Monthly Archives: March 2014

Huber Select Large Cap Value (formerly Huber Capital Equity Income), (HULIX), April 2014

By David Snowball

At the time of publication, this fund was named Huber Equity Income.
This fund was formerly named Huber Capital Equity Income.

Objective and strategy

The Fund is pursuing both current income and capital appreciation. They typically invest in 40 of the 1000 largest domestic large cap stocks. It normally invests in stocks with high cash dividends or payout yields relative to the market but can buy non-payers if they have growth potential unrecognized by the market or have undergone changes in business or management that indicate growth potential.

Adviser

Huber Capital Management, LLC, of Los Angeles. Huber has provided investment advisory services to individual and institutional accounts since 2007. The firm has about $4 billion in assets under management, including $450 million in its three mutual funds.

Manager

Joseph Huber. Mr. Huber was a portfolio manager in charge of security selection and Director of Research for Hotchkis and Wiley Capital Management from October 2001 through March 2007, where he helped oversee over $35 billion in U.S. value asset portfolios. He managed, or assisted with, a variety of successful funds across a range of market caps. He is assisted by seven other investment professionals.

Strategy capacity and closure

Approximately $10 billion. That’s based on their desire to allow each position to occupy about 2% of the fund’s portfolio while not owning a controlling position in any of their stocks. Currently they manage about $1.5 billion in their Select Large Value strategy.

Active share

Not calculated. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Mr. Huber, independently enough, dismisses it as “This year’s new risk-control nomenclature. Next year it’ll be something else.” 

Management’s stake in the fund

Mr. Huber has over $1 million invested in each of his three funds. His analysts are all on track to become partners and equity owners of the advisor.

Opening date

June 29, 2007

Minimum investment

$5,000 for regular accounts and $2,500 for retirement accounts.

Expense ratio

1.39% on $85 million in assets, as of July 2023. 

Comments

There’s no question that it works.

None at all.

Morningstar thinks it works:

huber1

Lipper lavishly thinks so:

huber2

And the Observer mostly concurs, recognizing both of the established Huber funds as Great Owls based on their consistently excellent risk-adjusted performance:

huber3

In addition to generating top-tier absolute and risk-adjusted returns, the Huber funds also generate very light tax burdens. By consciously managing when to sells securities (preferably when they qualify for lower long-term rates) and tax-loss harvesting, his investors have lost almost nothing to taxes over the past five years.

It works.

There’s only one question: does it work for you?

Mr. Huber pursues a rigorous, research-driven, value-oriented style. He’s been refining it for 20 years but the core has remained unchanged since his Hotchkis & Wiley days. He has done a lot of reading in behavioral finance and has identified a series of utterly predictable mistakes that investors – his team as much as other folks – are prone to make over and over. His strategy is two-fold:

Exploit other investors’ mistakes. Value investors tend to buy too early and sell too early; growth investors do the opposite. Both sides tend to extrapolate too much from the present, assuming that companies with miserable financials (for example, extremely low return on capital) will continue to flounder. His research demonstrates the inevitability of mean reversion, the currently poorest companies will tend to rise over time and the currently-strongest will fall. By targeting low ROC firms, which most investors dismiss as terminal losers, he harvests over time a sort of arbitrage gain as ROC rises toward the mean on top of market gains.

Guard against his own tendency to make mistakes. He’s created a red flags list, a sort of encyclopedia of all the errors that he or other investors have made, and then subjects each holding to a red flag review. They also have a “negative first to negative second derivative” tool that keeps them from doubling down on a firm whose rate of decline is accelerating and a positive version that might slow down their impulse to sell early.

Beyond that, they do rigorous and distinctive research. While many investors believe that large caps occupy the most efficient part of the market, Mr. Huber strongly disagrees. His argument is that large caps have an enormous number of moving parts, divisions within the firm that have their own management, culture, internal dynamics and financials. Pfizer, a top holding, has divisions specializing in Primary Care; Specialty Care and Oncology; Established Products and Emerging Markets; Animal Health; and Consumer Healthcare. Pfizer need not report the divisions’ financials separately, so many investors are stuck with investing backs on aggregate free cash flow firm-wide and a generic metric about what that flow should be. The Huber folks approach it differently: they start by looking at smaller monoline firms (for example, a firm that just specializes in animal care) which allows them to see that area’s internal dynamics. They then adjust the smaller firm’s financials to reflect what they know of Pfizer’s operations (Pfizer might, for example, have lower cost of capital than the smaller firm). By modeling each unit or division that way and then assembling the parts, they end up with a surrogate for Pfizer as a whole. 

Huber’s success is illustrated when we compare HULIX to three similarly-vintaged large-value funds:

Artisan Value (ARTLX), mostly because Artisan represents consistent excellence and this four-star fund from the U.S. Value team is no exception.

LSV Conservative Core (LSVPX) because LSV’s namesake founders published some 200 papers on behavioral finance and incorporated their research into LSV’s genes.

Hotchkis and Wiley Diversified Value (HWCAX) because Mr. Huber was the guy who built, designed and implemented H&W’s state of the art research program.

huber4

Higher returns, competitive downside, and higher risk-adjusted returns (those are all the ratios on the right where higher is better).

The problem is those returns are accompanied by levels of volatility that many investors are unprepared to accept. It’s a problem that haunted two other Morningstar Manager of the Decade award winners. Here are the markers to keep in mind:

    • Morningstar risk: over the past five years is high.
    • Beta: over the past five years is 1.18, or 18% greater than average.
    • Standard deviation: over the past five years is 18% compared to 14.9 for its peers.
    • Investor returns: by Morningstar’s calculation, the average investor in the fund over the past five years has earned 23.9% while the fund returned 32.1%. That pattern usually reflects bad investor behavior: buying in greed, selling in fear. This pattern is generally associated with funds that are more volatile investors can bear. (There’s an irony in the prospect that investors in the fund might be undone by the very sorts of behavioral flaws that the manager so profitably exploits.)

He also remains fully invested at all times, since he assumes that his clients have made their own asset allocation decisions. His job is to buy the best stocks possible for them, not to decide whether they should be getting conservative or aggressive.

Mr. Huber’s position on the matter is two-fold. First, short-term volatility should have no place in an investor’s decision-making. For the 45 year old with a 40 year investment horizon, nothing that happens over the next 40 months is actually consequential. Second, he and his team try to inform, guide, educate and calm their investors through both written materials and conference calls.

Bottom Line

Huber Equity Income has all the hallmarks of a classic fund: it has a disciplined, distinctive and repeatable process. There’s a great degree of intention and thought in its design.  Its performance, like that of its small cap sibling, is outstanding. It is a discipline well-suited to Huber’s institutional and pension-plan accounts, which contribute 90% of the firm’s assets. Those institutions have long time horizons and, one hopes, the sort of professional detachment that allows them to understand what “investing for the long-term” really entails. The challenge is deciding whether, as a small investor or advisor, you will be able to maintain that same cool, unflustered demeanor. If so, this might be a very, very good move for you.

Fund website

Huber Capital Equity Income Fund

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

Evermore Global Value (EVGBX), April 2014

By David Snowball

 

This profile has been updated. Find the new profile here.
This is an update of our profile from April 2011.  The original profile is still available.

Objective and Strategy

Evermore Global Value Fund seeks capital appreciation by investing in a global portfolio of 30-40 securities. Their focus is on micro to mid-cap. They’re willing “to dabble” in larger cap names, but it’s not their core. Similarly they may invest beyond the equity market in “less liquid” investments such as distressed debt. They’ve frequently held short positions to hedge market risk and are willing to hold a lot of cash.

Adviser

Evermore Global Advisors, LLC. Evermore was founded by Mutual Series alumni David Marcus and Eric LeGoff in June 2009. David Marcus manages the portfolios. While they manage several products, including their US mutual fund, all of them follow the same “special situations” strategy. They have about $400 million in AUM.

Manager

David Marcus. Mr. Marcus co-founded the adviser. He was hired in the late 1980s by Michael Price at the Mutual Series Funds, started there as an intern and describes himself as “a believer” in the discipline pursued by Max Heine and Michael Price. He managed Mutual European (MEURX) and co-managed Mutual Discovery (MDISX) and Mutual Shares (MUTHX), but left in 2000 to establish a Europe-domiciled hedge fund with a Swedish billionaire partner. Marcus liquidated this fund after his partner’s passing and spent several years helping manage his partner’s family fortune and restructure a number of the public and private companies they controlled. He then went back to investing and started another European-focused hedge fund. In that role he was an activist investor, ending up on corporate boards and gaining additional operational experience. That operational experience “added tools to my tool belt,” but did not change the underlying discipline.

Strategy capacity and closure

$2 – 3 billion, which is large for a fund with a strong focus on small firms. Mr. Marcus explains that he’s previously managed far larger sums in this style, that he’s willing to take “controlling” positions in small firms which raises the size of his potential position in his smallest holdings and raises the manageable cap. He currently manages about $400 million, including some separate accounts which rely on the same discipline. He’ll close if he’s ever forced into style drift.

Active share

100. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio.  High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index.  An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for Evermore is 100.6, which reflects extreme independence plus the effect of several hedged positions.

Management’s stake in the fund

Substantial. The fund provides all of Mr. Marcus’s equity exposure except for long-held legacy positions that predate the launch of Evermore. He’s slowly “migrating assets” from those positions to greater investments in the fund and anticipates that his holdings will grow substantially. His family, business partner and all of his employees are invested. In addition, he co-owns the firm to which he and his partner have committed millions of their personal wealth. It’s striking that one of his two outside board members, the guy who helped build the Oppenheimer Funds group, has invested more than a million in the fund (despite receiving just a few thousand dollars a year for his work with the fund). That’s incredibly rare.

Opening date

December 31, 2009.

Minimum investment

$5000, reduced to $2000 for tax-advantaged accounts. The institutional share class (EVGIX) has a $1 million minimum, no load and a 1.37% expense ratio.

Expense ratio

1.62%, on assets of $235 million. There’s a 5% sales load which, because of agreements with advisers and financial intermediaries, is almost never paid.

Comments

Kermit the Frog famously crooned (or croaked) the song “It’s Not Easy Being Green” (“it seems you blend in with so many other ordinary things, And people tend to pass you over”). I suspect that if Mr. Marcus were the lyricist, the song would have been “It’s Not Easy Being Independent.” By any measure, Evermore Global is one of the most independent funds around.

Everyone else wants to be Warren Buffett. They’re all about buying “a wonderful company at a fair price.”  Mr. Marcus is not looking for “great companies selling at a modest price.” There are, he notes, a million guys already out there chasing those companies. That sort of growth-at-a-reasonable price focus isn’t in his genes and isn’t where he can distinguish himself. He does, faithfully and well, what Michael Price taught him to do: find and exploit special situations, often in uncovered or under-covered smaller stocks. That predisposition is reflected in his fund’s active share: 100.6 on a scale that normally tops-out at 100.

An active share of 100 means that it has essentially no overlap with its benchmark. The same applies to its peer group: Evermore has seven-times the exposure to small- and micro-cap stocks as does its peers. It has half of the US exposure and twice the European exposure of the average global fund.  And it has zero exposure to three defensive sectors (consumer defensive, healthcare, utilities) that make up a quarter of the average global fund.

The fund focuses on a small number of positions – rarely more than 40 – that fall into one of two categories:

  1. Cheap with a catalyst: he describes this as a private-equity mentality where “cheap” is attractive only if there’s good reason to believe it’s not going to remain cheap. The goal is to find businesses that merely have to stop being awful in order to recruit a profit to their investors, rather than requiring earnings growth to do so. This helps explain why the fund is lightly invested in both Japan (cheap, few catalysts) and the U.S. (lot of catalysts, broadly overpriced).
  2. Compounders: a term that means different things to different investors. Here he means family owned or controlled firms that have activist internal management. Some of these folks are “ruthless value creators.”  The key is to get to know personally the patriarch or matriarch who’s behind it all; establish whether they’re “on the same side” as their investors, have a record of value creation and are good people.

Mr. Marcus thinks of himself as an absolute value investor and follows Seth Klarman’s adage, “invest when you have the edge; when you don’t have the edge, don’t invest.”

There are two real downsides to being independent: you’re sometimes disastrously out-of-step with the herd and it’s devilishly hard to find an appropriate benchmark for the fund’s risk-return profile.

Evermore was substantially out-of-step for its first three years. It posted mid-single digit returns in 2010 and 2012, and crashed in 2011.  2011 was a turbulent year in the markets and Evermore’s loss of nearly 20% was among the worst suffered by global stock funds. Mr. Marcus would ask you to keep two considerations in mind before placing too much weight on those returns:

  1. Special situations stocks are, almost by definition, poorly understood, feared or loathed. These are often battered or untested companies with little or no analyst coverage. When markets correct, these stocks often fall fastest and furthest. 
  2. Special situations portfolios take time to mature. By definition, these are firms with unusual challenges. Mr. Marcus invests when there’s evidence that the firm is able to overcome their challenges and is moving to do so (i.e., there’s a catalyst), but that process might take years to unfold. In consequence, it takes time for the underlying value to be unlocked. He argues that the stocks he purchased in 2010-11 were beginning to pay off in 2012 and, especially, 2013. In baseball terms, he believes he now has a solid line-up of mid- to late-inning names.

The upside of special situations investing is two-fold. First, mispricing in their securities can be severe. There are few corners of the market further from efficient pricing than this. These stocks can’t be found or analyzed using standard quantitative measures and there are fewer and fewer seasoned analysts out there capable of understanding them. Second, a lot of the stocks’ returns are independent of the market. That is, these firms don’t need to grow revenue in order to see sharp share-price gains. If you have a firm that’s struggling because its CEO is a dolt and its board is in revolt, you’re likely to see the firm’s stock rebound once the dolt is removed. If you have a firm that used to be a solidly profitable division of a conglomerate but has been spun-off, you should expect an abnormally low stock price relatively to its value until it has a documented operating history. Investors like Mr. Marcus buy them cheap and early, then wait for what are essentially arbitrage gains.

Bottom Line

There’s no question that Evermore Global Value is a hard fund to love. It sports a one-star Morningstar rating and bottom-tier three year returns. The question is, does that say more about the fund or more about our ability to understand really independent, distinctive funds? The discipline that Max Heine taught to Michael Price, that Michael Price (who consulted on the launch of this fund) taught to David Marcus, and that David Marcus is teaching to his analysts, is highly-specialized, rarely practiced and – over long cycles – very profitable. Mr. Marcus, who has been described as the best and brightest of Price’s protégés, has attracted serious money from professional investors. That suggests that looking beyond the stars might well be in order here.

Fund website

Evermore Global Value Fund. In general, when a fund is presented as one manifestation of a strategy, it’s informative to wander around the site to learn what you can. With Evermore, there’s a nice discussion under “Active Value” of Mr. Marcus’s experience as an operating officer and its relevance for his work as an investor.

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

April 2014, Funds in Registration

By David Snowball

AR Capital International Real Estate Income Fund

AR Capital International Real Estate Income Fund, Advisor shares, will pursue current income with the potential for capital appreciation by investing in income producing securities related to the real estate industry.  “International” actually means “global,” since they expect “at least” 40% non-US and even that will be mostly achieved through ADRs.  The manager has not yet been named.  The minimum initial investment is $2500, raised to $100,000 for those buying directly from the advisor.  The opening expense ratio will be capped, but hasn’t yet been specified.

CM Advisors Defensive Fund

CM Advisors Defensive Fund will pursue capital preservation in all market conditions by using “various investment strategies and techniques.”  Uh-huh.  The only strategies or techniques clearly laid out are shorting and holding cash.  The managers will be James D. Brilliant and Stephen W. Shipman of Van Den Berg Management.  The minimum initial investment for “R” shares is $1,000.  The opening expense ratio will be 1.50%.

Day Hagan Tactical Dividend Fund

Day Hagan Tactical Dividend Fund, I shares, will pursue long-term capital appreciation with the possibility of current income by investing in large-cap, domestic dividend paying stocks.  Here’s the twist: they’ll target industries “at or near the top of their respective dividend yield cycle given the inverse relationship between price and yield.” The managers will be Robert Herman, Jeffrey Palmer of Gries Financial, and Donald Hagan of, well, “Donald L. Hagan LLC, also known as Day Hagan Asset Management.” The minimum initial investment is $1,000 for regular and IRA accounts, and $100 for an automatic investment plan account. The opening expense ratio will be 1.35%.

Schroder Global Multi-Asset Income Fund

Schroder Global Multi-Asset Income Fund will pursue income and capital growth over the medium to longer term by investing in a global portfolio high-quality, dividend-paying stocks and fixed income securities which promise sustainable income flows.  The managers will be Aymeric Forest and Iain Cunningham, both of Schroder Investment Management NA. They’ve also run reasonably successful separate accounts using this strategy but the track record there (less than two years) is too brief to provide much insight. The minimum initial investment for Advisor shares, which are intended to be sold through third-parties, is $2,500. The minimum for Investor shares, purchased directly from Schroder, is $250,000. (Can you tell they’d prefer you invest through Schwab?) The opening expense ratio has not yet been released.

T. Rowe Price Asia Opportunities Fund

T. Rowe Price Asia Opportunities Fund will pursue long-term growth of capital by investing in mid- to large-cap stocks of firms in, or tied to, China, Hong Kong, India, Indonesia, Malaysia, Philippines, Singapore, South Korea, Taiwan, and Thailand. The emphasis will be on high-quality, blue chip firms. The fund is registered as non-diversified, though that seems unlikely in practice given T. Rowe’s style.  The manager will be Eric C. Moffett, a long-time research analyst based in Hong Kong.  The minimum initial investment is $2500, reduced to $1000 for various sorts of tax-advantaged accounts.  The opening expense ratio will be 1.15%. 

