USS MUTUALFUND: REDEMPTION "ICEBERG" AHEAD
INTRODUCTION
The good ship USS MUTUALFUND has survived the first 20 months of this severe bear market, unaware of dangers lurking ahead. Despite major losses in investor assets, large redemptions from stock funds have not really begun.
In September 2001 they were just 0.87% of assets, well below the 5.6% mutual fund cash available on September 1. But our reading of history says that neither fund managements or their clients should assume that all is clear ahead. We see a major disaster for both funds and investors resulting from their failures to conserve assets during the past 20 months.
We have very vivid memories of the longest and deepest bear market since
1929. The media reports have always underestimated the 1973-75 bear by
quoting 48 to 50 percent drops in the major capitalization-weighted indices.
But, using an unweighted index of 3300 NYSE, OTC and AMEX stocks, the market started down a year earlier and fell 64%. This bear market, very scary at the time, caused net mutual redemptions for NINE years.
The 1982 -2000 bull market mania is estimated to be twice as large as that
leading up to the 1929 crash and very much larger than the one I experienced in 1973-75. It is not possible for anyone to guess how many years of mutual fund net redemptions will occur once they finally start this time, but we predict very serious problems from presently known facts. We describe below the present and potential problems that we see needing attention by fund managers and urge fund investor action right now.
Readers of my recent article DOW 1000? or DOW 20,000? know that I expect a long multi-decade bear market, broken by numerous confusing rallies. We have been, and continue to be, more concerned about capital preservation than growth of assets.
SERIOUS MUTUAL FUND MANAGEMENT PROBLEMS
- Unbridled competition for investor dollars. The situation has existed for decades but has gotten out of control in the mania years. It has caused most funds to keep very small cash reserves due to fear their performance will not keep up with competition. In similar fashion there are very few funds using the authority in their prospectus to move assets from equities into bonds or cash during the current major market decline.
- Misleading advertising. I am aware of only a tiny handful of funds that moved to a conservative posture or warned investors against expecting 20% returns forever. Almost all ads since the market top have been directed at urging investors to "keep the faith" and not redeem their investments. I have heard some outrageous claims by managers of major fund companies. Fidelity's Peter Lynch has run a series of ads which claim that mutual funds have always shown profits over a 20 year period. The truth is that, in the years 9001-9021, 1929-54 and 1976-82, stock prices made no progress. Vanguard's head, John Brennan, has continued to urge holding and adding to index funds that may be among the worst performers since they will match the market decline in the years ahead. So far, the funds are winning the battle to hold their assets.
- Failure to read and respond to the lessons of history. Senior fund managers at mutual funds should be expected to take defensive action against the possibility of very large bear market redemptions. Their failure to do so after 20 months of market decline will doubtless be the cause of many legal actions for misfeasance against them. Any fund manager who thinks a 5.6% cash reserve is adequate during a major bear market will be open to serious criticism and law suits. Although fund prospectuses may have the right to delay redemptions under certain conditions, that fact should not preclude responsible management action to prepare for potential redemptions.
- Unwise or frivolous investment management. Many major fund managers have been acting in herds to buy large quantities of overpriced, volatile stocks. During severe down markets these stocks may be unsalable to meet fund redemptions since no buyers can be found at any price. Other bad and possibly illegal practices include buying stocks in attempts to influence the fund net asset value at a month or quarter end.
- Violation of the "prudent man rule" with inappropriate holdings. A good example might be holding extensive amounts of stocks not meeting the criteria specified in the prospectus. Another example might be large holdings of stocks subject to huge selling panics like that of Enron very recently.
THE GOOD OLD FUND DAYS
In the 1950's we didn't have computers and the internet but we did have a
few mutual funds, some still here today, that were operated with two
objectives:
- Management of fund assets for the benefit of the fund investor using investment vehicles and management practices as described in the prospectus.
- Operation of the fund management to achieve growth and profits for the manager but considered at all times as secondary to the first objective.
A fund investor in those days could expect to receive fund performance in
line with the words in the prospectus. No fund, to my knowledge, was
operated with a principle objective of competing with another fund for
performance and investor dollars. Rather, the aim was to achieve performance at a level attractive to all investors.
THE GO-GO YEARS
In the mid sixties, the conservative fund era changed dramatically as a
number of very speculative funds were started. Some of them like the Mates fund held restricted securities that had to be held for a specified time period. The Mates fund NAVY rose like a rocket and fell even faster. The fund could not meet redemption requests and the investors were wiped out. Out of the shambles of this era rose the Nifty Fifty stocks that needed only to be bought and held - never sold.
There were relatively few funds in existence at the time of the 1973-75 bear market and their assets were very small compared to today's giants. Many equity funds dropped 60 or 70% or more in their NAV. Redemptions were handled by the managers without the problems we envision today. However, mutual fund investors were so disheartened by the "moderate" bear market that there were net fund redemptions for the next nine years. Just imagine, if you can, how long fund assets will be declining after the current huge bear market decline finally ends.
COMMENTS FROM A PROFESSIONAL INVESTOR
Completely unknown to the retail investor, are the shenanigans or games being played by fund managers today. Their behavior discloses a complete disregard for the assets of the fund clients in order to improve their image and promote more fund sales. Here are some pertinent quotes on this subject from Bill Fleckenstein's recent Daily Rap reports. Bill is a highly experienced hedge fund manager whose reports I prize highly.
"Speaking about the current environment, Bill Church, the chief investment
officer at SG Cowen, says, "It reminds me a little bit of the fourth quarter
of 1998, the Fed eased and we were really left in the dust." The article then
goes on to say, "One legacy of that period is that money managers are
terrified of lagging behind their indexes or the competitors. The risk, of
course, is that these managers will be so worried about tailing the indexes
that they will follow them down yet again."
