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,

Dear friends,

They’re gone. Five hundred and twenty-six Augie students who we’ve jollied, prodded, chided, praised, despaired of and delighted in for the past four years have been launched on the rest of you. They’re awfully bright-eyed, occasionally in reflection of the light coming from their cell phone screens. You might suspect that they’re not listening, but if you text them, they’ll perk right up.

This is usually the time for graduation pictures but I’ve never found those engaging since they reflect the dispersion of our small, close-knit community. I celebrate rather more the moments of our cohesion; the times when small and close were incredibly powerful.

Augie’s basketball team finished second in the nation in 2015, doing rather better in our division than the Kentucky Mildcats did in theirs, eh? We did not play in a grand arena but instead in a passionate one: Carver Gymnasium, home of the Carver Crazies. It was a place where the football team (the entire football team) jammed the sidelines of every game, generally shoulder to shoulder with the women’s basketball team and the choir, all shouting … hmmm, deprecations at opposing players.

When the team boarded buses at 5:00 a.m. for the trip east to compete in the Final Four, they were cheered off by hundreds of students and staff who stood in happy gaggles in the dark. A day later, hundreds more boarded buses and jammed in cars to follow them east. And when they came home, one win shy of a championship, they were greeted with the sound of trumpets and cheers.

And while the basketball players won’t go to the NBA, a fair number – over half of our juniors – will go to med school. And so perhaps we’ll yet meet the Kentuckians at an NBA contest as our guys patch together theirs.

I rather like kids, maddened though we make each other.

MFO on FOMO

No, FOMO is not that revolutionary white spray foam that’s guaranteed to remove the toughest pet stains from your carpet; neither is it a campaign rallying cry (“FOMO years! FOMO years!”).

FOMO is “fear of missing out” and it’s one of the more plausible explanations for the market’s persistent rise. There’s an almost-universal agreement that financial assets are, almost without exception, overpriced. Some (bonds) are more badly overpriced than others (small Japanese stocks), but that’s about the best defense that serious investors make of current conditions: they’re finding pockets of relative value rather than much by way of absolute value.

The question is: why are folks hanging around when they know this is going to end badly (again)? The surprising answer is, because everyone else is hanging around. It’s a logic reminiscent of those anxious moments back in our early high school years. We’d get invited to a party (surprise!), it would be great for a while then it would begin to drag. But really, you couldn’t be the first kid to leave. First off, everyone would notice and brand you as a wuss, or worse. Second, while it was late, all the cool kids were still around and that meant, you know, that something cool might happen.

And so you lingered until just after that kid from the football team threw up near the food, one of the girls used “the F word” kinda in your face and someone – no one knows who – knocked over the nice table lamp which really pissed off Emily’s dad. Then everyone was anxious to squeeze as quickly through the door as possible. On whole, the night would have been a lot better if you’d left just a little earlier but still …

It’s like that for professional investors, too. Reuters columnist James Saft points to research that shows professionals falling victim to the same pressures:  

Call it status anxiety, call it greed or just call it clever momentum trading, but the fear of missing out is an under-appreciated force in financial markets. No one likes to miss out on a good thing, especially when they see their friends, neighbors and rivals cashing in.

Much of this may be driven by concerns about relative wealth, or how much you have compared to those in your group, a force explored in a 2007 paper by Peter DeMarzo and Ilan Kramer of Stanford University and Ron Kaniel of Duke University. They found that even when traders understand that prices are too high they may stay in the market because they fear losing out as the overvaluation persists and extends.

Investors want to keep pace with their peers, and fear not having as much wealth. That raises, in a certain way, the risk of selling into a bubble. That status and group-motivated anxiety can blind investors towards other, seemingly obvious risks. (“The power of the fear of missing out,” 05/29/2015.)

You might think of it as a financial manifestation of Newton’s first law of motion: “unless acted upon by an outside force, an object in motion tends to stay in motion in the same direction and speed.” It’s sometimes called “the law of inertia.” One technical analyst, looking at the “pattern we have seen for much of 2015, namely choppy with a slight upward bias,” opined that despite “an increasing number of clouds gathering on the horizon  …  the path of least resistance likely remains to the upside.”

And so the smart money people remain, anxiously, present. Business Insider reporter Linette Lopez, covering the huge SALT Las Vegas hedge fund conference, observes that leading hedge fund strategists:

Across the board … believe asset prices are too high. Mostly bonds, sometimes stocks. Still, everyone is long the market. No one wants to be the first person out of the market as long as they’re making money. This is a huge issue on Wall Street, and everyone at this conference is now looking for a warning signal. (“We’ve already seen the beginning of the quake that could be coming,” 05/06/2015) – didn’t discuss h.f. fees (steadily rising) or h.f. performance (steadily lagging)…

In the same week that the hedgies were meeting in Las Vegas, the Buffett Believers gathered in Omaha. There renowned value investors, such as Jean-Marie Eveillard, now a senior advisor to First Eagle funds, fret that the market was overvalued, kept alive by artificial stimulus that’s coming to an end. Eveillard says investors don’t seem to be factoring that in. “Either everyone is thinking I will just keep dancing until the music stops, or they don’t see the risks that I do.” (“At Berkshire annual meeting, Warren Buffett hosts cautious investors,” 05/02/2015.)

In an interview with Reuters, Joel Tillinghast – one of Fidelity’s two best managers – captured the yin and yang of it:

“I think [the level of the financial markets are] colossally artificial, but I don’t see it ending. How long can we party with our bad selves?” Mr. Tillinghast asked. “You want to know so you can party on until five minutes before it ends.” (“Top Fidelity stockpicker: Financial markets are ‘colossally artificial,’” 05/26/2015)

We raised last month the notion of a “roach motel,” where getting in is easy and getting out is impossible. In the case of bugs, the problem is stickum. In the case of investors, it’s liquidity. At base, you may find that there’s no one willing to pay anything even vaguely like what you think your holdings are worth. Kevin Kinsella, president of a venture capital firm, notes that investors have been making 30% per quarter on privately traded shares, like Uber.

Given the various stratospheric private valuations some of these unicorn companies are reaching, there will be no trade buyers, and it is doubtful whether a sane investment bank would take such companies public at these market caps.

Investors historically delude themselves by concocting rationales as to why the insanity will continue, why it is completely reasonable and why an implosion won’t happen to them. They are always wrong. 

How will it end? When interest rates ultimately start to tick up and vast pools of capital begin to shift toward fixed income away from equities. It’s a historic cyclical shift. When the music stops and everyone needs to scramble for their chair, there will be a lot of fannies left hanging out there.

Predicting that this will happen is easy; predicting exactly when, not so easy. But my prediction is that it is not far off. (“Tech Boom 2015: What’s Driving Investor Insanity?” Forbes, 05/21/2015)

Michael Novogratz, head of the $67 billion Fortress hedge fund operation, shared that concern at the SALT gathering:

“I’m going to argue that I think something has fundamentally changed.” He is worried because even though managers know assets are expensive, they are still long. This is a recipe for a difficult exit once all they want to close their positions. The liquidity will disappear and assets will reprice. As legendary trader Stanley Druckenmiller said, assets need a lot of volume and money to go up and much less to crash.  (Michael Novogratz CEO of Fortress Investments Is Worried About The Markets)

The question is, what’s a fund investor to do? Five things come to mind:

1. Do a quick check on your asset allocation and risk exposure. Any idea of how long a core equity fund might remain underwater; that is, how many months it takes for a fund to rebound from a bad decline? I scanned MFO’s premium fund screener for large-cap core funds that had been around 10 years or more. The five best funds took, on average, over two years to rebound. The average large cap fund took 58 months, on average, to recover from their maximum drawdown. Here’s the test: look at your portfolio value today and ask whether you’re capable of waiting until April, 2020 to ever see a number that high again. That’s the worst case for a large cap stock portfolio. For a conservative asset allocation, the recovery time is a year or two. For a moderate portfolio, three or so years. At base, decide now how long you can wait and adjust accordingly.
2. Join the Dry Powder Gang. We profiled, last month, a couple dozen entirely admirable funds that are holding substantial cash stakes. Some have been badly punished for their caution, both by investors and raters, but all have strong, stable management teams, coherent strategies and a record of deploying cash when prices get juicy.
3. Allocate some to funds that have won in up and down markets. They’re rare. Daren Fonda at Barron’s recommends “[f]unds such as FPA Crescent (FPACX) and First Eagle Global (SGENX) have flexible strategies and defensive-minded managers.”  Charles identified a handful of long-term stalwarts in his April 2015 essay “Identifying Bear-Market Resistant Funds During Good Times.” Among the notable funds (not all open to new investors) he highlighted:
   
4. Cautiously approach the alt-fund space. There are some alt funds which have a plausible claim to thrive on volatility. We’ve profiled RiverPark Structural Alpha (RSAFX), for instance, and our colleagues at DailyAlts.com regularly highlight intriguing options.
5. Try to leave when everyone else heads out, too. The Latin word for those massive exits was “vomitaria” which would make you …

Liquidity Problem – What Liquidity Problem?

By Edward A. Studzinski

“Moon in a barrel: you never know just when the bottom will fall out.”

 Mabutsu

So as David Snowball mentioned in his May commentary, I have been thinking about the potential consequences of illiquidity in the fixed income market. Obviously, if you have a portfolio in U.S. Treasury issues, you assume you can turn it into cash overnight. If you can’t, that’s a potential problem. That appears to be a problem now – selling $10 or $20 million in Treasuries without moving the market is difficult. Part of the problem is there are not a lot of natural buyers, especially at these rates and prices. QE has given the Federal Reserve their fill of them. Banks have to hold them as part of the Dodd-Frank capital requirements, but are adding to their holdings only when growing their assets. And those people who always act in the best interests of the United States, namely the Chinese, have been liquidating their U.S. Treasury portfolio. Why? As they cut rates to stimulate their economy, they are trying to sterilize their currency from the effects of those rate cuts by selling our bonds, part of their foreign reserve holdings. Remember, the goal of China is to supplant, with their own currency, the dollar as a reserve currency, especially in Asia and the developing world. And our Russian friends have similarly been selling their Treasury holdings, but in that instance using the proceeds to purchase gold bullion to add to their reserves.

Who is there to buy bonds today? Bond funds? Not likely. If you are a fund manager and thought a Treasury bond was a cash equivalent, it is not. But if there are redemptions from your fund, there is a line of credit to use until you can sell securities to cover the redemptions, right? And it is a committed line of credit, so the bank has to lend on it, no worries! In the face of a full blown market panic, with the same half dozen banks in the business of providing lines of credit to the fund industry, where will your fund firm fall in the pecking order of mutual fund holding companies, all of whom have committed lines of credit? It now becomes more understandable why the mutual fund firms with a number of grey hairs still around, have been raising cash in their funds, not just because they are running out of things to invest in that meet their parameters. It also gives you a sense as to who understands their obligations to their shareholder investors.

We also saw this week, through an article in The Wall Street Journal, that there is a liquidity problem in the equity markets as well. There are trading volumes at the open. There are trading volumes, usually quite heavy, at the end of the day. The rest of the time – there is no volume and no liquidity. So if you thought you had protected yourself from another tsunami by having no position in your fund composed of more than three days average volume of a large or mega cap stock, surprise – you have again fought the last war. And heaven help you if you decide to still sell a position when the liquidity is limited and you trigger one or more parameters for the program and quant traders.

As Lenin asked, “What is to be done?” Jason Zweig, whom I regard as the Zen Philosopher King of financial columnists, wrote a piece in the WSJ on May 23, 2015 entitled “Lessons From A Buffett Believer.” It is a discussion about the annual meeting of Markel Corporation and the presentation given by its Chief Investment Officer, Tom Gayner. Gayner, an active manager, has compiled a wonderful long-term investment record. However, he also has a huge competitive advantage. Markel is a property and casualty company that consistently underwrites at a profitable combined ratio. Gayner is always (monthly) receiving additional capital to invest. He does not appear to trade his portfolio. So the investors in Markel have gotten a double compounding effect both at the level of the investment portfolio and at the corporation (book value growth). And it has happened in a tax-efficient manner and with an expense ratio in investing that Vanguard would be proud of in its index funds.

I recently was speaking with a friend in Japan, Alex Kinmont, who has compiled a very strong record as a deep value investor in the Japanese market, in particular the small cap end of the market. We were discussing the viability of a global value fund and whether it could successfully exist with an open-ended mutual fund as its vehicle. Alex reminded me of something that I know but have on occasion forgotten in semi-retirement, which is that our style of value can be out of favor for years. Given the increased fickleness today of mutual fund investors, the style may not fit the vehicle. Robert Sanborn used to say the same thing about those occasions when value was out of favor (think dot.com insanity). But Robert was an investment manager who was always willing to put the interests of his investors above the interests of the business.

Alex made another point which is more telling, which is that Warren Buffett has been able to do what is sensible in investing successfully because he has permanent capital. Not for him the fear of redemptions. Not for him the need to appear at noon on the Gong Show on cable to flog his investment in Bank America as a stroke of genius. Not for him the need to pander to colleagues or holding company managers more worried about their bonuses than their fiduciary obligations. Gayner at Markel has the same huge competitive advantage. Both of them can focus on the underlying business value of their investments over the long term without having to worry about short-term market pricing volatility.

What does this mean for the average fund investor? You have to be very careful, because what you think you are investing in is not always what you are getting. You can see the whole transformation of a fund organization if you look carefully at what Third Avenue was and how it invested ten years ago. And now look at what its portfolios are invested in with the departure of most of the old hands.

The annual Morningstar Conference happens in a few weeks here in Chicago. Steve Romick of FPA Advisors and the manager of FPA Crescent will be a speaker, both at Morningstar and at an Investment Analysts Society of Chicago event. Steve now has more than $20B in assets in Crescent. If I were in a position to ask questions, one of them would be to inquire about the consequences of style drift given the size of the fund. Another would be about fees, where the fee breakpoints are, and will they be adjusted as assets continue to be sought after.

I believe in 2010, Steve’s colleague Bob Rodriguez did a well-deserved victory lap as a keynote speaker at Morningstar and also as well at another Investment Analysts Society of Chicago meeting. And what I heard then, both in the presentation and in the q&a by myself and others then has made me wonder, “What’s changed?” Of course, this was just before Bob was going on a year’s sabbatical, leaving the business in the hands of others. But, he said we should not expect to see FPA doing conference calls, or having a large marketing effort. And since all of their funds at that time, with the exception of Crescent, were load funds I asked him why they kept them as load funds? Bob said that that distribution channel had been loyal to them and they needed to be loyal to it, especially since it encouraged the investors to be long term. Now all the FPA Funds are no load, and they have marketing events and conference calls up the wazoo. What I suspect you are seeing is the kind of generational shift that occurs at organizations when the founders die or leave, and the children or adopted children want to make it seem like the success of the organization and the investment brilliance is solely due to them. For those of us familiar with the history of Source Capital and FPA, and the involvement of Charlie Munger, Jim Gipson, and George Michaelis, this is to say the least, disappointing.

Does Your Fund Manager Consistently Beat the Stock Market?

I saw the headline at Morningstar and had two immediate thoughts: (1) uhh, no, and (2) why on earth would I care since “beating the stock market” is not one of my portfolio objectives?

Then I read the sub-title: “Probably not–but you shouldn’t much care.”

“Ah! Rekenthaler!” I thought. And I was right.

John recounts a column by Chuck Jaffe, lamenting the demise of the star fund manager.  Rekenthaler’s questions are (1) are they actually gone? And (2) should you care? The answers are “yes” and “no, not much,” respectively.

Morningstar researchers looked to determine how long “winning streaks” last; that is, for how many consecutive years might a fund manager beat his or her benchmark. Over the past 10 years, none of the 1000 U.S. stock funds have beaten the S&P500 for more than six years. Ten funds managed six year streaks, but four of those were NASDAQ 100 index funds. Worse yet, active managers performed worse than simple luck would dictate.

Outliers

“At the extreme outer edge of what is statistically plausible” is how Malcom Gladwell defines an outlier in his amazing book, Outliers: The Story of Success (2008).

The MFO Rating System ranks funds based on risk adjusted return within their respective categories across various evaluation periods. The rankings are by quintile. Those in the top 20 percentile are assigned a 5, while those in the bottom 20 percentile are assigned a 1.

The percentile is not determined from simple rank ordering. For example, say there are 100 funds in the Large Growth category. The 20 funds with the highest risk adjusted return may not necessarily all be given a 5. That’s because our methodology assumes fund performance will be normally distributed across the category, which means terms like category mean and standard deviation are taken into account.

It’s similar to grading tests in school using a bell curve and, rightly or wrongly, is in deference to the random nature of returns. While not perfect, this method produces more satisfactory ranking results than the simple rank order method because it ensures, for example, that the bottom quintile funds (Return Group 1) have returns that are so many standard deviations below the mean or average returning funds (Return Group 3). Similarly, top quintile funds (Return Group 5) will have returns that are so many standard deviations above the mean.

All said, there remain drawbacks. At times, returns can be anything but random or “normally” distributed, which was painfully observed when the hedge fund Long-Term Capital Management (LTCM) collapsed in 1998. LTCM used quant models with normal distributions that underestimated the potential for extreme under performance. Such distributions can be skewed negatively, creating a so-called “left tail” perhaps driven by a market liquidity crunch, which means that the probability of extreme under-performance is higher than depicted on the left edge of the bell curve above.

Then there are outliers. Funds that over- or under-perform several standard deviations away from the mean. Depending on the number of funds in the category being ranked, these outliers can meaningfully alter the mean and standard deviation values themselves. For example, if a category has only 10 funds and one is an outlier, the resulting rankings could have the outlier assigned Return Group 5 and all others relegated to Return Group 1.

The MFO methodology removes outliers, anointing them if you will to bottom or top quintile, then recalculates rankings of remaining funds. It keeps track of the outliers across the evaluation periods ranked. Below please find a list of positive outliers, or extreme over-performers, based on the latest MFO Ratings of some 8700 funds, month ending April 2015.

The list contains some amazing funds and warrants a couple observations:

• Time mitigates outliers, which seems to be a manifestation of reversion to the mean, so no outliers are observed presently for periods beyond 205 or so months, or about 17 years.
• Outliers rarely repeat across different time frames, sad to say but certainly not unexpected as observed in In Search of Persistence.
• Outliers typically protect against drawdown, as evidenced by low Bear Decile score and Great Owl designations (highlighted in dark blue – Great Owls are assigned to funds that have earned top performance rank based on Martin for all evaluation periods 3 years or longer).

The following outliers have delivered extreme over-performance for periods 10 years and more (the tables depict 20 year or life metrics, as applicable):

Here are the outliers for periods 5 years and more (the tables depict 10 year or life metrics, as applicable):

Finally, the outliers for periods 3 years and more (the tables depict 5 year or life metrics, as applicable):

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 Tenth Circuit vacated a district court’s order that had granted class certification in the prospectus disclosure lawsuit regarding the Oppenheimer California Municipal Bond Fund, finding that “[t]he district court’s class certification order at issue here did not analyze either the Rule 23(a) or 23(b) factors.” Defendants include independent directors. (In re Cal. Mun. Fund.)

New Lawsuits

A new securities fraud class action targets four Virtus funds, alleging that defendants misrepresented the performance track record of the funds’ “AlphaSector” strategy (created by an unaffiliated sub-adviser). Defendants include independent directors. (Youngers v. Virtus Inv. Partners, Inc.)

A new antitrust lawsuit alleges that Waddell & Reed and Ivy Funds “financed and aided” Al Haymon’s illegal efforts to monopolize professional boxing. (Golden Boy Promotions LLC v. Haymon.)

Briefs

Davis filed a reply brief in support of its motion to dismiss fee litigation regarding its New York Venture Fund. (In re Davis N.Y. Venture Fund Fee Litig.)

PIMCO filed a reply brief in support of its motion to dismiss fee litigation regarding its Total Return Fund (Kenny v. Pac. Inv. Mgmt. Co.)

Having lost in district court, plaintiffs filed their opening appellate brief defending their state-law claims regarding investments of Vanguard mutual fund assets in foreign gambling businesses. Defendants include independent directors. (Hartsel v. Vanguard Group, Inc.)

Amended Complaint

Plaintiffs filed a second amended complaint in fee litigation regarding four MainStay funds issued by New York Life. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

Answer

Having lost on appeal, Putnam filed an answer to fraud and negligence claims, filed by the insurer of a swap transaction, regarding Putnam’s collateral management services to a CDO. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)

The Alt Perspective: Commentary and news from DailyAlts

Every month Brian J. Haskin, founder, publisher and editor of DailyAlts shares news, perspective and commentary on the alt-space with the Observer’s readers. DailyAlts is the only website with a sole focus on liquid alternative investments.  They seek to provide a centralized source for high quality news, research and other information on one of the most dynamic and fastest growing segments of the investment industry. We’re always grateful for Brian’s commentary and he welcomes folks to drop by DailyAlts for more news in great depth. For now, the highlights:

The Access Revolution

There is an access revolution taking place in today’s investment world, especially with alternative investments. It started a number of years ago with platforms such as Kickstarter and Kiva, where everyday citizens could help others get their new idea off the ground. Today, individual investors can access a broad array of investments with just a few clicks of the mouse:

• Private equity via closed-end mutual funds
• Real estate lending and investing through crowdsourcing platforms
• Angel investing via online venture capital portals
• Private lending via online lending platforms

The list goes on, but the good news is that individual investors have far greater choice today than they did just a few years ago.

Much of the change taking place is due to changes in securities regulations that permit advertising and public promotion of private investment offerings. Other changes are driven by capital flowing to new technology-driven platforms and the broader use of existing investment vehicles.

Just this past month we had two new private equity offerings come to market in closed-end interval funds, one from Altegris / StepStone / KKR and the other from Pomona Capital / Voya:

• New Altegris Fund Gives Accredited Investors Exposure to Private Equity
• Pomona Capital and Voya Team Up on New Private Equity Fund

While these are not pure liquid alternatives (they don’t have daily liquidity, thankfully), they fall into the “near” liquid grouping. And furthermore, they give the mass-affluent access to investments that have never been available for as little as $25,000.

Expect to see more products such as these from the big name financial firms, as well as more access to alternatives through online investment portals. There is a revolution taking place.

Now, onto the liquid part of the alternatives market.

Monthly Liquid Alternative Flows

Investors allocated a total of $982 million to actively managed alternative mutual funds and ETFs in April, according to Morningstar’s most recent asset flows report, but pulled $259 million from passively managed alternative funds. Net flows totaled $723 million for the month, down from the healthy $2.8 billion of net new asset flows seen in March.

Interestingly, only two categories had positive flows in April: Multi-alternative funds and managed futures. Clearly a sign that advisors and investors are looking for either a one-stop shop for an alternatives allocation, or are looking to allocate to wholly uncorrelated strategies alongside equity and fixed income allocations. Managed futures strategies are generally expected to perform well during times of crisis, such as during the 2008 credit crisis, and when there are strong directional trends in markets, such as those we have seen in the past year with oil prices and the US dollar.

Last year was the year of non-traditional bonds, while 2015 is looking much stronger for several other strategies. Volatility based funds topped the charts for 12-month growth rates, with managed futures and multi-alternative funds not too far behind. And despite strong growth in 2014, non-traditional bond funds are only modestly keeping their head above water with a 12-month growth rate of 2.6%.

Based on growth rates and asset flows, diversification appears to be the primary focus of investors and allocators. In 2014, long/short equity fought against the $7.8 billion of outflows from the MainStay Marketfield Fund and still posted $6.4 billion of net inflows for the year. 2015 is looking quite different. Year-to-date, the long/short equity category is down $1.5 billion. While market neutral strategies can provide low levels of correlation with the equity markets, investors appear to be moving away from these strategies in favor of managed futures, volatility and multi-alternative funds.

Expect asset flows to liquid alternatives to continue on their current course of strong single-digit to low double-digit growth. Should markets falter, investors will look to allocate more to liquid alternatives.

New Fund Launches

We have seen 53 new funds launched this year, including alternative beta funds. In May, we logged 12 new funds, with nearly half being alternative beta funds. The remaining funds cut across multi-alternative, market neutral, non-traditional bonds, volatility and commodities. 

Two intriguing funds in the volatility space came to market in May:

• AccuShares Spot CBOE VIX Up Shares (VXUP)
• AccuShares Spot CBOE VIX Down Shares (VXDN)

These two funds are different because they provide direct exposure to the VIX Index, whereas other VIX related products are indexed to futures contracts on the VIX, and thus can have very high holding costs over the course of a month. Some time is needed on the new AccuShares ETFs, but if VIX is your game, these are worth keeping an eye on.

For more details, you can visit our New Funds 2015 page to see a full listing.

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.

JOHCM International Select II (JOHAX): it’s the single best performing international large growth fund in existence over the past 1, 3 and 5 years. It’s got five stars. It’s a Great Owl. You’ve probably never heard of it and it’s closing in mid-July. Now does any of that offer a compelling reason to add it to your portfolio?

Elevator Talk: Jon Angrist, Cognios Market Neutral Large Cap

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

Market-neutral funds are, on whole, dumb investments. They’re funds with complex strategies, high expenses and low returns which provide questionable protection for their investors. By way of simple illustration, the average market-neutral fund charges 1.70% while returning 1.25% annually over the past five years. Right: 60% of the portfolio’s (modest) returns go to the adviser in the form of fees, 40% go to you.

About the best you can say for them is that, as a group, they lost only a little money in 2008: about 0.3%. The worst you can say is that they also lost a little money in 2009. And then a little more in 2010. And yet again in 2011 before their … uh, ferocious rebound led to a 0.18% gain in 2012.

Into the mess steps Jon Angrist, Brian J. Machtley and the folks at Cognios Capital. In 2008, Messrs. Angrist and Machtley co-founded Cognios (from the Latin for “to learn” or “to inquire”) which manages about $325 million, mostly for high net worth individuals. Mr. Angrist, the lead manager, has experience managing investments through limited partnerships (Helzberg Angrist Capital), private equity firms (Harvest Partners) and mutual funds (Buffalo Microcap Fund, now called Buffalo Emerging Opportunities BUFOX).

Cognios argues that most market-neutral managers misconstruct their portfolios. Most managers simply balance their short and long books: if 5% gets invested in an attractively valued car company then another 5% is devoted to shorting an unattractively valued car company. The problem is that an over-priced company might well be more volatile than an underpriced one, which means that the portfolio ceases to be market-neutral. The twist at Cognios, then, is to use quant tools to construct an attractive large cap portfolio while changing the relative sizes of the long and short books to neutralize beta. Cognios Market Neutral Large Cap describes itself as providing a “beta-adjusted market neutral” portfolio.

In a Beta-adjusted market neutral portfolio the size of the short book can be larger or smaller than the size of the long book. If the Beta of the long book is higher than the Beta of the short book, the short book needs to be larger than the size of the long book in order to remove all of the market’s broad movements (i.e., to remove the market’s Beta) … Even though the portfolio will be net short on an absolute dollar basis in [this] example (i.e., more shorts than longs) … [it] both would be market neutral on a Beta-adjusted basis.

So far, this seems to be a profitable strategy. Below is the comparative performance of Cognios (blue line) since inception, against its market neutral peer group.

Here are Jon’s 264 words on why this might become a standout strategy:

Brian and I have been working in value investing for most of our careers and about three years ago, as we looked at the mutual fund universe, we saw a huge gap in market neutral offerings for individual investors. Even today, there are less than 40 market neutral mutual funds (not share classes). In today’s market environment, I believe a market neutral allocation, beta market neutral in particular, is a critical diversification tool in an investor’s overall asset allocation as it is the only strategy that strives to remove the impact of the market and macro events from the return of the strategy. Unlike most market neutral strategies that target risk-free rates of return, our fund targets equity-like returns over full market cycles because, in my opinion, if an investor wants Treasury-like returns why wouldn’t he/she just buy Treasuries?

There was a real need in the market for which our strategy could provide a solution if packaged in a mutual fund wrapper and because we only invest in large, liquid companies in the S&P 500, we didn’t have to change our strategy in order to deploy it in a mutual fund. Investors and their advisors are looking for strategies that seek to reduce volatility, standard deviation and downside risk in a portfolio, which is the primary objective of our fund. This fund has made it possible for a wide range of investors to access the same strategy that we provide to our institutional clients in other structures. As investors in our own fund, we have a very strong conviction about what we are doing.

Cognios Market Neutral Large Cap (COGMX/COGIX) has a $1000 minimum initial investment for its retail class and $100,000 for the institutional class. Both are modest in comparison to the $25 million minimum for a separately managed account. Expenses are capped at 1.95% on the investor shares, at least through early 2016. The fund has about gathered about $16 million in assets since its December 2012 launch. More information can be found at the fund’s homepage. There’s also a quick slideshow on a third-party website that walks through the basics of the fund’s strategy.

Funds in Registration

New mutual funds must be registered with the Securities and Exchange Commission before they can be offered for sale to the public. The SEC has a 75-day window during which to call for revisions of a prospectus; fund companies sometimes use that same time to tweak a fund’s fee structure or operating details.

Funds in registration this month are eligible to launch in July or August and some of the prospectuses do highlight that date.

This month our research associate David Welsch tracked down eight no-load retail funds in registration, which represents our core interest. Of those, four carry ESG screens (two from TIAA-CREF and two from Trillium) and three represent absolute value or absolute return strategies, while one is a short-term bond index. Interesting cluster of interests.

Manager Changes

This month 66 funds reported partial or complete changes in their management teams, a number slightly inflated by a dozen partial team changes in the AB (formerly AllianceBernstein) retirement date funds. The most striking were the imminent departures of PIMCO’s global equities CIO Virginie Maisonneuve plus several equity managers and analysts as PIMCO pulls back on their attempt to make a mark in pure equity investing. There was, in addition, announcement of the planned departure of Robert Mohn, Domestic Chief Investment Officer of Columbia Wanger Asset Management and Vice President of Wanger Advisors Trust who will step down in the fourth quarter of 2015. The change was announced for Wanger USA (WUSAX) but will presumably ripple through a series of Columbia Acorn funds eventually. In addition, Matt Paschke of the Leuthold Funds is taking a leave of absence to pursue personal interests for a bit. He’s a good and level-headed guy and we wish him well.

Updates

Andrew Foster, manager of Seafarer Overseas Growth & Income (SFGIX), was the guest on a sort-of video interview with Morningstar’s Jason Stipp in mid-May. The interview, entitled “Seeking Sustainable Growth in Emerging Markets,” covers much of the same ground as our recent conference call with Mr. Foster. One difference is that he spoke at greater length about China in his conversation with Mr. Stipp. I’ve designed it as a “sort of” video call because Jason was on-camera while Andrew was on a phone, with his picture superimposed on the screen.

Seafarer, with a three year record and five star rating, seems to have found its footing in the marketplace. The fund now boasts over a quarter billion in well-deserved assets.

Briefly Noted . . .

Ted, The Linkster and long-time stalwart of our discussion board, cheers for Dodge & Cox shareholders. He shared a USA Today story “3 AOL Investors Bag a Quick $200M” that calculates the gain to D&C shareholders from Verizon’s bid to acquire AOL. The Dodge & Cox funds own 15% of the outstanding shares of AOL, which netted them $95,000,000 in a single day. Sadly, the D&C funds are so big that AOL contributed just a fraction of a percent to returns that day. Iridian Asset Management and BlackRock finished second and third in total gains.

Ted also reports that the famously frugal Vanguard Group decided to chuck $200,000 at Bill Clinton in exchange for a 2012 speech for Vanguard’s institutional clients. That’s not an exceptional amount to hear from the former First Saxophonist; The Washington Post shows Bill pocketing $105 million for 542 speeches from the time he left the White House until the time Hilary Rodham-Clinton left the State Department. That comes to an average of $194,000 which suggests that Vanguard might have gotten just a bit flabby on their cost containment with this talk. The record might have been $300,000 paid by Dell that same year.

SMALL WINS FOR INVESTORS

Hmmm … does “nothing really bad has happened yet” qualify as a win? Other than that, we’ve got the reopening of BlackRock Event Driven Equity Fund (BALPX) on or about July 27, 2015. Bad news: BALPX is tiny, expensive and sucks. Good news: they brought in a new manager in early May, 2015. Mark McKenna left Harvard’s endowment team and joined BlackRock last year to run an event-driven hedge fund. He’s now been moved here. The other bad news: Harvard’s performance was surprisingly poor during McKenna’s tenure, which doesn’t say McKenna was responsible for the poor performance, just that he didn’t live up to the vaunted Harvard standard. As a result, this is a small win.

CLOSINGS (and related inconveniences)

American Century Small Cap Value Fund sort of closed on May 1. In an increasingly common move, the adviser left the door open for those who invest directly with the fund and for “certain financial intermediaries selected by American Century.”

ASTON/River Road Dividend All Cap Value Fund (ARDEX) and ASTON/Fairpointe Mid Cap Fund (CHTTX) have each been soft-closed. Each management team has a second fund still open.