Ten Market Cycles

By Charles Boccadoro

Originally published in April 1, 2014 Commentary

In response to the article In Search of Persistence, published in David’s January commentary, NumbersGirl posted the following on the MFO board:

I am not enamored of using rolling 3-year returns to assess persistence.

A 3-year time period will often be all up or all down. If a fund manager has an investing personality or philosophy then I would expect strong relative performance in a rising market to be negatively correlated with poor relative performance in a falling market, etc.

It seems to me that the best way to measure persistence is over 1 (or better yet more) market cycles.

There followed good discussion about pros and cons of such an assessment, including lack of consistent definition of what constitutes a market cycle.

Echoing her suggestion, fund managers also often ask to be judged “over full cycle” when comparing performance against their peers.

A quick search of literature (eg., Standard & Poor’s Surviving a Bear Market and Doug Short’s Bear Markets in the S&P since 1950) shows that bear markets are generally “defined as a drop of 20% or more from the market’s previous high.” Here’s how the folks at Steele Mutual Fund Expert define a cycle:

Full-Cycle Return: A full cycle return includes a consecutive bull and bear market return cycle.

Up-Market Return (Bull Market): A Bull market in stocks is defined as a 20% rise in the S&P 500 Index from its previous trough, ending when the index reaches its peak and subsequently declines by 20%.

Down-Market Return (Bear Market): A Bear market in stocks is defined as a 20% decline in the S&P 500 Index from its previous peak, and ends when the index reaches its trough and subsequently rises by 20%.

Applying this definition to the SP500 intraday price index indicates there have indeed been ten such cycles, including the current one still in process, since 1956: 

tencycles_1

The returns shown are based on price only, so exclude dividends. Note that the average duration seems to match-up pretty well with so-called “short term debt cycle” (aka business cycle) described by Bridgewater’s Ray Dalio in the charming How the Economic Machine Works – In 30 Minutes video.

Here’s break-out of bear and bull markets:

tencycles_2 
The graph below depicts the ten cycles. To provide some historic context, various events are time-lined – some good, but more bad. Return is on left axis, measured from start of cycle, so each builds where previous left off. Short-term interest rate is on right axis.  

tencycles_3a

Note that each cycle resulted in a new all-time market high, which seems rather extraordinary. There were spectacular gains for the 1980 and 1990 bull markets, the latter being 427% trough-to-peak! (And folks worry lately that they may have missed-out on the current bull with its 177% gain.) Seeing the resiliency of the US market, it’s no wonder people like Warren Buffett advocate a buy-and-hold approach to investing, despite the painful -50% or more drawdowns, which have occurred three times over the period shown.

Having now defined the market cycles, which for this assessment applies principally to US stocks, we can revisit the question of mutual fund persistence (or lack of) across them.

Based on the same methodology used to determine MFO rankings, the chart below depicts results across nine cycles since 1962:

tencycles_4

Blue indicates top quintile performance, while red indicates bottom quintile. The rankings are based on risk adjusted return, specifically Martin ratio, over each full cycle. Funds are compared against all other funds in the peer group. The number of funds was rather small back in 1962, but in the later cycles, these same funds are competing against literally hundreds of peers.

(Couple qualifiers: The mural does not account for survivorship-bias or style drift. Cycle performance is determined using monthly total returns, including any loads, between the peak-to-peak dates listed above, with one exception…our database starts Jan 62 and not Dec 61.)

Not unexpectedly, the result is similar to previous studies (eg., S&P Persistence Scorecard) showing persistence is elusive at best in the mutual fund business. None of the 45 original funds in four categories delivered top-peer performance across all cycles – none even came close.

Looking at the cycles from 1973, a time when several now well know funds became established, reveals a similar lack of persistence – although one or two come close to breaking the norm. Here is a look at some of the top performing names:

tencycles_5

MFO Great Owls Mairs & Powers Balanced (MAPOX) and Vanguard Wellington (VWELX) have enjoyed superior returns the last three cycles, but not so much in the first. The reverse is true for legendary Fidelity Magellan (FMAGX).

Even a fund that comes about as close to perfection as possible, Sequoia (SEQUX), swooned in the late ‘90s relative to other growth funds, like Fidelity Contrafund (FCNTX), resulting in underperformance for the cycle. The table below details the risk and return metrics across each cycle for SEQUX, showing the -30% drawdown in early 2000, which marked the beginning of the tech bubble. In the next couple years, many other growth funds would do much worse.

tencycles_6

So, while each cycle may rhyme, they are different, and even the best managed funds will inevitably spend some time in the barrel, if not fall from favor forever.

We will look to incorporate full-cycle performance data in the single-ticker MFO Risk Profile search tool. As suggested by NumbersGirl, it’s an important piece of due diligence and risk cognizance for all mutual fund investors.

26Mar14/Charles

Poplar Forest Partners Fund (PFPFX), April 2014

By David Snowball

Objective and strategy

The Fund seeks to deliver superior, risk-adjusted returns over full market cycles by investing primarily in a compact portfolio of domestic mid- to large-cap stocks. They invest in between 25-35 stocks. They’re fundamental investors who assess the quality of the underlying business and then its valuation. Factors they consider in that assessment include expected future profits, sustainable revenue or asset growth, and capital requirements of the business which allows them to estimate normalized free cash flow and generate valuation estimates. Typical characteristics of the portfolio:

  • 85% of the portfolio to be invested in investment grade companies
  • 85% of the portfolio to be invested in dividend paying companies
  • 85% of the portfolio to be invested in the 1,000 largest companies in the U.S.

Adviser

Poplar Forest Capital. Poplar Forest was founded in 2007. They launched a small hedge fund, Poplar Forest Fund LP, in October 2007 and their mutual fund in 2009. The firm has just over $1 billion in assets under management, as of March 2014, most of which is in separate accounts for high net worth individuals.

Manager

J. Dale Harvey. Mr. Harvey founded Poplar Forest and serves as their CEO, CIO and Investment Committee Chair. Before that, he spent 16 years at the Capital Group, the advisor to the American Funds. He was portfolio counselor for five different American Funds, accounting for over $20 billion of client funds. He started his career in the Mergers & Acquisitions department of Morgan Stanley. He’s a graduate of the University of Virginia and the business school at Harvard University. He’s been actively engaged in his community, with a special focus on issues surrounding children and families.

Management’s stake in the fund

Over $1 million. “Substantially all” of his personal investment portfolio and the assets of his family’s charitable foundation, along with part of his mom’s portfolio, are invested in the fund. One of the four independent members of his board of directors has an investment (between $50,000 – 100,000) in the fund. In addition, Mr. Harvey owns 82% of the advisor, his analysts own 14% and everyone at the firm is invested in the fund. While individuals can invest their own money elsewhere, “there’s damned little of it” since the firm’s credo is “If you’ve got a great idea, we should own it for our clients.”

Strategy capacity and closure

$6 billion, which is reasonable given his focus on larger stocks. He has approximately $1 billion invested in the strategy (as of March 2014). Given his decision to leave Capital Group out of frustration with their funds’ burgeoning size, it’s reasonable to believe he’ll be cautious about asset growth.

Active share

90.2. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio.  High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The active share for Poplar Forest is 90.2, which reflects a very high level of independence from its benchmark, the S&P 500 index.

Opening date

12/31/2009

Minimum investment

$25,000, reduced to $5,000 for tax-advantaged accounts. Morningstar incorrectly reports a waiver of the minimum for accounts with automatic investment provisions.

Expense ratio

1.20% on about $319 million in assets. The “A” shares carry a 5% sales load but it is available without a load through Schwab, Vanguard and a few others. The institutional share class (IPFPX) has a 0.95% expense ratio and $1 million minimum.

(as of July 2023)

Comments

Dale Harvey is looking for a few good investors. Sensible people. Not the hot money crowd. Folks who take the time to understand what they’ve invested in, and why. He’s willing to work to find them and to keep them.

That explains a lot.

It explains why he left American Funds, where he had a secure and well-paid position managing funds that were swelling to unmanageable, or perhaps poorly manageable, size. “I wanted to hold 30 names but had to hold 80. We don’t want to be big. We’re not looking for hot money. I still remember the thank-you notes from investors we got when I was young man. Those meant a lot.”

It explains why he chose to have a sales load and a high minimum. He really believes that good advisors add immense value and he wants to support and encourage them. Part of that encouragement is through the availability of a load, part through carefully-crafted quarterly letters that try to be as transparent as possible.  His hope is that he’ll develop “investor-partners” who will stay around long enough for Poplar Forest to make a real difference in their lives.

So far he’s been very pleased with the folks drawn to his fund. He notes that the shareholder turnover rate, industry-wide, is something like 25% a year while Poplar Forest’s rate is in the high teens. That implies a six or seven year holding period. Even during an early rough patch (“we were a year too early buying the banks and our results deviated from the benchmark negatively but we still didn’t see big redemptions”), folks have hung on. 

And, in truth, Mr. Harvey has given them reason to. The fund’s 17.1% annualized return places it in the top 1% of its peer group over the past three years, through March 2014. It has substantially outperformed its peers in three of its first four years; because of his purchase of financial stocks he was, he says, “out of sync in one of four years. Investing is inherently cyclical. It’s worked well for 17 years but that doesn’t mean it works well every year.”

So, what’s he do?  He tries to figure out whether a firm is something he’d be willing to buy 100% of and hold for the next 30 years. If he wouldn’t want to own all of it, he’s unlikely to want to own part of it. There are three parts to the process:

Idea generation: they run screens, read, talk to people, ponder. In particular, “we look for distressed areas. There are places people have lost confidence, so we go in to look for the prospect of babies being tossed with the bathwater.” Energy and materials illustrate the process. A couple years ago he owned none of them, today they’re 20% of the portfolio. Why? “They tend to be highly capital intensive but as the bloom started coming off the rose in China and the emerging markets, we started looking at companies there. A lot are crappy, commodity businesses, but along the way we found interesting possibilities including U.S. natural gas and Alcoa after it got bounced from the Dow.” 

Modeling:  their “big focus is normalized earnings power for the business and its units.” They focus on sustainable earnings growth, a low degree of capital intensity – that is, businesses which don’t demand huge, repeated capital investments to stay competitive – and healthy margins.  They build the portfolio security by security. Because “bond surrogates” were so badly bid up, they own no utilities, no telecom, and only one consumer staple (Avon, which they bought after it cut its dividend).

Reality checks: Mr. Harvey believes that “thesis drift is one of the biggest problems people have.”  An investor buys a stock for a particular reason, the reasoning doesn’t pan out and then they invent a new reason to keep from needing to sell the stock. To prevent that, Poplar Forest conducts a “clean piece of paper review every six months” for every holding. The review starts with their original purchase thesis, the date and price they bought it, and price of the S&P.”  The strategy is designed to force them to admit to their errors and eliminate them.   

Bottom Line

So why might he continue to win?  Two factors stand out. The first is experience: “Pattern recognition is helpful, you know if you’ve seen this story before. It’s like the movies: you recognize a lot of plotlines if you watch a lot of movies.”  The second is independence. Mr. Harvey is one of several independent managers we’ve spoken with who believe that being away from the money centers and their insular culture is a powerful advantage. “There’s a great advantage in being outside the flow that people swim in, in the northeast. They all go to the same meetings, hear the same stuff. If you want to be better than average, you’ve got to see things they don’t.” Beyond that, he doesn’t need to worry about getting fired. 

One of the biggest travesties in the industry today is that everyone is so afraid of being fired that they never differentiate from their benchmarks …  Our business is profitable, guys are getting paid, doing it because I get to do it and not because I’ve got to do it. It’s about great investment results, not some payday.

Fund website

Poplar Forest Partners Fund. While the fund’s website is Spartan, it contains links to some really thoughtful analysis in Mr. Harvey’s quarterly commentaries.  The advisor’s main website is more visually appealing but contains less accessible information.  

Fact Sheet

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

Walthausen Select Value (WSVRX), April 2014

By David Snowball

 
This is an update of our profile from September 2011.  The original profile is still available.

Objective

The Fund pursues long-term capital appreciation by investing primarily in common stocks of small and mid-cap companies, those with market caps under $5 billion. The Fund typically invests in 40 to 50 companies. The manager reserves the right to go to cash as a temporary move but is generally 94-97% invested.

Adviser

Walthausen & Co., LLC, which is an employee-owned investment adviser located in Clifton Park, NY. Mr. Walthausen founded the firm in 2007. In September 2007, he was joined by the entire investment team that had worked previously with him at Paradigm Capital Management, including an assistant portfolio manager, two analysts and head trader. Subsequently this group was joined by Mark Hodge, as Chief Compliance Officer, bringing the total number of partners to six. It specializes in small- and mid-cap value investing through separate and institutional accounts, and its two mutual funds. They have about $1.4 billion in assets under management.

Manager

John B. Walthausen. Mr. Walthausen is the president of the Advisor and has managed the fund since its inception. Mr. Walthausen joined Paradigm Capital Management on its founding in 1994 and was the lead manager of the Paradigm Value Fund (PVFAX) from January 2003 until July 2007. He oversaw approximately $1.3 billion in assets. He’s got about 35 years of experience and is supported by four analysts. He’s a graduate of Kenyon College (a very fine liberal arts college in Ohio), the City College of New York (where he earned an architecture degree) and New York University (M.B.A. in finance).

Strategy capacity and closure

In the neighborhood of $2 billion. That number is generated by three constraints: he wants to own 40 stocks, he does not want to own more than 5% of the stock issued by any company, and he wants to invest in companies with market caps in the $500 million – $5 billion range. In the hypothetical instance that  market conditions led him to invest mostly in $1 billion stocks, the calculation is $50 million invested in each of 40 stocks = $2 billion. Right now the strategy holds about $200 million.

Active share

Not calculated. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. They’ve done the calculation for an investor in their separate accounts but haven’t seen demand for it with the mutual funds.

Management’s stake in the fund

Mr. Walthausen has between $500,000 and $1,000,000 in this fund, over $1 million invested in his flagship fund, and he also owns a majority stake in the fund’s adviser.

Opening date

December 27 2010.

Minimum investment

$2,500 for all accounts. There’s also an institutional share class with a $100,000 minimum and 1.22% expense ratio.

Expense ratio

1.47% on an asset base of about $40 million (as of 03/31/2014).

Comments

It’s hard to know whether to be surprised by Walthausen Select Value’s excellent performance. On the one hand, the fund has some fairly pedestrian elements. It invests primarily in small- to mid-cap domestic stocks. Together they represent more than 90% of the portfolio, which is about average for a small-blend fund. Likewise for the average market cap. The portfolio is compact – about 40 names – but not dramatically so. Their strategy is to pursue two sorts of investments:

Special situations (firms emerging from bankruptcy or recently spun-off from larger corporations), which average about 20% of the portfolio though there’s no set allocation to such stocks.

Good dull plodders – about 80% of the portfolio. These are solid businesses with good management teams that know how to add value. This second category seems widely pursued by other funds under a variety of monikers, mid-cap blue chips and steady compounders among them.

His top holdings are shared with 350-700 other funds.

And yet, the portfolio has produced top-tier results. Over the past three years, the fund’s 17.8% annualized returns places it in the top 3% of all small-blend funds. It has finished in the top half of its peer group each year. It has never trailed its peer group for more than two consecutive months.

Should we be surprised? Not really. He’s doing here what he’s been doing for decades. The case for Walthausen Select Value is Paradigm Value (PVFAX), Paradigm Select (PFSLX) and Walthausen Small Cap Value (WSCVX). Those three funds had two things in common: each holds a mix of small and mid-cap stocks and each has substantially outperformed its peers.

Paradigm Select turned $10,000 invested at inception into $16,000 at his departure. His average mid-blend peer would have returned $13,800.

Paradigm Value turned $10,000 invested at inception to $32,000 at his departure. His average small-blend peer would have returned $21,400. From inception until his departure, PVFAX earned 28.8% annually while its benchmark index (Russell 2000 Value) returned 18.9%.

Walthausen Small Cap Value turned $10,000 invested at inception to $26,500 (as of 03/28/2014). His average small-value peer would have returned $17,200. Since inception, WSCVX has out-performed every Morningstar Gold-rated fund in the small-value and small-blend groups. Every one. Want the list? Sure:

  • Artisan Small Cap Value
  • DFA US Microcap
  • DFA US Small Cap
  • DFA US Small Cap Value
  • DFA US Targeted Value
  • Diamond Hill Small Cap
  • Fidelity Small Cap Discovery
  • Royce Special Equity
  • Vanguard Small Cap Index, and
  • Vanguard Tax-Managed Small Cap

The most intriguing part? Since inception (through March 2014), Select Value has outperformed the stellar Small Cap Value.

There are, of course, reasons for caution. First, like Mr. Walthausen’s other funds, this has been a bit volatile. Beta (1.02) and standard deviation (17.2) are just a bit above the group norm. Investors here need to be looking for alpha (that is, high risk-adjusted returns), not downside protection. Because it will remain fully-invested, there’s no prospect of sidestepping a serious market correction. Second, this fund is more concentrated than any of his other charges. It currently holds 40 stocks, against 80 in Small Cap Value and 65 in his last year at Paradigm Select. Of necessity, a mistake with any one stock will have a greater effect on the fund’s returns. At the same time, Mr. Walthausen believes that 80% of the stocks will represent “good, unexciting companies” and that it will hold fewer “special situation” or “deeply troubled” firms than does the small cap fund. And these stocks are more liquid than are small or micro-caps. All that should help moderate the risk. Third, Mr. Walthausen, born in 1945, is likely in the later stages of his investing career

Bottom line

There’s reason to give Walthausen Select careful consideration. There’s a quintessentially Mairs & Power feel about the Walthausen funds. In conversation, Mr. Walthausen is quiet, comfortable, thoughtful and understated. In execution, the fund seems likewise. It offers no gimmicks – no leverage, no shorting, no convertibles, no emerging markets – and excels, Mr. Walthausen suggests, because of “a dogged insistence on doing our own work and reaching our own conclusions.” He’s one of a surprising number of independent managers who attribute part of their success to being “far from the madding crowd” (Malta, New York, in his case). Folks willing to deal with a bit of volatility in order to access Mr. Walthausen’s considerable skill at adding alpha should carefully consider this splendid little fund.

