July 1, 2011

By David Snowball

Dear friends,

The craziness of summer always amazes me.  People, who should be out watching their kids play Little League, or lounging in the shade with a cold drink, instead fret like mad about the end of the (investing) world as we know it.  Who would have guessed, despite all of the screaming, that it’s been a pretty decent year in the market so far?  Vanguard’s Total Stock Market Index fund (VTSMX) returned 6.3% in the first six months of 2011.  The market turbulence in May and June still constituted a drop of less than 3% from the market’s late April highs.

In short, more heat than light, so far.

Justice Thomas to investors: “Sue the Easter Bunny!”

On June 13th, the Supreme Court issued another ruling (Janus Capital Group vs. First Derivative Traders)  that seemed to embrace political ideology rather more than the facts of the case. The facts are simple: Janus’s prospectuses said they did not tolerate market-timing of the funds.  In fact, they actively colluded in it.  When the news came out, Janus stock dropped 25%.  Shareholders sued, claiming that the prospectus statements were material and misleading.  The Court’s conservative bloc, led by Skippy Thomas, said that stockholders could sue the business trust in which the funds are organized, but not Janus.  Since the trust has neither employees nor assets, it seems to offer an impregnable legal defense against any lies embedded in a prospectus.
The decision strikes me as asinine and Thomas’s writing as worse.  The only people cheerleading for the decision are Janus’s lawyers (who were active in the post-decision press release business) and the editorial page writers for The Wall Street Journal:

In Janus Capital Group Inc. v. First Derivative Traders, investors claimed to have been misled into buying shares of stock at a premium by prospectuses that misrepresented Janus Investment Fund’s use of so-called market timing. . .

The Court’s ruling continues a string of recent cases that put limits on trial-bar marauding, but the dissent by the four liberal Justices all but invites further attempts. As in so many legal areas, this Supreme Court is only a single vote away from implementing through the courts a political agenda that Congress has consistently refused to pass.

The editorial can sustain its conclusion only by dodging the fact (the business trust is a shell) and quoting Thomas’s thoughtless speechwriter/speechmaker analogy (which fails to consider the implication of having the writer and maker being the same person).   The Journal‘s news coverage recognized the problem with the ruling:

William Birdthistle, a professor at the Chicago-Kent College of Law, said the ruling disregarded the practical reality that mutual funds are dominated by their investment advisers, who manage the business and appoint the funds’ boards of directors.

“Everyone knows the fund is an empty marionette. It doesn’t do anything,” said Prof. Birdthistle, who filed a brief supporting the Janus investors. “You’re left with a circumstance where no one is responsible for this.”

The New York Times gets closer:

With Justice Clarence Thomas writing for a 5-to-4 majority, the Supreme Court has made it much harder for private lawsuits to succeed against mutual fund malefactors, even when they have admitted to lying and cheating.

The court ruled that the only entity that can be held liable in a private lawsuit for “any untrue statement of a material fact” is the one whose name the statement is presented under. That’s so even if the entity presenting the statement is a business trust — basically a dummy corporation — with no assets, while its owner has the cash.

Justice Thomas’s opinion is short and, from the mutual fund industry’s perspective, very sweet: Janus Capital Group and Janus Capital Management were heavily involved in preparing the prospectuses, but they didn’t “make” the statements so they can’t be held liable. . . Which means that there is no one to sue for the misleading prospectuses.

The ICI was publicly silent (too busy preparing their latest “fund expenses have too plummeted” and “America, apple pie and 12(b)1 fee” press releases,) though you have to imagine silent high-fives in the hallway.  I’m not sure of what to make of Morningstar’s reaction.  They certainly expressed no concern about, displeasure with or, alternately, support for the decision.  Mostly they conclude that there’s no threat in the future:

The ruling should not have a material impact on Janus mutual fund shareholders, according to Morningstar’s lead Janus fund analyst, Kathryn Young. Janus has had procedures in place since 2003 to prevent market-timing . . .

Uhhh . . .  Uhhh . . .  if those procedures are expressed as a sort of contract – communicated to investors – in the prospectus . . .  uhhh . . . hello?

The more pressing question is whether the decision also guts the SEC’s enforcement power, since the decision seems to insulate a firm’s decision-makers from the legal consequences of their acts.  It’s unclear why that insulation wouldn’t protect them from regulators quite as thoroughly as from litigators.