Effective June 12, 2015, $4.2 billion Diamond Hill Long-Short Fund (DIAMX) will close to most new investors. The fund has exceptional returns for an exceptional period. Its 3-, 5- and 10-year records cluster around the 25^th percentile of all long-short funds. Potential investors need to take two factors into consideration when deciding whether to jump in: (1) performance is driven primarily by the strength of its long portfolio and (2) the lead manager for the long portfolio, Chuck Bath, is stepping aside. He’ll remain as a sort of backup manager but wants to focus his attention on Diamond Hill Large Cap. There’s no easy way of guessing how much his reorientation will cost the fund, so proceed thoughtfully if at all.

Effective as of the close of business on July 15, 2015, the $2.8 billion, five-star JOHCM International Select Fund (JOHIX) will be soft-closed. As friend Marjorie Pannell points out, the fund is an MFO Great Owl with eye-popping performance:

1 year – top 1% – (1 out of 339 funds) 
3 year – top 1% – (1 out of 293 funds) 
5 year – top 1% – (1 out of 277 funds)

Vulcan Value Partners (VVLPX) closed on June 1, rather later than originally planned. Out of respect for manager C.T. Fitzpatrick’s excellent long-term record here and at the Longleaf Funds, we sent out a notice of the extended window of opportunity to the 6000 or so folks on our email list.The $14 billion T. Rowe Price Health Sciences Fund (PRHSX) closed to new investors on June 1, 2015. Morningstar covered the fund avidly until the departure of star manager Kris Jenner. Over 13 years, Jenner nearly doubled the annualized returns of his benchmark. He left with two analysts, leaving the remaining analyst to take the reins. There was about $6 billion in the fund when Jenner (and Morningstar) left. Since then the fund has been much more T. Rowe Price-like: it has converted consistent, modest outperformance and risk consciousness into a fine record under manager Taymour Tamaddon.

OLD WINE, NEW BOTTLES

Barrow All-Cap Core Fund (BALAX) is now Barrow Value Opportunity Fund and Barrow All-Cap Long/Short Fund (BFLSX) has been renamed Barrow Long/Short Opportunity Fund. Morningstar hasn’t caught up with the change yet.

Brown Capital Management Mid-Cap Fund is now Brown Capital Management Mid Company Fund (BCSMX). Rather than investing in mid-cap stocks, the fund will target mid-sized companies: those with total operating revenues of $500 million to $10 billion.

Catalyst Absolute Total Return Fund, will undergo a name and objective change to Catalyst Intelligent Alternative Fund in July.

Over the course of the past month, The Hartford Emerging Markets Research Fund (HERAX) was … uhh, tweaked a bit so that it has a new investment mandate, lower management fee (though no break on the bottom line expense ratio), new manager (Cheryl Duckworth is out, David Elliott of Wellington is in) and new name, Hartford Emerging Markets Equity Fund. One striking element of the change was the introduction of a new “related accounts performance” table, which shows how Mr. Elliott’s other EM porfolios perform before and after deductions for Hartford’s sales charges and expenses. Since inception, Elliott’s portfolio has returned 6.9% which crushes his benchmark’s 3.6%. Deduct sales charges and expenses and investors would pocket only 3.9%. That is, 56% of the manager’s raw performance gets routed to The Hartford and 44% goes to his investors. Other than for that, it was pretty much status quo in Hartford.

Roxbury/Mar Vista Strategic Growth Fund was recently rechristened as the Mar Vista Strategic Growth Fund (MVSGX) while Roxbury/Hood River Small-Cap Growth Fund became Hood River Small-Cap Growth Fund (HRSMX). Both are tiny but have really solid records. Heck, in Hood River’s case, it has a top tier 3-, 5- and 10 year record

On July 1, 2015, the T. Rowe Price Strategic Income Fund (PRSNX) will change its name to the T. Rowe Price Global Multi-Sector Bond Fund.

Effective May 30, 2015, the name of Turner Spectrum Fund was changed to Turner Titan II Fund. . Under its new dispensation, the fund “invests primarily in equity securities of companies with large capitalization ranges across major industry sectors using a long/short strategy in seeking to capture alpha, reduce volatility, and preserve capital in declining markets.”

On May 1, 2015, the European Equity Fund (VEEEX) became the Global Strategic Income Fund. Morningstar continues its membership in the European equity peer group despite the fact that, well, it ain’t.

OFF TO THE DUSTBIN OF HISTORY

It was a bad month for both alternative strategy and bond funds. Of the 23 funds that went extinct this month, five pursued alternative strategies, four were fixed-income funds – mostly international – and two were stock/bond hybrids.

361 Market Neutral Fund (ALSQX) underwent “termination, liquidation and dissolution” on May 29, 2015. The fund had an all-star management team, spotty record and trivial asset base.

As of March 9, 2015, AllianzGI Opportunity Fund merged into AllianzGI Small-Cap Blend Fund (AZBAX). The topic came up in a mid-May SEC filing, so I thought I’d mention.

Ancora Equity Fund (ANQIX) will be liquidated and dissolved on or about June 26, 2015.

Ave Maria Opportunity Fund (AVESX), a tiny small-value fund with a lot of faith in energy stocks, will merge into Ave Maria Catholic Values Fund (AVEMX) at the end of July.

Catalyst Event Arbitrage Fund (CEAAX), which was a good hedge fund and a bad mutual fund, will be liquidated on June 15, 2015.

Clear River Fund (CLRVX) will liquidate on June 30, 2015. No, I’ve never heard of it, either. The closest to a fun fact about the fund is that it never managed to finish any calendar year with above-average returns relative to its Morningstar peer group.

A new speed record: The Trustees of Context Capital Funds launched the Context Alternative Strategies Fund (CALTX) with two managers and seven sub-advisers in March, 2014. Performance started out as mediocre but by December turned ugly. Having been patient for more than a year(!), the Trustees dismissed their two managers on May 18, then filed a prospectus supplement on Friday, May 29, 2015 that announced the liquidation of the fund on the next business day, Monday, June 1, 2015. That liquidation leaves Context with one fund, Context Macro Opportunities (CMOTX), which nominally launched in December, hasn’t traded yet, has $100,000 in assets and a $1,000,000 minimum.

Encompass Fund (ENCPX) liquidated on May 27, 2015. They launched about seven years ago, convinced that it was time to focus on materials stocks. They were right, then they were very wrong; the fund tended to finish in the top 1% or the bottom 1% of its noticeably volatile natural resources peer group. At the end, they had $2 million in AUM and were dead last in their peer group. The managers and trustees, to their great credit if not to their personal gain, held about half of the fund’s total assets.

That said, the managers wrote a thoughtful and appropriate eulogy for the fund in their last letter to shareholders.

We want the shareholders to know that we resigned with a keen sense of disappointment. After posting exceptional returns in 2009 and 2010, we were optimistic that the Fund’s overweight in precious and industrial metals would continue to enable Encompass to excel. However, the last 4 years were difficult ones for resource companies and the Fund has underperformed. We did increase exposure to the energy sector in late 2013 and early 2014. Those stocks performed very well until oil prices shocked investors by declining more than 50% in the second half of 2014.

More recently we increased the Fund’s exposure to the health care, cybersecurity and airline industries with good results. However, the resource companies have continued to weigh on overall portfolio performance even though exposure to metals has been significantly reduced.

When we launched Encompass in mid-2006, we believed the time was right for a diversified mutual fund that emphasized resource companies. For several years we were proven right, but despite fundamentals that historically have been good for metals companies, the last few years have been very challenging. The Fund has not been able to grow and thus we came to the very difficult decision that we should resign as Manager. The Fund’s independent Trustees considered various alternatives and concluded that the Fund should be liquidated.

We have begun liquidating the Fund’s holdings, and intend to complete the process in the next couple of weeks. Of course, we are attempting to maximize the proceeds for the benefit of shareholders.

Guggenheim Enhanced World Equity Fund (GEEWX) will liquidate on June 26, 2015. $6 million in assets with a 600% annual turnover which, I presume, is the “enhancement” implied by the name.

Innealta Capital Global All Asset Opportunity Fund (ROMAX) will discontinue operations on June 19^th. The fund managed to rake in just about $3 million in its two years of high expense/high turnover/low returns operations.

In mid-July, Jamestown Balanced Fund (JAMBX) will ask its shareholders for permission to merge into Jamestown Equity Fund (JAMEX). The rationale is that the funds have “similar investment objectives, investment strategies and risk factors,” which is true give or take the nearly 50% higher volatility that investors in the equity fund experience over investors in the balanced one.

The trustees of the fund have authorized the liquidation of the Pioneer Emerging Markets Local Currency Debt Fund (LCEMX) which will occur on August 7, 2015. To put the decision in context: over the past couple years, investing in emerging markets bonds (the orange line) has been a bad idea, investing in EM bonds denominated in local currencies (green) has been a worse idea and investing in the Pioneer fund (blue) has been a thorough disaster.

On the upside, with only $10 million in assets, no one much was hurt. As of the last SAI, the manager hadn’t invested a single dinar, rupee or pataca in the fund so his portfolio was pretty much unscathed.

The Listed Private Equity Plus Fund become unlisted on May 18, 2015.

On May 15, 2015, the Loomis Sayles International Bond Fund was liquidated. A subsequent SEC filing helpfully notes: “The Fund no longer exists, and as a result, shares of the Fund are no longer available for purchase or exchange.”

PIMCO is retreating from the equity business with the liquidation of PIMCO Emerging Multi-Asset (PEAAX), PIMCO EqS^® Emerging Markets (PEQAX) and PIMCO EqS Pathfinder (PATHX) funds, all on July 14, 2015. Pathfinder, with nearly $900 million in assets, was supposed to be a vehicle to showcase the talents of two Franklin Mutual Series managers who defected to PIMCO. That didn’t play out during the fund’s five year history, arguably because it was better positioned for down markets than for rising ones. PEAAX was a small, sucky fund of PIMCO funds. PEQAX was a slightly less small, slightly less sucky fund that was supposed to be the star vehicle for an imported GSAM team. Oops.

Rx Tax Advantaged Fund (FMERX) will liquidate soon. It managed to parlay high expenses and a low-return asset class (muni bonds) into a tiny, money-losing proposition.

Templeton Constrained Bond Fund (FTCAX) goes the way of the dodo bird on August 27, 2015 which “may be delayed if unforeseen circumstances arise.” I can’t for the life of me figure out what the “constraint” in the fund name referred to. The prospectus announces:

Under normal market conditions, the Fund invests at least 80% of its net assets in “bonds.” Bonds include debt obligations of any maturity, such as bonds, notes, bills and debentures.

The constraint is that the bond fund must buy “bonds”? The last portfolio report shows them at 90% cash in a $10 million portfolio.

Touchstone International Fixed Income Fund (TIFAX), in recognition of “its small size and limited growth potential,” will liquidate on July 21, 2015. “An overweight to peripheral and speculative issuers” helped performance, right up to the moment when it didn’t:

Okay, they really, really mean it this time: The Turner Funds determined to close and liquidate the Turner Titan Fund (TTLFX), effective on or about June 19, 2015. The Fund had previously been scheduled to close and liquidate on or about June 1, 2015. That’s followed its closure at the end of 2014 and previously announced plans to liquidate in mid-March and late April.

V2 Hedged Equity Fund (VVHEX/VVHIX), responding to “an anticipated decline in Fund assets,” liquidated in early May.

I appreciate thoroughness: “Effective April 30, 2015, the Virtus Global Commodities Stock Fund … was liquidated. The Fund has ceased to exist and is no longer available for sale. Accordingly, the prospectus and SAI are no longer valid.” Any questions?

In Closing . . .

Thanks, as always, to the folks who support the Observer. To Binod, greetings and good luck with the rising waters in Houston. We feel for you! Thanks to Joe for the thumbs-up on our continuing redesign of the Observer’s site; it’s always good to get an endorsement from a pro! Tom, thank you, we’re so glad that you find our site useful. Thanks, finally, to the folks who’ve bookmarked the Observer’s link to Amazon. Normally our Amazon revenue tails off dramatically at mid-year. So far this season, it’s held up reasonably well and we’re grateful.

We’ll look for you at Morningstar. I’ll be the one dressed like a small oak. It’s a ploy! John Rekenthaler (Bavarian for “thunder talker,” I think) recently mused “I don’t actually get invited to parties, but if I did, I’d be chatting with the potted plants.” I figure that with proper foliage I might lure the Great Man into amiable conversation.

If any of you would like to join Hedda, Jake, (maybe) Tadas and the good folks from the Queens Road funds (they’ve promised me fresh peanuts) in diverting my attention and saving John from my interminable prattle, please do drop us a note and we’ll set up a time to meet. The Observer folks should be around the conference from early Wednesday until well past its Friday close.

As always, we’ll post daily conference highlights on MFO’s discussion board. (No, I don’t tweet and you can’t make me.) If you miss them there, we’ll share them in our July issue. In addition, we have profiles of some new ESG/green funds – equity, income and hybrid – on tap. We’ll explain why in July!

As ever,

Dear friends,

It’s May, a sweet and anxious time at college. The End is tantalizingly close; just two weeks remain in the academic year and, for many, in their academic career.  Both the trees on the Quad and summer wardrobes are bursting out. The days remaining and the brain cells remaining shrink to a precious few. We all wonder where another year (my 31^st here) went, holding on to its black-robed closing days even as we long for the change of pace and breathing space that summer promises.

For investors too summer holds promise, for days away and for markets unhinged. Perhaps thinking a bit ahead while the hinges remain intact might be a prudent course and a helpful prologue to lazy, hazy and crazy.

The Dry Powder Crowd

A bunch of fundamentally solid funds have been hammered by their absolute value orientation; that is, their refusal to buy stocks when they believe that the stock’s valuations and the underlying corporation’s prospects simply do not offer a sufficient margin of safety for the risks they’re taking, much less compelling opportunities. The mere fact that a fund sports just one lonely star in the Morningstar system should not disqualify it from serious consideration. Many times a low star rating reflects the fact that a particular style or perspective is out-of-favor, but the managers were unwilling to surrender their discipline to play to what’s popular.

That strikes us as admirable.

Sometimes a fund ends up with a one-star rating simply because it’s too independent to fit into one of Morningstar’s or Lipper’s predetermined boxes.

We screened for one-star equity funds with over 20% cash. From that list we looked for solid, disciplined funds whose Morningstar ratings have taken a pounding. Those include:

Frankly, any one of the funds above has the potential to be the best performer in your portfolio over the next five years especially if interest rates and valuations begin to normalize.

The challenge of overcoming cash seems so titanic that it’s worth noting, especially, the funds whose managers have managed to marry substantial cash strong with ongoing strong absolute and relative returns. These funds all have at least 20% cash and four- or five-star ratings from Morningstar, as of April 2015.

Fans of large funds (or Goodhaven) might want to consult Morningstar’s recommended list of “Cash-Heavy Funds for the Cautious Investor” which includes five names:

It’s time for an upgrade

The story was all over the place on the morning of April 20^th:

• Reuters: “Carlyle to shutter its two mutual funds”
• Bloomberg: “Carlyle to close two mutual funds in liquid alts setback”
• Ignites: “Carlyle pulls plug on two mutual funds”
• ValueWalk: “Carlyle to liquidate a pair of mutual funds”
• Barron’s: “Carlyle closing funds, gold slips”
• MFWire dutifully linked to three of them in its morning link list

Business Insider gets it closest to right: “Private equity giant Carlyle Group is shutting down the two mutual funds it launched just a year ago,” including Carlyle Global Core Allocation Fund.

What’s my beef? 

1. Carlyle doesn’t have two mutual funds, they have one. They have authorization to launch the second fund, but never have. It’s like shuttering an unbuilt house. Reuters, nonetheless, solemnly notes that the second fund “never took off [and] will also be wound down,” implying that – despite Carlyle’s best efforts, it was just an undistinguished performer.
2. The fund they have isn’t the one named in the stories. There is no such fund as Carlyle Global Core Allocation Fund, a fund mentioned in every story. Its name is Carlyle Core Allocation Fund(CCAIX/CCANX). It’s rather like the Janus Global Unconstrained Bond Fund that, despite Janus’s insistence, didn’t exist at the point that Mr. Gross joined the team. “Global” is a description but not in the name.
3. The Carlyle fund is not newsworthy. It’s less than one year old, it has a trivial asset base ($50 million) and has not yet made a penny ($10,000 at inception is now $9930).

If folks wanted to find a story here, a good title might be “Another big name private investor trawls the fund space for assets, doesn’t receive immediate gratification and almost immediately loses interest.” I detest the practice of tossing a fund into the market then shutting it in its first year; it really speaks poorly of the adviser’s planning, understanding and commitment but it seems distressingly common.

What’s my solution?

Upgrade. Most news outlets are no longer capable of doing that for you; they simply don’t have the resources to do a better job or to separate press release from self-serving bilge from news so you need to do it for yourself.

Switch to Bloomberg TV from, you know, the screechy guys. If it’s not universally lauded, it does seem broadly recognized as the most thoughtful of the financial television channels.

Develop the habit of listening to Marketplace, online or on public radio. It’s a service of American Public Media and I love listening to Kai Ryssdal and crew for their broad, intelligent, insightful reporting on a wide range of topics in finance and money.

Read the Saturday Wall Street Journal, which contains more sensible content per inch than any other paper that lands on my desk. Jason Zweig’s column alone is worth the price of admission. His most recent weekend piece, “A History of Mutual-Fund Doors Opening and Closing,” is outstanding, if only because it quotes me.  About 90% of us would benefit from less saturation with the daily noise and more time to read pieces that offer a bit of perspective.

Reward yourself richly on any day when your child’s baseball score comes immediately to mind but you can honestly say you have no earthly clue what the score of the Dow Jones is. That’s not advice for casual investors, that’s advice for professionals: the last thing on earth that you want is a time horizon that’s measured in hours, days, weeks or months. On that scale the movement of markets is utterly unpredictable and focusing on those horizons will damage you more deeply and more consistently than any other bad habit you can develop.

Go read a good book and I don’t mean financial porn. If your competitive advantage is seeing things that other people (uhh, the herd) don’t see, then you’ve got to expose yourself to things other people don’t experience. In a world increasingly dominated by six inch screens, books – those things made from trees – fit the bill. Bill Gates recommends The Bully Pulpit, by Doris Kearns Goodwin. Goodwin “studies the lives of America’s 26th and 27th presidents to examine a question that fascinates me: How does social change happen?” That is, Teddy Roosevelt and William Taft. Power down your phone while you’re reading. The aforementioned Mr. Zweig fusses that “you can’t spend all day reading things that train your brain to twitch” and offers up Daniel Kahneman’s Thinking, Fast and Slow. Having something that you sip, rather than gulp, does help turn reading from an obligation to a calming ritual. Nina Kallen, a friend, insurance coverage lawyer in Boston and one of the sharpest people we know, declares Roger Fisher and William Ury’s Getting to Yes: Negotiating Agreement Without Giving In to be “life-changing.” In her judgment, it’s the one book that every 18-year-old should be handed as part of the process of becoming an adult. Chip and I have moved the book to the top of our joint reading list for the month ahead. Speaking of 18-year-olds, it wouldn’t hurt if your children actually saw you reading; perhaps if you tell them they wouldn’t like it, they’d insist on joining you.

How Good Is Your Fund Family? An Update…

Baseball season has started. MLB.TV actually plays more commercials than it used to, which sad to say I enjoy more than the silent “Commercial Break In Progress” screen, even if they are repetitive.

One commercial is for The Hartford Funds. The company launched a media campaign introducing a new tagline, “Our benchmark is the investor℠,” and its focus on “human-centric investing.”

Its website touts research they have done with MIT on aging, and its funds are actually sub-advised by Wellington Management.

A quick look shows 66 funds, each with some 6 share classes, and just under $100B AUM. Of the 66, most charge front loads up to 5.5% with an average annual expense ratio of just over 1%, including 12b-1 fee. And, 60 have been around for more than 3 years, averaging 15 years in fact.

How well have their funds performed over their lifetimes? Just average … a near even split between funds over-performing and under-performing their peers, including expenses.

We first started looking at fund family performance last year in the piece “How Good Is Your Fund Family?” Following much the same methodology, with all the same qualifications, below is a brief update. Shortly, we hope to publish an ongoing tally, or “Fund Family Score Card” if you will, because … during the next commercial break, while watching a fund family’s newest media campaign, we want to make it easier for you to gauge how well a fund family has performed against its peers.

The current playing field has about 6200 US funds packaged and usually marketed in 225 families. For our tally, each family includes at least 5 funds with ages 3 years or more. Oldest share class only, excluding money market, bear, trading, and specialized commodity funds. Though the numbers sound high, the field is actually dominated by just five families, as shown below:

It is interesting that while Vanguard represents the largest family by AUM, with nearly twice its nearest competitor, its average annual ER of 0.22% is less than one third either Fidelity or American Funds, at 0.79% and 0.71%, respectively. So, even without front loads, which both the latter use to excess, they are likely raking in much more in fees than Vanguard.

Ranking each of the 225 families based on number of funds that beat their category averages produces the following score card, by quintile, best to worst:

Of the five families, four are in top two quintiles: Vanguard, American Funds, Fidelity, and T. Rowe Price.  In fact, of Vanguard’s 145 funds, 119 beat their peers. Extraordinary. But BlackRock is just average, like Hartford.

The difference in average total return between top and bottom fund families on score card is 3.1% per year!

The line-ups of some of the bottom quintile families include 100% under-performers, where every fund has returned less than its peers over their lifetimes: Commonwealth, Integrity, Lincoln, Oak Associates, Pacific Advisors, Pacific Financial, Praxis, STAAR. Do you think their investors know? Do the investors of Goldman Sachs know that their funds are bottom quintile … written-off to survivorship bias possibly?

Visiting the website of Oberweis, you don’t see that four of its six funds under-performed. Instead, you find: TWO FUNDS NAMED “BEST FUND” IN 2015 LIPPER AWARDS. Yes, its two over-performers.

While the line-ups of some top quintile families include 100% over-performers: Cambiar, Causeway, Dodge & Cox, First Eagle, Marsico, Mirae, Robeco, Tocqueville.

Here is a summary of some of the current best and worst:

While not meeting the “five funds” minimum, some other notables: Tweedy Browne has 4 of 4 over-performers, and Berwyn, FMI, Mairs & Power, Meridian, and PRIMECAP Odyssey all have 3 of 3.

(PRIMECAP is an interesting case. It actually advises 6 funds, but 3 are packaged as part of the Vanguard family. All 6 PRIMECAP advised funds are long-term overperformers … 3.4% per year across an average of 15 years! Similarly with OakTree. All four of its funds beat their peers, but only 2 under its own name.)

As well as younger families off to great starts: KP, 14 of 14 over-performers, Rothschild 7 of 7, Gotham 5 of 5, and Grandeur Peak 4 of 4. We will find a way to call attention to these funds too on the future “Fund Family Score Card.”

Ed is on assignment, staking out a possible roach motel

Our distinguished senior colleague Ed Studzinski is a deep-value investor; his impulse is to worry more about protecting his investors when times turn dark than in making them as rich as Croesus when the days are bright and sunny. He’s been meditating, of late, on the question of whether there’s anything a manager today might do that would reliably protect his investors in the case of a market crisis akin to 2008.

Ed is one of a growing number of investors who are fearful that we might be approaching a roach motel; that is, a situation where it’s easy to get into a particular security but where it might be impossible to get back out of it when you urgently want to.

Structural changes in the market and market regulations have, some fear, put us at risk for a liquidity crisis. In a liquidity crisis, the ability of market makers to absorb the volume of securities offered for sale and to efficiently match buyers and sellers disappears. A manager under pressure to sell a million dollars’ worth of corporate bonds might well find that there’s only a market for two-thirds of that amount, the remaining third could swiftly become illiquid – that is, unmarketable – securities.

David Sherman, president of Cohanzick Asset Management and manager of two RiverPark’s non-traditional bond funds addressed the issue in his most recent shareholder letter. I came away from it with two strong impressions:

There may be emerging structural problems in the investment-grade fixed-income market. At base, the unintended consequences of well-intended reforms may be draining liquidity from the market (the market makers have dramatically less cash and less skin in the game than they once did) and making it hard to market large fixed-income sales. An immediate manifestation is the problem in getting large bond issuances sold.

Things might get noticeably worse for folks managing large fixed-income portfolios. His argument is that given the challenges facing large bond issues, you really want a fund that can benefit from small bond issues. That means a small fund with commitments to looking beyond the investment-grade universe and to closing before size becomes a hindrance.

Some of his concerns are echoed on a news site tailored for portfolio managers, ninetwentynine.com. An article entitled “Have managers lost sight of liquidity risk?” argues:

A liquidity drought in the bond space is a real concern if the Fed starts raising rates, but as the Fed pushes off the expected date of its first hike, some managers may be losing sight of that danger. That’s according to Fed officials, who argue that if a rate hike catches too many managers off their feet, the least they can expect is a taper tantrum similar to 2013, reports Reuters. The worst-case-scenario is a full-blown liquidity crisis.

The most recent investor letter from the managers of Driehaus Active Income Fund (LCMAX) warns that recent structural changes in the market have made it increasingly fragile:

Since the end of the credit crisis, there have been a number of structural changes in the credit markets, including new regulations, a reduced size of broker dealer trading desks, changes in fund flows, and significant growth of larger index-based mutual funds and ETFs. The “new” market environment and players have impacted nearly all aspects of the market, including trading liquidity. The transfer of risk is not nearly as orderly as it once was and is now more expensive and volatile … one thing nearly everyone can agree on is that liquidity in the credit markets has decreased materially since the credit crisis.

The federal Office of Financial Research concurs: “Markets have become more brittle because liquidity may be less available in a downturn.” Ben Inker, head of GMO’s asset allocation group, just observed that “the liquidity in [corporate credit] markets has become shockingly poor.”

More and more money is being stashed in a handful of enormous fixed income funds, active and passive. In general, those might be incredibly regrettable places to be when liquidity becomes constrained:

Generally speaking, you’re going to need liquidity in your bond fund when the market is stressed. When the market is falling apart, the ETFs are the worst place to be, as evidenced by their underperformance to the index in 2008, 2011 and 2013. So yes, you will have liquidity, but it will be in something that is cratering.

What does this mean for you?

1. Formerly safe havens won’t necessarily remain safe.
2. You need to know what strategy your portfolio manager has for getting ahead of a liquidity crunch and for managing during it. The Driehaus folks list seven or eight sensible steps they’ve taken and Mr. Sherman walks through the structural elements of his portfolio that mitigate such risks.
3. If your manager pretend not to know what the concern is or suggests you shouldn’t worry your pretty little head about it, fire him.

In the interim, Mr. Studzinski is off worrying on your behalf, talking with other investors and looking for a safe(r) path forward. We’re hoping that he’ll return next month with word of what he’s found.

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 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

• The SEC charged BlackRock Advisors with breaching its fiduciary duty by failing to disclose a conflict of interest created by the outside business activity of a top-performing portfolio manager. BlackRock agreed to settle the charges and pay a $12 million penalty.
• In a blow to Putnam, the Second Circuit reinstated fraud and negligence-based claims made by the insurer of a swap transaction. The insurer alleges that Putnam misrepresented the independence of its management of a collateralized debt obligation. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)

New Appeals

• Plaintiffs have appealed the lower court’s dismissal of an ERISA class action regarding Fidelity‘s practices with respect to the so-called “float income” generated from plan participants’ account transactions. (In re Fid. ERISA Float Litig.)

Briefs

• Plaintiffs filed their opposition to Davis‘s motion to dismiss excessive-fee litigation regarding the New York Venture Fund. Brief: “Defendants’ investment advisory fee arrangements with the Davis New York Venture Fund . . . epitomize the conflicts of interest and potential for abuse that led Congress to enact § 36(b). Unconstrained by competitive pressures, Defendants charge the Fund advisory fees that are as much as 96% higher than the fees negotiated at arm’s length by other, independent mutual funds . . . for Davis’s investment [sub-]advisory services.” (In re Davis N.Y. Venture Fund Fee Litig.)
• Plaintiffs filed their opposition to PIMCO‘s motion to dismiss excessive-fee litigation regarding the Total Return Fund. Brief: “In 2013 alone, the PIMCO Defendants charged the shareholders of the PIMCO Total Return Fund $1.5 billion in fees, awarded Ex-head of PIMCO, Bill Gross, a $290 million bonus and his second-in-command a whopping $230 million, and ousted a Board member who dared challenge Gross’s compensation—all this despite the Fund’s dismal performance that trailed 70% of its peers.” (Kenny v. Pac. Inv. Mgmt. Co.)
• In the purported class action regarding alleged deviations from two fundamental investment objectives by the Schwab Total Bond Market Fund, the Investment Company Institute and Independent Directors Council filed an amici brief in support of Schwab’s petition for rehearing (and rehearing en banc) of the Ninth Circuit’s 2-1 decision allowing the plaintiffs’ state-law claims to proceed. Brief: “The panel’s decision departs from long-standing law governing mutual funds and creates confusion and uncertainty nationwide.” Defendants include independent directors. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)

Amended Complaint

• Plaintiffs filed a new complaint in the fee litigation against New York Life, adding a fourth fund to the case: the MainStay High Yield Opportunities Fund. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

Answer

• P. Morgan filed an answer in an excessive-fee lawsuit regarding three of its bond funds. (Goodman v. J.P. Morgan Inv. Mgmt., Inc.)

The Alt Perspective: Commentary and News from Daily Alts

The spring has brought new life into the liquid alternatives market with both March and April seeing robust activity in terms of new fund launches and registrations, as well as fund flows. Touching on new fund flows first, March saw more than $2 billion of new asset flow into alternative mutual funds and ETFs, while US equity mutual funds and ETFs had combined outflows of nearly $6 billion.

At the top of the inflow rankings were international equity and fixed income, which provides a clear indication that investors were seeking both potentially higher return equity markets (non-US equity) and shelter (fixed income and alternatives). With increased levels of volatility in the markets, I wouldn’t be surprised to see this cash flow trend continue on into April and May.

New Funds Launched in April

We logged eight new liquid alternative funds in April from firms such as Prudential, Waycross, PowerShares and LoCorr. No particular strategy stood out as being dominant among the eight funds as they ranged from long/short equity and alternative fixed income strategies, to global macro and multi-strategy. A couple highlights are as follows:

1) LoCorr Multi-Strategy Fund – To date, LoCorr has done a thoughtful job of brining high quality managers to the liquid alts market, and offers funds that cover managed futures, long/short commodities, long/short equity and alternative income strategies. In this new fund, they bring all of these together in a single offering, making it easier for investors to diversify with a single fund.

2) Exceed Structured Shield Index Strategies Fund – This is the first of three new mutual funds that provide investors with a structured product that is designed to protect downside volatility and provide a specific level of upside participation. The idea of a more defined outcome can be appealing to a lot of investors, and will also help advisors figure out where and how to use the fund in a portfolio.

New Funds Registered in April

Fund registrations are where we see what is coming a couple months down the road – a bit like going to the annual car show to see what the car manufacturers are going to be brining out in the new season. And at this point, it looks like June/July will be busy as we counted 9 new alternative fund registration in April. A couple interesting products are listed below:

1) Hatteras Market Neutral Fund – Hatteras has been around the liquid alts market for quite some time, and with this fund will be brining multiple managers in as sub-advisors. Market neutral strategies are appealing at times when investors are looking to take risk off the table yet generate returns that are better than cash. They can also serve as a fixed income substitute when the outlook is flat to negative for the fixed income market.

2) Franklin K2 Long Short Credit Fund – K2 is a leading fund of hedge fund manager that works with large institutional investors to invest in and manage portfolios of hedge funds. The firm was acquired by Franklin Templeton back in 2012 and has so far launched one alternative mutual fund. The fund will be managed by multiple sub-advisors and will allocate to several segments of the fixed income market. 

Debunking Active Share

High active share does not equal high alpha. I’ll say that again. High active share does not equal high alpha. This is the finding in a new AQR white paper that essentially proves false two of the key tenents of a 2009 research paper (How Active is Your Fund Manager? A New Measure That Predicts Performance) by Martijn Cremers and Antti Petajisto. These two tenents are:

1) Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.

2) Non-index funds with the lowest Active Share underperform their benchmarks.

AQR explains that other factors are in play, and those other factors actually explain the outperformance that Cremers and Petajisto found in their work. You can read more here: AQR Deactivates Active Share in New White Paper.

And finally, for anyone considering the old “Sell in May and Go Away” strategy this month, be sure to have a read of this article, or watch this video. Or, better yet, just make a strategic allocation to a few solid alternative funds that have some downside protection built into them.

Feel free to stop by DailyAlts.com for more coverage of liquid alternatives.

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.

