June 1, 2011

By David Snowball

Dear friends,

After a lovely month in England, I returned to discover that things are getting back to “normal” again in the financial markets.

Top executives of publicly traded money management firms got raises averaged 33% “as improved financial results and increases in assets under management put them further away from the market turmoil of years past” (Randy Diamond, “Good times rollin’ once again for money manager execs,” Pensions and Investments Online, May 16 2011). While paltry by bankers’ standards, some of the money firm chiefs should be able to cover their mortgages: Larry Fink of BlackRock took home $24 million, while Janus CEO Richard Weil and Affiliated Managers Group CEO Sean Healey each got $20 million.

Pension plans are moving back into hedge fund investing.  According to the consulting firm Prequin, pension plans have 6.8% of their money in hedge funds now compared to 3.6% in 2007.  One motive for the change: hedge funds have returned 6.8% on average over the decade compared to 5.7% for the plans’ stock investments.  By increasing exposure to hedge funds, the plans can mask the magnitude of their uncovered commitments.  That is, they can project higher future returns and so argue that they’ll surely be able to cover their apparently huge deficits.  (“Pensions leap back to hedge funds,” WSJ, May 27 2011)

Rich folks are losing interest in managing their own investments, and are back to handing money over to their “wealth managers” to shepherd.  In 2009, 69% of high net worth investors wanted to take “an active role” in managing their investments.  It’s down to 47% in 2011, which Clifford Favrot of Delta Financial Advisers describes as “returning to normal” (“Rich relax a bit but stay on guard,” WSJ, May 27 2011).

In general, any time folks decide that it’s time to stop worrying, it’s time to start worrying.  Worrier par excellence Jeremy Grantham of GMO argues that the strong performance of risk assets – both stocks and bonds – is detached from the underlying economy.  His advice: “the environment has simply become too risky to justify prudent investors hanging around, hoping to get luck.  So now is not the time to float along with the Fed, but to fight it.”  While Grantham ruefully admits “to a long and ignoble history of being early on market calls” (well, sometimes two years early), he’s renewed his calls to concentrate on high quality US blues and emerging market equities (“Time to be serious – and probably too early – once again,” GMO Quarterly Letter, May 2011).

Part of Wall Street’s Normal: Gaming the System

Folks who suspect that the game is rigged against them have gotten a lot of fodder in the last two months.  A widely discussed article in Rolling Stone Magazine (“The Real Housewives of Wall Street,” April 2011) looks at how federal bailout money was allocated.  In general: (1) poorly and (2) to the rich.  While Stone is not generally a voice of conservatism, its story might have a comfortable home even in the National Review:

. . . the government attempted to unfreeze the credit markets by handing out trillions to banks and hedge funds. And thanks to a whole galaxy of obscure, acronym-laden bailout programs, it eventually rivaled the “official” budget in size — a huge roaring river of cash flowing out of the Federal Reserve to destinations neither chosen by the president nor reviewed by Congress, but instead handed out by fiat by unelected Fed officials using a seemingly nonsensical and apparently unknowable methodology.

Stone argues that “the big picture” of a multi-trillion dollar bailout is simply too big for human comprehension, but that you can learn a lot by looking through the lens of the assistance given a single firm: Waterfall TALF Opportunity.  While Waterfall received a pittance – a mere quarter billion compared to Goldman Sachs $800 billion – Waterfall was distinguished by the credentials of its two chief investors: Christy Mack and Susan Karches.

Christy is the wife of John Mack, the chairman of Morgan Stanley. Susan is the widow of Peter Karches, a close friend of the Macks who served as president of Morgan Stanley’s investment-banking division. Neither woman appears to have any serious history in business, apart from a few philanthropic experiences. Yet the Federal Reserve handed them both low-interest loans of nearly a quarter of a billion dollars through a complicated bailout program that virtually guaranteed them millions in risk-free income.

Stone details the story of the women’s risk-free profits, courtesy of a category of bailout program they describe as “giving already stinking rich people gobs of money for no ****ing reason at all.”  Waterfall investors put up $15 million, then received $220 million in federal funds with the promise that they could receive 100% of any investment gains but be responsible for only 10% of any investment losses they incurred.  It’s a fascinating, frustrating story.

