March 2020 IssueLong scroll reading

YCG Enhanced Fund (YCGEX)

By David Snowball

Objective and strategy

The YCG Enhanced Fund seeks to maximize long-term capital appreciation consistent with reasonable investment risk. The portfolio consists of an equity component and an options component. The equity component attempts to identify and invest in the world’s best companies, which they designated “global champions.” The central characteristic of such firms is that they’re among the very few with long-term pricing power; that is, the nature of their industry and business is that they can consistently dictate prices to their users in exchange for irreplaceable services. The equity component ranges from 15-50 names, mostly large cap, mostly domiciled in the US. The median market cap of $80 billion because “global champions” aren’t small. The managers may also write put options and covered call options on a substantial portion of the equity portfolio to generate additional income and heighten tax efficiency. They do not use options to generate leverage.

Adviser

YCG, LLC, which was founded in 2007 and is located in Austin, Texas. They describe themselves as “a high-touch boutique investment firm” with approximately $920 million in mutual fund and separately managed account assets. The firm was founded by Brian Yacktman and is privately owned by its three partners: Brian Yacktman, William Kruger, and Elliott Savage.

Manager

Brian Yacktman and Elliott Savage. Mr. Yacktman founded YCG in 2007. He is their president and CIO, as well as a portfolio manager.  Prior to founding YCG, he was an Associate at Yacktman Asset Management, the adviser to The Yacktman Funds. Mr. Savage joined YCG in 2012. Prior to that, he was an analyst for a long/short equity hedge fund domiciled in Dallas.

Strategy capacity and closure

Considerable but variable. The equity capacity is massive, since it’s focused on global, mostly-large-cap stocks. The option component imposes the limit on size, but the extent of that limit is constantly changing. Given the massive extent of insider ownership, Mr. Yacktman is credible when he describes himself as “highly motivated to close when it’s in the best interest of the fund’s shareholders.” In the event that they’re forced to close the fund because of limits in the options universe, there remains the prospect of opening a strategy with the equity component but without the options overlay.

Active share

84.78. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. The “active share” research done by Martijn Cremers and Antti Petajisto finds that only 30% of U.S. fund assets are in funds that are reasonably independent of their benchmarks (80 or above) and only a tenth of assets go to highly active managers (90 or above).

FAMEX has an active share of 84.8, which reflects a reasonable degree of independence from the benchmark assigned by Morningstar, the Russell 1000.

Management’s stake in the fund

Each manager has invested more than a million in the fund. The officers and trustees of the fund owned 9.36% of outstanding shares, as of the last SAI. The fund’s trustees are very modestly compensated, $4,000/year; one of the two independent trustees has an investment in the $50,000-100,000 range while the other has not chosen to invest in the fund.

The Yacktman family’s collective commitment to the fund is reflected in the fact that the fund’s six largest shareholders are Yacktman; by my rough calculation their collective stake approaches $100 million. I’ve only ever seen a comparable level of insider ownership in one other fund.

Opening date

December 28, 2012

Minimum investment

$2500

Expense ratio

1.19% on assets of $351 million.

Comments

The Observer’s passion is for small funds that provide competitive returns with a high level of risk awareness. One of the worst periods in recent market history was the downturn at the end of 2018-19. When we looked at funds that held up best during that series of scary drops, YCG Enhanced was there (“Learning from the fall fall,” April 2019). When we recognize funds for consistently top tier risk adjusted performance, our Great Owl designation which was earned by only five of 135 multi-cap growth funds, YCG Enhanced was there.

Across its seven year life, the fund has posted consistently competitive returns with nearly unmatched risk management.

  Absolute value Rank Peer group average
Annual return 13.8% 74th 13.8
Sharpe ratio 1.27 8th 1.02
Martin ratio 5.16 6th 3.16
Ulcer Index 2.5 3rd 4.6
Maximum drawdown -11.9% 4th -16.9
Downside deviation 5.9% 3rd 7.9
Down month deviation 5.7% 3rd 7.9
Bear market deviation 5.4% 4th 6.8
Capture ratio/SP 500 1.1 13th 1.0
Downside capture 81 4th 103

Source: MFO Premium, using Lipper Global Data Feed, current as of 1/30/2020

How do you read that table?

Annual returns over the seven year period are perfectly respectable. Optimists would point out that the fund’s lifetime performance figures are hampered by a rough first year, 2013, when the fund’s 27.5% returns trailed most of its peers. Morningstar’s report of its one, three and five year record place it in the top 1-2% of their domestic large growth peer group (as of 2/28/2020).

