By David Snowball

Dear friends,

The folks in Washington are, for the most part, acting like six-year-olds who missed their nap times.  The New York Fed is quietly warning money market managers to reduce their exposure to European debt.  A downgrade of the federal government’s bond rating seems nearly inevitable. The stock market managed only one three-day set of gains in a month.

In short, it’s summer again.

Grandeur Peak and the road less traveled

A team of managers, led by Robert Gardiner, and executives left Wasatch Advisors at the end of June 2011 to strike out on their own.  In mid July they announced the formation of Grandeur Peak Global Advisors and they filed to launch two mutual funds.  The new company is immediately credible because of the success that Mr. Gardiner and colleague Blake Walker had as Wasatch managers.

Robert Gardiner managed or co-managed Wasatch Microcap (WMICX), Small Cap Value (WMCVX) and Microcap Value (WAMVX, in which I own shares).  In 2007, he took a sort of sabbatical from active management but continued as Director of Research.  During that sabbatical, he reached a couple conclusions: (1) global microcap investing was the world’s most interesting sector and (2) he’d like to manage his own firm.  He returned to active management with the launch of Wasatch Global Opportunities (WAGOX), a global micro-to small-cap fund.  From inception in late 2008 to July 2011, WAGOX turned a $10,000 investment into $23,500 while an investment in its average peer would have led to a $17,000 portfolio.  Put another way, WAGOX earned $13,500 or 92% more than its average peer managed.

Blake Walker co-managed Wasatch International Opportunities (WAIOX) from 2005-2011.  The fund was distinguished by outsized returns (top 10% of its peer group over the past five years, top 1% over the past three), and outsized stakes in emerging markets (nearly 50% of assets) and micro- to small-cap stocks (66% of assets, roughly twice what peer funds have).  In March 2011, Lipper designated WAIOX as the top International Small/Mid-Cap Growth Fund based on consistent (risk-adjusted) return for the five years through 2010. In March 2009, it had received Lipper’s award for best three-year performance.

Wasatch published an interesting paper on the ongoing case for global small and micro-cap investing, “Think International, Think Small” (January 2011).

Gardiner had talked with Wasatch about starting his own firm for a number of years. At age 46, he decided that it was time to pursue that dream. Grandeur Peak’s president, Eric Huefner described the eventual departure of Gardiner & co. as “very friendly,” and he stressed the ongoing ties between the firms.  The fact that Grandeur Peak is one of the most visible mountains in the Wasatch Range, one does get a sense of amity.

According to SEC filings and pending SEC approval, Grandeur Peaks will launch two funds at the beginning of October: Global Opportunities and International Opportunities.  Both will be managed jointed by Messrs. Gardiner and Walker. The short version:

Grandeur Peak Global Opportunities will seek long-term growth by investing, primarily, in a small- and micro-cap global portfolio.  The target universe is stocks valued under $5 billion, though up to one-third of the portfolio might be invested in worthy, larger firms.  Emerging markets exposure will range from 5-50%.   The minimum investment will be $2000, reduced to $1000 for funds with an automatic investment plan.  Expenses will be capped at 1.75% with a 2% redemption fee on shares held for 60 days or less.

Grandeur Peak International Opportunities will seek long-term growth by investing, primarily, in a small- and micro-cap international portfolio.  The target universe is stocks valued under $2.5 billion.  Emerging markets exposure will range from 10-60%.   As with Global, the minimum investment will $2000, reduced to $1000 for funds with an automatic investment plan, and expenses will be capped at 1.75% with a 2% redemption fee on shares held for 60 days or less.

Global’s investment strategies closely parallel Wasatch Global’s.  International differs from its Wasatch counterpart in a couple ways: its target universe has a higher cap ($1 billion for Wasatch, $2.5 billion for Grandeur) and it has a bit more wiggle room on emerging markets exposure (20-50% for Wasatch, 10 – 60% for Grandeur).

A key difference is that Grandeur intends to charge substantially less for their funds.  Both of the new funds will have expenses capped at 1.75%, while the Wasatch funds charge 1.88 and 2.26% for International and Global, respectively. That expense cap represents a substantial and, I’m sure, well considered risk for Grandeur.  Small global funds cost a lot to run.  A fund’s actual expenses are listed in its annual report to shareholders.  There are a couple dozen no-load, retail global funds with small asset bases.  Here are the asset bases and actual expenses for a representative sample of them:

Advisory Research Global Value (ADVWX), $13 million in assets, 5.29% in expenses

Artisan Global Equity (ARTHX), $15 million, 1.5%

Alpine Global Infrastructure (AIFRX ), $12 million , 3.03%

Chou Equity Opportunity (CHOEX), $24 million, 28.6%

Commonwealth Global (CNGLX), $15 million, 3.02%

Encompass (ENCPX), $25 million, 1.45%

Jubak Global Equity (JUBAX), $35 million, 5.43%

Roge Partners (ROGEX), $13.5 million, 2.46%

Unlike many start-ups, Grandeur has chosen to focus initially on the mutual fund market, rather than managing separate accounts or partnerships for high net worth individuals and institutions.

Mr. Gardiner is surely familiar with Robert Frost’s The Road Not Taken, from which we get the endlessly quoted couplet, “Two roads diverged in a wood, and I— I took the one less traveled by.”  From microcap growth investing to international microcaps to launching his own firm, he’s traveled many “paths less traveled by.” And he’s done it with consistent success.  I wish him well with the launch of Grandeur Peaks and hope to speak with one or another of the managers after their funds launch in October.

And yet I’m struck by Frost’s warning that his poem was “tricky, very tricky that one.”  Americans uniformly read the poem to say “I took the road less traveled and won as a result.”  In truth, the poem says no such thing and recounts a tale told, many years later, “with a sigh.”

Fund Update: RiverPark Short Term High Yield (RPHYX)

Like Grandeur Peak, RiverPark Advisors grew from the decision of high-profile executives and managers to leave a well-respected mid-sized fund company.  Morty Schaja, president of Baron Asset Management, left with an investment team in 2009 to found RiverPark.  The firm runs two small funds (RiverPark Small Cap Growth RPSFX and Large Cap Growth RPXFX) and advises three other, sub-advised funds.

I profiled (and invested in) RiverPark Short Term High Yield, one of the sub-advised funds, in July.  The short version of the profile is this: RPHYX has the unique and fascinating strategy (investing in called high yield bonds, among other things) that allows it to function as a cash management fund with a yield 400-times greater than the typical money market.  That profile engendered considerable discussion and a number of reader questions.  The key question is whether Cohanzick, the adviser, had the strategy in place during the 2008 meltdown and, if so, how it did.

Mr. Schaja was kind enough to explain that while there wasn’t a stand-alone strategy in 2008, these investments did quite well as part of Cohanzick’s broader portfolios during the turmoil.  He writes?

Unfortunately, the pure separate accounts using this strategy only began in 2009, so we have to look at investments in this strategy that were part of larger accounts (investing the excess cash).   While we can’t predict how the fund may perform in the hypothetical next crisis, we take comfort that in 2008 the securities performed exceedingly well.  As best as we can tell there were some short term negative marks as liquidity dried up, but no defaults.  Therefore, for those investors that were not forced to sell, within weeks and months the securities matured at par.   Therefore, under this hypothetical scenario, even if the Fund’s NAV fell substantially over a few days because markets became illiquid and pricing difficult, we would expect the Fund’s NAV would rebound quickly (over a few months) as securities matured.  If we were lucky enough to receive positive flows into the Fund in such an environment, the Fund could take advantage of short term volatility to realize unusually and unsustainable significantly higher returns.

One reader wondered with RPHYX would act rather like a floating-rate fund, which Mr. Schaja rather doubted:

In an environment where default risk is of primary concern, we would expect the Fund to compare favorably to a floating rate high income fund.   While floating rate funds protect investors from increasing interest rates they are typically invested in securities with longer maturities and therefore inherently greater default risk.   Additionally, the Fund is focused not only on securities with limited duration but where Cohanzick believes there is limited risk of default in the short period until the time in which it believes the securities will either mature or be redeemed.

It is striking to me that during the debt-related turmoil of the last weeks of August, RPHYX’s net asset value never moved: it sold for $9.98 – 10.01 with most of the change accounted for by the fund’s monthly income distribution.  It remains, in my mind, a fascinating option for folks distraught by money market funds taking unseen risks and returning nothing.