In short, you’ll have about as much prospect of winning a suit against the Easter Bunny as you will of winning against a fund’s fictitious structure.

The Odd Couple: Manager Gerry Sullivan and the Vice Fund (VICEX)

One of the fund industry’s nicest guys, Gerry Sullivan, has been appointed to run an awfully unlikely fund: VICEX.  Gerry has managed the Industry Leaders fund (ILFIX) since its launch.  The fund uses a quantitative approach to identify industries in which there are clear leaders and then looks to invest in the one or two leading firms.  The fund has a fine long-term record, though it’s been stuck in the mud for the past couple years.  The problem is the fund’s structural commitment to financial stocks, which have been the downfall of many good managers (think: Bruce Berkowitz, 90% financials, bottom 1% of large cap funds through the first half of 2011).  Since financial services match the criteria for inclusion, Sullivan has stuck with them – and has been stuck with them.  The rest of the portfolio is performing well, and he’s waiting for the inevitable rebound in U.S. financials.

In the interim, he’s been appointed manager of two very distinctive, sector-limited funds:

Generation Wave Growth Fund (GWGF), a sort of “megatrends” fund targeting the health care, financial services and technology sectors, and

Vice Fund (VICEX), which invests in “sin stocks.”  It defines those as stocks involved with aerospace/defense, gaming, tobacco and alcoholic beverages.

I’m sure there are managers with less personal engagement in sin industries than Gerry (maybe John Montgomery, he of the church flute choir, at Bridgeway), but not many.

Almost all of the research on sin stocks reaches the same conclusion: investing here is vastly more profitable than investing in the market as a whole.  Sin stocks tend to have high barriers to entry (can you imagine anyone starting a new tobacco company?  or a new supersonic fighter manufacturer?) and are often mispriced because of investor uneasiness with them.  Over the medium- to long-term, they consistently outperform both the market and socially-responsible indexes.  One recent study found a global portfolio of sin stocks outperforming the broad market indexes in 35 of 37 years, with “an annual excess return between 11.15% and 13.70%”  (Fabozzi, et al, “Sin Stock Returns,” Journal of Portfolio Management, Fall 2008).

About two-thirds of the portfolio will be selected using quantitative models and one-third with greater qualitative input.  He’s begun reshaping the portfolio, and I expect to profile the fund once he’s had a couple quarters managing it.

Who You Callin’ a “Perma-bear”?

Kiplinger’s columnist Andrew Feinberg wrote an interesting column on the odd thought patterns of most perma-bears (“Permanent Pessimists,” May 2011).  My only objection is his assignment of Jeremy Grantham to the perma-bear den.  Grantham is one of the founders of the institutional money manager GMO (for Grantham, Mayo, and van Otterloo).  He writes singularly careful, thoughtful analyses – often poking fun at himself and his own errors (“I have a long and ignoble history of being early on market calls and, on two occasions, damaged the financial well-being of two separate companies – Batterymarch and GMO”) – which are accessible through the GMO website.

Feinberg notes that Grantham has been bearish on the US stock market for 20 years.  That’s a half-truth.  Grantham has been frequently bearish about whatever asset class has been most in vogue recently.  The bigger questions are, is he wrong and is he dangerous?  In general, the answers are “sometimes” and “not so much.”

One way of testing Grantham’s insights is to look at the performance of GMO funds that have the flexibility to actually act on his recommendations.  Those funds have consistently validated Grantham’s insights.  GMO Global Balanced, Global Equity Allocation and U.S. Equity Allocation are all value-conscious funds whose great long-term records seem to validate the conclusion that Grantham, skeptical and grumpy or not, is right quite often enough.

Who You Callin’ “Mr. Charge Higher Prices”?

This is painful, but an anonymous friend in the financial services industry sent along really disturbing ad for a webinar (a really ugly new word).  The title of the June 8th webinar was “How to Influence Clients to Select Premium-Priced Financial Products and Services! (While Reinforcing Your Valuable Advice).”    The seminar leader “is known as Mr. Charge Higher Prices because he specializes in teaching how to get to the top of your customer’s price . . . and stay there!”

