Comparing Apples and OrangesSubmitted by CHARLES CARROLL FINANCIAL PARTNERS on September 7th, 2017
The phrase that is the title of this article has been used many times to derail or deflate opinions whether it be politics, sports, cooking, or any other number of topics. It serves to make an argument or stance less meaningful in the eyes of the opposing party. I would like to make you aware of an apples to oranges comparison that occurs now in the Financial Services arena. However, before I do, it makes sense to delve further into the make-up of the comparison to determine if the premise has validity.
Mutual Fund investing has been around for nearly a century and through its development, it has provided a sensible and trustworthy platform for the wealth of many Americans to improve and prosper. The mutual fund industry is dominated by a handful of immense financial powerhouses. Fidelity Investments, Vanguard, and American Funds lead the field with nearly $6 Trillion invested on their platforms. Their success has caused many other firms to search for a competitive foothold in prying the $6 Trillion in assets away from the mutual fund powerhouses into other investments like Exchange Traded Funds (ETFs).
In earlier quarterly posts, I have made a point of showing the incredible growth of ETFs over mutual funds and the differences that make ETFs a more viable platform for investors over mutual funds. (“The Outlook for the Rest of 2017,” posted on the blog page for August 8th, 2017 at www.charlescarrollusa.com is an example). This change in financial flows away from mutual funds and into ETFs has wide spread implications in the mutual fund industry. For the American Funds as well as the Fidelity Fund platforms, the need to provide “actively” managed fund performance results that are better than ETF results is extremely important. (Vanguard has built its reputation on being a passive index investment company so their need to “outperform” may not be as dramatic. See our Quarterly Review of 05-31-2017 at www.charlescarrollusa.com for more information).
This change in the financial services industry may have actually started back in 2004. You see the Mutual Fund Reform act of 2004 did away with many of the direct advantages that mutual fund companies and brokerage companies had over their competitors. Prior to 2004, a mutual fund company might have literally dozens of senior officers of publicly traded companies travelling to the Fidelity, Vanguard, or American Funds offices daily to tout their own firm’s prowess at providing better earnings and cash flow. These meetings provided greater insight to the fund portfolio managers in making decisions about which firms had the best market potential. However, the reform act leveled the playing field for individual investors, as well as financial services companies, by calling these practices a violation of SEC guidelines should these practices continue. The financial services companies were now stripped of their inherent advantage.
The expected result of a more level playing field for money managers and individual investors spurred on investment firms and money managers to find other avenues where their size and scope could provide an advantage. Unfortunately, the need to produce better returns places pressure on investment disciplines, that have been established over time, in order to keep overall investment risk low. Little by little, the need to compete and produce better results than those being touted by weak or strong adversaries becomes more important than preserving fundamental precepts of the organization.
The apples to oranges comparison
In the Financial Services Industry, there are certain gray areas that can be used by mutual fund companies to foster supposedly better returns or take on more risk than other players in the financial industry may want to, or may be regulated against taking. One of these gray areas is the use of non-publicly traded securities. Charles Carroll Financial Partners has several custodians to house client assets. Those custodians do not allow Charles Carroll Financial Partners to purchase non-publicly traded securities within the accounts. This makes absolute sense. How can you determine the market value of a security if the security is in a thinly traded non-public market? Where do you go in a downturn to sell the security?
CNBC recently reported the following:
Data from CNBC's Disruptors List shows that several investments have been made by mutual fund businesses into unicorn (non-publicly traded securities) companies. Fidelity Investments has stakes in nine companies, T. Rowe Price has bought into seven businesses. Franklin Templeton Investments and Brandes Investment Partners own part of IEX, while several others have stakes in at least one or more unicorns.
While it has been common knowledge that Fidelity Investments has its own Private Capital Group that invests in non-publicly traded companies, some of these non-public securities are in publicly traded mutual funds.
Morningstar reported the following at the end of 2016:
According to Morningstar, as of the end of 2016, 3.7 percent of U.S. equity and allocation funds had some money in private operations. While that's a small amount compared to their overall holdings, the number is rising every year, says Katie Reichart, an associate director at Morningstar.
This issue is apparently more widespread than initially thought. Here is an excerpt from CNBC Disruptor series from May 17th, 2017:
Generally, it's large-cap growth-oriented managers who are interested in unicorns, says Reichart, though several mid-cap funds own private operations, too. For instance, according to her research, large-cap funds such as Hartford Growth Opportunities and Davis International hold more than 6 percent of their assets in private companies, while the Alger SMid Cap Growth Fund has more than 10 percent of its assets in non-listed operations.
Does this create issues with regards to risk to the individual investor in mutual funds? We think it does for a few reasons that we will spell out below but here is what Robert Stammers, the CFA Institute’s director of investor engagement says:
Investing in unicorns does come with a considerable amount of risk, says Robert Stammers, the CFA Institute's director of investor engagement. These are illiquid investments, so it can be difficult to cash out if something goes awry. Managers may also have to sell off public investments to meet redemptions, instead of hard-to-sell private operations.
Katie Reichardt at Morningstar clarifies the risk issue further by stating the following:
The other risk is valuation, says Reichart. Because these companies aren't listed, they don't have to follow the same disclosure practices as public operations do, which can make these companies hard to value.
It's up to companies to place their own value on a business — that's done by a valuation committee, not the managers themselves — which is typically based on funding rounds, public company comparisons and a firm's own internal metrics.
"A company is valued at any point in time, and that can be a challenge because there're no standard," says Reichart. "Different asset managers can do different valuations at any point."
