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Investing

Closed-end funds in the simplest possible terms

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Side benefits of having a blog: when you get tired of trying to explain a concept, you can use the platform to explain it in the simplest possible terms.

Let me also begin with a promise. As this essay gets more involved, I will let you know at those points, so you can say “nah, we done now” rather than go further. It looks long. It need not be.

Because we live in dumbth nation, I must include the disclaimer that nothing herein should be construed as investment advice; that all investments should be evaluated through one’s own research; and that the aim of this article is to promote the understanding of how investments work, not to encourage investment in any specific security or security type. And that, therefore, the author assumes no liability or responsibility for nincompoopery in anyone’s investing.

God, how I hate that. One day tire irons will come with warnings saying “DO NOT EAT.”

A substantial part of my investing energies goes into closed-end funds, which many people seem not to know exist. I try to explain them, and how they differ from conventional open-end mutual funds, and eyes go vacant.

All right. This is too simple to be eye-glazing.

Cora, Eve, and Clark offer to invest your money. Each will give you his or her own branded poker chips representing shares. How much each share (white chip) costs depends on the day. Hear out their plans.

If you go with Cora, she accepts your money, manufactures the proper amount of chips, and issues them to you through your broker. Some may be fractional; in fact it’s rare for anyone to hit a perfectly round number. Cora will invest your money, along with that of others, according to guidelines she publishes. Cora’s value lies in her perceived market savvy and expertise. She has a prestigious degree, lots of whizbang charts, and other marketing hoo-hah to convince you to buy and hold onto her chips.

The price of a Cora chip is based on the total value of her investments divided by the number of her chips that exist, so that changes every day and is determined about two hours after the markets close. Sometimes the government makes Cora pay you dividends or capital gains, so they can get tax from you sooner. To fire Cora, before the trading day is over you tell your brokerage to sell however much $ worth of her chips. This occurs at the price that is determined after market close. Cora gets your chips back and melts them down, then pays you based on that day’s price. If you don’t place your order with the brokerage before market close, your order happens tomorrow. Note that you lack firm control over the price you pay. Market went nuts in last five minutes? Could be good for you. Could be bad.

 

Eve has a different plan. She is like Cora in that she invests other people’s money, and she does publish a base chip price determined in the same way Cora does, but you don’t do business directly with Eve nor at that base price. You pay a brokerage to find someone to sell you his or her Eve chips. The amount of Eve chips stays the same, unless Eve makes one of her rare new chip productions.

Eve’s guidelines say that she has to mimic a given stock or bond index to the best of her ability. Therefore, the market price never gets far from the base price Eve calculates (referred to as an NAV). Eve pays regular dividends, and you have to pay tax on them. Unlike Cora, though, who coughs up the tax bomb as a Christmas present, Eve pays them regularly throughout the year with little suspense. Because Eve gets a small fee for her work, she never quite beats the index she tries to mimic. But she comes damn close without fail and, about 60-70% of the time, Eve’s results pummel Cora’s.

Cora gets very good at filling up her regular chipowner reports with great excuses for why she again underperformed her target index. Oh, and Cora’s annual fees are ten times Eve’s. She hopes chipholders won’t stop to think about that. She also hopes the people holding her chips won’t stop to ask why, during a year in which she actually lost them money, they still had to pay a bunch of tax on gains. If bugged about it, she blames the government and the law.

 

Clark’s program resembles Eve’s. When he started up, like Eve did, he made a bunch of chips and sold them into the market through an investment banker; thereafter he doesn’t create or destroy or transact them. Like Eve’s, you buy Clark’s chips from someone who wants to unload theirs. Because Clark is not trying to mimic an index, his chips’ market price can swing well above or below the base price he calculates. His job is as hard as Cora’s. He can screw up.

Clark only invests in bonds with moby payouts, and he buys hundreds of them. High-risk bond issuers have to offer high interest to attract buyers. Because some are at risk of not being repaid, Clark spreads the money out very thinly. He pays chip owners high yields, often 10-12% per year in monthly installments. Sometimes the money comes out of interest on the bonds, sometimes out of profits from selling bonds, and at times out of uninvested cash. Clark’s chip owners will have a shit fit if he cuts the payout, so he does his best to avoid that. However, Clark is human, and if he screws the pooch, the payout could go down. If he does that, his base value might go down, and his chips will probably trade for a lot lower price than his base value.

 

Cora manages a conventional open-end stock mutual fund. Eve manages an exchange-traded stock index mutual fund. Clark manages a closed-end bond mutual fund.

If you want to, keep reading for more details. If you just wanted the simplest possible explanation that I promised you, I hope I succeeded, and thanks for giving me a chance to explain it.

 

It’s important to know what the terms mean. Without definitions, one wanders blindfolded through an explanation.

A security is a (nowadays mostly virtual) piece of paper that says you own something. In conventional investing, one buys shares of securities in pursuit of growth (one hopes to sell them later at a profit) and/or income (one wants to be paid just for owning them). Sometimes both goals are in play, and obviously anyone seeking income at least wants his or her original money back in the end.

There are other rational goals, but those are the two big ones. It’s foolish to buy securities without knowing what you want from them.

What are securities? Many types: common stocks (you own a little piece of a corporation), bonds (you own a little piece of a loan), preferred stocks (you own a weird hybrid of stock and bond), publicly traded partnerships (like stocks, but instead you own a little piece of a limited liability company), mutual funds (you own a little piece of a whole bunch of securities someone else picks out), and some more.

If you are following the main thrust of this post, it has registered with you that this makes a mutual fund a security of securities. True.

Most individuals and many professionals lose money buying individual stocks. Buying individual bonds is sometimes risky and usually cumbersome for individual investors. Thus, someone proclaims him or herself an expert, files an ocean of paperwork, and says: “I will invest other people’s money according to some preset guidelines. I know what I am doing.” This results in what we call a pooled investment–as in ‘your money is pooled with others’– commonly called a mutual fund.