Sound sleazy?  Not at all, since the ad quotes a PhD, Professor of Ethics saying that the seminar leader shows you how to sell high-priced products which are also “higher-value products that more closely align with their goals and objectives.  [He] teaches them how to do so with integrity and professionalism.”  Of course, a quick internet search of the professor’s name and credentials turns up the fact that his doctorate is from an online diploma mill and not a university near London. It’s striking that seven years after public disclosure of his bought-and-paid-for PhD, both the ethicist and Mr. Higher Prices continue to rely on the faux credential in their advertising.

And so, one simple ad offers two answers to the question, “why don’t investors trust me more?”

Two Funds, and why they’re worth your time

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 funds:

RiverPark Short Term High Yield (RPHYX): put your preconceptions aside and pick up your copy of Graham and Dodd’s Security Analysis (1940).  Benjamin Graham was the genius who trained the geniuses and one of his favorite investments was “cigar butt stocks.”  Graham said of cigar butts found on the street, they might only have two or three good puffs left in them but since they were so cheap, you should still pick them up and enjoy them.  Cigar butt stocks, likewise: troubled companies in dying industries that could be bought for cheap and that might still have a few quarters of good returns.

You could think of RiverPark as a specialist in “cigar butt bonds.” They specialize in buying high-yield securities that have been, or soon will be, called.  Effectively, they’re buying bonds that yield 4% or more, but which mature in the next month or two.  The result is a unique, extremely low volatility cash management fund that’s earning several hundred times more than a money market.

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 gf them.

The stars are all time-tested funds, many of which have everything except shareholders.

The selection of this month’s star was inspired by a spate of new fund launches.  As a result of some combination of anxiety about a “new normal” investing world dominated by low returns and high volatility, fund companies have become almost obsessive about launching complex, expensive funds, whose managers have an unprecedented range of investment options.  Eight of the nine no-load funds on July’s funds in registration page represent that sort of complex strategy:

  • Litman Gregory Masters Alternative Strategies
  • PIMCO Credit Absolute Return Fund
  • PIMCO Inflation Response Multi-Asset
  • PIMCO Real Income 2019 and 2029
  • PIMCO Tax Managed Real Return Fund
  • Schooner Global Absolute Return Fund
  • Toews Hedged Commodities Fund

The same thing’s true of the May and June lists: 75% “alternative strategy” funds.

We don’t list load-bearing funds, in general, but recent registrations and launches there show the same pattern:

  • Franklin Templeton Global Allocation
  • BlackRock Credit Opportunities
  • BlackRock Emerging Market Long/Short Equity
  • Parametric Structured Commodity Strategy Fund
  • Neuberger Berman Global Allocation

The question is: if managers asked to execute a simple strategy (say, buying domestic stocks) couldn’t beat a simple index (the S&P 500), what’s the prospect that they’re going to soar when charged with executing hugely complex strategies?

This month’s star tests the hypothesis, “simpler really is better”:

ING Corporate Leaders Trust Series B (LEXCX): at $500 million in assets, you might think LEXCX a bit large to qualify as “in the shadows.”  This 76 year old fund is almost never in the news.  There’s never been an interview with its manager, because it has no manager.  There’s never been a shift in portfolio strategy, because it has no portfolio strategy.  Born in the depths of the Great Depression, LEXCX has the industry’s simplest, more stable portfolio.  It bought an equal number of shares of America’s 30 leading companies in 1935, and held them.  Period.  No change.  No turnover.  No manager.

The amazing thing?  This quiet antique has crushed not only its domestic stock peers for decades now, it’s also outperforming the high-concept funds in the very sort of market that should give them their greatest advantage.  Read on, Macduff!

Nassim Taleb is launching a Black Swan ETF!

Or not. Actually just “not.”

Nassim Taleb, a polymath academic, is the author of Fooled by Randomness (2001) and The Black Swan: The Impact of the Highly Improbable (2007).  The latter book, described by the Times of London as one of the “Books that helped to change the world,” argues that improbable events happen rather frequently, are effectively unpredictable, and have enormous consequences.  He seems to have predicted the 2007-09 meltdown, and his advice lends itself to specific portfolio actions.

