Dear friends,

I’ve been reading two strands of research lately. One shows that simple expressions of gratitude and acts of kindness have an incredibly powerful effect on your mental and physical health. Being consciously grateful of the goodness in your life, for example, carries most of the same benefits of meditation without the need for … well, sitting on the floor and staring at candle flames. The other shows that people tend to panic when you express gratitude to them or try to do kind things for them. Apparently giving money away to strangers is a lot harder than you’d imagine.

The midwinter holidays ahead – not just Christmas but a dozen other celebrations rooted in other cultures and other traditions – are, at base, expressions of gratitude. They occur in the darkest, coldest, most threatening time of year. They occur at the moment when we most need others, and they most need us. No one thrives when they’re alone and each day brings 14 to 18 hours of darkness. And so we’ve chosen, from time immemorial, to open our hearts and our homes, our arms and our pantries, to friends and strangers alike.

Don’t talk yourself out of that impulse. Don’t worry about whether your gift is glittery (if people actually care about that, you’re sharing gifts with the wrong people) or your meal is perfect (Martha Stewart’s were and she ended up in the Big House). People most appreciate gifts that make them think of you; give a part of yourself. Follow the Grinch. Take advice from Scrooged. Tell someone they make you smile, hug them if you dare, smile and go.

Oh, by the way, you make me smile. I’m endlessly humbled (and pleased) at the realization that you’re dropping by to see what we’ve been thinking. Thanks for that!

Built on failure

Success is not built on success. It’s built on failure. It’s built on frustration. Sometimes it’s built on catastrophe. Sumner Redstone (2007)

My dad never had much tolerance of failure. Perhaps because he’d experienced more than his share. Perhaps because he judged people so harshly and assumes that others did the same to him. No matter. For him, a failed project was the sign of a failed person. And so we learned to keep our heads down, volunteer nothing, risk nothing, and never fail.

And, at the same time, we never succeeded. “In order to succeed, you have to live dangerously,” Mr. Redstone advised. The notion of taking risks came late and hesitantly.

I wish I’d risked more and failed more, perhaps even failed more joyfully. But I’m working on it. You should, too. Being comfortable with failure is good; it means that you’re less likely to sabotage yourself through timidity. It’s a human resources truism that a guy with 10% of the necessary qualifications for a job will apply for it. A woman with 90% of the qualifications will not. Both ask themselves the same question, “what’s the worst that could happen?” but give themselves strikingly different answers. Talking comfortably about failure is better; it means that you’re removing the terror from other’s minds, enabling them to take the risks that might lead to failure but that are also essential for success. You should practice both. There’s also some interesting research that suggests that people who think of themselves as “experts” get all puffed up, then become rigid and dogmatic. That’s hardly a recipe for success.

The Wall Street Journal recently published “How not to flunk at failure,” (10/25/2015) by John Danner and Mark Coopersmith. Both are faculty at UC-Berkeley’s Haas School of Business. They’ve co-authored The Other “F” Word: How Smart Leaders, Teams, and Entrepreneurs Put Failure to Work (2015). They argue that it’s more common to fail poorly than to fail well because we so horrified at the notion that we failed at all. As a result, we feel sick and learn nothing.

They offer four recommendations for failing well.

1. The first step: admit you’ve had failures yourself. The guys who growl that “failure is not an option” end up, they say, creating a culture of “trial and terror” rather than a healthy culture of “trial and error.”
2. Ask the right questions when the inevitable failure occurs. Abandon the witch hunt that begins with the question “who was responsible?” Instead, think “hmmm, that was the damnedest thing” and begin exploring it with the sorts of who, what, why, where, when questions familiar to journalists.
3. Borrow a page, or at least a term, from the lab. Stop talking in excited terms about mission-critical strategic imperatives and start talking about experiments. Experiments are just a tool, a means to learn something. Sometimes we learn the most when an experiment does something utterly freakish. “We’ll try this as an experiment, see what comes of it and plan from there” involves less psychological commitment and more distance.
4. Make the ending count. Your staff needs your support much less when things go right than when they go wrong. You need to celebrate the end of an experiment that went poorly with at least as much ceremony as you do when one went well. “Well, that Why don’t I take you out for a nice dinner and we’ll figure out what we’ve learned and where we go from here,” would be a spectacularly good use of your time and the corporate credit card.

Nice article. I can’t link directly to it but if you Google the title, the first result will be the article and you’ll be able to get it. (Alternately, you might, like me, subscribe to the newspaper and simply open it in your browser.)

We’ve tried a bunch of things that have failed and have learned a lot from them. Three stand out.

1. I suck as a stock investor. Suck, suck, suck. I tried it for a few years. Subscribed to Morningstar Stock Investor. Read Value Line reports. Looked carefully through three years of annual reports. Bought only deeply discounted stocks with viable business models and good managers. I still ended up owning WorldCom (which went to zero) and a bunch of stocks that inexplicably refused to go up. Ended up selling the lot of them, booking a useful tax loss and shifting the money to a diversified fund.

   What I learned was that I’m temperamentally unsuited to stock investing. Having spent months researching an investment, I expect it to do something. As in good! And now! When they staggered about like drunken sailors, I kept feeling the pressure to do something myself. That’s always a losing proposition. And I learned that a few thousand dollars in a fund bought you much better diversification than a few thousand dollars in individual securities.

2. The Best of the Web isn’t very good. You’ll find it, covered with cobwebs, under “The Best” tab up there at the top right of the screen. Our plan was to sort through a bunch of web-based resources – from fund screeners to news sources – so that you didn’t have to. It’s a worthy project give or take the cobwebs and the occasional references you might find there to President Grover Cleveland’s recent initiatives.

   What I learned was that there are limits to what we can do well. The number of hours it took to review 30 or 40 news sites or to assess the research behind various firms fund ratings, even with a former colleague doing a lot of the legwork, was enormous. The additional time to review and edit drafts was substantial. The gain to our readers was not. We’ve become much more canny about asking the hard “but then what will we stop doing?” question as we consider innovations that add to the 100 hour a month workload that many of us already accept.

3. The Utopia Funds profile was a disaster. This dates back eight years to our FundAlarm days and it still makes me wince whenever I think of it. Utopia Funds were launched by a small firm out of Michigan and I ridiculed them for the presumptuousness of the name. Imagine my surprise to be having a wonderfully pleasant conversation, a week later, to the firm’s CEO and CIO. The funds, arrayed on a risk scale from Growth to Very Conservative, invested in orphan securities: little bits and pieces that were too small to interest large investment houses and that were often underpriced. Bonds in Malaysia, apartments in Milan, microcap stocks in Austin. The CIO had been managing the strategy in separate accounts, was charming and they appealed to many of my biases (small firm, interesting portfolio, reasonable expenses, ultra-low minimum investments). I got enthused, ran two positively fawning pieces about the funds and Zach the lead manager (He’s Zachtastic!) and invested in them for myself and for family. They absolutely imploded in 2008 – Very Conservative was down about 35% by November – and were liquidated with no explanation and very short notice. I felt betrayed by the adviser and like I had betrayed my readers.

   What I learned was caution. My skeptical first reaction was correct but I let it get washed away by the CIO’s passion, attention and well-told tale. I also overlooked the fact that the strategy’s record was generated in separately-managed accounts and that the CIO was delegating day-to-day responsibility to two talented but less-experienced colleagues. Since then, I’ve changed the way I deal with managers. I now write the profile first, based on the data and the public statements on file. I identify things that cannot be ascertained from those sources and then approach the managers with a limited, targeted set of questions. That helps keep me from substituting their narrative for mine. In addition, I’ve become a lot more skeptical of track records generated in vehicles (separate accounts, SICAVs, hedge funds) other than mutual funds; the structural differences between them really matter. In each draft, I try to flag areas of concern and then share them with you. Forcing myself to ask the question “what are the soft spots here” helps maintain a sort of analytic discipline.

   Utopia’s advisers, by the way, are doing well: still in Traverse City at what appears to be a thriving firm that, true to their owner’s vision, uses part of the firm’s profits to fund a charitable foundation. Me, too: I took the proceeds from the redemption and used it to open positions in FPA Crescent (FPACX) and Matthews Asian Growth & Income (MACSX).

It’s okay to fail, if you fail well. I think that the Observer has been strengthened by my many failures and I hope it will continue to be.

For your part, you need to go find your manager’s discussion of his or her failures. Good managers take ownership of them in no uncertain terms; folks from Bridgeway, Oberweis, Polaris and Seafarer have all earned my respect for the careful, thoughtful discussions they’ve offered of their screw-ups and their responses. If you can’t find any discussion of failures, I’d worry. And if your manager is ducking responsibility (mumbly crap about “contingencies not fully anticipated”), dump him.

Speaking of the opportunity to take a risk and succeed (or fail) spectacularly, it’s time to introduce …

MFO Premium, just because “MFO Extra” sounded silly

We are pleased to announce the launch of MFO Premium. We’re offering it as a gesture of thanks to folks who have supported MFO in the past and an incentive for those who have been promising themselves to support us but haven’t quite gotten there. You can gain a year’s access for a contribution of at least $100; if there are firms that would like multiple log-ins, we’d happily talk through a package.

MFO Premium has been in development for more than a year. Its genesis lays in the tools that Charles, Ed and I rely on as we’re trying to make sense of a fund’s track record. We realized early on that the traditional reporting time frames (YTD, 1-, 3-, 5- and 10-year periods) were meaningless at best and seriously misleading at worst since they capture arbitrary periods unrelated to the rhythms of the market. As a result, we made a screener that allowed us to look at performance in up cycles, down cycles and across full cycles. We also concluded that most services have simple-minded risk measurements; while reporting standard deviation and beta are nice, they represent a small and troubled toolkit since they simplify risk down to short-term volatility. As a result, we made a screener that provides six or eight different lens (from maximum drawdown in each measurement period to recovery times, Ulcer indexes and a simple “risk group” snapshot) through which to judge what you’re getting into.

Along the way we added a tool for side-by-side comparisons of individual funds, side-by-side comparisons with ETFs, previews of our works in progress, a slowly-evolving piece on demographic change and the future of the fund world, sample screener runs (mostly recently, resilient small caps and tech funds that might best hold value in an extended bear) and a small discussion area you can use if something is goofed up.

We think it has three special characteristics:

1. It’s interesting: so far as we can tell, most of this content is not available in the tools available to “normal” folks and it’s stuff we’ve found useful.
2. It’s evolving: our current suite of tools is slated to expand as we add more functions that we, personally, have needed or wanted. Sam Lee has been meditating upon the subject since his Morningstar days and has ideas about what we might be able to offer, and I suspect you folks do, too.
3. It’s responsive: we’re trying to make our tools as useful as possible. If you can show us something that would make the site better and if it’s within our capabilities, we’ll likely do it.

To be clear: we are taking nothing away from MFO’s regular site. Not now, not ever. Nothing’s moving behind a paywall. We’re a non-profit and, more particularly, a non-profit that has a long-standing, principled dedication to helping people make sense of their options. If anything, the success of MFO Premium will allow us to expand and strengthen the offerings on MFO itself.

We operate MFO on revenues of a little more than $1,000/month, mostly from our Amazon affiliation. At 25,000 readers, that comes to income of about $0.04 per reader per month. We got two immediate and two longer-term goals for any additional contributions that the premium site engenders:

1. Pay for the data. Our Lipper data feed, which powers the premium screener and supports our other analyses, costs $1,000/month. That cost goes up if we have more than a couple thousand people using the premium screener, a problem we’re unlikely to face for a while. For the nonce, our first-year contract costs us $12,000.
2. Pay for design and programming support. As folks point out monthly, our current format – one long scrolling essay – is exceedingly cumbersome. It arose from the days of FundAlarm, where my first monthly “comments and highlights” column was about as long as your annual Christmas letter. Our plan is to switch to a template which makes MFO looks distinctly magazine-like with a table of contents and a series of separate stories and features. At the same time, we’ll continue to look like MFO. We’ve got outside professionals available to customize the template we’ve chosen and to do the design work. We’ve budgeted about $1,500 for that work.

If we end up with 140 contributions, and we’re already half way there, we can cover those expenses and contemplate the two longer-term plans:

3. Offer some compensation for the folks who write for, do programming for or manage the Observer. Currently our compensation budget in most months is zero.
4. Expand our efforts to help guide and support independent managers and boutique firms. There are an awful lot of smart, talented people out there who are working in splendid isolation from one another. We suspect that helping small fund advisers find ways to exchange thoughts and share angst might well make a difference in the breadth and quality of services that other folks receive.

Three final questions that have come up: (1) What if I’ve already contributed this year? In response to a frequently asked question, we’ve kept track of all of the folks who’ve already contributed to the Observer this year. You’re not getting left behind but it may take a couple weeks for us to catch up with you. (2) Is my contribution tax-deductible? Melissa, our attorney, has been very stern with me about how I’m allowed to answer this question so I’ll let her answer it.

Contributions are tax-deductible to the extent allowable under law. In accordance with IRS regulations, the fair market value of the online premium access of $15 is not tax-deductible. MFO is not confirming or guaranteeing that any donor can take charitable deductions; no nonprofit can do that since it depends on the individual donor’s tax situation. For example, donors can only take the deduction if they itemize and donors are subject to certain AGI limits. The nonprofit can only state that it is a 501(c)(3) organization and contributions may be tax-deductible under the law.

(3) Is there an alternative to using PayPal? Well, yes. PayPal is the default. But you do not need a PayPal account. We just use the secure PayPal portal, which allows credit or debit card payment methods. Alternately, writing a check works: Mutual Fund Observer, Inc., 5456 Marquette Street, Davenport, IA 52806. (Drop us an email when the check is in the mail and we will access you pronto.) We’re also working to activate an Amazon Pay option.

That’s about it. We think that the site is useful, the contribution target is modest and the benefits are substantial. We hope you agree and agree chip in. Too, clicking on and bookmarking our Amazon link helps us a lot, costs you nothing and minimizes your time at the mall.

Now, back to our story!

Charge of the Short-Pants Brigade

“What is youth except a man or a woman before it is ready or fit to be seen.”

Evelyn Waugh

We are now in that time of the year, December, which I will categorize as the silly season for investors, both institutional and individual. Generally things should be settling down into the holiday whirl of Christmas parties and distribution of bonus checks, at least in the world of money management. Unfortunately, things have not gone according to plan. Once again that pesky passive index, the S&P 500, is outperforming many active managers. And in some instances, it is not just outperforming, but in positive total-return territory while many active managers are in negative territory. So for the month of December, there is an unusual degree of pressure to catch-up the underperformance by year-end.

We have seen this play out in the commodities, especially the energy sector. As the price of oil has drifted downwards, bouncing but now hovering around $40 a barrel, it has been dangerous to assume that all energy stocks were alike, that leverage did not matter, and that lifting costs and the ability to get product to market did not matter. It did, which is why we see some companies on the verge of being acquired at a very low price relative to barrels of energy in the ground and others faced with potential bankruptcy. It did matter whether your reserves were shale, tar sands, deep water, or something else.

Some of you wonder why, with a career of approaching thirty years as an active value investor, I am so apparently negative on active management. I’m not – I still firmly believe that over time, value outperforms, and active management should add positive alpha. But as I have also said in past commentaries, we are in the midst of a generational shift of analysts and money managers. And it is often a shift where there is not a mentoring overlap or transition (hard to have an overlap when someone is spending much of his or her time a thousand miles away). Most of them have never seen, let alone been through, a protracted bear market. So I don’t really know how they will react. Will they panic or will they freeze? It is very hard to predict, especially from the outside looking in. But in a world of email, social media, and other forms of instantaneous communication, it is also very hard to shut out the outside noise and intrusions. I have talked to and seen managers and analysts who retreated into their offices, shut the door, and melted under the pressure.

For many of you, I think the safer and better course of action is to allocate certain assets, particularly retirement, to passively-managed products which will track the long-term returns of the asset classes in which they are invested. They too will have maximum draw-down and other bear market issues, but you will eliminate a human element that may negatively impact you at the wrong time.

The other issue of course is benchmarking and time horizons, which is difficult for non-value investors to appreciate. Value can be out of favor for a long, long period of time. Indeed it can be out of favor so long that you throw in the towel. And then, you wish you had not. The tendency towards short-termism in money management is the enemy of value investing. And many in money management who call themselves value managers view the financial consultant or intermediary as the client rather than Mr. and Mrs. Six-Pack whose money it is in the fund. They play the game of relative value, by using strategies such as regression to the mean. “See, we really are value investors. We lost less money than the other guys.”

The Real Thing

One of the high points for me over the last month was the opportunity to attend a dinner hosted by David Marcus, of Evermore Global Value, in Boston, at the time of the Schwab Conference. I would like to say that David Snowball and I attended the Schwab Conference, but Schwab does not consider MFO to be a real financial publication. They did not consider David Snowball to be a financial journalist.

I have known of David Marcus for some years, as one of the original apostles under Max Heine and Michael Price at Mutual Shares. I am unfortunately old enough to remember that the old Mutual Shares organization was something special, perhaps akin to the Brooklyn Dodgers team of 1955 that beat the Yankees in the World Series (yes, children, the Dodgers were once in Brooklyn). Mutual Shares nurtured a lot of value investing talent, many of whom you know and others, like Seth Klarman of Baupost and my friend Bruce Crystal, whom you may not.

David Snowball and I subsequently interviewed David Marcus for a profile of his fund. I remember being struck by his advice to managers thinking of starting another 1940 Act mutual fund – “Don’t start another large cap value fund just like every other large cap value fund.” And Evermore Global is not like any other fund out there that I can see. How do I know? Well, I have now listened to David Marcus at length in person, explaining what he and his analysts do in his special situation fund. And I have done what I always do to see whether what I am hearing is a marketing spiel or not. I have looked at the portfolio. And it is unlike any other fund out there that I can see in terms of holdings. Its composition tells me that they are doing what they say they are doing. And, David can articulate clearly, at length, about why he owns each holding.

What makes me comfortable? Because I don’t think David is going to morph into something different than what he is and has been. Apparently Michael Price, not known for suffering fools gladly, said that if the rationale for making an investment changed or was not what you thought it was, get rid of the investment. Don’t try and come up with a new rationale. I will not ruin your day by telling you that in many firms today the analysts and portfolio managers regularly reinvent a new rational, especially when compensation is tied to invested assets under management. I also believe Marcus when he says the number of stocks will stay at a certain level, to make sure they are the best ideas. You will not have to look back at prior semi-annual reports to wonder why the relatively concentrated fund of forty stocks became the concentrated fund of eighty stocks (well it’s active share because there are not as many as Fidelity has in their similar fund). So, I think this is a fund worth looking at, for those who have long time horizons. By way of disclosure, I am an investor in the fund.

Final Thoughts

For those of you who like history, and who want to understand what I am talking about in terms of the need for appreciating generational shifts in management when they happen, I commend to you Rick Atkinson’s first book in his WWII trilogy, An Army at Dawn.

My friend Robin Angus, at the very long-term driven UK Investment Trust Personal Assets, in his November 2015 Quarterly Report quoted Brian Spector of Baupost Partners in Boston, whose words I think are worth quoting again. “One of the most common misconceptions regarding Baupost is that most outsiders think we have generated good risk-adjusted returns despite holding cash. Most insiders, on the other hand, believe we have generated those returns BECAUSE of that cash. Without that cash, it would be impossible to deploy capital when … great opportunities became widespread.”

Finally, to put you in the holiday mood, another friend, Larry Jeddeloh of The Institutional Strategist, recently came back from a European trip visiting clients there. A client in Geneva said to Larry, “If you forget for a moment analysis, logic, reasoning and just sniff the air, one smells gunpowder.”

Not my hope for the New Year, but ….

Edward A. Studzinski

When Good Managers Go Bad

By Leigh Walzer, founder and principal of Trapezoid, LLC. Leigh’s had a distinguished career working in investment management, in part in the tricky field of distressed securities analysis. He plied that trade for seven years with Michael Price and the Mutual Series folks. He followed that with a long stint as a director at Angelo, Gordon & Co., a well-respected alternatives manager and a couple private partnerships. Through it all, Leigh has been insatiably curious about not just “what works?” but, more importantly, “why does it work?” That’s the work now of Trapezoid LLC.

Continuing the theme of learning from failure… One of the toughest decisions for investors is what to do when a portfolio manager who had been performing well turns in a bad year? We can draw on our extensive database of manager skill for insight and precedents.

The Trapezoid system parses out manager skill over time. Our firm strives to understand whether past success was the result of luck or skill and determine which managers are likely to earn their fees going forward. Readers can demo the system for free at www.fundattribution.com where most of the active US equity mutual funds are modelled. The demo presents free access to certain categories with limited functionality.

To answer the question we look back in time for portfolio managers who experienced what we call a “Stumble.” Specifically, we looked for instances where a manager who had negative skill over the latest twelve months and positive skill in the preceding three years. The skill differential had to be at least 5 points. Skill in this case is a combination of Security Selection and Sector Selection. We evaluated data over the past 20 years, ignoring funds with a manager change or insufficient history.

Our goal was to see how these managers did following the Stumble. To make the comparison as fair and unbiased as possible, we compared the Stumble managers to a control group who had the same historical skill with no Stumble.

Exhibit I illustrates with two hypothetical funds. Coyote Fund had the same cumulative skill over a four year period – but investors in Roadrunner followed a much rougher path, and saw their value plummet in Year 4.

EXHIBIT I

Returns from Two Hypothetical Funds

Should holders of Roadrunner switch? Does the most recent performance suggest Roadrunner might have lost its Mojo? Does Roadrunner deserve a mulligan for an uncharacteristic year? Or should investors stick to their conviction that over the long haul Roadrunner and Coyote are equally skilled and stay the course? Or that Roadrunner is due for a bounce back?

Our database indicates that managers who stumble take approximately 30 months to regain their footing. During that thirty month period, these funds underperform by an incremental 3%. (See Exhibit II) This suggests investors would do well to switch from Roadrunner to Coyote. Note that a lot of the performance disparity occurs in the first few months after a Stumble, so close monitoring might allow investors to contain the damage. But if you don’t react quickly, there is a stronger case to stay put.

Why are managers slow to recover after a stumble? For many funds skill is partly cyclical. Cyclicality can occur because funds participate in market themes and seams of opportunity which play out over time. Strong or poor performance may affect funds flow which may further impact returns. So a Stumble may not tell investors much about the long term prognosis, but it is helpful in predicting over the short term. Our algorithms try to distinguish secular from cyclical trends and, equally important, how confident we can be in making predictions.

EXHIBIT II

Typical Skill Trend after Stumble Event

On a related note, we are sometimes asked whether managers learn from their experience and become better over time. We are sympathetic to the view that managers with a few gray hairs might do better than their younger peers, but the data doesn’t support this. In general managers with more experience don’t outperform the greenhorns, but they don’t seem to lose their fastball either.

But there is something interesting in this chart. Managers who survive a crisis do a little better than their peers in later years. One explanation is that with the battle scars come some valuable lessons which helps managers navigate the market better.

We looked for specific funds which stumbled recently. They are listed in Exhibit III. Some of these funds actually have good 3-5 year track records and have fund classes on the Trapezoid Honor Roll, which is separate from the Observer’s. Think of the Stumble Event as an early warning indicator: we are looking for funds that have lost altitude or veered off their trajectory.

EXHIBIT III

Funds with Stumble Event in the 12 Months Ending June 2015

We took a harder look at the largest fund on the list, ClearBridge Aggressive Growth (SAGYX).

EXHIBIT IV

ClearBridge Aggressive Growth Fund: Recent Performance

This $14bn fund has a 32 year history with the same lead manager in place throughout. At various times in the past it was known as Shearson, Smith Barney, or Legg Mason Aggressive Growth Fund.

We don’t have data back to inception, but over the past 20 years, the manager (Richard Freeman) has demonstrated sector selection skill of approximately 1% per year. Exhibit IV shows the recent net returns (courtesy of Morningstar). We see little or no stock picking skill. The fund is very concentrated and differentiated; the Active Index (or OAI) is 23; in general when we see scores over 18, we read it as evidence of a truly active manager). Over the past 5 years, sector selection has contributed approximately 3%/year. Based on this showing, our Orthogonal Attribution Engine (or OAE, the tool we use to parse out the effects of each of the six sources of a fund’s over- or under-performance) has enough confidence to incur expenses of roughly 1%/year. As a result, several fund classes are on our Trapezoid Honor Roll – i.e., we have 60% confidence skill justifies expenses. The fund has tripled in size in three years which is a bit of a concern. We can replicate the fund with 87% R-squared. Our “secret sauce” to replicate the fund is a blend of S&P500, small-cap, a very large dollop of biotech, and small twists of media, energy, and healthcare. The recipe doesn’t seem to have changed much over time.

Exhibit V gives a sense of the cyclicality of combined skill over time, the manager has had some periods of exceptional performance but also some slumps. The first half of 2002 was a rough period for the fund; the negative skill reflects mainly that the fund had (as always) a heavy overweight on biotech which badly underperformed the market during that timeframe.

EXHIBIT V

ClearBridge Aggressive Growth: Combined Skill from Security Selection and Sector Rotation (1995-2015)

Coming into the second half of 2014, the fund had its characteristic strong overweight on biotech. This weighting should have served the fund well. However, security selection was negative in the twelve months ended July 2014. (NB: The fund’s Fiscal Year ends August) Some of the stocks the fund had held for several years and ridden up like Biogen, SanDisk, Cree, and Weatherford did not work in this environment. We view this as negative skill, since the manager could have sold high and redeployed to other stocks in the same sector. Our math suggests the fund also incurred above average trading costs over the past year, which shows up in our model as negative skill. We asked ClearBridge to review our findings but they did not respond as of this writing.

ClearBridge Aggressive Growth re-entered Stumble territory in June. We noted earlier that funds with a Stumble event tend to lose another 2.5% before regaining their footing. In their case, that prediction has held true. We have not refreshed their skill but they have lagged the S&P500 badly. Most recently, another big biotech position they rode up, Valeant Pharmaceuticals, has come undone.

Bottom Line: Investors should consider heading to the sidelines when a fund stumbles and wait until the dust clears. We usually pay more heed to long term track record than short term blips and momentum. But a sudden drop-off in skill usually portends more pain to come. So for marginally attractive funds a Stumble Event may be a sell signal.

ClearBridge has had the conviction to remain overweight biotech for many years which has served them well. That sector now has negative momentum. We expect the poor security selection will even out over time. Investors who are neutral or positive on the sector should give the fund the benefit of the doubt.

To see additional details, please register at www.fundattribution.com and click on the Stumbles link from the Dashboard. As always, we welcome your comments at [email protected]

Quick hits: Resilient small caps and tech funds

Partly as a teaching tool, I’ve been walking folks through how to use our fund screener. Two outputs that you might find interesting:

Resilient small cap winners: which small cap funds came closest to letting you have your cake and eat it, too? That is, which were cautious enough to post both relatively limited losses in the 2007-09 bear market and to manage top tier returns across the entire market cycle (2007 – present)? Three stand out:

Intrepid Endurance (ICMAX), a cash-heavy absolute value fund once skippered by Eric Cinnamond, now of Aston River Road Independent Value (ARIVX).

Dreyfus Opportunistic Small Cap (DSCVX), a much more volatile fund whose upside has outpaced its downside. It’s closed to new investors.

Diamond Hill Small Cap (DHSCX), a star that’s set to close to new investors at the end of December.

Resilient tech: did any tech funds manage both of the past two bears, 2000-02 and 2007-09? I screened for the funds that had the lowest maximum drawdowns and Ulcer Indexes in both crashes. Turns out that risk-sensitivity persisted: four of the five most stable funds in 2002 were on the list again in 2007. The best prospect is Zachary Shafran’s Ivy Science & Tech (WSTAX). It’s more of a “great companies that use tech brilliantly” firm than a pure tech play. Paul Wick’s Columbia Seligman Communication & Information (SLMCX) was almost as good but there’s been a fair turnover in the management team lately. Two Fidelity Select sector funds, IT Services (FBSOX) and the soon-to-be-renamed Software & Computer Services (FSCSX), also repeated despite 17 manager changes between them. Chip, our IT services guru, mumbles “told you so.”

Category Averages

As promised, we’ve added a Category Averages tool on the MFO Premium page. Averages are presented for 144 categories across 10 time frames, including the five full market cycles period dating back to 1968. The display metrics include averages for Total Return, Annualized Percent Return (APR), Maximum Drawdown (MAXDD), MAXDD Recovery Time, Standard Deviation (STDEV, aka volatility), and MFO Risk Group ranking.

Which equity category has delivered the most consistently good return during the past three full market cycles? Consumer Goods. Nominally 10% per year. It’s also done so with considerably less volatility and drawdown than most equity categories.

One of the lower risk established funds in this category is Vanguard Consumer Staples Index ETF VDC. (It is also available in Admiral Shares VCSAX.) Here are its risk and return metrics for various time frames:

The new tool also enables you to examine Number of Funds used to compute the averages, as well as Fund-To-Fund Variation in APR within each category.

Morningstar anoints the “emerging, unknown, and up-and-coming”

In mid-November, Dan Culloton shared the roster of Morningstar Prospects with readers. These are funds that “emerging, unknown and up-and-coming.” They’re listed below, while the link above will take you to the Morningstar video center where a commercial and a video interview will auto-launch.

One measure of the difference between Morningstar’s universe and ours: they can see 23 year old funds as “emerging” and $10 billion ones as “unknown.” We don’t.

Farewell to FundFox

We’re saddened to report the closure of FundFox, the only service devoted exclusively to target federal litigation involving the fund industry. It was started in 2012 by David Smith, who used to work for the largest liability insurance provider to the fund industry, as a simpler, cleaner, more specialized alternative to services such as WestLaw or Lexis. David drew an exceedingly loyal (think: 100% resubscription rate) readership that never grew enough for the service to become financially self-sustaining. David closed on Friday the 13^th of last month. David’s monthly column has run in the Observer for the past 17 months. We’ll miss him.

David’s going to take a deep breath now, enjoy the holidays and think about his next steps. One possibility would be to work in a fund compliance group; another would be to join his family’s century-old citrus business.

“Two roads diverged in a yellow wood, And sorry I could not travel both.” Diverged indeed.

Cap gains 2015: Not as bad as last year, except for those that are much worse

CapGainsValet.com is up and running again (and still free). CGV is designed to be the place for you to easily find mutual fund capital gains distribution information. If this concept is new to you, have a look at the Articles section of the CGV website where you’ll find educational pieces ranging from beginner concepts to more advanced tax saving strategies.

I’ve been gathering and posting 2015 capital gain distribution estimates for CapGainsValet.com for the last two months. My database currently has distribution estimates for almost 190 fund firms. This represents 90% of the firms I’m hoping to eventually add, which means the 2015 database is nearly complete. (Hurray for me!)

I recently had a look through last year’s database to see how it compares to this year’s numbers. Here’s what I found:

• Fewer funds are distributing more than 10%. Last year I found 517 mutual funds that distributed more than 10% of their NAV. From all indications, 2014 was one of the biggest distribution years on record. For 2015, I’ve found 367 funds that are going to distribute more than 10%. My guess is that we’ll end the year in the 375-380 range.
• More BIG distributions. In 2014, I was able to find 12 funds that distributed more than 30% of their NAV. This year that number has already jumped to 19. Even though the number of 30% distributors has increased, the number of funds that are distributing between 20% and 30% of NAV is about half of what it was last season.
• Several big names in the doghouse. If you take a look at my “In the Doghouse” list, you will find that there are some of the bigger names in the actively managed funds universe. Montag & Caldwell Growth, Columbia Acorn and Fairholme will be distributing billions. Successful funds with large fund outflows are likely going to have trouble controlling future capital gains distributions.
• ETFs are still looking very tax efficient. Although CGV does not track ETF distributions, I am seeing very low capital gain numbers from ETF providers. Market-cap weighted index funds and ETFs continue to be tax efficient.
• More tax swapping opportunities. Last year’s distributions corresponded to a fairly solid year of gains – it is not looking like that will be the case this year. Last year, selling a fund before its large capital gain distribution meant little difference because the fund’s embedded gains were similar or larger. If you bought a fund this year, receiving a large distribution will likely result in a higher tax bill than if you sell the fund before its record date. At Tarbox (my day job) we have already executed a number of tax-swap trades that will save our clients hundreds to thousands of dollars on their 2015 tax return. Have a look through your holdings for these types of opportunities.

Of course, CGV is not the only site providing shortcuts to capital gain distribution estimates. MFO’s discussion board has an excellent list of capital gain distribution estimates with a number of fund firms too small for the CGV database. Check it out and provide some assistance if you can.

Mark Wilson, APA, CFP®
Chief Investment Officer, The Tarbox Group, Inc.
Chief Valet, CapGainsValet

The Alt Perspective: Commentary and news from DailyAlts.

Give Up The Funk

Every once in a while an asset category gets into a funk. Value investing was in a funk leading up to the dotcom bubble, growth stocks were in a funk following the dotcom bubble, etc. You probably know what I mean. Interestingly, active management is in a funk right now – just take a look at the below chart from Morningstar’s most recent U.S. Asset Flows report (includes both mutual funds and ETFs):

Actively managed funds have lost $136 billion in assets over the past year! Are investors taking their dollars out of funds? No. Passive funds have pulled in $457 billion over that same time period. That’s a gap of nearly $600 billion! On a net basis, investors have poured $320 billion of new dollars into mutual funds and ETFs in the past 12 months, nearly $27 billion per month on average. That’s some serious coin.

Is Active Management Dead?

So what is the story, is active management dead? No, active management is not dead, and it never will be. Part of the problem is that most actively managed funds are mutual funds, while most passive funds are ETFs. ETFs have a lower cost structure and a lower barrier to entry. Advantage passive ETFs. This will shift over time with new product development, and the pendulum will swing back, at least part way. Other factors are also at play, and just like other funks, things will change.

But in the meantime, one of the four categories of actively managed funds to garner assets over the past year, and only one of two in October, was that of Alternatives. Why? Because alternative funds offer diversification beyond traditional stock and bond portfolios. They offer investors exposure to more unconstrained forms of investing that can generate lower risk and/or provide improved portfolio diversification due to their low correlation with long-only stocks and bonds.

A recent paper by the Alternative Investment Management Association (AIMA) and the Chartered Alternative Investment Analyst Association (CAIA Association) appropriately breaks hedge funds down into two categories: Substitutes and Diversifiers. This is an important distinction since each grouping has a different role in a portfolio, and can have a different impact on overall results. Substituted replace assets that are already existing in most portfolios, such as stocks and bonds, while diversifiers are investment strategies that have a low to zero correlation with traditional asset classes. If you are considering, or even currently using alternatives, I would encourage you to read the paper.

Liquid Alts Asset Flows

So let’s take a quick look at the asset flows into, or out of, liquid alternatives for October. The picture hasn’t changed much in the past few months. Flows are going into multi-alternative funds, managed futures funds and volatility funds, while assets are flowing out of non-traditional bonds funds and bit out of other categories.

Leading up to 2015, non-traditional bond fund had significant inflows as everyone expected rates to rise. Many of these funds are designed to protect against rising rates. Here we are in late November 2015 and still no rate rise. Mediocre performance and not significant rate rise in sight, and out go investors who need income and returns more than protection.

Quick Wrap

A couple final notes of interest from the news and research categories this past month:

• Putnam published a thoughtful paper on how alternatives perform in different economic environments: Evaluating Alternatives In Four Growth and Inflation Scenarios.
• John Dolfin and Chris Maxey of Steben & Company review the Importance of Manager Selection as it relates to alternative investments.
• A new liquid form of venture capital investing is available to retail investors via a mutual fund as outlined in New Mutual Fund Aims to Democratize Access to Venture Capital.
• DailyAlts has a new column called Best and Worst where we publish a series of stories each month highlighting the best and worst performing funds in each main category of liquid alternatives.

Be sure to check out DailyAlts.com for more updates on the liquid alternatives market, and feel free to sign up for our free daily or weekly newsletter.

Observer Fund Profiles: Fidelity Total Emerging Markets

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. 

Fidelity Total Emerging Markets (FTEMX): we’ve long argued that EM investors need to find a strategy for managing volatility and that a balanced fund is the best strategy they’ve got. There’s a good argument that John Carlson’s fund is the best option for pursuing that best strategy.

Elevator Talk: Bryn Torkelson, Matisse Discounted Closed-End Fund Strategy (MDCAX/MDCEX)

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.

Bryn Torkelson

Bryn Torkelson manages MDCAX, which launched at the end of October 2012. He also co-founded and owns the advisor (launched in 2010) and the sub-adviser, Deschutes Portfolio Strategies (launched in 1997). Bryn started in the investment industry in 1981 as a broker with Smith Barney and later worked with Dain Bosworth. He has a B.S. in Finance from the University of Oregon, which is helpful since some of the research underlying the strategy was conducted at the university’s Lundquist College of Business. He manages one hedge fund, Matisse Absolute Return Fund, a 5 star rated fund by Morningstar, and about 700 separate accounts, mostly for high net-worth individuals. In all, the firm manages about $900 million.

He’s headquartered in Lake Oswego, Oregon, a curiously hot spot for investment firms. It’s also home for the advisers of the Jensen and Auxier funds.

The story here’s pretty simple. Taken as a group, closed-end fund (CEF) portfolios return about what the overall market does. So if you simply invested in all the existing CEFs, you’d own an expensive index fund. CEFs, much more than other investment vehicles, are owned mostly by individual investors. Those folks are given to panic and regularly offer to sell $100 in stocks for $80; on a really bad day, they’ll trade $100 in stocks for $60 in cash. That’s irrational. Buyers move in, snap up assets at lunatic discounts and the discounts largely evaporate.

Here’s the Matisse plan: research and construct a portfolio from the 20% most discounted funds in the overall universe of income-producing CEFs, wait for the discounts to evaporate, then rebalance typically monthly to restock the portfolio with the most-discounted quintile. Research from the Securities Analysis Center at Oregon, looking back as far as they could get monthly price and discount data (1988), suggests that strategy produced 20% a year with a beta of .75. In their separate accounts which started in 2006, the strategy has produced approximately 9% net annually mostly from income and 2-3% capital gains from the contraction of the CEF discounts. Those gains are useful because they’re market neutral; that is, the discounts tend to contract over time whether the overall market is rising or falling.

Sadly, in the three years since launch, the mutual fund has returned just 3.3% a year (through late November 2015) which is better than the average tactical allocation fund but far lower than a generic balanced fund. Mr. Torkelson argues that CEF discounts reached, and have stayed at near-record levels this year which accounts for the modest gains. The folks at RiverNorth, who use a different CEF arbitrage strategy in RiverNorth Core Opportunities (RNCOX), agree with that observation. Despite “tough sledding,” Mr. T. believes the CEF market likely bottomed-out in October, which leaves him “very optimistic going forward.” He notes that, since 1988, discounts have only been wider 3% of the time – during a few months in 2008-2009, the tech bubble in 2000 and during the recession of 1990. Today his portfolios have an average discount of 17.5% and a distribution yield of 8.2%.

Here are Mr. Torkelson’s 281 words on why you should add MDCAX to your due-diligence list:

I started our fund/strategy to help investors gain access to higher income opportunities than available in ETF’s or open ended mutual funds. Today the funds distribution income is approximately 8.2%. The misunderstood market of “closed end mutual funds” (CEF’s) presents investors opportunities to buy quality income funds at 15-20% discounts to published market values. When we buy discounts our clients’ portfolios will generates substantially higher income than similar ETF’s or open ended mutual funds.

The entire CEF universe is approximately 500+ funds representing $230 billion in assets. Most of these funds are designed to pay income, often distributed monthly or quarterly. The source of the income varies on each funds objective. However, income is generated from taxable or municipal bonds, preferred stock, convertible bonds, bank loans, MLP’s, REIT’s, return of capital (ROC) or even income from “covered call writing” strategies on the portfolio.

The exciting aspect of the strategy is these CEFs trade on stock exchanges and they often trade at market values well below their published daily Net Asset Values (NAV). Our studies indicate there is a high probability for the discounts to be “mean reverting”. When this happens our clients receive both capital gains in addition to income. For example, firms like Blackrock or PIMCO manage both open ended mutual funds and closed end funds often with the same manager and or objectives. If you purchase the highly discounted vehicle of CEF’s instead of the opened ended equivalent vehicle, you’ll typically get much better returns. The other great part of our strategy is our investors get a highly diversified portfolio without any concentration worries. On a look-through basis our investors get a highly discounted income oriented global balanced portfolio.

Matisse Discounted Closed-End Fund Strategy has a $1000 minimum initial investment on its “A” shares, which bear a sales load, and $25,000 on its Institutional shares, which do not. Matisse has limited the funds expense ratio to 1.25% on the “I” shares. The pass-through costs of CEF funds in which they invest are included and a central and unavoidable contributor to the overall fees. Those pass-throughs accounted for 1.37% last year. With those fees included the expenses on the “I” shares run a stiff 2.62% while the “A” shares are 25 basis points higher. The fund has gathered about $120 million in assets since its October 2012 launch. They have $200 million the overall strategy. It just earned its initial Morningstar rating of three stars within the “tactical allocation” universe for the “I” shares and two stars for the “A” shares for investors who pay the full load.

You’ve got a sort of embarrassment of riches as far as web contacts go. In addition to the sub-adviser’s site, there are separate sites for the Matisse strategy and for the Matisse mutual fund. The former is a bit more informative about what they’re up to; the latter is better for details on the fund. Bryn’s strategy predates his mutual fund. The first six slides on this presentation gives a view of the strategy’s longer-term performance.

Launch Alert: DoubleLine Global Bond Funds

For those who can’t get enough of bondfant terrible Jeffrey Gundlach, DoubleLine Global Bond Fund (DLGBX) is arriving just in time. The fund launched on November 30, 2015 with Mr. Gundlach at the helm. This will be the 17^th fund on Mr. Gundlach’s daily to-do list which also includes nine funds on which DoubleLine is a sub-adviser and seven in-house ones. On whole he’s responsible for 50 accounts and about $70 billion in assets.

The fund’s investment objective is to seek long-term total return. The plan is to invest, mostly, in investment-grade debt issued, mostly, by G-20 countries. Once we’re past the “mostly,” things open up to include high-yield debt, swaptions, shorting, currency hedges, bank loans, corporate bonds and other creatures. They expect an average duration of 1-10 years.

In case you’re wondering if there are any particular risks to be aware of, DoubleLine offers this list:

The minimum initial investment for the retail shares is $2000 and the opening expense ratio is 0.96%.

Folks on our discussion board would urge you to consider T. Rowe Price Global Multi-Sector Bond (PRSNX) and PIMCO Total Return Active ETF (BOND) as worthy, tested, less-expensive alternatives.

Funds in Registration

We’ve reached the slow time of the year. Funds in registration now won’t be able to claim full-year returns for 2016, so there tends to be a lull in new fund releases. This month we found just five retail, no-load funds in SEC registration. Two are hedge funds undergoing conversion (LDR Preferred Income and Livian Equity Opportunity), two are edgy internationals (Frontier Silk Invest New Horizons and Harbor International Small Cap, managed by Barings) and one an ESG-oriented blue chip fund, TCW New America Premier Equities. All are them are here. 

Manager Changes

Chip tracked down 69 full or partial management changes this month, substantial but not a record. The retirement of Jason Cross, one of the founding managers and lead on their long/short trading strategy, from the Whitebox Funds is pretty consequential. Clifton Hoover is stepping away from Dreman Contrarian SCV (DRSAX) to become Dreman’s CIO. Otherwise, it’s mostly not front-page news.

Rekenthaler: “Great” funds aren’t worth the price of admission

John Rekenthaler, a guy who regularly thinks interesting thoughts, collaborated with colleague Jeff Ptak to test the truism that the best long-term strategy is to invest in “singles hitters.” That is, to invest in funds that are consistently a bit above average rather than alternately brilliant and disastrous. By at least one measure, that’s an … um, untruism. Rekenthaler and Ptak concluded that the funds with the best long-term records are ones that frequently land in their peer group’s top tier. They were home run hitters; singles hitters fell well behind.

Sadly, they also concluded that such funds (think Fairholme FAIRX or CGM Focus CGMFX) are often impossible to own. Mr. Ptak writes:

Great funds probably aren’t good. Rather, they’re intermittently amazing and horrendous. Streaky. Hard to stick with. Demanding. That would seem to match findings that the long-term standouts have often plumbed their category’s depths, owning securities that others neglect. Bad stuff routinely happens to great funds. Being merely good isn’t enough. You have to be bad … awful at times … and stick with it … and then maybe you’ll be great.

