January 2017 IssueLong scroll reading

“What Goes Around ……”

By Edward A. Studzinski

Democracy – “The substitution of election by the incompetent many for the appointment of the corrupt few.”

        George Bernard Shaw

So, another calendar year has gone by, and fund managers everywhere are dissecting their relative performance in comparison to some benchmark index. To put things into perspective for a real-world comparison (at least in terms of the performance numbers), the Admiral shares of the Vanguard S&P 500 Index Fund, which charges a five basis point fee, had a one-year total return of 11.9%, a five-year total return of 14.6% and a ten-year total return of 6.9%. These are all annualized numbers. It is also worth looking at the calendar year 2016 return for the Vanguard Value Index Fund, which has an expense ratio of eight basis points. It achieved a one-year total return of 16.9%, a five-year total return of 15.0%, and a ten-year return of 6.0% (again, annualized numbers).

I have been saying for some time that I think in this kind of world, there will be a place where active managers will outperform index funds. This is why however, that looking at fees AND performance numbers over longer periods of time is so important. There is a wonderful Dilbert cartoon in which in the first frame, Dogbert says, “The best way to evaluate an investment fund is to look at its misleading claims of past performance.” The second frame says, “The Dogbert Hedge Fund beat the market average for a three-week period ….. that one time.”

When you look at performance numbers over at least a five-year period, you generally find two things. One, performance differences tend to smooth out over time, giving one a real opportunity to understand whether the active manager is truly adding anything to performance (again relative to a benchmark). Two, rarely do any of you reading this make investments on the basis of having the money go into the market at the beginning of the performance measurement period, and then come out at the end of the performance measurement period. But you do tend to get impatient. That impatience, used to be reflected to me in emails “Why did you underperform the index last week on Wednesday, when it was up half a per cent and your fund was down.” This is one of the things that has happened – there are no, especially in the retail area, long-term investors. And the idea that a value approach will be lumpy, that is under-perform often for years before having the opportunity to show its true nature. Of course the other issue becomes whether the manager has the patience to not try and “fix” things when there is the double whammy of underperformance leading to negative fund flows (anathema to the asset gathering organizations). And for an example of lumpy performance in value funds, take a look at Fairholme Focused Income Fund, with its one-year total return of 32.3% and its five-year total return of 11.5% (annualized).

To make the comparisons a little easier to the three large cap Vanguard index funds I referred to above, let’s look at two large-cap actively-managed Vanguard funds. Vanguard Admiral Equity Income Fund has an expense ratio of seventeen basis points, and achieved a one-year total return of 14.7%, a five-year total return of 14.6%, and a ten-year total return of 7.4% (again, annualized). Vanguard PrimeCap Core, with an expense ratio of forty-seven basis points, had a one-year total return of 12.4%, a five-year total return of 16.1%, and a ten-year total return of 9.2% (again, annualized). Both of those funds would warrant a look for investment, given the five-year and ten-year numbers I would also suggest the less common index fund, the Vanguard Value Index Admiral Fund shares would also be worth a serious look. Look at performance over a longer period than just one-year or three-years.

 Fees Redux

“Skimming” is the term used when a casino management takes some profits off the total funds running through the books without having to account for it. I have spent a lot of time in this column railing against excessive fees. Where like-kind active funds are available, and the same period annualized total returns are available from the cheaper fund, the choice should be an easy choice. And it should be easy because the excess fees from your money are being skimmed off the top by the fund management controlling company. In the case of a corporate parent such as Affiliated Managers or PIMCO, anywhere from thirty to fifty basis points is being skimmed off the top and going into the corporate coffers, contributing little if anything to the investment decision-making and management process.

Hope and Change

An active manager I know mentioned last week that his fund flows, and those of his firm, which had been bleeding out all year, turned slightly positive in December. And while we have concerned ourselves with the competition that passive products present for active managers in the mutual fund arena, the competition is even greater in the hedge fund area. Think of it this way – the usual fee schedule for equity hedge funds is “two and twenty” meaning a two percent fee with a twenty percent performance fee (talk about skimming). A wonderful little article in The Financial Times on December 21st pointed out that analysts and quantitative managers have “reverse-engineered” the returns of many common hedge fund strategies such as long-short, and are replicating them in an ETF format. And for that matter, why pay a two percent expense ratio for one of the Gotham Funds, when Goldman Sachs has Smart Beta (multi-factor) ETF’s available at expense ratios of nine to forty-five basis points.