Word that “Taleb is launching a black swan ETF” is rippling through various blogs, discussion boards (both here and Morningstar) and websites.  There are three small problems with the story:

  1. Taleb isn’t launching anything.  The original story, “Protect Your Tail,” from Forbes magazine, points to Taleb’s former investment partner and hedge fund manager, Mark Spitznagel.  The article notes, “After Taleb became seriously ill the duo shut the fund. Taleb has since given up money management . . .”
  2. It’s not clear that Spitznagel is launching anything.  Forbes says, “In July Universa intends to tap the financial adviser market by offering its own black swan ETF. The fund will mimic some of the strategies employed by its institutional-only hedge fund and will have an expense ratio of 1.5%.”  Unfortunately, as of late June, there’s no such fund in registration with the SEC.
  3. And you wouldn’t need it if there was such a fund.  Spitznagel himself calls for allocating “about 1% of an investment portfolio to fund such a ‘black swan protection protocol.'”  (Hmmm… in my portfolio that’d be about $12.50.)  If you wanted to have some such protection without a fund with a trendy name, you could adopt Taleb’s recommendation for a “barbell strategy,” in which you place 80% into stable investments, like government bonds and cash, and 20% into risky ones, such stocks and commodities.

Oddly enough, that comes close to describing the sort of strategy already pursued by funds like Permanent Portfolio (PRPFX) and Fidelity Strategic Income (FSICX) and those funds charge half of the reported “black swan” expenses.

Briefly noted:

Long-time SmartMoney columnist, James B. Stewart has moved to The New York Times.  Stewart helped found the publication and has been writing the “Common Sense” column for it for 19 years, yet the letter from the editor in that issue made no mention of him and his own final column offered his departure as an afterthought. On June 24th, his first column, also entitled “Common Sense,” appeared in the Times.  Stewart’s first story detailed the bribery of Mexican veterinarians by Tyson Foods.  He’ll be a Saturday columnist for the Business Day section of the paper, but they’re no word on what focus – if any – the feature might have.

For those interested in hiking their risk profiles, Matthews Asia launched its new Matthews China Small Companies Fund (MCSMX) on May 31, 2011.  As with most Matthews funds, there’s a lead manager (Richard Gao, who also manages Matthews China MCHFX) and a guy who’s there in case the manager gets hit by a bus (Henry Zhang, also the back-up guy on Matthews China).

Possible investors will want to read Andrew Foster’s new commentary for Seafarer Capital.  Andrew managed Matthews Asia Growth & Income (2005-2011) before leaving to found Seafarer.  While he has not yet filed to launch a mutual fund, Andrew has been posting a series of thoughtful essays on Asian investing, including several that focus on odd numbers and Chinese finance.  He promises in the next essay to look at BRICS in general but will also “touch upon China’s elevated (some would say breakneck) pace of investment, and what it means for the future of that country.”

Investors will also want to look at the prevalence of financial fraud in Chinese companies.  A recent Barron’s article provides a list of 20 Chinese firms that had a stop trading on the NASDAQ recently, a sign that their American accountants wouldn’t sign-off on the books.  While Matthews has a fine record and Gao promises extensive face-to-face meetings and fundamental research, these seem to be investments treacherous even for major firms.

Vanguard’s new actively managed emerging-markets fund, Vanguard Emerging Markets Select Stock (VMMSX) launched at the end of June.  It will complement their existing emerging markets index fund (VEIEX), the largest e.m. fund in existence.  Vanguard has four high-quality sub-advisors (M&G Investment Management, Oaktree Capital Management, Pzena Investment Management, and Wellington Management) none of whom have yet run an emerging markets funds.  Minimum investment is $3000 and the expense ratio is 0.95%, far below the category average.Rejoice!  AllianceBernstein is liquidating AllianceBernstein Global Growth (ABZBX). It’s no surprise, given the fund’s terrible performance of late.

Schwab plans to liquidate Schwab YieldPlus (SWYSX), a fund which once had $12 billion in assets.  Marketed as a higher-yield alternative to money markets, it blew apart in 2008 – down 47% – and Schwab has spent hundreds of millions on federal and state claims related to the fund, and faced charges filed by the SEC. Schwab will liquidate Schwab Tax-Free YieldPlus (SWYTX) and Schwab California Tax-Free YieldPlus (SWYCX) at the same time.