It’s an interesting, though incomplete, argument. We should think about it.

Updates: Gross, Black, Sequoia

In July 2014, after listening to Bill Gross’s disjointed maundering as a Morningstar keynote speaker, we suggested that he’d lost his marbles and that it was time either for him to go or for you to. In September 2014 he stomped off. In October 2015 he decided to sue PIMCO for succumbing to “a lust for power” in their efforts to oust him. A quarter billion or so would make him feel better. Now PIMCO has filed a motion to dismiss the suit, claiming that

The complaint, parts of which read more like a screenplay than a court pleading, uses irrelevant and false personal attacks on Mr. Gross’s former colleagues in an apparent effort to distract attention from the fundamental failings of these ‘contract’ claims.

They’ve urged him to get on with his life. Stay tuned, since I don’t see that happening. 

We reported in October, in an admirably dispassionate voice, on the sudden departure of Gary Black from Calamos Investments. In September, Calamos noted that Mr. Black was gone from the firm “effective immediately.” The company positioned it as “an evolution of the management.” He left after three years, a Calamos rep explained, because he “completed the work he was hired to do.” They had no idea of what he was going to be doing next.

Randy Diamond, writing for Pensions & Investments (11/30/2015) hints at a rather more colorful tale in his essay “Calamos continues fighting after another change at the top.”

Mr. Black lasted a little more than three years at Calamos. He joined the firm in August 2012 to replace Mr. Calamos’ nephew, Nick Calamos. Although a news release at the time said Nick Calamos “decided to step back from the day-to-day business of the firm to pursue personal interests,” sources interviewed said he left after frequent clashes with his uncle over how to fix poor investment performance in the firm’s strategies.

Sources said one reason Mr. Black left involved the team from his New York-based long-short investment business, which he sold to Calamos Investments when he joined the firm. Sources said five of the team’s seven investment professionals left this year in a dispute with John Calamos over compensation.

After the dissolution of Mr. Black’s long-short unit, the firm acquired a new long-short team, Phineus Partners LP of San Francisco.

In November 2015, we argued that the Sequoia Fund “seems in the midst of the worst screw-up in its history.” The fund, against the warnings of its board, sunk a third of its portfolio in Valeant Pharmaceuticals (VRX). The managers’ defense of Valeant’s business practices sound a lot like they were written by Valeant or by folks pressured into being cheerleaders. James Stewart, writing in the New York Times, did a really nice follow-up piece, “Huge Valeant Stake Exposes Rift at Sequoia Fund” (11/12/2015). In addition to dripping acid on Sequoia’s desperate argument that betting the farm on Valeant CEO Michael Pearson was no different than when they bet the farm on Berkshire-Hathaway CEO Warren Buffett, Stewart also managed to get some information on the arguments made by the two board members who resigned. It’s very much worth reading.

The fund lost another 1.26% in November, which places it in the bottom 1% of its peer group. Valeant dropped 22% in the same period which suggests its impact on the portfolio is dwindling. Over the past three years, it trails 98% of its peers. (Leigh Walzer might say this qualifies as “a stumble.”)

After talking with Sequoia management (“they were very cooperative”) but not with the trustees who resigned in protest, Morningstar reaffirmed Sequoia’s Gold rating.

Several of us have taken the position that we’re likely in the early stages of a bear market. The Wall Street Journal (12/01/2015) reports two troubling bits of economic data that might feed that concern: US corporate capital expenditures (capex) continue dropping and emerging market corporate debt defaults continue rising. For the first time in recent years, e.m. default rates exceed U.S. rates.

Briefly Noted . . .

One of the odder SEC filings this month: “Effective November 30, 2015, the Adaptive Allocation Fund (AAXAX) will no longer operate a website, and any references within the Prospectus and SAI to www.unusualfund.com are hereby deleted.” No idea.

BofA Global Capital Management is selling their cash asset management business to BlackRock, sometime in the first half of 2016.

Templeton Foreign Smaller Companies Fund (FINEX), Templeton Global Balanced Fund (TAGBX) and Templeton Global Opportunities Trust (TEGOX) have each added the ability to “sell (write) exchange traded and over-the-counter equity put and call options on individual securities held in its portfolio in an amount up to 10% of its net assets to generate additional income for the Fund.”

SMALL WINS FOR INVESTORS

The Fairholme Allocation Fund (FAAFX) reopened to new investors on November 18. The fund has had one great year (2013) since inception and has trailed 97% over the past three years. Assets have dropped from $379 million at the end of November 2014 to $298 million a year later.

JPMorgan Small Cap Equity Fund (VSEAX) reopened to new investors on November 16, 2015. It’s an exceptionally solid fund with a large asset base; I assume the reopening came because inflows stabilized rather than in response to outflows.

Effective January 1, 2016, Royce is dropping the management fee on Royce European Small-Cap Fund (RISCX), Global Value Fund (RIVFX), International Small-Cap Fund (RYGSX), and International Premier Fund (RYIPX) by 25 bps.

Effective November 17, 2015, the management fees of Schwab U.S. Broad Market, U.S. Large-Cap, U.S. Large-Cap Growth, and U.S. Large-Cap Value ETFs have been reduced by one basis point each. The resulting expense ratios range from 3-6 bps.

CLOSINGS (and related inconveniences)

Effective January 29, 2016, the AQR Style Premia Alternative Fund (QSPNX) and AQR Style Premia Alternative LV Fund (QSLNX) will be closed to new investors. They’re two year old institutional funds. Both have posted exceedingly strong returns with the Alternative Fund drawing $1.6 billion and Alternative LV accumulating $170 million in assets.

Effective December 31, 2015, the Diamond Hill Small Cap Fund (DHSCX) will close to most new investors. Told you so.

On December 31, 2015, the Undiscovered Managers Behavioral Value Fund (UBVAX) will institute a soft close. Shhh! Don’t tell anyone but the undiscovered managers are Russell Fuller and David Potter! And don’t tell David, but Russell is running an even-more undiscovered fund without him: Fuller & Thaler Behavioral Core Equity (FTHAX). The former is a large small cap fund, the latter is small large cap one.

OLD WINE, NEW BOTTLES

Effective October 31, 2015, Aberdeen U.S. Equity Fund became Aberdeen U.S. Multi-Cap Equity Fund.

Effective on or about January 4, 2016, Clearbridge Mid Cap Core will be renamed ClearBridge Mid Cap Fund.

Effective January 1, 2016, Fidelity Medical Delivery Portfolio will be renamed Health Care Services Portfolio and Fidelity Software and Computer Services Portfolio will be renamed Software and IT Services Portfolio.

Effective January 25, 2016, Merk Asian Currency Fund (MEAFX) becomes Merk Chinese Yuan Currency and Income Fund. The fund already reports having 98% of its portfolio in the Chinese currency (and 20.2% in Hong Kong?), so it’s largely symbolic.

On February 24, 2016, the word “Retirement” will be removed from the names of all of the T. Rowe Price Target Retirement Funds (Funds).

OFF TO THE DUSTBIN OF HISTORY

AlphaCentric Smart Money Fund (SMRTX) smartly lost 19% in 15 months of existence, which might explain why its board decided that it’s in “the best interests of the Fund and its shareholders that the Fund cease operations.” Those interests will be expressed in the fund’s liquidation, just before Christmas.

On October 27, Andrew Kerai stepped aside as manager of BDC Income Fund (ABCDX) less than a year after the fund’s launch. Six days later, the fund’s board of trustees voters to close and liquidate it. It disappeared on November 30, 2015, still short of its one-year mark.

Carne Hedged Equity Fund (CRNEX) is liquidating on December 7, 2015. The board forthrightly attributed the closure to “recent Fund performance, the inability of the Fund to garner additional assets, the relatively small asset size of the Fund, recent significant shareholder redemptions, and other factors.” The fund buys mostly household names (Gilead, PayPal, Apple, Michael Kors, IBM) and was doing well until early 2014. Since then it’s dropped 24% in a steadily rising market. Neither the fund’s shareholders nor I know what happened. The 2014 annual report contains one cryptic passage from the manager, “I looked to optimize the hedging without diverting from the core portfolio. This strategy was a poor choice.” The subsequent semi-annual report contains no text and the website offers neither commentary nor shareholder letters.

Catalyst Activist Investor Fund (AIXAX) will liquidate on December 21, 2015. The fund looked to invest in companies where the public filings, typically Form 13D, showed activity by activist investors. The idea is to follow the smart money in, and out. The strategy lost about 25% since its summer 2014 launch. If you’re intrigued by the strategy, there’s still the 13D Activist Fund (DDDAX) which has also lost money on that period but a lot less money.

CRM Global Opportunity Fund (CRMWX) has closed in advance of a December 16, 2015 liquidation.

Curian/PIMCO Income Fund has closed and will cease operations on the as-yet unannounced cessation date.

Dreyfus International Value Fund (DVLAX) merges into Dreyfus International Equity Fund (DIEAX) on January 22, 2016. DIEAX isn’t particularly good but it does have better performance and significantly lower expenses than the liquidating fund.

On December 23, 2015, Forward Tactical Enhanced Fund (FTEEX) becomes the latest attraction at Forward’s LiquidationFest. It takes a 9,956% turnover ratio with it.

Speaking of firm-wide festivities, Franklin is unleashing a bundle of liquidations. For the sake of space, I’ve stuck them in a table.

Here’s a filing written by a former philosophy major: “On November 12, 2015, Gateway International Fund was liquidated. The Fund no longer exists, and as a result, shares of the Fund are no longer available for purchase or exchange.”

JPMorgan Global Natural Resources Fund (JGNAX) will liquidate on or about December 16, 2015. Over five years, the fund turned a $10,000 initial investment into a $3,500 portfolio.

In January 2016, shareholders will vote on a proposed merger of Keeley Mid Cap Value Fund (KMCVX) into the Keeley Mid Cap Dividend Value Fund (KMDVX). They should approve.

MAI Energy Infrastructure and MLP Fund (VMLPX) will liquidate on December 23, 2015.

MFS Global Leaders Fund was terminated as of November 18, 2015.

RBC Prime Money Market Fund is closing on September 30, 2016 and liquidating shortly thereafter. The combination of zero interest and new liquidity regs are making such filings a lot more common.

SMH Representation Trust (SMHRX) liquidates on December 21, 2015. There’s been a bit of a performance slump of late.

I wonder if Morningstar ever looks at these things and thinks “perhaps labeling this chart as growth of $10,000 is a misnomer”?

Sometime in the first quarter of 2016, Templeton BRIC Fund (TABRX) will merge into Templeton Developing Markets Trust (TEDMX).

Thomas Crown Global Long/Short Equity Fund (TCLSX) liquidated on November 13, 2015 following the painful realization that “there are no meaningful prospects for growth in assets.”

Visium Event Driven Fund became driverless on November 27, 2015.

In Closing . . .

We’d like to thank all those who have contributed to MFO. That certainly includes the folks who contributed for premium access, but we’re equally grateful to the folks who made other levels of contribution. To Mitchell, Frank, John, Edward, and Charles, you’re golden!. Thank you, too, to all those who loyally use our Amazon link. It was a good month.

We wish you all a joyous holiday season. We know your families are crazy; hug them all the tighter for it. In the end they matter more than all the trinkets and all the bling and all the toys and all the square footage you’ll ever buy.

We’ll look for you in the New Year.

Dear friends,

As you read this, I’ll be wading through a drift of candy wrappers, wondering if my son’s room is still under there somewhere. Weeks ago my local retailers got into the Halloween spirit by setting up their Christmas displays and now I live in terror of the first notes of that first Christmas carol inflicted over storewide and mall-wide sound systems.

But between the two, I pause for thanksgiving and Thanksgiving. I’m thankful for all the things I don’t have: they’re mostly delusion and clutter. I’m thankful for the stores not open on Black Friday (REI most recently) just as I’m thankful for the ones not open on Sundays (Fareway grocery stores, locally); we’ve got to get past the panic and resentment that arises if there’s a whole day without shopping. I’m grateful for those who conspire to keep me young, if only through their contagious craziness. I’m grateful for gravy, for the sweet warmth of a friend hugged close, for my son’s stunning ability to sing and for all the time my phone is turned off.

And I’m grateful, most continually, for the chance to serve you. It’s a rare honor.

Had I mentioned apple pie with remarkably thick and flaky crust? If not, that’s way up on the list too.

There’s a break in the rain. Get up on the roof!

… a bear market is not the base case for most of Wall Street. Adam Shell, 9/29/15

Duh. Cheerleaders lead cheers.

Good news: the sun is out. The Total Stock Market Index (VTSMX) soared 7.84% in October, offsetting a 7.29% decline in the third quarter. It’s now above water for the year, through Halloween, with a return of 1.8%. Optimists note that we’re now in the best six months of the year for stocks, and they anticipate healthy gains.

Bad news: none of the problems underlying the third quarter decline have changed.

We have no idea of whether the market will soar, stagger or crash over the next six months. Any of those outcomes are possible, none are predictable. Morningstar’s John Rekenthaler argues that the market isn’t priced for an imminent crash (“Are US stocks overripe?” 10/30/2015). BlackRock’s chief strategist agrees. The Leuthold Group says it’s “a bear until proven otherwise” but does allow for the prospect of a nice, tradable bounce (10/7/2015).

A lot of fairly serious adults are making the same argument: crash or not, the U.S. stock market is priced for futility.

GMO estimates (as of 10/14/2015) US real returns close to zero over the next 5-7 years. They estimate that high quality stocks might make 1% a year, small caps will be flat and large caps in general will lose nearly 1% a year. Those estimates assume simple reversions to long-term average profit margins and stock prices, both of which have been goofed by the Fed’s ongoing zero rate policy.

Jack Bogle (10/14/2015, warning: another auto-launch video) likewise thinks you’ll make about zero. His calculation is a rougher version of GMO’s. Investment gains are dividends plus earnings growth. An optimist would say 2% and 6%, respectively. Bogle thinks the 6% is too optimistic and pencils-in 5%. You then inflate or deflate the investment returns by changes in valuations. He notes that a P/E of 15 is about normal, so if you buy when the P/E is below 15 you get a boost. If you buy when the P/E is above 15, you get a penalty. By his calculations, the market P/E is about 20.

So you start with a 7% investment return (2% + 5%) and begin making deductions:

• P/E contraction would cost 3% then
• inflation might easily cost 2%, and of course
• fund fees and expenses cost 1%, after which
• stupid investor behavior eats 1.5%.

That leaves you with a “real” return of about zero (which at least cuts into your tax bill).

Henry Blodget was the poster child for the abuses of the financial markets in the 1990s. He went on to launch Business Insider, which became the web most popular business news site. It (well, 88% of it) was just sold to the German publisher Axel Springer for $340 million.

Blodget published an essay (10/4/2015) which concluded that we should anticipate “weak” or “crappy” returns for the next decade. The argument is simple and familiar to folks here: stocks are “fantastically expensive relative to most of recorded history.” Vigorous government intervention prevented the phenomenal collapse that would have returned market valuations to typical bear market lows, building the base for a decades-long bull. Zero interest rates and financial engineering conspired to keep stocks from becoming appropriately loathed (though it is clear that many institutional investors are, for better or worse, making structural changes in their endowment portfolios which brings their direct equity exposure down into the single digits).

Adding fuel to the fire, Rob Arnott’s group – Research Affiliates – has entered the debate. They are, mildly put, not optimistic about US stocks. Like Leuthold and unlike Blodget, they’re actually charged with finding way to invest billions ($174 billion, in RA’s case) profitably.

Key points from their latest essay:

1. “High stock prices, just like high house prices, are harbingers of low returns.
2. Investing in price-depressed residential rental property in Atlanta is like investing in EM equities today-the future expected long-term yield is much superior to their respective high-priced alternatives.
3. Many parallels exist between the political/economic environment and the relative valuation of U.S. and EM equities in the periods from 1994 to 2002 and 2008 to 2015.
4. Our forecast of the 10-year real return for U.S. equities is 1% compared to that of EM equities at 8%, now valued at less than half the U.S. C A P E.”

Bottom line: Leuthold – bear’s at the door. GMO – pretty much zero, real, with the prospect of real ugliness after the US election. Bogle – maybe 2% real. Blodget – “crap.” Research Affiliates – 1%.

For most of us, that’s the hole in the roof.  

Recommendation One: fix it now, while the sun’s out and you’re feeling good about life. Start by looking at your Q3 losses and asking, “so, if I lost twice that much in the next year and didn’t get it back until the middle of President Trump’s second term, how much would that affect my life plans?” If you lost 3%, imagine an additional 6% and shrug, then fine. If you lost 17%, deduct another 34% from your portfolio and feel ill, get up on the roof now!  In general, simplify both your life and your portfolio, cut expenses when you can, spend a bit less, save a bit more. As you look at your portfolio, ask yourself the simple questions: what was I thinking? Why do I need that there? Glance at the glidepaths for T. Rowe Price’s retirement date funds to see how really careful folks think you should be invested. If your allocation differs a lot from theirs, you need to know why. If you don’t know your allocation or don’t have one, now would be the time to learn.

Recommendation Two: reconsider the emerging markets. Emerging markets have been slammed by huge capital outflows as investors panic over the prospect that China is broken. Over a trillion dollars in capital has fled in fear. The “in fear” part is useful to you since it likely signals an overshoot. The International Monetary Fund believes that the fears of Chinese collapse are overblown. Josh Brown, writing as The Reformed Broker, raises the prospect of that emerging markets may well have bottomed. No one doubts that another market panic in the U.S. will drive the emerging markets down again.

That having been said, there’s also evidence that the emerging markets may hold the only assets offering decent returns over the remainder of the decade. GMO estimates that EM stocks (4.6% real/year) and bonds (2.8% real/year) will be the two highest-returning asset classes over the next five-to-seven years. Research Affiliates is more optimistic, suggesting that EM stocks are priced to return 7.9% a year with high volatility, about 1.1% in the US and 5.3% in the other developed markets. Leuthold finds their valuations very tempting. Bill Bernstein (auto-launch video, sorry), an endlessly remarkable soul, allows “They are cheap; they are not good and cheap …  It’s important for small investors to realize that you can’t buy low unless you are willing to deal with bad news.”

Look for ways of decoupling from the herd, since the EM herd is a particularly volatile bunch. That means staying away from funds that focus on the largest, most liquid EM stocks since those are often commodity producers and exporters whose fate is controlled by China’s. That may point toward smaller companies, smaller markets and a domestic orientation. It certainly points toward experienced managers. We commend Driehaus Emerging Markets Small Cap Growth (DRESX), Seafarer Overseas Growth & Income (SFGIX and Matthews Asia Strategic Income (MAINX) to you.

A second approach is to consider a multi-asset or balanced fund targeting the emerging markets. We know of just a handful of such funds:

• AB Emerging Markets Multi-Asset Portfolio (ABAEX), AllianceBernstein.
• Capital Emerging Markets Total Opportunities Fund (ETOPX) – a boutique manager affiliated with the American Funds. Capital Guardian Trust Company
• Dreyfus Total Emerging Markets (DTMAX)
• Fidelity Total Emerging Markets (FTEMX)
• Lazard Emerging Markets Multi-Asset (EMMIX)
• PIMCO Emerging Multi Asset (PEAWX) The fund was liquidated on 14 July 2015.
• TCW Emerging Markets Multi-Asset Opportunities (TGMEX)
• First Trust Aberdeen Emerging Opportunities (FEO), a closed-end fund.

Of the options available, Fidelity makes a surprisingly strong showing. We’ll look into it further for you.

Sequoia: “Has anybody seen our wheels? They seem to have fallen off.”

The most famous active fund seems in the midst of the worst screw-up in its history. The fund invested over 30% of its portfolio in a single stock, Valeant Pharmaceuticals (VRX). Valeant made money by buying other pharmaceutical firms, slashing their overhead and jacking up the prices of the drugs they produced. The day after buying to rights to heart medications Nitropress or Isuprel, Valeant increased their prices by six-fold and three-fold, respectively. Hedge funds, and Sequoia, loved it! Everyone else – including two contenders for the Democratic presidential nomination – despised it.

Against the charge that Valeant’s actions are unethical (they put people’s lives at risk in order to reap a windfall profit that they didn’t earn), Sequoia obliquely promises, “When ethical concerns arise, management tends to address them forthrightly, but in the moment.” I have no idea of what “but in the moment” means.

Then, in October, after months of bleeding value, Valeant’s stock did this:

That collapse, which cost Sequoia shareholders about 6% in a single day, was pursuant to a research report suggesting that Valeant was faking sales through a “phantom pharmacy” it owned. Separately, Federal prosecutors subpoenaed documents related to Valeant’s drug pricing.

Three things stand out:

There’s a serious question about whether Sequoia management drank the Kool-Aid. One intriguing signal that they weren’t maintaining an appropriate distance from Valeant is a tendency, noted by Lewis Braham in a post to our discussion board, for the Sequoia managers to call Valeant CEO Michael D. Pearson, “Mike.” From a call transcript he pointed to:

Mike does not like to issue equity.

… not that Mike would shy away from taking a price increase.

… early on in Mike’s reign …

I think Mike said the company was going to …

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.

On whole, he was “Mike” about three times more often than “Mike Pearson.” He was never “Mr. Pearson” or “the CEO.” There was no other CEO given comparable acknowledgement; in the case of their other investments, it was “Google” or “MasterCard.”

Sequoia’s research sounds a lot like Valeant’s press releases. The most serious accusation against Valeant, Sequoia insists in its opening paragraph, “is false.” That confidence rests on a single judgment: that changes in sales and changes in inventory parallel each other, so there can’t be anything amiss. Ummm … Google “manipulate inventory reporting.” The number of tricks that the accountants report is pretty substantial. The federal criminal investigation of Valeant doesn’t get mentioned. There is no evidence that Sequoia heightened its vigilance as Valeant slowly lost two-thirds of its value. Instead, they merely assert that it’s a screaming buy “at seven times the consensus estimate of 2016 cash earnings.”

Two of their independent directors resigned shortly thereafter. Rather than announcing that fact, Sequoia filed a new Statement of Additional information that simply lists three independent trustees rather than five. According to press reports, Sequoia is not interested in explaining the sudden and simultaneous departure. One director refused to discuss it with reporters; the other simply would not answer calls or letters.

Sequoia vigorously defends both Valeant’s management (“honest and extremely driven”) and its numbers. A New York Times analysis by Gretchen Morgenson is caustic about the firm’s insistence on highlighting “adjusted earnings” which distort the picture of the firm’s health. They are, Morgenson argues, “fantasy numbers.”

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.

The Price of Everything and the Value of Nothing

By Edward Studzinski

“The pure and simple truth is rarely pure and never simple.”

                             Oscar Wilde

There are a number of things that I was thinking about writing, but given what has transpired recently at Sequoia Fund as a result of its investment in and concentration in Valeant Pharmaceuticals, I should offer some comments and thoughts to complement David’s. Mine are from the perspective of an investor (I have owned shares in Sequoia for more than thirty years), and also as a former competitor.

Sequoia Fund was started back in 1970. It came into its own when Warren Buffett, upon winding up his first investment partnership, was asked by a number of his investors, what they should do with their money since he was leaving the business for the time being. Buffett advised them to invest with the Sequoia Fund. The other part of this story of course is that Buffett had asked his friend Bill Ruane to start the Sequoia Fund so that there would be a place he could refer his investors to and have confidence in how they would be treated.

Bill Ruane was a successful value investor in his own right. He believed in concentrated portfolios, generally fewer than twenty stock positions. He also believed that you should watch those stock investments very carefully, so that the amount of due diligence and research that went into making an investment decision and then monitoring it, was considerable. The usual course of business was for Ruane, Dick Cunniff and almost the entire team of analysts to descend upon a company for a full day or more of meetings with management. And these were not the kind of meetings you find being conducted today, as a result of regulation FD, with company managements giving canned presentations and canned answers. These, according to my friend Tom Russo who started his career at Ruane, were truly get down into the weeds efforts, in terms of unit costs of raw materials, costs of manufacturing, and other variables, that could tell them the quality of a business. In terms of something like a cigarette, they understood what all the components and production costs were, and knew what that individual cigarette or pack of cigarettes, meant to a Philip Morris. And they went into plants to understand the manufacturing process where appropriate.

Fast forward to the year 2000, and yes, there is a succession plan in place at Ruane, with Bob Goldfarb and Carly Cunniff (daughter of Dick, but again, a formidable talent in her own right who would have been a super investor talent if her name had been Smith) in place as President and Executive Vice President of the firm respectively. The two of them represented a nice intellectual and personality balance, complementing or mellowing each other where appropriate, and at an equal level regardless of title.

Unfortunately, fate intervened as Ms. Cunniff was diagnosed with cancer in 2001, and passed away far too early in life, in 2005. Fate also intervened again that year, and Bill Ruane also passed away in 2005.

At that point, it became Bob Goldfarb’s firm effectively, and certainly Bob Goldfarb’s fund. At the end of 2000, according to the 12/31/2000 annual report, Sequoia had 11 individual stock positions, with Berkshire representing 35.6% and Progressive Insurance representing 6.4%. At the end of 2004, according to the 12/31/2004 annual report, Sequoia had 21 individual stock positions, with Berkshire representing 35.3% and Progressive Insurance representing 12.6% (notice a theme here). By the end of 2008, according to the 12/31/2008, Berkshire represented 22.8% of the fund, Progressive was gone totally from the portfolio, and there were 26 individual stock positions in the fund. By the end of 2014, according to the 12/31/2014 report, Sequoia had 41 individual stock positions, with Berkshire representing 12.9% and healthcare representing 21.4%.

So, clearly at this point, it is a different fund than it used to be, in terms of concentration as well as the types of businesses that it would invest in. In 2000 for instance, there was no healthcare and in 2004 it was de minimis. Which begs the question, has the number of high quality businesses expanded in recent years? The answer is probably not. Has the number of outstanding managements increased in recent years, in terms of the intelligence and integrity of those management teams? Again, that would not seem to be the case. What we can say however, is that this is a Goldfarb portfolio, or more aptly, a Goldfarb/Poppe portfolio, distinct from that of the founders.

An interesting question is, given the fund’s present composition, would Buffett, if asked today for a recommendation as to where his investors should go down the road, still suggest Sequoia? My suspicion is he would not with how the fund is presently managed and, given his public comments advocating that his wife’s money after his demise should go to an S&P 500 index fund.

A fairer question is – why have I held on to my investment at Sequoia? Well, first of all, Bob Goldfarb is 70 and one would think by this point in time he has proved whatever it was that he felt he needed to prove (and perhaps a number of things he didn’t). But secondly, there is another great investor at Ruane, and that is Greg Alexander. Those who attend the Sequoia annual meetings see Greg, because he is regularly introduced, even though he is a separate profit center at Ruane and he and his team have nothing to do with Sequoia Fund. However, Bruce Greenwald of Columbia, in a Value Walk interview in June of 2010 said Buffett had indicated there were three people he would like to have manage his money after he died (this was before the index fund comment). One of them was Seth Klarman at Baupost. Li Lu who manages Charlie Munger’s money was a second, and Greg Alexander at Ruane was the third. Greg has been at Ruane since 1985 and his partnerships have been unique. In fact, Roger Lowenstein, a Sequoia director, is quoted as saying that he knows Greg and thinks Warren is right, but that was all he would say. So my hope is that the management of Ruane as well as the outside directors remaining at Sequoia, wake up and refocus the fund to return to its historic roots.

Why is the truth never pure and simple in and of itself. We have said that you need to watch the changes taking place at firms like Third Avenue and FPA. I must emphasize that one can never truly appreciate the dynamics inside an active management firm. Has a co-manager been named to serve as a Sancho Panza or alternatively to truly manage the portfolio while the lead manager is out of the picture for non-disclosed reasons? The index investor doesn’t have to worry about these things. He or she also doesn’t have to worry about whether an investment is being made or sold to prove a point. Is it being made because it is truly a top ten investment opportunity? But the real question you need to think about is, “Can an active manager be fired, and if so, by whom?” The index investor need not worry about such things, only whether he or she is investing in the right index. But the active investor – and that is why I will discuss this subject at length down the road.

Dancing amidst the elephants: Active large core funds that earn their keep

By Leigh Walzer

Last month in these pages we reviewed actively managed utility funds. Sadly, we could not recommend any of those funds. Either they charged too much and looked too much like the cheaper index funds or they strayed far afield and failed to distinguish themselves.

We are not here to bury the actively managed fund industry. Trapezoid’s goal is to help investors and allocators identify portfolio managers who have predictable skill and evaluate whether the fees are reasonable. Fees are reasonable if investors can expect with 60% confidence a better return with an active fund than a comparable passive fund. (Without getting too technical, the comparable fund is a time-weighted replication portfolio which tries to match the investment characteristics at a low cost.)

To demonstrate how this works, we review this month our largest fund category, large blend funds. (We sometimes categorize differently than Morningstar and Lipper. We categorize for investors’ convenience but our underlying ratings process does not rely on performance relative to a peer group.)

We found 324 unique actively-managed large blend funds where the lead manager was on the job at least 3 years.

We recently posted to the www.fundattribution.com website a skill rating for each of these funds. Our “grades” are forward-looking and represent the projected skill decile for each fund over the 12 months ending July 2016.  “A” means top 10%; “J” is bottom 10%. In our back-testing, the average skill for funds rated A in the following year exceeded the skill for B-rated funds, and so on with the funds rated J ranking last. Table I presents the grades for some of the largest funds in the category.  For example, the Fidelity Puritan Fund is projected to demonstrate more skill in the coming year than 80-90% of its peer group.

MFO readers who want to see the full list can register for demo access at no cost. (The demo includes a few fund categories and limited functionality.)  Demo users can also see backtesting results.

Table I

Skill Projections for Major US Large Blend Funds

A few caveats:

• Our grades represent projected skill, not performance. Gross return reflects skill together with the manager’s positioning. Fund expenses are considered separately.
• The difference in skill level between an E and F tends to be small while at the extremes the difference between A and B or I and J is larger.
• Generally, deciles A through E have positive skill while F thru J are negative. The median fund may have skill which is slightly positive. This occurs because of survivorship bias: poorly managed funds are closed or merged out of existence
• We do not have a financial interest in any of these funds or their advisors

Of course, costs matter. So we ran 1900 large blend fund classes through our Orthogonal Attribution Engine (OAE) to get the probability the investment would outperform its replication portfolio by enough to cover expenses. The good news (for investors and the fund industry) is there are some attractive actively managed funds. Our analysis suggest the fund classes in Table II will outperform passive funds, despite their higher fees.

Table II

Highly-rated Large blend Fund Classes (based on skill through July 2015)

_{[a]   Morningstar ratings as of 10/20/15. G means gold (e.g. 5G means 5stars and “Gold”), S is silver, B is bronze}

_{[b]   For those of you who like ActiveShare, OAI provides a measure of how active each fund is.  A closet indexer should have an OAI near zero. If we can replicate the fund, even with more complicated techniques, it will also score low. Funds which are highly differentiated can score up to 100.}

_{[c]    Red funds are closed to new investors. Green are limited to institutional investors and retirement plans. Blue are limited to retirement plans}

The bad news is that top-rated fund, Vanguard PrimeCap (VPCCX), is closed to new investors. So, too, is Vulcan Value Fund (VVPLX).  Fortunately, the PRIMECAP Odyssey Stock Fund (POSKX) is open and accessible to most investors.  Investors have 66% confidence this fund will generate excess return next year after considering costs. The Primecap funds have done well by overweighting pharma and tech over utilities and financials and have rotated effectively into and out of high-dividend stocks.

In many cases only the institutional or retirement classes are good deals for investors. For example, the Fidelity Advisor New Insights Fund classes I and Z offer 70% confidence; but a new investor who incurs the higher fees/load for classes A, B, C, and T would be less than 55% confident of success. Of course investors who already paid the load should stay the course.

While all these funds are worthy, we have space today to profile just a few funds.

Sterling Capital Special Opportunities Fund (BOPIX, BOPAX, etc.) is just under $1 billion. This fund was once known as BB&T Special Opportunities Equity Fund and was rated five-stars by Morningstar. The rating of the A class later fell to 3 stars and recently regained four-stars. 

Table III

Return Attribution: Sterling Capital Special Opportunities Fund

Special Opps’ gross return was 22% before expenses over the past 3 years. (Table III) Even after fees, returns trounced the S&P500 by over 300bps for the past 3 years and over the past 10 years. The one and 5 year comparisons are less favorable but still positive. Combined skill has been consistently positive over the twelve year history of the fund.

However, that doesn’t tell the whole story. Comparing this to the S&P500 (or the Russell 1000) is neither accurate nor fair. The replicating portfolio – i.e., the one the OAE chooses as the best comparison – is approximately 90% equities (mostly the S&P500 with a smattering of small cap and hedged international which has decreased over time) plus 25% fixed income. The fixed income component surprised us at first, because the portfolio includes no bonds and does not utilize leverage. But the manager likes to write covered calls to generate extra income. We observe he sells about 5% of the portfolio on average about 10 to 20% out of the money. In this way he probably generates premium income of 25bp/yr., which the fixed income component captures well.  As always, the model evaluates the manager based on what he actually does, rather than against his stated benchmark (Russell 1000) or peer group.

Option writing helps explain why his beta is lower (We estimate .89, you will find other figures as low as .84.)  In the eyes of the Orthogonal Attribution Engine, that makes his performance more remarkable. We are not quite so impressed to pay an upfront 5.75% load for BOPAX (Class A), but BOPIX rates well. BOPAX is available no-load and NTF through Schwab and several smaller brokerages.

We had an opportunity to speak to the manager, George Shipp. Table III shows his skill derives much more from stock selection than sector rotation, a view he shared.  We can make a few observations.   He has a team of experienced generalists and a lot of continuity. His operation in Virginia Beach is separate from the other Sterling/BB&T operations in North Carolina.  He also manages Sterling Capital Equity Income (BAEIX), a much larger fund with zero historical overlap. The team follows a stable of companies, mainly industry leaders. They like to buy when the stock is dislocated and they see a catalyst.  The investment process is deliberative. That sounds like a contrarian, value philosophy, but in fact they have an even balance of growth and value investments. We reviewed his portfolio from 5 years ago, several of the top holdings trounced the market. (The exceptions were energy stocks.) Shipp noted he had good timing buying Apple when it was pummeled. He doesn’t specifically target M&A situations, but his philosophy puts the fund in a position to capture positive event risk. It is not unusual for the fund to own the same company more than once.

We also had a chance to speak to the folks at Davis Opportunity Fund (RPEAX). What jumps out about this $530mm fund is their ability to grind out excess return of 1 to 1.25% /yr. for nearly twenty years.  It is no great feat that DGOYX net returns just match the S&P500 for the past 5 years but they managed to do this despite two tailwinds: a 20% foreign allocation (partly hedged) and moderate cash balances. There is an old saw: “You can’t eat relative performance.” But when a fund shows positive relative performance for two decades with some consistency the Orthogonal model concludes the manager is skillful and some of that skill might carry over to the future.   We are willing to pay an incremental 60bp for their institutional class compared with an index fund but we cannot recommend the other share classes. A new co-manager was named in 2013, we see no drop-off in performance since then. (As with Sterling, the team manages a $15bn fund called Davis NY Venture (NYVTX) which does not rate nearly as well; there is some performance correlation between the two funds.)

Their process is geared toward global industry leaders and is somewhat thematic.  OAI of 24 indicates they run a very concentrated portfolio which cannot be easily replicated using passives. (We will talk more about OAI in the future.) Looking back at their portfolio from 5 years ago, their industry weightings were favorable and they did very well with CVS and Google but took hits from Sino Forest (ouch!) and Blount.

In general, the expected skill for a purely passive large blend fund will be close to zero and the probability will be around 50%. (There are exceptions including funds which don’t track well against our indices.)  However, there are a number of quantitatively driven and rules-based funds competing in the large blend space which show skill and some make our list

Table IV

Highly-Rated Large Blend Quantitative Funds

We are a little cautious in applying the model to quantitative funds. We know from backtesting that smart managers tend to stay smart, but there is a body of view that good quantitative strategies invite competition and have to be reinvented every few years. Nevertheless, here are the top-rated quant funds. All funds in Table IV carry five-star ratings from Morningstar except ACGOX is rated four-stars)

We had a chance to speak to the team managing American Century Legacy Large Cap (ACGOX), led by John Small and Stephen Pool in Kansas City.  Their approach is to devise models which predict what stock characteristics will work in a given market environment and load up on those stocks. There is some latitude for the managers to override the algorithms. Note this fund is rather small at $23 mm. The fund was evaluated based on data since management started in 2007.  However, the model was overhauled from 2010-2012 and has been tweaked periodically since then as market conditions change. The same team manages three other funds (Legacy Multicap, Legacy Focused, and Veedot); since 2012 they have used the same process, except they apply it to different market sectors.

Bottom Line:

If you are ready to throw in the towel on active funds, you are only 94% right.  There are a few managers who offer investors a decent value proposition. Mostly these managers have sustained good records over long periods with moderate expense levels.   Our thinking on quant funds will evolve over time. Based on our look at American Century Legacy, we suggest investors evaluate these managers based on the ability to react and adapt their quant models rather and not focus too much on the current version of the black box.   Remember to check out our fearless predictions for the entire large blend category at www.fundattribution.com (registration required)

If you have any questions, drop me a line at [email protected]

Five great overlooked little funds

Barron’s recently featured an article by journalist Lewis Braham, entitled “Five great overlooked little funds” (10/17/2015). Lewis, a frequent contributor of the Observer’s discussion board, started by screening for small (>$100 milllion), excellent (top 20% performance over five years) funds, of which he found 173. He then started doing what good journalists do: he dug around to understand when and why size matters, then started talking with analysts and managers. His final list of worthies is:

• SSgA Dynamic Small Cap(SSSDX) which has been added to Morningstar’s watchlist. A change of management in 2010 turned a perennial mutt into a greyhound. It’s beaten 99% of its peers and charged below average expenses.
• Hood River Small-Cap Growth(HRSRX) has $97 million but “its 14.1% annualized five-year return beats its peers by 2.3 percentage points a year.” The boutique fund remains small because, the manager avers, “We’re stockpickers, not marketers.”
• ClearBridge International Small Cap(LCOAX), sibling to a huge domestic growth fund, has a five-year annualized return of 8.5%, which beats 95% of its peers. It has $131 million in assets, 1% of what ClearBridge Aggressive Growth (SHRAX) holds.
• LKCM Balanced (LKBAX) holds an inexpensive, low-turnover portfolio of blue-chip stocks and high-grade bonds. It’s managed to beat 99% of its peers over the past decade while still attracting just $37 million.
• Sarofim Equity (SRFMX) is a virtual clone of Dreyfus Appreciation (DGAGX). Both buy ultra-large companies and hold them forever; in some periods, the turnover is 2%. It has a great long-term record and a sucky short-term one.

Lewis is also the author of The House that Bogle Built: How John Bogle and Vanguard Reinvented the Mutual Fund Industry(2011), which has earned a slew of positive, detailed reviews on Amazon. He is a graceful writer and lives in Pittsburgh; I’m jealous of both. Then, too, when I Googled his name in search of a small photo for the story I came up with

To which I can only say, “wow.”

Here Mr. Herro, have a smoke and a smile!

After all, science has never been able to prove that smoking is bad for you. Maureen O’Hara, for example, enjoyed the pure pleasure of a Camel:

And she passed away just a week ago (24 October 2015), cancer-free, at age 95. And the industry’s own scientists confirm that there are “no adverse effects.”

And, really, who’d be in a better position to know? Nonetheless, the Association of National Advertisers warns, this “legal product in this country for over two centuries, manufactured by private enterprise in our free market system” has faced “a fifty-year conspiracy” to challenge the very place of cigarettes in the free enterprise system. The debate has “lost all sense of rationality.”

It’s curious that the industry’s defense so closely mirrors the federal court’s finding against them. Judge Marion Kessler, in a 1700 page finding, concluded that “the tobacco industry has engaged in a conspiracy for decades to defraud or deceive the public … over the course of more than 50 years, defendants lied, misrepresented and deceived the American public … suppress[ed] research, destroyed documents, destroyed the truth and abused the legal system.”

David Herro is the famously successful manager of Oakmark International (OAKIX), as well as 13 other funds for US or European investors. Two of Mr. Herro’s recent statements give me pause.

On climate change: “pop science” and “environmental extremism”

In an interview with the Financial Times, Mr. Herro denounced the 81 corporate leaders, whose firms have a combined $5 trillion market cap, who’d signed on to the White House Climate Pledge (“Fund manager David Herro criticizes corporate ‘climate appeasers,’” 10/21/15). The pledge itself has an entirely uncontroversial premise:

…delaying action on climate change will be costly in economic and human terms, while accelerating the transition to a low-carbon economy will produce multiple benefits with regard to sustainable economic growth, public health, resilience to natural disasters, and the health of the global environment.

As part of the pledge, firms set individual goals for themselves. Coke wants to reduce its carbon footprint by 25%. Facebook promises to power its servers with power from renewables. Bloomberg would like to reduce its energy use by half while achieving an internal rate of return of 20% or more on its energy investments.

To which Mr. Herro roars: “climate appeasers!” They had decided, he charged, to “cave in to pop science and emotion.” Shareholders “should seriously question executives who appease such environmental extremism and zealotry.”

Like others on his island, he engages in a fair amount of arm-flapping. Climate change, he claims, “is not proven by the data.” The Grist.org project, “How to Talk to Climate Deniers” explains the problem of “proof” quite clearly:

There is no “proof” in science — that is a property of mathematics. In science, what matters is the balance of evidence, and theories that can explain that evidence. Where possible, scientists make predictions and design experiments to confirm, modify, or contradict their theories, and must modify these theories as new information comes in.

In the case of anthropogenic global warming, there is a theory (first conceived over 100 years ago) based on well-established laws of physics. It is consistent with mountains of observation and data, both contemporary and historical. It is supported by sophisticated, refined global climate models that can successfully reproduce the climate’s behavior over the last century.

Given the lack of any extra planet Earths and a few really large time machines, it is simply impossible to do any better than this.

But Mr. Herro has a reply at hand: “Their answer is … per cent of scientists and Big Oil. My answer is data, data, data.”

What does that even mean, other than the fact that the undergrad science requirement for business majors at Mr. Herro’s alma mater (lovely UW-Platteville) ought to be strengthened? Is he saying that he’s competent to assess climatological data? That he can’t find any data? (If so, check NASA’s “evidence” page here, sir.) That the data’s not perfect? Duh. That you’ve found the data, data, data straight from the source: talk radio and self-published newsletters? Or that there’s some additional bit not provided by the roughly 14,000 peer-reviewed studies that have corroborated the science behind global warming?

Can you imagine what would happen if you used to same criteria for assessing evidence about investments?

None of which I’d mention except for the fact that Herro decided to expand on the subject in his Financial Times interview which moves the quality of his analysis from the realm of the personal to the professional.

In my endless poking around, I came upon a clear, thoughtful, entertaining explanation of global warming that even those who aren’t big into science or the news could read, enjoy and learn from. The site is Wait But Why and it attempts to actually explain things (including sad millennials and procrastination) using, well, facts and humor.

Climate Change is a Thing

Let’s ignore all the politicians and professors and CEOs and filmmakers and look at three facts.

1. Burning Fossil Fuels Makes Atmospheric CO2 Levels Rise
2. Where Atmospheric CO2 Levels Go, Temperatures Follow
3. The Temperature Doesn’t Need to Change Very Much to Make Everything Shitty

In between our essays, you should go peek at the site. If you can understand the designs on the stuff in their gift shop, you really should drop me a note and explain it.

On emerging markets: “never again”

In an interview with the Associated Press (“answers have been edited for clarity”), Mr. Herro makes a statement that’s particularly troubling for the future of the Oakmark funds. The article, “Fund manager touts emerging-market stocks” (10/25/15), explains that much of the success of Oakmark International (OAKIX) was driven by Mr. Herro’s prescient and substantial investment in emerging markets:

If we back up to 1998 or 1999, during the Asian financial crisis, we had 25 or 26% of the portfolio in emerging markets. We built up a huge position and we benefited greatly from that the whole next decade. It was the gift that kept giving.

The position was eventually reduced as he harvested gains and valuations in the emerging markets were less attractive. The logical question is, would the fund be bold enough to repeat the decision that “benefited [them] greatly” for an entire decade. Would he ever go back to 25%.