The three major sorts of mutual funds all work differently. That’s why I began this article with that poker chip explanation. I believe it is the least understood, most-needed-to-be-understood aspect of modern personal finance. I believe that understanding liberates you from bad decisions. Here’s the less simplified version, which I hope the first example made easier to follow.

First, you need to know what is meant by ‘ticker symbol.’ Stocks, mutual funds, and stock-like securities all go by shorthand labels called ‘ticker symbols,’ consisting of letters. Microsoft is MSFT. Alaska Airlines is ALK. Long ago, Continental Illinois Bank was CIL. RCS is the Pimco Strategic Income Fund, a closed-end bond fund.

Conventional mutual funds (CMFs; Cora’s fund) work like this. All shares are bought and sold through the fund manager or its agent. All CMFs are distinguished by five-letter ticker symbols ending in X. Thus, FCNTX happens to be Fidelity Contrafund. VFINX is Vanguard S&P 500 Index Fund, and so on. Thousands exist. They usually trade by dollar amounts rather than numbers of shares, which are recorded to three decimal places. (Going back to our starting example, imagine Cora, Eve, and Clark’s chips stamped with their ticker symbols.)

When you buy CMF shares, the company accepts your money and issues (creates) the shares to you. When you sell them, the company redeems (destroys) the shares and pays you their market value, which is based on that percentage of every security the fund owns. A CMF’s share price is referred to as its net asset value (NAV). That distinction matters because they are not stocks and must not be viewed as stocks. The number of shares of a CMF in existence thus changes daily.

If CMF shareholders sell (redeem) enough shares at once, the company may not be able to pay the sellers from free cash. Those following along very well have registered that the company might have to sell some of its security holdings to fund very large redemptions, thus demonstrating one of CMFs’ biggest problems: their mechanics can force them to trade when its managers might not prefer to do so, which means your highly paid professionals aren’t allowed to use their full best judgment, which in turn is what you (yes, you) pay them for. It’s like a computer managing a baseball game that calls for a bunt even when a slugger–and a lousy bunter–is at the plate. The slugger can only shrug and attempt the bunt, knowing it’s a bad idea.

I used to work for a company that managed CMFs. The big money situation works in both directions. What if a huge pile of money comes into the fund at a time when it’s a lousy time to buy? And yet the fund guideline says that it will be no more than 5% in cash? There is no choice. Disobey their own guidelines and they will be in big trouble. They must pick the least unpromising choices available in compliance with their guidelines. It’s like hiring a contractor when there’s too much work for contractors (or at any time in Portland): all the best options are booked six months out. Only the inferior builders will even come out to look at your job, and they will charge too much for crappy work.

Ever hired a house-sitter? If that person was an adult, you probably set out some guidelines, but ultimately you realized that the reason for having a house-sitter was to have a responsible adult keeping an eye on your place. If the adult could not contact you, or detected an emergency, you would have to trust that adult to do intelligent and prudent things to protect your property. Owning a non-index CMF is like hiring a house-and-pet-sitter but with such extensive rules as to paralyze the sitter’s best judgment. Who hires a house-sitter without trusting that judgment? This is stupid.

Index CMFs, a variation on the above, take the judgment out of the equation by attempting to imitate a stock or bond index (fictional investment portfolio meant to represent some portion of the market for benchmarking purposes). A Standard & Poor’s 500 index fund buys, in proper proportion, all the stocks in the S&P500. If S&P ditches a stock, so does the fund. (This may sound to you like Eve’s method. It is. Think Cora’s chip issuance mechanics combined with Eve’s investing plan.)

In workplace 401ks, an index CMF is often the least doggy of the ten or twelve dogs on offer. And if it’s a conventional 401k, there won’t be an annual tax hit. Most 401k CMF offering lists I have seen were full of mediocre funds. I believe that most are selected by the 401k custodian through kickbacks. I am also convinced that the 401k custodian often pays off the employer’s representatives in order to be selected. It’s the most logical reason for such laggard choices.

Index ETFs represent the same basic idea as index CMFs, but with different mechanics since one buys or sells them on the open market at a price negotiated with another investor by brokers. Either way, the NAV (and thus your price) goes up and down in lockstep with the index. Both charge low fees because this doesn’t take that much brainpower. If Slave Labor & Prostitution, Inc. (ticker: SLAP) gets big enough for Standard & Poor’s to include it in the S&P 500, the index fund managers of S&P 500 index funds will obediently buy the correct proportion of SLAP shares to mimic the new composition of the index. Since Rust Belt Decay Corporation (RBDC) got thrown out of the index to make room, the managers dump its shares. All of them. Eve’s ETF does it this way.

Index ETFs can attempt to imitate bond indices, or in fact any imaginable security index. So can index CMFs, of course, and they do. In the case of bonds, pooled investments represent the primary way individual investors park their money in fixed income (the sophisticate term for bonds, but which includes some other investments that also pay a, wait for it, fixed income).

CEFs, like Clark’s, are the main subject of this article; however, to understand them, one needs to understand how they differ from their lookalikes. Most invest in bonds, but there are stock CEFs and perhaps other kinds. Maybe there are some that invest in partnerships, or preferred stocks, or gold coins. My focus here is on high-yield fixed income CEFs, because I’m impatient and greedy and don’t have much faith in long-term promises or institutions. I have faith in what can no longer readily be taken away from me.

CEFs interest me because if I buy them intelligently, I get distributions amounting 10-12% per year, paid in monthly installments. I may even get a capital gain if I ever sell them–but the goal is not growth. It is income, paid now and not later, which means two things I like:

  1. It’s too late for them to screw my money up or take it back. I got it. Not theirs anymore.
  2. Because I get it now, not later, I can use it now. I can buy more shares now and increase the amount of money that’s paying me that 10-12%.

