Dear friends,

They’ve done it again. After 32 years at Augustana, I’m still amazed and delighted each spring. For all that I grumble about their cell phone-addled intellects and inexplicable willingness to drift along sometimes, their energy, bravery and insistence on wanting to do good continue to inspire me. I wish them well and will soon begin to prepare for the challenges posed by my 33^rd set of first-year students.

But not right now. Right now, Chip and I are enjoying being in Scotland, being in each other’s company and being without cell service. Grand and languorous adventure awaits on islands and Highlands. While she and I are away, we’ve turned most of this month’s issue over to our colleagues though I did have time to write just a bit. And so…

Funds without fillers

Here are two simple truths:

1. Owning stocks makes sense because, over the long run, returns on stocks far outstrip returns on other liquid, publicly-accessible asset classes. Over the past 90 years, large cap stocks have returned 10% a year while government bonds have made 5-6%.

Sadly, that simple observation leads to this sort of silliness:

See? As long as your retirement is at least 87 years off, it’s silly to put your money anywhere other than common stocks. (The article’s author, a pharmacist and active investor, concludes that you shouldn’t trust mutual funds or ETFs but should, instead, be a do-it-yourself value investor. Uhhh … no thanks.) For those of us with a time horizon shorter than 87 years though, there’s a second truth to cope with.

2. Owning stocks doesn’t always make sense because the price of higher long-term returns is higher immediate volatility. That’s because stocks are more exciting than bonds. Frankly, no normal human ever said “yup, I got me some 30-year Ginnie Mae jumbos with a coupon of 3.5%” with nearly the same visceral delight as “yup, I got into Google at the IPO.” Maaaagic! That desire to own magic often enough leads investors to spend hundreds of dollars to buy shares which are earning just pennies a year. Good news leads to excitement, excitement leads to a desire to own more, that desire leads to a bidding war for shares, which leads to a soaring stock price, which leads to more bidding … and, eventually, a head-first tumble into a black hole.

GMO’s Ben Inker quantified the magnitude of the hysteria: “the volatility of U.S. since 1881 has been a little over 17% per year. The volatility of the underlying fair value of the market has been a little over 1%. Well over 90% of the volatility of the stock market cannot be explained as a rational response to the changing value of the stream of dividends it embodies” (“Keeping the Faith,” Quarterly Letter, 1Q 2016).

One reasonable conclusion, if you accept the two arguments above, is you should rely on stock managers who are not wedded to stocks. When we enter a period when owning stocks makes less sense, then your manager should be free to … well, own less stock. There are at least three ways of doing that: making bets that the market or particular sectors or securities will fall (long/short equity), shifting assets from overvalued asset classes to undervalued ones (flexible portfolios) or selling stocks as they become overvalued and holding the proceeds in cash until stocks become undervalued again (absolute value investing). Any of the three strategies can work though the first two tend to be expensive and complicated.

So why are long/short and flexible portfolios vastly more popular with investors than straightforward value investing? Two reasons:

1. They’re sexy. It’s almost like being invested in a hedge fund which, despite outrageous expenses, illiquidity, frequent closures and deplorable performance, is where all the Cool Kids hang out.
2. You demand managers that do something! (Even if it’s something stupid.) Batters who swing at the first pitch, and every pitch thereafter, are exciting. They may go down, but they go down in glory. Batters who wait for a fat pitch, watching balls and marginal strikes go by, are boring. They may get solid hits but fans become impatient and begin screaming “we’re not paying you to stand there, swing!” As the season goes on, batters feel the pressure to produce and end up swinging at more and more bad pitches.

In The Dry Powder Gang, Revisited (May 2016), we concluded:

[B]eing fully invested in stocks all the time is a bad idea. Allowing greed and fear, alternately, to set your market exposure is a worse idea. Believing that you, personally, are magically immune from those first two observations is the worst idea of all.

You should invest in stocks only when you’ll be richly repaid for the astronomical volatility you might be exposed to. Timing in and out of “the market” is, for most of us, far less reliable and far less rewarding than finding a manager who is disciplined and who is willing to sacrifice assets rather than sacrifice you. The dozen teams listed above have demonstrated that they deserve your attention, especially now.

One of those managers, Eric Cinnamond of ASTON River Road Absolute Value (ARIVX) wrote to take issue with our claim that cash necessarily serves as a drag on a portfolio. He writes:

This is another misconception about not being fully invested. If you have large discounts you can still generate attractive returns without being invested in what I call “fillers.” Just like with processed food, investment fillers are often there just to fill up the portfolio, but often provide little value and in some cases can be hazardous to your health! Open the hood of most fully invested small cap funds and you’ll find plenty of fillers these days, especially in sectors like consumer and health care. The stocks are clearly overvalued but managers think because they’re in lower risk sectors they won’t get destroyed. Good example WD-40 (WDFC) at 30x earnings! Great company but you could lose half your capital if it ever reverted to a more justifiable 7% free cash flow yield. 

That led us to the question, “so, how good are absolute value guys as stock-pickers.” That is, if you don’t feel compelling to buy “fillers” just for the optical value of a full-invested portfolio, how well do the stocks you find compelling perform?

Answer: really quite well. In the chart below, we look at the YTD performance of cash-heavy funds through early May. We then calculate how the stock portion of the portfolio performed, assuming that the cash portion was returning zero. For example, if a fund was 10% invested in stocks and had returned 1% YTD, we impute a stock return of 10% for that period.

	Style	Cash	2016 return, as of 5/6/16	Imputed active return
ASTON / River Road Independent Value ARIVX	Small-cap value	85	8.5	56.7
Intrepid Endurance ICMAX	Small-cap value	67	4.2	12.7
Hennessy Total Return HDOGX	Large-cap value, Dogs of the Dow	49	5.3	10.4
Intrepid Disciplined Value ICMCX	Mid-cap value	48	4.8	9.2
Castle Focus MOATX	Global multi-cap core	34	6.0	9.1
Pinnacle Value PVFIX	Small-cap core	47	4.2	8.9
Frank Value FRNKX	Mid-cap core	60	2.8	7.0
Cook & Bynum COBYX	Global large-cap core	37	4.3	6.8
Centaur Total Return TILDX	Equity-income	45	3.6	6.6
Bruce BRUFX	Flexible	26	2.5	3.4
Bread & Butter BABFX	Multi-cap value	42	1.3	2.2
FPA Crescent FPACX	Flexible	36	0.2	0.3
Chou Opportunity CHOEX	Flexible	22	(16.6)	(21.3)
Two plausible benchmarks
Vanguard Total Stock Market VTSMX	Multi-cap core	0	1	1
Vanguard Balanced Index VBINX	Hybrid	2	2.3	2.3

Two things stand out: first, the absolute value guys have, almost without exception, outperformed a fully invested portfolio during the year’s violent ups and downs. Second, the stocks in their portfolios have dramatically outperformed the stocks in a broad market index. Excluding the freakish Chou Opportunity fund, the stocks in the remaining twelve portfolio returned 10.6% on average while the Total Stock Market Index made 1%.

Bottom line: the demand for a fully-invested portfolio forces managers to buy stocks they don’t want to own. Judged by reasonable measures (risk-adjusted returns measured by the Sharpe ratio) over reasonable periods (entire market cycles rather than arbitrary 1/3/5 year snippets), you are better served by portfolios without fillers and by the sorts of managers we characterized as the “we’ve got your back” guys. Go check them out. The clock is ticking and you really don’t do your best work in the midst of a panic.

Wait! You can’t start a new bear market. We’re not done with the last one yet!

Many thoughtful people believe that the bull market that began in March 2009, the second oldest in 70 years, is in its final months. The S&P 500, despite periods of startling volatility, has gone nowhere in the year since reaching its all-time high on May 21, 2015; as I write on May 21, 2016, it sits 1% below that peak. It looks like this:

That’s bad: Randall Forsyth reports that no bull market in 30 years has gone so long without a new high (“Stocks Are Stuck in the Twilight Zone,” Barrons, 5/21/16). Of 13 bull markets since 1946 that have gone a year without a high, ten have ended in bear markets (“Clock ticks on bull market,” 5/20/16).

Meanwhile earnings have declined for a fourth consecutive quarter (and are well on their way to a fifth quarter). FactSet (5/20/16) notes we haven’t seen a streak that long or a quarterly drop so great since the financial crisis. The stock market is, in consequence, somewhere between “pricey” and “ridiculously pricey.” A new bear market may not be imminent (check with the Fed), but it will arrive sooner rather than later.

“But wait!” cries one cadre of managers, “we can’t have a new bear market yet. The old one hasn’t finished with us yet.”

That’s right. There are funds that still haven’t recovered their October 2007 levels. We screened the MFO Premium database, looking for funds that have spent the past 101 months still mauled by the bear.

We’ve found 263 funds, collectively holding $507 billion in assets, that haven’t recovered from the financial crisis. Put another way, $10,000 invested in one of these funds 3,150 days ago in October 2007 still isn’t worth $10,000.

Highlights of the list:

• Thirteen funds have managed double-digit annual losses since the start of the crisis. These are ranked from the greatest annualized loss down.

Direxion Monthly Emerging Markets Bull 2x (DXELX)
UltraEmerging Markets ProFund (UUPIX)
Guinness Atkinson Alternative Energy (GAAEX)
Midas (MIDSX)
Direxion Monthly 7-10 Year Treasury Bear 2x (DXKSX)
Mobile Telecommunications UltraSector ProFund (WCPIX)
ProShares Ultra Financials(UYG)
Rising Rates Opportunity ProFund (RRPIX)
Banks UltraSector ProFund (BKPIX)
UltraInt’l ProFund (UNPIX)
UltraJapan ProFund (UJPIX)
Calvert Global Energy Solutions (CAEIX)
Rydex Inverse Government Long Bond Strategy (RYJUX)

Ten of those funds could reasonably claim that they’re simple, mechanical trading vehicles which are designed for sophisticated (hah!) investors to hold for hours or a few days, not years. Three of the funds have no such excuse.

• Sixteen of the funds are double-dippers; they crashed in 2007-09 and then crashed even worse between 2009 and 2016. Technically we’re measuring a fund’s maximum drawdown, the greatest decline registered after it had begun to recover. Most of the double-dippers were leveraged equity, income or currency funds. Four funds managed the feat on (tremendously bad) luck and skill alone. Funds whose maximum drawdowns occurred after March 2009 include
  • Midas, down 88%, bottoming in December 2015
  • Calvert Global Energy Solutions, down 75% and Guinness Atkinson Alternative Energy, down 85%, both as of July 2012
  • Nysa, down 55% as of February 2016.
• One hundred ninety of the funds, around 72%, are international vehicles: 114 diversified international, 47 are emerging markets funds, 13 Europe-centered and 16 variously Asia-centered. There are no Latin American funds on the list.
• 78 of the funds are passive, quasi-passive or smart beta sorts of funds, including ETFs, ETNs, mechanical leveraged equity and enhanced index funds. The advisor that appears most frequently is iShares.
• Five simple domestic equity funds must take the Walk of Shame

AMG Managers Brandywine Advisors Mid Cap Growth (BWAFX), a mid-cap growth fund that’s lost 3.7% annually over the full market cycle.

Schneider Value (SCMLX) is a concentrated $20 million deep value fund that’s lost 1.2% annually, buoyed by a 15% return so far in 2016. It has a maddening tendency to finish way above average one year then crash for the next two.

Stonebridge Small Cap Growth (SBSGX) has lost 2.9% annually over the full market cycle but wins points for consistency: by Morningstar’s assessment, it has trailed at least 99% of its peers for the trailing 3, 5, 10 and 15 year periods.

Nysa (NYSAX), a small cap fund that would appall even Steadman. The fund’s not only lost 7.6% per year over the current market cycle, it’s lost over 50% in the 19 years since inception. In a hopeful move, the fund installed a new manager in February, 2013. He’s down 28% since then.

Jacobs Small Cap Growth (JSCGX) is the product of a bizarre marketing decision. In 2010, Jacob Investment Management decided to acquire Rockland Small Cap Growth Fund, a dying small cap fund with a terrible record and rechristen it as their own. The hybrid product is down 4.7% annually over the full market cycle. Since conversion, the fund has trailed its peers every year and appears to trail, well, all of them.

• 55 are multi-billion dollar funds. The Biggest Losers, all with over $10 billion in assets, are
  • Vanguard Total International Stock Index (VGTSX)
  • Vanguard Emerging Markets Stock Index (VEIEX)
  • iShares MSCI Emerging Markets ETF (EEM)
  • Vanguard FTSE All-World ex US Index ETF (VEU)
  • Financial Select Sector SPDR (XLF)
  • iShares MSCI Eurozone ETF (EZU)

The most famous funds on the list include Janus Overseas (JNSOX), T. Rowe Price Emerging Markets Stock (PRMSX) and Fidelity Overseas (FSOFX), one of 12 Fido funds to earn this sad distinction.

The complete list of Bear Chow Funds is here.

One bit of good news for investors in these funds; others have suffered more. Three funds have waited more than 20 years to recover their previous highs:

Bottom line: if you own one of these funds, you need to actively pursue an answer to the question “why?” First why: why did I choose to invest in this fund in the first place? Was it something I carefully researched, something pushed on me by a broker, an impulse or what? That’s a question only you can answer. Second why: why does this fund appear to be so bad? There might be a perfectly legitimate reason for its apparent misery. If so, either a fund’s representative or your adviser owes you a damned straight, clear explanation. Do not accept the answer “everyone was down” any more than you’d accept “everyone cheats.” Not everyone was down this much and not everyone stayed down. And if, after listening to them bloviate a bit you start to feel the waft of smoke up your … uhh, nethers, you need to fire them.

Smart people saying interesting stuff

Josh Brown, “The Repudiation Phase of the Bubble,” 05/09/2016:

One of the common threads of every financial or asset bubble throughout human history is that they all have a repudiation phase – a moment where all the lies that had been built up alongside the excess are aired in public. Every reputation companies and players get caught up in it… We’re there now. New shit is coming to light every five minutes. Every reputation you thought was untouchable and every omission you’d accepted because it was already accepted by the crowd – all back on the table for discussion (dissection?).

Snowball’s note: for some reason, an old aphorism popped into my head as I read this. “The function of liberal Republicans (yes, there were such once) is to shoot the wounded after the battle.”

Cullen Roche, “A catastrophe looms over high-fee mutual funds and investment advisers,” 04/28/2016:

Back in 2009 I wrote a very critical piece on mutual funds basically calling them antiquated products that do the American public a disservice. I was generalizing, of course, as there are some fine mutual funds out there. However, as a generalization I think it’s pretty fair to say that the vast majority of mutual funds are closet-indexing leaches that do no one any good (except for the management companies who charge the high fees). But there are smart ways to be active and very silly ways to be active. Mutual funds are usually a silly way to be active as they sell the low probability of market-beating returns in exchange for the guarantee of high fees and taxes.

Dan Loeb is right. A catastrophe is coming. The end of an era is here. And the American public is going to be better off because of it.

Snowball’s note: “the vast majority are …” is absolutely correct. The question for me is whether really worthwhile funds will stubbornly insist on self-destructing because (1) the managers are obsessed about talking about raw performance numbers and (2) firms would rather die on their own terms rather than looking for ways to collaborate with other innovators to redefine the grounds of the debate.

Had I mentioned my impending encounter with Cullen Skink (no relation), a sort of Scottish fish chowder?

Meb Faber, “Which Institution Has the Best Asset Allocation Model?” 05/18/2016. After analyzing the recommended asset allocations of the country’s 40 top brokerages and comparing their results over time, Faber fumes:

Bob Cochran’s Thinking beyond funds

We were delighted to announce last month that Bob Cochran joined MFO’s Board of Directors. Bob is the lead portfolio manager, Chief Compliance Officer, and a principal of PDS Planning in Columbus, Ohio, and a long-time contributor to the FundAlarm and MFO discussion boards.

The Observer strives to help two underserved groups: small independent investors and small independent managers. In an experiment in outreach to the former group, and most especially to younger, less confident investors, Bob has agreed to write a series of short articles that help people think beyond funds. That aligns nicely with Meg Faber’s recommendation, above, and with both Bob and Sam Lee’s approach to their clients. All agree that your investments are an important part of your financial life, but they don’t drive your success on their own. Here’s Bob’s first reminder of stuff worth knowing but often overlooked.

They Are Just Documents. How Important Can They Be?

Take a moment and think about what could happen if you were to suddenly become physically or mentally unable to handle your affairs. Young, old, single, married, in a committed relationship or not: the fact is unless you have certain documents in place, your financial and health well being could be in limbo. Everyone should have the following documents created, executed, and ready should they be needed.

• Durable Power of Attorney, sometimes called a financial power of attorney. This designates someone to act on your behalf should you be unable to pay bills and make other financial decisions. This allows your designee access to bank accounts, brokerage accounts, and retirement accounts (the latter only if specifically stated in the document), and the authority to make deposits, withdrawals, and pay bills, and allow access to any safe deposit boxes.
• Health Care Power of Attorney, also called a Health Care Directive or Medical Power of Attorney. This document allows your designee the authority to make health care decisions. In some states, this can be what is called a Springing Power of Attorney that takes effect only after your incapacity.

If you do not have these two documents, think of the problems that could arise should you become unable to handle your financial affairs or make health care decisions by yourself. How will your ongoing bills be paid? Who will respond to doctors and health care providers on your behalf? The time and money to have the courts make a ruling could be significant, and that does not ensure it is consistent with your wishes.

Both documents are easily created by your attorney, or you may find them online, specifically for the state in which you live. Generally, your spouse would be named as POA if you are married. If you are single, a parent, relative, or close friend are often selected. Remember the person you name will have broad powers, so be sure it is someone you trust. And be sure you provide a copy of the documents to the person you have named as POA.

Tragedies happen all the time. They are seldom anticipated. We have had clients who have spent money getting these documents created, but have never signed them. This is a huge mistake! Take action today to make sure you live your life on your own terms. After all, it’s your life, plan for it.

On Financial Planners

A family friend recently asked me to look at his mutual fund investments. He contributes to these investments periodically through his colleague, a Certified Financial Planner at a long-time neighborhood firm that provides investment services. The firm advertises it’s likely more affordable than other firms thanks to changes in how clients are billed, so it does not “charge hefty annual advisor fees of 1% or more.”

I queried the firm and planner on FINRA’s BrokerCheck site and fortunately found nothing of concern. FINRA stands for Financial Industry Regulatory Authority and is a “not-for-profit organization authorized by Congress to protect America’s investors by making sure the securities industry operates fairly and honestly.”

A couple recent examples of its influence: FINRA Fines Raymond James $17 Million for Systemic Anti-Money Laundering Compliance Failures and FINRA Sanctions Barclays Capital, Inc. $13.75 Million for Unsuitable Mutual Fund Transactions and Related Supervisory Failures.

The BrokerCheck site should be part of the due-diligence for all investors. Here for example is the type of allegations and settlements disclosed against the firm Edward Jones in 2015: “The firm was censured and agreed to pay $13.5 million including interest in restitution to eligible customers … that had not received available sales charge waivers … since 2009, approximately 18,000 accounts purchased mutual fund shares for which an available sales charge waiver was not applied.”

And, here an example of experience listed for an “Investment Adviser Representative” …

But I’m getting sidetracked, so back to my friend’s portfolio review.  Here’s what I found:

• He has 5 separate accounts – 2 Traditional IRAs, 2 Roth IRAs, and one 529.
• All mutual funds are American Funds, accessed directly through American Funds website.
• He owns 34 funds, across the 5 accounts.
• Adjusting for different share classes (both front-loaded A, and back-loaded B … no longer offered), he owns 8 unique funds.
• The 8 “unique” funds are not all that unique. Many hold the very same stocks. Amazon was held in 6 different funds. Ditto for Phillip Morris, Amgen, UnitedHealth Group, Home Depot, Broadcom, Microsoft, etc.
• The 8 funds are, in order of largest allocation (A class symbols for reference): Growth Fund of America (AGTHX), Capital World Growth & Income (CWGIX), Capital Income Builder (CAIBX), American Balanced (ABALX), AMCAP (AMCPX), EuroPacific Growth (AEPGX), New Perspective (ANWPX), and New Economy (CNGAX).

After scratching my head a bit at the sheer number of funds and attendant loads, annual expense ratios, and maintenance fees, I went through the exercise of establishing a comparable portfolio using only Vanguard index funds.

I used Morningstar’s asset allocation tool to set allocations, as depicted below. Not exact, but similar, while exercising a desire to minimize number of funds and maintain simple allocations, like 60/40 or 80/20. I found three Vanguard funds would do the trick: Total Stock Market Index 60%, Total International Market Index 20%, and Total Bond Index 20%.

The following table and corresponding plot shows performance since November 2007, start of current market cycle, through April 2016 (click on image to enlarge):

As Mr. Buffet would be quick to point out, those who simply invested in the Total Stock Market Index fund received the largest reward, if suffering gut-wrenching drawdown in 2009. The Total Bond Index rose rather steadily, except for brief period in 2013. The 60/40 Balanced Index performed almost as well as the Total stock index, with about 2/3 the volatility. Suspect such a fund is all most investors ever need and believe Mr. Bogle would agree. Similarly, the Vanguard founder would not invest explicitly in the Total International Stock fund, since US S&P 500 companies generate nearly half their revenue aboard. Over this period anyway, underperformance of international stocks detracted from each portfolio.

The result appears quite satisfying, since returns and volatility between the two portfolios are similar. And while past performance is no guarantee of future performance, the Vanguard portfolio is 66 basis points per year cheaper, representing a 5.8% drag to the American Funds’ portfolio over an 8.5 year period … one of few things an investor can control. And that difference does not include the loads American Funds charges, which in my friend’s case is about 3% on A shares.

My fear, of course, is that while this Certified Financial Planner may not directly “charge hefty annual advisor fees,” my friend is being directed toward fee-heavy funds with attendant loads and 12b-1 expenses that indirectly compensate the planner.

Inspired by David’s 2015 review of Vanguard’s younger Global Minimum Volatility Fund (VMVFX/VMNVX) I made one more attempt to simplify the portfolio even more and reduce volatility, while keeping global exposure similar. This fund’s 50/50 US/international stock split combined with the 60/40 stock/bond split of the Vanguard Balanced Fund, produces an even more satisfying allocation match with the American Funds portfolio. So, just two funds, each held at 50% allocation.

Here is updated allocation comparison: 

And here are the performance comparison summary table and plot from January 2014 through April 2016, or 2.33 years (click image to enlarge):

I should note that the Global Volatiliy Fund is not an index fund, but actively managed by Vanguard’s Quantitative Equity Group, so this portfolio is also 50/50 passive/active. While the over-performance may temper, lower volatility will persist, as will the substantially lower fees.

Other satisfying aspects of the two comparable Vanguard portfolios are truly unique underlying holdings in each fund and somewhat broader exposure to value and mid/small cap stocks. Both these characteristics have shown over time to deliver premiums versus growth and large cap stocks.

Given the ease at which average investors can obtain and maintain mutual fund portfolios at Vanguard, like those examined here, it’s hard to see how people like my friend will not migrate away from fee-driven financial planners that direct clients to fee-heavy families like American Funds.

Every Active Fund is a Long-Short Fund: A Simple Framework for Assessing the Quality, Quantity and Cost of Active Management

By Sam Lee

Here’s a chart of the 15-year cumulative excess return (that is, return above cash) of a long-short fund. Over this period, the fund generated an annualized excess return of 0.82% with an annualized standard deviation of 4.35%. The fund charges 0.66% and many advisors who sell it take a 5.75% commission off the top.

Though its best returns came during the financial crisis, making it a good diversifier, I suspect few would rush out to buy this fund. Its performance is inconsistent, its reward-to-risk ratio of 0.19 is mediocre, and its effective performance fee of 44% is comparable to that of a hedge fund. There are plenty of better-performing market-neutral or long-short funds with lower effective fees.

Despite the unremarkable record, about $140 billion is invested in a version of this strategy under the name of American Funds Growth Fund of America AGTHX. I simply subtracted the Standard & Poor’s 500 Index’s monthly total return from AGTHX’s monthly total return to create the long-short excess return track record (total return would include the return of cash).

This is an unconventional way of viewing a fund’s performance. But I think it is the right way, because, in a real sense, every active fund is a long-short strategy plus its benchmark.

Ignoring regulatory or legal hurdles, a fund manager can convert any long-only fund into a long-short fund by shorting the fund’s benchmark. He can also convert a long-short fund into a long-only fund by buying benchmark exposure on top of it (and closing out any residuals shorts). I could do the same thing to any fund I own through a futures account by overlaying or subtracting benchmark exposure.

Viewing funds this way has three major benefits. First, it allows you to visualize the timing and magnitude of a fund’s excess returns, which can alter your perception of a fund’s returns in major ways versus looking at a total return table or eyeballing a total return chart. Looking at a fund’s three-, five- and ten-year trailing returns tells you precious little about a fund’s consistency and the timing of its returns. The ten-year return contains the five-year return which contains the three-year return which contains the one-year return. (If someone says a fund’s returns are consistent, citing 3-, 5-, and 10-year returns, watch out!) Rolling period returns are a step up, but neither technique has the fidelity and elegance of simply cumulating a fund’s excess returns.

Second, it makes clear the price, historical quantity and historical quality of a fund’s active management. The “quantity” of a fund’s active management is its tracking error, or the volatility of the fund’s returns in excess of its benchmark. The “quality” of a fund’s management is its information ratio, or excess return divided by tracking error. Taking these two factors into consideration, it becomes clearer whether a fund has offered a good value or not. A fund shouldn’t automatically be branded expensive based on its expense ratio observed in isolation. I would happily give up my left pinky for the privilege of investing in Renaissance Technologies’ Medallion fund, which charges up to 5% of assets and 44% of net profits, and I would consider myself lucky.

Finally, it allows you to coherently assess alternative investments such as market-neutral funds on the same footing as long-only active managers. A depressingly common error in assessing long-short or market neutral funds is to compare their returns against the raw returns of long-only funds or benchmarks. A market neutral fund should be compared against the active component of a long-only manager’s returns.

To make these lessons concrete, let’s perform a simple case study with two funds: Vulcan Value Partners Small Cap VVPSX and Vanguard Market Neutral VMNFX. Here’s a total return chart for both funds since the Vulcan fund’s inception on December 30, 2009. (Note that Vanguard Market Neutral was co-managed by AXA Rosenberg until late 2010, after which Vanguard’s Quantitative Equity Group took full control.)

Given the choice between the two funds, which would you include in your portfolio? Over this period the Vanguard fund returned a paltry 3.7% annually and the Vulcan fund a blistering 14.2%. If you could only own one fund in your portfolio, the Vulcan fund is probably the better choice as it benefits from exposure to market risk and therefore has a much higher expected return. However, if you are looking for the fund that enhances the risk-adjusted return of portfolio, there isn’t enough information to say at this point; it is meaningless to compare a fund with market exposure with a market neutral fund on a total return basis.

A good alternative fund usually neutralizes benchmark-like exposure and leave only active, or skilled-based, returns. A fairer comparison of the two funds would strip out market exposure from Vulcan Small Cap (or, equivalently, add benchmark exposure to Vanguard Market Neutral). In the chart below, I subtracted the returns of the Vanguard Small Cap Value ETF VBR, which tracks the CRSP US Small Cap Value Index, from the Vulcan fund’s returns. While the Vulcan fund benchmarks itself against the Russell 2000 Value index, the Russell 2000 is terribly flawed and has historically lost about 1% to 2% a year to index reconstitution costs. Small-cap managers love the Russell 2000 and its variations because it is a much easier benchmark to beat. Technically, I’m also supposed to subtract the cash return (something like the 3-month T-bill or LIBOR rate) from Vanguard Market Neutral, but cash yields have effectively remained 0% over this period.

When comparing both funds simply based on their active returns, Vanguard Market Neutral Fund looks outstanding. Investors have paid a remarkably low management fee (0.25%) for strong and consistent outperformance. Even better, the fund’s outperformance was not correlated with broad market movements.

This is not to say that Vanguard has the better fund simply based on past performance. Historical quantitative analysis should supplement, not supplant, qualitative judgment. The quality of the managers and the process have to be taken into account when making a forecast of future outperformance as a fund’s past excess return is very loosely related to its future excess return. There is a short-term correlation, where high recent excess return predicts high future near-term excess return due to a momentum effect, but over longer horizons there is little evidence that high past return predicts high future return. Confusingly, low long-run excess returns predict low future returns, suggesting evidence of persistent negative skill. If a fund has historically displayed a long-term pattern of low active exposure and negative excess returns, its fees should either be extremely low or you shouldn’t own it at all.

—–

There’s a puzzle here. Imagine if Vanguard Market Neutral’s managers simply overlaid static market exposure on their fund. Here’s how their fund would have performed. A long-only fund that has beaten the market by 3.7% a year with minimal downside tracking error over five years would easily attract billions of dollars. But here Vanguard is, wallowing is relative obscurity, despite having remarkably low absolute and relative costs.

Why is this? In theory, the price of active management—in whatever form—should tend to equalize in a competitive market. However, what we see is that long-only active management tends to dominate and is often wildly expensive relative to the true exposures offered, and long-short active management tends to often repackage market beta and overcharge for it, creating pockets of outstanding value among strategies that are truly market neutral and highly active.

I think three forces are at work:

• Investors do not adjust a fund’s returns for its beta exposures. A high return fund, even if it’s almost from beta, tends to attract assets despite extremely high fees for the actively managed portion.
• Investors focus on absolute expense ratios, often ignoring the level of active exposure obtained.
• Investors are uncomfortable with unconventional strategies that use leverage and derivatives and incur high tracking error.

Given these facts, a profit-maximizing fund company will be most rewarded by offering up closet index funds. Alternative managers will offer up market beta in a different form. Active managers that offer truly market neutral exposure will be punished due to their unconventionality and comparisons against forms of active management where beta exposures are baked into the track record.

Investment Implications

When choosing among active strategies, all sources of excess return should be on a level playing field. There is no reason to compare long-only active managers against other long-only active managers. Your portfolio doesn’t care where it gets its excess returns from and neither should you.

However, because investors tend to anchor heavily on absolute expense ratios, the price of active management offered in a long-only format tends to be much more expensive per unit of exposure than in a long-short format. An efficient way to obtain active management while keeping tracking error in check is to construct a barbell of low-cost benchmark-like funds and higher-cost alternative funds.

The Education of a Portfolio Manager

By Leigh Walzer

Like 3 million of his peers, my son will graduate college this spring. In the technology space many of the innovative companies seem to care less about which elite institution is named on his piece of sheepskin and more about the skillset he brings to the role.

Asset management companies and investors entrusting their money to fund managers might wonder if the guys with fancy degrees actually do better than the rest of the pack.

There is an old adage that that the A students work for the C students. I remember working for Michael Price many years ago. Michael was a proud graduate and benefactor of the University of Oklahoma. He sometimes referred to my group (which did primarily distressed debt) as “the Ivy Leaguers.”

Graduates of Stanford and Harvard outperformed their peers by 1% per year for the past three years.

Thanks to the Trapezoid database, we were able to compile information to see if the Ivy Leaguers (like my son) actually perform better. Our laboratory is the mutual fund universe. We looked at 4000 funds managed by graduates of 400 universities around the world. We focused for this study on results for the three years ending April 30, 2016.

A few caveats: We concede to purists and academics that our study lacks rigor. The mutual fund database does not capture separate accounts, hedge funds, etc. We excluded many funds (comprising 25% of the AUM in our universe) where we lacked biographical data on the manager. Successful active funds rely on a team so it may be unfair to ascribe success to a single individual; in some cases we arbitrarily chose the first named manager. We used the institution associated with the manager’s MBA or highest degree. Some schools are represented by just 1 or 2 graduates. We combined funds from disparate sectors. Active and rules-based funds are sometimes strewn together. We haven’t yet crunched the numbers on the value of CFA certification. And we draw comparisons without testing for statistical validity.

I was a little surprised at the mix of colleges managing the nation’s mutual funds. Villanova has an excellent basketball program. But I didn’t expect it to lead the money manager tables. However, nearly all the funds managed by Villanova were Vanguard index funds. The same is true for Shippensburg, St. Joseph’s, Lehigh, and Drexel.

When we concentrated on active funds, the leading schools were Harvard, Wharton, Columbia University, University of Chicago, and Stanford. Note that Queens College cracks the top 10 – this is attributable almost entirely to one illustrious grad: Dina Perry, a money manager at Capital Re.

Who performed the best over the last 3 years? By one measure, Stanford graduates did the best followed by Harvard, Queens College, Dartmouth, and University of Wisconsin. Trapezoid looks mainly at each manager’s skill from security selection. Institutions managing fewer assets have a higher bar to clear to make the list. Managers from these top five schools ranked, on average, in the 77th percentile (100 being best) in their respective categories in skill as measured by Trapezoid.

Exhibit III: Fund Analysis Report for TRAIX

If size and sample size were disregarded, some other colleges would score well. Notably, Hillsdale College benefitted from very strong performance by David Giroux, manager of the T Rowe Price Capital Appreciation Fund (TRAIX – closed to new investors). Wellington’s Jean Hynes lifted Wellesley College to the top echelon. Strong international programs include University of Queensland and CUNEF.

I searched in vain for an alum of Professor Snowball’s Augustana College in our database. Bear in mind though that any Viking who went on to earn a post-graduate degree elsewhere will show up under that school. (Snowball’s note: Augie is a purely undergraduate college and most managers accumulate a grad degree or three, so we’d be invisible. And the only fund manager on our Board of Trustees, Ken Abrams at Vanguard Explorer VEXPX, earned both his degrees at that upstart institution in Palo Alto.)

By and large it doesn’t cost investors more to “hire” graduates of the leading schools. The average fee for active managers at these five schools is 69 bps compared with 87 bps for the overall universe.

It seems remarkable that graduates of Stanford and Harvard outperformed their peers by 1% per year for the past three years. If we add Chicago and Wharton (the next two highest ranked MBA institutions), the advantage for the elite graduates falls to 0.47%. If we expand it to include the 10 universities (as ranked by US News & World Report) the advantage falls to 30bps.

We confess we are a bit surprised by these findings. We wonder how efficient market proponents like Burton Malkiel and Jack Bogle would explain this. (Graduates of their institution, Princeton University, also outperformed the market by 1%.)

If we were recruiting for a mutual fund complex, we would focus on the leading MBA programs. Judging by the numbers many asset managers do precisely that; Over 20% of all active mutual fund managers come from these schools

Does it mean that investors should select managers on the basis of academic credentials? If the choice were between two active funds, the answer is yes. If the choice is between a fund managed actively managed by a Stanford MBA and a passive fund, the answer is less clear. We know for the past 3 years the return produced by a typical Stanford MBA adjusted for the portfolio’s characteristics exceeds expense. But we would need to be fairly confident our stable of well-educated managers would repeat their success over the long haul by a sufficient margin.

Trapezoid’s fundattribution.com website allows registered users to review funds to see whether skill is likely to justify expense for a given fund class. We do this based on a probabilistic analysis which looks at the manager’s entire track record, not just the three-year skill rating. MFO readers may register at www.fundattribution.com for a demo and see the probability for funds in certain investment categories.

Interestingly the school whose fund managers gave us the highest confidence is Dartmouth. But we wouldn’t draw too strong conclusion unless Dartmouth has figured out how to clone its star, Jeff Gundlach of DoubleLine.

Bottom Line:

Graduates of top schools seem to invest better than their peers. Our finding may not be surprising, but it contradicts the precept of efficient market theorists. Knowing the fund manager graduated a top school or MBA program is helpful at the margin but probably not sufficient to choose the fund over a low-cost passive alternative.

Elevator Talk: Goodwood SMid Cap Discovery (GAMAX/GAMIX)

Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we’ve decided to offer one or two managers each month the opportunity to make a 200 word pitch to you. That’s about the number of words a slightly-manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got 200 words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.

Goodwood SMid Cap isn’t your typical small-to-mid cap fund. In 2013, the manager of Caritas All-Cap Growth Fund (CTSAX) decided he’d had enough and left, leading the Board to order the fund’s closure and liquidation. I paraphrased their logic this way: “our fund is tiny, expensive, bad, and pursues a flawed investment strategy (long stocks, short ETFs). We’ll be going now.” Then, after liquidating all of the fund’s holdings, the Board put a stop to the action, appointed a transition manager and two months later sold the fund (and its record) to Goodwood.

The new manager moved it from all-cap growth with shorting via ETFs to small-to-mid cap value. According to one recent interview, the fund was originally a long-only product which has only recently added several hedging options. Managers Ryan Thibodeaux and Josh Pesses have a portfolio of 50-70 stocks with distinct biases toward smaller cap companies and value rather than growth. They’re able to hedge that portfolio with up to 20 short positions, cash, and a mix of puts and call options. Currently the fund’s net market exposure is 75%, which about 40% of the portfolio invested in small- to micro-cap stocks.

Mr. Thibodeaux founded Goodwood in 2012 after a nine year stint with Maple Leaf LP, a hedge fund that received a “seed” investment from Julian Robertson’s famous Tiger Management, leading to the informal designation of Maple Leaf as a “Tiger Seed.” Maple Leaf, like Goodwood, was a fundamental, value-biased long/short fund. Mr. Pesses joined Goodwood about a year later. Like Mr. Thibodeaux he was at Maple Leaf, served as a Partner and Senior Equity Research Analyst from 2007 to 2012. Their first products at Goodwood were long/short separate accounts which have done remarkably well. From January 1, 2008 – March 31, 2016, their long/short composite returned 8.6% annually after fees. The average Morningstar peer made 0.7%. That seems like a hopeful sign since those same strategies should help buoy GAMAX.

That said, performance has still been rocky. From the day Goodwood took over the fund (10/01/13) to 05/21/16, GAMAX has lost a bit over 6% while Morningstar’s small-blend category is up 7.3%. In 2015, the fund trailed 100% of its peers but so far in 2016, it’s returned 14.2% and is in the top 1% of its peer group. That sort of divergence led us to ask Messrs. Thibodeaux and Pesses to talk a bit more about what’s up. Here are their 200 (well, okay, 261 but that’s still only 130.5 per manager) words on why you need Goodwood:

There is not much about our firm and the Goodwood SMID Cap Discovery Fund that one would call conventional. From our background, to a geographic location that puts us well off the beaten path, to our atypical entree into the 40 Act world, to our investment strategy – we don’t fit neatly into any one box, Morningstar or otherwise.

When we took an over as manager to an existing mutual fund in October 2013, it was our first foray into the open-end side of the investment business. Up to that point, we’d spent the bulk our careers as analysts at a long/short hedge fund. That experience influences the way we approach stock selection and portfolio construction today and is a differentiator in the 40 Act space.

Our investment process is driven by a fundamental value-based approach, but that is not what sets our work apart. We see flexibility as a hallmark of our more “opportunistic” approach to investing. We invest in the sectors, both long and short, that we have covered for our entire careers – Consumer, Healthcare, Industrials and Technology. We are agnostic to benchmark weightings and when opportunities are scarce, we are comfortable with high cash balances. The Fund is and will always be long-biased, but we actively hedge our exposure using options and look at add alpha where possible through short selling individual securities.

Ultimately, our goal is to achieve superior risk adjusted returns over the intermediate to long term and we believe the Fund can serve as a valuable complement to core or passive Small and Mid cap positions.

The minimum initial investment for GAMAX is $2,500 with an expense ratio of 1.95%. The minimum investment for the institutional shares is $100,000; those shares carry a 1.7% E.R. Here’s the Goodwood website, it’s one of those fancy modern ones that doesn’t facilitate links to individual pages so you’ll have to go and click around a bit. If you’re interested in the strategy, you might choose to read through some of the many articles linked on their homepage.

Launch Alert: Centerstone Investors Fund (CETAX/CENTX)

Centerstone Investors and its sibling Centerstone International (CSIAX/CINTX) launched on May 3, 2016. The Investors fund will be a 60/40-ish global hybrid fund. Their target allocation ranges are 50-80% equity, 20-40% fixed income and 5-20% cash. Up to 20% of the fund might be in high-yield bonds. They anticipate that at least 15% of the total portfolio and at least 30% of their stocks will be non-U.S.

The argument for being excited about Centerstone Investors is pretty straightforward: it’s managed by Abhay Deshpande who worked on the singularly-splendid First Eagle Global (SGENX) fund for 14 years, the last six of them as co-manager. He spent a chunk of that time working alongside the fund’s legendary manager, Jean-Marie Eveillard and eventually oversaw “the vast majority” of First Eagle’s $100 billion. SGENX has a five star rating from Morningstar. Morningstar downgraded the fund from Silver to Bronze as a result of Mr. Deshpande’s departure. Before First Eagle, he was an analyst for Oakmark International and Oakmark International Small Cap and an acquaintance of Ed Studzinski’s. During his callow youth, he was also an analyst for Morningstar.

Here’s the goal: “we hope to address a significant need for investment strategies that effectively seek to manage risk and utilize active reserve management in an effort to preserve value for investors,” says Mr. Deshpande. “It’s our intention to manage Centerstone’s multi-asset strategies in such a way that they can serve as core holdings for patient investors concerned with managing risk.”

Given that he’s running this fund as a near-clone of SGENX, is there any reason to invest here rather than there? I could imagine three:

1. Deshpande was seen as the driver of SGENX’s success in the years after Mr. Eveillard’s departure, which is reflected in the Morningstar downgrade when he left. So there’s talent on Centerstone’s side.
2. SGENX has $47 billion in assets and is still open, which limits the fund’s investable universe and largely precludes many of the small issues that drove its early success. Centerstone, with $15 million in assets, should be far more maneuverable for far longer.
3. First Eagle is in the process of being taken over by two private equity firms after generations as a family-owned business. Centerstone is entirely owned by its founder and employees, so its culture is less at-risk.

The opening expense ratio for “A” shares is 1.36% after waivers and the minimum initial investment is $5000. The “A” shares have a 5% front load but Mr. Deshpande expects that load-waived shares will be widely available. The investment minimum for institutional shares is $100,000 but the e.r. does drop to 1.11%. In lieu of a conventional factsheet, Centerstone provides a thoughtful overview that works through the fund’s strategy and risk-return profile. Centerstone’s homepage is regrettably twitchy but there’s a thoughtful letter from Mr. Deshpande that’s well worth tracking down.

Launch Alert: Matthews Asia Credit Opportunities (MCRDX)

Matthews Asia Credit Opportunities (MCRDX/MICPX) launched on April 29, 2016.

Matthews International Capital Management, LLC, the Investment Advisor to the Matthews Asia Funds, was founded in 1991 by Paul Matthews. Since then they’ve been the only U.S. fund complex devoted to Asia. They have about $21 billion in fund assets and advise18 funds. Of those, two focus on Asian credit markets: Strategic Income (MAINX) and Credit Opportunities.

Both of the credit-oriented funds are managed by Teresa Kong and Satya Patel. Ms. Kong joined Matthews in 2010 after serving as Head of E.M. Investments for BlackRock, then called Barclays Global. She founded their Emerging Markets Fixed Income Group and managed a bunch of portfolios. Her degrees are both from Stanford, she’s fluent in Cantonese and okay at Mandarin. Mr. Patel joined Matthews in 2011 from Concerto Asset Management where he was an investment analyst. He’s also earned degrees from Georgia (B.A.), the London School of Economics (M.A. in accounting and finance) and the University of Chicago (M.B.A. ). The state of his Mandarin is undisclosed.

The fund invests primarily in dollar-denominated Asian credit securities. The fund’s managers want their returns driven by security selection rather than the vagaries of the international currency market. And so “credit” excludes all local currency bonds. At least 80% of the portfolio will be invested in traditional sorts of credit securities – mostly “sub-investment grade securities” – while up to 20% might be placed in convertibles or hybrid securities.

Four things stand out about the fund:

The manager is really good. In our conversations, Ms. Kong has been consistently sharp, clear and thoughtful. Her Strategic Income fund has returned 4.2% annually since inception, in line with its EM Hard Currency Debt peer group, but it has done it with substantially less volatility.

The fund’s targets are reasonable and clearly expressed. “The objective of the strategy,” Ms. Kong reports, “is to deliver 6-9% return with 6-9% volatility over the long term.”

Their opportunity set is substantial and attractive. The Asia credit market is over $600 billion and the sub-investment grade slice which they’ll target is $130 billion. For a variety of reasons, “about a quarter of Asian bonds are not rated by one of the Big Three US rating agencies anymore,” which limits competition for the bonds since many U.S. investors can only invest in rated bonds. That also increases the prospect for mispricing, which adds the Matthews’ advantage. “Over the past 15 years,” they report, “Asia high yield has a cumulative return double that of European, LATAM and US high yield, with less risk than Europe and LATAM.” Here’s the picture of it all:

You might draw a line between Asia Credit and Asia HY then assume that the fund will fall on that line rather nearer to Asia HY.

The fund’s returns are independent of the Fed. U.S. investors are rightly concerned about the effect of the Fed’s next couple tightening moves. The correlation between the Asia HY market and the Barclays US Aggregate is only 0.39. Beyond that, the managers have the ability to use U.S. interest rate futures to hedge U.S. interest rate risk.

The opening expense ratio for Investor shares is 1.1% and the minimum initial investment is $2500, reduced to $500 for IRAs. The investment minimum for institutional shares is $3 million but the e.r. does drop to 0.90%. Matthews has provide a thoughtful introduction that works through the fund’s strategy and risk-return profile. The fund’s homepage is understandably thin on content but Matthews, institutionally, is a pretty content-rich site.

Manager Changes

It’s been a singularly quiet month so far, with changes in the management teams at just 32 funds (tabulated below). In truth, none of the additions or subtractions appears to be game-changers.

Because bond fund managers, traditionally, had made relatively modest impacts of their funds’ absolute returns, Manager Changes typically highlights changes in equity and hybrid funds.

