By David Snowball

Dear friends,

It’s the BOJ’s fault. Or the price of oil’s. Perhaps the Fed. Probably China. Possibly Putin. Likely ISIL (or Assad). Alternately small investors. (ETF.com assures us it’s definitely not the effect of rapid, block-trading of ETFs on the market, though.) It’s all an overreaction or, occasionally, a lagging one. Could be fears of recession or even fears of fears.

We don’t like randomness. That’s why conspiracy theories are so persistent: they offer simple, satisfying explanations for otherwise inexplicable occurrences. We want explanations and, frankly, the financial media are addicted to offering them. The list in that opening paragraph captures just some of the explanations offered by talking heads to explain January’s turbulence. Those same sages have offered prognostications for the year ahead, ranging from a “cataclysmic” 40% decline and advice to “sell everything” to 7-11% gains, the latter from folks who typically foresee 7-11% gains.

As I drove to campus the other day, watching a huge flock of birds take wing and wheel and listening to financial analysis, it occurred to me that these guys had about as much prospect of understanding the market as they do of understanding the birds’ ballet.

Open confession is good for the soul.

I have two confessions.

First, I can’t find the source of the quotation that serves as the title of this essay. I keep hitting a wall as “Scottish proverb,” with no further discussion. All too often that translates to “some hack at The Reader’s Digest in 1934 made it up and added ‘Scottish proverb’ to dignify the insight.”

Second, until I began this essay, I had only the vaguest idea of how my portfolio had done in 2015. I preach a single doctrine: make a good plan, execute the plan, get on with your life.

Make a good plan: My retirement portfolio is largely hostage to Augustana College. As part of a Retirement Plan Redesign task force a few years ago, we discovered that the college’s plan was too complicated (it offered over 800 funds) and too lax (under 30% of our employees contributed anything beyond the college’s 10% contribution).  The research was clear and we followed it: we dramatically reduced the fund of investment choices so that in each asset class folks had one active fund and one passive fund, installed a lifecycle fund as the default option, the college went from a flat contribution to a modestly more generous one based on a matching system, we auto-enrolled everyone in a payroll deduction which started at 4%, and automatically escalated their contributions annually until they reached 10%. It was, of course, possible to opt out but we counted on the same laziness that kept folks from opting in to keep them from opting out.

We were right. Ninety-some percent of employees now contribute to their own retirements, the amount of money sitting in money markets for years is dramatically reduced, the savings rate is at a record and more accounts seem to contain a mix of assets.

Yay for everyone but me! In pursuit of the common good, I helped strip out my own access to the Fidelity and T. Rowe Price funds that were central to my plan. Those funds are now in a “can’t add more” account and continue to do quite well. Both growth funds (Fidelity Growth Discovery, T. Rowe Price Blue Chip Growth) and international small caps (Fidelity Japan Smaller Companies, T. Rowe Price International Discovery) were thriving, while my substantial emerging markets exposure and a small inflation hedge hurt. In these later years of my career at the college, the vast bulk of my retirement contributions are going into a combination of the CREF Stock Account (60% of my portfolio, down 0.9% in 2015, up 10.5% annually over the past three years), TIAA Real Estate Account (25% of my portfolio, up 8% in 2015, up 10% annually over the past three years) and a TIAA-CREF Retirement Income fund (15% of the portfolio, flat in 2015, up 4.5% over three years) for broad-based fixed income exposure.

My non-retirement account starts with a simple asset allocation:

• 50% growth / 50% income
• Within growth, 50% domestic equities, 50% foreign
• Within domestic, 50% smaller companies, 50% larger
• Within foreign, 50% developed, 50% emerging
• Within income, 50% conservative, 50% venturesome.

I know that I could optimize the allocation by adjusting the exact levels of exposure to each class, but I don’t need the extra complexity in my life. In most of my funds, the managers have some wiggle room so that they’re not locked into a single narrow asset class. That makes managing the overall asset allocation a bit trickier, but manageable.

The roster of funds, ranked from my largest to smallest positions:

FPA Crescent FPACX	A pure play on active management.  Mr. Romick is willing to go anywhere and frequently does. He’s been making about 6% a year and has done exceptionally well mitigating down markets. The fund lost 2% in 2015, its third loss in 20 years.
T. Rowe Price Spectrum Income RPSIX	A broadly diversified fund of income funds. Low cost, low drama. It’s been making about 4% in a low-rate environment. The fund lost 2% in 2015, its third loss, and its second-worst, in a quarter century.
Artisan International Value ARTKX	A fund that I’ve owned since inception and one of my few equity-only funds. It’s made about 7% a year and its long-term performance is in the top 1% of its peer group. Closed to new investors.
RiverPark Short-Term High Yield RPHYX	An exceedingly conservative cash-substitute for me. I’m counting on it to beat pure cash by 2-3% a year, which it has regularly managed. Up about 1% in 2015. Closed to new investors.
Seafarer Overseas Growth & Income SFGIX	An outstanding EM equity fund that splits its exposure between pure EM stocks and firms domiciled in developed markets but serving emerging ones. Up about 10% since launch while its peers are down 18%. Down 4% in 2015 while its peers were down 14%.
Artisan Small Cap Value ARTVX	(sigh) More below.
Matthews Asian Growth & Income MACSX	Traditionally one of the least volatile ways to invest in the world’s most dynamic economies. I started here when Mr. Foster, Seafarer’s manager, ran the fund. When he launched Seafarer, I placed half of my MACSX position in his new fund. MACSX has continued to be a top-tier performer but might fall victim to a simplification drive.
RiverPark Strategic Income RSIVX	Mr. Sherman, the RPHYX manager, positions this as “one step out the risk-return spectrum” from his flagship fund. His expectation was to about double RPHYX’s return. He was well on his way to do exactly that until three bad investments and some market headwinds derailed performance over the past six months. Concern is warranted.
Matthews Asian Strategic Income MAINX	The argument here is compelling: the center of the financial universe is shifting to Asia but most investors haven’t caught up with that transition. Matthews is the best Asia-centered firm available in the US retail market and Ms. Kong, the manager, is one of their brightest stars. The fund made a lot of money in its first year but has pretty much broken even over the next three. Sadly, there’s no clear benchmark to help answer the question, “is that great or gross?”
Grandeur Peak Global Reach GPROX	The flagship fund for Grandeur Peak, a firm specializing in global small and microcap growth investing.  The research is pretty clear that this is about the only place where active managers have a persistent edge, and none have had greater success than G.P. The fund was up 8% in 2014 and down 0.6% in 2015, outstanding and respectable performances, respectively.
Northern Global Tactical Asset Allocation BBALX	Northern aspires to be a true global hybrid fund offering low-cost access to global stocks, bonds and alternatives. It looks terrible benchmarked against its US-centered peers but I’m not sure that’s an argument against it.
Grandeur Peak Global Microcap GPMCX	This was simply too intriguing to pass up: G.P. wanted  a tiny fund to invest in the world’s tiniest companies, potentially explosive firms that would need to grow a lot even to become microcaps. It was open by subscription only to current GP shareholders and hard-closed at $27.5 million even before it opened.
ASTON/River Road Long Short ARLSX	This is a very small position, started mostly because I like the guys’ clear thinking and disciplined approach. Having even a small amount in a fund lends me to pay more attention to it, which was the goal. Other than for 2014, it typically finishes in the top third of L/S funds.

Execute the plan. So what did I do in 2015? Added Grandeur Peak Global Microcap and set up a monthly auto-invest. I also (finally!) transferred my Seafarer holdings from Scottrade directly to Seafarer where I took advantage of their offer to make lower-cost institutional shares available to retail investors who met the retail minimum and established an auto-investing plan. Otherwise, it was mostly stay the course and invest monthly.

What’s up for 2016? Artisan Small Cap Value is on the chopping block. Assets in the fund are down nearly 90% from peak, reflecting year after wretched year of underperformance. This is one of my oldest holdings, I’ve owned it since the late 1990s and have substantial embedded capital gains. Three issues are pushing me toward the door:

1. The managers seem to have fallen into a value trap. Their discipline is explicitly designed to avoid “value traps,” but their dogged commitments to energy and industrials seem to have ensnared them.
2. They don’t seem to be able to get out. Perhaps I’m jaundiced, but their shareholder communications haven’t been inspiring. The theme is “we’re not going to change our discipline just because it’s not working right now.” My fear is that “disciplined” transitions too easily into “bunkered down.” I experienced something similar with Ron Muhlenkamp of Muhlenkamp Fund (MUHLX), which was brilliant for 15 years then rigidly rotten for a decade. Mr. Muhlenkamp’s mantra was “we’re not sacrificing our long-term discipline for short-term gains” which sounded grand and worked poorly. I know of few instances where once-great funds rebound from several consecutive years in the basement. The question was examined closely by Leigh Walzer of Trapezoid in his December 2015 essay, When Good Managers Go Bad.
3. Lead manager Scott Satterwhite is retiring in October. The transition has been underway for a long while now but (a) it’s still epochal and (b) performance during the transition has not been noticeable better.

I may surrender to Ed’s desire to have me simplify my portfolio. (Does he simplify his? No, not so far as I can tell.) That might mean moving the MACSX money into Seafarer. Maybe closing out a couple smaller holdings because they’re not financially consequential. My asset allocation is a bit overweight in international stocks right now, so I’m probably going to move some into domestic smaller caps. (Yes, I know. I’ve read the asset class projections but my time horizon is still longer than five to seven years.) And making some progress in debt reduction (I took out a home equity loan to handle some fairly-pressing repairs) would be prudent.

Get on with life. I’m planning on resuming my War on Lawns this spring. I’m having a Davenport firm design a rain garden, an area designed to slow the rush of water off my property during storms, for me and I’ll spend some weeks installing it. I’ll add a bunch of native plants, mostly pollinator-friendly, to another corner once overrun by lawn. Together, I think they’ll make my space a bit more sustainable. Baseball season (which my son interprets as “I need expensive new stuff” season) impends. I really need to focus on strengthening MFO’s infrastructure, now that more people are depending on it. And my academic department continues to ask, “how can we change our teaching to help raise diverse, first-generation college students to that same level of achievement that we’ve traditionally expected?” That’s exhausting but exciting because I think, done right, we can make a huge difference in the lives of lots of bright kids who’ve been poorly served in some of their high schools. As a kid whose parents never had the opportunity to finish high school (World War Two interrupted their teen years), my faith in the transformative power of teaching remains undimmed.

It’ll be a good year.

Emerging markets: About as cheap as it gets

In the course of our conversation about Leuthold Core Investment (LCORX), Doug Ramsay shared the observation that emerging markets stocks are painfully cheap. Leuthold’s chart, below, shows the price/earnings ratio based on five-year normalized earnings for E.M. stocks from 2004 to now. Valuations briefly touched a p/e of 31 in 2007 then fell to 8 within a year. As we end January 2016, prices for E.M. stocks hover within a point of their market-crisis lows.

And still Leuthold’s not investing in them. Their E.M. exposure in Core and Global (GLBLX) are both near all-time lows because their analytics don’t (yet) show signs of a turnaround. Still, Mr. Ramsay notes, “they look impossibly cheap.”

Investing in five-star funds? It’s not as daft as you’d think

We asked the good folks at Morningstar if they’d generate a list of all five-star funds from ten years ago, then update their star ratings from five years ago and today. I’d first seen this data several years ago when it had been requested by a Wall Street Journal reporter and shared with us. The common interpretation is “it’s not worth it, since five-star funds aren’t likely to remain five-star funds.”

I’ve always thought that was the wrong concern. Really, I’m less concerned about whether my brilliant manager remains absolutely brilliant than whether he turns wretched. Frankly, if my funds kept bouncing between “reasonable,” “pretty good” and “really good,” I’d be thrilled. That is, if they stay in the three- to five-star range over time, that’s perfectly respectable.

Chip took the data and converted it into a pivot table. (Up until then, I thought “pivot table” was just another name for a “lazy Susan.” Turns out it’s actually a data visualization tool. Who knew?)

Here’s how to read it. There were 354 five-star funds in 2005. Of those, only 16 fell to one-star by 2010. You can see that in the top-center box. Of those 16 one-star funds, none rebounded to five stars by 2015 and only two made it back to four stars. On the upside, 187 of the original 354 remained four- or five-star funds across the whole time period and 245 of 354 never dropped below three stars.

We clearly need to do some refinement of the data to see whether a few categories are highly resilient (for example, single-state muni bond funds might never change their star ratings) and, thus, skewing the results. On whole, though, it seems clear that “first to worst” is a pretty low probability outcome and “first to kinda regrettable” isn’t hugely more likely.

The original spreadsheet is in the Commentary section at MFO Premium, for what interest that holds.

This Time It Really Is Different!

“Every revolution evaporates and leaves behind only the slime of a new bureaucracy.”

 Kafka

So, time now for something of a follow-up to my suggestion of a year ago that a family unit should own no more than ten mutual funds. As some will recall, I was instructed by “She Who Must Be Obeyed” to follow my own advice and get our own number of fund investments down from the more than twenty-five where it had been. We are now down to sixteen, which includes money market funds. My first observation would be that this is not as easy to do as I thought it would be, especially when you are starting from something of an ark approach (one of these, two of those). It is far easier to do when you start to build your portfolio from scratch, when you can be ruthless about diversification. That is, you don’t really need two large cap growth or four value funds. You may only add a new fund if you get rid of an old fund. You are quite specific about setting out the reasons for investing in a fund, and you are equally disciplined about getting rid of it when the reasons for owning it change, e.g. asset bloat, change in managers, style drift, no fund managers who are in Boston, etc., etc.

Which brings me to a point that I think will be controversial – for most families, mutual fund ownership should be concentrated in tax-exempt (retirement accounts) if taxes matter. And mutual fund ownership in retirement accounts should emphasize passive investments to maximize the effects of lower fees on compounding. It also lessens the likelihood of an active manager shooting himself or herself in the foot by selling the wrong thing at the wrong time because of a need to meet redemptions, or dare I suggest it, panic or depression overwhelm the manager’s common sense in maintaining an investment position (which often hits short seller specialists more than long only investors, but that is another story for another day).

The reasons for this will become clearer as holdings come out for 12/31 and 3/31, as well as asset levels (which will let you know what redemptions are – the rumor is that they are large). It will also become pretty clear as you look at your tax forms from your taxable fund accounts and are wondering where the money will come from to pay the capital gains that were triggered by the manager’s need to raise funds (actually they probably didn’t need to sell to meet redemptions as they all have bank lines of credit in place to cover those periods when redemptions exceed cash on hand, but …..).

The other thing to keep in mind about index funds that are widely diversified (a total market fund for instance) – yes, it will lag on the upside against a concentrated fund that does well. But it will also do better on the downside than a concentrated fund that does not do well. Look at it this way – a fifty stock portfolio that has a number of three and four per cent positions, especially in the energy or energy services sector this past year, that has seen those decline by 50% or more, has a lot of ground to make up. A total stock market portfolio that has a thousand or more positions – one or two or twenty or thirty bad stocks, do not cripple it. And in retirement accounts, it is the compounding effect that you want. The other issue of course is that the index funds will stay fully invested in the indices, rather than be caught out underinvested because they were trying to balance out exiting positions with adding positions with meeting redemptions. The one exception here would be for funds where the inefficiencies of an asset class can lead to a positive sustainable alpha by a good active manager – look for that manager as one to invest with in either taxable or tax-exempt accounts.

