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Over-Rated: Do Fund Asset Classifications Tell The Whole Liquidity Story?

By Hamlin Lovell, CFA Suspensions of dealing by the credit mutual funds Third Avenue and Stone Lion have prompted various knee-jerk requests for a simple rule of thumb to help avoid recurrence: Beware Level 3 assets. It is reported that Third Avenue owned 18% in Level 3 assets. Many credit funds have zero or less than 1% of their assets in this category. Behavioral finance teaches us that we are susceptible to messages that simplify the complex. Unfortunately, financial market liquidity may not be amenable to such simple rules. Level 3 assets are assets for which a fair value can’t be determined by observable measures such as models or market prices. Though they are commonly dubbed mark-to-model, any unobservable input applied to modify a market price can also lead assets to be classified as Level 3 despite their valuation not being entirely model driven. Furthermore, relying on the Level 1/2/3 breakdown as a proxy for liquidity can result in both false positives and false negatives. Let’s start with the false negatives. Absent or insufficient market prices or dealer quotes can be reasons for Level 3 classifications, but they are not the only reasons. For instance, derivatives with non-standard maturities may be valued by interpolating between broker quotes on those derivatives with standard maturities. So a six-week currency option might be valued roughly halfway between a one-month and a two-month quote, but if the fund in question offers quarterly dealing, there need not be grounds for concern about asset/liability mismatches. But Level 3 is a broad range. At the other end of the spectrum, Level 3 could include private equity that might never be monetized, leading to an immortal “zombie” fund. Many assets might fall between these negative extremes; structured credit, for example, can be self-liquidating if cash flows from underlying assets accrue to various tranches according to the predetermined schedule. Some short-dated structured credit assets could generate cash flows faster than, say, zero coupon or payment-in-kind (PIK) bonds, where there may be indicative broker quotes – but you’d only find out if the borrower could repay (or refinance) at the maturity date! So using Level 3 categorizations to avoid illiquids is a crude tool. Of course, for those investors not worried about missing some adequately liquid assets falling under the Level 3 umbrella, a “Level 3 is bad” rule should still avoid many of the least liquid and completely illiquid assets. Less discussed and of greater concern are the false positives that can arise from assuming Level 1 and Level 2 must be liquid. That assets have an exchange price or some form of counterparty quote does not mean they can be traded in unlimited amounts, as the price or quote may only be good up to certain volume levels. Indeed, Third Avenue claimed it cannot liquidate “at rational prices,” which may imply they could sell at discounted prices. Any asset’s liquidity needs to be seen in the context of the fund’s position size, and I have seen funds take months or years to exit some Level 1 or Level 2 securities when they are holding a substantial multiple of volumes. The bottom line is that valuation methods should not be used to draw inferences about liquidity. Credit Ratings Third Avenue owned significant amounts of assets with a CCC credit rating, which may be deemed extremely speculative. The impulsive response here is to suggest that funds with higher credit ratings are more liquid, or less risky, or both, than those with lower (or no) credit ratings. Let us remind ourselves that some asset-backed security vehicles stamped AAA and backed by subprime mortgages ended up worthless and illiquid during and after the 2008 crisis, to the chagrin of institutional investors ranging from Norwegian pension funds to German municipal banks. Some money market funds that were perceived as super-safe cash substitutes also had to suspend dealing in 2008, and they were, broadly speaking, required by Rule 2a-7 to hold assets bearing the highest two short-term credit ratings. Since September 2015, money market funds are no longer bound by this constraint , as Dodd-Frank requires them to ensure assets meet a range of appropriate criteria. “Unrated” Assets When an asset is unrated, it generally means that the issuer has declined to pay for a credit rating rather than that the ratings agency has declined to provide one. The amount of C-rated issuance seen in the United States and Europe over the past two years shows that agencies are perfectly willing to provide some of the lowest credit ratings to companies that may be stressed or distressed. Convertible debt is often not rated, but this does not necessarily mean it is less liquid. I recall convertible bond funds largely comprising unrated names in 2008 paying out plenty of redemptions on time. In any case, credit ratings are not necessarily a reliable proxy for liquidity. Some credit assets reportedly see higher volumes after they get downgraded or default, partly because some holders become forced sellers and specialist distressed investors then become interested in the higher potential returns on offer. So, neither valuation hierarchies nor credit ratings can necessarily guarantee fund liquidity. Nor can regulation – both US mutual funds and US money market funds are now allowed to suspend dealing, and the SEC has approved Third Avenue’s suspension. Investors and advisers need to broaden and deepen their levels of analysis to get a better handle on liquidity risks. Quantifying fund liquidity is not only nuanced but also fluid, particularly as there can be seasonal variations, with calendar year-end reportedly a less liquid time. Investors and asset management companies may be drawn to the apparent certainty of putting funds into a small number of boxes, buckets, or categories, but this may prove to be a false comfort. Exact estimates of fund liquidity could prove to be spuriously precise, so the concept needs to be presented in broad brush terms that allow plenty of margin for error. Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

To Be (The Market) Or Not To Be?