Ticker	Fund	Out with the old	In with the new	Date
ARDWX	Aberdeen Multi-Manager Alternative Strategies Fund II	Santa Fe Partners LLC no longer serves as a sub-adviser to the fund, and Henry Davis is no longer listed as a portfolio manager for the fund.	Ian McDonald, Averell Mortimer, Darren Wolf, Russell Barlow, Vicky Hudson, Peter Wasko and Kevin Lyons remain on the management team	5/16
ASTYX	AllianzGI Best Styles International Equity	No one, but …	Erik Mulder joined Michael Heldmann and Karsten Niemann in managing the fund.	5/16
AZDAX	AllianzGI Global Fundamental Strategy Fund	Andreas Utermann is no longer listed as a portfolio manager for the fund.	Neil Dwane joins the management team of Armin Kayser, Karl Happe, Eric Boess, and Steven Berexa.	5/16
BGEIX	American Century Global Gold Fund	William Martin and Lynette Pang are no longer listed as portfolio managers for the fund.	Yulin Long and Elizabeth Xie are now managing the fund.	5/16
BDMAX	BlackRock Global Long/Short Equity Fund	Paul Ebner is no longer listed as a portfolio manager for the fund.	Richard Mathieson joins Raffaele Savi and Kevin Franklin in managing the fund.	5/16
BMSAX	BlackRock Secured Credit Portfolio	Carly Wilson and C. Adrian Marshall are gone.	Mitchell Garfin remains and is joined by James Keenan, Jeff Cucunato, Jose Aguilar and Artur Piasecki.	5/16
BIALX	Brown Advisory Global Leaders Fund	No one, but …	Bertie Thomson joins Michael Dillon in managing the fund.	5/16
CSIBX	Calvert Bond Portfolio	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team.	5/16
CGAFX	Calvert Green Bond Fund	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team.	5/16
CYBAX	Calvert High Yield Bond Fund	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team and will be joined by Patrick Faul.	5/16
CFICX	Calvert Income Fund	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team.	5/16
CLDAX	Calvert Long-Term Income Fund	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team.	5/16
CSDAX	Calvert Short Duration Income Fund	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team.	5/16
CULAX	Calvert Ultra-Short Income Fund	Matthew Duch will no longer serve as a portfolio manager for the fund.	Vishal Khanduja and Brian  Ellis will remain on the portfolio management team.	5/16
SDUAX	Deutsche Ultra Short Duration Bond Fund, soon to be the Deutsche Fixed Income Opportunities Fund	As of August 31, Eric Meyer will no longer serve as a portfolio manager for the fund.	John Ryan is joined by Roger Douglas and Rahmila Nadi in managing the fund.	5/16
DGANX	Dreyfus Global Infrastructure Fund	Joshua Kohn is no longer listed as a portfolio manager for the fund.	Maneesh Chhabria is joined by Theodore Brooks on the management team.	5/16
ETMGX	Eaton Vance Tax-Managed Small-Cap Fund	Nancy Took, lead portfolio manager, announced her intention to retire at the end of October, 2016.	Michael McLean and J. Griffith Noble will continue with the fund.	5/16
GSBFX	Goldman Sachs Income Builder Fund	Effective immediately, Lale Topcuoglu no longer serves as a portfolio manager for the fund.	Daniel Lochner, Charles Dane, Colin Bell, Ronald Arons, Andrew Braun and David Beers will continue to manage the fund.	5/16
HBIAX	HSBC Global High Income Bond Fund	Lisa Chua is no longer listed as a portfolio manager for the fund.	Nishant Upadhyay joins Rick Liu and Jerry Samet in managing the fund.	5/16
HBYAX	HSBC Global High Yield Bond Fund	Lisa Chua is no longer listed as a portfolio manager for the fund.	Nishant Upadhyay joins Rick Liu and Mary Gottshall Bowers in managing the fund.	5/16
WASAX	Ivy Asset Strategy Fund	Mike Avery will no longer manage the fund, effective June 30, 2016.	F. Chace Brundige and Cynthia Prince-Fox will continue to co-manager the fund.	5/16
IVTAX	Ivy Managed International Opportunities Fund	Mike Avery will no longer manage the fund, effective June 30, 2016.	At that time, F. Chace Brundige and Cynthia Prince-Fox will become co-managers of the fund.	5/16
JMMAX	JPMorgan Multi-Manager Alternatives Fund	No one, but …	P/E Global LLC has been added as an eleventh subadvisor to the fund.	5/16
SCGLX	Scout Global Equity Fund	James Moffett and founding manager James Reed are no longer listed as portfolio managers for the fund.	Charles John is joined by John Indellicate and Derek Smashey. Somehow the combination of “indelicate” and “smashy” seems like fodder for a bunch of in-jokes.	5/16
UMBWX	Scout International Fund	Michael P. Fogarty no longer serves as a portfolio manager of the fund.	Michael Stack and Angel Luperico will continue to manage the fund.	5/16
SEQUX	Sequoia Fund	No one, but …	John Harris, Arman Gokgol-Kline, Trevor Magyar, and David Sheridan join David Poppe as co-managers.	5/16
TVOAX	Touchstone Small Cap Value Fund	DePrince Race & Zollo, Inc. will no longer subadvise the fund. Gregory Ramsby and Randy Renfrow will no longer serve as portfolio managers for the fund.	Russell Implementation Services will subadvise the fund, with Wayne Holister as portfolio manager, until June 30, 2016. After June 30, LMCG Investments will become the subadvisor to the fund.	5/16
USIFX	USAA International Fund	No one, but …	Filipe Benzinho is joining Susanne Willumsen, James Shakin, Craig Scholl, Paul Moghtader, Ciprian Marin, Taras Ivanenko, Andrew Corry, Daniel Ling and Marcus Smith to manage the fund.	5/16
HEMZX	Virtus Emerging Markets Opportunities Fund	No one, but …	Brian Bandsma and Jin Zhang join Matthew Benkendorf in managing the fund	5/16
JVIAX	Virtus Foreign Opportunities Fund	No one, but …	Daniel Kranson and David Souccar will join Matthew Benkendorf in managing the fund	5/16
NWWOX	Virtus Global Opportunities Fund	No one, but …	Ramiz Chelat will join Matthew Benkendorf in managing the fund	5/16
UNASX	Waddell & Reed Advisors Asset Strategy Fund	Mike Avery will no longer manage the fund, effective June 30, 2016.	F. Chace Brundige and Cynthia Prince-Fox will continue to co-manager the fund.	5/16

A Road Trip to Seafarer

Ben Peters, a CFP and chief compliance officer for Burton Enright Welch in the Bay Area, reported on his field trip to Seafarer in his Q1 shareholder letter. Ben had first learned of Seafarer through the Observer and was kind enough to share these reflections on his trip to Larkspur.

The more we communicated with Seafarer the more confidence we gained. Seafarer’s managers are undeniably, overwhelmingly smart. They have a deep understanding of EM investing and are serious and forthright about the risks. And as with most upper echelon managers, they leave you so impressed as to be uneasy: your impulse is to hand over your last dime.

Our visit to Seafarer’s Larkspur headquarters hammered home our conviction. Many fund managers want to be seen as the masters of the universe. Their offices usually have the downtown location, sweeping views, and fancy artwork to match.

Seafarer’s HQ is refreshing. Seafarer resides in a 3-story, non-descript office park in a quaint Bay-side town. There was no receptionist, flat screen TVs, or abstract paintings … the grand tour didn’t require any walking because the whole office is visible from the middle of the room …

The humble setting is symbolic. Seafarer is one of the lowest fee active emerging markets managers available even though it is relatively small.

Updates

Execution postponed: back in February 2016, the Board of $95 million ASTON Small Cap Fund (ATASX) moved to appoint GW&K Investment Management, LLC as subadviser to the fund in anticipation merging it into the year-old, $1.5 million AMG GW&K Small Cap Growth Fund (GWGIX). In May the board reversed course on the merger, though it still hopes to have GW&K run the fund permanently.

With the same enthusiasm that Republican leaders bring to their belated embrace of Donald Trump, mutual fund advisers are buying active/smart/tilted ETFs to stanch the bleeding. Garth Freisen, a principal at III Capital Management, reports:

[Contining movement of assets from funds to ETFs] helps explain recent moves by traditional asset management companies to acquire ETF-focused firms specializing in the construction of low-cost, active indexing portfolios:

• Hartford Funds bought Lattice Strategies
• Columbia Threadneedle purchased Emerging Global Advisors
• JP Morgan Asset Management made a minority investment in Global X Funds
• New York Life Investment Management acquired IndexIQ
• Oppenheimer Funds purchased RevenueShares
• Janus Capital Group bought VS Holdings (Velocity Shares)
• Legg Mason bought QS Investors

In addition, he notes that Goldman Sachs and Fido are launching their own quant-driven ETFs (“Active Management Is Worth It When The Price Is Right,” 5/23/2016).

Briefly Noted . . .

Boston Partners Emerging Markets Long/Short Fund (BDMAX) has announced that “the Adviser expects that the Fund’s long positions will not exceed approximately 50% of the Fund’s net assets with an average of 30% to 70% net long.” Heretofore the extent of the fund’s market exposure wasn’t constrained in the prospectus.

Stonebridge Capital Management has announced they no longer intend to advise the Stonebridge Small-Cap Growth Fund (SBSGX). “The Board is considering alternative plans with respect to the Fund, which may include closure and liquidation of the Fund.” Here’s what the Board has to wrestle with: an utterly dismal track record that will haunt any future manager, $12 million in assets and expenses north of 2.1% per year. One of the two managers has been with the fund for 16 years and still has not invested a penny in it. The only bright side is that the fund has a substantial embedded tax loss (Morningstar estimates about 17%) so liquidation would partially offset taxable gains elsewhere in an investor’s portfolio.

From the file labeled “I learn something new every month.” Touchstone Small Cap Value Fund (TVOAX) is switching managers. On May 20, 2016, DePrince, Race & Zollo, Inc. are out. On June 30, 2016, LMCG steps in. And what happens during the six week interregnum? Russell happens. Russell Implementation Services provides caretaker management in the window between the departure of one manager or team and the arrival of the next. Touchstone’s SEC filing reports:

Russell will make investment decisions for the Fund and also ensure compliance with the Fund’s investment policies and guidelines. Russell has been providing transition management services to clients since 1992. Russell has transitioned nearly $2.3 trillion in assets for clients in over 2,300 transition events in the last three calendar years. As of December 2015, Russell was managing 17 mandates with $1.7 billion in assets across a broad range of asset classes.

That implies $800 billion/year in assets temporarily managed by a caretaker. Who knew?

SMALL WINS FOR INVESTORS

All eight share classes of AB Small Cap Growth (QUASX) re-opened to new investors on June 1, 2016.

Effective June 3, 2016, Dreyfus International Stock Fund (DISAX) will be re-opened to new investors.

Touchstone Sands Capital Select Growth Fund (TSNAX) closed to new accounts, with certain exceptions, on April 8, 2013. With due consideration, the Advisor has determined to re-open the Fund for sales to investors making purchases in an account or relationship related to a fee-based, advisory platform.

CLOSINGS (and related inconveniences)

Undiscovered Managers Behavioral Value Fund (UBVAX) appears to be closing a bit more tightly. The fund is currently closed to new investors which eight classes of exceptions. As of June 27, 2016, the number of exceptions decreases to six and the wording on some of those six seems a bit more restrictive. It appears from the filing that the two lost exceptions will be:

• Approved brokerage platforms where the Fund is on a recommended list compiled by a Financial Intermediary’s research department as of the Closing Date may continue to utilize the Fund for new and existing accounts.
• Approved Section 529 college savings plans utilizing the Fund as of the Closing Date may do so for new and existing accounts.

OLD WINE, NEW BOTTLES

On July 1, 2016, BlackRock Managed Volatility Portfolio (PBAIX) will be renamed BlackRock Tactical Opportunities Fund. The revised statement of investment strategy doesn’t mention volatility but, instead, talks about “an appropriate return-to-risk trade-off” and warns of the prospect of frequent trading.

Also on July 1, BlackRock Secured Credit Portfolio (BMSAX) gets renamed BlackRock Credit Strategies Income Fund. Up until now it has invested, quite successfully, in “secured instruments, including bank loans and bonds, issued primarily, but not exclusively, by below investment grade issuers.” Going forward it will have one of those “invest in any danged thing we want to” strategies. Pursuant thereunto, two of the three current managers get sacked and four new managers get added. After the dust settles, four of the fund’s five managers will bear the rank “Managing Director.” The fifth, poor Artur Piasecki, is merely “Director.”

That same exhausting day, BlackRock Managed Volatility Portfolio (PCBAX) becomes BlackRock Tactical Opportunities Fund. The new investment strategy highlights frequent trading and the use of derivatives. It also abandons the old 50% global stocks / 50% global bonds benchmark.

As of August 1, 2016, Deutsche Ultra-Short Duration Fund (SDUAX) will be renamed Deutsche Fixed Income Opportunities Fund. Following the fund’s name change, its amorphous investment goal (“current income consistent with total return”) remains but its strategy changes from allowing up to 50% non-investment grade plus up to 20% cash to 30% non-investment grade with no reference to cash. Its principal benchmark becomes a 3-month LIBOR index.

Effective June 14, 2016, “Fidelity” will replace “Spartan” in the fund name for each Spartan Index Fund a/k/a each Fidelity Index fund.

On July 5, 2016, Victory CEMP Multi-Asset Growth Fund (LTGCX) will be renamed the Victory CEMP Global High Dividend Defensive Fund and its investment objective will change to reflect a dividend income component. This will be the fund’s second name in a year; up until November it was Compass EMP Multi-Asset Growth Fund. It’s a fund of Victory CEMP’s volatility-weighted ETFs. At 2.12% in expenses for 1.46% in long-term annual returns, one might suspect that it’s overpriced.

The sub-adviser to SilverPepper Merger Arbitrage Fund (SPABX/SPAIX) has changed its name from Brown Trout Management, LLC to Chicago Capital Management, LLC.

OFF TO THE DUSTBIN OF HISTORY

AAM/HIMCO Unconstrained Bond Fund (AHUAX) will undergo “termination, liquidation and dissolution” on June 28, 2016.

Eaton Vance Richard Bernstein Market Opportunities Fund (ERMAX) has closed and will liquidate on June 29, 2016. This is another “well, we gave it almost two years (!) before pulling the plug” fund.

Eaton Vance Currency Income Advantage Fund (ECIAX) will return its $1 million in assets to investors and vanish, after almost three years of operation, on June 29, 2016.

Goldman Sachs Financial Square Tax-Exempt California Fund (ITCXX) and Goldman Sachs Financial Square Tax-Exempt New York Fund (IYAXX) were slated for liquidation on August 31, 2016 but the Board and advisor got twitchy. Each fund now faces execution on June 10, 2016.

Harbor Funds’ Board of Trustees has determined to liquidate and dissolve the Harbor Unconstrained Bond Fund (HRUBX), which is roughly but not perfectly a clone of PIMCO Unconstrained Bond (PUBDX). The liquidation of the Fund is expected to occur on July 29, 2016.

Little Harbor Multi-Strategy Composite Fund (LHMSX), which you didn’t know existed, now no longer exists.

The Board of Trustees of Northern Funds has decreed that Multi-Manager Large Cap Fund (NMMLX), Multi-Manager Small Cap Fund (NMMSX), and Multi-Manager Mid Cap Fund (NMMCX) be liquidated on July 22, 2016. About that “multi-manager” thing: each of the funds is run by same two Northern Trust managers. They haven’t been noticeably “multi” since about 2012. They have about $900 million in assets between them with the smallest, Small Cap, posted the best relative returns.

Oppenheimer Commodity Strategy Total Return Fund (QRAAX) will liquidate on July 15, 2016. Why, you ask? Uhhhh …

The Board of Trustees of The Purisima Funds has determined that it is advisable “to liquidate, dissolve and terminate the legal existence” of The Purisima Total Return Fund (PURIX) and The Purisima All-Purpose Fund (PURLX). Their departure is notable primarily because of their manager, Kenneth Fisher, America’s largest investment advisor and source of, oh, I don’t know, one-third of all of the pop-up ads on the internet.

As of May 9, PURLX had $46,374 and PURIX has $257 million. Whether you judge PURIX as “unimpressive” or “almost freakishly bad” depends on whether you ask Lipper or Morningstar. Lipper benchmarks it against the Flexible Portfolio group, which it trails only modestly since inception. Morningstar categorizes it as domestic large-blend, and it trails the vast majority of such funds over every period from one-year to fifteen. In reality, Lipper is probably a truer fit. The fund is about 65% US large caps, 20% international large caps and 10% “other,” which includes two exchange-traded notes in its top 10 holdings. Regardless of the rater, the funds’ record suggests that Mr. Fisher – son of Phil Fisher (author of Common Stocks and Uncommon Profits, 1958, and “one of the great investors of all time,” according to Morningstar) – seems better suited to marketing than managing.

The month’s oddest closure announcement: “On May 6, 2016, at the recommendation of SF Advisors, LLC, the investment adviser to the Trust, the Trust’s Board of Trustees approved the closing and subsequent liquidation of the Funds. Accordingly, the Funds are expected to cease operations, liquidate any assets, and distribute the liquidation proceeds to shareholders of record on June 6, 2016.” Uhhh … no such funds were ever launched. This raises the same philosophical question as the speculation that near black holes, particles could be destroyed the moment before they’re created. Can funds that have never commenced operations cease them?

Pending shareholder approval (which is a lot like saying “pending the rising of the sun”), Stratus Government Securities (STGSX) and Stratus Growth (STWAX) will liquidate on June 10, 2016. How much suspense is there about the outcome of the vote? Well, the vote is Tuesday, June 7and liquidation is scheduled (tentatively, of course) for Friday of that same week.

Thomson Horstmann & Bryant Small Cap Value Fund (THBSX) will liquidate on June 24, 2016.

Effective May 6, 2016, Virtus Alternative Income Solution Fund, Virtus Alternative Inflation Solution Fund and Virtus Alternative Total Solution Fund were liquidated. Lest that phrase confuse us, the adviser clarifies: “The funds have ceased to exist.”

In Closing . . .

If you own an Android smart phone, you should go download and use the Ampere app. As you’re reading this, Chip and I will be in Scotland, likely in the vicinity of Inverness. One of the great annoyances of modern travel is the phenomenal rate at which phones drain their batteries and the subsequent need to search for charging options in airports and rail stations. What I didn’t know is how much of a different your charging cable makes in how much time it will take to regain a reasonable charge. Ampere is an app which measures, among other useful things, how quickly your phone is recharging.

It turns out that the quality of charging cable makes a huge difference. Below are two screencaps. I started with same charger and the phone then worked my way through a set of four different charging cables. The charge rates varied greatly from cable to cable.

In the instance above, it would take nearly four times as long to recharge my phone using the cable on the left. Every cable I tested produced a different charge rate, from a low of 300 mA to a high of 1200 mA.

My suggestion for travelers: download Ampere, use it to identify your best-performing cables then ditch the rest, and remember to switch to “airplane mode” for faster charging.

You’re welcome.

As ever, we want to take a moment to offer a sincere xei xei to all the folks who’ve supported us this month in thought, word and deed. To our faithful friends, Deb (still hoping to make it to Albuquerque) and Greg, thank you. Thanks, too, to Andrew, William, Robert, and Jason (all the way from Surrey, UK). We appreciate your generosity. 

We’ll look for you at Morningstar! We’re hopeful of catching up with a number of folks at the conference including folks from Centerstone, Evermore, FPA, Intrepid, Matthews and Seafarer … with maybe just a hint of Poplar Forest, a glimpse of Polaris and the teasing possibility of ride down Queens Road. We’ll post synopses to our discussion board each day and we’ll offer some more-refined prose when you come by for our July issue.

Remember, as you’re reading this, Chip and I are chillin’ in Scotland. If you’ve got questions or concerns about this month’s issue and you’d like them addressed before my return on June 7^th, please drop a note to our colleague and data wizard, Charles Boccadoro. He’s got the keys to the back door.

As ever,

Dear friends,

There are days in spring when I’m not sure whether what I’m hearing is ticking or dripping. My students know that the end of the school year is nigh. If they glance up from their phones, it’s to glance out the window and across Augustana’s campus. It’s always pretty here, even in November, but there are about four to six weeks when it’s absolutely stunning. For three weeks in spring, the central campus is festooned with blossoms as serviceberry, cherry, apple, and lilac erupt. Again in October the maples dominate, painting the campus crimson and gold.

It’s glorious!

Unless you’re trying to get students to learn about Nazi rhetorical strategies and the parallel strategies of demonization used across cultures. If you do that, then you hear the rhythmic tick, tick, tick as they count down the final weeks of the year.

Or is it the slower drip, drip, drip as their brains leak out of their ears and their IQs puddle on the classroom floor?

And still we find joy in the occasional glimpses of the tremendous growth they’ve already experienced and in the prospect that, come fall, they’ll be back, cheerful and recharged.

At least, until those durn maples take over.

The Dry Powder Gang, revisited

“Put your trust in God but keep your powder dry.”

Oliver Cromwell, 1650, to the soldiers of the New Model Army as they prepared to forge an Irish river and head into battle.

Cromwell was a dour, humorless (or “humourless”) religious fanatic charged with squashing every Catholic and every independent thought in the British Isles because, well, that’s what God demanded. Famine, plague, deportations, mass death and deportations followed.

But even Cromwell knew that the key to victory was prudent preparation; faith did not win battles in the absence of the carefully stocked dry gunpowder that powered the army. There were times to charge ahead and there were times to gather powder.

With investing likewise: there are times to be charge ahead and times to withdraw. Most investors struggle with that decision. Why?

1. Most investment products feed our worst impulses. The investment industry has come to be dominated by passive, fully-invested products over the past five years; not coincidentally, that period has seen just one break in the upward rush. In cap-based funds, more money goes to the best performing stocks in the index so markets get driven by the momentum of fewer and fewer stocks. In 2015, for instance, just four stocks accounted for the S&P 500’s entire gain.
2. Most professional investors worry more about accumulating assets than about serving investors. By most measures, the U.S. stock market is substantially overpriced but the cash reserves at mutual funds are at their lowest levels in history. Why? Because, as Jason Zweig writes, “cash is now a sin.” Cash is a drag on short-term returns and investors fixated on 1/3/5 year returns have poured their money into funds that are fully invested all the time, both index products and the cowardly “active” managers who merely shadow them. The technical term for “skilled investors who do not attract assets to the firm” is “unemployed.”
3. Most of us are too optimistic. Most guys think of themselves as “good investors” or “above average” investors, mostly because “good” is such a vague term and almost none of us actually know how or what we’ve done. Quick quiz: what’s your personal rate of return over the last five years? How much of your portfolio was invested cautiously as the market approached its top in October 2007 and how much was invested aggressively at its bottom in March 2009? The honest answers for most of us are “dunno, dunno, dunno.”

It’s not just about investing. 95% of us think we’re above average drivers. One 1965 study of drivers responsible for car accidents that put people in the hospital found the same: the majority of those drivers rated themselves as “really good.” Jason Zweig talked through a lot of the research and its implications in chapter four of his book Your Money and Your Brain (2007). We originally linked to what turned out to be a plagiarized version of Jason’s work, masquerading as an advisor’s newsletter. (Thanks to Jason for letting us know of the goof.)

The result is that we’re tempted to take on too much risk, sublimely confident that it will all work out.

But it won’t. It never does. You need a manager who’s got your back, and you need him now. Here are three arguments in three pictures.

Argument one: stock prices are too danged high.

This chart shows valuation of the US stock market back to 1880; numbers get really sketchy before that. Valuation, on the left axis, is the CAPE P/E ratio which tries to adjust for the fact that earnings tend to be “lumpy” so it averages them over time. The “mean” line is the average value over 140 years. The adjacent red lines mark the boundaries of one standard deviation from the normal. That reflects the prices you’d expect to see in two years out of three. If you get above the two S.D. line, those are once in 20 years prices. Three standard deviation prices should occur once in 300 years.

The U.S. market went over a CAPE P/E of 24 just three times in the 20^th century; it’s lived there in the 21^st. The market’s P/E at its February 2016 bottom was still higher than the P/E at its October 2007 top.

Argument two: Price matters.

If you overpay for something, whether it’s $72 million for a “franchise quarterback” who’s only started seven NFL games ever, or 115 years’ worth of earnings for a share of Netflix stock, you’re going to be disappointed.

The chart above reflects the stock market’s valuation (measured by the value of the stock market as a percentage of the value of the “real economy,” so when the blue line is high, stocks are relatively inexpensive) overlaid with its returns over the following 12 years. With considerable consistency, price predicts future returns. By this measure, U.S. stocks are priced to return 2% a year. The only ways for that number to go up is for the U.S. economy to grow at an eye-watering rate or for prices to come down. A lot. Based on the market’s performance over the past 60 years, the folks at the Leuthold Group find that a return to the valuations seen in the average bear market would require a fall of 30-40% from where we were at the end of March. Given that earnings have deteriorated and prices have risen in the 30 days since then, you might need to add a point or two to the decline.

Argument three: Market collapses are scary

I think of this as “the icicle chart.” Ben Carlson, one of the Ritholtz managers, wrote a really thoughtful essay, rich in visuals, in April. He posted it on his Wealth of Commonsense blog under the name “180 years of market drawdowns.” He provided this graph as an antidote to those relentlessly cheerful logarithmic “mountain charts.” Those are the ones that show the stock market’s relentless climb with just niggling little “oopsies” from time to time. Losing half your portfolio is, viewed from the perspective of a few decades or a century, just a minor annoyance. Losing half your portfolio is, viewed from the perspective of a guy who needs to meet a mortgage, fund a college education and plan for the end of a teaching career, rather a bigger deal. Mr. Carlson concludes:

…stocks are constantly playing mind games with us. They generally go up but not every day, week, month or year. No one can predict what the future returns will be in the market … But predicting future risk is fairly easy — markets will continue to fluctuate and experience losses on a regular basis.

Market losses are the one constant that don’t change over time — get used to it.

Managers who’ve got your back

There are only a handful of managers left who take all of that seriously. The rest have been driven to unemployment or retirement by the relentless demand: fully invested, price be damned. They typically follow a simple model: stock by stock, determine a reasonable price for everyone in our investable universe. Recognize that stocks are risky, so buy them only when they’re selling at a healthy discount to that price. Hold them until they’re around full value, then move on regardless of whether their prices are still rising. Get out while the getting is good. If you can’t find anything worth buying today, hold cash, keep your powder dry and know that the next battle awaits.

They bear a terrible price for hewing to the discipline. Large firms won’t employ them since large firms, necessarily, value “sticky assets” above all else. 99.7% of the investment community views them as relics and their investors steadily drift away in favor of “hot hands.”

They are, in a real sense, the individual investor’s best friends. They’re the people who are willing to obsess over stocks when you’d rather obsess over the NFL draft or the Cubs’ resurgence. And they’re willing, on your behalf, to walk away from the party, to turn away from the cliff, to say “no” and go. They are the professionals who might reasonably claim …

This chart reflects every equity-oriented mutual fund that currently has somewhere between “a lot” and “the vast majority” of their portfolio in cash, awaiting the return of good values. Here’s how to read it. The first two columns are self-explanatory. The third represents how their portfolios have been repositioned between 2011 (when there are still reasonable valuations) and now. Endurance, for example, had two-thirds of its money in stocks in 2011 but only a quarter invested now. The fourth column is fund’s annual return for the period noted (full market cycle or since inception). The fifth shows the fund’s Sharpe ratio, a measure of risk-adjusted returns, against its peers. The sixth column shows you how its performed, again relative to its peer group, in bear market months. The last column is the comparison time frame. I’ve marked decisive superiority in blue, comparable performance in amber and underperformance in red. All data is month end, March 2016.

	Style	Change in equity exposure from 2011 – 2016	Annual return	Sharpe ratio, compared to peers	Bear market rating, compared to peers	Comparison period
Intrepid Endurance ICMAX	Small-cap value	64%->24%	8.0%	0.64 vs 0.23	1 vs 6	FMC
Bruce BRUFX	Flexible	41 -> 46	7.2	0.56 vs 0.22	4 vs 6	FMC
FPA Crescent FPACX	Flexible	57 -> 52	6.0	0.54 vs 0.22	4 vs 6	FMC
Centaur Total Return TILDX	Equity-income	89 -> 40	7.4	0.51 vs 0.30	1 vs 5	FMC
Pinnacle Value PVFIX	Small-cap core	51 -> 52	3.9	0.41 vs 0.24	1 vs 6	FMC
Intrepid Disciplined Value ICMCX	Mid-cap value	81 -> 51	5.4	0.37 vs 0.29	1 vs 6	FMC
Frank Value FRNKX	Mid-cap core	83 -> 40	5.4	0.25 vs 0.27	1 vs 6	FMC
Hennessy Total Return HDOGX	Large-cap value, Dogs of the Dow	73 -> 51	3.4	0.24 vs 0.20	4 vs 4	FMC
Bread & Butter BABFX	Multi-cap value	69 -> 58	2.8	0.18 vs 0.21	1 vs 6	FMC
Funds with records >5 years but less than the full market cycle
Cook & Bynum COBYX	Global large-cap core	67% -> 54%	9.6%	1.21 vs 0.61	1 vs 6	08/2009
Castle Focus MOATX	Global multi-cap core	67 -> 66	7.5	1.02 vs 0.63	1 vs 6	08/2010
ASTON / River Road Independent  Value ARIVX	Small-cap value	49 -> 18	4.1	0.61 vs 0.50	1 vs 6	01/2011
Chou Opportunity CHOEX	Flexible	74 -> 51	1.4	0.07 vs 0.62	10 vs 6	08/2010
Two plausible benchmarks
Vanguard Total Stock Market VTSMX	Multi-cap core	100 -> 100	5.8%	0.32	4	FMC
Vanguard Balanced Index VBINX	Hybrid	60 -> 60	5.6%	0.52	1	FMC

There are four funds just beyond the pale: the funds have shorter records (though the managers often have long ones in other vehicles) but have disciplined investors at the helm and lots of cash on the books. They are:

Goodhaven GOODX

Hussman Strategic Dividend Value HSDVX

Linde Hansen Contrarian Value LHVAX

Poplar Forest Outlier PFOFX

No single measure is perfect and no strategy, however sensible, thrives in the absence of a sufficiently talented, disciplined manager. This is not a “best funds” list, much less a “you must buy it now, now, now!” list.

Bottom Line: being fully invested in stocks all the time is a bad idea. Allowing greed and fear, alternately, to set your market exposure is a worse idea.  Believing that you, personally, are magically immune from those first two observations is the worst idea of all.

You should invest in stocks only when you’ll be richly repaid for the astronomical volatility you might be exposed to.  Timing in and out of “the market” is, for most of us, far less reliable and far less rewarding than finding a manager who is disciplined and who is willing to sacrifice assets rather than sacrifice you. The dozen teams listed above have demonstrated that they deserve your attention, especially now.

 

Garbage in, garbage out: The 1/3/5/10 follies

On whole, we are not fans of reporting a fund’s one, three, five or even ten year records. In a dyspeptic moment I might suggest that the worship of standard reporting periods is universal, lunatic, destructive, obligatory, deluding, crippling, deranged, lazy, unwise, illogical and mayhap phantasmagoric.

On whole, I’d prefer that you not do it.

The easiest analogy might be to baseball. Here’s a quick quiz. Which of these statements is most meaningful to a baseball fan?

(a) My team won the last one, three and five innings!
(b) My team won the game.

We think it’s more useful to assess how a manager has performed over a full market cycle; that is, in good time and bad. The current market cycle began in October 2007, the day that the previous cycle reached its final peak and the market began its historic tumble. This cycle has included both a 51% loss for US large caps and a 223% rise. Folks who held on through both are up about 58% since the cycle began. That’s punky compared to the cycle that dominated the 1990s (up 533%) but durned fine compared to the cycle that ended in 2007 with a tiny 14% gain over seven years.

If you don’t judge your investments by meaningful measures, you cannot make meaningful decisions. Here’s a simple illustration.

If you look at the past 12 months, the Vanguard 500 Index is up 1.8% (through the end of March) and FPA Crescent is down 2.4%. Conclusion: Crescent sucks, buy the index!

Over the past three years, the 500 is up 39% and Crescent is up 18.6%. More sucking.

Over the past five years, the 500 is up 71% and Crescent is up 38%. Maximum suckage! But so far, we’re measuring only raw performance in the good times.

Over the course of the full market cycle, including the 2007-09 crash, Crescent is up 64% to the 500’s gain of 58%. More importantly, the index subjected its investors to a 51% decline compared to Crescent’s 29% drop. In bear market months, Crescent’s investors have slipped 7%, while the index investors dropped 11%.

We weigh the balance of your risks and returns by computing measures of risk-adjusted performance, such as the Sharpe and Martin ratios. Taking both halves of the equation (risk and return) into account and measuring performance over a meaningful period (the full market cycle), Crescent clubs the index.

	Sharpe	Martin	Ulcer Index
Crescent	0.54	0.72	7.9
Vanguard 500	0.32	0.30	17.6

Three quick points:

1. It’s easy to disastrously misjudge a fund when you rely on the wrong metrics; we think that arbitrary time periods and returns without consideration of risks are the disastrously wrong metrics.
2. It’s not just that funds like Crescent serve their investors better, it’s that funds such as Crescent serve long-term investors decisively better. Over time, they allow their investors to both eat well and sleep well.
3. The key is a manager’s willingness to let money walk out the door rather than betray his investors and his standards. In the late 1990s, GMO – a staunchly contrarian bunch who would not bend to the demands of investors blinded by the market’s 50-60% annual gains – lost over half of its assets. Crescent has lost $5 billion. Centaur, Intrepid, Pinnacle – all down by 50% or more all because they’ve refused to sell out to an increasingly narrow, extraordinarily overpriced bull market that’s approaching its eighth year.

Eight years of gains. Wow.

Had I mentioned, per Leuthold, that the only other bull market to reach its eight year anniversary ended in 1929?

Who has served their investors best?

Using Charles’s fund data screener at MFO Premium, I searched among the funds that predominately invest in U.S. equities for those with the highest risk-adjusted returns over the full market cycle.

This table shows the funds with the highest Sharpe ratios, along with supplemental risk-return measures. It’s sorted by Sharpe but I’ve also highlighted the top five funds (more in the case of a tie) in each measure with Vanguard’s Total Stock Market Index added as a sort of universal benchmark.

		Category	Ulcer Index	Sharpe Ratio	Sortino Ratio	Martin Ratio
			Lower is better	Higher	Higher	Higher
Reynolds Blue Chip Growth	RBCGX	Multi-C Growth	5.9	0.68	1.15	1.76
Intrepid Endurance	ICMAX	SC Value	4.6	0.64	1.13	1.68
Monetta Young	MYIFX	Multi-C Core	10.6	0.6	0.97	0.91
AMG Yacktman Focused	YAFFX	LC Core	8.4	0.58	0.97	1.16
AMG Yacktman	YACKX	LC Core	9.2	0.57	0.94	1.01
Parnassus Core Equity	PRBLX	Equity Income	9.2	0.57	0.82	0.88
Bruce	BRUFX	Flexible Portfolio	12	0.56	0.81	0.57
First Trust Value Line Dividend Index	FVD	Multi-C Value	12.3	0.56	0.8	0.64
American Century NT Mid Cap Value	ACLMX	Multi-C Value	11.2	0.55	0.8	0.77
Intrepid Capital	ICMBX	Flexible Portfolio	6.3	0.55	0.82	0.94
Parnassus Endeavor	PARWX	Multi-C Core	10.9	0.55	0.86	0.94
Prospector Opportunity	POPFX	Mid-Cap Core	8.6	0.55	0.83	0.86
FPA Crescent	FPACX	Flexible Portfolio	7.9	0.54	0.77	0.72
Vanguard Dividend Growth	VDIGX	Equity Income	11	0.54	0.78	0.66
American Century Mid Cap Value	ACMVX	Multi-C Value	11.4	0.53	0.77	0.73
BBH Core Select	BBTEX	LC Core	9.4	0.53	0.77	0.76
Marsico Flexible Capital	MFCFX	Flexible Portfolio	13.5	0.52	0.8	0.65
Nicholas Equity Income	NSEIX	Equity Income	10.8	0.52	0.77	0.73
Centaur Total Return	TILDX	Equity Income	9	0.51	0.8	0.79
PRIMECAP Odyssey Aggressive Growth	POAGX	Mid-Cap Growth	15.8	0.51	0.79	0.66
Principal MidCap	PMBPX	Multi-C Growth	13.6	0.51	0.73	0.62
Fidelity Small Cap Discovery	FSCRX	SC Core	11.5	0.5	0.76	0.94
Nicholas	NICSX	Multi-C Growth	13	0.5	0.73	0.65
Pioneer Fundamental Growth	PIGFX	LC Growth	11.6	0.5	0.75	0.62
American Century Equity Income	TWEIX	Equity Income	11.1	0.48	0.68	0.5
For comparison
Vanguard Total Stock Market	VTSMX		17	0.32	0.46	0.32

Things that stand out:

1. Small, independent firms dominate the list. The ten largest fund complexes account for about two-thirds of the industry’s $18 trillion in assets. And yet, between them, they managed to produce two or three funds (depending on how you think about Primecap) on the list. American Century, a mid-sized firm, managed three. Intrepid, Nicholas, Parnassus and Yacktman each appeared twice and most appeared frequently on our top 50 list.
2. Active managers dominate the list. Only one index fund finished among the top 25. Only seven of the top 50 funds are passive products. If you sort by our most risk-sensitive measure, the Ulcer Index, only three passive products place in the top 50. Apparently “fully invested all the time” costs more than low fees save.
3. At most this is a place to start, not a place to end your inquiries. There are some truly excellent funds on the list and some whose presence might well be seriously misleading. Reynolds Blue Chip Growth, for instance, benefits a great deal by its decision to go entirely to cash before the market crashed in 2007. It outperformed its peers by 36% in the downturn but, other than for that one fortuitous move, has mostly trailed them in measures of both risk and return before and since.

Bottom line: The stock market, like war, is famous for “Months of boredom punctuated by moments of terror.” It’s those “moments of terror” that you’ve got to watch out for. That means you must look at how a manager serves you in both periods rather than limiting yourself to the “what have you done for me lately?” mindset.

My colleague Charles Boccadoro has been poring over oceans of data available through our premium fund screener. In the following story, he looks beyond the realm of individual funds to look for which fund families, including some fascinating smaller entrants, get it right most consistently.

Fund Family Scorecard

We started looking at fund family performance two years ago, first in June 2014 commentary with How Good Is Your Fund Family?, and then An Update in May 2015.

Below please find our MFO Family Fund Scorecard for May 2016, which reflects fund performance through 1st quarter. As a reminder, the card measures how well each fund in a family has performed against its peers since inception (or at least back to January 1960, which starts our Lipper database). Performance is absolute total return, reflecting reinvested dividends, but inclusive of fees and maximum front load, if applicable. The card groups families by quintile. (Download pdf version here.)

Some changes to methodology since last year:

• Categories now reflect those used by Lipper versus Morningstar, as discussed in Comparing Lipper Ratings. Similarly, all categories except money market are included, even so-called trading categories.
• Reduced from five to three the number of funds required to comprise a “fund family.” These changes respond to reader feedback from last year’s score card (eg., Where’s PRIMECAP?).
• Reduced from three years to just three months the minimum age for evaluation. Reasoning here being the desire to get heads-up of which young families are beating their peers out of the gate (eg., Grandeur Peak).

The result is about 400 “fund families,” or more precisely fund management companies; distilled from the 9,350 funds overall, oldest share class only.

We recognize the card is flawed from the start. Results can be skewed by multiple factors, including survivorship-bias, share class differences, “improper” categorization, adviser and fund ownership changes, multiple sub-advisers, and inconsistent time frames … three months is too short to matter, lifetime is too long to care.  Flaws notwithstanding, there is value in highlighting families that, for example, have not had a single fund beat its category average since inception. Like our legacy Three Alarm designation, prospective investors should ask: Why is that?

Take Saratoga Capital Management who is celebrating 20 years and offers a line-up of mutual funds as “The Portfolios of the Saratoga Advantage Trust.” From its brochure: “There are over 22,000 investment management firms in the United States. How do you choose the right one? Research, research and more research.” Fourteen of the funds offered in its line-up are managed by Saratoga itself. Average age: 15.6 years. How many have beaten average return in their respective categories? None. Zero. 0.

Fact is all seventeen funds in the Saratoga Advantage line-up have underperformed category average since inception. Why is that?

On a more positive note, a closer look at a couple groupings …

Good to see: Vanguard heads list of Top Families with Largest Assets Under Management (AUM), along with other shareholder friendly firms, like Dodge & Cox.

And, a nod to the young and unbeaten … a short list of top families where every fund beats its category average.

Gotham is led by renowned investor Joel Greenblatt. As for Grandeur Peak, David has been an outspoken champion since its inception. Below are its MFO Ratings (click image to enlarge):

MFO Fund Family Scorecard will soon be a regular feature on our Premium site, updated monthly, with downloadable tables showing performance and fund information for all families, like average ER, AUM, load, and shares classes.

All That Glitters …

By Edward Studzinski

One should forgive one’s enemies, but not before they are hanged.

Heinrich Heine

So, we are one-third through another year, and things still continue to be not as they should be, at least to the prognosticators of the central banks, the Masters of the Universe on Wall Street, and those who make their livings reporting on same, at Bubblevision Cable and elsewhere. I am less convinced than I used to be that, for media commentators, especially on cable, the correct comparison is to The Gong Show. More often than not, I think a more appropriate comparison is to the skit performed by the late, great, and underappreciated Ernie Kovacs, “The Song of the Nairobi Trio.”

And lest I forget, this is the day after another of Uncle Warren’s Circuses, held in Omaha to capacity crowds. An interesting question there is whether, down the road some fifty years, students of financial and investing history discover after doing the appropriate first order original source research, that what Uncle Warren said he did in terms of his investment research methodology and what he in reality did, were perhaps two different things. Of course, if that were the case, one might wonder how all those who have made almost as good a living selling the teaching of the methodology, either through writing or university programs, failed to observe same before that. But what the heck, in a week where the NY Times prints an article entitled “Obama Lobbies for His Legacy” and the irony is not picked up on, it is a statement of the times.

The best performing asset class in this quarter has been – gold. Actually the best performing asset class has been the gold miners, with silver not too far behind. We have had gold with a mid-teen’s total return. And depending on which previous metals vehicle you have invested in, you may have seen as much as a 60%+ total return (looking at the germane Vanguard fund). Probably the second best area generically has been energy, but again, you had to choose your spots, and also distinguish between levered and unlevered investments, as well as proven reserves versus hopes and prayers.

I think gold is worth commenting on, since it is often reviled as a “barbarous relic.” The usual argument against it that it is just a hunk of something, with a value that goes up and down according to market prices, and it throws off no cash flow.

That argument changes of course in a world of negative interest rates, with central banks in Europe and one may expect shortly, parts of Asia, penalizing the holding of cash by putting a surcharge on it (the negative rate).

A second argument against it is that is often subject to governmental intervention and political manipulation. A wonderful book that I still recommend, and the subjects of whom I met when I was involved with The Santa Fe Institute in New Mexico, is The Predictors by Thomas A. Bass. A group of physicists used chaos theory in developing a quantitative approach to investing with extensive modeling. One of the comments from that book that I have long remembered is that, as they were going through various asset and commodity classes, doing their research and modeling, they came to the conclusion that they could not apply their approach to gold. Why? Because looking at its history of price movements, they became convinced that the movements reflected almost always at some point, the hand of government intervention. An exercise of interest would be to ponder how, over the last ten years, at various points it had been in the political interests of the United States and/or its allies, that the price of gold in relation to the price of the dollar, and those commodities pegged to it, such as petroleum, had moved in such a fashion that did not make sense in terms of supply and demand, but made perfect sense in terms of economic power and the stability of the dollar. I would suggest, among other things, one follow the cases in London involving the European banks that were involved in price fixing of the gold price in London. I would also suggest following the timetable involving the mandated exit of banks such as J.P. Morgan from commodity trading and warehousing of various commodities.

Exeunt, stage left. New scenario, enter our heroes, the Chinese. Now you have to give China credit, because they really do think in terms of centuries, as opposed to when the next presidential or other election cycle begins in a country like the U.S. Faced with events around 2011 and 2012 that perhaps may have seemed to be more about keeping the price of gold and other financial metrics in synch to not impact the 2012 elections here, they moved on. We of course see that they moved on in a “fool me once fashion.” We now have a Shanghai metals exchange with, as of this May, a gold price fixing twice a day. In fact, I suspect very quickly we will see whole set of unintended consequences. China is the largest miner of gold in the world, and all of its domestic supply each year, stays there. As I have said previously in these columns, China is thought to have the largest gold reserves in the world, at in excess of 30,000 tons. Russia is thought to be second, not close, but not exactly a slouch either.

So, does the U.S. dollar continue as the single reserve currency (fiat only, tied solely to our promise to pay) in the world? Or, at some point, does the Chinese currency become its equal as a reserve currency? What happens to the U.S. economy should that come to pass? Interesting question, is it not? On the one hand, we have the view in the U.S. financial press of instability in the Chinese stock market (at least on the Shanghai stock exchange), with extreme volatility. And on the other hand, we have Chinese companies, with some degree of state involvement or ownership, with the financial resources to acquire or make bids on large pieces of arable land or natural resources companies, in Africa, Australia, and Canada. How do we reconcile these events? Actually, the better question is, do we even try and reconcile these events? If you watch the nightly network news, we are so self-centered upon what is not important or critical to our national survival, that we miss the big picture.

Which brings me to the question most of you are asking at this point – what does he really think about gold? Some years ago, at a Grant’s Interest Rate Observer conference, Seth Klarman was one of the speakers and was asked about gold. And his answer was that, at the price it was at, they wanted to have some representation, not in the physical metal itself, but in some of the gold miners as a call option. It would not be more than 5% of a portfolio so that in the event it proved a mistake, the portfolio would not be hurt too badly (the opposite of a Valeant position). If the price of gold went up accordingly, the mine stocks would perhaps achieve a 5X or 10X return, which would help the overall returns of the portfolio (given the nature of events that would trigger those kinds of price movements). Remember, Klarman above all is focused on preserving capital.