So let’s end this with a semi-real example to think about. Harold retires at age sixty with a $200,000 balance in his 401(k) account which he rolls over to an IRA at the beginning of the year. He doesn’t plan to file for Social Security payments until age seventy, when he will have maximized the annuity payout he can get from Social Security. For those ten years, he does not need to work or tap into his savings, as he receives a pension check for a vested defined benefit pension plan he had at another employer. Invested in the Vanguard Value Index Fund, Admiral shares, the investment would have grown to $358,170 when he would have had to start taking minimum distributions.

Alternatively, Harold rolls his $200,000 over at age sixty into the Vanguard PrimeCap Core Fund (assuming he can get into a closed fund), the initial amount has grown to $482,232 when he needs to start taking his required minimum distributions at age seventy. And if you don’t think the example is real since you can’t get into the Vanguard fund mentioned, the numbers work almost as well if you were to use the PrimeCap Odyssey Growth Fund, run by the same team as the Vanguard fund but available directly from the PrimeCap firm.

End of an Era

Another piece in the Financial Times (hint: I consider this to be the best financial newspaper in the English-speaking world) on December 30th spoke of the anger of investors with actively-managed funds.

They have pulled $30B a month out of actively-managed funds in 2016. What’s different is that in the past, those negative flows were usually tied to large stock market debacles. This year, what finally appears to have sunk in is the years of data showing that most active managers fail to keep up passive index funds’ performance over long periods of time. That said, another factor appears to be an increasing awareness by the investors of the “lifestyles of the rich” which many fund managers have adopted with multiple homes, Net Jets cards, and minimal working hours. As a result, in 2016 a full 301 funds had shut down and returned their investors’ funds. Another 97 were merged into better performing funds in the same fund family. (The article David Snowball and I have talked about writing is “Mutual Funds that Do Not Deserve to Exist.”). So what is the solution? Well, I can tell you from my vantage point, it appears that costs are being cut, but more to sustain margins so that the payouts can continue to the highly compensated (here I think of the fund manager whom one of his peers referred to as the “$30M a year” man). Often, as support staff and analysts are cut, it is the investment performance that continues to suffer as the investment research process becomes gutted. The other thing that happens is the quality of the personnel hired is ratcheted down (good enough) rather than the best available talent.

We have seen this in a number of situations where the industry was not understood (off-balance sheet assets and liabilities) but the income forecast model looked good. In that regard, investment analysis has become like much of American medicine today, with an overreliance on laboratory tests rather than the art of physical diagnosis. And in investment analysis, the similar paradigm has been an overreliance on models and “Investor Day” presentations which have been religiously scrubbed, often attended by not curious people to begin with.

A Final Comment

Whole forests are being destroyed for the paper being used in stories about this year’s Presidential election, not to mention the blizzard of stories on the internet. I am going to offer only one comment to ponder. Years ago, growing up in eastern Massachusetts (where politics are part of the air and water), I asked my grandmother, who had immigrated from what would have been then Russian Poland, why people voted for the Kennedy family. Her answer was simple but elegant. She said, “because they have too much money to steal.”

Happy New Year!

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About Edward A. Studzinski

Ed Studzinski has more than 30 years of institutional investment experience. He was a partner at Harris Associates in Chicago, Illinois. Harris is known for its value-oriented, bottom-up investment approach that frames the investment process as owning a piece of the business relative to the business value of the whole, ideally forever. At Harris, Ed was co-manager of the Oakmark Equity & Income Fund (OAKBX). During the nearly twelve years that he was in that role, the fund in 2006 won the Lipper Award in the balanced category for "Best Fund Over Five Years." Additionally, in 2011 the fund won the Lipper Award in the mixed-asset allocation moderate funds category as "Best Fund Over Ten Years. Concurrently Ed was also an equity research analyst, providing many of the ideas that contributed to the fund’s success. He has specialist knowledge in the defense, property-casualty insurance, and real estate industries, having followed and owned companies as diverse as Catellus Development, General Dynamics, Legacy Hotels, L-3, PartnerRe, Progressive Insurance, Renaissance Reinsurance, Rockwell Collins, SAFECO, St. Joe Corporation, Teledyne, and Textron. Before joining Harris Associates, over a period of more than 10 years, Ed was the Chief Investment Officer at the Mercantile National Bank of Indiana, and also served on their Executive and Asset-Liability Committees. Prior to Mercantile, Ed practiced law. A native of Peabody, Massachusetts, he received his A.B. in history (magna cum laude) from Boston College, where he was a Scholar of the College. He has a J.D. from Duke University and an M.B.A. in marketing and finance, as well as a Professional Accounting Program Certificate, from Northwestern University. Ed has earned the Chartered Financial Analyst credential. Ed belongs to the Investment Analyst Societies of Boston, Chicago, and New York City. He is admitted to the Bar in the District of Columbia, Illinois, and North Carolina.