No, no, no. It could come up to 10 or 15% … but we’ll try to cap it there because, nowadays, people use managers (who are dedicated to emerging markets). And we don’t bill ourselves as an emerging-market manager.

This is to say, his decisions are now being driven by the demands of asset gathering and retention, not by the investment rationale. He’ll cap his exposure at perhaps half its previous peak because “people” (read: large investment advisers) want their investments handled by specialists. Having OAKIX greatly overweighted in EMs, even if they were the best values available, would make the fund harder to sell. And so they won’t do it.

Letting marketability drive the portfolio is a common decision, but hardly an admirable one.

A picture for the Ultimus Client Conference folks

At the beginning of September, I had the opportunity to irritate a lot of nice people who’d gathered for the annual client conference hosted by Ultimus Fund Services. My argument about the fund industry was two-fold:

1. You’re in deep, deep trouble but
2. There are strategies that have the prospect of reversing your fortunes.

Sometimes the stuff we publish takes three or four months to come together. Our premium site has a feature called “Works in Progress.” It’s the place that we’ll share stuff that’s not ready for publication here. Between now and year’s end, we’ll be posting pieces of the “how to save yourself” essay bit-by-bit.

But that’s not what most folks at the conference wanted to talk about. No, for 12 hours after my talk, the corporate managers at various fund companies and advisers brought up the same topic: I have no idea of how to work with the Millennials in my office. They have no sense of time, urgency, deadlines or focus. What’s going on with these people? All of that was occasioned by a single, off-hand comment I’d made about the peculiar decisions made by a student of mine.

We talked through the evidence on evolving cultural norms and workplace explanations, and I promised to try to help folks find some useful guidance. I found a great explanation of why yuppies are unhappy in an essay at WaitButWhy, the folks above. After explaining why young folks are delusional, they illustrated the average Millennial’s view of their career trajectory:

If you’ve been banging your head on the desk for a while now, you should read it. You’ll feel better. Pwc, formerly Price, Waterhouse, Cooper, published an intricate analysis (Millennials at work 2015) of Millennial expectations and strategies for helping them be the best they can be. They also published a short version of their recommendations as How to manage the millennials (2015). Scholars at Harvard and the Wharton School of Business are rather more skeptical, taking the counter-intuitive position that there are few real generational differences. Their sources seem intrigued by the notion of work teams that combine people of different generations, who contrasting styles might complement and strengthen one another.

It’s worth considering.

Jack and John, Grumpy Old Men II

Occasionally you encounter essays that make you think, “Jeez, and I thought I was old and grouchy.” I read two in quick, discouraging succession.

Jack Bogle grouched, “I don’t do international.” As far as I can tell, Mr. Bogle’s argument is “the world’s a scary place, so I’m not going there.” At 86 and rich, that’s an easy and sensible personal choice. For someone at 26 or 36 or 46, it seems incredibly short-sighted. While he’s certainly right that “Outside of the U.S., you can be very disappointed,” that’s also true inside the United States. In an oddly ahistoric claim, Bogle extols our 250 year tradition of protecting shareholders rights; that’s something that folks familiar with the world before the Securities Act of 1934 would find freakishly ill-informed.

A generation Mr. Bogle’s junior, the estimable John Rekenthaler surveyed the debate concerning socially responsible investing (alternately, “sustainable” or “ESG”) and grumped, “The debate about the merits of the genre is pointless.” Why? Because, he concludes, there’s no clear evidence that ESG funds perform differently than any other fund. Exactly! We reviewed a lot of research in “It’s finally easy being green” (July 2015). The overwhelming weight of evidence shows that there is no downside to ESG investing. You lose nothing by way of performance. As a result, you can express your personal values without compromising your personal rate of return. If you’re disgusted at the thought that your retirement is dependent on addicting third world children to cigarettes or on clearing tropical forests, you can simply say “no.” We profiled clear, palatable investment choices, the number of which is rising.

The freak show behind the curtain: 25,000 funds that you didn’t even know existed

Whatever their flaws (see above), mutual funds are relatively stable vehicles that produce reasonable returns. Large cap funds, on average and after expenses, have returned 7.1% over the past 15 years which puts them 70 bps behind the S&P 500 for the same period.

But those other 25,000 funds …

Which others? ETFs? Nope. There are just about 1,800 of them – with a new, much-needed Social Media Sentiment Index ETF on the way (whew!) – controlling only $3 trillion. You already know about the 7,700 ’40 Act funds and the few hundred remaining CEFs are hardly a blip (with apologies to RiverNorth, to whom they’re a central opportunity).

No, I mean the other 24,725 private funds, the existence of which is revealed in unintelligible detail in a recent SEC staff report entitled Private Fund Statistics, 4th Quarter 2014 (October 2015). That roster includes:

• 8,625 hedge funds, up by 1100 since the start of 2013
• 8,407 private equity funds, up by 1400 in that same period
• 4,058 “other” private funds
• 2,386 Section 4 private equity funds
• 1,789 real estate funds
• 1,541 qualifying hedge funds
• 1,327 securitized asset funds
• 504 venture capital funds
• 69 liquidity funds
• 49 Section 3 liquidity funds, these latter two being the only categories in decline

The number of private funds was up by 4,200 between Q1/2013 and Q4/2014 with about 200 new advisers entering the market. They have $10 trillion in gross assets and $6.7 trillion in net assets. (Nope, I don’t know what gross assets are.) SEC-registered funds own about 1% of the shares of those private funds.

Sadly, the report explains nothing. You get tables of technical detail with nary a definition nor an explanation in sight. “Asset Weighted-Average Qualifying Hedge Fund Investor and Portfolio Liquidity” assures that that fund liquidity at seven days is about 58% while investor liquidity in that same period is about 15%. Not a word anywhere about what that means. An appendix defines about 10 terms, no one of which is related to their data reports.

A recent report in The Wall Street Journal does share one crucial bit of information: equity hedge funds don’t actually make money for their investors. The HRFX Equity Hedge Fund Index is, they report, underwater over the past decade. That is, “if you have invested … in this type of fund 10 years ago, you would have less than you started with.” An investment in the S&P 500 would have doubled (“Funds wrong-footed as Glencore, others gain,” 10/31/2015).

About a third of hedge funds fold within three years of launch; the average lifespan is just five years. Unlike the case of mutual funds, size seems no guardian against liquidation. Fortress Investment Group is closing its flagship macro fund by year’s end as major domo Michael Novogratz leaves. Renaissance Capital is closing their $1.3 billion futures fund. Bain Capital is liquidating their Absolute Return Capital fund. Many funds, including staunch investors in Valeant such as William Ackman of Pershing Square, are having their worst year since the financial crisis. As a group, they’re underwater for 2015.

---

Hedge Fund, n. Expensive and exclusive funds numbering in the thousands, of which only about a hundred might be run by managers talented enough to beat the market with consistency and low risk. “The rest,” says the financial journalist Morgan Housel, “charge ten times the fees of mutual funds for half the performance of index funds, pay half the income-tax rates of taxi drivers, and have triple the ego of rock stars. Jason Zweig, The Devil’s Financial Dictionary (2015)

---

 

Matching your funds and your time horizon

The Observer has profiled, and praised, the two RiverPark funds managed by David Sherman of Cohanzick. The more conservative, RiverPark Short Term High Yield (RPHYX/RPHIX, closed), usually makes 300-400 bps over a money market fund with scarcely more volatility. Year-to-date, through Halloween, the fund has returned a bit over 1% in a difficult market. The slightly more aggressive, RiverPark Strategic Income (RSIVX/RSIIX) might be expected to about double its sibling’s return with modest volatility, a feat that it has managed regularly. Strategic has had a performance hiccup lately; leading some of the folks on our discussion board to let us know that they’d headed for the exits.

For me, the questions are (1) is there a systemic problem with the fund? And (2) what’s the appropriate time-frame for assessing the fund’s performance? I don’t see evidence of the former, though we’re scheduled to meet Mr. Sherman in November and will talk more.

On the latter, the Observer’s fund-screener tracks “recovery times” for every fund over 20 time periods. Carl Bacon, in the book, Practical Risk Advanced Performance Measurements (2012), defines recovery time, or drawdown duration, as the time taken to recover from an individual or maximum drawdown to the original level. Recovery time helps investors approximate reasonable holding periods and also assessment periods. If funds of a particular type have recovery times of, say, 18-24 months, then (1) it would be foolish to use them for assets you might need in less than 18-24 months and (2) it would be foolish to panic if it takes them 18-24 months to recover.

Below, for comparison, are the maximum recovery times for the flexible bond funds that Morningstar considers to be the best.

Gold- and Silver-rated Flexible bond funds

The Observer has decided to license data for our fund screener from Lipper rather than Morningstar; dealing with the sales rep from Morningstar kept making my systolic soar. Within about a week the transition will be complete. The difference you’ll notice is a new set of fund categories and new peer groups for many funds. Here are the recovery times for the top “flexible income” and “multi-sector” income funds, measured by Sharpe ratio over the current full market cycle (11/2007 – present). This screens out any fund that hasn’t been around for at least eight years.

Bottom line: Before you succumb to the entirely understandable urge to do something in the face of an unexpected development, it’s essential to ask “am I being hasty?” Measures such as Recovery Time help, both in selecting an investment appropriate to your time horizon and in having reasonable criteria against which to assess the fund’s behavior.

Last fall we were delighted to welcome Mark Wilson, Chief Investment Officer for The Tarbox Group which is headquartered in Newport Beach, California. As founder and chief valet for the website CapGainsValet, Mark provided a remarkable service: free access to both thoughtful commentaries on what proved to be a horror of a tax season and timely data on hundreds of distributions. We’re more delighted that he agreed to join us again for the next few months.

Alive and kicking: The return of Cap Gains Valet

By Mark Wilson, APA, CFP®, Chief Valet

CapGainsValet.com is up and running again (and still free). CGV is designed to be the place for you to easily find mutual fund capital gains distribution information. If this concept is new to you, have a look at the Articles section of the CGV website where you’ll find educational pieces ranging from beginner concepts to more advanced tax saving strategies.

It’s quite early in the reporting season, but here are some of my initial impressions:

• Many firms have already posted 2015 estimates. The site already has over 75 firms’ estimates posted so there is already some good information available. This season I’m expecting to post estimates for over 190 fund firms. I’ll continue to cycle through missing firms and update the fund database as new information becomes available. Keep checking in.
• This year might feel more painful than last year. Based on estimates I’ve found to-date, I’m expecting total distributions to be lower than last year’s numbers. However, if fund performance ends the year near today’s (flat to down) numbers, investors can get a substantial tax bill without accompanying investment gains.
• It’s already an unusual year. My annual “In the Doghouse” list compiles funds with estimated (or actual) distributions over 20% of NAV. The list will continue to grow as fund firms post information. Already on the list is a fund that distributed over 80%, an index fund and a “tax-managed” fund – oddball stuff!
• Selling/swapping a distributing fund could save some tax dollars. If you bought almost any fund this year in a taxable account, you should consider selling those shares if the fund is going to have a substantial distribution. (No, fund companies do not want to hear this.) Tax wise, running some quick calculations can help you decide a good strategy. Be careful not to run afoul of the “wash sale” rules.

Of course, the MFO Discussion board (led by TheShadow) puts together its own list of capital gains distribution links. Be sure to check their work out as that list may have some firms that are not included on CGV due to their smaller asset base. Between the two resources, you should be well covered.

I value the input of the MFO community, so if you have any comments to share about CapGainsValet.com, feel free to contact me.

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized, searchable, and filtered as never before. For the complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

Orders & Decisions

• A U.S. Magistrate Judge recommended that the court deny First Eagle‘s motion to dismiss fee litigation regarding two of its international equity funds. (Lynn M. Kennis Trust v. First Eagle Inv. Mgmt., LLC)
• In Jones v. Harris Associates—the fee litigation regarding Oakmark funds in which the U.S. Supreme Court set the legal standard for liability under section 36(b)—the Seventh Circuit denied the plaintiffs’ petition for rehearing en banc in their unsuccessful appeal of the district court’s summary judgment in favor of Harris Associates.
• J.P. Morgan Investment Management was among six firms named in SEC enforcement actions for short selling violations in advance of stock offerings. J.P. Morgan agreed to pay $1.08 million to settle the charges.
• Further extending the fund industry’s dismal losing record on motions to dismiss section 36(b) fee litigation, the court denied New York Life‘s motion to dismiss a lawsuit regarding four of its MainStay funds. The court viewed allegations that New York Life delegated “substantially all” of its responsibilities as weighing in favor of the plaintiff’s claim. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)
• After the Tenth Circuit reversed a class certification order in a prospectus disclosure case regarding Oppenheimer‘s California Municipal Bond Fund, the district court reaffirmed the order such that the litigation is once again proceeding as a certified class action. Defendants include independent directors. (In re Cal. Mun. Fund.)
• Denying Schwab defendants’ petition for certiorari, the U.S. Supreme Court declined to review the controversial Ninth Circuit decision that allowed multiple state common-law claims to proceed with respect to Schwab’s Total Bond Market Fund. Defendants include independent directors. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)
• In the same lawsuit, the district court partly denied Schwab‘s motion to dismiss, holding (among other things) that defendants had abandoned their SLUSA preclusion arguments with respect to Northstar’s breach of fiduciary duty claims. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)
• Two UBS advisory firms agreed to pay $17.5 million to settle SEC charges arising from their purported roles in failing to disclose a change in investment strategy by a closed-end fund they advised.
• By order of the court, the securities fraud class action regarding four Virtus funds transferred from C.D. Cal. to S.D.N.Y. (Youngers v. Virtus Inv. Partners, Inc.)

New Lawsuits

• Allianz Global Investors and PIMCO are targets of a new ERISA class action that challenges the selection of proprietary mutual funds for the Allianz 401(k) plan. Complaint: “the Fiduciary Defendants treat the Plan as an opportunity to promote the Allianz Family’s mutual fund business and maximize profits at the expense of the Plan and its participants.” (Urakhchin v. Allianz Asset Mgmt. of Am., L.P.)
• J.P. Morgan is the target of a new section 36(b) excessive fee lawsuit regarding five of its funds. The plaintiffs rely on comparisons to purportedly lower fees that J.P. Morgan charges to other clients. (Campbell Family Trust v. J.P. Morgan Inv. Mgmt., Inc.)
• Metropolitan West‘s Total Return Bond Fund is the subject of a new section 36(b) excessive fee lawsuit. The plaintiff relies on comparisons to purportedly lower fees that Metroplitan West charges to other clients. (Kennis v. Metro. W. Asset Mgmt., LLC.)

The Alt Perspective: Commentary and news from DailyAlts.

October proved to be less than spooky for the equity market as the S&P 500 Index rose 8.44% over the month, leading major asset classes and alternative investment categories. While bonds and commodities were relatively flat, long/short equity funds topped the list of alternative funds and returned an average of 2.88%, while bear market funds shed 11.30% over the month as stocks rallied. Managed futures funds gave back gains they had made earlier in the year with a loss of 1.82% on average, according to Morningstar, while multi-alternative funds posted gains of 1.33%.  All in all, a mixed bag for nearly everything but long-only equity.

Asset Flows

September turned out to be a month when investors decided that it was time to pull money from actively managed mutual funds and ETFs, regardless of asset class, style or strategy – except for alternatives. Every actively managed category, as reported by Morningstar saw outflows other than alternatives, which had net inflows of $719 million to actively managed funds and another $884 million to passively managed alternative mutual funds and ETFs.

As you will recall, volatility started to spike in August when the Chinese devaluated the Yuan, and the turmoil carried into September. But not all alternative categories saw positive inflows in September – in fact few did. Were it not for trading strategy funds, such as inverse funds, the overall alternatives category would be negative:

• Trading strategies, such as inverse equity funds, added $1.5 billion
• Multi-alternative funds picked up $998 million
• Managed futures funds added $744 million
• Non-traditional bond funds shed $1.3 billion
• Volatility based funds lost $551 million

New Fund Filings

AlphaCentric and Catalyst both teamed up with third parties to invest in managed futures or related strategies. AlphaCentric partnered with Integrated Managed Futures Corp for a more traditional, single manager managed futures fund while Catalyst is looking to Millburn Ridgefield Corporation to run a managed futures overlay on an equity portfolio – very institutional like!

Another interesting filing was that from a new company called Castlemaine who plans to launch five new alternative mutual funds – all managed by one individual. That’s just hard to do! Hard to criticize that this point, but we will keep an eye on the firm as they come out with new products later this year.

Research

Finally, there were a couple pieces of interesting research that we uncovered this past month, as follows:

• The Pros and Cons of Single- and Multi-Manager Alternative Funds – this is a thoughtful piece from Steben & Co. that outlines the pros and cons of investing in single and multi-manager funds. Some important points are made in the paper for anyone looking to allocate to an actively managed fund.
• Enhancing Performance With Dynamic Timing of Factor Exposures – this paper from State Street Global Advisors presents an outline for potentially enhancing returns of a static “factor” allocation portfolio. For anyone using smart beta products, this is a solid paper to read.

Have a wonderful November, and Happy Thanksgiving to all.

Observer Fund Profiles: RNCOX

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.

RiverNorth Core Opportunity (RNCOX). RiverNorth turns the typical balanced strategy (boring investments, low costs) on its head. At the price of higher pass-through costs, the fund attempts to exploit the occasionally-irrational pricing of the closed-end fund market to add a market-neutral layer of returns to a flexible underlying allocation. That’s work well far more often than it hasn’t.

Launch Alert: T. Rowe Price Emerging Markets Value (PRIJX)

Price launched its Emerging Markets Value fund at the end of September. The manager is Ernest C. Yeung. He started at Price in 2003 as an analyst covering E.M. telecommunication stocks. In 2009 he became a co-manager of the International Small Cap Equity strategy (manifested in the U.S. as Price International Discovery PRIDX), where he was the lead guy on Asian stock selection. Nick Beecroft in Price’s Hong Kong office reports that at the end of 2014, “he began to manage a paper portfolio for the new T. Rowe Price Emerging Markets Value Stock Fund, which he then ran until the fund was launched publicly in September 2015. So Ernest [has] been part of our emerging markets team at T. Rowe for over 12 years.”

The fund will target 50-80 stocks and stock selection will drive both country and sector exposure. Characteristics he’ll look for:

• low valuation on various earnings, book value, sales, and cash flow metrics, in absolute terms and/or relative to the company’s peers or its own historical norm;
• low valuation relative to a company’s fundamentals;
• companies that may benefit from restructuring activity or other turnaround opportunities;
• a sound balance sheet and other positive financial characteristics;
• strong or improving position in an overlooked industry or country; and
• above-average dividend yield and/or the potential to grow dividends.

As Andrew Foster and others have pointed out, value investing has worked poorly in emerging markets. Their argument is that many EM markets, especially Asian ones, have powerful structural impediments to unlocking value. Those include interlocking directorships, control residing in founding families rather than in the corporate management, cross-ownership and a general legal disregard for the rights of minority shareholders. I asked the folks at Price what they thought had changed. Mr. Beecroft replied:

We agree that traditional, fundamental value investing can be challenging in emerging markets. Companies can destroy value for years for all the reasons that you mention. Value traps are prevalent as a result. Our approach deliberately differs from the more traditional fundamental value approach. We take a contrarian approach and actively seek stocks that are out of favour with investors or which have been “forgotten” by the market. We also look for them to have a valuation anchor in the form of a secure dividend yield or book value support. These stocks typically offer attractive valuations and with limited downside risk.

But in emerging markets, just being cheap is not enough. So, we look for a re-rating catalyst. This is where our research team comes in. Re-rating catalysts might be external to the company (e.g., industry structure change, or an improving macro environment) or internal (ROE/ROIC improvement, change in management, improved capital allocation policy, restructuring, etc.). Such change can drive a significant re-rating on the stock.

The emerging markets universe is wide and deep. We are able to find attractive upside potential in stocks that other investors are not always focused on.

The fund currently reports about a quarter million in its portfolio. The initial expense ratio, after waivers, is 1.5%. The minimum initial investment is just $1,000.

Funds in Registration

There are fifteen or so new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. The funds in registration now have a good chance of launching on December 31, which is critical to allowing them to report full-year results for 2016.

There are some interesting possibilities. Joe Huber is launching a mid-cap fund. ASTON will have an Asia dividend one. And Homestead is launching their International II fund, sub-advised by Harding Loevner.

Manager Changes

Chip tracked down 63 manager changes this month, a fairly typical tally. This month continues the trend of many more women being removed from management teams (9) than added to them (1). There were a few notable changes. The outstanding Boston Partners Long/Short Equity Fund (BPLEX) lost one of its two co-managers. Zac Wydra left Beck Mack & Oliver Partners Fund (BMPEX) to become CIO of First Manhattan Corporation. In an unusual flurry, Kevin Boone left Marsico Capital, then Marsico Capital got booted from the Marsico Growth FDP Fund (MDDDX) that Kevin co-managed, then the fund promptly became the FDP BlackRock Janus Growth Fund.

The Navigator: Fund research fast

One of the coolest resources we offer is also one of the least-used: The Navigator. It’s located on the Resources tab at the top-right of each page. If you enter a fund’s name or ticker symbol in The Navigator, it will instantly search 27 sites for information on the fund:

If you click on any of those links, it takes you directly to the site’s profile of the fund. (Did you even know The Google had fund pages? They do.)

Updates: INNAX, liquidity debate

In October we featured Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX) in our Elevator Talk. Energy-light portfolio, distinctive profile given their focus on “soft” resources like trees and cattle. Substantially above-average performance. They’d just passed their three year anniversary and seven days later they received their inaugural star rating from Morningstar. They’re now recognized as a four star fund within the natural resources group.

We’ve argued frequently that liquidity in the U.S. securities market, famously the most liquid in the world, might be drying up. The translation is: you might not be able to get a fair price for your security if you need to sell at the same time lots of other people are. The SEC is propounding rules to force funds to account for the liquidity of their holdings and to maintain a core of highly-liquid securities that would be sufficient to cover several days’ worth of panicked redemptions. The Wall Street Journal provided a nice snapshot of the potential extent of such problems even in large, conservative fixed-income funds. Using the ability to sell a security within seven days, the article “Bond funds push limits” (9/22/2015) estimates the extent of illiquid assets in five funds:

Between them, those funds hold $130 billion. The Investment Company Institute, the industry’s mouthpiece, immediately denounced the story.

It’s not quite The Satanic Verses, but ….

In October, Jason Zweig published his The Devil’s Financial Dictionary. The title, of course, draws from Ambrose Bierce’s classic The Devil’s Dictionary (1906). Critics of Wall Street still nod at entries like “Finance: the art or science of managing revenues or resources for the best advantage of the manager.”

With a combination of wit and a long career during which he incubates both insight and annoyance, Jason wrote what’s become a bedside companion for me. It’s full of short, snippy entries, each of which makes a point that bears making. I think you’d enjoy it, even if you’re the object of it.

---

Financial Journalist, n. Someone who is an expert at moving words about markets around on a page or screen until they sound impressive, regardless of whether they mean anything. Until the early 20^th century, financial journalists knew exactly what they were doing, as many of them were paid overtly or covertly by market manipulators to promote or trash various investments … Nowadays, most financial journalists are honest, which is progress—and ignorant, which isn’t.

---

Another thing to be thankful for: New data and our impending launch

We’ll be writing to the 6,000 or so of you on our mailing list in the next week or so with updates about our database and other analytics, as well as word of the formal launch of the “MFO premium” site, which will give all of our contributors access to all of this stuff and more.

Comparing Lipper Ratings

MFO recently started computing its risk and performance fund metrics and attendant fund ratings using the Lipper Data Feed Service for U.S. Open End funds. (See MFO Switches To Lipper Database.) These new data have now been fully incorporated on the MFO Premium beta site, and on the Great Owl, Fund Alarm, and Dashboard of Profiled Funds pages of our legacy Search Tools. (The Risk Profile and Miraculous Multi-Search pages will be updated shortly).

Last month we noted that the biggest difference MFO readers were likely to find was in the assigned classifications or categories, which are described in detail here. (Morningstar’s categories are described here,  and Lipper nicely compares the two classification methodologies here.) Some examples differences:

• Lipper uses “Core” instead of “Blend.” So, you will find Large-Cap Growth, Large-Cap Core, and Large Cap Value.
• Lipper includes a “Multi-Cap” category, in addition to Large-Cap, Medium-Cap, and Small-Cap. “Funds that, by portfolio practice, invest in a variety of market capitalization ranges …” Examples are Vanguard Total Stock Market Index Inv (VTSMX), Auxier Focus Inv (AUXFX), and Bretton (BRTNX).
• Lipper does not designate an “Asset Allocation” category type, only “Equity” and “Fixed Income.” The traditional asset allocation funds, like James Balanced: Golden Rainbow Retail (GLRBX) and Vanguard Wellesley Income Inv (VWINX) can be found in the categories “Mixed-Asset Target Allocation Moderate” and “Mixed-Asset Target Allocation Conservative,” respectively.
• Lipper used “Core Bond” instead of say “Intermediate-Term Bond” to categorize funds like Dodge & Cox Income (DODIX).
• Lipper extends data back to January 1960 versus January 1962. Number of funds still here today that were here in January 1960? Answer: 72, including T Rowe Price Growth Stock (PRGFX).

A few other changes that readers may notice with latest update:

• Ratings for funds in all the commodities categories, like Commodities Agriculture, where previously we only included “Broad Basket.”
• Ratings for funds of leveraged and short bias categories, so-called “trading” funds.
• Ratings for 144 categories versus 96 previously. We continue to not rate money market funds or funds less than 3 months old.
• No ratings for funds designated as a “variable insurance product,” which typically cannot be purchased directly by investors. Examples are certain Voya, John Hancock, and Hartford funds.
• There may be a few differences in the so-called “Oldest Share Class (OSC)” funds. MFO has chosen to define OSC as share class with earliest First Public Offering (FPO) date. (If there is a tie, then fund with lowest expense ratio. And, if tied again, then fund with largest assets under management.)

Overall, the changes appear quite satisfactory.

Briefly Noted . . .

Columbia Acorn Emerging Markets (CAGAX) has lifted the cap on what constitutes “small- and mid-sized companies,” their target universe. It has been $5 billion. Effective January 1 their limit bumps to $10 billion. That keeps their investment universe roughly in line with their benchmark’s.

Goldman Sachs Fixed Income Macro Strategies Fund (GAAMX) is making “certain enhancements” to its investment strategies. Effective November 20, 2015, the Fund will use a long/short approach to invest in certain fixed income securities. The trail of the blue line certainly suggests that “certain enhancements” might well be in order.

Here’s something I’ve not read before: “The shareholder of Leland Thomson Reuters Private Equity Index Fund (LDPAX) … approved changing the Fund’s classification from a diversified Fund to a non-diversified Fund under the Investment Company Act of 1940.”

SMALL WINS FOR INVESTORS

Not a lot to cheer for.

CLOSINGS (and related inconveniences)

The closure of the 361 Managed Futures Strategy Fund (AMFQX/ AMFZX) has been delayed “until certain administrative and other implementation matters have been completed.” The plan is to close by December 31, 2015.

The shareholders of Hennessy Cornerstone Large Growth Fund, the Hennessy Cornerstone Value Fund, and the Hennessy Large Value Fund bravely voted to screw themselves by adding 12(b)1 fees to their funds, beginning on November 1, 2015. The Hennessy folks note, in passing, that “This will increase the fees of the Investor Class shares of such Hennessy Funds.”

Invesco European Small Company Fund (ESMAX) will close to new investors on November 30, 2015. By pretty much all measures, it offers access to higher growth rates at lower valuations than the average European stock fund does. The question for most of us is whether such a geographically limited small cap fund ever makes sense. 

Effective after November 13, 2015, the RiverNorth/DoubleLine Strategic Income Fund (RNDLX) is closed to new investors.

OLD WINE, NEW BOTTLES

On December 30, the microscopic and undististinguished Alger Analyst Fund (SPEAX) will become Alger Mid Cap Focus Fund. Usually when a fund highlights Analyst in its name, it’s run by … well, the firm’s analysts. “Research” often signals the same thing. In this case, the fund has been managed since inception by CEO/CIO Dan Chung. After the name change, the fund will be managed by Alex Goldman. 

In one of those “I just want to slap someone” moves, the shareholders of City National Rochdale Socially Responsible Equity Fund (AHRAX) are voting on whether to become the Baywood SociallyResponsible Fund. The insistence of fund firms to turn two words into one word is silly but I could imagine some argument about the ability to trademark a name that’s one word (DoubleLine) that wouldn’t be available if it were two. But mashed-together with the second half officially italicized? Really, guys? The fact that the fund has trailed 97% of its peers over the past decade suggests the need to step back and ask questions more probing than this.

Effective December 31, 2015, Clearbridge Global Growth (LGGAX) becomes ClearBridge International Growth Fund.

Oppenheimer International Small Company Fund (OSMAX) becomes Oppenheimer International Small-Mid Company Fund on December 30, 2015. It’s a very solid fund except for the fact that, at $5.1 billion, is no longer targets small caps: 75% of the portfolio are mid- to large-cap stocks.

On January 11, 2016, the Rothschild U.S. Large-Cap Core Fund, U.S. Large-Cap Value, U.S. Small/Mid-Cap Core, U.S. Small-Cap Core, U.S. Small-Cap Value and U.S. Small-Cap Growth funds will become part of the Pacific Funds Series Trust. Rothschild expects that they’ll continue to manage the year-old funds with Pacific serving as the parent. The new fund names will be simpler than the old and will drop “U.S.”, though the statement of investment strategies retains U.S. as the focus. The funds will be Pacific Funds Large Cap, Large Cap Value, Small/Mid-Cap, Small-Cap, Small-Cap Value and Small-Cap Growth. It appears that the tickers will change.

On December 18, 2015, SSgA Emerging Markets Fund (SSELX) will become State Street Disciplined Emerging Markets Equity Fund, leading mayhap to speculation that it hadn’t been disciplined up until then. The fund will use quant screens “to select a portfolio that the Adviser believes will exhibit low volatility and provide competitive long-term returns relative to the Index.”

As part of a continuing series of fund adoptions, Sound Point Floating Rate Income Fund (SPRFX) will reorganize into the American Beacon Sound Point Floating Rate Income Fund.

Effective October 28, 2015, Victory Fund for Income became Victory INCORE Fund for Income. Presumably because the audience arose, applauding and calling “incore! incore!” Victory Investment Grade Convertible Fund was also rechristened Victory INCORE Investment Grade Convertible Fund.

And, too, Victory renamed all of its recently-acquired Compass EMP funds. The new names will all begin Victory CEMP. So, for example, in testing the hypothesis that no name is too long and obscure to be attractive, Compass EMP Ultra Short-Term Fixed Income Fund (COFAX) will become Victory CEMP Ultra Short Term Fixed Income Fund.

Voya Growth Opportunities Fund changed its name to Voya Large-Cap Growth Fund.

OFF TO THE DUSTBIN OF HISTORY

3D Printing, Robotics and Technology Fund (TDPNX) will liquidate on November 13, 2015. In less than two years, the managers lost 39% for their investors while the average tech fund rose 20%. The Board blamed “market conditions and economic factors” rather than taking responsibility for a fatally-flawed conception. Reaction on the Observer’s discussion board was limited to a single word: “surprised?”

Not to worry, 3D printing fans! The ETF industry has rushed in to fill the (non-existent) gap with the pending launch of the ARK 3D Printing ETF.

Acadian Emerging Markets Debt Fund (AEMDX) has closed and will liquidate on November 20, 2015. It’s a $36 million institutional fund that’s had one good year in five; otherwise, it trailed 70-98% of its peers. Performance seems to have entirely fallen off a cliff in 2015.

AllianzGI NFJ All-Cap Value Fund (PNFAX) is slated for liquidation on December 11, 2015. Their International Managed Volatility (PNIAX) and U.S. Managed Volatility (NGWAX) funds will follow on March 2, 2016. The theory says that managed volatility funds should be competitive with their benchmarks over the long term by limiting losses during downturns. The latter two funds suffered because they couldn’t consistently manage that feat.

Carne Hedged Equity Fund (CRNEX) was a small, decent long/short fund for four years. Then the recent past happened; the fund went from well above average through December 2013 to well below average since. Finally, the last week of October 2015 happened. Here’s the baffling picture:

Right: 23% loss over four days in a flat market. No word on the cause, though the liquidation filing does refer to a large redemption and anticipated future redemptions. (Ya think?) So now it’s belatedly becoming “a former fund.” Graveside services will be conducted December 30, 2015.

Forward continues … in reverse? To take one step Forward and two back? Forward Global Dividend Fund (FFLRX) will liquidate on November 17^th and the liquidation of Forward Select EM Dividend Fund will occur on December 15, 2015. Those appear to be Forward’s fifth and sixth liquidations in 2015, and the fourth since being acquired by Salient this summer.

In order “to optimize the Goldman Sachs Funds and eliminate overlap,” Goldman Sachs has (insightfully) decided to merge Goldman Sachs International Small Cap Fund (GISAX) into Goldman Sachs International Small Cap Insights Fund (GISAX). The target date is February, 2016. That’s a pretty clean win for shareholders. GISAX is, by far, the larger, stronger and cheaper option.

GuideMark® Global Real Return Fund has been liquidated and terminated and, for those of you who haven’t yet gotten the clue, “shares of the Fund are no longer available for purchase or exchange.”

JPMorgan U.S. Research Equity Plus Fund (JEPAX) liquidated after fairly short notice on October 28, 2015. It was a long/short fund of the 130/30 variety: it had a leveraged long position and a short portfolio which together equaled 100% long exposure. That’s an expensive proposition whose success relies on your ability to get three or four things (extent of leverage, target market exposure, long and short security selection) consistently and repeatedly right. Lipper helpfully classifies it as a “Lipper Alternative Active Extension Fund.” It had a few good years rather precisely offset by bad years; in the end, the fund charged a lot (2.32% despite a mystifying Morningstar report of 1.25%), churned the portfolio (178% per year) but provided nothing special (its returns exactly matched the average 100% long large cap fund).

Larkin Point Equity Preservation Fund (LPAUX), a two-year-old long/short fund of funds, will neither preserve or persevere much longer. It has closed and expects to liquidate on November 16, 2015.

On October 16, 2015, Market Vectors got out of the Quality business as they bumped off the MSCI International Quality, MSCI Emerging Markets Quality Dividend, MSCI International Quality Dividend and MSCI Emerging Markets Quality ETFs.

The Board of Trustees of The Royce Fund recently approved the fund reorganizations effective in the first half of 2016. In the first half of 2016, Royce International Premier (RIPN) will eat two of its siblings: European Small Cap (RESNX) and Global Value (RGVIX). Why does it make sense for a $9 million fund with no star rating to absorb its $22 million and $62 million siblings? Of course, Royce is burying a one-star fund that’s trailed 90% of its peers over the past five years. And, too, a one-star fund that’s trailed 100% in the same period. Yikes. Global Value averaged 0.8% annually over the past five years; its average peer pumped out ten times as much.

While they were at it, Royce’s Board of Trustees approved a plan of liquidation for Royce Micro-Cap Discovery Fund (RYDFX), to be effective on December 8, 2015. The $5 million fund is being liquidated “primarily because it has not attracted and maintained assets at a sufficient level for it to be viable.” That suggests that International Micro Cap (ROIMX) with lower returns, two stars and $6 million in assets might be next in line.

Salient MLP Fund (SAMCX) will liquidate on December 1, 2015. Investors will continue to be able to access the management team’s skills through Salient MLP & Energy Infrastructure Fund II (SMAPX) which has over a billion in assets. It’s not a particularly good fund, but it is better than SAMCX.

Schroder Global Multi-Cap Equity Fund (SQQJX) liquidated on October 27, 2015, just days short of its fifth anniversary.

Sirios Focus Fund (SFDIX) underwent “final liquidation” on Halloween, 2015. It’s another fund abandoned after two years of operation.

Tygh Capital Management has recommended the liquidation of its TCM Small-Mid Cap Growth Fund (TCMMX). That will occur just after Thanksgiving.

Touchstone Growth Allocation Fund (TGQAX) is getting absorbed by Touchstone Moderate Growth Allocation Fund (TSMAX) just before Thanksgiving. Both have pretty sad records, but Growth has the sadder of the two. At the same time, Moderate Growth brings in managers Nathan Palmer and Anthony Wicklund from Wilshire Associates. Wilshire replaces Ibbotson Associates (a Morningstar company) as the fund’s advisor. Both are funds-of-mostly-Touchstone funds. After the repositioning, Moderate Growth will offer 40% non-US exposure with 45-75% of its assets in equities. Currently Growth is entirely equities.

UBS Multi-Asset Income Fund (MAIAX) will liquidate on or about December 3, 2015.

The Virtus Disciplined Equity Style (VDEAX), Virtus Disciplined Select Bond (VDBAX) and Virtus Disciplined Select Country (VDCAX) funds will close on November 20^th and will liquidate by December 2, 2015. They share about $7 million in assets and a record of consistent underperformance.

Virtus Dynamic Trend Fund (EMNAX) will merge into Virtus Equity Trend Fund (VAPAX), they’re hoping sometime in the first quarter of 2016. I have no idea of why, since EMNAX has $600 million and a better record than VAPAX.

In Closing . . .

In a good year, nearly 40% of our Amazon revenue is generated in November and December. That’s in part because I endlessly nag people about how ridiculously simple, painless and useful it is to bookmark our Amazon link or set it as one of your tabs that opens whenever you start your favorite browser.

Please don’t make me go find some cute nagging-related image to illustrate this point. Just bookmark our Amazon link or set it as an opening tab. That would help so me. Here’s the link http://www.amazon.com/?_encoding=UTF8&tag=mutufundobse-20. Alternatively, you can click on the banner.

A quick tip of the cap to folks who made tax-deductible contributions to the Observer this month: regular subscribers, Greg and Deb; PayPal contributors, Beatrice and David; and those who preferred to mail checks, Marjorie, Tom G. and the folks at Ultimus Fund Solutions. We’re grateful to all of you.

The fund managers I’ve spoken with are nearly unanimous in their loathing of Schwab. Words like “arrogant, high-handed and extortionate” capture the spirit of their remarks. I hadn’t dealt with the folks at Schwab until now, so mostly I nodded sympathetically. I now nod more vigorously.

It’s likely that we’ll be in the vicinity of, but not at, the Schwab IMPACT conference in November. We requested press credentials and were ignored for a good while. Then after poking a couple more times, we were reminded of how rare and precious they were and were asked to submit examples of prior conference coverage. We did, on September 28^th. That’s the last we heard from them so we’ll take that as a “we’re Schwab. Go away, little man.” Drop us a note if you’re going to be there and would like to chat at some nearby coffee shop.

We’ll look for you.

Dear friends,

Welcome to fall. Welcome to October, the time of pumpkins.

October’s a month of surprises, from the first morning that you see frost on the grass to the appearance of ghosts and ghouls at month’s end. (Also sports mascots. Don’t ask.) It’s a month famous of market crashes – 1929, 1987, 2008 – and for being the least hospitable to stocks. And it has the prospect of setting new records for political silliness and outbreaks of foot-in-mouth disease.

It’s the month of golden leaves, apple cider, backyard fires and weekend football.  (I’m a bit torn. Sam Frasco, Augie’s quarterback, broke Ken Anderson’s school record for total offense – 469 yards in a game – and lost. In the next week, he broke his own record – 575 – and lost again.) 

It’s the month where we discover that Oktoberfest actually takes place in September, and we’ve missed it. 

In short, it’s a good month to be alive and to share with you.

Leuthold: a cyclical bear has commenced

As folks on our mailing list know, the Leuthold Group has concluded that a cyclical bear market has begun. They make the argument in the lead section of Perception for the Professional, their monthly report for paying research clients (and us). It’s pretty current, with data through September 8th. A late September update of that essay, posted on the Leuthold Group’s website, reiterates the conclusion: “We strongly suspect the decline from the September 17th intraday highs is the bear market’s second downleg, and we’d expect all major U.S. indexes to undercut their late August lows before this leg is complete.” While declines during the 3^rd quarter took some of the edge off the market’s extreme valuation, they note with concern the buoyant optimism of the “buy the dips” crowd.

Who are they?

The Leuthold Group was founded in 1981 by Steve Leuthold, who is now mostly retired to Bar Harbor, Maine. (I’m intensely jealous.) They’re an independent firm that produces financial research for institutional investors. They do unparalleled quantitative work deeply informed by historical studies that other firms simply don’t attempt. They write well and thoughtfully.

Why pay any attention?

They write well and thoughtfully. Hadn’t I mentioned? Quite beyond that, they put their research into practice through the Leuthold Core (LCORX) and Leuthold Global (GLBLX) funds. Core was a distinguished “world allocation” fund before the term existed. $10,000 entrusted to Leuthold in 1995 would have grown to $53,000 today (10/01/2015). Over that same period, an investment in the Vanguard 500 Index Fund (VFINX) would have growth to $46,000 while the average tactical allocation manager would have managed to grow it to $26,000. All of which is to say, they’re not some ivory tower assemblage of perma-bears peddling esoteric strategies to the rubes.

What’s their argument?

The bottom line is that a cyclical bear began in August and it’s got a ways to go. Their bear market targets for the S&P 500 – based on a variety of different bear patterns – are in the range of 1500-1600; it began October at about 1940. The cluster of the Russell 2000 is around 1000; the October 1 open was 1100. 

The S&P target was a composite drawn from the levels necessary to achieve:

1. a reversion to 1957-present median valuations
2. 50% retracement of gains from the October 2011 low
3. the October 2007 peak
4. the median decline in a postwar bear
5. the March 2000 secular bull market peak
6. 50% retracement of the gain from the March 2009 low
7. April 2011 market peak

Each of those represents what some technicians see as a “support level” in a typical cyclical bear. Since Leuthold recognizes that it’s not possible to be both precise and meaningful, they look for clustered values. Most of the ones about lie between 1525 and 1615, so …

They address some of the self-justificatory blather (“it’s the most hated bull market in history,” to which they reply that sales of leveraged bull market funds and equity exposure by market-timing newsletters were at records for 2014 and much of 2015 which some might think of as showin’ some lovin’), then make two arguments:

1. Market internals have been breaking down all summer.
2. After the August declines, the market’s forward P/E ratio was still higher than it was at the peaks of the last three bull markets.

In their tactical portfolios, they’ve dropped their equity exposure to 35%. Their early September asset allocation in the portfolios (such as Leuthold Core LCORX and Leuthold Global GLBLX) was:

52% long equities

21% equity hedge a/k/a short for a net long of 31%

4% EM equities, which are in addition to the long position above

20% fixed income, with both EM and TIPS eliminated in August. The rest is relatively short and higher quality.

3% cash

They seem especially chary of energy stocks and modestly positive toward consumer discretionary and health care ones.

They are torn on the emerging markets. They argue that “there must be serious fundamental problems with any asset class that commands a Normalized P/E of only 13x at the peak (in May 2015) of one of the greatest liquidity-driven bull markets in history. We now expect EM valuations will undercut their 2008 lows before the current market decline has run its course. That washout might also serve up the best stock market bargains in many years…” (emphasis in original) Valuations are already so low that they’ve discussed overriding their own models but will not abandon their discipline in favor of their guts.

The turmoil in the emerging markets has struck down saints and sinners alike. The two emerging markets funds in my personal account, Seafarer Overseas Growth & Income (SFGIX) and Grandeur Peak Emerging Opportunities (GPEOX, closed) are down about 18% from their late May highs while the EM group as a whole has declined by just over 20%. As Ed Studzinski notes, below, those declines were occasioned by a panic over Chinese stocks which triggered a trillion dollar capital flight and a liquidity crisis.

Seafarer and Grandeur Peak both have splendid records, exceptional managers and success in managing through turmoil. Given the advice that we offered readers last month – briefly put, the worst time to fix a leaky roof is in a storm – I was struck by manager Andrew Foster’s thoughtful articulation of that same perspective in the context of the emerging markets. He made the argument in a September video, in which he and Kate Jaquet discussed risk and risk management in an emerging markets portfolio.

Once a crisis begins to unfold, there’s very little we can do amid the crisis to really change how we manage the fund to somehow dampen down the risk or the exposure the fund has. .. The best way to control risk within the fund is preventative… to try and put in place a portfolio construction that anticipates different kinds of market conditions well ahead of time such that when the crisis unfolds or the volatility ensues that you’re at least reasonably well positioned for it.