Website

Walthausen Funds homepage, which remains a pretty durn Spartan spot but there’s a fair amount of information if you click on the tiny text links across the top.

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

Does Size Matter?

By Edward A. Studzinski

By Edward Studzinski

 “Convictions are more dangerous enemies of truth than lies.”

                    Nietzsche

One of the more interesting consequences of the performance of equities in 2013 is the ramp-up of the active investment management marketing machines to explain why their performance in many instances lagged that of inexpensive index funds.  This has resulted in a manure storm media blitz with terms and phrases such as “stock picker’s market” or “active share” or “concentrated portfolios.” 

“Stock picker’s market” is generally a euphemism for active management.  That is, why you should pay me 100 basis points for investing in a subset of the S&P 500, rather than pay Vanguard or some other index fund provider 5 basis points for their product.  One of the rationales I used to regularly hear to justify active management fees was that the active manager will know when to get out of the market and when to get back in, whereas the small investor will always go in and out at the wrong time.  The period of 2008-2009 puts paid to that argument when one looks at maximum drawdown numbers.  The question it raises however is whether the time horizon most investment managers and investors use is far too short.  I think it clearly is and that rather than three years or three to five years, we should be thinking of ten years at a minimum.  Unfortunately, given personnel turnover in many investment organizations, it is difficult for the investing public to know or understand that the people who gave a fund its long-term performance, looking in the rear-view mirror, are not the ones doing the analysis  or selecting the investments going forward.  And if they are, often their time and attention is pulled in many other directions.  This is why I now, sitting on an endowment investment committee, appreciate why an integral part of the investment consultant’s report covers stability of personnel and succession planning at current firms invested in as well as firms proposed for consideration.  Of course, if you are the average retail investor, you are far better off to focus on your risk tolerance, true time horizon, and asset allocation, again making use of low cost index products if you are not going to spend the time and effort to replicate the work of the consultants used by endowments and pension funds.

I am going to leave it to others to discuss “active share.”  I do think the question of “concentrated portfolios” is worth a few thoughts.  I once asked a friend of mine, at a large East Coast fund complex, how he managed to keep track of the two hundred or so stocks in his fund portfolio.  His answer was illuminating.  He said that his firm had a very large research department and prided itself on its selection and training of analysts.  Politically then, over time he had to use an idea or two from everyone or every area.  His preference would have been to have a much more concentrated portfolio.  I will refer to that then as the “ark” approach to investment management.  Other firms, such as Longleaf, have tended from the get-go to have truly concentrated portfolios , say somewhere between twenty to twenty five stocks, given that the benefits of diversification run-out at a certain number of securities.  Their rationale has been that rarely, when you are building a portfolio from the bottom up based on what are the most undervalued ideas, do ideas number thirty to forty have the same expected return potential as ideas number one to ten.  (That is even more the case with the S&P 500 hitting new all time highs now).

There is another way to look at this which I think makes it more understandable for the average person.  In 2006, Huber Capital Managed LLC performed a study, looking at value-oriented investors, entitled “Limited Assets Under Management is a Competitive Advantage.”   The study assumed an equal weighted portfolio of 2.5% positions (forty stocks) to show how the investable universe of securities shrank at certain asset levels.  It looked at the Russell 1000 Value Index and the Russell 200 Value Index.  The conclusion of the study was that as assets under management grew, portfolio managers faced increasingly unpleasant choices.  One choice of course was to shrink the investment universe, what I have referred to in the past as the rule limiting investments to securities that can be bought or sold in five days average trading volume.

 Another alternative was to increase the number of stocks held in the portfolio.  You can see whether your manager has done this by going back five or ten years and looking at annual reports.  When the fund was $5B in asset size, did it own thirty stocks?  Do you really believe that with the fund at $10B or $15B in asset size, that it has found another twenty or thirty undervalued stocks?  Look also to see if the number of research analysts has increased materially.  Are roughly the same number of analysts covering more names? 

The third choice was to make the fund very concentrated or even non-diversified by SEC standards, with individual positions greater than five per cent.  That can work, but it entails taking on career risk for the analysts and fund managers, and enterprise risk for the management company.   A fund with $10B in assets under management has available only 50% of the investable set of stocks to invest in, assuming it is going to continue to focus on liquidity of the investment as an implicit criteria.  That is why you see more and more pension funds, endowments, and family office managers shifting to low-cost index or ETF vehicles for their large cap investments.  The incremental return is not justified by the incremental fee over the low-cost vehicle.  And with a long-term time horizon, the compounding effect of that fee differential becomes truly important to returns.

My thanks to Huber Capital Manangement LLC for doing this study, and to Long Short Advisors for making me aware of it in one of their recent reports.  Both firms are to be commended for their integrity and honesty.  They are truly investment managers rather than asset gatherers. 

March 1, 2014

By David Snowball

Dear friends,

It’s not a question of whether it’s coming.  It’s just a question of whether you’ve been preparing intelligently.

lighthouse

A wave struck a lighthouse in Douro River in Porto, Portugal, Monday. The wave damaged some nearby cars and caused minor injuries. Pictures of the Day, Wall Street Journal online, January 6, 2014. Estela Silva/European Pressphoto Agency

There’s an old joke about the farmer with the leaky roof that never gets fixed.  When the sun’s out, he never thinks about the leak and when it’s raining, he can’t get up there to fix it anyway.  And so the leak continues.

Our investments likewise: people who are kicking themselves for not having 100% equity exposure in March 2009 and 200% exposure in January 2013 have been pulling money steadily from boring investments and adding them to stocks.  The domestic stock market has seen its 13th consecutive month of inflows and the S&P 500 closed February at its highest nominal level ever.

I mention this now because the sun has been shining so brightly.  March 9, 2014 marches the five-year anniversary of the current bull market.  In those five years, a $10,000 investment in the S&P500 would have grown to $30,400.  The same amount invested in the NASDAQ on March 9 would have grown to $35,900. The last remnants of the ferocious bear markets of 2000-02 and 2007-09 have faded from the ratings.  And investors really want a do-over.  All the folks hiding under their beds in 2009 and still peering out from under the blankies in 2011 feel cheated and they want in on the action, and they want it now.

Hence inflows into an overpriced market.

Our general suggestion is to learn from the past, but not to live there.  Nothing we do today can capture the returns of the past five years for us.  Sadly, we still can damage the next five.  To help build a strong prospects for our future, we’re spending a bit of time this month talking about hedging strategies – ways to get into a pricey market without quite so much heartache – and cool funds that might be better positioned for the next five than you’d otherwise find.

And, too, we get to celebrate the onset of spring!

The search for active share

It’s much easier to lose in investing than to win.  Sometimes we lose because we’re offered poor choices and sometimes we lose because we make poor ones.  Frankly, it doesn’t take many poor choices to trash the best laid plans.

Winning requires doing a lot of things right.  One of those things is deciding whether – or to what extent – your portfolio should rely on actively and passively managed funds.  A lot of actively managed funds are dismal but so too are a lot of passive products: poorly constructed indexes, trendy themes, disciplines driven by marketing, and high fees plague the index and EFT crowd.

If you are going to opt for active management, you need to be sure that it’s active in more than name alone.  As we’ve shown before, many active managers – especially those trying to deploy billions in capital – offer no advantage over a broad market index, and a lot of disadvantages. 

One tool for measuring the degree to which your manager is active is called, appropriately enough, “active share.”  Active share measures the degree to which your fund’s holdings differ from its benchmark’s.  The logic is simple: you can’t beat an index by replicating it and if you can’t beat it, you should simply buy it.

The study “How Active Is Your Manager” (2009) by Cremers and Petajitso concluded that “Funds with high active share actually do outperform their benchmarks.” The researchers originally looked at an ocean of data covering the period from 1990 to 2003, then updated it through 2009.  They found that funds with active share of at least 90% outperformed their benchmarks by 1.13% (113 basis points per year) after fees. Funds with active share below 60% consistently underperformed by 1.42 percentage points a year, after accounting for fees.

Some researchers have suggested that the threshold for active share needs to be adjusted to account for differences in the fund’s investment universe: a fund that invests in large to mega-cap names should have an active share north of 70%, midcaps should be above 80% and small caps above 90%. 

So far, we’ve only seen research validating the 60% and 90% thresholds though the logic of the step system is appealing; of the 5008 publicly-traded US stocks, there are just a few hundred large caps but several thousand small and micro-caps.

There are three problems with the active share data.  We’d like to begin addressing one of them and warn you of the other two.

Problem One: It’s not available.  Morningstar has the data but does not release it, except in occasional essays. Fund companies may or may not have it, but almost none of them share it with investors. And journalists occasionally publish pieces that include an active share chart but those tend to be an idiosyncratic, one-time shot of a few funds. Nuts.

Problem Two: Active share is only as valid as the benchmark used. The calculation of active share is simply a comparison between a fund’s portfolio and the holdings in some index. Pick a bad index and you get a bad answer. By way of simple illustration, the S&P500 stock index has an active share of 100 (woo hoo!) if you benchmark it against the MSCI Emerging Markets Index.

Fund companies might have the same incentive and the same leverage with active share providers that the buyers of bond ratings did: bond issuers could approach three ratings agencies and say “tell me how you’ll rate my bond and I’ll tell you whether we’re paying for your rating.” A fund company looking for a higher active share might simply try several indexes until they find the one that makes them look good. Here’s the warning: make sure you know what benchmark was used and make sure it makes sense.

Problem Three: You can compare active share between two funds only if they’ve chosen to use the same benchmark. One large cap might have an active share of 70 against the Mergent Dividend Achievers Index while another has a 75 against the Russell 1000 Value Index. There’s no way, from that data, to know whether one fund is actually more active than the other. So, look for comparables.

To help you make better decisions, we’ve begun gathering publicly-available active share data released by fund companies.  Because we know that compact portfolios are also correlated to higher degrees of independence, we’ve included that information too for all of the funds we could identify.  A number of managers and advisors have provided active share data since our March 1st launch.  Thanks!  Those newly added funds appear in italics.

Fund

Ticker

Active share

Benchmark

Stocks

Artisan Emerging Markets (Adv)

ARTZX

79.0

MSCI Emerging Markets

90

Artisan Global Equity

ARTHX

94.6

MSCI All Country World

57

Artisan Global Opportunities

ARTRX

95.3

MSCI All Country World

41

Artisan Global Value

ARTGX

90.5

MSCI All Country World

46

Artisan International

ARTIX

82.6

MSCI EAFE

68

Artisan International Small Cap

ARTJX

97.8

MSCI EAFE Small Cap

45

Artisan International Value

ARTKX

92.0

MSCI EAFE

50

Artisan Mid Cap

ARTMX

86.3

Russell Midcap Growth

65

Artisan Mid Cap Value

ARTQX

90.2

Russell Value

57

Artisan Small Cap

ARTSX

94.2

Russell 2000 Growth

68

Artisan Small Cap Value

ARTVX

91.6

Russell 2000 Value

103

Artisan Value

ARTLX

87.9

Russell 1000 Value

32

Barrow All-Cap Core Investor 

BALAX

92.7

S&P 500

182

Diamond Hill Select

DHLTX

89

Russell 3000 Index

35

Diamond Hill Large Cap

DHLRX

80

Russell 1000 Index

49

Diamond Hill Small Cap

DHSIX

97

Russell 2000 Index

68

Diamond Hill Small-Mid Cap

DHMIX

97

Russell 2500 Index

62

DoubleLine Equities Growth

DLEGX

88.9

S&P 500

38

DoubleLine Equities Small Cap Growth

DLESX

92.7

Russell 2000 Growth

65

Driehaus EM Small Cap Growth

DRESX

96.4

MSCI EM Small Cap

102

FPA Capital

FPPTX

97.7

Russell 2500

28

FPA Crescent

FPACX

90.3

Barclays 60/40 Aggregate

50

FPA International Value

FPIVX

97.8

MSCI All Country World ex-US

23

FPA Perennial

FPPFX

98.9

Russell 2500

30

Guinness Atkinson Global Innovators

IWIRX

99

MSCI World

28

Guinness Atkinson Inflation Managed Dividend

GAINX

93

MSCI World

35

Linde Hansen Contrarian Value

LHVAX

87.1 *

Russell Midcap Value

23

Parnassus Equity Income

PRBLX

86.9

S&P 500

41

Parnassus Fund

PARNX

92.6

S&P 500

42

Parnassus Mid Cap

PARMX

94.9

Russell Midcap

40

Parnassus Small Cap

PARSX

98.8

Russell 2000

31

Parnassus Workplace

PARWX

88.9

S&P 500

37

Pinnacle Value

PVFIX

98.5

Russell 2000 TR

37

Touchstone Capital Growth

TSCGX

77

Russell 1000 Growth

58

Touchstone Emerging Markets Eq

TEMAX

80

MSCI Emerging Markets

68

Touchstone Focused

TFOAX

90

Russell 3000

37

Touchstone Growth Opportunities

TGVFX

78

Russell 3000 Growth

60

Touchstone Int’l Small Cap

TNSAX

97

S&P Developed ex-US Small Cap

97

Touchstone Int’l Value

FSIEX

87

MSCI EAFE

54

Touchstone Large Cap Growth

TEQAX

92

Russell 1000 Growth

42

Touchstone Mid Cap

TMAPX

96

Russell Midcap

33

Touchstone Mid Cap Growth

TEGAX

87

Russell Midcap Growth

74

Touchstone Mid Cap Value

TCVAX

87

Russell Midcap Value

80

Touchstone Midcap Value Opps

TMOAX

87

Russell Midcap Value

65

Touchstone Sands Capital Select

TSNAX

88

Russell 1000 Growth

29

Touchstone Sands Growth

CISGX

88

Russell 1000 Growth

29

Touchstone Small Cap Core

TSFAX

99

Russell 2000

35

Touchstone Small Cap Growth

MXCAX

90

Russell 2000 Growth

81

Touchstone Small Cap Value

FTVAX

94

Russell 2000 Value

75

Touchstone Small Cap Value Opps

TSOAX

94

Russell 2000 Value

87

William Blair Growth

WBGSX

83

Russell 3000 Growth

53

*        Linde Hansen notes that their active share is 98 if you count stocks and cash, 87 if you look only at the stock portion of their portfolio.  To the extent that cash is a conscious choice (i.e., “no stock in our investable universe meets our purchase standards, so we’ll buy cash”), count both makes a world of sense.  I just need to find out how other investors have handled the matter.

Who’s not on the list? 

A lot of firms, some of whose absences are in the ironic-to-hypocritical range. Firms not choosing to disclose active share include:

BlackRock – which employs Anniti Petajisto, the guy who invented active share, as a researcher and portfolio manager in their Multi-Asset Strategies group. (They do make passing reference to an “active share buyback” on the part on one of their holdings, so I guess that’s partial credit, right?)

Fidelity – whose 5 Tips to Pick a Winning Fund tells you to look for “stronger performers [which are likely to] have a high ‘active share’”.  (They do reprint a Reuters article ridiculing a competitor with a measly 56% active share, but somehow skip the 48% for Fidelity Blue Chip Growth, 47% for Growth & Income, the 37% for MegaCap Stock or the under 50% for six of their Strategic Advisers funds). (per the Wall Street Journal, Is Your Fund a Closet Index Fund, January 14, 2014).

Oakmark – which preens about “Harris Associates and Active Share” without revealing any.

Are you active?  Would you like someone to notice?

We’ve been scanning fund company sites for the past month, looking for active share reports. If we’ve missed you, we’re sorry. Help us correct the oversight  by sending us the link to where you report your active share stats. We’d be more than happy to offer a permanent home for the web’s largest open collection of active share data.

Does Size Matter?

edward, ex cathedraBy Edward Studzinski

“Convictions are more dangerous enemies of truth than lies.”

                    Nietzsche

One of the more interesting consequences of the performance of equities in 2013 is the ramp-up of the active investment management marketing machines to explain why their performance in many instances lagged that of inexpensive index funds. This has resulted in a manure storm media blitz with terms and phrases such as “stock picker’s market” or “active share” or “concentrated portfolios.” 

“Stock picker’s market” is generally a euphemism for active management. That is, why you should pay me 100 basis points for investing in a subset of the S&P 500, rather than pay Vanguard or some other index fund provider 5 basis points for their product. One of the rationales I used to regularly hear to justify active management fees was that the active manager will know when to get out of the market and when to get back in, whereas the small investor will always go in and out at the wrong time. The period of 2008-2009 puts paid to that argument when one looks at maximum drawdown numbers.  The question it raises however is whether the time horizon most investment managers and investors use is far too short. I think it clearly is and that rather than three years or three to five years, we should be thinking of ten years at a minimum.  Unfortunately, given personnel turnover in many investment organizations, it is difficult for the investing public to know or understand that the people who gave a fund its long-term performance, looking in the rear-view mirror, are not the ones doing the analysis or selecting the investments going forward. And if they are, often their time and attention is pulled in many other directions.  This is why I now, sitting on an endowment investment committee, appreciate why an integral part of the investment consultant’s report covers stability of personnel and succession planning at current firms invested in as well as firms proposed for consideration. Of course, if you are the average retail investor, you are far better off to focus on your risk tolerance, true time horizon, and asset allocation, again making use of low cost index products if you are not going to spend the time and effort to replicate the work of the consultants used by endowments and pension funds.

