back and I got to about 170 by the end of it, so there’s a shitload of my thoughts on paper. It’s funny reading some of the earlier notes compared to my later ones. One of those things where you go into the summer thinking “alright I know a solid amount let’s crushingtons”. Then you end the summer and all you can think is “wow I learned so much… and I didn’t know DICK coming in”. But ya I’m gonna start posting some of the better notes I took and maybe see if my opinion has changed since.

This note is from one of my last days when I was having a conversation with my boss about different types of careers. We started talking about mutual funds, and how they differ from say, a broker like him. To preface, my boss is an extremely hard worker, the kind of guy who gets 4 hours of sleep a night because he’s got trade strategies running through his head non-stop. More than that, he’s extremely old school. Doesn’t pay attention to P/E ratios or any technical indicators like that. And to his defense, he’s good as HELL at what he does… making money for other people. But back to my main point, he has a strong anti-mutual fund opinion. And here’s why.

Let’s say you want to get into bonds right now. While there are tons of strategies you can use for bond exposure, the two most basic are buying your own bonds straight up or investing in a bond fund. For most people, the latter means your broker will purchase shares in whatever bond mutual fund it is you want. Right off the bat you should notice something. You’re paying a broker to manage your money, but the asset you hold (shares of the bond fund) is being managed by someone else entirely. Seems stupid to me at least.

The next issue is the mutual fund managers’ motives, which have to be tilted toward the fund investors. Most investors who want to get into a bond mutual fund are curious about one thing: what is their yearly return? When you buy your own bond(s), you know the YTM, call protection status, maturity date, etc. All of these things let you know exactly what your total return is, not just what your coupon rate is. If you’re not following, this is what I mean. An investor buys into a fund because he sees it gives a 5% semi-annual return, in other words the fund’s structure is made up of 5% coupon bonds that pay every 6 months. This sounds great to the investor, but the actual return isn’t going to be 5%. If all the investors care about is that 5% coupon, the managers will have no problem paying premiums on those bonds when structuring the fund just to get that 5% coupon (not a 5% YTM). So in reality, when you sell your shares or the fund closes you won’t be making a total return of 5%/6-months.

The last part shows how mutual fund management can be bad (obviously there’s a ton of good mutual funds out there with great managers, but I’m speaking in general right now). The main goal of the fund is that % return, while brokers and FA’s must also worry about their clients retirement goals, whether or not they need to send kids to college, etc. So, mutual fund managers can apply one single strategy to every investor, whether or not that strategy applies to that investor. The managers don’t have to speak directly to the investors, and only have to worry about the structure of the fund (making sure they’re solvent enough to pay out investors who want out). In the end, mutual fund managers don’t have too much incentive to actively manage the fund for higher returns. They know that they can load up on coupon bonds paying out what people want, and that’s good enough. I’ll expand on that point in my next post.

The last problem goes back to the fund structure. Money is always coming in and going out of these funds. Therefore, the structure of the fund is always being changed (i.e., diversification %, maturity structure, etc.). Unlike a broker, where you know exactly what you hold at all times, it’s much more difficult finding out the funds exact holdings, and therefore your own holdings (as a % of the fund). All in all, it’s a pretty lazy way to invest your money. There are plenty of ways to find higher returns, more income/cash flow, or whatever your personal strategy should be.

Rationale behind stock splits

Jobs: So did you hear my stock is at 370 now?  Gates: Ya… you’re still a gaydude tho

So I basically haven’t even thought about posting on this blog anymore once I started my summer internship, but I thought I might as well keep the bitch goin’. I got in an argument the other day with my mom after telling her about the stocks I’ve been looking at lately. I told her OpenTable Inc. (OPEN) was trading at 160/share the day before, and she gave me this look like I was a complete idiot. For the sake of me looking only slightly retarded, I was thinking of Salesforce Inc. (CRM), while OPEN was closer to 80 (down to 75 since then). Well the argument came when she said something like, “Oh are you looking at it that high so you can wait for it to split?” And I said something like, “Uhhh no not really, there’s a lot of stocks above 100/share”. Then came the ever-present tone of, “Oh DopiesChron, don’t act like you’re some big shot know-it-all nobody likes that blah blah blah”. Well… I went to work the next day and asked my boss what he thought about the conversation, and it turns out we were both right for different reasons.

My point was that I wasn’t playing these stocks for the split, but for the fact that they should grow regardless of a split. And that 1000 shares at 50 should be no different from 500 shares at 100. Academics love that last point–and it turns out it’s total bullshit and I’m an idiot (can I call my econ profs idiots now too?). The rationale behind a lot of stock splits is this: many people see a triple digit price and think it’s too expensive for them, but once a stock splits they think they’re getting a bargain and will snap them up. This is because many investors feel wealth based on their share amount, not the total value of their shares. While this may not seem like “rational behavior”, it makes a lot of sense. Grams over here didn’t wanna buy 20 AAPL shares at 300 because it looks like the only way it can go to her is down… now she’s crying herself to sleep as the price hits 370. Then there’s a 4:1 split and she thinks 75/share is the deal of a lifetime. Not only that, she can have 80 shares instead of 20… and that makes her feel goodski.

I saw on Bloomberg the other day some guy pull up a pie chart. It showed the share of the stock market held by… I wanna say Hedge Funds, Brokers (as in Wealth Advisors, etc.), and Institutional Investors. It showed that Brokers, who have clients ranging from $40 grand to $20 mil in assets, make up about 44% of that pie. In other words, a large amount of people are susceptible to behaving exactly like what I just described. Obviously, there’s a simple way to play off of this. Looking at historical prices, you’ll notice a lot of good, growing companies will have pops in their share price after the announcement of a split. Once the split occurs, people will be calling their brokers telling them to buy shares while the price is so low. So, the pop that occurs after the announcement is usually due to people trying to get a position in before the split, so they can ride out the bull when smaller investors get in.

Now, what usually happens is the price can jump as much as 20% the first day after a split is announced, with some earlier gains maybe being attributed to speculation of a split (or you know Rajat Gupta personally and you don’t have to speculate, you just know exactly when they’ll announce it). So, the trick is being able to get in before that initial price pop. Moreover, a 2:1 split is great, and the above scenario will likely play out. But a 3:1 or higher will usually make the institutionals back out, because they don’t want to hold so many shares. So, they’ll liquidate some or all of their position after (or before) the split.

This brings me back to my initial point: that I was looking at CRM for strong growth, not specifically to play a split. This is because we currently have way more triple digit stocks now than ever before. Whether or not they’ll eventually split is above my head, but there could be a few reasons why they’ve stayed so high. For one, the high prices reduce volatility, making their stock appear strong and their board members appear smart (the ones who decide on a split). Another more low-brow approach is that share price has become almost like dick-size to board members and chief officers. I can see it now… Reed Hastings of Netflix walking around a party saying “Hey slut, Netflix is trading at 280 right now… and if you stay at my place it might be 290 by the time you wake up”. Fuckin’ CEO’s. Always a party.