The reason why it doesn’t make a great deal of sense to react substantially during a crisis is because most financial crises stem from liquidity panics or some sort of liquidity shortage. And so if you try and trade your portfolio or restructure it radically in the middle of such an event, you’re inevitably trading right into a liquidity panic. What you want to sell will be difficult to sell and you won’t realize efficient prices. What you want to buy – the stuff that might seem safe or might be able to steer you through the crisis – will inevitably be overpriced or expensive … [prices] tend to be at extremes. You’re going to manifest the risk in a more pronounced way and crystallize the loss you’re trying to avoid.

The solution he propounds is the same one you should adopt: Build an all-weather portfolio that manages to be “strong and happy” in good markets and “reasonably resilient” in bad ones.

A more striking response was offered by the good folks at Vulcan Value Partners whose Vulcan Value Partners Small Cap (VVPSX, closed) we profiled four years ago. Vulcan Value Partners does really good work (“all of our investment strategies are ranked in the top 1% of our peers since inception and both Large Cap and Focus are literally the best performing investment programs among their peers”), part and parcel of which is being really thoughtful about the risks they’re asking their partners to face. Their most recent shareholder letter is bracing:

In Small Cap, we have sold a number of positions at our estimate of fair value but have been unable to redeploy capital back into replacements at prices that provide us with a margin of safety. Consequently, cash levels are rising, and price to value ratios in the companies we do own are not as low as in Large Cap. Our investment philosophy tends to keep us fully invested most of the time. However, at extremes, cash levels can rise. We will not compromise on quality, and we will not pay fair value for anything. .. We encourage our Small Cap partners to reduce their small cap exposure in general and with us if they have better alternatives. At the very least, we strongly ask you to not add to your Small Cap allocation with us. There will be a day when we write the opposite of what we are writing today. We look forward to writing that letter, but for the time being Small Cap risks are rising and potential returns are falling. (Thanks for Press, one of the stalwarts of MFO’s discussion board, for bringing the letter to my attention.)

The Field Guide to Bears

Financial professionals tend to distinguish “cyclical” markets from “secular” ones. A secular bear market is a long-term decline that might last a decade or more. Such markets aren’t steady declines; rather, it’s an ongoing decline that’s punctuated by furious short-term market rallies – called “cyclical bulls” – that fizzle out. “Short term” is relative, of course. A short-term rally might roll on for 12-18 months before investors capitulate and the market crashes once again. As Barry Ritzholtz pointed out earlier this year, “Knowing one from the other isn’t always easy.”

There’s an old hiker’s joke that plays with the same challenge of knowing which sort of bear you’re facing:

Park visitors are advised to wear little bells on their clothes to make noise when hiking. The bell noise allows the bears to hear the hiker coming from a distance and not be startled by a hiker accidently sneaking up on them. This might cause a bear to charge. Hikers should also carry pepper spray in case they encounter a bear. Spraying the pepper in the air will irritate a bear’s sensitive nose and it will run away.

It also a good idea to keep an eye out for fresh bear scat so you’ll know if there are bears in the area. People should be able to tell the difference between black bear scat and grizzly bear scat. Black bear scat is smaller and will be fibrous, with berry seeds and sometimes grass in it. Grizzly bear scat will have bells in it and smell like pepper spray.

Some Morningstar ETF Conference Observations

Overcast and drizzling in Chicago on the day Morningstar’s annual ETF Conference opened September 29, the 6^th such event, with over 600 attendees. The US AUM is $2 trillion across 1780 predominately passive exchange traded products, or about 14% of total ETF and mutual fund assets. The ten largest ETFs , which include SPDR S&P 500 ETF (SPY) and Vanguard Total Stock Market ETF (VTI), account more for nearly $570B, or about 30% of US AUM.  Here is a link to Morningstar’s running summary of conference highlights.

Joe Davis, Vanguard’s global head of investment strategy group, gave a similarly overcast and drizzling forecast of financial markets at his opening key note, entitled “Perspectives on a low growth world.” Vanguard believes GDP growth for next 50 years will be about half that of past 50 years, because of lack of levered investment, supply constraints, and weak global demand. That said, the US economy appears “resilient” compared to rest of world because of the “blood -letting” or deleveraging after the financial crisis. Corporate balances sheets have never been stronger. Banks are well capitalized.

US employment environment has no slack, with less than 2 candidates available for every job versus more than 7 in 2008. Soon Vanguard predicts there will be just 1 candidate for every job, which is tightest environment since 1990s. The issue with employment market is that the jobs favor occupations that have been facilitated by the advent of computer and information technology. Joe believes that situation contributes to economic disparity and “return on education has never been higher.”

Vanguard believes that the real threat to global economy is China, which is entering a period of slower growth, and attendant fall-out with emerging markets. He believes though China is both motivated and has proven its ability to have a “soft landing” that relies more on sustainable growth, if slower, as it transitions to more of a consumer-based economy.

Given the fragility of the global economy, Vanguard does not see interest rates being raised above 1% for the foreseeable future. End of the day, it estimates investors can earn 3-6% return next five year via a 60/40 balanced fund.

J. Martijn Cremers and Antti Petajisto introduced a measure of active portfolio management in 2009, called Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. A formal definition and explanation can be found here (scroll to bottom of page), extracted from their paper “How Active Is Your Fund Manager? A New Measure That Predicts Performance.”

Not everybody agrees that the measure “Predicts Performance.” AQR’s Andrea Frazzini, a principal on the firm’s Capital Management Global Stock Selection team, argued against the measure in his presentation “Deactivating Active Share.” While a useful risk measure, he states it “does not predict actual fund returns; within individual benchmarks, it is as likely to correlate positively with performance as it is to correlate negatively.” In other words, statistically indistinguishable.

AQR examined the same data as the original study and found the same quantitative result, but reached a different implication. Andrea believes the 2% higher returns versus the benchmark the original paper touted is not because of so-called high active share, but because the small cap active managers during the evaluation period happened to outperform their benchmarks. Once you break down the data by benchmark, he finds no convincing argument.

He does believe it represents a helpful risk measure. Specifically, he views it as a measure of activity.  In his view, high active share means concentrated portfolios that can have high over-performance or high under-performance, but it does not reliably predict which.

He also sees its value in helping flag closest index funds that charge high fees, since index funds by definition have zero active share.

Why is a large firm like AQR with $136B in AUM calling a couple professors to task on this measure? Andrea believes the industry moved too fast and went too far in relying on its significance.

The folks at AlphaArchitect offer up a more modest perspective and help frame the debate in their paper, ”The Active Share Debate: AQR versus the Academics.”

Charles Ellis, renowned author and founder of Greenwich Associates, gave the lunchtime keynote presentation. It was entitled “Falling Short: The Looming Problem with 401(k)s and How To Solve It.”

He started by saying he had “no intention to make an agreeable conversation,” since his topic addressed the “most important challenge to our investment world.”

The 401(k) plans, which he traces to John D. Rockefeller’s gift to his Standard Oil employees, are falling short of where they need to be to support an aging population whose life expectancy keeps increasing.

He states that $110K is the median 401(k) plus IRA value for 65 year olds, which is simply not enough to life off for 15 years, let alone 25.

The reasons for the shortfall include employers offering a “You’re in control” plan, when most people have never had experience with investing and inevitably made decisions badly. It’s too easy to opt out, for example, or make an early withdrawal.

The solution, if addressed early enough, is to recognize that 70 is the new 65. If folks delay drawing on social security from say age 62 to 70, that additional 8 years represents an increase of 76% benefit. He argues that folks should continue to work during those years to make up the shortfall, especially since normal expenses at that time tend to be decreasing.

He concluded with a passionate plea to “Help America get it right…take action soon!” His argument and recommendations are detailed in his new book with co-authors Alicia Munnell and Andrew Eschtruth, entitled “Falling Short: The Coming Retirement Crisis and What to Do About It.”

We Are Where We Are!

By Edward A. Studzinski

“Cynicism is an unpleasant way of saying the truth.”

Lillian Hellman

Current Events:

While we may be where we are, it is worth a few moments to talk about how we got here. In recent months the dichotomy between the news agendas of the U.S. financial press and the international press has become increasingly obvious. At the beginning of August, a headline on the front page of the Financial Times read, “One Trillion Dollars in Capital Flees Emerging Markets.” I looked in vain for a similar story in The Wall Street Journal or The New York Times. There were many stories about the next Federal Reserve meeting and whether they would raise rates, stories about Hillary Clinton’s email server, and stories about Apple’s new products to come, but nothing about that capital flight from the emerging markets.

We then had the Chinese currency devaluation with varying interpretations on the motivation. Let me run a theme by you that was making the rounds of institutional investors outside of the U.S. and was reported at that time. In July there was a meeting of the International Monetary Fund in Europe. One of the issues to be considered was whether or not China’s currency, the renminbi, would be included in the basket of currencies against which countries could have special drawing (borrowing) rights. This would effectively have given the Chinese currency the status of a reserve currency by the IMF. The IMF’s staff, whose response sounded like it could have been drafted by the U.S. Treasury, argued against including the renminbi. While the issue is not yet settled, the Executive Directors accepted the staff report and will recommend extending the lifespan of the current basket, now set to expire December 31, until at least September 2016. At the least, that would lock out the renminbi for another year. The story I heard about what happened next is curious but telling. The Chinese representative at the meeting is alleged to have said something like, “You won’t like what we are going to do next as a result of this.” Two weeks after the conclusion of the IMF meeting, we then had the devaluation of China’s currency, which in the minds of some triggered the increased volatility and market sell-offs that we have seen since then.

I know many of you are saying, “Pshaw, the Chinese would never do anything as irrational as that for such silly reasons.” And if you think that dear reader, you have yet to understand the concept of “Face” and the importance that it plays in the Asian world. You also do not understand the Chinese view of self – that they are a Great People and a Great Nation. And, that we disrespect them at our own peril. If you factor in a definition of long-term, measured in centuries, events become much more understandable.

One must read the world financial press regularly to truly get a picture of global events. I suggest the Financial Times as one easily accessible source. What is reported and considered front page news overseas is very different from what is reported here. It seems on occasion that the bobble-heads who used to write for Pravda have gotten jobs in public relations and journalism in Washington and Wall Street.

One example – this week the Financial Times reported the story that many of the sovereign wealth funds (those funds established by countries such as Kuwait, Norway, and Singapore to invest in stocks, bonds, and other assets, for pension, infrastructure or healthcare, among other things), have been liquidating investments. And in particular, they have been liquidating stocks, not bonds. Another story making the rounds in Europe is that the various “Quantitative Easing” programs that we have seen in the U.S., Europe, and Japan, are, surprise, having the effect of being deflationary. And in the United States, we have recently seen the three month U.S. Treasury Bill trading at negative yields, the ultimate deflationary sign. Another story that is making the rounds – the Chinese have been selling their U.S. Treasury holdings and at a fairly rapid clip. This may cause an unscripted rate rise not intended or dictated by the Federal Reserve, but rather caused by market forces as the U.S. Treasury continues to come to market with refinancing issues.

The collapse in commodity prices, especially oil, will sooner or later cause corporate bodies to float to the surface, especially in the energy sector. Counter-party (the other side of a trade) risk in hedging and lending will be a factor again, as banks start shrinking or pulling lines of credit. Liquidity, which was an issue long before this in the stock and bond markets (especially high yield), will be an even greater problem now.

The SEC, in response to warnings from the IMF and the Federal Reserve, has unanimously (which does not often happen) called for rules to prevent investors’ demands for redemptions in a market crisis from causing mutual funds to be driven out of business. Translation: don’t expect to get your money as quickly as you thought. I refer you to the SEC’s Proposal on Liquidity Risk Management Programs.

I mention that for the better of those who think that my repeated discussions of liquidity risk is “crying wolf.”

“It’s a Fine Kettle of Fish You’ve Gotten Us in, Ollie.”

I have a friend who is a retired partner from Wellington in Boston (actually I have a number of friends who are retired partners from there). Wellington is not unique in that, like Fidelity, it is very unusual for an analyst or money manager to stay much beyond the age of fifty-five.

So I asked him one day how he had his retirement investments structured, hoping I might get some perspective into thinking on the East Coast, as well as perhaps some insights into Vanguard’s products, given the close relationship between Vanguard and Wellington. His answer surprised me – “I have it all in index funds.” I asked if there were any particular index funds. Again the answer surprised me. “No bond funds, and actually only one index fund – the Vanguard S&P 500 Index Fund.” And when I asked for further color on that, the answer I got was that he was not in the business full time anymore, looking at markets and security valuations every day, so this was the best way to manage his retirement portfolio for the long-term at the lowest cost. Did he know that there were managers, that 10% or so, who consistently (or at least for a while, consistently) outperform the index? Yes, he was aware that such managers were out there. But at this juncture in his life he did not think that he either (a) had the time, interest, and energy to devote to researching and in effect “trading managers” by trading funds and (b) did not think he had any special skill set or insights that would add value in that process that would justify the time, the one resource he could not replace. Rather, he knew what equity exposure he wanted over the next twenty or thirty years (and he recognized that life expectancies keep lengthening). The index fund over that period of time would probably compound at 8% a year as it had historically with minimal transaction costs and minimal tax consequences. He could meet his needs for a diversified portfolio of equities at an expense ratio of five basis points. The rest of his assets would be in cash or cash equivalents (again, not bonds but rather insured certificates of deposit).

I have talked in the past about the need to focus on asset allocation as one gets older, and how index funds are the low cost way to achieve asset diversification. I have also talked about how your significant other may not have the same interest or ability in managing investments (trading funds) after you go on to your just reward. But I have not talked about the intangible benefits from investing in an index fund. They lessen or eliminate the danger of portfolio manager or analyst hubris blowing up a fund portfolio with a torpedo stock. They also eliminate the divergence of interests between the investment firm and investors that arises when the primary focus is running the investment business (gathering assets).

What goes into the index is determined not by the entity running the fund (although they can choose to create their own index, as some of the European banks have done, and charge fees close to 2.00%). There is no line drawn in the sand because a portfolio manager has staked his public reputation on his or her genius in investing in a particular entity. There is also no danger in an analyst recommending sale of an issue to lock in a bonus. There is no danger of an analyst recommending an investment to please someone in management with a different agenda. There is no danger of having a truncated universe of opportunities to invest in because the portfolio manager has a bias against investing in companies that have women chief executive officers. There is no danger of stock selection being tainted because a firm has changed its process by adding an undisclosed subjective screening mechanism before new ideas may be even considered. While firm insiders may know these things, it is a very difficult thing to learn them from the outside.

Is there a real life example here? I go back to the lunch I had at the time of the Morningstar Conference in June with the father-son team running a value fund out of Seattle. As is often the case, a subject that came up (not raised by me) was Washington Mutual (WaMu, a bank holding company that collapsed in 2008, trashing a bunch of mutual funds when it did). They opined how, by being in Seattle (a big small town), they had been able to observe up close and personally how the roll-up (which was what Washington Mutual was) had worked until it didn’t. Their observation was that the Old Guard, who had been at the firm from the beginning with the chair of the board/CEO had been able to remind him that he put his pants on one leg at a time. When that Old Guard retired over time, there was no one left who had the guts to perform that function, and ultimately the firm got too big relative to what had driven past success. Their assumption was that their Seattle presence gave them an edge in seeing that. Sadly, that was not necessarily the case. In the case of many an investment firm, Washington Mutual became their Stalingrad. Generally, less is more in investing. If it takes more than a few simple declarative sentences to explain why you are investing in a business, you probably should not be doing it. And when the rationale for investing changes and lengthens over time, it should serve as a warning.

I suspect many of you feel that the investment world is not this way in reality. For those who are willing to consider whether they should rein in their animal spirits, I commend to you an article entitled “Journey into the Whirlwind: Graham-and-Doddsville Revisited” by Louis Lowenstein (2006) and published by The Center for Law and Economic Studies at Columbia Law School. (Lowenstein, father of Roger Lowenstein, looks at the antics of large growth managers and conclude, “Having attracted, not investors, but speculators trying to catch the next new thing, management got the shareholders they deserved.” Snowball). When I look at the investment management profession today, as well as its lobbying efforts to prevent the imposition of stricter fiduciary standards, I question whether what they really feel in their hearts is that the sin of Madoff was getting caught.

The End

Is there anything I am going to say this month that may be useful to the long-term investor? There is at present much fear abroad in the land about investing in emerging and frontier markets today, driven by what has happened in China and the attendant ripple effect.

The question I will pose for your consideration is this. What if five years from now it becomes compellingly obvious that China has become the dominant economic force in the world? Since economic power ultimately leads to political and military power, China wins. How should one be investing a slice of one’s assets (actively-managed of course) today if one even thinks that this is a remotely possible outcome? Should you be looking for a long-term oriented, China-centric fund?

There is one other investment suggestion I will make that may be useful to the long-term investor. David has raised it once already, and that is dedicating some assets into the micro-cap stock area. Focus on those investments that are in effect too small and extraordinarily illiquid in market capitalization for the big firms (or sovereign wealth funds) to invest in and distort the prices, both coming and going. Micro-cap investing is an area where it is possible to add value by active management, especially where the manager is prepared to cap the assets that it will take under management. Look for managers or funds where the strategy cannot be replicated or imitated by an exchange traded fund. Always remember, when the elephants start to dance, it is generally not pleasant for those who are not elephants.

Edward A. Studzinski

P.S. – Where Eagles Dare

The fearless financial writer for the New York Times, Gretchen Morgenson, wrote a piece in the Sunday Times (9/27/2015) about the asset management company First Eagle Investment Management. The article covered an action brought by the SEC for allegedly questionable marketing practices under the firm’s mutual funds’ 12b-1 Plan. Without confirming or denying the allegations, First Eagle settled the matter by paying $27M in disgorgement and interest, and $12.5M in fines. With approximately $100B in assets generating an estimated $900+M in revenues annually, one does not need to hold a Tag Day for the family-controlled firm. Others have written and will write more about this event than I will.

Of more interest is the fact that Blackstone Management Partners is reportedly purchasing a 25% stake in First Eagle that is being sold by T/A Associates of Boston, another private equity firm. As we have seen with Matthews in San Francisco, investments in investment management firms by private equity firms have generally not inured to the benefit of individual investors. It remains to be seen what the purpose is of this investment for Blackstone. Blackstone had had a right-time, right-strategy investment operation with its two previously-owned closed-end funds, The Asia Tigers Fund and The India Fund, both run by experienced teams. The funds were sold to Aberdeen Asset Management, ostensibly so Blackstone could concentrate on asset management in alternatives and private equity. With this action, they appear to be rethinking that.

Other private equity firms, like Oaktree, have recently launched their own specialist mutual funds. I would note however that while the First Eagle Funds have distinguished long-term records, they were generated by individuals now absent from the firm. There is also the question of asset bloat. One has to wonder if the investment strategy and methodology could not be replicated by a much lower cost (to investors) vehicle as the funds become more commodity-like.

Which leaves us with the issue of distribution – is a load-based product, going through a network of financial intermediaries, viable, especially given how the Millennials appear to make their financial decisions? It remains to be seen. I suggest an analogy worth considering is the problem of agency-driven insurance firms like Allstate. Allstate would clearly like to not have an agency distribution system, and would make the switch overnight if it could without losing business. It can’t, because too much of the book of business would leave. And yet, when one looks at the success of GEICO and Progressive in going the on-line or 1-800 route, one can see the competitive disadvantage, especially in automobile insurance, which is the far more profitable business to capture. It remains to be seen how distribution will evolve in the investment management world, especially as pertains to funds. As fiduciary requirements change, there is the danger of the entire industry model also changing.

Why Vanguard Will Take Over the World

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

Vanguard is eating everything. It is the biggest fund company in the U.S., with over $3 trillion in assets under management as of June-end, and the second biggest asset manager in the world, after BlackRock. Size hasn’t hampered Vanguard’s growth. According to Morningstar, Vanguard took in an estimated $166 billion in U.S. ETF and mutual fund assets in the year-to-date ending in August, over three times the next closest company, BlackRock/iShares. Not only do I think Vanguard will eventually overtake BlackRock, it will eventually extend its lead to become by far the most dominant asset manager in the world.

With index funds, investors mostly care about having their desired exposure at the lowest all-in cost, the most visible component of which is the expense ratio. In other words, index funds are commodities. In a commodity industry with economies of scale, the lowest-cost producer crushes the competition. Vanguard is the lowest-cost producer. Not only that, it enjoys a first-mover advantage and possesses arguably the most trusted brand in asset management. These advantages all feed on each other in virtuous cycles.

It’s commonly known Vanguard is owned by its mutual funds, so everything is run “at cost.” (This is a bit of a fiction; some Vanguard funds subsidize others or outside ventures.) “Profits” flow back to the funds as lower expense ratios. There are no external shareholders to please, no quarterly earnings targets to hit. Many cite this as the main reason why Vanguard has been so successful. However, the mutual ownership structure has not always led to lower all-in costs or dominance in other industries, such as insurance, or even in asset management. Mutual ownership is a necessary but not a sufficient condition for Vanguard’s success.

What separates Vanguard from other mutually owned firms is that it operates in a business that benefits from strong first-mover advantages. By being the first company to offer index funds widely, it achieved a critical mass of assets and name recognition before anyone else. Assets begot lower fees which begot even more assets, a cycle that still operates today.

While Vanguard locked up the index mutual fund market, it almost lost its leadership by being slow to launch exchange-traded funds. By the time Vanguard launched its first in 2001, State Street and Barclays already had big, widely traded ETFs covering most of the major asset classes. While CEO and later chairman of the board, founder Jack Bogle was opposed to launching ETFs. He thought the intraday trading ETFs allowed would be the rope by which investors hung themselves. From a pure growth perspective, this was a major unforced error. The mistake was reversed by his successor, Jack Brennan, after Bogle was effectively forced into retirement in 1999.

In ETFs, the first-movers not only enjoy economies of scale but also liquidity advantages that allows them to remain dominant even when their fees aren’t the lowest. When given the choice between a slightly cheaper ETF with low trading volume and a more expensive ETF with high trading volume, most investors go with the more traded fund. Because ETFs attract a lot of traders, the expense ratio is small in comparison to cost of trading. This makes it very difficult for new ETFs to gain traction when an established fund has ample trading volume. The first U.S. ETF, SPDR S&P 500 ETF SPY, remains the biggest and most widely traded. In general, the biggest ETFs were also the first to come out in their respective categories. The notable exceptions are where Vanguard ETFs managed to muscle their way to the top. Despite this late start, Vanguard has clawed its way up to become the second largest ETF sponsor in the U.S.

This feat deserves closer examination. If Vanguard’s success in this area was due to one-off factors such as the tactical cleverness of its managers or missteps by competitors, then we can’t be confident that Vanguard will overtake entrenched players in other parts of the money business. But if it was due to widely applicable advantages, then we can be more confident that Vanguard can make headway against entrenched businesses.

A one-off factor that allowed Vanguard to take on its competitors was its patented hub and spoke ETF structure, where the ETF is simply a share class of a mutual fund. By allowing fund investors to convert mutual fund shares into lower-cost ETF shares (but not the other way around), Vanguard created its own critical mass of assets and trading volume.

But even without the patent, Vanguard still would have clawed its way to the top, because Vanguard has one of the most powerful brands in investing. Whenever someone extols the virtues of index funds, they are also extoling Vanguard’s. The tight link was established by Vanguard’s early dominance of the industry and a culture that places the wellbeing of the investor at the apex. Sometimes this devotion to the investor manifests as a stifling paternalism, where hot funds are closed off and “needless” trading is discouraged by a system of fees and restrictions. But, overall, Vanguard’s culture of stewardship has created intense feelings of goodwill and loyalty to the brand. No other fund company has as many devotees, some of whom have gone as far as to create an Internet subculture named after Bogle.

Over time, Vanguard’s brand will grow even stronger. Among novice investors, Vanguard is slowly becoming the default option. Go to any random forum where investing novices ask how they should invest their savings.  Chances are good at least someone will say invest in passive funds, specifically ones from Vanguard.

Vanguard is putting its powerful brand to good use by establishing new lines of business in recent years. Among the most promising in the U.S. is Vanguard Personal Advisor Services, a hybrid robo-advisor that combines largely automated online advice with some human contact and intervention. VPAS is a bigger deal than Vanguard’s understated advertising would have you believe. VPAS effectively acts like an “index” for the financial advice business. Why go with some random Edward Jones or Raymond James schmuck who charges 1% or more when you can go with Vanguard and get advice that will almost guarantee a superior result over the long run?

VPAS’s growth has been explosive. After two years in beta, VPAS had over $10 billion by the end of 2014. By June-end it had around $22 billion, with about $10 billion of that  growth from the transfer of assets from Vanguard’s traditional financial advisory unit. This already makes Vanguard one of the biggest and fastest growing registered investment advisors in the nation. It dwarfs start-up robo-advisors Betterment and Wealthfront, which have around $2.5 billion and $2.6 billion in assets, respectively.

Abroad, Vanguard’s growth opportunities look even better. Passive management’s market share is still in the single digits in many markets and the margins from asset management are even fatter. Vanguard has established subsidiaries in Australia, Canada, Europe and Hong Kong. They are among the fastest-growing asset managers in their markets.

The arithmetic of active management means over time Vanguard’s passive funds will outperform active investors as a whole. Vanguard’s cost advantages are so big in some markets its funds are among the top performers.

Critics like James Grant, editor of Grant’s Interest Rate Observer, think passive investing is too popular. Grant argues investing theories operate in cycles, where a good idea transforms into a fad that inevitably collapses under its own weight. But passive investing is special. Its capacity is practically unlimited. The theoretical limit is the point at which markets become so inefficient that price discovery is impaired and it becomes feasible for a large subset of skilled retail investors to outperform (the less skilled investors would lose even more money more quickly in such an environment—the arithmetic of active management demands it). However, passive investing can make markets more efficient if investors opting for index funds are largely novices rather than highly trained professionals. A poker game with fewer patsies means the pros have to compete with each other.

There are some problems with passive investing. Regularities in assets flows due to index-based buying and selling has created profit opportunities for clever traders. Stocks added to and deleted from the S&P 500 and Russell 2000 indexes experience huge volumes of price-insensitive trading driven by dumb, blind index funds. But these problems can be solved by smart fund management, better index construction (for example, total market indexes) or greater diversity in commonly followed indexes.

Why Vanguard May Not Take Over the World

I’m not imaginative or smart enough to think of all the reasons why Vanguard will fail in its global conquest, but a few risks pop out.

First is Vanguard’s relative weakness in institutional money management (I may be wrong on this point). BlackRock is still top dog thanks to its fantastic institutional business. Vanguard hasn’t ground BlackRock into dust because expense ratios for institutional passively managed portfolios approach zero. Successful asset gatherers offer ancillary services and are better at communicating with and servicing the key decision makers. BlackRock pays more and presumably has better salespeople. Vanguard is tight with money and so may not be willing or able to hire the best salespeople.

Second, Vanguard may make a series of strategic blunders under a bad CEO enabled by an incompetent and servile board. I have the greatest respect for Bill McNabb and Vanguard’s current board, but it’s possible his successors and future boards could be terrible.

Third, Vanguard may be corrupted by insiders. There is a long and sad history of well-meaning organizations that are transformed into personal piggybanks for the chief executive officer and his cronies. Signs of corruption include massive payouts to insiders and directors, a reversal of Vanguard’s long-standing pattern of lowering fees, expensive acquisitions or projects that fuel growth but do little to lower fees for current investors (for example, a huge ramp up in marketing expenditures), and actions that boost growth in the short-run at the expense of Vanguard’s brand.

Fourth, Vanguard may experience a severe operational failure, such as a cybersecurity hack, that damages its reputation or financial capacity.

Individually and in total, these risks seem manageable and remote to me. But I could be wrong.

Summary

• Vanguard’s rapid growth will continue for years as it benefits from three mutually reinforcing advantages: mutual ownership structure where profits flow back to fund investors in the form of lower expenses, first-mover advantage in index funds, and a powerful brand cultivated by a culture that places the investor first.
• Future growth markets are huge: Vanguard has subsidiaries in Australia, Canada, Hong Kong and Europe. These markets are much less competitive than the U.S., have higher fees and lower penetration of passive investing. Arithmetic of active investing virtually guarantees Vanguard funds will have a superior performance record over time.
• Vanguard Personal Advisor Services VPAS stands a good chance of becoming the “index” for financial advice. Due to fee advantages and brand, VPAS may be able to replicate the runaway growth Vanguard is experiencing in ETFs.
• Limits to passive investing are overblown; Vanguard still has lots of runway.
• Vanguard may wreck its campaign of global domination through several ways, including lagging in institutional money management, incompetence, corruption, or operational failure.

Needles, haystacks and grails

By Leigh Walzer, principal of Trapezoid LLC.

The Holy Grail of mutual fund selection is predictive validity. In other words, does a positive rating today predict exceptional performance in the future? Jason Zweig of The Wall Street Journal recently cited an S&P study which found three quarters of active mutual funds fail to beat their benchmark over the long haul.

We believe it’s possible, with a reasonable degree of predictive validity, to identify the likelihood a manager will succeed in the future. Trapezoid’s Orthogonal Attribution Engine (OAE) searches for the proverbial needles in a haystack: portfolio managers who exhibit predictable skill, and particularly those who justify based on a statistical analysis paying the higher freight of an active fund. In today’s case only 1 fund has predictable skill, and none justify their expenses. In general fewer than 5% of funds meet our criteria.

One of our premises is that managers who made smart decisions in the past tend to continue and vice versa. We try to break out the different types of decisions that managers have to make (e.g., selecting individual securities, sectors to overweight or currency exposure to avoid). Our system works well based on “back testing;” that is, sitting here in 2015, constructing models of what funds looked like in the past and then seeing if we could predict forward. We have published the results of back-testing, available on our website. (Go to www.fundattribution.com, demo registration required, free to MFO readers.) Using data through July 2014, historical stock-picking skill predicted skill for the subsequent 12 months with 95% confidence. Performance over the past 5 years received the most weight but longer term results (when available) were also very important. We got similar results predicting sector-rotation skills. We repeated the tests using data through July 2013 and got nearly identical results.

We are also publishing forward looking predictions (for large blend funds) to demonstrate this point.

The hard part is measuring skill accurately. The key is to analyze portfolio weightings and characteristics over time. We derive this using both historic funds holdings data and regression/inference, supported by data on individual securities.

Here’s your challenge: you need to decide how high the chances of success need to be to justify choosing a higher-cost option in your portfolio. Should managers with great track records command a higher fee? Yes, with caveats. Although the statistical relationship is solid, skill predictions tend to be fairly conservative. This is a function of the inherent uncertainty about what the future will bring.

The confidence band around individual predictions is fairly wide. The noise level varies: some funds have longer and richer history, more consistent display of skill, longer manager tenure, better data, etc. The less certain we are the past will repeat, the less we should be willing to pay a manager with a great track record. In theory we might be willing to hire a manager if we have 51% confidence he will justify his fees, but investors may want a margin of safety.

Let’s look at some concrete examples of what that means. We are going to illustrate this month with utility funds. Readers who register at the FundAttribution website will be able to query individual funds and access other data. I do not own any of the funds discussed in this piece

Active utility funds are coming off a tough year. The average fund returned only 2.2% in the year ending July 31, 2015; that’s signaled by the “gross return” for the composite at the bottom of the fourth column. Expenses consumed more than half of that. This sector has faced heavy redemptions which may intensify as the Fed begins to taper.

FundAttribution tracks 15 active utility funds. (We also follow 2 rules-based funds and 30 active energy infrastructure funds.) We informally cluster them into three groups:

TABLE 1: Active Utility Funds. Data as of July 31, 2015

*”Predict” is our extrapolation of skill for the 12 months ending July 2016

The Conservative funds tend to stick to their knitting with 70-90% exposure to traditional utilities, <10% foreign exposure, and beta of under 60%. The Aggressive funds are the most adventurous in pursuing related industries and foreign stocks; their beta is 85% (boosted for Duff & Phelps by leverage).

Without being too technical, the OAE determines a target return for each fund each period based on all its characteristics. The difference between gross return and the target equals skill. Skill can be further decomposed into components (e.g. sector selection (sR) vs security selection (sS.) For today’s discussion skill will mean the combination of sR and sS. Here’s how to read the table above: the managers at Franklin Utilities – a huge Morningstar “gold” fund – did slightly better than a passive manager over the past year (before expenses) and underperformed for the past three and five years. We anticipate that they’re going to slightly underperform a passive alternative in the year ahead. That’s better than our system predicts for, say, Fidelity, Putnam or Gabelli but it’s still no reason to celebrate.

In the aggregate these funds have below average beta, moderate non-US exposure, value tilt and a slight midcap bias. The OAE’s target return for the sector over the last year is 6.3%, so the basket of active utility funds had skill of-3.7%. Only two of the 15 funds had positive skill. Negative overall skill means that investors could have chosen other sectors with similar characteristics which produced better returns.

The 2014 energy shock was a major contributing factor. These funds allocated on average only 60-70% to regulated electric and gas generation and distribution. Much of the balance went to Midstream Energy, Merchant Power, Exploration & Production, and Telecom. Those decisions explain most of the difference among funds. Funds which stayed close to home (Icon, Franklin, Rydex, and Putnam) navigated this environment best.

Security selection moved the needle at a few funds. Prudential Jennison stuck to S&P500 components but did a good job overweighting winners. Duff & Phelps had some dreadful performers in its non-utility portfolio.

Skill last year for the two Fidelity funds was impacted by volatile returns which may reflect increased risk-taking.

We use the historic skill to predict next year’s skill. Success over the past 5 years carries the most weight, but we look at managers’ track record, consistency, and trends over their entire tenure.

The predicted skill for next year falls within a relatively tight range: Prudential has the highest skill at 0.8%, Gabelli has the lowest at -1.4%. Either the difference between best and worst in this sector is not that great or our model is not sufficiently clairvoyant.

Either way, these findings don’t excite us to pay 120bps, which is the typical expense ratio in this sector. The OAE rates the probability a fund’s skill this year will justify the freight. Cost in the chart below is the differential between the expense ratio of a fund class and the ~15bp you would pay for a passive utility fund. This analysis varies by share class, the table below shows one representative class for each fund.

We look for funds with a probability of at least 60%, and (as shown in Table 2) none of the active funds here come close. Here’s how to read the table: our system predicts that Franklin Utilities will underperform by 0.2% over the next 12 years but that number is the center of a probable performance band that’s fairly wide, so it could outperform over the next year. Given its expenses of 60 basis points, how likely are they to pull it off? They have about a 40% chance of it to which we’d say, “not good enough.”

TABLE 2

The bottom line: We can’t recommend any of these funds. Franklin might be the least bad choice based on its low fees. Prudential Jennison (PCUFX) has shown flashes of replicable stock picking skill; they would be more competitive if they reduced fees.

Duff & Phelps (DPG) merits consideration. At press time this closed end fund trades at a 15% discount to NAV. This is arguably more than required to compensate investors for the high expenses. The fund is more growth-oriented than the peer group, runs leverage of 1.28x, and maintains significant foreign exposure. There is a 9% “dividend yield;” however, performance last year and over time was dreadful, the dividend does not appear sustainable, and the prospect of rising rates adds to the negative sentiment. So, the timing may not be right.

We show the Morningstar ratings of these funds for comparison. We don’t grade on a curve and from our perspective none of the funds deserve more than 3 stars. Investors looking for such exposure might improve their odds by buying and holding Vanguard Utilities ETF (VPU) with its 0.12% expense ratio or Utilities Select Sector SPDR (XLU)

It is hard for active utility funds to generate enough skill to justify their cost structure. The conservative funds have more or less matched passive indices, so why pay an extra 60 bps. The funds which took on more risk have a mixed record, and their fee structures tend to be even higher.

 Perhaps the industry has recognized this: outflows from actively-managed utility funds have accelerated to double digits over the past 2.5 years and the share of market held by passive funds has increased steadily. A number of industry players have repositioned their utility funds as dividend income funds or merged them into other strategies.

Next month: we will apply the same techniques to large blend funds where we hope to find a few active managers worthy of your attention

Investors who want a sneak preview (of the predicted skill by fund) can register at www.fundattribution.com and click the link near the bottom of the Dashboard page.

Your feedback is welcome at [email protected].

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized, searchable, and filtered as never before. For the complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

Orders

• In the first case brought under the agency’s distribution-in-guise initiative, the SEC charged First Eagle and its affiliated fund distributor with improperly using mutual fund assets to pay for the marketing and distribution of fund shares. (In re First Eagle Inv. Mgmt., LLC.)
• In the purported class action by direct investors in Northern Trust‘s securities lending program, the court struck defendants’ motion for summary judgment without prejudice. (La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)
• Adopting a Magistrate Judge’s recommendation, a court granted Nuveen‘s motion to dismiss a securities fraud lawsuit regarding four closed-end bond funds affected by the 2008 collapse of the market for auction rate preferred securities. Defendants included the independent chair of the funds’ board. (Kastel v. Nuveen Invs. Inc.)

New Lawsuits

• Alleging the same fee claim but for a different damages period, plaintiffs filed a second “anniversary complaint” in the fee litigation regarding six Principal target-date funds. The litigation has previously survived defendants’ motion to dismiss. (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal Mgmt. Corp.)
• Investment adviser Sterling Capital is among the defendants in a new ERISA class action that challenges the selection of proprietary funds for its parent company’s 401(k) plan. (Bowers v. BB&T Corp.)

Briefs

• Calamos filed a reply brief in support of its motion to dismiss fee litigation regarding its Growth Fund. (Chill v. Calamos Advisors LLC.)
• In the ERISA class action regarding Fidelity‘s practices with respect to “float income” generated from transactions in retirement plan accounts, plaintiffs filed their opening appellate brief in the First Circuit, seeking to reverse the district court decision granting Fidelity’s motion to dismiss. The U.S. Secretary of Labor filed an amicus brief in support of plaintiffs, arguing that ERISA prohibits fiduciaries from using undisclosed float income obtained through plan administration for any purpose other than to benefit the ERISA-covered plan. (Kelley v. Fid. Mgmt. Trust Co.)

The Alt Perspective: Commentary and news from DailyAlts

I think it would be safe to say that most of us are happy to see the third quarter come to an end. While a variety of issues clearly remain on the horizon, it somehow feels like the potholes of the past six weeks are a bit more distant and the more joyous holiday season is closing in. Or, it could just be cognitive biases on my part.

Either way, the numbers are in. Here is a look at the 3rd Quarter performance for both traditional and alternative mutual fund categories as reported by Morningstar.

• Large Blend U.S. Equity: -7.50%
• Foreign Equity Large Blend: -10.37
• Intermediate Term Bond: 0.32%
• World Bond: -1.22%
• Moderate Allocation: -5.59%

Anything with emerging markets suffered even more. Now a look at the liquid alternative categories:

• Long/Short Equity: -4.44
• Non-Traditional Bonds: -1.96%
• Managed Futures: 0.38%
• Market Neutral: -0.26
• Multi-Alternative: -3.05
• Bear Market: 13.05%

And a few non-traditional asset classes:

• Commodities: -14.38%
• Multi-Currency: -3.35%
• Real Estate: 1.36%
• Master Limited Partnerships: -25.73%

While some media reports have questioned the performance of liquid alternatives over the past quarter, or during the August market decline, they actually have performed as expected. Long/short funds outperformed their long-only counterparts, managed futures generated positive performance (albeit fairly small), market neutral funds look fairly neutral with only a small loss on the quarter, and multi-alternative funds outperformed their moderate allocation counterparts.

The one area in question is the non-traditional bond category where these funds underperformed both traditional domestic and global bond funds. Long exposure to riskier fixed income asset would certainly have hurt many of these funds.

Declining energy prices zapped both the commodities and master limited partnerships categories, both of which had double-digit losses. Surprisingly, real estate held up well and there is even talk of developers looking to buy-back REITs due to their low valuations.

Let’s take a quick look at asset flows for August. Investors continued to pour money into managed futures funds and multi-alternative funds, the only two categories with positive inflows in every month of 2015. Volatility also got a boost in August as the CBOE Volatility Index spiked during the month. The final category to gather assets in August was commodities, surprisingly enough.

A few research papers of interest this past month:

PIMCO Examines How Liquid Alternatives Fit into Portfolios – this is a good primer on liquid alternatives with an explanation of how evaluated and use them in a portfolio.

The Path Forward for Women in Alternatives – this is an important paper that documents the success women have had in the alternative investment business. While there is much room for growth, having a study to outline the state of the current industry helps create more awareness and attention on the topic.

Investment Strategies for Tough Times – AQR provides a review of the 10 worst quarters for the market since 1972 and shows which investment strategies performed the best (and worst) in each of those quarters.

And finally, there were two regulatory topics that grabbed headlines this past month. The first was an investor alert issued by FINRA regarding “smart beta” product. Essentially, FINRA wanted to warn investors that not all smart beta products are alike, and that many different factors drive their returns. Essentially, buyer beware. The second was from the SEC who is proposing new liquidity rules for mutual funds and ETFs. One of the more pertinent rules is that having to do with maintain a three-day liquid asset minimum that would likely force many funds to hold more cash, or cash equivalents. This proposal is now in the 90-day comment period.

Have a great October and we will talk again (in this virtual way) just after Halloween! Let’s just hope the Fed doesn’t have any tricks up their sleeve in the meantime.

Elevator Talk: Michael Underhill, Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX)

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.

Michael Underhill manages INNAX, which launched at the end of September 2012. Mr. Underhill worked as a real asset portfolio manager for AllianceBernstein and INVESCO prior to founding Capital Innovations in 2007. He also manages about $170 million in this same strategy through separate accounts and four funds available only to Canadian investors.

Assets can be divided into two types: real and financial. Real assets are things you can touch: gold, oil, roads, bridges, soybeans, and lumber. Financial assets are intangible; stocks, for example, represent your hypothetical fractional ownership of a corporation and your theoretical claim to some portion of the value of future earnings.

Most individual portfolios are dominated by financial assets. Most institutional portfolios, however, hold a large slug of real assets and most academic research says that the slug should be even larger than it is.

Why so? Real assets possess four characteristics that are attractive and difficult to achieve.

They thrive in environments hostile to stocks and bonds. Real assets are positively correlated with inflation, stocks are weakly correlated with inflation and bonds are negatively correlated. That is, when inflation rises, bonds fall, stocks stall and real assets rise.

They are uncorrelated with the stock and bond markets. The correlation of returns for the various types of real assets hover somewhere just above or just below zero with relation to both the stock and bond market.

They are better long term prospects than stocks or bonds. Over the past 10- and 20-year periods, real assets have produced larger, steadier returns than either stocks or bonds. While it’s true that commodities have cratered of late, it’s possible to construct a real asset portfolio that’s not entirely driven by commodity prices.

A portfolio with real assets outperforms one without. The research here is conflicted. Almost everything we’ve read suggests that some allocation to real assets improves your risk-return profile. That is, a portfolio with real assets, stocks and bonds generates a greater return for each additional unit of risk than does a pure stock/bond portfolio. Various studies seem to suggest a more-or-less permanent real asset allocation of between 20-80% of your portfolio. I suspect that the research oversimplifies the situation since some of the returns were based on private or illiquid investments (that is, someone buying an entire forest) and the experience of such investments doesn’t perfectly mirror the performance of liquid, public investments.

Inflation is not an immediate threat but, as Mr. Underhill notes, “it’s a lot cheaper to buy an umbrella on a sunny day than it is once the rain starts.” Institutional investors, including government retirement plans and university endowments, seem to concur. Their stake in real assets is substantial (14-20% in many cases) and growing (their traditional stakes, like yours, were negligible).

INNAX has performed relatively well – in the top 20% of its natural resources peer group – over the past three years, aided by its lighter-than-normal energy stake. The fund is down about 5% since inception while its peers posted a 25% loss in the same period. The fund is fully invested, so its outperformance cannot be ascribed to sitting on the sidelines.

Here are Mr. Underhill’s 200 words on why you should add INNAX to your due-diligence list:

There was no question about what I wanted to invest in. The case for investing in real assets is compelling and well-established. I’m good at it and most investors are underexposed to these assets. So real asset management is all we do. We’re proud to say we’re an inch wide and a mile deep.

The only question was where I would be when I made those investments. I’ve spent the bulk of my career in very large asset management firms and I’d grown disillusioned with them. It was clear that large fund companies try to figure out what’s going to raise the most in terms of fees, and so what’s going to bring in the most fees. The strategies are often crafted by senior managers and marketing people who are concerned with getting something trendy up and out the door fast. You end up managing to a “product delivery specification” rather than managing for the best returns.