At this point, I consider CEFs well explained. Everything after this para expounds my experiences and observations, and may herewith wander from the topic. If all you cared about was the topic, school’s out. Thank you!

 

Most people investing in the stock market would figure 12% a reasonable goal, year over year on average. They would accept major declines, and might stay invested for years without having actually locked in most of their gains (i.e. sold the shares). And 12% is in fact a very rational goal based on long-term historic performance. But I want my money now, not later, so that I have it to reinvest.

That’s what I do with CEFs. I buy them, at a discount to NAV where possible. I hold them unless/until they decrease the distribution, or I find better options. If they cut the distribution far enough to make them unattractive, I find better options with ease. I may take a capital loss doing so, but remember that all along–for years, even decades–I got my 10-12%. And all along, therefore, I had that money to use for something else–such as more CEF shares.

Yeah, I paid tax on those distributions…except when I did not owe any. Those CEFs in my traditional IRA were not subject to tax. I got that money every month. When enough of it piled up, I looked over my CEF universe (current holdings plus potential holdings of interest), decided which would pay me the most money without being too overweighted in a given CEF, and bought shares. Those shares then started to pay me money.

Now and then, I’d see a major share price dump in a CEF. I’d go to find out why. Usually it was that they’d cut their distribution, absorbed another CEF, experienced shareholder drama, or otherwise done something excitingly harmful to my pleasantly dull regular payments. Most commonly, I’d just dump the CEF shares regardless of capital gain or loss. I would redeploy that amount into the best available option at the time.

A surprising percentage of the time, thanks to cheapskate buying practices, I’d realize a capital gain from selling the shares. Now that was fun. Pay me monthly for eight years, then a parting bonus for firing you? Yes, please.

This took me minimal work. Every month or two, I’d go to my spreadsheet comprising my CEF watch list. I would update current market values, current NAVs (so I could see whether it was trading at a premium or discount, and what magnitude), monthly payouts, and my own original cost for the shares. The latter numbers were essential to me knowing what I was currently being paid. The rest of the numbers related to what I would be paid if I bought shares now. I would also seek to add a CEF to my universe, searching my brokerage for the best paying bond CEF, then reading up to filter out the ones that seemed unsustainable or outlandish. If it looked too good, probably was. The biggest dog in my universe, after all the updating? I’d cease tracking it. If I actually still owned it, I’d place a sell order. If I knew I could get 11%, why would I even follow something offering 7%? No need.

Some years, the stock market would eat flaming death. Many people would freak out. Many would panic-sell their stock shares, mutual fund shares, everything, eek, the sky is falling, sellsellsell. I would go shopping. When my CEFs looked to be down about 25%, I’d update my spreadsheet and blow every dollar of cash in my account on dirt-cheap shares. I knew what I was seeing was panic, irrationality–and opportunity. I didn’t buy on margin, but I bought with every real dollar that had been piling up. Since I paid less for the shares, I got much higher yields, some almost embarrassing.

I would be paid those grotesque yields for years and years, until they either cut the distribution or I sold the shares.

Eventually I no longer bought separate issue securities at all. With money I couldn’t afford to have bounce up and down to any degree, I bought conservative bond index ETFs. With money I wanted to grow, I put part of it into CEFs, and part into a rough 80/20 mix of small-cap stock and conservative bond ETFs called the 3% Signal. I no longer even cared what high-flying tech stock the pundits touted. I stopped reading financial pundits, none of whom ever paid a penalty for being wrong. I decided that I was never again going to take advice from a Jim Cramer unless he was putting in writing to reimburse me any potential losses. If the market were to crash, I would make a lot of money and it would recover within a couple of years. History supported me.

Only a total collapse of the national economy, including the dollar’s value, would wreck me. If I ever came to believe that was likely, I would have invested in some other way that was immune to such a cataclysm. All those ways are very big bets on very unlikely outcomes. I realized that everyone who bought any form of securities, no matter how preppy he or she talked, didn’t really believe in this impending disaster. I have pure contempt for the concept of professing a philosophy one does not in fact believe, be it religious, economical, what have you. If you believe it, your actions will prove it.

How you invest money you can’t afford to have vanish is what you really think about the economic future. What one says means nothing. If you buy gold, but you leave it on deposit at Edward Jones, evidently you think there is a greater risk of home burglary or theft than of a cataclysm causing Edward Jones to close its offices. If you put money into your 401k, but talk big about how everything is going to be destroyed, you are lying. If you were that sure of your outcome, you wouldn’t put one dime into a 401k even if your employer matched it. Double nothing is still nothing.

There could still be a total collapse that renders everything irrelevant. If there is, it’ll also nullify most of my potential protective measures and screw me (and nearly everyone else) up real bad. It doesn’t make sense for me to prepare for something that has been predicted annually going way back, without happening or punishment for the wrong predictors. It is more logical for me to prepare for recurrences of what has been demonstrated to occur.

I’ll keep collecting my 10-12%.

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Investing

Shareholder revolts

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I love closed-end fund shareholder revolts, when you get two different ballots, and one of them is all about how management sucks. Such a refreshing change from ballots issued by management, which typically say that management is wonderful and that we should therefore vote as management desires.

(If you do not know, a closed-end fund is a form of mutual fund. Most trade in bonds. The biggest difference between CEFs and conventional funds, the kind most people think of when they hear the term ‘mutual fund,’ is that conventional funds are open-ended. All their trading is between the investor and the fund. Thus, when you buy shares, they are created; when you sell (redeem) them, they are annihilated. In a closed-end fund, shares are not created or annihilated. They are traded between buyer and seller, neither of which is the fund. I have given lengthy criticisms of conventional funds in the past, and probably will do so again, just because they need frequent slappage.)