Fund Update: Aston/River Road Independent Value

One of my last FundAlarm profiles celebrated the launch of Aston/River Road Independent Value (ARIVX) was “the third incarnation of a splendid, 15-year-old fund.”  Eric Cinnamond, the manager here and formerly of Intrepid Small Cap (ICMAX), has an outstanding record for investing in small and midcap stocks while pursuing an “absolute return” strategy.  He hates losing money and does it rarely.  The bottom line was, and is, this:

Aston / River Road Independent Value is the classic case of getting something for nothing. Investors impressed with Mr. Cinnamond’s 15 year record – high returns with low risk investing in smaller companies – have the opportunity to access his skills with no higher expenses and no higher minimum than they’d pay at Intrepid Small Cap. The far smaller asset base and lack of legacy positions makes ARIVX the more attractive of the two options. And attractive, period.

Mr. Cinnamond wrote at the end of July with a series of updates on his fund.

Performance is outstanding.  The fund is up 8% YTD, through the end of July 2011.  In the same period, his average peer is up 1.3% and ICMAX (his former fund) is up 0.73%. Eric notes that, “The key to performance YTD has been our equity performance and limiting mistakes. Although this is too short of a period to judge a Fund, it’s ideally our ultimate goal in this absolute return strategy — limit mistakes and require an adequate return given the risk of each small cap equity investment.”

The portfolio is half cash, 48% at the end of the second quarter.  Assuming that the return on cash is near-zero, that means that his stocks have returned around 16% so far this year.

Money is steadily flowing in.  He notes, “We are now at $265 million after seven months with good flows and a healthy institutional pipeline.”  He plans to partially close the fund at around $800 million in assets.

The fund is more attractive to advisors than to institutions, though it should be quite attractive to bright individual investors as well.  The problem with institutions, he believes, is that they’re more style-box bound than are individual advisors.  “The absolute return strategy requires flexibility so it doesn’t fit perfectly in the traditional institutional consultant style box.  For most consultants, the Independent Value strategy would not be used as their core small cap allocation as it has above average tracking error.  For the most part, advisors seem to be less concerned about the risk of looking different than a benchmark and are more concerned about protecting their private clients’ capital…so it’s a nice fit.”

On the bigger picture issues, Eric is “hopeful volatility increases in the near future — ultimately creating opportunity.”  He notes that the government’s “printing party” has inflated the earnings of a lot of firms, many of them quite marginal.  He’s concerned with valuation distortions, but comfortable that patience and discipline will, now as ever, see him through.

Cash Isn’t Trash (but it’s also not enough)

ARIVX is not alone in holding huge cash reserves this year, but it is alone in profiting from it. There are 75 retail, no-load funds which were holding at least 40% in cash this year.  ARIVX has the best YTD returns (7.92%) followed by Merk Hard Currency (MERKX) at 7.46% with several dozen cash-heavy funds under water so far this year.  The great bulk of those funds have returned between 1-3% while the (volatile) Total U.S. Market index is up 4% (as of July 29, 2011). Notable cash-heavy funds include

Hussman Strategic Total Return (HSTRX), an always-defensive mix of bonds, foreign currencies, cash and precious-metals exposure.   Five stars, up 2.3% YTD.

Intrepid Small Cap (ICMAX), Mr. Cinnamond’s previous fund, now run by the very competent team that almost handles Intrepid Capital (ICMBX). Five stars, up 0.73%.

Pinnacle Value (PVFIX), John Deysher’s perennially cash-heavy microcap value fund.  Five stars, down 1.7%.

Forester Discovery (INTLX), international sibling to the only equity fund to have made money in 2008.   Four stars, up 2.3%.

Congressional Effect Fund (CEFFX), a three-star freak that goes entirely to cash whenever Congress is in session.  800% portfolio turnover, 2.3% returns.

Harbor Bond (HABDX), a clone of the titanic PIMCO Total Return (PTTRX) fund.  Bill Gross is nervous, having raised cash and cut risk.  Five stars, up 4%.

Morningstar’s Hot on My Heels!

Morningstar ran a couple essays this month that reflect issues that the Observer took up earlier.

Russel Kinnel, Morningstar’s director of mutual fund research, felt the urge to “get really contrarian” and look at four of the smallest funds in the Morningstar 500 (“Four Tiny but Potent Mutual Funds,” 08/01/2011).  They’re described as “being ignored by fund investors, but they’ve really got a lot to like.”  Three of the four have been profiled here, while (WHG Balanced) the fourth has a $100,000 minimum investment.   That’s a bit rich for my budget.

The funds, with links to the Observer’s profiles, are:

Queens Road Small Cap Value (QRSVX):  “Manager Steve Scruggs has done a great job of deep value investing . . . Its return on $10,000 since that time is $25,500 versus $20,100 for the average small-value fund.”

Ariel Focus (ARFFX): “Can Ariel’s emphasis on stable, low-valuation companies work in a focused large-cap fund? I think so. The emphasis on stability has kept volatility roughly in line with other large-blend funds despite the concentration.”

Masters Select Focused Opportunities (MSFOX): “Now, this fund really counts as contrarian. It has a Morningstar rating of 1 star, and its 20-stock portfolio has added up to high risk . . . [They have several excellent sub-advisers who have had a long stretch of poor performance.] That’s not likely to continue, and this fund could well have a bright future.”  My concern when MSFOX launched was that taking six ideas from each of three teams might not get you the same results that you’d get if any of the sub-advisers had the option to construct the whole portfolio.  That still seems about right.

WHG Balanced (WHGBX): “. . . a virtual clone, GAMCO Westwood Balanced (WEBAX), dates back to 1991, and Mark Freeman and Susan Byrne have a strong record over that period. Moreover, it’s conservatively positioned with high-quality stocks and high-quality bonds.”

In Investors Behaving Badly, analyst Shannon Zimmerman fretted about the inability of investors to profit from the “wildly volatile yet in some ways utterly predictable performance” performance of Fidelity Leveraged Company Stock fund (FLVCX). Manager Tom Soviero buys the stock of the kinds of companies which have been forced to issue junk bonds.  Zimmerman notes that the fund has some of the industry’s strongest returns over the decade, but that it’s so wildly volatile that very few investors have held on long enough to benefit: “in all trailing periods of three or more years, [the fund’s investor returns] rank among the peer group’s worst.”  In closing, Zimmerman struck a cautious, balanced note:

As an analyst, I try to square the vicious circle outlined above by giving Soviero credit where it’s due but encouraging prospective buyers, not to beware, but to be aware of the fund’s mandate and its penchant for wild performance swings.

The Observer highlighted the same fund in May 2011, in “Successor to ‘The Worst Best Fund Ever’.”  We were growling about a bunch of fawning articles about “The Decade’s Best Stock Picker,” almost none of which confronted the truth of the matter: wildly volatile funds are a disaster.  Period.  Their excellent returns don’t matter because (1) 90% of their investors flee at the worst possible moment and (2) the remainder eat the resulting tax bill and performance distortions.  We concluded:

People like the idea of high-risk, high-return funds a lot more than they like the reality of them. Almost all behavioral finance research finds the same dang thing about us: we are drawn to shiny, high-return funds just about as powerfully as a mosquito is drawn to a bug-zapper.

And we end up doing just about as well as the mosquito does.

Two Funds and why they’re worth your time

Really worth it.  Every month the Observer profiles two to four funds that we think you really need to know more about.  They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention.  They might come from a great boutique or be offered by a top-tier manager who has struck out on his own.  The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought.  This month’s two new funds:

T. Rowe Price Global Infrastructure (TRGFX): governments around the world are likely to spend several trillion dollars a year on building or repairing transportation, power and water systems.  Over the past decade, owning either the real assets (that is, owning a pipeline) or stock in the asset’s owners has been consistently profitable.  Price has joined the dozen or so firms which have launched funds to capitalize on those large, predictable investments.  It’s not clear that rushing in, here or in its peers, is called for.

Stars in the shadows: Small funds of exceptional merit. There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar.  Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples).  Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention.  There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight of them.

The stars are all time-tested funds, many of which have everything except shareholders.

Marathon Value (MVPFX): Marathon is the very archetype of a “star in the shadows.”  It’s an unmarketed, friends-and-family fund that exists to give smaller stakeholders access to the adviser’s stock picking.  The fund has a nearly unparalleled record for excellent risk-managed returns over the decade and it’s certainly worth the attention of folks who know they need stock exposure but who get a bit queasy at the thought. Thanks to the wise and wily Ira Artman for recommending a profile of the fund.