And that is how I pretty much view gold, as I view flood insurance or earthquake insurance. Which, when you study flood insurance contracts you learn does not just cover flooding but also cases of extreme rain where, the house you built on the hill or mountain goes sliding down the hill in a massive mudslide. So when the catastrophic event can be covered for a reasonable price, you cover it (everyone forgets that in southern Illinois we have the New Madrid fault, which the last time it caused a major quake, made recent California or Japanese events seem like minor things). And when the prices to cover those events become extreme, recognizing the extreme overvaluation of the underlying asset, you should reconsider the ownership (something most people with coastal property should start to think about).

Twenty-odd years ago, when I first joined Harris Associates, I was assigned to cover DeBeers, the diamond company, since we were the largest shareholders in North America. I knew nothing about mining, and I knew nothing about diamonds, but I set out to learn. I soon found myself in London and Antwerp studying the businesses and meeting managements and engineers. And one thing I learned about the extractive industries is you have to differentiate the managements. There are some for whom there is always another project to consume capital. You either must expand a mine or find another vein, regardless of what the price of the underlying commodity may be (we see this same tendency with managements in the petroleum business). And there are other managements who understand that if you know the mineral is there sitting in the ground, and you have a pretty good idea of how much of it is there, you can let it sit, assuming a politically and legally stable environment, until the return on invested capital justifies bringing it out. For those who want to develop this theme more, I suggest subscribing to Grant’s Interest Rate Observer and reading not just its current issues but its library of back issues. Just remember to always apply your own circumstances rather than accept what you read or are told.

Drafting a Fixed Income Team

By Leigh Walzer

It is May 1. The time of flowers, maypoles and labor solidarity.

For football fans it is also time for that annual tradition, the NFL draft.  Representatives of every professional football team assemble in Chicago and conspire to divide up the rights to the 250 best college players.  The draft is preceded by an extensive period of due diligence.

Some teams are known to stockpile the best available talent. Other teams focus on the positions where they have the greatest need; if there are more skilled players available at other positions they try to trade up or down to get the most value out of their picks. Others focus on the players who offer the best fit, emphasizing size, speed, precision, character, or other traits.

The highly competitive world of professional sports offers a laboratory for investors selecting managers. Usually at Trapezoid we focus on finding the most skillful asset managers, particularly those with active styles who are likely to give investors their money’s worth. In the equity world, identifying skill is three quarters of the recipe for investment success.

But when we apply our principles to fixed income investing, the story is a little different.  The difference in skill between the top 10% and bottom 10% is only half as great as for the equity world. In other words, time spent looking for the next Jeff Gundlach is only half as productive as time spent looking for the next Bill Miller.

Exhibit I

That assumes you can identify the good fixed income managers.  Allocators report the tools at their disposal to analyze fixed income managers are not as good as in equities.

Some people argue that in sports, as in investing, the efficient market hypothesis rules. The blog Five-thirty-eight argues that  No Team Can Beat the Draft. General managers who were seen as geniuses at one point in their career either reverted to the mean or strayed from their discipline.

Readers might at this point be tempted to simply buy a bond ETF or passive mutual fund like VTBXX. Our preliminary view is that investors can do better. Many fixed income products are hard to reproduce in indices; and the expense difference for active management is not as great. We measure skill (see below) and estimate funds in the top ten percentile add approximately 80 basis points over the long haul; this is more than sufficient to justify the added expense.

However, investors need to think about the topic a little differently. In fixed income, skillful funds exist but they are associated with a fund which may concentrate in a specific sector, duration, and other attributes.  It is often not practical to hedge those attributes – you have to take the bundle.  Below, we identify n emerging market debt fund which shows strong skill relative to its peers; but the sector has historically been high-risk and low return which might dampen your enthusiasm. It is not unlike the highly regarded quarterback prospect with off-the-field character issues.

When selecting managers, skill has to be balanced against not only the skill and the attractiveness of the sector but also the fit within a larger portfolio. We are not football experts. But we are sympathetic to the view that the long term success of franchises like the New England Patriots is based on a similar principle: finding players who are more valuable to them than the rest of the league because the players fit well with a particular system.

To illustrate this point, we constructed an idealized fixed income portfolio. We identified 22 skilled bond managers and let our optimizer choose the best fund allocation. Instead of settling upon the manager with the best track record or highest skill, the model allocated to 8 different funds. Some of those were themselves multi-sector funds. So we ended up fairly diversified across fixed income sectors.

Exhibit  I
Sector Diversification in one Optimized Portfolio

Characteristics of a Good Bond Portfolio

We repeated this exercise a number of times, varying the choice of funds, the way we thought of skill, and other inputs. We are mindful that not every investor has access to institutional classes and tax-rates vary. While the specific fund allocations varied considerably with each iteration, we observed many similarities throughout.:

BUSINESS CREDIT: Corporate bonds received the largest allocation; the majority of that went to high yield and bank loans rather than investment grade bonds

DON’T OVERLOAD ON MUNIs. Even for taxable investors, municipal funds comprised only a minority of the portfolio.

STAY SHORT: Shorter duration funds were favored. The example above had a duration of 5.1 years, but some iterations were much shorter

DIVERSIFY, UP TO A POINT:  Five to eight funds may be enough.

Bond funds are more susceptible than equity funds to “black swan” events. Funds churn out reliable yield and NAV holds steady through most of the credit cycle until a wave of defaults or credit loss pops up in an unexpected place.  It is tough for any quantitative due diligence system to ferret out this risk, but long track records help. In the equity space five years of history may be sufficient to gauge the manager’s skill. But in fixed income we may be reluctant to trust a strategy which hasn’t weathered a credit crunch. It may help to filter out managers and funds which weren’t around in 2008. Even then, we might be preparing our portfolio to fight the last war.

Identifying Skilled Managers

The recipe for a good fixed income portfolio is to find good funds covering a number of bond sectors and mix them just right. We showed earlier that fixed income manager skill is distributed along a classic bell curve. What do we mean by skill and how do we identify the top 10%? 

The principles we apply in fixed income are the same as for equities but the methodology is the same. While the fixed income model is not yet available on our website, readers of Mutual Fund Observer may sample the equity model by registering at www.fundattribution.com.  We value strong performance relative to risk. While absolute return is important, we see value in funds which achieve good results while sitting on large cash balances – or with low correlation to their sectors. And we look for managers who have outperformed their peer group -or relevant indices – preferably over a long period of time.  We also consider the trend in skill.

For fixed income we currently rely on a fitted regression model do determine skill. A few caveats are in order. This approach isn’t quite as sophisticated as what we do with equity funds. We don’t use the holdings data to directly measure what the manager is up to, we simply infer it. We don’t break skill down into a series of components. We rely on gross performance of subsectors rather than passive indices.  We haven’t back-tested this approach to see whether it makes relevant predictions for future periods.  And we don’t try to assess the likelihood that future skill will exceed expenses.  Essentially, the funds which show up well in this screen outperformed a composite peer group chosen by an algorithm over a considerable period of time. While we call them skillful, we haven’t ruled out that some were simply lucky. Or, worse, they could be generating good performance through a strategy which back to bite them in the long term. For all the reasons noted earlier, quantitative due diligence of portfolio managers has limitations. Ultimately, it pays to know what is inside the credit “black box”

Exhibit II lists some of the top-ranking funds in some of the major fixed income categories. We culled these from a list of 2500 fixed income funds, generally seeking top-decile performance, AUM of at least $200mm, and sufficient history with the fund and manager. 

We haven’t reviewed these funds in detail. Readers with feedback on the list are welcome to contact me at [email protected]

From time to time, the media likes to anoint a single manager as the “bond king.” But we suggest that different shops seem to excel in different sectors. Four High Yield funds are included in the list led by Osterweis Strategic Income Fund (OSTIX).  In the Bank Loan Category several funds show better but Columbia Floating-Rate Fund (RFRIX) is the only fund with the requisite tenure. The multi-sector funds listed here invest in corporate, mortgage, and government obligations.  We are not familiar with Wasatch-Hoisington US Treasury Fund (WHOSX), but it seems to have outperformed its category by extending its duration.

FPA New Income Fund (FPNIX) is categorized with the Mortgage Funds, but 40% of its portfolio is in asset-backed securities including subprime auto.  Some mortgage-weighted funds with excellent five year records who show up as skillful but weren’t tested in the financial crisis or had a management change were excluded. Notable among those is TCW Total Return Bond Fund (TGLMX).

Skilled managers in the municipal area include Nuveen (at the short to intermediate end), Delaware, Franklin, and Blackrock (for High Yield Munis).

Equity

Style diversification seems less important in the equity area. We tried constructing a portfolio using 42 “best of breed” equity funds from the Trapezoid Honor Roll.  Our optimizer proposed investing 80% of the portfolio in the fund with the highest Sharpe Ratio. While this seems extreme, it does suggest equity allocators can in general look for the “best available athlete” and worry less about portfolio fit.

Bottom Line

Even though fixed income returns fall in a narrower range than their equity counterparts, funds whose skill justify their expense structure are more abundant. Portfolio fit and sector timeliness sometimes trumps skill; diversification among fixed income sectors seems to be very important; and the right portfolio can vary from client to client. If in doubt, stay short. Quantitative models are important but strive to understand what you are investing in.

The Alt Perspective: Commentary and news from DailyAlts.

April has come to a close and another Fed meeting has passed without a rate rise. At the same time, markets have continued to rally with the equity market, as measured by the S&P 500 Index, gaining another 0.39% in April, bringing the 3-month total return to 7.05%. Bonds also rallied as the Barclays U.S. Aggregated Bond Index gained 0.38% in April, and 2.02% over the past 3-months. Not bad for traditional asset classes.

Strong rallies are periods when alternative strategies lag the broad markets given that they are often hedged in their exposure to traditional asset classes. And this is what we saw in April, with managed futures funds dropping 1.76%, bear market funds losing 1.36% and market neutral funds shedding 0.40%. At the same time, long/short equity funds eked out a gain of 0.06%, multi-alternative funds gained 0.29%, non-traditional bond funds gained 1.54% and multi-currency funds added 1.57%. Not a stellar month for alternative funds, but investors can’t always make money in all areas of their portfolio – diversification has its benefits as well as its drawbacks.

News Highlights from April

• Highland Capital, who had originally filed to launch a series of 17 alternative ETFs, decided to take a different course of action and shut down the 3 hedge fund replication ETFs it launched less than a year ago. It’s unlikely any of the remaining 14 funds will see the bid or ask of a trade.
• Morningstar has made some modifications to its alternative fund classifications, creating two new alternative fund categories: Long/Short Credit and Option Writing. The changes went into effect on April 29.
• Alternative fund (mutual funds and ETFs) inflows continued to be positive in March, with nearly $2.1 billion of new assets going into the category. Managed futures funds gained just over $1 billion in assets and multi-alternative funds picked up nearly $500 million, but the big gainer was volatility based funds which added $1.5 billion as a category.
• Both Calamos and Catalyst hit the market this month with new alternative mutual funds what were converted from hedge funds. Calamos launched a global long/short equity fund managed by Phineus Partners, a firm they acquired in 2015, while Catalyst launched a hedged equity (with an alpha overlay) fund (this one is a bit more complicated on the surface) that is sub-advised by Millburn Ridgefield.
• Fidelity Investments did an about face on more than $2 billion of assets allocated to two multi-alternative mutual funds that were set up specifically, and exclusively, for their clients. One fund was managed by Blackstone, while the other by Arden Asset Management (which was recently acquired by Aberdeen).

Potential Regulatory Changes

One of the more serious issues currently on the table is a proposal by the Securities and Exchange Commission (SEC) to limit the use of derivatives and leverage in mutual funds. Keith Black, Managing Director of Curriculum and Exams for the CAIA Association, wrote a good piece for Pensions & Investments that covers some of the key issues. In the article, Black states that if the regulations are passes as is, it will “substantially alter the universe of alternative strategy funds available to investors.” While not expected to be implemented in its current form, fund managers are nevertheless concerned. The limitations proposed by the SEC would severely constrain some fund managers in their ability to implement the investment strategies they use today, and that would not be limited just to managers of alternative funds.

Greater levels of transparency and more sensible reporting are certainly needed for many funds. This is an initiative that funds should undertake themselves, rather than wait for the regulators to force their hand. But greater limits on the use of derivatives and leverage would, in many cases, go against the grain of benefiting investors.

Observer Fund Profiles: ARIVX and TILDX

Each month the Observer provides in-depth profiles of between two and four funds.  Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds.  “Stars in the Shadows” are older funds that have attracted far less attention than they deserve. 

Aston River Road Independent Value (ARIVX). If James Brown is the godfather of soul, then Eric Cinnamond might be thought the godfather of small cap, absolute value investing. He’s been at it since 1996 and he suspects that folks who own lots of small cap stocks today are going to want to sell them to him, for a lot less than they paid, sooner rather than later.

Centaur Total Return (TILDX). If Steppenwolf (“I like smoke and lightnin’ / Heavy metal thunder”) was born to be wild, then Zeke Ashton was born to be mild (“thoughtless risk now damages future performance”). While Steppenwolf’s name is cool, Mr. Ashton’s combination of blue chips, cash and calls has been far more profitable (and, of course, prudent).

Launch Alert: LMCG International Small Cap

LMCG International Small Cap (ISMRX/ISMIX) launched on April 1, 2016 but it’s actually a new platform for an institutional “collective trust” that’s been in operation since August 26, 2010.

LMCG Investments is a Boston-based adviser with about $7 billion of mostly institutional and high net worth individual assets. They were once “Lee Munder Capital Group” and they do subadvise some retail funds but they are not linked to the old Munder family of funds.

The fund invests primarily in international small cap stocks from developed markets, though they can invest small slices in both the US and the emerging markets. “Small cap” translates to market caps between $50 million and $7 billion with the current weighted capitalization in the portfolio at $2.9 billion. They target companies with “good growth prospects and high quality of earnings,” then buy them when they’re attractively valued. They position themselves as a quant fund with a fundamentalist’s bias; that is, they’ve constructed screens to help them identify the same attributes that other good fundamental, bottoms-up guys look for. They screen 2,500 stocks daily and are hopeful that the quantitative discipline helps them avoid a lot of human errors such as style drift and overcommittment to particular stocks. Eventually the portfolio will hold between 90-125 more-or-less equally weighted stocks.

Four things stand out about the fund:

1.   It’s cheap.

Morningstar’s benchmarking data is too cute by half since they provide separate group benchmarks for load and no-load funds, institutional and non-institutional funds and both category average and “Fee Level Comparison Group Median” numbers. In general, you’d expect to pay somewhere between 1.35% and 1.50% for a fund in this category. With an opening e.r. of 1.10%, LMCG will be one of the four cheapest options for retail investors.

2.   It’s in an arena where active managers thrive.

Standard & Poor’s SPIVA scorecards track the prospect that an active manager will outperform his benchmark. In domestic small cap core funds, the chance is about 1 in 7 over a five year period. For international small cap core, though, the chance is 1 in 2 and that’s despite the generally high expenses that the average fund carries. More to the point, funds like Vanguard FTSE All-World ex-US Small Cap Index (VFSVX) are distinctly poor performers, trailing 90% of their peers over the past three- and five-year periods.

3.   It’s got an experienced management team.

The fund is managed by Gordon Johnson, who has 23 years of experience managing global portfolios and developing quantitative investment models. Before joining LMCG in 2006 he had six years at Evergreen Investments and, before that, managed the Colonial Fund. (And, like me, he has a PhD from UMass.) Co-manager Shannon Ericson joined LMCG at the same time, also from Evergreen, and has had stints at Independence International Associates and Mellon Trust. Together they also co-manage LMCG Global Market Neutral Fund, ASTON/LMCG Emerging Markets and PACE International Emerging Markets.  They’re assisted by Daniel Getler, CFA.

4.   It’s got a strong track record.

The predecessor fund has been around since 2010 and it has outperformed its peer group and its benchmark index in each of the five calendar years of its existence.

It’s particularly interesting that the fund has been more than competitive in both up- and down-market years.

The fund’s initial expense ratio is 1.10%, after waivers, on Investor class shares and 0.85% on Institutional ones.  The minimum initial investment is $2500 for Investor shares and $100,000 for the others. 

The ISMRX homepage is, understandably, thin on the content right now. The other funds’ homepages (Global Multicap and Global Market Neutral) aren’t exactly founts of information, but they do offer the prospect for a factsheet, manager Q&A and such as forthcoming. The LMCG homepage does offer access to their monthly commentary, LMCG Unfiltered. It’s short, clear and interesting. There was an note in their March 2016 issue that over the past eight years, US corporations have accounted for a slightly higher percentage of global corporate earnings (up from 36% in 2007 and 41% in 2015) but a substantially higher percentage of global stock market capitalization (from 47% to 59%). That suggests that the US market has been underwritten by the willingness of international investors to overpay for the safe haven of US markets and raises intriguing questions about what happens when there’s no longer a safe haven premium.

Funds in Registration

Before mutual funds can offered for sale to the public, their prospectuses and related documents need to be subject to SEC review for 75 days. During the so-called “silent period,” the prospectus is available for public (and regulator) review, but the advisers are not permitted to discuss them. We try to track down no-load retail funds and actively-managed ETFs in registration that you might want to put on your radar.

There are only five funds in registration now, most set to launch by the end of June.

While it’s not likely to lead to scintillating cocktail party conversation, DoubleLine Ultra Short Bond Fund is apt to be really solid and useful. And it is run by Bonnie Baha, who once asked The Jeffrey why he was such a jerk.

AMG SouthernSun Global Opportunities Fund is a sort of global version of SouthernSun Small Cap (SSSFX). Okay, it’s a sort of smid-cap global version of Small Cap. SSSFX tends to be a high-beta fund that captures a lot more of the upside than its peers; that boldness has hurt it lately but is has serious charms.

Manager Changes

We’ve track down rather more than 55 manager changes this month, including maternity leaves, sabbaticals, retirements and quietly unexplained departures. The most noteworthy might be the departure of Daniel Martino from T. Rowe Price New America Growth Fund (PRWAX).

Updates

Welcoming Bob Cochran

It is with undisguised, and largely unrestrained, glee that we announce the addition of Robert Cochran to the Mutual Fund Observer, Inc. Board of Directors. Bob is the lead portfolio manager, Chief Compliance Officer, and a principal of PDS Planning in Columbus, Ohio.

We’ve been following Bob’s posts for the past 10 or 15 years where, as BobC, he’s been one of the most respected, thoughtful and generous contributors to our discussion board and the FundAlarm’s before that. The Observer aspires to serve two communities: the small, independent managers who are willing to stray from the herd and who are passionate about what they do (rather than about how much they can make) and the individual investors who deserve better than the timid, marketing-driven pap they’re so often fed. As we begin our sixth year, we thought that finding someone who is both active in the industry and broad in mind and spirit would allow us to serve folks better.

We believe that Bob is a great fit there. He’s been a financial professional for the past 31 years (he earned his CFP the same year I earned my PhD), writes thoughtfully and well, and had a stint teaching at Humboldt State in Arcata, a lovely town in northern California. He also serves on the Board for the Columbus Symphony (and was formerly their principal bassoonist) and Neighborhood Services, Inc., one of Ohio’s oldest food banks. Had I mentioned he’s prepping a national display garden? Me, I mostly buy extra bags of shredded hardwood mulch to bury my mistakes.

We are delighted that Bob agreed to join us, hopeful that we’ll be able to chart a useful course together, and grateful to him, and to you all, for your faith in us.

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On being your own worst enemy

Chuck Jaffe, in “This is why mutual fund managers can’t beat a stock index more often” (April 14, 2016), meditated a bit upon the question of whether index funds and sliced bread belong in the same pantheon. He notes that while the easy comparisons favor index funds, there’s a strongly countervailing flow that starts with the simple recognition that 50% of funds must, by definition, underperform the group average. The question is, can you find the other 50%. Research by several large firms points in that direction. Fidelity reports that low-cost funds from large fund complexes are grrrrrrreat! American Funds reports that low cost funds with high levels of manager ownership are at least as great. My take was simpler: you need to worry less about whether your active fund is going to trail some index by 0.9% annually and worry more about whether you will, yet again, insist on being your own worst enemy:

“Your biggest risk isn’t that your manager will underperform, it’s that you’ll panic and do something stupid and self-destructive,” said David Snowball, founder of MutualFundObserver.com. “With luck, if you know what your manager is doing and why she’s doing it and if she communicates clearly and frequently, there’s at least the prospect that you’ll suppress the urge to self-immolation.”

On April 29, 2016, Morningstar added eight new fund categories, bringing their total is 122.The eight are:

They renamed 10 other categories. The most noticeable will be the replacement of conservative, moderate and aggressive allocation categories with stipulations of the degree of market exposure. The moderate allocation category, once called “balanced,” is now the “Allocation 50-70% Equity” category.

Briefly Noted . . .

With unassailable logic that Aristotle himself would affirm, we learn from a recent SEC filing that “The Aristotle Value Equity Fund has not commenced operations and therefore is currently not available for purchase.”

Effective April 1, 2016, QS Batterymarch Financial Management, Inc. merged with QS Investors, LLC, to form QS Investors, LLC. QS was an independent quant firm purchased, in 2014, by Legg Mason to run their QS Batterymarch funds.

SMALL WINS FOR INVESTORS

AMG SouthernSun Small Cap Fund (SSSFX) reopened to new investors in the first week of April.

On April 7, 2016, the Board of Trustees of Crow Point Defined Risk Global Equity Income Fund (CGHAX/CGHIX) voted to abandon the plan of liquidation for the Fund and continue the Fund’s operations.

The Board of Trustees voted to reduce the expense cap on Dean Mid Cap Value Fund (DALCX) by 1.50% to 1.10%. That includes a small drop in the management fee.

Franklin Biotechnology Discovery Fund (FBDIX) will re-open to new investors May 16, 2016. The fund’s 23% loss in the first four months of 2016 might have created some room for (well, need for) new investors.

RS Partners Fund (RSPFX) reopened to new investors on March 1, 2016, just in case you’d missed it. RS, once Robertson Stephens, has been acquired by Victory Capital, so the fund may be soon renamed Victory RS Partners.

Sequoia Fund (SEQUX) has reopened in hopes of finding new investors. I won’t be one of them. There’s the prospect of a really substantial tax hit this year. In addition, we still don’t know what happened, whether it’s been fixed and whether the folks who left – including the last of the original managers – were the cause of the mess or the scapegoats for it. Until there’s some clarity, I’d be unwilling to invest for the sake of just owning a legendary name.

WCM Investment Management has voluntarily agreed to waive all of its fees and pay all of the operating expenses for WCM Focused Global Growth Fund (WFGGX) and WCM Focused Emerging Markets Fund (WFEMX) from May 1, 2016, through April 30, 2017. “The Advisor will not seek recoupment of any advisory fees it waived or Fund expenses it paid during such period.”

CLOSINGS (and related inconveniences)

AC Alternatives® Market Neutral Value Fund (ACVQX) will close to new investors on May 25, 2016 except those who invest directly with American Century or through “certain financial intermediaries selected by American Century.” In an exceedingly odd twist, Morningstar describes it as having “average” returns, a fact belied by, well, all available evidence. In addition to beating their peers in every calendar year, the performance gap since inception is pretty substantial:

Folks closed out here and willing to consider an even more explosive take on market-neutral investing might want to look at Cognios Market Neutral Large Cap (COGIX).

Effective April 30, 2016, the Diamond Hill Small-Mid Cap Fund (DHMAX), with $1.8 billion in assets, closed to most new investors. 

OLD WINE, NEW BOTTLES

On or about May 31, 2016, each Strategic Advisers^® Multi-Manager Target Date Fund becomes a Fidelity Multi-Manager Target Date Fund.

The Primary Trend Fund has become Sims Total Return Fund (SIMFX). Sims Capital Management has been managing the fund since 2003 and just became the adviser, rather than just the sub-adviser. I wish them well, but the fact that they’ve trailed their peers in eight of the past 10 calendar years is going to make it a hard slog.

OFF TO THE DUSTBIN OF HISTORY

Appleton Group Risk Managed Growth Fund (AGPLX) has closed and will be liquidated at the close of business on June 27, 2016.

Aurora Horizons Fund (AHFAX) closed to new purchases on April 22, 2016 and will be liquidating its assets as of the close of business on May 31, 2016. As this alts fund passed its three-year mark, it was trailing 80% of its peers.

BPV Low Volatility Fund (BPLVX) has closed but “will continue to operate until on or about May 31, 2016, when it will be liquidated.” The fund is liquidating just as Morningstar is creating a category to track such option-writing strategies.

The Braver Tactical Opportunity Fund (BRAVX) has closed to new investors and will discontinue its operations effective May 27, 2016. It’s not at all a bad fund, it’s just not magical. Increasingly, it seems like that’s what it takes.

Stepping back from the edge of the grave: On March 30, 2016, the Board of Trustees of Two Roads Trust voted to abandon the plan of liquidation for the Breithorn Long/Short Fund (BRHIX) that was scheduled to occur on or about April 8, 2016. 

Fidelity Advisor Short Fixed-Income Fund (FSFAX) is merging into Fidelity Short-Term Bond Fund (FSHBX) on or about July 15, 2016. Their performance over any reasonable time frame is nearly identical and FSHBX is cheaper, so it’s a clear winner for shareholders.

Nuveen Global Growth (NGGAX) and Nuveen Tradewinds Emerging Markets (NTEAX) funds will both be liquidated after the close of business on June 24, 2016.

Oppenheimer Commodity Strategy Total Return Fund (QRAAX) will liquidate on June 29, 2016. While the fund has almost $300 million in assets, its watershed moment might have happened in 2008:

Driven by the adviser’s “its inability to market the Fund and [fact] that it does not desire to continue to support the Fund,” Outfitter Fund (OTFTX) and its fly-fishing logo will liquidate on or about May 26, 2016.

Panther Small Cap Fund (PCGSX) will be liquidated on or about May 16, 2016. Cool name, no assets, quickly deteriorating performance.

Putnam Voyager Fund (PVOYX) is merging into Putnam Growth Opportunities (POGAX) on July 15, 2016. Voyager’s performance was rightly described as “dismal” by Morningstar. Voyager’s manager was replaced in February by Growth Opportunities, after a string of bad bets: in the past six years, he mixed one brilliant year with two dismal ones and three pretty bad ones. He was appointed in late 2008 just before the market blasted off, rewarding all things risky. As soon as that phase passed, Voyager sank in the mud. To their credit, Voyager’s investors stayed with the fund and assets, still north of $3 billion, have only recently begun to slip. The new combined fund’s manager is no Peter Lynch, but he’s earning his keep.

Rivington Diversified International Equity Fund By WHV and Rivington Diversified Global Equity Fund By WHV have been closed and liquidated. “By WHV” sounds like a bad couture brand.

Stratus Government Securities (STGAX) and Growth Portfolio (STWAX) are both moving toward liquidation. Shareholders will rubberstamp the proposal on June 7, 2016.

The Board of Trustees, citing in light of “the ever-present goal of continuing to make all decisions and actions in the Best Interests of the Shareholders,” has decided to liquidate Valley Forge Fund (VAFGX). 

A queer and wonderful ride. Bernie Klawans – an aerospace engineer – ran it for decades, from 1971-2011, likely out of his garage. One-page website, no 800-number, no reports or newsletters or commentaries. Also an incredibly blurry logo that might well have been run through a mimeograph machine once or twice. Mr. Klawans brought on a successor when he was in his late 80s, worked with him for a couple years, retired in April and passed away within about six months. Then his chosen successor, Craig Arnholt, died unexpectedly within a year. The Board of Trustees actually managed the fund for six months (quite successful – they beat both their LV peers and the S&P) before finding a manager who’d run the fund for a pittance. The new guy was doing fine then … kapow! He lost 22% in September and October of 2014, when the rest of the market was essentially flat. That was a combination of a big stake in Fannie and Freddie – adverse court ruling cut their market value by half in a month – and energy exposure. He’s been staggering toward the cliff ever since.

Tocqueville Alternative Strategies Fund (TALSX) will “liquidate, dissolve and terminate [its] legal existence,” all on May 17, 2016. The fund is better than its three year record looks: it’s had two bad quarters in the last three, but often moved in the opposite direction of other alt funds and had a solid record up until Q3 2015.

William Blair Directional Multialternative Fund closed and liquidated on April 21, 2016.

William Blair Large Cap Value Fund (WLVNX) has closed and will liquidate on or about June 15, 2016. Soft performance, $3 million in assets, muerte.

In Closing . . .

Mutual Fund Observer celebrates its fifth anniversary with this issue. Our official launch was May 1, 2011 and since then we’ve enjoyed the company of nearly 800,000 readers (well, 795,688 seems like it’s near 800,000). Each month now we draw between 22,000 and 28,000 readers.

Thanks and thanks and more thanks to… David, Michael, William, and Richard. Many thanks, also, to John from California who sent a note with his donation that really brightened our day. As always, Gregory and Deb, your ongoing support is so appreciated.

If you’re grateful at the absence of ads or fees and would like to help support the Observer, there are two popular options. Simple: make a tax-deductible contribution to the Observer. Folks contributing $100 or more in a year receive access to MFO Premium, the site that houses our custom fund screener and all of the data behind our stories.

Simplest: use our link to Amazon.com. We received about 6-7% of the value of anything you purchase through that link. It costs you nothing extra and is pretty much invisible. For those of you interested in knowing a bit more about the Observer’s history, scope and mission, we’ve linked our factsheet to the thumbnail on the left.

As usual, we’ll be at the Morningstar Conference, 13-15 June. Let us know if we might see you there.

Our June issue will be just a wee bit odd for the Observer. At the end of May I’m having one of those annoying round-number birthdays. I decided that, on whole, it would be substantially less annoying if I celebrated it somewhere even nicer than the Iowa-Illinois Quad Cities. The Isle of Skye, off the west coast of Scotland, in particular. Chip saw it as an opportunity to refine her palate by trying regional varieties of haggis (and scotch), so she agreed to join me for the adventure.

That means we’ll have to finish the June issue by May 20^th, just about the time that some hundreds of students insist on graduating from our respective colleges. We’ll have the issue staged before we leave the country and will count on her IT staff to launch it. That means we’ll be out of contact for about two weeks, so we’ll have to ask for forbearance for unanswered email.

As ever,

Dear friends,

It’s May, a sweet and anxious time at college. The End is tantalizingly close; just two weeks remain in the academic year and, for many, in their academic career.  Both the trees on the Quad and summer wardrobes are bursting out. The days remaining and the brain cells remaining shrink to a precious few. We all wonder where another year (my 31^st here) went, holding on to its black-robed closing days even as we long for the change of pace and breathing space that summer promises.

For investors too summer holds promise, for days away and for markets unhinged. Perhaps thinking a bit ahead while the hinges remain intact might be a prudent course and a helpful prologue to lazy, hazy and crazy.

The Dry Powder Crowd

A bunch of fundamentally solid funds have been hammered by their absolute value orientation; that is, their refusal to buy stocks when they believe that the stock’s valuations and the underlying corporation’s prospects simply do not offer a sufficient margin of safety for the risks they’re taking, much less compelling opportunities. The mere fact that a fund sports just one lonely star in the Morningstar system should not disqualify it from serious consideration. Many times a low star rating reflects the fact that a particular style or perspective is out-of-favor, but the managers were unwilling to surrender their discipline to play to what’s popular.

That strikes us as admirable.

Sometimes a fund ends up with a one-star rating simply because it’s too independent to fit into one of Morningstar’s or Lipper’s predetermined boxes.

We screened for one-star equity funds with over 20% cash. From that list we looked for solid, disciplined funds whose Morningstar ratings have taken a pounding. Those include:

	Cash	3 yr return	Comment
ASTON/River Road Independent Value (ARIVX)	80%	3.7	Brilliant run from 2006-2011 when even his lagging years saw double digit absolute returns. Performance since has been sad; his peers have been rising 15% annually while ARIVX has been under 4%. The manager’s response is unambiguous: “As the rise in small cap prices accelerates and measures of valuation approach or exceed past bubble peaks, we believe it is now fair to characterize the current small cap market as a bubble.” After decades of small cap investing, he’s simply unwilling to chase bubbles so the fund is 80% cash.
Fairholme Allocation (FAAFX)	29	10.9	Mr. Berkowitz is annoyed with you for fleeing his funds a couple years ago. In response he closed the funds then reopened them with dramatically raised minimums. His funds manage frequent, dramatic losses often followed by dramatic gains. Just not as often lately as leaders surge and contrarian bets falter. He and his associates have about $70 million in the fund.
FPA Capital (FPPTX)	25	7.6	The only Morningstar medalist (Silver) in the group, FPA manages this as an absolute value small- to mid-cap fund. The manager of this closed fund has been onboard since 2007 and like many like-minded investors is getting whacked by holding both undervalued energy stocks and cash.
Intrepid Small Cap, soon to be Intrepid Endeavor (ICMAX)	68	6.3	Same story as with FPA and Aston: in response to increasingly irrational activity in small cap investing (e.g., the numbers of firms being acquired at record high earnings levels), Intrepid is concentrated in a handful of undervalued sectors and cash.  AUM has dropped from $760 million in September 2012 to $420 million now, of which 70% is cash.
Linde Hansen Contrarian Value (LHVAX)	21	13.5	Messrs. Linde and Hansen are long-term Lord Abbett managers. By their calculation, price to normalized earnings have, since 2014, been at levels last seen before the 2007-09 crash. That leaves them without many portfolio candidates and without a willingness to buy for the sake of buying: “We believe the worst investing mistakes happen when discipline is abandoned and criteria are stretched (usually in an effort to stay fully invested or chasing indexes). With that perspective in mind, expect us to be patient.”
The Cook & Bynum Fund (COBYX)	42	7.7	The phrase “global concentrated absolute value” does pretty much capture it: seven stocks, three sectors, huge Latin exposure and 40% cash. The guys have posted very respectable returns in four of their five years with the fund: double-digit absolute returns or top percentile relative ones. A charging market left them with fewer and fewer attractive options, despite long international field trips in pursuit of undiscovered gems. Like many of the other funds above, they have been, and likely will again be, a five star fund.

Frankly, any one of the funds above has the potential to be the best performer in your portfolio over the next five years especially if interest rates and valuations begin to normalize.

The challenge of overcoming cash seems so titanic that it’s worth noting, especially, the funds whose managers have managed to marry substantial cash strong with ongoing strong absolute and relative returns. These funds all have at least 20% cash and four- or five-star ratings from Morningstar, as of April 2015.

	Cash	3 yr return	Comment
Diamond Hill Small Cap (DHSCX)	20	17.2	The manager builds the portfolio one stock at a time, doing bottom-up research to find undervalued small caps that he can hold onto for 5-10 years. Mr. Schindler has been with the fund as manager or co-manager since inception.
Eventide Gilead (ETGLX)	20	26.1	Socially responsible stock fund with outrageous fees (1.55%) for a fund with a straightforward strategy and $1.6 billion in assets, but its returns are top 1-2% across most trailing time periods. Morningstar felt compelled to grump about the fund’s volatility despite the fact that, since inception, the fund has not been noticeably more volatile than its mid-cap growth peers.
FMI International (FMIJX)	20	16	In May 2012 we described this as “a star in the making … headed by a cautious and consistent team that’s been together for a long while.” We were right: highly independent, low turnover, low expense, team-managed. The fund has a lot of exposure to US multinationals and it’s the only open fund in the FMI family.
Longleaf Partners Small Cap (LLSCX)	23	23	Mason Hawkins and Staley Cates have been running this mid-cap growth fund for decades. It’s now closed to new investors.
Pinnacle Value (PVFIX)	44	11.3	Our March 2015 profile noted that Pinnacle had the best risk-return profile of any fund in our database, earning about 10% annually while subjecting investors to barely one-third of the market’s volatility.
Putnam Capital Spectrum (PVSAX)	29	19.3	At $10.7 billion in AUM, this is the largest fund in the group. It’s managed by David Glancy who established his record as the lead manager for Fidelity’s high yield bond funds and its leveraged stock fund.
TETON Westwood Mighty Mites (WEMMX)	24	16.8	There’s a curious balance here: huge numbers of stocks (500) and really low turnover in the portfolio (14%). That allows a $1.3 billion fund to remain almost exclusively invested in microcaps. The Gabelli and Laura Linehan have been on the fund since launch.
Tweedy, Browne Global Value (TBGVX)	22	12.6	I’m just endlessly impressed with the Tweedy funds. These folks get things right so often that it’s just remarkable. The fund is currency hedged with just 9% US exposure and 4% turnover.
Weitz Partners III Opportunity (WPOPX)	26	15.8	Morningstar likes it (see below), so who am I to question?

Fans of large funds (or Goodhaven) might want to consult Morningstar’s recommended list of “Cash-Heavy Funds for the Cautious Investor” which includes five names:

	Cash	3 yr return	Comment
FPA Crescent (FPACX)	38%	11.2	The $20 billion “free range chicken” has been managed by Mr. Romick since 1993. Its cash stake reflects FPA’s institutional impulse toward absolute value investing.
Weitz Partners Value (WPVLX)	19	16.2	Perhaps Mr. Weitz was chastened by his 53% loss in the 2007-09 market crises, which he entered with a 10% cash buffer.
Weitz Hickory (WEHIX)	19	13.7	On the upside, WEHIX’s 56% drawdown does make its sibling look moderate by comparison.
Third Avenue Real Estate Value (TAREX)	16	15.7	This is an interesting contrast to Third Avenue’s other equity funds which remain fully invested; Small Cap, for example, reports under 1% cash.
Goodhaven (GOODX)	0	5.7	I don’t get it. Morningstar is enamored with this fund despite the fact that it trails 99% of its peers. Morningstar reported a 19% cash stake in March and a 0% stake now. I have no idea of what’s up and a marginal interest in finding out.

It’s time for an upgrade

The story was all over the place on the morning of April 20^th:

• Reuters: “Carlyle to shutter its two mutual funds”
• Bloomberg: “Carlyle to close two mutual funds in liquid alts setback”
• Ignites: “Carlyle pulls plug on two mutual funds”
• ValueWalk: “Carlyle to liquidate a pair of mutual funds”
• Barron’s: “Carlyle closing funds, gold slips”
• MFWire dutifully linked to three of them in its morning link list

Business Insider gets it closest to right: “Private equity giant Carlyle Group is shutting down the two mutual funds it launched just a year ago,” including Carlyle Global Core Allocation Fund.

What’s my beef? 

1. Carlyle doesn’t have two mutual funds, they have one. They have authorization to launch the second fund, but never have. It’s like shuttering an unbuilt house. Reuters, nonetheless, solemnly notes that the second fund “never took off [and] will also be wound down,” implying that – despite Carlyle’s best efforts, it was just an undistinguished performer.
2. The fund they have isn’t the one named in the stories. There is no such fund as Carlyle Global Core Allocation Fund, a fund mentioned in every story. Its name is Carlyle Core Allocation Fund(CCAIX/CCANX). It’s rather like the Janus Global Unconstrained Bond Fund that, despite Janus’s insistence, didn’t exist at the point that Mr. Gross joined the team. “Global” is a description but not in the name.
3. The Carlyle fund is not newsworthy. It’s less than one year old, it has a trivial asset base ($50 million) and has not yet made a penny ($10,000 at inception is now $9930).

If folks wanted to find a story here, a good title might be “Another big name private investor trawls the fund space for assets, doesn’t receive immediate gratification and almost immediately loses interest.” I detest the practice of tossing a fund into the market then shutting it in its first year; it really speaks poorly of the adviser’s planning, understanding and commitment but it seems distressingly common.

What’s my solution?

Upgrade. Most news outlets are no longer capable of doing that for you; they simply don’t have the resources to do a better job or to separate press release from self-serving bilge from news so you need to do it for yourself.

Switch to Bloomberg TV from, you know, the screechy guys. If it’s not universally lauded, it does seem broadly recognized as the most thoughtful of the financial television channels.

Develop the habit of listening to Marketplace, online or on public radio. It’s a service of American Public Media and I love listening to Kai Ryssdal and crew for their broad, intelligent, insightful reporting on a wide range of topics in finance and money.

Read the Saturday Wall Street Journal, which contains more sensible content per inch than any other paper that lands on my desk. Jason Zweig’s column alone is worth the price of admission. His most recent weekend piece, “A History of Mutual-Fund Doors Opening and Closing,” is outstanding, if only because it quotes me.  About 90% of us would benefit from less saturation with the daily noise and more time to read pieces that offer a bit of perspective.

Reward yourself richly on any day when your child’s baseball score comes immediately to mind but you can honestly say you have no earthly clue what the score of the Dow Jones is. That’s not advice for casual investors, that’s advice for professionals: the last thing on earth that you want is a time horizon that’s measured in hours, days, weeks or months. On that scale the movement of markets is utterly unpredictable and focusing on those horizons will damage you more deeply and more consistently than any other bad habit you can develop.

Go read a good book and I don’t mean financial porn. If your competitive advantage is seeing things that other people (uhh, the herd) don’t see, then you’ve got to expose yourself to things other people don’t experience. In a world increasingly dominated by six inch screens, books – those things made from trees – fit the bill. Bill Gates recommends The Bully Pulpit, by Doris Kearns Goodwin. Goodwin “studies the lives of America’s 26th and 27th presidents to examine a question that fascinates me: How does social change happen?” That is, Teddy Roosevelt and William Taft. Power down your phone while you’re reading. The aforementioned Mr. Zweig fusses that “you can’t spend all day reading things that train your brain to twitch” and offers up Daniel Kahneman’s Thinking, Fast and Slow. Having something that you sip, rather than gulp, does help turn reading from an obligation to a calming ritual. Nina Kallen, a friend, insurance coverage lawyer in Boston and one of the sharpest people we know, declares Roger Fisher and William Ury’s Getting to Yes: Negotiating Agreement Without Giving In to be “life-changing.” In her judgment, it’s the one book that every 18-year-old should be handed as part of the process of becoming an adult. Chip and I have moved the book to the top of our joint reading list for the month ahead. Speaking of 18-year-olds, it wouldn’t hurt if your children actually saw you reading; perhaps if you tell them they wouldn’t like it, they’d insist on joining you.

How Good Is Your Fund Family? An Update…

Baseball season has started. MLB.TV actually plays more commercials than it used to, which sad to say I enjoy more than the silent “Commercial Break In Progress” screen, even if they are repetitive.

One commercial is for The Hartford Funds. The company launched a media campaign introducing a new tagline, “Our benchmark is the investor℠,” and its focus on “human-centric investing.”

Its website touts research they have done with MIT on aging, and its funds are actually sub-advised by Wellington Management.

A quick look shows 66 funds, each with some 6 share classes, and just under $100B AUM. Of the 66, most charge front loads up to 5.5% with an average annual expense ratio of just over 1%, including 12b-1 fee. And, 60 have been around for more than 3 years, averaging 15 years in fact.

How well have their funds performed over their lifetimes? Just average … a near even split between funds over-performing and under-performing their peers, including expenses.

We first started looking at fund family performance last year in the piece “How Good Is Your Fund Family?” Following much the same methodology, with all the same qualifications, below is a brief update. Shortly, we hope to publish an ongoing tally, or “Fund Family Score Card” if you will, because … during the next commercial break, while watching a fund family’s newest media campaign, we want to make it easier for you to gauge how well a fund family has performed against its peers.

The current playing field has about 6200 US funds packaged and usually marketed in 225 families. For our tally, each family includes at least 5 funds with ages 3 years or more. Oldest share class only, excluding money market, bear, trading, and specialized commodity funds. Though the numbers sound high, the field is actually dominated by just five families, as shown below:

It is interesting that while Vanguard represents the largest family by AUM, with nearly twice its nearest competitor, its average annual ER of 0.22% is less than one third either Fidelity or American Funds, at 0.79% and 0.71%, respectively. So, even without front loads, which both the latter use to excess, they are likely raking in much more in fees than Vanguard.

Ranking each of the 225 families based on number of funds that beat their category averages produces the following score card, by quintile, best to worst:

Of the five families, four are in top two quintiles: Vanguard, American Funds, Fidelity, and T. Rowe Price.  In fact, of Vanguard’s 145 funds, 119 beat their peers. Extraordinary. But BlackRock is just average, like Hartford.

The difference in average total return between top and bottom fund families on score card is 3.1% per year!

The line-ups of some of the bottom quintile families include 100% under-performers, where every fund has returned less than its peers over their lifetimes: Commonwealth, Integrity, Lincoln, Oak Associates, Pacific Advisors, Pacific Financial, Praxis, STAAR. Do you think their investors know? Do the investors of Goldman Sachs know that their funds are bottom quintile … written-off to survivorship bias possibly?

Visiting the website of Oberweis, you don’t see that four of its six funds under-performed. Instead, you find: TWO FUNDS NAMED “BEST FUND” IN 2015 LIPPER AWARDS. Yes, its two over-performers.

While the line-ups of some top quintile families include 100% over-performers: Cambiar, Causeway, Dodge & Cox, First Eagle, Marsico, Mirae, Robeco, Tocqueville.

Here is a summary of some of the current best and worst:

While not meeting the “five funds” minimum, some other notables: Tweedy Browne has 4 of 4 over-performers, and Berwyn, FMI, Mairs & Power, Meridian, and PRIMECAP Odyssey all have 3 of 3.

(PRIMECAP is an interesting case. It actually advises 6 funds, but 3 are packaged as part of the Vanguard family. All 6 PRIMECAP advised funds are long-term overperformers … 3.4% per year across an average of 15 years! Similarly with OakTree. All four of its funds beat their peers, but only 2 under its own name.)

As well as younger families off to great starts: KP, 14 of 14 over-performers, Rothschild 7 of 7, Gotham 5 of 5, and Grandeur Peak 4 of 4. We will find a way to call attention to these funds too on the future “Fund Family Score Card.”