I am going to leave it to others to discuss “active share.”  I do think the question of “concentrated portfolios” is worth a few thoughts.  I once asked a friend of mine, at a large East Coast fund complex, how he managed to keep track of the two hundred or so stocks in his fund portfolio. His answer was illuminating.  He said that his firm had a very large research department and prided itself on its selection and training of analysts.  Politically then, over time he had to use an idea or two from everyone or every area. His preference would have been to have a much more concentrated portfolio.  I will refer to that then as the “ark” approach to investment management. Other firms, such as Longleaf, have tended from the get-go to have truly concentrated portfolios, say somewhere between twenty to twenty five stocks, given that the benefits of diversification run-out at a certain number of securities. Their rationale has been that rarely, when you are building a portfolio from the bottom up based on what are the most undervalued ideas, do ideas number thirty to forty have the same expected return potential as ideas number one to ten. (That is even more the case with the S&P 500 hitting new all time highs now).

There is another way to look at this which I think makes it more understandable for the average person.  In 2006, Huber Capital Managed LLC performed a study, looking at value-oriented investors, entitled “Limited Assets Under Management is a Competitive Advantage.”   The study assumed an equal weighted portfolio of 2.5% positions (forty stocks) to show how the investable universe of securities shrank at certain asset levels. It looked at the Russell 1000 Value Index and the Russell 2000 Value Index. The conclusion of the study was that as assets under management grew, portfolio managers faced increasingly unpleasant choices. One choice of course was to shrink the investment universe, what I have referred to in the past as the rule limiting investments to securities that can be bought or sold in five days average trading volume.

Another alternative was to increase the number of stocks held in the portfolio. You can see whether your manager has done this by going back five or ten years and looking at annual reports.  When the fund was $5B in asset size, did it own thirty stocks? Do you really believe that with the fund at $10B or $15B in asset size, that it has found another twenty or thirty undervalued stocks?  Look also to see if the number of research analysts has increased materially. Are roughly the same number of analysts covering more names? 

The third choice was to make the fund very concentrated or even non-diversified by SEC standards, with individual positions greater than five per cent. That can work, but it entails taking on career risk for the analysts and fund managers, and enterprise risk for the management company. A fund with $10B in assets under management has available only 50% of the investable set of stocks to invest in, assuming it is going to continue to focus on liquidity of the investment as an implicit criteria. That is why you see more and more pension funds, endowments, and family office managers shifting to low-cost index or ETF vehicles for their large cap investments. The incremental return is not justified by the incremental fee over the low-cost vehicle. And with a long-term time horizon, the compounding effect of that fee differential becomes truly important to returns.

My thanks to Huber Capital Manangement LLC for doing this study, and to Long Short Advisors for making me aware of it in one of their recent reports. Both firms are to be commended for their integrity and honesty. They are truly investment managers rather than asset gatherers. 

On the impact of fund categorization: Morningstar’s rejoinder

charles balconyMorningstar’s esteemed John Rekenthaler replied to MFO’s February commentary on categorization, although officially “his views are his own.” His February 5 column is entitled How Morningstar Categorizes Funds.

Snowball’s gloss: John starts with a semantic quibble (Charles: “Morningstar says OSTFX is a mid-cap blend fund,” John: “Morningstar does not say what a fund is,” just what category it’s been assigned to), mischaracterizes Charles’s article as “a letter to MFO” (which I mention only because he started the quibble-business) and goes on to argue that the assignment of OSTFX to its category is about as reasonable a choice as could be made. Back to Charles:

Mr. R. uses BobC’s post to frame an explanation of what Morningstar does and does not do with respect to fund categorization. In his usual thoughtful and self-effacing manner, he defends the methodology, while admitting some difficulty in communicating. Fact is, he remains one of Morningstar’s best communicators and Rekenthaler Report is always a must read.

I actually agree with his position on Osterweis. Ditto for his position on not having an All Cap category (though I suspect I’m in the minority here and he actually admits he may be too). He did not address the (mis-)categorization of River Park Short Term High Yield Fund (RPHYX/RPHIX, closed). Perhaps because he is no longer in charge of categorization at Morningstar.

The debate on categorization is never-ending, of course, as evidenced by the responses to his report and the many threads on our own board. For the most part, the debate remains a healthy one. Important for investors to understand the context, the peer group, in which prospective funds are being rated.

In any case and as always, we very much appreciate Mr. Rekenthaler taking notice and sharing his views.

Snowball’s other gloss: geez, Charles is a lot nicer than I am. I respect John’s work but frankly I don’t really tingle at the thought that he “takes notice.” Well, except maybe for that time at the Morningstar conference when he swerved at the last minute to avoid crashing into me. I guess there was a tingle then.

Snowball’s snipe: at the sound of Morningstar’s disdain, MFWire did what MFWire does. They raised high the red-and-white banner, trumpeting John’s argument and concluding with a sharp “grow up, already!” I would have been much more impressed with them if they’d read Charles’s article beforehand. They certainly might have, but there’s no evidence in the article that they felt that need.

One of the joys of writing for the Observer is the huge range of backgrounds and perspectives that our readers bring to the discussion. A second job is the huge range of backgrounds and perspectives that my colleagues bring. Charles, in particular, can hear statistics sing. (He just spent a joyful week in conference studying discounted cash-flow models.) From time to time he tries, gently, to lift the veil of innumeracy from my eyes. The following essay flows from our extended e-mail exchanges in which I struggled to understand the vastly different judgments of particular funds implied by different ways of presenting their risk-adjusted statistics. 

We thought some of you might like to overhear that conversation.  

Morningstar’s Risk Adjusted Return Measure

Central to any fund rating system is the performance measure used to determine percentile rank order. MFO uses Martin ratio, as described Rating System Definitions. Morningstar developed its own risk adjusted return (MRAR), which Nobel Laureate William Sharpe once described as a measure that “…differs significantly from more traditional ones such as various forms of the Sharpe ratio.” While the professor referred to an earlier version of MRAR, the same holds true today.

Here is how Morningstar describes MRAR on its Data FAQ page: Morningstar adjusts for risk by calculating a risk penalty for each fund based on “expected utility theory,” a commonly used method of economic analysis. Although the math is complex, the basic concept is relatively straightforward. It assumes that investors are more concerned about a possible poor outcome than an unexpectedly good outcome and that those investors are willing to give up a small portion of an investment’s expected return in exchange for greater certainty. A “risk penalty” is subtracted from each fund’s total return, based on the variation in its month-to-month return during the rating period, with an emphasis on downward variation. The greater the variation, the larger the penalty. If two funds have the exact same return, the one with more variation in its return is given the larger risk penalty.

For the curious and mathematically inclined, the detailed equations are well documented in The Morningstar Rating Methodology. The following figure illustrates how MRAR behaves for three hypothetical funds over a 3 year period ending Dec 2013:

hypothetical fundsfund012

Each fund in the illustration delivers the same total return, but with varying levels of volatility. The higher the volatility, the lower the risk adjusted return. Fund 0 delivers consistent returns every month with zero volatility; consequently, it receives the highest MRAR, which in this case is the fund’s annualized total return minus the risk-free T-Bill (i.e., it’s the annualized “excess” return).

Morningstar computes MRAR for all funds over equivalent periods, and then percentile ranks them within their respective categories to assign appropriate levels, 1 star for those funds in the lowest group and the coveted 5 star rating for the highest.

It also computes a risk measure MRisk and performs a similar ranking to designate “low” to “high” risk funds within each category. MRisk is simply the difference between the annualized excess return of the fund and its MRAR.

The following figure provides further insight into how MRAR behaves for funds of varying volatility. This time, fund total returns have been scaled to match their category averages, again for the 3 year period ending Dec 2013. The figure includes results from several categories showing MRAR versus the tradition volatility measure, annualized standard deviation.

mrar sensitivity

Once again we see that funds with higher volatility generally receive lower MRARs and that the highest possible MRAR is equal to a fund’s annualized excess return, which occurs at zero standard deviation.

A consequence of Morningstar’s methodology is that low volatility funds with below average returns can quite possibly be out-ranked by average volatility funds with average returns. Put another way, the methodology generally penalizes funds with high volatility more so than it rewards funds with low volatility, since with the latter the benefit is “capped.”

This behavior is different from other risk adjusted return measures based on say Sharpe ratio, as can be seen in the figure below. Here the same funds from above are plotted against Sharpe, but now funds with low volatility are rewarded handsomely, even if they have below average total returns.

sharpe sensitivity

Revisiting the Morningstar risk measure MRisk, one finds another observation: it appears to correlate rather satisfactorily against a simple function based on standard deviation (up to about 30% for funds of positive total return without load):
morningstar risk

Which means that Morningstar’s risk adjusted return can be estimated from the following:

morningstar mrar

This simple approximation may come in handy, like when David wonders: “Why do RPHIX and ICMYX, which have superior 3 year Sharpe ratios, rate a very inferior 1 star by Morningstar?” He can use the above calculation to better understand, as illustrated here:

mrar approximation

While both do indeed have great 3 year Sharpe ratios – RPHIX is highest of any US fund – they both have below average total returns relative to their current peer group, as represented by say VWEHX, a moderate risk and average returning high yield bond “reference” fund.

Their low volatilities simply get no love from Morningstar’s risk adjusted return measure.

27Feb2014/Charles

Celebrating one-starness

I was having a nice back-channel conversation with a substantially frustrated fund manager this week. He read Charles’s piece on fund categorization and wrote to express his own dismay with the process. He’s running a small fund. It hit its three-year mark and earned five stars. People noticed. Then Morningstar decided to recategorize the fund (into something he thinks he isn’t). And it promptly became one star. And, again, people – potential investors – noticed, but not in a good way.

Five to one, with the stroke of a pen? It happens, but tends not to get trumpeted. After all, it rather implies negligence on Morningstar’s part if they’ve been labeling something as, say, a really good conservative allocation fund for years but then, on further reflection, conclude that it’s actually a sucky high-yield bond or preferred stock fund.

Here’s what Morningstar’s explanation for such a change looks like in practice:

Morningstar Alert

Osterweis Strategic Income Fund OSTIX

12-03-13 01:00 PM

Change in Morningstar Fund Star Rating: The Morningstar Star Rating for this fund has changed from 4 stars to 2 stars. For details, go to http://quicktake.morningstar.com/Fund/RatingsAndRisk.asp?Symbol=OSTIX.

Sadly, when you go to that page there are no details that would explain an overnight drop of that magnitude. On the “performance” page, you will find the clue:

fund category

I don’t have an opinion on the appropriateness of the category assignment but it would be an awfully nice touch, given the real financial consequences of such a redesignation, if Morningstar would take three sentences to explain their rationale at the point that they make the change.

Which got me to thinking about my own favorite one-star fund (RiverPark Short Term High Yield RPHYX and RPHIX, which is closed) and Charles’s favorite one-shot stat on a fund’s risk-adjusted returns (its Sharpe ratio).

And so, here’s the question: how many funds have a higher (i.e., better) Sharpe ratio than does RPHYX?

And, as a follow-up, how many have a Sharpe ratio even half as high as RiverPark’s?

That would be “zero” and “seven,” respectively, out of 6500 funds.

Taking up Rekenthaler’s offer

In concluding his response to Charles’s essay, John writes:

A sufficient critique is one that comes from a fund that truly does not behave like others in its category, that contains a proposal for a modification to the existing category system, that does not lead to rampant category proliferation, and that results in a significantly closer performance comparison between the fund and its new category. In such cases, Morningstar will consider the request carefully–and sometimes make the suggested change.

Ummm … short-term high-yield? In general, those are funds that are much more conservative than the high-yield group. The manager at RiverPark Short-Term High Yield (RPHYX) positions the fund as a “cash management” account. The managers at Intrepid Income (ICMYX) claim to be “absolute return” investors. Wells Fargo Advantage Short-Term High-Yield Bond (STHBX) seems similarly positioned. All are one-star funds (as of February 2014) when judged against the high-yield universe.

“Does not behave like others in its category” but “results in a significantly closer performance comparison [within] its new category.” The orange line is the high-yield category. That little cluster of parallel, often overlapping lines below it are the three funds.

high yield

“Does not lead to rampant category proliferation.” You mean, like creating a “preferred stock” category with seven funds? That sort of proliferation? If so, we’re okay – there are about twice as many short-term high-yield candidates as preferred stock ones.

I’m not sure this is a great idea. I am pretty sure that dumping a bunch of useful, creative funds into this particular box is a pretty bad one.

Next month’s unsought advice will highlight emerging markets balanced (or multi-asset) funds. We’re up to a dozen of them now and the same logic that pulled US balanced funds out of the equity category and global balanced funds out of the international equity category, seems to be operating here.

Two things you really should read

In general, most writing about funds has the same problem as most funds do: it’s shallow, unoriginal, unreflective. It contributes little except to fill space and get somebody paid (both honorable goals, by the way). Occasionally, though, there are pieces that are really worth some of our time, thought and reflection. Here are two.

I’m not a great fan of ETFs. They’ve always struck me as trading vehicles, tools for allowing hedge funds and others to “make bets” rather than to invest. Chuck Jaffe had a really solid piece entitled “The growing case against ETFs” (Feb. 23, 2014) that makes the argument that ETFs are bad for you. Why? Because the great advantage of ETFs are that you can trade them all day long. And, as it turns out, if you give someone a portfolio filled with ETFs that’s precisely – and disastrously – what they do.

The Observer was founded on the premise that small, independent, active funds are the only viable alternative to a low-cost indexed portfolio. As funds swell, two bad things happen: their investable universe shrinks and the cost of making a mistake skyrockets, both of which lead to bad investment choices. There’s a vibrant line of academic research on the issue. John Rekenthaler began dissecting some of that research – in particular, a recent study endorsing younger managers and funds – in a four-part series of The Rekenthaler Report. At this writing, John had posted two essays: “Are Young Managers All That?” (Feb. 27, 2014) and “Has Your Fund Become Too Large, Or Is Industry Size the Problem?” (Feb. 28, 2014).  The first essay walks carefully through the reasons why older, larger funds – even those with very talented managers – regress. To my mind, he’s making a very strong case for finding capacity-constrained strategies and managers who will close their funds tight and early. The second picks up an old argument made by Charles Ellis in his 1974 “The Loser’s Game” essay; that the growth and professionalization of the investment industry is so great that no one – certainly not someone dragging a load – can noticeably outrun the crowd. The problem is less, John argues, the bloat of a single fund as the effect of “$3 trillion in smart money chasing the same ideas.”  

Regardless of whether you disdain or adore ETFs, or find the industry’s difficulties located at the level of undisciplined funds or an unwieldy industry, you’ll come away from these essays with much to think about.

RiverPark Strategic Income: Another set of ears

I’m always amazed by the number of bright and engaging folks who’ve been drawn to the Observer, and humbled by their willingness to freely share some of their time, insights and experience with the rest of us. One of those folks is an investor and advisor named “Mark” who is responsible for extended family money, a “multi-family office” if you will. He had an opportunity to spend some time chatting with David Sherman in mid-January as he contemplated a rather sizeable investment in RiverPark Strategic Income (RSIVX) for some family members who would benefit from such a strategy. Herewith are some of the reflections he shared over the course of a series of emails with me.

Where he’s coming from

Mark wrote that to him it’s important to understand the “context” of RSIVX. Mr. Sherman manages private strategies and hedge fund monies at Cohanzick Management, LLC. He cut his teeth at Leucadia National (whose principal Ian Cumming is sometimes referred to as Canada’s Warren Buffett) and is running some sophisticated and high entry strategies that have big risks and big rewards. His shop is not as large as some, sure, but Mr. Sherman seems to prefer it that way.

Some of what Mr. Sherman does all day “informs” RSIVX. He comes across an instrument or an idea that doesn’t fit in one strategy but may in another. It has the risk/reward characteristics that he wants for a particular strategy and so he and his team perform their due diligence on it. More on that later.

Where he is

RSIVX only exists, according to Mr. Sherman, because it fills a need. The need is for an annuity like stream of income at a rate that “his mother could live off” and he did not see such a thing in the marketplace. (In 2007 you could park money at American Express Bank in a jumbo CD at 5.5%. No such luck today.) He saw many other total return products out there in the high yield space where an investor can get a bit higher returns than what he envisions. But some of those returns will be from capital appreciation, i.e., returns from in essence trading. Mr. Sherman did not want to rely on that. He wants a lower duration portfolio (3-4 years) that he can possibly but not necessarily hold to get nice, safe, relatively high coupons from. As long as his investor has that timeframe, Mr. Sherman believes he can compound the money at 6-8% annually, and the investor gets his money back plus his return.

Shorter timeframes, because of impatience or poor timing choices, carry no such assurances. It’s not a CD, it’s not a guaranteed annuity from an insurer, but it’s what is available and what he is able to get for an investor.

How? Well, one inefficiency he hopes to exploit is in the composition of SPDR Barclays High Yield Bond (JNK) and iShares High Yield Corporate Bond (HYG). He doesn’t believe they reflect the composition of high yield space accurately with their necessary emphasis on the most liquid names. He will play in a different sandbox with different toys. And he believes it’s no more risky and thinks it is less so. In addition, when the high yield market moves, especially down, those names move fast.

Mark wrote that he asked David whether the smoothness of his returns exhibited in RPHYX and presumably in RSIVX in the future was due or would be due to a laddering strategy that he employed. He said that it was not – RSIVX’s portfolio was more of a barbell presently- and he did not want to be pigeonholed into a certain formula or strategy. He would do whatever it took to produce the necessary safe returns and that may change from time to time depending upon the market.

What changing interest rates might mean

What if rates fall? If rates fall then, sure, the portfolio will have some capital appreciation. What if rates rise? Well, every day and every month, David said, the investor will grind toward the payday on the shorter duration instruments he is holding. Mark-to-market they will be “worth” less. The market will be demanding higher interest rates and what hasn’t rolled off yet will not be as competitive as the day he bought them. The investor will still be getting a relatively high 6-8% return and as opportunities present themselves and with cash from matured securities and new monies the portfolio will be repopulated over time in the new interest rate environment. Best he can do. He does not intend to play the game of hedging. 