What I love even more is when the rebels’ complaint is that the fund is going to be kept around two years before liquidation, and should be instead liquidated immediately. I guess I should have bothered to read their semi-annual reports, or perhaps this liquidation is a more recent development. In any case, it’s good to see something other than the standard blind endorsement of management. Usually the most revolutionary thing on the ballot is some proposal put forth by an environmental group or something, demanding greater accountability or constraints on executive pay. Management always votes against all such proposals, claiming that they are already doing more than what the proposal would require. You can believe them if you like; I don’t.

So. What to do?

In my case, first I go vote for the revolt. If I were keeping the shares, I might stick around to care who wins. However, if the fund is going to be liquidated, I don’t wait to be paid out. I slap trailing stop sell orders on my shares. Whatever drama they’re going to have, they can have it without my money. I can surely find a better job for my money than a fund that is being managed toward a liquidation date.

This one (KMM) was fun. It was one of my lowest yielding CEFs, and I had a capital gain to boot. Yes, please.

Investing, Religion, Social comment

Sitting by the window with my checkbook

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One of my investment philosophies I call “sitting by the window with my checkbook.”

Imagine there’s a downtown building, not too tall for openable windows. It houses mostly investment people. They are rich, but are too small to do it like the big boys, and have the public cover their biggest losing bets. If they take a bath, they’re wiped out.

They’re taking baths today, and they’re jumping from the 8th floor window. They cannot face their families with the news that they are falling out of the upper middle class. They will have to sell the cabin. The children will have to go to public school. The eldest will have to start doing yard chores, because the gardener is too costly. They have become what Trump calls ‘losers.’

They mistook their wealth for their sense of self. It’s impaired, and they are fundamental cowards who panic rather than hunker down and toughen up. I like that. I plan to profit from their pain. I’m not making any money today off anyone who isn’t a coward.

I’ve watched a few cowards jump already this morning. I judge the markets by the number of jumpers. When that number rises, I get my checkbook, grab a seat by the window (but not in their way; they will run you over), and wait.

They’re all still done for. They are all having trouble selling their shares. In fact, the shares have not declined in value that much, and will recover in time, but all these men (no women are this stupid) think purely short-term. They have become losers in life, according to their own hypercapitalist, left-hand path world view and assessment of human value. They would have to get real jobs.

I wait for them by the window. I keep the window down when no one’s jumping, to slow them down long enough to talk. As each one comes to the sill, we have a conversation. It may go like this:

Me: “Hey. Before you jump, think about this. Those shares you paid $11/share for? I’ll give you $6/share for them.”

The jumper looks at me in angry moral outrage. “You’ve got to be fucking kidding me! Why would I do that?”

“Well, you’re about to jump. If you find someone to buy them, there’ll be something to pass along to your family. If not, there won’t. Your call?”

“What kind of human being are you, to stop people on their way to this window and offer them bargain basement prices without trying to talk them out of jumping?”

“A smarter kind than you, apparently. You’re jumping and I’m buying. But if you don’t want to, feel free to jump. Another jumper will be along.”

“That is beyond evil. You don’t care about me.”

“Of course I don’t. That’s how this works. It’s how it worked for you until today. It’s not as evil as playing casino under rules that say you can’t lose. At least if I lose, I truly lose, and truly have to pay up. Or jump, if I’m afraid to face my consequences. If I were the jumper, you’d be happy to get a good deal from me before I jumped. Look in my eyes and you look into a mirror.”

“God! Okay, I’ll sell, you horrible bastard.”

Pleasant smile. “Price went down to $5.50.”

“You are insane!”

“$5.40. Deal or no deal?”

“Fine! Give me my $5.40! At least by jumping now, I never have to see your face again!” *leaps, screams, goes splat*

“True. Don’t care. Ah, another jumper. Hey, hold on just a sec, man. I don’t mind if you jump, but before you do, I’ll give you $5.25 for those shares…”

Evil? Yes, in the purely capitalistic, satanic sense of self-interested evil. Capitalism is the purest form of satanism, of left-hand path worship. In LHP worship, one takes what one can according to a few morals and one’s own self-interest and ability. There are reasons why the Judeo-Christian scriptures equate money with a big-ass demon, and say that one cannot worship their god and the demon at the same time.

It’s very amusing to me watching rich televangelists ask poor people for their money–and get it, up to nine figures of it. The televangelists are Anton Szandor LaVey’s wet dream of Satanic principles in action. If people are stupid enough to give them the money, take it, and live high on the hog! the old carny and bunco artist would say.

I’m not LHP, but I play one for the markets.

If I were truly that evil, I wouldn’t come out here and tell you how I do it.

If you think this requires six figures of disposable wealth, think again. Entry point is about $5000 of investable capital.

Interested?

=====

There’s a junk bond selloff. Junk bonds are bonds that pay high yields because they have low ratings, i.e., the chance they might fail is greater than infinitesimal.

When any selloff happens, it means people are very fearful. Buffett tells us to be greedy when people are fearful. Therefore, this morning, I am greedy.

What that means is that I’m shopping for closed-end junk bond fund shares. I find that this topic is eye-glazing for many people, so I am going with very short paras that won’t lose folks.

First, Sunday is a good day to do this, because the market is closed. Prices aren’t moving. If I make any decisions, I have all day to think about them, chicken out, whatever.

Mutual funds are pooled investments; in essence, you send them your money and they invest it for you.

Closed-end mutual funds are also pooled investments, except that they already got all the money, so when you buy the shares, you buy them from someone who wants to sell, at the market price.

All mutual funds have both a market price and a net asset value (NAV). NAV is what the fund’s actual investments (the bonds themselves) divide out to be worth, per share of the fund in existence. Market price is what you can actually buy or sell those same shares for.