Happily, the women wouldn’t need to worry about investment losses as long as they accepted guidance from the world’s best investors: members of the U.S. House of Representatives.  A study in Business and Politics examined the financial disclosure records of all the members of Congress.  They concluded that somehow members of Congress outperformed the stock market by “6.8% per annum after compounding – better than hedge-fund superstars.”  U.S. Senators performed even better.  While it’s possible that House members are simply smarter than hedge fund managers, the authors darkly conclude “We find strong evidence that Members of the House have some type of non-public information which they use for personal gain” (“Fire Your Hedge Fund, Hire Your Congressman,” Barron’s, 05/26/2011).

It’s the world’s scariest ad!

Remember Larry, Darryl and Darryl from the old Newhart TV show?  The three deranged brothers launched their first business – “Anything for a Buck”. They’ll do anything for a buck. If it’s something cool like digging up an old witch’s body from the cellar, they might even pay you the buck!


Larry, Darryl and Darryl

Apparently they’re now the masterminds behind iShares, whose slogan seems to be “anything can be an ETF!”



Fairholme Fund wobbles

Fairholme Fund (FAIRX), a huge, idiosyncratic beast run by Morningstar’s equity manager of the decade, Bruce Berkowitz, has had a bad year.  The fund trails its average peer by 15 percentage points of the past year and ranks in the bottom 1% of large cap value funds for the past quarter, two quarters and four quarters (as of June 2011).  The fund sucked in $4 billion of anxious money in 2010 after a long, remarkable run.  Predictable as the rains in spring, $1 billion of assets rushed back out the door in April alone (per Morningstar fund flow estimates).  That’s three times worse than any other month in its history.

Bruce Berkowitz didn’t dodge the fund’s problems in a May 11 conference call with investors:

Here are my thoughts on the Fairholme Funds recent performance: horrible, [and] that’s the summary in hindsight and it may be to be expected over the short term.

We’ve always stated in our reports that short-term performance should not be over emphasized. It’s the long term that counts. This is not the first time we’ve underperformed; it won’t be the last time and I don’t think it’s reality to outperform every month, quarter or year.

So it’s been lousy for months, we’ve been losing, we’re way underperforming, and it may stay lousy for more time.

He argues that the short-term problem is his decision to buy financial stocks (now 90% of the portfolio), which is expects to continue buying.  “We need to buy low and buy lower and buy lower. Even when the crowd yells you’re wrong. This is how we’ve achieved our performance over the past decade and this is how we will achieve our performance in the next couple of decades.”

One of his highest-visibility holdings, St. Joe Corporation (JOE) a Florida land company.  They started as a paper mill, got rich, got stupid, bought a bunch of stuff they shouldn’t have (brokerage firms, for example), had no debt but made no money.  After a long battle, Fairholme took control of St. Joe in March, forcing out the CEO and much of the board.

Why care?

There’s an interesting argument that St. Joe was less important for its huge land holdings than for its ability to make investments that Fairholme itself cannot make.  A fascinating article in Institutional Investor notes:

St. Joe may not seem like a major prize in the big scheme of things, with a market value of just $2.4 billion, but Berkowitz and Charles Fernandez, his No. 2 at Fairholme for the past three and a half years, saw a huge opportunity. Not only did they think that the company’s real estate operations could be worth a lot more in the future, they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett’s Berkshire Hathaway.

“We’re trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders,” Berkowitz says. (“Fairholme’s Bruce Berkowitz Is Beating Hedge Fund Managers at Their Own Game,” Institutional Investor, 05/19/2011).

Indeed, in his conference call, Berkowitz says, “JOE is, at its heart, an asset manager.”

The possibilities are intriguing.  In his interview with the Observer, Mr. Berkowitz argued that Fairholme’s size ($20 billion in assets) was critical to its future.  While many observers felt the fund was too unwieldy, Berkowitz argues that only its size allows it to become party to a set of expensive, unconventional opportunities.

Beyond the simple matter of corporate restructurings, bankruptcies and other conventional “special situations,” managers are looking increasingly far afield for opportunities.  Hedge fund manager David Einhorn, who lost big to Berkowitz in the St. Joe fight, recently announced a $200 million investment in the New York Mets.   And bond maestro Jeff Gundlach pushed the investment potential of gemstones at a recent investment conference:

[Gundlach] likes gold for its “Biblical street cred, if such a thing is possible.” But he advocates gem stones over gold. “Gold has shown itself to be money and pretty. Gems have also shown themselves to be money and prettier,” he says.  (Mark Gongloff, gundlach-leads-off-with-prostitutes, WSJ Marketbeat blog, 05/25/2011

Hmmm . . . perhaps Newt Gingrich’s reported $500,000 bill with Tiffany’s isn’t just egregious excess: it’s creative portfolio management.

