The Investment Scientist

Recently, Dimensional Fund Advisors (DFA,) a mutual fund company whose funds I use a lot for my clients, replaced its Tax-Advantaged US Core 2 Equity Fund DFTCX with an ETF DFAC. In this article, I will explain how a mutual fund can achieve tax-advantaged status, and I will further explain how it is even more advantageous to move to an EFT.

A mutual fund is simply a pooled investment vehicle. Many folks’ money is pooled together in the fund, and the fund manager invests it. As a fund investor, you may still hold the fund and therefore there is no realization of capital gains on the portfolio level. But on the fund level, there are still capital gains because of trading. These gains are passed down to each individual investor, and they must pay taxes on them. This is despite the fact that they have not sold the fund. 

A tax-aware fund manager can reduce this tax burden on the fund’s investors by trading less, especially by deferring the realization of gains. That’s why a fund’s turnover is an indicator of a fund’s hidden cost. The higher the turnover, the higher the transaction costs and tax burden. 

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Last week, I wrote an article on inflation and stock returns. This week I will continue the theme but study it from a different angle. 

Specifically, last April the inflation rate was 0.3%, but this April it was 4.2%. In one year’s time, the inflation rate has gone up nearly 4%, what does that portend for the stock market? Again, Taro helped me run the numbers and we came up with this scatter plot relating inflation changes to stock returns. Please look at it and see if you can draw some inferences yourself.

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Since I started investment management fifteen years ago, I can’t recall a time when the risk of inflation is as pronounced as it is today. Since the onset of the pandemic, the Fed has created $5 trillion worth of money. Now, as the economy is reopening, the torrent of money is gushing into circulation, lifting inflation to 4.16% in April alone and possibly higher down the road. How the market behaves is our study today. 

I asked Taro to look up Bob Shiller’s dataset and Kenneth French’s dataset and run a correlation analysis of stock returns vs inflation. Here is the result in a chart along with my observations. 

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Let me first define the term “small cap value premium.” It’s an observation (and indeed historical fact up until about five years ago) that small cap value stocks outperform large cap growth stocks in a rather consistent manner. 

In academia, there are two theories attempting to explain it: 1) risk-based and 2) behavior-based.

The risk-based theory was pioneered by Nobel winner Eugene Fama, who argued that small cap value stocks are inherently riskier than large cap growth stocks, thus they deserve higher returns to compensate for higher risks. 

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My long-term readers will remember that since I started writing investment missives, I have always advocated small-cap value investing. That is, holding a broadly diversified portfolio but with a weighting tilt towards small-cap value stocks. 

Up until 2014, the historical evidence is overwhelming. Literally, since there have been stock market data, looking at rolling ten-year periods (see chart below,) there have been only two ten-year periods when small-cap value stocks under-performed large-cap growth stocks, ending in 1998 and 1999 respectively. These ten-year periods corresponded to the dot-com tech-stock bubble in the US.

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I wrote this article in 2007. It’s every bit as valid today as 14 years ago.

I am an amateur pilot. I remember vividly an episode that happened during my training a few years ago. That was a very windy day. Up to that point, I had only experience flying in calm weather. As soon as my Cessna took off, I immediately felt the difference. My plane was tugged and pulled in all directions by crosswinds. I felt like I was losing control of the plane, and fear swelled up from the bottom of my spine to the top of my head. I sat stiffen in the pilot seat and my sweaty palms grabbed tightly at the control handles like a sinking person grabbing onto a straw.

My trainer sensed my tenseness and she asked: “Are you OK?”. Not willing to acknowledge my fear, I asked her instead: “Is it more dangerous to fly in turbulent weather like this?” The trainer smiled and said: “It is not more dangerous to fly in turbulent weather. The plan was built to withstand any turbulence. But occasionally, an amateur pilot would lose his cool and do something stupid. That’s the real danger.

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I promised to continue the GameStop story so here I am. Let me first explain why the broader market dropped about 3% to 4% while the GME frenzy was going on. Remember in the last article, Melvin, a name I will use to denote all the hedge funds that shorted GME, needed about $1.3 billion when GME prices rose from $20 to $30. When GME prices shot up to $420, Melvin needed $55 billion to meet the margin call. Where would they get the money? Well,  they could sell other stocks they hold.  This mass liquidation led to a small drop in the market. Should long-term investors worry? The answer is no, since a liquidity shock like this has no lasting effect. But the saga does reveal a flaw in the system that we weren’t aware of before. More about that later. 

Now in this pitched battle between the retail traders centered around Wall Street Bets and the hedge funds, I am afraid this will end badly for the retail traders. Yes, a few of them may benefit handsomely, turning $50k into $20mm as some of the stories go, but the majority of them who joined the battle when prices crossed $200, $300, and $400 may lose everything. In the end, prices will come back down to the stock’s fundamental value which is likely in the single or low double digits. After all, Melvin was not stupid.

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Before I tell the story, let’s get a few concepts clear.

Short Sell (short) means selling shares you don’t actually own. Instead, you borrow them from the brokerage to sell, but you have to buy them back at some point in the future, hopefully at a lower price, to pay back the brokerage shares you owe. To guarantee that you have the money to buy back shares you owe at all times, the brokerage requires you to have a maintenance margin of 130% of the value of the shorted shares to keep the position open. If you fall under the margin requirement, you will get a margin call to post additional money. Should you fail that, the brokerage will close your positions. This is done by buying shorted shares in the market using your money in the margin account. This forced action can cause a short squeeze. I will give you the definition with an actual example of GameStop (GME).