Key highlights After significant losses by large-capitalization and growth stocks during the 2000-2002 bear market, investors have become increasingly interested in non-market-cap index-weighting strategies that intentionally divorce a security’s index weighting from its price. Such rules-based alternatives to market-cap-weighted indexes include strategies labeled alternative indexing, fundamental indexing or, more commonly used, smart beta. Vanguard believes strongly that, by definition, smart beta indexes should be considered rules-based active strategies because their methodologies tend to generate meaningful security-level deviations, or tracking error, compared with a broad market-cap index. Our research shows that such strategies’ “excess return” can be partly (and in some cases largely) explained by time-varying exposures to various risk factors, such as size and style. Place “the market” in front of a mirror and what would you see? A perfect reflection of that market-same size and shape, nothing added, nothing taken away. If you wanted the reflection to show something different from the market-something better?-you’d need to place something different in front of the mirror. That’s the puzzle of smart beta, whose providers often suggest that they’re “like the market,” only better. If you’re looking to get different returns from, for example, the U.K. stock market, “you have to look different in some way, shape, or form,” said Don Bennyhoff, senior investment analyst in Vanguard Investment Strategy Group. “The first thing smart beta providers do is modify what the market looks like, based on their own active choices and biases.” Recent research by Bennyhoff and his colleagues Christopher Philips, Fran Kinniry, Todd Schlanger, and Paul Chin found that the rules-based methodologies employed by alternatives to market-cap-weighted indexes tend to generate meaningful tracking error compared with broad market-cap indexes. The methodologies may weight securities differently from their market-cap weighting. Or they may exclude securities that feature in a benchmark and include securities that aren’t part of the benchmark. “In our opinion,” Bennyhoff said, “these rules-based strategies are active, which means they’re not asset-class beta or ‘the market’ in the traditional sense.” The sources of outperformance “These strategies tend to result in portfolios that emphasize smaller-cap or value stocks, which have performed very well since the early 2000s,” Bennyhoff said. “So the question is, ‘Are these higher returns the result of higher risks?’ There is rigorous debate about that topic. But when we look at risk-adjusted returns, the excess return tends to go away, and maybe that’s a meaningful finding.” Moreover, as the figure below shows, smart beta strategies’ exposures to risk factors change over time. Non-market-cap-weighted strategies’ exposures to risk factors are time-varying 60-month rolling style and size exposure of alternative index versus broad developed-equity market, 1999-2014 Source: Illustration by Vanguard, based on data from MSCI, FTSE, S&P Dow Jones Indices, and Thomson Reuters Datastream. Figure displays 60-month rolling inferred benchmark weights resulting from tracking error minimization for each index across size and style indexes. Factors are represented by the following benchmarks: fundamental-weighted-FTSE RAFI Developed 1000 Index; equal-weighted-MSCI World Equal Weighted Index; GDP-weighted-MSCI World GDP Weighted Index; minimum volatility-MSCI World Minimum Volatility Index; risk-weighted-MSCI World Risk Weighted Index; dividend-weighted-STOXX Global Select Dividend 100 Index. “We’re not saying that paying attention to factors or tilting on value or small-cap is necessarily a bad thing,” Bennyhoff said. “Whether they pay off in the future as they’ve paid off in the past remains to be seen. But instead of putting together a strategy where the factor exposure is a by-product of the weighting scheme or the security-selection scheme, maybe it should be the primary focus .” And if you’re looking to capture the risk and reward of an asset class, Bennyhoff says, “the only way you can reflect that aggregate capital invested in the asset class is through market-cap weighting.” Interested in an overview of smart beta and other rules-based active strategies? Read our research brief . Notes: All investing is subject to risk, including possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