This never turns out well: the emerging markets debt obsession grows

A lot of emerging market debt funds are now coming to market, many of them specializing in debt priced in some local currency.  By Morningstar’s estimate, of the 20 emerging-markets local-currency funds, 14 have been opened in the last year.  These funds are a vote against the future of the US dollar and in favor of currencies supported – largely – by commodity-producing economies and growing populations.  Among the recent notable entrants:

Harbor Emerging Markets Debt (HAEDX) launched on May 2, 2011, and invests in securities that are economically tied to emerging markets, or priced in emerging-markets currencies. It’s being sub-advised, as all Harbor funds are.  The subadvisor is Stone Harbor Investment Partners whose Stone Harbor Emerging Markets Debt (SHMDX) has returned 10.5% annualized since inception. Harbor Emerging Markets Debt has an expense ratio of 1.05% and a $1000 minimum.

Aberdeen Asset Management launched Aberdeen Emerging Markets Debt Local Currency (ADLAX) on May 2, 2011. Brett Diment will lead the team responsible for managing the fund.

Forward Management launched Forward Emerging Markets Corporate Debt (FFXIX) on May 3, 2011. The fund will invest mainly in emerging-markets corporate debt, and will be subadvised by SW Asset Management. David Hinman and Raymond Zucaro will manage the fund.

T. Rowe Price launched T. Rowe Price Emerging Markets Local Currency Bond on May 26. The fund will invest in bonds denominated in emerging-markets currencies or derivatives that provide emerging-markets bond exposure.  Andrew Keirle and Christopher Rothery who manage the fund also have been managing a similar strategy for institutional investors in the T. Rowe Price Funds SICAV–Emerging Local Markets Bond Fund since 2007. That said, the institutional fund has consistently trailed T. Rowe Price Emerging Markets Bond (PREMX) since inception.

HSBC filed to launch HSBC Emerging Markets Debt, which will invest primarily in U.S.-dollar-denominated while Emerging Markets Local Debt will invest in local-currency debt. Both should come on-line on June 30, 2011.

PIMCO Developing Local Markets (PLMDX) will be renamed PIMCO Emerging Markets Currency on August 16, to reflect a slight strategy shift. The fund holds positions in short maturity local bonds and currency derivatives.  The change will give the managers a bit more freedom to choose which countries to pursue.

Emerging market bond funds have returned an average of 12-13% annually over the past 10-15 years. On face, easier and more diverse access to these assets should be a good thing.  Remember two things:  First, the asset class has done so well that future returns are likely modest.  Grantham, Mayo, van Otterloo (GMO) projects real returns on emerging market debt of just1.7% annually over the next 5-7 years (Asset Class Return Forecast, 04/30/2011).   That’s well below their projection for E.M. stocks (4.5% real) or U.S. blue chip companies (4.0%).   Second, much of those gains took place when relatively few investment companies were interested.  In 2003 for example, investors placed only $14 billion to work in emerging market debt.  Fidelity New Market Income (FNMIX) earned 31% that year. In 2010, it was $72 billion and the Fido fund returned 11%.  As more funds pile in, profits are going to become fewer and opportunities thinner.  While E.M. debt is a valid asset class, joining the herd rushing toward it might bear a moment’s reflect.

Funds worth your attention

Really worth it.  Every month the Observer profiles two to four funds that we think you really need to know more about.  They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention.  They might come from a great boutique or be offered by a top-tier manager who has struck out on his own.  The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought.  This month’s two new fund:

Fidelity Global Strategies (FDYSX): this relatively young fund has one of Fidelity’s broadest, most ambitious mandates.  In June 2011, it was rechristened to highlight a global approach.  It’s not clear that the changes are anything more than pouring old wine in a new bottle.

Stars in the shadows: Small funds of exceptional merit.  There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar.  Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples).  Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention.  There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight of them.

The stars are all time-tested funds, many of which have everything except shareholders.  This month’s star:

RiverNorth Core Opportunity (RNCOX): going, going, gone as of June 30.  This former “most intriguing new fund” is larger than most “stars,” but it deserves recognition for two reasons.  First, it’s truly a one-of-a-kind offering.  Second, its imminent closing makes this the idea time for potential investors to do their research and make a decision before regrets set in.

