Mutual Funds: Saner Markets Ahead

Industry Insights

Mutual Funds: Saner Markets Ahead

Michael Maiello 12.05.08, 6:00 AM ET

In the December issue of Dan Wiener's newsletter, "The Independent Adviser for Vanguard Investors," Wiener interviews James Barrow, lead manager for $31 billion Vanguard Windsor II, and learns that the venerated value manager believes that hedge fund liquidations should cease by the end of the year, taking a good deal of volatility and downward pressure out of the markets.

Barrow told Wiener that: "All of that money the banks loaned the hedge funds is getting called in. They are selling these guys out. Not only are these guys getting redeemed by their investors, they're getting redeemed by their lenders. I don't know how long this has to go on--it'll obviously be over by the end of the year, but it could be pretty bloody between now and then."

This served as the topic of this week's mutual fund discussion between Dan Wiener, Adam Bold of The Mutual Fund Store and Richard Gates of TFS Capital. The consensus was that 2009 will bring smoother markets and it's time for investors to prepare for a market, if not an economic recovery.

The Forbes.com mutual fund panelists are:
Daniel P. Wiener, editor of Independent Adviser for Vanguard Investors and CEO of Adviser Investments.
Adam Bold, founder and chief investment officer of the Mutual Fund Store.
Richard Gates, portfolio manager for TFS Capital.

Hedge Funds, Mutual Funds and Volatility

Wiener: Barrow has been around the block many times, and his contacts within the financial community are quite broad, so when he says he thinks the hedge fund selling is about complete I have to think he's on to something. In addition, I have at least one source within one of the big clearing banks that thinks the worst is behind us.

With the last two big recessions (73 to 75, and 81 to 82) having lasted 16 months each, and the current recession now having been date-stamped as starting December 2007, there is some historical precedent for assuming we are at worst midway through the economic crisis. And since we know that markets are discounting mechanisms and will begin to discount the recovery before it arrives, it's probably safe to assume that we'll see the markets move higher sometime in 2009.

The X factor right now is employment and of course Friday's report will almost certainly set a negative tone. But remember that unemployment rises, and continues rising after recessions end. Unemployment peaked at 8.6% two months after the end of the 75 recession and peaked at 6.8% 15 months after the 91 recession. The last recession, from Mar '01 to Nov '01 saw unemployment continue to rise to a high of 5.7% for 19 months after the official end.

Gates: I agree the recent market dynamics are primarily caused by a massive de-leveraging process. Hedge funds, firms formerly known as investment banks, and other big institutional investors have been fighting for their lives trying to stay solvent. During this process, fundamentals and valuations have been thrown out the window and spectacular volatility has been thrust onto the market. This makes this market relatively unique from anything we have seen since the 1930s. It is very scary for many investors.

Mr. Barrow could be right that the de-leveraging process may be near its end. In fact, TFS has seen many of our long-short equity and other hedge fund trading strategies normalize a bit recently after months of unprecedented volatility. Of course, though, nobody really knows when the forced selling will stop. For instance, year-end hedge fund liquidations may come in larger than anticipated and may force managers to raise additional cash. But the important thing that investors need to realize is that sooner or later it will pass.

On a positive note, the indiscriminate selling and short covering has produced wonderful opportunities in the markets. Look at the short squeeze that recently occurred in Volkswagen! Owners of that stock had a once in a lifetime opportunity to sell at hugely inflated prices. Also, many closed-end mutual funds owned by retail investors are trading at steep discounts not seen in decades. Investors have the opportunity to buy many of these funds for 70 cents or less on the dollar.

If Mr. Barrow believes that the de-leveraging is about to end, I am surprised that he is not more active in taking advantage of the dislocations that are clearly prevalent in the market. For instance, he could be selling stocks that have been artificially buoyed by short-covering and using the proceeds to buy stocks that have been grossly oversold. These dislocations will go away once the forced trading ends.

Bold: We're not hearing any predictions in our conversations with fund managers. No one we've spoken to is comfortable making any predictions at this point. As prices would indicate, most managers have strong levels of optimism toward future prospects but can't say when things will turn in a positive direction. History tells us the market will advance well in advance of the recession's end, and with Monday's declaration by the NBER that our economy has been in recession since last December, I'm hopeful we're closer to its end than its beginning.

Most managers we're talking to are hopeful that the current projections being made by many economists that the recession will end late in the second quarter next year or sometime mid-year are accurate. Of course, those projections are made with the knowledge that no one knows for certain, and can't possibly take into account any events that are unforeseen. Just [Monday], Bernanke was discussing the impact of the financial crisis on this recession and how it will continue to be intertwined in the recovery as that unfolds.

Gates: In 2009, I think the markets will be less volatile than what we have seen in recent months and that some semblance of rationality will be regained. The reason for this is that I think the highly levered investors have been wiped out already. Plus, the government has had time to put in some backstops to shore up the financial industry.

To capitalize on this belief, we have been gradually increasing our exposure to various trading strategies. In addition, we are actively trading our portfolios to attempt to sell positions that we think our overvalued and to buy positions that we believe are undervalued.

Wiener: Consider that the Dow has seen 27 days this year when the swing from low to high was 5% or more of the prior day's close. Over the past dozen years there were a total of 14 such days. We've had 122 days of 1% moves or greater in the Dow this year. This comes close to the 128 days we saw in 2002, which as you know was the final year of that bear market.

Gates: For undervalued names, I will mention closed-end funds. The median discounts of these securities were 18% as of [Tuesday's] close. In other words, you could spend 82 cents to get something worth $1. Prior to this last summer, we got really excited when the discounts got close to 10%.

For overvalued names, I would look at positions that had large short interest positions over the summer and have outperformed the market since that time. The outperformance could be primarily attributed to short covering.


http://www.forbes.com/intelligentinvesting/2008/12/04/industry-insights-mutual-fund-panelDec5.html