Seafarer Overseas Growth & Income (SFGIX/SIGIX): Our contention has always been that Seafarer represents one of the best possible options for investors interested in approaching the emerging markets. A steadily deepening record and list of accomplishments suggests that we’re right.

Towle Deep Value Fund (TDVFX): This fund positions itself a “an absolute value fund with a strong preference for staying fully invested.” For the past 33 years, Mr. Towle & Co. have been consistently successful at turning over more rock – in under covered small caps and international stocks alike – to find enough deeply undervalued stocks to populate the portfolio and produce eye-catching results.

Conference Call Highlights: Seafarer Overseas Growth & Income

Here are some quick highlights from our April 16^th conversation with Andrew Foster of Seafarer.

Seafarer’s objective: Andrew’s hope is to outperform his benchmark (the MSCI EM index) “slowly but steadily over time.” He describes the approach as a “relative return strategy” which pursues growth that’s more sustainable than what’s typical in developing markets while remaining value conscious.

Here’s the strategy: you need to start by understanding that the capital markets in many EM nations are somewhere between “poorly developed” and “cruddy.” Both academics and professional investors assume that a country’s capital markets will function smoothly: banks will make loans to credit-worthy borrowers, corporations and governments will be able to access the bond market to finance longer-term projects and stocks will trade regularly, transparently and at rational expense.

None of that may safely be assumed in the case of emerging markets; indeed, that’s what might distinguish an “emerging” market from a developed one. The question becomes: what are the characteristics of companies that might thrive in such conditions.

The answer seems to be (1) firms that can grow their top line steadily in the 7-15% per annum range and (2) those that can finance their growth internally. The focus on the top line means looking for firms that can increase revenues by 7-15% without obsessing about similar growth in the bottom line. It’s almost inevitable that EM firms will have “stumbles” that might diminish earnings for one to three years; while you can’t ignore them, you also can’t let them drive your investing decisions. “If the top line grows,” Andrew argues, “the bottom line will follow.” The focus on internal financing means that the firms will be capable of funding their operations and plans without needing recourse to the unreliable external sources of capital.

Seafarer tries to marry that focus on sustainable moderate growth “with some current income, which is a key tool to understanding quality and valuation of growth.” Dividends are a means to an end; they don’t do anything magical all by themselves. Dividends have three functions. They are:

An essential albeit crude valuation tool – many valuation metrics cannot be meaningfully applied across borders and between regions; there’s simply too much complexity in the way different markets operate. Dividends are a universally applicable measure.

A way of identifying firms that will bounce less in adverse market conditions – firms with stable yields that are just “somewhat higher than average” tend to be resilient. Firms with very high dividend yields are often sending out distress signals. 

A key and under-appreciated signal for the liquidity and solvency of a company – EMs are constantly beset by liquidity and credit shocks and unreliable capital markets compound the challenge. Companies don’t survive those shocks as easily as people imagine. The effects of liquidity and credit crunches range from firms that completely miss their revenue and earnings forecasts to those that drown themselves in debt or simply shutter. Against such challenges dividends provide a clear and useful signal of liquidity and solvency.

It’s certainly true that perhaps 70% of the dispersion of returns over a 5-to-10 year period are driven by macro-economic factors (Putin invades-> the EU sanctions-> economies falter-> the price of oil drops-> interest rates fall) but that fact is not useful because such events are unforecastable and their macro-level impacts are incalculably complex (try “what effect will European reaction to Putin’s missile transfer offer have on shadow interest rates in China?”). 

Andrew believes he can make sense of the ways in which micro-economic factors, which drive the other 30% of dispersion, might impact individual firms. He tries to insulate his portfolio, and his investors, from excess volatility by diversifying away some of the risk, imagining a “three years to not quite forever” time horizon for his holdings and moving across a firm’s capital structure in pursuit of the best risk-return balance.

While Seafarer is classified as an emerging markets equity fund, common stocks have comprised between 70-85% of the portfolio. “There’s way too much attention given to whether a security is a stock or bond; all are cash flows from an issuer. They’re not completely different animals, they’re cousins. We sometimes find instruments trading with odd valuations, try to exploit that.” As of January 2015, 80% of the fund is invested directly in common stock; the remainder is invested in ADRs, hard- and local-currency convertibles, government bonds and cash. The cash stake is at a historic low of 1%.

Thinking about the fund’s performance: Seafarer is in the top 3% of EM stock funds since launch, returning a bit over 10% annually. With characteristic honesty and modesty, Andrew cautions against assuming that the fund’s top-tier rankings will persist in the next part of the cycle:

We’re proud of performance over the last few years. We have really benefited from the fact that our strategy was well-positioned for anemic growth environments. Three or four years ago a lot of people were buying the story of vibrant growth in the emerging markets, and many were willing to overpay for it. As we know, that growth did not materialize. There are signs that the deceleration of growth is over even if it’s not clear when the acceleration of growth might begin. A major source of return for our fund over 10 years is beta. We’re here to harness beta and hope for a little alpha.

That said, he does believe that flaws in the construction of EM indexes makes it more likely that passive strategies will underperform:

I’m actually a fan of passive investing if costs are low, churn is low, and the benchmark is soundly constructed. The main EM benchmark is disconnected from the market. The MSCI EM index imposes filters for scalability and replicability in pursuit of an index that’s easily tradable by major investors. That leads it to being not a really good benchmark. The emerging markets have $14 trillion in market capitalization; the MSCI Core index captures only $3.8 trillion of that amount and the Total Market index captures just $4.2 trillion. In the US, the Total Stock Market indexes capture 80% of the market. The comparable EM index captures barely 25%.

Highlights from the questions:

As a practical matter, a 4-5% position is “huge for us” though he has learned to let his winners run a little longer than he used to, so the occasional 6% position wouldn’t be surprising.

A focus on dividend payers does not imply a focus on large cap stocks. There are a lot of very stable dividend-payers in the mid- to small-cap range; Seafarer ranges about 15-20% small cap and 35-50% midcap.

The fundamental reason to consider investing in emerging markets is because “they are really in dismal shape, sometimes the horrible things you read about them are true but there’s an incredibly powerful drive to give your kids a better life and to improve your life. People will move mountains to make things better. I followed the story of one family who were able to move from a farmhouse with a dirt floor to a comfortable, modern townhouse in one lifetime. It’s incredibly inspiring, but it’s also incredibly powerful.”

With special reference to holdings in Eastern Europe, you need to avoid high-growth, high-expectation companies that are going to get shell-shocked by political turmoil and currency devaluation. It’s important to find companies that have already been hit and that have proved that they can survive the shock.

Bottom line: Andrew has a great track record built around winning by not losing. His funds have posted great relative returns in bad markets and very respectable absolute returns in frothy ones. While he is doubtless correct in saying that the fund was unique well-suited to the current market and that it won’t always be a market leader, it’s equally correct to say that this is one of the most consistently risk-conscious, more consistently shareholder-sensitive and most consistently rewarding EM funds available. Those are patterns that I’ve found compelling.

We’ve also updated our featured fund page for Seafarer.

Funds in Registration

New mutual funds must be registered with the Securities and Exchange Commission before they can be offered for sale to the public. The SEC has a 75-day window during which to call for revisions of a prospectus; fund companies sometimes use that same time to tweak a fund’s fee structure or operating details.

Funds in registration this month are eligible to launch in late June and some of the prospectuses do highlight that date.

This month our research associate David Welsch tracked down 14 no-load retail funds in registration, which represents our core interest. By far the most interest was stirred by the announcement of three new Grandeur Peak funds:

• Global Micro Cap
• International Stalwarts
• Global Stalwarts

The launch of Global Micro Cap has been anticipated for a long time. Grandeur Peak announced two things early on: (1) that they had a firm wide strategy capacity of around $3 billion, and (2) they had seven funds in the works, including Global Micro, which were each allocated a set part of that capacity. Two of the seven projected funds (US Opportunities and Global Value) remain on the drawing board. President Eric Huefner remarks that “Remaining nimble is critical for a small/micro cap manager to be world-class,” hence “we are terribly passionate about asset capping across the firm.” 

The surprise comes with the launch of the two Stalwarts funds, whose existence was previously unanticipated. Folks on our discussion board reacted with (thoughtful) alarm. Many of them are GP investors and they raised two concerns: (1) this might signal a change in corporate culture with the business managers ascendant over the asset managers, and (2) a move into larger capitalizations might move GP away from their core area of competence.

Because they’re in a quiet period, Eric was not able to speak about these concerns though he did affirm that they’re entirely understandable and that he’d be able to address them directly after launch of the new funds.

Mr. Gardiner, Guardian Manager, at work

While I am mightily amused by the title GUARDIAN MANAGER given to Robert Gardiner to explain his role with the new funds, I’m not immediately distressed by these developments. “Stalwarts” has always been a designation for one of the three sorts of stocks that the firm invests in, so presumably these are stocks that the team has already researched and invested in. Many small cap managers find an attraction in these “alumni” stocks, which they know well and have confidence in but which have outgrown their original fund. Such funds also offer a firm the ability to increase its strategy capacity without compromising its investment discipline. I’ll be interested in hearing from Mr. Heufner later this summer and, perhaps, in getting to tap of Mr. Gardiner’s shield.

Manager Changes

A lot of funds were liquidated this month, which means that a lot of managers changed from “employed” to “highly motivated investment professional seeking to make a difference.” Beyond that group, 43 funds reported partial or complete changes in their management teams. The most striking were:

• The departure of Independence Capital Asset Partners from LS Opportunity Fund, about which there’s more below.
• The departure of Robert Mohn from both Columbia Acorn Fund (ACRNX) and Columbia Acorn USA (AUSAX) and from his position as their Domestic CIO. Mr. Mohn joined the fund in late 2003 shortly after the retirement of the legendary Ralph Wanger. He initially comanaged the fund with John Park (now of Oakseed Opportunity SEEDX) and Chuck McQuaid (now manager of Columbia Thermostat (CTFAX). Mr. Mohn is being succeeded by Zachary Egan, President of the adviser, and the estimable Fritz Kaegi, one of the managers of Columbia Acorn Emerging Markets (CAGAX). They’ll join David Frank who remained on the fund.

Updates

Centaur Total Return (TILDX) celebrated its 10-year anniversary in March, so I wish we’d reported the fact back then. It’s an interesting creature. Centaur started life as Tilson Dividend, though Whitney Tilson never had a role in its management. Mr. Tilson thought of himself (likely “thinks of himself”) as a great value investor, but that claim didn’t play out in his Tilson Focus Fund so he sort of gave up and headed to hedge fund land. (Lately he’s been making headlines by accusing Lumber Liquidators, a company his firm has shorted, of deceptive sales practices.) Mr. Tilson left and the fund was rechristened as Centaur.

Centaur’s record is worth puzzling over.  Morningstar gives it a ten-year ranking of five stars, a three-year ranking of one star and three stars overall. Over its lifetime it has modestly better returns and vastly lower risks than its peers which give it a great risk-adjusted performance.

Mostly it has great down market protection and reasonable upmarket performance, which works well if the market has both ups and downs. When the market has a whole series of strong gains, conservative value investors end up looking bad … until they look prescient and brilliant all over again.

There’s an oddly contrarian indicator in the quick dismissal of funds like Centaur, whose managers have proven adept and disciplined. When the consensus is “one star, bunch of worthless cash in the portfolio, there’s nothing to see here,” there might well be reason to start thinking more seriously as folks with a bunch of …

In any case, best anniversary wishes to manager Zeke Ashton and his team.

Briefly Noted . . .

American Century Investments, adviser to the American Century Funds, has elected to support the America’s Best Communities competition, a $10 million project to stimulate economic revitalization in small towns and cities across the country. At this point, 50 communities have registered first round wins. The ultimate winner will receive a $3 million economic development grant from a consortium of American firms.

In the interim, American Century has “adopted” Wausau, Wisconsin, which styles itself “the Chicago of the north.” (I suspect many of you think of Chicago as “the Chicago of the north,” but that’s just because you’re winter wimps.) Wausau won $35,000 which will be used to develop a comprehensive plan for economic revival and cultural enrichment. American Century is voluntarily adding another $15,000 to Wausau’s award and will serve as a sort of consultant to the town as they work on preparing a plan. It’s a helpful gesture and worthy of recognition.

LS Opportunity Fund (LSOFX) is about to become … well, something else but we don’t know what. The fund has always been managed by Independence Capital Asset Partners in parallel with ICAP’s long/short hedge fund. On April 23, 2015, the fund’s board terminated ICAP’s contract because of “certain portfolio management changes expected to occur within the sub-adviser.” On April 30, the board named Prospector Partners LLC has the fund’s interim manager, presumably with the expectation that they’ll be confirmed in June as the permanent replacement for ICAP. Prospector is described as “an investment adviser registered with the Securities and Exchange Commission with its principal offices [in] Guilford, CT. Prospector currently provides investment advisory services to corporations, pooled investment vehicles, and retirement plans.” Though they don’t mention it, Prospector also serves as the adviser to two distinctly unexciting long-only mutual funds: Prospector Opportunity (POPFX) and Prospector Capital Appreciation (PCAFX). LSOFX is a rated by Morningstar as a four-star fund with $170 million in assets, which makes the change both consequential and perplexing. We’ll share more as soon as we can.

Northern Global Tactical Asset Allocation Fund (BBALX) has added hedging via derivatives to the list of its possible investments: “In addition, the Fund also may invest directly in derivatives, including but not limited to forward currency exchange contracts, futures contracts and options on futures contracts, for hedging purposes.”

Gargoyle is on the move. RiverPark Funds is in the process of transferring control of RiverPark Gargoyle Hedged Value Fund (RGHVX) to TCW where it will be renamed … wait for it … TCW/Gargoyle Hedged Value Fund. It’s a solid five star fund with $73 million in assets. That latter number is what has occasioned the proposed move which shareholders will still need to ratify.

RiverPark CEO Morty Schaja notes that the strategy has spectacular long-term performance (it was a hedge fund before becoming a mutual fund) but that it’s devilishly hard to market. The fund uses two distinct strategies: a quantitatively driven relative value strategy for its stock portfolio and a defensive options overlay. While the options provide income and some downside protection, the fund does not pretend to being heavily hedged much less market neutral. As a result, it has a lot more downside volatility than the average long-short fund (it was down 34% in 2008, for example, compared with 15% for its peers) but also a more explosive upside (gaining 42% in 2009 against 10% for its peers). That’s not a common combination and RiverPark’s small marketing team has been having trouble finding investors who understand and value the combination. TCW is interested in developing a presence in “the liquid alts space” and has a sales force that’s large enough to find the investors that Gargoyle is seeking.

Expenses will be essentially unchanged, though the retail minimum will be substantially higher.

Zacks Small-Cap Core Fund (ZSCCX) has raised its upper market cap limit to $10.3 billion, which hardly sounds small cap at all.  That’s the range of stocks like Staples (SPLS) and L-3 Communications (LLL) which Morningstar classifies as mid-caps.

SMALL WINS FOR INVESTORS

Touchstone Merger Arbitrage Fund (TMGAX) has reopened to a select subset of investors: RIAs, family offices, institutional consulting firms, bank trust departments and the like. It’s fine as market-neutral funds go but they don’t go very far: TMGAX has returned under 2% annually over the past three years.  On whole, I suspect that RiverPark Structural Alpha (RSAFX) remains the more-attractive choice.

CLOSINGS (and related inconveniences)

Effective May 15, 2015, Janus Triton (JGMAX) and Janus Venture (JVTAX) are soft closing, albeit with a bunch of exceptions. Triton fans might consider Meridian Small Cap Growth, run by the team that put together Triton’s excellent record.

Effective at the close of business on May 29, 2015, MFS International Value Fund (MGIAX) will be closed to new investors

Effective June 1, 2015, the T. Rowe Price Health Sciences Fund (PRHSX) will be closed to new investors. 

Vulcan Value Partners (VVLPX) has closed to new investors. The firm closed its Small Cap strategy, including its small cap fund, in November of 2013, and closed its All Cap Program in early 2014. Vulcan closed, without advance notice, its Large Cap Programs – which include Large Cap, Focus and Focus Plus in late April. All five of Vulcan Value Partners’ investment strategies are ranked in the top 1% of their respective peer groups since inception.

OLD WINE, NEW BOTTLES

Effective April 30, 2015, American Independence Risk-Managed Allocation Fund (AARMX) was renamed the American Independence JAForlines Risk-Managed Allocation Fund. The objective, strategies and ticker remained the same. Just to make it unsearchable, Morningstar abbreviates it as American Indep JAFrl Risk-Mgd Allc A.

Effective on June 26, 2015 Intrepid Small Cap Fund (ICMAX) becomes Intrepid Endurance Fund and will no longer to restricted to small cap investing. It’s an understandable move: the fund has an absolute value focus, there are durned few deeply discounted small cap stocks currently and so cash has built up to become 60% of the portfolio. By eliminating the market cap restriction, the managers are free to move further afield in search of places to deploy their cash stash.

Effective June 15, 2015, Invesco China Fund (AACFX) will change its name to Invesco Greater China Fund.

Effective June 1, 2015, Pioneer Long/Short Global Bond Fund (LSGAX) becomes Pioneer Long/Short Bond Fund. Since it’s nominally not “global,” it’s no longer forced to place at least 40% outside of the U.S. At the same time Pioneer Multi-Asset Real Return Fund (PMARX) will be renamed Pioneer Flexible Opportunities.

As of May 1, 2015 Royce Opportunity Select Fund (ROSFX) became Royce Micro-Cap Opportunity Fund. For their purposes, micro-caps have capitalizations up to $1 billion. The Fund will invest, under normal circumstances, at least 80% of its net assets in equity securities of companies with stock market capitalizations up to $1 billion. In addition, the Fund’s operating policies will prohibit it from engaging in short sale transactions, writing call options, or borrowing money for investment purposes.

At the same time, Royce Value Fund (RVVHX) will be renamed Royce Small-Cap Value Fund and will target stocks with capitalizations under $3 billion. Royce Value Plus Fund (RVPHX) will be renamed Royce Smaller-Companies Growth Fund with a maximum market cap at time of purchase of $7.5 billion.

OFF TO THE DUSTBIN OF HISTORY

AlphaMark Small Cap Growth Fund (AMSCX) has been terminated; the gap between the announcement and the fund’s liquidation was three weeks. It wasn’t a bad fund at all, three stars from Morningstar, middling returns, modest risk, but wasn’t able to gain enough distinction to become economically viable. To their credit, the advisor stuck with the fund for nearly seven years before succumbing.

American Beacon Small Cap Value II Fund (ABBVX) will liquidate on May 12. The advisor cites a rare but not unique occurrence to explain the decision: “after a large redemption which is expected to occur in April 2015 that will substantially reduce the Fund’s asset size, it will no longer be practicable for the Manager to operate the Fund in an economically viable manner.”

Carlyle Core Allocation Fund (CCAIX) and Enhanced Commodity Real Return (no ticker) liquidate in mid-May.  

The Citi Market Pilot 2030 (CFTYX) and 2040 (CFTWX) funds each liquidated on about one week’s notice in mid-April; the decision was announced April 9 and the portfolio was liquidated April 17. They lasted just about one year.

The Trustees have voted to liquidate and terminate Context Alternative Strategies Fund (CALTX) on May 18, 2015.

Contravisory Strategic Equity Fund (CSEFX), a tiny low risk/low return stock fund, will liquidate in mid-May. 

Dreyfus TOBAM Emerging Markets Fund (DABQX) will be liquidated on or about June 30, 2015.

Franklin Templeton is thinning down. They merged away one of their closed-end funds in April. They plan to liquidate the $38 million Franklin Global Asset Allocation Fund (FGAAX) on June 30. Next the tiny Franklin Mutual Recovery Fund (FMRAX) is looking, with shareholder approval, to merge into the Franklin Mutual Quest Fund (TEQIX) likely around the end of August.

The Jordan Fund (JORDX) is merging into the Meridian Equity Income Fund (MRIEX), pending shareholder approval. The move is more sensible than it looks. Mr. Jordan has been running the fund for a decade but has little to show for it. He had five strong years followed by five lean ones and he still hasn’t accumulated enough assets to break even. Minyoung Sohn took over MRIEX last October but has only $26 million to invest; the JORDX acquisition will triple the fund’s size, move it toward financial equilibrium and will get JORDX investors a noticeable reduction in fees.

Leadsman Capital Strategic Income Fund (LEDRX) was liquidated on April 7, 2015, based on the advisor’s “representations of its inability to market the Fund and the Adviser’s indication that it does not desire to continue to support the Fund.” They lost interest in it? Okay, on the one hand there was only $400,005 in the fund. On the other hand, they launched it exactly six months before declaring failure and going home. I’m perpetually stunned by advisors who pull the plug after a few months or a year. I mean, really, what does that say about the quality of their business planning, much less their investment acumen?

I wonder if we should make advisers to new funds post bail? At launch the advisor must commit to running the fund for no less than a year (or two or three). They have to deposit some amount ($50,000? $100,000?) with an independent trustee. If they close early, they forfeit their bond to the fund’s investors. That might encourage more folks to invest in promising young funds by hedging against one of the risks they face and it might discourage “let’s toss it against the wall and see if anything sticks” fund launches.

Manning & Napier Inflation Focus Equity Series (MNIFX) will liquidate on May 11, 2015.

Merk Hard Currency ETF (formerly HRD) has liquidated. Hard currency funds are, at base, a bet against the falling value of the US dollar. Merk, for example, defines hard currencies as “currencies backed by sound monetary policy.” That’s really not been working out. Merk’s flagship no-load fund, Merk Hard Currency (MERKX), is still around but has been bleeding assets (from $280M to $160M in a year) and losing money (down 2.1% annually for the past five years). It’s been in the red in four of the past five years and five of the past ten. Here’s the three-year picture.

Presumably if investors stop fleeing to the safe haven of US Treasuries there will be a mighty reversal of fortunes. The question is whether investors can (or should) wait around until then. Can you say “Grexit”?

Effective May 1, 2015, Royce Select Fund I (RYSFX) will be closed to all purchases and all exchanges into the Fund in anticipation of the fund being absorbed into the one-star Royce 100 Fund (ROHHX). Mr. Royce co-manages both but it’s still odd that they buried a three-star small blend fund into a one-star one.

The Turner Funds will close and liquidate the Turner Titan Fund (TTLFX), effective on or about June 1, 2015. It’s a perfectly respectable long/short fund in which no one had any interest.

The two-star Voya Large Cap Growth Fund (ILCAX) is slated to be merged into the three-star Voya Growth Opportunities Fund (NLCAX). Same management team, same management fee, same performance: it’s pretty much a wash.

In Closing . . .

The first issue of the Observer appeared four years ago this month, May 2011. We resolved from the outset to try to build a thoughtful community here and to provide them with insights about opportunities and perspectives that they might never otherwise encounter. I’m not entirely sure of how well we did, but I can say that it’s been an adventure and a delight. We have a lot yet to accomplish and we’re deeply hopeful you’ll join us in the effort to help investors and independent managers alike. Each needs the other.

Thanks, as ever, to the folks – Linda, who celebrates our even temperament, Bill and James – who’ve clicked on our elegantly redesigned PayPal link. Thanks, most especially, to Deb and Greg who’ve been in it through thick and thin. It really helps.

A word of encouragement: if you haven’t already done so, please click now on our Amazon link and either bookmark it or set it as one of the start pages in your browser. We receive a rebate equivalent to 6-7% of the value of anything you purchase (books, music, used umbrellas, vitamins …) through that link. It costs you nothing since it’s part of Amazon’s marketing budget and if you bookmark it now, you’ll never have to think about it again.

We’re excited about the upcoming Morningstar conference. All four of us – Charles, Chip, Ed and I – will be around the conference and at least three of us will be there from beginning to end, and beyond. Highlights for me:

• The opportunity to dine with the other Observer folks at one of Ed’s carefully-vetted Chicago eateries.
• Two potentially excellent addresses – an opening talk by Jeremy Grantham and a colloquy between Bill Nygren and Steve Romick
• A panel presentation on what Morningstar considers off-the-radar funds: the five-star Mairs & Power Small Cap (MSCFX, which we profiled late in 2011), Meridian Small Cap Growth (MSGAX, which we profiled late in 2014) and the five-star Eventide Gilead Fund (ETAGX, which, at $1.6 billion, is a bit beyond our coverage universe).
• A frontier markets panel presented by some “A” list managers.
• The opportunity to meet and chat with you folks. If you’re going to be at Morningstar, as exhibitor or attendee, and would like a chance to chat with one or another of us, drop me a note and we’ll try hard to set something up. We’d love to see you.

As ever,

Dear friends,

What a difference a month makes. When I wrote to you last month, it was 18 degrees below zero. Right now it’s 90 … 100 degrees warmer … and my students have noticed. Not only is there spring finery on display, but attendance at late afternoon classes seems to be just a bit iffy. All for good reason, of course: horrible contagious hacking coughs, migraines, spontaneously-combusting roommates, all the usual signs of spring.

I admit to a profound ambivalence about the weather. I visited Lake Mead, the reservoir behind Boulder Dam, a couple weeks ago. The water level is 100’ below capacity and neither the recorded audio nor the tour guides really wanted to talk about why or what it might mean. As I flew home, I noticed mountains with virtually no snow pack. California today imposed the first statewide water restrictions in the state’s history as they faced the prospect of absolute rather than just relative shortage. Geologists have discovered rivers flowing under Antarctica’s “grounded ice” and oceanographers note that the Atlantic oceans currents are slowing.

I worry that all too many of us think something like, “the worst-case is too awful to imagine, so I’m not going to think about this stuff.” Meanwhile, members of the U.S. Congress excuse their refusal to take it seriously with the carefully-rehearsed excuse, “I’m not a scientist,” as if that had some meaning greater than “I don’t want to offend either donors or primary voters, so I think I’ve found a slick way to dodge my responsibilities.”

I worry, too, that my efforts (a garden that needs little by way of watering or chemicals, a carefully insulated house that sips electric, carbon offsets for my travel, a small car matched with a tendency to walk where I need to go) and the Observer’s (we’ve got a very small carbon footprint, in part because we use a “green” hosting service) are trivial. All of which puts me in a state to cry:

The End is coming! The End is coming!

Soon … er.

Or later. That is, the stock market is going to crash.

I don’t really know when. Okay, fine: I haven’t got an earthly clue. Then again, neither does anyone else. I looked back at the financial media in the months before the market crash in 2007. The Lexis-Nexis database contains around 800 stock market stories for the three months immediately before the worst collapse in three-quarters of a century. By limiting the search to U.S. sources, I got it down to a nearly-manageable 400 or so which I proceeded to scan.

Here’s what I discovered: almost without exception, the public statements of major financial media outlets, mutual fund managers and hedge fund managers were stunningly clueless. Almost without exception, the story was that other than for one or two little puffy clouds in the distance, the skies were clear, you should have a song in your heart and a buy order in your hands.

Kiplinger’s led that parade with “Why Stocks Will Keep Going Up” (July). BusinessWeek urged us, “Don’t Be Afraid of the Dark” (August 13). Money asked “Is This Bull Ready to Leave” (July) and concluded that the market was undervalued and that large cap growth stocks had “a strong outlook.” Fortune did some fortune-telling and found “A Sunny Second Half” (July 9); relying on “a hedge fund superstar,” they promised “This Bull Has Legs” (August 20). John Rogers of the Ariel Funds declared “Subprime Risks: Overblown … [it’s] time to buy” (September 17). Standard & Poor’s thought “equities could register nice gains by the end of the year” (September 20) as the result of a Fed-fueled breakout.

Only GMO’s Jeremy Grantham stood out:

Even if the credit crunch passes without a major catastrophe, the prices of stocks, bonds, and real estate have a long way to fall

Credit crises have always been painful and unpredictable. The current one is particularly hair-raising because it’s occurring amid the first truly global bubble in asset pricing. It is also accompanied by a plethora of new and ingenious financial instruments. These are designed overtly to spread risk around and to sell fee-bearing products that are in great demand. Inadvertently (to be generous), they have been constructed to hide risk and confuse buyers. How this credit crisis works out and what price we end up paying has to be largely unknowable, depending as it does on hundreds of interlocking and often novel factors and how they in turn affect animal spirits. In the end it is, of course, the management of animal spirits that makes and breaks credit crises. “Danger: Steep Drop Ahead” (Fortune, September 17).

My scan excludes results for The Wall Street Journal, since neither the Journal’s own archive search nor the Lexis database cover the Journal’s articles for the period so it’s possible that the clear-eyed Jason Zweig was standing on the parapet crying “beware!”

We do know that, in general, markets are more apt to fall when valuations get out of hand and the market encounters an exogenous shock. That is, some cataclysmic event outside of the market; for example, in 2013 Fed chair Ben Bernanke allowed that “we could take a step down in our pace of purchase” of Treasury securities. The subsequent “taper tantrum” saw US bond markets drop 3% in three months. Ummm … that would be a trillion dollar setback.

If we can’t know when the crash will come, can we at least figure out whether the market is overvalued?

Ummm … no, though heaven knows we’ve tried. Here’s a sampling:

• Morningstar suggests that the market is overvalued by 4% (as of 3/23), which seems modest until you notice that the market seems to correct when it hits 5% overvalued. It hit 5% in May 2011 and the market dropped about 19% by the beginning of August. The market reached 10-14% overvalued in late 2004 and 2005, during which time it surged 17%. Other than for that stretch, market overvaluation hasn’t exceeded 5-7% before correcting. Matt Coffina, StockInvestor editor, agrees that “we see little margin of safety and few opportunities in current stock prices… Investors in common stocks must have a long time horizon and the patience and discipline to ride out volatility.” He identified industrials, technology, health care, consumer defensive, and utilities as the most overvalued sectors. 
• Mark Hulbert argues that, “based on six well-known and time-tested indicators, equities are more overvalued today than they’ve been between 69% and 89% of the past century’s bull-market tops.”
• Doug Short, one of the guys behind Advisor Perspectives, worries that, “Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 64% to 98%, depending on the indicator, up from the previous month’s 60% to 94%.” He does allow that markets can remain overvalued for years, though today’s high valuations translate to tomorrow’s tepid returns.
• Jim Paulsen, chief investment strategist at Wells Capital Management, finds that the median stock in the NYSE trades, based on its price/earnings and price/cash flow ratios, at post WW2 highs. Why look at the median? Because most stock indices are cap-weighted, the valuations of the few largest stocks can materially change the entire index’s weight; he admits the S&P500 appears “slightly above average but not excessive.” By looking at the median stock, he’s trying to gauge whether the market is broadly overvalued.
• Doug Ramsey, chief investment officer for the Leuthold Group and co-manager of the outstanding Leuthold Core Investment Fund (LCORX), in an email exchange, notes that “We have a composite Intrinsic Value reading for the stock market based on 25 different measures, with weightings based on the long-term correlation of each measure with subsequent 3-, 5- and 10-yr. total returns … The composite of our 25 measures finds U.S. stocks moderately overvalued, but the situation is different than peaks like 2000 and 2007 because we find the overvaluation to be very broad-based. In other words, valuation measures on the median or ‘typical’ U.S. stock are even higher than seen at 2000 or 2007. This phenomenon isn’t fully captured by valuation measures on the cap-weighted indexes.”

Even when high valuations aren’t followed by crashes, they tend to predict weak future returns. GMO’s forward-looking asset class forecast is among the glummest I’ve seen: they anticipate negative real returns over the next 5-7 years in nine of the 12 asset classes they track:

(3.5%) Int’l bonds (currency hedged)
(3.4%) US small cap
(2.4%) US large cap
(1.0%) US bonds
(0.5%) TIPs
(0.3%) Cash
(0.2%) Int’l small cap
(0.1%) US high quality
0.0% Int’l large cap
2.6% EM bonds
2.9% EM equity
5.4% Managed timber

AQR, a global investment management firm “built at the intersection of financial theory and practical application” advises the AQR funds and manages about $120 billion. Their projections for the next five to ten years, courtesy of our friends at DailyAlts.com, are more optimistic than Leuthold’s, but nothing it celebrate:

AQR’s current estimate of U.S. stocks’ long-term real (above inflation) returns is just 3.8%. European, Australian, Canadian, and emerging market stocks are all projected to outperform the U.S., with respective long-term real returns of 5.5%, 6.1%, 4.6%, and 6.6%. U.K. stocks are expected to generate long-term real returns of 6.2%, also besting the U.S.; while only Japanese stocks are expected to underperform American equities, with returns of 3.5% above inflation.

So, 3.8 – 6.6% real returns. That’s not far from Leuthold’s estimate: “For investors who’ve missed the entire bull market to this point, we’d advise strongly against jumping into stocks with both feet; long-term (5- to 10-yr.) total returns are almost assured to be depressed (on the order of 3 to 5%, we would estimate).”

At the other end, several recent analyses by serious investors have reached the opposite conclusion: that the market is no more than modestly pricey, if that. After warning folks not to base their conclusions on a single valuation measure, the estimable Barry Ritholtz identifies a single valuation measure (enterprise value to EBITDA) as the most probative and concludes from it that the market is modestly valued.

