December, 2010

By Editor

. . . from the archives at FundAlarm

David Snowball’s
New-Fund Page for December, 2010

Dear friends,

Multiple stories in the past month (“Hedged mutual funds on the ascent,” “Here come the ‘hedged’ mutual funds”), complemented by a series of high profile fund launches, are heralding hedge funds as the future of mutual funds. So, despite their questionable performance, expensive strategies, secretive nature, frantic trading and tendency to be liquidated by the thousands, it appears that

It’s Hedge-Mania Time!

There are three ways in which we discuss “hedges” in regard to mutual funds: currency hedging by international funds, hedge fund-like strategies adopted by mutual funds, or mutual funds that attempt to replicate the performance of the hedge fund universe.

Currency hedging

The oldest, least expensive and least controversial practice is currency hedging by international funds. Currency hedges are a sort of insurance which, for a price, can largely nullify the effect of changing currency values on an international fund’s performance.

The simplest way to measure the effects of currency changes is to compare the performance of Tweedy, Browne Global Value (TBGVX), which does hedge its currency exposure, with Tweedy, Browne Global Value II (TBCUX) which is identical except that it doesn’t purchase currency hedges.

Over the past twelve months, the hedged version of the fund has earned its investors 12.85%, which places it in the top 1% of its peer group. The unhedged version (same stocks, same manager, same expenses) has returned 4.75%. Tweedy’s managers believe that, in the long term, neither currency strategy has an inherit advantage: the hedges cost some money but moderate short term volatility.

Hedge fund strategies

The second strategy, which has been around for a decade or more, has been the importation of hedge fund strategies into mutual fund portfolios. While the extent of those strategies is limited by federal regulation, such funds might sell securities shorts in order to benefit from their falling values, use leverage to over-expose themselves to a market, or use derivatives to hedge various risks. All of which is expensive: the average long-short fund charges 2.04% in expenses, with the worst of them charging over 5% annually for their services. With considerable confidence and absolutely no evidence, Alistair Barr and Sam Mamudi of The Wall Street Journal recently (11/15/10) assured readers that “Hedged mutual funds provide stock-like returns with less volatility.” Oddly, the only fund they point to – Thesis Flexible Fund (TFLEX) – had lost 0.4% since inception while the S&P was up 10%. Of all 562 “alternative” mutual funds tracked by Morningstar, only 86 managed “stock-like returns” in 2010. Nonetheless, the Journal’s sources pronounce us in “the very early stages of a multitrillion-dollar wave that’s going to wash over” the fund industry.

Whether “multi-trillion” or not, it’s clear that more and more long-established equity managers – recently Turner, Fairholme, Aston, Causeway, GRT, plus the bond guys at DoubleLine – have committed to new hedge-like funds.

Hedge fund replication

The most recent manifestation of hedge mania are the so-called “hedge fund replication” funds. Operating under the assumption that hedge funds are, by definition, good, these funds use complex mathematical modeling to construct portfolios of traditional investments (for example, convertible bonds) whose performance matches the risk and return profile of some part of the hedge fund universe. In theory, they offer all of the advantages of hedge fund investing with none of the pesky fees, minimums and liquidity problems.

The fact that they don’t work seems secondary. I compared the returns since inception for all of the “hedge fund replication” funds that I could identify with the returns of the simplest, blandest and cheapest alternative I could identify: Vanguard’s Balanced Index fund (VBINX). The Balanced Index charges next to nothing (0.08 – 0.25%, depending on share class) and offers a very simple 60/40 stock/bond split.

To date, every hedge fund replicant, from inception to late November 2010, trails the returns of the VBINX. Here’s the comparison of what you’d get it you’d place $10,000 either in a hedge replicating fund on the day it opened or in the balanced index on that same day. All results are rounded to the nearest $100:

Natixis ASG Global Alternatives (“A” shares) 11,000
Vanguard Balanced Index 11,500
Goldman Sachs Absolute Return Tracker (“A”) 9,100
Vanguard Balanced Index 10,400
IQ Alpha Hedge Strategy 10,800
Vanguard Balanced Index 10,900
Ramius Dynamic Replication (“A”) 10,000
Vanguard Balanced Index 10,600
IQ Hedge Multi-Strategy Tracker ETF QAI 11,100
Vanguard Balanced Index 13,900

While it’s true that the records of these funds are too short (between one and 30 months) to offer a great test, the fact that none of them have outperformed a simple alternative does remind us of Occam’s Razor. William of Ockham was a 14th century logician and friar, who embraced the minimalist notion that “entities must not be multiplied beyond what is necessary.” His “Razor” is generally rendered as “the simplest explanation is more likely the correct one” or “when you have two competing theories that make exactly the same predictions, the simpler one is the better.” The same, perhaps, might be said of investing: “if two different investments get you to the same spot, the simpler one is the better.”