Where he might be going

crystal ball

Mark said he also asked about a higher-risk follow-on to RSIVX. He said that David told him that if he doesn’t have something unique to bring that meets a need, he doesn’t want to do it. He believes RPHYX and RSIVX to be unique. He “knew” he could pull off RPHYX, that he could demonstrate its value, and then have the credibility to introduce another idea. That idea is the Strategic Income Fund.

He doesn’t see a need for him to step out on the spectrum right now. There are a hundred competitors out there and a lot of overlap. People can go get a total return fund with more risk of loss. Returns from them will vary a lot from year to year unless conditions are remarkably stable. This [strategy] almost requires a smaller, more nimble fund and manager. Here he is. Here it is. So the next step out isn’t something he is thinking [immediately] about, but he continually brings ideas to Morty.

Mark concludes: “We discussed a few of his strategies that had more risk. They are fascinating but definitely not vanilla or oatmeal and a few I had to write out by hand the mechanics afterward so I could “see” what he was doing. One of them took me about an hour to work through where the return came from and where it could go possibly wrong.

But he described it to me because working on it gave him the inspiration for a totally different situation that, if it came to pass, would be appropriate for RSIVX. It did, is much more vanilla and is in the portfolio. Very interesting and shows how he thinks. Would love to have a beer with this guy.”

Mark’s bottom line(s)

Mark wanted me to be sure to disclose that he and his family have a rather large position in RiverPark Strategic Income now, and will be holding it for an extended period assuming all goes well (years) so, yeah, he may be biased with his remarks. He says “the strategy is not to everyone’s taste or risk tolerance”. He holds it because it exactly fills a need that his family has.

Observer Fund Profiles:

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

Driehaus Emerging Markets Small Cap Growth (DRESX): There’s a lot to be said for EM small caps. They provide powerful diversification and performance benefits for a portfolio. The knock of them is that they’re too hot to handle. Driehaus’s carefully constructed, hedged portfolio seems to have cooled the handle by a lot.

Guinness Atkinson Inflation Managed Dividend (GAINX): It’s easy to agree that owning the world’s best companies, especially if you buy them on the cheap, is a really good strategy. GAINX approaches the challenge of constructing a very compact, high quality, low cost portfolio with quantitative discipline and considerable thought.

Intrepid Income (ICMUX): What’s not to like about this conservative little short-term, high-yield fund. It’s got it all: solid returns, excellent risk management and that coveted one-star rating! Intrepid, like almost all absolute value investors, is offering an object lesson on the important of fortitude in the face of frothy markets and serial market records.

RiverPark Gargoyle Hedged Value (RGHVX): The short story is this. Gargoyle’s combination of a compact, high quality portfolio and options-based hedging strategy has, over time, beaten just about every reasonable comparison group. Unless you anticipate a series of 20 or 30% gains in the stock market over the rest of the decade, it might be time to think about protecting some of what you’ve already made.

Elevator Talk: Ted Gardner, Salient MLP & Energy Infrastructure II (SMLPX)

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

Master limited partnerships (MLPs) are an intriguing asset class which was, until very recently, virtually absent from both open-end fund and ETF portfolios.

MLPs are a form of business organization, in the same way corporations are a form of organization. Their shares trade on US exchanges (NYSE and NASDAQ) and they meet the same SEC security registration requirements as corporations do. They were created in the 1980s primarily as a tool to encourage increased energy production in the country and the vast majority of MLPs (75% or so) are in the energy sector.

MLPs are distinct from corporations in a number of ways:

  • They’re organized around two groups: the limited partners (i.e., investors) and the general partners (i.e., managers). The limited partners provide capital and receive quarterly distributions.
  • MLPs are required, by contract, to pay minimum quarterly distributions to their limited partners. That means that they produce very consistent streams of income for the limited partners.
  • MLPs are required, by law, to generate at least 90% of their income from “qualified sources.” Mostly that means energy production and distribution.

The coolest thing about MLPs is the way they generate their income: they operate hugely profitable, economically-insensitive monopolies whose profits are guaranteed by law. A typical midstream MLP might own a gas or oil pipeline. The MLP receives a fee for every gallon of oil or cubic foot of gas moving through the pipe. That rate is set by a federal agency and that rate rises every year by the rate of inflation plus 1.3%. It doesn’t matter whether the price of oil soars or craters; the MLP gets its toll regardless. And it doesn’t really matter whether the economy soars or craters: people still need warm homes and gas to get to work. At worst, bad recessions eliminate a year’s demand rise but haven’t yet caused a net demand decrease. As the population grows and energy consumption rises, the amount moving through the pipelines rise and so does the MLPs income.

Those profits are protected by enormously high entry barriers: building new pipelines cost billions, require endless hearings and permits, and takes years. As a result, the existing pipelines function as de facto a regional monopoly, which means that the amount of material traveling through the pipeline won’t be driven down by competition for other pipelines.

Quick highlights of the benchmark Alerian MLP index:

  • From inception through early 2013, the index returned 16% annually, on average.
  • For that same period, it had a 7.1% yield which grew 7% annually.
  • There is a low correlation – 50 – between the stock market and the index. REITs say at around 70 and utility stocks at 25, but with dramatically lower yield and returns.

Only seven of the 17 funds with “MLP” in their names have been around long enough to quality for a Morningstar rating; all seven are four- or five-star funds, measured against an “energy equity” peer group. Here’s a quick snapshot of Salient (the blue line) against the two five-star funds (Advisory Research MLP & Energy Income INFIX and MLP & Energy Infrastructure MLPPX) and the first open-end fund to target MLPs (Oppenheimer SteelPath MLP Alpha MLPAX):

mlp

The quick conclusion is that Salient was one of the best MLP funds until autumn 2013, at which point it became the best one. I did not include the Alerian MLP index or any of the ETFs which track it because they lag so far behind the actively-managed funds. Over the past year, for example, Salient has outperformed the Alerian MLP Index – delivering 20% versus 15.5%.

High returns and substantial diversification. Sounds perfect. It isn’t, of course. Nothing is. MLP took a tremendous pounding in the 2007-09 meltdown when credit markets froze and dropped again in August 2013 during a short-lived panic over changes in MLP’s favorable tax treatment. And it’s certainly possible for individual MLPs to get bid up to fundamentally unattractive valuations.

Ted Gardner, Salient managerTed Gardner is the co‐portfolio manager for Salient’s MLP Complex, one manifestation of which is SMLPX. He oversees and coordinates all investment modeling, due diligence, company visits, and management conferences. Before joining Salient he was both Director of Research and a portfolio manager for RDG Capital and a research analyst with Raymond James. Here are his 200 words on why you should consider getting into the erl bidness:

Our portfolio management team has many years of experience with MLP investing, as managers and analysts, in private funds, CEFs and separate accounts. We considered both the state of the investment marketplace and our own experiences and thought it might translate well into an open-end product.

As far as what we saw in the marketplace, most of the funds out there exist inside a corporate wrapper. Unfortunately C-Corp funds are subject to double taxation and that can create a real draw on returns. We felt like going the traditional mutual fund, registered investment company route made a lot of sense.

We are very research-intensive, our four analysts and I all have a sell side background. We take cash flow modeling very seriously. It’s a fundamental modeling approach, modeling down to the segment levels to understand cash flows. And, historically, our analysts have done a pretty good job at it.

We think we do things a bit differently than many investors. What we like to see is visible growth, which means we’re less yield-oriented than others might be. We typically like partnerships that have a strategic asset footprint with a lot of organic growth opportunities or those with a dropdown story, where a parent company drops more assets into a partnership over time. We tend to avoid firms dependent on third-party acquisitions for growth. And we’ve liked investing in General Partners which have historically grown their dividends at approximately twice the rate of the underlying MLPs.

The fund has both institutional and retail share classes. The retail classes (SMAPX, SMPFX) nominally carry sales loads, but they’re available no-load/NTF at Schwab. The minimum for the load-waived “A” shares is $2,500. Expenses are 1.60% on about $630 million in assets. Here’s the fund’s homepage, but I’d recommend that you click through to the Literature tab to grab some of the printed documentation.

River Park/Gargoyle Hedged Value Conference Call Highlights

gargoyleOn February 12th we spoke for an hour with Alan Salzbank and Josh Parker, both of the Gargoyle Group, and Morty Schaja, CEO of RiverPark Funds. Here’s a brief recap of the highlights:

Alan handles the long portfolio. Josh, a securities lawyer by training, handles the options portfolio. He’s also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They have 35 and 25 years of experience, respectively, and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Morty has been investigating buy-write strategies since the mid-1980s and he described the Gargoyle guys as “the team I’ve been looking for for 25 years.”

The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month.

The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (P/B, P/E, P/CF, P/S) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the 100 more undervalued stocks, but maintain sector weightings that are close to the S&P 500’s.

The options portfolio is a collection of index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums.

Why index calls? Two reasons: (1) they are systematically mispriced, and so they always generate more profit than they theoretically should. In particular, they are overpriced by about 35 basis points/month 88% of the time. For sellers, that means something like a 35 bps free lunch. And (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their upside.

And it works. Their long portfolio has outperformed the S&P 500 by an average of 5% per year for 15 years. The entire strategy has outperformed the S&P in the long-term and has matched its returns, with less volatility, in the shorter term. Throughout, it has sort of clubbed its actively-managed long-short peers. It also anticipates clubbing the emerging bevy of buy-write ETFs.

rp gargoyle

The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month.

There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000-12, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P.

Except not so much in 2008. The fund’s maximum drawdown was 48%, between 10/07 and 03/08. The guys attributed that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback comes in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%.

The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble.

In general, the strategy fares poorest when the market has wild swings. It fares best in gently rising markets, since both the long and options portfolios can make money if the market rises but less than the strike price of the options – they can earn 2% a month on an option that’s triggered if the market rises by more than 1%. If the market rises but by less than 1%, they pay out nothing, pocket the 2% and pocket the capital appreciation from their long portfolio.

What’s the role of the fund in a portfolio? They view it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. For the guys, it’s 100% of their US equity exposure.

Morty Speaks!  The rationale for hedging a long-term portfolio.

The Gargoyle call sparked – here’s a surprise – considerable commentary on our discussion board. Some were impressed with Josh and Alan’s fortitude in maintaining their market exposure during the 2007-09 meltdown but others had a more quizzical response. “Expatsp” captured it this way: “Though this seems the best of the long/short bunch, I just don’t see the appeal of long/short funds for anyone who has a long-term horizon.

No.  Not Morty.

No. Not Morty.

There’s a great scene in Big Bang Theory where the brilliant but socially-inept Sheldon clears up a misunderstanding surrounding a comment he made about his roommate: “Ah, I understand the confusion. Uh, I have never said that you are not good at what you do. It’s just that what you do is not worth doing.” Same theme.

Morty Schaja, RiverPark’s president, is in an interesting position to comment on the question. His firm not only advises a pure long/short fund (RiverPark Long/Short Opportunity RLSFX) and a long hedged with options fund (RiverPark Gargoyle), but it also runs a very successful long-only fund (RiverPark Large Cap Growth RPXFX, which he describes as “our five-star secret weapon”).

With the obvious disclaimer that Morty has a stake in the success of all of the RiverPark funds (and the less-obvious note that he has invested deeply in each), we asked him the obvious question: Is it worth doing?

The question is simple. The answer is more complex.

I believe the market will rise over time and that over the long run investing in a long-only strategy makes investment sense. Most analysts stop there believing that a higher expected return is the driving factor and that volatility and risk are less relevant if you have the luxury of not needing the money over a long time period like ten years or greater. Yet, I believe allocating a portion of your investable assets in hedged strategies makes economic sense.

Why is that? I have a list of reasons:

  1. Limiting the downside adds to the upside: It’s the mathematics of compounding. Eliminating the substantial down drafts makes it easier to realize better long term average returns. For example, after a 30% decline you need to gain 42.85% to get back to even. A fund that goes up 20% every other year, and declines 10% every other year, averages 8.0% per year. In contrast, a fund that goes up 30% every other year and declines 20% every other year only averages 4.0% per year.  That’s why a strategy capturing, say, 80% of the market’s upside and 50% of its downside can, in the long term, produce greater returns than a pure equity strategy.
  2. Hedging creates an atmosphere of manageable, tolerable risk. Many studies of human nature show that we’re not nearly as brave as we think we are. We react to the pain of a 10% loss much more strongly than to the pleasure of a 10% gain. Hedged funds address that unquestioned behavioral bias. Smaller draw downs (peak to trough investment results) help decrease the fear factor and hopefully minimize the likelihood of selling at the bottom. And investors looking to increase their equity exposure may find it more tolerable to invest in hedged strategies where their investment is not fully exposed to the equity markets. This is especially true after the ferocious market rally we have experienced since the financial crisis.
  3. You gain the potential to play offense: Maintaining a portion of your assets in hedged strategies, like maintaining a cash position, will hopefully provide investors the funds to increase their equity exposure at times of market distress. Further, certain hedged strategies that change their exposure, either actively or passively, based on market conditions, allows the fund managers to play offense for your benefit.
  4. You never know how big the bear might be: The statistics don’t lie. The equity indices have historically experienced positive returns over rolling ten-year periods since we started collecting such data. Yet, there is no guarantee. It is not impossible that equities could enter a secular (that is, long-term) bear market and in such an environment long-only funds would arguably be at a distinct disadvantage to hedged strategies.

It’s no secret that hedged funds were originally the sole domain of very high net worth, very sophisticated investors. We think that the same logic that was compelling to the ultra-rich, and the same tools they relied on to preserve and grow their wealth, would benefit the folks we call “the mass affluent.”

 

Since RiverPark is one of the very few investment advisors to offer the whole range of hedged funds, I asked Morty to share a quick snapshot of each to illustrate how the different strategies are likely to play out in various sets of market conditions.

Let’s start with the RiverPark Long/Short Opportunity Fund.

Traditional long/short equity funds, such as the RiverPark Long/Short Opportunity Fund, involve a long portfolio of equities and a short book of securities that are sold short. In our case, we typically manage the portfolio to a net exposure of about 50%: typically 105%-120% invested on the long side, with a short position of typically 50%-75%. The manager, Mitch Rubin, manages the exposure based on market conditions and perceived opportunities, giving us the ability to play offense all of the time. Mitch likes the call the fund an all-weather fund; we have the ability to invest in cheap stocks and/or short expensive stocks. “There is always something to do”.

 

How does this compare with the RiverPark/Gargoyle Hedged Value Fund?

The RiverPark/Gargoyle Hedged Value Fund utilizes short index call options to hedge the portfolio. Broadly speaking this is a modified buy/write strategy. Like the traditional buy/write, the premium received from selling the call options provides a partial cushion against market losses and the tradeoff is that the Fund’s returns are partially capped during market rallies. Every month at options expiration the Fund will be reset to a net exposure of about 50%. The trade-off is that over short periods of time, the Fund only generates monthly options premiums of 1%-2% and therefore offers limited protection to sudden substantial market declines. Therefore, this strategy may be best utilized by investors that desire equity exposure, albeit with what we believe to be less risk, and intend to be long term investors.

 

And finally, tell us about the new Structural Alpha Fund.

The RiverPark Structural Alpha Fund was converted less than a year ago from its predecessor partnership structure. The Fund has exceptionally low volatility and is designed for investors that desire equity exposure but are really risk averse. The Fund has a number of similarities to the Gargoyle Fund but, on average the net exposure of the Fund is approximately 25%.

 

Is the Structural Alpha Fund an absolute return strategy?

In my opinion it has elements of what is often called an absolute return strategy. The Fund clearly employs strategies that are not correlated with the market. Specifically, the short straddles and strangles will generate positive returns when the market is range bound and will lose money when the market moves outside of a range on either the upside or downside. Its market short position will generate positive returns when the market declines and will lose money when the market rises. It should be less risky and more conservative than our other two hedge Funds, but will likely not keep pace as well as the other two funds in sharply rising markets.

Conference Call Upcoming

We haven’t scheduled a call for March. We only schedule calls when we can offer you the opportunity to speak with someone really interesting and articulate.  No one has reached that threshold this month, but we’ll keep looking on your behalf.

Conference call junkies might want to listen in on the next RiverNorth call, which focuses on the RiverNorth Managed Volatility Fund (RNBWX). Managed Volatility started life as RiverNorth Dynamic Buy-Write Fund. Long/short funds comes in three very distinct flavors, but are all lumped in the same performance category. For now, that works to the detriment of funds like Managed Volatility that rely on an options-based hedging strategy. The fund trails the long/short peer group since inception but has performed slightly better than the $8 billion Gateway Fund (GATEX). If you’re interested in the potential of an options-hedged portfolio, you’ll find the sign-up link on RiverNorth’s Events page.  The webcast takes place March 13, 2014 at 3:15 Central.

Launch Alert: Conestoga SMid Cap (CCSMX)

On February 28, 2014, Conestoga Mid Cap (CCMGX) ceased to be. Its liquidation was occasioned by negative assessments of its “asset size, strategic importance, current expenses and historical performance.” It trailed its peers in all seven calendar quarters since inception, in both rising and falling periods. With under $2 million in assets, its disappearance is not surprising.

Two things are surprising, however. First, its poor relative performance is surprising given the success of its sibling, Conestoga Small Cap (CCASX). CCASX is a four-star fund that received a “Silver” designation from Morningstar’s analysts. Morningstar lauds the stable management team, top-tier long-term returns, low volatility (its less volatile than 90% of its peers) and disciplined focus on high quality firms. And, in general, small cap teams have had little problem in applying their discipline successfully to slightly-larger firms.