China, China, China, All the Time

In both the financial print press and the financial media on television and cable, much of the “blame” for market volatility is attributed to nervousness about the Chinese economy, the Chinese stock market, in fact everything to do with China. There generally appear to be two sorts of stories about China these days. One recurring theme is that they are novices at capital markets, currencies, as well as dealing with volatility and transparency in their markets, and that this has exacerbated trends in the swings in the Shanghai market, which has spread to other emerging markets. Another element of this particular them is that China’s economy is slowing and was not transparent to begin with, and that lack of growth will flow through and send the rest of the world into recession. Now, mind you, we are talking about economic growth that by most accounts, has slowed from high single digits recently (above 7%) to what will be a range going forward of low to still mid-single digits (4 – 7%).

I think a couple of comments are in order about this first theme. One, the Shanghai market has very much been intended as a punter’s market, where not necessarily the best companies are listed (somewhat like Vancouver in Canada twenty-odd years ago). The best companies in China are listed on the Hong Kong market – always have been, and will continue to be for the foreseeable future. The second thing to be said is that if you think things happen in China by accident or because they have lost control, you don’t understand very much about China and its thousands of years of history. Let’s be realistic here – the currency is controlled, interest rates are controlled, the companies are controlled, the economy is controlled – so while there may be random events and undercurrents going on, they are probably not the ones we are seeing or are worried about.

This brings me to the second different theme you hear about China these days, which is that China and the Chinese economy have carried the global economy for the last several years, and that even last year, their contribution to the world economy was quite substantial. I realize this runs counter to stories that you hear emanating from Washington, DC these days, but much that you hear emanating from Washington now is quite surreal. But let’s look at a few things. China still has $3 trillion dollars of foreign exchange reserves. China does not look to be a debtor nation. China has really not a lot of places left to spend money domestically since they have a modern transportation infrastructure and, they have built lots of ghost cities that could be occupied by a still growing population. And while China has goods that are manufactured that they would like to export, the rest of the world is not in a buying mood. A rumor which I keep hearing, is that they have more than 30,000 metric tons of gold reserves with which to back their currency, should they so choose (by comparison, the US as of October 2014 was thought to have about 4,200 metric tons in Fort Knox).

For those familiar with magic shows and sleight of hand tricks, I think this is what we are seeing now. Those who watch the cable financial news shows come away with the impression that the world is ending in the Chinese equity markets, and that will cause the rest of the world to end as well. So while you are watching that, let’s see what you are missing. We have a currency that has become a second reserve currency to the world, supplanting the exclusive role of the U.S. dollar as countries that are commodity economies now price their commodities and do trade deals in Chinese currency. And, notwithstanding that, the prices of commodities have fallen considerably, we continue to see acquisition and investment in the securing of commodities (at fire sale prices) by China. And finally, we have a major expansion by China in Africa, where it is securing arable land to provide another bread basket for itself for the future, as well as an area to send parts of it population.

And let me suggest in passing that the one place China could elect to spend massively in their domestic economy is to build up their defense establishment far beyond what they have done to date. After all, President Reagan launched a massive arms build-up by the US during his terms in office, which in effect bankrupted the Soviets as they tried to keep up. One wonders whether we would or could try to keep up should China elect to do the same to us at this point.

So, dear readers, I will leave it to you to figure out which theme you prefer, although I suspect it depends on your time horizon. But let me emphasize again – looking at the equity markets in China means looking at the wrong things. By the end of this year, we should have a better sense of whether the industrial economy is China has undergone a rather strong recovery, driven by the wealth of a growing middle class (which is really quite entrepreneurial, and which to put it into context, should be approaching by the end of this year, 400M in size). And it will really also become clear that much of the capital that has been rumored to be “fleeing” China has to be split out to account for that which is investment in other parts of the world. Paying attention to those investment outflows will give you some insight as to why China still thinks of and refers to itself as, “The Middle Kingdom.”

— by Edward A. Studzinski

Looking for Bartolo Colon

by Leigh Walzer

Bartolo Colon is a baseball pitcher; he is the second oldest active major leaguer.  Ten years ago he won the coveted Cy Young award. Probably no investment firm has asked Colon for an endorsement but maybe they should. More on this shortly.

FROM THE MAILBAG:

A reader in Detroit who registered but has not yet logged into www.Fundattribution.com  writes: “We find little use for back tested or algorithmic results [and prefer an] index-based philosophy for clients.” 

Index funds offer a great approach for anyone who lacks the time or inclination to do their homework. We expect they will continue to gain share and pressure the fees of active managers.

Trapezoid does not advocate algorithmic strategies, as the term is commonly used. Nor do we oppose them. Rather, we rigorously test portfolio managers for skill. Our “null hypothesis” is that a low-cost passive strategy is best. We look for managers which demonstrate their worth, based on skill demonstrated over a sufficient period of time. Specifically, Honor Roll fund classes must have a 60% chance of justifying their expenses. Less than 10% of the fund universe satisfies this test.  Trapezoid does rate some quantitative funds, and we wrote in the November edition of Mutual Fund Observer about some of the challenges of evaluating them.

We do rely on quantitative methods, including back testing, to validate our tests and hone our understanding of how historic skill translates into future success.

VULCAN MIND MELD

A wealth manager (and demo client) from Denver asks our view of his favorite funds, Vulcan Value Partners (VVPLX). Vulcan was incepted December 2009.Prior to founding Vulcan, the manager, C.T. Fitzpatrick, worked for many years at Southeastern under famed value investor O. Mason Hawkins.  Currently it is closed to new investors.

VVPLX has performed very well in its 6 years of history. By our measure, investors accumulated an extra 20% compared to index funds based on the managers’ stock selection skill alone. We mentioned it favorably in the October edition of MFO.

Vulcan’s expense structure is 1.08%, roughly 90bps higher than an investor would require to hold a comparable ETF. Think of that as the expense premium to hire an active manager. Based on data through October, we assigned VVPLX a 55% probability of justifying its active expense premium. (This is down from 68% based on our prior evaluation using data through July 2015 and places them outside the Honor Roll.)

The wealth manager questioned why we classify VVPLX as large blend?  Vulcan describes itself as a value manager and the portfolio is heavily weighted toward financial services.

VVPLX is classified as large blend because, over its history, it has behaved slightly more like the large blend aggregate than large value. We base this on comparisons to indices and active funds. One of our upcoming features identifies the peer funds, both active and passive, which most closely resemble a given fund. For a majority of our funds, we supplement this approach by looking at historic holdings. We currently consider factors like the distribution of forward P/E ratios over time. Our categorization and taxonomy do not always conform to services like Morningstar and Lipper, but we do consider them as a starting point, along with the manager’s stated objective.  We frequently change classifications and welcome all input. While categories may be useful in screening for managers, we emphasize that the classifications have no impact on skill ratings, since we rely 100% on objective criteria such as passive indices.

The client noted we identified a few managers following similar strategies to VVPLX who were assigned higher probabilities. How is this possible considering VVPLX trounced them over its six-year history?

Broadly speaking, there are three reasons:

• Some of the active managers who beat out VVPLX had slightly lower expenses.
• While VVPLX did very well since 2010, some other funds have proven themselves over much longer periods. We have more data to satisfy ourselves (and our algorithms) that the manager was skillful and not just lucky. 
• VVPLX’s stock selection skill was not entirely consistent which also hurts its case. From April to October, the fund recorded negative skill of approximately 4%. This perhaps explain why management felt compelled to close the fund 4/22/15.

Exhibit I

		Mgr. Tenure	sS*	sR*	Proj.  Skill (Gross)	Exp.	∆	±	Prob.
Boston Partners All-Cap Value Fund [c]	BPAIX	2005	1.4%	0.3%	0.88%	0.80%(b)	23	1.5%	56.1
Vulcan Value Partners Fund	VVPLX	2010	3.8%	1.5%	1.19%	1.08%	.25	1.8%	55.2

1. Annualized contribution from stock selection or sector rotation over manager tenure
2. Expenses increased recently by 10bps as BPAIX’s board curtailed the fee waiver
3. Closed to new investors

Exhibit II: Boston Partners All-Cap Value Fund

Exhibit I compares VVPLX to Boston Partners All-Cap Value Fund. BPAIX is on the cusp of value and blend, much like VVPLX. Our model sees a 56.1% chance that the fund’s skill over the next 12 months will justify its expense structure. According to John Forelli, Senior Portfolio Analyst, the managers screen from a broader universe using their own value metrics. They combine this with in-depth fundamental analysis. As a result, they are overweight sectors like international, financials, and pharma relative to the Russell 3000 (their avowed benchmark.) Boston Partners separately manages approximately $10 billion of institutional accounts which closely tracks BPAIX.

Any reader with the www.fundattribution.com demo can pull up the Fund Analysis for VVPLX.  The chart for BPAIX is not available on the demo (because it is categorized in Large Value) so we present it in Exhibit II.  Exhibit III presents a more traditional attribution against the Russell 3000 Value Fund. Both exhibits suggest Boston Partners are great stock pickers. However, we attribute much less skill to Allocation because our “Baseline Return” construes they are not a dyed-in-the-wool value fund.

VVPLX has shown even more skill over the manager’s tenure than BPAIX and is expected to have more skill next year^[1]. But even if VVPLX were open, we would prefer BPAIX due to a combination of cost and longer history. (BPAIX investors should keep an eye on expenses: the trustees recently reduced the fee waiver by 10bps and may move further next year.)

Trapezoid has identified funds which are more attractive than either of these funds. The Trapezoid Honor Roll consists of funds with at least 60% confidence. The methodology behind these findings is summarized at here.

^[1] 12 months ending November 2016.

VETERAN BENEFITS

Our review of VVPLX raises a broader question. Investors often have to choose between a fund which posted stellar returns for a short period against another whose performance was merely above average over a longer period.

For those of you who watched the World Series a few months ago, the NY Mets had a number of very young pitchers with fastballs close to 100 miles per hour.  They also had some veteran pitchers like John Niese and the 42-year-old ageless wonder Bartolo Colon who couldn’t muster the same heat but had established their skill and consistency over a long period of time. We don’t know whether Bartolo Colon drank from the fountain of youth; he served a lengthy suspension a few years ago for using a banned substance. But his statistics in his 40s are on par with his prime ten year ago.  

Unfortunately, for every Bartolo Colon, there is a Dontrelle Willis. Willis was 2003 NL Rookie of the year for the Florida Marlins and helped his team to a World Series victory. He was less effective his second year but by his third year was runner up for the Cy Young award. The “D-Train” spent 6 more years in the major leagues; although his career was relatively free of injuries, he never performed at the same level.

Extrapolating from a few years of success can be challenging. If consistency is so important to investors, does it follow that a baseball team should choose the consistent veterans over the promising but less-tested young arms?

Sometimes there is a tradeoff between expected outcome (∆) and certitude (±).  The crafty veteran capable of keeping your team in the game for five innings may not be best choice in the seventh game of the World Series; but he might be the judicious choice for a general manager trying to stretch his personnel budget. The same is true for investment managers. Vulcan may have the more skillful management team. But considering its longevity, consistency, and expense Boston Partners is the surer bet.

HOW MUCH IS ENOUGH

How long a track record is needed before an investor can bet confident in a portfolio manager? This is not an easy question to answer.

In the December edition of MFO (When_Good_Managers_Go_Bad) we profiled the Clearbridge Aggressive Growth fund which rode one thesis successfully for 20 years. Six years of data might tell us less about them than a very active fund.   

Here is one stab at answering the question.  We reviewed the database to see what percentage of fund made the Trapezoid Honor Roll as a function of manager tenure. 

Recall the Trapezoid Honor Roll consists of fund classes for which we have 60% confidence that future skill will justify expense structure.  In Exhibit IV the Honor Roll fund classes are shown in blue while the funds we want no part of are in yellow.  16% of those fund classes where the manager has been on the job for twenty-five years make the Honor Roll compared with just 2% for those on the job less than three years.  The relationship is not a smooth line, but generally managers with more longevity give us more data points allowing us to be more confident of their skill.. or more likely persuade us they lack sufficient skill. 

There is an element of “survivorship” bias in this analysis. Every year 6% of funds disappear; generally, they are the smallest or worst performers. “All-stars” managers are more likely to survive for 20 years. But surprisingly a lot of “bad” managers survive for a long time. The percentage of yellow funds increases just as quickly as the blue.

It seems reasonable to ask why so many “bad” managers survive in a Darwinian business. We surveyed the top 10. (Exhibit V) We find that in the aggregate they have a modicum of skill, but nowhere sufficient to justify what they charge.  We can say with high confidence all these investors would be better off in index funds or (ideally) the active managers on the Trapezoid honor roll.

We haven’t distinguished between a new manager who takes over an old fund and a brand new fund. Should investors abandon all their confidence when a good manager retires and passes the baton? Should investors give the fund a mulligan when a poor performer is replaced?  Probably not.  From a review of 840 manager changes with sufficient data (Exhibit VI), strong performers tend to remain strong which suggests we may gain confidence by considering the track record of the previous manager.

The “rookie confidence” problem is a challenge for investors. The average manager tenure is about six years and only a quarter of portfolio managers have been on the job longer than 10 years. It is also a challenge for asset managers marketing a new fund or a new manager of an existing fund.  Without a long track record, it is hard to tell if a fund is good – investors have every incentive to stick with the cheaper index fund.  Asset managers incubate funds to give investors a track record but studies suggest investors shouldn’t take much comfort from incubated track records. (Richard Evans, CFA Digest, 2010.) We see many sponsors aggressively waiving fees for their younger funds.  Investors will take comfort when the individuals have a prior track record at another successful fund.  C.T. Fitzpatrick’s seventeen years’ experience under Mason Hawkins seems to have carried over to Vulcan.

BOTTOM LINE:  It is hard to gain complete trust that any active fund is better than an index fund. It is harder when a new captain takes the helm, and harder yet for a brand new fund. The fund with the best five-year record is not necessarily the best choice. Veteran managers are over represented in the Trapezoid Honor Roll — for good reason.

Unlike investing, baseball will always have rookies taking jobs from the veterans. But in 2016 we can still root for Bartolo Colon.

Why are investors so bad at picking alternatives?

By Sam Lee, principal of Severian Asset Management and former editor of Morningstar ETF Investor.

Gateway (GATEX) is the $8 billion behemoth of the long-short equity mutual fund category, and one of the biggest alternative mutual funds. I’ve long marveled at this fund’s size given its demonstrable lack of merit as a portfolio diversifier. Over the past 10 years the fund has behaved like an overpriced, underperforming 40% stock, 60% cash portfolio. Its R-squared over this period to the U.S. stock market index is 0.85.

Not only is its past performance damning, but little in the substance of the strategy suggests performance will radically change. Gateway owns a basket of stocks designed to track the S&P 500, with a slight dividend tilt. On this portfolio the managers sell calls on the S&P 500, capping the potential upside of the fund in exchange for a premium up front, and simultaneously buy puts, capping the potential downside of the fund at the cost of a premium up front. By implementing this “collar” strategy, the managers protect the portfolio from extreme ups and downs.

There is another way to soften volatility: Own less equities and more cash—which is pretty much what this fund achieves in a roundabout manner.

Portfolio theory says that an investment is only attractive to the extent that it improves the risk-adjusted return of a portfolio. That means three things matter for each asset: expected return, expected volatility, and expected correlation with other assets in the portfolio. The first two are intuitive, but many investors neglect the correlation piece. A low return, high volatility asset can be an excellent investment if it has a low enough correlation with the rest of the portfolio.