… what has been considered the best-performing measure of markets suggests that U.S. stocks are not expensive — are indeed priced fairly. This strongly suggests that the expected future returns for U.S. equities will be about their historic average.

Ritholtz’s faith in EV:EBITDA derives, in part, from research by Wesley Gray. We contacted Mr. Gray who was busily crunching numbers in response to Mr. Ritzholtz’s piece. In a mid-March essay, he too concluded that there was no cause for concern:

The metrics aren’t screaming “overvalued:” P/E, P/B, TEV/EBITDA, and TEV/GP are all in the 50-75 percentile; TEV/FCF is actually in the 2 to 25 percentile. In fact, adjusted for the current interest rate environment (much lower than it was in the past), the argument that the market is extremely overvalued is far-fetched.

Here’s where that leaves us: the stock market has recorded double-digit gains in five of the past six years, the Vanguard Total Stock Market Index Fund (VTSMX) is up 230% in six years (though, Charles hastens to remind us, only 4.6% annualized over the past 15 years dating back to the last days of the 1990s bubble), but we have no idea of whether a correction (or worse) is imminent nor even whether conditions are right for a major correction.

So what’s an investor to do? Your two most common reactions are:

1. Do nothing until the storm hits, utterly confident in your ability to diagnose and smoothly adjust to the storm when it comes (the technical term here is “delusional thinking”) or
2. Panic, needlessly churning your portfolio in hopes of finding The One Safe Spot.

As it turns out, we endorse neither. For almost every investor, success is the product of patience. And patience is the product of a carefully considered plan and a thorough understanding of the managers and funds that you’re entrusting to execute that plan.

To be plain: if you have only half a clue about what you’re invested in, and why, you have much less than half a chance of succeeding. That’s graphically illustrated in data on 20-year asset class and investor returns:

Some pundits, fearful that we don’t quite understand the significance of life on the far right of the chart clarify it for us:

The Observer tries to help. We’re one of the few places that treat risk-conscious managers with respect, even when sticking with their principles costs them dearly in relative performance and investor assets. We know that some of the funds we’ve profiled recently have not been at the top of the recent charts; in many cases, we view that as a very good thing. We explain how you might think about investing and give you the chance to speak directly with really good managers on our conference calls. Within the next few months we’ll make our fund screener more widely available; it’s distinguished by the fact that it focuses on risk as much as returns and on meaningful time periods (entire market cycles, as well as up- and down-market phases) rather than random periods (uhhh, “last week”? Why on earth would you care?).

We’re grateful for your support and we’d really like to encourage you to take more advantage of the rich archive and tools here. There’s a lot that can help, crash or no.

Identifying Bear-Market Resistant Funds During Good Times

It’s easy enough to look back at the last bear market to see which funds avoided massive drawdown. Unfortunately, portfolio construction of those same funds may not defend against the next bear, which may be driven by different instabilities.

Dodge & Cox Balanced Fund (DODBX) comes to mind. In the difficult period between August 2000 and September 2002, it only drew down 11.6% versus the S&P 500’s -44.7% and Vanguard’s Balanced Index VBINX -22.4%. Better yet, it actually delivered a healthy positive return versus a loss for most balanced funds.

Owners of that fund (like I was and remain) were disappointed then when during the next bear market from November 2007 to February 2009, DODBX performed miserably. Max drawdown of -45.8%, which took 41 months to recover, and underperformance of -6.9% per year versus peers. A value-oriented fund house, D&C avoided growth tech stocks during the 2000 bubble, but ran head-on into the financial bubble of 2008. Indeed, as the saying goes, not all bear markets are the same.

Similarly, funds may have avoided or tamed the last bear by being heavy cash, diversifying into uncorrelated assets, hedging or perhaps even going net short, only to underperform in the subsequent bull market. Many esteemed fund managers are in good company here, including Robert Arnott, John Hussman, Andrew Redleaf, Eric Cinnamond to name a few.

Morningstar actually defines a so-called “bear-market ranking,” although honestly this metric must be one of least maintained and least acknowledged on its website. “Bear-market rankings compare how funds have held up during market downturns over the past five years.” The metric looks at how funds have performed over the past five years relative to peers during down months. Applying the methodology over the past 50 years reveals just how many “bear-market months” investors have endured, as depicted in the following chart:

The long term average shows that equity funds experience a monthly drop below 3% about twice a year and fixed income funds experience a drop below 1% about three times every two years. There have been virtually no such drops this past year, which helps explain the five-year screening window.

The key question is whether a fund’s performance during these relatively scarce down months is a precursor to its performance during a genuine bear market, which is marked by a 20% drawdown from previous peak for equity funds.

Taking a cue from Morningstar’s methodology (but tailoring it somewhat), let’s define “bear market deviation (BMDEV)” as the downside deviation during bear-market months. Basically, BMDEV indicates the typical percentage decline based only on a fund’s performance during bear-market months. (See Ratings System Definitions and A Look at Risk Adjusted Returns.)

The bull market period preceding 2008 was just over five years, October 2002 through October 2007, setting up a good test case. Calculating BMDEV for the 3500 or so existing funds during that period, ranking them by decile within peer group, and then assessing subsequent bear market performance provides an encouraging result … funds with the lowest bear market deviation (BMDEV) well out-performed funds with the highest bear market deviation, as depicted below.

Comparing the same funds across the full cycle reveals comparable if not superior absolute return performance of funds with the lowest bear market deviation. A look at the individual funds includes some top performers:  

The correlation did not hold up in all cases, of course, but it is a reminder that the superior return often goes hand-in-hand with protecting the downside.

Posturing then for the future, which funds have the lowest bear-market deviation over the current bull market? Evaluating the 5500 or so existing funds since March 2009 produces a list of about 450 funds. Some notables are listed below and the full list can be downloaded here. (Note: The full list includes all funds with lowest decile BMDEV, regardless of load, manager change, expense ratio, availability, min purchase, etc., so please consider accordingly.)

All of the funds on the above list seem to make a habit of mitigating drawdown, experiencing a fraction of the market’s bear-market months. In fact, a backward look of the current group reveals similar over-performance during the financial crisis when compared to those funds with the highest BMDEV.

Also, scanning through the categories above, it appears quite possible to have some protection against downside without necessarily resorting to long/short, market neutral, tactical allocation, and other so-called alternative investments. Although granted, the time frame for many of the alternatives categories is rather limited.

In any case, perhaps there is something to be said for “bear-market rankings” after all. Certainly, it seems a worthy enough risk metric to be part of an investor’s due diligence. We will work to make available updates of bear-market rankings for all funds to MFO readers in the future.

There’s Got to be a Pony In This Room …….

By Edward Studzinski

“Life is an unbroken succession of false situations.”

                                     Thornton Wilder

Given my predilection to make reference to scenes from various movies, some of you may conclude I am a frustrated film critic. Since much that is being produced these days appears to be of questionable artistic merit, all I would say is that there would be lifetime employment (or the standards that exist for commercial success have declined). That said, an unusual Clint Eastwood movie came out in 1970. One of the more notable characters in the movie was Sergeant “Oddball” the tanker, played by Canadian actor Donald Sutherland. And one of the more memorable scenes and lines from that movie has the “Oddball” character saying  “Always with the negative waves Moriarty, always with the negative waves.”

Over the last several months, my comments could probably be viewed as taking a pessimistic view of the world and markets. Those who are familiar with my writings and thoughts over the years would not have been surprised by this, as I have always tended to be a “glass half-empty” person. As my former colleague Clyde McGregor once said of me, the glass was not only half-empty but broken and on the floor in little pieces. Some of this is a reflection of innate conservatism. Some of it is driven by having seen too many things “behind the curtain” over the years. In the world of the Mutual Fund Observer, there is a different set of rules by which we have to play, when comments are made “off the record” or a story cannot be verified from more than one source. So what may be seen as negativism or an excess of caution is driven by a journalistic inability to allow those of you would so desire, to paraphrase the New Testament, to “put your hands into the wounds.”  Underlying it all of course, as someone who finds himself firmly rooted in the camp of “value investor” is the need for a “margin of safety” in investments and adherence to Warren Buffett’s Rules Numbers One and Two for Investing. Rule Number One of course is “Don’t lose money.” Rule Number Two is “Don’t forget Rule Number One.”

So where does this leave us now? It is safe to say that it is not easy to find investments with a margin of safety currently, at least in the U.S. domestic markets. Stocks on various metrics do not seem especially undervalued. A number of commentators would argue that as a whole the U.S. market ranges from fully valued to over-valued. The domestic bond market, on historic measures does not look cheap either. Only when one looks at fixed income on a global basis does U.S. fixed income stand out when one has negative yields throughout much of Europe and parts of Asia starting to move in that direction. All of course is driven by central banks’ increasing fear of deflation. 

Thus, global capital is flowing into U.S. fixed income markets as they seem relatively attractive, assuming the strengthening U.S. currency is not an issue.  Overhanging that is the fear that later this year the Federal Reserve will begin raising rates, causing bond prices to tumble.  Unfortunately, the message from the Fed seems to be clearly mixed.  Will it be a while before rates really are increased in the U.S. , or,  will they start to raise rates in the second half of this year?  No one knows, nor should they.

As one who built portfolios on a stock by stock basis, rather than paying attention to index weightings, does this mean I could not put together a portfolio of undervalued stocks today?   I probably could but it would be a portfolio that would have a lot of energy-related and commodity-like issues in it.  And I would be looking for long-term investors who really meant it (were willing to lock up their money) for at least a five-year time horizon.  Since mutual funds can’t do that, it explains why many of the value-oriented investors are carrying a far greater amount of cash than they would like or is usual.  As an aside, let me say that in the last month, I have had more than one investment manager tell me that for the first time in their investing careers, they really were unsure as to how to deal with the current environment.

What I will leave you with are questions to ponder.  Over the years, Mr. Buffett and Mr. Munger have indicated that they would prefer to buy very good businesses at fair prices. And those businesses have traditionally been tilted towards those that did not require a lot of capital expenditures but rather threw off lots of cash with minimal capital investment requirements, and provided very high returns on invested capital. Or they had a built-in margin of safety, such as property and casualty insurance businesses where you were in effect buying a bond portfolio at a discount to book, had the benefit of investing the premium float, had a necessary product (automobile insurance) and again did not need a lot of capital investment. But now we see, with the Burlington Northern and utility company investments a different kettle of fish. These are businesses that will require continued capital investment going forward, albeit in oligopoly-like businesses with returns that may be fairly certain (in an uncertain world). Those investments will however not leave as much excess capital to be diverted into new portfolio investments as has historically been the case. There will be in effect required capital calls to sustain the returns from the current portfolio of businesses.  And, we see investments being made as joint ventures (Kraft, Heinz) with private equity managers (3G) with a very different mindset than U.S. private equity or investment banking firms. That is, 3G acquires companies to fix, improve, and run for the long term. This is not like your typical private equity firm here, which buys a company to put into a limited life fund which they will sell or take public again later.

So here are your questions to ponder?  Does this mean that the expectation for equity returns in the U.S. for the foreseeable future is at best in the low single digit range?  Are the days of the high single digit domestic long-term equity returns a thing of the past?   And, given how Buffett and Munger have positioned Berkshire now, what does this say about the investing environment?  And in a world of increased volatility (which value investors like as it presents opportunities) what does it say about the mutual fund model, with the requirement for daily pricing and liquidity?

Morningstar: one hit and one miss

Morningstar, like many effective monopolies, provides an essential service. The quality of that service varies rather more than you might suspect. Last month I suggested that the continued presence of their “buy the unloved” strategy has increasingly become a travesty. Likewise, the folks on our discussion board, for example, have been maddened by the prevalence of “stale data” in the site’s daily NAV reports. To their enduring credit, one of the folks from Morningstar actually waded into the discussion, albeit briefly and ankle-deep.

On the other hand, the Morningstar folks really do some very solid, actionable research. As a recent case in point, Russel Kinnel, directory of fund analysis, offered up Why You Should Invest With Managers Who Eat Their Own Cooking (3/31/15). While the metrics (Success Rate and Success Rate MRAR) could use a bit of clarification, his research continues to substantiate an important point: when your manager is deeply invested, your prospects for success – both in raw and risk-adjusted returns – climbs substantially. It’s one of the reasons why we report so consistently on manager ownership in our fund profiles. The data point that almost no one discusses but which turns out to be equally important, ownership of fund shares by the board’s trustees, is something we’ll pursue in the next couple months.

Now if only I could understand the logic of Morningstar’s grumbling about my portfolio. U.S. equities accounted for 36% of the total market capitalization of all equities markets worldwide on 10/21/14. In my portfolio, US equities account for 40% of all equity exposure. On face, that’s a slight underweight. Morningstar’s x-ray interpreter, however, insists on fretting that I have “a very large stake in foreign stocks” (no, I’m underweight), with special notes of my “extremely large” stake in Asia (“this is very risky”) and extremely small stake in Western Europe (which “probably isn’t a big deal”). I understand that most American investors have a substantial “home bias,” but I’m not sure that the bias should be reinforced in Morningstar’s portfolio analyzer.

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 and filtered as never before. For a 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

• The U.S. Supreme Court denied a certiorari petition in the section 36(b) lawsuit regarding BlackRock‘s securities lending practices with respect to iShares ETFs. The district court, affirmed on appeal, held that an SEC exemptive order (approving the challenged securities lending arrangements) constituted an exception to potential liability under section 36(b). Defendants included independent directors. (Laborers’ Local 265 Pension Fund v. iShares Trust.)
• The court denied BlackRock‘s motion to dismiss fee litigation regarding its Global Allocation and Equity Dividend Funds, stating that plaintiffs’ fee comparison (between the challenged fees and fees charged by BlackRock as sub-advisor to unaffiliated funds) “is appropriate.” (In re BlackRock Mut. Funds Advisory Fee Litig.)
• The court granted Fidelity‘s motion to dismiss an ERISA class action regarding Fidelity’s practices with respect to the “float income” generated from retirement plan redemptions, holding that “plaintiffs have not plausibly alleged that float income is a plan asset” and that “Fidelity is not an ERISA fiduciary as to float.” (In re Fid. ERISA Float Litig.)
• The court denied J.P. Morgan‘s motion to dismiss fee litigation regarding three bond funds. The court cited allegations of “a notable disparity” between the fees obtained by J.P. Morgan for servicing those three funds and the fees obtained by J.P. Morgan for subadvising unaffiliated funds, notwithstanding that its services in each instance were allegedly “substantially the same.” (Goodman v. J.P. Morgan Inv. Mgmt., Inc.)
• The court preliminarily approved settlements totaling $60 million in a pair of class actions regarding Northern Trust‘s securities lending program. (Diebold v. N. Trust Invs., N.A.; La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)
• The court granted plaintiffs’ motion for class certification in consolidated litigation alleging bad prospectus disclosure for Oppenheimer‘s California Municipal Bond Fund. Plaintiffs’ claims are premised on a theory that the fund’s stated investment objectives and implied price volatility assurances were rendered materially misleading by the fund’s heavy investment in derivative instruments known as inverse floaters. Defendants include independent directors. (In re Cal. Mun. Fund.)
• The court granted Oppenheimer‘s motion to dismiss a breach-of-contract suit filed by assignees of claims purportedly held by the New Mexico boards that administered the state’s 529 college savings plans. (Lu v. OppenheimerFunds, Inc.)
• The court consolidated fee lawsuits regarding ten Russell funds. (In re Russell Inv. Co. Shareholder Litig.)
• In the long-running securities class action alleging that the Schwab Total Bond Market Fund deviated from two fundamental investment objectives adopted by a shareholder vote, a divided panel of the Ninth Circuit allowed multiple state-law claims to proceed but declined to reach the question of whether any of those claims are barred by the Securities Litigation Uniform Standards Act (leaving that issue to the district court on remand). Schwab has filed a petition for rehearing en banc. Defendants include independent directors. (Northstar Fin. Advisors Inc. v. Schwab Invs.)
• In the class action alleging that TIAA-CREF failed to honor customer requests to pay out funds in a timely fashion, the court dismissed the state-law claims, holding that they were preempted by ERISA. (Cummings v. TIAA-CREF.)

The Alt Perspective: Commentary and news from DailyAlts.

Before we dive into the details of liquid alternatives, there are two important publications that were released this past month that have implications for nearly all investors.

The first is a paper from AQR that provides forward looking return projections for stocks, bonds and smart beta. This is the first return projection I have seen that includes smart beta (given that AQR offers smart beta products, they do have an incentive to include the strategy in their assumptions). The projections for stocks and bonds don’t look so rosy: 3.8% real return for US stocks and 0.60% for US 10-year government bonds. Multi-factor smart beta looks a bit better at 5.7% over inflation. Download a copy, have a look and re-calibrate your expectations: AQR Q1 2015 Alternative Thinking.

The second paper is from Howard Marks, founder and co-chairman of Oaktree Capital who released his quarterly memo that discussed, among other things, liquid alternatives. But more importantly, Marks made two important points that we, as investors, shouldn’t forget – especially in this era of liquidity and rising markets:

• “Liquidity is ephemeral: it can come and go.”
• “No investment vehicle should promise greater liquidity than is afforded by its underlying assets.”

In regard to point one, Marks reminds us that when we most want liquidity is when it is hard to find. The second point is a warning to investors – don’t expect something for nothing. The liquidity of an investment vehicle is only as good as its underlying investments in times of crisis. I would recommend you read the entire paper.

Now, jumping to a few highlights of flows and assets for liquid alternatives:

• February flows totaled $1.5 billion, which were interestingly split but active funds ($767 million) and passive funds $768 million)
• 1 year flows of $13.5 billion ($9.5 billion to active funds and $4.1 billion to passive funds)
• Total category assets of $204 billion
• 1 year organic growth rate of 6.9% based on Morningstar’s Alternative category classification

February Asset Flow Details

In February, multi-alternative and managed futures funds dominated the inflows, while investors soured on non-traditional bonds, market neutral and long/short equity funds.

Flows out of the long/short equity category continue to be dominated by outflows from the MainStay Marketfield Fund, which saw $941 million of outflows in January, bringing the 12-month total to $11.6 billion. Excluding Marketfield, the long/short equity category had $564 million of inflows in February.

With increased levels of volatility, a rising dollar and a potential bottoming of commodity prices, investors jumped into each of those categories in February, driving up assets in each by $$527 million (volatility), $389 million (currencies) and $657 million (commodities), respectively. In fact, have gathered almost $5 billion in assets in the first two months of 2015.

On a 1-year basis, non-traditional bonds and multi-alternative funds have dominated the inflows to alternative funds, gathering $11.2 billion and $9.4 billion, respectively. Non-traditional bond funds have filled the need for investors and advisors who have a concern about the potential negative impact of rising interest rates, as well as the need for higher levels of income.

At the same time, most investors looking to gain exposure to alternative investment strategies are looking to diversified alternative funds for that first time exposure. This is done with pre-packaged alternative funds that deliver exposure to a range of alternative strategies in a single fund. As the market matures, and investors become more comfortable with individual strategies, this trend may shift as it did in the institutional market.

New Funds

I will keep it short, but there were several new funds of interest that launched this month, most notably a long/short equity fund from Longboard, which we wrote about in a story titled Longboard Launches Second Alternative Mutual Fund and two new hedge fund replication ETFs from IndexIQ, both of which are detailed in New ETFs Allow Investors to Build their Own Hedge Fund Strategies.

Until next month, feel free to stop by DailyAlts.com for regular news and analysis of the liquid alts market.

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.

Queens Road Small Cap Value (QRSVX): in writing last month’s profile of Pinnacle Value, we used our risk-sensitive screener to screen for a bunch of measures over a bunch of time periods. We kept coming up with a very short, very consistent list of the best small cap value funds. That list might be described as “closed, closed, loaded, institutional, Pinnacle and Queens Road.”

Vanguard Global Minimum Volatility (VMVFX): at our colleague Ed’s behest, I spent a bit of time reading about VMVFX, reviewing Charles’s data and a lot of academic research on the “low volatility anomaly.” The combination of inquiries points to VMVFX as a potentially quite compelling core holding which quietly and economically exploits a durable anomaly.

Elevator Talk: Lee Kronzon, Gator Opportunities (GTOAX/GTOIX)

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

Gator Opportunities Fund describes itself as “a concentrated, quality-driven, valuation-sensitive, small/midcap-focused mutual fund.” They’re a very Graham-and-Dodd kind of bunch, invoking maxims like

• Buy for the long-term
• Invest in high-quality growth businesses
• Purchase businesses we understand
• Invest with a margin of safety
• Concentrate!

They hold 36 stocks, more or less equally split between small caps and midcaps, at least as of March 2015. The fund has substantially more exposure to international markets, both developed and developing, than does its peers.

On face, it’s a pretty mainstream fund. What’s striking is that it’s produced distinctly non-mainstream returns. While Morningstar characterizes it as a mid-cap blend fund, its current portfolio leans a bit more toward smaller and growthier stocks. Regardless of which peer group you use, the results are striking. The fund (in blue) has substantially outperformed both midcap (orange) and small growth (green) Morningstar peer groups since launch.

Lee Kronzon manages the Gator Opportunities Fund (GTOAX/GTOIX), which launched in early November 2013. While this is his first stint managing a mutual fund, he’s had a interesting and varied career, and it appears that lots of serious people have reason to respect him. He came to Gator after more than a decade as an equity analyst and strategist with the Fundamental Equities Group at Goldman Sachs Asset Management (GSAM). Earlier he cofounded Tower Hill Securities, a merchant bank that funded global emerging growth companies. Earlier still he taught at Princeton as a Faculty Lecturer at the Woodrow Wilson School. In that role he co-taught several courses in applied quantitative and economic analysis with Professors Ben Bernanke (subsequently chairman of the Federal Reserve) and Alan Krueger (chair of Obama’s Council of Economic Advisors). Fortunately, he predated a rating at RateMyProfessors.com where Princeton professor and talking head Paul Krugman gets a pretty durn mediocre rating.

His celebration of the alligator gives you a sense of how he’s thinking: “The gator is a survivor, one of the planet’s oldest species and a remnant of the dinosaur era. He’s made it through all sorts of different climates and challenges. And his strategy just works: be still, wait patiently for an opportunity to present itself and then strike. Really, it’s a creature with no weaknesses!”

Here’s a lightly-edited version of Mr. Kronzon’s 200 words on why you should add GTOAX to your due-diligence list:

As a Warren Buffett disciple, I believe that growth and value investment disciplines are joined at the hip, and I try to provide investors the best of both worlds. Quality is the key indicator of business success, and that it ultimately separates investment winners from losers. The Fund focuses on quality by investing in firms with sizable and sustainable competitive advantages, best-in-class business models that generate attractive and predictable returns, and successful, shareholder-friendly management teams. My goal is to invest in such superior businesses when they are undiscovered, out of favor, or misunderstood; curiously, I often find them in dynamic sectors like Industrials and Technology.

Our strategy is to achieve the intersection of quality with growth and value by investing long-term in a concentrated set of public equities issued primarily by domestically-listed, small/mid-cap firms that I believe are high quality and have solid growth prospects yet are undervalued based on fundamental analysis with catalysts to close this valuation gap. We have a flexible mandate to invest across all sectors and regions, and a high active share since it is built bottom-up and not managed to track any benchmark. And I’m proud of the fact that the Fund has delivered robust returns since its launch in November 2013 to date.

Gator Opportunities (GTOAX) has a $5000 minimum initial investment which is reduced to $1000 for IRAs and other types of tax-advantaged accounts. Expenses are capped at 1.49% on the investor shares, at least through 2017. The fund has about gathered about $1 million in assets since its November 2013 launch. More information can be found at the fund’s homepage. Here’s a nice interview with Mr. Kronzon that Chuck Jaffe did in late March, 2015.

Conference Call Highlights: David Berkowitz, RiverPark Focused Value

David Berkowitz, manager of the newly-launched RiverPark Focused Value Fund, and Morty Schaja, RiverPark’s cofounder and CEO, chatted with me (and about 30 of you) for an hour in mid-March. It struck me as a pretty remarkable call, largely because of the clarity of Mr. Berkowitz’s answers. Here are what I take to be the highlights.

The snapshot: 20-25 stocks, likely all US-domiciled because he likes GAAP reporting standard (even where they’re weak, he knows where the weaknesses are and compensate for them), mostly north of$10 billion in market cap though some in the $5-9 billion range. Long only with individual positions capped at 10%. They have price targets for every stock they buy, so turnover is largely determined by how quickly a stock moves to its target. In general, higher turnover periods are likely to correspond with higher returns.

His background (and why it matters): Mr. Berkowitz was actually interested in becoming a chemist, but his dad pushed him into chemical engineering because “chemists don’t get jobs, engineers do.” He earned a B.A. and M.A. in chemical engineering at MIT and went to work first for Union Carbide, then for Amoco (Standard Oil of Indiana). While there he noticed how many of the people he worked with had MBAs and decided to get one, with the expectation of returning to run a chemical company. While working on his MBA at Harvard, he discovered invested and a new friend, Bill Ackman. Together they launched the Gotham Partners LP fund. Initially Gotham Partners used the same discipline in play at the RiverPark funds and he described their returns in the mid-90s as “spectacular.” They made what, in hindsight, was a strategic error in the late 1990s that led to Gotham’s closure: they decided to add illiquid securities to the portfolio. That was not a good mix; by 2002, they decided that the strategy was untenable and closed the hedge fund.

Takeaways: (1) the ways engineers are trained to think and act are directly relevant to his success as an investor. Engineers are charged with addressing complex problems while possessing only incomplete information. Their challenge is to build a resilient system with a substantial margin of safety; that is, a system which will have the largest possible chance of success with the smallest possible degree of system failure. As an investor, he thinks about portfolios in the same way. (2) He will never again get involved in illiquid investments, most especially not at the new mutual fund.

His process: as befits an engineer, he starts with hard data screens to sort through a 1000 stock universe. He’s looking for firms that have three characteristics:

• Durable predictable businesses, with many firms in highly-dynamic industries (think “fast fashion” or “chic restaurants,” as well as firms which will derive 80% of their profits five years hence from devices they haven’t even invented yet) as too hard to find reliable values for. Such firms get excluded.
• Shareholder oriented management, where the proof of shareholder orientation is what the managers do with their free cash flows. 
• Valuations which provide the opportunity for annual returns in the mid-teens over the next 3-5 years. This is where the question of “value” comes in. His arguments are that overpaying for a share of a business will certainly depress your future returns but that there’s no simple mechanical metric that lets you know when you’re overpaying. That is, he doesn’t look at exclusively p/e or p/b ratios, nor at a firm’s historic valuations, in order to determine whether it’s cheap. Each firm’s prospects are driven by a unique constellation of factors (for example, whether the industry is capital-intensive or not, whether its earnings are interest rate sensitive, what the barriers to entry are) and so you have to go through a painstaking process of disassembling and studying each as if it were a machine, with an eye to identifying its likely future performance and possible failure points.

Takeaways: (1) The fund will focus on larger cap names both because they offer substantial liquidity and they have the lowest degree of “existential risk.” At base, GE is far more likely to be here in a generation than is even a very fine small cap like John Wiley & Sons. (2) You should not expect the portfolio to embrace “the same tired old names” common in other LCV funds. It aims to identify value in spots that others overlook. Those spots are rare since the market is generally efficient and they can best be exploited by a relatively small, nimble fund.

Current ideas: He and his team have spent the past four months searching for compelling ideas, many of which might end up in the opening portfolio. Without committing to any of them, he gave examples of the best opportunities he’s come across: Helmerich & Payne (HP), the largest owner-operator of land rigs in the oil business, described as “fantastic operators, terrific capital allocators with the industry’s highest-quality equipment for which clients willingly pay a premium.” McDonald’s (MCD), which is coming out of “the seven lean years” with a new, exceedingly talented management team and a lot of capital; if they get the trends right “they can explode.” AutoZone (AZO), “guys buying brake pads” isn’t sexy but is extremely predictable and isn’t going anywhere. Western Digital (WDG), making PCs isn’t a good business because there’s so little opportunity to add value and build a moat, but supplying components like hard drives – where the industry has contracted and capital needs impose relatively high barriers to entry – is much more attractive. 

Even so, he describes this is “the most challenging period” he’s seen in a long while. If the fund were to open today, rather than at the end of April, he expects it would be only 80% invested. He won’t hesitate to hold cash in the absence of compelling opportunities (“we won’t buy just for the sake of buying”) but “we work really hard, turn over a lot of rocks and generally find a substantial number of names” that are worth close attention.

His track record: There is no public record of Mr. Berkowitz alone managing a long-only strategy. In lieu of that, he offers three thoughts. First, he’s sinking a lot of his own money – $10 million initially – into the fund, so his fortunes will be directly tied to his investors’. Second, “a substantial number of people who have direct and extensive knowledge of my work will invest a substantial amount of money in the fund.” Third, he believes he can earn investors’ trust in part by providing “a transparent, quantitative, rigorous, rational framework for everything we own. Investors will know what we’re doing and exactly why we’re doing it. If our process makes sense, then so will investing in the fund.” 

Finally, Mr. Schaja announced an interesting opportunity. For its first month of operation, RiverPark will waive the normal minimum investment on its institutional share class for investors who purchase directly from them. The institutional share class doesn’t carry a 12(b)1 fee, so those shares are 0.25% (25 bps) cheaper than retail: 1.00 rather than 1.25%. (Of course it’s a marketing ploy, but it’s a marketing ploy that might well benefit you in you’re interested in the fund.)

The fund will also be immediately available NTF at Fidelity, Schwab, TDAmeritrade, Vanguard and maybe Pershing. It will eventually be available on most of the commercial platforms. Institutional shares will be available at the same brokerages but will carry transaction fees.

Bottom Line

Mr. Berkowitz comes across as a smart guy and RiverPark’s offer to waive the institutional minimum is really attractive. At the same time, most investors will be proceeding mostly on faith since we can’t document Mr. B’s track record. We don’t know the overall picture, much less what has blown up (things always blow up) and how he’s recovered. A lot of smart, knowledgeable people seem excited at the opportunity. In general, if I were you I’d proceed with caution and after a fair number of additional inquiries (Morty, in particular, is famously available to RiverPark’s investors).

Here’s the link to the mp3 of the call.

Conference Call Upcoming

We’d like to invite you to join us for a conversation with Andrew Foster, manager of Seafarer Overseas Growth & Income (SFGIX/SIGIX) on Thursday, April 16, from 7:00 – 8:00 Eastern. Click, well “register” to register: 

Our contention has always been that Seafarer represents one of the best possible options for investors interested in approaching the emerging markets. There are two reasons for that conclusion.

1. He’s a superb investor. While Andrew is a very modest and unassuming guy, and I know that fortune is fleeting, it’s hard to ignore the pattern reflected in Morningstar’s report of where Seafarer stands in its peer group over a variety of trailing periods:
   
2. He’s a superb steward. Mr. Foster has produced consistently first-rate shareholder communications that are equally clear and honest about the fund’s successes and occasional lapses. And he’s been near-evangelical about reducing the fund’s expenses, often posting voluntary mid-year fee reductions as assets permit.

The first part of that judgment was substantiated in early March when Seafarer received its inaugural five-star rating from Morningstar. It is also a Great Owl fund, a designation which recognizes funds whose risk-adjusted returns have finished in the top 20% of their peers for all trailing periods. Our greater sensitivity to risk, based on the evidence that investors are far less risk-tolerant than they imagine, leads to some divergence between our results and Morningstar’s: five of their five-star EM funds are not Great Owls, for instance, while some one-star funds are.

Of 219 diversified EM funds currently tracked by Morningstar, 18 have a five-star rating (as of mid-March, 2015). 13 are Great Owls. Seafarer and nine others (representing 5% of the peer group) are both five-star and Great Owls.

As Andrew and I have talked about the call, he reflected on some of the topics that he thought folks should be thinking about:

• a brief (re) introduction to Seafarer’s strategy
• a discussion of why the strategy searches for growth, and why we make sure to marry that growth with some current income (dividends, bond coupons). Andrew’s made some interesting observations lately on whether “value investing” might finally be coming into play in the emerging markets.
• other key elements of Seafarer’s philosophy including his considerable skepticism about the construction of the various EM indexes, which leads to some confidence about his ability to add considerable value over what might be offered by passive products
• why the emerging markets (EM) have been so weak over the past few years and the implications of anemic growth in the EM, both in terms of economic output and corporate profits
• maybe some stuff on currency weakness and the decision of EM central banks to cut their rates while we raise ours
• Where do things go from here?
• And, of course, your questions.

By way of fair disclosure, I should note that I’ve owned shares of Seafarer in my personal account, pretty much since its inception, and also own shares of Matthews Asian Growth & Income (MACSX), which he managed (brilliantly) before leaving to found Seafarer.