Shaving USAA Total Return Strategy with Occam’s Razor

“Scott,” an active and cheerful contributor to FundAlarm’s discussion board, made a sharp-eyed observation about the USAA Total Return Strategy (USTRX) fund: “it has 70% in SPY [an ETF which tracks the S&P 500]. I’ve never seen a mutual fund with 70% of its weighted portfolio in one position. . . For the record, the performance combined with the expenses of the fund are not attractive. In its worst year it lost almost twice as much as it gained in its best year. Have you ever seen a fund with almost 75% in one ETF?”

Actually, Scott, not until now.

USAA is a financial services company open to “anyone who has ever served honorably in the military,” a restriction you could dodge by investing through one of the several fund supermarkets who offer the funds NTF. Since they restrict information about their funds to members, outsiders need to work through SEC filings to get much detail.

The Total Return portfolio is divided into three parts. There’s a tiny market-neutral sleeve, which invests long and short in equities. There’s a tiny, bizarre sleeve invested in a hedge fund. Here’s their attempt to explain it:

[We employ] a global tactical asset allocation overlay strategy (GTAA) by investing in hedge or other funds that invests in short-term money market instruments and long and short positions in global equity and fixed-income exchange-traded futures, currency forward contracts, and other derivative instruments such as swaps.

But 92% of the portfolio consists of SPY (70%) and “Currency United States” (at 21% and somehow distinct from “cash”). The strategy is to sell index calls or buy puts in an “attempt to create a collar on our stock market exposure that effectively limits downside (and upside) potential and gives us the flexibility to quickly change the Fund’s risk.”

Which would be nice except for the fact that it doesn’t actually do anything. $10,000 invested in the fund nearly six years ago has grown to $10,100. The same investment in the bland Vanguard Balanced Index grew to $12, 900. (The fund trails its Lipper Flexible Portfolio Funds peer group by a comparable amount.) And the Balanced Index imposed virtually the same degree of volatility (a five-year standard deviation of 11.27 versus USTRX’s 10.84), had virtually the same downside (down 22% in 2008 versus 21% for USTRX) and charges one-fifth as much.

And in the background, one hears the good Friar Ockham intoning, “don’t make it unnecessarily complicated, ye sinners.”

Silly advice of the month: “Why You Must ‘Time’ This Market”

Levisohn & Kim’s lead story in The Wall Street Journal’s “Weekend Investor” section (11/13/10) begins: “Forget ‘buy and hold.’ It’s time to time the stock market.”

You can’t imagine how much of a headache these stories give me. The story begins with the conspiratorial insight, if timing “sounds like sacrilege, it may be because mutual-fund firms have spent decades persuading you to keep your money in their stock funds through thick and thin so they could collect bigger profits.” The depth of the conspiracy is illustrated by a hypothetical $1 million doing investment (because bigger numbers are, well, bigger) in the S&P 500 made on December 24 1998. Since then, you’d have made nuthin’.

The solution? Tactical allocation funds which “have the flexibility to jump into and out of asset classes to avoid market losses.”

There are three problems with Levisohn and Kim’s advice:

First, it tells you what might have worked 12 years ago, which is a lot different than telling you what will work in the years ahead. Did the WSJ advocate market timing in 1998 (or 2002, for that matter)? Nope, not so far as I can find in the paper’s archive. Why not? Because they had no idea of what the next decade in the market would be like. Nor do Levisohn and Kim have any particular evidence of insight into the decade ahead.

Second, it relies on your ability to time the market. “And,” they assure us, “it turns out sometimes you can.” Sometimes, it turns out, is a dangerous notion. Their faith depends on knowing that you’re “stuck in a trading range for an extended period” (the same assumption made by the folks selling you day-trading software). Unfortunately, the market of the past 12 years hasn’t been stuck in a trading range: it’s had two catastrophic collapses and two enormous rallies.

