A question and answer session (dated 4/12/2019) with the founder of Sabino Investment Management, LLC, Robert G. Kahl, CFA, CPA, MBA follows:
Q: What types of funds do you use?
RGK: We use mutual funds, ETFs (exchange-traded funds), and closed-end funds in our investment model portfolios.
Q: What is unique about your approach?
RGK: I think there are others that do some of the things that I recommend but the combination of strategies is somewhat unique. 1) I am an advocate of using the CAPE (cyclically adjusted price earnings) ratio to adjust the equity allocation as stock valuation levels change. If valuation levels are high like they are now, investors should lower the equity allocation. And when valuation levels are low, investors should normally increase their allocation to stocks. Use of the CAPE ratio tends to mitigate the impact of drawdowns by reducing risk before financial markets decline. 2) I have a value bias when it comes to choosing equity funds. The long-term studies are consistent: value stocks have outperformed growth stocks. Growth stock Investors tend to overestimate the period of high growth and as a result, they often pay too much for future potential growth. However, it is a good idea to monitor relative valuation levels of value and growth stocks. If value stocks were to outperform growth stocks for several consecutive years, they might be getting pricey. 3) I use some closed-end funds in my portfolio model allocations when I am able to find some that hold what I want to own and sell at an attractive discount to net asset value. 4) I include Sprott precious metals bullion trusts (CEF, PHYS, PSLV) in my portfolio models. They own actual bullion that is stored at the Canadian Mint. If you have enough shares, they can be tendered for bullion bars. Given the fiscal and monetary policy of the last decade, I believe it is wise to have some “portfolio insurance” against potential sovereign defaults and currency devaluations. Gold and silver bullion that is secure serve that purpose well.
Q: Why do you include closed-end funds
in your portfolio models?
RGK: Some closed-end funds offer an opportunity for incremental return. Closed-end funds differ from mutual funds because they have a fixed number of shares and the price is determined by investors buying and selling the shares on an exchange. The price may deviate from the net asset value and the shares may sell either at a premium or a discount to net asset value. I only have two closed-end funds in the model portfolios at this time because I look for other attributes besides the discount to net asset value.
Tri-Continental Corporation (TY) holds US stocks (about 70% of the portfolio), convertible securities, and some corporate bonds. It has a current yield of 3.6%, a 5-star rating by Morningstar for performance, and an operating expense ratio of 0.49%. It also sells at a 10.9% discount to net asset value, which is a smaller discount than a few years ago but investors are paying 89 cents per dollar of market value for securities in the portfolio. If it goes to a larger discount, I will probably increase its allocation in the model portfolios.
Templeton Global Income Fund (GIM) holds foreign bonds, has a distribution yield of 6.6%, and it sells at a 11.5% discount to net asset value. It has a negative duration of 1.0 year and they hedge most of their foreign currency risk. I currently recommend a 4% allocation for some of the portfolio models that have a larger allocation to fixed income. Franklin Templeton also has a similar mutual fund called the Templeton Global Bond Fund, which is managed by the same manager and has a portfolio which is very similar to GIM. However, GIM investors are paying 88.5 cents per dollar of market value for securities in the fund’s portfolio instead of full price (net asset value).
Q: Why don’t more advisors use closed-end funds.
RGK: I think there are three reasons. 1) They’re a little more complicated. Advisors and brokers don’t want to explain them to clients and it takes more research time to monitor the discounts and adjust the portfolios accordingly. 2) Even though a closed-end fund is selling at an attractive discount to net asset value, the discount could potentially increase. In the short-term, a wider discount will have a negative impact on performance relative to a benchmark. You want to buy only closed-end funds that have a portfolio that you want to own and trade at a wide discount to net asset value based on the historical range of the discount. And finally, 3) Advisors with significant assets under management may have difficulty placing buy and sell orders for closed-end funds without having an impact on the price of the shares. It’s much easier to place a mutual fund order for a large number of accounts.
Q: Do you use active or passive funds?
RGK: We use both, as well as quantitatively driven (quant) portfolios from managers that provide the service for a lower management fee than the traditional active manager. We will use an actively managed fund or quant fund if we believe the fund manager is likely to add enough value to cover their higher management fee. The weighted average expense ratio for our model portfolios is typically about 0.35% (35 basis points) – much lower than what many people are paying.
Q: What is the advantage of using institutional class shares?
RGK: Institutional class shares don’t have any sales charges and they have lower operating expenses than retail class shares for the same mutual funds. For the Vanguard Short-Term Investment Grade Fund, the retail class shares have an operating expense ratio of 0.20% vs. 0.10% for the institutional class shares. For DoubleLine and American Funds, the operating expense ratio for retail class shares is typically 0.25% higher than the institutional class shares. They are not big differences but they add up over time.
We have access to institutional class shares and use them.