With old school open-end funds, you have to pay NAV. With CEFs, they may trade (could also say: “market price may vary”) at a discount or premium to NAV.

I like discounts, the bigger the better. I especially like them when they come from people’s panic and irrational behavior, because I believe courage should always defeat terror. I am not only willing to make money from freakouts, I find it sardonically satisfying.

Since mutual funds must adjust their investment values to agree with the markets, and since the markets are affected by fear and panic (or euphoria, in its time), we can agree that the NAV incorporates fear into its price, right?

If we agree that fear is priced into the NAV, it follows that a discount to NAV means that said fear is priced into the fund’s shares a second time. It has to be.

Example: If the JKK closed-end fund holds securities that the market has pummeled down to a total NAV of $20/share, but you can buy JKK on the markets for $15/share, obviously the market is adding a second dose of fear. That dose is irrational. The markets already beat it up once.

It’s too bad there isn’t a CEF that invests purely in CEFs of junk bonds. We could get yet another level of fear pricing.

When you look at a yield, the % is meaningless without understanding how your payout money would be calculated if you bought it.

One buys CEFs mostly for yield, not growth. If they appreciate, that’s a bonus, and the best way to have a shot at that is to buy during fear.

That goal harmonizes with the goal of maximum yield, so it’s even greater reason to go full avarice at those times.

That has me updating my CEF shopping list. I might sell some and buy others.

I keep a list of CEFs. Now and then, I look them all up and note the NAV, the market price, the payout, how many of those payouts per year. All that is easy to discover.

From that, the list will calculate the annual yield at market price (this matters), yield at NAV (this is fantasy, since I can’t really buy it, but it helps me compare and gloat), and current premium or discount of market price relative to NAV (of reality to fantasy).

If I see a good chance for a great yield emerge from that list, I consider buying. If I still feel like buying on Monday, I make a note to place an order.

Of course, by then, the market rate will have fluctuated. Naturally, I am not satisfied with a ridiculous bargain. I hold all the leverage here and I’m going to insist on an even bigger discount. If no one will sell it to me for that, fine, no deal. No hard feelings.

Therefore, if I do buy on Monday, I’ll place an order at a price lower than the day’s lowest market price. It will be good until canceled (I’ll have it expire about a month out). Maybe it will reach that price and fill, today or in days to come. Maybe not.

The best deals are when people are jumping.

At first, they all lose more money. That’s fine. A few of the underlying junk bonds may even go bust. All of them won’t. And all the while, every month (in the case of most CEFs), they will send me my yield payout. For years.

Today, I’m checking to see if any of those payouts have dropped, and how they relate to the prices I might have to pay as I sit beside my window with my checkbook.

Days like this come less than once a year, so I’m taking a comfortable seat.

Investing

Other investments besides stocks, bonds and conventional mutual funds

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Many months ago I did a piece trashing conventional open-end mutual funds. I have no regrets. I promised that if even one person asked, I’d explain about other investments that may be better alternatives for most people who want to make money (rather than pay it to people in return for losing them money). It took a very long time, but someone finally asked.

Disclaimer: I am not an investment professional, and none of this is to be taken as a recommendation to transact any particular security. Examples given are not recommendations, merely samples so that the reader may get a look at one as a starting point for broad-based research. I assume no responsibility for anyone’s independent investment choices, and urge everyone to do careful research before choosing to put money at risk. All investment entails risk, and it is wise to consult a fee-only professional advisor for actual investment guidance.

ETFs (exchange-traded funds) and CEFs (closed-end funds)

These are also mutual funds, and are more similar to one another than different. Both are pooled investments that do not regularly issue new shares, so once they sell off the full initial offering, they trade on the open market like stocks. Both have tickers that look like normal Nasdaq tickers, typically three letters, sometimes two or four, whereas conventional mutual funds have five-letter tickers ending in X. A given fund’s description should say whether it is a CEF or ETF on your brokerage’s website, and the prospectus certainly will.

You will, of course, read the prospectus? With nearly all of them in downloadable .pdfs, it’s pretty rash not to do so. I’d read the most recent annual report, too. You especially want to take a look at what it holds, because what it holds would be what you would own.

Here’s the salient difference: ETFs are designed never to trade too far from NAV (net asset value…the total value of assets owned by the fund, minus any liabilities, divided by number of shares; we might call it the ‘basic share value’). This is because big hitters can swap in their ETF shares for what’s called a ‘basket’ of the underlying shares, and the market has different rules for the big boys and girls. CEFs do not allow this swapping. It assures that ETFs will always trade close to NAV, which itself fluctuates based on the underlying securities’ value. By and large, most ETFs are invested in stocks, and many are indexed–they seek only to mimic a given index, owning that index’s components in exact proportion to it.

Since CEFs can trade at steep discounts or premiums to NAV (most are fixed income dividend payers), opportunities periodically occur to purchase their shares at steep discounts to NAV. This is because market fear or euphoria, as I see it, is priced in twice. Suppose the NAV is $10, and it pays $0.70 annually based on NAV. That’s a fairly typical yield relative to NAV of 7%. But you don’t give a damn about the NAV, because the yield you will receive is based on what you pay, not the NAV. So, suppose you waited until you could get it for $8 (or as you would tend to evaluate it, a 20% discount to NAV, assuming the NAV happened to remain at $10 just for the sake of the illustration), and you buy. Your yield will be 8.75%. The yield relative to NAV means little, since you didn’t pay NAV. The annual payout, divided by what you paid, is your yield in an income investment.