Consider an asset that’s expected to return 0% with stock-like volatility and a perfectly negative correlation to the stock market (meaning it moves in the opposite direction of the market without fail). Many investors, looking at the asset’s standalone returns and volatility, would be turned off. Someone fluent in portfolio theory would salivate. Assume the expected excess return of the stock market is 5%. If you own the stock market and the negatively correlated asset in equal measure, the portfolio’s expected excess return halves to 2.5% and its expected volatility drops to 0%. Apply some leverage to double the portfolio’s return and you end up with a 5% expected excess return with no volatility.

In practice, many investors do not assess assets from the portfolio perspective. They fixate on standalone return and volatility. Much of the time this is a harmless simplification. But it can go wrong when assessing alternatives, such as with Gateway. Judged by its Sharpe ratio and other risk-adjusted measures, Gateway looks like a reasonable investment. Judged by its ability to enhance a portfolio’s risk-adjusted return, it falls flat.

I don’t believe individual investors are responsible for Gateway’s size. If anything, institutional investors (particularly RIAs) are to blame. You would think that supposedly sophisticated investors would not fall into this trap. But they do. A large part of the blame belongs to committee-driven investment processes, which dominate institutional money management. When a committee is responsible for a portfolio, they often hire consultants. These consultants in turn promise to help members of the committee avoid getting fired or sued.

In this context, the consultants like to create model portfolios that have predefined allocations to investment types—X% in large growth, Y% in small-cap value, Z% in long-short equity, and so on—and then find suitable managers within those categories. When picking those managers, they tend to focus on return and volatility as well as performance relative to peers. If not done carefully, a fund like Gateway gets chosen, despite its utter lack of diversifying power.

 

Smallest, Shortest, Lowest

David invariably cuts to the chase when it comes to assessing mutual funds. It’s a gift he shares with us each month.

So, in evolving the MFO Premium site, he suggested we provide lists of funds satisfying interesting screening criteria to help users get the most from our search tools.

Last month we introduced two such lists: “Best Performing Rookie Funds” and “Dual Great Owl & Honor Roll Funds.”

This month our MultiSearch screener incorporates three more: “Smallest Drawdown Fixed Income Funds,” “Shortest Recovery Time Small Caps,” and “Lowest Ulcer Moderate Allocation Funds.”

Smallest Drawdown Fixed Income Funds generates a list of Fixed Income (e.g., Bond, Muni) funds that have experienced the smallest levels of Maximum Drawdown (MAXDD) in their respective categories. More specifically, they are in the quintile of funds with smallest MAXDD among their peers.

Looking back at performance since the November 2007, which represents the beginning of the current full market cycle, we find 147 such funds. Two top performing core bond funds are TCW Core Fixed-Income (TGCFX) and RidgeWorth Seix Total Return (SAMFX). The screen also uncovered notables like First Pacific Advisors’ FPA New Income (FPNIX) and Dan Ivascyn’s PIMCO Income (PIMIX).

Here are some risk/return metrics for these Fixed Income funds (click on images to enlarge):

TCW Core Fixed-Income (TGCFX) and RidgeWorth Seix Total Return (SAMFX)

First Pacific Advisors’ FPA New Income (FPNIX)

PIMCO Income (PIMIX)

Shortest Recovery Time Small Caps generates a list of Small Cap (Small Core, Small Value, Small Growth) funds that have incurred shortest Recovery Times (number of months a fund retracts from previous peak) in their respective categories.

For Full Cycle 5, this screen produces 62 such funds through December 2015. Among the best performing funds with shortest Recovery Times, under 30 months, only one remains open and/or accessible: Queens Road Small Cap Value (QRSVX). It was profiled by David in April 2015.

Here’s a short list and risk/return numbers for QRSVX across various timeframes:

Queens Road Small Cap Value (QRSVX)

Lowest Ulcer Moderate Allocation Funds generates a list of Mixed Asset Moderate Allocation funds that have incurred the lowest Ulcer Indices in their respective categories. 

Topping the list (fund with lowest UI) is James Balanced: Golden Rainbow (GLRBX), profiled last August :

The Alt Perspective: Commentary and news from DailyAlts.

We can all be thankful that January 2016 is over. I am at a point in my life where I don’t really enjoy rollercoaster rides, of any sort, as much as I did when I was younger. And this past month has been nothing short of a financial rollercoaster. In many ways, however, it shouldn’t have been a surprise that investors decided to take some air out of the balloon.

In a grand experiment, the central banks around the world have been pumping hot air into the global market balloon since November 2008. But the U.S. Fed officially took its foot off the gas pedal and applied a bit of light pressure to the brakes with its scant rate rise in December. And on top of that, China’s slowdown has raised concerns of contagion, and its equity markets have taken the brunt of that concern.

With all of the re-adjustments of market expectations and valuations currently taking place, 2016 may turn out to be quite a good year to be invested in alternatives.

Performance Review

Let’s start with traditional asset classes for the month of January 2015, where the average mutual fund for all of the major equity markets (per Morningstar) delivered negative performance in the month:

• Large Blend U.S. Equity: -6.95%
• Small Blend U.S. Equity: -9.18%
• Foreign Equity Large Blend: -7.32%
• Diversified Emerging Markets: -6.46%
• Intermediate Term Bond: 0.94%
• World Bond: -0.03%
• Moderate Allocation: -4.36%

Now a look at the liquid alternative categories, per Morningstar’s classification. Only Managed Futures and Bear Market funds generated positive returns in January, as one would expect. Long/Short Equity was down more than expected, but with small cap stocks being down just over 9%, it is not a surprise. Multi-alternative funds held up well, as did market neutral funds.

• Long/Short Equity: -4.18%
• Non-Traditional Bonds: -1.15%
• Managed Futures: 2.34%
• Market Neutral: -0.22%
• Multi-Alternative: -1.65%
• Bear Market: 11.92%

And a few non-traditional asset classes, where none escaped January’s downdraft:

• Commodities: -3.01%
• Multi-Currency: -0.49%
• Real Estate: -5.16%
• Master Limited Partnerships: -9.77%

Overall, a mixed bag for January.

Asset Flows

One of the more surprising aspects of 2015 was the concentration of asset flows into multi-alternative funds and managed futures funds. All other categories of funds, except for volatility funds, experienced outflows over the full twelve months of 2015, as documented in the below chart:

And despite the massive outflows from non-traditional bonds, the category remains the largest with more than $135 billion in assets. This compares to commodities at $67 billion and multi-alternative at $56 billion.

Hot Topics

Only six new liquid alternative funds were launched in January – four were long/short equity funds, one was a managed futures fund and the sixth was a non-traditional bond fund. Of the six funds, two were ETFs, and fairly innovative ETFs at that. We wrote about their structure in an article titled, Reality Shares Builds Suite of Dividend-Themed ETFs.

On the research front, we published summaries of two important research papers in January, both of which have been popular with readers:

• Using Active Share to Evaluate High-Yield Bond Portfolios – An interesting look at how to use active share to evaluate fixed income portfolios.
• Using Momentum and Hedge Funds to Build a Better Portfolio – It is often documented how hedge funds can help a traditionally allocated portfolio, but this article takes a look at a research paper that proposes something a bit different.

If you would like to keep up with all the news from DailyAlts, feel free to sign up for our daily or weekly newsletter.

I’ll be back next month, and until then, let’s hope the rollercoaster ride that started in January has come to an end.

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.

Cognios Market Neutral Large Cap (COGMX): this tiny fund does what its category is supposed to do, but never has. It makes good money even when the market stinks.

Leuthold Core Investment (LCORX): We celebrate the 20^th anniversary of Leuthold Core, a singularly disciplined and adaptive fund. Just one more year and it will be old enough to drink! We’re hopeful that the markets don’t give it, or us, reason to.

RiverNorth Opportunities (RIV): This is the closed-end fund for serious investors who know there’s a lot of money to be made in the irrational pricing of closed-end funds, but who don’t have the time or expertise to construct such a portfolio on their own.

Launch Alert: Davenport Balanced Income (DBALX)

Most folks haven’t heard of the Davenport Funds, which is understandable but also too bad. Davenport & Company is an employee-owned investment adviser that’s headquartered in Richmond, VA. They’ve been around since 1863 and now “custodies more than $20 billion in assets.” They manage five no-load funds, all somewhere in the solid-to-excellent range. Their newest fund, Davenport Balanced Income, launched on December 30, 2015.

Three things worth knowing:

1. The equity portion of the portfolio mirrors the holdings of the Davenport Value and Income Fund (DVIPX). All Davenport funds target firms with exceptionally high levels of insider equity ownership. Value & Income, in particular, targets three investment themes: Dividend Aristocrats, High Yielders with Capital Appreciation Potential and deep-value Contrarian/Special Situations.
2. Value and Income has performed exceedingly well. The fund just celebrated its fifth anniversary. Morningstar places it in the top 4% of all large value funds since inception. Perhaps more importantly, it significantly outperformed its peers in 2015 and again in 2016’s choppy first month. Since inception, its returns have been about a third higher than its equity income peers while all measures of its volatility have been lower. Based on the conventional measures of risk-adjusted return (Sharpe, Martin and Sortino ratios or Ulcer Index), it’s a Top 20 equity income fund.
3. The equity allocation is fluid, ranging from 25 to 75% of assets. The balance between the two sleeves is determined by the managers’ analysis of “economic trends, changes in the shape of the yield curve and sector analysis.” The income portion of the portfolio is invested for stability rather than appreciation.

John Ackerly, one of Davenport’s directors, claims they have “a long history of developing funds that manage downside risk and produce positive returns … over full market cycles.” The equity portion of the fund is managed by Davenport’s Investment Policy Committee; the fixed-income portion by two of the guys who manage their fixed-income separate accounts. Their managers have, on average, 30 years of experience. Expenses are capped at 1.25%. The minimum initial investment is $5,000 for regular accounts and $2,000 for tax-advantaged ones. More details are at Davenport Asset Management, with the funds linked under the Strategies tab.

Manager Changes

There’s always churn in the manager ranks. This month we tracked down changes at 67 equity or balanced funds. While no cry out “sea change!”, three fairly well-known Fidelity managers – Peter Saperstone, Adam Kutas and Charles Myers – are having their responsibilities changed. Mr. Kutas drops Latin America to focus on EMEA. Mr. Myers takes a six-month leave of absence starting in March. Mr. Saperstone has been steadily moving away for months. I also discovered that I don’t recognize the names of any of the Janus managers (except, of course, Mr. Gross).

Updates

Speaking of Mr. Gross, his Janus Unconstrained Bond (JUCAX) fund’s performance chart looks like this:

So far the fund has been above water for about one month, April 2015, since Mr. Gross came on board. That said, it certainly shows a dogged independence compared to its nontraditional bond peers (the orange line). And it does look a lot better than Miller Income Opportunity Fund (LMCJX), Legg Mason’s retirement gift to former star Bill Miller. Mr. Miller co-manages the fund with his son. Together they’ve managed to lose about 24% for their investors in the same period that Mr. Gross dropped two or three.

Briefly Noted . . .

There was a great thread on our discussion board about the fate of the Berwyn Funds. The Berwyn funds are advised by The Killen Group. The founder, Robert E. Killen, turned 75 and has chosen to sell his firm to the Chartwell Investment Partners. The fear is that Chartwell will use this as an opportunity to vacuum up assets. Their press release on the acquisition reads, in part:

“This transaction creates an investment management firm with annual revenues approaching $50 million and more than $10 billion in assets under management, as part of our well-defined strategy for growing our Chartwell Investment Partners business into a world-class asset manager,” TriState Capital Chief Executive Officer James F. Getz said. “We have an exceptional opportunity to combine Killen’s highly credible investment performance, particularly by the Morningstar five-star rated Berwyn Income Fund, with our proven national financial services distribution model to meaningfully accelerate growth in client assets….”

The fate of Berwyn’s small no-load shareholders seems unresolved.

Thanks, in passing but as always, to The Shadow, the indomitable Ted and the folks on our discussion board. They track down more cool stuff, and think more interesting thoughts, than about any group I know. I browse their work daily and learn a lot.

GoodHaven Fund (GOODX) is reorganizing itself. The key change is that it will have a new board of trustees, rather than relying on a board provided by the Professionally Managed Portfolios trust.

Effective at the end of January, 2016, the Innealta Capital Country Rotation (ICCNX) and Capital Sector Rotation (ICSNX) funds no longer include “consistent with the preservation of capital” as part of their investment objectives.

Manning & Napier has agreed to acquire a majority interest in Rainier Investment Management, the investment adviser to the Rainier Funds. 

Effective February 1, 2016, the T. Rowe Price Mid-Cap Index Fund and the T. Rowe Price Small-Cap Index Fund were added as options for all of the T. Rowe Price Retirement Fund. 

SMALL WINS FOR INVESTORS

Buffalo Emerging Opportunities Fund (BUFOX) and the Buffalo Small Cap Fund (BUFSX) have re-opened to new investors. They were closed for three and six years, respectively. Both funds posted wretched performance in 2014 and 2015 which might be a sign of disciplined investors out of step with an undisciplined market.

The Fairholme Focused Income (FOCIX) and Allocation (FAAFX) funds have reduced their minimum initial investment from $25,000 to $10,000.

Effective January 29, 2016, the redemption fee for the TCM Small Cap Growth Fund (TCMSX) was removed and the fund reduced its minimum initial investment from $100,000 to $2,500. It’s actually a pretty solid little small-growth fund.

Tweedy, Browne Global Value Fund II -Currency Unhedged (the “Fund”) reopened to new investors on February 1, 2016.

Effective as of January 1, 2016, the Valley Forge Fund’s (VAFGX) advisor, Boyle Capital Management, LLC, has voluntarily agreed to waive the full amount of its management fee. The voluntary waiver may be discontinued at any time. It was always a cute, idiosyncratic little fund run by a guy named Bernie Klawans. The sort of fund that had neither a website nor an 800 number. Bernie passed away at age 90, having run the fund until the last six months of his life. His handpicked successor died within the year. The Board of Trustees actually ran the fund for six months. Their eventual choice for a new manager did okay for a year, then performance fell off a cliff in the middle of 2014.

It’s never recovered and the fund is down to $7 million in assets, down by two-thirds since Mr. Klawan’s passing.

Vanguard Treasury Money Market Fund (VUSXX) has re-opened to all investors without limitations. It’s been charging four basis points and returning one basis point a year for the past three.

CLOSINGS (and related inconveniences)

AQR Style Premia Alternative Fund and AQR Style Premia Alternative LV Fund will both close to new investors on March 31, 2016. AQR’s Diversified Arbitrage Risk Parity and Multi-Strategy Alternative funds closed in 2012 and 2013. Sam Lee did a really strong analysis of the two Style Premia funds in our September 2015 issue.

Ziegler Strategic Income Fund (ZLSCX) has liquidated its Investor share class and has converted the existing Investor Class accounts into institutional accounts.

OLD WINE, NEW BOTTLES

The American Independence funds announced five name changes, including shortening American Independence to AI.

Old Name	New Name
American Independence JAForlines Risk-Managed Allocation	AI JAForlines Risk-Managed Allocation
American Independence International Alpha Strategies	AI Navellier International
American Independence Boyd Watterson Core Plus	AI Boyd Watterson Core Plus
American Independence Kansas Tax-Exempt Bond	AI Kansas Tax-Exempt Bond
American Independence U.S. Inflation-Indexed	AI U.S. Inflation-Protected

Aston Small Cap Fund (ATASX) – formerly Aston TAMRO Small Cap – is soon-to-be AMG GW&K Small Cap Growth Fund.