HOW CAN YOU JOIN IN?

If you’d like to join in the RiverPark call, just click on register and you’ll be taken to the Chorus Call site. In exchange for your name and email, you’ll receive a toll-free number, a PIN and instructions on joining the call. If you register, I’ll send you a reminder email on the morning of the call.

Remember: registering for one call does not automatically register you for another. You need to click each separately. Likewise, registering for the conference call mailing list doesn’t register you for a call; it just lets you know when an opportunity comes up. 

WOULD AN ADDITIONAL HEADS UP HELP?

Over four hundred readers have signed up for a conference call mailing list. About a week ahead of each call, I write to everyone on the list to remind them of what might make the call special and how to register. If you’d like to be added to the conference call list, just drop me a line.

Emerging markets funds that might be worth your attention

We mentioned, above, that only ten funds have earned both our designation as Great Owls (meaning that they have top-tier risk-adjusted returns in every trailing time period longer than one year) and Morningstar’s five-star rating. Knowing that you were being eaten alive with curiosity, here’s the quick run-down.

Baron Emerging Markets (BEXFX) – $1.5 billion in AUM, 1.5% e.r., not quite five years old, large-growth with an Asian bias. The manager also runs Baron International Growth (BIGFX). “Big F”? Really? BIG F actually earns a BIG C-.

City National Rochdale Emerging Markets (RIMIX) – 90% invested in Asia, City National Bank, headquartered in Hollywood, bought the Rochdale Funds and agreed t in January 2015 to be bought by the Royal Bank of Canada. Interesting funds. No minimum investment but a 1.61% e.r. The EM fund acquires exposure to Indian stocks by investing in a wholly owned subsidiary domiciled in Mauritius. Hmmm.

Driehaus EM Small Cap Growth (DRESX) – a $600 million hedged fund (and former hedge fund) for which we have a profile and some fair enthusiasm. Expenses are 1.71%.

Federated EM Equity (FGLEX) – a $13 million institutional fund with a $1 million minimum, not quite five years old and a mostly mega cap portfolio. It seems to have had two really good years followed by two really soft ones.

HSBC Frontier Markets (HSFAX) – 5% front load, 2.2% e.r., $200 million in AUM, midcap bias and a huge overweight in Africa & the Middle East at the expense of Asia. Curious.

Harding Loevner Frontier EM (HLMOX) – modest overweight in Asia, huge overweight in Africa & the Middle East, far lower-than-average market cap, half a billion in assets, 2.2% e.r.

Seafarer Overseas Growth & Income (SFGIX) – $136 million in AUM, 1.4% e.r., small- to mid-cap bias, top 4% returns over its first three years of operation.

Thornburg Developing World (THDAX) – oopsie: lead manager Lewis Kaufman just jumped from the $3 billion ship to launch Artisan Developing World Fund this summer.

Wasatch Frontier Emerging Small Countries (WAFMX) – $1.3 billion in AUM, 2.24% e.r. and closed to new investors

William Blair EM Small Cap Growth (WESNX) – $300 million in AUM, 1.65% e.r. and closed to new investors.

On face, the pattern seems to be that small works. The top tier of funds have lots of exposure to smaller firms and/or those located in smaller markets, even by EM standards. 

The other big is big works. Big funds charging big fees. If you’re looking for no-load funds that are open to retail investors and charge under 2%, your due-diligence list is reduced to four funds: Baron, City Rochdale, Driehaus and Seafarer.

SFGIX is the second-smallest fund in the whole five star/Great Owl group, which makes it all the more striking that it’s the least expensive of all. And it’s among the least risky of this elite group.

Funds in Registration

Funds in Registration focuses on no-load, retail funds. There are three funds outside of that range are currently in registration and are worth noting.

Fidelity has jumped on two bandwagons at once, passive management and low volatility, with the impending launch of Fidelity SAI U.S. Minimum Volatility Index Fund and Fidelity SAI International Minimum Volatility Index Fund. The key is that the funds are not available for purchase by the public, they’re only available to folks running Fido funds-of-funds and similar products. That said, they seem to support the attractiveness of the minimum volatility strategy, which we discuss in this month’s Vanguard profile.

Speaking of Vanguard, it’s making its second foray in the world of liquid alts (after Vanguard Market Neutral) with Vanguard Alternative Strategies Fund seeks to generate returns that have low correlation with the returns of the stock and bond markets, and that are less volatile than the overall U.S. stock market. Michael Roach, who also helps manage Vanguard Global Minimum Volatility (VMVFX) and Vanguard Market Neutral (VMNFX), will manage the fund. Expenses of 1.10% and a $250,000 minimum, which manages the Market Neutral Minimum.

Of the retail funds in registration, by far the most intriguing is Artisan Developing World. The fund will be managed by Lewis Kaufman who had been managing the five-star, $2.8 billion Thornburg Developing World Fund (THDAX). By most accounts, Mr. Kaufman is one of the field’s legitimate stars.

All eight funds in the pipeline are sketched out on our Funds in Registration page.

Manager Changes

Chip reports that it felt like there were a million of them this month but the actual count is just 38 manager changes, none of them earth-shaking.

Briefly Noted . . .

GlobalX ups the rhetorical stake: not satisfied to hang with the mere “smart beta” crowd, GlobalX has filed to launch a series of “scientific beta” ETFS. Cranking Thomas Dolby’s cautionary tale, “She Blinded Me with Science,” in the background, I ventured into the prospectus, hoping to discover what sort of science I might be privy to.

As long as you think of “scientific” as a synonym for “impenetrable morass,” I found science. The US ETF will replicate the returns of the Scientific Beta United States Multi-Beta Multi-Strategy Equal Risk Contribution Index (scientific! It says so!), authored by EDHEC Risk Institute Asia Ltd. According to their website, EDHEC’s research is “Asia-focused work” which is being extended globally. Here’s the word on index composition:

The Index is composed of four sub-indices, each of which represents a specific beta exposure (or factor tilt): (i) high valuation, (ii) high momentum, (iii) low volatility, and (iv) size (each, a “Beta Sub-Index”). Each Beta Sub-Index comprises the top 50% of companies from the pre-screening universe that best represent that Beta Sub-Index’s specific beta exposure, except that the “size” sub-index is comprised of the bottom 50% of companies in the pre-screening universe according to free-float market capitalization. Once these companies are selected for the Beta Sub-Index, five different weighting schemes are applied to the constituents: (i) maximum deconcentration, (ii) diversified risk-weighting, (iii) maximum decorrelation, (iv) efficient minimum volatility and (v) efficient maximum Sharpe Ratio.

If you can understand all that, you might consider investing in the fund. If you have no earthly idea of what they’re saying, you might be better off moving quietly on.

Janus Diversified Alternatives Fund (JDDAX) has changed its statement of investing strategies to reflect the fact that they now have a higher volatility target and a higher “notional investment exposure.” They anticipate a standard deviation of about 6% and a notional exposure (a way of valuing the impact of their derivatives) of 300-400%.

Linde Hansen Contrarian Value Fund (LHVAX/LHVIX) has officially embraced diversification. It’s advertised itself as “non-diversified” since launch but it’s been “managed as a diversified fund since its inception.” The fund holds 20% cash and 22 stocks, which implies that their notion of “diversified” is “more than 20 stocks.”

SMALL WINS FOR INVESTORS

Effective February 28, 2015, the ASTON/TAMRO Small Cap Fund (ATASX) and the ASTON/River Road Independent Value Fund (ARIVX) are open to all investors. 

Fairholme Focused Income (FOCIX) has reopened after a two year closure. Mr. Berkowitz closed all three of his funds simultaneously, and mostly in reaction to the flight of fickle investors. Well, “fickle,” “shell-shocked,” what’s in a name?

The key to this mostly high-yield bond fund is that it focuses more than anybody: it owns two stocks, two bonds (which seem to account for over 50% of the portfolio) and a handful of preferred shares. In any case, assets at FOCIX have declined from $240 to $210 million and the advisor is pretty sure that he’s got places to profitably invest new cash.

Effective immediately, all 15 of the Frost Funds have eliminated their sales loads and have redesignated their “A” shares as “Investor” shares. A couple of their shorter-term bond funds are worth a check and their Total Return Bond Fund (FIJEX) qualifies as a Great Owl. Of it, Charles notes: “Among highest return in short bond category across current full cycle (since Sept 2007 through Jan 2015…still going) and over its 14 year life. Low expenses. Low volatility. High dividend. 10 Year Great Owl.”

Lebenthal Asset Management purchased a minority stake in AH Lisanti Capital Growth LLC, adviser to Adams Harkness Small Cap Growth Fund, now called Lebenthal Lisanti Small Cap Growth (ASCGX). Mary Lisanti has been managing the fund since 2004 and has compiled a fine record without the benefit of, well, many shareholders in the fund. The fund is a small part (say 8%) of the assets of a small adviser, Adam Harkness & Hill. In theory, the partnership with Lebenthal will help raise the fund’s visibility. I wish them well, since Ms. Lisanti and her fund are both solid and under-appreciated.

Effective March 4, 2015, the management fee of Schwab International Small-Cap Equity ETF was reduced by one basis point! Woo hoo! The happy perspective is “by about 5%.”

Vanguard Convertible Securities Fund (VCVSX) is now open to new accounts for institutional clients who invest directly with Vanguard.

CLOSINGS (and related inconveniences)

On March 13, The Giralda Fund (GDMAX – really? The G-dam fund?) closed to new investors. It’s a five star fund with $200 million in assets, which makes the closing seem really disciplined and principled.

Vanguard Wellington Fund (VWELX) has closed to “all prospective financial advisory, institutional, and intermediary clients (other than clients who invest through a Vanguard brokerage account).”  At base they’re trying to close the tap a bit by restricting investment through third-parties like Schwab though, at $90 billion, the question might be whether they’re a bit late. The fund is still performing staunchly, but the track record of funds at $100 billion is not promising.

Wasatch Emerging Markets Small Cap Fund, Frontier Emerging Small Countries Fund, International Growth Fund and Small Cap Growth Fund have all closed to new third-party accounts.

OLD WINE, NEW BOTTLES

In theory AllianzGI Behavioral Advantage Large Cap Fund (AZFAX) is going to be reorganized “with and into” Fuller & Thaler Behavioral Core Equity Fund, which sounds like the original fund is disappearing. Nay, nay. Fuller & Thayer manage the fund now. The Allianz fund simply becomes the Fuller & Thaler one, likely some time in the third quarter though the reorganization may be delayed. Nice fund, low expenses, good longer-term performance.

Effective May 1, 2015, the name of Eaton Vance Investment Grade Income Fund (EAGIX) changes to Eaton Vance Core Bond Fund.

Emerald Advisers has agreed to acquire the tiny Elessar Small Cap Value Fund (LSRIX). It appears that Emerald will manage the fund on a interim basis until June, when shareholders are asked to make it permanent. Not clear when or if the name will change.

Effective March 31, 2015, Henderson Emerging Markets Opportunities Fund (HEMAX) was renamed Henderson Emerging Markets Fund. The current five-person management team has been replaced by Glen Finegan. Finegan had been responsible for about $13 billion as an EM portfolio manager for First State Stewart, an Edinburgh-domiciled investment manager.

Henderson Global Investors (North America) Inc. is the investment adviser of the Fund. Henderson Investment Management Limited is the subadviser of the Fund. Glen Finegan, Head of Global Emerging Markets Equities, Portfolio Manager, has managed the Fund since March 2015.

Effective April 15, 2015, PIMCO Worldwide Long/Short Fundamental Strategy Fund (PWLAX) became PIMCO RAE Worldwide Long/Short PLUS Fund. The fund launched in December 2014 and I’m guessing that “RAE” is linked to its sub-advisor, Research Affiliates, Inc., Rob Arnott’s firm.

Effective March 1, Manning & Napier Dividend Focus Series (MDFSX) changed to the Disciplined Value Series.

Effective on or about May 1, 2015, the following “enhancements” are expected to be made to the Manning & Napier Core Plus Bond Series (EXCPX) – M&N doesn’t admit to having “funds,” they have “series.”

• It’s rechristened the Unconstrained Bond Series
• Its mandate shifts from “long-term total return by investing primarily in fixed income securities” to “long-term total return, and its secondary objective is to provide preservation of capital.”
• It stops buying just bonds and adds purchases of preferred stocks, ETFs and derivatives as well
• It stops focusing on US investment-grade debt and gains the freedom to own up to 50% high yield and up to 50% international, including emerging markets debt. Not clear whether those circles will overlap into EM HY debt.

Other than for those few tweaks, which were certainly not “fundamental,” it remains the same fund that investors have known and tolerated for the past decade.

Ryan Labs has agreed to be purchased by SunLife, whereupon SL acquired Ryan Labs Core Bond Fund (RLCBX). Given that the fund is tiny and launched four months ago, I’d guess that’s not what drove the purchase. In any case, the acquisition might change the fund’s name but apparently not its advisory contract.

Value Line Larger Companies Fund has changed its name to Value Line Larger Companies Focused Fund (VALLX). The plan is to shrink the portfolio from its current 45 stocks down to 30-50. You can see the new focusedness there.

OFF TO THE DUSTBIN OF HISTORY

This feature usually highlights funds slated to disappear in the next month or two. (Thanks to the indefatigable Shadow and the shy ‘n’ retiring Ted for their leads here.) We’re reporting this month on a slightly different phenomenon. A lot of these funds have already liquidated because their boards shortened the period between decision and death from months down to weeks, often three weeks or less. That really doesn’t give investors much time to adjust though I suppose the boards might be following Macbeth’s advice: “If [murder] were done when ’tis done, then ’twere well It were done quickly.”

But what to make of the rest of Macbeth’s insight?

… we but teach
Bloody instructions, which, being taught, return
To plague the inventor: this even-handed justice
Commends the ingredients of our poison’d chalic
To our own lips.

Perhaps that our impulse to sell, to liquidate, to dispatch might come back to bite us in the … uhh, we mean, “to haunt us”? During our conference call, David Berkowitz recounted the findings of a Fidelity study. Fidelity reviewed thousands of the portfolios they manage, trying to discover the shared characteristics of their most successful investors.

Their findings? The best performance came in accounts where the investors were dead or had forgotten that the account even existed.

ALPS Real Asset Income Fund became, on March 31^st, an EX fund.

‘E’s not pinin’! ‘E’s passed on! This parrot is no more! He has ceased to be! ‘E’s expired and gone to meet ‘is maker!

‘E’s a stiff! Bereft of life, ‘e rests in peace! If you hadn’t nailed ‘im to the perch ‘e’d be pushing up the daisies!

‘Is metabolic processes are now ‘istory! ‘E’s off the twig!

(Monty Python)

BTS Hedged Income Fund (BDIAX), a fund of funds, will disappear on April 27, 2015. Apparently the combination of $300,000 in assets and poor performance weighed against its survival.

Dreyfus Greater China Fund (DPCAX) will be liquidated around May 21, 2015 

Forward Equity Long/Short Fund (FENRX) goes backward, pretty much terminally backward, on April 24, 2015. It’s not a terrible fund, as long/short funds go; it’s just that nobody was interested in investing in it.

The Board of Trustees approved liquidation of the Fountain Short Duration High Income Fund, with the execution carried out March 27, 2015

Harbor Funds’ Board of Trustees has determined to liquidate and dissolve Harbor Emerging Markets Debt Fund (HAEDX) on April 29, 2015. The fund lost roughly 4% over its four-year life while its peers made roughly the same amount. It’s admirable that the fund was doggedly independent of its peers; it’s less admirable that it lost money in 17 calendar months, often while its peers were posting gains. It’s curious that the same team manages another EM debt fund with a dramatically different record of success:

* 05/02/2011

In mid-March, ISI Total Return U.S. Treasury Fund (TRUSX) and North American Government Bond Fund (NOAMX, which had 15% each in Canadian and Mexican bonds) reorganized into Centre Active U.S. Treasury Fund (DHTRX, which has no such exposure to explain its parlous performance); ISI Strategy Fund (STRTX, which holds a 10% bond stake) merged into Centre American Select Equity Fund (DHAMX, which doesn’t but which still manages to trail STRTX, its peers and the S&P 500); and, finally, Managed Municipal Fund (MUNIX, which was also a substantial laggard) was absorbed by Centre Active U.S. Tax Exempt Fund (DHBIX).

On March 13, the Board of Trustees decided to liquidate the tiny, sucky Loomis Sayles International Bond Fund (LSIAX), which will take place around May 15, 2015.

Morgan Stanley finalized in March a fund merger that we highlighted a couple months ago: the five-star, $350 million Morgan Stanley Global Infrastructure Fund (UTLAX) merged into Morgan Stanley Institutional Fund Select Global Infrastructure Portfolio (MTIPX) at the end of March. MTIPX is … uhh, dramatically smaller, more expensive and marginally less successful. No word on whether the five-fold rise in assets at MTIPX will be occasioned by a dramatic expense reduction, or at least a reduction to the level enjoyed by the former UTLAX shareholders.

Pathway Advisors Growth and Income Fund (PWGFX) was closed and liquidated on March 31, 2015. It strikes me as the sort of fund that an adviser might want to sell to someone getting into the business since those filings are a lot cheaper than the initial filings for a new fund. Generally buying a failed fund is undesirable because you’re buying (and hauling along) its failed record, but there are instances like this where the trailing record isn’t disastrous. Curiously, this decision leaves open the family’s other two (weaker, smaller) funds.

On March 12, 2015, the Board of Directors of The Glenmede Fund approved a plan of liquidation and termination for the Glenmede Philadelphia International Fund (GTIIX). On or about May 15, the fund will be liquidated

The Royce Fund’s Board of Trustees recently approved a plan of liquidation for Royce Select Fund II (RSFDX), Royce Enterprise Select Fund (RMISX), Royce SMid-Cap Value Fund (RMVSX), Royce Partners Fund (RPTRX) and Royce Global Dividend Value Fund (RGVDX). In their delicately worded phrase, “the plan will be effective on April 23, 2015.” That puts the plan in contrast to the funds themselves, which were part of the seemingly mindless expansion of the Royce lineup. Between 1962 and 2001, Royce launched nine funds – all domestic small caps. They were acquired by Legg Mason in 2001. Between 2001 and the present, they launched 21 mutual funds and three closed-end funds in a striking array of flavors. Almost none of the newer funds found traction, with 10 of the 21 sitting under $10 million in assets. Shostakovich, one of our discussion board’s most experienced correspondents, pretty much cut to the chase: “Chuck sold his soul. He kept his cashmere sweaters and his bow ties, but he sold his soul. And the devil’s name is Legg Mason.”

Lutherans are a denomination renowned for the impulse toward merger, so it should be no real surprise that Lutheran funds (Thrivent Funds used to be the Aid Association for Lutherans Funds) would follow the same path. On August 28, eight Thrivent funds will become three:

Pending shareholder approval, Touchstone Capital Growth Fund (TSCGX) merges into the Touchstone Large Cap Fund (TACLX) on or about June 26, 2015. Pending that move, Capital Growth is closed to new investors. Not to suggest that anyone is trying to bury a consistently bad record, but the decedent fund is 12 years old where the acquiring fund is barely 12 months old and the decedent is well more than twice the size of its acquirer.

Sometime during the third quarter, Transamerica Tactical Allocation (TTAAX) will merge into Transamerica Tactical Rotation (ATTRX). They were launched on the same day and are managed by the same team, but the Rotation fund has posted far stronger returns. That said, neither fund has attracted serious assets.

The Turner Titan Fund (TTLFX) is now scheduled to be liquidated on April 30, about six weeks later than originally announced. No word as to why. It wasn’t a bad fund as far as long/short funds go but that, sadly, isn’t saying much. It’s up about 22% total since inception in 2011 (right, about 4% a year) against a peer average of 15%. But no one was impressed and the fund never attracted enough assets to cover its cost of operation.

Van Eck Multi-Manager Alternatives Fund VMAAX) “is expected to be liquidated and dissolved on or about June 3, 2015.” $10 million in assets, 2.84% e.r., consistently bottom decile returns. Yeah, it’s about time to go.

On February 25, 2015, the Board of Trustees of the Virtus Opportunities Trust voted to liquidate the Virtus Global Commodities Stock Fund (VGCAX). On or about April 30, 2015, the Fund will be no more. The fund has turned $10,000 invested at inception into $7200, bad even by the standards of the funds in Morningstar’s natural resources category.

In Closing . . .

My friend Linda approaches some holidays, particularly those that lead to her receiving presents, with the mantra “it’s not a day, it’s a season!” We’re taking the same perspective on the Observer’s fourth anniversary. We launched in phases between early April and early May, 2011. April saw the “soft launch” as we got the discussion board and archival fund profiles moved over from our former home as FundAlarm. Since then, something like 550,000 readers have joined us with about 25,000 “unique” visitors each month now. May saw the debut of our first monthly commentary and our first four fund profiles (each of which, by the way, was brilliant).

In that same easy spirit, we rolled out a series of visual upgrades this month. The new design features our trademark owl peering at you from the top of the page, a brighter and more consistent color palette, better response times (pages are loading about 30% faster than before), new Amazon and Paypal badges (try them out! really) and a responsive design that should provide much better readability on smart phones, tablets and other mobile devices.

In May we’ll freshen up our homepage and will look back at the stories and funds that launched the Observer.

Your support, both intellectual and financial, makes that happen. Thanks most immediately go to the Messrs. Gardey & co. at Gardey Financial, to Dan at Callahan Capital, to Capt. Neel (hope retirement is treating you well, sir!), to Ed and Charles (no, not the Ed and Charles whose work appears above; rather, the Ed and Charles who seem to appreciate the yeoman work done by, well, Ed and Charles), to Joseph whom we haven’t met before and Eric E. who’s a sort of repeat offender when it comes to supporting the Observer and, as ever, to our two subscribers. (Deb and Greg have earned the designation by setting up automatic monthly contributions through PayPal. It was even their idea.)

As ever,

Egads! I’ve been unmasked.

Dear friends,

As I begin this essay the thermostat registers an attention-grabbing minus 18 degrees Fahrenheit.  When I peer out of the window nearest my (windowless) office, I’m confronted with:

All of which are sure and certain signs that it’s what? Yes, Spring Break in the Midwest!

Which funds? “Not ours,” saith Fidelity!

If you had a mandate to assemble a portfolio of the stars and were given virtually unlimited resources with which to identify and select the country’s best funds and managers, who would you pick? And, more to the point, how cool would it be to look over the shoulders of those who actually had that mandate and those resources?

Welcome to the world of the Strategic Advisers funds, an arm of Fidelity Investments dedicated to providing personalized portfolios for affluent clients. The pitch is simple: “we can do a better job of finding and matching investment managers, some not accessible to regular people, than you possibly could.” The Strategic Advisers funds have broad mandates, with names like Core Fund (FCSAX) and Value Fund (FVSAX). Most are funds of funds, explicitly including Fidelity funds in their selection universe, or they’re hybrids between a fund-of-funds and a fund where other mutual fund managers contribute individual security names.

SA celebrates its manager research process in depth and in detail. The heart of it, though, is being able to see the future:

Yet all too often, yesterday’s star manager becomes tomorrow’s laggard. For this reason, Strategic Advisers’ investment selection process emphasizes looking forward rather than backward, and seeks consistency, not of performance per se, but of style and process.

They’re looking for transparent, disciplined, repeatable processes, stable management teams and substantial personal investment by the team members.

The Observer researched the top holdings of every Strategic Advisers fund, except for their target-date series since those funds just invest in the other SA funds. Here’s what we found:

A small handful of Fidelity funds found their way in. Only four of the eight domestic equity funds had any Fido fund in the sample and each of those featured just one fund. The net effect: Fidelity places something like 95-98% of their domestic equity money with managers other than their own. Fidelity funds dominate one international equity fund (FUSIX), while getting small slices of three others. Fidelity has little presence in core fixed-income funds but a larger presence in the two high-yield funds.

The Fidelity funds most preferred by the SA analysts are:

Fidelity favors managers that are household names. No “undiscovered gems” here. The portfolios are studded with large, safe bets from BlackRock, JPMorgan, MetWest, PIMCO and T. Rowe.

DFA and Vanguard are missing. Utterly, though whether that’s Fidelity’s decision or not is unknown.

JPMorgan appears to be their favorite outside manager. Five different SA funds have invested in JPMorgan products including Core Bond, Equity Spectrum, Short Duration, US Core Plus Large Cap Select and Value Advantage.

The word “Focus” is notably absent. Core hold 550 positions, including funds and individual securities while Core Multi-Manager holds 360. Core Income holds a thousand while Core Income Multi-Managers holds 240 plus nine mutual funds. International owns two dozen funds and 400 stocks.

Some distinguished small funds do appear further down the portfolios. Pear Tree Polaris Foreign Value (QFVOX) is a 1% position in International. Wasatch Frontier Emerging Small Countries (WAFMX) was awarded a freakish 0.02% of Emerging Markets Fund of Funds (FLILX), as well as 0.6% in Emerging Markets (FSAMX). By and large, though, timidity rules!

Bottom Line: the tyranny of career risk rules! Most professional investors know that it’s better to be wrong with the crowd than wrong by yourself. That’s a rational response to the prospect of being fired, either by your investors or by your supervisor. That same pattern plays out in fund selection committees, including the college committee on which I sit. It’s much more important to be “not wrong” than to be “right.” We prefer choices that we can’t be blamed for. The SA teams have made just such choices: dozens of funds, mostly harmless, and hundreds of stocks, mostly mainstream, in serried ranks.

If you’ve got a full-time staff that’s paid to do nothing else, that might be manageable if not brilliant. For the rest of us, private and professional investors alike, it’s not.

One of the Observers’ hardest tasks is trying to insulate ourselves, and you, from blind adherence to that maxim. One of the reasons we’ll highlight one- and two-star funds, and one of the reasons I’ve invested in several, is to help illustrate the point that you need to look beyond the easy answers and obvious choices. With the steady evolution of our Multi-Search screener, we’re hoping to help folks approach that task more systematically. Details soon!

The Death of “Buy the unloved”

You know what Morningstar would say about a mutual fund that claimed a spiffy 20 year record but has switched managers, dramatically changed its investment strategy, went out of business for several years, and is now run by managers who are warning people not to buy the fund. You can just see the analysts’ soured, disbelieving expression and hear the incredulous “what is this cr…?”

Welcome to the world of Buy the Unloved, which used to be my favorite annual feature. Begun in 1993, the strategy drew up the indisputable observation that investors tend to be terrible at timing: over and over again they sell at the bottom and buy at the top. So here was the strategy: encourage people to buy what everyone else was selling and sell what everyone else was buying. The implementation was simple:

Identify the three fund categories that saw the greatest outflows, measured by percentage of assets, then buy good funds in each of those categories and prepare to hold them for three years. At the same time identify the three fund categories with the greatest inrush and sell them.

I liked it, it worked, then Morningstar stopped publishing it. Investment advisor Neil Stoloff provided an interesting history of the strategy, detailed on pages 12-16 of a 2011 essay he wrote. When they resumed, the strategy had a far more conservative take: buy the three sectors that saw the greatest outflows measured in total dollar volume and hold them, while selling the most popular sectors.

The problem with, and perhaps strength of, the newer version is that it means that you’ll mostly be limited to playing with your core sectors rather than volatile smaller ones. By way of example, large cap blend holds about $1.6 trillion – a 1% outflow there ($16 billion) would be an amount greater than the total assets in any of the 50 smallest fund categories. Large cap growth at $1.2 trillion is close behind.

Oh, by the way, they haven’t traditionally allowed bond funds to play. They track bond flows but, in a private exchange, Mr. Kinnel allowed that “Generally they are too dull to provide much of a signal.”

Morningstar now faces two problems:

1. De facto, the system is rigged to provide “sell” signals on core fund groups.
2. Morningstar is not willing to recommend that you ever sell core fund groups.

Katie Reichart’s 2013 presentation of the strategy (annoying video ahead) warned that “It can be used just on the margin…perhaps for a small percentage of their portfolio.” In 2014, it was “Add some to the unloved pile and trim from the loved” and by 2015 there was a flat-out dismissal of it: “I’m sharing the information for those who want to follow the strategy to the letter–but I wouldn’t do it.”

The headline:	The bottom line:
	So, I’m sharing the information for those who want to follow the strategy to the letter–but I wouldn’t do it. R. Kinnel

So what’s happened? Kinnel’s analysis seems odd but might well be consistent with the data:

But since 2008, performance and flows have decoupled on the asset-class level even though they continue to be linked on a fund level.

Now flows are more linked to headlines. Since 2008, some people have taken a pessimistic (albeit incorrect) view of America’s economy and looked to China as a superior bet. It hasn’t worked that way the past five years, and it leaves us in the odd position of seeing the nature of fund flows change.

I don’t actually know what that means.

Morningstar has released complete 2014 fund flow data, by fund family and fund category. (Thanks, Dan!) It reveals that investors fled from:

• US Large Growth (-41 billion)
• Bank Loans (-20 billion)
• High Yield Bonds (-16 billion).

Since two of the three areas are bonds, you’re not supposed to use those as a signal. And since the other is a core category buffeted by headline risk, really there’s nothing there, either. Further down the list, categories such as commodities and natural resources saw outflows of 10% or so. But those aren’t signals, either.

Whither goest investors?

• US Large Blend (+105 billion)
• International Large Blend (+92 billion)
• Intermediate Bonds (+34 billion)
• Non-traditional Bonds (+23 billion)

Two untouchable core categories, two irrelevant bond ones. Meanwhile, the Multialternative category saw an inrush of about 33% of its assets in a year. Too small in absolute terms to matter.

Bottom Line: Get serious or get rid of it. The underlying logic of the strategy is psychological: investors are too cowardly to do the right thing. On face, that’s afflicting Morningstar’s approach to the feature. If the data says it works, they need to screw up their courage and announce the unpopular fact that it might be time to back away from core stock categories. If the data says it doesn’t work, they need to screw up their courage, explain the data and end the game.

The current version, “for amusement only,” version serves no real purpose and no one’s interest.

Whitebox Tactical Opportunities 4Q14 Conference Call 

Portfolio managers Andrew Redleaf and Dr. Jason Cross, along with Whitebox Funds’ President Bruce Nordin and Mike Coffey, Head of Mutual Fund Distribution, hosted the 4^th quarter conference call for their Tactical Opportunities Fund (WBMIX) on February 26. Robert Vogel and Paul Twitchell, the fund’s third and fourth portfolio managers, did not participate.

Prolific MFO board contributor Scott first made us aware of the fund in August 2012 with the post “Somewhat Interesting Tiny Fund.” David profiled its more market neutral and less tactical (less directionally oriented) sibling WBLFX in April 2013. I discussed WBMIX in the October 2013 commentary, calling the fund proper “increasingly hard to ignore.” Although the fund proper was young, it possessed the potential to be “on the short list … for those who simply want to hold one all-weather fund.”

WBMIX recently pasted its three year mark and at $865M AUM is no longer tiny. Today’s question is whether it remains an interesting and compelling option for those investors looking for alternatives to the traditional 60/40 balanced fund at a time of interest rate uncertainty and given the two significant equity drawdowns since 2000.

Mr. Redleaf launched the call by summarizing two major convictions:

• The US equity market is “expensive by just about any measure.” He noted examples like market cap to GDP or Shiller CAPE, comparing certain valuations to pre great recession and even pre great depression. At such valuations, expected returns are small and do not warrant the downside risk they bear, believing there is a “real chance of 20-30-40 even 50% retraction.” In short, “great risk in hope of small gain.”

• The global markets are fraught with risk, still recovering from the great recession. He explained that we were in the “fourth phase of government action.” He called the current phase competitive currency devaluation, which he believes “cannot work.” It provides temporary relief at best and longer term does more harm than good. He seems to support only the initial phase of government stimulus, which “helped markets avert Armageddon.” The last two phases, which included the zero interest rate policy (ZIRP), have done little to increase top-line growth.

Consequently, toward middle of last year, Tactical Opportunities (TO) moved away from its long bias to market neutral. Mr. Redleaf explained the portfolio now looks to be long “reasonably priced” (since cheap is hard to find) quality companies and be short over-priced storybook companies (some coined “Never, Nevers”) that would take many years, like 17, of uninterrupted growth to justify current prices.

The following table from its recent quarterly commentary illustrates the rationale:

Mr. Redleaf holds a deep contrarian view of efficient market theory. He works to exploit market irrationalities, inefficiencies, and so-called dislocations, like “mispriced securities that have a relationship to each other,” or so-called “value arbitrage.” Consistently guarding against extreme risk, the firm would never put on a naked short. Its annual report reads “…a hedge is itself an investment in which we believe and one that adds, not sacrifices returns.”

But that does not mean it will not have periods of underperformance and even drawdown. If the traditional 60/40 balanced fund performance represents the “Mr. Market Bus,” Whitebox chose to exit middle of last year. As can be seen in the graph of total return growth since WBMIX inception, Mr. Redleaf seems to be in good company.

