October, 2010

By Editor

. . . from the archives at FundAlarm

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

Dear friends,

September: who’d have guessed? The NFL has three remarkably unlikely undefeated teams: the Pittsburgh Steelers (led by the world’s nicest fourth-string quarterback), Da Bears, and the Kansas City Chiefs (4-12 last year). The Hindenburg has moved from being an Omen back to another of history’s sad tales (press mentions of The Hindenburg Omen dropped by 60% between August and September, and the remaining coverage scoffs at all of last month’s chumps). Ninety-five percent of all mutual funds (6,100+ by count) made money this month and over 1000 returned 10% or more in September. All of that from what is, historically, the cruelest month of all for stock investors.

A Celebration of Predictably Bad Funds

The math on bad funds is irresistible. Morningstar tracks 6400 funds. By definition, 3200 of them will post below-average performances this year. If performance were determined by pure chance (hello, Mr. Bogle!), 1600 funds would post back-to-back sub-par years, while the rest of the progress is shown below.

To test that hypothesis, I counted 2010 as a complete year and then checked a database for the number of funds that have managed to turn in below average returns year after year after year.

Consecutive Years
Below Average
Predicted Number Observed Number
1 3200 3016
2 1600 1693
3 800 413
4 400 173
5 200 62
6 100 25
7 50 14
8 25 11
9 12 7
10 6 5

Good news, I guess. “Continually horrible” is a bit less likely than you might guess. Two reasons suggest themselves. Fund companies either (1) bury the manager or (2) bury the fund. If you want to wander through the graveyard, check out FundAlarm’s master list of manager changes.

Highlights from the list of awful funds:

The Futile Five are Davis Government Bond “B,” Embarcadero Market Neutral (Garret Van Wagoner is back in the saddle again!), ING Emerging Countries “A”, Performance (that’s ironic)Short-Term Government Income and ProFunds Bull. Between them, they hold $465 million in assets. Two of the four funds (Davis and Performance) have had the same manager for the entire period, while Embarcadero had no manager for a number of years (it was one of the Van Wagoner zombie funds), and ING has all-new managers in 2010. I wish them well.

Over the past three years, investors in the Invesco funds, 17 of which are on three-year cold streaks, have suffered the greatest misery. Likewise 16 Fidelity, six Bridgeway and three Hennessy funds. (That probably makes it a poor time for Mr. Hennessey to pick a public fight with the Bogles, pere and fils, over fund fees and performance. Mr. Bogle the Elder recently suggested, “[Hennessy] is running an enormously profitable management company with inferior performance in these funds, in part because of the excessive fees he charges.”)

At the five-year mark, there are two Hennessy funds, five from Invesco and four from Fido. After eight years, Fidelity Growth & Income (FGRIX) is still hanging on as the $5 billion poster child for irremediable incompetence. In defense of the new manager, James Catudal, who was appointed in January 2009, the fund now consistently trails its peers and benchmark – but by less than it used to.

Permanent Portfolio: Unlikely Superstar?

I was prepared, from the outset, to dislike Jason Zweig’s recent article on the $6 billion Permanent Portfolio Fund (PRPFX) (“Unlikely Superstar: How a Forgotten Fund Got Hot in a Hurry,” WSJ, September 18-19, 2010). Mr. Z., however, produced an essay more thoughtful than the headline assigned to it.

For those unfamiliar with Permanent Portfolio, the fund holds a series of uncorrelated assets, some of which are likely to thrive regardless of the state of the market or of the economy. Harry Browne propounded the underlying notion in the 1970s. He saw the strategy as, of all things, a way to run toward the despised stock market rather than away from it. The fund’s asset allocation never changes, except in the sense that sharp market fluctuations might temporarily throw it out of whack. Give or take a little, the fund invests:

20% in gold

5% in silver

10% in Swiss francs

15% in real estate and natural resources stocks

15% in aggressive growth stocks

35% in cash and U.S. bonds

The fund has produced perfectly splendid results over the past decade, with an annualized return of 10.7% and a 2008 loss of only 8%. The fund is no-load, it takes only $1000 to get in and expenses are 0.8%.