I launched Capital Innovations because I wanted the freedom and opportunity to serve clients and be truly innovative; we do that with global, all-cap portfolios that strive to avoid some of the pitfalls – overexposure to volatile commodity marketers, disastrous tax drags – that many natural resources funds fall prey to. We launched our fund at the request of some of our separate account clients who thought it would make a valuable strategy more broadly available.

Capital Innovations Global Agri, Timber, Infrastructure Fund has a $2500 minimum initial investment which is reduced to $500 for IRAs and other types of tax-advantaged accounts. Expenses are capped at 1.50% on the investor shares and 1.25% for institutional shares, with a 2.0% redemption fee on shares sold within 90 days. There’s a 5.75% front load that’s waived on some of the online platforms (e.g., Schwab). The fund has about gathered about $7 million in assets since its September 2012 launch. Here’s the fund’s homepage. It’s understandably thin on content yet but there’s some fairly rich analysis on the Capital Innovations page devoted to the underlying strategy. Our friends at DailyAlts.com interviewed Mr. Underhill in December 2014, and he laid out the case for real assets there. An exceptionally good overview of the case for real asset investing comes from Brookfield Asset Management, in Real Assets: The New Essential (2013) though everyone from TIAA-CREF to NACUBO have white papers on the subject.

My retirement portfolio has a small but permanent niche for real assets, which T. Rowe Price Real Assets (PRAFX) and Fidelity Strategic Real Return (FSRRX) filling that slot.

Launch Alert: Thornburg Better World

Earlier this summer, we argued that “doing good” and “doing well” were no longer incompatible goals, if they ever were. A host of academic and professional research has demonstrated that sustainable (or ESG) investing does not pose a drag on portfolio performance. That means that investors who would themselves never sell cigarettes or knowing pollute the environment can, with confidence, choose investing vehicles that honor those principles.

The roster of options expanded by one on October 1, with the launch of Thornburg Better World International Fund (TBWAX).  The fund will target “high-quality, attractively priced companies making a positive impact on the world.” That differs from traditional socially-responsible investments which focused mostly on negative screens; that is, they worked to exclude evil-doers rather than seeking out firms that will have a positive impact.

They’ll examine a number of characteristics in assessing a firm’s sustainability: “environmental impact, carbon footprint, senior management diversity, regulatory and compliance track record, board independence, capital allocation decisions, relationships with communities and customers, product safety, labor and employee development practices, relationships with vendors, workplace safety, and regulatory compliance, among others.”

The fund is managed by Rolf Kelly, CFA, portfolio manager of Thornburg’s Socially Screened International Equity Strategy (SMA). The portfolio will have 30-60 names. The initial expense ratio is 1.83%. The minimum initial investment is $5000.

Funds in Registration

There are seven new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase in December.

While the number is small, many of them represent new offerings from “A” tier shops: DoubleLine Global Bond, Matthews Asia Value and two dividend-oriented international index funds from Vanguard

Manager Changes

Give or take Gary Black’s departure from Calamos, there were about 46 mostly low-visibility shifts in teams.

Thinking outside the model is hazardous to one’s wealth…

The title comes from the AlphaArchitect’s DIY Investing site, which is led by Wesley Gray. We profiled the firm’s flagship ValueShares US Quantitative Value ETF (QVAL) last December. Wes, along with Jack Vogel and David Foulke, recently published the Wiley Finance Series book, “DIY Finanical Advisor – A Simple Solution to Build and Protect Your Wealth.” It’s a great read.

It represents a solid answer to the so-called “return gap” problem described by Jason Hsu of Research Associates during Morningstar’s ETF Conference yesterday. Similar to and inspired by Morningstar’s “Investor Return” metric, Jason argues that investors’ bad decisions based on performance chasing and bad timing account for a 2% annualized short-fall between a mutual fund’s long-term performance and what investors actually receive. (He was kind enough to share his briefing with us, as well as his background position paper.)

“Investors know value funds achieve a premium, but they are too undisciplined to stay the course once the value fund underperforms the market.” It’s not just retail investors, Jason argues the poor behavior has actually been institutionalized and at some level may be worse for institutional investors, since their jobs are often based on short-term performance results.

DIY Financial Advisor opens by questioning society’s reliance on “expert opinion,” citing painful experiences of Victor Niederhoffer, Meredith Whitney, and Jon Corzine. It attempts to explain why financial experts often fail, due various biases, overconfidence, and story versus evidence-based decisions. The book challenges so-called investor myths, like…

• Buffett’s famous advice: “It’s far better to buy a wonderful company at a fair price than a fair company at the wonderful price.”
• Economic growth drives stock returns.
• Payout superstition, where observers predict that lower-dividend payout ratios imply higher earnings growth.

In order to be good investors, the book suggests that we need to appreciate our natural preference for coherent stories over evidence that conflicts with the stories. Don’t be the pigeon doing a “pellet voodoo dance.”

It advocates adoption of simple and systematic investment approaches that can be implemented by normal folks without financial background. The approaches may not be perfect, but they have been empirically validated, like the capture of value and momentum premiums, to work “for a large group of investors seeking to preserve capital and capture some upside.”

Wes details how and why Harry Markowitz, who won the Nobel Prize in 1990 for his groundbreaking work in portfolio selection and modern portfolio theory, used a simple equal-weight 50/50 allocation between bond and equities when investing his own money.

The book alerts us to fear, greed, complexity, and fear tactics employed by some advisors and highlights need for DIY investors to examine fees, access/liquidity, complexity, and taxes when considering investment vehicles.

It concludes by stating that “as long as we are disciplined and committed to a thoughtful process that meets our goals, we will be successful as investors. Go forth and be one of the few, one of the proud, one of the DIY investors who took control of their hard-earned wealth. You won’t regret the decision.”

As with Wes’ previous book, Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, DIY Financial Advisor is chock full of both anecdotes and analytical results. He and his team at AlphaArchitect continue to fight the good fight and we investors remain the beneficiaries.

Briefly Noted . . .

I hardly know how to talk about this one. Gary Black is “no longer a member of the investment team managing any of the series of the Calamos Investment Trust other than the Calamos Long/Short Fund … all references to Mr. Black’s position of Global Co-CIO and his involvement with all other series of the Calamos Investment Trust except for the Calamos Long/Short Fund shall be deemed deleted from the Summary Prospectuses, Prospectuses, and Statement of Additional Information of the Calamos Investment Trust.” In addition, Mr. Black ceased managing the fund that he brought to the firm, Calamos Long/Short (CALSX), on September 30, 2015. Mr. Black’s fund had about $100 million in assets and perfectly reasonable performance. The announcement of Mr. Black’s change of status was “effectively immediately,” which has rather a different feel than “effective in eight weeks after a transition period” or something similar.

Mr. Black came to Calamos after a tumultuous stint at the Janus Funds. Crain’s Chicago Business reports that Mr. Black “expanded the Calamos investment team by 50 percent, adding 25 investment professionals, and launched four funds,” but was not necessarily winning over skeptical investors.  The firm had $23.2 billion in assets under management at the end of August, 2015. That’s down from $33.4 billion on June 30, 2012, just before his hiring.

He leaves after three years, a Calamos rep explained, because he “completed the work he was hired to do. With John’s direction, he helped expand the investment teams and create specialized teams. During the past 18 months, performance has improved, signaling the evolution of the investment team is working.” Calamos, like PIMCO, is moving to a multiple CIO model. When asked if the experience of PIMCO after Gross informed their decision, Calamos reported that “We’ve extensively researched the industry overall and believe this is the best structure for a firm our size.”

“Mr. Black’s future plans,” we’ve been told, “are undecided.”

Toroso Newfound Tactical Allocation Fund (TNTAX) is a small, expensive, underperforming fund-of-ETFs. Not surprisingly, it was scheduled for liquidation. Quite surprisingly, at the investment advisor’s recommendation, the fund’s board reversed that decision and reopened the fund to new investors.  No idea of why.

Thanks, as always, to The Shadow for his help in tracking publicly announced but often little-noticed developments in the fund industry. Especially in month’s like the one just passed, it’s literally true that we couldn’t do it without his assistance. Cheers, big guy!

SMALL WINS FOR INVESTORS

Artisan Global Value Fund (ARTGX) reopened to new investors on October 1, 2015. I’m not quite sure what to make of it. Start with the obvious: it’s a splendid fund. Five stars. A Morningstar “Silver” fund. A Great Owl. Our profiles of the fund all ended with the same conclusion: “Bottom Line: We reiterate our conclusion from 2008, 2011 and 2012: ‘there are few better offerings in the global fund realm.’” That having been said, the fund is reopening with $1.6 billion in assets. If Morningstar’s report is to be trusted, assets grew by $700 million in the past 30 days. The fund is just one manifestation of Artisan’s Global Value strategy so one possible explanation is that Artisan is shifting assets around inside the $16 billion strategy, moving money from separate accounts into the fund. And given market volatility, the managers might well see richer opportunities – or might anticipate richer opportunities in the months ahead.

Effective September 15, 2015, the Westcore International Small-Cap Fund (the “Fund”) will reopen to new investors.

CLOSINGS (and related inconveniences)

Effective September 30, 361 Managed Futures Strategy Fund (AMFQX) closed to new investors.  It’s got about a billion in assets and a record that’s dramatically better than its peers’.

Artisan International Fund (ARTIX) will soft-close on January 29, 2016. The fund is having a tough year but has been a splendid performer for decades. The key is that it has tripled in size, to $18 billion, in the past four years, driven by a series of top-tier performances.

As of the close of business on October 31, 2015, Catalyst Hedged Futures Strategy Fund (HFXAX) will close to “substantially all” new investors.

Glenmede Small Cap Equity Portfolio (GTCSX) closed to new investors on September 30^th, on short notice. The closure also appears to affect current shareholders who purchased the fund through fund supermarkets.

OLD WINE, NEW BOTTLES

Aberdeen U.S. Equity Fund

Effective October 31, 2015, the name of the Aberdeen U.S. Equity Fund will change to the Aberdeen U.S. Multi-Cap Equity Fund.

Ashmore Emerging Markets Debt Fund will change its name to Ashmore Emerging Markets Hard Currency Debt Fund on or about November 8, 2015

Columbia Marsico Global Fund (COGAX) is jettisoning Marsico (that happens a lot) and getting renamed Columbia Select Global Growth Fund.

Destra Preferred and Income Securities Fund (DPIAX) has been renamed Destra Flaherty & Crumrine Preferred and Income Fund.

Dividend Plus+ Income Fund (DIVPX) has changed its name to MAI Managed Volatility Fund.

Forward Dynamic Income Fund (FDYAX) and Forward Commodity Long/Short Strategy Fund (FCOMX) have both decided to change their principal investment strategies, risks, benchmark and management team, effective November 3.

KKM U.S. Equity ARMOR Fund (UMRAX) terminated Equity Armor’s advisory contract. KKM Financial will manage the fund, now called KKM Enhanced U.S. Equity Fund (KKMAX) on its own

Effective September 10, 2015, the Pinnacle Tactical Allocation Fund change its name to the Pinnacle Sherman Tactical Allocation Fund (PTAFX).

At an August meeting, the Boards of the Wells Fargo Advantage Funds approved removing the word “Advantage” from its name, effective December 15, 2015.

Royce 100 Fund (RYOHX) was renamed Royce Small-Cap Leaders Fund on September 15, 2015. The new investment strategy is to select “securities of ‘leading’ companies—those that in its view are trading at attractive valuations that also have excellent business strengths, strong balance sheets, and/or improved prospects for growth, as well as those with the potential for improvement in cash flow levels and internal rates of return.” Chuck Royce has run the fund since 2003. It was fine through the financial crisis, and then began stumbling during the protracted bull run and trails 98% of its peers over the past five years.

Effective November 20, 2015, Worthington Value Line Equity Advantage Fund (WVLEX) becomes Worthington Value Line Dynamic Opportunity Fund. The fund invests, so far with no success, mostly in closed-end funds. It’s down about 10% since its launch in late January and the pass-through expenses of the CEFs it holds pushes the fund’s e.r. to nearly 2.5%. At that point its investment objective becomes the pursuit of “capital appreciation and current income” (income used to be “secondary”) and Liane Rosenberg gets added as a second manager joining Cindy Starke. Rosenberg is a member of the teams that manage Value Line’s other funds and, presumably, she brings fixed-income expertise to the table. The CEF universe is a strange and wonderful place, and part of the fund’s wretched performance so far (it’s lost more than twice as much since launch than the average large cap fund) might be attributed to a stretch of irrational pricing in the CEF market. Through the end of August, equity CEFs were down 12% YTD in part because their discounts steadily widened. WVLEX was also handicapped by an international stake (21%) that was five times larger than their peers. That having been said, it’s still not clear how the changes just announced will make a difference.

OFF TO THE DUSTBIN OF HISTORY

AB Market Neutral Strategy-U.S. (AMUAX) has closed and will liquidate on December 2, 2015. The fund has, since inception, bounced a lot and earned nothing: $10,000 at inception became $9,800 five years later.

Aberdeen High Yield Fund (AUYAX) is yielding to reality – it is trailing 90% of its peers and no one, including its trustees and two of its four managers, wanted to invest in it – and liquidating on October 22, 2015.

Ashmore Emerging Markets Currency Fund (ECAX), which is surely right now a lot like the “Pour Molten Lava on my Chest Fund (PMLCX), will pass from this vale of tears on October 9, 2015.

The small-and-dull, but not really bad, ASTON/TAMRO Diversified Equity Fund (ATLVX) crosses into the Great Unknown on Halloween. It’s a curious development since the same two managers run the half billion dollar Small Cap Fund (ATASX) that’s earned Morningstar’s Silver rating.

BlackRock Ultra-Short Obligations Fund (BBUSX): “On or about November 30, 2015,all of the assets of the Fund will be liquidated completely.” It’s a perfectly respectable ultra-short bond fund, with negligible volatility and average returns, that only drew $30 million. For a giant like BlackRock, that’s beneath notice.

At the recommendation of the fund’s interim investment adviser, Cavalier Traditional Fixed Income Fund (CTRNX) will be liquidated on October 5, 2015. Uhhh … yikes!

Dreyfus International Value Fund (DVLAX) is being merged into Dreyfus International Equity Fund (DIEAX). On whole, that’s a pretty clean win for the DVLAX shareholders.

Eaton Vance Global Natural Resources Fund (ENRAX) has closed and will liquidate on or about Halloween.  $4 million dollars in a portfolio that’s dropped 41% since launch, bad even by the standards of funds held hostage to commodity prices.

Shareholders have been asked to approve liquidation of EGA Frontier Diversified Core Fund (FMCR), a closed-end interval fund. Not sure how quickly the dirty deed with be done.

Fallen Angels Value Fund (FAVLX) joins the angels on October 16, 2015.

The termination and liquidation the Franklin Global Allocation Fund (FGAAX), which was scheduled to occur on or about October 23, 2015, has again been delayed due to foreign regulatory restrictions that prohibit the fund from selling one of its portfolio securities. The new liquidation target is January 14, 2016.

The $7 million Gateway International Fund (GAIAX) will liquidate on November 12, 2015. It’s an international version of the $7.7 billion, options-based Gateway Fund (GATEX) and is run by the same team. GAIAX has lost money since launch, and in two of the three years it’s been around, and trails 90% of its peers. Frankly, I’ve always been a bit puzzled by the worshipful attention that Gateway receives and this doesn’t really clear it up for me.

Inflation Hedges Strategy Fund (INHAX) has closed and will liquidate on October 22, 2015.

Janus Preservation Series – Global (JGSAX) will be unpreserved as of December 11, 2015.

Shareholders are being asked to merge John Hancock Fundamental Large Cap Core Fund (JFLAX) into John Hancock Large Cap Equity Fund TAGRX). The question will be put to them at the end of October. They should vote “yes.”

MFS Global Leaders (GLOAX) will liquidate on November 18, 2015.

Riverside Frontier Markets Fund ceased to exist on September 25, 2015 but the board assures us that the liquidation was “orderly.”

Salient Global Equity Fund (SGEAX) will liquidate around October 26, 2015.

Transamerica is proposing a rare reorganization of a closed-end fund (Transamerica Income Shares, Inc.) into one of their open-end funds, Transamerica Flexible Income (IDITX). The proposal goes before shareholders in early November.

MFO Switches To Lipper Database

In weeks ahead, MFO will begin using a Lipper provided database to compute mutual fund risk and return metrics found on our legacy Search Tools page and on the MFO Premium beta site.

Specifically, the monthly Lipper DataFeed Service provides comprehensive fund overview details, expenses, assets, and performance data for US mutual funds, ETFs, and money market funds (approximately 29,000 fund share classes).

Lipper, part of Thomson Reuters since 1998, has been providing “accurate, insightful, and timely collection and analysis of fund data” for more than 40 years. Its database extends back to 1960.

The methodologies MFO uses to compute its Great Owl funds, Three Alarm and Honor Roll designations, and Fund Dashboard of profiled funds will remain the same. The legacy search tool site will continue to be updated quarterly, while the premium site will be updated monthly.

Changes MFO readers can expect will be 1) quicker posting of updates, typically within first week of month, 2) more information on fund holdings, like allocation, turnover, market cap, and bond quality, and 3) Lipper fund classifications instead of the Morningstar categories currently used.

A summary of the Lipper classifications or categories can be found here. The more than 150 categories are organized under two main types: Equity Funds and Fixed Income Funds.

The Equity Funds have the following sub-types: US Domestic, Global, International, Specialized, Sector, and Mixed Asset. The Fixed Income Funds have: Short/Intermediate-Term U.S. Treasury and Government, Short/Intermediate-Term Corporate, General Domestic, World, Municipal Short/Intermediate, and Municipal General.

The folks at Lipper have been a pleasure to work with while evaluating the datafeed and during the transition. The new service supports all current search tools and provides opportunity for content expansion. The MFO Premium beta site in particular features:

• Selectable evaluation periods (lifetime, 20, 10, 5, 3, and 1 year, plus full, down, and up market cycles) for all risk and performance metrics, better enabling direct comparison.
• All share classes, not just oldest.
• More than twenty search criteria can be selected simultaneously, like Category, Bear Decile, and Return Group, plus sub-criteria. For example, up to nine individual categories may be selected, along with multiple risk and age characteristics.
• Compact, sortable, exportable search table outputs.
• Expanded metrics, including Peer Count, Recovery Time, and comparisons with category averages.

Planned content includes: fund rankings beyond those based on Martin ratio, including absolute return, Sharpe and Sortino ratios; fund category metrics; fund house performance ratings; and rolling period fund performance.

In Closing . . .

The Shadow is again leading the effort on MFO’s discussion board to begin cataloging capital gain’s announcements. Ten firms had year-end estimates out as of October 1. Last year’s tally on the board reached 160 funds. Mark Wilson’s Cap Gains Valet site is still hibernating. If Mark returns to the fray, we’ll surely let you know.

It’s hard to remember but, in any given month, 7000-8000 people read the Observer for the first time. Some will flee in horror, others will settle in. That’s my excuse for repeating the exhortation to bookmark MFO’s link to Amazon.com!  While we are hopeful that our impending addition of a premium site will generate a sustainable income stream to help cover the costs of our new data feed and all, Amazon still provides the bulk of our revenue. That makes our September 2015 returns, the lowest in more than two years, a bit worrisome.

The system is simple: (1) bookmark our link to Amazon. Better yet, set it as one of your browser’s “open at launch” tabs. (2) When you want to shop at Amazon, click on that link or use that tab.  You do not have to come to MFO and click on the link on your way to Amazon. You go straight there. On your address bar, you’ll see a bit of coding (encoding=UTF8&tag=mutufundobse-20) that lets Amazon know you’re using our link. (3) Amazon then contributes an amount equivalent to 5% or so of your purchase to MFO. You’re charged nothing since it’s part of their marketing budget. And we get the few hundred a month that allows us to cover our “hard” expenses.

I’m not allowed to use the link myself, so my impending purchases of Halloween candy (Tootsie Rolls and Ring Pops, mostly) and a coloring book (don’t ask), will benefit the music program at my son’s school.

Thanks especially to the folks who made contributions to the Observer this month.  That includes a cheerful wave to our subscribers, Greg and Deb, to the good folks at Cook & Bynum and at Focused Finances, to Eric E. and Sunil, both esteemed repeat offenders, as well as to Linda Who We’ve Never Met Before and Richard. To one and all, thanks! You made it a lot easier to have the confidence to sign the data agreement with Lipper.

We’ll look for you.

Dear friends,

They’re baaaaaack!

My students came rushing back to campus and, so far as I can tell, triggered some sort of stock market rout upon arrival. I’m not sure how they did it, but I’ve learned not to underestimate their energy and manic good spirits.

They’re a bright bunch, diverse in my ways. While private colleges are often seen as bastion of privilege, Augustana was founded to help the children of immigrants make their way in a new land. Really that mission hasn’t much changed in the past 150 years: lots of first-generation college students, lots of students of color, lots of kids who shared the same high school experience. They weren’t the class presidents so much as the ones who quietly worked to make sure that things got done.

It’s a challenge to teach them, not because they don’t want to learn but because the gulf between us is so wide. By the time they were born, I was already a senior administrator and a full-blown fuddy duddy. But we’re working, as always we do, to learn from each other. Humility is essential, both a sense of humor and cookies help.

Your first and best stop-loss order

The week’s events have convinced us that you all need to learn how to execute a stop-loss order to protect yourself in times like these. A stop-loss order is an automatic, pre-established command which kicks in when markets gyrate and which works to minimize your losses. Generally they’re placed through your broker (“if shares of X fall below $12/share, sell half my holdings. If it falls below $10, liquidate the position”) but an Observer Stop Loss doesn’t require one. Here’s how it works:

• On any day in which the market falls by enough to make you go “sweet Jee Zus!”
• Step Away from the Media
• Put Down your Phone
• Unhand that Mouse
• And Do Nothing for seven days.

Well, more precisely, “do nothing with your portfolio.” You’re more than welcome to, you know, have breakfast, go to the bathroom, wonder what it’s going to take for anyone to catch the Cardinals, figure out what you’re going to do with that ridiculous pile of tomatoes and all that.

My Irish grandfather told me that the worst time to fix a leaky roof is in a storm. “You’ll be miserable, you might break your neck and you’ll surely make a hames of it.” (I knew what Gramps meant and didn’t get around to looking up the “hames” bit until decades later when I was listening to the thunder and staring at a growing damp spot in the ceiling.)

The financial media loves financial cataclysm to the same extent, and for the same reason, that The Weather Channel loves superstorms. It’s a great marketing tool for them. It strokes their egos (we are important!). And it drives ratings.

Really, did you think this vogue for naming winter storms came from the National Weather Service? No, no, no.  “Winter Storm Juno” was straight from the marketing folks at TWC.

If CNBC’s ratings get any worse, I’m guessing that we’ll be subjected to Market Downturn Alan soon enough.

By and large, coverage of the market’s recent events has been relentlessly horrible. Let’s start with the obvious: if you invested $10,000 into a balanced portfolio on August 18, on Friday, August 28 you had $9,660.

That’s it. You dropped 3.4%.

(Don’t you feel silly now?)

The most frequently-invoked word in headlines? “Bloodbath.”

MarketWatch: What’s next after market’s biggest bloodbath of the year ? (Apparently they’re annual events.)

ZeroHedge: US Market Bouncing Back After Monday’s Bloodbath (hmm, maybe they’re weekly events?)

Business Insider: Six horrific stats about today’s market bloodbath. (“Oil hit its lowest level since March 2009.” The horror, the horror!)

ZeroHedge: Bloodbath: Emerging Market Assets Collapse. (Ummm … a $10,000 investment in an emerging markets balanced fund, FTEMX in this case, would have “collapsed” to $9872 over those two weeks.)

RussiaToday: It’s a Bloodbath. (Odd that this is the only context in which Russia Today is willing to apply that term.)

By Google’s count, rather more than 64,000 market bloodbaths in the media.

Those claims were complemented by a number of “yeah, it could get a lot worse” stories:

NewsMax: Yale’s Shiller, “Even bigger” plunge may follow.

Brett Arends: Dow 5,000? Yes, it could happen. (As might a civilization-ending asteroid strike or a Cubs’ World Series win.)

Those were bookended with celebratory but unsubstantiated claims (WSJ: U.S. stock swings don’t shake investors; Barry Ritholz: Mom and pop outsmart Wall Street pros) that “mom ‘n’ pop” stood firm.

Bottom line: nothing you read in the media over the past couple weeks improved either your short- or long-term prospects. To the contrary, it might well have encouraged you (or your clients) to do something emotionally satisfying and financially idiotic. The markers of panic and idiocy abound: Vanguard had to do the “all hands on deck” drill in which portfolio managers and others are pulled in to manage the phone banks, Morningstar’s site repeatedly froze, the TD Ameritrade and Scottrade sites couldn’t execute customer orders, and prices of thousands of ETFs became unmoored from the prices of the securities they held. We were particularly struck by trading volume for Vanguard’s Total Stock Market ETF (VTI).

That’s a 600% rise from its average volume.

Two points:

1. Winter is coming. Work on your roof now!

   Some argue that a secular bear market started last week. (Some always say that.) Some serious people argue that a sharp jolt this year might well be prelude to a far larger disruption later next year. Optimists believe that we are on a steadily ascending path, although the road will be far more pitted than in recent memory.

   Use the time you have now to plan for those developments. If you looked at your portfolio and thought “I didn’t know it could be this bad this fast,” it’s time to rethink.

   Questions worth considering:

   • Are you ready to give up Magical Thinking yet? Here’s the essence of Magical Thinking: “Eureka! I’ve found it! The fund that makes over 10% in the long-term and sidesteps turbulence in the short-term! And it’s mine. Mine! My Preciousssss!” Such a fund does not exist in the lands of Middle-Earth. Stop expecting your funds to act as if they do.
   • Do you have more funds in your portfolio than you can explain? Did you look at your portfolio Monday and think, honestly puzzled, “what is that fund again?”
   • Do you know whether traditional hybrid funds, liquid alt funds or a slug of low-volatility assets is working better as your risk damper? Folks with either a mordant sense of humor or stunted perspective declared last week that liquid alts funds “passed their first test with flying colors.” Often that translated to: “held up for one day while charging 2.75% for one year.”
   • Have you allocated more to risky assets than you can comfortably handle? We’re written before about the tradeoffs embedded in a stock-light strategy where 70% of the upside for 50% of the downside begins to sound less like cowardice and more like an awfully sweet deal.
   • Are you willing to believe that the structure of the fixed income market will allow your bond funds to deliver predictable total returns (current income plus appreciation) over the next five to seven years? If critics are right, a combination of structural changes in the fixed-income markets brought on by financial reforms and rising interest rates might make traditional investment-grade bond funds a surprisingly volatile option.

   If your answer is something like “I dunno,” then your answer is also something like “I’m setting myself up to fail.” We’ll try to help, but you really do need to set aside some time to plan (goals –> resources –> strategies –>tactics) with another grown-up. Bring black coffee if you’re Lutheran, Scotch if you aren’t.

2. If you place your ear tightly against the side of any ETF, you’re likely to hear ticking.

   My prejudices are clear and I’ll repeat them here. I think ETFs are the worst financial innovation since the Ponzi scheme. They are trading vehicles, not investment vehicles. The Vanguard Total Stock Market ETF has no advantage over the Vanguard Total Stock Market Index fund (the tiny expense gap is consumed in trading costs) except that it can be easily and frequently traded. The little empirical research available documents the inevitable: when given a trading vehicle, investors trade. And (the vast majority of) traders lose.

   Beyond that, ETFs cause markets to move in lockstep: all securities in an ETF – the rock solid and the failing, the undervalued and the overpriced – are rewarded equally when investors purchase the fund. If people like small cap Japanese stocks, they bid up the price of good stocks and bad, cheap and dear, which distorts the ability of vigilantes to enforce some sort of discipline.

   And, as Monday demonstrates, ETFs can fail spectacularly in a crisis because the need for instant pricing is inconsistent with the demands of rational pricing. Many ETFs, CEFs and some stocks opened Monday with 20-30% losses, couldn’t coordinate buyers and sellers fast enough and that caused a computer-spawned downward price spiral. Josh Brown makes the argument passionately in his essay “Computers are the new dumb money” and followed it up with the perhaps jubilant report that some of the “quants I know told me the link was hitting their inboxes all day from friends and colleagues around the industry. A few desk traders I talk to had some anecdotes backing my assumptions up. One guy, a ‘data scientist’, was furiously angry, meaning he probably blew himself up this week.”

   As Chris Dietrich concludes in his August 29 Barron’s article, “Market Plunge Provides Harsh Lessons for ETF Investors”

   For long-term investors unsure of their trading chops, or if uncertainty reigns, mutual funds might be better options. Mutual fund investors hand over their money and let the fund company do the trading. The difference is that you get the end-of-day price; the price of an ETF depends on when you sold or bought it during the trading day. “There are benefits of ETFs, including transparency and tax efficiency, but those come at a cost, which is that is you must be willing to trade,” says Dave Nadig, director of ETFs at FactSet Research Systems. “If you don’t want to be trading, you should not be using ETFs.”

The week’s best

Jack Bogle, Buddhist. Jack Bogle: “I’ve seen turbulence in the market. This is not real turbulence. Don’t do something. Just stand there.” (Thanks for johnN for the link.) Vanguard subsequently announced, “The Inaction Plan.”

All sound and fury, signifying nothing. Jason Zweig: “The louder and more forcefully a market pundit voices his certainty about what is going to happen next, the more likely it is that he will turn out to be wrong.”

Profiting from others’ insanity

Anyone looking at the Monday, 8/24, opening price for, say, General Electric – down 30% within the first few seconds – had to think (a) that’s insanity and (b) hmmm, wonder if there’s a way to profit from it? It turns out that the price of a number of vehicles – stocks, a thousand ETFs and many closed-end funds – became temporarily unmoored from reality. The owners of many ETFs, for example, were willing to sell $10 worth of stock for $7, just to get rid of it.

The folks at RiverNorth are experts at arbitraging such insanity. They track the historical discounts of closed-end funds; if a fund becomes temporarily unmoored, they’ll consider buying shares of it. Why? Because when the panic subsides, that 30% discount might contract by two-thirds. RiverNorth’s shareholders have the opportunity to gain from that arbitrage, whether or not the general direction of the stock market is up or down.

I spoke with Steve O’Neill, one of RiverNorth’s portfolio managers, about the extent of the market panic. Contrary to the popular stories about cool-headed investors, Steve described them as “vomiting up assets” at a level he hadn’t seen since the depth of the financial meltdown when the stability of the entire banking sector was in question.

In 2014, RiverNorth reopened their flagship RiverNorth Core Opportunity (RNCOX) fund after a three-year closure. We’ll renew our profile of this one-of-a-kind product in our October issue. In the meanwhile, interested parties really should …

RiverNorth is hosting a live webcast with Q&A on September 17, 2015 at 3:15pm CT / 4:15pm ET. Their hosts will be Patrick Galley, CIO, Portfolio Manager, and Allen Webb, Portfolio Specialist. Visit www.rivernorth.com/events to register.

Update: Finding a family’s first fund 

In August, we published a short guide to finding a family first fund. We started with the premise that lots of younger (and many not-so-younger) folks were torn between the knowledge that they should do something and the fear that they were going to screw it up. To help them out, we talked about what to look for in a first fund and proposed three funds that met our criteria: solid long term prospects, a risk-conscious approach, a low minimum initial investment and reasonable expenses.

How did the trio do in August? Not bad.

 Several readers wrote to commend Manning & Napier Pro-Blend Conservative (EXDAX) as a great “first fund” candidate as well.  We entirely agree. Unlike TIAA-CREF and Vanguard, it invests in individual securities rather than other funds. Like them, however, it has a team-managed approach that reduces the risk of a fund going awry if a single person leaves. It has a splendid 20 year record. We’ve added it to our original guide and have written a profile of the fund, which you can get to below in our Fund Profiles section.

We Are Where We Are, Or, If The Dog Didn’t Stop To Crap, He Would Have Caught The Rabbit

“I prefer the company of peasants because they have not been educated sufficiently to reason incorrectly.”

               Michel de Montaigne

At this point in time, rather than focus on the “if only” questions that tend to freeze people in their tracks in these periods of market volatility, I think we should consider what is important. For most of us, indeed, the vast majority of us, the world did not end in August and it is unlikely to end in September.  Indeed, for most Americans and therefore by definition most of us, the vagaries of the stock market are not that important.

What then is important? A Chicago Tribune columnist, Mary Schmich, recently interviewed Edward Stuart, an economics professor at Northeastern Illinois University as a follow-up to his appearance on a panel on Chicago Public Television’s “Chicago Tonight” show. Stuart had pointed out that the ownership of stock (and by implication, mutual funds) in the United States is quite unequal. He noted that while the stock market has done very well in recent years, the standard of living of the average American citizen has not done as well. Stuart thinks that the real median income for a household size of four is about $40,000 …. and that number has not changed since the late 70’s. My spin on this is rather simple – the move up the economic ladder that we used to see for various demographic groups – has stopped.

If you think about it, the evidence is before us. How many of us have friends whose children went to college, got their degrees, and returned home to live with their parents while they hunted for a job in their chosen field, which they often could not find? When one drives around city and suburban streets, how many vacancies do we see in commercial properties?  How many middle class families that used to bootstrap themselves up by investing in and owning apartment buildings or strip malls don’t now? What is needed is a growing economy that offers real job prospects that pay real wages. Stuart also pointed out that student debt is one of the few kinds of debt that one cannot expunge with bankruptcy.

As I read that piece of Ms. Schmick’s and reflected on it, I was reminded of another column I had read a few months back that talked about where we had gone off the rails collectively. The piece was entitled “Battle for the Boardroom” by Joe Nocera and was in the NY Times on May 9, 2015. Nocera was discussing the concept of “activist investors” and “shareholder value” specifically as it pertained to Nelson Peltz, Trian Investments, and a proxy fight with the management and board of DuPont.  And Nocera pointed out that Trian, by all accounts, had a good record and was often a constructive force once it got a board seat or two.

Nocera’s concern, which he raised in a fashion that went straight for the jugular, was simple. Have we really reached the point where the activist investor gets to call the tune, no matter how well run the company? What is shareholder value, especially in a company like DuPont? Trian’s argument was that DuPont was not getting a return on its spending on research and development? Yet R&D spending is what made DuPont, given the years it takes to often produce from scientific research a commercial product. Take away the R&D spending argued Nocera, and you have not just a poorer DuPont, but also a poorer United States. He closed by talking with and quoting Martin Lipton, a corporate attorney who has made a career out of disparaging corporate activists. Lipton said, “Activism has caused companies to cut R&D, capital investment, and, most significantly, employment,” he said. “It forces companies to lay off employees to meet quarterly earnings.”

“It is,” he concluded, “a disaster for the country.”

This brings me to my final set of ruminations. Some years ago, my wife and I were guests at a small dinner party at the home of a former ambassador (and patriot) living in Santa Fe.  There were a total of six of us at that dinner. One of the other guests raised the question as to whether any of us ever thought about what things would have been like for the country if Al Gore, rather than George W. Bush, had won the presidential election. My immediate response was that I didn’t think about such things as it was just far too painful to contemplate.

In like vein, having recently read Ron Suskind’s book Confidence Men, I have been forced to contemplate what it would have meant for the country if President-elect Barack Obama had actually followed through with the recommendations of his transition advisors and appointed his “A” Economic Team. Think about it – Paul Volcker as Secretary of the Treasury, the resurrection of Glass-Steagall, the break-up of the big investment banks – it too is just too painful to contemplate.  Or as the line from T.H. White’s Once and Future King goes, “I dream things that never were, and ask why not?”

Now, a few thoughts about the carnage and how to deal with it.  Have a plan and stick to it. Do not panic, for inevitably all panic does is lead to self-inflicted wounds. Think about fees, but from the perspective of correlated investments. That is, if five large (over $10B in assets) balanced funds are all positively correlated in terms of their portfolios, does it really make sense not to own the one with the lowest expense ratio (and depending on where it is held, taxes may come into play)? Think about doing things where other people’s panic does not impact you, e.g., is there a place for closed end funds in a long-term investment portfolio? And avoid investments where the bugs have not been worked out, as the glitches in pricing and execution of trades for ETF’s have shown us over the last few weeks.

There is a wonderful Dilbert cartoon where the CEO says “Asok, you can beat market averages by doing your own stock research. Asok then says, “So … You believe every investor can beat the average by reading the same information? “Yes” says the CEO. Asok then says, “Makes you wonder why more people don’t do it.” The CEO closes saying, “Just lazy, I guess.”

Edward A. Studzinski

Checking in on MFO’s 20-year Great Owls

MFO first introduced its rating system in the June 2013 commentary. That’s also when the first “Great Owl” funds were designated. These funds have consistently delivered top quintile risk adjusted returns (based on Martin Ratio) in their categories for evaluation periods 3 years and longer. The most senior are 20-year Great Owls. These select funds have received Return Group ranking of 5 for evaluation periods of 3, 5, 10, and 20 years. Only about 50 funds of the 1500 mutual funds aged 20 years or older, or about 3%, achieve the GO designation. An impressive accomplishment.

Below are the current 20-year GOs (excluding muni funds for compactness, but find complete list here, also reference MFO Ratings Definitions.)

Of the original 20-year GO list of 47 funds still in existence today, only 19 remain GOs. These include notables: Fidelity GNMA (FGMNX), PIMCO Foreign Bond – USD-Hedged I (PFORX), James Balanced: Golden Rainbow R (GLRBX), T. Rowe Price Capital Appreciation (PRWCX), Vanguard Wellington Inv (VWELX), Meridian Growth Legacy (MERDX), and Hennessy Gas Utility Investor (GASFX).

The current 20-year GOs also include 25 Honor Roll funds, based on legacy Fund Alarm ranking system. Honor Roll funds have delivered top quintile absolute returns in its category for evaluation periods of 1, 3, and 5 years. These include: AMG Managers Interm Dur Govt (MGIDX), PIMCO Foreign Bond – USD-Hedged I (PFORX), James Balanced: Golden Rainbow R (GLRBX), T. Rowe Price Capital Appreciation (PRWCX), and T. Rowe Price Mid-Cap Growth (RPMGX).

A closer look at performance of the original list of 20-year GOs, since they were introduced a little more than two years ago, shows very satisfactory performance overall, even with funds not maintaining GO designation. Below is a summary of Return Group rankings and current three-year performance.

Of the 31 funds in tables above, only 7 have underperformed on a risk adjusted basis during the past three years, while 22 have outperformed.

Some notable outperformers include: Vanguard Wellesley Income Inv (VWINX), Oakmark International I (OAKIX), Sequoia (SEQUX), Brown Capital Mgmt Small Co Inv (BCSIX), and T. Rowe Price New Horizons (PRNHX).

And the underperformers? Waddell & Reed Continental Inc A (UNCIX), AMG Yacktman (YACKX), Gabelli Equity Income AAA (GABEX), and Voya Corporate Leaders Trust (LEXCX).

A look at absolute returns shows that 10 of the 31 underperformed their peers by an average of 1.6% annualized return, while the remaining 21 beat their peers by an average of 4.8%.

Gentle reminder: MFO ratings are strictly quantitative and backward looking. No accounting for manager or adviser changes, survivorship bias, category drift, etc.

Will take a closer look at the three-year mark and make habit of posting how they have fared over time.

New Voices at the Observer: The Tale of Two Leeighs

We’re honored this month to be joined by two new contributors: Sam Lee and Leigh Walzer.

Sam is the founder of Severian Asset Management, Chicago. He is also former editor of Morningstar analyst and editor of their ETF Investor newsletter. Sam has been celebrated as one of the country’s best financial writers (Morgan Housel: “Really smart takes on ETFs, with an occasional killer piece about general investment wisdom”) and as Morningstar’s best analyst and one of their best writers (John Coumarianos: “Lee has written two excellent pieces [in the span of a month], and his showing himself to be Morningstar’s finest analyst”). Sam claims to have chosen “Severian” for its Latinate gravitas.

We’ll set aside, for now, any competing observations. For example, we’ll make no mention of the Severian Asset Management’s acronym. And certainly no reflections upon the fact that Severian was the name of the Journeyman torturer who serves as narrator in a series of Gene Wolfe’s speculative fiction. Nor that another Severian was a popular preacher and bishop. Hmmm … had I mentioned that one of Sam’s most popular pieces is “Losing My Religion”?

You get a better sense of what Sam brings to the table from his discussion of his approach to things as an investment manager:

Investing well is hard. We approach the challenge with a great deal of humility, and try to learn from the best thinkers we can identify. One of our biggest influences is Warren Buffett, who stresses that predictions about the future should be based on an understanding of economic fundamentals and human nature, not on historical returns, correlations and volatilities. He stresses that we should be skeptical of the false precision and unwarranted sense of control that come with the use of quantitative tools, such as Monte Carlo simulations and Markowitz optimizations. We take these warnings seriously.

Our approach is based on economic principles that we believe are both true and important:

• First and foremost, we believe an asset’s true worth is determined by the cash you can pull out of it discounted by the appropriate interest rate. Over the long run, prices tend to converge to intrinsic value … Where we differ with Buffett and other value investors is that we do not believe investment decisions should be made solely on the basis of intrinsic value. It is perfectly legitimate to invest in a grossly overpriced asset if one knows a sucker will shortly come along to buy it … The trick is anticipating what the suckers will do.
• Second, we believe most investors should diversify. As Buffett says, “diversification is protection against ignorance.” This should not be interpreted as a condemnation of the practice. Most investors are ignorant as to what the future holds. Because most of us are ignorant and blind, we want to maximize the protection diversification affords.
• Third, we believe risk and reward are usually, but not always, positively related … Despite equities’ attractive long-term returns, investors have managed to destroy enormous amounts of wealth while investing in them by buying high and selling low. To avoid this unfortunate outcome, we scale your equity exposure to your behavioral makeup, as well as your time horizon and goals.
• Fourth, the market makes errors, but exploiting them is hard.

We prefer to place actively managed funds (and other high-tax-burden assets) in tax-deferred accounts. In taxable accounts, we prefer tax-efficient, low-cost equities, either held directly or through mutual funds. Many exchange-traded funds are particularly tax-advantaged because they can aggressively rid themselves of low cost-basis shares without passing on capital gains to their investors.

In my experience, Sam’s writing is bracingly direct, thoughtful and evidence-driven. I think you’ll like his work and I’m delighted by his presence. Sam’s debut offering is a thoughtful and data rich profile of AQR Style Premia Alternative (QSPIX). You’ll find a summary and link to his profile under Observer Fund Profiles.

Leigh Walzer is now a principal of Trapezoid LLC and a former member of Michael Price’s merry band at the Mutual Series funds. In his long career, Leigh has brought his sharp insights and passion for data to mutual funds, hedge funds, private equity funds and even the occasional consulting firm.

We had a chance to meet during June’s Morningstar conference, where he began to work through the logic of his analysis of funds with me. Two things were quickly clear to me. First, he was doing something distinctive and interesting. As base, Leigh tried to identify the distinct factors that might qualify as types of managerial skill (two examples would be stock selection and knowing when to reduce risk exposure) and then find the data that might allow him to take apart a fund’s performance, analyze its component parts and predict whether success might persist. Second, I was in over my head. I asked Leigh if he’d be willing to share sort of bite-sized bits of his research so that folks could begin to understand his system and test the validity of its results. He agreed.

Here’s Leigh’s introduction to you all. His first analytic piece debuts next month.

Mutual Fund Observer performs a great service for the investment community. I have found information in these pages which is hard to obtain anywhere else. It is a privilege to be able to contribute.

I founded Trapezoid a few years ago after a long career in the mutual fund and hedge fund industry as an analyst and portfolio manager. Although I majored in statistics at Princeton many moons ago and have successfully modelled professional sports in the past, most of my investing was in credit and generally not quantitative in nature. As David Snowball mentioned earlier, I spent 7 years working for Mutual Shares, led by Michael Price. So the development of the Orthogonal Attribution Engine marks a return to my first passion.

I have always been interested in whether funds deliver value for investors and how accurately allocators and investors understand their managers.  My freshman economics course was taught by Burton Malkiel, author of a Random Walk Down Wall Street, who preached that the capital markets were pretty efficient. My experience in Wall Street and my work at Orthogonal have taught me this is not always true.  Sometimes a manager or a strategy can significantly outperform the market for a sustained period.  Of course, competitors react and capital flows until an equilibrium is achieved, but not nearly as quickly as Malkiel assumes.