First Days And ADM

Well the first days of my break from work are going well so far. We’ve been hanging out at the beach, which has been a nice break from our normal life. Removed from my home repairs and trip planning… I’ve been able to spend time reading, writing and researching potential investments. My hope is to spend a few hours each morning, both now and on our upcoming road trip , reading/writing/researching. While this intentional time doesn’t bring the immediate financial rewards, like clocking in at my former day job, I find it immensely satisfying. We (my wife and I) still spend a lot of “busy time” with our son, but we try to schedule breaks for each other to relax and think. One of the things I’ve been meaning to do is dig into Archer Daniel Midland’s (NYSE: ADM ) financials and business model. Now that I’m unemployed, I have time to do just that. I acquired several hundred shares of ADM stock back in 2008 and held it for several years, before selling the shares for a tidy profit. In the summer of 2012, I again bought a few hundred shares of ADM stock, when the share price dropped from the $30s to about $26. My wife and I were actually on our honeymoon at the time… and I know she was wondering what she was getting herself into. A few months later, the price recovered and we again sold at a tidy profit. We did so another time, this time for a smaller profit. (The short-term swing trades we purchased through my Roth IRA brokerage account for the tax advantages.) You may wonder why I have traded in and out of ADM stock when we otherwise do very little trading. There are a few reasons, but one of the biggest is that until 2015, the share price traded in a fairly consistent range. (Take a look at the stock chart over the last 5 or 6 years.) That range was useful to me, as I was trying to slant the risk/reward ratio in my favor. I was, and am, also bullish on the industry that ADM participates in. While the net margins aren’t great (single digits) and the capital costs are high, ADM has positioned itself well within the food/sweetner/animal feed space. That being said, you may wonder why I didn’t just plan to buy and hold the stock for the next several decades. After all, many investment greats suggest not buying the stock of an individual company unless you intend to hold that stock for a very long time. I clearly had no intention of long-term ownership. The next two sections address what were/are my chief two issues historically, but I thought with so many of my investing friends snapping up shares of ADM, and the share price dropping into the lower $30s, it might be worth a look. Ethanol Ethanol is essentially an alcohol which can be made from various plants. The process requires sugar, so most ethanol in the United States is made from modified corn, sugar beets, or sugar cane. About 10 years ago, ADM got into this business in a huge way. American politicians foolishly, in my opinion, encouraged the production of ethanol through tax incentives and subsidies. At the time, oil prices were very high, and these programs were set up under the guise of “reducing our dependence on foreign oil”. Therefore, ethanol was mixed with gasoline as a fuel additive, because subsidized ethanol cost less per gallon than refined gasoline did. What’s not to like?! Well, I’ve never been a fan of political interference in the business world, particularly as politicians have a horrible record of capital allocation, but my political grandstanding aside, it was a risky bet for ADM. The company spent billions to purchase (or build) the various processing facilities in the appropriate farming regions. While ethanol had legislative support for a few years, the useful life of a processing facility could be expected to far outlast the average politician’s ethanol attention span. Fast-forward a few years, and you can see that the price of oil has fallen tremendously, and with it the margins on ethanol production. ADM’s management has talked about the collapsing, and about the volatility of ethanol margins for a few years now. They have also spoken extensively of the excess capacity of ethanol processing facilities as a result of the federal government subsidizing the building boom of such facilities over the past 10 years. Ethanol margins have actually been negative for nearly 2 years now. Management must know that they made a mistake investing so heavily in ethanol production, because they don’t even break out that part of the business in reports anymore. Instead, it’s lumped in with processing food sweeteners and additives. Unfortunately for the company, the genetically modified corn it purchases to make ethanol isn’t actually useful for anything else. It has been developed for its high sugar content and doesn’t lend itself to human or animal consumption. I guess it can have cattle graze the corn stubble once the ears of corn are harvested. (Makes me glad we grow wheat for human consumption and sorghum for animal grain on our farm.) Anyway, despite the miserable business line, the company has remained profitable and been paid down some debt. Speaking of debt… Debt The companies that make up the long-term holdings in our portfolio tend to have little, or at least reasonable, levels of debt. The reason is obvious. While the profitability of a given business can suffer, it’s really hard to go “bankrupt” if you’re not in debt. ADM’s debt load was my other chief concern a few years ago. The business requires large capital expenditures, which reduces the amount of free cash flow. A few years ago, debt exceeded the cash on hand by a tremendous amount. That, coupled with such a huge push into the ethanol space was enough to make me a trader, or rather than an investor, in the company’s common stock. Fast-forward a few years, and the total outstanding debt per share has fallen by almost 30%. Additionally, the Return on Equity and Net Margins have improved over the last 4 years (to 9.8% and 2.7%, respectively). While not great metrics, they aren’t horrible for such a volatile (and capital-intensive) business. Most importantly, as you can see from the table below, the amount of debt coming due in the next few years is fairly small as a percentage of the total. See the due dates in the table below. You’ll also notice that the bonds due in the next few years have interests rates far above the prevailing rates. These factors, along with the reduction of debt over the last few years should continue to give the company flexibility for the next few years. Click to enlarge ADM’s 2014 Annual Report So, will we invest in Archer Daniel Midland’s common stock over the next few months? We just might. I feel like the company’s financial position has improved over the past few years, though I still don’t love ADM. It has been reporting somewhat poor results for the last couple of years, which, I largely believe, is based on industry headwinds. I think it’s a good sign that against such a tough backdrop, the company has remained profitable and paid down debt. It should gain market share. The common shares currently have a Price-to-Earnings multiple around 11 and sport a dividend yield near 3%. Most interestingly, company insiders have made several stock purchases over the last 3 months. Those purchases have far outpaced the few stock sales and were made at higher prices. I don’t like the business prospects enough to be a long-term investor in ADM, but I like it enough to buy a slug of shares if the price approaches $30 in the near term. Ugh, I know, I’m a hypocrite. What are your thoughts on ADM common stock? Disclosure: I do not currently own shares in ADM, but may buy in the near term. This article is for informational purposes only and should not be considered a recommendation for anyone to buy, sell, or hold any equities. I am not a financial professional. The information above is provided by GuruFocus.com and Yahoo Finance.