Second, Conestoga’s decision to launch (on January 21, 2014) a new fund – SMid Cap – in virtually the same space is surprising, given their ability simply to tweak the existing fund. It smacks of an attempt to bury a bad record.

My conclusion after speaking with Mark Clewett, one of the Managing Directors at Conestoga: yeah, pretty much. But honorably.

Mark made two arguments.

  1. Conestoga fundamentally mis-fit its comparison group. Conestoga targeted stocks in the $2 – 10 billion market cap range. Both its Morningstar peers and its Russell Midcap Growth benchmark have substantial investments in stocks up to $20 billion. The substantial exposure to those large cap names in a mid-cap wrapper drove its peer’s performance.

    The evidence is consistent with that explanation. It’s clear from the portfolio data that Conestoga was a much purer mid-cap play that either its benchmark or its peer group.

    Portfolio

    Conestoga Mid Cap

    Russell Mid-cap Growth

    Mid-cap Growth Peers

    % large to mega cap

    0

    35

    23

    % mid cap

    86

    63

    63

    % small to micro cap

    14

    2

    14

    Average market cap

    5.1M

    10.4M

    8.4M

     By 2013, over 48% of the Russell index was stocks with market caps above $10 billion.

    Mark was able to pull the attribution data for Conestoga’s mid-cap composite, which this fund reflects. The performance picture is mixed: the composite outperformed its benchmark in 2010 and 2011, then trailed in 2013 and 2013. The fund’s holdings in the $2-5 billion and $5–10 billion bands sometimes outperformed their peers and sometimes trailed badly.

  2. Tweaking the old fund would not be in the shareholders’ best interest.  The changes would be expensive and time-consuming. They would, at the same time, leave the new fund with the old fund’s record; that would inevitably cause some hesitance on the part of prospective investors, which meant it would be longer before the fund reached an economically viable size.

The hope is that with a new and more appropriate benchmark, a stable management team, sensible discipline and clean slate, the fund will achieve some of the success that Small Cap’s enjoyed.  I’m hopeful but, for now, we’ll maintain a watchful, sympathetic silence.

Funds in Registration

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

Funds in registration this month are eligible to launch in late April or early May 2014 and some of the prospectuses do highlight that date.

This month David Welsch battled through wicked viruses and wicked snowstorms to track down eight funds in registration, one of the lowest totals since we launched three years ago.

The clear standout in the group is Dodge & Cox Global Bond, which the Dodge & Cox folks ran as “a private fund” since the end of December 2012.  It did really well in its one full year of operation – it gained 2.6% while its benchmark lost the same amount – and it comes with D&C’s signature low minimum, low expenses, low drama, team management.

Three other income funds are at least mildly interesting: Lazard Emerging Markets Income, Payden Strategic Income and Whitebox Unconstrained Income.

Manager Changes

On a related note, we also tracked down 50 sets of fund manager changes. The most intriguing of those include fallout from the pissing match at Pimco as Marc Seidner, an El-Erian ally, leaves to become GMO’s head of fixed-income operations.

Updates: The Observer here and there

I had a long conversation with a WSJ reporter which led to a short quotation in “Infrastructure funds are intriguing, but ….” The Wall Street Journal, Feb. 4 2014.  My bottom line was “infrastructure funds appear to be an incoherent mish-mash, with no two funds even agreeing on what sectors are worth including much less what stocks.  I don’t see any evidence of them adding value to a portfolio,” an observation prompted in part by T. Rowe Price’s decision to close their own Global Infrastructure fund. The writer, Lisa Ward, delicately quotes me as saying “you probably already own these same stocks in your other funds.” 

I was quoted as endorsing Artisan Global Small Cap (ARTWX) in Six promising new funds (though the subtitle might have been: “five of which I wouldn’t go near”), Kiplinger’s, Feb. 12 2014.  ARTWX draws on one of the most storied international management teams around, led by Mark Yockey.  The other funds profiled include three mutual funds and two ETFs.  The funds are Miller Income Opportunity (I’ve written elsewhere that “The whole enterprise leaves me feeling a little queasy since it looks either like Miller’s late-career attempt to prove that he’s not a dinosaur or Legg’s post-divorce sop to him”), Fidelity Event-Driven (FARNX: no record that Fido can actually execute with new funds anymore, much less with niche funds and untested managers), and Vanguard Global Minimum Volatility (VMVFX: meh – they work backward from a target risk level to see what returns they can generate).  The ETFs are two of the “smart beta” sorts of products, iShares MSCI USA Quality Factor (QUAL) and Schwab Fundamental U.S. Broad Market (FNDB). 

Finally, there was a very short piece entitled “Actively managed funds with low volatility,” in Bottom Line, Feb. 15 2014.  The publication is not online, at least not in an accessible form.  The editors were looking for funds with fairly well-established track records that have a tradition of low volatility.  I offered up Cook & Bynum Fund (COBYX, I’ve linked to our 2013 profile of them), FPA Crescent (FPACX, in which I’m invested) and Osterweis Fund (OSTWX).

Updates: Forbes discovers Beck, Mack & Oliver Partners (BMPEX)

Forbes rank a nice article on BMPEX, “Swinging at Strikes,” in their February 10, 2014 issue. Despite the lunacy of describing a $175 million fund as “puny” and “tiny,” the author turns up some fun facts to know and tell (the manager, Zac Wydra, was a premed student until he discovered that the sight of blood made him queasy) and gets the fund’s basic discipline right. Zac offers some fairly lively commentary in his Q4 shareholder letter, including a nice swipe at British haughtiness and a reflection on the fact that the S&P 500 is at an all-time high at the same time that the number of S&P 500 firms issuing negative guidance is near an all-time high.

Briefly Noted . . .

BlackRock has added the BlackRock Emerging Markets Long/Short Equity Fund (BLSAX) and the BlackRock Global Long/Short Equity Fund (BDMAX) as part of the constituent fund lineup in its Aggressive Growth, Conservative , Growth and Moderate Prepared Portfolios, and its Lifepath Active-Date series. Global has actually made some money for its investors, which EM has pretty much flatlined while the emerging markets have risen over its lifetime.  No word on a target allocation for either.

Effective May 1, Chou Income (CHOIX) will add preferred stocks to the list of their principal investments: “fixed-income securities, financial instruments that provide exposure to fixed-income securities, and preferred stocks.” Morningstar categorizes CHOIX as a World Bond fund despite the fact that bonds are less than 20% of its current portfolio and non-U.S. bonds are less than 3% of it.

Rydex executed reverse share splits on 13 of its funds in February. Investors received one new share for between three and seven old shares, depending on the fund.

Direxion will follow the same path on March 14, 2014 with five of their funds. They’re executing reverse splits on three bear funds and splits on two bulls.  They are: 

Fund Name

Reverse Split

Ratio

Direxion Monthly S&P 500® Bear 2X Fund

1 for 4

Direxion Monthly 7-10 Year Treasury Bear 2X Fund

1 for 7

Direxion Monthly Small Cap Bear 2X Fund

1 for 13

 

Fund Name

Forward Split

Ratio

Direxion Monthly Small Cap Bull 2X Fund

2 for 1

Direxion Monthly NASDAQ-100® Bull 2X Fund

5 for 1

 SMALL WINS FOR INVESTORS

Auxier Focus (AUXIX) is reducing the minimum initial investment for their Institutional shares from $250,000 to $100,000. Investor and “A” shares remain at $5,000. The institutional shares cost 25 basis points less than the others.

TFS Market Neutral Fund (TFSMX) reopened to new investors on March 1, 2014.

At the end of January, Whitebox eliminated its Advisor share class and dropped the sales load on Whitebox Tactical. Their explanation: “The elimination of the Advisor share class was basically to streamline share classes … eliminating the front load was in the best interest of our clients.” The first makes sense; the second is a bit disingenuous. I’m doubtful that Whitebox imposed a sales load because it was “in the best interest of our clients” and I likewise doubt that’s the reason for its elimination.

CLOSINGS (and related inconveniences)

Artisan Global Value (ARTGX) closed on Valentine’s Day.

Grandeur Peak will soft close the Emerging Markets Opportunities (GPEOX) and hard close the Global Opportunities (GPGOX) and International Opportunities (GPIOX) strategies on March 5, 2014.

 Effective March 5, 2014, Invesco Select Companies Fund (ATIAX) will close to all investors.

Vanguard Admiral Treasury Money Market Fund (VUSSX) is really, really closed.  It will “no longer accept additional investments from any financial advisor, intermediary, or institutional accounts, including those of defined contribution plans. Furthermore, the Fund is no longer available as an investment option for defined contribution plans. The Fund is closed to new accounts and will remain closed until further notice.”  So there.

OLD WINE, NEW BOTTLES

Effective as of March 21, 2014, Brown Advisory Emerging Markets Fund (BIAQX) is being changed to the Brown Advisory – Somerset Emerging Markets Fund. The investment objective and the investment strategies of the Fund are not being changed in connection with the name change for the Fund and the current portfolio managers will continue. At the same time, Brown Advisory Strategic European Equity Fund (BIAHX) becomes Brown Advisory -WMC Strategic European Equity Fund.

Burnham Financial Industries Fund has been renamed Burnham Financial Long/Short Fund (BURFX).  It’s a tiny fund (with a sales load and high expenses) that’s been around for a decade.  It’s hard to know what to make of it since “long/short financial” is a pretty small niche with few other players.

Caritas All-Cap Growth Fund has become Goodwood SMID Cap Discovery Fund (GAMAX), a name that my 13-year-old keeps snickering at.  It’s been a pretty mediocre fund which gained new managers in October.

Compass EMP Commodity Long/Short Strategies Fund (CCNAX) is slated to become Compass EMP Commodity Strategies Enhanced Volatility Weighted Fund in May. Its objective will change to “match the performance of the CEMP Commodity Long/Cash Volatility Weighted Index.”  It’s not easily searchable by name at Morningstar because they’ve changed the name in their index but not on the fund’s profile.

Eaton Vance Institutional Emerging Markets Local Debt Fund (EELDX) has been renamed Eaton Vance Institutional Emerging Markets Debt Fund and is now a bit less local.

Frost Diversified Strategies and Strategic Balanced are hitting the “reset” button in a major way. On March 31, 2014, they change name, objective and strategy. Frost Diversified Strategies (FDSFX) becomes Frost Conservative Allocation while Strategic Balanced (FASTX) becomes Moderate Allocation. Both become funds-of-funds and discover a newfound delight in “total return consistent with their allocation strategy.” Diversified currently is a sort of long/short, ETFs, funds and stocks, options mess … $4 million in assets, high expense, high turnover, indifferent returns, limited protection. Strategic Balanced, with a relatively high downside capture, is a bit bigger and a bit calmer but ….

Effective on or about May 30, 2014, Hartford Balanced Allocation Fund (HBAAX) will be changed to Hartford Moderate Allocation Fund.

At the same time, Hartford Global Research Fund (HLEAX) becomes Hartford Global Equity Income Fund, with a so far unexplained “change to the Fund’s investment goal.” 

Effective March 31, 2014, MFS High Yield Opportunities Fund (MHOAX) will change its name to MFS Global High Yield Fund.

In mid-February, Northern Enhanced Large Cap Fund (NOLCX) became Northern Large Cap Core Fund though, at last check, Morningstar hadn’t noticed. Nice little fund, by the way.

Speaking of not noticing, the folks at Whitebox have accused of us ignoring “one of the most important changes we made, which is Whitebox Long Short Equity Fund is now the Whitebox Market Neutral Equity Fund.” We look alternately chastened by our negligence and excited to report such consequential news.

OFF TO THE DUSTBIN OF HISTORY

BCM Decathlon Conservative Portfolio, BCM Decathlon Moderate Portfolio and BCM Decathlon Aggressive Portfolio have decided that they can best serve their shareholders by liquidating.  The event is scheduled for April 14, 2014.

BlackRock International Bond Portfolio (BIIAX) has closed and will liquidate on March 14, 2014.  A good move given the fund’s dismal record, though you’d imagine that a firm with BlackRock’s footprint would want a fund of this name.

Pending shareholder approval, City National Rochdale Diversified Equity Fund (AHDEX) will merge into City National Rochdale U.S. Core Equity Fund (CNRVX) of the Trust. I rather like the honesty of their explanation to shareholders:

This reorganization is being proposed, among other reasons, to reduce the annual operating expenses borne by shareholders of the Diversified Fund. CNR does not expect significant future in-flows to the Diversified Fund and anticipates the assets of the Diversified Fund may continue to decrease in the future. The Core Fund has significantly more assets [and] … a significantly lower annual expense ratio.

Goldman Sachs Income Strategies Portfolio merged “with and into” the Goldman Sachs Satellite Strategies Portfolio (GXSAX) and Goldman Sachs China Equity Fund with and into the Goldman Sachs Asia Equity Fund (GSAGX) in mid-February.

Huntington Rotating Markets Fund (HRIAX) has closed and will liquidate by March 28, 2014.

Shareholders of Ivy Asset Strategy New Opportunities Fund (INOAX) have been urged to approve the merger of their fund into Ivy Emerging Markets Equity Fund (IPOAX).  The disappearing fund is badly awful but the merger is curious because INOAX is not primarily an emerging markets fund; its current portfolio is split between developed and developing.

The Board of Trustees of the JPMorgan Ex-G4 Currency Strategies Fund (EXGAX) has approved the liquidation and dissolution of the Fund on or about March 10, 2014.  The “strategies” in question appear to involve thrashing around without appreciable gain.

After an entire year of operation (!), the KKR Board of Trustees of the Fund approved a Plan of Liquidation with respect to KKR Alternative Corporate Opportunities Fund (XKCPX) and KKR Alternative High Yield Fund (KHYZX). Accordingly, the Fund will be liquidated in accordance with the Plan on or about March 31, 2014 or as soon as practicable thereafter. 

Loomis Sayles Mid Cap Growth Fund (LAGRX) will be liquidated on March 14th, a surprisingly fast execution given that the Board approved the action just the month before.

On February 13, 2014, the shareholders of the Quaker Small Cap Growth Tactical Allocation Fund (QGASX) approved the liquidation and dissolution of the Fund. 

In Closing . . .

We asked you folks, in January, what made the Observer worthwhile.  That is, what did we offer that brought you back each month?  We poured your answers into a Wordle in hopes of capturing the spirit of the 300 or so responses.

wordle

Three themes recurred:  (1) the Observer is independent. We’re not trying to sell you anything.  We’re not trying to please advertisers. We’re not desperate to write inflated drivel in order to maximize clicks. We don’t have a hidden agenda. 

(2) We talk about things that other folks do not. There’s a lot of appreciation for our willingness to ferret out smaller, emerging managers and to bring them to you in a variety of formats. There’s also some appreciate of our willingness to step back from the fray and try to talk about important long-term issues rather than sexy short-term ones.

(3) We’re funny. Or weird. Perhaps snarky, opinionated, cranky and, on a good day, curmudgeonly.

And that helps us a lot.  As we plan for the future of the Observer, we’re thinking through two big questions: where should we be going and how can we get there? We’ll write a bit next time about your answer to the final question: what should we be doing that we aren’t (yet)?

We’ve made a couple changes under the hood to make the Observer stronger and more reliable.  We’ve completed our migration to a new virtual private server at Green Geeks, which should help with reliability and allow us to handle a lot more traffic.  (We hit records again in January and February.)  We also upgraded the software that runs our discussion board.  It gives the board better security and a fresher look.  If you’ve got a bookmarked link to the discussion board, we need you to reset your link to http://www.mutualfundobserver.com/discuss/discussions.  If you use your old bookmark you’ll just end up on a redirect page.  

In April we celebrate our third anniversary. Old, for a website nowadays, and so we thought we’d solicit the insights of some of the Grand Old Men of the industry: well-seasoned, sometimes storied managers who struck out on their own after long careers in large firms. We’re trying hard to wheedle our colleague Ed, who left Oakmark full of years and honors, to lead the effort. While he’s at that, we’re planning to look again at the emerging markets and the almost laughable frenzy of commentary on “the bloodbath in the emerging markets.”  (Uhh … Vanguard’s Emerging Market Index has dropped 8% in a year. That’s not a bloodbath. It’s not even a correction. It’s a damned annoyance. And, too, talking about “the emerging markets” makes about as much analytic sense as talking about “the white people.”  It’s not one big undifferentiated mass).  We’ve been looking at fund flow data and Morningstar’s “buy the unloved” strategy.  Mr. Studzinski has become curious, a bit, about Martin Focused Value (MFVRX) and the arguments that have led them to a 90% cash stake. We’ll look into it.

Please do bookmark our Amazon link.  Every bit helps! 

 As ever,

David

Guinness Atkinson Dividend Builder (GAINX), March 2014

By David Snowball

*This fund has been converted into an ETF (February 2021)*

Objective and Strategy

Guinness Atkinson Inflation Managed Dividend seeks consistent dividend growth at a rate greater than the rate of inflation by investing in a global portfolio of about 30 dividend paying stocks. Stocks in the portfolio have survived four screens, one for business quality and three for valuation. They are:

  1. They first identify dividend-paying companies that have provided an inflation-adjusted cash flow return on investment of at least 10% in each of the last 10 years. (That process reduces the potential field from 14,000 companies to about 400.) That’s the “10 over 10” strategy that they refer to often.
  2. They screen for companies with at least a moderate dividend yield, a history of rising dividends, low levels of debt and a low payout ratio.
  3. They do rigorous fundamental analysis of each firm, including reflections on macro issues and the state of the company’s business.
  4. They invest in the 35 most attractively valued stocks that survived those screens and weight each equally in the portfolio.

Active share is a measure of a portfolio’s independence, the degree to which is differs from its benchmark. In general, for a fund with a large cap bias, a value above 70 is desirable. The most recent calculation (February 2014) places this fund’s active share at 92.