Whether the “exit” was a because of deliberate tactical moves, like a market-neutral stance, or because particular trades, especially long/short trades went wrong, or both … many alternative funds missed-out on much of the market’s gains this past year, as evidenced in following chart:

But TO did not just miss much of the upside, it’s actually retracted 8% through February, based on month ending total returns, the greatest amount since its inception in December 2011; in fact, it has been retracting for ten consecutive months. Their explanation:

Our view of current opportunity has been about 180 degrees opposite Mr. Market’s. Currently, we love what we’d call “intelligent value” while Mr. Market apparently seems infatuated with what we’d call “unsustainable growth.”

Put bluntly, the stocks we disfavored most (and were short) were among the stocks investors remained enamored with.

A more conservative strategy would call for moving assets to cash. (Funds like ASTON RiverRoad Independent Value, which has about 75% cash. Pinnacle Value at 50%. And, FPA Crescent at 44%.) But TO is more aggressive, with attendant volatilities above 75% of SP500, as it strives to “produce competitive returns under multiple scenarios.” This aspect of the fund is more evident now than back in October 2013.

Comparing its performance since launch against other long-short peers and some notable alternatives, WBMIX now falls in the middle of the pack, after a strong start in 2012/13 but disappointing 2014:

From the beginning, Mr. Redleaf has hoped TO would be judged in comparison to top endowments. Below are a couple comparisons, first against Yale and Harvard, which report on fiscal basis, and second against a simple Ivy asset allocation (computed using Alpha Architect’s Allocation Tool) and Vanguard’s 60/40 Balanced Index. Again, a strong showing in 2012/13, but 2014 was a tough year for TO (and Ivy).

Looking beyond strategy and performance, the folks at Whitebox continue to distinguish themselves as leaders in shareholder friendliness – a much welcomed and refreshing attribute, particularly with former hedge fund shops now offering the mutual funds and ETFs. Since last report:

• They maintain a “culture of transparency and integrity,” like their name suggests providing timely and thoughtful quarterly commentaries, published on their public website, not just for advisors. (In stark contrast to other firms, like AQR Funds, which in the past have stopped publishing commentaries during periods of underperformance, no longer make commentaries available without an account, and cater to Accredited Investors and Qualified Eligible Persons.)
• They now benchmark against SP500 total return, not just SPX.
• They eliminated the loaded advisor share class.
• Their expense ratio is well below peer average. Institutional shares, available at some brokerages for accounts with $100K minimum, have been running between 1.25-1.35%. They impose a voluntary cap of 1.35%, which must be approved by its board annually, but they have no intention of ever raising … just the opposite as AUM grows, says Mr. Coffey. (The cap is 1.6% for investor shares, symbol WBMAX.)

These ratios exclude the mandatory reporting of dividend and interest expense on short sales and acquired fund fees, which make all long/short funds inherently more expensive than long only equity funds. The former has been running about 1%, while the latter is minimal with selective index ETFs.

• They do not charge a short-term redemption fee.

All that said, they could do even better going forward:

• While Mr. Redleaf has over $1M invested directly with the fund, the most recent SAI dated 15 January 2015, indicates that the other three portfolio managers have zero stake. A spokesman for the fund defends “…as a smaller company, the partners’ investment is implicit rather than explicit. They have ‘Skin in the game,’ as a successful Tac Ops increases Whitebox’s profitability and on the other side of the coin, they stand to lose.”

David, of course, would argue that there is an important difference: Direct shareholders of a fund gain or lose based on fund performance, whereas firm owners gain or lose based on AUM.

Ed, author of two articles on “Skin in the Game” (Part I & Part II), would warn: “If you want to get rich, it’s easier to do so by investing the wealth of others than investing your own money.”

• Similarly, the SAI shows only one of its four trustees with any direct stake in the fund.
• They continue to impose a 12b-1 fee on their investor share class. A simpler and more equitable approach would be to maintain a single share class eliminating this fee and continue to charge lowest expenses possible.
• They continue to practice a so-called “soft money” policy, which means the fund “may pay higher commission rates than the lowest available” on broker transactions in exchange for research services. Unfortunately, this practice is widespread in the industry and investors end-up paying an expense that should be paid for by the adviser.

In conclusion, does the fund’s strategy remain interesting? Absolutely. Thoughtfulness, logic, and “arithmetic” are evident in each trade, in each hedge. Those trades can include broad asset classes, wherever Mr. Redleaf and team deem there are mispriced opportunities at acceptable risk.

Another example mentioned on the call is their longstanding large versus small theme. They believe that small caps are systematically overpriced, so they have been long on large caps while short on small caps. They have seen few opportunities in the credit markets, but given the recent fall in the energy sector, that may be changing. And, finally, first mentioned as a potential opportunity in 2013, a recent theme is their so-called “E-Trade … a three‐legged position in which we are short Italian and French sovereign debt, short the euro (currency) via put options, and long US debt.”

Does the fund’s strategy remain compelling enough to be a candidate for your one all-weather fund? If you share a macro-“market” view similar to the one articulated above by Mr. Redleaf, the answer to that may be yes, particularly if your risk temperament is aggressive and your timeline is say 7-10 years. But such contrarianism comes with a price, shorter-term at least.

During the call, Dr. Cross addressed the current drawdown, stating that “the fund would rather be down 8% than down 30% … so that it can be positioned to take advantage.” This “positioning” may turn out to be the right move, but when he said it, I could not help but think of a recent post by MFO board member Tampa Bay:

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch 

Mr. Redleaf is no ordinary investor, of course. His bet against mortgages in 2008 is legendary. Whitebox Advisers, LLC, which he founded in 1999 in Minneapolis, now manages more than $4B.

He concluded the call by stating the “path to victory” for the fund’s current “intelligent value” strategy is one of two ways: 1) a significant correction from current valuations, or 2) a fully recovered economy with genuine top-line growth.

Whitebox Tactical Opportunities is facing its first real test as a mutual fund. While investors may forgive not making money during an upward market, they are notoriously unforgiving losing money (eg., Fairholme 2011), perhaps unfairly and perhaps to their own detriment, but even over relatively short spans and even if done in pursuit of “efficient management of risk.”

We’ve Seen This Movie Before

By Edward Studzinski

“We do not have to visit a madhouse to find disordered minds; our planet is the mental institution of the universe.”          Goethe

For students of the stock market, one of the better reads is John Brooks’, The Go-Go Years.   It did a wonderful job of describing the rather manic era of the 60’s and 70’s (pre-1973). One of the arguments made then was that the older generation of money managers was out of touch with both technology and new investment ideas. This resulted in a youth movement on Wall Street, especially in the investment management firms. You needed to have a “kid” as a portfolio manager, which was taken to its logical conclusion in a cartoon which showed an approximately ten-year old sitting behind a desk, looking at a Quotron machine. Around 2000, a similar youth movement came along during the dot.com craze, where once again investment managers, especially value managers, were told that their era was over, that they didn’t understand the new way and new wave of investing. Each of those two eras ended badly for those who had entrusted their assets to what was in vogue at the time.

In 2008, we had a period of over-valuation in the markets that was pretty clear in terms of equities. We also had what appears in retrospect to have been the deliberate misrepresentation and marketing of certain categories of fixed income investments to those who should have known better and did not. This resulted in a market meltdown that caused substantial drawdowns in value for many equity mutual funds, in a range of forty to sixty per cent, causing many small investors to panic and suffer a permanent loss of capital which many of them could not afford nor replace. The argument of many fund managers who had invested in their own funds (and as David has often written about, many do not), was that they too had skin in the game, and suffered the losses alongside of their investors.

Let’s run some simple math. Assume a fund management firm that at 2/27/2015 has $100 billion in assets under management. Assets are equities, a mix of international and domestic, the international with fees and expenses of 1.30% and the domestic with fees and expenses of 0.90%. Let’s assume a 50/50 international/domestic split of assets, so $50 billion at 0.90% and $50 billion at 1.30%. This results in $1.1billion in fees and expenses to the management company. Assuming $300 million goes in expenses to non-investment personnel, overhead, and the other expenses that you read about in the prospectus, you could have $800 million to be divided amongst the equity owners of the management firm. In a world of Marxian simplicity, each partner is getting $40 million dollars a year. But, things are often not simple if we take the PIMCO example. Allianz as owners of the firm, having funded through their acquisitions the buy-out of the founders, may take 50% of profits or revenues off the top. So, each equal-weighted equity owner may only be getting paid $20 million a year. Assets under management may go down with the market sell-off so that fees going forward go down. But it should be obvious that average mutual fund investors are not at parity with the fund managers in risk exposure or tolerance.

Why am I beating this horse into the ground again? U.S. economic growth for the final quarter was revised down from the first reported estimate of 2.6% to 2.2%. More than 440 of the companies in the S&P 500 index had reported Q4 numbers by the end of last week showed revenue growth of 1.5% versus 4.1% in the previous quarter. Earnings increased at an annual rate that had slowed to 5.9% from 10.4% in the previous quarter. Earnings downgrades have become more frequent. 

Why then has the market been rising – faith in the Federal Reserve’s QE policy of bond repurchases (now ended) and their policy of keeping rates low. Things on the economic front are not as good as we are being told. But my real concern is that we have become detached from thinking about the value of individual investments, the margin of safety or lack thereof, and our respective time horizons and risk tolerances. And I will not go into at this time, how much deflation and slowing economies are of concern in the rest of the world.

Look at the energy sector, where the price of oil has come down more than 50% since the 2014 high. Each time we see a movement in the price of oil, as well as in the futures, we see swings in the equity prices of energy companies. Should the valuations of those companies be moving in sync with energy prices, and are the balance sheets of each of those companies equal? No, what you are seeing is the algorithmic trading programs kicking in, with large institutional investors and hedge funds trying to grind out profits from the increased volatility. Most of the readers of this publication are not playing the same game. Indeed they are unable to play that game. 

So I say again, focus upon your time horizons and risk tolerance. If your investment pool represents the accumulation of your life’s work and retirement savings, your focus should be not on how much you can make but rather how much you can afford to lose. As the U.S. equity market has continued to hit one record high after another,  recognize that it is getting close to trading at nearly thirty times long-term, inflation-adjusted earnings. In 2014, the S&P 500 did not fall for more than three consecutive days.

We are in la-la land, and there is little margin for error in most investment opportunities. On January 15, 2015, when the Swiss National Bank eliminated its currency’s Euro-peg, the value of that currency moved 30% in minutes, wiping out many currency traders in what were thought to be low-risk arbitrage-like investments. 

What should this mean for readers of this publication? We at MFO have been looking for absolute value investors. I can tell you that they are in short supply. Charlie Munger had some good advice recently, which others have quoted and I will paraphrase. Focus on doing the easy things. Investment decisions or choices that are complex, and by that I mean things that include shorting stocks, futures, and the like – leave that to others. One of the more brilliant value investors and a contemporary of Benjamin Graham, Irving Kahn, passed away last week. He did very well with 50% of his assets in cash and 50% of his assets in equities. For most of us, the cash serves as a buffer and as a reserve for when the real, once in a lifetime, opportunities arise. I will close now, as is my wont, with a quote from a book, The Last Supper, by one of the great, under-appreciated American authors, Charles McCarry. “Do you know what makes a man a genius? The ability to see the obvious. Practically nobody can do that.”

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 and filtered as never before. For a 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 Lawsuits

The Calamos Growth Fund is the subject of a new section 36(b) lawsuit that alleges excessive advisory and 12b-1 fees. The complaint alleges that Calamos extracted higher investment advisory fees from the Growth Fund than from “third-party, arm’s length institutional clients,” even though advisory services were “similar” and “in some cases effectively identical.” (Chill v. Calamos Advisors LLC.)

A new lawsuit accuses T. Rowe Price of infringing several patents relating to management of its target-date funds. (GRQ Inv. Mgmt., LLC v. T. Rowe Price Group, Inc.)

New Appeal

Plaintiffs have appealed a district court’s dismissal of state-law claims against Vanguard regarding fund holdings of gambling-related securities. The district court held that the claims were time barred and, alternatively, that the fund board’s refusal to pursue plaintiffs’ litigation demand was protected by the business judgment rule. Defendants include independent directors. (Hartsel v. Vanguard Group, Inc.)

Settlements

ERISA class action plaintiffs filed an unopposed motion to settle their claims against Northern Trust for $36 million. The lawsuit alleged mismanagement of the securities lending program in which collective trust funds participated. (Diebold v. N. Trust Invs., N.A.)

In an interrelated class action against Northern Trust that asserts non-ERISA claims, plaintiffs filed an unopposed motion to partially settle the lawsuit for $24 million. The settlement covers plaintiffs who participated in the securities lending program indirectly (i.e., through investments in commingled investment funds); the litigation will continue with respect to plaintiffs who participated directly (i.e., through a securities lending agreement with Northern Trust). (La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)

The Alt Perspective: Commentary and news from DailyAlts.

By Brian Haskin, editor of DailyAlts.com

February is in the books, and fortunately it ended with a significant decline in volatility, and a nice rally in the equity market. Bonds took it on the chin as rates rose over the month, but commodities rallied on the back of rising oil prices over the month. In the alternative mutual fund are, all of the major categories put up positive returns over the month, with long/short equity leading the way with a category return of 1.88%, according to Morningstar. Multi-alternative funds posted a category return of 0.98%, while non-traditional bonds ended the month 0.88% higher and managed futures funds added 0.47%.

Industry Evolution

The liquid alternatives industry continues to evolve in many ways, the most obvious of which is the continuous launch of new funds. However, we are now beginning to see more activity and consolidation of players at the company level. In December of 2014, we ended the year with New York Life’s MainStay arm purchasing IndexIQ, an alternative ETF provider. This acquisition gave MainStay immediate access to two of the hottest segments of the investment field, all in one package: active ETFs and liquid alternatives.

In February, we saw two more firms combine forces with Salient Partner’s purchase of Forward Management. Both firms have strong footholds in the liquid alternatives market, and the combination of the two firms will expend both their product platforms and distribution capabilities. Scale becomes more important as competition continues to grow. Expect more mergers over the year as firms jockey for position.

Waking Giants

Aside from merger activity, some firms just finally wake up and realize there is an opportunity passing them by. Columbia Management is one of them. The firm has been making some moves over the past few months with new hires and product filings, and finally put the pedal to the metal this month and launched a new alternative mutual fund in partnership with Blackstone. At the same time, Columbia rationalized some of their existing offerings and announced the termination terminated three alternative mutual funds that were launched more than three years ago.

In addition to Columbia, American Century has decided to formalize their liquid alternatives business with new branding (AC Alternatives) and three new alternative mutual funds. These new funds join a stable of two equity market neutral funds and two long/short “130-30” funds (these funds remain beta 1 funds but increase their long exposure to 130% of the portfolio’s value and offset that with 30% shorting, bringing the fund to a net long position of 100%). With at least five alternative mutual funds (the 130-30 funds are technically not liquid alternatives since they are beta 1 funds), American Century will have a solid stable of products to roll under their new AC Alternatives brand that has been created just for their liquid alternatives business.

Featured New Funds

February new fund activity picked up over January with a few notable new funds that hit the market. One theme that has emerged is the growth of globally focused long/short equity funds. Up until last year, a large majority of long/short equity funds were focused on US equities, however last year, firms began introducing funds that could invest in globally developed and emerging markets. The Boston Partners Global Long/Short Fund was one of note, and was launched after the firm had closed its first two long/short equity funds.

This increased diversity of funds is good for both asset managers and investors. Asset managers have a larger global pond in which to fish, thus creating more opportunities, while investors can diversify across both domestic and globally focused funds. Four new funds of note are as follows:

Meeder Spectrum Fund – This is the firm’s first alternative mutual fund, but not their first unconstrained fund. The fund will use a quantitative process to create a globally allocated long/short equity fund, and will use both stocks and other mutual funds or ETFs to implement its strategy. The fund’s management fee is a reasonable 0.75%.

Stone Toro Market Neutral Fund – While described as market neutral, the fund can move between -10% net short to +60% net long. This means that the fund will likely have some beta exposure, but it does allocate globally to both developed and emerging market stocks using an arbitrage approach that looks for structural imperfections related to investor behavior and corporate actions. This is different from the traditional valuation driven approach and could prove to add some value in ways other funds will not.

PIMCO Multi-Strategy Alternative Fund – This fund will allocate to a range of PIMCO alternative mutual funds, including alternative asset classes such as commodities and real assets. Research Affiliates will also sub-advise on the fund and assist in the allocation to funds advised by Research Affiliates.

Columbia Adaptive Alternatives Fund – launched in partnership with Blackstone, this fund invests across three different sleeves (one of which is managed by Blackstone), and allocates to twelve different investment strategies. Lots of complexity here – give it time to see what it can deliver.

While there is plenty more news and fund activity to discuss, let’s call it a wrap there. If you would like to receive daily or weekly updates on liquid alternatives, feel free to sign up for our free newsletter: http://dailyalts.com/mailinglist.php.

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.

Northern Global Tactical Asset Allocation (BBALX): This fund is many things: broadly diversified, well designed, disciplined, low priced and successful. It is not, however, a typical “moderate allocation” fund. As such, it’s imperative to get past the misleading star rating (which has ranged from two to five) to understand the fund’s distinctive and considerable strengths.

Pinnacle Value (PVFIX): If they (accurately) rebranded this as Pinnacle Hedged Microcap Value, the liquid alts crowd would be pounding on the door (and Mr. Deysher would likely be bolting it). While it doesn’t bear the name, the effect is the same: hedged exposure to a volatile asset class with a risk-return profile that’s distinctly asymmetrical to the upside.

Elevator Talk: Waldemar Mozes, ASTON/TAMRO International Small Cap (AROWX/ATRWX)

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

Waldemar Mozes manages AROWX which launched at the end of December 2014. The underlying strategy, however, has a record that’s either a bit longer or a lot longer, depending on whether you’re looking at the launch of separately managed accounts in this style (from April 2013) or the launch of TAMRO’s investment strategy (2000), of which this is just a special application. Mr. Mozes joined TAMRO in 2008 after stints with Artisan Partners and The Capital Group, adviser to the American Funds.

TAMRO uses the same strategy in their private accounts and all three of the funds they sub-advise for Aston:

… we identify undervalued companies with a competitive advantage. We attempt to mitigate our investment risk by purchasing stocks where, by our calculation, the potential gain is at least three times the potential loss (an Upside reward-to-Downside risk ratio of 3:1 or greater). While our investments fall into three different categories – Leaders, Laggards and Innovators – all share the key characteristics of success:

• Differentiated product or service offering

• Capable and motivated leadership

• Financial flexibility

As a business development matter, Mr. Mozes proposed extending the strategy to the international small cap arena. There are at least three reasons why that made sense:

• The ISC universe is huge. Depending on who’s doing the calculation, there are 10,000 – 25,000 stocks.
• It is the one area demonstrably ripe for active managers to add value. The average ISC stock is covered by fewer than five analysts and it’s the only area where the data shows the majority of active managers consistently outperforming passive products. Across standard trailing time periods, international small caps outperform international large caps with higher Sharpe and Sortino ratios.
• Most investors are underexposed to it. International index funds (e.g, BlackRock International Index MDIIX, Schwab International IndexSWISX, Rowe Price International Index PIEQX or Vanguard Total International Stock Index VGTSX) typically commit somewhere between none of their portfolio (BlackRock, Price, Schwab) to up a tiny slice (Vanguard) to small caps. Of the 10 largest actively managed international funds, only one has more than 2% in small caps.

There are very few true international small cap funds worth examining since most that claim to be small cap actually invest more in mid- and large-cap stocks than in actual small caps. Here are Waldemar’s 268 words on why you should add AROWX to your due-diligence list:

At TAMRO, our objective is to invest in high-quality companies trading below their intrinsic value due to market misperceptions. This philosophy has enabled our domestic small cap strategy to beat its benchmark, 10 of the past 14 calendar years. We’re confident, after 3+ years of rigorous testing and nearly a two-year composite performance track record, that it will work for international small cap too. 

Here’s why:

Bigger Universe = Bigger Opportunity. The international equity universe is three times larger than the domestic universe and probably contains both three times as many high-quality and three times as many poorly-run companies. We exploit this weakness by focusing on quality: businesses that generate high and consistent ROIC/ROE, are run by skilled capital allocators, and produce enough free cash flow to self-fund growth without excessive leverage or dilution. But we also care deeply about downside risk, which is why our valuation mantra is: the price you pay dictates your return.

GDP Always Growing Somewhere. Smaller companies tend to be the engines of local economic growth and GDP is always growing somewhere. We use a proprietary screening tool that provides a timely list of potential research ideas based on fundamental and valuation characteristics. It’s not a black box, but it does flag companies, industries, or countries that might otherwise be overlooked.

Something Different. One reason international small-cap as an asset class has such great appeal is lower correlation. We strive to build on this advantage with a concentrated (40-60 positions), quality-biased portfolio. Ultimately, we care little about growth/value styles and focus on market-beating returns with high active share, low tracking error, and low turnover.

ASTON/TAMRO International Small Cap 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. The fund has about gathered about $1.3 million in assets since its December 2014 launch. Here’s the fund’s homepage. It’s understandably thin on content yet but there’s some fairly rich analysis on the TAMRO Capital page devoted to the underlying strategy.

Conference Call Highlights: Guinness Atkinson Global Innovators

Every month through the winter, the Observer conspires to give folks the opportunity to do something rare and valuable: to hear directly from managers, to put questions to them in-person and to listen to the quality of the unfiltered answers. A lot of funds sponsor quarterly conference calls, generally web-based. Of necessity, those are cautious affairs, with carefully screened questions and an acute awareness that the compliance folks are sitting there. Most of the ones I’ve attended are also plagued by something called a “slide deck,” which generally turns out to be a numbing array of superfluous PowerPoint slides. We try to do something simpler and more useful: find really interesting folks, let them talk for just a little while and then ask them intelligent questions – yours and mine – that they don’t get to rehearse the answers to. Why? Because the better you understand how a manager thinks and acts, the more likely you are to make a good decision about one.

In February with spoke with Matthew Page and Ian Mortimer of the Guinness Atkinson funds. Both of their funds have remarkable track records, we’ve profiled both and I’ve had good conversations with the team on several occasions. Here’s what we heard on the call.

The guys run two strategies for US investors. The older one, Global Innovators, is a growth strategy that Guinness has been pursuing for 15 years. The newer one, Dividend Builder, is a value strategy that the managers propounded on their own in response to a challenge from founder Tim Guinness. These strategies are manifested in “mirror funds” open to European investors. Curiously, American investors seem taken by the growth strategy ($180M in the US, $30M in the Euro version) while European investors are prone to value ($6M in the US, $120M in the Euro). Both managers have an ownership stake in Guinness Atkinson and hope to work there for 30 years, neither is legally permitted to invest in the US version of the strategy, both intend – following some paperwork – to invest their pensions in the Dublin-based version. The paperwork hang up seems to affect, primarily, the newer Dividend Builder (in Europe, “Global Equity Income”) strategy and I failed to ask directly about personal investment in the older strategy.

The growth strategy, Global Innovators IWIRX, starts by looking for firms “doing something smarter than the average company in their industry. Being smarter translates, over time, to higher return on capital, which is the key to all we do.” They then buy those companies when they’re underpriced. The fund holds 30 equally-weighted positions.

Innovators come in two flavors: disruptors – early stage growth companies, perhaps with recent IPOs, that have everyone excited and continuous improvers – firms with a long history of using innovation to maintain consistently high ROC. In general, the guys prefer the latter because the former tend to be wildly overpriced and haven’t proven their ability to translate excitement into growth.

The example they pointed to was the IPO market. Last year they looked at 180 IPOs. Only 60 of those were profitable firms and only 6 or 7 of the stocks were reasonably priced (p/e under 20). Of those six, exactly one had a good ROC profile but its debt/equity ratio was greater than 300%. So none of them ended up in the portfolio. Matthew observes that their portfolio is “not pure disruptors. Though those can make you look extremely clever when they go right, they also make you look extremely stupid when they go wrong. We would prefer to avoid that outcome.”

This also means that they are not looking for a portfolio of “the most innovative companies in the world.” A commitment to innovation provides a prism or lens through which to identify excellent growth companies. That’s illustrated in the separate paths into the portfolio taken by disruptors and continuous improvers. With early stage disruptors, the managers begin by looking for evidence that a firm is truly innovative (for example, by looking at industry coverage in Fast Company or MIT’s Technology Review) and then look at the prospect that innovation will produce consistent, affordable growth. For the established firms, the team starts with their quantitative screen that finds firms with top 25% return on capital scores in every one of the past ten years, then they pursue a “very subjective qualitative assessment of whether they’re innovative, how they might be and how those innovations drive growth.”

In both cases, they have a “watch list” of about 200-250 companies but their discipline tends to keep many of the disruptors out because of concerns about sustainability and price. Currently there might be one early stage firm in the portfolio and lots of Boeing, Intel, and Cisco.

They sell when price appreciates (they sold Shire pharmaceuticals after eight months because of an 80% share-price rise), fundamentals deteriorate (fairly rare – of the firms that pass the 10 year ROC screen, 80% will continue passing the screen for each of the subsequent five years) or the firm seems to have lost its way (shifting, for example, from organic growth to growth-through-acquisition).

The value strategy, Dividend Builder GAINX is a permutation of the growth strategy’s approach to well-established firms. The value strategy looks only at dividend-paying companies that have provided an inflation-adjusted cash flow return on investment of at least 10% in each of the last 10 years. The secondary screens require at least a moderate dividend yield, a history of rising dividends, low levels of debt and a low payout ratio. In general, they found a high dividend strategy to be a loser and a dividend growth one to be a winner.

In general, the guys are “keen to avoid getting sucked into exciting stories or areas of great media interest. We’re physicists, and we quite like numbers rather than stories.” They believe that’s a competitive advantage, in part because listening to the numbers rather than the stories and maintaining a compact, equal-weight portfolio both tends to distance them from the herd. The growth strategy’s active share, for instance, is 94. That’s extraordinarily high for a strategy with a de facto large cap emphasis.

Bottom line: I’m intrigued by the fact that this fund has consistently outperformed both as a passive product and as an active one and with three different sets of managers. The gain is likely a product of what their discipline consciously and uniquely excludes, firms that don’t invest in their futures, as what it includes. The managers’ training as physicists, guys avowedly wary of “compelling narratives” and charismatic CEOs, adds another layer of distinction.

We’ve gathered all of the information available on the two Guinness Atkinson funds, including an .mp3 of the conference call, into its new Featured Fund page. Feel free to visit!

Conference Call Upcoming: RiverPark Focused Value

We’d be delighted if you’d join us on Tuesday, March 17^th, from 7:00 – 8:00 Eastern, for a conversation with David Berkowitz and Morty Schaja of the RiverPark Funds. Mr. Berkowitz has been appointed as RiverPark’s co-chief investment officer and is set to manage the newly-christened RiverPark Focused Value Fund (RFVIX/RFVFX) which will launch on March 31.

It’s unprecedented for us to devote a conference call to a manager whose fund has not launched, much less one who also has no public performance record. So why did we?

Mr. Berkowitz seems to have had an eventful career. Morty describes it this way:

David’s investment career began in 1992, when, with a classmate from business school, he founded Gotham Partners, a value-oriented investment partnership. David co-managed Gotham from inception through 2002. In 2003, he joined the Jack Parker Corporation, a New York family office, as Chief Investment Officer; in 2006, he launched Festina Lente, a value-oriented investment partnership; and in 2009 joined Ziff Brothers Investments where he was a Partner and Chief Risk and Strategy Officer.

It will be interesting to talk about why a public fund for the merely affluent is a logical next step in his career and how he imagines the structural differences might translate to differences in his portfolio.

RiverPark’s record on identifying first-tier talent is really good. Pretty much all of the RiverPark funds have met or exceeded any reasonable expectation. In addition, they tend to be distinctive funds that don’t fit neatly into style boxes or fund categories. In general they represent thoughtful, distinctive strategies that have been well executed.

Good value investors are in increasingly short supply. When you reach the point that everyone’s a value investor, then no one is. It becomes just a sort of rhetorical flourish, devoid of substance. As the market ascends year after year, fewer managers take the career risk of holding out for deeply-discounted stocks. Mr. Berkowitz professes a commitment to a compact, high commitment portfolio aiming for “substantial discounts to conservative assessments of value.” As a corollary to a “high commitment” mindset, Mr. Berkowitz is committing $10 million of his own money to seed the fund, an amount supplemented by $2 million from the other RiverPark folk. It’s a promising gesture.

Andrew Foster of Seafarer Overseas Growth & Income (SFGIX) has agreed to join us on April 16. We’ll share details in our April issue.

HOW CAN YOU JOIN IN? 

If you’d like to join in the RiverPark call, just click on register and you’ll be taken to the Chorus Call site. In exchange for your name and email, you’ll receive a toll-free number, a PIN and instructions on joining the call. If you register, I’ll send you a reminder email on the morning of the call.

Remember: registering for one call does not automatically register you for another. You need to click each separately. Likewise, registering for the conference call mailing list doesn’t register you for a call; it just lets you know when an opportunity comes up. 

WOULD AN ADDITIONAL HEADS UP HELP?

Over four hundred readers have signed up for a conference call mailing list. About a week ahead of each call, I write to everyone on the list to remind them of what might make the call special and how to register. If you’d like to be added to the conference call list, just drop me a line.

Launch Alert

At the end of January, T. Rowe Price launched their first two global bond funds. The more interesting of the two might be T. Rowe Price Global High Income Bond Fund (RPIHX). The fund will seek high income, with the prospect of some capital appreciation. The plan is to invest in a global portfolio of corporate and government high yield bonds and in floating rate bank loans.  The portfolio sports a 5.86% dividend yield.

It’s interesting, primarily, because of the strength of its lead managers.  It will be managed by Michael Della Vedova and Mark Vaselkiv. Mr. Della Vedova runs Price’s European high-yield fund, which Morningstar UK rates as a four-star fund with above average returns and just average risk.  Before joining Price in 2009, he was a cofounder and partner of Four Quarter Capital, a credit hedge fund focusing on high-yield European corporate debt.  There’s a video interview with Mr. Della Vedova on Morningstar’s UK site. (Warning: the video begins playing automatically and somewhat loudly.) Mr. Vaselkiv manages Price’s first-rate high yield bond fund which is closed to new investors. He’s been running the fund since 1996 and has beaten 80% of his peers by doing what Price is famous for: consistent, disciplined performance, lots of singles and no attempts to goose returns by swinging for the fences. His caution might be especially helpful now if he’s right that we’re “in the late innings of an amazing cycle.” With European beginning to experiment with negative interest rates on its investment grade debt, carefully casting a wider net might well be in order.

The opening expense ratio is 0.85%. The minimum initial investment is $2,500, reduced to $1,000 for IRAs.

Funds in Registration

After months of decline, the number of new no-load funds in the pipeline, those in registration with the SEC for April launch, has rebounded a bit. There are at least 16 new funds on the way.  A couple make me just shake my head, though they certainly will have appeal to fans of Rube Goldberg’s work. There are also a couple niche funds – a luxury brands fund and an Asian sustainability one – that might have merit beyond their marketing value, though I’m dubious. That said, there are also a handful of intriguing possibilities:

American Century is launching a series of multi-manager alternative strategies funds.

Brown Advisory is launching a global leaders fund run by a former be head of Asian equities for HSBC.

Brown Capital Management is planning an international small cap fund run by the same team that manages their international large growth fund.

They’re all detailed on the Funds in Registration page.

Manager Changes

February was a month that saw a number of remarkable souls passing from this vale of tears. Irving Kahn, Benjamin Graham’s teaching assistant and Warren Buffett’s teacher, passed away at 109. All of his siblings also lived over 100 years. Jason Zweig published a nice remembrance of him, “Investor Irving Kahn, Disciple of Benjamin Graham, Dies at 109,” which you can read if you Google the title but which I can’t directly link to.  Leonard Nimoy, whose first autobiography was entitled I Am Not Spock (1975), died of chronic obstructive pulmonary disease at age 83. He had a global following, not least among mixed-race youth who found solace in the character Spock’s mixed heritage. Of immediate relevance to this column, Don Hodges, founder of the Hodges Funds, passed away in late January at age 80. He’d been a professional investor for 50 years and was actively managing several of the Hodges Funds until a few weeks before his death.

You can see all of the comings and goings on our Manager Changes page.

Updates

Bretton Fund (BRTNX) is a small, concentrated portfolio managed by Stephen Dodson. The fund launched in 2010 in an attempt to bring a Buffett-like approach to the world of funds. In thinking about his new firm and its discipline, he was struck by a paradox: almost all investment professionals worshipped Warren Buffett, but almost none attempted to invest like him. Stephen’s estimate is that there are “a ton” of concentrated long-term value hedge funds, but fewer than 20 mutual funds (Pinnacle Value PVFIX and The Cook and Bynum Fund COBYX, for example) that follow Buffett’s discipline: he invests in “a small number of good business he believes that he understands and that are trading at a significant discount to what they believe they’re worth.” Stephen seemed particularly struck by his interviews of managers who run successful, conventional equity funds: 50-100 stocks and a portfolio sensitive to the sector-weightings in some index.