And ten other funds that our readers think are really worth your time

One intriguing thread on the Observer’s discussion board asked, “what fund do you to love more and more over the years“?  While several folks made the obvious point (“don’t love an investment, it can’t love you back”), a number of readers contributed thoughtful and well-argued choices.  The most popular, all-weather funds:

Permanent Portfolio (PRPFX), endorsed by ron, MikeM, rono.  “I’m not sure there has been a better “low risk – great return” fund then PRPFX.”

FPA Crescent (FPACX), Scott, MikeM, “one fund with a terrific long-term track record.”

Oakmark Equity & Income (OAKBX), from ron, cee (The fund just does great year after year and even in the 2008 bear market it only lost 16%. This will be a long-term relationship :)

Matthews Asian Growth & Income (MACSX), DavidS, Scott, PatShuff, “our oldest fund for lower volatility Asian exposure.”  Andrew Foster just left this fund in order to found Seafarer Capital

I’m not sure that it’s just a sign of the times that the common characteristic of these longest-term holdings is the flexibility they accord their managers, their low risk and long-tenured management.

Other interesting nominees included two Fidelity funds (the hybrids Capital & Income FAGIX and Global Balanced FGBLX), Franklin Income (FKINX), Metropolitan West Total Return Bond (MWTRX), Matthews Asia Dividend (MAPIX) and T. Rowe Price Spectrum Income (RPSIX), my own favorite fund-of-Price funds.

Briefly Noted . . .

Joseph Rohm is no longer manager of the T. Rowe Price Africa & Middle East (TRAMX) after leaving T. Rowe on June 30 to relocate to his hometown, Cape Town, South Africa.  It’s hard to know what to make of the move or the fund.  Two reasons:

The management team has shifted several times already.  Rohm was the founding manager, but his stint lasted only ten weeks.  Alderson then stepped in for 18 months, followed by 27 months of Rohm again, and now Alderson.  That’s awfully unusual, especially for Price which values management stability and smooth transitions.

The fund lacks a meaningful peer group or public benchmark.  Measured against diversified emerging markets funds, TRAMX stinks with deep losses in 2011 (through July 29) and a bottom of the heap peer ranking since inception.  The problem is that it’s not a diversified emerging markets fund.   While it would be tempting to measure it against one of the existing Africa ETFs – SPDR S&P Emerging Middle East and Africa (GAF), for instance – those funds invest almost exclusively in a single country, South Africa.  GAF has 90% of its assets in South Africa and virtually 100% in just three countries (South Africa, Egypt and Morocco).

Ed Giltanen, a Price representative, expects a new management team to be in-place within a few months.  Morningstar recommends that folks avoid the fund.  While the long-term case for investing in Africa is undamaged, it’s hard to justify much short term movement in the direction of TRAMX.

On June 30, Guinness Atkinson launched its Renminbi Yuan & Bond Fund.  It invests in Renminbi Yuan-denominated bonds issued by corporations and by the Chinese government.  It may also hold cash, bank deposits, CDs and short-term commercial paper denominated in Renminbi or Yuan. Edmund Harriss will manage the fund.  He also manages three other GA funds: China & Hong Kong Fund, the Asia Focus Fund, and the Asia Pacific Dividend Fund. The China & Hong Kong fund has been around a long time and it’s been a solid but not outstanding performer.  The two newer funds have been modestly unfortunate.  The expense ratio will be 0.90% and there’s a $10,000 minimum investment for regular accounts.  That is reduced to $5000 if you’re already a GA shareholder, or are buying for a retirement or gift account.

I’ve long argued that an emerging-markets balanced fund makes a huge amount of investment sense, but the only option so far has been the closed-end First Trust/Aberdeen Emerging Opportunities (FEO).  I’m pleased to report that Franklin Templeton will launch Templeton Emerging Markets Balanced, likely by October 1.  The fund will been managed by famous guys including Michael Hasenstab and Mark Mobius. “A” shares of the fund will cost 1.53%.

The rush to launch emerging markets bond funds continues with MFS’s planned launch of MFS Emerging Markets Debt Local Currency in September 2011.  The industry has launched, or filed to launch, more than a dozen such funds this year.

Aston closed and liquidated the Aston/New Century Absolute Return ETF (ANENX) in late July.  The three-year-old was a fund of ETFs while its parent, New Century Alternative Strategies (NCHPX) is a very solid, high expense fund of hedge-like mutual funds.

Aston also canned Fortis Investment Management as the subadvisor to Aston/Fortis Real Estate (AARIX). Harrison Street Securities replaced them on the renamed Aston/Harrison Street Real Estate fund.

TCW is in the process of killing off two losing funds.  TCW Large Cap Growth (TGLFX) will merge into TCW Select Equities (TGCNX) and TCW Relative Value Small Cap (TGOIX) merges into TCW Value Opportunities (TGVOX).  In an additional swipe, the Large Cap Growth managers will be dismissed from the team managing TCW Growth (TGGIX).  Owie.

Wells Fargo Advantage Strategic Large Cap Growth (ESGAX) has a new manager: Tom Ognar and his team.  The change is worth noting just because I’ve always liked the manager’s name: it has that “Norse warrior” ring to it.  “I am Ognar the Fierce and I am here to optimize your portfolio.”

 

New names and new missions

Janus Dynamic Allocation (JAMPX), a consistently mediocre three-year-old, will become more global in fall.  Its name changes to Janus World Allocation and it will switch from a domestic benchmark to the MSCI All Country World index.

Janus Long/Short (JALSX) will become Janus Global Market Neutral on September 30, and will change its benchmark from the S&P500 to a 3-month T-Bill index.

ING Janus Contrarian (IJCAX) fired Janus Capital Management as subadvisor and changed its name to ING Core Growth and Income Portfolio. The fund is currently managed by ING Investment Management, and will merge into ING Growth and Income in early 2012.

Effective Sept. 1, 2011, Invesco Select Real Estate Income (ASRAX) will change its name to Invesco Global Real Estate Income.  The name change is accompanying by prospectus changes allowing a more-global portfolio and a global benchmark.

MFS Sector Rotational (SRFAX) changed its name to MFS Equity Opportunities on August 1, 2011.

DWS Strategic Income (KSTAX) will change its name to DWS Unconstrained Income at the end of September.  “Strategic” is so 2010 . . . this season, everyone is wearing “unconstrained.”

Dreyfus S&P Stars Opportunities (BSOBX) becomes Dreyfus MidCap Core on November 1st.

The FaithShares folks will close and liquidate their entire line of ETFs (the Baptist, Catholic, Christian, Lutheran and Methodist Values ETFs).  The ETFs in question were fine investment vehicles except for two small flaws: (1) poor returns and (2) utterly no investor interest.  FaithShares will then change their name to Exchange Traded Concepts, LLC.  And what will ETC, LLC do?   Invoking the “those who can’t do, consult” dictum, they propose to sell their expertise as ETF providers to other aspiring investment managers.   Their motto: “Launch your own ETF without lifting a finger.”  Yep, that’s the level of commitment I’d like to see in an adviser.

In closing . . .

Special thanks to “Accipter,” a long-time contributor to the FundAlarm and Observer discussion boards and Chip, the Observer’s Technical Director, for putting dozens of hours into programming and testing The Falcon’s Eye.  Currently, when you enter a fund’s ticker symbol into a discussion board comment, our software automatically generates a link to a new window, in which you find the fund’s name and links to a half dozen fund reports.  Falcon’s Eye will provide direct access through a search box; it’ll cover ETFs as well and will include links to the Observer’s own fund profiles.  This has been a monumental project and I’m deeply grateful for their work.  Expect the Eye to debut in the next two weeks.

Thanks, too, to the folks who have used the Observer’s Amazon link.  If you haven’t done so yet, visit the “Support Us” page where you’ll see the Amazon link.  From there, you can bookmark it, set it as your homepage, right-click and play it on your desktop or copy it and share it with your deranged brother-in-law.  In addition, we’ve created the Observer’s Amazon store to replace our book recommendations page.  Click on “Books” to visit it.  The Amazon store brings together our readers’ best ideas for places to learn more about investing and personal finance in general.  We’ll add steadily to the collection, as you find and recommend new “must read” works.