Research on the cutting edge of “duh”

Investment managers and strategies plow through an enormous amount of behavioral research these days, trying to use the predictable patterns of human (i.e., investor) behavior to better position their portfolios.  That said, a remarkable amount of published research in the area seems to cry out “duh!”

On unusually warm days, people are more likely to believe in global warming than they are on cold days, according to a survey of 1200 Americans and Australians by the Center for Decision Sciences at the Columbia Business School.

In a related study, people sitting in a steadily warming room are more likely to believe in global warming than those who are not.

On sunny days, investors are more like to choose stocks over bonds but when it’s ridiculously hot, investors become cranky and markets become volatile.

By the way, if you hand folks a warm drink, they’re more likely to rate you as a “warm” person than it you hand them a cold drink.

Extreme market volatility is bad for investors’ hearts: among Chinese investors anyway.  A 1% market jump correlates with a 2% jump in heart attacks among Chinese investors (and you thought you had problems with emerging markets’ volatility).

If you build more highways, that is, if you make driving easier and more convenient, people drive more, according to a study soon to be published in the American Economic Review.

Work is stressful, which can be scientifically measured by checking levels of the stress hormone cortisol.  A new study in the Journal of Family Psychology suggests that women’s stress levels drop when their husbands are helping with chores, but it’s the opposite for men: Their stress levels fall when their wives are busy while they’re relaxing. Oddly, the scientists didn’t report results for families in which dad did the housework, and mom relaxed.

Briefly noted:

Janus did something right and cool: kudus to Janus for publicizing the investments made by each manager in each fund, as well as in Janus funds as a whole.  While this information is purely available (it’s in the Statement of Additional Information), I know of no other fund company that brings it all together in one place.  For those interested, check here to see how serious their Janus manager is about his or her fund.

Janus Venture (JAVTX) reopened to new investors on May 6 and launched a series of new share classes (A, C, S and I).  As usual, it’s not clear why Janus re-opened the fund: it has a larger portfolio ($1.3 billion) for a small cap fund, the largest in its history, and small caps are already coming off an extended run.  The best reason to take the fund seriously, at least if you can access it without a load, is the strength of its new management team.  Janus Triton (JATTX) managers Chad Meade and Brian Schaub have run Venture for less than a year, but have made a real difference in that time.  They’ve decreased the fund’s concentration and eliminated some of its micro-cap exposure, and have generated very solid returns.  Triton, also a small cap fund, has been an exceedingly solid performer for Janus and noticeably less volatile than the typical Janus fund.  The advantage of a fee cap (holding total expenses to 1.05% for the next year) makes it more attractive still.

Journalists are funny. You can almost hear the breathlessness in Neal Anderson’s prose: “The MFWire has learned that the Boston-based mutual fund giant is re-branding the large cap blend fund as the Fidelity Global Strategies Fund. . . “(“Fido Shifts a Fund’s Name and Strategies,” 05/04/2011).  True enough, but it’s not exactly as if you needed a secret contact to find this out: Fidelity duly submitted the paperwork and it was made publicly available a week before in the SECs EDGAR database.

RiverNorth Core Opportunity (RNCOX) will close to new investors on June 30, 2011.  You really might want to read the new fund profile this month.

The Quant Funds have a new name.  They’re now the Pear Tree Funds because the former name “no longer reflects the true nature of the mutual fund family.”  At base, the funds have three sub-advisors (Polaris, PanAgora and Columbia Partners), not all of who are quant investors and the advisor felt “the former name no longer reflects the true nature” of their funds.  Apparently “pear trees” (dense, brittle and short-lived) comes closer.

During the FundAlarm hiatus, Fidelity launched Fidelity Conservative Income Bond (FCONX).  It’s an ultra-short term bond fund run by Kim Miller.  While he’s been with Fidelity for 20 years, his management experience is limited most to money market funds, though he was on the team for several of the Asset Manager and municipal bond funds.  The fund’s expense ratio is 0.40% and it has accumulated $100 million in assets in three months.  (A slow start for a Fido fund!)

Similarly, the BearlyBullish fund registered in March and launched in early May.  At base, it’s a mid- to large-cap stock fund, mostly invested in the US and Canada.  When the managers’ market indicators turn negative, the fund simply moves more of its assets to cash.  That strategy worked in 2008, when the separately managed accounts that use this system dropped 24% while the broad market dropped by 37%.  It’s run by a team from Alpha Capital Management.  The investment minimum is $1000 and the expense ratio is 1.49%.