Here is Bill's comment on the above quote: "And that's exactly what will
happen. They will. But they don't think that's a problem. You see, most
people believe that if they lose money and everyone else loses money, it's
okay. What they're terrified of is having the market go up and then
under-performing on the upside. That is what the money management industry has degenerated into over the course of the last five or six years, and of course that is wrong. One of the reasons people act this way is because the mutual fund managers, etc., and other forms of money managers often don't worry about losing money. Why worry when your own money is not at risk? It's also why they are willing to waste assets by ramping stocks up. Ladies and gentlemen, in my opinion that is what we saw a great example of late last week. And I believe it's one of the reasons why the market fell straight out of bed this morning".
Here are Bill's comments on a recent New York Times article on the Enron
disaster: "buried in the middle of it were a couple of comments by mutual
fund companies which just go to show how callous they are when it comes to
losing money. As I have pointed out before, they don't really care -- it's
not their money. Regarding Enron, the Fidelity spokesman quoted in the article said, "[It] has not had a material impact on the performance of our
funds." The Janus spokesman said that his firm has "a strong process that
models companies well and has worked pretty successfully in the past."
See Enron? What Enron? It doesn't matter to us. And that, ladies and
gentlemen, is how they treat your money. It's all about a performance game.
They don't really care if they lose money, provided they don't lose so much
as to lag behind the competition."
THE REDEMPTION "ICEBERG" LIES STRAIGHT AHEAD
As many objective, expert commentators have stated recently, the stock market mania still exists for mutual fund managers and the vast majority of
investors. When will their bullish attitude change? As in all previous bear
markets, it will end when many individual investors decide to cut their losses and sell their shrinking assets. Are today's mutual fund managers blind to this certain fact? Based on their current inadequate cash positions and huge speculative stock holdings, they are failing to see the huge "iceberg" looming immediately ahead!
In the last serious bear market of 1973-75, which I remember vividly, there
were no 800 phone numbers and no on-line trading accounts at mutual funds
and brokers. Although I have tried to imagine what the coming panic will be
like, I am unable to visualize anything but it's colossal, unprecedented size. How will it end? Again, it is hard to find the words to describe what I see ahead. I see huge redemptions and losses by investors. I see large failures and closings of individual funds and of fund managements. I see many mergers of funds within a given family and many mergers of mutual fund
companies.
WHICH FUNDS WILL SURVIVE?
Over the past 50 or more years, I have owned hundreds of funds of all types
in both small and large fund complexes. The funds I now own were very
carefully selected on the basis of my total prior experience. I currently own only relatively small funds whose performance history and management skills convince me that they will be survivors. I do not own one of the very large funds of the type I expect will see massive redemptions.All of my funds are owned in the expectation that they will do well in a severe bear market. Except for MM funds, none of them are widely advertised or part of huge fund complexes. I do not want any of my chosen funds to seek massive redemptions. I want the fund managers to be able to continue doing what they are now doing so well. My select list of fund names is closely held within a small circle of family and friends.
I expect that, as a class, the funds called "hybrids" or "balanced" will have the best chance of survival. A good example is the very old and expertly managed Vanguard Wellesley Income fund which holds about 70% bonds
and 30% stocks. It's price may go down but, in my opinion, it will be here
at the bear's end. Equity funds whose prospectus permits short positions may still be here at the end depending on their manager's skills. The small
group of 100% short funds will probably do well for a while during price declines so long as their asset total remains fairly low. But a flood of new
money could create management problems that might jeopardize their operations and performance.
Our expectation is that the thousands of large, heavily advertised "growth"
funds will see huge price declines and loss of assets. The "momentum" style
of investing will no doubt disappear only to be resurrected by some future
generation of investors. After huge price declines, the survivors in this
group will present some excellent buying opportunities some years hence when fund buyers will be almost extinct. As history tells us, at the end of a
typical bear market, buyers are very scarce. And for this very Super Bear,
they may virtually disappear.
WHAT THE FUTURE MAY HOLD
My views at this point are simple conjecture based on my experiences in the
volatile climate of the 1960's and 1970's. I see a major shakeup in the mutual fund management industry. Hopefully, when it is over some of the
industry problems cited earlier will be eliminated or greatly improved. So,
at some future period, mutual fund investors may again be able to anticipate
owning funds that will provide the type of fund management and performance described in the fund prospectus.
It is my firm expectation that the number of mutual funds will be much lower and their asset size will be greatly reduced. Hopefully, the thousands of inept, inexperienced fund managers will have disappeared and been replaced by others who have learned that markets go down as well as up. Perhaps, some bright industry executive will decide to replace their "momentum" style investing managers with others possessing more of the Warren Buffet type of management skills.
INVESTOR ACTION IS NEEDED
With the great majority of equity mutual funds now headed on their perilous
course, it behooves all investors aware of the "iceberg" ahead to take
independent action to safeguard their mutual fund assets. The current bear
market rally presents a special one-of-a-kind opportunity for investor
action. Unlike the unfortunate passengers on the ill-fated Titanic, mutual
fund investors are free at any time to take an independent course of action
to preserve their assets. We urge readers to seize this opportunity to act.
This article was written to give my personal views on what the future may bring. Reader response is welcomed but I cannot give opinions on any mutual
fund or fund group.
Robert B. Gordon Sc.D.
Sun City West AZ
rgordon145@aol.com
December 8, 2001
Also by Robert B. Gordon
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