With respect,

David

By David Snowball

Dear friends,

The craziness of summer always amazes me.  People, who should be out watching their kids play Little League, or lounging in the shade with a cold drink, instead fret like mad about the end of the (investing) world as we know it.  Who would have guessed, despite all of the screaming, that it’s been a pretty decent year in the market so far?  Vanguard’s Total Stock Market Index fund (VTSMX) returned 6.3% in the first six months of 2011.  The market turbulence in May and June still constituted a drop of less than 3% from the market’s late April highs.

In short, more heat than light, so far.

Justice Thomas to investors: “Sue the Easter Bunny!”

On June 13^th, the Supreme Court issued another ruling (Janus Capital Group vs. First Derivative Traders)  that seemed to embrace political ideology rather more than the facts of the case. The facts are simple: Janus’s prospectuses said they did not tolerate market-timing of the funds.  In fact, they actively colluded in it.  When the news came out, Janus stock dropped 25%.  Shareholders sued, claiming that the prospectus statements were material and misleading.  The Court’s conservative bloc, led by Skippy Thomas, said that stockholders could sue the business trust in which the funds are organized, but not Janus.  Since the trust has neither employees nor assets, it seems to offer an impregnable legal defense against any lies embedded in a prospectus.
The decision strikes me as asinine and Thomas’s writing as worse.  The only people cheerleading for the decision are Janus’s lawyers (who were active in the post-decision press release business) and the editorial page writers for The Wall Street Journal:

In Janus Capital Group Inc. v. First Derivative Traders, investors claimed to have been misled into buying shares of stock at a premium by prospectuses that misrepresented Janus Investment Fund’s use of so-called market timing. . .

The Court’s ruling continues a string of recent cases that put limits on trial-bar marauding, but the dissent by the four liberal Justices all but invites further attempts. As in so many legal areas, this Supreme Court is only a single vote away from implementing through the courts a political agenda that Congress has consistently refused to pass.

The editorial can sustain its conclusion only by dodging the fact (the business trust is a shell) and quoting Thomas’s thoughtless speechwriter/speechmaker analogy (which fails to consider the implication of having the writer and maker being the same person).   The Journal‘s news coverage recognized the problem with the ruling:

William Birdthistle, a professor at the Chicago-Kent College of Law, said the ruling disregarded the practical reality that mutual funds are dominated by their investment advisers, who manage the business and appoint the funds’ boards of directors.

“Everyone knows the fund is an empty marionette. It doesn’t do anything,” said Prof. Birdthistle, who filed a brief supporting the Janus investors. “You’re left with a circumstance where no one is responsible for this.”

The New York Times gets closer:

With Justice Clarence Thomas writing for a 5-to-4 majority, the Supreme Court has made it much harder for private lawsuits to succeed against mutual fund malefactors, even when they have admitted to lying and cheating.

The court ruled that the only entity that can be held liable in a private lawsuit for “any untrue statement of a material fact” is the one whose name the statement is presented under. That’s so even if the entity presenting the statement is a business trust — basically a dummy corporation — with no assets, while its owner has the cash.

Justice Thomas’s opinion is short and, from the mutual fund industry’s perspective, very sweet: Janus Capital Group and Janus Capital Management were heavily involved in preparing the prospectuses, but they didn’t “make” the statements so they can’t be held liable. . . Which means that there is no one to sue for the misleading prospectuses.

The ICI was publicly silent (too busy preparing their latest “fund expenses have too plummeted” and “America, apple pie and 12(b)1 fee” press releases,) though you have to imagine silent high-fives in the hallway.  I’m not sure of what to make of Morningstar’s reaction.  They certainly expressed no concern about, displeasure with or, alternately, support for the decision.  Mostly they conclude that there’s no threat in the future:

The ruling should not have a material impact on Janus mutual fund shareholders, according to Morningstar’s lead Janus fund analyst, Kathryn Young. Janus has had procedures in place since 2003 to prevent market-timing . . .

Uhhh . . .  Uhhh . . .  if those procedures are expressed as a sort of contract – communicated to investors – in the prospectus . . .  uhhh . . . hello?

The more pressing question is whether the decision also guts the SEC’s enforcement power, since the decision seems to insulate a firm’s decision-makers from the legal consequences of their acts.  It’s unclear why that insulation wouldn’t protect them from regulators quite as thoroughly as from litigators.

In short, you’ll have about as much prospect of winning a suit against the Easter Bunny as you will of winning against a fund’s fictitious structure.

The Odd Couple: Manager Gerry Sullivan and the Vice Fund (VICEX)

One of the fund industry’s nicest guys, Gerry Sullivan, has been appointed to run an awfully unlikely fund: VICEX.  Gerry has managed the Industry Leaders fund (ILFIX) since its launch.  The fund uses a quantitative approach to identify industries in which there are clear leaders and then looks to invest in the one or two leading firms.  The fund has a fine long-term record, though it’s been stuck in the mud for the past couple years.  The problem is the fund’s structural commitment to financial stocks, which have been the downfall of many good managers (think: Bruce Berkowitz, 90% financials, bottom 1% of large cap funds through the first half of 2011).  Since financial services match the criteria for inclusion, Sullivan has stuck with them – and has been stuck with them.  The rest of the portfolio is performing well, and he’s waiting for the inevitable rebound in U.S. financials.

In the interim, he’s been appointed manager of two very distinctive, sector-limited funds:

Generation Wave Growth Fund (GWGF), a sort of “megatrends” fund targeting the health care, financial services and technology sectors, and

Vice Fund (VICEX), which invests in “sin stocks.”  It defines those as stocks involved with aerospace/defense, gaming, tobacco and alcoholic beverages.

I’m sure there are managers with less personal engagement in sin industries than Gerry (maybe John Montgomery, he of the church flute choir, at Bridgeway), but not many.

Almost all of the research on sin stocks reaches the same conclusion: investing here is vastly more profitable than investing in the market as a whole.  Sin stocks tend to have high barriers to entry (can you imagine anyone starting a new tobacco company?  or a new supersonic fighter manufacturer?) and are often mispriced because of investor uneasiness with them.  Over the medium- to long-term, they consistently outperform both the market and socially-responsible indexes.  One recent study found a global portfolio of sin stocks outperforming the broad market indexes in 35 of 37 years, with “an annual excess return between 11.15% and 13.70%”  (Fabozzi, et al, “Sin Stock Returns,” Journal of Portfolio Management, Fall 2008).

About two-thirds of the portfolio will be selected using quantitative models and one-third with greater qualitative input.  He’s begun reshaping the portfolio, and I expect to profile the fund once he’s had a couple quarters managing it.

Who You Callin’ a “Perma-bear”?

Kiplinger’s columnist Andrew Feinberg wrote an interesting column on the odd thought patterns of most perma-bears (“Permanent Pessimists,” May 2011).  My only objection is his assignment of Jeremy Grantham to the perma-bear den.  Grantham is one of the founders of the institutional money manager GMO (for Grantham, Mayo, and van Otterloo).  He writes singularly careful, thoughtful analyses – often poking fun at himself and his own errors (“I have a long and ignoble history of being early on market calls and, on two occasions, damaged the financial well-being of two separate companies – Batterymarch and GMO”) – which are accessible through the GMO website.

Feinberg notes that Grantham has been bearish on the US stock market for 20 years.  That’s a half-truth.  Grantham has been frequently bearish about whatever asset class has been most in vogue recently.  The bigger questions are, is he wrong and is he dangerous?  In general, the answers are “sometimes” and “not so much.”

One way of testing Grantham’s insights is to look at the performance of GMO funds that have the flexibility to actually act on his recommendations.  Those funds have consistently validated Grantham’s insights.  GMO Global Balanced, Global Equity Allocation and U.S. Equity Allocation are all value-conscious funds whose great long-term records seem to validate the conclusion that Grantham, skeptical and grumpy or not, is right quite often enough.

Who You Callin’ “Mr. Charge Higher Prices”?

This is painful, but an anonymous friend in the financial services industry sent along really disturbing ad for a webinar (a really ugly new word).  The title of the June 8^th webinar was “How to Influence Clients to Select Premium-Priced Financial Products and Services! (While Reinforcing Your Valuable Advice).”    The seminar leader “is known as Mr. Charge Higher Prices because he specializes in teaching how to get to the top of your customer’s price . . . and stay there!”