Third, most of the solution seems to come down to the fact that two funds have done well. The authors point to the sparkling performance of FPA Crescent(FPACX) and Ivy Asset Strategy (WASAX). Of the remaining 82 funds in the “world allocation” category, three-quarters either haven’t made it to their fifth anniversary, or have made it and still trail the modest returns of Vanguard’s Total Stock Market Index (VTSMX).

“Transparent” is relative

“Ira Artman,” a long-time reader and thoughtful guy, wrote one of the shortest and most provocative notes that Roy and I have lately received. Here, in its entirety, is Ira’s note concerning the Transparent Value family of funds:


Which got me to thinking: “what’s up, Ira?”

Might it be that the actual names of the funds are longer than some summary prospectuses, as in: Transparent Value Dow Jones RBP® U.S. Large-Cap Aggressive Index Fund (Class F-1 shares)? The name’s long enough that you can’t search for “Transparent Value” at Morningstar, which squeezed the name to Transparent Val DJ RBP US LC Agr Idx F-1.

Or that the funds’ “Principal Investment Strategies” appear to have been penned by an irascible French historian?

The Aggressive Index consists of common stock of companies in the Dow Jones U.S. Large-Cap Total Stock Market IndexSMthat Dow Jones Indexes has selected for inclusion in the Index by applying Required Business Performance® (RBP®) Probability scores (as defined below), as further described in the “Index Construction” section on page 22 of this prospectus. Dow Jones Indexes is part of CME Group Index Services LLC, a joint-venture company which is owned 90% by CME Group and 10% by Dow Jones (“Dow Jones Indexes”). The RBP® Probability scores are derived from a quantitative process of Transparent Value, LLC.

Might he wonder about the claim that the fund offers “High RBP, weighted by RBP”?

Perhaps even that the fund tracks its index by investing in stuff not included in the index?

The Fund also may invest up to 20% of its net assets in securities not included in the Index, but which the Adviser, after consultation with the Sub-Adviser, believes will help the Fund track the Index . . .

He might be worried about his difficulty in “seeing through” management’s decision to charge 1.50% (after waivers) for an index fund that has, so far, done nothing more than track the S&P 500.

The fact that Morningstar has cross-linked all of Tamarack Value’s (TVAAX) analyst reports with Transparent Value’s fund profile doesn’t materially help.

Doubtless, Ira will clear it all up for us!

Searching for “perfect” mutual funds

Warren Boroson has been writing about personal finance for several decades now. (He has also written about blondes, dueling, and Typhoid Mary – though not in the same column.) Lately he decided to go “In search of ‘perfect’ mutual funds” (10/18/2010), which he designates as “six star funds.” That is, funds which combine a current five-star rating from Morningstar with a “high” rating for return and a “low” rating for risk. In addition to funds that his readers certainly have heard of, Boroson found three “intriguing newcomers, funds that may become the Fidelity Magellans, Vanguard Windsors, or Mutual Series funds of tomorrow.” They are:

  • Appleseed (APPLX) which he describes as “a mid-cap value fund.” One might note that it’s a socially responsible investor with no particular commitment to midcaps and a 15% gold stake
  • Pinnacle Value (PVFIX), “a small-cap fund, run by John Deysher, a protégé of Charles Royce . . . 47% in cash.” Actually Mr. Deysher is 57% in cash as of his last portfolio report which is absolutely typical for the fund. The fund has held 40-60% in cash every year since launch.
  • Intrepid Small Cap (ICMAX), “a value fund . . . [r]un by Eric Cinnamond . . . Up an amazing 12.24%-a-year over three years.”

Or not. Mr. Cinnamond resigned from the fund six weeks before Mr. Boroson’s endorsement, and now works for River Road Asset Management. The fund’s lead manager, Jayme Wiggins, returned to the company from b-school just weeks before taking over the Small Cap fund. Wiggins was a small cap analyst at the turn of the century, but his last assignment before leaving for school was to run the firm’s bond fund. He’s assisted by the team that handles Intrepid Capital (ICMBX), which I described as “a fund that offers most of the stock market’s thrills with only a fraction of its chills.”

All of which raises the question: should you follow Mr. Cinnamond out the door? He was clearly a “star manager” and his accomplishments – though, go figure, not his departure – are celebrated at Intrepid’s website. One way to answer that question is to look at the fate of funds which lost their stars. I’ve profiled seven funds started by star managers stepping out on their own. Two of those funds are not included in the comparison below: Presidio (PRSDX) was splendid, but manager Kerry O’Boyle lost interest in liquidated the fund. And the River Park Small Cap Growth fund, at only a month, is too new. Here’s the performance of the five remaining funds, plus a first look at the decade’s highest-profile manager defection (Jeff Gundlach from TCW).