On January 28, 2016, Centre Global Select Equity Fund became Centre Global ex-U.S. Select Equity Fund (DHGRX). Not entirely sure why “Global ex-US” isn’t “International,” but maybe they had some monogrammed stationery that they didn’t want to throw out.

Effective on February 19, 2016, Columbia Intermediate Bond Fund (LIBAX) becomes Columbia Total Return Bond Fund. 

On February 1, 2016, Ivy Global Real Estate Fund (IREAX) became Ivy LaSalle Global Real Estate Fund, and Ivy Global Risk-Managed Real Estate Fund changed to Ivy LaSalle Global Risk-Managed Real Estate Fund (IVRAX). For the past three years, both funds have been sub-advised by Lasalle Investment Management. IVRAX has performed splendidly; IREAX, not so much.

Silly reader. You thought it was Touchstone Small Cap Core Fund. Actually it’s just Touchstone Small Cap Fund (TSFAX). Now, anyway.

OFF TO THE DUSTBIN OF HISTORY

“Because of the difficulty encountered in distributing the Fund’s shares,” 1492 Small Cap Core Alpha Fund (FNTSX) will liquidate on February 26, 2016. The fact that it’s not very good probably contributed to the problem.

American Beacon Retirement Income and Appreciation Fund and American Beacon Treasury Inflation Protected Securities Fund ( ) will be liquidated and terminated on March 31, 2016. Presumably that’s part of the ongoing house-cleaning as American Beacon tries to reposition itself as a sort of alternatives manager.

Anfield Universal Fixed Income Fund (AFLEX) liquidated two of its share classes (A1 and R) on February 1, 2016. Rather than moving those investors into another share class, they received a check in the mail and a tax bill. Odd. 

ASTON/TAMRO International Small Cap Fund (AROWX) liquidated on February 1, 2016. On the one hand, it only had $2 million in assets. On the other, the adviser pulled the plug after just a year. The manager, Waldemar Mozes, is a bright guy with experience at Artisan and Capital Group. He jokingly described himself as “the best fund manager ever to come from Transylvania.” We wish him well.

Columbia Global Inflation-Linked Bond Plus Fund liquidated after very short notice, on January 29, 2016.

Gator Opportunities Fund (GTOAX) thought it had to hang on until March 21, 2016. The board has discovered that a swifter execution would be legal, and now it’s scheduled to disappear on February 15, 2016.

Hodges Equity Income Fund (HDPEX) will merge into Hodges Blue Chip Equity Income Fund (currently named the Hodges Blue Chip 25 Fund HDPBX) at the end of March, 2016.

Its board simultaneously announced new managers for, and liquidation of, KF Griffin Blue Chip Covered Call Fund (KFGAX). The former occurred on January 6, the latter is slated for February 16, 2016.

Madison Large Cap Growth Fund (MCAAX) merges into Madison Investors (MNVAX) on February 29, 2016,

Don’t blink: McKinley Non-U.S. Core Growth Fund (MCNUX) will be gone by February 5, 2016. It was an institutional fund with a minimum investment of $40 million and assets of $37 million, so ….

Midas Magic (MISEX) and Midas Perpetual Portfolio (MPERX) are both slated to merge into Midas Fund (MIDSX). In reporting their taxable distributions this year, Midas announced that “One of Midas’ guiding principles is that we will communicate with our shareholders and prospective investors as candidly as possible because we believe shareholders and prospective investors benefit from understanding our investment philosophy and approach.” That makes it ironic that there’s no hint about why they’ve folding a diversified equity fund and a tactical allocation fund into a gold portfolio with higher fees than either of the other two.

We previously noted the plan to merge the Royce European Small-Cap and Global Value funds into Royce International Premier, pending shareholder approval. The sheep baa’ed shareholders approved the mergers, which will be executed sometime in February, 2016.

On March 24, 2016, Sentinel Mid Cap Fund (SNTNX) will be absorbed by Sentinel Small Company Fund (SAGWX), which have “identical investment objectives and similar investment strategies.” That’s a clear win for the investors, give or take any actual interest in investing in mid-caps. At the same time, Sentinel Sustainable Mid Cap Opportunities Fund (WAEGX) will be absorbed into Sentinel Sustainable Core Opportunities Fund (MYPVX).

TeaLeaf Long/Short Deep Value Fund (LEFAX) closed on January 25 and liquidated on January 29, 2016.

I’m okay with the decision to liquidate UBS U.S. Equity Opportunity Fund (BNVAX): it’s a tiny fund that’s trailed 98% of its peers over the past decade. The UBS board decided you needed to hear their reasoning for the decision, which they included in a section entitled:

Rationale for liquidating the Fund

Based upon information provided by UBS Asset Management (Americas) Inc., the Fund’s investment advisor, the Board determined that “it is in the best interests of the Fund and its shareholders to liquidate and dissolve the Fund pursuant to a Plan of Liquidation (the “Plan”). To arrive at this decision, the Board considered factors that have adversely affected, and will continue to adversely affect, the ability of the Fund to conduct its business and operations in an economically viable manner.”

Quick note to the board: that’s not a rationale. It’s a conclusion (“it’s in your best interest”) and a cryptic passage about the process “we considered factors.”

The Board of Trustees of Monetta Trust has concluded “that it would be in the best interests of the Fund and its shareholders” to liquidate Varsity/Monetta Intermediate Bond Fund (MIBFX), which will occur on February 18, 2016.

Vivaldi Orinda Hedged Equity Fund (OHEAX) is victim of its advisor’s “strategic decision to streamline its product offerings.” The fund will liquidate on February 26, 2016.

Voya Emerging Markets Equity Dividend Fund (IFCAX) will liquidate on April 8, 2016.

In Closing . . .

Please do double-check to see if you’ve set our Amazon link as a bookmark or starting tab in your browser. From Christmas 2014 to Christmas 2015, Amazon’s sales rose 60% but our little slice of the pie fell by 15% in the same period. We try not to be too much of a pesterance on the subject, but the Amazon piece continues as a financial mainstay so it helps to mention it.

If you’re curious about how the Amazon Associates program works, here’s the short version: if you enter Amazon using our link, an invisible little piece of text (roughly: “for the benefit of MFO”) follows you. When you buy something, that tag is attached to your order and we receive an amount equivalent to 6% or so of the value of the stuff ordered. It’s invisible and seamless from your perspective, and costs nothing extra. Sadly the tag expires after a day so if you put something in your cart on Guy Fawkes Day and places the order on Mardi Gras, the link will have expired.

Thanks, too, to the folks whose ongoing support makes it possible for us to keep the lights on (and even to upgrade them to LEDs!). That includes the growing cadre of folks using MFO Premium but also Paul R and Jason B, our most faithful subscribers Deb and Greg, the good folks at Andrei Financial and Gardey Financial and Carl R. (generous repeat offenders in the “keep MFO going” realm).

We’re about 90% done on a profile of the “new” LS Opportunity Fund (LSOFX), so that’s in the pipeline for March. Readers and insiders both have been finding interesting options for us to explore which, with Augustana’s spring break occurring in February, I might actually have time to!

We’ll look for you.

By David Snowball

Dear friends,

Talk about sturm und drang. After 75 days with in which the stock market rose or fell by 1% or more, the Vanguard Total Stock Market Index managed to roar ahead to a gain … of 0.29%. Almost 3000 mutual funds hung within two percentage points, up or down, of zero. Ten managed the rare feat of returning precisely zero. Far from a Santa Claus rally, 2015 couldn’t even manage a Grinchy Claus one.

And the Steelers lost to the Ravens. Again! Just rip my heart out, why doncha?

Annus horribilis or annus mediocris?

In all likelihood, the following three statements described your investment portfolio: your manager lost money, you suspect he’s lost touch with the market, and you’re confused.

Welcome to the club! 2015 saw incredibly widespread disappointment for investors. Investors saw losses in:

• 8 of 9 domestic equity categories, excluding large growth
• 17 of 17 asset allocation categories, from retirement income to tactical allocation
• 8 of 15 international stock categories
• 14 of 15 taxable bond categories and
• 6 of 6 alternative or hedged fund categories.

Anything that smacked of “real assets” (energy, MLPs, natural resources) or Latin America posted 20-30% declines. Foreign and domestic value strategies, regardless of market cap, trailed their growth-oriented peers by 400-700 basis points. The average hedge fund finished the year down about 4% and Warren Buffett’s Berkshire-Hathaway dropped 11.5%. The Masters of the Universe – William Ackman, David Einhorn, Joel Greenblatt, and Larry Robbins among them – are all spending their holidays penning letters that explain why 10-25% losses are no big deal. The folks at Bain, Fortress Investments and BlackRock spared themselves the bother by simply closing their hedge funds this year.

And among funds I actually care about (a/k/a “own”), T. Rowe Price Spectrum Income (RPSIX) lost money for just the third time in its 25 year history. As in 1994, it’s posting an annual loss of about 2%.

What to make of it? Opinions differ. Neil Irwin, writing in The New York Times half-celebrated:

Name a financial asset — any financial asset. How did it do in 2015?

The answer, in all likelihood: Meh.

It might have made a little money. It might have lost a little money. But, barring any drastic moves in the final trading days of 2015, the most widely held classes of assets, including stocks and bonds across the globe, were basically flat … While that may be disappointing news for people who hoped to see big returns from at least some portion of their portfolio, it is excellent news for anyone who wants to see a steady global economic expansion without new bubbles and all the volatility that can bring. (“Financial markets were flat in 2015. Thank goodness.” 12/30/2015)

Stephanie Yang, writing for CNBC, half-despaired:

It’s been a really, really tough year for returns.

According to data from Societe Generale, the best-performing asset class of 2015 has been stocks, whose meager 2 percent total return (that is, including dividends) still surpasses those of long-term bonds, short-term Treasury bills and commodities. These minimal gains make 2015 the worst year for finding returns since 1937, when the cash-like 3-month Treasury bill beat out other major asset classes with a return of 0.3 percent. (“2015 was the hardest year to make money in 78 years,” 12/31/2015).

Thirty-one liquid alts funds subsequently liquidated, the most ever (“The Year the Hedge-Fund Model Stalled on Main Street,” WSJ, 12/31/2015).

The most pressing question is whether 2015 is a single bad year or the prelude to something more painful than “more or less flat.” The folks at the Leuthold Group, advisers to the Leuthold funds as well as good institutional researchers, make the argument that the global equity markets have topped out. In support of that position, they break the market out into both component parts (MSCI Emerging Markets or FTSE 100) and internal measures (number of new 52-week highs in the NYSE or the ratio of advancing to declining stocks). With Leuthold’s permission, we’ve reproduced their timeline here.

Two things stand out. First, it appears that “the market’s” gains, if any, are being driven by fewer and fewer stocks. That’s suggested by the fact the number of 52-week highs peaked in 2013 and the number of advancing stocks peaked in spring 2015. The equal-weight version of the S&P 500 (represented by the Guggenheim S&P 500 Equal Weight ETF RSP) trailed the cap-weighted version by 370 basis points. The Value Line Arithmetic Index, which tracks the performance of “the average stock” by equally weighting 1675 issues, is down 11% from its April peak. Nearly 300 of the S&P 500 stocks will likely finish the year in the red. Second, many of the components followed the same pattern: peak in June, crash in August, partially rally in September then fade. The battle cry “there’s always a bull market somewhere!” seems not to be playing out just now.

The S&P 500 began 2015 at 2058. The consensus of market strategists in Barron’s was that it would finish 2015 just north of 2200. It actually ended at 2043. The new consensus is that it will finish 2016 just north of 2200.

The Leuthold Group calculates that, if we were to experience a typical bear market over the next year, the S&P 500 would drop to somewhere between 1500-1600.

By most measures, US stocks remain overpriced. There’s not much margin for safety in the bond market right now with US interest rates near zero and other major developing markets cutting theirs. Those interest rate cuts reflect concerns about weak growth and the potential for a China-led recession. The implosion of Third Avenue Focused Credit (TFCVX) serves as a reminder that liquidity challenges remain unresolved ahead of potentially disruptive regulations contemplated by the SEC.

The path forward is not particularly clear to me because we’ve never managed such a long period of global economic weakness and zero to negative interest rates before. My plan is to remind myself that I need to care about 2026 more than about 2016, to rebalance soon, and to stick with my discipline which is, roughly put, “invest regularly and automatically in sensible funds that execute a reasonable plan, ignore the market and pay attention to the moments, hours and days that life presents me.” On whole, an hour goofing around with my son or the laughter of dinner guests really does make a much bigger difference in my life than anything my portfolio might do today.

As Sergeant Phil Esterhaus used to remind the guys at Hill Street station as they were preparing to leave on patrol, “Hey, let’s be careful out there.”

For those seeking rather more direct guidance, our colleague Leigh Walzer of Trapezoid offers guidance, below, on the discipline of finding all-weather managers. Helpfully enough, he names a couple for you.

Good-Bye to All That

I cribbed the title from Robert Graves’ 1929 autobiography, one of a host of works detailing the horrors of fighting the Great War and the British military’s almost-criminal incompetence.

We bid farewell, sometimes with sadness, to a host of friends and funds.

Farewell to the Whitebox Funds

The Whitebox Advisors come from The Land of Giants. From the outside, I could never tell whether their expression was “swagger” or “sneer” but I found neither attractive. Back in 2012 readers urged us to look into the funds, and so we did. Our first take was this:

There are some funds, and some management teams, that I find immediately compelling.  Others not.

So far, this is a “not.”

Here’s the argument in favor of Whitebox: they have a Multi-Strategy hedge fund which uses some of the same strategies and which, per a vaguely fawning article in Barron’s, returned 15% annually over the past decade while the S&P returned 5%. I’ll note that the hedge fund’s record does not get reported in the mutual fund’s, which the SEC allows when it believes that the mutual fund replicates the hedge. 

Here’s the reservation: their writing makes them sound arrogant and obscure.  They advertise “a proprietary, multi-factor quantitative model to identify dislocations within and between equity and credit markets.”  At base, they’re looking for irrational price drops.  They also use broad investment themes (they like US blue chips, large cap financials and natural gas producers), are short both the Russell 2000 (which is up 14.2% through 9/28) and individual small cap stocks, and declare that “the dominant theories about how markets behave and the sources of investment success are untrue.”  They don’t believe in the efficient market hypothesis (join the club).

I’ll try to learn more in the month ahead, but I’ll first need to overcome a vague distaste.

I failed to overcome it. The fact that their own managers largely avoided the funds did not engender confidence.

In the face of poor performance and shrinking assets, they announced the closure of their three liquid alts funds in December. My colleague Charles offers a bit of further reflection on the closure, below.

Farewell to The House of Whitman

Marty Whitman become a fund manager at age 60 and earned enormous respect for his outspokenness and fiercely independent style. Returns at Third Avenue Value Fund (TAVFX) were sometimes great, sometimes awful but always Marty. Somewhere along the way, he elevated David Barse to handle all the business stuff that he had no earthly interest in, got bought by AMG, promised to assemble at least $25 billion in assets and built a set of funds that, save perhaps Third Avenue Real Estate Value (TAREX), never quite matched the original. It’s likely that his ability to judge people, or perhaps the attention he was willing to give to judging them, matched his securities analysis. The firm suffered and Mr. Whitman, in his 80s, either drifted or was pushed aside. Last February we wrote:

In sum, the firm’s five mutual funds are down by $11 billion from their peak asset levels and nearly 50% of the investment professionals on staff five years ago, including the managers of four funds, are gone. At the same time, only one of the five funds has had performance that meets the firm’s long-held standards of excellence.