Ed is on assignment, staking out a possible roach motel

Our distinguished senior colleague Ed Studzinski is a deep-value investor; his impulse is to worry more about protecting his investors when times turn dark than in making them as rich as Croesus when the days are bright and sunny. He’s been meditating, of late, on the question of whether there’s anything a manager today might do that would reliably protect his investors in the case of a market crisis akin to 2008.

Ed is one of a growing number of investors who are fearful that we might be approaching a roach motel; that is, a situation where it’s easy to get into a particular security but where it might be impossible to get back out of it when you urgently want to.

Structural changes in the market and market regulations have, some fear, put us at risk for a liquidity crisis. In a liquidity crisis, the ability of market makers to absorb the volume of securities offered for sale and to efficiently match buyers and sellers disappears. A manager under pressure to sell a million dollars’ worth of corporate bonds might well find that there’s only a market for two-thirds of that amount, the remaining third could swiftly become illiquid – that is, unmarketable – securities.

David Sherman, president of Cohanzick Asset Management and manager of two RiverPark’s non-traditional bond funds addressed the issue in his most recent shareholder letter. I came away from it with two strong impressions:

There may be emerging structural problems in the investment-grade fixed-income market. At base, the unintended consequences of well-intended reforms may be draining liquidity from the market (the market makers have dramatically less cash and less skin in the game than they once did) and making it hard to market large fixed-income sales. An immediate manifestation is the problem in getting large bond issuances sold.

Things might get noticeably worse for folks managing large fixed-income portfolios. His argument is that given the challenges facing large bond issues, you really want a fund that can benefit from small bond issues. That means a small fund with commitments to looking beyond the investment-grade universe and to closing before size becomes a hindrance.

Some of his concerns are echoed on a news site tailored for portfolio managers, ninetwentynine.com. An article entitled “Have managers lost sight of liquidity risk?” argues:

A liquidity drought in the bond space is a real concern if the Fed starts raising rates, but as the Fed pushes off the expected date of its first hike, some managers may be losing sight of that danger. That’s according to Fed officials, who argue that if a rate hike catches too many managers off their feet, the least they can expect is a taper tantrum similar to 2013, reports Reuters. The worst-case-scenario is a full-blown liquidity crisis.

The most recent investor letter from the managers of Driehaus Active Income Fund (LCMAX) warns that recent structural changes in the market have made it increasingly fragile:

Since the end of the credit crisis, there have been a number of structural changes in the credit markets, including new regulations, a reduced size of broker dealer trading desks, changes in fund flows, and significant growth of larger index-based mutual funds and ETFs. The “new” market environment and players have impacted nearly all aspects of the market, including trading liquidity. The transfer of risk is not nearly as orderly as it once was and is now more expensive and volatile … one thing nearly everyone can agree on is that liquidity in the credit markets has decreased materially since the credit crisis.

The federal Office of Financial Research concurs: “Markets have become more brittle because liquidity may be less available in a downturn.” Ben Inker, head of GMO’s asset allocation group, just observed that “the liquidity in [corporate credit] markets has become shockingly poor.”

More and more money is being stashed in a handful of enormous fixed income funds, active and passive. In general, those might be incredibly regrettable places to be when liquidity becomes constrained:

Generally speaking, you’re going to need liquidity in your bond fund when the market is stressed. When the market is falling apart, the ETFs are the worst place to be, as evidenced by their underperformance to the index in 2008, 2011 and 2013. So yes, you will have liquidity, but it will be in something that is cratering.

What does this mean for you?

1. Formerly safe havens won’t necessarily remain safe.
2. You need to know what strategy your portfolio manager has for getting ahead of a liquidity crunch and for managing during it. The Driehaus folks list seven or eight sensible steps they’ve taken and Mr. Sherman walks through the structural elements of his portfolio that mitigate such risks.
3. If your manager pretend not to know what the concern is or suggests you shouldn’t worry your pretty little head about it, fire him.

In the interim, Mr. Studzinski is off worrying on your behalf, talking with other investors and looking for a safe(r) path forward. We’re hoping that he’ll return next month with word of what he’s found.

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized and filtered as never before. For the complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

Orders

• The SEC charged BlackRock Advisors with breaching its fiduciary duty by failing to disclose a conflict of interest created by the outside business activity of a top-performing portfolio manager. BlackRock agreed to settle the charges and pay a $12 million penalty.
• In a blow to Putnam, the Second Circuit reinstated fraud and negligence-based claims made by the insurer of a swap transaction. The insurer alleges that Putnam misrepresented the independence of its management of a collateralized debt obligation. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)

New Appeals

• Plaintiffs have appealed the lower court’s dismissal of an ERISA class action regarding Fidelity‘s practices with respect to the so-called “float income” generated from plan participants’ account transactions. (In re Fid. ERISA Float Litig.)

Briefs

• Plaintiffs filed their opposition to Davis‘s motion to dismiss excessive-fee litigation regarding the New York Venture Fund. Brief: “Defendants’ investment advisory fee arrangements with the Davis New York Venture Fund . . . epitomize the conflicts of interest and potential for abuse that led Congress to enact § 36(b). Unconstrained by competitive pressures, Defendants charge the Fund advisory fees that are as much as 96% higher than the fees negotiated at arm’s length by other, independent mutual funds . . . for Davis’s investment [sub-]advisory services.” (In re Davis N.Y. Venture Fund Fee Litig.)
• Plaintiffs filed their opposition to PIMCO‘s motion to dismiss excessive-fee litigation regarding the Total Return Fund. Brief: “In 2013 alone, the PIMCO Defendants charged the shareholders of the PIMCO Total Return Fund $1.5 billion in fees, awarded Ex-head of PIMCO, Bill Gross, a $290 million bonus and his second-in-command a whopping $230 million, and ousted a Board member who dared challenge Gross’s compensation—all this despite the Fund’s dismal performance that trailed 70% of its peers.” (Kenny v. Pac. Inv. Mgmt. Co.)
• In the purported class action regarding alleged deviations from two fundamental investment objectives by the Schwab Total Bond Market Fund, the Investment Company Institute and Independent Directors Council filed an amici brief in support of Schwab’s petition for rehearing (and rehearing en banc) of the Ninth Circuit’s 2-1 decision allowing the plaintiffs’ state-law claims to proceed. Brief: “The panel’s decision departs from long-standing law governing mutual funds and creates confusion and uncertainty nationwide.” Defendants include independent directors. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)

Amended Complaint

• Plaintiffs filed a new complaint in the fee litigation against New York Life, adding a fourth fund to the case: the MainStay High Yield Opportunities Fund. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

Answer

• P. Morgan filed an answer in an excessive-fee lawsuit regarding three of its bond funds. (Goodman v. J.P. Morgan Inv. Mgmt., Inc.)

The Alt Perspective: Commentary and News from Daily Alts

The spring has brought new life into the liquid alternatives market with both March and April seeing robust activity in terms of new fund launches and registrations, as well as fund flows. Touching on new fund flows first, March saw more than $2 billion of new asset flow into alternative mutual funds and ETFs, while US equity mutual funds and ETFs had combined outflows of nearly $6 billion.

At the top of the inflow rankings were international equity and fixed income, which provides a clear indication that investors were seeking both potentially higher return equity markets (non-US equity) and shelter (fixed income and alternatives). With increased levels of volatility in the markets, I wouldn’t be surprised to see this cash flow trend continue on into April and May.

New Funds Launched in April

We logged eight new liquid alternative funds in April from firms such as Prudential, Waycross, PowerShares and LoCorr. No particular strategy stood out as being dominant among the eight funds as they ranged from long/short equity and alternative fixed income strategies, to global macro and multi-strategy. A couple highlights are as follows:

1) LoCorr Multi-Strategy Fund – To date, LoCorr has done a thoughtful job of brining high quality managers to the liquid alts market, and offers funds that cover managed futures, long/short commodities, long/short equity and alternative income strategies. In this new fund, they bring all of these together in a single offering, making it easier for investors to diversify with a single fund.

2) Exceed Structured Shield Index Strategies Fund – This is the first of three new mutual funds that provide investors with a structured product that is designed to protect downside volatility and provide a specific level of upside participation. The idea of a more defined outcome can be appealing to a lot of investors, and will also help advisors figure out where and how to use the fund in a portfolio.

New Funds Registered in April

Fund registrations are where we see what is coming a couple months down the road – a bit like going to the annual car show to see what the car manufacturers are going to be brining out in the new season. And at this point, it looks like June/July will be busy as we counted 9 new alternative fund registration in April. A couple interesting products are listed below:

1) Hatteras Market Neutral Fund – Hatteras has been around the liquid alts market for quite some time, and with this fund will be brining multiple managers in as sub-advisors. Market neutral strategies are appealing at times when investors are looking to take risk off the table yet generate returns that are better than cash. They can also serve as a fixed income substitute when the outlook is flat to negative for the fixed income market.

2) Franklin K2 Long Short Credit Fund – K2 is a leading fund of hedge fund manager that works with large institutional investors to invest in and manage portfolios of hedge funds. The firm was acquired by Franklin Templeton back in 2012 and has so far launched one alternative mutual fund. The fund will be managed by multiple sub-advisors and will allocate to several segments of the fixed income market. 

Debunking Active Share

High active share does not equal high alpha. I’ll say that again. High active share does not equal high alpha. This is the finding in a new AQR white paper that essentially proves false two of the key tenents of a 2009 research paper (How Active is Your Fund Manager? A New Measure That Predicts Performance) by Martijn Cremers and Antti Petajisto. These two tenents are:

1) Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.

2) Non-index funds with the lowest Active Share underperform their benchmarks.

AQR explains that other factors are in play, and those other factors actually explain the outperformance that Cremers and Petajisto found in their work. You can read more here: AQR Deactivates Active Share in New White Paper.

And finally, for anyone considering the old “Sell in May and Go Away” strategy this month, be sure to have a read of this article, or watch this video. Or, better yet, just make a strategic allocation to a few solid alternative funds that have some downside protection built into them.

Feel free to stop by DailyAlts.com for more coverage of liquid alternatives.

Observer Fund Profiles:

Each month the Observer provides in-depth profiles of between two and four funds. Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds. “Stars in the Shadows” are older funds that have attracted far less attention than they deserve.

Seafarer Overseas Growth & Income (SFGIX/SIGIX): Our contention has always been that Seafarer represents one of the best possible options for investors interested in approaching the emerging markets. A steadily deepening record and list of accomplishments suggests that we’re right.

Towle Deep Value Fund (TDVFX): This fund positions itself a “an absolute value fund with a strong preference for staying fully invested.” For the past 33 years, Mr. Towle & Co. have been consistently successful at turning over more rock – in under covered small caps and international stocks alike – to find enough deeply undervalued stocks to populate the portfolio and produce eye-catching results.

Conference Call Highlights: Seafarer Overseas Growth & Income

Here are some quick highlights from our April 16^th conversation with Andrew Foster of Seafarer.

Seafarer’s objective: Andrew’s hope is to outperform his benchmark (the MSCI EM index) “slowly but steadily over time.” He describes the approach as a “relative return strategy” which pursues growth that’s more sustainable than what’s typical in developing markets while remaining value conscious.

Here’s the strategy: you need to start by understanding that the capital markets in many EM nations are somewhere between “poorly developed” and “cruddy.” Both academics and professional investors assume that a country’s capital markets will function smoothly: banks will make loans to credit-worthy borrowers, corporations and governments will be able to access the bond market to finance longer-term projects and stocks will trade regularly, transparently and at rational expense.

None of that may safely be assumed in the case of emerging markets; indeed, that’s what might distinguish an “emerging” market from a developed one. The question becomes: what are the characteristics of companies that might thrive in such conditions.

The answer seems to be (1) firms that can grow their top line steadily in the 7-15% per annum range and (2) those that can finance their growth internally. The focus on the top line means looking for firms that can increase revenues by 7-15% without obsessing about similar growth in the bottom line. It’s almost inevitable that EM firms will have “stumbles” that might diminish earnings for one to three years; while you can’t ignore them, you also can’t let them drive your investing decisions. “If the top line grows,” Andrew argues, “the bottom line will follow.” The focus on internal financing means that the firms will be capable of funding their operations and plans without needing recourse to the unreliable external sources of capital.

Seafarer tries to marry that focus on sustainable moderate growth “with some current income, which is a key tool to understanding quality and valuation of growth.” Dividends are a means to an end; they don’t do anything magical all by themselves. Dividends have three functions. They are:

An essential albeit crude valuation tool – many valuation metrics cannot be meaningfully applied across borders and between regions; there’s simply too much complexity in the way different markets operate. Dividends are a universally applicable measure.

A way of identifying firms that will bounce less in adverse market conditions – firms with stable yields that are just “somewhat higher than average” tend to be resilient. Firms with very high dividend yields are often sending out distress signals. 

A key and under-appreciated signal for the liquidity and solvency of a company – EMs are constantly beset by liquidity and credit shocks and unreliable capital markets compound the challenge. Companies don’t survive those shocks as easily as people imagine. The effects of liquidity and credit crunches range from firms that completely miss their revenue and earnings forecasts to those that drown themselves in debt or simply shutter. Against such challenges dividends provide a clear and useful signal of liquidity and solvency.

It’s certainly true that perhaps 70% of the dispersion of returns over a 5-to-10 year period are driven by macro-economic factors (Putin invades-> the EU sanctions-> economies falter-> the price of oil drops-> interest rates fall) but that fact is not useful because such events are unforecastable and their macro-level impacts are incalculably complex (try “what effect will European reaction to Putin’s missile transfer offer have on shadow interest rates in China?”). 

Andrew believes he can make sense of the ways in which micro-economic factors, which drive the other 30% of dispersion, might impact individual firms. He tries to insulate his portfolio, and his investors, from excess volatility by diversifying away some of the risk, imagining a “three years to not quite forever” time horizon for his holdings and moving across a firm’s capital structure in pursuit of the best risk-return balance.

While Seafarer is classified as an emerging markets equity fund, common stocks have comprised between 70-85% of the portfolio. “There’s way too much attention given to whether a security is a stock or bond; all are cash flows from an issuer. They’re not completely different animals, they’re cousins. We sometimes find instruments trading with odd valuations, try to exploit that.” As of January 2015, 80% of the fund is invested directly in common stock; the remainder is invested in ADRs, hard- and local-currency convertibles, government bonds and cash. The cash stake is at a historic low of 1%.

Thinking about the fund’s performance: Seafarer is in the top 3% of EM stock funds since launch, returning a bit over 10% annually. With characteristic honesty and modesty, Andrew cautions against assuming that the fund’s top-tier rankings will persist in the next part of the cycle:

We’re proud of performance over the last few years. We have really benefited from the fact that our strategy was well-positioned for anemic growth environments. Three or four years ago a lot of people were buying the story of vibrant growth in the emerging markets, and many were willing to overpay for it. As we know, that growth did not materialize. There are signs that the deceleration of growth is over even if it’s not clear when the acceleration of growth might begin. A major source of return for our fund over 10 years is beta. We’re here to harness beta and hope for a little alpha.

That said, he does believe that flaws in the construction of EM indexes makes it more likely that passive strategies will underperform:

I’m actually a fan of passive investing if costs are low, churn is low, and the benchmark is soundly constructed. The main EM benchmark is disconnected from the market. The MSCI EM index imposes filters for scalability and replicability in pursuit of an index that’s easily tradable by major investors. That leads it to being not a really good benchmark. The emerging markets have $14 trillion in market capitalization; the MSCI Core index captures only $3.8 trillion of that amount and the Total Market index captures just $4.2 trillion. In the US, the Total Stock Market indexes capture 80% of the market. The comparable EM index captures barely 25%.

Highlights from the questions:

As a practical matter, a 4-5% position is “huge for us” though he has learned to let his winners run a little longer than he used to, so the occasional 6% position wouldn’t be surprising.

A focus on dividend payers does not imply a focus on large cap stocks. There are a lot of very stable dividend-payers in the mid- to small-cap range; Seafarer ranges about 15-20% small cap and 35-50% midcap.

The fundamental reason to consider investing in emerging markets is because “they are really in dismal shape, sometimes the horrible things you read about them are true but there’s an incredibly powerful drive to give your kids a better life and to improve your life. People will move mountains to make things better. I followed the story of one family who were able to move from a farmhouse with a dirt floor to a comfortable, modern townhouse in one lifetime. It’s incredibly inspiring, but it’s also incredibly powerful.”

With special reference to holdings in Eastern Europe, you need to avoid high-growth, high-expectation companies that are going to get shell-shocked by political turmoil and currency devaluation. It’s important to find companies that have already been hit and that have proved that they can survive the shock.

Bottom line: Andrew has a great track record built around winning by not losing. His funds have posted great relative returns in bad markets and very respectable absolute returns in frothy ones. While he is doubtless correct in saying that the fund was unique well-suited to the current market and that it won’t always be a market leader, it’s equally correct to say that this is one of the most consistently risk-conscious, more consistently shareholder-sensitive and most consistently rewarding EM funds available. Those are patterns that I’ve found compelling.

We’ve also updated our featured fund page for Seafarer.

Funds in Registration

New mutual funds must be registered with the Securities and Exchange Commission before they can be offered for sale to the public. The SEC has a 75-day window during which to call for revisions of a prospectus; fund companies sometimes use that same time to tweak a fund’s fee structure or operating details.

Funds in registration this month are eligible to launch in late June and some of the prospectuses do highlight that date.

This month our research associate David Welsch tracked down 14 no-load retail funds in registration, which represents our core interest. By far the most interest was stirred by the announcement of three new Grandeur Peak funds:

• Global Micro Cap
• International Stalwarts
• Global Stalwarts

The launch of Global Micro Cap has been anticipated for a long time. Grandeur Peak announced two things early on: (1) that they had a firm wide strategy capacity of around $3 billion, and (2) they had seven funds in the works, including Global Micro, which were each allocated a set part of that capacity. Two of the seven projected funds (US Opportunities and Global Value) remain on the drawing board. President Eric Huefner remarks that “Remaining nimble is critical for a small/micro cap manager to be world-class,” hence “we are terribly passionate about asset capping across the firm.” 

The surprise comes with the launch of the two Stalwarts funds, whose existence was previously unanticipated. Folks on our discussion board reacted with (thoughtful) alarm. Many of them are GP investors and they raised two concerns: (1) this might signal a change in corporate culture with the business managers ascendant over the asset managers, and (2) a move into larger capitalizations might move GP away from their core area of competence.

Because they’re in a quiet period, Eric was not able to speak about these concerns though he did affirm that they’re entirely understandable and that he’d be able to address them directly after launch of the new funds.

While I am mightily amused by the title GUARDIAN MANAGER given to Robert Gardiner to explain his role with the new funds, I’m not immediately distressed by these developments. “Stalwarts” has always been a designation for one of the three sorts of stocks that the firm invests in, so presumably these are stocks that the team has already researched and invested in. Many small cap managers find an attraction in these “alumni” stocks, which they know well and have confidence in but which have outgrown their original fund. Such funds also offer a firm the ability to increase its strategy capacity without compromising its investment discipline. I’ll be interested in hearing from Mr. Heufner later this summer and, perhaps, in getting to tap of Mr. Gardiner’s shield.

Manager Changes

A lot of funds were liquidated this month, which means that a lot of managers changed from “employed” to “highly motivated investment professional seeking to make a difference.” Beyond that group, 43 funds reported partial or complete changes in their management teams. The most striking were:

• The departure of Independence Capital Asset Partners from LS Opportunity Fund, about which there’s more below.
• The departure of Robert Mohn from both Columbia Acorn Fund (ACRNX) and Columbia Acorn USA (AUSAX) and from his position as their Domestic CIO. Mr. Mohn joined the fund in late 2003 shortly after the retirement of the legendary Ralph Wanger. He initially comanaged the fund with John Park (now of Oakseed Opportunity SEEDX) and Chuck McQuaid (now manager of Columbia Thermostat (CTFAX). Mr. Mohn is being succeeded by Zachary Egan, President of the adviser, and the estimable Fritz Kaegi, one of the managers of Columbia Acorn Emerging Markets (CAGAX). They’ll join David Frank who remained on the fund.

Updates

Centaur Total Return (TILDX) celebrated its 10-year anniversary in March, so I wish we’d reported the fact back then. It’s an interesting creature. Centaur started life as Tilson Dividend, though Whitney Tilson never had a role in its management. Mr. Tilson thought of himself (likely “thinks of himself”) as a great value investor, but that claim didn’t play out in his Tilson Focus Fund so he sort of gave up and headed to hedge fund land. (Lately he’s been making headlines by accusing Lumber Liquidators, a company his firm has shorted, of deceptive sales practices.) Mr. Tilson left and the fund was rechristened as Centaur.

Centaur’s record is worth puzzling over.  Morningstar gives it a ten-year ranking of five stars, a three-year ranking of one star and three stars overall. Over its lifetime it has modestly better returns and vastly lower risks than its peers which give it a great risk-adjusted performance.

Mostly it has great down market protection and reasonable upmarket performance, which works well if the market has both ups and downs. When the market has a whole series of strong gains, conservative value investors end up looking bad … until they look prescient and brilliant all over again.

There’s an oddly contrarian indicator in the quick dismissal of funds like Centaur, whose managers have proven adept and disciplined. When the consensus is “one star, bunch of worthless cash in the portfolio, there’s nothing to see here,” there might well be reason to start thinking more seriously as folks with a bunch of …

In any case, best anniversary wishes to manager Zeke Ashton and his team.

Briefly Noted . . .

American Century Investments, adviser to the American Century Funds, has elected to support the America’s Best Communities competition, a $10 million project to stimulate economic revitalization in small towns and cities across the country. At this point, 50 communities have registered first round wins. The ultimate winner will receive a $3 million economic development grant from a consortium of American firms.

In the interim, American Century has “adopted” Wausau, Wisconsin, which styles itself “the Chicago of the north.” (I suspect many of you think of Chicago as “the Chicago of the north,” but that’s just because you’re winter wimps.) Wausau won $35,000 which will be used to develop a comprehensive plan for economic revival and cultural enrichment. American Century is voluntarily adding another $15,000 to Wausau’s award and will serve as a sort of consultant to the town as they work on preparing a plan. It’s a helpful gesture and worthy of recognition.

LS Opportunity Fund (LSOFX) is about to become … well, something else but we don’t know what. The fund has always been managed by Independence Capital Asset Partners in parallel with ICAP’s long/short hedge fund. On April 23, 2015, the fund’s board terminated ICAP’s contract because of “certain portfolio management changes expected to occur within the sub-adviser.” On April 30, the board named Prospector Partners LLC has the fund’s interim manager, presumably with the expectation that they’ll be confirmed in June as the permanent replacement for ICAP. Prospector is described as “an investment adviser registered with the Securities and Exchange Commission with its principal offices [in] Guilford, CT. Prospector currently provides investment advisory services to corporations, pooled investment vehicles, and retirement plans.” Though they don’t mention it, Prospector also serves as the adviser to two distinctly unexciting long-only mutual funds: Prospector Opportunity (POPFX) and Prospector Capital Appreciation (PCAFX). LSOFX is a rated by Morningstar as a four-star fund with $170 million in assets, which makes the change both consequential and perplexing. We’ll share more as soon as we can.

Northern Global Tactical Asset Allocation Fund (BBALX) has added hedging via derivatives to the list of its possible investments: “In addition, the Fund also may invest directly in derivatives, including but not limited to forward currency exchange contracts, futures contracts and options on futures contracts, for hedging purposes.”

Gargoyle is on the move. RiverPark Funds is in the process of transferring control of RiverPark Gargoyle Hedged Value Fund (RGHVX) to TCW where it will be renamed … wait for it … TCW/Gargoyle Hedged Value Fund. It’s a solid five star fund with $73 million in assets. That latter number is what has occasioned the proposed move which shareholders will still need to ratify.

RiverPark CEO Morty Schaja notes that the strategy has spectacular long-term performance (it was a hedge fund before becoming a mutual fund) but that it’s devilishly hard to market. The fund uses two distinct strategies: a quantitatively driven relative value strategy for its stock portfolio and a defensive options overlay. While the options provide income and some downside protection, the fund does not pretend to being heavily hedged much less market neutral. As a result, it has a lot more downside volatility than the average long-short fund (it was down 34% in 2008, for example, compared with 15% for its peers) but also a more explosive upside (gaining 42% in 2009 against 10% for its peers). That’s not a common combination and RiverPark’s small marketing team has been having trouble finding investors who understand and value the combination. TCW is interested in developing a presence in “the liquid alts space” and has a sales force that’s large enough to find the investors that Gargoyle is seeking.

Expenses will be essentially unchanged, though the retail minimum will be substantially higher.

Zacks Small-Cap Core Fund (ZSCCX) has raised its upper market cap limit to $10.3 billion, which hardly sounds small cap at all.  That’s the range of stocks like Staples (SPLS) and L-3 Communications (LLL) which Morningstar classifies as mid-caps.

SMALL WINS FOR INVESTORS

Touchstone Merger Arbitrage Fund (TMGAX) has reopened to a select subset of investors: RIAs, family offices, institutional consulting firms, bank trust departments and the like. It’s fine as market-neutral funds go but they don’t go very far: TMGAX has returned under 2% annually over the past three years.  On whole, I suspect that RiverPark Structural Alpha (RSAFX) remains the more-attractive choice.

CLOSINGS (and related inconveniences)

Effective May 15, 2015, Janus Triton (JGMAX) and Janus Venture (JVTAX) are soft closing, albeit with a bunch of exceptions. Triton fans might consider Meridian Small Cap Growth, run by the team that put together Triton’s excellent record.

Effective at the close of business on May 29, 2015, MFS International Value Fund (MGIAX) will be closed to new investors

Effective June 1, 2015, the T. Rowe Price Health Sciences Fund (PRHSX) will be closed to new investors. 

Vulcan Value Partners (VVLPX) has closed to new investors. The firm closed its Small Cap strategy, including its small cap fund, in November of 2013, and closed its All Cap Program in early 2014. Vulcan closed, without advance notice, its Large Cap Programs – which include Large Cap, Focus and Focus Plus in late April. All five of Vulcan Value Partners’ investment strategies are ranked in the top 1% of their respective peer groups since inception.

OLD WINE, NEW BOTTLES

Effective April 30, 2015, American Independence Risk-Managed Allocation Fund (AARMX) was renamed the American Independence JAForlines Risk-Managed Allocation Fund. The objective, strategies and ticker remained the same. Just to make it unsearchable, Morningstar abbreviates it as American Indep JAFrl Risk-Mgd Allc A.

Effective on June 26, 2015 Intrepid Small Cap Fund (ICMAX) becomes Intrepid Endurance Fund and will no longer to restricted to small cap investing. It’s an understandable move: the fund has an absolute value focus, there are durned few deeply discounted small cap stocks currently and so cash has built up to become 60% of the portfolio. By eliminating the market cap restriction, the managers are free to move further afield in search of places to deploy their cash stash.

Effective June 15, 2015, Invesco China Fund (AACFX) will change its name to Invesco Greater China Fund.

Effective June 1, 2015, Pioneer Long/Short Global Bond Fund (LSGAX) becomes Pioneer Long/Short Bond Fund. Since it’s nominally not “global,” it’s no longer forced to place at least 40% outside of the U.S. At the same time Pioneer Multi-Asset Real Return Fund (PMARX) will be renamed Pioneer Flexible Opportunities.

As of May 1, 2015 Royce Opportunity Select Fund (ROSFX) became Royce Micro-Cap Opportunity Fund. For their purposes, micro-caps have capitalizations up to $1 billion. The Fund will invest, under normal circumstances, at least 80% of its net assets in equity securities of companies with stock market capitalizations up to $1 billion. In addition, the Fund’s operating policies will prohibit it from engaging in short sale transactions, writing call options, or borrowing money for investment purposes.

At the same time, Royce Value Fund (RVVHX) will be renamed Royce Small-Cap Value Fund and will target stocks with capitalizations under $3 billion. Royce Value Plus Fund (RVPHX) will be renamed Royce Smaller-Companies Growth Fund with a maximum market cap at time of purchase of $7.5 billion.

OFF TO THE DUSTBIN OF HISTORY

AlphaMark Small Cap Growth Fund (AMSCX) has been terminated; the gap between the announcement and the fund’s liquidation was three weeks. It wasn’t a bad fund at all, three stars from Morningstar, middling returns, modest risk, but wasn’t able to gain enough distinction to become economically viable. To their credit, the advisor stuck with the fund for nearly seven years before succumbing.

American Beacon Small Cap Value II Fund (ABBVX) will liquidate on May 12. The advisor cites a rare but not unique occurrence to explain the decision: “after a large redemption which is expected to occur in April 2015 that will substantially reduce the Fund’s asset size, it will no longer be practicable for the Manager to operate the Fund in an economically viable manner.”

Carlyle Core Allocation Fund (CCAIX) and Enhanced Commodity Real Return (no ticker) liquidate in mid-May.  

The Citi Market Pilot 2030 (CFTYX) and 2040 (CFTWX) funds each liquidated on about one week’s notice in mid-April; the decision was announced April 9 and the portfolio was liquidated April 17. They lasted just about one year.

The Trustees have voted to liquidate and terminate Context Alternative Strategies Fund (CALTX) on May 18, 2015.

Contravisory Strategic Equity Fund (CSEFX), a tiny low risk/low return stock fund, will liquidate in mid-May. 

Dreyfus TOBAM Emerging Markets Fund (DABQX) will be liquidated on or about June 30, 2015.

Franklin Templeton is thinning down. They merged away one of their closed-end funds in April. They plan to liquidate the $38 million Franklin Global Asset Allocation Fund (FGAAX) on June 30. Next the tiny Franklin Mutual Recovery Fund (FMRAX) is looking, with shareholder approval, to merge into the Franklin Mutual Quest Fund (TEQIX) likely around the end of August.

The Jordan Fund (JORDX) is merging into the Meridian Equity Income Fund (MRIEX), pending shareholder approval. The move is more sensible than it looks. Mr. Jordan has been running the fund for a decade but has little to show for it. He had five strong years followed by five lean ones and he still hasn’t accumulated enough assets to break even. Minyoung Sohn took over MRIEX last October but has only $26 million to invest; the JORDX acquisition will triple the fund’s size, move it toward financial equilibrium and will get JORDX investors a noticeable reduction in fees.

Leadsman Capital Strategic Income Fund (LEDRX) was liquidated on April 7, 2015, based on the advisor’s “representations of its inability to market the Fund and the Adviser’s indication that it does not desire to continue to support the Fund.” They lost interest in it? Okay, on the one hand there was only $400,005 in the fund. On the other hand, they launched it exactly six months before declaring failure and going home. I’m perpetually stunned by advisors who pull the plug after a few months or a year. I mean, really, what does that say about the quality of their business planning, much less their investment acumen?

I wonder if we should make advisers to new funds post bail? At launch the advisor must commit to running the fund for no less than a year (or two or three). They have to deposit some amount ($50,000? $100,000?) with an independent trustee. If they close early, they forfeit their bond to the fund’s investors. That might encourage more folks to invest in promising young funds by hedging against one of the risks they face and it might discourage “let’s toss it against the wall and see if anything sticks” fund launches.

Manning & Napier Inflation Focus Equity Series (MNIFX) will liquidate on May 11, 2015.

Merk Hard Currency ETF (formerly HRD) has liquidated. Hard currency funds are, at base, a bet against the falling value of the US dollar. Merk, for example, defines hard currencies as “currencies backed by sound monetary policy.” That’s really not been working out. Merk’s flagship no-load fund, Merk Hard Currency (MERKX), is still around but has been bleeding assets (from $280M to $160M in a year) and losing money (down 2.1% annually for the past five years). It’s been in the red in four of the past five years and five of the past ten. Here’s the three-year picture.

Presumably if investors stop fleeing to the safe haven of US Treasuries there will be a mighty reversal of fortunes. The question is whether investors can (or should) wait around until then. Can you say “Grexit”?

Effective May 1, 2015, Royce Select Fund I (RYSFX) will be closed to all purchases and all exchanges into the Fund in anticipation of the fund being absorbed into the one-star Royce 100 Fund (ROHHX). Mr. Royce co-manages both but it’s still odd that they buried a three-star small blend fund into a one-star one.

The Turner Funds will close and liquidate the Turner Titan Fund (TTLFX), effective on or about June 1, 2015. It’s a perfectly respectable long/short fund in which no one had any interest.

The two-star Voya Large Cap Growth Fund (ILCAX) is slated to be merged into the three-star Voya Growth Opportunities Fund (NLCAX). Same management team, same management fee, same performance: it’s pretty much a wash.

In Closing . . .

The first issue of the Observer appeared four years ago this month, May 2011. We resolved from the outset to try to build a thoughtful community here and to provide them with insights about opportunities and perspectives that they might never otherwise encounter. I’m not entirely sure of how well we did, but I can say that it’s been an adventure and a delight. We have a lot yet to accomplish and we’re deeply hopeful you’ll join us in the effort to help investors and independent managers alike. Each needs the other.

Thanks, as ever, to the folks – Linda, who celebrates our even temperament, Bill and James – who’ve clicked on our elegantly redesigned PayPal link. Thanks, most especially, to Deb and Greg who’ve been in it through thick and thin. It really helps.

A word of encouragement: if you haven’t already done so, please click now on our Amazon link and either bookmark it or set it as one of the start pages in your browser. We receive a rebate equivalent to 6-7% of the value of anything you purchase (books, music, used umbrellas, vitamins …) through that link. It costs you nothing since it’s part of Amazon’s marketing budget and if you bookmark it now, you’ll never have to think about it again.

We’re excited about the upcoming Morningstar conference. All four of us – Charles, Chip, Ed and I – will be around the conference and at least three of us will be there from beginning to end, and beyond. Highlights for me:

• The opportunity to dine with the other Observer folks at one of Ed’s carefully-vetted Chicago eateries.
• Two potentially excellent addresses – an opening talk by Jeremy Grantham and a colloquy between Bill Nygren and Steve Romick
• A panel presentation on what Morningstar considers off-the-radar funds: the five-star Mairs & Power Small Cap (MSCFX, which we profiled late in 2011), Meridian Small Cap Growth (MSGAX, which we profiled late in 2014) and the five-star Eventide Gilead Fund (ETAGX, which, at $1.6 billion, is a bit beyond our coverage universe).
• A frontier markets panel presented by some “A” list managers.
• The opportunity to meet and chat with you folks. If you’re going to be at Morningstar, as exhibitor or attendee, and would like a chance to chat with one or another of us, drop me a note and we’ll try hard to set something up. We’d love to see you.

As ever,

 

Dear friends,

As I begin this essay the thermostat registers an attention-grabbing minus 18 degrees Fahrenheit.  When I peer out of the window nearest my (windowless) office, I’m confronted with:

All of which are sure and certain signs that it’s what? Yes, Spring Break in the Midwest!

Which funds? “Not ours,” saith Fidelity!

If you had a mandate to assemble a portfolio of the stars and were given virtually unlimited resources with which to identify and select the country’s best funds and managers, who would you pick? And, more to the point, how cool would it be to look over the shoulders of those who actually had that mandate and those resources?

Welcome to the world of the Strategic Advisers funds, an arm of Fidelity Investments dedicated to providing personalized portfolios for affluent clients. The pitch is simple: “we can do a better job of finding and matching investment managers, some not accessible to regular people, than you possibly could.” The Strategic Advisers funds have broad mandates, with names like Core Fund (FCSAX) and Value Fund (FVSAX). Most are funds of funds, explicitly including Fidelity funds in their selection universe, or they’re hybrids between a fund-of-funds and a fund where other mutual fund managers contribute individual security names.

SA celebrates its manager research process in depth and in detail. The heart of it, though, is being able to see the future:

Yet all too often, yesterday’s star manager becomes tomorrow’s laggard. For this reason, Strategic Advisers’ investment selection process emphasizes looking forward rather than backward, and seeks consistency, not of performance per se, but of style and process.

They’re looking for transparent, disciplined, repeatable processes, stable management teams and substantial personal investment by the team members.

The Observer researched the top holdings of every Strategic Advisers fund, except for their target-date series since those funds just invest in the other SA funds. Here’s what we found:

A small handful of Fidelity funds found their way in. Only four of the eight domestic equity funds had any Fido fund in the sample and each of those featured just one fund. The net effect: Fidelity places something like 95-98% of their domestic equity money with managers other than their own. Fidelity funds dominate one international equity fund (FUSIX), while getting small slices of three others. Fidelity has little presence in core fixed-income funds but a larger presence in the two high-yield funds.

The Fidelity funds most preferred by the SA analysts are:

Blue Chip Growth (FBGRX), a five-star $19 billion fund whose manager arrived in 2009, just after the start of the current bull market. Not clear what happens in less hospitable climates.

Capital & Income (FAGIX), five star, $10 billion high yield hybrid fund It’s classified as high-yield bond but holds 17% of its portfolio in the stock of companies that have issued high-yield debt.

Emerging Markets (FEMKX), a $3 billion fund that improved dramatically with the arrival of manager Sammy Simnegar in October, 2012.

Growth Company (FDGRX), a $40 billion beast that Steven Wymer has led since 1997. Slightly elevated volatility, substantially elevated returns.

Advisor Stock Selector Mid Cap (FSSMX), which got new managers in 2011 and 2012, then recently moved from retail to Advisor class. The long term record is weak, the short term record is stronger.

Conservative Income Bond (FCONX), a purely pedestrian ultra-short bond fund.

Diversified International (FDIVX), a fund that had $60 billion in assets, hit a cold streak around the financial crisis, and is down to $26 billion despite strong returns again under its long-time manager.

International Capital Appreciation (FIVFX), a small fund by Fido standards at $1.3 billion, which has been both bold and successful in the current upmarket. It’s run by the Emerging Markets guy.

International Discovery (FIGRX), a $10 billion upmarket darling that’s stumbled badly in down markets and whose discipline seems to wander. Making it, well, not disciplined.

Low-Priced Stock (FLPSX), Mr. Tillinghast has led the fund since 1989 and is likely one of the five best managers in Fidelity’s history. Which, at $50 billion, isn’t quite a secret.

Short Term Bond (FSHBX), another perfectly pedestrian, low-risk, undistinguished return bond fund. Meh.

Fidelity favors managers that are household names. No “undiscovered gems” here. The portfolios are studded with large, safe bets from BlackRock, JPMorgan, MetWest, PIMCO and T. Rowe.

DFA and Vanguard are missing. Utterly, though whether that’s Fidelity’s decision or not is unknown.

JPMorgan appears to be their favorite outside manager. Five different SA funds have invested in JPMorgan products including Core Bond, Equity Spectrum, Short Duration, US Core Plus Large Cap Select and Value Advantage.

The word “Focus” is notably absent. Core hold 550 positions, including funds and individual securities while Core Multi-Manager holds 360. Core Income holds a thousand while Core Income Multi-Managers holds 240 plus nine mutual funds. International owns two dozen funds and 400 stocks.

Some distinguished small funds do appear further down the portfolios. Pear Tree Polaris Foreign Value (QFVOX) is a 1% position in International. Wasatch Frontier Emerging Small Countries (WAFMX) was awarded a freakish 0.02% of Emerging Markets Fund of Funds (FLILX), as well as 0.6% in Emerging Markets (FSAMX). By and large, though, timidity rules!

Bottom Line: the tyranny of career risk rules! Most professional investors know that it’s better to be wrong with the crowd than wrong by yourself. That’s a rational response to the prospect of being fired, either by your investors or by your supervisor. That same pattern plays out in fund selection committees, including the college committee on which I sit. It’s much more important to be “not wrong” than to be “right.” We prefer choices that we can’t be blamed for. The SA teams have made just such choices: dozens of funds, mostly harmless, and hundreds of stocks, mostly mainstream, in serried ranks.

If you’ve got a full-time staff that’s paid to do nothing else, that might be manageable if not brilliant. For the rest of us, private and professional investors alike, it’s not.

One of the Observers’ hardest tasks is trying to insulate ourselves, and you, from blind adherence to that maxim. One of the reasons we’ll highlight one- and two-star funds, and one of the reasons I’ve invested in several, is to help illustrate the point that you need to look beyond the easy answers and obvious choices. With the steady evolution of our Multi-Search screener, we’re hoping to help folks approach that task more systematically. Details soon!

The Death of “Buy the unloved”

You know what Morningstar would say about a mutual fund that claimed a spiffy 20 year record but has switched managers, dramatically changed its investment strategy, went out of business for several years, and is now run by managers who are warning people not to buy the fund. You can just see the analysts’ soured, disbelieving expression and hear the incredulous “what is this cr…?”

Welcome to the world of Buy the Unloved, which used to be my favorite annual feature. Begun in 1993, the strategy drew up the indisputable observation that investors tend to be terrible at timing: over and over again they sell at the bottom and buy at the top. So here was the strategy: encourage people to buy what everyone else was selling and sell what everyone else was buying. The implementation was simple:

Identify the three fund categories that saw the greatest outflows, measured by percentage of assets, then buy good funds in each of those categories and prepare to hold them for three years. At the same time identify the three fund categories with the greatest inrush and sell them.

I liked it, it worked, then Morningstar stopped publishing it. Investment advisor Neil Stoloff provided an interesting history of the strategy, detailed on pages 12-16 of a 2011 essay he wrote. When they resumed, the strategy had a far more conservative take: buy the three sectors that saw the greatest outflows measured in total dollar volume and hold them, while selling the most popular sectors.

The problem with, and perhaps strength of, the newer version is that it means that you’ll mostly be limited to playing with your core sectors rather than volatile smaller ones. By way of example, large cap blend holds about $1.6 trillion – a 1% outflow there ($16 billion) would be an amount greater than the total assets in any of the 50 smallest fund categories. Large cap growth at $1.2 trillion is close behind.

Oh, by the way, they haven’t traditionally allowed bond funds to play. They track bond flows but, in a private exchange, Mr. Kinnel allowed that “Generally they are too dull to provide much of a signal.”

Morningstar now faces two problems:

1. De facto, the system is rigged to provide “sell” signals on core fund groups.
2. Morningstar is not willing to recommend that you ever sell core fund groups.

Katie Reichart’s 2013 presentation of the strategy (annoying video ahead) warned that “It can be used just on the margin…perhaps for a small percentage of their portfolio.” In 2014, it was “Add some to the unloved pile and trim from the loved” and by 2015 there was a flat-out dismissal of it: “I’m sharing the information for those who want to follow the strategy to the letter–but I wouldn’t do it.”

The headline:	The bottom line:
	So, I’m sharing the information for those who want to follow the strategy to the letter–but I wouldn’t do it. R. Kinnel

So what’s happened? Kinnel’s analysis seems odd but might well be consistent with the data:

But since 2008, performance and flows have decoupled on the asset-class level even though they continue to be linked on a fund level.

Now flows are more linked to headlines. Since 2008, some people have taken a pessimistic (albeit incorrect) view of America’s economy and looked to China as a superior bet. It hasn’t worked that way the past five years, and it leaves us in the odd position of seeing the nature of fund flows change.

I don’t actually know what that means.

Morningstar has released complete 2014 fund flow data, by fund family and fund category. (Thanks, Dan!) It reveals that investors fled from:

• US Large Growth (-41 billion)
• Bank Loans (-20 billion)
• High Yield Bonds (-16 billion).

Since two of the three areas are bonds, you’re not supposed to use those as a signal. And since the other is a core category buffeted by headline risk, really there’s nothing there, either. Further down the list, categories such as commodities and natural resources saw outflows of 10% or so. But those aren’t signals, either.

Whither goest investors?

• US Large Blend (+105 billion)
• International Large Blend (+92 billion)
• Intermediate Bonds (+34 billion)
• Non-traditional Bonds (+23 billion)

Two untouchable core categories, two irrelevant bond ones. Meanwhile, the Multialternative category saw an inrush of about 33% of its assets in a year. Too small in absolute terms to matter.

Bottom Line: Get serious or get rid of it. The underlying logic of the strategy is psychological: investors are too cowardly to do the right thing. On face, that’s afflicting Morningstar’s approach to the feature. If the data says it works, they need to screw up their courage and announce the unpopular fact that it might be time to back away from core stock categories. If the data says it doesn’t work, they need to screw up their courage, explain the data and end the game.

The current version, “for amusement only,” version serves no real purpose and no one’s interest.

 

Whitebox Tactical Opportunities 4Q14 Conference Call 

Portfolio managers Andrew Redleaf and Dr. Jason Cross, along with Whitebox Funds’ President Bruce Nordin and Mike Coffey, Head of Mutual Fund Distribution, hosted the 4^th quarter conference call for their Tactical Opportunities Fund (WBMIX) on February 26. Robert Vogel and Paul Twitchell, the fund’s third and fourth portfolio managers, did not participate.

Prolific MFO board contributor Scott first made us aware of the fund in August 2012 with the post “Somewhat Interesting Tiny Fund.” David profiled its more market neutral and less tactical (less directionally oriented) sibling WBLFX in April 2013. I discussed WBMIX in the October 2013 commentary, calling the fund proper “increasingly hard to ignore.” Although the fund proper was young, it possessed the potential to be “on the short list … for those who simply want to hold one all-weather fund.”

WBMIX recently pasted its three year mark and at $865M AUM is no longer tiny. Today’s question is whether it remains an interesting and compelling option for those investors looking for alternatives to the traditional 60/40 balanced fund at a time of interest rate uncertainty and given the two significant equity drawdowns since 2000.

Mr. Redleaf launched the call by summarizing two major convictions:

• The US equity market is “expensive by just about any measure.” He noted examples like market cap to GDP or Shiller CAPE, comparing certain valuations to pre great recession and even pre great depression. At such valuations, expected returns are small and do not warrant the downside risk they bear, believing there is a “real chance of 20-30-40 even 50% retraction.” In short, “great risk in hope of small gain.”

• The global markets are fraught with risk, still recovering from the great recession. He explained that we were in the “fourth phase of government action.” He called the current phase competitive currency devaluation, which he believes “cannot work.” It provides temporary relief at best and longer term does more harm than good. He seems to support only the initial phase of government stimulus, which “helped markets avert Armageddon.” The last two phases, which included the zero interest rate policy (ZIRP), have done little to increase top-line growth.