Manager Inception New fund Old fund Peer group
Chuck Akre 09/01/09 $11,900 Akre Focus $13,400, FBR Focus $13,600, mid-growth
David Winters 10/17/05 $14,200, Wintergreen $14,200, Mutual Discovery Z $12,200, global
David Marcus 12/31/09 $10,000, Evermore Global Value $10,700, Mutual Shares Z $10,900, global
Rudolph Kluiber 05/01/08 $11,000, GRT Value $9600, Black Rock Mid-Cap Value $10,000, mid-blend
John B. Walthausen 02/01/08 $15,200, Walthausen Small Cap Value $11,200, Paradigm Value $10,700, small value
Jeffrey Gundlach 04/06/10 $11,700,DoubleLine Total Return $11,000, TCW Total Return $10,600, intermediate bond

What are the odds? The managers new fund has outperformed his previous charge four times out of six (Wintergreen was a touch ahead before rounding). But the old funds continue to perform solidly: three of the six beat their peer group while another two were pretty close. The only substantial loser is BlackRock Mid-Cap Value (BMCAX) which is only a distant echo of Mr. Kluiber’s State Street Aurora fund.

Briefly noted . . .

Oops! They may have done it again! The folks at Janus are once again attracting the interest of Federal enforcement agencies. According to the New York Times, “SAC Capital Advisors, the hedge fund giant run by the billionaire investor Steven A. Cohen, received an ‘extraordinarily broad’ subpoena from federal authorities” while Wellington Management Company and the Janus Capital Group were among the fund companies which received subpoena requests seeking “a wide range of information.” Coincidentally or not, the subpoenas were revealed the day after the feds raided the offices of three hedge funds. This is part of a year-long investigation in which the funds are suspected of insider trading. Wellington and Janus, I presume, became implicated because they’re clients of John Kinnucan, a principal at Broadband Research, who is suspected of passing insider information to his clients. The WSJ quotes BU law professor Tamar Frankel as concluding that the investigation is building a picture of a vast “closed market in insider information.”

In a letter filed with the SEC, Janus’s CFO, Greg Frost, announced that Janus “intends to cooperate fully with that inquiry [but] does not intend to provide any further updates concerning this matter unless and until required by applicable law.”

As some of you may recall, Janus was knee-deep in the market-timing scandals from several years ago, and afterward the firm underwent a self-described transformation of its corporate culture. Note to Janus: In the area of “disclosing more than the bare minimum required by law,” it looks like you have a bit more work to do.

Repeat after Jack: “All men are mortal. Bruce Berkowitz is a man. Therefore…” In a recent interview, Vanguard founder Jack Bogle explained away Bruce Berkowitz’s inconvenient success. Mr. Berkowitz’s Fairholme Fund (FAIRX) has crushed his peers by turning $10,000 into $30,000 over the course of “the lost decade.” Mr. Bogle rather skirted the prospect that this performance qualifies as evidence of skill on Mr. Berkowitz part (“he seems like an intelligent manager” was about as good as it got) and focused on the real issue: “investors who start out in their 20s today could end up investing for 70 years, since people are living longer. Well, Bruce Berkowitz is not going to be around managing funds 70 years from now.” On the other hand, at 51, Mr. Berkowitz could be managing funds for another quarter century or more. For most people, that’s likely a good consolation prize.

TIAA-CREF seems to be steadily slipping. The Wall Street Journal reports (11/17) that T-C led all providers in sales of variable annuities in 2008, with $14.4 billion sold. In 2009 they slipped to third, with $13.9 in sales. During the first three quarters of 2010, they finished fourth with sales of $10.4 billion. That might reflect investor disenchantment (Morningstar’s ratings for their variable annuities, with the exception of Social Choice, reflect respectable mediocrity), or simply more competent competition.

Susan Bryne and the nice people at the Westwood Holdings Group just acquired McCarthy Multi-Cap Stock fund (MGAMX) to add to their family. It’s a solid little fund: $65 million in assets, mostly mid- to large-cap, mostly value-tilted, mostly domestic. The fund won’t quite compete with Ms. Bryne’s own WHG LargeCap Value (WHGLX), which has a substantially higher market cap and a slightly greater value tilt. On whole, it’s not good to compete with your new boss and downright bad to beat her (which MGAMX does, while both funds far outstrip their Morningstar peer group).