There has been much discussion over the years about the active–passive debate.  John Bogle was generous in his time reviewing my work.  I generally agree with Jack and he is a giant in the industry to whom we all owe a great deal.  For those who are ready to throw in the towel of active investing, Bogle makes two (related) assumptions which need to be critically reviewed:

1. Even if an active manager outperforms the average, he is likely to revert to the mean.
2. Active managers with true skill (in excess of their fee structure) are hard to identify, so investors are better off with an index fund

I try to measure skill in a way which is more accurate (and multi-faceted) than Bogle’s definition and I look at skill as a statistical process best measured over an extended period of time. I try to understand how the manager is positioned at every point in time, using both holdings and regression data, and I try to understand the implications of his or her decisions.

My work indicates that the active-passive debate is less black and white than you might discern from the popular press or the marketing claims of mutual fund managers. The good news for investors is there are in fact many managers who have demonstrated skill over an extended period of time. Using statistical techniques, it is possible to identify managers likely to outperform in the future. There are some funds whose expected return over the next 12 months justifies what they charge. There are many other managers who show investment skill, but not enough to justify their expense structure.

Feel free to check out the website at www.fundattribution.com which is currently in beta test. Over 30,000 funds are modelled; users who register for demo access can see certain metrics measuring historic manager skill and likelihood of future success on a subset of the fund universe.

I look forward to sharing with you insights on specific funds in the coming months and provide MFO readers a way to track my results. Equally important, I hope to give you new insights to help you think about the role of actively managed funds in your portfolio and how to select funds. My research is still a work in process. I invite the readership of MFO to join me in my journey and invite feedback, suggestions, and collaboration.  You may contact me at [email protected].

We’re very much looking forward to October and Leigh’s first essay. Thanks to both. I think you’ll enjoy their good spirits and insight.

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized, searchable, and filtered as never before. For the complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

Court Decisions & Orders

• In the shareholder litigation regarding gambling-related securities held by the American Century Ultra Fund, the Eighth Circuit affirmed the district court’s grant of summary judgment in favor of American Century, agreeing that the shareholder could not bring suit against the fund adviser because the fund had declined to do so in a valid exercise of business judgment. Defendants included independent directors. (Seidl v. Am. Century Cos.)
• Setting the stage for a rare section 36(b) trial (assuming no settlement), a court denied parties’ summary judgment motions in fee litigation regarding multiple AXA Equitable funds. The court cited only “reasons set forth on the record.” (Sanford v. AXA Equitable Funds Mgmt. Group, LLC; Sivolella v. AXA Equitable Life Ins. Co.)
• A court gave its final approval to (1) a $24 million partial settlement of the state-law class action regarding Northern Trust‘s securities lending program, and (2) a $36 million settlement of interrelated ERISA claims. The state-law class action is still proceeding with respect to plaintiffs who invested directly in the program. (Diebold v. N. Trust Invs., N.A.; La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)
• In the long-running fee litigation regarding Oakmark funds that had made it all the way to the U.S. Supreme Court, the Seventh Circuit affirmed a lower court’s grant of summary judgment for defendant Harris Associates. The appeals court cited the lower court’s findings that (1) “Harris’s fees were in line with those charged by advisers for other comparable funds” and (2) “the fees could not be called disproportionate in relation to the value of Harris’s work, as the funds’ returns (net of fees) exceeded the norm for comparable investment vehicles.” Plaintiffs have filed a petition for rehearing en banc. (Jones v. Harris Assocs.)
• Extending the fund industry’s dismal record on motions to dismiss section 36(b) litigation, a court denied PIMCO‘s motion to dismiss an excessive-fee lawsuit regarding the Total Return Fund. Court: “Throughout their Motion, Defendants grossly exaggerate ‘the specifics’ needed to survive a 12(b)(6) motion, essentially calling for Plaintiff to prove his case now, before discovery.” (Kenny v. Pac. Inv. Mgmt. Co.)
• A court granted the motion to dismiss a state-law and RICO class action alleging mismanagement by a UBS investment adviser, but without prejudice to refile the state-law claims as federal securities fraud claims. (Knopick v. UBS Fin. Servs., Inc.)

The Alt Perspective: Commentary and news from DailyAlts.

As we all now know, August was anything but calm. Despite starting that way, the month delivered some tough love in the last two weeks, just when we were all supposed to be relaxing with family and friends. Select Morningstar mutual fund categories finished the month with the following returns:

• Large Blend (US Equity): -6.07%
• Intermediate-Term Bond: -0.45%
• Long/Short Equity: -3.57%
• Nontraditional Bonds: -0.91%
• Managed Futures: -2.52%

The one surprise of the five categories above is Managed Futures. This is a category that typically does well when markets are in turmoil and trending down. August proved to be an inflection point, and turned out to be challenging in what was otherwise a solid year for the strategies.

However, let’s take a look at balanced portfolio configurations. Using the above category returns, at traditional long-only 60/40 blend portfolio (60% stocks / 40% bonds) would have returned -3.82% in August, while an alternative balanced portfolio of 50% long/short equity, 30% nontraditional bonds and 20% managed futures would have returned -2.56%. Compare these to the two categories below:

• Moderate Allocation: -4.17%
• Multialternative: -2.22%

Moderate Allocation funds, which are relatively lower risk balance portfolios, turned in the lowest of the balanced portfolio configurations. The Multialternative category of funds, which are balanced portfolios made up of mostly alternative strategies, performed the best, beating the traditional 60/40 portfolio, the 50/30/20 alternative portfolio and the Moderate Allocation category. Overall, it looks like alternatives did their job in August.

August Highlights

Believe it or not, Vanguard launched its second alternative mutual fund in August. The new Vanguard Alternative Strategies Fund will invest across several alternative investment strategies, including long/short equity and event driven, and will also allocate some assets to currencies and commodities. Surprisingly, Vanguard will be managing the fund in-house, but does that the ability to outsource some or all of the management of the fund. Sticking with its low cost focus, Vanguard will charge a management fee of 0.18% – a level practically unheard of in the liquid alternatives space.

In a not quite so surprising move, Catalyst Funds converted its fourth hedge fund into a mutual fund in August with the launch of the Catalyts/Auctos Multi Strategy Fund. In this instance, the firm did go one step beyond prior conversions and actually acquired the underlying manager, Auctos Capital Management. One key benefit of the hedge fund conversion is the fact that the fund can retain its performance track record, which dates back to 2008.

Finally, American Century (yes, that conservative, mid-western asset management firm) launched a new brand called AC Alternatives under which it will manage a series of alternative mutual funds. The firm currently has three funds under the new brand, with two more in the works. Similar to Vanguard, the firm launched a market neutral fund back in 2005, and a value tilted version in 2011. The third fund, an alternative income fund, is new this year.

Let’s Get Together

Two notable acquisitions occurred in August. The first is the acquisition of Arden Asset Management, a long-time institutional fund-of-hedge funds manager, by Aberdeen. The latter has been on the acquisition trail over the past several years, with a keen eye on alternative investment firms. Through the transaction, Arden will get global distribution, while Aberdeen will pick up very specific hedge fund due diligence, manager research and portfolio construction capabilities. Looks like a win-win.

The second transaction was the acquisition of 51% of the Australian-based unconstrained fixed income shop Kapstream Capital by Janus for a cool $85 million. Janus also has the right to purchase the remainder of the firm, which has roughly $6 billion under management. Good for Kapstream as the valuation appears to be on the high end, but perhaps Bill Gross needed some assistance managed his unconstrained portfolios.

The Fall

A lot happens in the Fall. Back to school. Football. Interest rate hike. Changing leaves. Halloween. Thanksgiving. Federal debt ceiling. Maybe there is enough for us all to take our minds off the markets for just a bit and let things settle down. Time will tell, but until next month, enjoy the Labor Day weekend and the beginning of a new season.

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. 

AQR Style Premia Alternative (QSPIX). AQR’s new long-short multi-strategy fund takes factor investing to its logical extreme: It applies four distinct strategies–value, momentum, carry, and defensive–across stock, bond, commodity, and currency markets. The standard version of the fund targets a 10% volatility and a 0.7 Sharpe ratio while maintaining low to no correlation with conventional portfolios. In its short life, the fund has delivered in spades. Please note, this profile was written by our colleague, Sam Lee.

Manning & Napier Pro-Blend Conservative (EXDAX): this fund has been navigating market turbulences for two decades now. Over the course of the 21^st century, it’s managed to outperform the Total Stock Market Index with only one-third of the stocks and one-third of the volatility. And you can start with just $25!  

TCW/Gargoyle Hedged Value (TFHVX/TFHIX):  if you understand what you’re getting – a first-rate value fund with one important extra – you’re apt to be very happy. If you see “hedged” and think “tame,” you’ve got another thing coming.

Launch Alert: Falcon Focused SCV (FALCX)

The fact that newly-launched Falcon Focused SCV has negligible assets (it’s one of the few funds in the world where I could write a check and become the fund’s largest shareholder) doesn’t mean that it has negligible appeal.

The fund is run by Kevin Silverman whose 30 year career has been split about equally between stints on the sell side and on the buy side.  He’s a graduate of the University of Wisconsin’s well-respect Applied Securities Analysis Program . Early in his career he served as an analyst at Oakmark and around the turn of the century was one of the managers of ABN AMRO Large Cap Growth Fund. He cofounded Falcon Capital Management in April 2015 and is currently one of the folks responsible for a $100 million small cap value strategy at Dearborn Partners in Chicago. They’ve got an audited 14 year record.

I’m endlessly attracted to the potential of small cap value investing. The research, famously French and Fama’s, and common sense concur: this should be the area with the greatest potential for profits. It’s huge. It’s systemically mispriced because there’s so little analyst coverage and because investors undervalue value stocks. Growth stocks are all cool and sexy and you want to own them and brag to all your friends about them. Value stocks are generally goofed up companies in distressed industries. They’re boring and a bit embarrassing to own; on whole, they’re sort of the midden heap of the investing world.

The average investor’s unwillingness or inability to consider them raises the prospect that a really determined investor might find exceptional returns. Kevin and his folks try to build 5 to 10 year models for all of their holdings, then look seriously at years four and five. The notion is that if they can factor emotion out of the process (they invoke the pilot’s mantra, “trust your instruments”) and extend their vision beyond the current obsession with this quarter and next quarter, they’ll find opportunities that will pay off handsomely a few years from now. Their target is to use their models to construct a portfolio that has the prospect for returns “in the mid-20s over the next three years.” Mathematically, that works out to a doubling in just over three years.

I’m not sure that the guys can pull it off but they’re disciplined, experienced and focused. That puts them ahead of a lot of their peers.

The initial expense ratio, after waivers, is 1.25%. The no-load Institutional shares carry a $10,000 minimum, which is reduced to $5000 for tax-advantaged accounts and those set up with an automatic investing plan. The fund’s website is still pretty sparse (okay, just under “pretty sparse”), but you can find a bit more detail and one pretty panorama at the adviser’s website.

Launch Alert: Grandeur Peak Global Stalwarts Fund (GGSOX/GGSYX)

Grandeur Peak launched two “alumni” funds on September 1, 2015. Grandeur Peak’s specialty is global micro- and small-cap stocks, generally at the growth end of the spectrum. If they do a good job, their microcap stocks soon become small caps, their small caps become midcaps, and both are at risk of being ejected from the capitalization-limited Grandeur Peak funds.

Grandeur Peak was approached by a large investor who recognized the fact that many of those now-larger stocks were still fundamentally attractive, and asked about the prospect of a couple “alumni” funds to hold them. Such funds are attractive to advisors since you’re able to accommodate a much larger asset base when you’re investing in $10 billion stocks than in $200 million ones.

One investor reaction might be to label Grandeur Peak as sell-outs. They’ve loudly touted two virtues: a laser-like focus and a firm-wide capacity cap at $3 billion, total. With the launch of the Stalwarts funds, they’re suddenly in the mid-cap business and are imagining firmwide AUM of about $10 billion.

Grandeur Peak, however, provided a remarkable wide-ranging, thoughtful defense of their decision. In a letter to investors, dated July 15, they discuss the rationale for and strategies embodied by three new funds:

Grandeur Peak Global Micro Cap Fund (GPMCX): A micro-cap strategy primarily targeting companies in the $50M-350M market cap range across the globe; very limited capacity.

Grandeur Peak Global Stalwarts Fund (GGSOX/GGSYX): A small/mid-cap (SMID) strategy focused on companies above $1.5B market cap across the globe.

Grandeur Peak International Stalwarts Fund (GISOX/GISYX): A small/mid-cap strategy focused on companies above $1.5B market cap outside of the U.S.

They argue that they’d always imagined Stalwarts funds, but didn’t imagine launching them until the firm’s second decade of operation. Their success in identifying outstanding stocks and drawing assets brought high returns, a lot of attention and a lot of money. While they hoped to be able to soft-close their funds, controlling inflows forced a series of hard closes instead which left some of their long-time clients adrift. By adding the Stalwarts funds as dedicated vehicles for larger cap names (the firm already owns over 100 stocks in the over $1.5 billion category), they’re able to provide continuing access to their investors without compromising the hard limits on the micro- and nano-cap products. Here’s their detail:

As you know, capacity is a very important topic to us. We believe managing capacity appropriately is another critical competitive advantage for Grandeur Peak. We plan to initially close the Global Micro Cap Fund at around $25 million. We intend to keep it very small in order to allow the Fund full access to micro and nanocap companies …

Looking carefully at the market cap and liquidity of our holdings above $1.5 billion in market cap, the math suggests that we could manage up to roughly $7 billion across the Stalwarts family without sacrificing our investment strategy or desired position sizes in these names. This $7 billion is in addition to the roughly $3 billion that we believe we can comfortably manage below $1.5 billion in market cap.

Our existing strategies will remain hard closed as we are committed to protecting these strategies and their ability to invest in micro-cap and small-cap companies. We are very aware that many good small cap firms lose their edge by taking in too many assets and being forced to adjust their investment style. We will not do this! We are taking a more unique approach by partitioning the lower capacity, less liquid names and allowing additional assets in the higher capacity, liquid stocks where the impact will not be felt by the smaller-cap funds.

The minimum initial investment is $2000 for the Investor share class, which will be waived if you establish the account with an automatic investment plan. Unlike Global Micro Cap, there is no waiver of the institutional minimum available for the Stalwarts. Each fund will charge 1.35%, retail, after waivers. You might want to visit the Global Stalwarts or International Stalwarts homepages for details.

Funds in Registration

There are 17 new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase in November.

Two of the funds will not be available for direct purchase: T. Rowe Price is launching Mid Cap and Small Cap index funds to use with 529 plans, funds-of-funds and so on. Of the others, there are new offerings from two solid boutiques: Driehaus Turnaround Opportunities will target “distressed” investing and Brown Advisory Equity Long/Short Fund will do about what you expect except that the filings bracket the phrase Equity Long/Short. That suggests that the fund’s final name might be different. Harbor is launching a clone of Vanguard Global Equity. A little firm named Gripman is launched a conservative allocation fund (I wish them well) and just one of the funds made my eyes roll. You’ll figure it out.

Manager Changes

We tracked down 60 or 70 manager changes this month; the exact number is imprecise because one dude was leaving a couple dozen Voya funds which we reduced to just a single entry. We were struck by the fact that about a dozen funds lost women from the management teams, but it appears only two funds added a female manager.

Sympathies to Michael Lippert, who is taking a leave from managing Baron Opportunity (BIOPX) while he recovers from injuries sustained in a serious bicycle accident. We wish him a speedy recovery.

Updates

A slightly-goofed SEC filing led us to erroneously report last month that Osterweis Strategic Investment (OSTVX) might invest up to 100% in international fixed-income. A “prospectus sticker” now clarifies the fact that “at the fund level OSTVX is limited to 50% foreign.” Thanks to the folks at Osterweis for sharing the update with us. Regrets for any confusion.

Morningstar giveth: In mid-August, Morningstar initiated coverage of two teams we’ve written about. Vanguard Global Minimum Volatility (VMVFX) received a Bronze rating, mostly because it’s a Vanguard fund. Morningstar praises the low expenses, Vanguard culture and the “highly regarded–and generally successful–quantitative equity group.” The fund’s not quite two years old but has a solid record and has attracted $1.1 billion in assets.

Vulcan Value Partners (VVPLX) was the other Bronze honoree. Sadly, Morningstar waited until after the fund had closed before recognizing it. The equally excellent Vulcan Value Partners Small Cap (VVPSX) fund is also closed, though Morningstar has declined to recognize it as a medalist fund.

Morningstar taketh away: Fidelity Capital Appreciation (FDCAX) is no longer a Fanny Fifty Fund: it has been doing too well. There’s an incentive fee built into the fund’s price structure; if performance sucks, the e.r. drops. If performance soars, the e.r. rises.

Rewarding good performance sounds to the novice like a good idea. Nonetheless, good performance has had the effect of disqualifying FDCAX as a “Fantastic” fund. Laura Lutton explains why, in “These Formerly ‘Fantastic’ Funds Now Miss the Mark.”

In 2013, the fund outpaced that index by 2.47 percentage points, upping the expense ratio by 4 basis points to 0.81%. This increase moved the fund’s expenses beyond the category’s cheapest quintile…

Uhhh … yup. 247 basis points of excess return in exchange for 4 basis points of expense is clearly not what we expect of Fantastic funds. Out!

From Ira’s “What the hell is that?” file: A rare T Rowe flub

Ira Artman, a long-time friend of the Observer and consistently perceptive observer himself, shared the following WTF performance chart from T. Rowe Price:

Good news: T. Rowe Price Latin America (PRLAX) is magic! It’s volatility-free emerging market fund.

Bad news: the chart is rigged. The vertical axis is compressed so eliminate virtually all visible volatility. There’s a sparky discussion of the chart on our discussion board that provides both uncompressed versions of the chart and the note that the other T. Rowe funds did not receive similarly scaled axes. Consensus on the board: someone deserves a spanking for this one.

Thanks to Ira for catching and sharing.

Briefly Noted . . .

CRM Global Opportunity Fund (CRMWX) is becoming CRM Slightly-Less-Global Opportunity Fund, in composition if not in name. Effective October 28, the fund is changing its principal investment strategy from investing “a majority” of its assets outside the US to investing “at least 40%” internationally, less if markets get ugly. Given that the fund’s portfolio is just 39% global now (per Morningstar), I’m a little fuzzy on why the change will make a difference.

SMALL WINS FOR INVESTORS

Seafarer’s share class model is becoming more common, which is a good thing. Seafarer, like other independent funds, needs to be available on brokerage platforms like Schwab and Scottrade; those platforms allow for lower cost institutional shares so long as the minimum exceeds $100,000 and higher cost retail shares with baked-in 12(b)1 fees to help pay Schwab’s platform fees. Seafarer complied but allows a loophole: they’ll waive the minimum on the institutional shares if you (a) buy it directly from them and (b) set up an automatic investing plan so that you’re moving toward the $100,000 minimum. Whether or not you reach it isn’t the consideration. Seafarer’s preference is to think of their low-cost institutional class as their “universal share class.”

Grandeur Peak is following suit. They intend to launch their new Global Micro Cap Fund by year’s end, then to close it as soon as assets hit $25 million. That raises the real prospect of the fund being available for a day or two. During that time, though, they’ll offer institutional shares to retail investors who invest directly with them. They write:

We want the Global Micro Cap Fund to be available to both our retail and institutional clients, but without the 0.25% 12b-1 fee that comes with the Investor share class. Our intention is to make the Institutional class available to all investors, and waive the minimum to $2000 for regular accounts and $100 for UTMA accounts.

Invesco International Small Company Fund will reopen to all investors on September 11, 2015. Morningstar has a lot of confidence in it (the fund is “Silver”) and it has a slender asset base right now, $330 million, down from its peak of $700 million before the financial crisis. The fund has been badly out of step with the market in recent years, which is reflected in the fact that it has one of its peer group’s best ten-year record and worst five-year records. Since neither the team nor the strategy has changed, Morningstar remains sanguine.

Matthews Pacific Tiger Fund (MAPTX) has reopened to new investors.

Effective July 1, 2015 the shareholder servicing fee for the Investor Class Shares of each of the Meridian Funds was reduced from 0.25% to 0.05%. Somehow I missed it. Sorry for the late notice. The Investor shares continue to sport their bizarre $99,999 minimum initial investment.

Wells Fargo Advantage Index Fund (WFILX) reopens to new investors on October 1. It’s an over-priced S&P 500 Index fund. Assuming you can dodge the front load, the 0.56% expense ratio is a bit more than triple Vanguard’s (0.17% for Investor shares of Vanguard 500, VFINX). That difference adds up: over 10 years, a $10,000 investment in WFILX would have grown to $19,800 while the same money in VFINX grew to $20,700.

CLOSINGS (and related inconveniences)

Acadian Emerging Markets (AEMGX) is slated to close to new investors on October 1. The adviser is afraid that the fund’s ability to execute its strategy will be impaired “if the size of the Fund is not limited.” The fund has lost an average of 3.7% annually for the current market cycle, through July 2015. You’d almost think that losing money, trailing the benchmark and having higher-than-normal volatility would serve as automatic brakes limiting the size of the portfolio.” Apparently not so much.

M.D. Sass 1-3 Year Duration U.S. Agency Bond Fund (MDSHX) is closing the fund’s retail share class and converting them to institutional shares. It’s an okay fund in a low return category, which means expenses matter. Over the past three years, the retail shares trail 60% of their peer group while the institutional shares lead 60% of the group. The conversion will give existing retail shareholders a bit of a boost and likely cut the adviser’s expenses by a bit.

OLD WINE, NEW BOTTLES

Effective August 27, 2015 361 Global Managed Futures Strategy Fund (AGFQX) became the 361 Global Counter-Trend Fund. I wish them well, but the new prospectus language is redolent of magic wands and sparkly dust: “counter-trend strategy follows an investment model designed to perform in volatile markets, regardless of direction, by taking advantage of fluctuations.  Using a combination of market inputs, the model systematically identifies when to purchase and sell specific investments for the Fund.” What does that mean? What fund isn’t looking to identify when to buy or sell specific investments?

American Independence Laffer Dividend Growth Fund (LDGAX) has … laughed its last laff? Hmmm. Two year old fund run by Laffer Investments, brainchild of Arthur B. Laffer, the genius behind supply-side economics. Not, as it turns out, a very good two year old fund.  At the end of July, American Independence merged with FolioMetrix LLC to form RiskX Investments. Somewhere in the process, the fund was declared to be surplus.

Effective September 1, 2015, the name of the Anchor Alternative Income Fund (AAIFX) will be changed to Armor Alternative Income Fund.

Effective August 7, 2015, Eaton Vance Tax-Managed Small-Cap Value Fund became Eaton Vance Tax-Managed Global Small-Cap Fund (ESVAX).

The Hartford Emerging Markets Research Fund is now Hartford Emerging Markets Equity Fund (HERAX) while The Hartford Small/Mid Cap Equity Fund has become Hartford Small Cap Core Fund (HSMAX).  HERAX is sub-advised by Wellington. Back in May they switched out managers, with the new guy bringing a more-driven approach so they’ve also added “quantitative investing” as a risk factor in the prospectus.  For HSMAX, midcaps are now out.

In mid-November, three Stratton funds add “Sterling Capital” to their names: Stratton Mid Cap Value (STRGX) becomes Sterling Capital Stratton Mid Cap Value. Stratton Real Estate (STMDX) and Stratton Small Cap Value (STSCX) get the same additions.

Effective September 17, 2015, ROBO-STOX^TM Global Robotics and Automation Index ETF (ROBO) will be renamed ROBO Global^TM Robotics and Automation Index ETF. If this announcement affects your portfolio, consider getting therapy and a Lab puppy.

OFF TO THE DUSTBIN OF HISTORY

American Beacon is pretty much cleaning out the closet. They’ve announced liquidation of their S&P 500 Index Fund, Small Cap Index Fund, International Equity Index Fund, Emerging Markets Fund, High Yield Bond Fund, Intermediate Bond Fund, Short-Term Bond Fund and Zebra Global Equity Fund (AZLAX). With regard to everything except Zebra, the announcement speaks of “large redemptions which are expected to occur by the end of 2015” that would shrink the funds by so much that they’re not economically viable. American Beacon started as the retirement plan for American Airlines, was sold to one private equity firm in 2008 and then sold again in 2015. It appears that they lost the contract for running a major retirement plan and are dumping most of their vanilla funds in favor of their recent ventures into trendier fare. The Zebra Global Equity Fund was a perfectly respectable global equity fund that drew just $5 million in assets.

In case you’re wondering whatever happened to the Ave Maria Opportunity Fund, it was eaten by the Ave Maria Catholic Values Fund (AVEMX) at the end of July.

Eaton Vance announced liquidation of its U.S. Government Money Market Fund, around about Halloween, 2015. As new SEC money market regs kick in, we’ve seen a lot of MMFs liquidate.  

Eaton Vance Hexavest U.S. Equity Fund (EHUAX) is promoted to the rank of Former Fund on or about September 18, 2015, immediately after they pass their third anniversary.  What is a “hexavest,” you ask? Perhaps a protective garment donned before entering the magical realms of investing? Hmmm … haven’t visited WoW lately, so maybe. Quite beyond that it’s an institutional equity investment firm based in Montreal that subadvises four (oops, three) funds for Eaton Vance.  Likely the name derived from the fact that the firm had six founders (Greek, “hex”) who wore vests.

Rather more quickly, Eaton Vance also liquidated Parametric Balanced Risk Fund (EAPBX). The Board announced the liquidation on August 11; it was carried out August 28. And you could still say they might have been a little slow on the trigger:

The Eudora Fund (EUDFX) has closed and will liquidate on September 10, 2015.

Hundredfold Select Equity Fund (SFEOX) has closed and will discontinue its operations effective October 30, 2015. It’s the sort of closure about which I think too much. On the one hand, the manager (described on the firm’s Linked-In page as “an industry visionary”) is a good steward: almost all of the money in the fund is his own (over $1 million of $1.8 million), he doesn’t get paid to manage it, his Simply Distribute Foundation helps fund children’s hospitals and build orphanages. On the other hand, it’s a market-timing fund of funds will an 1100% turnover which has led the fund to consistently capture much more of the downside, and much less of the upside, than its peers. And, in a slightly disingenuous move, the Hundredfold Select website has already been edited to hide the fact that the Select Equity fund even exists.

Ticker symbols are sometimes useful time capsules, helping you unpack a fund’s evolution. Matthews Asian Growth and Income is “MACSX” because it once was their Asian Convertible Securities fund. Hundredfold Select is “SFEOX” because it once was the Direxion Spectrum Funds: Equity Opportunity fund.

KKM Armor Fund (RMRAX) was not, it appears, bullet-proof. Despite a 30% gain in August 2015, the 18 month old, $8 million fund has closed and will liquidate on September 24, 2015. RMRAX was one of only two mutual funds in the “volatility” peer group. The other is Navigator Sentry Managed Volatility (NVXAX). I bet you’re wondering, “why on earth would Morningstar create a bizarre little peer group with only two funds?” The answer is that there are a slug of ETFs that allow you to bet changes in the level of market volatility; they comprise the remainder of the group. That also illustrates why I prefer funds to ETFs: encouraging folks to speculate on volatility changes is a fool’s errand.

The Modern Technology Fund (BELAX) has closed and will liquidate on September 25, 2015.

There’s going to be one less BRIC in the wall: Goldman Sachs has announced plans to merge Goldman Sachs BRIC Fund (GBRAX) into their Emerging Markets Equity Fund (GEMAX) sometime in October.  The Trustees unearthed a new euphemism for “burying this dog.” They want “to optimize the Goldman Sachs Funds.” The optimized line-up removes a fund that, over the past five years, turned $10,000 into $8,500 by moving its assets into a fund that turned $10,000 into $10,000.

In an interesting choice of words, the Board of Directors authorized the “winding down” Keeley Alternative Value Fund (KALVX) and the Keeley International Small Cap Value Fund (KISVX). By the time you read this, the funds will already have been quite unwound. The advisor gave Alternative Value about four years to prove its … uhh, alternative value (it couldn’t). It gave International Small Cap all of eight months. Founder John Keeley passed away in June at age 75. The firm had completed their transition planning just a month before his passing.

PIMCO Tax Managed Real Return Fund (PXMDX) will be liquidated on or about October 30, 2015.  In addition, three PIMCO ETFs are getting deposited in the circular file: 3-7 Year U.S. Treasury Index (FIVZ), 7-15 Year U.S. Treasury Index (TENZ) and Foreign Currency Strategy Active (FORX) ETFs all disappear on September 30, 2015. “This date may be changed without notice at the discretion of the Trust’s officers.” Their average daily trading volume was just a thousand or two shares.

Ramius Hedged Alpha Fund (RDRAX) will undergo “termination, liquidation and dissolution,” all on September 4, 2015.

A reminder to all muddled Lutherans: your former Aid Association for Lutherans (AAL) Funds and/or your former Lutheran Brother Funds, which merged to become your Thrivent Funds, aren’t exactly thriving. The latest evidence is the decision to merge Small Value and Small Growth into Thrivent Small Cap, Mid Cap Value and Mid Cap Growth into Thrivent Mid Cap Stock and Natural Resources and Technology into Thrivent Large Cap Growth

Toroso Newfound Tactical Allocation Fund (TNTAX) has closed and will liquidate at the end of September, 2015.  The promise of riches driven by “a proprietary, volatility-adjusted and momentum driven model” never quite panned out for this tiny fund-of-ETFs.

In Closing . . .

Warren Buffett turned 85 on Sunday. I can only hope that we all have his wits and vigor when we reach a similar point in our lives. To avoid copyright infringement and the risk of making folks ears bleed, I didn’t sing “happy birthday” but I celebrate his life and legacy.

As you read this, I’m boring at bunch of nice folks in Cincinnati to tears. I was asked to chat with the folks at the Ultimus Fund Services conference about growth in uncertain times. It’s a valid concern and I’ll try to share in October the gist of the argument. In late August, a bright former student of mine, Jonathon Woo, had me visit with some of his colleagues in the mutual fund research group at Edward Jones. I won’t tell you what I said to them (it was all Q&A and I rambled) but what I should have said about how to learn (in this case about the prospect of an individual mutual fund) from talking with others. And, if the market doesn’t scramble things up again, we’ll finally run the stuff that’s been in the pipeline for two months.

We’re grateful to the folks who continue to support the Observer, both financially and with an ongoing stream of suggestions. Thanks to Tyler for his recent advice, and to Rick, Kirk, William, Beatrice, Courtney, Thaddeus, Kevin, Virginia, Sunil, and Ira (a donor advised fund – that’s so cool) for their financial support. You guys rock! A number of planning firms have also reaching out with support, kind words and suggestions. So thanks to Wealth Care, LLC, Evergreen Asset Management, and Integrity Financial Planning.  I especially need to track down our friends at Evergreen Asset Management for some beta testing questions. Too, we can’t forget the folks whose support comes from the use of our Amazon Affiliate link. Way to go on finding those back-to-school supplies!

I don’t mean to frighten anyone before Halloween, but historically September and October are the year’s most volatile months. Take a deep breath, try to do a little constructive planning on quiet days, pray for the Cubs (as I write, they’re in third place but with a record that would have them leading four of the six MLB divisions), cheer for the Pirates, laugh at the dinner table and remember that we’re thinking of you.

As ever,

Dear friends,

Welcome to the dog days.

“Dog days” didn’t originally have anything to do with dogs, of course. It derived from the ancient belief shared by Egyptians, Greeks and Romans that summer weather was controlled by Sirius, the Dog Star. Why? Because Sirius rises just at dawn in the hottest, most sultry months of the year.

FreeImages.com/superburg

In celebration of the fact that the dog days of summer have arrived and you should be out by the pool with family, we’re opening our annual summer-weight issue with some good news.

MFO is a charity case

And you just thought we were a basket case!

As a matter of economic and administrative necessity, the Observer has always been organized as a sole proprietorship. We’re pleased to announce that, in June, our legal status changed. On June 29, we became a non-profit corporation (Mutual Fund Observer, Inc.) under Iowa law. On July 6, the Internal Revenue Service “determined that [we’re] exempt from federal income tax under Internal Revenue Code Section 501(c)(3).”

Why does that matter?

1. It means that all contributions to the Observer are now tax-deductible. We’ve always taken a moment to send hand-written thanks to folks for their support; going forward, we’ll include a card for their tax records.
2. It means that any contribution made on or after May 27, 2015 is retroactively tax deductible. After this issue is live and we’ve handled the monthly cleanup chores, we’ll begin sending the appropriate documents to the folks involved.
3. It means we’re finding ways to become a long-term source of commentary and analysis.

It’s no secret that the Observer’s annual operating budget is roughly equivalent to what some … hmmmm, larger entities in the field spend on paperclips. That works as long as highly talented individuals work pro bono (technically pro bono publico, literally, “for the public good”). As we turn more frequently to outsiders, whether for access to fund data or programming services, we’ll need to strengthen our finances. These changes are part of that effort.

Other changes in the media environment lead us to conclude that there’s an increasingly important role for an independent, authoritative public voice speaking for (and to) smaller investors and smaller fund firms. At the June Morningstar conference, there was quiet, nervous conversation about the prospect that The Wall Street Journal staff had been forced to re-apply for their own jobs. The editors of the Journal announced, in June, a plan to reduce personal finance coverage in the paper:

We will be scaling back significantly our personal finance team, though we will continue to provide high quality reporting and commentary on topics of personal financial interest to our readers.

These closures and realignments do not reflect on the quality of the work done by these teams but simply speak to the pressing need to become more focused as a newsroom on areas we believe are ripe for growth.

We will be better-equipped and better able to exploit the opportunities that exist in the fastest growing parts of our business: with enhanced and improved coverage of the news that we know translates into additional circulation and long-term growth. 

Details of the restructuring emerged in July. At base, resources are being moved from serving individual investors to serving financial advisors. While that’s good for the Journal’s profits and might be good for the 300,000 or so financial advisers in the country (a number that’s dropping steadily), it represents a further shift from serious service to the rest of us. (Thanks to Ari Weinberg for leading us to good coverage of these changes.)

Being a non-profit makes sense for us. It allows us to maintain our independence and focus (a nonprofit corporation is legally owned by all the people of a state and chartered to serve the public interest).

The Observer has always tried to act responsibly and our new legal status reflects that commitment. In addition to that whole “giving voice to the voiceless” thing, we consciously try to act as good stewards. By way of examples:

We work hard to minimize the stress we place on the planet and its systems. We travel very little and, when we do, we purchase carbon offsets through Carbonfund. Carbonfund allows individuals or businesses to calculate the amount of carbon released by their activities and to offset them with investments in a variety of climate-friendly projects from building renewable power systems to recapturing the methane produced in landfills and helping farmers control the effects of animal containment facilities. They’re a non-profit, seem to generate consistently high ratings from folks who assess their operations and write sensibly. In general, we tend to be carbon-negative.

The Observer is hosted by GreenGeeks. They host over 300,000 sites and are distinguished for the environmental commitment. They promise “if we pull 1X of power from the grid we purchase enough wind energy credits to put back into the grid 3X of power having been produced by wind power. Your website hosted with GreenGeeks will be powered by 300% wind energy, making your website’s carbon footprint negative.”

We think of food banks as something folks need mid-winter, which misses the fact that many children receive their only hot meal of the day (sometimes, only meal of the day) as part of their school’s breakfast and lunch programs. That’s led some charities to characterize summer as “the hungriest time of the year” for children. There’s a really worthy federal summer meals program, but it only reaches 15% of the kids who are fed during the regular school year.

We use the same approach here as we do in investing: make a commitment and automate it. On the last day of every month, there’s an automatic transfer from our checking to the River Bend FoodBank. It’s a good group that spends under 3% on administration. Our contribution is not major – enough to provide 150 meals for hungry families – but it’s the sort of absolutely steady inflow that allows an organization to help folks and do a meaningful planning.

All of which is, by the way, exciting and terrifying.

If you’d like to support the Mutual Fund Observer, you have two options:

1. To make a tax deductible contribution, please use our PayPal button on the right, or visit our Support Us page for our address to mail a check. You’ll receive a thank you with a receipt for your tax records.
2. We also strongly encourage everyone who shops at Amazon, now America’s largest retailer (take that Walmart!), to bookmark our Amazon link. Every time you buy anything at Amazon, using our link, we get a small percentage of the sale, and it costs you nothing.

Finding a family’s first fund

I suspect that very few of our readers need advice on selecting a “first fund.” But I’m very certain that you know people who are, or should be, starting their first investment account. Our faithful research associate David Welsch is starting down that road: first “real” job, the prospect of his first modest apartment and the need for starting to put money aside. The contractor who did a splendid job rebuilding my rotted deck admitted that up until now he’s had to spend everything he’s made to support his family and company, but now is in a place to start (just start) thinking about the future. A friend had a passing conversation with a grocery cashier (we’re in the Midwest, this sort of stuff happens a lot) who was saddened by an elderly friend struggling with money in his 70s; my friend suggested that the young lady ought to begin a small account for her own sake. “I know,” she sighed, “I knooow.” For the young men and women serving in the armed forces and making $20,000-30,000 a year, the challenge is just as great.

Mostly they think it’s hard, don’t know where to start, don’t know who to ask and can’t imagine it will make a difference. And you’re feeling a bit guilty because you haven’t been as much help as you’d like.

Here’s what to do. Read the article below. Print it out (we’ve even created a nice .pdf of it for you). Hand it to a young friend with the simple promise, “this will make it easy to get started.”

“The journey of a thousand miles begins …

with one step.” Lao-Tzu.

Good news: you’re ready to take that step and we’re here to help make it happen. We’re going to guide you through the process of setting up your first investment account. There are only two things you need to know:

It’s easy and

It will make a big difference. You’ll be glad you did it.

It’s easy. A mutual fund is simply a way of sharing with others in the costs of hiring a professional to make investments on your behalf. Mostly your manager will invest in either stocks or bonds. Stocks give you part-ownership in a company (Apple, Google, Ford); if the value of the company rises, the value of your shares will rise too. Some companies will soar; others will crash so it’s wiser for investors to invest broadly in a bunch of companies than to try to find individual winners. Bonds are ways for governments or companies to borrow money and pay it back, with interest, over time. “Iffy” borrowers have to pay a bit more in interest, so you earn a bit more on loans to them; high quality borrowers pay you a bit less but you can be pretty sure that they’ll repay their borrowings promptly and fully.

Over very long periods, stocks make more money than bonds but, over shorter periods, stocks can lose a lot more money than bonds.  Your best path is to own some of each, rather than betting entirely on one or the other. If you look back over the last 65 years, you can see the pattern: stocks provide the most long-term gain but also the greatest short-term pain.

How do you read the table? As you double your exposure to stocks, going from 40% to 80%, you add 2.4% to your average annual return. That’s good, though the gain is not huge. At the same time, you increase by 30% the chance of finishing a year in the red and you triple the size of the loss you might expect.  

We searched through about 7000 mutual funds on your behalf, looking for really good first funds. We looked for four virtues:

• They can handle stormy weather. All investments rise and fall; we found ones that won’t fall far and long.
• They can handle sunny weather. Over time, things get better. The world’s economy grows, people have better lives and the world’s a richer place. We found funds that earned good returns over time so you could benefit from that growth.
• They don’t overcharge you. Your mutual fund is a business with bills to pay; as a shareholder in the fund you help pay those bills. Paying under 1% a year is reasonable. While 1% doesn’t seem like a lot, if your fund only makes 6% gains, you’d be returning 17% of those profits to the manager.
• They require only a small investment to get started. As low as $50 a month seemed within reach of folks who were determined to get started.

Getting the account set up requires about 20 minutes, a two page form and knowing your checking account numbers.

It will make a difference. How much can $50 a month get you? In one year, not so much. Over time, a surprising lot. Here’s how much your account might grow using three pretty conservative rates of return (5-7% per year) and four holding periods.

You read that correctly: if you’re a young investor able to put $50 a month away between now and retirement, just that contribution might translate to $100,000 or more.

Two things to remember: (1) Patience is your ally. Markets can be scary; sometimes they’re going down and you think they’ll never go up again. But they do. Always have. Here’s how to win: set up your account with a small automatic monthly investment, check in on it every year or so, add a bit more as your finances improve and go enjoy your life. (2) Small things add up over time. In the example above, if your fund pays you just 1% more it makes a 30% difference in how much you’ll have over the long term. Buying a fund with low expenses can make that 1% difference all by itself, and so can a small increase in the percentage of your account invested in stocks.

Three funds to consider. The August 2015 issue of Mutual Fund Observer, available free on-line, provides a more complete discussion of each of these funds. In addition to our own explanation of them, we’ve provided links to the form you’d need to complete to open an account, the most recent fact sheet provided by the fund company (it’s a two page “highlights of our fund” document) and a link to the fund’s homepage.

James Balanced: Golden Rainbow (ticker symbol: GLRBX). The fund invests about half of its money in stocks and half in bonds, though the managers have the ability to become much more cautious or much more daring if the situation calls for it. Mostly they’ve been cautious, successful investors; they’ve made about 6.9% per year over the past decade, with less risk than their peers. During the very bad period in 2008, the stock market fell about 40% while Golden Rainbow lost less than 6%. The fund’s operating expenses average 1.01% per year, which is low. Starting an account requires a monthly investment of $500 or a one-time investment of $2,000.

Why consider it? Very low starting investment, very cautious managers, very solid returns.

TIAA-CREF Lifestyle Conservative (TSCLX). TIAA-CREF’s traditional business has been providing low cost, conservatively managed investment accounts for people working at hospitals, universities and other non-profit organizations.  Today they manage about $630 billion for investors. The Lifestyle Conservative Fund invests about 40% of its money in stocks and 60% in bonds. It does that by investing in other TIAA-CREF mutual funds that specialize in different parts of the stock or bond market. This fund has only been around for four years but most of the funds in which it invests have long, solid records. The fund’s operating expenses average 0.87% per year, well below average. Starting an account requires a monthly investment of $100 or a one-time investment of $2,500.

Why consider it? The most conservative stock-bond mix in the group, solid lineup of funds it invests in, low expenses and a rock-solid advisor.

Vanguard STAR (VGSTX). Vanguard has a unique corporate structure; it’s owned by the shareholders in its funds. As a result, it has been famous for keeping its expenses amazingly low and its standards consistently high. They now manage over $3 trillion, which represents a powerful vote of confidence on the part of millions of investors. STAR is designed to be Vanguard’s first fund for beginning investors. STAR invests about 60% of its money in stocks and 40% in bonds. It does that by investing in other Vanguard funds. Over the past 10 years, it has earned about 6.8% per year and it lost 25% in 2008. The fund’s operating expenses are 0.34% per year, which is very low. Starting an account requires a one-time investment of $1,000.

Why consider it? The lowest expenses in the group, one-stop access to many of the best funds offered by the firm many consider the best in the world.

We’re targeting funds for you whose portfolios are somewhere around 40-60% stocks. Why so cautious? You might be thinking, “hey, these are Old People funds! I’m young. I’ve got time.  I want to invest in stocks, exciting 3D printing stocks!” Owning too many stocks is bad for your financial health. Imagine that you were really good, invested steadily and built a $10,000 portfolio. How would you feel if someone broke in, stole $5,000 from it and the police said that they thought it might take five to ten years to solve the crime and get your money back? In the meantime, you were out of luck. That’s essentially what happens from time to time in the stock market and it’s really discouraging. Those 3D printing stocks that seem so exciting? They’ve lost two-thirds of their value in the past year, many will never recover.

If you balance your portfolio, you get much better odds of success. Remember Table One, which gives you the tradeoff?  Balancing gives you a really good bargain, especially for the first step in your journey.

So what’s the next step? It’s easy. Pick the one that makes the most sense to you. Take 20 minutes to fill out a short account set-up form online. Tell them if you want to start by investing a little money or a lot. Fill it out, choose the option that says “reinvest my gains, please!” and go back to doing the stuff you really enjoy.

Two bits of follow-up for our regular readers. You might ask, why didn’t we tell folks to start with a six-month emergency fund? Two reasons. First, they are many good personal finance steps folks need to take: build a savings account, avoid eating out frequently, pay down high interest rate credit card debt and all. Since we’re not personal finance specialists, we decided to start where we could add value. Second, a conservative fund can act as a supplement to a savings account; if you’ve got a conservative $5,000 that will still hold $4,000-4,500 at the trough of a bear does provide emergency backup. In my own portfolio, I use T. Rowe Price Spectrum Income (RPSIX) and RiverPark Short-Term High Yield (RPHYX, closed) as my cash-management accounts. Both can lose money but both thump CDs and other “safe” choices most years while posting manageable losses in the worst of times.