Consequently, toward middle of last year, Tactical Opportunities (TO) moved away from its long bias to market neutral. Mr. Redleaf explained the portfolio now looks to be long “reasonably priced” (since cheap is hard to find) quality companies and be short over-priced storybook companies (some coined “Never, Nevers”) that would take many years, like 17, of uninterrupted growth to justify current prices.

The following table from its recent quarterly commentary illustrates the rationale:

Mr. Redleaf holds a deep contrarian view of efficient market theory. He works to exploit market irrationalities, inefficiencies, and so-called dislocations, like “mispriced securities that have a relationship to each other,” or so-called “value arbitrage.” Consistently guarding against extreme risk, the firm would never put on a naked short. Its annual report reads “…a hedge is itself an investment in which we believe and one that adds, not sacrifices returns.”

But that does not mean it will not have periods of underperformance and even drawdown. If the traditional 60/40 balanced fund performance represents the “Mr. Market Bus,” Whitebox chose to exit middle of last year. As can be seen in the graph of total return growth since WBMIX inception, Mr. Redleaf seems to be in good company.

Whether the “exit” was a because of deliberate tactical moves, like a market-neutral stance, or because particular trades, especially long/short trades went wrong, or both … many alternative funds missed-out on much of the market’s gains this past year, as evidenced in following chart:

But TO did not just miss much of the upside, it’s actually retracted 8% through February, based on month ending total returns, the greatest amount since its inception in December 2011; in fact, it has been retracting for ten consecutive months. Their explanation:

Our view of current opportunity has been about 180 degrees opposite Mr. Market’s. Currently, we love what we’d call “intelligent value” while Mr. Market apparently seems infatuated with what we’d call “unsustainable growth.”

Put bluntly, the stocks we disfavored most (and were short) were among the stocks investors remained enamored with.

A more conservative strategy would call for moving assets to cash. (Funds like ASTON RiverRoad Independent Value, which has about 75% cash. Pinnacle Value at 50%. And, FPA Crescent at 44%.) But TO is more aggressive, with attendant volatilities above 75% of SP500, as it strives to “produce competitive returns under multiple scenarios.” This aspect of the fund is more evident now than back in October 2013.

Comparing its performance since launch against other long-short peers and some notable alternatives, WBMIX now falls in the middle of the pack, after a strong start in 2012/13 but disappointing 2014:

From the beginning, Mr. Redleaf has hoped TO would be judged in comparison to top endowments. Below are a couple comparisons, first against Yale and Harvard, which report on fiscal basis, and second against a simple Ivy asset allocation (computed using Alpha Architect’s Allocation Tool) and Vanguard’s 60/40 Balanced Index. Again, a strong showing in 2012/13, but 2014 was a tough year for TO (and Ivy).

Looking beyond strategy and performance, the folks at Whitebox continue to distinguish themselves as leaders in shareholder friendliness – a much welcomed and refreshing attribute, particularly with former hedge fund shops now offering the mutual funds and ETFs. Since last report:

• They maintain a “culture of transparency and integrity,” like their name suggests providing timely and thoughtful quarterly commentaries, published on their public website, not just for advisors. (In stark contrast to other firms, like AQR Funds, which in the past have stopped publishing commentaries during periods of underperformance, no longer make commentaries available without an account, and cater to Accredited Investors and Qualified Eligible Persons.)
• They now benchmark against SP500 total return, not just SPX.
• They eliminated the loaded advisor share class.
• Their expense ratio is well below peer average. Institutional shares, available at some brokerages for accounts with $100K minimum, have been running between 1.25-1.35%. They impose a voluntary cap of 1.35%, which must be approved by its board annually, but they have no intention of ever raising … just the opposite as AUM grows, says Mr. Coffey. (The cap is 1.6% for investor shares, symbol WBMAX.)

These ratios exclude the mandatory reporting of dividend and interest expense on short sales and acquired fund fees, which make all long/short funds inherently more expensive than long only equity funds. The former has been running about 1%, while the latter is minimal with selective index ETFs.

• They do not charge a short-term redemption fee.

All that said, they could do even better going forward:

• While Mr. Redleaf has over $1M invested directly with the fund, the most recent SAI dated 15 January 2015, indicates that the other three portfolio managers have zero stake. A spokesman for the fund defends “…as a smaller company, the partners’ investment is implicit rather than explicit. They have ‘Skin in the game,’ as a successful Tac Ops increases Whitebox’s profitability and on the other side of the coin, they stand to lose.”

David, of course, would argue that there is an important difference: Direct shareholders of a fund gain or lose based on fund performance, whereas firm owners gain or lose based on AUM.

Ed, author of two articles on “Skin in the Game” (Part I & Part II), would warn: “If you want to get rich, it’s easier to do so by investing the wealth of others than investing your own money.”

• Similarly, the SAI shows only one of its four trustees with any direct stake in the fund.
• They continue to impose a 12b-1 fee on their investor share class. A simpler and more equitable approach would be to maintain a single share class eliminating this fee and continue to charge lowest expenses possible.
• They continue to practice a so-called “soft money” policy, which means the fund “may pay higher commission rates than the lowest available” on broker transactions in exchange for research services. Unfortunately, this practice is widespread in the industry and investors end-up paying an expense that should be paid for by the adviser.

In conclusion, does the fund’s strategy remain interesting? Absolutely. Thoughtfulness, logic, and “arithmetic” are evident in each trade, in each hedge. Those trades can include broad asset classes, wherever Mr. Redleaf and team deem there are mispriced opportunities at acceptable risk.

Another example mentioned on the call is their longstanding large versus small theme. They believe that small caps are systematically overpriced, so they have been long on large caps while short on small caps. They have seen few opportunities in the credit markets, but given the recent fall in the energy sector, that may be changing. And, finally, first mentioned as a potential opportunity in 2013, a recent theme is their so-called “E-Trade … a three‐legged position in which we are short Italian and French sovereign debt, short the euro (currency) via put options, and long US debt.”

Does the fund’s strategy remain compelling enough to be a candidate for your one all-weather fund? If you share a macro-“market” view similar to the one articulated above by Mr. Redleaf, the answer to that may be yes, particularly if your risk temperament is aggressive and your timeline is say 7-10 years. But such contrarianism comes with a price, shorter-term at least.

During the call, Dr. Cross addressed the current drawdown, stating that “the fund would rather be down 8% than down 30% … so that it can be positioned to take advantage.” This “positioning” may turn out to be the right move, but when he said it, I could not help but think of a recent post by MFO board member Tampa Bay:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch 

Mr. Redleaf is no ordinary investor, of course. His bet against mortgages in 2008 is legendary. Whitebox Advisers, LLC, which he founded in 1999 in Minneapolis, now manages more than $4B.

He concluded the call by stating the “path to victory” for the fund’s current “intelligent value” strategy is one of two ways: 1) a significant correction from current valuations, or 2) a fully recovered economy with genuine top-line growth.

Whitebox Tactical Opportunities is facing its first real test as a mutual fund. While investors may forgive not making money during an upward market, they are notoriously unforgiving losing money (eg., Fairholme 2011), perhaps unfairly and perhaps to their own detriment, but even over relatively short spans and even if done in pursuit of “efficient management of risk.”

We’ve Seen This Movie Before

By Edward Studzinski

“We do not have to visit a madhouse to find disordered minds; our planet is the mental institution of the universe.”          Goethe

For students of the stock market, one of the better reads is John Brooks’, The Go-Go Years.   It did a wonderful job of describing the rather manic era of the 60’s and 70’s (pre-1973). One of the arguments made then was that the older generation of money managers was out of touch with both technology and new investment ideas. This resulted in a youth movement on Wall Street, especially in the investment management firms. You needed to have a “kid” as a portfolio manager, which was taken to its logical conclusion in a cartoon which showed an approximately ten-year old sitting behind a desk, looking at a Quotron machine. Around 2000, a similar youth movement came along during the dot.com craze, where once again investment managers, especially value managers, were told that their era was over, that they didn’t understand the new way and new wave of investing. Each of those two eras ended badly for those who had entrusted their assets to what was in vogue at the time.

In 2008, we had a period of over-valuation in the markets that was pretty clear in terms of equities. We also had what appears in retrospect to have been the deliberate misrepresentation and marketing of certain categories of fixed income investments to those who should have known better and did not. This resulted in a market meltdown that caused substantial drawdowns in value for many equity mutual funds, in a range of forty to sixty per cent, causing many small investors to panic and suffer a permanent loss of capital which many of them could not afford nor replace. The argument of many fund managers who had invested in their own funds (and as David has often written about, many do not), was that they too had skin in the game, and suffered the losses alongside of their investors.

Let’s run some simple math. Assume a fund management firm that at 2/27/2015 has $100 billion in assets under management. Assets are equities, a mix of international and domestic, the international with fees and expenses of 1.30% and the domestic with fees and expenses of 0.90%. Let’s assume a 50/50 international/domestic split of assets, so $50 billion at 0.90% and $50 billion at 1.30%. This results in $1.1billion in fees and expenses to the management company. Assuming $300 million goes in expenses to non-investment personnel, overhead, and the other expenses that you read about in the prospectus, you could have $800 million to be divided amongst the equity owners of the management firm. In a world of Marxian simplicity, each partner is getting $40 million dollars a year. But, things are often not simple if we take the PIMCO example. Allianz as owners of the firm, having funded through their acquisitions the buy-out of the founders, may take 50% of profits or revenues off the top. So, each equal-weighted equity owner may only be getting paid $20 million a year. Assets under management may go down with the market sell-off so that fees going forward go down. But it should be obvious that average mutual fund investors are not at parity with the fund managers in risk exposure or tolerance.

Why am I beating this horse into the ground again? U.S. economic growth for the final quarter was revised down from the first reported estimate of 2.6% to 2.2%. More than 440 of the companies in the S&P 500 index had reported Q4 numbers by the end of last week showed revenue growth of 1.5% versus 4.1% in the previous quarter. Earnings increased at an annual rate that had slowed to 5.9% from 10.4% in the previous quarter. Earnings downgrades have become more frequent. 

Why then has the market been rising – faith in the Federal Reserve’s QE policy of bond repurchases (now ended) and their policy of keeping rates low. Things on the economic front are not as good as we are being told. But my real concern is that we have become detached from thinking about the value of individual investments, the margin of safety or lack thereof, and our respective time horizons and risk tolerances. And I will not go into at this time, how much deflation and slowing economies are of concern in the rest of the world.

Look at the energy sector, where the price of oil has come down more than 50% since the 2014 high. Each time we see a movement in the price of oil, as well as in the futures, we see swings in the equity prices of energy companies. Should the valuations of those companies be moving in sync with energy prices, and are the balance sheets of each of those companies equal? No, what you are seeing is the algorithmic trading programs kicking in, with large institutional investors and hedge funds trying to grind out profits from the increased volatility. Most of the readers of this publication are not playing the same game. Indeed they are unable to play that game. 

So I say again, focus upon your time horizons and risk tolerance. If your investment pool represents the accumulation of your life’s work and retirement savings, your focus should be not on how much you can make but rather how much you can afford to lose. As the U.S. equity market has continued to hit one record high after another,  recognize that it is getting close to trading at nearly thirty times long-term, inflation-adjusted earnings. In 2014, the S&P 500 did not fall for more than three consecutive days.

We are in la-la land, and there is little margin for error in most investment opportunities. On January 15, 2015, when the Swiss National Bank eliminated its currency’s Euro-peg, the value of that currency moved 30% in minutes, wiping out many currency traders in what were thought to be low-risk arbitrage-like investments. 

What should this mean for readers of this publication? We at MFO have been looking for absolute value investors. I can tell you that they are in short supply. Charlie Munger had some good advice recently, which others have quoted and I will paraphrase. Focus on doing the easy things. Investment decisions or choices that are complex, and by that I mean things that include shorting stocks, futures, and the like – leave that to others. One of the more brilliant value investors and a contemporary of Benjamin Graham, Irving Kahn, passed away last week. He did very well with 50% of his assets in cash and 50% of his assets in equities. For most of us, the cash serves as a buffer and as a reserve for when the real, once in a lifetime, opportunities arise. I will close now, as is my wont, with a quote from a book, The Last Supper, by one of the great, under-appreciated American authors, Charles McCarry. “Do you know what makes a man a genius? The ability to see the obvious. Practically nobody can do that.”

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized and filtered as never before. For a complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

New Lawsuits

The Calamos Growth Fund is the subject of a new section 36(b) lawsuit that alleges excessive advisory and 12b-1 fees. The complaint alleges that Calamos extracted higher investment advisory fees from the Growth Fund than from “third-party, arm’s length institutional clients,” even though advisory services were “similar” and “in some cases effectively identical.” (Chill v. Calamos Advisors LLC.)

A new lawsuit accuses T. Rowe Price of infringing several patents relating to management of its target-date funds. (GRQ Inv. Mgmt., LLC v. T. Rowe Price Group, Inc.)

New Appeal

Plaintiffs have appealed a district court’s dismissal of state-law claims against Vanguard regarding fund holdings of gambling-related securities. The district court held that the claims were time barred and, alternatively, that the fund board’s refusal to pursue plaintiffs’ litigation demand was protected by the business judgment rule. Defendants include independent directors. (Hartsel v. Vanguard Group, Inc.)

Settlements

ERISA class action plaintiffs filed an unopposed motion to settle their claims against Northern Trust for $36 million. The lawsuit alleged mismanagement of the securities lending program in which collective trust funds participated. (Diebold v. N. Trust Invs., N.A.)

In an interrelated class action against Northern Trust that asserts non-ERISA claims, plaintiffs filed an unopposed motion to partially settle the lawsuit for $24 million. The settlement covers plaintiffs who participated in the securities lending program indirectly (i.e., through investments in commingled investment funds); the litigation will continue with respect to plaintiffs who participated directly (i.e., through a securities lending agreement with Northern Trust). (La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)

The Alt Perspective: Commentary and news from DailyAlts.

By Brian Haskin, editor of DailyAlts.com

February is in the books, and fortunately it ended with a significant decline in volatility, and a nice rally in the equity market. Bonds took it on the chin as rates rose over the month, but commodities rallied on the back of rising oil prices over the month. In the alternative mutual fund are, all of the major categories put up positive returns over the month, with long/short equity leading the way with a category return of 1.88%, according to Morningstar. Multi-alternative funds posted a category return of 0.98%, while non-traditional bonds ended the month 0.88% higher and managed futures funds added 0.47%.

Industry Evolution

The liquid alternatives industry continues to evolve in many ways, the most obvious of which is the continuous launch of new funds. However, we are now beginning to see more activity and consolidation of players at the company level. In December of 2014, we ended the year with New York Life’s MainStay arm purchasing IndexIQ, an alternative ETF provider. This acquisition gave MainStay immediate access to two of the hottest segments of the investment field, all in one package: active ETFs and liquid alternatives.

In February, we saw two more firms combine forces with Salient Partner’s purchase of Forward Management. Both firms have strong footholds in the liquid alternatives market, and the combination of the two firms will expend both their product platforms and distribution capabilities. Scale becomes more important as competition continues to grow. Expect more mergers over the year as firms jockey for position.

Waking Giants

Aside from merger activity, some firms just finally wake up and realize there is an opportunity passing them by. Columbia Management is one of them. The firm has been making some moves over the past few months with new hires and product filings, and finally put the pedal to the metal this month and launched a new alternative mutual fund in partnership with Blackstone. At the same time, Columbia rationalized some of their existing offerings and announced the termination terminated three alternative mutual funds that were launched more than three years ago.

In addition to Columbia, American Century has decided to formalize their liquid alternatives business with new branding (AC Alternatives) and three new alternative mutual funds. These new funds join a stable of two equity market neutral funds and two long/short “130-30” funds (these funds remain beta 1 funds but increase their long exposure to 130% of the portfolio’s value and offset that with 30% shorting, bringing the fund to a net long position of 100%). With at least five alternative mutual funds (the 130-30 funds are technically not liquid alternatives since they are beta 1 funds), American Century will have a solid stable of products to roll under their new AC Alternatives brand that has been created just for their liquid alternatives business.

Featured New Funds

February new fund activity picked up over January with a few notable new funds that hit the market. One theme that has emerged is the growth of globally focused long/short equity funds. Up until last year, a large majority of long/short equity funds were focused on US equities, however last year, firms began introducing funds that could invest in globally developed and emerging markets. The Boston Partners Global Long/Short Fund was one of note, and was launched after the firm had closed its first two long/short equity funds.

This increased diversity of funds is good for both asset managers and investors. Asset managers have a larger global pond in which to fish, thus creating more opportunities, while investors can diversify across both domestic and globally focused funds. Four new funds of note are as follows:

Meeder Spectrum Fund – This is the firm’s first alternative mutual fund, but not their first unconstrained fund. The fund will use a quantitative process to create a globally allocated long/short equity fund, and will use both stocks and other mutual funds or ETFs to implement its strategy. The fund’s management fee is a reasonable 0.75%.

Stone Toro Market Neutral Fund – While described as market neutral, the fund can move between -10% net short to +60% net long. This means that the fund will likely have some beta exposure, but it does allocate globally to both developed and emerging market stocks using an arbitrage approach that looks for structural imperfections related to investor behavior and corporate actions. This is different from the traditional valuation driven approach and could prove to add some value in ways other funds will not.

PIMCO Multi-Strategy Alternative Fund – This fund will allocate to a range of PIMCO alternative mutual funds, including alternative asset classes such as commodities and real assets. Research Affiliates will also sub-advise on the fund and assist in the allocation to funds advised by Research Affiliates.

Columbia Adaptive Alternatives Fund – launched in partnership with Blackstone, this fund invests across three different sleeves (one of which is managed by Blackstone), and allocates to twelve different investment strategies. Lots of complexity here – give it time to see what it can deliver.

While there is plenty more news and fund activity to discuss, let’s call it a wrap there. If you would like to receive daily or weekly updates on liquid alternatives, feel free to sign up for our free newsletter: http://dailyalts.com/mailinglist.php.

Observer Fund Profiles:

Each month the Observer provides in-depth profiles of between two and four funds. Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds. “Stars in the Shadows” are older funds that have attracted far less attention than they deserve.

Northern Global Tactical Asset Allocation (BBALX): This fund is many things: broadly diversified, well designed, disciplined, low priced and successful. It is not, however, a typical “moderate allocation” fund. As such, it’s imperative to get past the misleading star rating (which has ranged from two to five) to understand the fund’s distinctive and considerable strengths.

Pinnacle Value (PVFIX): If they (accurately) rebranded this as Pinnacle Hedged Microcap Value, the liquid alts crowd would be pounding on the door (and Mr. Deysher would likely be bolting it). While it doesn’t bear the name, the effect is the same: hedged exposure to a volatile asset class with a risk-return profile that’s distinctly asymmetrical to the upside.

Elevator Talk: Waldemar Mozes, ASTON/TAMRO International Small Cap (AROWX/ATRWX)

Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we’ve decided to offer one or two managers each month the opportunity to make a 200 word pitch to you. That’s about the number of words a slightly-manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got 200 words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.

Waldemar Mozes manages AROWX which launched at the end of December 2014. The underlying strategy, however, has a record that’s either a bit longer or a lot longer, depending on whether you’re looking at the launch of separately managed accounts in this style (from April 2013) or the launch of TAMRO’s investment strategy (2000), of which this is just a special application. Mr. Mozes joined TAMRO in 2008 after stints with Artisan Partners and The Capital Group, adviser to the American Funds.

TAMRO uses the same strategy in their private accounts and all three of the funds they sub-advise for Aston:

… we identify undervalued companies with a competitive advantage. We attempt to mitigate our investment risk by purchasing stocks where, by our calculation, the potential gain is at least three times the potential loss (an Upside reward-to-Downside risk ratio of 3:1 or greater). While our investments fall into three different categories – Leaders, Laggards and Innovators – all share the key characteristics of success:

• Differentiated product or service offering

• Capable and motivated leadership

• Financial flexibility

As a business development matter, Mr. Mozes proposed extending the strategy to the international small cap arena. There are at least three reasons why that made sense:

• The ISC universe is huge. Depending on who’s doing the calculation, there are 10,000 – 25,000 stocks.
• It is the one area demonstrably ripe for active managers to add value. The average ISC stock is covered by fewer than five analysts and it’s the only area where the data shows the majority of active managers consistently outperforming passive products. Across standard trailing time periods, international small caps outperform international large caps with higher Sharpe and Sortino ratios.
• Most investors are underexposed to it. International index funds (e.g, BlackRock International Index MDIIX, Schwab International IndexSWISX, Rowe Price International Index PIEQX or Vanguard Total International Stock Index VGTSX) typically commit somewhere between none of their portfolio (BlackRock, Price, Schwab) to up a tiny slice (Vanguard) to small caps. Of the 10 largest actively managed international funds, only one has more than 2% in small caps.

There are very few true international small cap funds worth examining since most that claim to be small cap actually invest more in mid- and large-cap stocks than in actual small caps. Here are Waldemar’s 268 words on why you should add AROWX to your due-diligence list:

At TAMRO, our objective is to invest in high-quality companies trading below their intrinsic value due to market misperceptions. This philosophy has enabled our domestic small cap strategy to beat its benchmark, 10 of the past 14 calendar years. We’re confident, after 3+ years of rigorous testing and nearly a two-year composite performance track record, that it will work for international small cap too. 

Here’s why:

Bigger Universe = Bigger Opportunity. The international equity universe is three times larger than the domestic universe and probably contains both three times as many high-quality and three times as many poorly-run companies. We exploit this weakness by focusing on quality: businesses that generate high and consistent ROIC/ROE, are run by skilled capital allocators, and produce enough free cash flow to self-fund growth without excessive leverage or dilution. But we also care deeply about downside risk, which is why our valuation mantra is: the price you pay dictates your return.

GDP Always Growing Somewhere. Smaller companies tend to be the engines of local economic growth and GDP is always growing somewhere. We use a proprietary screening tool that provides a timely list of potential research ideas based on fundamental and valuation characteristics. It’s not a black box, but it does flag companies, industries, or countries that might otherwise be overlooked.

Something Different. One reason international small-cap as an asset class has such great appeal is lower correlation. We strive to build on this advantage with a concentrated (40-60 positions), quality-biased portfolio. Ultimately, we care little about growth/value styles and focus on market-beating returns with high active share, low tracking error, and low turnover.

ASTON/TAMRO International Small Cap has a $2500 minimum initial investment which is reduced to $500 for IRAs and other types of tax-advantaged accounts. Expenses are capped at 1.50% on the investor shares and 1.25% for institutional shares, with a 2.0% redemption fee on shares sold within 90 days. The fund has about gathered about $1.3 million in assets since its December 2014 launch. Here’s the fund’s homepage. It’s understandably thin on content yet but there’s some fairly rich analysis on the TAMRO Capital page devoted to the underlying strategy.

Conference Call Highlights: Guinness Atkinson Global Innovators

Every month through the winter, the Observer conspires to give folks the opportunity to do something rare and valuable: to hear directly from managers, to put questions to them in-person and to listen to the quality of the unfiltered answers. A lot of funds sponsor quarterly conference calls, generally web-based. Of necessity, those are cautious affairs, with carefully screened questions and an acute awareness that the compliance folks are sitting there. Most of the ones I’ve attended are also plagued by something called a “slide deck,” which generally turns out to be a numbing array of superfluous PowerPoint slides. We try to do something simpler and more useful: find really interesting folks, let them talk for just a little while and then ask them intelligent questions – yours and mine – that they don’t get to rehearse the answers to. Why? Because the better you understand how a manager thinks and acts, the more likely you are to make a good decision about one.

In February with spoke with Matthew Page and Ian Mortimer of the Guinness Atkinson funds. Both of their funds have remarkable track records, we’ve profiled both and I’ve had good conversations with the team on several occasions. Here’s what we heard on the call.

The guys run two strategies for US investors. The older one, Global Innovators, is a growth strategy that Guinness has been pursuing for 15 years. The newer one, Dividend Builder, is a value strategy that the managers propounded on their own in response to a challenge from founder Tim Guinness. These strategies are manifested in “mirror funds” open to European investors. Curiously, American investors seem taken by the growth strategy ($180M in the US, $30M in the Euro version) while European investors are prone to value ($6M in the US, $120M in the Euro). Both managers have an ownership stake in Guinness Atkinson and hope to work there for 30 years, neither is legally permitted to invest in the US version of the strategy, both intend – following some paperwork – to invest their pensions in the Dublin-based version. The paperwork hang up seems to affect, primarily, the newer Dividend Builder (in Europe, “Global Equity Income”) strategy and I failed to ask directly about personal investment in the older strategy.

The growth strategy, Global Innovators IWIRX, starts by looking for firms “doing something smarter than the average company in their industry. Being smarter translates, over time, to higher return on capital, which is the key to all we do.” They then buy those companies when they’re underpriced. The fund holds 30 equally-weighted positions.

Innovators come in two flavors: disruptors – early stage growth companies, perhaps with recent IPOs, that have everyone excited and continuous improvers – firms with a long history of using innovation to maintain consistently high ROC. In general, the guys prefer the latter because the former tend to be wildly overpriced and haven’t proven their ability to translate excitement into growth.

The example they pointed to was the IPO market. Last year they looked at 180 IPOs. Only 60 of those were profitable firms and only 6 or 7 of the stocks were reasonably priced (p/e under 20). Of those six, exactly one had a good ROC profile but its debt/equity ratio was greater than 300%. So none of them ended up in the portfolio. Matthew observes that their portfolio is “not pure disruptors. Though those can make you look extremely clever when they go right, they also make you look extremely stupid when they go wrong. We would prefer to avoid that outcome.”

This also means that they are not looking for a portfolio of “the most innovative companies in the world.” A commitment to innovation provides a prism or lens through which to identify excellent growth companies. That’s illustrated in the separate paths into the portfolio taken by disruptors and continuous improvers. With early stage disruptors, the managers begin by looking for evidence that a firm is truly innovative (for example, by looking at industry coverage in Fast Company or MIT’s Technology Review) and then look at the prospect that innovation will produce consistent, affordable growth. For the established firms, the team starts with their quantitative screen that finds firms with top 25% return on capital scores in every one of the past ten years, then they pursue a “very subjective qualitative assessment of whether they’re innovative, how they might be and how those innovations drive growth.”

In both cases, they have a “watch list” of about 200-250 companies but their discipline tends to keep many of the disruptors out because of concerns about sustainability and price. Currently there might be one early stage firm in the portfolio and lots of Boeing, Intel, and Cisco.

They sell when price appreciates (they sold Shire pharmaceuticals after eight months because of an 80% share-price rise), fundamentals deteriorate (fairly rare – of the firms that pass the 10 year ROC screen, 80% will continue passing the screen for each of the subsequent five years) or the firm seems to have lost its way (shifting, for example, from organic growth to growth-through-acquisition).

The value strategy, Dividend Builder GAINX is a permutation of the growth strategy’s approach to well-established firms. The value strategy looks only at dividend-paying companies that have provided an inflation-adjusted cash flow return on investment of at least 10% in each of the last 10 years. The secondary screens require at least a moderate dividend yield, a history of rising dividends, low levels of debt and a low payout ratio. In general, they found a high dividend strategy to be a loser and a dividend growth one to be a winner.

In general, the guys are “keen to avoid getting sucked into exciting stories or areas of great media interest. We’re physicists, and we quite like numbers rather than stories.” They believe that’s a competitive advantage, in part because listening to the numbers rather than the stories and maintaining a compact, equal-weight portfolio both tends to distance them from the herd. The growth strategy’s active share, for instance, is 94. That’s extraordinarily high for a strategy with a de facto large cap emphasis.

Bottom line: I’m intrigued by the fact that this fund has consistently outperformed both as a passive product and as an active one and with three different sets of managers. The gain is likely a product of what their discipline consciously and uniquely excludes, firms that don’t invest in their futures, as what it includes. The managers’ training as physicists, guys avowedly wary of “compelling narratives” and charismatic CEOs, adds another layer of distinction.

We’ve gathered all of the information available on the two Guinness Atkinson funds, including an .mp3 of the conference call, into its new Featured Fund page. Feel free to visit!

Conference Call Upcoming: RiverPark Focused Value

We’d be delighted if you’d join us on Tuesday, March 17^th, from 7:00 – 8:00 Eastern, for a conversation with David Berkowitz and Morty Schaja of the RiverPark Funds. Mr. Berkowitz has been appointed as RiverPark’s co-chief investment officer and is set to manage the newly-christened RiverPark Focused Value Fund (RFVIX/RFVFX) which will launch on March 31.

It’s unprecedented for us to devote a conference call to a manager whose fund has not launched, much less one who also has no public performance record. So why did we?

Mr. Berkowitz seems to have had an eventful career. Morty describes it this way:

David’s investment career began in 1992, when, with a classmate from business school, he founded Gotham Partners, a value-oriented investment partnership. David co-managed Gotham from inception through 2002. In 2003, he joined the Jack Parker Corporation, a New York family office, as Chief Investment Officer; in 2006, he launched Festina Lente, a value-oriented investment partnership; and in 2009 joined Ziff Brothers Investments where he was a Partner and Chief Risk and Strategy Officer.

It will be interesting to talk about why a public fund for the merely affluent is a logical next step in his career and how he imagines the structural differences might translate to differences in his portfolio.

RiverPark’s record on identifying first-tier talent is really good. Pretty much all of the RiverPark funds have met or exceeded any reasonable expectation. In addition, they tend to be distinctive funds that don’t fit neatly into style boxes or fund categories. In general they represent thoughtful, distinctive strategies that have been well executed.

Good value investors are in increasingly short supply. When you reach the point that everyone’s a value investor, then no one is. It becomes just a sort of rhetorical flourish, devoid of substance. As the market ascends year after year, fewer managers take the career risk of holding out for deeply-discounted stocks. Mr. Berkowitz professes a commitment to a compact, high commitment portfolio aiming for “substantial discounts to conservative assessments of value.” As a corollary to a “high commitment” mindset, Mr. Berkowitz is committing $10 million of his own money to seed the fund, an amount supplemented by $2 million from the other RiverPark folk. It’s a promising gesture.

Andrew Foster of Seafarer Overseas Growth & Income (SFGIX) has agreed to join us on April 16. We’ll share details in our April issue.

HOW CAN YOU JOIN IN? 

If you’d like to join in the RiverPark call, just click on register and you’ll be taken to the Chorus Call site. In exchange for your name and email, you’ll receive a toll-free number, a PIN and instructions on joining the call. If you register, I’ll send you a reminder email on the morning of the call.

Remember: registering for one call does not automatically register you for another. You need to click each separately. Likewise, registering for the conference call mailing list doesn’t register you for a call; it just lets you know when an opportunity comes up. 

WOULD AN ADDITIONAL HEADS UP HELP?

Over four hundred readers have signed up for a conference call mailing list. About a week ahead of each call, I write to everyone on the list to remind them of what might make the call special and how to register. If you’d like to be added to the conference call list, just drop me a line.

Launch Alert

At the end of January, T. Rowe Price launched their first two global bond funds. The more interesting of the two might be T. Rowe Price Global High Income Bond Fund (RPIHX). The fund will seek high income, with the prospect of some capital appreciation. The plan is to invest in a global portfolio of corporate and government high yield bonds and in floating rate bank loans.  The portfolio sports a 5.86% dividend yield.

It’s interesting, primarily, because of the strength of its lead managers.  It will be managed by Michael Della Vedova and Mark Vaselkiv. Mr. Della Vedova runs Price’s European high-yield fund, which Morningstar UK rates as a four-star fund with above average returns and just average risk.  Before joining Price in 2009, he was a cofounder and partner of Four Quarter Capital, a credit hedge fund focusing on high-yield European corporate debt.  There’s a video interview with Mr. Della Vedova on Morningstar’s UK site. (Warning: the video begins playing automatically and somewhat loudly.) Mr. Vaselkiv manages Price’s first-rate high yield bond fund which is closed to new investors. He’s been running the fund since 1996 and has beaten 80% of his peers by doing what Price is famous for: consistent, disciplined performance, lots of singles and no attempts to goose returns by swinging for the fences. His caution might be especially helpful now if he’s right that we’re “in the late innings of an amazing cycle.” With European beginning to experiment with negative interest rates on its investment grade debt, carefully casting a wider net might well be in order.

The opening expense ratio is 0.85%. The minimum initial investment is $2,500, reduced to $1,000 for IRAs.

Funds in Registration

After months of decline, the number of new no-load funds in the pipeline, those in registration with the SEC for April launch, has rebounded a bit. There are at least 16 new funds on the way.  A couple make me just shake my head, though they certainly will have appeal to fans of Rube Goldberg’s work. There are also a couple niche funds – a luxury brands fund and an Asian sustainability one – that might have merit beyond their marketing value, though I’m dubious. That said, there are also a handful of intriguing possibilities:

American Century is launching a series of multi-manager alternative strategies funds.

Brown Advisory is launching a global leaders fund run by a former be head of Asian equities for HSBC.

Brown Capital Management is planning an international small cap fund run by the same team that manages their international large growth fund.

They’re all detailed on the Funds in Registration page.

Manager Changes

February was a month that saw a number of remarkable souls passing from this vale of tears. Irving Kahn, Benjamin Graham’s teaching assistant and Warren Buffett’s teacher, passed away at 109. All of his siblings also lived over 100 years. Jason Zweig published a nice remembrance of him, “Investor Irving Kahn, Disciple of Benjamin Graham, Dies at 109,” which you can read if you Google the title but which I can’t directly link to.  Leonard Nimoy, whose first autobiography was entitled I Am Not Spock (1975), died of chronic obstructive pulmonary disease at age 83. He had a global following, not least among mixed-race youth who found solace in the character Spock’s mixed heritage. Of immediate relevance to this column, Don Hodges, founder of the Hodges Funds, passed away in late January at age 80. He’d been a professional investor for 50 years and was actively managing several of the Hodges Funds until a few weeks before his death.

You can see all of the comings and goings on our Manager Changes page.

Updates

Bretton Fund (BRTNX) is a small, concentrated portfolio managed by Stephen Dodson. The fund launched in 2010 in an attempt to bring a Buffett-like approach to the world of funds. In thinking about his new firm and its discipline, he was struck by a paradox: almost all investment professionals worshipped Warren Buffett, but almost none attempted to invest like him. Stephen’s estimate is that there are “a ton” of concentrated long-term value hedge funds, but fewer than 20 mutual funds (Pinnacle Value PVFIX and The Cook and Bynum Fund COBYX, for example) that follow Buffett’s discipline: he invests in “a small number of good business he believes that he understands and that are trading at a significant discount to what they believe they’re worth.” Stephen seemed particularly struck by his interviews of managers who run successful, conventional equity funds: 50-100 stocks and a portfolio sensitive to the sector-weightings in some index.

I asked each of them, “How would you invest if it was only your money and you never had to report to outside shareholders but you needed to sort of protect and grow this capital at an attractive rate for the rest of your life, how would you invest. Would you invest in the same approach, 50-100 stocks across all sectors.” And they said, “absolutely not. I’d only invest in my 10-20 best ideas.” 

One element of Stephen’s discipline is that he only invests in companies and industries that he understands; that is, he invests within a self-defined “circle of competence.”

In February he moved to dramatically expand that circle by adding Raphael de Balmann as co-principal of the adviser and co-manager of BRTNX. Messrs. Dodson and de Balmann have known each other for a long time and talk regularly and he seems to have strengths complementary to Mr. Dodson’s. De Balmann has primarily been a private equity investor, where Dodson has been public equity. De Balmann is passionate about understanding the sources and sustainability of cash flows, Dodson is stronger on analyzing earnings. De Balmann understands a variety of industries, including industrials, which are beyond Dodson’s circle of competence.

Stephen anticipates a slight expansion of the number of portfolio holdings from the high teens to the low twenties, a fresh set of eyes finding value in places that he couldn’t and likely a broader set of industries. The underlying discipline remains unchanged.

We wish them both well.

Star gazing

Seafarer Overseas Growth & Income (SFGIX) celebrated its third anniversary on February 5^th. By mid-March it should receive its first star rating from Morningstar. With a risk conscious strategy and three year returns in the top 3% of its emerging markets peer group, we’re hopeful that the fund will gain some well-earned recognition from investors.

Guinness Atkinson Dividend Builder (GAINX) will pass its three-year mark at the end of March, with a star rating to follow by about five. The fund has returned 49% since inception, against 38% for its world-stock peers.

A resource for readers

Our colleague Charles Boccadoro is in lively and continuing conversation with a bunch of folks whose investing disciplines have a strongly quantitative bent. He offers the following alert about a new book from one of his favorite correspodents.

Official publication date is tomorrow, March 2.

Like his last two books, Shareholder Yield and Global Value, reviewed in last year’s May commentary, Meb Faber’s new book “Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies” is a self-published ebook, available on Amazon for just $2.99.

On his blog, Mr. Faber states “my goal was to keep it short enough to read in one sitting, evidence-based with a basic summary that is practical and easily implementable.”

That description is true of all Meb’s books, including his first published by Wiley in 2009, The Ivy Portfolio. To celebrate he’s making downloads of Shareholder Yield and Global Value available for free.

We will review his new book next time we check-in on Cambria’s ETF performance.

 

Here appears to be its Table of Contents:

INTRODUCTION

CHAPTER 1 – A History of Stocks, Bonds, and Bills

CHAPTER 2 – The Benchmark Portfolio: 60/40

CHAPTER 3 – Asset Class Building Blocks

CHAPTER 4 – The Risk Parity and All Seasons Portfolios

CHAPTER 5 – The Permanent Portfolio

CHAPTER 6 – The Global Market Portfolio

CHAPTER 7 – The Rob Arnott Portfolio

CHAPTER 8 – The Marc Faber Portfolio

CHAPTER 9 – The Endowment Portfolio: Swensen, El-Erian, and Ivy

CHAPTER 10 – The Warren Buffett Portfolio

CHAPTER 11 – Comparison of the Strategies

CHAPTER 12 – Implementation (ETFs, Fees, Taxes, Advisors)

CHAPTER 13 – Summary

APPENDIX A – FAQs

Briefly Noted . . .

Vanguard, probably to Jack Bogle’s utter disgust, is making a pretty dramatic reduction in their exposure to US stocks and bonds. According an SEC filing, the firm’s retirement-date products and Life Strategy Funds will maintain their stock/bond balance but, over “the coming months,” the domestic/international balance with the stock and bond portfolios will swing.

For long-dated funds, those with target dates of 2040 or later, the US stock allocation will drop from 63% to 54% while international equities will rise from 27% to 36%. In shorter-date funds, there’s a 500 – 600 basis point reallocation from domestic to international. There’s a complementary hike in international body exposure, from 2% of long-dated portfolios up to 3% and uneven but substantial increases in all of the shorter-date funds as well.

SMALL WINS FOR INVESTORS

Okay, it might be stretching to call this a “win,” but you can now get into two one-star funds for a lot less money than before. Effective February 27, 2015, the minimum investment amount in the Class I Shares of both the CM Advisors Fund (CMAFX) and the CM Advisors Small Cap Value (CMOVX) was reduced from $250,000 to $2,500.

CLOSINGS (and related inconveniences)

None that we noticed.

OLD WINE, NEW BOTTLES

Around May 1, the $6 billion ClearBridge Equity Income Fund (SOPAX) becomes ClearBridge Dividend Strategy Fund. The strategy will be to invest in stocks and “other investments with similar economic characteristics that pay dividends or are expected to initiate their dividends over time.”

Effective May 1, 2015, European Equity Fund (VEEEX/VEECX) escapes Europe and equities. It gets renamed at the Global Strategic Income Fund and adds high-yield bonds to its list of investment options.

On April 30, Goldman Sachs U.S. Equity Fund (GAGVX) becomes Goldman Sachs Dynamic U.S. Equity Fund. The “dynamic” part is that the team that guided it to mediocre large cap performance will now guide it to … uh, dynamic all-cap performance.

Goldman Sachs Absolute Return Tracker Fund (GARTX) attempts to replicate the returns of a hedge fund index without, of course, investing in hedge funds. It’s not clear why you’d want to do that and the fund has been returning 1-3% annually. Effective April 30, the fund’s investment strategies will be broadened to allow them to invest in an even wider array of derivatives (e.g. master limited partnership indexes) in pursuit of their dubious goal.

Effective March 31, 2015, MFS Research Bond Fund will change to MFS® Total Return Bond Fund and MFS Bond Fund will change to MFS® Corporate Bond Fund.

OFF TO THE DUSTBIN OF HISTORY

Aberdeen Global Select Opportunities Fund was swallowed up by Aberdeen Global Equity Fund (GLLAX) on Friday, February 25, 2015. GLLAX is … performance-challenged.

As we predicted a couple months ago when the fund suddenly closed to new investors, Aegis High Yield Fund (AHYAX/AHYFX) is going the way of the wild goose. Its end will come on or before April 30, 2015.

Frontier RobecoSAM Global Equity Fund (FSGLX), a tiny institutional fund that was rarely worse than mediocre and occasionally a bit better, will be closed and liquidated on March 23, 2015.

Bad news for Chuck Jaffe. He won’t have the Giant 5 to kick around anymore. Giant 5 Total Investment System Fund received one of Jaffe’s “Lump of Coal” awards in 2014 for wasting time and money changing their ticker symbol from FIVEX to CASHX. Glancing at their returns, Jaffe suggested SUCKX as a better move. From here it starts to get a bit weird. The funds’ adviser changed its name from Willis Group to Index Asset Management, which somehow convinced them to spend more time and money changed the ticker on their other fund, Giant 5 Total Index System Fund, from INDEX to WILLX. So they decided to surrender a cool ticker that reflected their current name for a ticker that reminds them of the abandoned name of their firm. Uh-huh. At this point, cynics might suggest changing their URL from weareindex.com to the more descriptively accurate wearecharging2.21%andchurningtheportfolio.com. Doubtless sensing Chuck beginning to stock up on the slings and arrows of outrageous fortune, the adviser sprang into action on February 27 … and announced the liquidation of the funds, effective March 30^th.

The $24 million Hatteras PE Intelligence Fund (HPEIX) will liquidate on March 13, 2015. The plan was to produce the returns of a Private Equity index without investing in private equity. The fund launched in November 2013, has neither made nor lost any meaningful money, so the adviser pulled the plug after 15 months.

JPMorgan Alternative Strategies Fund (JASAX), a fund mostly comprised of other Morgan funds, will liquidate on March 23, 2015.

Martin Focused Value Fund (MFVRX), a dogged little fund that held nine stocks and 70% cash, has decided that it’s not economically viable and that’s unlikely to change. As a result, it will cease operations by the end of March.

Old Westbury Real Return Fund (OWRRX), which has about a half billion in assets, is being liquidated in mid-March 2015. It was perfectly respectable as commodity funds go. Sadly, the fund’s performance charts had a lot of segments that looked like

and like

In consequence of which it finished down 9% since inception and down 24% over the past five years.

Parnassus Small Cap Fund (PARSX) is being merged into the smaller but far stronger Parnassus Mid Cap (PARMX) at the end of April, 2015. PARMX’s prospectus will be tweaked to make it SMID-ier.

The Board of Trustees of PIMCO approved a plan of liquidation for the PIMCO Convertible Fund (PACNX) which will occur on May 1, 2015. The fund has nearly a quarter billion in assets, so presumably the Board was discouraged by the fund’s relatively week three year record: 11% annually, which trailed about two-thirds of the funds in the tiny “convertibles” group.

The Board of Rainier Balanced Fund (RIMBX/RAIBX) has approved, the liquidation and termination of the fund. The liquidation is expected to occur as of the close of business on March 27, 2015. It’s been around, unobjectionable and unremarkable, since the mid-90s but has under $20 million in assets.

S1 (SONEX/SONRX), the Simple Alternatives fund, will liquidate in mid-March. We were never actually clear about what was “simple” about the fund: it was a high expense, high turnover, high manager turnover operation.

Salient Alternative Strategies Master Fund liquidated in mid-February, around the time they bought Forward Funds to get access to more alternative strategies.

In examples of an increasingly common move, Touchstone decided to liquidated both Touchstone Institutional Money Market Fund and Touchstone Money Market Fund, proceeds of the move will be rolled over into a Dreyfus money market.

In a sort of “snatching Victory from the jaws of defeat, then chucking some other Victory into the jaws” development, shareholders have learned that Victory Special Value (SSVSX) is not going to be merged out of existence into Victory Dividend Growth. Instead, Special Value has reopened to new investment while Dividend Growth has closed and replaced it on Death Row. Liquidation of Dividend Growth is slated for April 24, 2015. In the meantime, Victory Special Value got a whole new management team. The new managers don’t have a great record, but it does beat their predecessors’, so that’s a small win.

Wasatch Heritage Growth Fund (WAHGX) has closed to new investors and will be liquidated at the end of April, 2015. The initial plan was to invest in firms that had grown too large to remain in Wasatch’s many small cap portfolios; those “graduates” were the sort of the “heritage” of the title. The strategy generated neither compelling results nor investor interest.

In Closing . . .

The Observer celebrates its fourth anniversary on April 1^st. We’re delighted (and slightly surprised) at being here four years later; the average lifespan of a new website is generally measured in weeks. We’re delighted and humbled by the realization that nearly 30,000 folks peek in each month to see what we’re up to. We’re grateful, especially to the folks who continue to support the Observer, both financially and with an ongoing stream of suggestions, leads, questions and corrections. I’m always anxious about thanking folks for their contributions because I’m paranoid about forgetting anyone (if so, many apologies) and equally concerned about botching your names (a monthly goof). To the folks who use our Paypal link (Lee – I like the fact that your firm lists its professionals alphabetically rather than by hierarchy, Jeffrey who seems to have gotten entirely past Twitter and William, most recently), remember that you’ve got the option to say “hi”, too. It’s always good to hear from you. One project for us in the month ahead will be to systematize access for subscribers to our steadily-evolved premium site.