Fidelity Canada (FICDX), the fund Morningstar loves to hate, has posted top percentile returns in 2010 (through 11/26). Which isn’t unusual. FICDX has returns in the top 1% for the week, month, year, five year, ten year and fifteen year periods.

Driehaus International Small Cap Growth Fund (DRIOX ) will close to new investors on the last day of 2010. In my original profile of the fund, I concluded that “for investors with $10,000 to spare and a high tolerance for risk, this might be as good as bet for sheer, pulse-pounding, gut-wrenching, adrenaline-pumping performance as you’re going to find.” That’s still true: $10,000 invested in the fund at launch (August 2002) has grown to $53,000 versus $28000 for international small cap peers. The fund holds about a third of its assets in emerging markets, roughly twice its peers’ stake. Despite above average volatility, it has trailed peers only once, ever, and spent four of its eight years in the top 10% of international small cap funds. It remains, for 30 days, an intriguing option for the bold.

The launch of the Market Vectors Kuwait Index ETF is been delayed until, at least, the week before Christmas. Dang, I’d been so looking forward to investing in an exchange with “an independent judicial personality with the right of litigation in a mode facilitating the performance of its functions for the purpose of realizing the objectives of its organization in the best manner within the scope of regulations and laws governing the Stock Exchange operations.” So saith the Kuwaiti Stock Exchange. Likewise RiverFront Strategic Income has been delayed.

The former Dreman Contrarian Large Cap Value (DRLVX) morphed into an institutional fund Dreman High Opportunity with loaded retail shares in 2010, so it’s being dropped from our Archive listings.

In closing . . .

For most folks, the “fourth quarter holiday retail season” (4QHRS) is the easiest time of year to help support FundAlarm. Folks spend, on average, $400 on gifts, and another $800 on entertaining and decorations, over next four weeks. As many of you know, if you choose to shop using FundAlarm’s link to Amazon, FundAlarm receives an amount equivalent to about 7% of your purchase that Roy uses to defray the cost of servers and bandwidth and such.

Many folks think of Amazon as a bookseller, but my own holiday purchases highlight the breadth of its opportunities. Among other things, I’ve recently squirreled away are a case of herbal tea, an iPod and a smart phone, a really nice chef’s knife (8″ Victorinox Fibrox, wonderfully light, wickedly sharp), a hospital quality air cleaner, four movies, a dozen books and a videogame.

For bookish Bogleheads, one new book stands out: Goldie and Murray’s Investment Answer Book. Mr. Murray is a former Goldman Sachs institutional bond seller and Managing Director at Lehman Brothers. He discovered, only after retirement, that most of his professional life – spent trying to beat the market – was wasted. He became a consultant to Dimensional Fund Advisers and then discovered he was dying of a brain tumor. Last summer he ceased his medical treatments and worked to complete a readable, short book that reduces your investment plan to five decisions, the fourth of which is whether you want to continue pouring your money down the rathole of actively managed investing. (His sentiments, not mine.) Mr. Murray hopes to see Christmas, but has little prospect of experiencing another spring. By all accounts, the book is readable, sensible and useful.

For the merely perverse, my favorite travel book ever, The Clumsiest People in Europe: Or, Mrs. Mortimer’s Bad-Tempered Guide to the Victorian World, has been rereleased in paperback. Mrs. Mortimer, a wildly popular Victorian travel writer, seems never to have ventured five miles from home. Nonetheless she offers up sober, unintentionally ridiculous descriptions of two dozen nations from Ireland (“there are no huts in the world so miserable as Irish cottages”) or China (“All the religions of China are bad, but of the three, the religion of Confucius is least foolish”). It’s at least as delightful as Michael Bell’s Scouts in Bondage: And Other Violations of Literary Propriety or Catherine Price’s 101 Places Not to See Before You Die. All worthy whimsies to lighten a winter’s eve.

Oh, and those of you who had the good sense to respond to our profiles of Wasatch Emerging Markets Small Cap (WAEMX) or Walthausen Small Cap Value (WSCVX) — both up 35% this year — well, you might choose the simpler route of a direct contribution through PayPal.

Wishing you all a wonderful 4QHRS,