Sound sleazy?  Not at all, since the ad quotes a PhD, Professor of Ethics saying that the seminar leader shows you how to sell high-priced products which are also “higher-value products that more closely align with their goals and objectives.  [He] teaches them how to do so with integrity and professionalism.”  Of course, a quick internet search of the professor’s name and credentials turns up the fact that his doctorate is from an online diploma mill and not a university near London. It’s striking that seven years after public disclosure of his bought-and-paid-for PhD, both the ethicist and Mr. Higher Prices continue to rely on the faux credential in their advertising.

And so, one simple ad offers two answers to the question, “why don’t investors trust me more?”

Two Funds, and why they’re worth your time

Really worth it.  Every month the Observer profiles two to four funds that we think you really need to know more about.  They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention.  They might come from a great boutique or be offered by a top-tier manager who has struck out on his own.  The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought.  This month’s two new funds:

RiverPark Short Term High Yield (RPHYX): put your preconceptions aside and pick up your copy of Graham and Dodd’s Security Analysis (1940).  Benjamin Graham was the genius who trained the geniuses and one of his favorite investments was “cigar butt stocks.”  Graham said of cigar butts found on the street, they might only have two or three good puffs left in them but since they were so cheap, you should still pick them up and enjoy them.  Cigar butt stocks, likewise: troubled companies in dying industries that could be bought for cheap and that might still have a few quarters of good returns.

You could think of RiverPark as a specialist in “cigar butt bonds.” They specialize in buying high-yield securities that have been, or soon will be, called.  Effectively, they’re buying bonds that yield 4% or more, but which mature in the next month or two.  The result is a unique, extremely low volatility cash management fund that’s earning several hundred times more than a money market.

Stars in the shadows: Small funds of exceptional merit. There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar.  Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples).  Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention.  There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight gf them.

The stars are all time-tested funds, many of which have everything except shareholders.

The selection of this month’s star was inspired by a spate of new fund launches.  As a result of some combination of anxiety about a “new normal” investing world dominated by low returns and high volatility, fund companies have become almost obsessive about launching complex, expensive funds, whose managers have an unprecedented range of investment options.  Eight of the nine no-load funds on July’s funds in registration page represent that sort of complex strategy:

• Litman Gregory Masters Alternative Strategies
• PIMCO Credit Absolute Return Fund
• PIMCO Inflation Response Multi-Asset
• PIMCO Real Income 2019 and 2029
• PIMCO Tax Managed Real Return Fund
• Schooner Global Absolute Return Fund
• Toews Hedged Commodities Fund

The same thing’s true of the May and June lists: 75% “alternative strategy” funds.

We don’t list load-bearing funds, in general, but recent registrations and launches there show the same pattern:

• Franklin Templeton Global Allocation
• BlackRock Credit Opportunities
• BlackRock Emerging Market Long/Short Equity
• Parametric Structured Commodity Strategy Fund
• Neuberger Berman Global Allocation

The question is: if managers asked to execute a simple strategy (say, buying domestic stocks) couldn’t beat a simple index (the S&P 500), what’s the prospect that they’re going to soar when charged with executing hugely complex strategies?

This month’s star tests the hypothesis, “simpler really is better”:

ING Corporate Leaders Trust Series B (LEXCX): at $500 million in assets, you might think LEXCX a bit large to qualify as “in the shadows.”  This 76 year old fund is almost never in the news.  There’s never been an interview with its manager, because it has no manager.  There’s never been a shift in portfolio strategy, because it has no portfolio strategy.  Born in the depths of the Great Depression, LEXCX has the industry’s simplest, more stable portfolio.  It bought an equal number of shares of America’s 30 leading companies in 1935, and held them.  Period.  No change.  No turnover.  No manager.

The amazing thing?  This quiet antique has crushed not only its domestic stock peers for decades now, it’s also outperforming the high-concept funds in the very sort of market that should give them their greatest advantage.  Read on, Macduff!

Nassim Taleb is launching a Black Swan ETF!

Or not. Actually just “not.”

Nassim Taleb, a polymath academic, is the author of Fooled by Randomness (2001) and The Black Swan: The Impact of the Highly Improbable (2007).  The latter book, described by the Times of London as one of the “Books that helped to change the world,” argues that improbable events happen rather frequently, are effectively unpredictable, and have enormous consequences.  He seems to have predicted the 2007-09 meltdown, and his advice lends itself to specific portfolio actions.

Word that “Taleb is launching a black swan ETF” is rippling through various blogs, discussion boards (both here and Morningstar) and websites.  There are three small problems with the story:

1. Taleb isn’t launching anything.  The original story, “Protect Your Tail,” from Forbes magazine, points to Taleb’s former investment partner and hedge fund manager, Mark Spitznagel.  The article notes, “After Taleb became seriously ill the duo shut the fund. Taleb has since given up money management . . .”
2. It’s not clear that Spitznagel is launching anything.  Forbes says, “In July Universa intends to tap the financial adviser market by offering its own black swan ETF. The fund will mimic some of the strategies employed by its institutional-only hedge fund and will have an expense ratio of 1.5%.”  Unfortunately, as of late June, there’s no such fund in registration with the SEC.
3. And you wouldn’t need it if there was such a fund.  Spitznagel himself calls for allocating “about 1% of an investment portfolio to fund such a ‘black swan protection protocol.'”  (Hmmm… in my portfolio that’d be about $12.50.)  If you wanted to have some such protection without a fund with a trendy name, you could adopt Taleb’s recommendation for a “barbell strategy,” in which you place 80% into stable investments, like government bonds and cash, and 20% into risky ones, such stocks and commodities.

Oddly enough, that comes close to describing the sort of strategy already pursued by funds like Permanent Portfolio (PRPFX) and Fidelity Strategic Income (FSICX) and those funds charge half of the reported “black swan” expenses.

Briefly noted:

Long-time SmartMoney columnist, James B. Stewart has moved to The New York Times.  Stewart helped found the publication and has been writing the “Common Sense” column for it for 19 years, yet the letter from the editor in that issue made no mention of him and his own final column offered his departure as an afterthought. On June 24^th, his first column, also entitled “Common Sense,” appeared in the Times.  Stewart’s first story detailed the bribery of Mexican veterinarians by Tyson Foods.  He’ll be a Saturday columnist for the Business Day section of the paper, but they’re no word on what focus – if any – the feature might have.

For those interested in hiking their risk profiles, Matthews Asia launched its new Matthews China Small Companies Fund (MCSMX) on May 31, 2011.  As with most Matthews funds, there’s a lead manager (Richard Gao, who also manages Matthews China MCHFX) and a guy who’s there in case the manager gets hit by a bus (Henry Zhang, also the back-up guy on Matthews China).

Possible investors will want to read Andrew Foster’s new commentary for Seafarer Capital.  Andrew managed Matthews Asia Growth & Income (2005-2011) before leaving to found Seafarer.  While he has not yet filed to launch a mutual fund, Andrew has been posting a series of thoughtful essays on Asian investing, including several that focus on odd numbers and Chinese finance.  He promises in the next essay to look at BRICS in general but will also “touch upon China’s elevated (some would say breakneck) pace of investment, and what it means for the future of that country.”

Investors will also want to look at the prevalence of financial fraud in Chinese companies.  A recent Barron’s article provides a list of 20 Chinese firms that had a stop trading on the NASDAQ recently, a sign that their American accountants wouldn’t sign-off on the books.  While Matthews has a fine record and Gao promises extensive face-to-face meetings and fundamental research, these seem to be investments treacherous even for major firms.

Vanguard’s new actively managed emerging-markets fund, Vanguard Emerging Markets Select Stock (VMMSX) launched at the end of June.  It will complement their existing emerging markets index fund (VEIEX), the largest e.m. fund in existence.  Vanguard has four high-quality sub-advisors (M&G Investment Management, Oaktree Capital Management, Pzena Investment Management, and Wellington Management) none of whom have yet run an emerging markets funds.  Minimum investment is $3000 and the expense ratio is 0.95%, far below the category average.Rejoice!  AllianceBernstein is liquidating AllianceBernstein Global Growth (ABZBX). It’s no surprise, given the fund’s terrible performance of late.

Schwab plans to liquidate Schwab YieldPlus (SWYSX), a fund which once had $12 billion in assets.  Marketed as a higher-yield alternative to money markets, it blew apart in 2008 – down 47% – and Schwab has spent hundreds of millions on federal and state claims related to the fund, and faced charges filed by the SEC. Schwab will liquidate Schwab Tax-Free YieldPlus (SWYTX) and Schwab California Tax-Free YieldPlus (SWYCX) at the same time.