1.75% is a significant difference, and since most pay monthly, you get paid often. I believe that the divergence between NAV and market price is the impact of fear (or euphoria). If people are dogging fixed income, the NAV will drop because many people are selling the bonds. However, the market price will also drop because people are selling the fund. I believe that this can present buying opportunities for those with patience and discipline. It is also easy to take the market pulse on high-yield fixed income just by seeing whether a number of bond CEFs are trading at discounts or premiums to NAV. I have zero interest in shopping unless I get a ridiculous discount. The notion of paying NAV, or buying at a premium, isn’t for me. I want to buy when they’re jumping out the windows. Before they jump, if the price is cheap enough, they can sell me their shares if they like. Or not. Someone else will be along soon enough.

What’s the catch with CEFs? Most are invested in higher-risk high-yield bonds. There might be Kenyan government bonds, bonds from some outfit in Pakistan, whatever; depends on what the fund’s prospectus says they hold or can hold. Most are very well diversified, much more so than many stock funds, with issues spread around many sectors. It is possible that this bond or that bond might fail to perform, but it is unlikely that the whole portfolio will go bust. And over the years, you collect a steady yield. The better you bought, the better your yield, and if you bought cheap enough, you probably have an unrealized capital gain at any given time. Now, that yield can decline if the overall interest/dividends paid to the fund happen to decline. There’s no guarantee. However, in practice, it probably will not go too far in any direction. And of course, one must always consider one’s comfort zone. Not all CEFs buy more speculative bonds. If you’re willing to take less return, you can find funds that go with higher-grade stuff, which pays less.

Most of my stock-related investing is in index ETFs, and all my bond-related investing is in CEFs. It is boring and successful, just the way I like my investing. I don’t do this to be excited; I do it to make money, and if I get my money, I am satisfied.

VO is an ETF. KMM is a CEF.

PTPs (publicly traded partnerships)

These are weird creatures. One often hears them called LPs (limited partnerships). They look like stocks until it’s time to make out your income tax. Their shares are called units, and they make regular distributions. It is a mistake to confuse these with dividends, because with PTPs, the payouts are considered returns of capital. From a tax standpoint, RoCs go to reduce your cost basis (what it looks like you paid for the units), so you don’t pay tax on that money unless you hold the units long enough to reduce your cost basis to $0.

Not that you avoid tax. In fact, these complicate tax, because the partnership has to issue you a K-1, which says in essence: “here’s your share of the tax liability based on how we did.” Often the K-1s don’t become available until very close to April 15, and you can almost guarantee that they will issue a revised K-1 as soon as you file your taxes. And if you sell the units, of course, since the returns of capital lowered your tax basis, from the IRS standpoint you made a big taxable gain.

If you can tolerate the tax headache, PTPs can be a good way to invest in energy. They pay you regularly. Like shares of any company, it makes sense to research them. What is a bad idea: buying PTPs in a traditional tax-deferred retirement account. I don’t fully understand how it works, but evidently they can cause havoc leading to your IRA having to file a tax return as if it were a person. Best to just keep PTPs out of your IRA.

LGCY is a PTP.

ETBs (exchange-traded bonds)

Most corporate bonds aren’t sold on a market like stocks. Most are held in brokerage inventories after their issuance. For the individual investor, it’s a little difficult to just buy these bonds, and very difficult to buy them sensibly. Not impossible, but harder than just buying stocks. For one thing, most bonds are sold in multiples of $1000 par value, so non-rich people have a tough time diversifying. This is why bond funds exist, although I greatly dislike conventional open-end bond funds. All the flaws of a stock fund, all the limitations of bonds, and all the weaknesses of conventional mutual funds rolled into one unattractive little package. ETBs are another way to invest in the bond sector while avoiding the crappiness that is conventional bond funds.

Because most have a par value of $25, ETBs are more accessible. However, these aren’t pooled investments. They are individual securities. They can appreciate, deteriorate and fail entirely, in which case you will probably get nothing. If a bond is trading at a ridiculous discount to par, with a correspondingly incredible yield, I’d bet that there’s serious underlying trouble and the odds are high you won’t see that next payout.

PPX is an ETB.

REITs (real estate investment trusts)

These got a very bad name in 2008, and for good reason: some went to zero. They trade like stocks. They often pay nice yields, and if bought well, so much the better. This is because they might best be described as a pooled investment that is required to distribute most of its gains to shareholders.

The hangup is obvious to anyone who watched them bleed out in 2008-09: if their assets drop in value, or stop performing (sending money), the value and distributions will drop. To buy a REIT without a full understanding of where they invest their money is asking for trouble; hell, it’s prostrating oneself and pleading for trouble. For example, what if it turned out a REIT was mostly in outlet malls? How many outlet malls have you seen lately that are half empty, pathetic shells? That might be why it’s so cheap. But, you might rejoin, the yield is currently 17%? That’s literally incredible. People are dumping that because they do not believe they will be paid that 17%. They’re probably right.

SPG is a REIT.

Preferred stocks

In general, these are classified as fixed income securities (the insider way to say ‘bonds’), though they are neither bonds nor common stocks. I would describe them as stocks lacking some common stock characteristics and adding some bond-like characteristics.

While you might get some capital growth from preferreds if you buy well, the dividend is the main reason for the play. Preferred stock is also senior to common stock in the pecking order for dividend payouts if the issuer comes up short on money to distribute, though junior to bonds. You won’t get proxy ballots for preferred stock; the shares are non-voting, so you don’t get to annoy the company by voting in favor of goofy or quixotic shareholder initiatives. Preferreds come in many flavors, and if you do not check into a given issue to find out exactly how it works, you’re making a mistake.

My own drag with preferreds is that my brokerage, Fidelity, uses a different ticker convention than the NYSE (or at least it did the last time I futilely attempted to place a trade for a preferred). Very uncool.

AHT.PE is a preferred stock.

Investing

Screw this. The conventional mutual fund model is broken.