We’d been planning a party with party hats, festive noisemakers, a round of pin-the-tail-on-the-overrated-manager and a cake. Chip and Charles were way into it. 

Hmmm … apparently we might end up with something a bit more dignified instead. At the very least we’ll all be around the Morningstar conference in June and open to the prospect of a celebratory drink.

Spring impends. Keep a good thought and we’ll see you in a month!

Dear friends,

Dear friends,

Well, we’ve done it again. Augustana just launched its 154^th set of graduates in your direction. Personally, it’s my 29^th set of them. I think you’ll enjoy their company, if not always the quality of their prose. They’re good kids and we’ve spent an awful lot of time teaching them to ask questions more profound than “how much does it pay?” or “would you like fries with that?”  We’ve tried, with some success, to explain to them that leadership flows from service, that words count, that deeds count, and that other people count.

They are, on whole, a work well begun. The other half is up to you and to them.

As for me and my colleagues, two months to recoup and then 714 more chances to make a difference.

All the noise, noise, noise, noise!

Here’s my shameful secret: I have no idea of why global stock markets at all-time highs nor when they will cease to be there. I also don’t know quite what investors are doing or thinking, much less why. Hmmm … also pretty much confused about what actions any of it implies that I should take.

I spent much of the month of May paying attention to questions like the ones implied above and my interim conclusion is that that was not a good use of my time. There are about 300 million Americans who need to make sense out of their world and about 57,000 Americans paid to work as journalists and four times that many public relations specialists who are charged with telling them what it all means. And, sadly, there’s a news hole that can never be left unfilled; that is, if you have a 30 minute news program (22.5 minutes plus commercials), you need to find 22.5 minutes worth of something to say even when you think there’s nothing to say.

And so we’re inundated with headlines like these from the May issues of The Wall Street Journal and The New York Times (noted as NYT):

Investors Abandon Riskier Assets (WSJ, May 16, C1) “Investors stepped up their retreat from riskier assets …”   Except when they did the opposite four pages later:

Higher-Yielding Bank Debt Draws Interest (WSJ, May 16, C4) “Investors are scooping up riskier bonds sold by banks …”

Small Stocks Fuel a Run to Records (WSJ, May 13, C1) but then again Smaller Stocks Slammed in Selloff (WSJ, May 21, C1)

The success of “safe” strategies is encourage folks to pursue unsafe ones. Bonds Flip Scripts on Risk, Reward (WSJ, May 27, C1) “Bonds perceived as safe have produced better returns than riskier ones for the first time since 2010… in response, many investors are doubling down on riskier debt.”And so Riskier Fannie Bonds Are Devoured (WSJ, May 21, C1).

Market Loses Ground as Investors Seek Safety (NYT, May 14) “The stock market fell back from record levels on Wednesday as investors decided it was better to play it safe… ‘There’s some internal self-correction and rotation going on beneath the surface,’ said Jim Russell, a regional investment director at U.S. Bank.”  But apparently that internal self-correction self-corrected within nine days because Investors Show Little Fear (WSJ, May 23, C1) “Many traders say they detect little fear in the market lately.  They cite a financial outlook that is widely perceived to pose little risk of an economic or market downturn: near-record stock prices, low interest rates, steady if unspectacular U.S. growth and expansive if receding Federal Reserve support for the economy and financial markets.”

And so the fearless fearful are chucking money around:

Penny Stocks Fuel Big-Dollar Dreams (WSJ, May 23, C1) “Investors are piling into the shares of small, risky companies at the fastest clip on record, in search of investments that promise a chance of outsize returns.  Investors are buying up so-called penny stocks … at a pace that far eclipses the tech boom of the 1990s.”  The author notes that average trading volume is up 40% over last year which was, we’ll recall, a boom year for stocks.

Investors Return to Emerging World (WSJ, May 29, C1) “Investors are settling in for another ride in emerging markets … The speed with which investors appear to have forgotten losses of 30% in some markets has been startling.”

Searching for Yield, at Almost Any Price (NYT, May 1) “Fixed-income investors trying to increase their income essentially have two options. One is to extend maturities. The other is to reduce credit quality. There are risks to both. The prices of long-term bonds fall sharply when interest rates go up. Lower-quality bonds are more likely to default.  These days, lower quality, rather than longer maturities, seems to be more popular. Money has poured into mutual funds that invest in bank loans — often low-quality ones. To a lesser extent, it has also gone into high-yield mutual funds that buy bonds rated below investment grade, known as junk bonds to those who are dubious of them.”

So, all of this risk-chasing means that it’s Time to Worry About Stock Market Bubbles (NYT, May 6) “Relative to long-term corporate earnings – and more in a minute on why that measure is important – stocks have been more expensive only three times over the past century than they are today, according to data from Robert Shiller, a Nobel laureate in economics. Those other three periods are not exactly reassuring, either: the 1920s, the late 1990s and in the prelude to the 2007 financial crisis.” … Based on history, stocks look either very expensive or somewhat expensive right now. Mr. Shiller suggests that the most likely outcome may be worse returns in coming years than the market has delivered over recent decades – but still better than the returns of any other investment class.”  Great. Worst except for all the others.

Good news, though: there’s no need to worry about stock market bubbles as long as people are worrying about stock market bubbles. That courtesy of the Leuthold Group, which argues that bubbles are only dangerous once we’ve declared that there is no bubble but only a new, “permanently high plateau.”

Happily, our Republican colleagues in the House agree and seem to have decided that none of the events of 2007-08 actually occurred. Financial Crisis, Over and Already Forgotten (NYT, May 22) “Michael S. Barr, a law professor at the University of Michigan who was an assistant Treasury secretary when the financial crisis was at its worst, is working on a book titled Five Ways the Financial System Will Fail Next Time. The first of them, he says, is ‘amnesia, willful and otherwise,’ regarding the causes and consequences of the crisis. Let’s hope the others are not here yet [since a]mnesia was on full view this week.”

Wait!  Wait!  Josh Brown is pretty sure that they did occur, might well re-occur and probably still won’t get covered right:

Okay can we be honest for a second?

The similarities between now and the pre-crisis era are f**king sickening at this point.

There, I said it.  

 (After a couple paragraphs and one significant link.)

To recap – Volatility is nowhere to be found – not in currencies, in fixed income or in equities. Complacency rules the day as investors and institutions gradually add more risk, using leverage and increasingly exotic vehicles to reach for diminishing returns in an aging bull market. This as economic growth – led by housing and consumer spending – stalls out and the Fed removes stimulus that never really worked in the first place.

And once again, the media is oblivious for the most part, fixated as it is on a French economist and the valuations of text messaging startups.

(Second Verse, Same as the First, 05/29/14)

You wouldn’t imagine that those of us who try to communicate for a vocation might argue that you need to read (watch and listen) less, rather than more but that is the position that several of us tend toward.

Tadas Viskanta , proprietor of the very fine Abnormal Returns blog, calls for “a news diet” in his book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere (2012).  He argues:

A media diet, as practiced by Nassim Taleb, is a conscious effort to decrease the amount of media we consume. Most of what we consume is “empty calories.” Most of it has little information value and can only serve to crowd out other more interesting and informative sources.

That’s all consistent with Barry Ritzholz’s argument that the stuff which makes great and tingly headlines – Black Swans, imminent crashes, zombie apocalypses – aren’t what hurts the average investor most. We’re hurt most, he says during a presentation at the FPA NorCal Conference in 2014, by the slow drip, drip, drip of mistakes: high expenses, impulsive trading and performance chasing. None of which is really news.

Josh Brown, who writes under the moniker The Reformed Broker at a blog of the same name, disagrees.  One chapter of this new book The Clash of the Financial Pundits (2014)is entitled “The Myth of the Media Diet.”  Brown argues that we have no more ability to consistently abstain from news than we have to consistently abstain from sugary treats.  In his mind, the effort of suppressing the urge in the first place just leads to cheating and then a return, unreformed, to our original destructive habits: “A true media diet virtually assures an overreaction to market volatility and expert prognostication once the dieter returns to the flashing lights and headlines.”  He argues that we need to better understand the financial media in order to keep intelligently informed, rather than entirely pickled in the daily brew.

And Snowball’s take on it all?

I actually teach about this stuff for a living, from News Literacy to Communication and Emerging Technologies. My best reading of the research supports the notion that we’ve become victims of continuous partial attention. There are so many ways of reaching us and we’re so often judged by the speed of our response (my students tell me that five minutes is the longest you can wait before responding to text without giving offense), that we’re continually dividing our attention between the task at hand and a steady stream of incoming chatter. (15% of us have interrupted sex to take a cellphone call while a third text while driving.) It’s pervasive enough that there are now reports in the medical literature of sleep-texting; that is, hearing an incoming text while asleep, rousing just enough to respond and then returning to sleep without later knowing that any of this had happened. We are, in short, training ourselves to be distracted, unsure and unfocused.

Fortunately, we can also retrain ourselves to become more focused. Focus requires discipline; not “browsing” or “link-hopping,” but regular, structured attention. In general, I pay no attention to “the news” except during two narrow windows each day (roughly, the morning when I have coffee and read two newspapers and during evening commutes). During those windows, I listen to NPR News which – so far as I can determine – has the most consistently thoughtful, in-depth journalism around.

But beyond that, I do try to practice paying intense and undivided attention to the stuff that’s actually important: I neither take and make calls during my son’s ballgames, I have no browser open when my students come for advice, and I seek no distraction greater than jazz when I’m reading a book. 

It’s not smug self-indulgence, dear friends. It’s survival. I really want to embrace my life, not wander distractedly through it. For investors, that means making fewer, more thoughtful decisions and learning to trust that you’ve gotten it right rather than second-guessing yourself throughout the day and night.

How Good Is Your Fund Family?

Question: How many funds at Dodge & Cox beat their category average returns since inception?

Answer: All of them.

In the case of Dodge & Cox, “all” is five funds:  DODBX, DODFX, DODGX, DODIX, and DODWX. Since inception, or at least as far back as January 1962, through March 2014, each has beaten its category average.

Same is true for these families: First Eagle, Causeway, Marsico, and Westwood.

For purposes of this article, a “fund family” comprises five funds or more, oldest share class only, with each fund being three years or older.

Obviously, no single metric should be used or misused to select a fund. In this case, fund lifetimes are different. Funds can perform inconsistently across market cycles. Share class representing “oldest” can be different. Survivorship bias and category drift can distort findings. Funds can be mis-categorized or just hard to categorize, making comparisons less meaningful.

Finally, metrics based on historical performance may say nothing of future returns, which is why analysis houses (e.g., Morningstar) examine additional factors, like shareholder friendliness, experience, and strategy to identify “funds with the highest potential of success.”

In the case of Marsico, for example, its six funds have struggled recently. The family charges above average expense ratios, and it has lost some experienced fund managers and analysts. While Morningstar acknowledges strong fund performance within this family since inception, it gives Marsico a negative “Parent” rating.

Nonetheless, these disclaimers acknowledged, prudent investors should know, as part of their due diligence, how well a fund family has performed over the long haul.

So, question: How many funds at Pacific Life beat category average returns since inception?

Applying the same criteria as above, the sad truth is: None of them.

PL funds are managed by Pacific Life Fund Advisors LLC, a wholly owned subsidiary of Pacific Life Insurance Company of Newport Beach, CA. Here from their web-site:

Got that?

Same sad truth for these families: AdvisorOne, Praxis, Integrity, Oak Associates, Arrow Funds, Pacific Financial, and STAAR.

In the case of Oak Associates, its seven funds have underperformed against their categories by 2.4% every year for almost 15 years! (They also experience maximum drawdown of -70.0% on average, or 13.1% worse than their categories.) Yet it proudly advertises recent ranking recognition by US News and selection to Charles Schwab’s OneSource. Its motto: “A Focus on Growth.”

To be clear, my colleague Professor Snowball has written often about the difficulties of beating benchmark indices for those funds that actually try. The headwinds include expense ratios, loads, transaction fees, commissions, and redemption demands. But the lifetime over- and under-performance noted above are against category averages of total returns, which already reflect these headwinds.

Overview. Before presenting performance results for all fund families, here’s is an overall summary, which will put some of the subsequent metrics in context:

It remains discouraging to see half the families still impose front load, at least for some share classes – an indefensible and ultimately shareholder unfriendly practice. Three quarters of families still charge shareholders a 12b-1 fee. All told shareholders pay fund families $12.3 billion every year for marketing. As David likes to point out, there are more funds in the US today than there are publically traded US companies. Somebody must pay to get the word out.

Size. Fidelity has the most number of funds. iShares has the most ETFs. But Vanguard has the largest assets under management.

Expense. In last month’s MFO commentary, Edward Studzinski asked: “It Costs How Much?”

As a group, fund families charge shareholders $83.3 billion each year for management fees and operating costs, which fall under the heading “expense ratio.” ER includes marketing fees, but excludes transaction fees, loads, and redemption fees.

It turns out that no fund family with an average ER above 1.58% ranks in the top performance quintile, as defined below, and most families with an average ER above 2.00 end up in the bottom quintile.

While share class does not get written about very often, it helps reveal inequitable treatment of shareholders for investing in the same fund. Typically, different share classes charge different ERs depending on initial investment amount, load or transaction fee, or association of some form. American has the largest number of share classes per fund with nearly five times the industry average.

Rankings. The following tables summarize top and bottom performing families, based on the percentage of their funds with total returns that beat category averages since inception:

As MFO readers would expect, comparison of top and bottom quintiles reveals the following tendencies:

• Top families charge lower ER, 1.06 versus 1.45%, on average
• Fewer families in top quintile impose front loads, 21 versus 55%
• Fewer families in top quintile impose 12b-1 fees, 64 versus 88%

For this sample at least, the data also suggests:

• Top families have longer tenured managers, if slightly, 9.6 versus 8.2 years
• Top families have fewer share classes, if slightly (1.9 versus 2.3 share class ratio, after 6 sigma American is removed as an outlier; otherwise, just 2.2 versus 2.3)

The complete set of metrics, including ER, AUM, age, tenure, and rankings for each fund family, can be found in MFO Fund Family Metrics, a downloadable Google spreadsheet. (All metrics were derived from Morningstar database found in Steel Mutual Fund Expert, dated March 2014.)

A closer look at the complete fund family data also reveals the following:

Some fund families, like Oakmark and Artisan, have beaten their category averages by 3-4% every year for more than 10 years running, which seems quite extraordinary. Whether attributed to alpha, beta, process, people, stewardship, or luck…or all the above. Quite extraordinary.

While others, frankly too many others, have done just the opposite. Honestly, it’s probably not too hard to figure out why.

31May14/Charles

Good news for Credit Suisse shareholders

CS just notified its shareholders that they won’t be sharing a cell with company officials.

On May 19, 2014, the Department of Justice nailed CS for conspiracy to commit tax fraud. At base, they allowed US citizens to evade taxes by maintaining illegal foreign accounts on their behalf. CS pled guilty to one criminal charge, which dents the otherwise universal impulse “to neither admit nor deny” wrongdoing. In consequence, they’re going to make a substantial contribution to reducing the federal budget deficit. CS certainly admits to wrong-doing, they have agreed to pay “over $1.8 billion” to the government, to ban some former officials, and to “undertake certain remedial actions.” The New York Times reports that the total settlement will end up around $2.6 billion dollars. The Economist calls it $2.8 billion.

Critics of the settlement, including Senator John McCain of Arizona, were astonished that the bank was not required to turn over the names of the tax cheats nor were “any officers, directors or key executives individually accountable for wrongdoing.” Comparable action against UBS, another Swiss bank with a presence in the US mutual fund market, in 2009 forced them to disclose the identities of 4700 account holders. The fact that CS seems intent to avoid discovering the existence of wrongdoing (the Times reports that the firm “did not retain certain documents, failed to interview potentially culpable bankers before they left the firm, and did not start an internal inquiry” for a long while after they had reason to suspect a crime), some argue that the penalties should have been more severe and more targeted at senior management.

If you want to get into the details, the Times also has a nice online archive of the legal documents in the case.

Here’s the good news part: CS reports that “The recent settlements … do not involve the Funds or Credit Suisse Asset Management, LLC, Credit Suisse Asset Management Limited or Credit Suisse Securities (USA) LLC [and] will not have any material impact on the Funds or on the ability of the CS Service Providers to perform services for the Funds.” Of course the fact that CSAM is tied to a criminal corporation would impede their ability to run US funds except for a “temporary exemptive order” from the SEC “to permit them to continue serving as investment advisers and principal underwriters for U.S.-registered investment companies, such as the Funds. Due to a provision in the law governing the operation of U.S.-registered investment companies, they would otherwise have become ineligible to perform these activities as a result of the plea in the Plea Agreement.”

If the SEC makes permanent its temporary exemptive order, then CSAM could continue to manage the funds albeit with the prospect of somewhat-heightened regulatory interest in their behavior. If the commission does not grant permanent relief, the house of cards will begin to tumble.

Which is to say, the SEC is going to play nice and grant the exemption.

One other bit of good news for CS and its shareholders: at least you’re not BNP Paribas which was hoping to get off with an $8 billion slap on the wrist but might actually be on the hook for $10 billion in connection with its assistance to tax dodgers.

Another argument for a news diet: Reuters on the end of the world

A Reuter’s story of May 28 reads, in its entirety:

BlackRock CEO says leveraged ETFs could ‘blow up’ whole industry

May 28 (Reuters) – BlackRock Inc Chief Executive Larry Fink said on Wednesday that leveraged exchange-traded funds contain structural problems that could “blow up” the whole industry one day.

Fink runs a company that oversees more than $4 trillion in client assets, including nearly $1 trillion in ETF assets.

“We’d never do one (a leveraged ETF),” Fink said at Deutsche Bank investment conference in New York. “They have a structural problem that could blow up the whole industry one day.”

Didja notice anything perhaps missing from that story?  You know, places where the gripping narrative might have gotten just a bit thin?

How about: WHAT DOES “BLOW UP” EVEN MEAN? WHAT INDUSTRY EXACTLY?  Or WHY?

Really, guy, you claim to be covering the end of the world – or of the investment industry or ETF industry or something – and the best you could manage was 75 words that skipped, oh, every essential element of the story?

Observer Fund Profiles:

Each month the Observer provides in-depth profiles of between two and four funds.  Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds.  “Stars in the Shadows” are older funds that have attracted far less attention than they deserve. 

Dodge & Cox Global Bond (DODLX): Dodge & Cox, which has been helping the rich stay rich since the Great Depression, is offering you access to the world’s largest asset class, international bonds.  Where their existing Income fund (DODIX) is domestic and centered on investment-grade issues, Global Bond is a converted limited partnership that can go anywhere and shows a predilection for boldness.

RiverNorth/Oaktree High Income (RNOTX): “high income” funds are often just high-yield bond funds with a handful of dividend stocks tossed in for flavor. RiverNorth and Oaktree promise a distinctive and principled take on the space: they’re allocating resources tactically between three very distinct high-income asset classes. Oaktree will pursue their specialty in senior loan and high-yield debt investing while RiverNorth continues to exploit inefficiency and volatility with their opportunistic closed-end fund strategy. They are, at base, looking for investors rational enough to profit from the irrationality of others.

Lookin’ goooood!

As you’ve noticed, the Observer’s visual style is pretty minimalist – there are no flashing lights, twirling fonts, or competing columns and there’s pretty minimal graphic embellishment.  We’re shooting for something that works well across a variety of platforms (we know that a fair chunk of you are reading this on your phone or tablet while a brave handful are relying on dial-up connections).

From time to time, fund companies commission more visually appealing versions of those reprints.  When they ask for formatted reprints, two things happen: we work with them on what are called “compliance edits” so that they don’t run afoul of FINRA regulations and, to a greater or lesser extent, our graphic design team (well, Barb Bradac is pretty much the whole team but she’s really good) works to make the profiles more visually appealing and readable.

Those generally reside on the host companies’ websites, but we thought it worthwhile to share some of the more recent reprints with folks this month.  Each of the thumbnails opens into a full .pdf file in a separate tab.

A sample of recent reprints:

Beck, Mack & Oliver	Tributary Balanced	Evermore Global Value
Intrepid Income	Guinness Atkinson Inflation Managed Dividend	RiverPark/Gargoyle Hedged Value

And what about the other hundred profiles?

We’ve profiled about a hundred funds, all of which are accessible under the Funds tab at the top of the page. Through the kind of agency of my colleague Charles, there’s also a monthly update for every profiled fund in his MFO Dashboard, which he continues to improve. If you want an easy, big picture view, check out the Dashboard – also on the Funds page. 

Elevator Talk: David Bechtel, Principal, Barrow All-Cap Core (BALAX / BALIX)

Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we’ve decided to offer one or two managers each month the opportunity to make a 200 word pitch to you. That’s about the number of words a slightly manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got 200 words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.

Barrow All-Cap Core has the unusual distinction of sporting a top tier five year record despite being less than one year old. The secret is that the fund began life as a private partnership at the end of 2008. It was designed as a public equity vehicle run by private equity investors.

Their argument is that they understand both value and business prospects in ways that are fundamentally different than typical stock investors do. Combining both operating experience with a record of buying entire companies, they’re used to different metrics and different perspectives.

While you might be tempted to dismiss that as “big talk,” two factors might moderate your skepticism. First, their portfolio – typically about 200 names – really is way different from their competitors’. While Morningstar benchmarks them against the large-value group (a style box in which Barrow places just 5% of their money), the fund nearly reversed the size profile of its peers: it has about 20% in large caps, 30% in mid caps and 50% in small caps. Its peer group has about 80% in large caps. The entire portfolio is invested in six sectors, with effectively zero exposure to the four others (including financials and tech). By almost any measure (long-term earnings growth, level of corporate debt, free cash flow generation), their portfolio is substantially higher-quality than its peers. Second, the strategy’s performance – primarily as a private partnership, lately as a mutual fund – has been absolutely first tier: top 3% since inception 12/31/08 and in the top 20% in every calendar year since inception. Overall they’ve earned about 20% annually, better than both the S&P 500 and its large-value peers.

BALAX is managed by Nicholas Chermayeff, formerly of Morgan Stanley’s Principal Investment Group, and Robert F. Greenhill, who co-founded Barrow Street Advisors LLC, the fund’s advisor, after a stint at Goldman Sachs’ Whitehall Funds. Both are Harvard graduates (unlike some of us). The Elevator Talk itself, though, was provided by Yale graduate David Bechtel, a Principal of Barrow Street Advisors LLC, the fund’s advisor, who serves on its Investment Committee, and advises on the firm’s business development activities. He is a Founder and Managing Member of Outpost Capital Management LLC which structures and manages investments in the natural resources and financial services sectors. Mr. Bechtel offered just a bit more than 200 words to explain Barrow’s distinctiveness:

We are, first and foremost, private equity investors. Since Barrow Street was founded in 1997, we have invested and managed hundreds of millions in private market opportunities. The public equity strategy (US stocks only) used in Barrow All-Cap was funded by our own capital in 2008.

We launched this strategy and the fund to meet what we viewed as a market need. We take a private equity approach to security selection. We are not a “value” manager – selecting stocks based on low p/e, etc. – nor a pure “quality” manager – buying blue chips at any price. We look for very high quality companies whose shares are temporarily trading at a discount.

We look at value and quality the way a control investor in a business would. We emphasize cash flow, sales growth per unit of capital, operating margins, and we like companies that reinvest in their businesses. That gives us a very good feeling that not only is the management team interested in growing their business, but also that the business itself is good at generating cash.

On the valuation side, we’re looking for firms that are “momentarily” trading well-below intrinsic value. The general idea is to look at total enterprise value – equity market cap plus debt and preferred stock minus cash on the books – which controls for variations on capital structures, leverage, etc.

We’re trying to differentiate by combining our private equity approach to quality and value into one strategy at the security selection level. And, we are just as dedicated to portfolio diversification to help our investors better weather market volatility. It’s a portfolio without compromises. We think that’s very unusual in the mutual fund universe.

The fund has both institutional and retail share classes. The retail class (BALAX) has a $2500 minimum initial investment. Expenses are 1.41% with about $22 million in assets. The institutional share class (BALIX) is $250,000 and 1.16%. Here’s the fund’s homepage. The content there is modest but useful. 

Funds in Registration

Funds currently in registration with the SEC will generally be available for purchase some time in July, 2014. Our dauntless research associate David Welsch tracked down 12 new no-load funds in registration this month. While there are no immediately tantalizing registrants, there are two flexible bond funds being launched by well-respected small fund families (Weitz Core Plus Income and William Blair Bond Fund) plus the conversion of a pretty successful private options-hedged equity strategy (V2 Hedged Equity Fund, though I would prefer that we not name our investments after the Nazi “Vengeance Weapon 2”).

All of the new registrants are available on the June Funds in Registration page.

Manager Changes

The manager change story-of-the-month comes from S&P Capital IQ. While the report is not publicly available, its conclusion is widely reported: “Of 6,185 U.S. equity mutual funds tracked by Rosenbluth’s firm, more than a thousand of them, or 16.3%, have experienced a manager change since February 2011.” Oddly, the journalists reporting on the story including Brendan Conaway at Barron’s and the Mutual Fund Wire staff, don’t seem to ask the fundamental question: how often does it matter?  They do point to do instances cited by Rosenbluth (Janus Contrarian and Fidelity Growth & Income) where the manager change was worth noting, but don’t ask how typical those cases are.

A far more common pattern, however, is that what’s called a “fund manager change” is actually a partial shuffle of an existing management team. For example, our May “manager changes” feature highlighted 52 manager changes but 36 of those (70% of the total) were partial changes. Example would be New Covenant Growth Fund (NCGFX) where one of the 17 members of the management team departed, Fidelity Series Advisor Growth Opportunities Fund (FAOFX) where there’s a long-term succession strategy or a bunch of the Huntington funds where no one left but a new co-manager was added to the collection.

Speaking of manager changes, Chip this month tracked down 57 sets of them.

Updates: the Justin Frankel/Josh Brown slapfest over liquid alts

Josh Brown, the above-named “reformed broker,” ran a piece in mid-May entitled Brokers, Liquid Alts and the Fund that Never Goes Up. He discusses the fate of Andrew Lo and ASG Diversifying Strategies Fund (DSFAX):

Dr. Andrew Lo vehicle called ASG Diversifying Strategies Fund. The idea was that Dr. Lo, perhaps one of the most brilliant quantitative scientists and academicians in finance (MIT, Harvard, all kinds of awards, PhDs out the ass, etc), would be incorporating a variety of approaches to manage the fund using all asset classes, derivatives and trading methodologies that he and his team saw fit to apply.

What actually did happen was this: Andy Lo, maybe one of the smartest men in the history of finance, managed to invent a product that literally cannot make money in any environment. It’s an extraordinarily rare accomplishment; I don’t think you could go out and invent something that always loses money if you were actually attempting to.

Brown’s argument is less with liquid alts as an arena for investing, and more with the brokers who continue to push investors into a clearly failed strategy.

Justin Frankel, probably the only RiverPark manager that we haven’t spoken with and co-manager of RiverPark Structural Alpha Fund (RSAFX), quickly rushed to the barricades to defend Alt-land from the barbarian horde (and, in doing so, responded to an argument that Brown wasn’t actually making). He published his defense on, of all things, his Tumblr page:

The Wall Street machine has a long history of favoring institutions over individuals, and the ultra-high net worth over the mass affluent. After all, finance is a service industry, and it is those larger clients that pay the lion’s share of fees.

Liquid Alternatives are simply hedge fund strategies wrapped in a mutual fund format … From a practical standpoint, investors should view these strategies as a way to diversify either bond or stock holdings in order to provide non-correlated returns to their investment portfolios, cushion portfolios against downside risks, and improve risk-adjusted returns.

Individual investors have become more sophisticated consumers of financial products. Liquid Alternatives are not just a democratization of the alternative investing landscape. They represent an evolution in how investors can gain access to strategies that they could never invest in before.

Frankel’s argument is redolent of Morty Schaja’s stance, that RiverPark is bringing hedge fund strategies to the “mass affluent” though with a $1000 minimum, they’re available to the mass mass, too.

Both pieces, despite their possibly excessive fraternity, are worth reading.

Briefly Noted . . .

Manning and Napier is adding options to the funds in their Pro-Blend series. Effective on July 14, 2014, the funds will gain the option of writing (which is to say, say selling) options on securities and pursuing a managed futures (a sort of asset-class momentum) strategy. And since the Pro-Blend funds are used in Manning & Napier’s target-date retirement funds, the strategy changes ripple into them, too.

This month, most especially, I’m drawing on the great good work of The Shadow in tracking down the changes below. “Go raibh mile maith agaibh as bhur gcunamh” big guy! Thanks, too, to the folks on the discussion board for their encouragement during the disruptions caused by my house move this month.

 

SMALL WINS FOR INVESTORS

Donald P. Carson, formerly the president of an Atlanta-based investment holding company and now a principal at Ansley Securities, joined the Board of The Cook & Bynum Fund (COBYX) in April and has already made an investment in the fund in the range of $100,001 – $500,000.  Two things are quite clear from the research: (1) having directors – as distinct from managers – invested in a fund improves its risk-return profile and (2) it’s relatively rare to see substantial director investment in a fund.  The managers are deeply invested in the fund and it’s great that their directors are, too.

The Osterweis funds (Osterweis, Strategic Income, Strategic Investment and Institutional Equity) will all, effective June 30 2014 drop their 30-day, 2.0% redemption fees.  I’m always ambivalent about eliminating such fees, since they discourage folks from trading in and out of funds, but most folks cheer the flexibility so we’re willing to declare it “a small win.”  

Effective May 16, 2014, the minimum initial investment on the institutional class of the RiverPark funds (Large Growth, RiverPark/Wedgewood Fund, Short Term High Yield, Long/Short Opportunity, RiverPark/Gargoyle Hedged Value, Structural Alpha Fund and Strategic Income) were all reduced from $1,000,000 to $100,000.   Of greater significance to many of us, the expense ratios were reduced for Short Term High Yield (from 1.25% to 1.17% on RPHYX and from 1.00% to 0.91% on RPHIX) and RiverPark/Wedgewood (from 1.25% to 1.05% on RPCFX and from 1.00% to 0.88% on RWGIX).

CLOSINGS (and related inconveniences)

Effective on July 8, 2014, Franklin Biotechnology Discovery Fund (FBDIX) will close to new investors. It’s a fund for thrill seekers – it invests in very, very growth-y midcap biotech firms which are (ready for this?) really volatile. The fund’s returns have averaged about 12% over the past decade – 115 bps better than its peers – but the cost has been high: a beta of 1.77 and a standard deviation nearly 50% about the Specialty-Health group norm. That hasn’t been enough to determine $1.3 billion in investment from flowing in.

Morningstar’s been having real problems with their website this month.  During the last week of the month, some fund profiles were completely unavailable while, in other cases, clicking on the link to one fund would take you to the profile of another. I assume something similar is going on here, since the MPT data for this biotech stock fund benchmarks it against “BofAML Convertible Bonds All Qualities.”

Update: One of the Corporate Communication folks at Morningstar reached out in response to my comment on their site stability which itself was triggered mostly by the vigorous thread on the point. Ms. Spelhaug writes: “Hope you’re well. I saw your column mentioning issues you’ve experienced with the Quote pages on Morningstar.com. I wanted to let you know that we’re aware that there have been some issues and have been in the process of retiring the system that’s causing the problems.”

Effective as of May 30, 2014, the investor class of Samson STRONG Nations Currency Fund (SCRFX) closed its “Investor” class to new investors. On that same day, those shares were re-designated as Institutional Class shares. Given the fund’s parlous performance (down about 8% since inception compared to a peer group that’s down about 0.25%), the closure might be prelude to …. uhhh, further action.

T. Rowe Price Capital Appreciation (PRWCX) will close to new investors on June 30, 2014. Traditionally famous for holding convertible securities, the fund’s fixed-income exposure is almost entirely bonds now with a tiny sliver of convertibles. That reflects the manager’s judgment that converts are way overpriced. The equity part of the portfolio targets blue chips, though the orientation has slowly but surely shifted toward growthier stocks over the years.

The fund is bloated at over $20 billion in assets but it’s sure hard to criticize. It’s posted peer-beating returns in 11 of the past 12 years, including all five years since crossing the $10 billion in AUM threshold. It’s particularly impressive that the fund has outperformed Prospector Capital Appreciation (PCAFX), which is run by Richard Howard, PRWCX’s long-time manager, over the past seven years. While I’m generally reluctant to recommend large funds, much less large funds that are about to close, this one really does warrant a bit of attention on your part.

All classes of the Wells Fargo Advantage Discovery Fund (WFDAX) are closed to new investors. The $3.2 billion fund has posted pretty consistently above average returns, but also consistently above average risks.

OLD WINE, NEW BOTTLES

Effective July 1, 2014, the AllianzGI Structured Alpha Fund (AZIAX) will change its name to the AllianzGI Structured Return Fund. Its investment objective, principal investment strategies, management fee and operating expenses change as well. The plan is to write exchange-traded call options or FLEX call options (i.e. listed options that are traded on an exchange, but with customized strike prices and expiration dates) to generate income and some downside protection. The choice strikes me as technical rather than fundamental, since the portfolio is already comprised of 280 puts and calls. The most significant change is a vast decrease in the fund’s expense ratio, from 1.90% for “A” shares down to 1.15%.

Crow Point Hedged Global Equity Income Fund (CGHAX) has been rechristened Crow Point Defined Risk Global Equity Income Fund. The Fund’s investment objective, policies and strategies remain unchanged.

Hansberger International Growth (HIGGX/HITGX) is in the process of becoming one of the Madison (formerly Mosaic) Funds. I seem to have misread the SEC filing last month and reported that they’re becoming part of the Madison Fund (singular) rather than Madison Funds (plural). The management team is responsible for about $4 billion in mostly institutional assets. They’re located in, and will remain in, Toronto. This will be Madison’s second international fund, beside Madison NorthRoad International (NRIEX) whose managers finish their third solid year at the helm on June 30^th.

Effective June 4 2014, the Sustainable Opportunities (SOPNX) fund gets renamed the Even Keel Multi-Asset Managed Risk Fund. The Fund’s investment objective, policies and strategies remain unchanged. Given the fund’s modest success over its first two years, I suppose there are investors who might have preferred keeping the name and shifting the strategy.

The Munder Funds are in the process of becoming Victory funds. Munder Capital Management, Munder’s advisor, got bought by Victory Capital Management, so the transition is sensible and inevitable. Victory will create a series of “shell” funds which are “substantially similar, if not identical” to existing Munder funds, then merge the Munder funds into them. This is all pending shareholder approval.

Touchstone Core Bond Fund has been renamed Touchstone Active Bond Fund (TOBAX). The numbers on the fund are a bit hard to decipher – by some measures, lots of alpha, by others

Effective on or about July 1, 2014, Transamerica Diversified Equity (TADAX) will be renamed Transamerica US Growth and the principal investment strategy will be tweaked to require 80% U.S. holdings. Roughly speaking, TADAX trailed 90% of its peers during manager Paul Marrkand’s first calendar year. The next year it trailed 80%, then 70% and so far in 2014, 60%.  Based on that performance, I’d put it on your buy list for 2019.

OFF TO THE DUSTBIN OF HISTORY

On May 29, 2014 (happy birthday to me, happy birthday to me …), the tiny and turbulent long/short AllianzGI Redwood Fund (ARRAX) was liquidated and dissolved.

The Giralda Fund (GDAIX) liquidates its “I” shares on June 27, 2014 but promises that you can swap them for “I” shares of Giralda Risk-Managed Growth Fund (GRGIX) if you’d really like.

Harbor Target Retirement 2010 Fund (HARFX) has changed its asset allocation over time in accordance with its glide path and its allocation is now substantially similar to that of Harbor Target Retirement Income Fund, and so 2010 is merging into Retirement Income on Halloween.  Happily, the merger will not trigger a tax bill.

In mid-May, 2014, Huntington suspended sales of the “A” and institutional shares of its Fixed Income Securities, Intermediate Government Income, Mortgage Securities, Ohio Tax-Free, and Short/Intermediate Fixed Income Securities funds.

On May 16, 2014, the Board of Trustees of Oppenheimer Currency Opportunities Fund (OCOAX) approved a plan to liquidate the Fund on or about August 1, 2014.  Since inception, the fund offered its investors the opportunity to turn $100 into $98.50 which a fair number of them inexplicably accepted.

At the recommendation of LSV Asset Management, the LSV Conservative Core Equity Fund (LSVPX) will cease operations and liquidate on or about June 13, 2014. Morningstar has it rated as a four-star fund and its returns have been in the top decile of its large-value peer group over the past five years, which doesn’t usually presage elimination. As the discussion board’s senior member Ted puts it, “With only $15 Million in AUM, and a minimum investment of $100,000 hard to get off the ground in spite of decent performance.”

Turner All Cap Growth Fund (TBTBX) is slated to merge into Turner Midcap Growth Fund (TMGFX) some time in the fall of 2014. Since I’ve never seen the appeal of Turner’s consistently high-volatility funds, I mostly judge nod and mumble about tweedle-dum and …

Wilmington’s small, expensive, risky, underperforming Large-Cap Growth Fund (VLCPX) and regrettably similar Large-Cap Value Fund (VEINX) have each been closed to new investors and are both being liquidated around June 20th.

In Closing . . .

The Morningstar Investment Conference will be one of the highlights of June for us. A number of folks responded to our offer to meet and chat while we’re there, and we’re certainly amenable to the idea of seeing a lot more folks while we’re there.

I don’t tweet (despite Daisy Maxey’s heartfelt injunction to “build my personal brand”) but I do post a series of reports to our discussion board after each day at the conference. If you’re curious and can’t be in Chicago, please to feel free to look in on the board.

Finally, thanks to all those who continue to support the Observer – with their ideas and patience, as much as with their contributions and purchases. It’s been a head-spinning time and I’m grateful to all of you as we work through it.

Just a quick reminder that we’re going to clean our email list. We’ve got two targets, addresses that make absolutely no sense and folks who haven’t opened one of our emails in a year or more.

We’ll talk soon!

Dear friends,

It’s not a question of whether it’s coming.  It’s just a question of whether you’ve been preparing intelligently.

There’s an old joke about the farmer with the leaky roof that never gets fixed.  When the sun’s out, he never thinks about the leak and when it’s raining, he can’t get up there to fix it anyway.  And so the leak continues.

Our investments likewise: people who are kicking themselves for not having 100% equity exposure in March 2009 and 200% exposure in January 2013 have been pulling money steadily from boring investments and adding them to stocks.  The domestic stock market has seen its 13^th consecutive month of inflows and the S&P 500 closed February at its highest nominal level ever.

I mention this now because the sun has been shining so brightly.  March 9, 2014 marches the five-year anniversary of the current bull market.  In those five years, a $10,000 investment in the S&P500 would have grown to $30,400.  The same amount invested in the NASDAQ on March 9 would have grown to $35,900. The last remnants of the ferocious bear markets of 2000-02 and 2007-09 have faded from the ratings.  And investors really want a do-over.  All the folks hiding under their beds in 2009 and still peering out from under the blankies in 2011 feel cheated and they want in on the action, and they want it now.

Hence inflows into an overpriced market.

Our general suggestion is to learn from the past, but not to live there.  Nothing we do today can capture the returns of the past five years for us.  Sadly, we still can damage the next five.  To help build a strong prospects for our future, we’re spending a bit of time this month talking about hedging strategies – ways to get into a pricey market without quite so much heartache – and cool funds that might be better positioned for the next five than you’d otherwise find.

And, too, we get to celebrate the onset of spring!

The search for active share

It’s much easier to lose in investing than to win.  Sometimes we lose because we’re offered poor choices and sometimes we lose because we make poor ones.  Frankly, it doesn’t take many poor choices to trash the best laid plans.

Winning requires doing a lot of things right.  One of those things is deciding whether – or to what extent – your portfolio should rely on actively and passively managed funds.  A lot of actively managed funds are dismal but so too are a lot of passive products: poorly constructed indexes, trendy themes, disciplines driven by marketing, and high fees plague the index and EFT crowd.

If you are going to opt for active management, you need to be sure that it’s active in more than name alone.  As we’ve shown before, many active managers – especially those trying to deploy billions in capital – offer no advantage over a broad market index, and a lot of disadvantages. 

One tool for measuring the degree to which your manager is active is called, appropriately enough, “active share.”  Active share measures the degree to which your fund’s holdings differ from its benchmark’s.  The logic is simple: you can’t beat an index by replicating it and if you can’t beat it, you should simply buy it.

The study “How Active Is Your Manager” (2009) by Cremers and Petajitso concluded that “Funds with high active share actually do outperform their benchmarks.” The researchers originally looked at an ocean of data covering the period from 1990 to 2003, then updated it through 2009.  They found that funds with active share of at least 90% outperformed their benchmarks by 1.13% (113 basis points per year) after fees. Funds with active share below 60% consistently underperformed by 1.42 percentage points a year, after accounting for fees.

Some researchers have suggested that the threshold for active share needs to be adjusted to account for differences in the fund’s investment universe: a fund that invests in large to mega-cap names should have an active share north of 70%, midcaps should be above 80% and small caps above 90%. 

So far, we’ve only seen research validating the 60% and 90% thresholds though the logic of the step system is appealing; of the 5008 publicly-traded US stocks, there are just a few hundred large caps but several thousand small and micro-caps.

There are three problems with the active share data.  We’d like to begin addressing one of them and warn you of the other two.

Problem One: It’s not available.  Morningstar has the data but does not release it, except in occasional essays. Fund companies may or may not have it, but almost none of them share it with investors. And journalists occasionally publish pieces that include an active share chart but those tend to be an idiosyncratic, one-time shot of a few funds. Nuts.

Problem Two: Active share is only as valid as the benchmark used. The calculation of active share is simply a comparison between a fund’s portfolio and the holdings in some index. Pick a bad index and you get a bad answer. By way of simple illustration, the S&P500 stock index has an active share of 100 (woo hoo!) if you benchmark it against the MSCI Emerging Markets Index.

Fund companies might have the same incentive and the same leverage with active share providers that the buyers of bond ratings did: bond issuers could approach three ratings agencies and say “tell me how you’ll rate my bond and I’ll tell you whether we’re paying for your rating.” A fund company looking for a higher active share might simply try several indexes until they find the one that makes them look good. Here’s the warning: make sure you know what benchmark was used and make sure it makes sense.

Problem Three: You can compare active share between two funds only if they’ve chosen to use the same benchmark. One large cap might have an active share of 70 against the Mergent Dividend Achievers Index while another has a 75 against the Russell 1000 Value Index. There’s no way, from that data, to know whether one fund is actually more active than the other. So, look for comparables.

To help you make better decisions, we’ve begun gathering publicly-available active share data released by fund companies.  Because we know that compact portfolios are also correlated to higher degrees of independence, we’ve included that information too for all of the funds we could identify.  A number of managers and advisors have provided active share data since our March 1^st launch.  Thanks!  Those newly added funds appear in italics.

Fund	Ticker	Active share	Benchmark	Stocks
Artisan Emerging Markets (Adv)	ARTZX	79.0	MSCI Emerging Markets	90
Artisan Global Equity	ARTHX	94.6	MSCI All Country World	57
Artisan Global Opportunities	ARTRX	95.3	MSCI All Country World	41
Artisan Global Value	ARTGX	90.5	MSCI All Country World	46
Artisan International	ARTIX	82.6	MSCI EAFE	68
Artisan International Small Cap	ARTJX	97.8	MSCI EAFE Small Cap	45
Artisan International Value	ARTKX	92.0	MSCI EAFE	50
Artisan Mid Cap	ARTMX	86.3	Russell Midcap Growth	65
Artisan Mid Cap Value	ARTQX	90.2	Russell Value	57
Artisan Small Cap	ARTSX	94.2	Russell 2000 Growth	68
Artisan Small Cap Value	ARTVX	91.6	Russell 2000 Value	103
Artisan Value	ARTLX	87.9	Russell 1000 Value	32
Barrow All-Cap Core Investor	BALAX	92.7	S&P 500	182
Diamond Hill Select	DHLTX	89	Russell 3000 Index	35
Diamond Hill Large Cap	DHLRX	80	Russell 1000 Index	49
Diamond Hill Small Cap	DHSIX	97	Russell 2000 Index	68
Diamond Hill Small-Mid Cap	DHMIX	97	Russell 2500 Index	62
DoubleLine Equities Growth	DLEGX	88.9	S&P 500	38
DoubleLine Equities Small Cap Growth	DLESX	92.7	Russell 2000 Growth	65
Driehaus EM Small Cap Growth	DRESX	96.4	MSCI EM Small Cap	102
FPA Capital	FPPTX	97.7	Russell 2500	28
FPA Crescent	FPACX	90.3	Barclays 60/40 Aggregate	50
FPA International Value	FPIVX	97.8	MSCI All Country World ex-US	23
FPA Perennial	FPPFX	98.9	Russell 2500	30
Guinness Atkinson Global Innovators	IWIRX	99	MSCI World	28
Guinness Atkinson Inflation Managed Dividend	GAINX	93	MSCI World	35
Linde Hansen Contrarian Value	LHVAX	87.1 *	Russell Midcap Value	23
Parnassus Equity Income	PRBLX	86.9	S&P 500	41
Parnassus Fund	PARNX	92.6	S&P 500	42
Parnassus Mid Cap	PARMX	94.9	Russell Midcap	40
Parnassus Small Cap	PARSX	98.8	Russell 2000	31
Parnassus Workplace	PARWX	88.9	S&P 500	37
Pinnacle Value	PVFIX	98.5	Russell 2000 TR	37
Touchstone Capital Growth	TSCGX	77	Russell 1000 Growth	58
Touchstone Emerging Markets Eq	TEMAX	80	MSCI Emerging Markets	68
Touchstone Focused	TFOAX	90	Russell 3000	37
Touchstone Growth Opportunities	TGVFX	78	Russell 3000 Growth	60
Touchstone Int’l Small Cap	TNSAX	97	S&P Developed ex-US Small Cap	97
Touchstone Int’l Value	FSIEX	87	MSCI EAFE	54
Touchstone Large Cap Growth	TEQAX	92	Russell 1000 Growth	42
Touchstone Mid Cap	TMAPX	96	Russell Midcap	33
Touchstone Mid Cap Growth	TEGAX	87	Russell Midcap Growth	74
Touchstone Mid Cap Value	TCVAX	87	Russell Midcap Value	80
Touchstone Midcap Value Opps	TMOAX	87	Russell Midcap Value	65
Touchstone Sands Capital Select	TSNAX	88	Russell 1000 Growth	29
Touchstone Sands Growth	CISGX	88	Russell 1000 Growth	29
Touchstone Small Cap Core	TSFAX	99	Russell 2000	35
Touchstone Small Cap Growth	MXCAX	90	Russell 2000 Growth	81
Touchstone Small Cap Value	FTVAX	94	Russell 2000 Value	75
Touchstone Small Cap Value Opps	TSOAX	94	Russell 2000 Value	87
William Blair Growth	WBGSX	83	Russell 3000 Growth	53

*        Linde Hansen notes that their active share is 98 if you count stocks and cash, 87 if you look only at the stock portion of their portfolio.  To the extent that cash is a conscious choice (i.e., “no stock in our investable universe meets our purchase standards, so we’ll buy cash”), count both makes a world of sense.  I just need to find out how other investors have handled the matter.