Adviser

Guinness Atkinson Asset Management. The firm started in 1993 as the US arm of Guinness Flight Global Asset Management and their first American funds were Guinness Flight China and Hong Kong (1994) and Asia Focus (1996). Guinness Flight was acquired by Investec, then Tim Guinness and Jim Atkinson’s acquired Investec’s US funds business to form Guinness Atkinson. Their London-based sister company is Guinness Asset Management which runs European funds that parallel the U.S. ones. The U.S. operation has about $375 million in assets under management and advises the eight GA funds.

Manager

Ian Mortimer and Matthew Page. Dr. Mortimer joined GA in 2006 and also co-manages the Global Innovators (IWIRX) fund. Prior to joining GA, he completed a doctorate in experimental physics at the University of Oxford. Mr. Page joined GA in 2005 and working for Goldman Sachs. He earned an M.A. from Oxford in 2004. The guys also co-manage European versions of their funds including the Dublin-based version of this one, called Guinness Global Equity Income.

Strategy capacity and closure

About $1 billion. The smallest stock the fund will invest in is about $1 billion. With a compact, equal-weighted portfolio, having much more than $1 billion in the strategy would impede their ability to invest in their smallest targeted names.

Management’s stake in the fund

It’s a little complicated. The managers, both residents of England, do not own shares of the American version of the fund but both do own shares of the European version. That provides the same portfolio, but a different legal structure and far better tax treatment. Matt avers “it’s most of my pension pot.” Corporately Guinness Atkinson has about $180,000 invested in the fund and, separately, President Jim Atkinson appears to be the fund’s largest shareholder

Opening date

March 30, 2012. The European version of the fund is about a year older.

Minimum investment

$10,000, reduced to $5,000 for IRAs. There are lower minimums at some brokerages. Schwab, for example, has the fund NTF for $2500 for regular accounts and $1000 for IRAs. Fidelity requires $2500 for either sort of account.

Expense ratio

0.68% on assets of $3 million (as of February 2014). That’s competitive with the ETFs in the same space and lower than the ETNs.

Comments

There are, in general, two flavors of value investing: buy cigar butts on the cheap (wretched companies whose stocks more than discount their misery) or buy great companies at good prices. GAINX is firmly in the latter camp. Many investors share their enthusiasm for the sorts of great firms that Morningstar designates as having “wide moats.”

The question is: how can we best determine what qualifies as a “great company”? Most investors, Morningstar included, rely on a series of qualitative judgments about the quality of management, entry barriers, irreproducible niches and so on. Messrs. Mortimer and Page start with a simpler, more objective premise: great companies consistently produce great results. They believe the best measurement of “great results” is high and consistent cash flow return on investment (CFROI). In its simplest terms, CFROI asks “when a firm invests, say, a million dollars, how much additional cash flow does that investment create?” Crafty managers like cash flow calculations because they’re harder for firms to manipulate than are the many flavors of earnings. One proof of its validity is the fact that a firm’s own management will generally use CFROI – often called the internal rate of return – to determine whether a project, expansion or acquisition is worth undertaking. If you invest a million and get $10,000 in cash flows the first year, your CFROI is 1%. At that rate, it would take the firm a century to recoup its investment.

The GAINX managers set a high and objective initial bar: firms must be paying a dividend and must have a CFROI greater than 10% in each of the past 10 years. Only about 3% of all publicly-traded companies clear that hurdle. Cyclical firms whose fortunes soar and dive disappear from the pool, as well as many utilities and telecomm firms whose “excess” returns get regulated away. More importantly, they screen out firms whose management do not consistently and substantially add demonstrable value. That 3% are, by their standards, great companies.

One important signal that they’ve found a valid measure of a firm’s quality is the stability of the list. About 95% of the stocks that qualify this year will qualify next year as well, and about 80% will continue to qualify four years hence. This helps contribute to the fund’s very low turnover rate, 13%.

Because such firms tend to see their stocks bid up, the guys then apply a series of valuation and financial stability screens as well as fundamental analyses of the firm’s industry and challenges. In the end they select the 30-35 most attractively valued names in their pool. That value-consciousness led them to add defense contractors when they hit 10 year valuation lows in the midst of rumors of defense cutbacks and H&R Block when the specter of tax simplification loomed. Overall, the portfolio sells at about a 9% discount to the MSCI World index despite holding higher-quality firms.

The fund has done well since inception: from inception through December 30, 2013, $10,000 in GAINX would have grown to $13,600 versus $12,900 in its average global stock peer. In that same period the fund outperformed its peers in five of six months when the peer group lost money.

The fund underperformed in the first two months of 2014 for a surprising reason: volatility in the emerging markets. While the fund owns very few firms domiciled in the emerging markets, about 25% of the total revenues of all of their portfolios firms are generated in the emerging markets. That’s a powerful source of long-term growth but also a palpable drag during short-term panics; in particular, top holding Aberdeen Asset Management took a huge hit in January because of the performance of their emerging markets investments.

Bottom Line

The fund strives for two things: investments in great firms and a moderate, growing income stream (current 2.9%) that might help investors in a yield-starved world. Their selection criteria strike us as distinctive, objective, rigorous and reasonable, giving them structural advantages over both passive products and the great majority of their active-managed peers. While no investment thrives in every market, this one has the hallmarks of an exceptional, long-term holding. Investors worried about the fund’s tiny U.S. asset base should take comfort from the fact that the strategy is actually around $80 million when you account for the fund’s Dublin-domiciled version.

Fund website

Guinness Atkinson Inflation-Managed Dividend. Folks interested in the underlying strategy might want to read their white paper, 10 over 10 Investment Strategy. The managers offered a really nice portfolio update, in February 2014, for their European investors.

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

Intrepid Income (ICMUX), March 2014

By David Snowball

Objective and strategy

The fund is pursuing both high current income and capital appreciation. The fund primarily invests in shorter-term high-yield corporate bonds, bank debt, convertibles and U.S. government securities. They have the option of buying a wider array of income-producing securities, including investment-grade debt, dividend-paying common or preferred stock. It shifts between security types based on what the manager’s believe offers the best risk-adjusted prospective returns and is also willing to hold cash. The portfolio is generally very concentrated. 

Adviser

Intrepid Capital Management of Jacksonville Beach, Florida. Intrepid, founded in 1994, primarily serves high net worth individuals.  As of December 30, 2013, it had $1.4 billion in assets under management. Intrepid advises the four Intrepid funds (Capital, Small Cap, Disciplined Value and Income).

Manager

Jason Lazarus, with the help of Ben Franklin, and Mark Travis. Messrs. Franklin and Lazarus joined Intrepid in 2008 after having completed master’s degrees at the University of North Florida and Florida, respectively. Mr. Travis is a founding partner and has been at Intrepid Capital since 1994. Before that, he was Vice President of the Consulting Group of Smith Barney and its predecessor firms for ten years.

Strategy capacity and closure

The managers estimate they might be able to handle up to $1 billion in this strategy. Currently the strategy manifests itself here, in balanced separate accounts and in the fixed-income portion of Intrepid Capital Fund (ICMBX/ICMVX).  In total, they’re currently managing about $300 million.   

Management’s stake in the fund

All of the managers have investments in the fund. Mr. Lazarus has invested between $50,000 – 100,000; Mr. Franklin has invested between $10,000 – 50,000 and Mr. Travis has between $100,000 – 500,000. That strikes me as entirely reasonable for relatively young investors committing to a relatively conservative fund.

Opening date

You get your pick! The High-Yield Fixed Income strategy, originally open only to private clients, was launched on April 30, 1999.  The fund’s Investor class was launched on July 2, 2007 and the original Institutional class on August 16, 2010.

Minimum investment

$2,500.  On January 30, 2014, the Investor and Institutional share classes of the fund were merged. Technically the surviving fund is institutional, but it now carries the low minimum formerly associated with the Investor class.

Expense ratio

0.90% on assets of $106 million. With the January 2014 merger, retail investors saw a 25 bps reduction in their fees, which we celebrate.

Comments

There are some very honorable ways to end up with a one-star rating from Morningstar.  Being stubbornly out-of-step with the herd is one path, being assigned to an inappropriate peer group is another. 

There are a number of very good conservative managers running short-term high yield bond funds who’ve ended up with one star because their risk-return profiles are so dissimilar from their high-yield bond peer group.  Few approach the distinction with as much panache as Intrepid Income:

intrepid

Why the apparent lack of concern for a stinging and costly badge? Two reasons, really. First, Intrepid was founded on the value of independence from the investment herd. Mr. Lazarus reports that “the firm is set up to avoid career risk which frequently leads to closet-indexing.  Mark and his dad [Forrest] started it, Mark believes in the long-term so managers are evaluated on process rather than on short-term outcomes. If the process is right but the returns don’t match the herd in the short term, he doesn’t care.”  Their goal, and expectation, is to outperform in the long-term. And so, doing the right thing seems to be a more important value than getting recognized.

In support of that observation, we’ll note that Intrepid once employed the famously independent Eric Cinnamond, now of Aston/River Road Independent Value (ARIVX), as a manager – including on this fund.

Second, they recognize that their Morningstar rating does not reflect the success of their strategy. Their intention was to provide reasonable return without taking unnecessary risks. In an environment where investment-grade bonds look to return next-to-nothing (by GMO’s most recent calculations, the aggregate US bond market is priced to provide a real – after inflation – yield of 0.4% annually for the remainder of the decade), generating a positive real return requires looking at non-investment-grade bonds (or, in some instances, dividend-paying equities). 

They control risk – which they define as “losing money” or “permanent loss of capital,” as opposed to short-term volatility – in a couple ways.

First, they need to adopt an absolute value discipline – that is, a willingness both to look hard for mispriced securities and to hold cash when there are no compelling options in the securities market – in order to avoid the risk of permanent impairment of capital. That generally leads them to issuers in healthy industries, with predictable free cash flow and tangible assets. It also leads to higher-quality bonds which yield a bit less but are much more reliable.

Second, they tend to invest in shorter-term bonds in order to minimize interest rate risk. 

If you put those pieces together well, you end up with a low volatility fund that might earn 3.5 to 4.5% in pricey markets and a multiple of that in attractively valued ones. Because they’ve never had a bond default and they rarely sell their bonds before they’re redeemed (Mr. Lazarus recalls that “I can count on two hands the number of core bond positions we’ve sold in the past five years,” though he also allows that they’ve sold some small “opportunistic” positions in things like convertibles), they can afford to ignore the day-to-day noise in the market. 

In short, you end up with Intrepid Income, a fund which might comfortably serve as “a big part of your mother’s retirement account” and which “lots of private clients use as their core fixed-income fund.”

In both the short- and long-term, their record is excellent.  The longest-term picture comes from looking at the nearly 15 year record of the High-Yield Fixed Income strategy which is manifested both in separate accounts and, for the past seven years, in this fund.

riskreturn 

Since inception, the strategy has earned 7.25% annually, trailing the Merrill Lynch high-yield index by just 38 basis points.  That’s about 94% of the index’s total return with about 60% of its volatility.  Over most shorter periods (in the three to ten year range), annual returns have been closer to 5-6%.

In the shorter term, we can look at the risks and returns of the fund itself.  Here’s Intrepid Income charted against its high-yield peer group.

intrepid chart 

By every measure, that’s a picture of very responsible stewardship of their shareholders’ money.  The fund’s beta is around 0.25, meaning that it is about one-fourth as volatile as its peers. Its standard deviation from inception to January 2014 is just 5.52 while its peers are around nine. Its maximum drawdown – 14.6% – occurred over a period of just three months (September – November 2008) before the fund began rebounding. 

Bottom Line

The fund’s careful, absolute value focus – shorter term, higher quality high-yield bonds and the willingness to hold cash when no compelling values present themselves – means that it will rarely keep up with its longer-term, lower quality, fully invested peer group.

And that’s good. By the Observer’s calculation, Intrepid Income qualifies as a “Great Owl” fund. That’s determined by looking at the fund’s risk-adjusted returns (measured by the fund’s Martin Ratio) for every period longer than one year and then recognizing only funds which are in the top 20% for every period. Intrepid is one of the few high-yield funds that have earned that distinction. While this is not a cash management account, it seems entirely appropriate for conservative investors who are looking for real absolute returns and have a time horizon of at least three to five years. You owe it to yourself to look beyond the star rating to the considerable virtues the fund holds.

Fund website

We think it’s entirely worth looking at both the Intrepid Income Fund homepage and the homepage for the underlying High-Yield Fixed Income strategy. Because the strategy has a longer public record and a more sophisticated client base, the information presented there is a nice complement to the fund’s documentation.

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

Driehaus Emerging Markets Small Cap Growth Fund (DRESX), March, 2014

By David Snowball

Objective and strategy

Driehaus Emerging Markets Small Cap Growth Fund seeks superior risk-adjusted returns over full market cycles relative to those of the MSCI Emerging Markets Small Cap Index. The managers combine about 100 small cap names with an actively-managed portfolio hedge. They create the hedge by purchasing sector, country, or broad market index options, generally. 

Adviser

Driehaus Capital Management is a privately-held investment management firm based in Chicago.  They have about $12 billion in assets under management as of January 31, 2014. The firm manages five broad sets of strategies (global, emerging markets, and U.S. growth equity, hedged equity, and alternative investment) for a global collection of institutional investors, family offices, and financial advisors. Driehaus also advises the 10 Driehaus funds which have about $8 billion in assets between them, more than half of that in Driehaus Active Income (LCMAX, closed) and 90% in three funds (LCMAX, Driehaus Select Credit DRSLX, also closed and Driehaus Emerging Markets Growth DREGX).

Managers

Chad Cleaver and Howard Schwab. Mr. Cleaver is the lead manager on this fund and co-manager for the Emerging Markets Growth strategy. He’s responsible for the strategy’s portfolio construction and buy/sell decisions. He began his career with the Board of Governors of the Federal Reserve System and joined Driehaus Capital Management in 2004.  Mr. Schwab is the lead portfolio manager for the Emerging Markets Growth strategy and co-manager here and with the International Small Cap Growth strategy. In his role as lead portfolio manager, Mr. Schwab is responsible for the strategy’s portfolio construction. As co-manager he oversees the research team and evaluates investment ideas. He is also involved in analyzing macro-level trends and associated market risks. Mr. Schwab joined Driehaus Capital Management in 2001. Both of the managers have undergraduate degrees from strong liberal arts colleges, as well as the requisite graduate degrees and certifications.

Strategy capacity and closure

Between $600 – 800 million, at which point the firm would soft-close the fund as they’ve done to several others. DRESX is the only manifestation of the strategy.

Active Share

Active share is a measure of a portfolio’s independence, the degree to which is differs from its benchmark. The combination of agnosticism about their benchmark, fundamental security selection that often identifies out-of-index names and their calls typically results in a high active share. The most recent calculation (February 2014) places it at 96.4.

Management’s stake in the fund

Each of the managers has invested between $100,000 and $500,000 in the fund. They have a comparable amount invested in the Emerging Markets Growth Fund (DREGX), which they also co-manage. As of March 2013, insiders own 23% of the fund shares, including 8.4% held by the Driehaus Family Partnership.

Opening date

The fund began life on December 1, 2008 as Driehaus Emerging Markets Small Cap Growth Fund, L.P. It converted to a mutual fund on August 22, 2011.

Minimum investment

$10,000, reduced to $2000 for IRAs.

Expense ratio

1.25%, after waivers, on assets of $109.5 million (as of July 2023). 

Comments

Emerging markets small cap stocks are underappreciated. The common stereotype is just like other emerging markets stocks, only more so: more growth, more volatility, more thrills, more chills.

That stereotype is wrong. Stock ownership derives value from the call it gives you on a firm’s earnings, and the characteristic of EM small cap earnings are fundamentally and substantially different from those of larger EM firms. In particular, EM small caps represent, or offer:

Different countries: not all countries are equally amenable to entrepreneurship. In Russia, for instance, 60% of the market capitalization is in just five large firms. In Brazil, it’s closer to 25%.

Different sectors: small caps are generally not in sectors that require huge capital outlays or provide large economies of scale. They’re substantially underrepresented in the energy and telecom sectors but overrepresented in manufacturing, consumer stocks and health care.

More local exposure: the small cap sectors tend to be driven by relatively local demand and conditions, rather than global macro-factors. On whole EM small caps derive about 24% of their earnings from international markets (including their immediate neighbors) while EM large caps have a 50% greater exposure. As a result, about 20% of the volatility in global cap small stocks is explained by macro factors, compared to 33% for all global stocks.

Higher dividends: EM small caps, as a group, pay about 3.2% while large caps pay 3.0%.

Greater insider ownership: about 44% of the stock for EM small caps is held by corporate insiders against 34% for larger EM stocks. The more important question might be who doesn’t own EM small caps. “State-owned enterprises” are more commonly larger firms whose financial decisions may be driven more by the government’s needs than the private investors’.  Only 2% of the stock of EM small caps is owned by local governments.

Historically higher returns: from 2001-2013, EM small caps returned 12.7% annually versus 11.1% for EM large caps and 3.7% for US large caps.

But, oddly, slower growth (11.2% EPS growth versus 12.2% for all EM) and comparable volatility (26.1 SD versus 24.4 for large caps).

The data understates the magnitude of those differences because of biases built into EM indexes.  Those indexes are created to support exchange-traded and other passive investment products (no one builds indexes just for the heck of it). In order to be useful, they have to be built to support massive, rapid trades so that if a hedge fund wants to plunk a couple hundred million into EM small caps this morning and get back out in the afternoon, it can. To accommodate that, indexes build in liquidity, scalability and tradeability screens. That means indexes (hence ETFs) exclude about 600 publicly-traded EM small caps – about 25% of that universe – and those microcap names are among the firms least like the larger-cap indexes.