Mr. Zweig’s article makes two points. First, much of the fund’s success is driven by mania. Bill Bernstein of Efficient Frontier Advisors wrote an essay critical of Permanent Portfolio’s newfound popularity. Fifty-five percent of the fund is in bonds and gold, which Bill Bernstein describes as being in the midst of “a non-stop beer-and-pizza party.” Those same wildly attractive assets, over the long term, have been dismal losers. Mr. Bernstein reports:

Diversifying asset classes, as Harry Browne knew well, can benefit a portfolio. The secret is deploying them before those diversifying assets shoot the lights out. Harry certainly did so by moving away from gold and into poorly performing stocks and bonds in the late 1970s. Sadly, this is the opposite of what the legions of new TPP adherents and PRPFX owners have been doing recently—effectively increasing their allocations to red-hot long Treasuries and gold. Consider: over the long sweep of financial history, the annual real return of long bonds and gold have been 2% and 0%, respectively; over the decade ending 2009, they were 5% and 11%. (“Wild About Harry“)

Second, all of the money that poured in will – just as quickly – pour out. “[M]any of its new buyers,” Zweig opines, “seem to be seeking capital appreciation – chasing this fund the same way they chased Internet funds in 1999 and 2000. They could leave just as quickly.” Mr. Bernstein is rather more pointed: “During the frothy 1990s stock market, however, investors abandoned the fund in droves.”

That is, by the way, an enormous problem for the remaining shareholders. The rush out forces the manager to sell, without regard to the wisdom of selling, just to meet redemptions.

Some of FundAlarm’s most thoughtful professional investors use Permanent Portfolio as a core position in their more conservative portfolios, providing substantial and consistent profits for their clients in the process. Despite that fact, I have never warmed up to the fund, and doubt that I ever will.

Setting aside the fact that it’s an index fund that charges 0.8%, I’m troubled by two things. First, the manager has neither closed nor even discussed the possibility of closing the fund. In most cases, responsible managers seek to dissuade a mindless inrush of (highly profitable) cash. Vanguard imposes high investment minimums, for example, $25,000 in the case of its Health Care fund (VGHCX). Oakmark restricts access through third-party vendors for several of its funds. Bridgeway, Artisan, Leuthold, Wasatch and others simply close their funds. Permanent Portfolio, instead, welcomed an additional $3,000,000,000 in the first eight months of the year – which provides an additional $24,000,000 in revenue to the advisor. In 2009, Mr. Cuggino’s firm, of which he is sole owner, received $31,286,640 in fees from the fund. In 2010, that’s likely to approach $60,000,000.

Mr. Cuggino does report “I’ve educated people right out of our fund.” Given that the fund’s website dubs it “a fund for all seasons” and the manager is a frequent speaker at money shows, it’s not clear exactly who he has talked away or how.

Second, the manager’s interests are not aligned with his investors. Though Mr. Cuggino has had a long association with the fund and has managed it since 2003, he’s been very reluctant to invest any of his own money in it. The fund’s 2006 Statement of Additional Information reports, “As of April 30, 2006, Mr. Cuggino and his immediate family members owned no shares of the Fund.” A year later that changed, but in an odd way. The SAI now reports that Mr. Cuggino 2,3 owns “over $100,000” in fund shares. Those footnotes, though, indicate that “As of April 30, 2010, Mr. Cuggino owned shares in each of the Fund’s Portfolios through his ownership of Pacific Heights.”

Which seems to say, the company buys the shares for him. And the company likely pays him well. My favorite passage from the 2010 SAI, with emphasis added,

Pacific Heights, of which Mr. Cuggino is the manager and sole member (also its President and Chief Executive Officer), compensates Mr. Cuggino for service as the portfolio manager for each of the Fund’s Portfolios. As the manager and sole member of Pacific Heights, Mr. Cuggino is the owner of Pacific Heights and determines his own compensation. Mr. Cuggino’s compensation from Pacific Heights is in the form of a share of Pacific Heights’ total profits.