Downside risk, measured by maximum drawdown, downside (day-to-day) deviation, down market and bear market deviation are all in the top 5 of 135 peers, as is its downside capture.

The risk-return balance, measured by the Sharpe and Martin ratios, the Ulcer Index (a measure of how far a fund falls and for how long its underwater) and capture ratio is consistently top tier.

That’s reflected in the fund’s performance during the turbulence in early 2020: Morningstar places it in the top 13% during the crash at the end of February, top 11% for the month of February and top 13% over the first two months of 2020. The moment you extend your time horizon beyond that, the fund pops into the top 1-2%.

What does the manager do?

The managers share, with many value investors, the realization that the average investor is irrational: they’re hopeful of getting rich quick, beguiled by stories of the hottest tech and hottest firms, and are prone to overpaying for high visibility, high volatility stocks.

Mr. Yacktman is pretty sure that that’s a bad idea. He’s concluded, as did his famous father before him, that the highest quality stocks seem “perpetually under-priced relative to their dominance and predictability” because they’re not … well, sexy. He describes his strategy this way:

We believe the best way to achieve excess returns without excessive risk is to: (1) Invest in Global Champions with enduring pricing power and long-term volume growth opportunities (2) Minimize other long-term business risk factors by partnering with ownership-minded management teams and avoiding companies with aggressive capital structures. (3) Avoid overpaying by focusing on the high-quality business mispricing, by remaining vigilant to market-timing mispricings, and by comparing the forward risk-adjusted rates of returns of our businesses with other investment alternatives. (4) Diversify as much as possible (without going overboard, 50 securities or less) among the attractively-priced, great businesses we’ve identified, and (5) Wait. This approach has served us well over the years, and we believe it will continue to do so in the future.

The manager has a realistic perspective on the state of the market, somewhat richly valued and likely overextended. That said, the fund is in general fully invested. Mr. Yacktman notes:

We’re fully invested because nobody is good at timing the market; we don’t want to be overconfident and believe we have an edge against everybody else. We take the humble approach and recognize we don’t have that skill. The best thing we can do is find the highest risk-adjusted returns and build the portfolio for the long-term. If you’re invested in great businesses and you have a very long horizon, the time to invest is always now and the high of the fund is far in the future.

The fund will hold cash if the projected return on cash exceeds the projected return on the other assets available to them, but that’s rare.

In lieu of cash as high-stability / long-return ballast in the portfolio, Mr. Yacktman has the ability to add options to the portfolio. As it turns out, investors bring the same silly biases to the options market as to the stock market: they want to get rich quick, are entranced by bright, shiny objects and systematically overpay for their purchases. By accommodating the impulses of others in his options strategy, he accomplishes two ends:

    1. he buffers volatility since he can sell options at a premium, almost like getting paid to put in a limit order, which then acts like an additional margin of safety.” He likens this to be “the house” in a casino; you might win or lose, but the house always gets its cut.
    2. he enhances the fund’s tax efficiency, because the vagaries of the Tax Code allow an option’s short term income to be treated as long term capital gains.

Bottom Line

For conservative (i.e. “rational”) growth investors, this has clearly been a top 10 fund. Competitive returns and exceptional downside resilience are complemented by exceedingly high sustainability scores, especially with regard to carbon exposure. It should clearly be on their short list of “funds for turbulent times.”

Fund website

YCG Funds. The “News” page linked to a Barron’s article, “The Best Mutual Fund You’ve Never Heard of” (7/5/19) but the link runs straight into the paywall.  Presumably it wasn’t worth the adviser’s money to provide access to the article. Their 2019 annual letter is one of the best-written I’ve encountered: informative about their intellectual underpinnings, strategy, risk management and its implications. That’s wildly more useful than the rote recitation of “top three contributors” that many managers provide.

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About David Snowball

David Snowball, PhD (Massachusetts). Cofounder, lead writer. David is a Professor of Communication Studies at Augustana College, Rock Island, Illinois, a nationally-recognized college of the liberal arts and sciences, founded in 1860. For a quarter century, David competed in academic debate and coached college debate teams to over 1500 individual victories and 50 tournament championships. When he retired from that research-intensive endeavor, his interest turned to researching fund investing and fund communication strategies. He served as the closing moderator of Brill’s Mutual Funds Interactive (a Forbes “Best of the Web” site), was the Senior Fund Analyst at FundAlarm and author of over 120 fund profiles. David lives in Davenport, Iowa, and spends an amazing amount of time ferrying his son, Will, to baseball tryouts, baseball lessons, baseball practices, baseball games … and social gatherings with young ladies who seem unnervingly interested in him.