I asked each of them, “How would you invest if it was only your money and you never had to report to outside shareholders but you needed to sort of protect and grow this capital at an attractive rate for the rest of your life, how would you invest. Would you invest in the same approach, 50-100 stocks across all sectors.” And they said, “absolutely not. I’d only invest in my 10-20 best ideas.” 

One element of Stephen’s discipline is that he only invests in companies and industries that he understands; that is, he invests within a self-defined “circle of competence.”

In February he moved to dramatically expand that circle by adding Raphael de Balmann as co-principal of the adviser and co-manager of BRTNX. Messrs. Dodson and de Balmann have known each other for a long time and talk regularly and he seems to have strengths complementary to Mr. Dodson’s. De Balmann has primarily been a private equity investor, where Dodson has been public equity. De Balmann is passionate about understanding the sources and sustainability of cash flows, Dodson is stronger on analyzing earnings. De Balmann understands a variety of industries, including industrials, which are beyond Dodson’s circle of competence.

Stephen anticipates a slight expansion of the number of portfolio holdings from the high teens to the low twenties, a fresh set of eyes finding value in places that he couldn’t and likely a broader set of industries. The underlying discipline remains unchanged.

We wish them both well.

Star gazing

Seafarer Overseas Growth & Income (SFGIX) celebrated its third anniversary on February 5^th. By mid-March it should receive its first star rating from Morningstar. With a risk conscious strategy and three year returns in the top 3% of its emerging markets peer group, we’re hopeful that the fund will gain some well-earned recognition from investors.

Guinness Atkinson Dividend Builder (GAINX) will pass its three-year mark at the end of March, with a star rating to follow by about five. The fund has returned 49% since inception, against 38% for its world-stock peers.

A resource for readers

Our colleague Charles Boccadoro is in lively and continuing conversation with a bunch of folks whose investing disciplines have a strongly quantitative bent. He offers the following alert about a new book from one of his favorite correspodents.

Official publication date is tomorrow, March 2.

Like his last two books, Shareholder Yield and Global Value, reviewed in last year’s May commentary, Meb Faber’s new book “Global Asset Allocation: A Survey of the World’s Top Asset Allocation Strategies” is a self-published ebook, available on Amazon for just $2.99.

On his blog, Mr. Faber states “my goal was to keep it short enough to read in one sitting, evidence-based with a basic summary that is practical and easily implementable.”

That description is true of all Meb’s books, including his first published by Wiley in 2009, The Ivy Portfolio. To celebrate he’s making downloads of Shareholder Yield and Global Value available for free.

We will review his new book next time we check-in on Cambria’s ETF performance.

Here appears to be its Table of Contents:

INTRODUCTION

CHAPTER 1 – A History of Stocks, Bonds, and Bills

CHAPTER 2 – The Benchmark Portfolio: 60/40

CHAPTER 3 – Asset Class Building Blocks

CHAPTER 4 – The Risk Parity and All Seasons Portfolios

CHAPTER 5 – The Permanent Portfolio

CHAPTER 6 – The Global Market Portfolio

CHAPTER 7 – The Rob Arnott Portfolio

CHAPTER 8 – The Marc Faber Portfolio

CHAPTER 9 – The Endowment Portfolio: Swensen, El-Erian, and Ivy

CHAPTER 10 – The Warren Buffett Portfolio

CHAPTER 11 – Comparison of the Strategies

CHAPTER 12 – Implementation (ETFs, Fees, Taxes, Advisors)

CHAPTER 13 – Summary

APPENDIX A – FAQs

Briefly Noted . . .

Vanguard, probably to Jack Bogle’s utter disgust, is making a pretty dramatic reduction in their exposure to US stocks and bonds. According an SEC filing, the firm’s retirement-date products and Life Strategy Funds will maintain their stock/bond balance but, over “the coming months,” the domestic/international balance with the stock and bond portfolios will swing.

For long-dated funds, those with target dates of 2040 or later, the US stock allocation will drop from 63% to 54% while international equities will rise from 27% to 36%. In shorter-date funds, there’s a 500 – 600 basis point reallocation from domestic to international. There’s a complementary hike in international body exposure, from 2% of long-dated portfolios up to 3% and uneven but substantial increases in all of the shorter-date funds as well.

SMALL WINS FOR INVESTORS

Okay, it might be stretching to call this a “win,” but you can now get into two one-star funds for a lot less money than before. Effective February 27, 2015, the minimum investment amount in the Class I Shares of both the CM Advisors Fund (CMAFX) and the CM Advisors Small Cap Value (CMOVX) was reduced from $250,000 to $2,500.

CLOSINGS (and related inconveniences)

None that we noticed.

OLD WINE, NEW BOTTLES

Around May 1, the $6 billion ClearBridge Equity Income Fund (SOPAX) becomes ClearBridge Dividend Strategy Fund. The strategy will be to invest in stocks and “other investments with similar economic characteristics that pay dividends or are expected to initiate their dividends over time.”

Effective May 1, 2015, European Equity Fund (VEEEX/VEECX) escapes Europe and equities. It gets renamed at the Global Strategic Income Fund and adds high-yield bonds to its list of investment options.

On April 30, Goldman Sachs U.S. Equity Fund (GAGVX) becomes Goldman Sachs Dynamic U.S. Equity Fund. The “dynamic” part is that the team that guided it to mediocre large cap performance will now guide it to … uh, dynamic all-cap performance.

Goldman Sachs Absolute Return Tracker Fund (GARTX) attempts to replicate the returns of a hedge fund index without, of course, investing in hedge funds. It’s not clear why you’d want to do that and the fund has been returning 1-3% annually. Effective April 30, the fund’s investment strategies will be broadened to allow them to invest in an even wider array of derivatives (e.g. master limited partnership indexes) in pursuit of their dubious goal.

Effective March 31, 2015, MFS Research Bond Fund will change to MFS® Total Return Bond Fund and MFS Bond Fund will change to MFS® Corporate Bond Fund.

OFF TO THE DUSTBIN OF HISTORY

Aberdeen Global Select Opportunities Fund was swallowed up by Aberdeen Global Equity Fund (GLLAX) on Friday, February 25, 2015. GLLAX is … performance-challenged.

As we predicted a couple months ago when the fund suddenly closed to new investors, Aegis High Yield Fund (AHYAX/AHYFX) is going the way of the wild goose. Its end will come on or before April 30, 2015.

Frontier RobecoSAM Global Equity Fund (FSGLX), a tiny institutional fund that was rarely worse than mediocre and occasionally a bit better, will be closed and liquidated on March 23, 2015.

Bad news for Chuck Jaffe. He won’t have the Giant 5 to kick around anymore. Giant 5 Total Investment System Fund received one of Jaffe’s “Lump of Coal” awards in 2014 for wasting time and money changing their ticker symbol from FIVEX to CASHX. Glancing at their returns, Jaffe suggested SUCKX as a better move. From here it starts to get a bit weird. The funds’ adviser changed its name from Willis Group to Index Asset Management, which somehow convinced them to spend more time and money changed the ticker on their other fund, Giant 5 Total Index System Fund, from INDEX to WILLX. So they decided to surrender a cool ticker that reflected their current name for a ticker that reminds them of the abandoned name of their firm. Uh-huh. At this point, cynics might suggest changing their URL from weareindex.com to the more descriptively accurate wearecharging2.21%andchurningtheportfolio.com. Doubtless sensing Chuck beginning to stock up on the slings and arrows of outrageous fortune, the adviser sprang into action on February 27 … and announced the liquidation of the funds, effective March 30^th.

The $24 million Hatteras PE Intelligence Fund (HPEIX) will liquidate on March 13, 2015. The plan was to produce the returns of a Private Equity index without investing in private equity. The fund launched in November 2013, has neither made nor lost any meaningful money, so the adviser pulled the plug after 15 months.

JPMorgan Alternative Strategies Fund (JASAX), a fund mostly comprised of other Morgan funds, will liquidate on March 23, 2015.

Martin Focused Value Fund (MFVRX), a dogged little fund that held nine stocks and 70% cash, has decided that it’s not economically viable and that’s unlikely to change. As a result, it will cease operations by the end of March.

Old Westbury Real Return Fund (OWRRX), which has about a half billion in assets, is being liquidated in mid-March 2015. It was perfectly respectable as commodity funds go. Sadly, the fund’s performance charts had a lot of segments that looked like

and like

In consequence of which it finished down 9% since inception and down 24% over the past five years.

Parnassus Small Cap Fund (PARSX) is being merged into the smaller but far stronger Parnassus Mid Cap (PARMX) at the end of April, 2015. PARMX’s prospectus will be tweaked to make it SMID-ier.

The Board of Trustees of PIMCO approved a plan of liquidation for the PIMCO Convertible Fund (PACNX) which will occur on May 1, 2015. The fund has nearly a quarter billion in assets, so presumably the Board was discouraged by the fund’s relatively week three year record: 11% annually, which trailed about two-thirds of the funds in the tiny “convertibles” group.

The Board of Rainier Balanced Fund (RIMBX/RAIBX) has approved, the liquidation and termination of the fund. The liquidation is expected to occur as of the close of business on March 27, 2015. It’s been around, unobjectionable and unremarkable, since the mid-90s but has under $20 million in assets.

S1 (SONEX/SONRX), the Simple Alternatives fund, will liquidate in mid-March. We were never actually clear about what was “simple” about the fund: it was a high expense, high turnover, high manager turnover operation.

Salient Alternative Strategies Master Fund liquidated in mid-February, around the time they bought Forward Funds to get access to more alternative strategies.

In examples of an increasingly common move, Touchstone decided to liquidated both Touchstone Institutional Money Market Fund and Touchstone Money Market Fund, proceeds of the move will be rolled over into a Dreyfus money market.

In a sort of “snatching Victory from the jaws of defeat, then chucking some other Victory into the jaws” development, shareholders have learned that Victory Special Value (SSVSX) is not going to be merged out of existence into Victory Dividend Growth. Instead, Special Value has reopened to new investment while Dividend Growth has closed and replaced it on Death Row. Liquidation of Dividend Growth is slated for April 24, 2015. In the meantime, Victory Special Value got a whole new management team. The new managers don’t have a great record, but it does beat their predecessors’, so that’s a small win.

Wasatch Heritage Growth Fund (WAHGX) has closed to new investors and will be liquidated at the end of April, 2015. The initial plan was to invest in firms that had grown too large to remain in Wasatch’s many small cap portfolios; those “graduates” were the sort of the “heritage” of the title. The strategy generated neither compelling results nor investor interest.

In Closing . . .

The Observer celebrates its fourth anniversary on April 1^st. We’re delighted (and slightly surprised) at being here four years later; the average lifespan of a new website is generally measured in weeks. We’re delighted and humbled by the realization that nearly 30,000 folks peek in each month to see what we’re up to. We’re grateful, especially to the folks who continue to support the Observer, both financially and with an ongoing stream of suggestions, leads, questions and corrections. I’m always anxious about thanking folks for their contributions because I’m paranoid about forgetting anyone (if so, many apologies) and equally concerned about botching your names (a monthly goof). To the folks who use our Paypal link (Lee – I like the fact that your firm lists its professionals alphabetically rather than by hierarchy, Jeffrey who seems to have gotten entirely past Twitter and William, most recently), remember that you’ve got the option to say “hi”, too. It’s always good to hear from you. One project for us in the month ahead will be to systematize access for subscribers to our steadily-evolved premium site.

We’d been planning a party with party hats, festive noisemakers, a round of pin-the-tail-on-the-overrated-manager and a cake. Chip and Charles were way into it. 

Hmmm … apparently we might end up with something a bit more dignified instead. At the very least we’ll all be around the Morningstar conference in June and open to the prospect of a celebratory drink.

Spring impends. Keep a good thought and we’ll see you in a month!

Dear friends,

Investing by aphorism is a tricky business.

“Buy on the sound of cannons, sell on the sound of trumpets.” It’s widely attributed to “Baron Nathan Rothschild (1810).” Of course, he wasn’t a baron in 1810. There’s no evidence he ever said it. 1810 wouldn’t have been a sensible year for the statement even if he had said it. And the earliest attributions are in anti-Semitic French newspapers advancing the claim that some Rothschild or another triggered a financial panic for family gain.

And then there’s weiji. It’s one of the few things that Condoleeza Rice and Al Gore agree upon. Here’s Rice after a trip to the Middle East:

I don’t read Chinese but I’m told that the Chinese character for crisis is “weiji”, which means both danger and opportunity. And I think that states it very well.

And Gore, accepting the Nobel Prize:

In the Kanji characters used in both Chinese and Japanese, “crisis” is written with two symbols, the first meaning “danger,” the second “opportunity.”

John Kennedy, Richard Nixon, business school deans, the authors of The Encyclopedia of Public Relations, Flood Planning: The Politics of Water Security, On Philosophy: Notes on A Crisis, Foundations of Interpersonal Practice in Social Work, Strategy: A Step by Step Approach to the Development and Presentation of World Class Business Strategy (apparently one unencumbered by careful fact-checking), Leading at the Edge (the author even asked “a Chinese student” about it, the student smiled and nodded so he knows it’s true). One sage went so far as to opine “the danger in crisis situations is that we’ll lose the opportunity in it.”

Weiji, Will Robinson! Weiji!

Except, of course, that it’s not true. Chinese philologists keep pointing out that “ji” is being misinterpreted. At base, “ji” can mean a lot of things. Since at least the third century CE, “weiji” meant something like “latent danger.” In the early 20^th century it was applied to economic crises but without the optimistic “hey, let’s buy the dips!” sense now given it. As Victor Mair, a professor of Chinese language and literature at the University of Pennsylvania put it:

Those who purvey the doctrine that the Chinese word for “crisis” is composed of elements meaning “danger” and “opportunity” are engaging in a type of muddled thinking that is a danger to society, for it lulls people into welcoming crises as unstable situations from which they can benefit. Adopting a feel-good attitude toward adversity may not be the most rational, realistic approach to its solution.

Maybe in our March issue, I’ll expound on the origin of the phrase “furniture polish.” Did you know that it’s an Olde English term that comes from the French. It reflects the fact that the best furniture in the world was made around the city of Krakow, Poland so if you had furniture Polish, you had the most beautiful anywhere.

The good folks at Leuthold foresee a market decline of 30%, likely some time in 2015 or 2016 and likely sooner rather than later. Professor Studzinski suspects that they’re starry-eyed optimists. Yale’s Crash Confidence Index is drifting down, suggesting that investors think there will be a crash, a perception that moves contrary to the actual likelihood of a crash, except when it doesn’t. AAII’s Investor Confidence Index rose right along with market volatility. American and Chinese investors became more confident, Europeans became less confident and US portfolios became more risk-averse.

Meanwhile oil prices are falling, Russia is invading, countries are unraveling, storms are raging, Mitt’s withdrawing … egad! What, you might ask, am I doing about it? Glad you asked.

Snowball and the power of positive stupidity

My portfolio is designed to allow me to be stupid. It’s not that I try to be stupid but, being human, the temptation is almost irresistible at times. If you’re really smart, you can achieve your goals by taking a modest amount and investing it brilliantly. My family suggested that I ought not be banking on that route, so I took the road less traveled. Twenty years ago, I used free software available from Fidelity, Price and Vanguard, my college’s retirement plan providers, to determine how much I needed to invest in order to fund my retirement. I used conservative assumptions (long-term inflation near 4% and expected portfolio returns below 8% nominal), averaged the three recommendations and ended up socking away a lot each month. 

Downside (?): I needed to be careful with our money – my car tends to be a fuel-efficient used Honda or Toyota that I drive for a quarter million miles or so, I tend to spend less on new clothes each year than on good coffee (if you’re from Pittsburgh, you know Mr. Prestogeorge’s coffee; if you’re not, the Steeler Nation is sad on your behalf), our home is solid and well-insulated but modest and our vacations often involve driving to see family or other natural wonders. 

Upside: well, I’ve never become obsessed about the importance of owning stuff. And the more sophisticated software now available suggests that, given my current rate of investment, I only need to earn portfolio returns well under 6% (nominal) in order to reach my long-term goals. 

And I’m fairly confident that I’ll be able to maintain that pace, even if I am repeatedly stupid along the way. 

It’s a nice feeling. 

A quick review of my fund portfolio’s 2015 performance would lead you to believe that I managed to be extra stupid last year with a portfolio return of just over 3%. If my portfolio’s goal was to maximize one-year returns, you’d be exactly right. But it isn’t, so you aren’t. Here’s a quick review of what I was thinking when I constructed my portfolio, what’s in it and what might be next.

The Plan: Follow the evidence. My non-retirement portfolio is about half equity and half income because the research says that more equity simply doesn’t pay off in a portfolio with an intermediate time horizon. The equity portion is about half US and half international and is overweighted toward small, value, dividend and quality. The income portion combines some low-cost “normal” stuff with an awful lot of abnormal investments in emerging markets, convertibles, and called high-yield bonds. On whole the funds have high active share, long-tenured managers, are risk conscious, lower turnover and relatively low expense. In most instances, I’ve chosen funds that give the managers some freedom to move assets around.

Pure equity:

Artisan Small Cap Value (ARTVX, closed). This is, by far, my oldest holding. I originally bought Artisan Small Cap (ARTSX) in late 1995 and, being a value kinda guy, traded those shares in 1997 for shares in the newly-launched ARTVX. It made a lot of money for me in the succeeding decade but over the past five years, its performance has sucked. Lipper has it ranked as 203 out of 203 small value funds over the past five years, though it has returned about 7% annually in the period. Not entirely sure what’s up. A focus on steady-eddy companies hasn’t helped, especially since it led them into a bunch of energy stocks. A couple positions, held too long, have blown up. The fact that they’re in a leadership transition, with Scott Satterwhite retiring in October 2016, adds to the noise. I’ll continue to watch and try to learn more, but this is getting a bit troubling.

Artisan International Value (ARTKX, closed). I acquired this the same way I acquired ARTVX, in trade. I bought Artisan International (ARTIX) shortly after its launch, then moved my investment here because of its value focus. Good move, by the way. It’s performed brilliantly with a compact, benchmark-free portfolio of high quality stocks. I’m a bit concerned about the fund’s size, north of $11 billion, and the fact that it’s now dominated by large cap names. That said, no one has been doing a better job.

Grandeur Peak Global Reach (GPROX, closed). When it comes to global small and microcap investing, I’m not sure that there’s anyone better or more disciplined than Grandeur Peak. This is intended to be their flagship fund, with all of the other Grandeur Peak funds representing just specific slices of its portfolio. Performance across the group, extending back to the days when the managers ran Wasatch’s international funds, has been spectacular. All of the existing funds are closed though three more are in the pipeline: US Opportunities, Global Value, and Global Microcap.

Pure income

RiverPark Short Term High Yield (RPHYX, closed). The best and most misunderstood fund in the Morningstar universe. Merely noting that it has the highest Sharpe ratio of any fund doesn’t go far enough. Its Sharpe ratio, a measure of risk-adjusted returns where higher is better, since inception is 6.81. The second-best fund is 2.4. Morningstar insists on comparing it to its high yield bond group, with which it shares neither strategy nor portfolio. It’s a conservative cash management account that has performed brilliantly. The chart is RPHYX against the HY bond peer group.

RiverPark Strategic Income (RSIVX). At base, this is the next step out from RPHYX on the risk-return spectrum. Manager David Sherman thinks he can about double the returns posted by RPHYX without a significant risk of permanent loss of capital. He was well ahead of that pace until mid-2014 when he encountered a sort of rocky plateau. In the second half of 2014, the fund dropped 0.45% which is far less than any plausible peer group. Mr. Sherman loathes the prospect of “permanent impairment of capital” but “as long as the business model remains acceptable and is being pursued consistently and successfully, we will tolerate mark-to-market losses.” He’s quite willing to hold bonds to maturity or to call, which reduces market volatility to annoying noise in the background. Here’s the chart of Strategic Income (blue) against its older sibling.

Matthews Strategic Income (MAINX). I think this is a really good fund. Can’t quite be sure since it’s essentially the only Asian income fund on the market. There’s one Asian bond fund and a couple ETFs, but they’re not quite comparable and don’t perform nearly as well. The manager’s argument struck me as persuasive: Asian fixed-income offers some interesting attributes, it’s systematically underrepresented in indexes and underfollowed by investors (the fund has only $67 million in assets despite a strong record). Matthews has the industry’s deepest core of Asia analysts, Ms. Kong struck me as exceptionally bright and talented, and the opportunity set seemed worth pursuing.

Impure funds

FPA Crescent (FPACX). I worry, sometimes, that the investing world’s largest “free-range chicken” (his term) might be getting fat. Steve Romick has one of the longest and most successful records of any manager but he’s currently toting a $20 billion portfolio which is 40% cash. The cash stash is consistent with FPA’s “absolute value” orientation and reflects their ongoing concerns about market valuations which have grown detached from fundamentals. It’s my largest fund holding and is likely to remain so.

T. Rowe Price Spectrum Income (RPSIX). This is a fund of TRP funds, including one equity fund. It’s been my core fixed income holding since it’s broadly diversified, low cost and sensible. Over time, it tends to make about 6% a year with noticeably less volatility than its peers. It’s had two down years in a quarter century, losing about 2% in 1994 and 9% in 2008. I’m happy.

Seafarer Overseas Growth & Income (SFGIX). I believe that Andrew Foster is an exceptional manager and I was excited when he moved from a large fund with a narrow focus to launch a new fund with a broader one. Seafarer is a risk-conscious emerging markets fund with a strong presence in Asia. It’s my second largest holding and I’ve resolved to move my account from Scottrade to invest directly with Seafarer, to take advantage of their offer of allowing $100 purchase minimums on accounts with an automatic investing plan. Given the volatility of the emerging markets, the discipline to invest automatically rather than when I’m feeling brave seems especially important.

Matthews Asian Growth & Income (MACSX). I first purchased MACSX when Andrew Foster was managing this fund to the best risk-adjusted returns in its universe. It mixes common stock with preferred shares and convertibles. It had strong absolute returns, though poor relative ones, in rising markets and was the best in class in falling markets. It’s done well in the years since Andrew’s departure and is about the most sensible option around for broad Asia exposure.

Northern Global Tactical Asset Allocation (BBALX). Formerly a simple 60/40 balanced fund, BBALX uses low-cost ETFs and Northern funds to execute their investment planning committee’s firm-wide recommendations. On whole, Northern’s mission is to help very rich people stay very rich so their strategies tend to be fairly conservative and tilted toward quality, dividends, value and so on. They’ve got a lot less in the US and a lot more emerging markets exposure than their peers, a lot smaller market cap, higher dividends, lower p/e. It all makes sense. Should I be worried that they underperform a peer group that’s substantially overweighted in US, large cap and growth? Not yet.

Aston River Road Long/Short (ARLSX). Probably my most controversial holding since its performance in the past year has sucked. That being said, I’m not all that anxious about it. By the managers’ report, their short positions – about a third of the portfolio – are working. It’s their long book that’s tripping them up. Their long portfolio is quite different from their peers: they’ve got much larger small- and mid-cap positions, their median market cap is less than half of their peers’ and they’ve got rather more direct international exposure (10%, mostly Europe, versus 4%). In 2014, none of those were richly rewarding places to be. Small caps made about 3% and Europe lost nearly 8%. Here’s Mr. Moran’s take on the former:

Small-cap stocks significantly under-performed this quarter and have year-to-date as well. If the market is headed for a correction or something worse, these stocks will likely continue to lead the way. We, however, added substantially to the portfolio’s small-cap long positions during the quarter, more than doubling their weight as we are comfortable taking this risk, looking different, and are prepared to acknowledge when we are wrong. We have historically had success in this segment of the market, and we think small-cap valuations in the Fund’s investable universe are as attractive as they have been in more than two years.

It’s certainly possible that the fund is a good idea gone bad. I don’t really know yet.

Since my average holding period is something like “forever” – I first invested in eight of my 12 funds shortly after their launch – it’s unlikely that I’ll be selling anyone unless I need cash. I might eventually move the Northern GTAA money, though I have no target in mind. I suspect Charles would push for me to consider making my first ETF investment into ValueShares US Quantitative Value (QVAL). And if I conclude that there’s been some structural impairment to Artisan Small Cap Value, I might exit around the time that Mr. Satterwhite does. Finally, if the markets continue to become unhinged, I might consider a position in RiverPark Structural Alpha (RSAFX), a tiny fund with a strong pedigree that’s designed to eat volatility.

My retirement portfolio, in contrast, is a bit of a mess. I helped redesign my college’s retirement plan to simplify and automate it. That’s been a major boost for most employees (participation has grown from 23% to 93%) but it’s played hob with my own portfolio since we eliminated the Fidelity and T. Rowe funds in favor of a greater emphasis on index funds, funds of index funds and a select few active ones. My allocation there is more aggressive (80/20 stocks) but has the same tilt toward small, value, and international. I need to find time to figure out how best to manage the two frozen allocations in light of the more limited options in the new plan. Nuts.

For now: continue to do the automatic investment thing, undertake a modest bit of rebalancing out of international equities, and renew my focus on really big questions like whether to paint the ugly “I’m so ‘70s” brick fireplace in my living room.

Strange doings, currency wars, and unintended consequences

By Edward A. Studzinski

Imagine the Creator as a low comedian, and at once the world becomes explicable.     H.L. Mencken

January 2015 has perhaps not begun in the fashion for which most investors would have hoped. Instead of continuing on from last year where things seemed to be in their proper order, we have started with recurrent volatility, political incompetence, an increase in terrorist incidents around the world, currency instability in both the developed and developing markets, and more than a faint scent of deflation creeping into the nostrils and minds of central bankers. Through the end of January, the Dow, the S&P 500, and the NASDAQ are all in negative territory. Consumers, rather than following the lead of the mass market media who were telling them that the fall in energy prices presented a tax cut for them to spend, have elected to save for a rainy day. Perhaps the most unappreciated or underappreciated set of changed circumstances for most investors to deal with is the rising specter of currency wars.

So, what is a currency war? With thanks to author Adam Chan, who has written thoughtfully on this subject in the January 29, 2015 issue of The Institutional Strategist, a currency war is usually thought of as an effort by a country’s central bank to deliberately devalue their currency in an effort to stimulate exports. The most recent example of this is the announcement a few weeks ago by the European Central Bank that they would be undertaking another quantitative easing or QE in shorthand. More than a trillion Euros will be spent over the next eighteen months repurchasing government bonds. This has had the immediate effect of producing negative yields on the market prices of most European government bonds in the stronger economies there such as Germany. Add to this the compound effect of another sixty billion Yen a month of QE by the Bank of Japan going forward. Against the U.S. dollar, those two currencies have depreciated respectively 20% and 15% over the last year.

We have started to see the effects of this in earnings season this quarter, where multinational U.S. companies that report in dollars but earn various streams of revenues overseas, have started to miss estimates and guide towards lower numbers going forward. The strong dollar makes their goods and services less competitive around the world. But it ignores another dynamic going on, seen in the collapse of energy and other commodity prices, as well as loss of competitiveness in manufacturing.

Countries such as the BRIC emerging market countries (Brazil, Russia, India, China) but especially China and Russia, resent a situation where the developed countries of the world print money to sustain their economies (and keep the politicians in office) by purchasing hard assets such as oil, minerals, and manufactured goods for essentially nothing. For them, it makes no sense to allow this to continue.

The end result is the presence in the room of another six hundred pound gorilla, gold. I am not talking about gold as a commodity, but rather gold as a currency. Note that over the last year, the price of gold has stayed fairly flat while a well-known commodity index, the CRB, is down more than 25% in value. Reportedly, former Federal Reserve Chairman Alan Greenspan supported this view last November when he said, “Gold is still a currency.” He went on to refer to it as the “premier currency.” In that vein, for a multitude of reasons, we are seeing some rather interesting actions taking place around the world recently by central banks, most of which have not attracted a great deal of notice in this country.

In January of this year, the Bundesbank announced that in 2014 it repatriated 120 tons of its gold reserves back to Germany, 85 tons from New York and the balance from Paris. Of more interest, IN TOTAL SECRECY, the central bank of the Netherlands repatriated 122 tons of its gold from the New York Federal Reserve, which it announced in November of 2014. The Dutch rationale was explained as part of a currency “Plan B” in the event the Netherlands left the Euro. But it still begs the question as to why two of the strongest economies in Europe would no longer want to leave some of their gold reserves on deposit/storage in New York. And why are Austria and Belgium now considering a similar repatriation of their gold assets from New York?

At the same time, we have seen Russia, with its currency under attack and not by its own doing or desire as a result of economic sanctions. Putin apparently believes this is a deliberate effort to stimulate unrest in Russia and force him from power (just because you are paranoid, it doesn’t mean you are wrong). As a counter to that, you see the Russian central bank being the largest central bank purchaser of gold, 55 tons, in Q314. Why? He is interested in breaking the petrodollar standard in which the U.S. currency is used as the currency to denominate energy purchases and trade. Russia converts its proceeds from the sale of oil into gold. They end up holding gold rather than U.S. Treasuries. If he is successful, there will be considerably less incentive for countries to own U.S. government securities and for the dollar to be the currency of global trade. Note that Russia has a positive balance of trade with most of its neighbors and trading partners.

Now, my point in writing about this is not to engender a discussion about the wisdom or lack thereof in investing in gold, in one fashion or another. The students of history among you will remember that at various points in time it has been illegal for U.S. citizens to own gold, and that on occasion a fixed price has been set when the U.S. government has called it in. My purpose is to point out that there have been some very strange doings in asset class prices this year and last. For most readers of this publication, since their liabilities are denominated in U.S. dollars, they should focus on trying to pay those liabilities without exposing themselves to the vagaries of currency fluctuations, which even professionals have trouble getting right. This is the announced reason, and a good one, as to why the Tweedy, Browne Value Fund and Global Value Fund hedge their investments in foreign securities back into U.S. dollars. It is also why the Wisdom Tree ETF’s which are hedged products have been so successful in attracting assets. What it means is you are going to have to pay considerably more attention this year to a fund’s prospectus and its discussion of hedging policies, especially if you invest in international and/or emerging market mutual funds, both equity and fixed income.

My final thoughts have to do with unintended consequences, diversification, and investment goals and objectives. The last one is most important, but especially this year. Know yourself as an investor! Look at the maximum drawdown numbers my colleague Charles puts out in his quantitative work on fund performance. Know what you can tolerate emotionally in terms of seeing a market value decline in the value of your investment, and what your time horizon is for needing to sell those assets. Warren Buffett used to speak about evaluating investments with the thought as to whether you would still be comfortable with the investment, reflecting ownership in a business, if the stock market were to close for a couple of years. I would argue that fund investments should be evaluated in similar fashion. Christopher Browne of Tweedy, Browne suggested that you should pay attention to the portfolio manager’s investment style and his or her record in the context of that style. Focus on whose record it is that you are looking at in a fund. Looking at Fidelity Magellan’s record after Peter Lynch left the fund was irrelevant, as the successor manager (or managers as is often the case) had a different investment management style. THERE IS A REASON WHY MORNINGSTAR HAS CHANGED THEIR METHODOLOGY FROM FOLLOWING AND EVALUATING FUNDS TO FOLLOWING AND EVALUATING MANAGERS.

Diversification is another key issue to consider. Outstanding Investor Digest, in Volume XV, Number 7, published a lecture and Q&A with Philip Fisher that he gave at Stanford Business School. If you don’t know who Philip Fisher was, you owe it to yourself to read some of his work. Fisher believed strongly that you had achieved most of the benefits of risk reduction from diversification with a portfolio of from seven to ten stocks. After that, the benefits became marginal. The quote worth remembering, “The last thing I want is a lot of good stocks. I want a very few outstanding ones.” I think the same discipline should apply to mutual fund portfolios. You are not building an investment ark, where you need two of everything.

Finally, I do expect this to be a year of unintended consequences, both for institutional and individual investors. It is a year (but the same applies every year) when predominant in your mind should not be, “How much money can I make with this investment?” which is often tied to bragging rights at having done better than your brother-in-law. The focus should be, “How much money could I lose?” And my friend Bruce would ask if you could stand the real loss, and what impact it might have on your standard of living? In 2007 and 2008, many people found that they had to change their standard of living and not for the better because their investments were too “risky” for them and they had inadequate cash reserves to carry them through several years rather than liquidate things in a depressed market.