So he collects a salary (“not based directly on the performance of any of the Fund’s Portfolios or their levels of net assets”) for serving as the firm’s president and gets to allocate to himself (apparently at his discretion) a share of the firm’s considerable profits.

What does he do with his money, if not invest it alongside his shareholders? I don’t know, though the SAI contains the slightly-nervous warning that

Actual or apparent conflicts of interest may arise because Mr. Cuggino has day-to-day management responsibilities with respect to each of the Fund’s Portfolios and certain personal accounts. The management of the Fund’s Portfolios and these other accounts may result in Mr. Cuggino devoting unequal time and attention to the management of the Fund’s Portfolios and these other accounts.

Mr. Cuggino is subject to the Fund’s and Pacific Heights’ Amended and Restated Code of Ethics, discussed in this SAI under “Code of Ethics,” which seeks to address potential conflicts of interest that may arise in connection with Mr. Cuggino’s management of any personal accounts. There is no guarantee, however, that such procedures will detect each situation in which a potential conflict may arise.

There is no reason to believe that Mr. Cuggino has done, is doing or ever will do anything improper in his management of the fund (unless sopping up assets to generate huge fees is wrong). Nonetheless, given the tremendously foul history of the fund under its previous management (after repeated violations of SEC rules, Morningstar became so disgusted that they dropped commentary on the fund for 15 years), a far more transparent approach would seem appropriate.

Update on the best fund that doesn’t exist

A couple months ago, I pointed out the obvious hole in the fund and ETF universe: there is no emerging markets balanced fund in existence. Given that both E.M. stocks and E.M. bonds are seen as viable, perhaps imperative, investments, I can’t for the life of me figure out why no enterprising group has pursued the idea.

In the decade just passed, the storied “Lost Decade,” a perfectly sensible investment of $10,000 into Vanguard’s Total Stock Market Index (VTSMX) on the first day of the decade (January 1, 2000) would be worth $9700 on the last day of the decade (December 31, 2009).

I attempted a painfully simple, back-of-the-napkin calculation for the returns generated by a 60/40 emerging markets balanced fund over that same period. I did that by starting with T. Rowe Price’s Emerging Markets Stock (PRMSX) and Emerging Markets Bond (PREMX) funds. I placed 60% of a hypothetical $10,000 investment into stocks and 40% into bonds. On January 1 of every year thereafter, I rebalanced to 60/40. Mostly that meant selling bonds and buying stocks. Here’s how the hypothetical E.M. balanced fund (ROYX) would compare to investing all of the money into either of the Price funds:

“FundAlarm Emerging Markets Balanced” (ROYX) $30,500
Price Emerging Markets Stocks (PRMSX) 24,418
Price Emerging Markets Bonds (PREMX) 30,600

Had the fund existed, it would have suffered two losing years in the past decade (down 9.7% in 2000 and 43.4% in 2008), while an all-stock portfolio would have had twice as many losing years including a gut-wrenching 61% drop in 2008. An all-bond portfolio would have suffered one losing year, 2008, in which it would have lost 18%.

It’s clear that a pure emerging markets bonds commitment would have been a (slightly) better bet. In reality, though, it’s a bet that almost no investor would make or would long live with.

We can also compare our hypothetical balanced fund with the best of the global funds, including the highly flexible Leuthold Core (LCORX) fund and a number of the Morningstar “analyst pick” picks which have been around for the whole decade.

“FundAlarm Emerging Markets Balanced” (ROYX) $30,500
Oakmark Global (OAKGX): 30,300
Leuthold Core (LCORX): 23,700
Mutual Quest (TEQIX): 20,700
American Funds New World Perspective(ANWPX): 14,800

The results are pretty striking, though I’m not pretending that a simple back-test provides anything more than a reason to stop and go, “hmmmmm.”

Briefly noted

David Dreman, one of those guys to whom terms like “guru” and “legend” are attached, has decided to step down as his firm’s co-CIO. The 74-year-old, who started his firm 33 years ago, will keep busy running two funds (High Opportunity and Market Overreaction), serving as chairman and writing a fifth book.