Many outsiders noted not just the departure of long-tenured members of the Third Avenue community, but also the tendency to replace some those folks with outsiders … Industry professionals we talked with spoke of “a rolling coup,” the intentional marginalization of Mr. Whitman within the firm he created and the influx of outsiders. Understandably, the folks at Third Avenue reject that characterization.

Mr. Barse was, reportedly, furious about our story. An outstanding bit of reporting by Gregory Zuckerman and Matt Wirz from The Wall Street Journal in the wake of the collapse of Third Avenue Focused Credit revealed that “furious” was a more-or-less constant state for him.

Mr. Barse also harangued other fund managers who grew disgruntled. Mr. Whitman took no public steps to rein in the CEO, the people said, preferring to focus on investing.

The dispute boiled over in the fall of 2011, when about 50 employees gathered in the firm’s largest conference room after an annual meeting with investors. Mr. Barse screamed at Mr. Whitman, inches from his face, demanding better performance, according to people who were in the room.

Mr. Whitman “was pounding the table so hard with his fist it was shaking,” said another person at the meeting. Mr. Whitman eventually withdrew money from the Value Fund and quit running it to focus on investing for himself, while remaining chairman of the firm.

As most of Third Avenue’s funds underperformed relevant benchmarks … Mr. Barse seemed to become more irritated, the people said.

Staff stopped using the conference room adjoining Mr. Barse’s office because sometimes he could be heard shouting through the walls.

Most employees received part of their pay on a deferred basis. After 2008, Mr. Barse began personally determining compensation for most personnel, often without explaining his decision, one of the people said. (“How the Third Avenue Fund Melted Down,” 12/23/2015).

Yikes. The Focused Credit fund, Mr. Barse’s brainchild, came into the summer of 2015 with something like one third of its assets invested in illiquid securities, so-called “Level 3 securities.” There are two things you need to know about illiquid securities: you probably can’t sell them (at least not easily or quickly) and you probably can’t know what they’re actually worth (which is defined as “what someone is willing to buy it for”). A well-documented panic ensued when it looked like Focused Credit would need to hurriedly sell securities for which there were no buyers. Mr. Barse ordered the fund’s assets moved to a “liquidating trust,” which meant that shareholders (a) no longer knew what their accounts were worth and (b) no longer could get to the money. The plan, Third Avenue writes, is to liquidate the illiquid securities whenever they find someone willing to pay a decent price for them. Investors will receive dribs and drabs as that process unfolds.

We wrote Third Avenue to ask whether the firm would honor the last-published NAV for their fund and whether the firm had a commitment to “making whole” their investors. Like The Wall Street Journal reporters, we found that folks were unwilling to talk.

And so now investors wait. How long might they wait? Oh, could be eight or ten years. The closest analogue we have is the 2006 blowup of the Amaranth Advisors hedge fund. Amaranth announced that they’d freeze redemptions for two months. That’s now stretched to ten years with the freeze extended until at least December 2016. (“Ten Years After Blowup, Amaranth Investors Waiting to Get Money Back,” WSJ, 12/30/2015). In the interim, it’s hard to understand why investment advisors wouldn’t follow Mr. Whitman out the door.

Farewell to Mainstay Marketfield

Marketfield (MFLDX) was an excellent small no-load liquid alts fund that aspired to be more. It aspired to be a massive liquid alts fund, a goal achieved by selling themselves to New York Life and becoming Mainstay Marketfield. New York Life adopted a $1.7 billion overachiever in 2012 and managed to jam another $20 billion in assets into the fund in two years. The fund hasn’t been the same since. Over the past three years, it’s earned a one-star rating from Morningstar and lost almost 90% of its assets while trailing 90% of its peers.

On December 15, 2015, Mainstay announced an impending divorce:

At a meeting held on December 8-10, 2015, the Board of Trustees of MainStay Funds Trust approved an Agreement and Plan of Reorganization [which] provides for the reorganization of the Fund into the Marketfield Fund (the “New Fund”) …

Prior to the Reorganization, which is expected to occur on or about March 23, 2016, Marketfield Asset Management, LLC, the Fund’s current subadvisor, will continue to manage the Fund … The New Fund will have the same investment objective, principal investment strategies and investment process.

There are very few instances of a fund recovering from such a dramatic fall, but we wish Mr. Aronstein and his remaining investors the very best.

Farewell to Sequoia’s mystique

The fact that Sequoia (SEQUX) lost money in 2015 should bother no one. The fact that they lost their independence should bother anyone who cares about the industry. Sequoia staked its fate to the performance of Valeant Pharmaceuticals, a firm adored by hedge fund managers and Sequoia – which plowed over a third of its portfolio into the stock – for its singular strategy: buy small drug companies with successful niche medicines, then skyrocket the price of those drugs. One recent story reported:

The drugstore price of a tube of Targretin gel, a topical treatment for cutaneous T cell lymphoma, rose to about $30,320 this year from $1,687 in 2009. Most of that increase appears to have occurred after Valeant acquired the drug early in 2013. A patient might need two tubes a month for several months, Dr. Rosenberg said.

The retail price of a tube of Carac cream, used to treat precancerous skin lesions called actinic keratoses, rose to $2,865 this summer from $159 in 2009. Virtually all of the increase occurred after 2011, when Valeant acquired the product. (“Two Valeant drugs lead steep price increases,” 11/25/2015)

Remember that Valeant didn’t do anything to discover or create the drugs; they simply gain control of them and increase the price by 1800%.

Sequoia’s relationship to Valeant’s CEO struck me as deeply troubling: Valeant’s CEO Michael Pearson was consistently “Mike” when Sequoia talked about him, as in “my buddy Mike.”

We met with Mike a few weeks ago and he was telling us how with $300 million, you can get an awful lot done.

Mike can get a lot done with very little.

Mike is making a big bet.

The Sequoia press releases about Valeant sound like they were written by Valeant, two members of the board of trustees resigned in protest, a third was close to following them and James Stewart, writing for The New York Times, described “Sequoia’s infatuation with Valeant.” In a desperate gesture, Sequoia’s David Poppe tried to analogize Sequoia’s investment in Valeant with a long-ago bet on Berkshire Hathaway. Mr. Stewart drips acid on the argument.

Sequoia’s returns may well rebound. Their legendary reputation, built over decades of principled decision-making, will not. Our November story on Sequoia ended this way:

Sequoia’s recent shareholder letter concludes by advising Valeant to start managing with “an eye on the company’s long-term corporate reputation.” It’s advice that we’d urge upon Sequoia’s managers as well.

Farewell to Irving Kahn

Mr. Kahn died at his home in February 2015. At age 109, he was the nation’s oldest active professional investor. He began trading in the summer of 1929, made good money by shorting overvalued stock at the outset of the Crash, and continued working steadily for 85 more years. He apprenticed with Benjamin Graham and taught, at Graham’s behest, at the Columbia Business School. At 108, he still traveled to his office three days a week, weather permitted. His firm, Kahn Brothers Group, manages over a billion dollars.

Where Are the Jedi When You Need Them?

“In present-day America it’s very difficult, when commenting on events of the day, to invent something so bizarre that it might not actually come to pass while your piece is still on the presses.”

Calvin Trillin, remarking on the problems in writing satire today.

So, the year has ended and again there is no joy in Mudville. The investors have no yachts or NetJet cards but on a trailing fee basis, fund managers still got rich. The S&P 500, which by the way has 30-35% of the earnings of its component companies coming from overseas so it is internationally diversified, trounced most active managers again. We continued to see the acceleration of the generational shift at investment management companies, not necessarily having anything to do with the older generation becoming unfit or incompetent. After all, Warren Buffett is in his 80’s, Charlie Munger is even older, and Roy Neuberger kept working, I believe, well into his 90’s. No, most such changes have to do with appearances and marketing. The buzzword of the day is “succession planning.” In the investment management business, old is generally defined as 55 (at least in Boston at the two largest fund management firms in that town). But at least it is not Hollywood.

One manager I know who cut his teeth as a media analyst allegedly tried to secure a place as a contestant on “The Bachelor” through his industry contacts. Alas, he was told that at age 40 he was too old. Probably the best advice I had in this regard was a discussion with a senior infantry commander, who explained to me that at 22, a man (or woman) was probably too old to be in the front lines in battle. They no longer believed they couldn’t be killed. The same applies to investment management, where the younger folks, especially when dealing with other people’s money, think that this time the “new, new thing” really is new and this time it really is different. That is a little bit of what we have seen in the energy and commodity sectors this year, as people kept doubling down and buying on the dips. This is not to say that I am without sin in this regard myself, but at a certain point, experience does cause one to stand back and reassess. Those looking for further insight, I would advise doing a search on the word “Passchendaele.” Continuing to double down on investments especially where the profit of the underlying business is tied to the price of a commodity has often proved to be a fool’s errand.

The period between Christmas and New Year’s Day is when I usually try to catch up on seeing movies. If you go to the first showing in the morning, you get both the discounted price and, a theater that is usually pretty empty. This year, we saw two movies. I highly recommend both of them. One of them was “The Big Short” based on the book by Michael Lewis. The other was “Spotlight” which was about The Boston Globe’s breaking of the scandal involving abusive priests in the Archdiocese of Boston.

Now, I suspect many of you will see “The Big Short” and think it is hyped-up entertainment. That of course, the real estate bubble with massive fraud taking place in the underwriting and placement of mortgages happened in 2006-2008 but ….. Yes, it happened. And a very small group of people, as you will see in the story, saw it, thought something did not make sense, asked questions, researched, and made a great deal of money going against the conventional wisdom. They did not just avoid the area (don’t invest in thrifts or banks, don’t invest in home building stocks, don’t invest in mortgage guaranty insurers) but found vehicles to invest in that would go up as the housing market bubble burst and the mortgages became worthless. I wish I could tell you I was likewise as smart to have made those contrary investments. I wasn’t. However, I did know something was wrong, based on my days at a bank and on its asset-liability committee. When mortgages stopped being retained on the books by the institutions that had made them and were packaged to be sold into the secondary market (and then securitized), it was clear that, without ongoing accountability, underwriting standards were being stretched. Why? With gain-on-sale accounting, profits and bonuses were increased and stock options went into the money. That was one of the reasons I refused to drink the thrift/bank Kool-Aid (not the only time I did not go along to get along, but we really don’t change after the age of 8). One food for thought question – are we seeing a replay event in China, tied as their boom was to residential construction and real estate?

One of the great scenes in “The Big Short” is when two individuals from New York fly down to Florida to check on the housing market and find unfinished construction, mortgages on homes being occupied by renters, people owning four or five homes trying to flip them, and totally bogus underwriting on mortgage lending. The point here is that they did the research – they went and looked. Often in fund management, a lot of people did not do that. After all, fill-in-the blank sell-side firm would not be recommending purchase of equities in home builders or mortgage lenders, without actually doing the real due diligence. Leaving aside the question of conflicts of interest, it was not that difficult to go look at the underlying properties and check valuations out against the deeds in the Recorder’s Office (there is a reason why there are tax stamps on deeds). So you might miss a few of your kid’s Little League games. But what resonates most with me is that no senior executive that I can remember from any of the big investment banks, the big thrifts, the big commercial banks was criminally charged and went to jail. Instead, what seems to have worked is what I will call the “good German defense.” And another aside, in China, there is still capital punishment and what are capital crimes is defined differently than here.

This brings me to “Spotlight” where one of the great lines is, “We all knew something was going on and we didn’t do anything about it.” And the reason it resonates with me is that you see a similar conspiracy of silence in the financial services industry. Does the investor come first or the consultant? Is it most important that the assets grow so the parent company gets a bigger return on its investment, or is investment performance most important? John Bogle, when he has spoken about conflicts of interest, is right when he talks about the many conflicts that came about when investment firms were allowed to sell themselves and basically eliminate personal responsibility.

This year, we have seen the poster child for what is wrong with this business with the ongoing mess at The Third Avenue Funds. There is a lot that has been written so far. I expect more will be written (and maybe even some litigation to boot). I commend all of you to the extensive pieces that have appeared in the Wall Street Journal. But what they highlight that I don’t think has been paid enough attention to is the problem of a roll-up investment (one company buying up and owning multiple investment management firms) with absentee masters. In the case of Third Avenue, we have Affiliated Managers Group owning, as reported by the WSJ, 60% of Third Avenue, and those at Third Avenue keeping a 40% stake (to incentivize them). With other companies from Europe, such as Allianz, the percentages may change but the ownership is always majority. So, 60% of the revenues come off the top, and the locals are left to grow the business, reinvest in it by hiring and retaining talent, focus on investment performance, etc., with their percentage. Unfortunately, when the Emperor is several states, or an ocean away, one often does not know what is really going on. You get to see numbers, you get told what you want to hear (ISIS has been contained, Bill Gross is a distraction to the other people), and you accept it until something stops working.

So I leave you with my question for you all to ponder for 2016. Is the 1940 Act mutual fund industry, the next big short? Investors, compliments of Third Avenue, have now been reminded that daily liquidity and redemption is that until it is not. As I have mentioned before, this is an investment class with an unlimited duration and a mismatch of assets and liabilities. This is perhaps an unusual concern for a publication named “Mutual Fund Observer.” But I figure if nothing else, we can always start a separate publication called “Mutual Fund Managers Address Book” so you can go look at the mansions and townhouses in person.

– by Edward A. Studzinski

Quietly successful: PYGSX, RSAFX, SCLDX, ZEOIX

Amidst the turmoil, a handful of the funds we’re profiled did in 2015 exactly what they promised. They made a bit of money with little drama and, sadly, little attention. You might want to glance in their direction if you’ve found that your managers were getting a little too creative and stretching a little too far in their pursuit of “safe” income.

Payden Global Low Duration (PYGSX): the short-term global bond fund made a modest 0.29% in 2015 while its peers lost about 4.6%. In our 2013 profile we suggested that “flexibility and opportunism coupled with experienced, disciplined management teams will be invaluable” and that Payden offered that combo.

Riverpark Structural Alpha (RSAFX): this tiny fund used a mix of options which earned their investors 1.3% while its “market neutral” peers lost money. The fund, we suggested, was designed to answer the question, “where should investors who are horrified by the prospects of the bond market but are already sufficiently exposed to the stock market turn for stable, credible returns?” It’s structurally exposed to short-term losses but also structurally designed to rebound, automatically and quickly, from them. In the last five years, for example, it’s had four losing quarters but has never had back-to-back losing quarters.

Scout Low Duration Bond Fund (SCLDX): this flexible, tiny short-term bond tiny fund made a bit of money in 2015 (0.6%), but it’s more impressive that the underlying strategy also made money (1.4%) during the 2008 meltdown. Mr. Eagan, the lead manager, explained it this way: “Many short-term bond funds experienced negative returns in 2008 because they were willing to take on what we view as unacceptable risks in the quest for incremental yield or income …When the credit crisis occurred, the higher risks they were willing to accept produced significant losses, including permanent impairment. We believe that true risk in fixed income should be defined as a permanent loss of principle. Focusing on securities that are designed to avoid this type of risk has served us well through the years.”