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It pains me to say that.  I used to work for Rainier Investment Management, a good company with smart managers that ran (and still run) several relatively successful mutual funds.  They treated me well; I still have friends there, and I hope they prosper as a firm and as individuals.  I learned so much there–and ironically, learned why conventional mutual funds are a broken model.  At the time (mid-1990s), they were not.  Now they are as outdated as the idea of scanning a newspaper for stock prices, phoning a broker to get a current quote, and paying him 7% to buy a stock.

But at this point, I can’t recommend anyone invest money in conventional mutual funds unless there is no adequate alternative (as in most 401ks).  They have three big problems:  the creation/destruction of shares, the way they are transacted, and the fee locusts that eat away the money.  And that’s the no-load funds.  If there is a load (a massive commission paid to the manager for the privilege of becoming his or her customer), add a fourth big problem.  If your broker charges a transaction fee of any size, add a fifth.

Before we get into that, for benefit of anyone who’s not sure, let’s detail how a conventional mutual fund works.  I was present for the founding of four of them, so I understand how this happens.  A money management firm files all the necessary paperwork to open a mutual fund, gets assigned a 5-letter ticker ending in X, invests some seed capital, hires an agenting bank to custody the money/shares, and writes up a prospectus.  Included in this are the investment guidelines, which are what keep the manager from just buying whatever the hell s/he wants.  Typical guidelines sound like:  the Fund will invest no less than 80% of its assets in U.S. equities (that would be stocks)  with capitalization levels below $1 billion (that would be small cap stocks, i.e., little companies).  The fund may hold up to 10% of its assets in cash equivalents (that would be money market mutual funds, essentially the savings accounts of the investing world) at the manager’s discretion. Okay, fine.

All well and good…so you go to buy it.  You place an order (in dollars, not shares) during the market day.  A couple hours after market close, the fund reports its Net Asset Value (that’s the price per share) for that day, and your purchase executes, with amount of shares calculated to three decimal places.  Those shares were created on the fly, just for you.  Had you redeemed (sold), shares would have been destroyed.  Tomorrow morning at 6:30 AM PT (9:30 AM ET), your manager will start thinking about how to invest the new money you sent him (so to speak).  You’ll share in the fund’s gains, losses and fees.  What’s wrong with fees? Everyone’s got to make a little money, right?

Let us say that everyone’s got to earn a little money.  It is stupid to pay someone a fee to underperform (do worse than) the overall market, the performance of which can be purchased using an index fund.  The idea of hiring a pro, right, is that s/he knows stuff you do not, does major research, digs deep, knows the right questions to ask, has a finger on the market pulse? Then how come a majority of them do worse than the market indices they compare to, a majority of the time? With all respect to the pro’s hard work, what the hell benefit is the investor getting?

It makes sense here to explain the alternative, the index fund.  It may be conventional (which suffers from all the flaws of all conventional mutual funds, but suffers them with lower fees) or exchange-traded (hereafter called an ETF, mechanics different from conventional funds, explained later).  Its basic idea is that the manager just buys the securities in a given index.  Doesn’t take much brains, as the manager has zero discretion.  S/he must maintain the fund in as perfect a mirror of the given index as possible.  If you own the fund, your performance will be the performance of that index less relatively small, more reasonable fees than actively managed funds.

The only reason to pick conventional funds over index funds is the belief that the manager will beat the market on a consistent basis.  Most do not.  Most get beat by the market, accentuated by the fees.  This adds value…how?

In fact, it subtracts value–and you pay for that service.  Well, if I want to do worse than the market, I don’t need professional help for that.  If I want my investments screwed up, I’m capable of that all by myself.  Now that I’ve explained the model and how it functions, let’s detail why it is broken.

1) Creation/destruction of shares.  Sounds simple enough, right? Not so much.  Suppose the market is going great guns.  Everything the manager bought is fairly expensive right now.  Because the market is going great guns, investors’ money pours in.  The manager’s guidelines require him or her to buy–but there’s nothing out there that’s a good deal.  S/he must buy at the inflated prices.  Okay, now the market is eating flaming death, or the fund had a bad quarter.  Investors head for the exits.  They must be paid, meaning the manager must raise cash for redemptions.  But there’s nothing s/he really wants to sell right now! There is no choice.  The manager must sell a security s/he did not want to unload, probably because this is a terrible time to sell, locking in a large loss.  Both of those dynamics damage performance.  It’s bad enough with stocks; it’s worse with bonds, which is why conventional bond funds are such a dumb investment.  Bonds are mostly not traded on markets, but are sold from broker inventories.  One can’t just buy a bond index, as the bonds in it are not always available.  This is why bond funds can go up and down in price:  after their issue, bonds will trade at premiums or discounts to their original par.  So for a bond fund, you get the potential for losing money of a stock fund, but you don’t get the high upside of stocks.  Seriously? Who wants this?

2) The way they are transacted.  If you buy a stock or bond, you buy at a market price.  You can issue trading instructions.  If your trade conditions are met, bang, you bought it–same is true for selling.  If you buy a conventional mutual fund, you issue the order when the market is open, and after it closes, you find out the price you paid.  In what world is this even remotely acceptable? I have some books for sale.  If you place an order during the business day, I’ll fill it this evening, but I don’t yet know the price you’ll pay.  I’ll know that later.  Would you buy books that way? Then why will you buy thousands of dollars worth of mutual funds this way? Do you hate your money and want rid of it? If so, send it to me.  I won’t charge you any fees and I will pay your postage and/or wire fees with a friendly smile.