The very fine Intrepid Small Cap fund (ICMAX) lost manager Eric Cinnamond at the start of September. He’s joined institutional manager River Road Asset Manager as head of their “Independent Value strategy.” The fund remains in good hands, since the two co-managers added in 2009 also guide Intrepid Capital (ICMBX, a star in the shadows!).

Oak Value (OAKVX) just became RS Capital Appreciation. Oak Value gathered only $70 million in 17 years of operation, despite a strong record and stable management. After the acquisition, everything stays the same for this fine small fund. Except a change in name and ticker symbol (RCAPX for the “A” shares). And, oh yes, the imposition of a 4.75% front load.

Driehaus Select Credit Fund (DRSLX), which seeks “to provide positive returns under a variety of market conditions” through long and short positions in both equity and debt (primarily US) went live on September 30th. The lead manager, K.C. Nelson, also runs Driehaus Active Income(LCMAX). The fund’s $25,000 minimum and 2.0% expenses might spook off most folks except, perhaps, those looking to add to their hedge fund collection.

In closing . . .

I want to offer a belated thanks to Stacy Havener of Havener Capital Partners LLC for recommending that I profile Evermore Global Value (EVGBX). Back in August, she mentioned that Mr. Marcus has “banded together a team of former Mutual Series people (including Jae Chung most recently PM at Davis Advisors) to start a new firm called Evermore Global Advisors. David and team are utilizing the same deep value with catalyst investment approach learned under the tutelage of Michael Price.” I was, as is too often the case, entirely clueless and deeply grateful for her perceptiveness.

Thanks to Kenster, a contributor to FundAlarm’s boisterous Discussion Board, for the New York Magazine article on hedge fund managers. The last quarter of the article includes a discussion with David Marcus, formerly of Mutual Series and now lead manager at Evermore. Mr. Marcus certainly comes across as the voice of anguished reason in a story redolent with self-important young fools.

I often stockpile reader suggestions over the summer for use in fall. I’d like to acknowledge a couple particularly good ones. First, apologies to Scott Lee, who recommended this summer a fund that I haven’t yet written about (but will). Scott writes of an “undiscovered fund manager here in Birmingham. I’m sure you’re aware of Southeastern Asset Management, the advisers behind the Longleaf Partners funds. Three years ago, Mason Hawkins’s ‘second in command,’ C.T. Fitzpatrick left Longleaf after running money there for about 20 years. . . C.T. Fitzpatrick resurfaced in his hometown of Birmingham, AL and has now started a new fund company known as Vulcan Value Partners. Thus far he has put up astounding performance numbers, with his small-cap value fund (VVPSX) ranked in top decile amongst its peer group.” Vulcan Value Partners Small Cap (VVPSX) launched in December 2009, has returned 4.6% over the first nine months of 2010. That places it in the top 4% of small core funds. The large cap Vulcan Value Partners (VVPLX) made a modest 2.5% in the same period.

Brian Young, another sensible soul, recommended that I look at two funds in the months ahead:Iron Strategic Income (IRNIX) – “a great way to get exposure to high-yield bonds without losing your shorts” – and Sierra Core Retirement (SIRIX) – “fund of funds asset allocation fund that looks more like a multisector bond fund.” Folks on the Discussion Board have had a lengthy conversation – diplomats use phrases like “frank and open” to describe the tenor of such conversations – about Sierra in late June and early July of this year. The funds are a bit larger ($500 million) than those I normally cover (under three years old and/or under $100 million), but are definitely worth a look.

Speaking of the Discussion Board, we’re quickly coming up on another milestone: our 300,000thpost. The range of topics covered in a single day – the allure of emerging market debt funds, the growing timidity of Fidelity’s equity managers, what small cap fund might be appropriate for a college-aged investor – is remarkable. If you haven’t visited and spoken up, you should! If you have, then you’ve got a sense of the value that FundAlarm offers. Please consider using a strategy as simple to FundAlarm’s link to Amazon to help support its continued vitality.

As ever,