Zeo Strategic Income (ZEOIX): this short-term, mostly high-yield fund made 2.0% in 2015 while its peers dropped 4.1%. It did a particularly nice job in the third quarter, making a marginal gain as the high-yield market tanked. Positioned as a home for your “strategic cash holdings,” we suggested that “Modestly affluent folks who are looking to both finish ahead of inflation and sleep at night should likely make the effort to reach out and learn more.”

RiverPark Short-Term High Yield (RPHYX) likewise posted a gain – 0.86% – for the year but remains closed to new investors. PIMCO Short Asset Investment (PAIUX) which provides the “cash” strategy for all the PIMCO funds, eked out a 0.25% gain, modestly ahead of its ultra-short peers. 

These are very different strategies, but are unified by the presence of thoughtful, experienced managers who are exceedingly conscious of market risk.

Candidates for Rookie of the Year

We’ve often asked, by journalists and others, which are the young funds to keep an eye on. We decided to search our database for young funds that have been exceptionally risk-sensitive and have, at the same time, posted strong returns over their short lives. We used our premium screener to identify funds that had several characteristics:

They were between 12 and 24 months old; that is, they’d completed at least one full year of existence but were no more than two. I suspect a few funds in the 2-3 year range slipped through, but it should be pretty few.

They had a Martin Ratio greater than one; the Martin Ratio is a variation of the Sharpe ratio which is more sensitive to downward movements

They had a positive Sharpe ratio and had one of the five highest Sharpe ratios in their peer group.

Hence: young, exceptional downside sensitivity so far and solid upside. We limited our search to a dozen core equity categories, such as Moderate Balanced and Large Growth.

In all of these tables, “APR vs Peer” measures the difference in Annual Percentage Return between a fund’s lifetime performance and its average peers. A fund might have a 14 month record which the screener annualizes; that is, it says “at this rate, you’d expect to earn X in a year.” That’s important because a fund with a scant 12 month record is going to look a lot worse than one at 20 or 24 months since 2015, well, sucked.

Herewith, the 2016 Rookie of the Year nominees:

Small cap rookies	Sharpe Ratio	Martin Ratio	APR vs Peer
Acuitas US Microcap (AFMCX)	0.83	3.10	9.6	Three sets of decent sub-advisors, tiny market cap but the fund is institutional only.
Hodges Small Intrinsic Value (HDSVX)	0.79	2.37	9.3	Same team that manages the five-star Hodges Small Cap fund.
Perritt Low Priced Stock (PLOWX)	0.74	2.05	8.8	The same manager runs Perritt UltraMicro and Microcap Opportunities, neither of which currently look swift when benchmarked against funds that invest in vastly larger stocks.
Hancock Horizon US Small Cap (HSCIX)	0.70	2.61	8.6	Hmmm… the managers also run, with limited distinction, Hancock Horizon Growth, a large cap fund.
SunAmerica Small-Cap (SASAX)	0.70	2.51	8.1	Some overlap with the management team for AMG Managers Cadence Emerging Companies, a really solid little institutional fund.

 

Mid cap rookies	Sharpe Ratio	Martin Ratio	APR vs Peer
PowerShares S&P MidCap Low Volatility Portfolio (XMLV)	0.99	4.11	10.4	Low vol. Good thought.
Diamond Hill Mid Cap (DHPAX)	0.75	3.22	7.9	In various configurations, members of the team are responsible for six other Diamond Hill funds, some very fine.
Nuance Mid Cap Value (NMAVX)	0.45	2.03	6.7	Two years old; kinda clubbed its competition in 2015. The lead manager handled $10 billion as an American Century manager.
Hodges Small-to-Midcap (HDSMX)	0.43	1.32	5.5	Same team that manages the five-star Hodges Small Cap fund.
Barrow Value Opportunity (BALAX)	0.41	1.58	5.3	David Bechtel talked through the fund’s strategy in a 2014 Elevator Talk.

 

Large cap rookies	Sharpe Ratio	Martin Ratio	APR vs Peer
iShares MSCI USA Momentum Factor ETF (MTUM)	0.64	2.68	3.6	Momentum tends to dominate at the ends of bull markets, so this isn’t particularly surprising.
iShares MSCI USA Quality Factor ETF (QUAL)	0.53	2.61	2.5
Arin Large Cap Theta (AVOLX)	0.52	2.73	4.5	A covered call fund that both M* and Lipper track as if it were simple large cap equity.
SPDR MFS Systematic Core Equity ETF (SYE)	0.48	1.99	6	An active ETF managed by MFS
SPDR MFS Systematic Value Equity ETF (SYV)	0.46	1.8	8.0	And another.

Hmmm … you might notice that the large cap list is dominated by ETFs, two active and two passive. There were a larger number of active funds on the original list but I deleted Fidelity funds (three of them) that were only available for use by other Fidelity managers.

Multi-cap rookies	Sharpe Ratio	Martin Ratio	APR vs Peer
SPDR MFS Systematic Growth Equity ETF (SYG)	0.74	3.3	10.4	Another active ETF managed by MFS
Segall Bryant & Hamill All Cap (SBHAX)	0.69	2.73	5.4	The lead manager used to run a Munder health care fund. M* treats this as a large growth fund, a category in which it does not excel.
Riverbridge Growth (RIVRX)	0.66	2.43	4.6	The team has been subadvising a Dreyfus Select Managers small cap fund for about five years.
AT Mid Cap Equity (AWMIX)	0.52	1.74	3.5	AT is Atlantic Trust, once known for the Atlantic Whitehall funds. It’s currently limiting itself to rich folks. Pity.
BRC Large Cap Focus Equity (BRCIX)	0.37	1.31	5.3	Institutional only. Pity.

This is another category where we had to dump a bunch of internal-only Fidelity funds. It’s interesting that no passive fund was even near the top of the list, perhaps because the ability to move between size ranges is active and useful?

Global rookies	Sharpe Ratio	Martin Ratio	APR vs Peer
William Blair Global Small Cap Growth (WGLIX)	0.99	3.99	11.9	Sibling to an excellent but closed international small growth fund. They’re liquidating it anyway (Thanks for the reminder, JoJo).
Vanguard Global Minimum Volatility (VMVFX)	0.96	3.96	9.4	A fund we profiled.
WCM Focused Global Growth (WFGGX)	0.81	3.48	11.2	The team runs eight funds, mostly as sub-advisors, including the five star Focused International Growth fund.
QS Batterymarch Global Dividend (LGDAX)	0.3	1.16	8.1
Scharf Global Opportunity (WRLDX)	0.3	1.14	4.1	0.50% e.r. The same manager runs four or five Scharf funds, several with exceptional track records.

At the other end of the spectrum, it was durn tough to find strong performance among “rookie” international funds. In the emerging markets arena, for example, just one fund had a positive Martin Ratio: Brown Advisory Emerging Markets Small-Cap (BIANX). Everyone else was down a deep, deep hole.

While we’re not endorsing any of these funds just yet, they’ve distinguished themselves with creditable starts in tough markets. In the months ahead, we’ll be trying to learn more about them on your behalf.

For the convenience of MFO Premium members who are interesting in digging into rookie funds more deeply, Charles created a preset screen for high-achieving younger funds. He offers dozens of data points on each of those funds where we only have room, or need, for a handful here.

Premium Site Update

New to MFO Premium this month are several additions to the MultiSearch Tool, which now can screen our monthly fund database with some 44 performance metrics and other parameters. (Here are links to current Input and Output MultiSearch Parameter Lists.) The new additions include SubType (a kind of super category), exchange-traded fund (ETF) flag, Profiled Funds flag, and some initial Pre-Set Screens.

SubType is a broad grouping of categories. Lipper currently defines 144 categories, excluding money market funds. MFO organizes them into 9 subtypes: U.S. Equity, Mixed Asset, Global Equity, International Equity, Sector Equity, Commodity, Alternative & Other, Bond, and Municipal Bond funds. The categories are organized further into broader types: Fixed Income, Asset Allocation, and Equity funds. The MultiSearch Tool enables screening of up to 9 categories, 3 subtypes, or 2 types along with other criteria.

The Profiled Funds flag enables screening of funds summarized monthly on our Dashboard (screenshot here). Each month, David (and occasionally another member of MFO’s staff), typically provides in-depth analysis of two to four funds, continuing a FundAlarm tradition. Through November 2015, 117 profiles are available on MFO legacy site Funds page. “David’s Take” precariously attempts to distill the profile into one word: Positive, Negative, or Mixed.

The ETF flag is self-explanatory, of course. How many ETFs are in our November database? A lot! 1,716 of the 9,034 unique (aka oldest share class) funds we cover are ETFs, or nearly 19%. The most populated ETF subtype is Sector Equity with 364, followed by International Equity with 343, US Equity with 279, and Bonds with 264. At nearly $2T in assets under management (AUM), ETFs represent 12% of the market. Our screener shows 226 ETFs with more than $1B in AUM. Here is a summary of 3-year performance for top ten ETFs by AUM (click on image to enlarge):

The Pre-Set Screen option is simply a collection of screening criteria. The two initial screens are “Best Performing Rookie Funds” and “Both Great Owl and Honor Roll Funds.” The former generates a list of 160 funds that are between the age of 1 and 2 years old and have delivered top quintile risk adjusted return (based on Martin Ratio) since their inception. The latter generates a list of 132 funds that have received both our Great Owl distinction as well as Honor Roll designation. Here is a summary of 3-year performance for top ten such funds, again by AUM (click on image to enlarge) … it’s an impressive list:

Other Pre-Screens David has recommended include “moderate allocation funds with the best Ulcer Index, small caps with the shortest recovery times, fixed-income funds with the smallest MAXDD …” Stay tuned.

Along with the parameters above, new options were added to existing criteria in the MultiSearch Tool. These include 30, 40, and 50 year Age groups; a “Not Three Alarm” rating; and, a “0% Annual or More” Absolute Return setting.

Using the new “0% Annual or More” criterion, we can get a sense of how tough the past 12 months have been for mutual funds. Of the 8,450 funds across all categories at least 12 months old through November 2015, nearly 60% (4,835) returned less than 0% for the year. Only 36 of 147 moderate allocation funds delivered a positive return, which means nearly 75% lost money … believe it or not, this performance was worse than the long/short category.

A closer look at the long/short category shows 56 of 121 funds delivered positive absolute return. Of those, here are the top five based on risk adjusted return (Martin Ratio) … click on image to enlarge:

AQR Long/Short

AQR’s rookie Long/Short Equity I (QLEIX) has been eye-watering since inception, as can be seen in its Risk Profile (click on images to enlarge):

While I’ve always been a fan of Cliff Asness and the strategies at AQR, I’m not a fan of AQR Funds, since experiencing unfriendly shareholder practices, namely lack of disclosure when its funds underperform … but nothing speaks like performance.

Whitebox Funds

I have also always been a fan of Andrew Redleaf and Whitebox Funds, which we featured in the March 2015 Whitebox Tactical Opportunities 4Q14 Conference Call and October 2013 Whitebox Tactical Opportunities Conference Call. David has remained a bit more guarded, giving them a “Mixed” profile in April 2013 Whitebox Market Neutral Equity Fund, Investor Class (WBLSX), April 2013.

This past month the Minneapolis-based shop decided to close its three open-end funds, which were based on its hedge-fund strategies, less than four years after launch. A person familiar with the adviser offered: “They were one large redemption away from exposing remaining investors to too great a concentration risk … so, the board voted to close the funds.” AUM in WBMIX had grown to nearly $1B, before heading south. According to the same person, Whitebox hedge funds actually attracted $2B additional AUM the past two years and that was where they wanted to concentrate their efforts.

The fund enjoyed 28 months (about as long as QLEIX is old) of strong performance initially, before exiting the Mr. Market bus. Through November 2015, it’s incurred 19 consecutive months of drawdown and a decline from its peak of 24.2%. Depicting its rise and fall, here is a Morningstar growth performance plot of WBMIX versus Vanguard’s Balanced Fund Index (VBINX), as well as the MFO Risk Profile (click on images to enlarge):

Ultimately, Mr. Redleaf and company failed to deliver returns across the rather short life span of WBMIX consistent with their goal of “the best endowments.” Ultimately, they also failed to deliver performance consistent with the risk tolerance and investment timeframe of its investors. Ultimately and unfortunately, there was no “path to victory” in the current market environment for the fund’s “intelligent value” strategy, as compelling as it sounded and well-intended as it may have been.

As always, a good discussion can be found on the MFO Board Whitebox Mutual Funds Liquidating Three Funds, along with news of the liquidations.

Year-end MFO ratings will be available on or about 4th business day, which would be January 7^th on both our premium and legacy sites.

Snow Tires and All-Weather portfolios

By Leigh Walzer

Readers of a certain age will remember when winter meant putting on the snow tires. All-season tires were introduced in 1978 and today account for 96% of the US market. Not everyone is sure this is a good idea; Edmunds.com concludes “snow and summer tires provide clear benefits to those who can use them.”

As we begin 2016, most of the country is getting its first taste of winter weather. “Putting on the snow tires” is a useful metaphor for investors who are considering sacrificing performance for safety. Growth stocks have had a great run while the rest of the market sits stagnant. Fed-tightening, jittery credit markets, tight-fisted consumer, commodity recession, and sluggishness outside the US are good reasons for investor caution.

Some clients have been asking if now is a good time to dial back allocations to growth. In other words, should they put the snow tires on their portfolio.

The dichotomy between growth and value and the debate over which is better sometimes approaches theological overtones. Some asset allocators are convinced one or the other will outperform over the long haul. Others believe each has a time and season. There is money to be made switching between growth and value, if only we had 20/20 hindsight about when the business cycle turns.

When has growth worked better than value?

Historically, the race between growth and value has been nearly a dead heat. Exhibit 1 shows the difference in the Cumulative return of Growth and Value strategies over the past twenty years. G/V is a measure of the difference in return between growth and value in a given period Generally speaking, growth performed better in the 90s, a period of loose money up to the internet bust. Value did better from 2000-2007. Since 2007, growth has had the edge despite a number of inflections. Studies going back 50 years suggest value holds a slight advantage, particularly during the stagflation of the 1970s.

Exhibit I

Growth tends to perform better in up-markets. This relationship is statistically valid but the magnitude is almost negligible. Over the past twenty years Trapezoid’s US Growth Index had a beta of 1.015 compared with 0.983 for Value.

Exhibit II

The conventional wisdom is that growth stocks should perform better early to mid-cycle while value stocks perform best late in the business cycle and during recession. That might loosely describe the 90s and early 2000s. However, in the run up the great recession, value took a bigger beating as financials melted down. And when the market rebounded in April 2009, value led the recovery for the first six months.

Value investors expect to sacrifice some upside capture in order to preserve capital during declining markets. Exhibit III, which uses data from Morningstar.com about their Large Growth (“LG”) and Large Value (“LV”) fund categories, shows the reality is less clear. In 2000-2005 LV lived up to its promise: it captured 96% of LG’s upside but only 63% of its downside. But since 2005 LV has actually participated more in the downside than LG.

Exhibit III	2001-2005	2006-2010	2011- 2015
LG Upside Capture	105%	104%	98%
LG Downside Capture	130%	101%	106%
LV Upside Capture	101%	99%	94%
LV Downside Capture	82%	101%	111%
LV UC / LG Up Capt	96%	95%	97%
LV DC / LG Dn Capt	63%	100%	104%

Recent trend

In 2015 (with the year almost over as of this writing), value underperformed growth by about 5%. Value funds are overweight energy and underweight consumer discretionary which contributed to the shortfall.