Vanguard Structured Large-Cap Growth liquidated on May 31, 2011.

John Hancock Classic Value Mega Cap (JMEAX) will liquidate on Aug. 19, 2011.

Calvert Large Cap Growth (CLGAX) will merge into Calvert Equity (CSIEX), assuming that shareholders (baaaa!) approve.  They’ve got the same management team and Calvert will lower CSIEX’s expenses a bit.

Morgan Stanley Special Growth (SMPAX) will soon merge into Morgan Stanley Institutional Small Company Growth (MSSGX).

ING Value Choice (PAVAX) and ING Global Value Choice (NAWGX) will close to most new investors on July 29, 2011.

Nuveen Tradewinds Value Opportunities (NVOAX) and Nuveen Tradewinds Global All-Cap (NWGAX) will close to most new investors on August 1, 2011.

Fidelity Advisor Mid Cap (FMCDX) will change its name to Fidelity Advisor Stock Selector Mid Cap on August 1, 2011.

JPMorgan Dynamic Small Cap Growth (VSCOX) and JPMorgan Small Cap Growth (PGSGX) will close to most new investors on August 12, 2011.

The MFO Mailbag . . .

I receive a couple dozen letters a month.  By far, the most common is a notice that someone goofed up their email address when signing up our e-mail notification service or registering for the site.  Regrets to Wolfgang and fjujv1.  The system generated a flood of mail reporting on its daily failure to reach you.  For other folks, please double-check the email you register with and, if you have a spam blocker, put the Mutual Fund Observer on your “white list” or our mail won’t get through.

Is there a Commentary archive (Les S)?  Yes, Les, there is.  You just can’t see it yet.  Chip is adjusting the site navigation and, within a week, the April through June commentaries will be available through links on the main commentary page.

Will the Observer post lists of Alarming, Three-Alarm and Most Alarming Three-Alarm funds (Joe B, Judy S, Ed S)?  Sorry, but no.  Those were Roy’s brainchild and I lack the time, expertise and passion needed to maintain them.  Morningstar’s free fund screener will allow you to generate lists of one-star funds, but I’m not familiar with other free screening tools aimed at finding the stinkers.

Is it still possible to access stuff you’d written at FundAlarm (Charles C)?  Not directly now that FundAlarm has gone dark.  I’d be happy to share copies of anything that I’ve retained (drop an email note), though that’s a small fraction of FundAlarm’s material.  There’s an interesting back door.  Google allows you to search for cached material by site.  That is, for example, you can ask The Google if it could provide a list of all references to Fidelity Canada that appeared at FundAlarm.com.  To do that, simple add the word site, a colon, and a web address to your search.

Fidelity Canada site:fundalarm.com

If the word “cached” appears next to a result, it means that Google has saved a copy of that page for you.

Shouldn’t Marathon Value be considered a Star in the Shadows (Ira A)?  Yes, quite possibly. Ira has recommended several other find small funds in the past and Marathon Value (MVPFX) seems to be another with a lot going for it.  I’ll check it out.  Thanks, Ira.  If you’ve got a fund you think we should look at more closely, drop a line to [email protected], and I’ll do a bit of reading.

In closing . . .

Thanks to all the folks who’ve provided financial support for the Observer this month.  In addition to a half dozen friends who provided cash contributions, either via PayPal or by check, readers purchased almost 250 items through the Observer’s Amazon link.  We have, as a result, paid off almost all of our start-up expenses.  Thanks!

For July, we’ll role out three new features: our Amazon store (which will make it easier to find highly-recommended books on investing, personal finance and more), our readers’ guide to the best commentary on the web, and The Falcon’s Eye.  (Cool, eh?)  Currently, if you enter a fund’s ticker symbol in a discussion board post, it generates a pop-up window linking you to the best web-based resources for researching and assessing that fund.  In July we’ll roll that out as a free-standing tool: a little box leading you to a wealth of information, including the Observer’s own fund profiles.

Speaking of which, there are a number of fund profiles in the works for August and September.  Those include Goodhaven Fund, T. Rowe Price Global Infrastructure and Emerging Markets Local Currency Bond funds, RiverPark Wedgewood Fund and, yes, even Marathon Value.

Until then, take care and keep cool!



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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.