In this same article, Andrew Boyd, head of global equities capital markets at Fidelity said the following:
The SEC tries to protect against these issues, by saying that only 15 percent of a fund's total assets can be in illiquid investments. Fidelity doesn't allow its mangers to have more than 10 percent of a fund's assets in private companies, though most of the dozen funds that do hold private companies only have about 1 percent to 3 percent in non-listed businesses, says Boyd. As for Boyd, private companies are now just part of his investible universe. "This kind of investing is here to stay," he says.
Based upon what we found it looks like Mr. Boyd is correct. It does look like this type of investing is here to stay. However, it should be pointed out that while 1% to 3% of a mutual fund doesn't sound like a sizable amount, the reality is that with billions of dollars invested in a single mutual fund the total dollars invested in a single fund is staggering.
Mutual Fund Risk
So is the introduction of non-publicly traded securities into publicly traded mutual funds good for investors? Well, let’s look at how non-publicly traded securities affect overall performance.
In what could be distressing to Fidelity mutual fund owners was this article that appeared in the Wall Street Journal on August 22nd, 2017:
Four mutual fund companies have marked down their investments in Uber Technologies Inc [UBER.UL] by as much as 15 percent following a scandal-ridden year for the ride-hailing company.Uber has suffered a series of setbacks in recent months, including a federal probe into its use of technology to evade regulators in certain cities and a trade secrets lawsuit filed by Alphabet Inc's (GOOGL.O) self-driving unit, Waymo.
Chief Executive Travis Kalanick also resigned in June, pressured by accounts of a corporate culture of sexism and bullying.
Vanguard Group, Principal Funds and Hartford Funds marked down their shares in Uber, which is not listed, by 15 percent to $41.46 a share in June, filings from the companies showed.
T. Rowe Price Group Inc (TROW.O) cut the estimated price of Uber shares by more than 12 percent to $42.73 during the second quarter ended June 30.
Another investor, Fidelity Investments, appeared to have maintained its estimate of $48.77 as of June 30.
Vanguard spokeswoman Arianna Stefanoni Sherlock declined to comment on the reasons for the reduced valuation.
What other privately held companies may be in your mutual fund portfolio?
Market Watch had the following article that made us wince a bit:
All of the mutual funds have valuation policies and procedures for these private-company investments that address the fact that market quotations are not readily available or often not reliable. The holdings in a fund’s portfolio are reported at fair market value, which is defined by the accounting standards, “as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Generally Accepted Accounting Principles say that when there are “no observable inputs” for determining price, as is often the case with private companies not traded on a public exchange, the assets are categorized as Level 3, and the fund can use its best judgment to determine a fair value.
Wasn’t Bernie Madoff found to be in compliance with Generally Accepted Accounting Principles?
Fidelity’s Growth Company
So, we looked at one Fidelity Mutual Fund to see if what Mr. Boyd said in this article was correct. We looked at Fidelity’s Growth Company fund. Here is what we found:
From the Fidelity Growth Company Monthly Holdings Report for 07/30/2017
Caterpillar, Inc. $237,991,662 0.627%
Amgen, Inc. $234,370,584 0.618%
Uber Technologies, Inc. Series D, 8.00% $232,652,307 0.613%
(top 50 holding)
Other non-public traded securities within the Growth Company Fund (there are at least 30 but here are the largest 15 after Uber):
Intarcia Therapeutics $92 MM
Intarcia Therapeutics Series CC $63 MM
Tory Burch LLC Class B $57 MM
Nutanix Inc Class A $53 MM
Your People Series C $47 MM
Space Exploration Technologies $43 MM
Moderna Therapeutics Class E $32 MM
Roku Series F $32 MM
Mongo DB $32 MM
Wheels UP $31 MM
App Nexus $29 MM
Moderna Therapeutics Class D $27 MM
Nutanix $23 MM
Space Exploration Technologies $22 MM
Moderna Therapeutics Class C $3 MM
Collectively, including Uber Technologies that is listed above, these 16 securities would mean that non-publicly traded securities would be the 7th largest holding in the portfolio just behind these companies: Nvidia, Apple, Amazon, Alphabet/Google, Facebook, and Salesforce. According to the Fidelity Growth Company Monthly Holdings Report for June 30th, 2017 over $800,000,000 was held in non-publicly traded securities in just THE FIDELITY GROWTH COMPANY FUND.
The Uber position alone is a larger position than McDonald’s, Blackrock, Disney, JP Morgan, United Health Group, Boeing, and Pepsi to name a few within the Growth Company Fund.
Our answer to Mr. Boyd’s assertion that the mutual funds at Fidelity hold only 1 to 3% of the fund’s total asset base in non-publicly traded securities is that he is correct. Based upon the valuations that Fidelity places on its own non-publicly traded securities, it looks like the funds have less than 3% of their total valuation in these securities.
However, if Facebook, which is 3.2% of the Growth Company fund total assets as of June 30th, 2017 was to take a 15% write down, could you still find a place to sell it? Obviously yes because it is publicly traded. However, if it was not publicly traded, what then?
The Fidelity Growth Company fund has shown an increase of 23.31% year -to-date as of 08-24-2017. If the information above from the different news services is correct, how is it that a publicly traded mutual fund is allowed to calculate the return on its own fund based upon the valuation it determines for no-publicly traded securities? Please understand that even a small improvement in return over a competitor may mean enormous cash flows to the fund, to the fund company, and to the fund managers.
So when you look at the return of your own portfolio enclosed in this package, please remember that all of your securities are publicly traded and that there is a public market to sell the assets should there be an event requiring such an action.
As far as the Fidelity Growth Company is concerned, not so much!