Can growth/value switches be predicted accurately?

In the long haul, the two strategies perform nearly equally. If the weatherman can’t predict the snow, maybe it makes sense to leave the all-season tires on all year.

We can look through the historical Trapezoid database to see which managers had successfully navigated between growth and value. Recall that Trapezoid uses the Orthogonal Attribution Engine to attribute the performance of active equity managers over time to a variety of skills. Trapezoid calculates the contribution to portfolio return from overweighting growth or value in a given period. We call this sV.

Bear in mind that Trapezoid LLC does not call market turns or rate sectors for timeliness. And Trapezoid doesn’t try to forecast whether growth or value will work better in a given period. But we do try to help investors make the most of the market. And we look at the historic and projected ability of money managers to outperform the market and their peer group based on a number of skills.

The Trapezoid data does identify managers who scored high in sV during particular periods. Unfortunately, high sV doesn’t seem to carry over from period to period. As Professor Snowball would say, sV lacks predictive validity; the weatherman who excelled last year missed the big storm this year. However, the data doesn’t rule out the possibility that some managers may have skill. As we have seen, growth or value can dominate for many years, and few managers have sufficient tenure to draw a strong conclusion.

We also checked whether market fundamentals might help investors allocate between growth and value. We are aware of one macroeconomic model (Duke/Fuqua 2002) which claims to successfully anticipate 2/3 of growth and value switches over the preceding 25 years.

One hypothesis is that value excels when valuations are stretched while growth excels when the market is not giving enough credit to earnings growth. In principle this sounds almost tautologically correct. However, implementing an investment strategy is not easy. We devised an index to see how much earnings growth the market is pricing in a given time (S&P500 E/P less 7-year AAA bond yield adjusted for one year of earning growth). When the index is high, it means either the equity market is attractive relative bonds or that the market isn’t pricing in much earnings growth. Conversely, when the index is low it means valuations of growth stocks are stretched and therefore investors should load up on value. We looked at data from 1995-2015 and compared the relative performance of growth and value strategies over the following 12 months. We expected that when the index is high growth would do better.

Exhibit IV

There are clearly times when investors who heeded this strategy would have correctly anticipated investing cycles. We found the index was directionally correct but not statistically significant. Exhibit IV shows the Predictor has been trending lower in 2015 which would suggest that the growth cycle is nearly over.

All-Weather Managers

Since it is hard to tell when value will start working, investors could opt for all-weather managers, i.e. managers with a proven ability to thrive during value and growth periods.

We combed our database for active equity managers who had an sV contribution of at least 1%/year in both the growth era since 1q07 and the value market which preceded it. Our filter excludes a large swath of managers who haven’t been around 9 years. Only six funds passed this screen – an indication that skill at navigating between growth and value is rare. We knocked out four other funds because, using Trapezoid’s standard methodology, projected skill is low or expenses are high. This left just two funds.

Century Shares Trust (CENSX), launched in 1928, is one of the oldest mutual funds in the US. The fund tracks itself against the Russell 1000 Growth Index but does not target a particular sector mix and apply criteria like EV/EBITDA more associated with value. Expenses run 109bps. CENSX’s performance has been strong over the past three years. Their long-term record selecting stocks and sectors is not sufficient for inclusion in the Trapezoid Honor Roll.

Does CENSX merit extra consideration because of the outstanding contribution from rotating between growth and value? Serendipity certainly plays a part. As Exhibit V illustrates, the current managers inherited in 1999 a fund which was restricted by its charter to financials, especially insurance. That weighting was very well-suited to the internet bust and recession which followed. They gradually repositioned the portfolio towards large growth. And he has made a number of astute switches. Notably, he emphasized consumer discretionary and exited energy which has worked extremely well over the past year. We spoke to portfolio manager Kevin Callahan. The fund is managed on a bottom-up fundamentals basis and does not have explicit sector targets. But he currently screens for stocks from the Russell 1000 Growth Index and seem reluctant to stray too far from its sector weightings, so we expect growth/value switching will be much more muted in the future.

The other fund which showed up is Cohen & Steers Global Realty Fund (CSSPX). The entire real estate category had positive sV over the past 15-20 years; real estate (both domestic and global) clobbered the market during the value years, gave some back in the run-up to the financial crisis, and has been a market performer since then.

We are not sure how meaningful it is that CSSPX made this list over some other real estate funds with similar focus and longevity. Investors may be tempted to embrace real estate as an all-weather sector. But over the longer haul real estate has had a more consistent market correlation with beta averaging 0.6 which means it participated equally in up and down markets.

More complete information can be found at www.fundattribution.com. MFO readers can sign up for a free demo. Please click the link from the Model Dashboard (login required) to the All-Weather Portfolio.

The All-Season Portfolio

Since we are not sure that good historic sV predicts future success and managers with a good track record in this area are scarce, investors might take a portfolio approach to all-season investing.

1. Find best of breed managers. Use Trapezoid’s OAE to find managers with high projected skill relative to cost. While the Trapezoid demo rates only Large Blend managers (link to the October issue of MFO), the OAE also identifies outstanding managers with a growth or value orientation.
2. Strike the right balance. Many thoughtful investors believe “value is all you need” and some counsel 100% allocation to growth. Others apply age-based parameters. Based on the portfolio-optimization model I consulted and my dataset, the recommended weighting of growth and value is nearly 50/50. In other words: snow tires on the front, summer tires on the back. (Note this recommendation is for your portfolio, for auto advice please ask a mechanic.) I used 20 years of data; using a longer time frame, value might look better.

Bottom line:

It is hard to predict whether growth or value will outperform in a given year. Demonstrable skill shifting between growth and value is surprisingly scarce. Investors who are content to be passive can just stick to funds which index the entire market. A better strategy is to identify skillful growth and value managers and weight them evenly.

The Alt Perspective: Commentary and news from DailyAlts.

As they say out here in Los Angeles, that’s a wrap. 2015 has come to a close and we begin anew. But before we get too far into 2016, let’s do a quick recap of some of the activity in the liquid alternatives market that occurred over the past year, starting with a performance review.

Performance Review

Let’s start with traditional asset classes for the full year of 2015, where the average mutual fund for all of the major asset classes (per Morningstar) delivered negative performance on the year:

• Large Blend U.S. Equity: -1.06%
• Foreign Equity Large Blend: -1.56%
• Diversified Emerging Markets: -13.83%
• Intermediate Term Bond: -0.35%
• World Bond: -4.09%
• Moderate Allocation: -1.96%

Now a look at the liquid alternative categories, per Morningstar’s classification. As with the traditional asset classes, none of the alternative categories escaped a negative return on the year:

• Long/Short Equity: -2.08%
• Non-Traditional Bonds: -1.84%
• Managed Futures: -1.06%
• Market Neutral: -0.39%
• Multi-Alternative: -2.48%
• Bear Market: -3.16%

And a few non-traditional asset classes, where real estate generated a positive return:

• Commodities: -24.16%
• Multi-Currency: -0.62%
• Real Estate: 2.39%
• Master Limited Partnerships: -35.12%

Overall, a less than impressive year across the board with energy leading the way to the bottom.

Asset Flows

Flows into alternative mutual funds and ETFs remained fairly constant over the year in terms of where the flows were directed, with a total of $20 billion of new assets being allocated to funds in Morningstar’s alternative categories. However, non-traditional bond funds, which are not included in Morningstar’s alternatives categories, saw nearly $10 billion of outflows through November.

While the flows appeared strong, only three categories had net positive flows over the past twelve months: Multi-alternative funds, managed futures funds and volatility based funds. The full picture is below (data source: Morningstar):

This concentration is not good for the industry, but just as we saw a shift from 2014 to 2015 (non-traditional bond funds were the largest asset gatherer in 2014), the flows will likely shift in 2016. I would expect managed futures to continue to see strong inflows, and both long/short equity and commodities could see a turn back to the positive.

Hot Topics

While there have been a slew of year-end fund launches (we will cover those next month), a dominant theme coming into the end of the year was fund closures. While the Third Avenue Focused Credit Fund announced an abrupt closure of its mutual fund due to significant outflows, the concentration of asset flows to alternative funds is causing a variety of managers to liquidate funds. Most recently, the hedge fund firm Whitebox Advisors decided to close three alternative mutual funds, the oldest of which was launched in 2011. This is a concerning trend, but reminds us that performance still rules.

On the research front, we published summaries of three important research papers in December, all three of which have been popular with readers:

• Will Retiring Baby Boomers Continue the Liquid Alts Boom? – Approximately 10,000 baby boomers turn 65 every day. Where will they invest their nest eggs when they retire? Liquid alternatives can provide a low volatility solution to keeping their wealth.
• Goldman Sachs Outlines the Case for a Multimanager Approach to Alternatives – While individual strategies can top the charts in any one year, mixing multiple strategies and allocating assets across multiple managers can provide more consistent results over time.
• AQR Puts Risk Parity Performance into Perspective – While risk parity strategies have had lackluster performance over the past few years, it doesn’t mean they need to be tossed aside.

If you would like to keep up with all the news from DailyAlts, feel free to sign up for our daily or weekly newsletter.

All the best for 2016! Have a happy, safe and prosperous year.

Elevator Talk: Randy Swan, Swan Defined Risk (SDRAX/SDRIX)

Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we have 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.

Randy Swan manages SDRAX, which launched at the end of July 2012. He founded Swan Capital Management, which uses this strategy in their separately managed accounts in 1997. Before then, Mr. Swan was a CPA and senior manager for KPMG’s Financial Services Group, primarily working with insurance companies and risk managers. Mr. Swan manages about $27 million in other accounts, including the new Swan Defined Risk Emerging Markets (SDFAX).

“Stocks for the long term” is an attractive claim, give or take two small problems. First, investors live in the short term; their tolerance for pain is somewhere between three days and three years with most sitting toward the shorter end of that range. Second, sharp losses in the short term push the long-term further off; many of the funds that suffered 50% losses in the 2007-09 debacle remain underwater seven years later.

Bright investors know both of those things and try to hedge their portfolios against risk. The questions become (1) what risk do you try to hedge out? and (2) what tools do you choose? The answers include “everything conceivable and several inconceivable risks” and “balanced portfolios” to “expensive, glitch, inexplicably complicated black box schemes.”

Mr. Swan’s answers are (1) the risk of grinding bear markets but not short-term panics and (2) cheap, value-oriented equity exposure and long-dated options. The strategy is, he says, “always invested, always hedged.”

It’s nice to note that the strategy has outperformed both pure equity and balanced strategies, net of fees, since inception. $10,000 invested with Swan in 1997 has now grown to roughly $44,000 while a comparable investment in the S&P500 climbed to $30,300 and a balanced portfolio would have reached $25,000. I’m more struck, though, by the way that Swan generated those returns. The graphic below compares the variability in returns of the S&P and Swan’s strategy over the nearly 19 years he’s run the strategy. Each line represents the performance for one 10-year period (1998-2007, 1999-2008 and so on).

The consistency of Swan’s returns are striking: in his worst 10-year run, he averaged 7.5% annually while the best run generated 9%. The S&P returns are, in contrast, highly variable, unpredictable and lower.

Here are Mr. Swan’s 222 words on why you should add SDRAX to your due-diligence list:

We’ve managed this strategy since 1997 as a way of addressing the risks posed by bear markets. We combine tax-efficient, low-cost exposure to the U.S. stock market with long-dated options that protect against bears rather than corrections. We’re vulnerable to short-term declines like August’s correction but we’ve done a great job protecting against bears. That’s a worthwhile tradeoff since corrections recover in months (August’s losses are pretty much wiped out already) but bears take years.

Most investors try to manage risk with diversification but you can’t diversify market risk away. Instead, we choose to directly attack market risk by including assets that have an inverse correlation to the markets. At the same time, we maintain a stock portfolio that equally weights all nine sectors through the Select SPDR ETFs which we rebalance regularly. In the long-term, all of the research we’ve seen says an equal-weight strategy will outperform a cap-weighted one because it forces you to continually buy undervalued sectors. That strategy underperforms at the end of a bull market when index gains are driven by a handful of momentum-driven stocks, but over full market cycles it pays off.

Our maxim is KISS: keep it simple, stupid. Low-cost market exposure, reliable hedges against bear markets, no market timing, no attempts at individual security selection. It’s a strategy that has worked for us.

The fund lost about 4% in 2015. Over the past three years, the fund has returned 5.25% annually, well below the S&P 500’s 16%. With the fund’s structural commitment to keeping 10% in currently-loathed sectors such as energy, utilities and basic materials, that’s neither surprising nor avoidable.

Swan Defined-Risk has a $2500 minimum initial investment on its “A” shares, which bear a sales load, and $100,000 on its Institutional shares, which do not. Expenses on the “A” shares run a stiff 1.58% on assets of $1.4 billion, rather below average, while the institutional shares are 25 basis points less. Load-waived access to the “A” shares is available through Schwab, Fidelity, NFS, & TD Ameritrade. Pershing will be added soon.

Here’s the fund’s homepage. Morningstar also wrote a reasonably thoughtful article reflecting on the difference in August 2015 performance between Swan and a couple of apparently-comparable funds. A second version of the article features an annoying auto-launch video.

Funds in Registration

There are 14 new no-load funds in the pipeline. Most will be available by late February or early March. While the number is not extraordinarily high, their parentage is. This month saw filings on behalf of American Century (three funds), DoubleLine, T. Rowe Price (three) and Vanguard (two).

The most intriguing registrant, though, is a new fund from Seafarer. Seafarer Overseas Value Fund will invest in an all-cap EM stock portfolio. Beyond the bland announcement that they’ll use a “value” approach (“investing in companies that currently have low or depressed valuations, but which also have the prospect of achieving improved valuations in the future”), there’s little guidance as to what the fund’s will be doing.

The fund will be managed by Paul Espinosa. Mr. Espinosa had 15 years as an EM equity analyst with Legg Mason, Citigroup and J.P. Morgan before joining Seafarer in May, 2014. Seafarer’s interest in moving in the direction of a value fund was signaled in November, with their publication of Mr. Espinosa’s white paper entitled On Value in the Emerging Markets. It notes the oddity that while emerging markets ought to be rife with misvalued securities, only 3% of emerging markets funds appear to espouse any variety of a value investing discipline. That might reflect Andrew Foster’s long-ago observer that emerging markets were mostly value traps, where corporate, legal and regulatory structures didn’t allow value to be unlocked. More recently he’s mused that those circumstances might be changing.

In any case, after a detailed discussion of what value investing might mean in the emerging markets, the paper concludes:

This exploration discovered a large value opportunity set with an aggregate market capitalization of $1.4 trillion, characterized by financial metrics that strongly suggest the pervasive presence of discounts to intrinsic worth.

After examining most possible deterrents, this study found no compelling reason that investors would forgo value investing in the emerging markets. On the contrary, this paper documented a potential universe that was both large and compelling. The fact that such an opportunity set remains largely untapped should make it all the more attractive to disciplined value practitioners.

The initial expense ratio has not yet been set, though Seafarer is evangelical about providing their services at the lowest practicable cost to investors, and the minimum initial investment is $2,500.

Manager Changes

Fifty-six funds saw partial or complete turnover in their management teams in the past month. Most of the changes seemed pretty modest though, in one case, a firm’s president and cofounder either walked out, or was shown, the door. Curious.