Who’s not on the list? 

A lot of firms, some of whose absences are in the ironic-to-hypocritical range. Firms not choosing to disclose active share include:

BlackRock – which employs Anniti Petajisto, the guy who invented active share, as a researcher and portfolio manager in their Multi-Asset Strategies group. (They do make passing reference to an “active share buyback” on the part on one of their holdings, so I guess that’s partial credit, right?)

Fidelity – whose 5 Tips to Pick a Winning Fund tells you to look for “stronger performers [which are likely to] have a high ‘active share’”.  (They do reprint a Reuters article ridiculing a competitor with a measly 56% active share, but somehow skip the 48% for Fidelity Blue Chip Growth, 47% for Growth & Income, the 37% for MegaCap Stock or the under 50% for six of their Strategic Advisers funds). (per the Wall Street Journal, Is Your Fund a Closet Index Fund, January 14, 2014).

Oakmark – which preens about “Harris Associates and Active Share” without revealing any.

Are you active?  Would you like someone to notice?

We’ve been scanning fund company sites for the past month, looking for active share reports. If we’ve missed you, we’re sorry. Help us correct the oversight  by sending us the link to where you report your active share stats. We’d be more than happy to offer a permanent home for the web’s largest open collection of active share data.

Does Size Matter?

By Edward Studzinski

“Convictions are more dangerous enemies of truth than lies.”

                    Nietzsche

One of the more interesting consequences of the performance of equities in 2013 is the ramp-up of the active investment management marketing machines to explain why their performance in many instances lagged that of inexpensive index funds. This has resulted in a manure storm media blitz with terms and phrases such as “stock picker’s market” or “active share” or “concentrated portfolios.” 

“Stock picker’s market” is generally a euphemism for active management. That is, why you should pay me 100 basis points for investing in a subset of the S&P 500, rather than pay Vanguard or some other index fund provider 5 basis points for their product. One of the rationales I used to regularly hear to justify active management fees was that the active manager will know when to get out of the market and when to get back in, whereas the small investor will always go in and out at the wrong time. The period of 2008-2009 puts paid to that argument when one looks at maximum drawdown numbers.  The question it raises however is whether the time horizon most investment managers and investors use is far too short. I think it clearly is and that rather than three years or three to five years, we should be thinking of ten years at a minimum.  Unfortunately, given personnel turnover in many investment organizations, it is difficult for the investing public to know or understand that the people who gave a fund its long-term performance, looking in the rear-view mirror, are not the ones doing the analysis or selecting the investments going forward. And if they are, often their time and attention is pulled in many other directions.  This is why I now, sitting on an endowment investment committee, appreciate why an integral part of the investment consultant’s report covers stability of personnel and succession planning at current firms invested in as well as firms proposed for consideration. Of course, if you are the average retail investor, you are far better off to focus on your risk tolerance, true time horizon, and asset allocation, again making use of low cost index products if you are not going to spend the time and effort to replicate the work of the consultants used by endowments and pension funds.

I am going to leave it to others to discuss “active share.”  I do think the question of “concentrated portfolios” is worth a few thoughts.  I once asked a friend of mine, at a large East Coast fund complex, how he managed to keep track of the two hundred or so stocks in his fund portfolio. His answer was illuminating.  He said that his firm had a very large research department and prided itself on its selection and training of analysts.  Politically then, over time he had to use an idea or two from everyone or every area. His preference would have been to have a much more concentrated portfolio.  I will refer to that then as the “ark” approach to investment management. Other firms, such as Longleaf, have tended from the get-go to have truly concentrated portfolios, say somewhere between twenty to twenty five stocks, given that the benefits of diversification run-out at a certain number of securities. Their rationale has been that rarely, when you are building a portfolio from the bottom up based on what are the most undervalued ideas, do ideas number thirty to forty have the same expected return potential as ideas number one to ten. (That is even more the case with the S&P 500 hitting new all time highs now).

There is another way to look at this which I think makes it more understandable for the average person.  In 2006, Huber Capital Managed LLC performed a study, looking at value-oriented investors, entitled “Limited Assets Under Management is a Competitive Advantage.”   The study assumed an equal weighted portfolio of 2.5% positions (forty stocks) to show how the investable universe of securities shrank at certain asset levels. It looked at the Russell 1000 Value Index and the Russell 2000 Value Index. The conclusion of the study was that as assets under management grew, portfolio managers faced increasingly unpleasant choices. One choice of course was to shrink the investment universe, what I have referred to in the past as the rule limiting investments to securities that can be bought or sold in five days average trading volume.

Another alternative was to increase the number of stocks held in the portfolio. You can see whether your manager has done this by going back five or ten years and looking at annual reports.  When the fund was $5B in asset size, did it own thirty stocks? Do you really believe that with the fund at $10B or $15B in asset size, that it has found another twenty or thirty undervalued stocks?  Look also to see if the number of research analysts has increased materially. Are roughly the same number of analysts covering more names? 

The third choice was to make the fund very concentrated or even non-diversified by SEC standards, with individual positions greater than five per cent. That can work, but it entails taking on career risk for the analysts and fund managers, and enterprise risk for the management company. A fund with $10B in assets under management has available only 50% of the investable set of stocks to invest in, assuming it is going to continue to focus on liquidity of the investment as an implicit criteria. That is why you see more and more pension funds, endowments, and family office managers shifting to low-cost index or ETF vehicles for their large cap investments. The incremental return is not justified by the incremental fee over the low-cost vehicle. And with a long-term time horizon, the compounding effect of that fee differential becomes truly important to returns.

My thanks to Huber Capital Manangement LLC for doing this study, and to Long Short Advisors for making me aware of it in one of their recent reports. Both firms are to be commended for their integrity and honesty. They are truly investment managers rather than asset gatherers. 

On the impact of fund categorization: Morningstar’s rejoinder

Morningstar’s esteemed John Rekenthaler replied to MFO’s February commentary on categorization, although officially “his views are his own.” His February 5 column is entitled How Morningstar Categorizes Funds.

Snowball’s gloss: John starts with a semantic quibble (Charles: “Morningstar says OSTFX is a mid-cap blend fund,” John: “Morningstar does not say what a fund is,” just what category it’s been assigned to), mischaracterizes Charles’s article as “a letter to MFO” (which I mention only because he started the quibble-business) and goes on to argue that the assignment of OSTFX to its category is about as reasonable a choice as could be made. Back to Charles:

Mr. R. uses BobC’s post to frame an explanation of what Morningstar does and does not do with respect to fund categorization. In his usual thoughtful and self-effacing manner, he defends the methodology, while admitting some difficulty in communicating. Fact is, he remains one of Morningstar’s best communicators and Rekenthaler Report is always a must read.

I actually agree with his position on Osterweis. Ditto for his position on not having an All Cap category (though I suspect I’m in the minority here and he actually admits he may be too). He did not address the (mis-)categorization of River Park Short Term High Yield Fund (RPHYX/RPHIX, closed). Perhaps because he is no longer in charge of categorization at Morningstar.

The debate on categorization is never-ending, of course, as evidenced by the responses to his report and the many threads on our own board. For the most part, the debate remains a healthy one. Important for investors to understand the context, the peer group, in which prospective funds are being rated.

In any case and as always, we very much appreciate Mr. Rekenthaler taking notice and sharing his views.

Snowball’s other gloss: geez, Charles is a lot nicer than I am. I respect John’s work but frankly I don’t really tingle at the thought that he “takes notice.” Well, except maybe for that time at the Morningstar conference when he swerved at the last minute to avoid crashing into me. I guess there was a tingle then.

Snowball’s snipe: at the sound of Morningstar’s disdain, MFWire did what MFWire does. They raised high the red-and-white banner, trumpeting John’s argument and concluding with a sharp “grow up, already!” I would have been much more impressed with them if they’d read Charles’s article beforehand. They certainly might have, but there’s no evidence in the article that they felt that need.

One of the joys of writing for the Observer is the huge range of backgrounds and perspectives that our readers bring to the discussion. A second job is the huge range of backgrounds and perspectives that my colleagues bring. Charles, in particular, can hear statistics sing. (He just spent a joyful week in conference studying discounted cash-flow models.) From time to time he tries, gently, to lift the veil of innumeracy from my eyes. The following essay flows from our extended e-mail exchanges in which I struggled to understand the vastly different judgments of particular funds implied by different ways of presenting their risk-adjusted statistics. 

We thought some of you might like to overhear that conversation.  

Morningstar’s Risk Adjusted Return Measure

Central to any fund rating system is the performance measure used to determine percentile rank order. MFO uses Martin ratio, as described Rating System Definitions. Morningstar developed its own risk adjusted return (MRAR), which Nobel Laureate William Sharpe once described as a measure that “…differs significantly from more traditional ones such as various forms of the Sharpe ratio.” While the professor referred to an earlier version of MRAR, the same holds true today.

Here is how Morningstar describes MRAR on its Data FAQ page: Morningstar adjusts for risk by calculating a risk penalty for each fund based on “expected utility theory,” a commonly used method of economic analysis. Although the math is complex, the basic concept is relatively straightforward. It assumes that investors are more concerned about a possible poor outcome than an unexpectedly good outcome and that those investors are willing to give up a small portion of an investment’s expected return in exchange for greater certainty. A “risk penalty” is subtracted from each fund’s total return, based on the variation in its month-to-month return during the rating period, with an emphasis on downward variation. The greater the variation, the larger the penalty. If two funds have the exact same return, the one with more variation in its return is given the larger risk penalty.

For the curious and mathematically inclined, the detailed equations are well documented in The Morningstar Rating Methodology. The following figure illustrates how MRAR behaves for three hypothetical funds over a 3 year period ending Dec 2013:

Each fund in the illustration delivers the same total return, but with varying levels of volatility. The higher the volatility, the lower the risk adjusted return. Fund 0 delivers consistent returns every month with zero volatility; consequently, it receives the highest MRAR, which in this case is the fund’s annualized total return minus the risk-free T-Bill (i.e., it’s the annualized “excess” return).

Morningstar computes MRAR for all funds over equivalent periods, and then percentile ranks them within their respective categories to assign appropriate levels, 1 star for those funds in the lowest group and the coveted 5 star rating for the highest.

It also computes a risk measure MRisk and performs a similar ranking to designate “low” to “high” risk funds within each category. MRisk is simply the difference between the annualized excess return of the fund and its MRAR.

The following figure provides further insight into how MRAR behaves for funds of varying volatility. This time, fund total returns have been scaled to match their category averages, again for the 3 year period ending Dec 2013. The figure includes results from several categories showing MRAR versus the tradition volatility measure, annualized standard deviation.

Once again we see that funds with higher volatility generally receive lower MRARs and that the highest possible MRAR is equal to a fund’s annualized excess return, which occurs at zero standard deviation.

A consequence of Morningstar’s methodology is that low volatility funds with below average returns can quite possibly be out-ranked by average volatility funds with average returns. Put another way, the methodology generally penalizes funds with high volatility more so than it rewards funds with low volatility, since with the latter the benefit is “capped.”

This behavior is different from other risk adjusted return measures based on say Sharpe ratio, as can be seen in the figure below. Here the same funds from above are plotted against Sharpe, but now funds with low volatility are rewarded handsomely, even if they have below average total returns.

Revisiting the Morningstar risk measure MRisk, one finds another observation: it appears to correlate rather satisfactorily against a simple function based on standard deviation (up to about 30% for funds of positive total return without load):

Which means that Morningstar’s risk adjusted return can be estimated from the following:

This simple approximation may come in handy, like when David wonders: “Why do RPHIX and ICMYX, which have superior 3 year Sharpe ratios, rate a very inferior 1 star by Morningstar?” He can use the above calculation to better understand, as illustrated here:

While both do indeed have great 3 year Sharpe ratios – RPHIX is highest of any US fund – they both have below average total returns relative to their current peer group, as represented by say VWEHX, a moderate risk and average returning high yield bond “reference” fund.

Their low volatilities simply get no love from Morningstar’s risk adjusted return measure.

27Feb2014/Charles

Celebrating one-starness

I was having a nice back-channel conversation with a substantially frustrated fund manager this week. He read Charles’s piece on fund categorization and wrote to express his own dismay with the process. He’s running a small fund. It hit its three-year mark and earned five stars. People noticed. Then Morningstar decided to recategorize the fund (into something he thinks he isn’t). And it promptly became one star. And, again, people – potential investors – noticed, but not in a good way.

Five to one, with the stroke of a pen? It happens, but tends not to get trumpeted. After all, it rather implies negligence on Morningstar’s part if they’ve been labeling something as, say, a really good conservative allocation fund for years but then, on further reflection, conclude that it’s actually a sucky high-yield bond or preferred stock fund.

Here’s what Morningstar’s explanation for such a change looks like in practice:

Morningstar Alert

Osterweis Strategic Income Fund OSTIX

12-03-13 01:00 PM

Change in Morningstar Fund Star Rating: The Morningstar Star Rating for this fund has changed from 4 stars to 2 stars. For details, go to http://quicktake.morningstar.com/Fund/RatingsAndRisk.asp?Symbol=OSTIX.

Sadly, when you go to that page there are no details that would explain an overnight drop of that magnitude. On the “performance” page, you will find the clue:

I don’t have an opinion on the appropriateness of the category assignment but it would be an awfully nice touch, given the real financial consequences of such a redesignation, if Morningstar would take three sentences to explain their rationale at the point that they make the change.

Which got me to thinking about my own favorite one-star fund (RiverPark Short Term High Yield RPHYX and RPHIX, which is closed) and Charles’s favorite one-shot stat on a fund’s risk-adjusted returns (its Sharpe ratio).

And so, here’s the question: how many funds have a higher (i.e., better) Sharpe ratio than does RPHYX?

And, as a follow-up, how many have a Sharpe ratio even half as high as RiverPark’s?

That would be “zero” and “seven,” respectively, out of 6500 funds.

Taking up Rekenthaler’s offer

In concluding his response to Charles’s essay, John writes:

A sufficient critique is one that comes from a fund that truly does not behave like others in its category, that contains a proposal for a modification to the existing category system, that does not lead to rampant category proliferation, and that results in a significantly closer performance comparison between the fund and its new category. In such cases, Morningstar will consider the request carefully–and sometimes make the suggested change.

Ummm … short-term high-yield? In general, those are funds that are much more conservative than the high-yield group. The manager at RiverPark Short-Term High Yield (RPHYX) positions the fund as a “cash management” account. The managers at Intrepid Income (ICMYX) claim to be “absolute return” investors. Wells Fargo Advantage Short-Term High-Yield Bond (STHBX) seems similarly positioned. All are one-star funds (as of February 2014) when judged against the high-yield universe.

“Does not behave like others in its category” but “results in a significantly closer performance comparison [within] its new category.” The orange line is the high-yield category. That little cluster of parallel, often overlapping lines below it are the three funds.

“Does not lead to rampant category proliferation.” You mean, like creating a “preferred stock” category with seven funds? That sort of proliferation? If so, we’re okay – there are about twice as many short-term high-yield candidates as preferred stock ones.

I’m not sure this is a great idea. I am pretty sure that dumping a bunch of useful, creative funds into this particular box is a pretty bad one.

Next month’s unsought advice will highlight emerging markets balanced (or multi-asset) funds. We’re up to a dozen of them now and the same logic that pulled US balanced funds out of the equity category and global balanced funds out of the international equity category, seems to be operating here.

Two things you really should read

In general, most writing about funds has the same problem as most funds do: it’s shallow, unoriginal, unreflective. It contributes little except to fill space and get somebody paid (both honorable goals, by the way). Occasionally, though, there are pieces that are really worth some of our time, thought and reflection. Here are two.

I’m not a great fan of ETFs. They’ve always struck me as trading vehicles, tools for allowing hedge funds and others to “make bets” rather than to invest. Chuck Jaffe had a really solid piece entitled “The growing case against ETFs” (Feb. 23, 2014) that makes the argument that ETFs are bad for you. Why? Because the great advantage of ETFs are that you can trade them all day long. And, as it turns out, if you give someone a portfolio filled with ETFs that’s precisely – and disastrously – what they do.

The Observer was founded on the premise that small, independent, active funds are the only viable alternative to a low-cost indexed portfolio. As funds swell, two bad things happen: their investable universe shrinks and the cost of making a mistake skyrockets, both of which lead to bad investment choices. There’s a vibrant line of academic research on the issue. John Rekenthaler began dissecting some of that research – in particular, a recent study endorsing younger managers and funds – in a four-part series of The Rekenthaler Report. At this writing, John had posted two essays: “Are Young Managers All That?” (Feb. 27, 2014) and “Has Your Fund Become Too Large, Or Is Industry Size the Problem?” (Feb. 28, 2014).  The first essay walks carefully through the reasons why older, larger funds – even those with very talented managers – regress. To my mind, he’s making a very strong case for finding capacity-constrained strategies and managers who will close their funds tight and early. The second picks up an old argument made by Charles Ellis in his 1974 “The Loser’s Game” essay; that the growth and professionalization of the investment industry is so great that no one – certainly not someone dragging a load – can noticeably outrun the crowd. The problem is less, John argues, the bloat of a single fund as the effect of “$3 trillion in smart money chasing the same ideas.”  

Regardless of whether you disdain or adore ETFs, or find the industry’s difficulties located at the level of undisciplined funds or an unwieldy industry, you’ll come away from these essays with much to think about.

RiverPark Strategic Income: Another set of ears

I’m always amazed by the number of bright and engaging folks who’ve been drawn to the Observer, and humbled by their willingness to freely share some of their time, insights and experience with the rest of us. One of those folks is an investor and advisor named “Mark” who is responsible for extended family money, a “multi-family office” if you will. He had an opportunity to spend some time chatting with David Sherman in mid-January as he contemplated a rather sizeable investment in RiverPark Strategic Income (RSIVX) for some family members who would benefit from such a strategy. Herewith are some of the reflections he shared over the course of a series of emails with me.

Where he’s coming from

Mark wrote that to him it’s important to understand the “context” of RSIVX. Mr. Sherman manages private strategies and hedge fund monies at Cohanzick Management, LLC. He cut his teeth at Leucadia National (whose principal Ian Cumming is sometimes referred to as Canada’s Warren Buffett) and is running some sophisticated and high entry strategies that have big risks and big rewards. His shop is not as large as some, sure, but Mr. Sherman seems to prefer it that way.

Some of what Mr. Sherman does all day “informs” RSIVX. He comes across an instrument or an idea that doesn’t fit in one strategy but may in another. It has the risk/reward characteristics that he wants for a particular strategy and so he and his team perform their due diligence on it. More on that later.

Where he is

RSIVX only exists, according to Mr. Sherman, because it fills a need. The need is for an annuity like stream of income at a rate that “his mother could live off” and he did not see such a thing in the marketplace. (In 2007 you could park money at American Express Bank in a jumbo CD at 5.5%. No such luck today.) He saw many other total return products out there in the high yield space where an investor can get a bit higher returns than what he envisions. But some of those returns will be from capital appreciation, i.e., returns from in essence trading. Mr. Sherman did not want to rely on that. He wants a lower duration portfolio (3-4 years) that he can possibly but not necessarily hold to get nice, safe, relatively high coupons from. As long as his investor has that timeframe, Mr. Sherman believes he can compound the money at 6-8% annually, and the investor gets his money back plus his return.

Shorter timeframes, because of impatience or poor timing choices, carry no such assurances. It’s not a CD, it’s not a guaranteed annuity from an insurer, but it’s what is available and what he is able to get for an investor.

How? Well, one inefficiency he hopes to exploit is in the composition of SPDR Barclays High Yield Bond (JNK) and iShares High Yield Corporate Bond (HYG). He doesn’t believe they reflect the composition of high yield space accurately with their necessary emphasis on the most liquid names. He will play in a different sandbox with different toys. And he believes it’s no more risky and thinks it is less so. In addition, when the high yield market moves, especially down, those names move fast.

Mark wrote that he asked David whether the smoothness of his returns exhibited in RPHYX and presumably in RSIVX in the future was due or would be due to a laddering strategy that he employed. He said that it was not – RSIVX’s portfolio was more of a barbell presently- and he did not want to be pigeonholed into a certain formula or strategy. He would do whatever it took to produce the necessary safe returns and that may change from time to time depending upon the market.

What changing interest rates might mean

What if rates fall? If rates fall then, sure, the portfolio will have some capital appreciation. What if rates rise? Well, every day and every month, David said, the investor will grind toward the payday on the shorter duration instruments he is holding. Mark-to-market they will be “worth” less. The market will be demanding higher interest rates and what hasn’t rolled off yet will not be as competitive as the day he bought them. The investor will still be getting a relatively high 6-8% return and as opportunities present themselves and with cash from matured securities and new monies the portfolio will be repopulated over time in the new interest rate environment. Best he can do. He does not intend to play the game of hedging. 

Where he might be going

Mark said he also asked about a higher-risk follow-on to RSIVX. He said that David told him that if he doesn’t have something unique to bring that meets a need, he doesn’t want to do it. He believes RPHYX and RSIVX to be unique. He “knew” he could pull off RPHYX, that he could demonstrate its value, and then have the credibility to introduce another idea. That idea is the Strategic Income Fund.

He doesn’t see a need for him to step out on the spectrum right now. There are a hundred competitors out there and a lot of overlap. People can go get a total return fund with more risk of loss. Returns from them will vary a lot from year to year unless conditions are remarkably stable. This [strategy] almost requires a smaller, more nimble fund and manager. Here he is. Here it is. So the next step out isn’t something he is thinking [immediately] about, but he continually brings ideas to Morty.

Mark concludes: “We discussed a few of his strategies that had more risk. They are fascinating but definitely not vanilla or oatmeal and a few I had to write out by hand the mechanics afterward so I could “see” what he was doing. One of them took me about an hour to work through where the return came from and where it could go possibly wrong.

But he described it to me because working on it gave him the inspiration for a totally different situation that, if it came to pass, would be appropriate for RSIVX. It did, is much more vanilla and is in the portfolio. Very interesting and shows how he thinks. Would love to have a beer with this guy.”

Mark’s bottom line(s)

Mark wanted me to be sure to disclose that he and his family have a rather large position in RiverPark Strategic Income now, and will be holding it for an extended period assuming all goes well (years) so, yeah, he may be biased with his remarks. He says “the strategy is not to everyone’s taste or risk tolerance”. He holds it because it exactly fills a need that his family has.

Observer Fund Profiles:

Each month the Observer provides in-depth profiles of between two and four funds. Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds. “Stars in the Shadows” are older funds that have attracted far less attention than they deserve.

Driehaus Emerging Markets Small Cap Growth (DRESX): There’s a lot to be said for EM small caps. They provide powerful diversification and performance benefits for a portfolio. The knock of them is that they’re too hot to handle. Driehaus’s carefully constructed, hedged portfolio seems to have cooled the handle by a lot.

Guinness Atkinson Inflation Managed Dividend (GAINX): It’s easy to agree that owning the world’s best companies, especially if you buy them on the cheap, is a really good strategy. GAINX approaches the challenge of constructing a very compact, high quality, low cost portfolio with quantitative discipline and considerable thought.

Intrepid Income (ICMUX): What’s not to like about this conservative little short-term, high-yield fund. It’s got it all: solid returns, excellent risk management and that coveted one-star rating! Intrepid, like almost all absolute value investors, is offering an object lesson on the important of fortitude in the face of frothy markets and serial market records.

RiverPark Gargoyle Hedged Value (RGHVX): The short story is this. Gargoyle’s combination of a compact, high quality portfolio and options-based hedging strategy has, over time, beaten just about every reasonable comparison group. Unless you anticipate a series of 20 or 30% gains in the stock market over the rest of the decade, it might be time to think about protecting some of what you’ve already made.

Elevator Talk: Ted Gardner, Salient MLP & Energy Infrastructure II (SMLPX)

Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we’ve decided to offer one or two managers each month the opportunity to make a 200 word pitch to you. That’s about the number of words a slightly-manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got 200 words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.

Master limited partnerships (MLPs) are an intriguing asset class which was, until very recently, virtually absent from both open-end fund and ETF portfolios.

MLPs are a form of business organization, in the same way corporations are a form of organization. Their shares trade on US exchanges (NYSE and NASDAQ) and they meet the same SEC security registration requirements as corporations do. They were created in the 1980s primarily as a tool to encourage increased energy production in the country and the vast majority of MLPs (75% or so) are in the energy sector.

MLPs are distinct from corporations in a number of ways:

• They’re organized around two groups: the limited partners (i.e., investors) and the general partners (i.e., managers). The limited partners provide capital and receive quarterly distributions.
• MLPs are required, by contract, to pay minimum quarterly distributions to their limited partners. That means that they produce very consistent streams of income for the limited partners.
• MLPs are required, by law, to generate at least 90% of their income from “qualified sources.” Mostly that means energy production and distribution.

The coolest thing about MLPs is the way they generate their income: they operate hugely profitable, economically-insensitive monopolies whose profits are guaranteed by law. A typical midstream MLP might own a gas or oil pipeline. The MLP receives a fee for every gallon of oil or cubic foot of gas moving through the pipe. That rate is set by a federal agency and that rate rises every year by the rate of inflation plus 1.3%. It doesn’t matter whether the price of oil soars or craters; the MLP gets its toll regardless. And it doesn’t really matter whether the economy soars or craters: people still need warm homes and gas to get to work. At worst, bad recessions eliminate a year’s demand rise but haven’t yet caused a net demand decrease. As the population grows and energy consumption rises, the amount moving through the pipelines rise and so does the MLPs income.

Those profits are protected by enormously high entry barriers: building new pipelines cost billions, require endless hearings and permits, and takes years. As a result, the existing pipelines function as de facto a regional monopoly, which means that the amount of material traveling through the pipeline won’t be driven down by competition for other pipelines.

Quick highlights of the benchmark Alerian MLP index:

• From inception through early 2013, the index returned 16% annually, on average.
• For that same period, it had a 7.1% yield which grew 7% annually.
• There is a low correlation – 50 – between the stock market and the index. REITs say at around 70 and utility stocks at 25, but with dramatically lower yield and returns.

Only seven of the 17 funds with “MLP” in their names have been around long enough to quality for a Morningstar rating; all seven are four- or five-star funds, measured against an “energy equity” peer group. Here’s a quick snapshot of Salient (the blue line) against the two five-star funds (Advisory Research MLP & Energy Income INFIX and MLP & Energy Infrastructure MLPPX) and the first open-end fund to target MLPs (Oppenheimer SteelPath MLP Alpha MLPAX):

The quick conclusion is that Salient was one of the best MLP funds until autumn 2013, at which point it became the best one. I did not include the Alerian MLP index or any of the ETFs which track it because they lag so far behind the actively-managed funds. Over the past year, for example, Salient has outperformed the Alerian MLP Index – delivering 20% versus 15.5%.

High returns and substantial diversification. Sounds perfect. It isn’t, of course. Nothing is. MLP took a tremendous pounding in the 2007-09 meltdown when credit markets froze and dropped again in August 2013 during a short-lived panic over changes in MLP’s favorable tax treatment. And it’s certainly possible for individual MLPs to get bid up to fundamentally unattractive valuations.

Ted Gardner is the co‐portfolio manager for Salient’s MLP Complex, one manifestation of which is SMLPX. He oversees and coordinates all investment modeling, due diligence, company visits, and management conferences. Before joining Salient he was both Director of Research and a portfolio manager for RDG Capital and a research analyst with Raymond James. Here are his 200 words on why you should consider getting into the erl bidness:

Our portfolio management team has many years of experience with MLP investing, as managers and analysts, in private funds, CEFs and separate accounts. We considered both the state of the investment marketplace and our own experiences and thought it might translate well into an open-end product.

As far as what we saw in the marketplace, most of the funds out there exist inside a corporate wrapper. Unfortunately C-Corp funds are subject to double taxation and that can create a real draw on returns. We felt like going the traditional mutual fund, registered investment company route made a lot of sense.

We are very research-intensive, our four analysts and I all have a sell side background. We take cash flow modeling very seriously. It’s a fundamental modeling approach, modeling down to the segment levels to understand cash flows. And, historically, our analysts have done a pretty good job at it.

We think we do things a bit differently than many investors. What we like to see is visible growth, which means we’re less yield-oriented than others might be. We typically like partnerships that have a strategic asset footprint with a lot of organic growth opportunities or those with a dropdown story, where a parent company drops more assets into a partnership over time. We tend to avoid firms dependent on third-party acquisitions for growth. And we’ve liked investing in General Partners which have historically grown their dividends at approximately twice the rate of the underlying MLPs.

The fund has both institutional and retail share classes. The retail classes (SMAPX, SMPFX) nominally carry sales loads, but they’re available no-load/NTF at Schwab. The minimum for the load-waived “A” shares is $2,500. Expenses are 1.60% on about $630 million in assets. Here’s the fund’s homepage, but I’d recommend that you click through to the Literature tab to grab some of the printed documentation.

River Park/Gargoyle Hedged Value Conference Call Highlights

On February 12th we spoke for an hour with Alan Salzbank and Josh Parker, both of the Gargoyle Group, and Morty Schaja, CEO of RiverPark Funds. Here’s a brief recap of the highlights:

Alan handles the long portfolio. Josh, a securities lawyer by training, handles the options portfolio. He’s also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They have 35 and 25 years of experience, respectively, and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Morty has been investigating buy-write strategies since the mid-1980s and he described the Gargoyle guys as “the team I’ve been looking for for 25 years.”

The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month.

The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (P/B, P/E, P/CF, P/S) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the 100 more undervalued stocks, but maintain sector weightings that are close to the S&P 500’s.

The options portfolio is a collection of index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums.

Why index calls? Two reasons: (1) they are systematically mispriced, and so they always generate more profit than they theoretically should. In particular, they are overpriced by about 35 basis points/month 88% of the time. For sellers, that means something like a 35 bps free lunch. And (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their upside.

And it works. Their long portfolio has outperformed the S&P 500 by an average of 5% per year for 15 years. The entire strategy has outperformed the S&P in the long-term and has matched its returns, with less volatility, in the shorter term. Throughout, it has sort of clubbed its actively-managed long-short peers. It also anticipates clubbing the emerging bevy of buy-write ETFs.

The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month.

There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000-12, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P.

Except not so much in 2008. The fund’s maximum drawdown was 48%, between 10/07 and 03/08. The guys attributed that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback comes in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%.

The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble.

In general, the strategy fares poorest when the market has wild swings. It fares best in gently rising markets, since both the long and options portfolios can make money if the market rises but less than the strike price of the options – they can earn 2% a month on an option that’s triggered if the market rises by more than 1%. If the market rises but by less than 1%, they pay out nothing, pocket the 2% and pocket the capital appreciation from their long portfolio.

What’s the role of the fund in a portfolio? They view it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. For the guys, it’s 100% of their US equity exposure.

Morty Speaks!  The rationale for hedging a long-term portfolio.

The Gargoyle call sparked – here’s a surprise – considerable commentary on our discussion board. Some were impressed with Josh and Alan’s fortitude in maintaining their market exposure during the 2007-09 meltdown but others had a more quizzical response. “Expatsp” captured it this way: “Though this seems the best of the long/short bunch, I just don’t see the appeal of long/short funds for anyone who has a long-term horizon.”

There’s a great scene in Big Bang Theory where the brilliant but socially-inept Sheldon clears up a misunderstanding surrounding a comment he made about his roommate: “Ah, I understand the confusion. Uh, I have never said that you are not good at what you do. It’s just that what you do is not worth doing.” Same theme.

Morty Schaja, RiverPark’s president, is in an interesting position to comment on the question. His firm not only advises a pure long/short fund (RiverPark Long/Short Opportunity RLSFX) and a long hedged with options fund (RiverPark Gargoyle), but it also runs a very successful long-only fund (RiverPark Large Cap Growth RPXFX, which he describes as “our five-star secret weapon”).

With the obvious disclaimer that Morty has a stake in the success of all of the RiverPark funds (and the less-obvious note that he has invested deeply in each), we asked him the obvious question: Is it worth doing?

 

Since RiverPark is one of the very few investment advisors to offer the whole range of hedged funds, I asked Morty to share a quick snapshot of each to illustrate how the different strategies are likely to play out in various sets of market conditions.

Let’s start with the RiverPark Long/Short Opportunity Fund.

 

How does this compare with the RiverPark/Gargoyle Hedged Value Fund?

 

And finally, tell us about the new Structural Alpha Fund.

 

Is the Structural Alpha Fund an absolute return strategy?

Conference Call Upcoming

We haven’t scheduled a call for March. We only schedule calls when we can offer you the opportunity to speak with someone really interesting and articulate.  No one has reached that threshold this month, but we’ll keep looking on your behalf.

Conference call junkies might want to listen in on the next RiverNorth call, which focuses on the RiverNorth Managed Volatility Fund (RNBWX). Managed Volatility started life as RiverNorth Dynamic Buy-Write Fund. Long/short funds comes in three very distinct flavors, but are all lumped in the same performance category. For now, that works to the detriment of funds like Managed Volatility that rely on an options-based hedging strategy. The fund trails the long/short peer group since inception but has performed slightly better than the $8 billion Gateway Fund (GATEX). If you’re interested in the potential of an options-hedged portfolio, you’ll find the sign-up link on RiverNorth’s Events page.  The webcast takes place March 13, 2014 at 3:15 Central.

Launch Alert: Conestoga SMid Cap (CCSMX)

On February 28, 2014, Conestoga Mid Cap (CCMGX) ceased to be. Its liquidation was occasioned by negative assessments of its “asset size, strategic importance, current expenses and historical performance.” It trailed its peers in all seven calendar quarters since inception, in both rising and falling periods. With under $2 million in assets, its disappearance is not surprising.

Two things are surprising, however. First, its poor relative performance is surprising given the success of its sibling, Conestoga Small Cap (CCASX). CCASX is a four-star fund that received a “Silver” designation from Morningstar’s analysts. Morningstar lauds the stable management team, top-tier long-term returns, low volatility (its less volatile than 90% of its peers) and disciplined focus on high quality firms. And, in general, small cap teams have had little problem in applying their discipline successfully to slightly-larger firms.

Second, Conestoga’s decision to launch (on January 21, 2014) a new fund – SMid Cap – in virtually the same space is surprising, given their ability simply to tweak the existing fund. It smacks of an attempt to bury a bad record.

My conclusion after speaking with Mark Clewett, one of the Managing Directors at Conestoga: yeah, pretty much. But honorably.

Mark made two arguments.

1. Conestoga fundamentally mis-fit its comparison group. Conestoga targeted stocks in the $2 – 10 billion market cap range. Both its Morningstar peers and its Russell Midcap Growth benchmark have substantial investments in stocks up to $20 billion. The substantial exposure to those large cap names in a mid-cap wrapper drove its peer’s performance.

   The evidence is consistent with that explanation. It’s clear from the portfolio data that Conestoga was a much purer mid-cap play that either its benchmark or its peer group.

   Portfolio	Conestoga Mid Cap	Russell Mid-cap Growth	Mid-cap Growth Peers
   % large to mega cap	0	35	23
   % mid cap	86	63	63
   % small to micro cap	14	2	14
   Average market cap	5.1M	10.4M	8.4M

    By 2013, over 48% of the Russell index was stocks with market caps above $10 billion.

   Mark was able to pull the attribution data for Conestoga’s mid-cap composite, which this fund reflects. The performance picture is mixed: the composite outperformed its benchmark in 2010 and 2011, then trailed in 2013 and 2013. The fund’s holdings in the $2-5 billion and $5–10 billion bands sometimes outperformed their peers and sometimes trailed badly.

2. Tweaking the old fund would not be in the shareholders’ best interest.  The changes would be expensive and time-consuming. They would, at the same time, leave the new fund with the old fund’s record; that would inevitably cause some hesitance on the part of prospective investors, which meant it would be longer before the fund reached an economically viable size.

The hope is that with a new and more appropriate benchmark, a stable management team, sensible discipline and clean slate, the fund will achieve some of the success that Small Cap’s enjoyed.  I’m hopeful but, for now, we’ll maintain a watchful, sympathetic silence.

Funds in Registration

New mutual funds must be registered with the Securities and Exchange Commission before they can be offered for sale to the public. The SEC has a 75-day window during which to call for revisions of a prospectus; fund companies sometimes use that same time to tweak a fund’s fee structure or operating details.

Funds in registration this month are eligible to launch in late April or early May 2014 and some of the prospectuses do highlight that date.

This month David Welsch battled through wicked viruses and wicked snowstorms to track down eight funds in registration, one of the lowest totals since we launched three years ago.

The clear standout in the group is Dodge & Cox Global Bond, which the Dodge & Cox folks ran as “a private fund” since the end of December 2012.  It did really well in its one full year of operation – it gained 2.6% while its benchmark lost the same amount – and it comes with D&C’s signature low minimum, low expenses, low drama, team management.

Three other income funds are at least mildly interesting: Lazard Emerging Markets Income, Payden Strategic Income and Whitebox Unconstrained Income.

Manager Changes

On a related note, we also tracked down 50 sets of fund manager changes. The most intriguing of those include fallout from the pissing match at Pimco as Marc Seidner, an El-Erian ally, leaves to become GMO’s head of fixed-income operations.

Updates: The Observer here and there

I had a long conversation with a WSJ reporter which led to a short quotation in “Infrastructure funds are intriguing, but ….” The Wall Street Journal, Feb. 4 2014.  My bottom line was “infrastructure funds appear to be an incoherent mish-mash, with no two funds even agreeing on what sectors are worth including much less what stocks.  I don’t see any evidence of them adding value to a portfolio,” an observation prompted in part by T. Rowe Price’s decision to close their own Global Infrastructure fund. The writer, Lisa Ward, delicately quotes me as saying “you probably already own these same stocks in your other funds.” 

I was quoted as endorsing Artisan Global Small Cap (ARTWX) in Six promising new funds (though the subtitle might have been: “five of which I wouldn’t go near”), Kiplinger’s, Feb. 12 2014.  ARTWX draws on one of the most storied international management teams around, led by Mark Yockey.  The other funds profiled include three mutual funds and two ETFs.  The funds are Miller Income Opportunity (I’ve written elsewhere that “The whole enterprise leaves me feeling a little queasy since it looks either like Miller’s late-career attempt to prove that he’s not a dinosaur or Legg’s post-divorce sop to him”), Fidelity Event-Driven (FARNX: no record that Fido can actually execute with new funds anymore, much less with niche funds and untested managers), and Vanguard Global Minimum Volatility (VMVFX: meh – they work backward from a target risk level to see what returns they can generate).  The ETFs are two of the “smart beta” sorts of products, iShares MSCI USA Quality Factor (QUAL) and Schwab Fundamental U.S. Broad Market (FNDB). 

Finally, there was a very short piece entitled “Actively managed funds with low volatility,” in Bottom Line, Feb. 15 2014.  The publication is not online, at least not in an accessible form.  The editors were looking for funds with fairly well-established track records that have a tradition of low volatility.  I offered up Cook & Bynum Fund (COBYX, I’ve linked to our 2013 profile of them), FPA Crescent (FPACX, in which I’m invested) and Osterweis Fund (OSTWX).

Updates: Forbes discovers Beck, Mack & Oliver Partners (BMPEX)

Forbes rank a nice article on BMPEX, “Swinging at Strikes,” in their February 10, 2014 issue. Despite the lunacy of describing a $175 million fund as “puny” and “tiny,” the author turns up some fun facts to know and tell (the manager, Zac Wydra, was a premed student until he discovered that the sight of blood made him queasy) and gets the fund’s basic discipline right. Zac offers some fairly lively commentary in his Q4 shareholder letter, including a nice swipe at British haughtiness and a reflection on the fact that the S&P 500 is at an all-time high at the same time that the number of S&P 500 firms issuing negative guidance is near an all-time high.

Briefly Noted . . .

BlackRock has added the BlackRock Emerging Markets Long/Short Equity Fund (BLSAX) and the BlackRock Global Long/Short Equity Fund (BDMAX) as part of the constituent fund lineup in its Aggressive Growth, Conservative , Growth and Moderate Prepared Portfolios, and its Lifepath Active-Date series. Global has actually made some money for its investors, which EM has pretty much flatlined while the emerging markets have risen over its lifetime.  No word on a target allocation for either.

Effective May 1, Chou Income (CHOIX) will add preferred stocks to the list of their principal investments: “fixed-income securities, financial instruments that provide exposure to fixed-income securities, and preferred stocks.” Morningstar categorizes CHOIX as a World Bond fund despite the fact that bonds are less than 20% of its current portfolio and non-U.S. bonds are less than 3% of it.

Rydex executed reverse share splits on 13 of its funds in February. Investors received one new share for between three and seven old shares, depending on the fund.

Direxion will follow the same path on March 14, 2014 with five of their funds. They’re executing reverse splits on three bear funds and splits on two bulls.  They are: 

 

 SMALL WINS FOR INVESTORS

Auxier Focus (AUXIX) is reducing the minimum initial investment for their Institutional shares from $250,000 to $100,000. Investor and “A” shares remain at $5,000. The institutional shares cost 25 basis points less than the others.

TFS Market Neutral Fund (TFSMX) reopened to new investors on March 1, 2014.

At the end of January, Whitebox eliminated its Advisor share class and dropped the sales load on Whitebox Tactical. Their explanation: “The elimination of the Advisor share class was basically to streamline share classes … eliminating the front load was in the best interest of our clients.” The first makes sense; the second is a bit disingenuous. I’m doubtful that Whitebox imposed a sales load because it was “in the best interest of our clients” and I likewise doubt that’s the reason for its elimination.

CLOSINGS (and related inconveniences)

Artisan Global Value (ARTGX) closed on Valentine’s Day.

Grandeur Peak will soft close the Emerging Markets Opportunities (GPEOX) and hard close the Global Opportunities (GPGOX) and International Opportunities (GPIOX) strategies on March 5, 2014.

 Effective March 5, 2014, Invesco Select Companies Fund (ATIAX) will close to all investors.

Vanguard Admiral Treasury Money Market Fund (VUSSX) is really, really closed.  It will “no longer accept additional investments from any financial advisor, intermediary, or institutional accounts, including those of defined contribution plans. Furthermore, the Fund is no longer available as an investment option for defined contribution plans. The Fund is closed to new accounts and will remain closed until further notice.”  So there.

OLD WINE, NEW BOTTLES

Effective as of March 21, 2014, Brown Advisory Emerging Markets Fund (BIAQX) is being changed to the Brown Advisory – Somerset Emerging Markets Fund. The investment objective and the investment strategies of the Fund are not being changed in connection with the name change for the Fund and the current portfolio managers will continue. At the same time, Brown Advisory Strategic European Equity Fund (BIAHX) becomes Brown Advisory -WMC Strategic European Equity Fund.

Burnham Financial Industries Fund has been renamed Burnham Financial Long/Short Fund (BURFX).  It’s a tiny fund (with a sales load and high expenses) that’s been around for a decade.  It’s hard to know what to make of it since “long/short financial” is a pretty small niche with few other players.

Caritas All-Cap Growth Fund has become Goodwood SMID Cap Discovery Fund (GAMAX), a name that my 13-year-old keeps snickering at.  It’s been a pretty mediocre fund which gained new managers in October.

Compass EMP Commodity Long/Short Strategies Fund (CCNAX) is slated to become Compass EMP Commodity Strategies Enhanced Volatility Weighted Fund in May. Its objective will change to “match the performance of the CEMP Commodity Long/Cash Volatility Weighted Index.”  It’s not easily searchable by name at Morningstar because they’ve changed the name in their index but not on the fund’s profile.

Eaton Vance Institutional Emerging Markets Local Debt Fund (EELDX) has been renamed Eaton Vance Institutional Emerging Markets Debt Fund and is now a bit less local.

Frost Diversified Strategies and Strategic Balanced are hitting the “reset” button in a major way. On March 31, 2014, they change name, objective and strategy. Frost Diversified Strategies (FDSFX) becomes Frost Conservative Allocation while Strategic Balanced (FASTX) becomes Moderate Allocation. Both become funds-of-funds and discover a newfound delight in “total return consistent with their allocation strategy.” Diversified currently is a sort of long/short, ETFs, funds and stocks, options mess … $4 million in assets, high expense, high turnover, indifferent returns, limited protection. Strategic Balanced, with a relatively high downside capture, is a bit bigger and a bit calmer but ….

Effective on or about May 30, 2014, Hartford Balanced Allocation Fund (HBAAX) will be changed to Hartford Moderate Allocation Fund.

At the same time, Hartford Global Research Fund (HLEAX) becomes Hartford Global Equity Income Fund, with a so far unexplained “change to the Fund’s investment goal.” 