Vanguard Structured Large-Cap Growth liquidated on May 31, 2011.

John Hancock Classic Value Mega Cap (JMEAX) will liquidate on Aug. 19, 2011.

Calvert Large Cap Growth (CLGAX) will merge into Calvert Equity (CSIEX), assuming that shareholders (baaaa!) approve.  They’ve got the same management team and Calvert will lower CSIEX’s expenses a bit.

Morgan Stanley Special Growth (SMPAX) will soon merge into Morgan Stanley Institutional Small Company Growth (MSSGX).

ING Value Choice (PAVAX) and ING Global Value Choice (NAWGX) will close to most new investors on July 29, 2011.

Nuveen Tradewinds Value Opportunities (NVOAX) and Nuveen Tradewinds Global All-Cap (NWGAX) will close to most new investors on August 1, 2011.

Fidelity Advisor Mid Cap (FMCDX) will change its name to Fidelity Advisor Stock Selector Mid Cap on August 1, 2011.

JPMorgan Dynamic Small Cap Growth (VSCOX) and JPMorgan Small Cap Growth (PGSGX) will close to most new investors on August 12, 2011.

The MFO Mailbag . . .

I receive a couple dozen letters a month.  By far, the most common is a notice that someone goofed up their email address when signing up our e-mail notification service or registering for the site.  Regrets to Wolfgang and fjujv1.  The system generated a flood of mail reporting on its daily failure to reach you.  For other folks, please double-check the email you register with and, if you have a spam blocker, put the Mutual Fund Observer on your “white list” or our mail won’t get through.

Is there a Commentary archive (Les S)?  Yes, Les, there is.  You just can’t see it yet.  Chip is adjusting the site navigation and, within a week, the April through June commentaries will be available through links on the main commentary page.

Will the Observer post lists of Alarming, Three-Alarm and Most Alarming Three-Alarm funds (Joe B, Judy S, Ed S)?  Sorry, but no.  Those were Roy’s brainchild and I lack the time, expertise and passion needed to maintain them.  Morningstar’s free fund screener will allow you to generate lists of one-star funds, but I’m not familiar with other free screening tools aimed at finding the stinkers.

Is it still possible to access stuff you’d written at FundAlarm (Charles C)?  Not directly now that FundAlarm has gone dark.  I’d be happy to share copies of anything that I’ve retained (drop an email note), though that’s a small fraction of FundAlarm’s material.  There’s an interesting back door.  Google allows you to search for cached material by site.  That is, for example, you can ask The Google if it could provide a list of all references to Fidelity Canada that appeared at FundAlarm.com.  To do that, simple add the word site, a colon, and a web address to your search.

Fidelity Canada site:fundalarm.com

If the word “cached” appears next to a result, it means that Google has saved a copy of that page for you.

Shouldn’t Marathon Value be considered a Star in the Shadows (Ira A)?  Yes, quite possibly. Ira has recommended several other find small funds in the past and Marathon Value (MVPFX) seems to be another with a lot going for it.  I’ll check it out.  Thanks, Ira.  If you’ve got a fund you think we should look at more closely, drop a line to [email protected], and I’ll do a bit of reading.

In closing . . .

Thanks to all the folks who’ve provided financial support for the Observer this month.  In addition to a half dozen friends who provided cash contributions, either via PayPal or by check, readers purchased almost 250 items through the Observer’s Amazon link.  We have, as a result, paid off almost all of our start-up expenses.  Thanks!

For July, we’ll role out three new features: our Amazon store (which will make it easier to find highly-recommended books on investing, personal finance and more), our readers’ guide to the best commentary on the web, and The Falcon’s Eye.  (Cool, eh?)  Currently, if you enter a fund’s ticker symbol in a discussion board post, it generates a pop-up window linking you to the best web-based resources for researching and assessing that fund.  In July we’ll roll that out as a free-standing tool: a little box leading you to a wealth of information, including the Observer’s own fund profiles.

Speaking of which, there are a number of fund profiles in the works for August and September.  Those include Goodhaven Fund, T. Rowe Price Global Infrastructure and Emerging Markets Local Currency Bond funds, RiverPark Wedgewood Fund and, yes, even Marathon Value.

Until then, take care and keep cool!

David

 

By David Snowball

Dear friends,

After a lovely month in England, I returned to discover that things are getting back to “normal” again in the financial markets.

Top executives of publicly traded money management firms got raises averaged 33% “as improved financial results and increases in assets under management put them further away from the market turmoil of years past” (Randy Diamond, “Good times rollin’ once again for money manager execs,” Pensions and Investments Online, May 16 2011). While paltry by bankers’ standards, some of the money firm chiefs should be able to cover their mortgages: Larry Fink of BlackRock took home $24 million, while Janus CEO Richard Weil and Affiliated Managers Group CEO Sean Healey each got $20 million.

Pension plans are moving back into hedge fund investing.  According to the consulting firm Prequin, pension plans have 6.8% of their money in hedge funds now compared to 3.6% in 2007.  One motive for the change: hedge funds have returned 6.8% on average over the decade compared to 5.7% for the plans’ stock investments.  By increasing exposure to hedge funds, the plans can mask the magnitude of their uncovered commitments.  That is, they can project higher future returns and so argue that they’ll surely be able to cover their apparently huge deficits.  (“Pensions leap back to hedge funds,” WSJ, May 27 2011)

Rich folks are losing interest in managing their own investments, and are back to handing money over to their “wealth managers” to shepherd.  In 2009, 69% of high net worth investors wanted to take “an active role” in managing their investments.  It’s down to 47% in 2011, which Clifford Favrot of Delta Financial Advisers describes as “returning to normal” (“Rich relax a bit but stay on guard,” WSJ, May 27 2011).

In general, any time folks decide that it’s time to stop worrying, it’s time to start worrying.  Worrier par excellence Jeremy Grantham of GMO argues that the strong performance of risk assets – both stocks and bonds – is detached from the underlying economy.  His advice: “the environment has simply become too risky to justify prudent investors hanging around, hoping to get luck.  So now is not the time to float along with the Fed, but to fight it.”  While Grantham ruefully admits “to a long and ignoble history of being early on market calls” (well, sometimes two years early), he’s renewed his calls to concentrate on high quality US blues and emerging market equities (“Time to be serious – and probably too early – once again,” GMO Quarterly Letter, May 2011).

Part of Wall Street’s Normal: Gaming the System

Folks who suspect that the game is rigged against them have gotten a lot of fodder in the last two months.  A widely discussed article in Rolling Stone Magazine (“The Real Housewives of Wall Street,” April 2011) looks at how federal bailout money was allocated.  In general: (1) poorly and (2) to the rich.  While Stone is not generally a voice of conservatism, its story might have a comfortable home even in the National Review:

. . . the government attempted to unfreeze the credit markets by handing out trillions to banks and hedge funds. And thanks to a whole galaxy of obscure, acronym-laden bailout programs, it eventually rivaled the “official” budget in size — a huge roaring river of cash flowing out of the Federal Reserve to destinations neither chosen by the president nor reviewed by Congress, but instead handed out by fiat by unelected Fed officials using a seemingly nonsensical and apparently unknowable methodology.

Stone argues that “the big picture” of a multi-trillion dollar bailout is simply too big for human comprehension, but that you can learn a lot by looking through the lens of the assistance given a single firm: Waterfall TALF Opportunity.  While Waterfall received a pittance – a mere quarter billion compared to Goldman Sachs $800 billion – Waterfall was distinguished by the credentials of its two chief investors: Christy Mack and Susan Karches.

Christy is the wife of John Mack, the chairman of Morgan Stanley. Susan is the widow of Peter Karches, a close friend of the Macks who served as president of Morgan Stanley’s investment-banking division. Neither woman appears to have any serious history in business, apart from a few philanthropic experiences. Yet the Federal Reserve handed them both low-interest loans of nearly a quarter of a billion dollars through a complicated bailout program that virtually guaranteed them millions in risk-free income.

Stone details the story of the women’s risk-free profits, courtesy of a category of bailout program they describe as “giving already stinking rich people gobs of money for no ****ing reason at all.”  Waterfall investors put up $15 million, then received $220 million in federal funds with the promise that they could receive 100% of any investment gains but be responsible for only 10% of any investment losses they incurred.  It’s a fascinating, frustrating story.