3) The fee locusts that eat your money.  The fees are not inconsequential.  How it works:  the fund pays out money, including (most significantly) to the manager for his or her professional expertise.  Okay, fine.  Typical management fees for actively managed stock funds amount to about 1-3% of the total money in the fund.  You pay that, though you do not see it occur.  Worse:  you pay that even when the manager underperforms the market.  Dead serious.  You often pay them to lose you money.  Is there a one of us who cannot lose his own money without help, for free? If you want a free money-losing service, the offer above stands.  I’ll take it off your hands and I swear not only never to charge you a fee, but to cover all costs.  Hang on; there are also 12b-1 fees, ranging from 0.25% to 1%, that go to pay people for marketing the fund.  I’m pretty sure, for example, that’s how Fidelity gets paid for its no-transaction-fee funds.  These, too, you pay whether the fund wins or loses.  How does it add value to you? It doesn’t.  It’s just a way to get you to pay the freight for marketing and distribution of someone else’s goods.  You are the customer, not the manufacturer.  Why are you paying your vendor to market his product to you? Isn’t that rightly his expense?

4) Sales loads.  Typically 5.75%, a one-time fee assessed when one buys (front-end load) or sells (back-end load).  Often called a ‘sales charge.’  The very term is insulting to one’s intellect and commercial sense.  You have to pay them a massive fee for the privilege of having them charge you further hefty fees to underperform the market? In order to make up for the crater this fee will put in your returns, the manager must outperform for years at a time.  Odds are heavily against that.  So, let me get this straight.  You’re willing to buy something this disadvantageous? I have a better idea.  Buy an index fund, and send me any portion of the 5.75% you feel fair and right.  I will cover all fees and expenses for this process, and I’ll never charge you any further fees for it.  Why do load funds even exist? That’s so that full-commission brokers, who sell the illusion that they are acting in their clients’ best interests and who get paid every time they trade securities, can get paid to put the client in mutual funds (which will not generate ongoing commissions for the broker, being typically buy-and-hold investments).  Full-commission brokers are as obsolete as sales loads, conventional mutual funds and learning the stock results from a newspaper.

5) Broker transaction fees.  These vary from discount brokerage to discount brokerage, so let’s talk about how Fidelity does it.  At Fidelity, I pay $7.95 to trade stocks up to some large amount of shares.  Some conventional mutual funds have no transaction fees (I assume because the fund managers agreed to slip Fidelity some 12b-1 fees).  Here is an excellent article about this.  Others have a $75 transaction fee.  If I buy $7500 worth of stock, I pay about 0.1% in commission.  If I buy $7500 worth of mutual fund shares, I pay 1% in commission (let’s call this what it is, shall we?). Every nickel of commission that you pay is a loss to you.  One always pays something, but in the gods’ names, why pay more for no benefit? Ah, but say you really want into that fund.  Do you want it badly enough to lose this much money immediately, so that a professional manager can then pay him or herself a handsome annual fee to do a worse job than an index fund? Because on balance, that is what is going to occur.

Think of your finances as a human body.  The conventional mutual fund model is a series of leeches, slowly but surely drinking the body’s nutrients.  In return for what? On balance, on average, in return for lowering the body’s health. What is the benefit? A sexy name? An illusion of security? Sorry, but to me it just looks like being covered with leeches.

If a single person asks, I will author a follow-up article about why ETFs and CEFs (closed-end funds) are so far superior.

Investing

Being greedy when others are fearful

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One of my life philosophies is that if very successful and smart people say things, one should pay careful attention.  This blog, for example, resulted from just such a situation.

I look at the markets today and I see and smell fear.  Never mind that much of the fear is generated by skewed, distortionary indices like the Dow; never mind that the media deliberately worsen it by anthropomorphizing and exaggerating the market.*  Never mind that it’s all based on taking advantage of a fundamentally innumerate public’s emotions.  I can’t change any of that.  I can, however, profit from it.

(*Think I’m exaggerating, myself? Riddle me this, Robin.  When I first started losing money buying stocks because I thought I was smarter than other people, in 1987, the useless, worthless, despised Dow was around 2000.  A 100-point triple-digit loss would be 5% at least–a really bad market day by nearly any measure.  Fast forward to our modern day of Dow 10000+.  A triple-digit loss of 100 today is 1%–essentially the expected daily fluctuation.  And yet today, even today, a triple-digit day (by itself a meaningless threshold anyway, just a number) gets big reactions, reactions like it used to get in the early 1990s.  Why?  This is stupid. If you get taken in by it, or even influenced by it, you harm yourself. And when the media characterizes the market as ‘struggling to hold gains’, you surely can see how stupid that is. The market does not care what it did five minutes ago. It does not struggle. It is not a person. The way the media present this offends me on editorial, mathematical, and intellectual levels. They twist perception to create volatility and interest.)

Anyway.  My own philosophy on investing is fairly simple:  patient and ruthless.  I don’t use investing as a social responsibility tool.  I would buy Wal-Mart in a heartbeat if I thought I could make good money.  Owning their stock does not help them because the initial offering is already subscribed; if you sell it, someone else will own it.  Plus, if you want to use it as a social responsibility tool, buy up a ton of shares and then vote them against the board of directors, and start shareholder movements that annoy management. That actually affects them.

So when I see a big selloff after a week or two of selloff, I’m not nervous.  I never look at the market without asking myself what I would do if this were the day–the day it plunged 20% followed by another 10% tomorrow.  Having seen that in life, when I see the markets go south, I start doing like Buffett says:  others are fearful, so be greedy.  I am bargain hunting.  I want to buy solid income investments at bargain prices, gaining high yields.  Why do I like income? Very, very simple.  I don’t have to worry about when to sell the investment.  I just collect my money and thank them.  The important thing is to buy so cheaply that your own yield is ridiculously higher than what most people will get.

Waiting, watching and checking cash balances.  C’mere, high yields.  I won’t hurt ya.  We’ll be friends for a long time.  I won’t freak out and sell you in a panic like most people.  It’ll be great for both of us.  Stability, steadiness, profit.