Updates

Back in May, John Waggoner took a buyout offer from USA Today after 25 years as their mutual funds guru. Good news: he’s returning to join InvestmentNews as a senior contributor and mutual funds specialist. Welcome back, big guy!

Briefly Noted . . .

At a Board meeting held on December 11, 2015, RiskX Investments, LLC (formerly American Independence Financial Services, LLC), the adviser to the RX Dynamic Stock Fund (IFCSX formerly, the American Independence Stock Fund), recommended to the Trustees of the Board that the Fund change its investment strategy from value to growth. On whole, that seems like a big honkin’ shift if you were serious about value in the first place but they weren’t: the fund’s portfolio – which typically has a turnover over 200% a year – shifted from core to value to core to value to growth over five consecutive years. That’s dynamic!

SMALL WINS FOR INVESTORS

“The closure of the 361 Managed Futures Strategy Fund (AMFQX) to investment by new investors that was disclosed by the Fund in Supplements dated September 9, 2015, and September 30, 2015, has been cancelled.” Well, okay then!

On December 31^st, Champlain Emerging Markets Fund (CIPDX) announced that it was lowering its expense ratio from 1.85% to 1.60%. With middle-of-the-road performance and just $2 million in assets, it’s worth trying.

It appears that AMG Frontier Small Cap Growth Fund (MSSGX) and AMG TimesSquare Mid Cap Growth Fund (TMDIX) reopened to new investors on January 1. Their filings didn’t say that they reopening; they said, instead, that “With respect to the sub-section ‘Buying and Selling Fund Shares’ in the section ‘Summary of the Funds’ for the Fund, the first paragraph is hereby deleted in its entirety.” The first paragraph explained that the funds were soft-closed.

Effective January 1, ASTON/Cornerstone Large Cap Value Fund (RVALX) will reduce its expense ratio from 1.30% to 1.14% on its retail shares. Institutional shares will see a comparable drop.

Effective as of February 1, 2016, the Columbia Acorn Emerging Markets Fund (CAGAX) and Columbia Small Cap Growth Fund (CGOAX) will be opened to new investors and new accounts.

Effective January 1, 2016, Diamond Hill reduced its management fee for the four-star Diamond Hill Large Cap Fund (DHLAX) from an annual rate of 0.55% to 0.50%.

Effective immediately, the minimum initial investment requirements for the Class I Shares of Falcon Focus SCV Fund (FALCX) are being lowered to $5,000 for direct regular accounts and $2,500 for direct retirement accounts, automatic investment plans and gift accounts for minors.

Here’s why we claim to report nothing grander than “small wins” for investors: the board of Gotham Absolute 500 Fund (GFIVX) has graciously agreed to reduce the management fee from 2.0% to 1.5% and the expense cap from 2.25% to 1.75%. All of this on an institutional long/short fund with high volatility and a $250,000 minimum. The advisor calculates that it actually costs them 5.42% to run the fund. The managers both have over $1 million in each of their four funds.

Grandeur Peak has reduced fees on two of its funds. Grandeur Peak Emerging Markets Opportunities Fund (GPEOX) to 1.95% and 1.70% and Grandeur Peak Global Reach Fund (GPGRX) to 1.60% and 1.35%.

Effective January 4, 2016, Royce Premier Fund (RYPRX) and Royce Special Equity Fund (RYSEX) will reopen to new shareholders. Why, you ask? Each fund’s assets have tumbled by 50% since 2013 as Premier trailed 98% of its peers and Special trailed 92%. Morningstar describes Special as “a compelling small-cap option” and gives it a Gold rating.

Teton Westwood Mid-Cap Equity Fund (WMCRX) has reduced the expense cap for Class I shares of the Fund to 0.80%.

CLOSINGS (and related inconveniences)

Effective as of the close of business on December 31, 2015, Emerald Growth Fund (HSPGX) closed to new investors

The Class A shares of Hatteras Managed Futures Strategies Fund were liquidated in mid-December. The institutional class (HMFIX) remains in operation for now. Given that there’s a $1 million minimum initial investment and far less than $1 million in assets in the fund, I suspect we’ll continue thinning out of liquid-alts category soon.

Effective as of the close of business on January 28, 2016, Vontobel International Equity Institutional (VTIIX) and Vontobel Global Equity Institutional Fund (VTEIX) will soft close. Given that the funds have only $30 million between them, I suspect that they’re not long for this world. 

OLD WINE, NEW BOTTLES

At the end of February, Aberdeen Small Cap Fund (GSXAX) becomes Aberdeen U.S. Small Cap Equity Fund. Two bits of good news: (1) it’s already a very solid performer and (2) it already invests 93% of its money in U.S. small cap equities, so it’s not likely that that’s going to change. At the same time, Aberdeen Global Small Cap Fund (WVCCX) will become Aberdeen International Small Cap Fund. The news here is mixed: (1) the fund kinda sucks and (2) it already invests more than 80% of its money in international small cap equities, so it’s not likely that that’s going to change either.

Sometime in the first quarter of 2016, Arden Alternative Strategies Fund (ARDNX) becomes Aberdeen Multi-Manager Alternative Strategies Fund, following Aberdeen’s purchase of Arden Asset Management.

Effective on February 1, 2016: AC Alternatives Equity Fund, which hasn’t even launched yet, will change its name to AC Alternatives Long Short Fund. After the change, the fund will no longer be required to invest at least 80% of its portfolio in equities.

As of February 27, 2016, Balter Long/Short Equity Fund (BEQRX) becomes Balter L/S Small Cap Equity Fund.

At an as-yet unspecified date, Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX) will become RidgeWorth Capital Innovations Global Resources and Infrastructure Fund. Interesting little fund, the subject of an Elevator Talk several months ago.

Gator Opportunities Fund (GTOAX) is on its way to becoming BPV Small Cap Fund, likely by the beginning of summer, 2016. The fund will shed its mid-cap holdings in the process.

At the end of January 2016, Marsico Growth FDP Fund (MDDDX) will become FDP BlackRock Janus Growth Fund. Which is to say, yes, Marsico lost another sub-advisory contract.

Effective December 31, 2015, the Meeder Strategic Growth Fund (FLFGX) changed its name to Global Opportunities Fund.

On February 24, 2016, the T. Rowe Price Diversified Small-Cap Growth Fund (PRDSX) will change its name to the T. Rowe Price QM U.S. Small-Cap Growth Equity Fund. The addition of “QM” in the fund’s name reflects the concept that the fund employs a “quantitative management” strategy.

On March 1, Transamerica Asset Management will make a few tweaks to Transamerica Growth Opportunities (ITSAX). The managers will change (from Morgan Stanley to Alta Capital); likewise the “fund’s investment objective, principal investment strategies, principal risks, benchmark index, portfolio managers [and] name, will change. The fund will also have a lower advisory fee schedule.” The reborn fund will be named Transamerica Multi-Cap Growth.

Effective January 31, 2016, the principal investment strategy of Turner Emerging Growth Fund (TMCGX) shifts from focusing on “small and very small” cap stocks to “small and mid-cap” ones. The fund will also change its name to the Turner SMID Cap Growth Opportunities Fund. 

OFF TO THE DUSTBIN OF HISTORY

All Terrain Opportunity Fund (TERAX) liquidated on December 4, 2015. Why? It was only a year old, had $30 million in assets and respectable performance.

Big 4 OneFund (FOURX) didn’t make it to the New Years. The fund survived for all of 13 months before the managers despaired for the “inability to market the Fund.” It was a fund of DFA funds (good idea) which lost 12% in 12 months and trailed 94% of its peers. One wonders if the adviser should have ‘fessed up the “the inability to manage a fund that was worth buying”?

BPV Income Opportunities Fund liquidated on December 22, 2015, on about a week’s notice.

The Board of Trustees of Natixis Funds determined that it would be in the best interests of CGM Advisor Targeted Equity Fund (NEFGX) that it be liquidated, which will occur on February 17, 2016. Really, they said that: “it’s in the fund’s best interests to die.” The rest of the story is that CGM is buying itself back from Natixis; since Natixis won’t accept outside managers, the fund needed either to merge or liquidate. Natixis saw no logical place for it to merge, so it’s gone.

C Tactical Dynamic Fund (TGIFX) liquidated on December 31, 2015.

Clinton Long Short Equity Fund (WKCAX) liquidates on January 8, 2016.

Columbia has proposed merging away a half dozen of its funds, likely by mid-2016 though the date hasn’t yet been settled.

Acquired Fund	Acquiring Fund
Columbia International Opportunities	Columbia Select International Equity
Columbia International Value	Columbia Overseas Value
Columbia Large Cap Growth II, III, IV and V	Columbia Large Cap Growth
Columbia Multi-Advisor Small Cap Value	Columbia Select Smaller-Cap Value
Columbia Value and Restructuring	Columbia Contrarian Core

On or about March 31, 2016, the ESG Managers Growth Portfolio (PAGAX) will be consolidated into the ESG Managers Growth and Income Portfolio (PGPAX), which will then be renamed Pax Sustainable Managers Capital Appreciation Fund. At the same time, ESG Managers Balanced Portfolio (PMPAX) will be consolidated into the ESG Managers Income Portfolio (PWMAX) which will then be known as Pax Sustainable Managers Total Return Fund. The funds are all sub-advised by Morningstar staff.

Fortunatus Protactical New Opportunity Fund (FPOAX) liquidated on December 31, 2015. Why? The fund launched 12 months ago, had respectable performance and had drawn $40 million in assets. Perhaps combining the name of a 15^th century adventurer (and jerk) with an ugly neologism (protactical? really?) was too much to bear.

Foundry Small Cap Value Fund liquidated on December 31, 2015.

Frost Cinque Large Cap Buy-Write Equity Fund (FCBWX) will cease operations and liquidate on or about February 29, 2016.

The tiny, one-star Franklin All Cap Value Fund (FRAVX), a fund that’s about 60% small caps, is slated to merge with huge, two-star Franklin Small Cap Value Fund (FRVLX), pending shareholder approval. That will likely occur at the beginning of April.

Back in 2008, if you wanted to pick a new fund that was certain to succeed, you’d have picked GRT Value. It combined reasonable expenses, a straightforward discipline and the services of two superstar managers (Greg Frasier, who’d been brilliant at Fidelity Diversified International and Rudy Kluiber who beat everyone as manager of State Street Research Aurora). Now we learn that GRT Value Fund (GRTVX) and GRT Absolute Return Fund (GRTHX) will liquidate on or about January 25, 2016. What happened? Don’t know. The fund rocketed out of the gate then, after two years, began to wobble, then spiral down. Both Value and its younger sibling ended up as tiny, failed shells. Perhaps the managers’ attention was riveted on their six hedge funds or large private accounts? Presumably the funds’ fate was sealed by GRT’s declining business fortunes. According to SEC filing, the firm started 2015 with $950 million in AUM, which dropped by $785 million by June and $500 million by September. The declining size of their asset base was accompanied by a slight increase in the number of accounts they were managing, which suggests the departure of a few major clients and a scramble to replace them with new, smaller accounts.

The folks behind the Jacobs/Broel Value Fund (JBVLX) have decided to liquidate the fund based on “its inability to market the Fund and the Adviser’s indication that it does not desire to continue to support the Fund.” Nearly all of the assets in the fund are the managers’ own money, perhaps because others wondered about paying 1.4% for:

The fund will liquidate on January 15, 2016.

On or around January 28, 2016, JOHCM Emerging Markets Small Mid Cap Equity Fund Service Class shares (JOMIX) will liquidate.

The Board of Directors of the Manning & Napier Fund, Inc. has voted to completely liquidate the Focused Opportunities Series (MNFSX) on or about January 25, 2016.

HSBC Growth Fund (HOTAX) will cease its investment operations and liquidate on or about February 12, 2016. Apparently the combination of consistently strong results with a $78 million asset base was not compelling.

McKinley Diversified Income Fund (MCDRX) is merging with Innovator McKinley Income Fund (IMIFX), pending shareholder approval. The reorganization will occur January 29, 2016.

Leader Global Bond Fund (LGBMX) will close, cease operations, redeem all outstanding shares and liquidate, all on January 29, 2016.

Madison Large Cap Growth Fund (MCAAX) merges with and into the Madison Investors Fund (MNVAX) on February 29, 2016. The Board mentions the identical objectives, strategies, risk profile and management as reason for why the merger is logical.

The Newmark Risk-Managed Opportunistic Fund (NEWRX) liquidated on December 31, 2015. The Board attributed the decision to the fund’s small size, rather than to the underlying problem: consistently bad short- and long-term performance.

Nile Frontier and Emerging Fund (NFRNX) liquidated, on about three weeks’ notice, on December 31, 2015.

QES Dynamic Fund (QXHYX) liquidated on December 17, 2015, after a week’s notice.

On January 29, 2016, Redmont Resolute Fund I (RMREX) becomes Redmont Dissolute Fund as it, well, dissolves.

Royce has now put the proposals to merge Royce European Small-Cap Fund (RESNX) and Global Value (RIVFX) into Royce International Premier Fund (RYIPX) to their shareholders. The proposal comes disturbingly close to making the argument that, really, there isn’t much difference among the Royce funds. Here is Royce’s list of similarities:

• the same objective;
• the same managers;
• the same investment approach;
• the same investment universe, small-cap equities;
• the same sort of focused portfolio;
• all provide substantial exposure to foreign securities;
• the same policy on hedging;
• the same advisory fee rates;
• the same restrictions on investments in developing country securities; and
• almost identical portfolio turnover rates.

Skeptics have long suggested that that’s true of the Royce funds in general; they have pretty much one or two funds that have been marketed in the guise of 20 distinct funds.

Third Avenue Focused Credit Fund (TFCVX) nominally liquidated on December 9, 2015. As a practical matter, cash-on-hand was returned to shareholders and the remainder of the fund’s assets were placed in a trust. Over the next year or so, the adviser will attempt to find buyers for its various illiquid holdings. The former fund’s shareholders will receive dribs and drabs as individual holdings are sold “at reasonable prices.”

Valspresso Green Zone Select Tactical Fund liquidated on December 30, 2015.

On December 2, 2015, Virtus Disciplined Equity Style, Virtus Disciplined Select Bond and Virtus Disciplined Select Country funds were liquidated.

Whitebox is getting out of the mutual fund business. They’ve announced plans to liquidate their Tactical Opportunities (WBMAX), Market Neutral Equity (WBLSX) and Tactical Advantage (WBIVX) funds on or about January 19, 2016.

In Closing . . .

In case you sometimes wonder, “Did I learn anything in the past year?” Josh Brown offered a great year-end compendium of observations from his friends and acquaintances, fittingly entitled “In 2015, I learned that …” Extra points if you can track down the source of “Everything’s amazing and nobody’s happy.”

And as for me, thanks and thanks and thanks! Thanks to the 140 or so folks who’ve joined MFO Premium as a way of supporting everything we’re doing. Thanks to the folks who’ve shared books, both classic (Irrational Exuberance, 3e) and striking (Spain: The Centre of the World, 1519-1682) and chocolates. I’m so looking forward to a quiet winter’s evening to begin them. Thanks to the folks who’ve read us and written to us, both the frustrated and the effusive. Thanks to my colleagues, Charles, Ed and Chip, who do more than I could possibly deserve. Thanks to the folks on the discussion board, who keep it lively and civil and funny and human. Thanks to the folks who’ve volunteered to help me learn to be halfway a businessperson, Sisyphus had it easier.

And thanks, especially, to all of you who’ll be here again next month.

We’ll look for you.