Happily, the women wouldn’t need to worry about investment losses as long as they accepted guidance from the world’s best investors: members of the U.S. House of Representatives.  A study in Business and Politics examined the financial disclosure records of all the members of Congress.  They concluded that somehow members of Congress outperformed the stock market by “6.8% per annum after compounding – better than hedge-fund superstars.”  U.S. Senators performed even better.  While it’s possible that House members are simply smarter than hedge fund managers, the authors darkly conclude “We find strong evidence that Members of the House have some type of non-public information which they use for personal gain” (“Fire Your Hedge Fund, Hire Your Congressman,” Barron’s, 05/26/2011).

It’s the world’s scariest ad!

Remember Larry, Darryl and Darryl from the old Newhart TV show?  The three deranged brothers launched their first business – “Anything for a Buck”. They’ll do anything for a buck. If it’s something cool like digging up an old witch’s body from the cellar, they might even pay you the buck!

 

 

Apparently they’re now the masterminds behind iShares, whose slogan seems to be “anything can be an ETF!”

 

 

Fairholme Fund wobbles

Fairholme Fund (FAIRX), a huge, idiosyncratic beast run by Morningstar’s equity manager of the decade, Bruce Berkowitz, has had a bad year.  The fund trails its average peer by 15 percentage points of the past year and ranks in the bottom 1% of large cap value funds for the past quarter, two quarters and four quarters (as of June 2011).  The fund sucked in $4 billion of anxious money in 2010 after a long, remarkable run.  Predictable as the rains in spring, $1 billion of assets rushed back out the door in April alone (per Morningstar fund flow estimates).  That’s three times worse than any other month in its history.

Bruce Berkowitz didn’t dodge the fund’s problems in a May 11 conference call with investors:

Here are my thoughts on the Fairholme Funds recent performance: horrible, [and] that’s the summary in hindsight and it may be to be expected over the short term.

We’ve always stated in our reports that short-term performance should not be over emphasized. It’s the long term that counts. This is not the first time we’ve underperformed; it won’t be the last time and I don’t think it’s reality to outperform every month, quarter or year.

So it’s been lousy for months, we’ve been losing, we’re way underperforming, and it may stay lousy for more time.

He argues that the short-term problem is his decision to buy financial stocks (now 90% of the portfolio), which is expects to continue buying.  “We need to buy low and buy lower and buy lower. Even when the crowd yells you’re wrong. This is how we’ve achieved our performance over the past decade and this is how we will achieve our performance in the next couple of decades.”

One of his highest-visibility holdings, St. Joe Corporation (JOE) a Florida land company.  They started as a paper mill, got rich, got stupid, bought a bunch of stuff they shouldn’t have (brokerage firms, for example), had no debt but made no money.  After a long battle, Fairholme took control of St. Joe in March, forcing out the CEO and much of the board.

Why care?

There’s an interesting argument that St. Joe was less important for its huge land holdings than for its ability to make investments that Fairholme itself cannot make.  A fascinating article in Institutional Investor notes:

St. Joe may not seem like a major prize in the big scheme of things, with a market value of just $2.4 billion, but Berkowitz and Charles Fernandez, his No. 2 at Fairholme for the past three and a half years, saw a huge opportunity. Not only did they think that the company’s real estate operations could be worth a lot more in the future, they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett’s Berkshire Hathaway.

“We’re trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders,” Berkowitz says. (“Fairholme’s Bruce Berkowitz Is Beating Hedge Fund Managers at Their Own Game,” Institutional Investor, 05/19/2011).

Indeed, in his conference call, Berkowitz says, “JOE is, at its heart, an asset manager.”

The possibilities are intriguing.  In his interview with the Observer, Mr. Berkowitz argued that Fairholme’s size ($20 billion in assets) was critical to its future.  While many observers felt the fund was too unwieldy, Berkowitz argues that only its size allows it to become party to a set of expensive, unconventional opportunities.

Beyond the simple matter of corporate restructurings, bankruptcies and other conventional “special situations,” managers are looking increasingly far afield for opportunities.  Hedge fund manager David Einhorn, who lost big to Berkowitz in the St. Joe fight, recently announced a $200 million investment in the New York Mets.   And bond maestro Jeff Gundlach pushed the investment potential of gemstones at a recent investment conference:

[Gundlach] likes gold for its “Biblical street cred, if such a thing is possible.” But he advocates gem stones over gold. “Gold has shown itself to be money and pretty. Gems have also shown themselves to be money and prettier,” he says.  (Mark Gongloff, gundlach-leads-off-with-prostitutes, WSJ Marketbeat blog, 05/25/2011

Hmmm . . . perhaps Newt Gingrich’s reported $500,000 bill with Tiffany’s isn’t just egregious excess: it’s creative portfolio management.

This never turns out well: the emerging markets debt obsession grows

A lot of emerging market debt funds are now coming to market, many of them specializing in debt priced in some local currency.  By Morningstar’s estimate, of the 20 emerging-markets local-currency funds, 14 have been opened in the last year.  These funds are a vote against the future of the US dollar and in favor of currencies supported – largely – by commodity-producing economies and growing populations.  Among the recent notable entrants:

Harbor Emerging Markets Debt (HAEDX) launched on May 2, 2011, and invests in securities that are economically tied to emerging markets, or priced in emerging-markets currencies. It’s being sub-advised, as all Harbor funds are.  The subadvisor is Stone Harbor Investment Partners whose Stone Harbor Emerging Markets Debt (SHMDX) has returned 10.5% annualized since inception. Harbor Emerging Markets Debt has an expense ratio of 1.05% and a $1000 minimum.

Aberdeen Asset Management launched Aberdeen Emerging Markets Debt Local Currency (ADLAX) on May 2, 2011. Brett Diment will lead the team responsible for managing the fund.

Forward Management launched Forward Emerging Markets Corporate Debt (FFXIX) on May 3, 2011. The fund will invest mainly in emerging-markets corporate debt, and will be subadvised by SW Asset Management. David Hinman and Raymond Zucaro will manage the fund.

T. Rowe Price launched T. Rowe Price Emerging Markets Local Currency Bond on May 26. The fund will invest in bonds denominated in emerging-markets currencies or derivatives that provide emerging-markets bond exposure.  Andrew Keirle and Christopher Rothery who manage the fund also have been managing a similar strategy for institutional investors in the T. Rowe Price Funds SICAV–Emerging Local Markets Bond Fund since 2007. That said, the institutional fund has consistently trailed T. Rowe Price Emerging Markets Bond (PREMX) since inception.

HSBC filed to launch HSBC Emerging Markets Debt, which will invest primarily in U.S.-dollar-denominated while Emerging Markets Local Debt will invest in local-currency debt. Both should come on-line on June 30, 2011.

PIMCO Developing Local Markets (PLMDX) will be renamed PIMCO Emerging Markets Currency on August 16, to reflect a slight strategy shift. The fund holds positions in short maturity local bonds and currency derivatives.  The change will give the managers a bit more freedom to choose which countries to pursue.

Emerging market bond funds have returned an average of 12-13% annually over the past 10-15 years. On face, easier and more diverse access to these assets should be a good thing.  Remember two things:  First, the asset class has done so well that future returns are likely modest.  Grantham, Mayo, van Otterloo (GMO) projects real returns on emerging market debt of just1.7% annually over the next 5-7 years (Asset Class Return Forecast, 04/30/2011).   That’s well below their projection for E.M. stocks (4.5% real) or U.S. blue chip companies (4.0%).   Second, much of those gains took place when relatively few investment companies were interested.  In 2003 for example, investors placed only $14 billion to work in emerging market debt.  Fidelity New Market Income (FNMIX) earned 31% that year. In 2010, it was $72 billion and the Fido fund returned 11%.  As more funds pile in, profits are going to become fewer and opportunities thinner.  While E.M. debt is a valid asset class, joining the herd rushing toward it might bear a moment’s reflect.

Funds worth your attention

Really worth it.  Every month the Observer profiles two to four funds that we think you really need to know more about.  They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention.  They might come from a great boutique or be offered by a top-tier manager who has struck out on his own.  The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought.  This month’s two new fund:

Fidelity Global Strategies (FDYSX): this relatively young fund has one of Fidelity’s broadest, most ambitious mandates.  In June 2011, it was rechristened to highlight a global approach.  It’s not clear that the changes are anything more than pouring old wine in a new bottle.