Second, there may be other funds out there which would fit our parameters and provide a more-attractive profile than one of the three we’ve highlighted. If so, let us know at [email protected]! I’d love to follow-up next month with suggestions for other ways to help young folks who have neither the confidence nor the awareness to seek out a fully qualified financial advisor. One odd side-note: there are several “Retirement Income” funds with really good profiles; I didn’t mention them because I figured that 99% of young folks would reject them just for the name alone.

Where else might small investors turn for a second or third fund?

Once upon a time, the fund industry had faith in the discipline of average investors so they offered lots of funds with minuscule initial investments. The hope was that folks would develop the discipline of investing regularly on their own.

Oops. Not even I can manage that feat. As the industry quickly and painfully learned, if it’s not on auto-pilot, it’s not getting funded.

That’s a real loss, even if a self-inflicted one, for small investors.  Nonetheless, there remain about 130 funds accessible to folks with modest budgets and the willingness to make a serious commitment to improving their finances.  By my best reading, there are thirteen smaller fund families still taking the risk of getting stiffed by undisciplined investors.  The families willing to waive their normal investment minimums are:

Potpourri

by Edward A. Studzinski

Some men are born mediocre, some men achieve mediocrity, and some men have mediocrity thrust upon them.

       Joseph Heller

We are now at the seven month mark. All would not appear to be well in the investing world. But before I head off on that tangent, there are some housekeeping matters to address.

First, at the beginning of the year I suggested that the average family unit should own no more than ten mutual funds, which would cover both individual and retirement assets. When my long-suffering spouse read that, the question she asked was how many we had. I stopped counting when I got to twenty-five, and told her the results of my search. I was then told that if I was going to tell others they should have ten or less per family unit, we should follow suit. I am happy to report that the number is now down to seventeen (exclusive of money market funds), and I am aiming to hit that ten number by year-end.

Obviously, tax consequences play a big role in this process of consolidation. One, there are tax consequences you can control, in terms of whether your ownership is long-term or short-term, and when to sell. Two, there are tax consequences you can’t control, which are tied in an actively-managed fund, to the decision by the portfolio manager to take some gains and losses in an effort to manage the fund in a tax-efficient manner. At least that is what I hope they are doing. There are other tax consequences you cannot control when the fund in question’s performance is bad, leading to a wave of redemptions. The wave of redemptions then leads to forced selling of equity positions, either en masse or on a pro rata basis, which then triggers tax issues (hopefully gains but sometimes not). The problem with these unintended or unplanned for tax consequences, is that in non-retirement accounts, you are often faced with a tax bill that you have not planned for at filing time, and need to come up with a check to pay the taxes due. A very different way to control the tax consequences, especially if you are of a certain age, is to own passive index funds, whose portfolios won’t change except for those issues going into or leaving the index. Turnover and hence capital gains distributions, tend to be minimized. And since they do tend to own everything as it were, you will pick up some of the benefit of merger and acquisition activity. However, index funds are not immune to an investor panic, which leads to forced selling which again triggers tax consequences.

In this consolidation process, one of the issues I am wrestling with is what to do with money market funds, given that later this year unless something changes again, they will be allowed to “break the buck” or no longer have a constant $1 share price. My inclination is to say that cash reserves for individuals should go back into bank certificates of deposit, up to the maximum amounts of the FDIC insurance. That will work until or unless, like Europe, the government through the banks decides to start charging a negative interest rate on bank deposits. The other issue I am wrestling with is the category of balanced funds, where I am increasingly concerned that the three usual asset classes of equities, fixed income, and cash, will not necessarily work in a complementary manner to reduce risk. The counter argument to that of course, is that most people investing in a balanced (or equity fund for that matter) investment, do not have a sufficiently long time horizon, ten years perhaps being the minimum commitment. If you look at recent history, it is extraordinary how many ten year returns both for equity funds and balanced funds, tend to cluster around the 8% annualized mark.

Morningstar, revisited:

One of the more interesting lunch meetings I had around the Morningstar conference that I did not attend, was with a Seattle-based father-son team with an outstanding record to date in their fund. One of the major research tools used was, shock of shock, the Value Line. But that should not surprise people. Many of Buffet’s own personal investments were, as he relates it, arrived at by thumbing through things like a handbook of Korean stocks. I have used a similar handbook to look at Japanese stocks. One needs to understand that in many respects, the purpose of hordes of analysts, producing detailed models and exhaustive reports is to provide the cover of the appearance of adequate due diligence. Years ago, when I was back in the trust investment world, I used to have various services for sale by the big trust banks (think New York and Philadelphia) presented to me as necessary. Not necessary to arrive at good investment decisions, but necessary to have as file drawer stuffers when the regulators came to examine why a particular equity issue had been added to the approved list. Now of course with Regulation FD, rather than individual access to managements and the danger of selective disclosure of material information, we have big and medium sized companies putting on analyst days, where all investors – buy side, sell side, and retail, get access to the same information at the same time, and what they make of it is up to them.

So how does one improve the decision making process, or rather, get an investment edge? The answer is, it depends on the industry and what you are defining as your circle of competency. Let’s assume for the moment it is property and casualty reinsurance. I would submit that one would want to make a point of attending the industry meetings, held annually, in Monte Carlo and Baden-Baden. If you have even the most rudimentary of social skills, you will come away from those events with a good idea as to how pricing (rate on line) is going to be set for categories of business and renewals. You will get an idea as to whose underwriting is conservative and whose is not. And you will get an idea as to who is under-reserved for prior events and who is not. You will also get a sense as to how a particular executive is perceived.

Is this the basis for an investment decision alone? No, but in the insurance business, which is a business of estimates to begin with, the two most critical variables are the intelligence and integrity of management (which comes down from the top). What about those wonderfully complex models, forecasting interest rates, pricing, catastrophic events leading to loss ratios and the like? It strikes me that fewer and fewer people have taken sciences in high school or college, where they have learned about the Law of Significant Numbers. Or put another way, perhaps appropriately cynical, garbage in/garbage out.

Now, many of you are sitting there thinking that it really cannot be this simple. And I will tell you that the finest investment analyst I have ever met, a contemporary of mine, when he was acting as an analyst, used to do up his research ideas by hand, on one or one and a half sheets of 8 ½ by 11 paper.

There would be a one or two sentence description of the company and lines of business, a simple income statement going out maybe two years beyond this year, several bullet points as to what the investment case was, with what could go right (and sometimes what could go wrong), and that was generally it, except for perhaps a concluding “Reasons to Own. AND HIS RETURNS WERE SPECTACULAR FOR HIS IDEAS! People often disbelieve me when I tell them that, so luckily I have saved one of those write-ups. My point is this – the best ideas are often the simplest ideas, capable of being presented and explained in one or two declarative sentences.

What’s coming?

And finally, for a drop of my usual enthusiasm for the glass half empty. There is a lot of strange stuff going on in the world at the moment, much of it not going according to plan, for governments, central banks, and corporations as one expected in January. Commodity prices are collapsing. Interest rates look to go up in this country, perhaps sooner rather than later. China may or may not have lost control of its markets, which would not augur well for the rest of us. I will leave you with something else to ponder. The “dot.com” crash in 2000 and the financial crisis of 2007-2008-2009 were water-torture events. Most of the people running money now were around for them, and it represents their experiential reference point. The October 1987 crash was a very different animal – you came in one day, and things just headed down and did not stop. Derivatives did not work, portfolio insurance did not work, and there was no liquidity as everyone panicked and tried to go through the door at once. Very few people who went through that experience are still actively running money. I bring this up, because I worry that the next event (and there will be one), will not necessarily be like the last two, where one had time to get out in orderly fashion. That is why I keep emphasizing – do not put at risk more than you can afford to lose without impacting your standard of living. Investors, whether professional or individual, need to guard mentally against always being prepared to fight the last war.

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized, searchable, and filtered as never before. For the complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

New Lawsuit

• A new excessive-fee lawsuit targets five State Farm LifePath target-date funds. Complaint: “The nature and quality of Defendant’s services to the LifePath Funds in exchange for close to half of the net management fee are extremely limited. Indeed, it is difficult to determine what management services, if any, [State Farm] provides to the LifePath Funds, since virtually all of the investment management functions of the LifePath Funds are delegated” to an unaffiliated sub-adviser. (Ingenhutt v. State Farm Inv. Mgmt. Corp.)

Orders

• A court gave its final approval to the $27.5 million settlement of an ERISA class action that had challenged the selection of proprietary Columbia and RiverSource funds for Ameriprise retirement accounts. (Krueger v. Ameriprise Fin., Inc.)
• In a decision on motion to dismiss, a court allowed a plaintiff to add new Morgan Keegan defendants to previously allowed Securities Act claims regarding four closed-end funds, rejecting the new defendants’ statute-of-limitations argument. (Small v. RMK High Income Fund, Inc.)
• Further extending the fund industry’s losing streak, a court allowed excessive-fee allegations regarding five SEI funds to proceed past motion to dismiss: “While the allegations in the Amended Complaint may well not survive summary judgment, they are sufficient to survive the motion-to-dismiss stage.” (Curd v. SEI Invs. Mgmt. Corp.)
• A court mostly denied the motion by Sterling Capital to dismiss a fraud lawsuit filed by its affiliated bank’s customer. (Bowers v. Branch Banking & Trust Co.)
• A court consolidated excessive-fee litigation regarding the Voya Global Real Estate Fund. (In re Voya Global Real Estate Fund S’holder Litig.)

Briefs

• Parties filed their oppositions to dueling motions for summary judgment in fee litigation regarding eight Hartford mutual funds. Plaintiffs’ section 36(b) claims, first filed in 2011, previously survived Hartford’s motion to dismiss. The summary judgment papers are unavailable on PACER. (Kasilag v. Hartford Inv. Fin. Servs. LLC; Kasilag v. Hartford Funds Mgmt. Co.)

The Alt Perspective: Commentary and news from DailyAlts.

Despite being the summer, there was no slowdown in activity around liquid alternatives in July. Seven new alternative mutual funds and ETFs came to market, bringing the year to date total to 79. And in addition to the new fund launches, private equity titans Apollo and Carlyle both announced plans to launch alternative mutual funds later this year. For Carlyle, this is their second time to the dance and this time they have picked TCW as their partner. Carlyle purchased a majority interest in TCW early 2013 and will wisely be leveraging the firm’s distribution into the retail market. In a similar vein, Apollo has partnered with Ivy and will look to Ivy for distribution leadership.

Apollo and Carlyle’s plans follow on the heals of KKR’s partnership with Altegris for the launch of a private equity offering for the “mass affluent” earlier this year, and Blackstone’s partnership with Columbia on a multi-alternative fund, also announced earlier this year. Distribution is key, and the private equity shops are starting to figure that out.

Asset Flows

Asset flows into liquid alternative funds (mutual funds and ETFs combined) continued on their positive streak for the sixth consecutive month, with total flows in June of more than $2.2 billion according to Morningstar’s June 2015 U.S. Asset Flows Update report.

For the fifth consecutive month, multi-alternative funds have dominated inflows into liquid alternatives as investors look for a one-stop shop for their alternatives allocation. Both long/short equity and market neutral have experienced outflows every month in 2015, while non-traditional bonds has had outflows in 5 of 6 months this year. Quite a change from 2014 when both long/short equity and non-traditional bonds ruled the roost.

Twelve month flows look fairly consistent with June’s flows with multi-alternative and managed futures funds leading the way, and long/short equity, market neutral and non-traditional bonds seeing the largest outflows.

Trends and Research

There were several worthwhile publications distributed in July that provide more depth to the liquid alts conversation. The firsts is the annual Morningstar / Barron’s survey of financial advisors, which notes that advisors are more inclined to allocate to liquid alternatives than they were last year. A summary of the results can be found here: Morningstar and Barron’s Release National Alternatives Survey Results.

In addition to the survey, both Morgan Stanley and Goldman Sachs published research papers on liquid alternatives. Both papers are designed to help investors better understand the category of investments and how to use them in a portfolio:

• Morgan Stanley Publishes Liquid Alts Investment Primer
• Goldman Sachs: Viewing Liquid Alternatives Through a Hedge Fund Lens

Educational Videos

Finally, we published a series of video interviews with several portfolio managers of leading alternative mutual funds, as well as a three part series with Keith Black, Managing Director of Exams and Curriculum of the CAIA Association. All of the videos can be viewed here: DailyAlts Videos. More will be on the way over the next couple weeks, so check back periodically.

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.

This month’s profiles are unusual, in that they’re linked to our story on “first funds.” Two of the three are much larger and older than we normally cover, but they make a strong case for themselves.

James Balanced: Golden Rainbow (GLRBX). The fund invests about half of its money in stocks and half in bonds, though the managers have the ability to become much more cautious or much more daring if the situation calls for it. Mostly they’ve been cautious. Their professed goal is “to seek to grow our clients’ assets…while stressing the preservation of principal, and the reduction of risk.” With a loss of just 6% in 2008, they seem to be managing that balance quite well. FYI, this profile was written by our colleague Charles Boccadoro and is substantially more data-rich than most.

TIAA-CREF Lifestyle Conservative (TSCLX). TIAA-CREF’s traditional business has been providing low cost, conservatively managed investment accounts for people working at hospitals, universities and other non-profit organizations.  Lifestyle Conservative is a fund-of-funds with about 40% of its money in stocks and 60% in bonds. They’ve got a short track record, but substantially below-average expenses and a solid lineup of funds in which to invest.

Vanguard STAR (VGSTX). STAR is designed to be Vanguard’s first fund for beginning investors. It invests only in Vanguard’s actively-managed funds, with a portfolio that’s about 60% of its money in stocks and 40% in bonds. The fund’s operating expenses are 0.34% per year, which is very low. The combination of Vanguard + low minimum has always had it on my short-list of funds for new investors.

We delayed publication of July’s fund profile while we finished some due diligence. Sorry ‘bout that but we’d rather get the facts right than rush to print.

Eventide Healthcare & Life Sciences (ETNHX): Morningstar’s 2015 conference included a laudatory panel celebrating “up and coming” funds, including the five star, $2 billion Eventide Gilead. And yet as I talked with the Eventide professionals the talk kept returning to the fund that has them more excited, Healthcare & Life Sciences. The fund’s combination of a strong record with a uniquely qualified manager compels a closer look.

Launch Alert

Triad Small Cap Value Fund (TSCVX) launched on June 29, 2015. Triad promises a concentrated but conservative take on small cap investing.

The fund is managed by John Heldman and David Hutchison, both of Triad Investment Management. The guys both have experience managing money for larger firms, including Bank of America, Deutsche Bank and Neuberger Berman. They learned from the experience, but one of the things they learned was that “we’d had enough of working for larger firms … having our own shop means we have a much more flexible organization and we’ll be able do what’s right for our investors.” Triad manages about $130 million for investors, mostly through separate accounts.

The Adviser analyzes corporate financial statements, management presentations, specialized research publications, and general news sources specifically focused on three primary aspects of each company: the degree of business competitive strength, whether management is capable and co-invested in the business, and the Adviser’s assessment of the attractiveness of a security’s valuation.

The guys approach is similar to Bernie Horn and the Polaris team: invest only where you think you can meaningfully project a firm’s future, look for management that makes smart capital allocation decisions, make conservative assumptions and demand a 50% discount to fair value.

That discipline means that some good companies are not good investments. Firms in technology and biotech, for example, are subject to such abrupt disruption of their business models that it’s impossible to have confidence in a three to five year projection. Other fundamentally attractive firms have simply been bid too high to provide any margin of safety.

They’re looking for 30-45 names in the portfolio, most of which they’ve followed for years. The tiny fund and the larger private strategy are both fully invested now despite repeated market highs. While they agree that “there aren’t hundreds of great opportunities, not a huge amount at all,” the small cap universe is so large that they’re still finding attractive opportunities.

The minimum initial purchase is $5,000. The opening expense ratio is 1.5% with a 2.0% redemption fee on shares held under 90 days.

The fund’s website is still pretty rudimentary but there’s a good discussion of their Small Cap Equity strategy available on the advisor’s site. For reasons unclear, Mornignstar’s profile of the fund aims you to the homepage of the Wireless Fund (WIREX). Don’t go there, it won’t help.

Funds in Registration

There are 17 new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase right around the end of September, which would allow the new funds to still report a full quarter’s worth of results in 2015.

The most important new registrations are a series of alternatives funds about to be launched by TCW. They’ve partnered with several distinguished sub-advisers, including our friends at Gargoyle who, at our first reading of the filings, are offered the best options including both Gargoyle Hedged Value and, separately, the unhedged Gargoyle long portfolio as a free-standing fund.

Manager Changes

There are 45 manager changes, at least if you don’t mind a bit of cheating on our part. Wyatt Lee’s arrival as co-manager marginally affected all the funds in the T. Rowe Price retirement series but we called that just one change. None are game-changers.

Updates

The Board at LS Opportunity Fund (LSOFX) just announced their interim plan for dealing with the departure of the fund’s adviser. Jim Hillary of Independence Capital Asset Partners and formerly of Marsico Capital, LLC ran LSOFX side-by-side with his ICAP hedge fund from 2010-2015. It’s been an above-average performer, though not a stunning one. DailyAlts reports that Mr. Hillary has decided to retire and return the hedge fund’s assets to its investors. The LS Board appointed Prospector Partners LLC to sub-advise the fund for now; come fall, they’ll ask shareholders for authority to add sub-advisors.

The Prospector folks come with excellent credentials but a spotty record. The managers have a lot of experience managing funds for White Mountains Insurance, T. Rowe Price (both Capital Appreciation and Growth Stock) and Neuberger Berman (Genesis). Prospector Capital Appreciation (PCAFX) was positioned as a nimbler version of T. Rowe Price Capital Appreciation (PRWCX), run by Cap App’s long-time manager. The fund did well during the meltdown but has trailed 99% of its peers since. Prospector Opportunity (POPFX) has done better, also by limiting losses in down markets at the price of losing some of the upside in rising ones.

The Board of Trustees has approved a change Zeo Strategic Income’s investment objective. Right now the fund seeks “income and moderate capital appreciation.” Effective August 31, 2015, the Fund’s investment objective will be to seek “low volatility and absolute returns consisting of income and moderate capital appreciation.” From our conversations with the folks at Zeo, that’s not a change; it’s an editorial clarification and a symbolic affirmation of their core values.

Briefly Noted . . .

Effective August 1, Value Line is imposing a 0.40% 12(b)1 fee on a fund that hasn’t been launched yet (Centurion) but then offers a 0.13% 12(b)1 waiver for a net 12(b)1 fee of 0.27%. Why? At the same time, they’ve dropped fees on their Core Bond Fund (VAGIX) by two basis points (woo hoo!). Why? Because the change drops them below the 1.0% expense threshold (to 0.99%), which might increase the number of preliminary fund screens they pass. Hard to know whether that will help: over the five years under its current management, the fund has been a lot more volatile (bigger maximum drawdown but much faster recovery) and more profitable than its peers; the question is whether, in uncertain times, investors will buy that combo – even after the generous cost reduction.

Thanks, as always, to The Shadow’s irreplaceable assistance on tracking down the following changes!

SMALL WINS FOR INVESTORS

Effective August 1, 2015, Aspiriant Risk-Managed Global Equity Fund’s (RMEAX) investment advisory fee will be reduced from 0.75% to 0.60%.

CLOSINGS (and related inconveniences)

Invesco International Growth Fund (AIIEX) will close to new investors on October 1, 2015. Nothing says “we’re serious” quite like offering a two-month window for hot money investors to join the fund. The $9 billion fund tends to be a top-tier performer when the market is falling and just okay otherwise.

Tweedy, Browne Global Value Fund II (TBCUX) has closed to new investors. Global Value II is the sibling to Global Value (TBGVX). The difference between them is that Global Value hedges its currency exposure and Global Value II does not. I don’t anticipate an extended closure. Global II has only a half billion in assets, against $9.3 billion in Global, so neither the size of the portfolio nor capacity constraints can explain the closure. A likelier explanation is the need to manage a large anticipated inflow or outflow caused, conceivably, by gaining or losing a single large institutional client.

OLD WINE, NEW BOTTLES

Effective July 9, 2015, the 3D Printing and Technology Fund (TDPNX) becomes the 3D Printing, Robotics and Technology Fund. The fact that General Electric is the fund’s #6 holding signals the essential problem: there simply aren’t enough companies whose earnings are driven by 3D printing or robotics to populate a portfolio, so firms where such earnings are marginal get drawn in.

Effective September 9, 2015, Alpine Accelerating Dividend Fund (AAADX) is getting renamed Alpine Rising Dividend Fund. The prospectus will no longer target “accelerating dividends” as an investment criterion. It’s simultaneously fuzzier and clearer on the issue of portfolio turnover: it no longer refers to the prospect of 150% annual turnover (the new language is “higher turnover”) but is clear that the strategy increases transaction costs and taxable short-term gains.

Calvert Tax-Free Bond Fund (CTTLX) has become Calvert Tax-Free Responsible Impact Bond Fund. “Impact investing” generally refers to the practice of buying the securities of socially desirable enterprises, for example urban redevelopment administrations, as a way of fostering their mission. At the start of September, Calvert Large Cap Value (CLVAX) morphs into Calvert Global Value Fund. The globalization theme continues with the change of Calvert Equity Income Fund (CEIAX) to Calvert Global Equity Income Fund. Strategy tweaks follow.

On September 22, 2015, Castlerigg Equity Event and Arbitrage Fund (EVNTX) becomes Castlerigg Event Driven and Arbitrage Fund. In addition to the name change, Castlerigg made what appear to be mostly editorial changes to the statement of investment strategies. It’s not immediately clear that either will address this:

Eaton Vance Small-Cap Value Fund has been renamed Eaton Vance Global Small-Cap Fund (EAVSX). Less value, more global. The fund trails more than 80% of its peers over pretty much every trailing measurement period. They’ve added Aidan M. Farrell as a co-manager. Good news: he’s managed Goldman Sachs International Small Cap (GISSX). Bad news: it’s not very good, either.

Effective July 13, 2015 Innovator Matrix Income® Fund became Innovator McKinley Income Fund (IMIFX), with the appointment of a new sub-advisor, McKinley Capital Management, LLC. The fund’s strategy was to harvest income primarily from high income securities which included master limited partnerships and REITs. The “income” part worked and the fund yields north of 10%. The “put the vast majority of your money into energy and real estate” has played out less spectacularly. The new managers bring a new quantitative model and modest changes in the investment strategy, but the core remains “income from equities.”

OFF TO THE DUSTBIN OF HISTORY

Effective October 23, 2015, Alpine Equity Income Fund (the “Fund”) and Alpine Transformations Fund (the “Fund”) will both be absorbed by Alpine Accelerating Dividend Fund. At the same time Alpine Cyclical Advantage Property Fund (the “Fund”) disappears into Alpine Global Infrastructure Fund (the “Acquiring Fund”).

Fidelity Fifty merged into Fidelity Focused Stock Fund (FTQGX) on July 24, 2015, just in case you missed it.

Forward is liquidating their U.S. Government Money Fund by the end of August.

MassMutual Select Small Company Growth Fund will be liquidated by September 28, 2015.

Neuberger Berman Global Thematic Opportunities Fund will disappear around August 21, 2015.

RiverNorth Managed Volatility Fund (RNBWX) is scheduled for a quick exit, on August 7, 2015.

The $1.2 million Stone Toro Long/Short Fund (STVHX) will be liquidated on or about August 19, 2015 following the manager’s resignation from the advisor.

UBS Equity Long-Short Multi-Strategy Fund (BMNAX) takes its place in history alongside the carrier pigeon on September 24, 2015. Advisors don’t have to explain why they’re liquidating a fund. In general, either the fund sucks or nobody is buying it. No problem. I do think it’s bad practice to go out of your way to announce that you’re about to explain your rationale and then spout gibberish.

Rationale for liquidating the Fund

Based upon information provided by UBS … 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. 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.

Our rationale is that we “considered factors that have adversely affected, and will continue to adversely affect” the fund. Why is that even worth saying? The honest statement would be “we’re in a deep hole, the fund has been losing money for the advisor for five year and even the stronger performance of the past 18 months hasn’t made a difference so we’re cutting our losses.”

In Closing . . .

In the months ahead we’ll add at least a couple new voices to the Observer’s family. Sam Lee, a principal of Severian Asset and former editor of Morningstar’s ETF Investor, would like to profile a fund for you in September. Leigh Walzer, a principal of Trapezoid LLC and a former member of Michael Price’s merry band at the Mutual Series funds, will join us in October to provide careful, sophisticated quantitative analyses of the most distinguished funds in a core investment category.

We’ve mentioned the development of a sort of second tier at the Observer, where we might be able to provide folks with access to some interesting data, Charles’s risk-sensitive fund screener and such. We’re trying to be very cautious in talking about any of those possibilities because we hate over-promising. But we’re working hard to make good stuff happen. More soon!

Our September issue will start with the following argument: it’s not time to give up on managers who insist on investing in Wall Street’s most despised creature: the high-quality, intelligently managed U.S. corporation. A defining characteristic of a high-quality corporation is the capital allocation decisions made by its leaders. High-quality firms invest intelligently, consistently, successfully, in their futures. Those are “capital expenditures” and investors have come to loathe them because investing in the future thwarts our desire to be rich, rich, rich, now, now, now. In general I loathe the editorial pages of The Wall Street Journal since they so often start with an ideologically mandated conclusion and invent the necessary supporting evidence. William Galston’s recent column, “Hillary gets it right on short-termism” (07/29/2015) is a grand exception:

Too many CEOs are making decisions based on short-term considerations, regardless of their impact on the long-run performance of their firms.

Laurence Fink is the chairman of BlackRock … expressed his concern that “in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” choosing instead to reduce capital expenditures in favor of higher dividends and increased stock buybacks.

His worries rest on a sound factual foundation. For the 454 companies listed continuously in the S&P 500 between 2004 and 2013, stock buybacks consumed 51% of net income and dividends an additional 35%, leaving only 14% for all other purposes.

It wasn’t always this way. As recently as 1981, buybacks constituted only 2% of the total net income of the S&P 500. But when economist William Lazonick examined the 248 firms listed continuously in this index between 1984 and 2013, he found an inexorable rise in buybacks’ share of net income: 25% in the 1984-1993 decade; 37% in 1994-2003; 47% in 2004-13. Between 2004 and 2013, some of America’s best-known corporations returned more than 100% of their income to shareholders through buybacks and dividends.

He cites a 2005 survey of CEOs, 80% of whom would cut R&D and 55% would avoid long-term capex if that’s what it took to meet their quarterly earnings expectations. We’ve been talking with folks like David Rolfe of Wedgewood, Zac Wydra of Beck, Mack and others who are taking their lumps for refusing to play along. We’ll share their argument as well as bring our modestly-delayed story on the Turner funds, Sam’s debut, and Charles’ return.

We’ll look for you.

Dear friends,

We really hope you enjoy the extra start-of-summer profundity that we’ve larded (excuse the expression) into this issue. We took advantage of the extra time afforded by the June 30^th leap second and the extra light generated that night by the once-in-two-millennia conjunction of Venus and Jupiter to squeeze in a family-sized portion of insight into this month’s issue.

And it all started with Morningstar.

Mania at the McCormick!

Morningstar’s annual investor conference is always a bit of a zoo. Two thousand people jam together in a building the size of a shopping mall, driven by a long schedule and alternating doses of caffeine (6:00 a.m. to 6:00 p.m.) and alcohol (thereafter). There are some dozens of presentations, ranging from enormously provocative to freakish, mostly by folks who have something to sell but, for the sake of decorum, are trying not to mention that fact.

Okay: the damned thing’s a lot bigger than any shopping mall except the Mall of America. MoA has about 4.2 million square feet total, McCormick is around 3.4 million. We were in the West Building, whose main ballroom alone runs to 100,000 square feet. 500,000 square feet of exhibition space, 250,000 of meeting space, with something like 60 meeting rooms. That building alone cost about $900 million, and McCormick has three others.

What follows are three sets of idiosyncratic observations: mine, Charles and Ed’s. I’ve linked to Morningstar’s video, where available. The key is that their videos auto-launch, which can be mightily annoying. Be ready for it.

Jeremy Grantham: The World Will End, You’ve Just Got to be Patient for a Bit

Grantham, one of the cofounders of GMO, a highly respected institutional investment firm originally named Grantham, Mayo, van Otterloo, is regularly caricatured as a perma-bear. He responds to the charge by asserting “I’m not a pessimist. You’re simply optimists.”

Grantham argues that we’re heading for a massive stock market crash (something on the order of a 60% fall), just not for a while yet. GMO’s study of asset bubbles found that asset prices regularly become detached from reality but they’re not subject to crashing until they exceed their normal levels by about two standard deviations.  Roughly speaking, that translates to asset prices that are higher than they are 95% of the time. Right now, we’re about 1.5 standard deviations above average. If current trends continue – and Grantham does expect stocks to follow the path of least resistance, higher – then we’ll reach the two standard deviation mark around the time of the presidential election.

Merely being wildly overvalued doesn’t automatically trigger a crash (in the UK, home prices reached a three standard deviation peak – 99.7% – before imploding) but it’s extremely rare for such a market not to find a reason to crash. And when the crash comes, the market typically falls at about twice the rate that it rose.

As an aside, Grantham also notes that no stock market crash has occurred until after average investors have been dragged into the party’s frenzied last hours, too late to make much money but just in time to have their portfolios gutted (again). While optimism, measured by various investor attitude surveys, is high, it’s not manic. Yet.

So, we’ve got a bit to savor ill-garnered gains and to reassure ourselves that this time we’ll be sharp, discerning and well on our way to safety ere the crash occurs.

Oddly, Grantham expects a crash because capitalism does work, but regulation (mostly) does not. Under capitalism, capital flows to the area of greatest opportunity: if your lemonade stand is able to draw a million in revenue today, you can be pretty much guaranteed that there will be a dozen really cool lemonade stands in your neighborhood within the week. As a result, your profit will decline. More stands will be built, and profits will continue declining, until capitalists conclude that there’s nothing special in the lemonade stand biz and they resume the search for great opportunities. Today’s record corporate profit margins must draw new competitors in to drive those excess profits down, or capitalism is failing.

Grantham argues that capitalism is failing for now. He blames the rise of “stock option culture” and a complicit U.S. fed for the problem. Up to 80% of executive compensation now flows from stock options, which are tied to short-term performance of a company’s stock rather than long-term performance of the company. People respond to the incentives they’re given, so managers tend toward those actions which increase the value of their stock options. Investing in the company is slow, uncertain and risky, and so capital expenditures (“capex”) by publicly-traded firms is falling. Buying back stock (overpriced or not) and issuing dividends is quick, clean and safe, and so that sort of financial engineering expands. Interest rates at or near zero even encourage the issuance of debt to fund buybacks (“Peter, meet Paul”). It would be possible to constrain the exercise of options, but we choose not to. And so firms are not moving capital into new ventures or into improving existing capabilities which, in the short run, continues to underwrite record profit margins.

David Marcus: We’re in the Bottom of the Third

All value investing starts with fundamentally, sometimes appallingly, screwed-up companies that have the potential to do vastly better than they’ve been doing. The question is whether anything will unleash those potential gains. That’s not automatically true; 50 to a hundred publicly-traded companies go bankrupt each year as do something like 30,000 private ones.

On whole, investors would prefer that the firms they invest in not go belly up. In the U.S., they’ve got great leverage to encourage corporate restructurings – spinoffs, mergers, acquisitions, division closures – which might serve to release that locked-up potential. We also have a culture that, for better and worse, endorses the notion of maximizing shareholder (rather than stakeholder or community) value.

Traditionally the U.S. has been one of the few places that countenanced, much less encouraged, frequent corporate dislocations. Europeans encourage a stakeholder model focused on workers’ interests and Asians have a tradition of intricately interwoven corporate interests where corporations share a web of directorships and reciprocal investments in each other.

David Marcus manages Evermore Global Value (EVGBX) and tries to do so in the spirit of his mentor, Michael Price. As one of Price’s Mutual Series managers, he specialized in “special situations” investing, a term that describes the whole array of “rotten company teetering between damnation and salvation” thing. Later, as a private investor in Europe, he saw the beginnings of a change in corporate culture; the first intimations that European managers were willing to make tentative moves toward a shareholder-focused culture. In December 2009, he launched the Evermore funds to exploit that unrecognized change.

The first three years were trying: his flagship fund lost 10% over the period and trailed 95% of its peers. When we spoke several years ago, Mr. Marcus was frustrated but patient: he likened his portfolio to a spring that’s already been compressed a lot but, instead of releasing, was getting compressed even more. In the past three years, the spring rebounded: top third relative returns, 15% annualized ones, with two stretches at the very top of the global equity heap.

Mr. Marcus’s portfolio remains Euro-centric, about 66% against his peers’ 30%, but he foresees a rotation. The 2008 financial meltdown provided an opportunity for European corporate insiders to pursue a reform agenda. International members started appearing on corporate boards, for instance, and managers were given leeway to begin reducing inefficiency. ThyssenKrupp AG, a German conglomerate, had 27 separate IT departments operating with inconsistent policies and often incompatible software. They’ve whittled that down to five and are pursuing the crazy dream of just one IT department. Such moves create a certain momentum: at first, restructuring seems impossible, then a minor restructuring frees up a billion in capital and managers begin to imagine additional work that might reap another billion and a half. As the great Everett Dirksen once reflected, “A billion here, a billion there, and pretty soon you’re talking about real money.” Mr. Marcus believes that Europeans are pursuing such reforms with greater vigor but without wasting capital “on crappy IPOs” that continue to dog the U.S. market.

A bigger change might be afoot in Asia and, in particular, in Japan. Corporate executives are, for the first time, beginning to unwind the complex web of cross-ownership which had traditionally been a one-way move: you invest in another corporation but never, ever sell your stake. Increasingly, managers see those investments as “cash cows,” the source of additional capital that might be put to better use.

Ironically, the same social forces that once held capital captive might now be working to free it. Several new Japanese stock indexes attempt to recognize firms that are good stewards of shareholder capital. The most visible is the Nikkei 400 ROE index, which tracks companies “with high appeal for investors, which meet requirements of global investment standards, such as efficient use of capital and investor-focused management perspectives.” Failure to qualify for inclusion has been deeply embarrassing for some management teams, which subsequently reoriented their capital allocations. Nomura Securities launched a competing index focusing on companies that use dormant cash to repurchase shares, though the effects of that are not yet known.

Mr. Marcus’s sense that the ground might be shifting is shared by several outstanding managers. Andrew Foster of Seafarer (SFGIX) has speculated that conditions favorable to value investing (primarily institutions that might serve as catalysts to unlock value) are evolving in the emerging markets. Messrs. Lee and Richyal at JOHCM International Select Fund (JOHAX) have directly invoked the significance of the Nikkei ROE Index in their Japan investing. Ralf Scherschmidt at Oberweis International Opportunities (OBIOX) has made a career of noticing that investors fail to react promptly to such changes; he tries to react to news promptly then wait patiently for others to begin believing that change is really. All three are five-star funds.

I’ll continue my reviews in August. For now, here are Charles’s quick takes.

Morningstar Investment Conference 2015 Notes

In contrast to the perfect pre-autumnal weather of last year’s ETF conference, Chicago was hot and muggy this past week, where some 2000 attendees gathered for Morningstar’s Investment Conference located at the massive, sprawling, and remote McCormick Place.

Morningstar does a great job of quickly publishing conference highlights and greatly facilitates press … large press room wired with high-speed internet, ample snacks and hot coffee, as well as adjacent media center where financial reporters can record fund managers and speakers then quickly post perspectives, like Chuck Jaffe’s good series of audio interviews.

On the MFO Discussion Board, David attempts to post nightly his impressions and linkster Ted relays newly published conference articles. To say the event is well covered would be a colossal understatement.

Nonetheless, some impressions for inclusion in this month’s commentary …

If you are a financial adviser not catering to women and millennials, your days are numbered.

On women. Per Sallie Krawcheck, former president of BAC’s Global Wealth division and currently chair of the Ellevate network, which is dedicated to economic engagement of women worldwide, women live six to eight years longer than men … 80% of men die married, while 80% of women die unmarried … 70% of widows leave their financial advisers within a year of their husband’s death.

While women will soon account for majority of US millionaires, most financials advisors don’t include spouses in the conversation. The issue extends to the buy side as well. In a pre-conference session entitled, “Do Women Investors Behave Differently Than Men,” panels cited that women control 51% investable wealth and currently account for 47% of high net worth individuals, yet professional women money managers account for only 5% of assets under management. How can that be?

The consequence of this lack of inclusion is “lack of diversification, higher risk, and money left on table.” Women, they state, value wealth preservation many times more than men. One panelist actually argues that women are better suited to handle the stress hormone cortisol since they need not suffer adverse consequences of interaction with testosterone.

While never said explicitly, I could not help but wonder if the message or perhaps question here is: If women played a greater role in financial institutions and at the Fed in years leading up to 2007, would we have avoided the financial or housing crises?  

On millennials. Per Joel Brukenstein of Financial Planning Magazine and creator of Technology Tools for Today website, explains that the days of financial advisors charging 1% annual fee for maintaining a client portfolios of four or five mutual funds are no longer sustainable … replaced with a proliferation of robo-advisors, like Schwab Intelligent Portfolios, which charges “no advisory fees, no account service fees, no commissions, period.”

Ditto, if your services are not available on a smart phone. Millennials are beyond internet savvy and mobile … all data/tools must be accessible via the cloud.

Mr. Brukenstein went so far as to suggest that financial advisors not offering services beyond portfolio management should consider exiting the business.

Keynote highlights. Jeremy Grantham, British-born co-founder of Boston-based asset management firm GMO, once again reiterated his belief that US stocks are 30 – 60% overvalued, still paying for overvaluation sins of our fathers … the great bull run of 1990, which started in 1987, finished in 2000, and was right on the heels of the great bull run of the 1980s. No matter that investors have suffered two 50% drawdowns the past 15 years with the S&P 500 and only received anemic returns, “it will take 25 years to get things right again.” So, 10 more years of suffering I’m afraid.

He blames Greenspan, Bernanke, and Yellen for distorting valuations, the capital markets, the zero interest rate policy … leading to artificially inflated equity prices and a stock-option culture that has resulted in making leaders of publically traded companies wealthy at the expense of capital investment, which would benefit the many. “No longer any room for city or community altruism in today’s capitalism … FDR’s social contract no more.”

All that said he does not see the equity bubble popping just yet … “no bubble peaks before abnormal buyers and deals come to market.” He predicts steady raise until perhaps coming presidential election.

Mr. Grantham is not a believer in efficient market theory. He views the cycles of equity expansion and contraction quite inefficiently driven by career risk (never be wrong on your own …), herding, momentum, extrapolation, excursions from replacement value, then finally, arbitrage and mean reversion at expense of client patience. Round and round it goes.

David Kelly, JP Morgan’s Chief Global Strategist whose quarterly “Guide To Markets” now reaches 169 thousand individuals in 25 countries, also does not see a bear market on horizon, which he believes would be triggered by one or more of these four events/conditions: recession, commodity spike, aggressive fed tightening, and/or extreme valuation. He sees none of these.

He sees current situation in Greece as a tragedy … Germany was too tough during recession. Fortunately, 80% of Greek debt is held by ECB, not Euro banks, so he sees no lasting domino effect if it defaults.

On the US economy, he sees it “not booming, but bouncing back.” Seven years into recovery, which represents the fourth longest expansion dating back to 1900. “Like a Yankees/Red Sox game … long because it is slow.”

He disputes Yellen’s position that there is slack in the economy, citing that last year 60 million people were hired … an extraordinary amount. (That is the gross number; subtract 57 million jobs left, for a net of 3 million.) The biggest threat to continued expansion is lack of labor force, given retiring baby boomers, 12.5% of population with felony convictions, scores addicted to drug, and restrictions on foreign nationals, which he calls the biggest tragedy: “We bring them in. They want to be here. We educate them. They are top of class. Then, we send them home. It’s crazy. We need immigration reform to allow skilled workers to stay.”

Like Grantham, he does see QE helping too much of the wrong thing at this point: “Fertilizer for weeds.”

On oil, which he views like potatoes – a classic commodity: “$110 is too much, but $40 is too low.” Since we have “genetically evolved to waste oil,” he believes now is good time to get in cause “prices have stabilized and will gradually go up.”

Like last fall, he continues to see EM cheap and good long term opportunity. Europe valuations ok … a mid-term opportunity.

He closed by reminding us that investors need courage during bear markets and brains during bull markets.

Breakout sessions. Wasatch’s Laura Geritz was stand-out panelist in break-out session “Are Frontier Markets Worth Pursuing?” She articulates her likes (“Active manager’s dream asset class … capital held dear by phenomenal FM management teams … investments by strong subsidiaries, like Nestle … China’s investment in FM … ”) and dislikes (“No practical index … current indices remain too correlated due to lack of diversification … lack of market liquidity …”). She views FM as strictly long-term investment proposition with lots of ups and downs, but ultimately compelling. If you have not listened to her interview with Chuck Jaffe, you should.

Another break-out session, panelists discussed the current increasing popularity of “ESG Investing.” (ESG stands for environmental, social, and governance. ESG funds, currently numbering more than 200, apply these criteria in their investments.) “Ignore increasingly at your own peril … especially given that women and millennials represent the biggest demographic on horizon.” Interestingly, data suggest such funds do just as well if not slightly better than the overall market.

Lengthening Noses

By Edward Studzinski

“A sign of celebrity is that his name is often worth more than his services.”

Daniel J. Boorstin

So the annual Morningstar Conference has come and gone again, with couple thousand attendees in town hoping to receive the benefit of some bit of investment or business wisdom. The theme of this year’s conference appears to have been that the world of investors now increasingly is populated by and belongs to “Gen X’ers” and “Millennials.” Baby Boomers such as yours truly, are a thing of the past in terms of influence as well as a group from whom assets are to be gathered. Indeed, according to my colleagues, advisors should be focused not on the current decision maker in a client family but rather the spouse (who statistically should outlive) or the children. And their process of decision making will most likely be very different than that of the patriarch. We can see that now, in terms of how they desire to communicate, which is increasingly less by the written word or in face to face meetings.

In year’s past, the conference had the flavor of being an investment conference. Now it has taken on the appearance of a marketing and asset allocation advice event. Many a person told me that they do not come to attend the conference and hear the speakers. Rather, they come because they have conveniently assembled in one place a large number of individuals that they have been interested either in meeting or catching up with. My friend Charles’ observation was that it was a conference of “suits” and “skirts” in the Exhibitors’ Hall. Unfortunately I have the benefit of these observations only second and third hand, as for the first part of the week I was in Massachusetts and did not get back to Chicago until late Wednesday evening. And while I could have made my way to events on Thursday afternoon and Friday morning, I have found it increasingly difficult to take the whole thing seriously as an investment information event (although it is obviously a tremendous cash cow for Morningstar). Given the tremendous success of the conference year in and year out, one increasingly wonders what the correct valuation metric is to be applied to Morningstar equity. Is it the Google of the investment and financial services world? Nonetheless, given the focus of many of the attendees on the highest margin opportunities in the investment business and the way to sustain an investment management franchise, I wonder if, notwithstanding how she said it, whether Senator Elizabeth Warren is correct when she says that “the game is rigged.”

Friday apparently saw two value-oriented investors in a small panel presenting and taking Q&A. One of those manages a fund with $20 Billion in assets, which is a larger amount of money than he historically has managed. Charging a 1% fee on that $20B, his firm is picking up $200 Million in revenue from that one fund alone, notwithstanding that they have other funds. Historically he has been more of a small-midcap manager, with a lot of special situations but not to worry, he’s finding lots of things to invest in, albeit with 40% or so in cash or cash equivalents. The other domestic manager runs two domestic funds as the lead manager, with slightly more than $24 Billion in assets, and for simplicity’s sake, let’s call it a blended rate of 90 basis points in fees. His firm is seeing than somewhat in excess of $216 Million in revenue from the two funds. Now let me point out that unless the assets collapse, these fees are recurring, so in five years, there has been a billion dollars in revenue generated at each firm, more than enough to purchase several yachts. The problem I have with this is it is not a serious discussion of the world we are in at present. Valuation metrics for stocks and bonds are at levels approaching if not beyond the two standard deviation warning bells. I suppose some of this is to be expected, as if is a rare manager who is going to tell you to keep your money. However, I would be hard pressed at this time if running a fund, to have it open. I am actually reminded of the situation where a friend sent me to her family’s restaurant in suburban Chicago, and her mother rattled off the specials of the evening, one of which was Bohemian style duck. I asked her to go ask the chef how the duck looked that night, and after a minute she came back and said, “Chef says the duck looks real good tonight.” At that point, one of the regulars at the bar started laughing and said, “What do you think? The chef’s going to say, oh, the duck looks like crap tonight?”