The downfall of EM small caps comes as a result of liquidity crises: street protests in Turkey, a corporate failure in Mexico, a somber statement by a bank in Malaysia and suddenly institutional investors are dumping baskets of stocks, driving down the good with the bad and driving small stocks down most of all. Templeton Emerging Markets Small Cap (TEMMX), for example, lost 66% of its value during the 2007-09 crash.

Driehaus thinks it has a way to harness the substantial and intriguing potential of EM small caps while buffering a chunk of the downside risk. Their strategy has two elements.

They construct a long portfolio of about 100 stocks.  In general they’re looking for firms at “growth inflection points.”  The translation is stocks where a change in the price trend is foreseeable. They often draw on insights from behavioral finance to identify securities mispriced because of investor biases in reacting to changes in the magnitude, acceleration or duration of growth prospects.

They hedge the portfolio with options. They call purchase or write options on ETFs, or short ETFs when no option is available. The extent of the hedge varies with market conditions; a 10-40% hedge would be in the normal range. In general they attempt to hedge country, sector and market risk. They can use options strategies offensively but mostly they’re for defense.

The available evidence suggests their strategy works well. Really well.  Really, really well.  Over the past three years (through 12/30/13), the fund has excelled in all of the standard risk metrics when benchmarked against the MSCI Emerging Markets Small Cap Index.

 

Driehaus

MSCI EM Small Cap

Beta

0.73

1.00

Standard deviation

16.2

19.1

Downside deviation

11.9

15.0

Downside capture

56.4%

100%

# negative months

11

18

The strategy of winning-by-not-losing has been vastly profitable over the past three, volatile years.  Between January 2011 – December 2013, DRESX returned 7.4% annually while its EM small cap peers lost 3.2% and EM stocks overall dropped 1.7% annually.

The universal question is, “but aren’t there cheaper, passive alternatives?”  There are four or five EM small cap ETFs.  They are, on whole, inferior to Driehaus. While they boast lower expenses, they’re marred by inferior portfolios designed for tradeability rather than value, and inferior performance.  Here’s the past three years of DRESX (the blue line) and the SPDR, WisdomTree and iShares ETFs:

dresx chart

Bottom Line

For long-term investors, substantial emerging markets exposure makes sense. Actively managing that investment to avoid the substantial, inherent biases which afflict EM indexes, and the passive products built around them, makes sense. In general, that means that the most attractive corner of the EM universe – measured by both fundamentals and diversification value – are smaller cap stocks.  There are only 18 funds oriented to small- and mid-cap EM stocks and just seven true small caps.  Driehaus’s careful portfolio construction and effective hedging should put them high on any EM investor’s due diligence list. They’ve done really first-rate work. 

Fund website

The Driehaus Emerging Markets Small Cap Growth homepage links to an embarrassing richness of information on the fund, its portfolio and its performance. The country-by-country attribution tables are, for the average investor, probably a bit much but the statistical information is unmatched.

Much of the information on EM small caps as a group was presented in two MSCI research papers, “Adding Global Small Caps: The New Investable Equity Opportunity Set?” (October 2012) and “Small Caps – No Small Oversight: Institutional Investors and Global Small Cap Equities” (March 2012). Both are available from MSCI but require free registration and I felt it unfair to link directly to them. In addition, Advisory Research has a nice summary of the EM small cap distinctions in a short marketing piece entitled “Investing in value oriented emerging market small cap and mid cap equities” (October 2013). 

© Mutual Fund Observer, 2014. All rights reserved. The information here reflects publicly available information current at the time of publication. For reprint/e-rights contact us.

Morningstar’s Risk Adjusted Return Measure

By Charles Boccadoro

Originally published in March 1, 2014 Commentary

Central to any fund rating system is the performance measure used to determine percentile rank order. MFO uses Martin ratio, as described Rating System Definitions. Morningstar developed its own risk adjusted return (MRAR), which Nobel Laureate William Sharpe once described as a measure that “…differs significantly from more traditional ones such as various forms of the Sharpe ratio.” While the professor referred to an earlier version of MRAR, the same holds true today.

Here is how Morningstar describes MRAR on its Data FAQ page: Morningstar adjusts for risk by calculating a risk penalty for each fund based on “expected utility theory,” a commonly used method of economic analysis. Although the math is complex, the basic concept is relatively straightforward. It assumes that investors are more concerned about a possible poor outcome than an unexpectedly good outcome and that those investors are willing to give up a small portion of an investment’s expected return in exchange for greater certainty. A “risk penalty” is subtracted from each fund’s total return, based on the variation in its month-to-month return during the rating period, with an emphasis on downward variation. The greater the variation, the larger the penalty. If two funds have the exact same return, the one with more variation in its return is given the larger risk penalty.

For the curious and mathematically inclined, the detailed equations are well documented in The Morningstar Rating Methodology. The following figure illustrates how MRAR behaves for three hypothetical funds over a 3 year period ending Dec 2013:

hypothetical fundsfund012

Each fund in the illustration delivers the same total return, but with varying levels of volatility. The higher the volatility, the lower the risk adjusted return. Fund 0 delivers consistent returns every month with zero volatility; consequently, it receives the highest MRAR, which in this case is the fund’s annualized total return minus the risk-free T-Bill (i.e., it’s the annualized “excess” return).

Morningstar computes MRAR for all funds over equivalent periods, and then percentile ranks them within their respective categories to assign appropriate levels, 1 star for those funds in the lowest group and the coveted 5 star rating for the highest.

It also computes a risk measure MRisk and performs a similar ranking to designate “low” to “high” risk funds within each category. MRisk is simply the difference between the annualized excess return of the fund and its MRAR.

The following figure provides further insight into how MRAR behaves for funds of varying volatility. This time, fund total returns have been scaled to match their category averages, again for the 3 year period ending Dec 2013. The figure includes results from several categories showing MRAR versus the tradition volatility measure, annualized standard deviation.

mrar sensitivity

Once again we see that funds with higher volatility generally receive lower MRARs and that the highest possible MRAR is equal to a fund’s annualized excess return, which occurs at zero standard deviation.

A consequence of Morningstar’s methodology is that low volatility funds with below average returns can quite possibly be out-ranked by average volatility funds with average returns. Put another way, the methodology generally penalizes funds with high volatility more so than it rewards funds with low volatility, since with the latter the benefit is “capped.”

This behavior is different from other risk adjusted return measures based on say Sharpe ratio, as can be seen in the figure below. Here the same funds from above are plotted against Sharpe, but now funds with low volatility are rewarded handsomely, even if they have below average total returns.

sharpe sensitivity

Revisiting the Morningstar risk measure MRisk, one finds another observation: it appears to correlate rather satisfactorily against a simple function based on standard deviation (up to about 30% for funds of positive total return without load):
morningstar risk

Which means that Morningstar’s risk adjusted return can be estimated from the following:

morningstar mrar

This simple approximation may come in handy, like when David wonders: “Why do RPHIX and ICMYX, which have superior 3 year Sharpe ratios, rate a very inferior 1 star by Morningstar?” He can use the above calculation to better understand, as illustrated here:

mrar approximation

While both do indeed have great 3 year Sharpe ratios – RPHIX is highest of any US fund – they both have below average total returns relative to their current peer group, as represented by say VWEHX, a moderate risk and average returning high yield bond “reference” fund.

Their low volatilities simply get no love from Morningstar’s risk adjusted return measure.

27Feb2014/Charles

TCW/Gargoyle Hedged Value (RGHVX)

By David Snowball

The fund:

TCW/Gargoyle Hedged Value (RGHVX)

Managers:

Alan Salzbank and Josh Parker, Gargoyle Group

The call:

On February 12th we spoke for an hour with Alan Salzbank and Josh Parker, both of the Gargoyle Group, and Morty Schaja, CEO of RiverPark Funds. Here’s a brief recap of the highlights:

Alan handles the long portfolio. Josh, a securities lawyer by training, handles the options portfolio. He’s also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They have 35 and 25 years of experience, respectively, and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Morty has been investigating buy-write strategies since the mid-1980s and he described the Gargoyle guys as “the team I’ve been looking for for 25 years.”

The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month.

The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (P/B, P/E, P/CF, P/S) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the 100 more undervalued stocks, but maintain sector weightings that are close to the S&P 500’s.

The options portfolio is a collection of index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums.

Why index calls? Two reasons: (1) they are systematically mispriced, and so they always generate more profit than they theoretically should. In particular, they are overpriced by about 35 basis points/month 88% of the time. For sellers, that means something like a 35 bps free lunch. And (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their upside.

And it works. Their long portfolio has outperformed the S&P 500 by an average of 5% per year for 15 years. The entire strategy has outperformed the S&P in the long-term and has matched its returns, with less volatility, in the shorter term. Throughout, it has sort of clubbed its actively-managed long-short peers. It also anticipates clubbing the emerging bevy of buy-write ETFs.

The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month.

There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000-12, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P.

Except not so much in 2008. The fund’s maximum drawdown was 48%, between 10/07 and 03/08. The guys attributed that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback comes in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%.

The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble.

In general, the strategy fares poorest when the market has wild swings. It fares best in gently rising markets, since both the long and options portfolios can make money if the market rises but less than the strike price of the options – they can earn 2% a month on an option that’s triggered if the market rises by more than 1%. If the market rises but by less than 1%, they pay out nothing, pocket the 2% and pocket the capital appreciation from their long portfolio.

What’s the role of the fund in a portfolio? They view it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. For the guys, it’s 100% of their US equity exposure.

podcastThe conference call

The profile:

On average and over time, a value-oriented portfolio works. It outperforms growth-oriented portfolios and generally does so with lower volatility. On average and over time, an options overlay works and an actively-managed one works better. It generates substantial income and effectively buffers market volatility with modest loss of upside potential. There will always be periods, such as the rapidly rising market of the past several years, where their performance is merely solid rather than spectacular. That said, Messrs. Parker and Salzbank have been doing this and doing this well for decades.

The Mutual Fund Observer profile of RGHVX, September, 2015.

Web:

TCW/Gargoyle Hedged Value homepage

Fund Focus: Resources from other trusted sources

Manager changes, February 2014

By Chip

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

Ticker

Fund

Out with the old

In with the new

Dt

ALHAX

AllianceBernstein Limited Duration High Income Fund

Amy Strugazow leaves the team

Ivan Rudolph-Shabinsky joins Michael Sohr, Ashish Shah, and Gershon Distenfeld.

2/14

IIESX

American Independence International Alpha Strategies Fund

Subadvisor Guggenheim Investments has been terminated by the Board, along with portfolio managers Nardin Baker and Ole Jakob Wold

Navellier & Associates will be the new subadvisor, after a rubber stamp by shareholders. James O’Leary and Michael Borgen will manage the fund.

2/14

CLTAX

Catalyst/Lyons Tactical Allocation

Louis Stevens

Michael Schoonover

2/14

ELDFX

Elfun Diversified Fund

Greg Hartch is out

Jeffrey Palma and David Wiederecht remain

2/14

FAHMX

Frost Small Cap Equity Fund

Cambiar Investors is terminated as a subadvisor to the fund, with its entire management team.

The new team consists of Craig Leighton, Tom Stringfellow, and Brad Thompson, of Frost Investment Advisors.

2/14

GSAGX

Goldman Sachs Asia Equity Fund

Edwin Perkins is gone

Alina Chiew and Kevin Ohn remain.

2/14

GBRAX

Goldman Sachs BRIC Fund

Edwin Perkins is gone

Alina Chiew and Kevin Ohn remain.

2/14

GSIFX

Goldman Sachs Concentrated International Equity Fund

Edwin Perkins is gone

Alexis Deladerriere remains

2/14

GEMEX

Goldman Sachs Emerging Markets Equity Fund

Edwin Perkins is gone

Alina Chiew remains.

2/14

GSAKX

Goldman Sachs Strategic International Equity Fund

Edwin Perkins is gone

Suneil Mahindru joins Alexis Deladerriere, who remains on the fund.

2/14

GGEFX

Golub Group Equity Fund

Michael Golub will no longer serve on the fund

The other managers, Colin Higgins, Kurt Hoefer, and John Dowling, remain.

2/14

ITGIX

ING T. Rowe Price Growth Equity Portfolio I

Rob Bartolo, manager of the underlying Price fund, resigned and relocated.

Joe Fath will take his place.

2/14

JMFAX

Janus Emerging Markets Fund

Matt Hochstetler

Hiroshi Yoh and Wahid Pierre Chammas remain.

2/14

HSKAX

JPMorgan Market Neutral (which some might label JPMorgan Zero Return)

No one, but . . .

Steven Lee and Raffaele Zingone join Terance Chen, who’s been on board just since December, 2013.

2/14

JMNAX

JPMorgan Research Market Neutral

No one, but . . .

Steven Lee and Raffaele Zingone join Terance Chen, who will be resigning in the fourth quarter of 2014.

2/14

MGFIX

Managers Bond Fund

No one, but . . .

Matthew Eagan and Elaine Stokes join Daniel Fuss

2/14

DVRAX

MFS Global Alternative Strategy

Effective April 30, 2014, Joseph Flaherty will no longer be an advisor to the fund, and …

Benjamin Nastou will join the rest of the team of Natalie Shapiro, Curt Custard, Jonathan Davies, Andreas Koester, and Lowell Yura.

2/14

MFEGX

MFS Growth Fund

No one, but . . .

Matthew Sabel joins Eric Fischman as a comanager.

2/14

OCTAX

MFS Mid Cap Growth

No one, but . . .

Matthew Sabel joins Eric Fischman and Paul Gordon

2/14

MMUFX

MFS Utilities Fund

Robert Persons

Maura Shaughnessy remains and is joined by Claud Davis

2/14

NRFAX

Natixis AEW Real Estate Fund

Jeffrey Caira left on Jan 1.

John Garofalo joins Matthew Troxell, J. Hall Jones, and Roman Ranocha

2/14

IIDPX

Natixis Diversified Income Fund

Jeffrey Caira left on Jan 1.

Maura Murphy, Kevin Kearns, and Elaine Kan join the extensive team.

2/14

OPOCX

Oppenheimer Discovery Fund

No one, but . . .

Ash Shah joins Ronald Zibelli Jr.

2/14

MSIGX

Oppenheimer Main Street Fund

No one, but . . .

Paul Larson joins Manind Govil and Benjamin Ram

2/14

PTSIX

PIMCO International Fundamental IndexPLUS AR Strategy

Marc Seidner

Scott Mather

2/14

PIPAX

PIMCO International StocksPLUS AR Strategy

Marc Seidner who was ousted as part of the post El-Erian purge is joining GMO as a  head of fixed-income

Scott Mather

2/14

PCFIX

PIMCO Small Company Fundamental IndexPLUS AR Strategy

Marc Seidner

Scott Mather

2/14

PWWAX

PIMCO Worldwide Fundamental Advantage AR Strategy

Marc Seidner

Scott Mather

2/14

RSCHX

RS China Fund

No one, but . . .

Tony Chu joins Michael Reynal

2/14

GUHYX

RS High Yield Fund

Howard Most is retiring after  five entirely okay years with the fund

Marc Gross and Kevin Booth remain

2/14

XXXXX

Russell LifePoints 2015, 2020, 2025, 2030, 2035, 2040, 2045, 2050, 2055

Michael Ruff

John Greves and Brian Meath

2/14

RBLEX

Russell LifePoints Balanced Strategy

Michael Ruff

Brian Meath

2/14

RCLEX

Russell LifePoints Conservative Strategy

Michael Ruff

Brian Meath

2/14

RELEX

Russell LifePoints Equity Growth Strategy

Michael Ruff

Brian Meath

2/14

RALEX

Russell LifePoints Growth Strategy

Michael Ruff

Brian Meath

2/14

RZLRX

Russell LifePoints in Retirement

Michael Ruff

John Greves and Brian Meath

2/14

RMLEX

Russell LifePoints Moderate Strategy

Michael Ruff

Brian Meath

2/14

SEBLX

Sentinel Balanced Fund

David Brownlee will retire at the end of June.

Jason Doiron and Daniel Manion remain

2/14

SECMX

Sentinel Conservative Strategies Fund

David Brownlee will retire at the end of June.

Jason Doiron, Daniel Manion, and Katherine Shapiro remain

2/14

SEGSX

Sentinel Government Securities Fund

David Brownlee will retire at the end of June.

Jason Doiron remains.

2/14

SSIGX

Sentinel Low Duration Bond Fund

David Brownlee will retire at the end of June.

Jason Doiron remains.

2/14

 

Sentinel Total Return Bond Fund

David Brownlee will retire at the end of June.

Jason Doiron remains.

2/14

FCSAX

Strategic Advisers Core Fund

Lawrence Rakers, who was moved out of the portfolio manager role at Fidelity Dividend Growth after five volatile years,  has been replaced …

… by Matthew Fruhan

2/14

FMJDX

Strategic Advisers International Multi-Manager Fund

W. George Greig has left the William Blair & Co. sleeve of the fund after 17 years

The rest of the team remains on the fund.

2/14

USMIX

USAA Extended Market Index Fund

Ed Corallo has retired

Alan Mason is the new portfolio manager

2/14

USFSX

USFS Funds Tactical Asset Allocation Fund

Chris Weber and Mark Elste are out

Robert Cummisford and Tommy Huie will take over

2/14

VALLX

Value Line Larger Companies

Mark Spellman

Stephen Grant will manage the fund

2/14

VGPMX

Vanguard Precious Metals and Mining Fund

No one, but . . .

Jamie Horvat joins Randeep Somel

2/14

CBEAX

Wells Fargo Advantage C & B Large Cap Value Fund

Daren Heitman is out.

The rest of the team remains on the fund.

2/14

CBMAX

Wells Fargo Advantage C & B Mid Cap Value Fund

Daren Heitman is out.

The rest of the team remains on the fund.

2/14