New Highs… Followed by More New Highs…

by | Mar 6, 2019 | Market Commentary

We own for you, as we own for ourselves, a globally, diversified portfolio of stocks and bonds with a value tilt. That is, we look for situations where the price of an asset is trading for less than its true worth. This helps put the odds of long-term, satisfactory, returns in your favor. We always want to have a buffer between what we pay for a security and what we think it is worth (you wouldn’t drive a car without a seatbelt; you shouldn’t invest without a margin or safety). Aligning capital with long-term, sensible, principles has tended to work out.

Yes, we believe in diversifying globally. It’s another one of those simple long-term principles that has tended to work out. Only the 21st century has seen such pure dominance of US stocks. European and Asian markets dominated the US markets for the 20 years preceding the year 2000. Assuming one market will subsume all other markets has been misguided in the past. It is a big wide world that is developing rapidly. So much so the US is taking up less space of the global markets than ever before.

Your portfolios continue to do well on an absolute basis. Because the U.S. has been the best performer in the world for the past 11 years, we can’t beat it as a reference point/benchmark, period. Another important point that matters around the fringes is the returns posted on the prior page carry no “friction”. That means the returns face no downward revisions for fees or taxes. Friction matters as it dampens returns and we try to avoid it in all portfolios. We always try to review friction relative to what we can expect to get for it. Yet, in August 2018 one of our most widely held funds introduced a massive amount of unwanted friction.

Even some of the most stalwart professional money managers have succumbed to the pressure of relative under-performance. The latest victim is Harbor International Fund. On 8/22/18, management fired Northern Cross as a sub-advisor and replaced them with Marathon Asset Management, LLP. We have had Harbor International in most portfolios since our inception in 2000. Back then it was being run by Hogan Castegren. He passed away in 2010, leaving his second in command to take over the fund. Despite the change in leadership, the philosophy and process remained the same and long-term holdings were not sold. Fast forward 8 years, and the Harbor International Fund portfolio contained many massively appreciated securities. The tax bill for these deferred gains is coming due this year. Marathon follows a different philosophy than Northern Cross and have announced plans to turn over the entire portfolio. This means that the transition will most likely result in a significant amount of gains. Distributions, as the new sub-advisor re-positions the portfolio, will be enormous. To date, they are estimated at 35% to 42% of NAV. The “friction” for some clients? Tens of thousands of dollars.

Immediately after the announcement was made, we analyzed the difference between the unrealized gain of the fund shares versus the estimated capital gain distributions. This was especially significant for taxable portfolios. If the unrealized gain was less than the estimated distribution, we sold the fund. We also tried to offset as much of the gains as possible with tax-loss harvesting. So, what about all those other portfolio dogs you’ve been fretting about? Gone. We are now revisiting each portfolio to select a replacement. We have even purchased and read a book published by the new manager. There are attributes to like, so don’t be concerned if you see Harbor International in your portfolio to start 2019. It will not be the same investment, and we won’t know it until we own, but our initial opinion is favorable.

Harbor International has raised an important lesson. Investors with taxable assets that invest in mutual funds should be aware of unrealized gains embedded in the portfolio. Why? Because at some point you should be expected to pay taxes on those gains. This is of no concern for investments in IRA’s; taxes are only paid at withdrawal and all gains are tax-deferred. This is why many clients will see more exchange traded funds (“ETFs”) in their taxable portfolios. Since ETFs are traded constantly, like stocks, they tend to carry little in the way of embedded gains. They beat mutual funds on this point of tax efficiency. More importantly, we believe there is a growing list of ETFs that we can buy that generally share the same expected return pattern as our normal line-up of mutual funds but with lower friction.

We are looking forward to a busy and hopefully continued prosperity in the fourth quarter!


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