Now, if I could make a suggestion in Senator Warren’s ear, it would be that hearings should be held about what kind of compensation in the investment management field is excessive. When the dispersion between the lowest paid employee and the highest results in the highest compensated being paid two hundred times more than the lowest, it seems extreme. I suppose we will hear that not all of the compensation is compensation, but rather some reflects ownership and management responsibilities. The rub is that many times the so-called ownership interests are artificial or phantom.

It just strikes that this is an area ripe for reform, for something in the nature of an excess profits tax to be proposed. After all, nothing is really being created here that redounds to the benefit of the U.S. economy, or is creating jobs (and yes Virginia, carried interest for hedge funds as a tax advantage should also be eliminated).

We now face a world where the can increasingly looks like it cannot be kicked down the road financially for either Greece or Puerto Rico. And that doesn’t even consider the states like Illinois and Rhode Island that have serious underfunded pension issues, as well as crumbling infrastructures. So, I say again, there is a great deal of risk in the global financial system at present. One should focus, as an investor, in not putting any more at risk than one could afford to write off without compromising one’s standard of living. Low interest rates have done more harm than good, for both the U.S. economy and the global economy. And liquidity is increasingly a problem, especially in the fixed income markets but also in stocks. Be warned! Don’t be one of the investors who has caught the disease known as FOMO or “Fear of Missing Out.”

It’s finally easy being green

The most widely accepted solution to Americans’ “retirement crisis” – our lifelong refusal to forego the joy of stuff now in order to live comfortably later – is pursuing a second (or third or fifth) career after we’ve nominally retired. Some of us serve as school crossing guards, greeters, or directors of mutual fund boards, others as consultants, carpenters and writers. Honorable choices, all.

But what if you could make more money another way, by selling cigarettes directly to adolescents in poor countries?  There’s a booming market, the U.S. Chamber of Commerce is working globally to be sure that folks keep smoking, and your customers do get addicted. A couple hours a day with a stand near a large elementary school or junior high and you’re golden.

Most of us would say “no.” Many of us would say “HELL NO.” The thought of imperiling the lives and health of others to prop up our own lifestyle just feels horribly wrong.

The question at hand, then, is “if you aren’t willing to participate directly in such actions, why are you willing to participate indirectly in them through your investments?” Your decision to invest in, for example, a tobacco company lowers their cost of capital, increases their financial strength and furthers their business. There’s no real dodging the fact: you become a part-owner of the corporation, underwrite its operations and expect to be well compensated for it.

And you are doing it. In the case of Phillip Morris International (PM), for example, 30% of the firm’s stock is owned by ten investment companies:

Capital World & Capital Research are the advisors to the American Funds. Barrow sub-advises funds for, among others, Vanguard and Touchstone.

That exercise can be repeated with a bunch of variations: what role would you like to play in The Sixth Great Extinction, the impending collapse of the Antarctic ice sheet, or the incineration of young people in footwear factories? In the past, many of us defaulted to one of two simple positions: I don’t have a choice or I can’t afford to be picky.

The days when socially-responsible investing was the domain of earnest clergy and tree-hugging professors are gone. How gone?  Here’s a quick quiz to help provide context: how many dollars are invested through socially-screened investment vehicles?

1. A few hundred million
2. A few billion
3. A few tens of billions
4. A few hundred billion
5. A few trillion
6. Just enough to form a really satisfying plug with which to muffle The Trump.

The answer is “E” (though I’d give credit, on principle, for “F”). ESG-screened investments now account for about one-sixth of all of the money invested in the U.S. —over $6.5 trillion— up by 76% since 2012. In the U.S. alone there are over 200 open-end funds and ETFs which apply some variety of environmental, social and governance screens on their investors’ behalf.

There are four reasons investors might have for pursuing, or avoiding, ESG-screened investments. They are, in brief:

1. It changes my returns. The traditional fear is that by imposing screening costs and limiting one’s investable universe, SRI funds were a financial drag on your portfolio. There have been over 1200 academic and professional studies published on the financial effects, and a dozen or so studies of the studies (called meta-analyses). The uniform conclusion of both academic and professional reviews is that SRI screens do not reduce portfolio returns. There’s some thin evidence of improved performance, but I wouldn’t invest based on that.
2. It changes my risk profile. The traditional hope is that responsible firms would be less subject to “headline risk” and less frequently involved in litigation, which might make them less risky investments. At least when examining SRI indexes, that’s not the case. TIAA-CREF examined a quarter century’s worth of volatility data for five widely used indexes (Calvert Social Index, Dow Jones Sustainability U.S. Index, FTSE4Good US Index, MSCI KLD 400 Social Index, and MSCI USA IMI ESG Index) and concluded that there were no systematic differences between ESG-screened indexes and “normal” ones.
3. It allows me to foster good in the world. The logic is simple: if people refuse to invest in a company, its cost of doing business rises, its products become less economically competitive and fewer people buy them. Conversely, if you give managers access to lots of capital, their cost of capital falls and they’re able to do more of whatever you want them to do. In some instances, called “impact investing,” you actually direct your manager to put money to work for the common ground through microfinance, underwriting housing construction in economically-challenged cities and so on.
4. It’s an expression of an important social value. In its simplest form, it’s captured by the phrase “I’m not giving my money to those bastards. Period.” Some critics of SRI have made convoluted arguments in favor of giving your money to the bastards on economic grounds and then giving other money to social causes or charities. The argument for investing in line with your beliefs seems to have resonated most strongly with Millennials (those born in the last two decades of the 20^th century) and with women. Huge majorities in both groups want to align their portfolio with their desires for a better world.

Our bottom line is this: you can invest honorably without weakening your future returns. There is no longer any credible doubt about it. The real problems you face are (1) sorting through the welter of funds which might impose both positive and negative screens on a conflicting collection of 20 different issues and (2) managing your investment costs.

We’ve screened our own data to help you get started. We divided funds into two groups: ESG Stalwarts, funds with long records and stable teams, and Most Intriguing New ESG Funds, those with shorter records, smaller asset bases and distinctly promising prospects. We derived those lists by looking for no-load options open to retail investors, then looking for folks with competitive returns, reasonable expenses and high Sharpe ratios over the full market cycle that began in October 2007.

In addition, we recommend that you consult the exceedingly cool, current table of SRI funds maintained by the Forum for Sustainable and Responsible Investment. The table, which is sadly not sortable, provides current performance data and screening criteria for nearly 200 SRI funds. In addition, it has a series of clear, concise summaries of each fund on the table.

ESG Stalwarts

Most intriguing new ESG funds

In the wings, socially responsible funds still in registration with the Securities and Exchange Commission which will be available by early autumn include:

Thornburg Better World Fund will seek long-term capital growth. The plan is to invest in international “companies that demonstrate one or more positive environmental, social and governance characteristics.” Details in this month’s Funds in Registration feature.

TIAA-CREF Social Choice International Equity Fund will seek a favorable long-term total return, reflected in the performance of ESG-screened international stocks. MSCI will provide the ESG screens and the fund will target developed international markets. This fund, and the next, will be managed by Philip James (Jim) Campagna and Lei Liao. The managers’ previous experience seems mostly to be in index funds.

TIAA-CREF Social Choice Low Carbon Equity Fund will seek a favorable long-term total return, reflected in the performance of ESG-screened US stocks. MSCI will provide the ESG screens, which will be supplemented by screens looking for firms with “demonstrate leadership in managing and mitigating their current carbon emissions and (2) have limited exposure to oil, gas, and coal reserves.”

Trillium All Cap Fund will seek long term capital appreciation by investing in an all-cap portfolio of “stocks with high quality characteristics and strong environmental, social, and governance records.” Up to 20% of the portfolio might be overseas. The fund will be managed by Elizabeth Levy and Stephanie Leighton of Trillium Asset Management. Levy managed Winslow Green Large Cap from 2009-11, Leighton managed ESG money at SunLife of Canada and Pioneer.

Trillium Small/Mid Cap Fund will seek long term capital appreciation by investing in a portfolio of small- to mid-cap “stocks with high quality characteristics and strong environmental, social, and governance records.” Small- to mid- is defined as stocks comparable in size to those in the S&P 1000, a composite of the S&P’s small and mid-cap indexes. Up to 20% of the portfolio might be overseas. The fund will be managed by Laura McGonagle and Matthew Patsky of Trillium Asset Management. Trillium oversees about $2.2 billion in assets. McGonagle was previously a research analyst at Adams, Harkness and Hill and is distantly related to Professor Minerva McGonagall. Patsky was Director of Equity Research for Adams, Harkness & Hill and a manager of the Winslow Green Solutions Fund.

We, now more than ever in human history, have a chance to make a difference. Indeed, we can’t avoid making a difference, for good or ill. In our daily lives, that might translate to helping our religious community, coaching youth sports, serving meals at a center for the marginally secure or turning our backs on that ever-so-manly Cadillac urban assault vehicle, the Escalade.

That’s all inconvenient, a bit limiting and utterly right, and so we do it. ESG advocates argue that we’ve reached the point where we can do the same things with our portfolios: we can make a difference, encourage good behavior and affirm important personal values, all with little or no cost to ourselves. It seems like a deal worth considering.

The league’s top rebounders

Even the best funds decline in value during either a correction or a bear market. Indeed, many of the best decline more dramatically than their peers because the high conviction, high independence portfolios that are signs of their distinction also can leave them exposed when things turn bad. The disastrous performance of the Dodge & Cox funds during the 2007-09 crash is a case in point.

The real question isn’t “will it fall?” We know the answer. The real question is “will the fall be so bad that I’ll get stupid and insist on selling at a painful loss (again), probably just before a rebound?” Two rarely discussed statistics address that question. The first is recovery time, which simply measures the number of months that it’s taken each fund to recover from its single worst drawdown. The second is the Ulcer Index, one of Charles’s favorite metrics if only because of the name, which was designed by Peter Martin to factor–in both the depth and duration of a fund’s drawdown.

For those casting about for tummy-calming options, we screened for funds that had been around for a full market cycle, then looked at funds which have the shortest recovery times and, separately, the lowest Ulcer Indexes over the current market cycle. That cycle started in October 2007 when the broad market peaked and includes both the subsequent brutal crash and ferocious rebound. Our general sense is that looking at performance across such a cycle is better than focusing on some arbitrary number of years (e.g., 5, 10 or 15 year results).

The first table highlights the funds with the fastest rebounders in each of six popular categories.

The rebound or recovery time doesn’t directly account for the depth of the drawdown. It’s possible, after all, for an utterly nerve-wracking fund to power dive then immediately rocket skyward again, leaving your stomach and sleep behind.  The Ulcer Index figures that in: two funds might each dive, swoop and recover in two months but the one dove least earned a better (that is, lower) Ulcer Index score.

Again, these calculations are looking at performance over the course of the current market cycle only.

How much difference does paying attention to risk make? Fully half of all international large cap funds are still underwater; 83 months after the onset of the crash, they have still not made their investors whole. That roster includes all of the funds indexed to the MSCI EAFE, the main index of large cap stocks in the developed world, as well as actively-managed managed funds from BlackRock, Goldman Sachs, Janus, JPMorgan and others.

In domestic large caps, both the median fund on the list and all major market index funds took 57 months to recover.

Bottom Line: the best time to prepare for the rain is while the sun is still shining. While you might not feel that a portfolio heavy on cash or short-term bonds meets your needs, it makes sense for you to investigate – within whatever asset classes you choose to pursue – funds likely to inflict only manageable amounts of pain. Metrics like recovery time and Ulcer Index should help guide those explorations.

FPA Perennial: Time to Go.

FPA Perennial (FPPFX) closed to new investors on June 15, 2015. The fund that re-opens to new investors at the beginning of October will bear no resemblance to it. If you are a current Perennial shareholder, you should leave now.

Perennial and its siblings, FPA Paramount (FPRAX) and the closed-end Source Capital (SOR), were virtual clones, managed by Steve Geist and Eric Ende. While the rest of FPA were hard-core absolute value guys, G&E ran splendid small- to mid-cap growth funds, fully invested in very high-quality companies, negligible turnover, drifting between small and mid, growth and blend. Returns were consistent and solid. Greg Herr was added to the team several years ago.

In 2013, FPA made the same transition at Paramount that’s envisaged here: the managers left, a new strategy was imposed and the portfolio was liquidated. Domestic growth became global value. Only the name remained the same.

With Perennial, not even the name will remain.

1. All of the managers are going. Mr. Geist retired in 2014 and Ende, at age 70, is moving toward the door. Mr. Herr is leaving to focus on Paramount. They are being replaced by Greg Nathan. Mr. Nathan is described as “the longest serving analyst for the Contrarian Value Strategy, including FPA Crescent Fund (FPACX).”
2. The strategy is going. Geist and Ende were small- to mid-cap growth. The new fund will be all-cap value. It will be the US equity manifestation of the stock-picking strategy used in Crescent, Paramount and International Value. It is a perfectly sensible strategy, but it bears no resemblance to the one for which the fund is known.
3. The portfolio is going. FPA warns that the change “will result in significant long-term capital gains.” Take that warning seriously.  Morningstar calculates your potential capital gains exposure at 63%, that is, 63% of the fund’s NAV is a result of so far untaxed capital gains. If the portfolio is liquidated, you could see up to $36/share in taxable distributions.  

   How likely is a hit of that magnitude? We can compare Paramount’s portfolio before and after the 2013 transition. Of the 31 stocks in Paramount’s portfolio:

   27 positions were entirely eliminated
   2 positions (WABCO and Zebra Technologies) were dramatically reduced
   1 position (Aggreko plc) was dramatically expanded
   1 position (Maxim Integrated Products) remained roughly equal

   During that transition, the fund paid out about 40% of its NAV in taxable gains including two large distributions over the course of two weeks at year’s end.

   Certainly the tax hit will vary based on your cost basis, but if your cost basis is high – $35/share or more – you might be better getting out before the big tax hit comes.

4. The name is going. The new fund will be named FPA S. Value Fund.

I rather like FPA’s absolute value orientation and FPA U.S. Value may well prove itself to be an excellent fund in the long-term. In the short term, however, it’s likely to be a tax nightmare led in an entirely new direction by an inexperienced manager. If you bought FPPFX because you likely want what Geist & Ende did, you might want to look at Motley Fool Great America (TMFGX). It’s got a similar focus on quality growth, low turnover and small- to mid-cap domestic stocks. It’s small enough to be nimble and we’ve identified it as a Great Owl Fund for its consistently excellent risk-adjusted returns.

The mills of justice turn slowly, but grind exceedingly fine.

The SEC this month announced sanctions against two funds for misdeeds that took place five to seven years ago while a third fund worked to get ahead of SEC concerns about its advisor.

On June 17, 2015, the SEC issued penalties to Commonwealth Capital Management and three former three independent members of its mutual fund board. The basic argument is that, between 2008 and 2010, the adviser fed crap to the board and they blindly gobbled it up. (Why does neither half of their equation surprise me?) The SEC’s exact argument is that the board provided misleading information about the fund to the directors and the independent directors failed to exercise reasonable diligence in examining the evidence before approving a new investment contract. The fund in question was small and bad; it quickly added “extinct” to its list of attributes.

On June 22, 2015, the Board of Trustees of the Vertical Capital Income Fund (VCAPX) terminated the investment advisory agreement with Vertical Capital Asset Management, LLC. The fund’s auditor has also resigned. The Board’s vaguely phrased concern is that VCAM “lacks sufficient resources to meet its obligations to the Fund, and failed to adequately monitor the actions of its affiliate Vertical Recovery Management in its duties as the servicing agent of the mortgage notes held by the Fund.”

On June 23, 2015, the SEC reached a settlement with Pekin Singer Strauss Asset Management (PSS), advisor to the Appleseed Fund (APPLX) and portfolio managers William Pekin and Joshua Strauss.  The SEC found “that the securities laws were violated in 2009 and 2010 when PSS did not conduct timely internal annual compliance reviews or implement and enforce certain policies and procedures.” PSS also failed to move clients from the higher-cost investor shares to the lower-cost institutional ones. No one admits or denies anything, though PSS were the ones who detected and corrected the share class issue on their own.

Morningstar, once a fan of the fund, has placed them “under review” as they sort out the implications. That’s got to sting since Appleseed so visibly positions itself as a socially-responsible fund.

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized, searchable, and filtered as never before. For the complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

Order

• The court gave its final approval to a $9.475 million settlement in the ERISA class action that challenged MassMutual‘s receipt of revenue-sharing payments from third-party mutual funds. (Golden Star, Inc. v. Mass Mut. Life Ins. Co.)

Briefs

• Calamos filed a motion to dismiss excessive-fee litigation regarding its Growth Fund. Brief: “Plaintiffs advance overwrought policy critiques of the entire mutual fund industry, legally inapt comparisons between services rendered to a retail mutual fund (such as the [Growth] Fund) and those provided to an institutional account or as sub-adviser, and conclusory assertions that the Fund grew over time but did not reduce its fees that are just the sort of allegations that courts in this Circuit have consistently dismissed for more than 30 years.” (Chill v. Calamos Advisors LLC.)
• Parties filed dueling motions for summary judgment in fee litigation regarding eight Hartford mutual funds. Plaintiffs’ section 36(b) claims, first filed in 2011, previously survived Hartford’s motion to dismiss. The summary judgment briefs are unavailable on PACER. (Kasilag v. Hartford Inv. Fin. Servs. LLC; Kasilag v. Hartford Funds Mgmt. Co.)
• New York Life filed a motion to dismiss excessive-fee litigation regarding four of its MainStay funds. Brief: Plaintiffs’ complaint “asserts in conclusory fashion that Defendant New York Life Investment Management LLC (‘NYLIM’) received excessive fees for management of four mutual funds, merely because NYLIM hired subadvisors to assist with its duties and paid them a portion of the total management fee. But NYLIM’s employment of this manager/subadvisor structure—widely utilized throughout the mutual fund industry and endorsed by NYLIM’s regulator—cannot itself constitute a breach of NYLIM’s fiduciary duty under Section 36(b) of the Investment Company Act . . . .” (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

The Alt Perspective: Commentary and news from DailyAlts.

Survey Says…

The spring is the season for surveys and big opinion pieces. Perhaps it is the looming summer vacations of readers that prompt companies to survey the market for opinions and views on particular topics before everyone heads out of the office for a long break. Regardless, the survey results are in, the results have been tallied and in the world of liquid alternatives, it appears that the future looks good.

Two industry surveys that were completed recently are cited in the articles below. The first provides the results of a survey of financial advisors about their allocations to alternative investments, and notes that more than half of the financial advisors surveyed think that their clients should allocate between 6% and 15% to alternative investments – a significant increase from today’s levels.

The second report below provides big picture industry thinking from Citi’s Business Advisory Services unit, and projects the market for liquid alternatives to double over the next five years, increasing to more than $1.7 trillion in assets.

• Majority of Advisors Plan to Continue Recommending Alternatives
• Citi Sees Boom in Unconstrained Long, Smart Beta and Liquid Alts

While industry surveys and big picture industry reports can often over-project the optimism and growth of a particular product group, the directional trends are important to watch. And in this case, the trends continue to be further growth of the liquid alternatives market, both here in the U.S. and abroad.

Monthly Liquid Alternative Flows

Consistent with the reports above, investors continued to allocate to alternative mutual funds and ETFs in May of this year. Investors allocated a net total of $2 billion to the space in May, a healthy increase from April’s level of $723 million, and a return to levels we saw earlier in the year.

While only two categories had positive inflows last month, this month has four categories with positive inflows. Once again, multi-alternative funds that combine multiple styles of investing, and often multiple asset managers, all into a single fund had the most significant inflows. These funds pulled in $1.8 billion in net new assets. Managed futures are once again in second place with just over $520 million in new inflows.

While the outflows from long/short equity funds have moved closer to $0, they have yet to turn positive this year. With equity market conditions as they are, this has the potential to shift to net inflows over the coming months. Commodity funds continued to struggle in May, but investors kicked it up a notch and increased the net outflows to more than $1.5 billion, more than a double from April’s level.

Diversification and one stop shopping continue to be an important theme for investors. Multi-alternative fund and managed futures funds provide both. Expect asset flows to liquid alternatives to continue on their current course of strong single-digit to low double-digit growth. Should the current Greek debt crisis or other global events cause the markets to falter, investors will look to allocate more to liquid alternatives.

New Fund Launches

We have seen 66 new funds launched this year, up from 53 at the end of April. This includes alternative beta funds as well as non-traditional bond funds, both of which provide investors with differentiated sources of return. In May, we logged 13 new funds, with nearly half being alternative beta funds. The remaining funds cut across multi-alternative, non-traditional bonds and hedged equity.

Two of the funds that were launched in May were unconstrained bond funds, one of the more popular categories for asset inflows in 2014. This asset category is meant to shield investors from the potential rise in interest rates and the related negative impact of bond prices. Both Virtus and WisdomTree placed a bet on the space in May with their new funds that give the portfolio managers wide latitude to invest across nearly all areas of the global fixed income market on a long and short basis.

While significant assets have flowed into this category of funds over the past several years, the rise in interest rates has yet to occur. This may change come September, and at that point we will find out if the unconstrained nature of these funds is helpful.

For more details on new fund launches, you can visit our New Funds 2015 page.

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. 

Eventide Healthcare & Life Sciences (ETNHX): Morningstar’s 2015 conference included a laudatory panel celebrating “up and coming” funds, including the five star, $2 billion Eventide Gilead. At yet as I talked with the Eventide professionals the talk kept returning to the fund that has them more excited, Healthcare. The fund looks fascinating and profitable. Unfortunately, we need answers to two final questions before publishing the profile. We’re hopeful of having those answers in the first couple days of July; we’ll notify the 6000 members of our mailing list as soon as the profile goes live

Launch Alert

Thornburg Developing World (THDAX) is one of the two reasons for being excited about Artisan Developing World (ARTYX). Artisan’s record for finding and nurturing outstanding management teams is the other.

Lewis Kaufman managed Thornburg Developing World from inception through early 2015. During that time, he amassed a remarkable record for risk-sensitive performance.  A $10,000 investment at inception would have grown to $15,700 on the day of Mr. Kaufman’s departure, while his peers would have earned $11,300. Morningstar’s only Gold-rated emerging markets fund (American Funds New World Fund NEWFX) would have clocked in at $13,300, a gain about midway between mediocre and Mr. Kaufmann.

By all of the risk and risk/return measures we follow, he achieved those gains with lower volatility than did his peers.

Mr. Kaufman pursues a compact, primarily large-cap portfolio. He’s willing to invest in firms tied to, but not domiciled in, the emerging markets. And he has a special interest in self-funding companies; that is, firms that generate free cash flow sufficient to cover their operating and capital needs. That allows the firms insulate themselves from both the risk of international capital flight and dysfunctional capital markets that are almost a defining feature of the emerging markets. Andrew Foster of Seafarer Overseas Growth & Income (SFGIX) shares that preference for self-funding firms and it has been consistently rewarding.

There are, of course, two caveats. First, Thornburg launched after the conclusion of the 2007-09 market crisis. That means that it only dealt with one sharply down quarter (3Q2011) and it trailed the pack then. Second, Thornburg’s deep analyst core doubtless contributed to Mr. Kaufmann’s success. It’s unclear how reliance on a smaller team will affect him.

In general, Artisan’s new funds have performed exceptionally well (the current E.M. product, which wasn’t launched in the retail market, is the exception). Artisan professes only ever to hire “category killers,” then gives them both great support and great autonomy. That process has worked exceptionally well. I suggested on our discussion board “that immediately upon launch, our short-list of emerging markets funds quite worth your money’ will grow by one.” I’m pretty comfortable with that prediction.

Artisan Developing World (ARTYX) has a 1.5% initial expense ratio and a $1,000 investment minimum.

Funds in Registration

There are eight new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase in September or early October.

Two funds sort of pop out:

RiverNorth Marketplace Lending Fund will invest in loans initiated by peer-to-peer lenders such as LendingClub and Prosper.com. It’s structured as a non-listed closed-end fund which will likely offer only periodic liquidity; that is, you might be able to get out just once a month or so. The portfolio’s characteristics should make it similar to high-yield bonds, offering the chance for some thrills and interest rate insulation plus high single-digit returns. It’s a small market; about $7 billion in loans were made last year, which makes it most appropriate to a specialist boutique firm like RiverNorth.

Thornburg Better World will be an international fund with strong ESG screens. Thornburg’s international funds are uniformly in the solid-to-outstanding range, though the departure of Lewis Kaufmann and some of his analysts for Artisan certainly make a dent. That said, Thornburg’s analyst core is large and well-respected and socially-responsible investing has established itself as an entirely mainstream strategy.

Manager Changes

This month there were only 38 funds reporting partial or complete changes in their management teams. This number is slightly inflated by the departure of Wayne Crumpler from eleven American Beacon funds. The most notable changes include Virginie Maisonneuve’s departure from another PIMCO fund, and Thomas Huber stepping down from T. Rowe Price Growth & Income. The good news is that he’s remaining at T. Rowe Price Dividend Growth where he’s had a longer record and more success.

Updates

In May we ran The Dry Powder Gang, a story highlighting successful funds that are currently holding exceptionally high levels of cash. After publication, we heard from two advisors who warned that their funds’ cash levels were dramatically lower than we’d reported: FMI International (FMIJX) and Tocqueville International Value (TIVFX).

The error came from, and remains in, the outputs from Morningstar’s online fund screener.  Here is Morningstar’s report of the most cash-heavy international funds, based on a June 30 2015 screening:

Cool, except for the fact the Brown is 9% cash, not 66%; FMI is 20%, not 62%; AQR is 7%, not 56% … down to Tocqueville which is 6%, not 38%.

Where do those lower numbers come from? Morningstar, of course, on the funds’ “quote” and “portfolio” pages.

We promptly corrected our misreport and contacted Morningstar. Alexa Auerbach, a kind and crafty wizard there, explained the difficulty: the cash levels reported in the screener are “long rescaled” numbers. If a fund has both long and short positions, which is common in international funds which are hedging their currency exposures, Morningstar recalculates the cash position as a percentage of the fund’s long portfolio. “So,” I asked, “if a fund was 99% short and 1% long, including a 0.3% cash position, the screener would report a 30% cash stake?” Yep.

When I mentioned that anomaly to John Rekenthaler, Morningstar’s resident thunderer and former head of research, he was visibly aroused. “Long-rescaled? I thought I’d killed that beast five years ago!” And, grabbing a cudgel, he headed off again in the direction of IT.

I’ll let you know how the quest goes. In the interim, we will, and you should be a bit vigilant in checking curious outputs from the software.

Trust but Verify

On December 9, 2014, BlackRock president Larry Fink told a Bloomberg TV interviewer, “I am absolutely convinced we will have a day, a week, two weeks where we will have a dysfunctional market. It’s going to create some sort of panic, create uncertainty again.” That’s pretty much the argument that Ed and I have made, in earlier months, about ongoing liquidity constraints and an eventual crisis. It’s a reasonably widespread topic of conversation about serious investment professionals, as well as the likes of us.

Fink’s solution was electronic bond trading and his fear was not the prospect of the market crisis but, rather, of regulators reacting inappropriately. In the interim, BlackRock applied for permission to do inter-fund lending: if one of their mutual funds needed cash to meet redemptions, they could take a short-term loan from a cash-rich BlackRock fund in lieu of borrowing from the banks or hastily selling part of the portfolio. It is a pretty common provision.

Which you’d never know from one gold bug’s conclusion that Fink sounded “BlackRock’s Warning: Get Your Money Out Of All Mutual Funds.” It’s the nature of the web that that same story, generally positioned as “What They Don’t Want You to Know,” appeared on a dozen other websites, some with remarkably innocuous names. Those stories stressed that the problem would last “days or even weeks,” which is not what Fink said.

Briefly Noted . . .

On June 4, 2015, John L. Keeley, Jr., the president and founder of Keeley Asset Management and a portfolio manager to several of the Keeley funds passed away at a still-young 75. He’s survived by his wife of 50+ years and a large family. His rich life, good works and premature departure remind us all of the need to embrace our lives while we can, rather than dully plodding through them.

Conestoga SMid Cap Fund (CCSMX) just gained, with shareholder approval, a 12(b)1 fee. (Shareholders are a potentially valuable source of lanolin.) Likewise, the Hennessy Funds are asking shareholders to raise their costs via a 12(b)1 fee on the Investor Class of the Hennessy Funds.

In the “let’s not be too overt about this” vein, Janus quietly added a co-manager to Janus Unconstrained Global Bond (JUCAX).  According to the WSJ, Janus bought the majority stake in an Australian bond firm, Kapstream Capital Pty Ltd., then appointed Kapstream’s founder to co-manage Unconstrained Bond.  Kumar Palghat, the co-manager in question, is a former PIMCO executive who managed a $22 billion bond portfolio for PIMCO’s Australian division. He resigned in 2006, reportedly to join a hedge fund.

It’s intriguing that Gross, who once managed $1.8 trillion, is struggling with one-tenth of one percent of that amount. Janus Unconstrained is volatile and underwater since launch. Its performance trails that of PIMCO Unconstrained (PFIUX), the BarCap Aggregate, its non-traditional bond peer group, and most other reasonable measures.

PIMCO has announced reverse share-splits of 2:1 or 3:1 for a series of its funds: PIMCO Commodity Real Return Strategy Fund (PCRAX), PIMCO RAE Fundamental Advantage PLUS Fund (PTFAX), PIMCO Real Estate Real Return Strategy Fund (PETAX) and PIMCO StocksPLUS Short Fund (PSSAX). Most of the funds have NAVs in the neighborhood of $2.50-4.00. At that level, daily NAV changes of under 0.25% don’t get reflected (they round down to zero) until a couple consecutive unreported changes pile up and trigger an unusually large one day move.

O Canada! Your home and native land!! Vanguard just noticed that Canada exists and that it is (who knew?) a developed market. As a result, the Vanguard Developed Markets Index Fund will now track the FTSE Developed All Cap ex US Index rather than the FTSE Developed ex North America Index. The board has also approved the addition of the Canadian market to the Fund’s investment objective. Welcome, o’ land of pines and maples, stalwart sons and gentle maidens!

Vanguard’s Emerging Markets, Pacific and European stock index funds will also get new indexes, some time late in 2015. Vanguard’s being intentionally vague on the timing of the transition to try to prevent front-running by hedge funds and others. In each case, the new index will include a greater number of small- to mid-cap names. The Emerging Markets index will, in addition, include Chinese “A” shares. One wonders if recent events are causing them to reconsider?

Villere Balanced Fund (VILLX) and Villere Equity Fund (VLEQX) may, effective immediately, lend securities – generally, that means “to short sellers” – “in order to generate return.”

SMALL WINS FOR INVESTORS

AMG Yacktman (YACKX) and AMG Yacktman Focused (YAFFX) both reopened to new investors on June 22, 2015. The reopening engendered a lively debate on our discussion board. One camp pointed out that these are top 1% performers over the past 10- and 15-year periods. The other mentioned that they’re bottom 10% performers over the past 3- and 5-year periods. The question of asset bloat (about $20 billion between them) came up as did the noticeable outflows ($4 billion between them) in the last several years. There was a sense that the elder Mr. Yacktman was brilliant and a phenomenally decent man but, really, moving well into the “elder” ranks. Son Steve, who has been handling the funds’ day-to-day operations for 15 years is … hmmm, well, a piece of work.

The Barrow Funds, Barrow Value Opportunity Fund (BALAX/BALIX) and Barrow Long/Short Opportunity Fund (BFLSX/BFSLX) are converting from two share classes to one. The investor share class closed to new purchases on June 2 and merged into the institutional share class on June 30. At that same time, the minimum investment requirement for the institutional shares dropped from $250,000 to $2,500.  The net effect is that Barrow gets administrative simplicity and their investors, current and potential, get a price break.

Effective immediately, the name of the Hatteras Hedged Strategies Fund has changed to Hatteras Alternative Multi-Manager Fund (HHSIX).  Here’s the “small wins” part: they’ve sliced their minimum initial investment from $150 million to $1 million! Woo hoo! And here’s the tricky part: the fund has only $97 million in assets which implies that the exalted minimum was honored mostly in the breach.

The Royce Funds reduced their advisory fees for their European Smaller-Companies Fund, Global Value, International Smaller-Companies, International Micro-Cap and International Premier funds on July 1, 2015. The reductions are about 15 basis points, which translates to a drop in the funds’ expense ratios of about 10%.

Nota bene: the Royce Funds make me crazy. After a series of liquidations in April, there are 22 funds left which will drop to 21 in a couple of months. Of those, two have above average returns for the past five years while 16 trail at least 80% of their peers. The situation over the past decade is better, but not much. If you screen out the sucky, high risk and economically unviable Royce funds, you get down to about five: Global Financial Services and a bunch that existed before Legg Mason bought the firm and got them to start churning out new funds.

Effective June 1, 2015, the Schroder U.S. Opportunities Fund (SCUIX), which had been closed to new investors, will become available for purchase by investors generally. Actually with a $250,000 investment minimum, it “became available for purchase by really rich investors generally.”

CLOSINGS (and related inconveniences)

Effective as of the close of business on July 15, 2015, Brown Advisory Small-Cap Fundamental Value Fund (BIAUX) will stop accepting new purchases through most broker-dealer firms.

Eaton Vance Atlanta Capital Horizon Growth Fund (EXMCX) announced its plan to close to new investors on July 13, 2015. I wouldn’t run for your checkbook just yet. The fund has only $34 million in assets and has trailed pretty much everybody in its peer group, pretty much forever:

INTECH U.S. Core Fund (JDOAX) closed to new investors on June 30, 2015. Why, you ask? Good question. It’s a small fund that invests in large companies with a doggedly mediocre record. Not “bad,” “mediocre.” Over the past decade, it’s trailed the S&P 500 by 0.11% annually with no particular reduction of volatility. The official reason: “because Janus Capital and the Trustees believe continued sales are not in the best interests of the Fund.”

OLD WINE, NEW BOTTLES

The Calvert Social Index Fund is now Calvert U.S. Large Cap Core Responsible Index Fund (CSXAX). At the same time, the adviser reduced the fund’s expense ratio by nearly one-third, from 0.75% down to 0.54% for “A” shares.  

Effective June 2, 2015, Columbia LifeGoal Growth Portfolio, a fund of funds, became Columbia Global Strategic Equity Fund (NLGIX). At the same time the principal investment strategies were revised (good plan! It trails 90% of its peers over the past 1, 3 and 5 years) to eliminate a lot of the clutter about how much goes into which Columbia fund. The proviso that the fund will invest at least “40% of its net assets in foreign currencies, and equity and debt securities” implies a currency-hedged portfolio.

FPA Perennial (FPPFX) has closed for a few months while it becomes an entirely different fund using the same name.

Effective immediately, the name of the Hatteras Hedged Strategies Fund has changed to Hatteras Alternative Multi-Manager Fund (HHSIX). 

On August 31, 2015: iShares MSCI USA ETF (EUSA) becomes iShares MSCI USA Equal Weighted ETF. We’ll leave it to you to figure out how they might be changing the portfolio.

Natixis Diversified Income Fund (IIDPX) becomes Loomis Sayles Multi-Asset Income Fund on August 31, 2015. The investment strategy gets tweaked accordingly.

-er, don’t panic! A handful of Royce funds have lost their –ers. On June 15, Royce International Smaller-Companies Fund became Royce International Small-Cap Fund (RYGSX), European Smaller-Companies Fund became European Small-Cap Fund (RISCX) and Royce Financial Services Fund became Royce Global Financial Services Fund (RYFSX). In the former two cases, the managers wanted to highlight the fact that they focused on a stock’s capitalization rather than the size of the underlying firm. In the latter case, RYFSX has about five times the international exposure of its peers. Given that excellent performance (top 2% over the past decade) and a distinctive portfolio (their market cap is one-twentieth of their peers) hasn’t drawn assets, I suppose they’re hoping that a new name will. At the very least, with eight funds – over a third of their lineup – renamed in the past three months, that’s the way they’re betting.

Oppenheimer Flexible Strategies Fund (QVOPX) becomes Oppenheimer Fundamental Alternatives Fund on August 3, 2015. There’s no change in the fund’s operation, so apparently “strategies” are “alternatives,” just not trendy alternatives.

On June 22, 2015, the Sterling Capital Strategic Allocation Conservative Fund (BCGAX) morphed into Sterling Capital Diversified Income Fund. Heretofore it’s been a fund of Sterling funds. With the new name comes the ability to invest in other funds as well.

In case you hadn’t noticed, on June 18, 2015, the letters “TDAM” were replaced by the word “Epoch” in the names of a bunch of funds: Epoch U.S. Equity Shareholder Yield Fund, Epoch U.S. Large Cap Core Equity Fund, Epoch Global Equity Shareholder Yield Fund, Epoch Global All Cap Fund, and Epoch U.S. Small-Mid Cap Equity Fund. The funds, mostly bad, have two share classes each and have authorization to launch eight additional share classes. Except for U.S. Small-Mid Cap, they have $3-6 million in assets.

Effective July 31, 2015 Virtus Global Dividend Fund (PGUAX), a perfectly respectable fund with lots of global infrastructure exposure, becomes Virtus Global Infrastructure Fund.

Effective August 28, 2015, the West Shore Real Return Income Fund (NWSFX) becomes West Shore Real Return Fund. They’re also changing their objective from “capital growth and current income” to “preserving purchasing power.” They’ve pretty much completely rewritten their “principal strategies” text so that it’s hard to know how exactly the portfolio will change, though the addition of a risk statement concerning the use of futures and other derivatives does offer a partial answer. I’ve been genially skeptical of the fund for a long while. Their performance chart doesn’t materially reduce that skepticism:

At a reader’s behest, I spoke at length with one of the managers whose answers seemed mostly circular and who was reluctant to share information about the fund. He claimed that they have a great record as a private strategy, that they’ve shown to the board, but that they’re not interested in sharing with others. His basic argument was: “we don’t intend to make information about the fund, our strategies or insights available on the web. Our website is just a pick-up point for the prospectus. We expect that people will either know us already or will follow our success and be drawn.” At the end of the call, he announced that he and co-manager James Rickards were mostly the public faces of the fund and that the actual work of managing it fell to the third member of the trio. Mr. Rickards has since left to resume his career as doom-sayer.

OFF TO THE DUSTBIN OF HISTORY

Aftershock Strategies Fund (SHKIX/SHKNX) has closed and will discontinue its operations effective July 6, 2015.

You’ll need to find an alternative to AMG FQ Global Alternatives Fund (MGAAX), which is in the process of liquidating. Apparently they’re liquidating (or solidifying?) cash:

Final shutdown should occur by the end of July.

Elessar SCV Fund has morphed into the Emerald Small Cap Value Fund (ELASX)

Franklin Templeton has delayed by a bit the liquidation of Franklin Global Allocation Fund (FGAAX). The original date of execution was June 30 but “due to delays in liquidating certain portfolio securities,” they anticipate waiting until October 23. That’s a fascinating announcement since it implies liquidity problems though that’s not listed as an investment risk in the prospectus.

Guggenheim Enhanced World Equity Fund “ceased operations, liquidated its assets, and distributed the liquidation proceeds to shareholders of record at the close of business on June 26, 2015.”

Salient recently bought the Forward Funds complex “in an effort to build scale in the rapidly growing liquid alternatives space.” The brilliance of the deal is debatable (Forward favors liquid alts investing, but only three of its 30 funds – Select Emerging Markets Dividend, Credit Analysis Long/Short (whose founding managers were sacked a year ago) and High Yield Bond – have outperformed their peers since inception). As it turns out, Forward Small Cap Equity Fund (FFSCX) and Forward Income & Growth Allocation Fund (AOIAX) fell into neither of those camps: good or alternative. Both are scheduled to be liquidated on August 12, 2015.

HSBC RMB Fixed Income Fund (HRMBX), an exceptionally strong EM bond fund with no investors, will be liquidated on or about July 21, 2015.

MainStay ICAP Global Fund (ICGLX) will be liquidated on or about September 30, 2015. Small, middling performer, culled from the herd.

Sometimes a picture is worth a thousand words. Other times a picture leaves me speechless. Such is the case with the YTD price chart for Merk Currency Enhanced U.S. Equity Fund (MUSFX).

Yuh. That’s a one-day spike of about 60%, followed by a 60% fall the next day for a net loss of a third over two days, at which point the fund was no longer “pursuing its investment objective.” The fund is scheduled to be liquidated July 15.

Montibus Small Cap Growth Fund (SGWAX) joins the legion of the dearly departed on August 24, 2015.

Nationwide HighMark Balanced Fund (NWGDX) will, pending shareholder approval, vanish on or about October 23, 2015. At about the same time Nationwide HighMark Large Cap Growth (NWGLX) is slated to merge into Nationwide Large Cap Core Equity while Nationwide HighMark Value (NWGTX) gets swallowed by Nationwide Fund (NWFAX). The latter has been rallying after getting a new manager in 2013, so we’ll be hopeful that this is a gain for shareholders.

At the end of July, shareholders will vote on a proposal to merge the small and sad Royce Select Fund (RYSFX) into the much larger and sadder Royce 100 (RYOHX). The proxy assures investors that “the Funds have identical investment objectives, employ substantially similar principal investment strategies to pursue those investment objectives, and have the same portfolio managers,” which raises the question of why they launched Select in the first place.

The previously announced liquidation of the half million dollar Rx Tax Advantaged Fund (FMERX) has been delayed until July 31, 2015. 

On or about August 25, 2015, the Vantagepoint Model Portfolio All-Equity Growth Fund (VPAGX) becomes Vantagepoint Model Portfolio Global Equity Growth Fund and increases its equity exposure to non-U.S. securities by adding an international index fund to its collection. The fund has about a billion in assets. Who knew?

Relationships come and relationships go. One of the few proprieties that my students observe is, if you’ve actually met and gone out in person, you should be willing to break up in person. Breaking up by text is, they agreed, cruel and cowardly. I suspect that they’re unusually sympathetic with the managers of Wells Fargo Advantage Emerging Markets Local Bond Fund (WLBAX) and Wells Fargo Advantage Emerging Markets Equity Select Fund (WEMTX). “At a telephonic meeting held on June 15, 2015, the Board of Trustees unanimously approved the liquidation of the Funds.” Cold, dude. If you’d like to extend your sympathies, best send the text before July 17, 2015.

Wilmington Mid-Cap Growth Fund (AMCRX) will liquidate on or about August 3, 2015. Being “not very good” (they’ve trailed two-thirds of their peers for the past five and ten years) didn’t stop them from accumulating a quarter billion in assets but somehow the combination wasn’t enough to keep them around. Wilmington Small-Cap Strategy Fund (WMSIX), a small institutional fund with a pretty solid record and stable management, goes into the vortex that same day.

In Closing . . .

Thank you, once again, to those whose support keeps the lights on at the Observer. To Diane & Tom, Allen & Cleo, Hjalmar, Ed (cool and mysterious email address, sir!): we appreciate you!  A great, big thanks to those who use the Observer’s Amazon link for all their Amazon purchases. Your consistency, and occasional exuberant purchase, continues to help us beat our normal pattern of declining revenue in the summer months. We’d also be remiss if we forgot to thank the faithful Deborah and Greg, our honorary subscribers and PayPal monthly contributors. Many thanks to you both.

Lots to do for August. We’ve been watching the folks at the Turner Funds thrash about, both in court and in the marketplace. We’ll try to give you some perspective on what some have called The Fall of the House of Turner. In addition, we’d like to look at the question, “where should you start out?” That is, if you or a young friend of yours is a 20-something with exceedingly modest cash flow but a determination to build a sensible, durable foundation, which funds might serve as your (or their) best first investment: conservative, affordable, sensible.

And, too, I’ve got to prepare for a couple presentations: a talk with some of the young analysts at Edward Jones in St. Louis and with the folks attending Ultimus Fund Solution’s client conference at the end of August and beginning of September. If I find something fun, you’ll be the second to know!

As ever,