Just two weeks ago, GME was being traded at around $20. Some big hedge funds like Melvin Capital (Melvin), thought it should be worth only $5, so they began to short the stock. At one point, the short interest ratio, the number of shorted shares relative to the number of outstanding shares, was 140%. Since GME has about 70 million shares outstanding, Melvin shorted nearly 100 million shares of GME. Apparently, a portion of those shares was borrowed and sold twice.

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In July of 2007, I attended a special send-off party for then Fed vice-chair Larry Meyer. As part of the program, we all listened to him spill his thoughts about the economy at the time. You can read my note titled “Larry Meyer: Diminishing Risks …” here.

He essentially saw the risk of a recession diminishing. When asked when he thought the next recession would be, his answer was “not within in the next two years.”

Shortly after his talk, the subprime mortgage company, Countrywide Financial, collapsed. Seven months later, Bear Stearns collapsed, followed in a few months by Lehman Brothers. By the end of 2008, we were already in the depths of the worst recession since the Great Depression. Larry Meyer surely did not see that coming!

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In June of 2007, I wrote my first article on stock market seasonality. There I wrote that there was a rather persistent and robust stock market phenomenon that the market tended to perform well in the winter months than in the summer month. By “persistent” I meant that it lasted for decades in the US market, by “robust” I meant that the phenomenon showed up in other stock markets as well, as can be seen by this chart. 

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I admit this is not exactly an investment piece. However, if you continue to read, it might yet turn out to be your best investment. Study after study has shown that what determines life satisfaction is not money, but relationships you are able to build with other human beings. Come to think of it, our lives are but tapestries of woven human connections. The stronger the connections, the happier and resilient you are. And what better way to strengthen your most important relationships than gifting meaningful songs during this holiday season. You can get a song custom-made for your loved ones on this website: http://VeryOwnSong.com

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I started writing the Investment Scientist newsletter in May of 2007, and I think it would be fun to review my old articles. First of all to see if I was right back then, and if I wasn’t completely right, to see what I would write differently with the benefit of hindsight.


In May, 2007, I wrote three articles. In the first one, “The Unbearable Lightness of Chinese Stocks,” I made the statement that there was a huge bubble in the Chinese equity market and investors should stay away. In fact during that time, many (American) clients wanted me to invest in Chinese stocks, so much so that they said the reason they signed up with me was they thought I would help them do that. At the time I wrote it, the Shanghai Stock Exchange Composite (SSEC) just passed 4000, now it stands at 3412. After 15 years, it is still 15% below the level at the time. I lost a few clients for steering their money away from Chinese stocks, but in retrospect, I am glad that I made the right call. 

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Some of you know that I went back to school in 2019. Specifically, I was accepted into the EMBA program at Oxford University Said Business School. The program was interrupted by the pandemic in April when I still had about a quarter of classes to finish, so I postponed it for a year. Now 2020 is coming to a close and the Dow has recovered all its losses. It’s a good time to reflect on how my studies there changed the way I invest. 

The most important thing I learned is about how central banking works, specifically how money is created. I came to understand that terms like “central bank balance sheet expansion”, “central bank asset purchases”, “quantitative easing” all mean one thing: printing money. I also came to understand that the amount of money the Fed releases into the economy to a large extent really determines asset prices. This understanding helped me make the right call during the stock market panic in March and April. 

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This is the opening story of my book “Physician Wealth Management Made Easy” published nearly three years ago. It was briefly the Amazon Bestseller in the physician category.

Twelve years ago, I got a call from my internist. “Michael, I am afraid I can’t be your doctor any more,” he said, right after hello. It was an odd opening, and his voice sounded strained. Doc Johnson and I had always been on friendly terms. Had I done something wrong to offend him?

“What’s going on, Doc?” I replied. “Is it .. is it my insurance?”

“No, Michael,” he said and took a deep breath. “I’ve been diagnosed with pancreatic cancer. And …” he paused again. “I have only a few months to live.”“Wow, that’s terrible, Doc.” I didn’t quite know how to go on and ask, “OK, but why did you call me? I am no doctor. What can I do about it?” So I just waited on the line.

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nfc-android.jpgNear-Field Communication  (contactless) payment either through your smart phone or through your credit card chip has revolutionized commerce.  Instead of swiping or inserting your credit card, waiting for a printout and signing your name, you can just wave your phone, wait for the beep and go. But just a moment ago, I learned the hard way that this technology is not secure.

I went to Giant to buy a bottle of Diet Coke. I do that because I know soda is a bad habit so I don’t keep it in my refrigerator. When I want to drink Coke, I will drive to the nearby Giant and buy only one.

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Co-founders are fighting so much that nearly half are forced to leave the startup - EliteBusinessMagazine.co.uk_03b9924d162c8f0d8bedf86ade5bf512

There are three major factors that drive the stock market: economic fundamentals, investor sentiment and the Fed. Lately the Fed’s role has become more and more prominent. It’s thus very important to be able to read Fed’s moves correctly. For instance, what does it mean when The Wall Street Journal reports “Fed Weighs Abandoning Pre-Emptive Moves to Curb Inflation.”

Let me show you how I read the Fed’s moves since the onset of the Pandemic …

On March 13th, as the Pandemic was picking up in the US, the Fed announced a $1.5T injection into the market. This prompted my newsletter article  “What Fed’s $1.5T Injection Means For The Market” when I wrote:

There are only three buckets into which this money “water” can go: 1) goods, 2) services and 3) assets. Do you think that over the next few months, we the people will consume more goods and services? Apparently not since we will all be hunkering down in our basements. The only place the new money can go is to purchase assets, meaning stocks, bonds, and real estate.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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