Stars in the shadows: Small funds of exceptional merit.  There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar.  Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples).  Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention.  There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight of them.

The stars are all time-tested funds, many of which have everything except shareholders.  This month’s star:

RiverNorth Core Opportunity (RNCOX): going, going, gone as of June 30.  This former “most intriguing new fund” is larger than most “stars,” but it deserves recognition for two reasons.  First, it’s truly a one-of-a-kind offering.  Second, its imminent closing makes this the idea time for potential investors to do their research and make a decision before regrets set in.

Research on the cutting edge of “duh”

Investment managers and strategies plow through an enormous amount of behavioral research these days, trying to use the predictable patterns of human (i.e., investor) behavior to better position their portfolios.  That said, a remarkable amount of published research in the area seems to cry out “duh!”

On unusually warm days, people are more likely to believe in global warming than they are on cold days, according to a survey of 1200 Americans and Australians by the Center for Decision Sciences at the Columbia Business School.

In a related study, people sitting in a steadily warming room are more likely to believe in global warming than those who are not.

On sunny days, investors are more like to choose stocks over bonds but when it’s ridiculously hot, investors become cranky and markets become volatile.

By the way, if you hand folks a warm drink, they’re more likely to rate you as a “warm” person than it you hand them a cold drink.

Extreme market volatility is bad for investors’ hearts: among Chinese investors anyway.  A 1% market jump correlates with a 2% jump in heart attacks among Chinese investors (and you thought you had problems with emerging markets’ volatility).

If you build more highways, that is, if you make driving easier and more convenient, people drive more, according to a study soon to be published in the American Economic Review.

Work is stressful, which can be scientifically measured by checking levels of the stress hormone cortisol.  A new study in the Journal of Family Psychology suggests that women’s stress levels drop when their husbands are helping with chores, but it’s the opposite for men: Their stress levels fall when their wives are busy while they’re relaxing. Oddly, the scientists didn’t report results for families in which dad did the housework, and mom relaxed.

Briefly noted:

Janus did something right and cool: kudus to Janus for publicizing the investments made by each manager in each fund, as well as in Janus funds as a whole.  While this information is purely available (it’s in the Statement of Additional Information), I know of no other fund company that brings it all together in one place.  For those interested, check here to see how serious their Janus manager is about his or her fund.

Janus Venture (JAVTX) reopened to new investors on May 6 and launched a series of new share classes (A, C, S and I).  As usual, it’s not clear why Janus re-opened the fund: it has a larger portfolio ($1.3 billion) for a small cap fund, the largest in its history, and small caps are already coming off an extended run.  The best reason to take the fund seriously, at least if you can access it without a load, is the strength of its new management team.  Janus Triton (JATTX) managers Chad Meade and Brian Schaub have run Venture for less than a year, but have made a real difference in that time.  They’ve decreased the fund’s concentration and eliminated some of its micro-cap exposure, and have generated very solid returns.  Triton, also a small cap fund, has been an exceedingly solid performer for Janus and noticeably less volatile than the typical Janus fund.  The advantage of a fee cap (holding total expenses to 1.05% for the next year) makes it more attractive still.

Journalists are funny. You can almost hear the breathlessness in Neal Anderson’s prose: “The MFWire has learned that the Boston-based mutual fund giant is re-branding the large cap blend fund as the Fidelity Global Strategies Fund. . . “(“Fido Shifts a Fund’s Name and Strategies,” 05/04/2011).  True enough, but it’s not exactly as if you needed a secret contact to find this out: Fidelity duly submitted the paperwork and it was made publicly available a week before in the SECs EDGAR database.

RiverNorth Core Opportunity (RNCOX) will close to new investors on June 30, 2011.  You really might want to read the new fund profile this month.

The Quant Funds have a new name.  They’re now the Pear Tree Funds because the former name “no longer reflects the true nature of the mutual fund family.”  At base, the funds have three sub-advisors (Polaris, PanAgora and Columbia Partners), not all of who are quant investors and the advisor felt “the former name no longer reflects the true nature” of their funds.  Apparently “pear trees” (dense, brittle and short-lived) comes closer.

During the FundAlarm hiatus, Fidelity launched Fidelity Conservative Income Bond (FCONX).  It’s an ultra-short term bond fund run by Kim Miller.  While he’s been with Fidelity for 20 years, his management experience is limited most to money market funds, though he was on the team for several of the Asset Manager and municipal bond funds.  The fund’s expense ratio is 0.40% and it has accumulated $100 million in assets in three months.  (A slow start for a Fido fund!)

Similarly, the BearlyBullish fund registered in March and launched in early May.  At base, it’s a mid- to large-cap stock fund, mostly invested in the US and Canada.  When the managers’ market indicators turn negative, the fund simply moves more of its assets to cash.  That strategy worked in 2008, when the separately managed accounts that use this system dropped 24% while the broad market dropped by 37%.  It’s run by a team from Alpha Capital Management.  The investment minimum is $1000 and the expense ratio is 1.49%.

Nuveen Quantitative Large Cap Core (FQCAX) changed its name to Nuveen Quantitative Enhanced Core.

Old Mutual Strategic Small Companies (OSSAX) changed its name to Old Mutual Copper Rock International Small Cap. The fund also changed its strategy from a domestic small-cap strategy to an international small-cap strategy.

Pending shareholder approval on June 27, Madison Mosaic Small/Mid-Cap Fund will become NorthRoad International Fund (MADMX) and the Fund’s investment objective will be changed from “long-term growth” to “long-term capital appreciation by investing in non-U.S. companies.” Under the proposal, total fund operating expenses will decrease from 1.25% to 1.15% (annualized). Madison owns a majority stake in New York-based NorthRoad already.  Northroad handles institutional accounts now and their three managers have good credentials, both in previous employment (Lazard Asset Management in a couple cases) and colleges (Williams, Columbia, Yale).  The Small/Mid-Cap fund drew negligible assets and was only a so-so performer in its short life, so this is likely a substantial gain for the firm and its shareholders.

Dreyfus Core Value will merge into Dreyfus Strategic Value (DAGVX) on Nov. 16.

MFS Core Growth (MFCAX) will merge into MFS Growth (MFEGX).

Munder Large-Cap Growth has merged into Munder Growth Opportunities (MNNAX).

RidgeWorth Large Cap Quantitative Equity (SQEAX) will merge into RidgeWorth Large Cap Core Growth Stock (CFVIX) on July 15.

Loomis Sayles Disciplined Equity liquidated on May 13.

William Blair Emerging Markets Growth (BIEMX) will close to new investors on June 30.  Heartland Value Plus (HRVIX) closed to new investors in mid-May.  Heartland noted some skepticism about the state of the small cap market in justifying their close.

In closing . . .

Google Analytics offers fascinating snapshots of the Observer community.  7000 people have visited the site and about a thousand drop by more than once a day.  Greetings to visitors from Canada, Spain, Israel, Mexico and the U.K. – our most popular countries outside the U.S.  A cheery smile to the women who (secretly) use the Observer: research just released by the market-research firm Mintel Group discovered that women, more than men, were likely to make their investments through mutual funds (“Girls just want to have funds,” Barron’s, 05/21/2011).  Over half of all the folks who wrote me before the launch of the Observer were women who relied on FundAlarm’s research and discussions, though most admitted to never feeling quite brave enough to post.

Men, contrarily, were more likely to use ETFs, stocks, options and futures – and to trade actively.  (Note to the guys: stop that!)

In addition, a special wave to our one visitor from Kenya, who seems faithfully to have read every page on the site!

Thanks to all the folks who’ve provided financial support to the Observer of the past month.  Thanks especially to the six friends of the Observer who made direct contributions through PayPal.  In response to a couple notes, I’ve also posted my snail mail address for the sake of people who want to either write or send a check (which dodges PayPal’s fees).   In addition, our Amazon link led to 244 purchases in May, which contributes a lot.  Thanks to you all!

A special thanks to Roy Weitz, who stepped in as moderator during my three weeks in England.

We read, and respond to, everything we can.  Chip continues to monitor the Board’s technical questions and I try to handle any of the emailed notes.  If you have a question, comment, compliment or concern, just write me!

If you write, please remember to include your name and contact information.  I’m always interested in learning about funds or investment trends that intrigue you, but I’m exceedingly wary of anonymous tips.

Take care and I’ll see you again on July 1!

 

David