Effective March 31, 2014, MFS High Yield Opportunities Fund (MHOAX) will change its name to MFS Global High Yield Fund.

In mid-February, Northern Enhanced Large Cap Fund (NOLCX) became Northern Large Cap Core Fund though, at last check, Morningstar hadn’t noticed. Nice little fund, by the way.

Speaking of not noticing, the folks at Whitebox have accused of us ignoring “one of the most important changes we made, which is Whitebox Long Short Equity Fund is now the Whitebox Market Neutral Equity Fund.” We look alternately chastened by our negligence and excited to report such consequential news.

OFF TO THE DUSTBIN OF HISTORY

BCM Decathlon Conservative Portfolio, BCM Decathlon Moderate Portfolio and BCM Decathlon Aggressive Portfolio have decided that they can best serve their shareholders by liquidating.  The event is scheduled for April 14, 2014.

BlackRock International Bond Portfolio (BIIAX) has closed and will liquidate on March 14, 2014.  A good move given the fund’s dismal record, though you’d imagine that a firm with BlackRock’s footprint would want a fund of this name.

Pending shareholder approval, City National Rochdale Diversified Equity Fund (AHDEX) will merge into City National Rochdale U.S. Core Equity Fund (CNRVX) of the Trust. I rather like the honesty of their explanation to shareholders:

This reorganization is being proposed, among other reasons, to reduce the annual operating expenses borne by shareholders of the Diversified Fund. CNR does not expect significant future in-flows to the Diversified Fund and anticipates the assets of the Diversified Fund may continue to decrease in the future. The Core Fund has significantly more assets [and] … a significantly lower annual expense ratio.

Goldman Sachs Income Strategies Portfolio merged “with and into” the Goldman Sachs Satellite Strategies Portfolio (GXSAX) and Goldman Sachs China Equity Fund with and into the Goldman Sachs Asia Equity Fund (GSAGX) in mid-February.

Huntington Rotating Markets Fund (HRIAX) has closed and will liquidate by March 28, 2014.

Shareholders of Ivy Asset Strategy New Opportunities Fund (INOAX) have been urged to approve the merger of their fund into Ivy Emerging Markets Equity Fund (IPOAX).  The disappearing fund is badly awful but the merger is curious because INOAX is not primarily an emerging markets fund; its current portfolio is split between developed and developing.

The Board of Trustees of the JPMorgan Ex-G4 Currency Strategies Fund (EXGAX) has approved the liquidation and dissolution of the Fund on or about March 10, 2014.  The “strategies” in question appear to involve thrashing around without appreciable gain.

After an entire year of operation (!), the KKR Board of Trustees of the Fund approved a Plan of Liquidation with respect to KKR Alternative Corporate Opportunities Fund (XKCPX) and KKR Alternative High Yield Fund (KHYZX). Accordingly, the Fund will be liquidated in accordance with the Plan on or about March 31, 2014 or as soon as practicable thereafter. 

Loomis Sayles Mid Cap Growth Fund (LAGRX) will be liquidated on March 14^th, a surprisingly fast execution given that the Board approved the action just the month before.

On February 13, 2014, the shareholders of the Quaker Small Cap Growth Tactical Allocation Fund (QGASX) approved the liquidation and dissolution of the Fund. 

In Closing . . .

We asked you folks, in January, what made the Observer worthwhile.  That is, what did we offer that brought you back each month?  We poured your answers into a Wordle in hopes of capturing the spirit of the 300 or so responses.

Three themes recurred:  (1) the Observer is independent. We’re not trying to sell you anything.  We’re not trying to please advertisers. We’re not desperate to write inflated drivel in order to maximize clicks. We don’t have a hidden agenda. 

(2) We talk about things that other folks do not. There’s a lot of appreciation for our willingness to ferret out smaller, emerging managers and to bring them to you in a variety of formats. There’s also some appreciate of our willingness to step back from the fray and try to talk about important long-term issues rather than sexy short-term ones.

(3) We’re funny. Or weird. Perhaps snarky, opinionated, cranky and, on a good day, curmudgeonly.

And that helps us a lot.  As we plan for the future of the Observer, we’re thinking through two big questions: where should we be going and how can we get there? We’ll write a bit next time about your answer to the final question: what should we be doing that we aren’t (yet)?

We’ve made a couple changes under the hood to make the Observer stronger and more reliable.  We’ve completed our migration to a new virtual private server at Green Geeks, which should help with reliability and allow us to handle a lot more traffic.  (We hit records again in January and February.)  We also upgraded the software that runs our discussion board.  It gives the board better security and a fresher look.  If you’ve got a bookmarked link to the discussion board, we need you to reset your link to http://www.mutualfundobserver.com/discuss/discussions.  If you use your old bookmark you’ll just end up on a redirect page.  

In April we celebrate our third anniversary. Old, for a website nowadays, and so we thought we’d solicit the insights of some of the Grand Old Men of the industry: well-seasoned, sometimes storied managers who struck out on their own after long careers in large firms. We’re trying hard to wheedle our colleague Ed, who left Oakmark full of years and honors, to lead the effort. While he’s at that, we’re planning to look again at the emerging markets and the almost laughable frenzy of commentary on “the bloodbath in the emerging markets.”  (Uhh … Vanguard’s Emerging Market Index has dropped 8% in a year. That’s not a bloodbath. It’s not even a correction. It’s a damned annoyance. And, too, talking about “the emerging markets” makes about as much analytic sense as talking about “the white people.”  It’s not one big undifferentiated mass).  We’ve been looking at fund flow data and Morningstar’s “buy the unloved” strategy.  Mr. Studzinski has become curious, a bit, about Martin Focused Value (MFVRX) and the arguments that have led them to a 90% cash stake. We’ll look into it.

Please do bookmark our Amazon link.  Every bit helps! 

 As ever,

Dear friends,

Given the intensity of the headlines, you’d think that Black Monday had revisited us weekly or, perhaps, that Smaug had settled his scaly bulk firmly atop our portfolios.  But no, the market wandered down a few percent for the month.  I have the same reaction to the near-hysterical headlines about the emerging markets (“rout,” “panic” and “sell-off” are popular headline terms). From the headlines, you’d think the emerging markets had lost a quarter of their value and that their governments were back to defaulting on debts and privatizing companies. They haven’t and they aren’t.  It makes you wonder how ready we are for the inevitable sharp correction that many are predicting and few are expecting.

Where are the customers’ yachts: The power of asking the wrong question

In 1940, Fred Schwed penned one of the most caustic and widely-read finance books of its time.  Where Are the Customers’ Yachts, now in its sixth edition, opens with an anecdote reportedly set in 1900 and popular on Wall Street in the 1920s.

An out-of-town visitor was shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some of the handsome ships riding at anchor. He said, “Look, those are the bankers’ and the brokers’ yachts.” The naïve visitor asked, “Where are the customer’s yachts?”

 

 

That’s an almost irresistibly attractive tale since it so quickly captures the essence of what we all suspect: finance is a game rigged to benefit the financiers, a sort of reverse Robin Hood scheme in which we eagerly participate. Disclosure of rampant manipulation of the London currency exchanges is just the most recent round in the game.

As charming as it is, it’s also fundamentally the wrong question.  Why?  Because “buying a yacht” was not the goal for the vast majority of those customers.  Presumably their goals were things like “buying a house” or “having a rainy day cushion,” which means the right question would have been “where are the customer’s houses?”

We commit the same fallacy today when we ask, “can your fund beat the market?”  It’s the question that drives hundreds of articles about the failure of active management and of financial advisors more generally.  But it’s the wrong question.  Our financial goals aren’t expressed relative to the market; they’re expressed in terms of life goals and objectives to which our investments might contribute.

In short, the right question is “why does investing in this fund give me a better chance of achieving my goals than I would have otherwise?”  That might redirect our attention to questions far more important than whether Fund X lags or leads the S&P500 by 50 bps a year.  Those fractions of a percent are not driving your investment performance nearly as much as other ill-considered decisions are.  The impulse to jump in and out of emerging markets funds (or bond funds or U.S. small caps) based on wildly overheated headlines are far more destructive than any other factor.

Morningstar calculates “investor returns” for hundreds of funds. Investor returns are an attempt to answer the question, “did the investors show up after the party was over and leave as things got dicey?”  That is, did investors buy into something they didn’t understand and weren’t prepared to stick with? The gap between what an investor could have made – the fund’s long-term returns – and what the average investor actually seems to have made – the investor returns – can be appalling.  T. Rowe Price Emerging Market Stock (PRMSX) made 9% over the past decade, its average investor made 4%. Over a 15 year horizon the disparity is worse: the fund earned 10.7% while investors were around for 4.3% gains.  The gap for Dodge & Cox Stock (DODGX) is smaller but palpable: 9.2% for the fund over 15 years but 7.0% for its well-heeled investors. 

My colleague Charles has urged me to submit a manuscript on mutual fund investing to John Wiley’s Little Book series, along with such classics as The Little Book That Makes You Rich and The Little Book That Beats the Market. I might. But if I do, it will be The Little Book That Doesn’t Beat the Market: And Why That’s Just Fine. Its core message will be this:

If you spend less time researching your investments than you spend researching a new kitchen blender, you’re screwed.  If you base your investments on a belief in magical outcomes, you’re screwed.  And if you think that 9% returns will flow to you with the smooth, stately grace of a Rolls Royce on a country road, you’re screwed.

But if you take the time to understand yourself and you take the time to understand the strategies that will be used by the people you’re hiring to provide for your future, you’ve got a chance.

And a good, actively managed mutual fund can make a difference but only if you look for the things that make a difference.  I’ll suggest four:

Understanding: do you know what your manager plans to do?  Here’s a test: you can explain it to your utterly uninterested spouse and then have him or her correctly explain it back?  Does your manager write in a way that draws you closer to understanding, or are you seeing impenetrable prose or marketing babble?  When you have a question, can you call or write and actually receive an intelligible answer?

Alignment: is your manager’s personal best interests directly tied to your success?  Has he limited himself to his best ideas, or does he own a bit of everything, everywhere?  Has he committed his own personal fortune to the fund?  Have his Board of Directors?  Is he capable of telling you the limits of his strategy; that is, how much money he can handle without diluting performance? And is he committed to closing the fund long before you reach that sad point?

Independence: does your fund have a reason to exist? Is there any reason to believe that you couldn’t substitute any one of a hundred other strategies and get the same results? Does your fund publish its active share; that is, the amount of difference between it and an index? Does it publish its r-squared value; that is, the degree to which it merely imitates the performance of its peer group? 

Volatility: does your manager admit to how bad it could get? Not just the fund’s standard deviation, which is a pretty dilute measure of risk. No, do they provide their maximum drawdown for you; that is, the worst hit they ever took from peak to trough.  Are the willing to share and explain their Sharpe and Sortino ratios, key measures of whether you’re getting reasonably compensated for the hits you’ll inevitable take?  Are they willing to talk with you in sharply rising markets about how to prepare for the sharply falling ones?

The research is clear: there are structural and psychological factors that make a difference in your prospects for success.  Neither breathless headlines nor raw performance numbers are among them.

Then again, there’s a real question of whether it could ever compete for total sales with my first book, Continuity and Change in the Rhetoric of the Moral Majority (total 20-year sales: 650 copies).

Absolute value’s sudden charm

Jeremy Grantham often speaks of “career risk” as one of the great impediments to investment success. The fact that managers know they’re apt to be fired for doing the right thing at the wrong time is a powerful deterrent to them. For a great many, “the right thing” is refusing to buy overvalued stocks. Nonetheless, when confronted by a sharply rising market and investor ebullience, most conclude that it’s “the wrong time” to act on principle. In short, they buy when they know  they probably shouldn’t.

A handful of brave souls have refused to succumb to the pressure. In general, they’re described as “absolute value” investors. That is, they’ll only buy stocks that are selling at a substantial discount to their underlying value; the mere fact that they’re “the best of a bad lot” isn’t enough to tempt them.

And, in general, they got killed – at least in relative terms – in 2013. We thought it would be interesting to look at the flip side, the performance of those same funds during January 2014 when the equity indexes dropped 3.5 – 4%.  While the period is too brief to offer any major insights, it gives you a sense of how dramatically fortunes can reverse.

THE ABSOLUTE VALUE GUYS

	Cash	Relative 2013 return	Relative 2014 return
ASTON River Road Independent Value ARIVX	67%	bottom 1%	top 1%
Beck, Mack & Oliver Partners BMPEX	18	bottom 3%	bottom 17%
Cook & Bynum COBYX	44	bottom 1%	top 8%
FPA Crescent FPACX *	35	top 5%	top 30%
FPA International Value FPIVX	40	bottom 20%	bottom 30%
Longleaf Partners Small-Cap LLSCX	45	bottom 23%	top 10%
Oakseed SEEDX	21	bottom 8%	top 5%
Pinnacle Value PVFIX	44	bottom 2%	top 3%
Yacktman YACKX	22	bottom 17%	top 27%

Motion, not progress

Cynic, n.  A blackguard whose faulty vision sees things as they are, not as they ought to be.

                                                                                                         Ambrose Bierce

One of the joys of having entered the investment business in the 1980’s is that you came in at a time when the profession was still populated by some really nice and thoughtful people, well-read and curious about the world around them.  They were and are generally willing to share their thoughts and ideas without hesitation. They were the kind of people that you hoped you could keep as friends for life.  One such person is my friend, Bruce, who had a thirty-year career on the “buy side” as both an analyst and a director of research at several well-known money management firms. He retired in 2008 and divides his time between homes in western Connecticut and Costa Rica.

Here in Chicago in January, with snow falling again and the wind chill taking the temperature below zero, I see that Bruce, sitting now in Costa Rica, is the smart one.  Then I reflected on a lunch we had on a warm summer day last August near the Mohawk Trail in western Massachusetts.  We stay in touch regularly but this was the first time the two of us had gotten together in several years. 

The first thing I asked Bruce was what he missed most about no longer being active in the business.  Without hesitation he said that it was the people. For most of his career he had interacted daily with other smart investors as well as company management teams.  You learned how they thought, what kind of people they were, whether they loved their businesses or were just doing it to make money, and how they treated their shareholders and investors. Some of his best memories were of one-on-one meetings or small group dinners.  These were events that companies used to hold for their institutional shareholders.  That ended with the implementation of Regulation FD (full disclosure), the purpose of which was to eliminate the so-called whisper number that used to be “leaked” to certain brokerage firm analysts ahead of earnings reporting dates. This would allow those analysts to tip-off favored clients, giving them an edge in buying or selling a position. Companies now deal with this issue by keeping tight control on investor meetings and what can be said in them, tending to favor multi-media analyst days (timed, choreographed, scripted, and rehearsed events where you find yourself one of three hundred in a room being spoon-fed drivel), and earnings conference calls (timed, choreographed, scripted, and rehearsed events where you find yourself one of a faceless mass listening to reporting without seeing any body language).  Companies will still visit current and potential investors by means of “road shows” run by a friendly brokerage firm coincidentally looking for investment banking business.  But the exchange of information can be less than free-flowing, especially if the brokerage analyst sits in on the meeting.  And, to prevent accidental disclosure, the event is still heavily scripted.  It has however created a new sideline business for brokerage firms in these days of declining commission rates.  Even if you are a large existing institutional shareholder, the broker/investment bankers think you should pay them $10,000 – $15,000 in commissions for the privilege of seeing the management of a company you already own.  This is apparently illegal in the United Kingdom, and referred to as “pay to play” there.  Here, neither the SEC nor the compliance officers have tumbled to it as an apparent fiduciary violation.

Next I asked him what had been most frustrating in his final years. Again without hesitation he said that it was difficult to feel that you were actually able to add value in evaluating large cap companies, given how the regulatory environment had changed. I mentioned to him that everyone seemed to be trying to replace the on-site leg work part of fundamental analysis with screening and extensive earnings modeling, going out multiple years. Unfortunately many of those using such approaches appear to have not learned the law of significant numbers in high school chemistry. They seek exactitude while in reality adding complexity.  At the same time, the subjective value of sitting in a company headquarters waiting room and seeing how customers, visitors, and employees are treated is no longer appreciated.

Bruce, like many value investors, favors private market value as the best underpinning for security valuation. That is, based on recent transactions to acquire a comparable business, what was this one worth? But you need an active merger & acquisition market for the valuation not to be tied to stale inputs. He mentioned that he had observed the increased use of dividend discount models to complement other valuation work. However, he thought that there was a danger in a low interest-rate environment that a dividend discount model could produce absurd results. One analyst had brought him a valuation write-up supported by a dividend discount model. Most of the business value ended up being in the terminal segment, requiring a 15 or 16X EBITDA multiple to make the numbers work.  Who in the real world pays that for a business?  I mentioned that Luther King, a distinguished investment manager in Texas with an excellent long-term record, insisted on meeting as many company managements as he could, even in his seventies, as part of his firm’s ongoing due diligence. He did not want his investors to think that their investments were being followed and analyzed by “three guys and a Bloomberg terminal.”  And in reality, one cannot learn an industry and company solely through a Bloomberg terminal, webcasts, and conference calls. 

Bruce then mentioned another potentially corrupting factor. His experience was that investment firms compensate analysts based on idea generation, performance of the idea, and the investment dollars committed to the idea. This can lead to gamesmanship as you get to the end of the measurement period for compensation. E.g., we tell corporate managements they shouldn’t act as if they were winding up and liquidating their business at the end of a quarter or year. Yet, we incent analysts to act that way (and lock in a profitable bonus) by recommending sale of an idea much too early. Or at the other extreme, they may not want to recommend sale of the idea when they should. I mentioned that one solution was to eliminate such compensation performance assessments as one large West Coast firm is reputed to have done after the disastrous 2008 meltdown. They were trying to restore a culture that for eighty years had been geared to producing the best long-term compounding investment ideas for the clients. However, they also had the luxury of being independent.      

Finally I asked Bruce what tipped him over the edge into retirement. He said he got tired of discussions about “scalability.” A brief explanation is in order. After the dot-com disaster at the beginning of the decade, followed by the debacle years of 2008-2009, many investment firms put into place an implicit policy. For an idea to be added to the investment universe, a full investment position had to be capable of being acquired in five days average trading volume for that issue. Likewise, one had to also be able to exit the position in five days average trading volume. If it could not pass those hurdles, it was not a suitable investment. This cuts out small cap and most mid-cap ideas, as well as a number of large cap ideas where there is limited investment float. While the benchmark universe might be the S&P 500, in actuality it ends up being something very different. Rather than investing in the best ideas for clients, one ends up investing in the best liquid ideas for clients (I will save for another day the discussion about illiquid investments consistently producing higher returns long-term, albeit with greater volatility). 

From Bruce’s perspective, too much money is chasing too few good ideas. This has resulted in what we call “style drift”.  Firms that had made their mark as small cap or mid cap investors didn’t want to kill the goose laying the golden eggs by shutting off new money, so they evolved to become large cap investors. But ultimately that is self-defeating, for as the assets come in, you either have to shut down the flows or change your style by adding more and larger positions, which ultimately leads to under-performance.

I mentioned to Bruce that the other problem of too much money chasing too few good new ideas was that it tended to encourage “smart guy investing,” a term coined by a mutual friend of ours in Chicago. The perfect example of this was Dell. When it first appeared in the portfolios of Southeastern Asset Management, I was surprised. Over the next year, the idea made its way in to many more portfolios at other firms. Why? Because originally Southeastern had made it a very large position, which indicated they were convinced of its investment merits. The outsider take was “they are smart guys – they must have done the work.” And so, at the end of the day after making their own assessments, a number of other smart guys followed. In retrospect it appears that the really smart guy was Michael Dell.

A month ago I was reading a summary of the 2013 annual investment retreat of a family office investment firm with an excellent reputation located in Vermont. A conclusion reached was that the incremental value being provided by many large cap active managers was not justified by the fees being charged. Therefore, they determined that that part of an asset allocation mix should make use of low cost index funds. That is a growing trend. Something else that I think is happening now in the industry is that investment firms that are not independent are increasingly being run for short-term profitability as the competition and fee pressures from products like exchange traded funds increases. Mike Royko, the Chicago newspaper columnist once said that the unofficial motto of Chicago is “Ubi est meum?” or “Where’s mine?” Segments of the investment management business seemed to have adopted it as well. As a long-term value investor in New York recently said to me, short-termism is now the thing. 

The ultimate lesson is the basic David Snowball raison d’etre for the Mutual Fund Observer. Find yourself funds that are relatively small and independent, with a clearly articulated philosophy and strategy. Look to see, by reading the reports and looking at the lists of holdings, that they are actually doing what they say they are doing, and that their interests are aligned with yours. Look at their active share, the extent to which the holdings do not mimic their benchmark index. And if you cannot be bothered to do the work, put your investments in low cost index vehicles and focus on asset allocation.  Otherwise, as Mr. Buffet once said, if you are seated at the table to play cards and don’t identify the “mark” you should leave, as you are it.

Edward Studzinski    

Impact of Category on Fund Ratings

The results for MFO’s fund ratings through quarter ending December 2013, which include the latest Great Owl and Three Alarm funds, can be found on the Search Tools page. The ratings are across 92 fund categories, defined by Morningstar, and include three newly created categories:

Corporate Bond. “The corporate bond category was created to cull funds from the intermediate-term and long-term bond categories that focused on corporate bonds,” reports Cara Esser.  Examples are Vanguard Interm-Term Invmt-Grade Inv (VFICX) and T. Rowe Price Corporate Income (PRPIX).

Preferred Stock. “The preferred stock category includes funds with a majority of assets invested in preferred stock over a three-year period. Previously, most preferred share funds were lumped in with long-term bond funds because of their historically high sensitivity to long-term yields.” An example is iShares US Preferred Stock (PFF).

Tactical Allocation. “Tactical Allocation portfolios seek to provide capital appreciation and income by actively shifting allocations between asset classes. These portfolios have material shifts across equity regions and bond sectors on a frequent basis.” Examples here are PIMCO All Asset All Authority Inst (PAUIX) and AQR Risk Parity (AQRIX).

An “all cap” or “all style” category is still not included in the category definitions, as explained by John Rekenthaler in Why Morningstar Lacks an All-Cap Fund Category. The omission frustrates many, including BobC, a seasoned contributor to the MFO board:

Osterweis (OSTFX) is a mid-cap blend fund, according to M*. But don’t say that to John Osterweis. Even looking at the style map, you can see the fund covers all of the style boxes, and it has about 20% in foreign stocks, with 8% in emerging countries. John would tell you that he has never managed the fund to a style box. In truth he is style box agnostic. He is looking for great companies to buy at a discount. Yet M* compares the fund with others that are VERY different.

In fairness, according to the methodology, “for multiple-share-class funds, each share class is rated separately and counted as a fraction of a fund within this scale, which may cause slight variations in the distribution percentages.” Truth is, fund managers or certainly their marketing departments are sensitive to what category their fund lands-in, as it can impact relative ratings for return, risk, and price.

As reported in David’s October commentary, we learned that Whitebox Funds appealed to the Morningstar editorial board to have its Tactical Opportunities Fund (WBMIX) changed from aggressive allocation to long/short equity. WBMIX certainly has the latitude to practice long/short; in fact, the strategy is helping the fund better negotiate the market’s rough start in 2014. But its ratings are higher and price is lower, relatively, in the new category.

One hotly debated fund on the MFO board, ASTON/River Road Independent Small Value (ARIVX), managed by Eric Cinnamond, would also benefit from a category change. As a small cap, the fund rates a 1 (bottom quintile) for 2013 in the MFO ratings system, but when viewed as a conservative or tactical allocation fund – because of significant shifts to cash – the ratings improve. Here is impact on return group rank for a couple alternative categories:

Of course, a conservative tactical allocation category would be a perfect antidote here (just kidding).

Getting It Wrong. David has commented more than once about the “wildly inappropriate” mis-categorization of Riverpark Short Term High Yield Fund (RPHIX), managed by David Sherman, which debuted with just a single star after its first three years of operation. The MFO community considers the closed fund more of a cash alternative, suited best to the short- or even ultrashort-term bond categories, but Morningstar placed it in the high yield bond category.

Exacerbating the issue is that the star system appears to rank returns after deducting for a so-called “risk penalty,” based on the variation in month-to-month return during the rating period. This is good. But it also means that funds like RPHIX, which have lower absolute returns with little or no downside, do not get credit for their very high risk-adjusted return ratios, like Sharpe, Sortino, or Martin.

Below is the impact of categorization, as well as return metrics, on its performance ranking. The sweet irony is that its absolute return even beat the US bond aggregate index!

RPHIX is a top tier fund by just about any measure when placed in a more appropriate bond category or when examined with risk-adjusted return ratios. (Even Modigliani’s M2, a genuinely risk-adjusted return, not a ratio, that is often used to compare portfolios with different levels of risk, reinforces that RPHIX should still be top tier even in the high yield bond category.) Since Morningstar states its categorizations are “based strictly on portfolio statistics,” and not fund names, hopefully the editorial board will have opportunity to make things right for this fund at the bi-annual review in May.

A Broader View. Interestingly, prior to July 2002, Morningstar rated funds using just four broad asset-class-based groups: US stock, international stock, taxable bond, and municipal bonds. It switched to (smaller) categories to neutralize market tends or “tailwinds,” which would cause, for example, persistent outperformance by funds with value strategies.

A consequence of rating funds within smaller categories, however, is more attention goes to more funds, including higher risk funds, even if they have underperformed the broader market on a risk-adjusted basis. And in other cases, the system calls less attention to funds that have outperformed the broader market, but lost an occasional joust in their peer group, resulting in a lower rating.

Running the MFO ratings using only the four board legacy categories reveals just how much categorization can alter the ratings. For example, the resulting “US stock” 20-year Great Owl funds are dominated by allocation funds, along with a high number of sector equity funds, particularly health. But rate the same funds with the current categories (Great Owl Funds – 4Q2013), and we find more funds across the 3 x 3 style box, plus some higher risk sector funds, but the absence of health funds.

Fortunately, some funds are such strong performers that they appear to transcend categorization. The eighteen funds listed below have consistently delivered high excess return while avoiding large drawdown and end-up in the top return quintile over the past 20, 10, 5, and 3 year evaluation periods using either categorization approach:

 Roy Weitz grouped funds into only five equity and six specialty “benchmark categories” when he established the legacy Three Alarm Funds list. Similarly, when Accipiter created the MFO Miraculous Multi-Search tool, he organized the 92 categories used in the MFO rating system into 11 groups…not too many, not too few. Running the ratings for these groupings provides some satisfying results:

A more radical approach may be to replace traditional style categories altogether! For example, instead of looking for best performing small-cap value funds, one would look for the best performing funds based on a risk level consistent with an investor’s temperament. Implementing this approach, using Risk Group (as defined in ratings system) for category, identifies the following 20-year Great Owls:

Bottom Line. Category placement can be as important to a fund’s commercial success as its people, process, performance, price and parent. Many more categories exist today on which peer groups are established and ratings performed, causing us to pay more attention to more funds. And perhaps that is the point. Like all chambers of commerce, Morningstar is as much a promoter of the fund industry, as it is a provider of helpful information to investors. No one envies the enormous task of defining, maintaining, and defending the rationale for several dozen and ever-evolving fund categories. Investors should be wary, however, that the proliferation may provide a better view of the grove than the forest.

28Jan2014/Charles

Our readers speak!

And we’re grateful for it. Last month we gave folks an opportunity to weigh-in on their assessment of how we’re doing and what we should do differently. Nearly 350 of you shared your reactions during the first week of the New Year. That represents a tiny fraction of the 27,000 unique readers who came by in January, so we’re not going to put as much weight on the statistical results as on the thoughts you shared.

We thought we’d share what we heard. This month we’ll highlight the statistical results.  In March we’ll share some of your written comments (they run over 30 pages) and our understanding of them.

Who are you?

80% identified themselves as private investors, 18% worked in the financial services industry and 2% were journalists, bloggers and analysts.

How often do you read the Observer?

The most common answer is “I just drop by at the start of the month” (36%). That combines with “I drop by once every month, but not necessarily at the start”) (14%) to explain about half of the results. At the same time, a quarter of you visit four or more times every month. (And thanks for it!)

Which features are most (or least) interesting to you?

By far, the greatest number of “great, do more!” responses came under “individual fund profiles.” A very distant second and third were the longer pieces in the monthly commentary (such as Motion, Not Progress and Impact of Category on Fund Ratings) and the shorter pieces (on fund liquidations and such) in the commentary. Folks had the least interest in our conference calls and funds in registration.

Hmmm … we’re entirely sympathetic to the desire for more fund profiles. Morningstar has an effective monopoly in the area and their institutional biases are clear: of the last 100 fund analyses posted, only 13 featured funds with under one billion in assets. Only one fund launched since January 2010 was profiled. In response, we’re going to try to increase the number of profiles each month to at least four with a goal of hitting five or six. 

We’re not terribly concerned about the tepid response to the conference calls since they’re useful in writing our profiles and the audience for them continues to grow. If you haven’t tried one, perhaps it might be worthwhile this month?

And so, in response to your suggestion, here’s the freshly expanded …

Observer Fund Profiles:

Each month the Observer provides in-depth profiles of between two and four funds.  Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds. “Stars in the Shadows” are older funds that have attracted far less attention than they deserve. 

ASTON/River Road Long Short (ARLSX): measured in the cold light of risk-return statistics, ARLSX is as good as it gets. We’d recommend that interested parties look at both this profile and at the conference call highlights, below.

Artisan Global Small Cap (ARTWX): what part of “phenomenally talented, enormously experienced management team now offers access to a poorly-explored asset class” isn’t interesting to you?

Grandeur Peak Emerging Opportunities (GPEOX): ditto!

RiverNorth Equity Opportunity (RNEOX): ditto! Equity Opportunity is a redesigned and greatly strengthened version of an earlier fund.  This new edition is all RiverNorth and that is, for folks looking for buffered equity exposure, a really interesting option.

We try to think strategically about which funds to profile. Part of the strategy is to highlight funds that might do you well in the immediate market environment, as well as others that are likely to be distinctly out of step with today’s market but very strong additions in the long-run. We reached out in January to the managers of two funds in the latter category: the newly-launched Meridian Small Cap Growth (MSGAX) and William Blair Emerging Markets Small Cap (WESNX). Neither has responded to a request for information (we were curious about strategy capacity, for instance, and risk-management protocols). We’ll continue reaching out; if we don’t hear back, we’ll profile the funds in March with a small caution flag attached.

RiverNorth conference call, February 25 2014

RiverNorth’s opportunistic CEF strategy strikes us as distinctive, profitable and very crafty. We’ve tried to explain it in profiles of RNCOX and RNEOX. Investors who are intrigued by the opportunity to invest with RiverNorth should sign up for their upcoming webcast entitled RiverNorth Closed-End Fund Strategies: Capitalizing on Discount Volatility. While this is not an Observer event, we’ve spoken with Mr. Galley a lot and are impressed with his insights and his ability to help folks make sense of what the strategy can and cannot do.

Navigate over to http://www.rivernorthfunds.com/events/ for free registration.

Conference Call Highlights:  ASTON River Road Long/Short (ARLSX)

We spoke with Daniel Johnson and Matt Moran, managers for the River Road Long-Short Equity strategy which is incorporated in Aston River Road Long-Short Fund (ARLSX). Mike Mayhew, one of the Partners at Aston Asset, was also in on the call to answer questions about the fund’s mechanics. About 60 people joined in.

The highlights, for me, were:

the fund’s strategy is sensible and straightforward, which means there aren’t a lot of moving parts and there’s not a lot of conceptual complexity. The fund’s stock market exposure can run from 10 – 90% long, with an average in the 50-70% range. The guys measure their portfolio’s discount to fair value; if their favorite stocks sell at a less than 80% of fair value, they increase exposure. The long portfolio is compact (15-30), driven by an absolute value discipline, and emphasizes high quality firms that they can hold for the long term. The short portfolio (20-40 names) is stocked with poorly managed firms with a combination of a bad business model and a dying industry whose stock is overpriced and does not show positive price momentum. That is, they “get out of the way of moving trains” and won’t short stocks that show positive price movements.

the fund grew from $8M to $207M in a year, with a strategy capacity in the $1B – 1.5B range. They anticipate substantial additional growth, which should lower expenses a little (and might improve tax efficiency – my note, not theirs). Because they started the year with such a small asset base, the expense numbers are exaggerated; expenses might have been 5% of assets back when they were tiny, but that’s no longer the case. 

shorting expenses were boosted by the vogue for dividend-paying stocks, which  drove valuations of some otherwise sucky stocks sharply higher; that increases the fund’s expenses because they’ve got to repay those dividends but the managers believe that the shorts will turn out to be profitable even so.

the guys have no client other than the fund, don’t expect ever to have one, hope to manage the fund until they retire and they have 100% of their liquid net worth in it.

their target is “sleep-at-night equity exposure,” which translates to a maximum drawdown (their worst-case market event) of no more than 10-15%. They’ve been particularly appalled by long/short funds that suffered drawdowns in the 20-25% range which is, they say, not consistent with why folks buy such funds.

they’ve got the highest Sharpe ratio of any long-short fund, their longs beat the market by 900 bps, their shorts beat the inverse of the market by 1100 bps and they’ve kept volatility to about 40% of the market’s while capturing 70% of its total returns.

A lot of the Q&A focused on the fund’s short portfolio and a little on the current state of the market. The guys note that they tend to generate ideas (they keep a watchlist of no more than 40 names) by paging through Value Line. They focus on fundamentals (let’s call it “reality”) rather than just valuation numbers in assembling their portfolio. They point out that sometimes fundamentally rotten firms manage to make their numbers (e.g., dividend yield or cash flow) look good but, at the same time, the reality is that it’s a poorly managed firm in a failing industry. On the flip side, sometimes firms in special situations (spinoffs or those emerging from bankruptcy) will have little analyst coverage and odd numbers but still be fundamentally great bargains. The fact that they need to find two or three new ideas, rather than thirty or sixty, allows them to look more carefully and think more broadly. That turns out to be profitable.

Bottom Line: this is not an all-offense all the time fund, a stance paradoxically taken by some of its long-short peers.  Neither is it a timid little “let’s short an ETF or two and hope” offering.”  It has a clear value discipline and even clearer risk controls.  For a conservative equity investor like me, that’s been a compelling combination.

Folks unable to make the call but interested in it can download or listen to the .mp3 of the call, which will open in a separate window.

As with all of these funds, we have a featured funds page for ARLSX which provides a permanent home for the mp3 and highlights, and pulls together all of the best resources we have for the fund.

Would An Additional Heads Up Help?

Over 220 readers have signed up for a conference call mailing list. About a week ahead of each call, I write to everyone on the list to remind them of what might make the call special and how to register. If you’d like to be added to the conference call list, just drop me a line.

Conference Call Upcoming:  Joshua B. Parker and Alan Salzbank, RiverPark / Gargoyle Hedged Value

Josh Parker and Alan Salzbank, Co-Portfolio Managers of the RiverPark/Gargoyle Hedged Value Fund (RGHVX) and Morty Schaja, RiverPark’s CEO; are pleased to join us for a conference call scheduled for Wednesday, February 12 from 7:00 – 8:00 PM Eastern. We profiled the fund in June 2013, but haven’t spoken with the managers before.  

Why speak with them now?  Three reasons.  First, you really need to have a strategy in place for hedging the substantial gains booked by the stock market since its March 2009 low. There are three broad strategies for doing that: an absolute value strategy which will hold cash rather than overpriced equities, a long-short equity strategy and an options-based strategy. Since you’ve had a chance to hear from folks representing the first two, it seems wise to give you access to the third. Second, RiverPark has gotten it consistently right when it comes to both managers and strategies. I respect their ability and their record in bringing interesting strategies to “the mass affluent” (and me). Finally, RiverPark/Gargoyle Hedged Value Fund ranks as a top performing fund within the Morningstar Long/Short category since its inception 14 years ago. The Fund underwent a conversion from its former partnership hedge fund structure in April 2012 and is managed using the same approach by the same investment team, but now offers daily liquidity, low  minimums and a substantially lower fee structure for shareholders.

I asked Alan what he’d like folks to know ahead of the call. Here’s what he shared:

Alan and Josh have spent the last twenty-five years as traders and managers of options-based investment strategies beginning their careers as market makers on the option floor in the 1980’s. The Gargoyle strategy involves using a disciplined quantitative approach to find and purchase what they believe to be undervalued stocks. They have a unique approach to managing volatility through the sale of relatively overpriced index call options to hedge the portfolio. Their strategy is similar to traditional buy/write option strategies that offer reduced volatility and some downside protection, but gains an advantage by selling index rather single stock options. This allows them to benefit from both the systemic overpricing of index options while not sacrificing the alpha they hope to realize on their bottom-up stock picking, 

The Fund targets a 50% net market exposure and manages the option portfolio such that market exposure stays within the range of 35% to 65%. Notably, using this conservative approach, the Fund has still managed to outperform the S&P 500 over the last five years. Josh and Alan believe that over the long term shareholders can continue to realize returns greater than the market with less risk. Gargoyle’s website features an eight minute video “The Options Advantage” describing the investment process and the key differences between their strategy and a typical single stock buy-write (click here to watch video).

That call is scheduled for Wednesday, February 12, from 7:00 – 8:00 Eastern. We’ll provide additional details in our February issue.  

HOW CAN YOU JOIN IN?

If you’d like to join in, just click on register and you’ll be taken to the Chorus Call site. In exchange for your name and email, you’ll receive a toll-free number, a PIN and instructions on joining the call. If you register, I’ll send you a reminder email on the morning of the call.

Funds in Registration

New mutual funds must be registered with the Securities and Exchange Commission before they can be offered for sale to the public. The SEC has a 75-day window during which to call for revisions of a prospectus; fund companies sometimes use that same time to tweak a fund’s fee structure or operating details.

Funds in registration this month are eligible to launch in late March or early April 2014, and some of the prospectuses do highlight that date.

This month David Welsch celebrated a newly-earned degree from SUNY-Sullivan and still tracked down 18 no-load retail funds in registration, which represents our core interest.

Four sets of filings caught our attention. First, DoubleLine is launching two new and slightly edgy funds (the “wherever I want to go” Flexible Income Fund managed by Mr. Gundlach and an emerging markets short-term bond fund). Second, three focused value funds from Pzena, a well-respected institutional manager. Third, Scout Equity Opportunity Fund which will be managed by Brent Olson, a former Aquila Three Peaks Opportunity Growth Fund (ATGAX) manager. While I can’t prove a cause-and-effect relationship, ATGAX vastly underperformed its mid-cap growth peers for the decade prior to Mr. Olson’s arrival and substantially outperformed them during his tenure. 

Finally, Victory Emerging Markets Small Cap Fund will join the small pool of EM small cap funds. I’d normally be a bit less interested, but their EM small cap separate accounts have substantially outperformed their benchmark with relatively low volatility over the past five years. The initial expense ratio will be 1.50% and the minimum initial investment is $2500, reduced to $1000 for IRAs.

Manager Changes

On a related note, we also tracked down 39 sets of fund manager changes. The most intriguing of those include what appears to be the surprising outflow of managers from T. Rowe Price, Alpine’s decision to replace its lead managers with an outsider and entirely rechristen one of their funds, and Bill McVail’s departure after 15 years at Turner Small Cap Growth.

Updates

We noted a couple months ago that DundeeWealth was looking to exit the U.S. fund market and sell their funds. Through legal maneuvers too complicated for me to follow, the very solid Dynamic U.S. Growth Fund (Class II, DWUHX) has undergone the necessary reorganization and will continue to function as Dynamic U.S. Growth Fund with Noah Blackstein, its founding manager, still at the helm. 

Briefly Noted . . .

Effective March 31 2014, Alpine Innovators Fund (ADIAX) transforms into Alpine Small Cap Fund.  Following the move, it will be repositioned as a domestic small cap core fund, with up to 30% international.  Both of Innovator’s managers, the Liebers, are being replaced by Michael T. Smith, long-time manager of Lord Abbett Small-Cap Blend Fund (LSBAX).  Smith’s fund had a very weak record over its last five years and was merged out of existence in July, 2013; Smith left Lord Abbett in February of that year.

Effective April 1, 2014, the principal investment strategy of the Green Century Equity Fund (GCEQX) will be revised to change the index tracked by the Fund, so as to exclude the stocks of companies that explore for, process, refine or distribute coal, oil or gas. 

The Oppenheimer Steelpath funds have decided to resort to English. It’s kinda refreshing. The funds’ current investment Objectives read like this:

The investment objective of Oppenheimer SteelPath MLP Alpha Fund (the “Fund” or “Alpha Fund”) is to provide investors with a concentrated portfolio of energy infrastructure Master Limited Partnerships (“MLPs”) which the Advisor believes will provide substantial long-term capital appreciation through distribution growth and an attractive level of current income.

As of February 28, it becomes:

The Fund seeks total return.

SMALL WINS FOR INVESTORS

The Board of Trustees of the Fund has approved an increase in the Congressional Effect Fund’s (CEFFX) expense cap from 1.50% to 3.00%. Since I think their core strategy – “go to cash whenever Congress is in session” – is not sensible, a suspicion supported by their 0.95% annual returns over the past five years, becoming less attractive to investors is probably a net good.

Driehaus Mutual Funds’ Board approved reductions in the management fees for the Driehaus International Discovery Fund (DRIDX) and the Driehaus Global Growth Fund (DRGGX) which became effective January 1, 2014.  At base, it’s a 10-15 bps drop. 

Effective February 3, 2014, Virtus Emerging Markets Opportunities Fund (HEMZX) will be open to new investors. Low risk, above average returns but over $7 billion in the portfolio. Technically that’s capped at “two cheers.”

CLOSINGS (and related inconveniences)

Effective February 14, 2014, American Beacon Stephens Small Cap Growth Fund (STSGX) will act to limit inflows by stopping new retirement and benefit plans from opening accounts with the fund.

Artisan Global Value Fund (ARTGX) will soft-close on February 14, 2014.  Its managers were just recognized as Morningstar’s international-stock fund managers of the year for 2013. We’ve written about the fund four times since 2008, each time ending with the same note: “there are few better offerings in the global fund realm.”

As of the close of business on January 28, 2014, the GL Macro Performance Fund (GLMPX) will close to new investments. They don’t say that the fund is going to disappear, but that’s the clear implication of closing an underperforming, $5 million fund even to folks with automatic investment plans.

Effective January 31, the Wasatch International Growth Fund (WAIGX) closed to new investors.

OLD WINE, NEW BOTTLES

Effective February 1, 2014, the name of the CMG Tactical Equity Strategy Fund (SCOTX) will be changed to CMG Tactical Futures Strategy Fund.

Effective March 3, 2014, the name of the Mariner Hyman Beck Portfolio (MHBAX) has been changed to Mariner Managed Futures Strategy Portfolio.

OFF TO THE DUSTBIN OF HISTORY

On January 24, 2014, the Board of Trustees approved the closing and subsequent liquidation of the Fusion Fund (AFFSX, AFFAX).

ING will ask shareholders in June 2014 to approve the merger of five externally sub-advised funds into three ING funds.   

Disappearing Portfolio	Surviving Portfolio
ING BlackRock Health Sciences Opportunities Portfolio	ING Large Cap Growth Portfolio
ING BlackRock Large Cap Growth Portfolio	ING Large Cap Growth Portfolio
ING Marsico Growth Portfolio	ING Large Cap Growth Portfolio
ING MFS Total Return Portfolio	ING Invesco Equity and Income Portfolio
ING MFS Utilities Portfolio	ING Large Cap Value Portfolio

 

The Board of Trustees of iShares voted to close and liquidate ten international sector ETFs, effective March 26, 2014.  The decedents are:  

• iShares MSCI ACWI ex U.S. Consumer Discretionary ETF (AXDI)
• iShares MSCI ACWI ex U.S. Consumer Staples ETF (AXSL)
• iShares MSCI ACWI ex U.S. Energy ETF (AXEN)
• iShares MSCI ACWI ex U.S. Financials ETF (AXFN)
• iShares MSCI ACWI ex U.S. Healthcare ETF (AXHE)
• iShares MSCI ACWI ex U.S. Industrials ETF (AXID)
• iShares MSCI ACWI ex U.S. Information Technology ETF (AXIT)
• iShares MSCI ACWI ex U.S. Materials ETF (AXMT)
• iShares MSCI ACWI ex U.S. Telecommunication Services ETF (AXTE) and
• iShares MSCI ACWI ex U.S. Utilities ETF (AXUT)

The Nomura Funds board has authorized the liquidation of their three funds:

• Nomura Asia Pacific ex Japan Fund (NPAAX)
• Nomura Global Emerging Markets Fund (NPEAX)
• Nomura Global Equity Income Fund (NPWAX)

The liquidations will occur on or about March 19, 2014.

On January 30, 2014, the shareholders of the Quaker Akros Absolute Return Fund (AARFX) approved the liquidation of the Fund which has banked five-year returns of (0.13%) annually. 

The Vanguard Growth Equity Fund (VGEQX)is to be reorganized into the Vanguard U.S. Growth Fund (VWUSX) on or about February 21, 2014. The Trustees helpfully note: “The reorganization does not require shareholder approval, and you are not being asked to vote.”

Virtus Greater Asia ex Japan Opportunities Fund (VGAAX) is closing on February 21, 2014, and will be liquidated shortly thereafter.  Old story: decent but not stellar returns, no assets.

In Closing . . .

Thanks a hundred times over for your continued support of the Observer, whether through direct contributions or using our Amazon link.  I’m a little concerned about Amazon’s squishy financial results and the risk that they’re going to go looking for ways to pinch pennies. Your continued use of that program provides us with about 80% of our monthly revenue.  Thanks, especially, to the folks at Evergreen Asset Management and Gardey Financial Advisors, who have been very generous over the years; while the money means a lot, the knowledge that we’re actually making a difference for folks means even more.

The next month will see our migration to a new, more reliable server, a long talk with the folks at Gargoyle and profiles of four intriguing small funds.  Since you make it all possible, I hope you join us for it all.

As ever,