Nuveen Quantitative Large Cap Core (FQCAX) changed its name to Nuveen Quantitative Enhanced Core.

Old Mutual Strategic Small Companies (OSSAX) changed its name to Old Mutual Copper Rock International Small Cap. The fund also changed its strategy from a domestic small-cap strategy to an international small-cap strategy.

Pending shareholder approval on June 27, Madison Mosaic Small/Mid-Cap Fund will become NorthRoad International Fund (MADMX) and the Fund’s investment objective will be changed from “long-term growth” to “long-term capital appreciation by investing in non-U.S. companies.” Under the proposal, total fund operating expenses will decrease from 1.25% to 1.15% (annualized). Madison owns a majority stake in New York-based NorthRoad already.  Northroad handles institutional accounts now and their three managers have good credentials, both in previous employment (Lazard Asset Management in a couple cases) and colleges (Williams, Columbia, Yale).  The Small/Mid-Cap fund drew negligible assets and was only a so-so performer in its short life, so this is likely a substantial gain for the firm and its shareholders.

Dreyfus Core Value will merge into Dreyfus Strategic Value (DAGVX) on Nov. 16.

MFS Core Growth (MFCAX) will merge into MFS Growth (MFEGX).

Munder Large-Cap Growth has merged into Munder Growth Opportunities (MNNAX).

RidgeWorth Large Cap Quantitative Equity (SQEAX) will merge into RidgeWorth Large Cap Core Growth Stock (CFVIX) on July 15.

Loomis Sayles Disciplined Equity liquidated on May 13.

William Blair Emerging Markets Growth (BIEMX) will close to new investors on June 30.  Heartland Value Plus (HRVIX) closed to new investors in mid-May.  Heartland noted some skepticism about the state of the small cap market in justifying their close.

In closing . . .

Google Analytics offers fascinating snapshots of the Observer community.  7000 people have visited the site and about a thousand drop by more than once a day.  Greetings to visitors from Canada, Spain, Israel, Mexico and the U.K. – our most popular countries outside the U.S.  A cheery smile to the women who (secretly) use the Observer: research just released by the market-research firm Mintel Group discovered that women, more than men, were likely to make their investments through mutual funds (“Girls just want to have funds,” Barron’s, 05/21/2011).  Over half of all the folks who wrote me before the launch of the Observer were women who relied on FundAlarm’s research and discussions, though most admitted to never feeling quite brave enough to post.

Men, contrarily, were more likely to use ETFs, stocks, options and futures – and to trade actively.  (Note to the guys: stop that!)

In addition, a special wave to our one visitor from Kenya, who seems faithfully to have read every page on the site!

Thanks to all the folks who’ve provided financial support to the Observer of the past month.  Thanks especially to the six friends of the Observer who made direct contributions through PayPal.  In response to a couple notes, I’ve also posted my snail mail address for the sake of people who want to either write or send a check (which dodges PayPal’s fees).   In addition, our Amazon link led to 244 purchases in May, which contributes a lot.  Thanks to you all!

A special thanks to Roy Weitz, who stepped in as moderator during my three weeks in England.

We read, and respond to, everything we can.  Chip continues to monitor the Board’s technical questions and I try to handle any of the emailed notes.  If you have a question, comment, compliment or concern, just write me!

If you write, please remember to include your name and contact information.  I’m always interested in learning about funds or investment trends that intrigue you, but I’m exceedingly wary of anonymous tips.

Take care and I’ll see you again on July 1!



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About David Snowball

David Snowball, PhD (Massachusetts). Cofounder, lead writer. David is a Professor of Communication Studies at Augustana College, Rock Island, Illinois, a nationally-recognized college of the liberal arts and sciences, founded in 1860. For a quarter century, David competed in academic debate and coached college debate teams to over 1500 individual victories and 50 tournament championships. When he retired from that research-intensive endeavor, his interest turned to researching fund investing and fund communication strategies. He served as the closing moderator of Brill’s Mutual Funds Interactive (a Forbes “Best of the Web” site), was the Senior Fund Analyst at FundAlarm and author of over 120 fund profiles. David lives in Davenport, Iowa, and spends an amazing amount of time ferrying his son, Will, to baseball tryouts, baseball lessons, baseball practices, baseball games … and social gatherings with young ladies who seem unnervingly interested in him.