Finally, I make two suggestions. One, the 2010 documentary on the financial crisis by Charles Ferguson entitled “Inside Job” is worth seeing and if you can’t find it, the interview of Mr. Ferguson by Charlie Rose, which is to be found on line, is quite good. As an aside, there are those who think many of the most important and least watched interviews in our society today are conducted by Mr. Rose, which I agree with and think says something about the state of our society. And for those who think history does not repeat itself, I would suggest reading volume I, With Fire and Sword of the great trilogy of Henryk Sienkiewicz about the Cossack wars of the Sixteenth Century set in present day Ukraine. I think of Sienkiewicz as the Walter Scott of Poland, and you have it all in these novels – revolution and uprising in Ukraine, conflict between the Polish-Lithuanian Commonwealth and Moscow – it’s all there, but many, many years ago. And much of what is happening today, has happened before.

I will leave you with a few sentences from the beginning pages of that novel.

It took an experienced ear to tell the difference between the ordinary baying of the wolves and the howl of vampires. Sometimes entire regiments of tormented souls were seen to drift across the moonlit Steppe so that sentries sounded the alarm and garrisons stood to arms. But such ghostly armies were seen only before a great war.

Genius, succession and transition at Third Avenue

The mutual fund industry is in the midst of a painful transition. As long ago as the 1970s, Charles Ellis recognized that the traditional formula could no longer work. That formula was simple:

1. Read Dodd and Graham
2. Apply Dodd and Graham
3. Crush the competition
4. Watch the billions flow in.

Ellis’s argument is that Step 3 worked only if you were talented and your competitors were not. While that might have described the investing world in the 1930s or even the 1950s, by the 1970s the investment industry was populated by smart, well-trained, highly motivated investors and the prospect of beating them consistently became as illusory as the prospect of winning four Super Bowls in six years now is. (With all due respect to the wannabees in Dallas and New England, each of which registered three wins in a four year period.)

The day of reckoning was delayed by two decades of a roaring stock market. From 1980 – 1999, the S&P 500 posted exactly two losing years and each down year was followed by eight or nine winning ones. Investors, giddy at the prospect of 100% and 150% and 250% annual reports, catapulted money in the direction of folks like Alberto Vilar and Garrett Van Wagoner. As the acerbic hedge fund manager Jim Rogers said, “It is remarkable how many people mistake a bull market for brains.”

That doesn’t deny the existence of folks with brains. They exist in droves. And a handful – Charles Royce and Marty Whitman among them – had “brains” to the point of “brilliance” and had staying power.

For better and worse, Step 4 became difficult 15 years ago and almost a joke in the past decade. While a handful of funds – from Michael C. Aronstein’s Mainstay Marketfield (MFLDX) and The Jeffrey’s DoubleLine complex – managed to sop up tens of billions, flows into actively-managed fund have slowed to a trickle. In 2014, for example, Morningstar reports that actively-managed funds saw $90 billion in outflows and passive funds had $156 billion in inflows.

The past five years have not been easy ones for the folks at Third Avenue funds. It’s a firm with that earned an almost-legendary reputation for independence and success. Our image of them and their image of themselves might be summarized by the performance of the flagship Third Avenue Value Fund (TAVFX) through 2007.

The Value Fund (blue) not only returned more than twice what their global equity peers made, but also essential brushed aside the market collapse at the end of the 1990s bubble and the stagnation of “the lost decade.” Investors rewarded the fund by entrusting it with billions of dollars in assets; the fund held over $11 billion at its peak.

But it’s also a firm that struggled since the onset of the market crisis in late 2007. Four of the firm’s funds have posted mediocre returns – not awful, but generally below-average – during the market cycle that began in early October 2007 and continues to play out. The funds’ five- and ten-year records, which capture parts of two distinct market cycles but the full span of neither, make them look distinctly worse. That’s been accompanied by the departure of both investment professionals and investor assets:

Third Avenue Value (TAVFX) saw the departure of Marty Whitman as the fund’s manager (2012) and of his heir presumptive Ian Lapey (2014), along with 80% of its assets. The fund trails about 80% of its global equity peers over the past five and ten years, which helps explain the decline. Performance has rallied in the past three years with the fund modestly outperforming the MSCI World index through the end of 2014, though investors have been slow to return.

Third Avenue Small Cap Value (TASCX) bid adieu to manager Curtis Jensen (2014) and analyst Charles Page, along with 80% of its assets. The fund trails 85% of its peers over the past five years and ten years.

Third Avenue International Value (TAVIX) lost founding manager Amit Wadhwaney (2014), his co-manager and two analysts. Trailing 96% of its peers for the past five and ten years, the fund’s AUM declined by 86% from its peak assets.

Third Avenue Focused Credit (TFCIX) saw its founding manager, Jeffrey Gary, depart (2010) to found a competing fund, Avenue Credit Strategies (ACSAX) though assets tripled from around the time of his departure to now. The fund’s returns over the past five years are almost dead-center in the high yield bond pack.

Only Third Avenue Real Estate Value (TAREX) has provided an island of stability. Lead manager Michael Winer has been with the fund since its founding, he’s got his co-managers Jason Wolfe (2004) and Ryan Dobratz (2006), a growing team, and a great (top 5% for the past 3, 5, 10 and 15 year periods) long-term record. Sadly, that wasn’t enough to shield the fund from a 67% drop in assets from 2006 to 2008. Happily, assets have tripled since then to about $3 billion.

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

Many outsiders noted not just the departure of long-tenured members of the Third Avenue community, but also the tendency to replace some those folks with outsiders, including Robert Rewey, Tim Bui and Victor Cunningham. The most prominent change was the arrival, in 2014, of Robert Rewey, the new head of the “value equity team.” Mr. Rewey formerly was a portfolio manager at Cramer Rosenthal McGlynn, LLC, where his funds’ performance trailed their benchmark (CRM Mid Cap Value CRMMX, CRM All Cap Value CRMEX and CRM Large Cap Opportunity CRMGX) or exceeded it modestly (CRM Small/Mid Cap Value CRMAX). Industry professionals we talked with spoke of “a rolling coup,” the intentional marginalization of Mr. Whitman within the firm he created and the influx of outsiders. Understandably, the folks at Third Avenue reject that characterization, noting that Mr. Whitman is still at TAM, that he attends every research meeting and was involved in every hiring decision.

Change in the industry is constant; the Observer reports on 500 or 600 management changes – some occasioned by a manager’s voluntary change of direction, others not – each year. The question for investors isn’t “had Third Avenue changed?” (It has, duh). The questions are “how has that change been handled and what might it mean for the future?” For answers, we turned to David Barse. Mr. Barse has served with Mr. Whitman for about a quarter century. He’s been president of Third Avenue, of MJ Whitman LLC and of its predecessor firm. He’s been with the operation continuously since the days that Mr. Whitman managed the Equity Strategies Fund in the 1980s.

From that talk and from the external record, I’ve reached three tentative conclusions:

1. Third Avenue Value Fund’s portfolio went beyond independent to become deeply, perhaps troublingly, idiosyncratic during the current cycle. Mr. Whitman saw Asia’s growth as a powerful driver to real estate values there and the onset of the SARS/avian flu panics as a driver of incredible discounts in the stocks’ prices. As a result, he bought a lot of exposure to Asian real estate and, as the markets there declined, bought more. At its peak, 65% of the fund’s portfolio was exposed to the Asian real estate market. Judging by their portfolios, neither the very successful Real Estate Value Fund nor the International Value Fund, the logical home of such investments, believed that it was prudent to maintain such exposure. Mr. Winer got his fund entirely out of the Asia real estate market and Mr. Wadhwaney’s portfolio contained none of the stocks held in TAVFX. Reportedly members of Mr. Whitman’s own team had substantial reservations about the extent of their investment and many shareholders, including large institutional investors, concluded that this was not at all what they’d signed up for. Third Avenue has now largely unwound those positions, and the Value Fund had 8.5% of its 2014 year-end portfolio in Hong Kong.
2. “Succession planning” always works better on paper than in the messy precinct of real life. Mr. Whitman and Mr. Barse knew, on the day that TAVFX launched, that they needed to think about life after Marty. Mr. Whitman was 67 when the fund launched and was setting out for a new adventure around the time that most professionals begin winding down. In consequence, Mr. Barse reports, “Succession planning was intrinsic to our business plans from the very beginning. This was a fantastic business to be in during the ‘90s and early ‘00s. We pursued a thoughtful expansion around our core discipline and Marty looked for talented people who shared his discipline and passion.” Mr. Whitman seems to have been more talented in investment management than in business management and none of this protégés, save Mr. Winer, showed evidence of the sort of genius that drove Mr. Whitman’s success. Finally, in his 89^th year of life, Mr. Whitman agreed to relinquish management of TAVFX with the understanding that Ian Lapey be given a fair chance as his successor. Mr. Lapey’s tenure as manager, both the five years which included time as co-manager with Mr. Whitman and the 18 months as lead manager, was not notably successful.
3. Third Avenue is trying to reorient its process from “the mercurial genius” model to “the healthy team” one. When Third Avenue was acquired in 2002 by the Affiliated Managed Group (AMG), the key investment professionals signed a ten year commitment to stay with the firm – symbolically important if legally non-binding – with a limited non-compete period thereafter. 2012 saw the expiration of those commitments and the conclusion, possibly mutual, that it was time for long-time managers like Curtis Jensen and Amit Wadhwaney to move on. The firm promoted co-managers with the expectation that they’d become eventual successors. Eventually they began a search for Mr. Whitman’s successor. After interviewing more than 50 candidates, they selected Mr. Rewey based on three factors: he understood the nature of a small, independent, performance-driven firm, he understood the importance of healthy management teams and he shared Mr. Whitman’s passion for value investing. “We did not,” Mr. Barse notes, “make this decision lightly.” The firm gave him a “team leader” designation with the expectation that he’d consciously pursue a more affirmative approach to cultivating and empowering his research and management associates.

It’s way too early to draw any conclusions about the effects of their changes on fund performance. Mr. Barse notes that they’ve been unwinding some of the Value Fund’s extreme concentration and have been working to reduce the exposure of illiquid positions in the International Value Fund. In the third quarter, Small Cap Value eliminated 16 positions while starting only three. At the same time, Mr. Barse reports growing internal optimism and comity. As with PIMCO, the folks at Third Avenue feel they’re emerging from a necessary but painful transition. I get a sense that folks at both institutions are looking forward to going to work and to the working together on the challenges they, along with all active managers and especially active boutique managers, face.

The questions remain: why should you care? What should you do? The process they’re pursuing makes sense; that is, team-managed funds have distinct advantages over star-managed ones. Academic research shows that returns are modestly lower (50 bps or so) but risk is significantly lower, turnover is lower and performance is more persistent. And Third Avenue remains fiercely independent: the active share for the Value Fund is 98.2% against the MSCI World index, Small Cap Value is 95% against the Russell 2000 Value index, and International Value is 97.6% against MSCI World ex US. Their portfolios are compact (38, 64 and 32 names, respectively) and turnover is low (20-40%).

For now, we’d counsel patience. Not all teams (half of all funds claim them) thrive. Not all good plans pan out. But Third Avenue has a lot to draw on and a lot to prove, we wish them well and will keep a hopeful eye on their evolution.

Where are they now?

We were curious about the current activities of Third Avenue’s former managers. We found them at the library, mostly. Ian Lapey’s LinkedIn profile now lists him as a “director, Stanley Furniture Company” but we were struck by the current activities of a number of his former co-workers:

Apparently time at Third Avenue instills a love of books, but might leave folks short of time to pursue them.

Would you give somebody $5.8 million a year to manage your money?

And would you be steamed if he lost $6.9 million for you in your first three months with him?

If so, you can sympathize with Bill Gross of Janus Funds. Mr. Gross has reportedly invested $700 million in Janus Global Unconstrained Bond (JUCIX), whose institutional shares carry a 0.83% expense ratio. So … (mumble, mumble, scribble) 0.0083 x 700,000,000 is … ummmm … he’s charging himself $5,810,000 for managing his personal fortune.

Oh, wait! That overstates the expenses a bit. The fund is down rather more than a percent (1.06% over three months, to be exact) so that means he’s no longer paying expenses on the $7,420,000 that’s no longer there. That’d be a $61,000 savings over the course of a year.

It calls to mind a universally misquoted passage from F. Scott Fitzgerald’s short story, “The Rich Boy” (1926)

Let me tell you about the very rich. They are different from you and me. They possess and enjoy early, and it does something to them, makes them soft, where we are hard, cynical where we are trustful, in a way that, unless you were born rich, it is very difficult to understand. 

Hemingway started the butchery by inventing a conversation between himself and Fitzgerald, in which Fitzgerald opines “the rich are different from you and me” and Hemingway sharply quips, “yes, they have more money.” It appears that Mary Collum, an Irish literary critic, in a different context, made the comment and Hemingway pasted it seamlessly into a version that made him seem the master.

P.S. please don’t tell the chairman of Janus. He’s the guy who didn’t know that all those millions flowing from a single brokerage office near Gross’s home into Gross’s fund was Gross’s money. I suspect it’s just better if we don’t burden him with unnecessary details.

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 and filtered as never before. For a 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.

Decision

• The court granted Vanguard‘s motion to dismiss shareholder litigation regarding two international funds’ holdings of gambling-related securities: “the court concludes that plaintiffs’ claims are time barred and alternatively that plaintiff has not established that the Board’s refusal to pursue plaintiffs’ demand for litigation violated Delaware’s business judgment rule.” Defendants included independent directors. (Hartsel v. Vanguard Group Inc.)

Settlement

• Morgan Keegan defendants settled long-running securities litigation, regarding bond funds’ investments in collateralized debt obligations, for $125 million. Defendants included independent directors. (In re Regions Morgan Keegan Open-End Mut. Fund Litig.; Landers v. Morgan Asset Mgmt., Inc.)

Briefs

• AXA Equitable filed a motion for summary judgment in fee litigation regarding twelve subadvised funds: “The combined investment management and administrative fees . . . for the funds were in all cases less than 1% of fund assets, and in some cases less than one half of 1%. These fees are in line with industry medians.” (Sanford v. AXA Equitable Funds Mgmt. Group, LLC; Sivolella v. AXA Equitable Life Ins. Co.)
• Plaintiffs filed their opposition to Genworth‘s motion for summary judgment in a fraud case regarding an investment expert’s purported role in the management of the BJ Group Services portfolios. (Goodman v. Genworth Fin. Wealth Mgmt., Inc.)
• Plaintiffs filed their opposition to SEI defendants’ motion to dismiss fee litigation regarding five subadvised funds: By delegating “nearly all of its investment management responsibilities to its army of sub-advisers” and “retaining substantial portions of the proceeds for itself,” SEI charges “excessive fees that violate section 36(b) of the Investment Company Act.” (Curd v. SEI Invs. Mgmt. Corp.)

Answer

• Having previously lost its motion to dismiss, Harbor filed an answer to excessive-fee litigation regarding its subadvised International and High-Yield Bond Funds. (Zehrer v. Harbor Capital Advisors, Inc.)

The Alt Perspective: Commentary and news from DailyAlts.

By Brian Haskin, editor of DailyAlts.com

Last month, I took a look at a few of the trends that took shape over the course of 2014 and noted how those trends might unfold in 2015. Now that the full year numbers are in, I thought I would do a 2014 recap of those numbers and see what they tell us.

Overall, assets in the Liquid Alternatives category, including both mutual funds and ETFs, were up 10.9% based on Morningstar’s classification, and 9.8% by DailyAlts classification. For ease of use, let’s call it 10%. Not too bad, but quite a bit short of the growth rates seen earlier in the year that hovered around 40%. But, compared to other major asset classes, alternative funds actually grew about 3 times faster. That’s quite good. The table below summarizes Morningstar’s asset flow data for mutual funds and ETFs combined:

The macro shifts in investor’s allocations were quite subtle, but nonetheless, distinct. Assets growth increased at about an equal rate for both stocks and bonds at a 3.4% and 3.7%, respectively, while commodities fell out of favor and lost 3.4% of their assets. However, with most investors underinvested in alternatives, the category grew at 10.9% and ended the year with $199 billion in assets, or 1.4% of the total pie. This is a far cry from institutional allocations of 15-20%, but many experts expect to see that 1.4% number increase to the likes of 10-15% over the coming decade.

Now, let’s take a look a more detailed look at the winning and loosing categories within the alternatives bucket. Here is a recap of 2014 flows, beginning assets, ending assets and growth rates for the various alternative strategies and alternative asset classes that we review:

The dominant category over the year was what Morningstar calls non-traditional bonds, which took in $22.8 billion. Going into 2014, investors held the view that interest rates would rise and, thus, they looked to reduce interest rate risk with the more flexible non-traditional bond funds. This all came to a halt as interest rates actually declined and flows to the category nearly dried up in the second half.

On a growth rate perspective, multi-alternative funds grew at a nearly 34% rate in 2014. These funds allocate to a wide range of alternative investment strategies, all in one fund. As a result, they serve as a one-stop shop for allocations to alternative investments. In fact, they serve the same purpose as fund-of-hedge funds serve for institutional investors but for a much lower cost! That’s great news for retail investors.

Finally, what is most striking is that the asset flows to alternatives all came in the first half of the year – $36.2 billion in the first half and only $622 million in the second half. Much of the second half slowdown can be attributed to two factors: A complete halt in flows to non-traditional bonds in reaction to falling rates, and billions in outflows from the MainStay Marketfield Fund (MFLDX), which had an abysmal 2014. The good news is that multi-alternative funds held steady from the first half to the second – a good sign that advisors and investors are maintaining a steady allocation to broad based alternative funds.

For 2015, expect to see multi-alternative funds continue to gather assets at a steady clip. The managed futures category, which grew at a healthy 19.5% in 2014 on the back of multiple difficult years, should see continued action as global markets and economies continue to diverge, thus creating a more favorable environment for these funds. Market neutral funds should also see more interest as they are designed to be immune to most of the market’s ups and downs.

Next month we will get back to looking at a few of the intriguing fund launches for early 2015. Until then, hold on for the ride and stay diversified!

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 two or three 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.

Osterweis Strategic Investment (OSTVX). I’m always intrigued by funds that Morningstar disapproves of. When you combine disapproval with misunderstanding, then add brilliant investment performance, it becomes irresistible for us to address the question “what’s going on here?” Short answer: good stuff.

Pear Tree Polaris Foreign Value Small Cap (QUSOX). There are three, and only three, great international small cap funds: Wasatch International Opportunities (WAIOX), Grandeur Peak International Opportunities (GPIOX) and Pear Tree Polaris Foreign Value Small Cap. Why have you only heard of the first two?

TrimTabs Float Shrink ETF (TTFS). This young ETF is off to an impressive start by following what it believes are the “best informed market participants.” This is a profile by our colleague Charles Boccadoro, which means it will be data-rich!

Touchstone Sands Capital Emerging Markets Growth (TSEMX). Sands Capital has a long, strong record in tracking down exceptional businesses and holding them close. TSEMX represents the latest extension of the strategy from domestic core to global and now to the emerging markets.

Conference Call Highlights: Bernie Horn, Polaris Global Value

About 40 of us gathered in mid-January to talk with Bernie Horn. It was an interesting talk, one which covered some of the same ground that he went over in private with Mr. Studzinski and me but one which also highlighted a couple new points.

Highlights:

• The genesis of the fund was in his days as a student at the Sloan School of Management at MIT at the end of the 1970s. It was a terrible decade for stocks in the US but he was struck by the number of foreign markets that had done just fine. One of his professors, Fischer Black, an economist whose work with Myron Scholes on options led to a Nobel Prize, generally preached the virtues of the efficient market theory but carries “a handy list of exceptions to EMT.” The most prominent exception was value investing. The emerging research on the investment effects of international diversification and on value as a loophole to EMT led him to launch his first global portfolios.
• His goal is, over the long-term, to generate 2% greater returns than the market with lower volatility.
• He began running separately-managed accounts but those became an administrative headache and so he talked his investors into joining a limited partnership which later morphed into Polaris Global Value Fund (PGVFX).
• The central discipline is calculating the “Polaris global cost of equity” (which he thinks separates him from most of his peers) and the desire to add stocks which have low correlations to his existing portfolio.
• The Polaris global cost of capital starts with the market’s likely rate of return, about 6% real. He believes that the top tier of managers can add about 2% or 200 bps of alpha. So far that implies an 8% cost of capital. He argues that fixed income markets are really pretty good at arbitraging currency risks, so he looks at the difference between the interest rates on a country’s bonds and its inflation rate to find the last component of his cost of capital. The example was Argentina: 24% interest rate minus a 10% inflation rate means that bond investors are demanding a 14% real return on their investments. The 14% reflects the bond market’s judgment of the cost of currency; that is, the bond market is pricing-in a really high risk of a peso devaluation. In order for an Argentine company to be attractive to him, he has to believe that it can overcome a 22% cost of capital (6 + 2 + 14). The hurdle rate for the same company domiciled elsewhere might be substantially lower.
• He does not hedge his currency exposure because the value calculation above implicitly accounts for currency risk. Currency fluctuations accounted for most of the fund’s negative returns last year, about 2/3s as of the third quarter. To be clear: the fund made money in 2014 and finished in the top third of its peer group. Two-thirds of the drag on the portfolio came from currency and one-third from stock selections.
• He tries to target new investments which are not correlated with his existing ones; that is, ones that do not all expose his investors to a single, potentially catastrophic risk factor. It might well be that the 100 more attractively priced stocks in the world are all financials but he would not overload the portfolio with them because that overexposes his investors to interest rate risks. Heightened vigilance here is one of the lessons of the 2007-08 crash.
• An interesting analogy on the correlation and portfolio construction piece: he tries to imagine what would happen if all of the companies in his portfolio merged to form a single conglomerate. In the conglomerate, he’d want different divisions whose cash generation was complementary: if interest rates rose, some divisions would generate less cash but some divisions would generate more and the net result would be that rising interest rates would not impair the conglomerates overall free cash flow. By way of example, he owns energy exploration and production companies whose earnings are down because of low oil prices but also refineries whose earnings are up.
• He instituted more vigorous stress tests for portfolio companies in the wake of the 2007-09 debacle. Twenty-five of 70 companies were “cyclically exposed”. Some of those firms had high fixed costs of operations which would not allow them to reduce costs as revenues fell. Five companies got “bumped off” as a result of that stress-testing.

A couple caller questions struck me as particularly helpful:

Ken Norman: are you the lead manager on both the foreign funds? BH: Yes, but … Here Bernie made a particularly interesting point, that he gives his associates a lot of leeway on the foreign funds both in stock selection and portfolio construction. That has two effects. (1) It represents a form of transition planning. His younger associates are learning how to operate the Polaris system using real money and making decisions that carry real consequences. He thinks that will make them much better stewards of Polaris Global Value when it becomes their turn to lead the fund. (2) It represents a recruitment and retention strategy. It lets bright young analysts know that they have a real role to play and a real future with the firm.

Shostakovich, a member of the Observer’s discussion board community and investor in PGVFX: you’ve used options to manage volatility. Is that still part of the plan? BH: Yes, but rarely now. Three reasons. (1) There are no options on many of the portfolio firms. (2) Post-08, options positions are becoming much more expensive, hence less rewarding. (3) Options trade away “excess” upside in exchange for limiting downside; he’s reluctant to surrender much alpha since some of the firms in the portfolio have really substantial potential.

Bottom line: You need to listen to the discussion of ways in which Polaris modified their risk management in the wake of 2008. Their performance in the market crash was bad. They know it. They were surprised by it. And they reacted thoughtfully and vigorously to it. In the absence of that one period, PGVFX has been about as good as it gets. If you believe that their responses were appropriate and sufficient, as I suspect they were, then this strikes me as a really strong offering.

We’ve gathered all of the information available on Polaris Global Value Fund, including an .mp3 of the conference call, into its new Featured Fund page. Feel free to visit!

Conference Call Upcoming: Matthew Page and Ian Mortimer, Guinness Atkinson Funds

We’d be delighted if you’d join us on Monday, February 9th, from noon to 1:00 p.m. Eastern, for a conversation with Matthew Page and Ian Mortimer, managers of Guinness Atkinson Global Innovators (IWIRX) and Guinness Atkinson Dividend Builder (GAINX). These are both small, concentrated, distinctive, disciplined funds with top-tier performance. IWIRX, with three distinctive strategies (starting as an index fund and transitioning to an active one), is particularly interesting. Most folks, upon hearing “global innovators” immediately think “high tech, info tech, biotech.” As it turns out, that’s not what the fund’s about. They’ve found a far steadier, broader and more successful understanding of the nature and role of innovation. Guinness reports:

Guinness Atkinson Global Innovators is the #1 Global Multi-Cap Growth Fund across all time periods (1,3,5,& 10 years) this quarter ending 12/31/14 based on Fund total returns.

They are ranked 1 of 500 for 1 year, 1 of 466 for 3 years, 1 of 399 for 5 years and 1 of 278 for 10 years in the Lipper category Global Multi-Cap Growth.

Goodness. And it still has under $200 million in assets.

Matt volunteered the following plan for their slice of the call:

I think we would like to address some of the following points in our soliloquy.

• Why are innovative companies an interesting investment opportunity?
• How do we define an innovative company?
• Aren’t innovative companies just expensive?
• Are the most innovative companies the best investments?

I suppose you could sum all this up in the phrase: Why Innovation Matters.

In deference to the fact that Matt and Ian are based in London, we have moved our call to noon Eastern. While they were willing to hang around the office until midnight, asking them to do it struck me as both rude and unproductive (how much would you really get from talking to two severely sleep-deprived Brits?).

Over the past several years, the Observer has hosted a series of hour-long conference calls between remarkable investors and, well, you. The format’s always the same: you register to join the call. We share an 800-number with you and send you an emailed reminder on the day of the call. We divide our hour together roughly in thirds: in the first third, our guest talks with us, generally about his or her fund’s genesis and strategy. In the middle third I pose a series of questions, often those raised by readers. Here’s the cool part, in the final third you get to ask questions directly to our guest; none of this wimpy-wompy “you submit a written question in advance, which a fund rep rewords and reads blankly.” Nay nay. It’s your question, you ask it. The reception has been uniformly positive.

HOW CAN YOU JOIN IN?

If you’d like to join in, just click on register and you’ll be taken to the Chorus Call site. In exchange for your name and email, you’ll receive a toll-free number, a PIN and instructions on joining the call. If you register, I’ll send you a reminder email on the morning of the call.

Remember: registering for one call does not automatically register you for another. You need to click each separately. Likewise, registering for the conference call mailing list doesn’t register you for a call; it just lets you know when an opportunity comes up. 

WOULD AN ADDITIONAL HEADS UP HELP?

Over two hundred readers have signed up for a conference call mailing list. About a week ahead of each call, I write to everyone on the list to remind them of what might make the call special and how to register. If you’d like to be added to the conference call list, just drop me a line.

Funds in Registration

There continued to be remarkably few funds in registration with the SEC this month and I’m beginning to wonder if there’s been a fundamental change in the entrepreneurial dynamic in the industry. There are nine new no-load retail funds in the pipeline, and they’ll launch by the end of April. The most interesting development might be DoubleLine’s move into commodities. (It’s certainly not Vanguard’s decision to launch a muni-bond index.) They’re all detailed on the Funds in Registration page.

Manager Changes

About 50 funds changed part or all of their management teams in the past month. An exceptional number of them were part of the continuing realignment at PIMCO. A curious and disappointing development was the departure of founding manager Michael Carne from the helm of Nuveen NWQ Flexible Income Fund (NWQAX). He built a very good, conservative allocation fund that holds stocks, bonds and convertibles. We wrote about the fund a while ago: three years after launch it received a five-star rating from Morningstar, celebration followed until a couple weeks later Morningstar reclassified it as a “convertibles” fund (it ain’t) and it plunged to one-star, appealed the ruling, was reclassified and regained its stars. It has been solid, disciplined and distinctive, which makes it odd that Nuveen chose to switch managers.

You can see all of the comings and goings on our Manager Changes  page.

Briefly Noted . . .

On December 1, 2014, Janus Capital Group announced the acquisition of VS Holdings, parent of VelocityShares, LLC. VelocityShares provides both index calculation and a suite of (creepy) leveraged, reverse leveraged, double leveraged and triple leveraged ETNs.

Fidelity Strategic Income (FSICX) is changing the shape of the barbell. They’ve long described their portfolio as a barbell with high yield and EM bonds on the one end and high quality US Treasuries and corporates on the other. They’re now shifting their “neutral allocation” to inch up high yield exposure (from 40 to 45%) and drop investment grade (from 30 to 25%).

GaveKal Knowledge Leaders Fund (GAVAX/GAVIX) is changing its name to GaveKal Knowledge Leaders Allocation Fund. The fund has always had an absolute value discipline which leads to it high cash allocations (currently 25%), exceedingly low risk … and Morningstar’s open disdain (it’s currently a one-star large growth fund). The changes will recognize the fact that it’s not designed to be a fully-invested equity fund. Their objective changes from “long-term capital appreciation” to “long-term capital appreciation with an emphasis on capital preservation” and “fixed income” gets added as a principal investment strategy.

SMALL WINS FOR INVESTORS

Palmer Square Absolute Return Fund (PSQAX/PSQIX) has agreed to a lower management fee and has reduced the cap on operating expenses by 46 basis points to 1.39% and 1.64% on its institutional and “A” shares.

Likewise, State Street/Ramius Managed Futures Strategy Fund (RTSRX) dropped its expense cap by 20 basis points, to 1.90% and 1.65% on its “A” and institutional shares.

CLOSINGS (and related inconveniences)

Effective as of the close of business on February 27, 2015, BNY Mellon Municipal Opportunities Fund (MOTIX) will be closed to new and existing investors. It’s a five-star fund with $1.1 billion in assets and five-year returns in the top 1% of its peer group.

Franklin Small Cap Growth Fund (FSGRX) closes to new investors on February 12, 2015. It’s a very solid fund that had a very ugly 2014, when it captured 240% of the market’s downside.

OLD WINE, NEW BOTTLES

Stand back! AllianceBernstein is making its move: all AllianceBernstein funds are being rebranded as AB funds.

OFF TO THE DUSTBIN OF HISTORY

Ascendant Natural Resources Fund (NRGAX) becomes only a fond memory as of February 27, 2015.

AdvisorShares International Gold and AdvisorShares Gartman Gold/British Pound ETFs liquidated at the end of January.

Cloumbia is cleaning out a bunch of funds at the beginning of March: Columbia Masters International Equity Portfolio, Absolute Return Emerging Markets Macro Fund,Absolute Return Enhanced Multi-Strategy Fund and Absolute Return Multi-Strategy Fund. Apparently having 10-11 share classes each wasn’t enough to save them. The Absolute Return funds shared the same management team and were generally mild-mannered under-performers with few investors.

Direxion/Wilshire Dynamic Fund (DXDWX) will be dynamically spinning in its grave come February 20^th.

Dynamic Total Return Fund (DYNAX/DYNIX) will totally return to the dust whence it came, effective February 20^th. Uhhh … if I’m reading the record correctly, the “A” shares never launched, the “I” shares launched in September 2014 and management pulled the plug after three months.

Loeb King Alternative Strategies (LKASX) and Loeb King Asia Fund (LKPAX) are being liquidated at the end of February because, well, Loeb King doesn’t want to run mutual funds anymore and they’re getting entirely out of the business. Both were pricey long/short funds with minimal assets and similar success.

New Path Tactical Allocation Fund became liquid on January 13, 2015.

In “consideration of the Fund’s asset size, strategic importance, current expenses and historical performance,” Turner’s board of directors has pulled the plug on Turner Titan Fund (TTLFX). It wasn’t a particularly bad fund, it’s just that Turner couldn’t get anyone (including one of the two managers and three of the four trustees) to invest in it. Graveside ceremonies will take place on March 13, 2015 in the family burial plot.

In Closing . . .

I try, each month, to conclude this essay with thanks to the folks who’ve supported us, by reading, by shopping through our Amazon link and by making direct, voluntary contributions. Part of the discipline of thanking folks is, oh, getting their names right. It’s not a long list, so you’d think I could manage it.

Not so much. So let me take a special moment to thank the good folks at Evergreen Asset Management in Washington for their ongoing support over the years. I misidentified them last month. And I’d also like to express intense jealousy over what appears to be the view out their front window since the current view out my front window is

With extra careful spelling, thanks go out to the guys at Gardey Financial of Saginaw (MI), who’ve been supporting us for quite a while but who don’t seem to have a particularly good view from their office, Callahan Capital Management out of Steamboat Springs (hi, Dan!), Mary Rose, our friends Dan S. and Andrew K. (I know it’s odd, but just knowing that there are folks who’ve stuck with us for years makes me feel good), Rick Forno (who wrote an embarrassingly nice letter to which we reply, “gee, oh garsh”), Ned L. (who, like me, has professed for a living), David F., the surprising and formidable Dan Wiener and the Hastingses. And, as always, to our two stalwart subscribers, Greg and Deb. If we had MFO coffee mugs, I’d sent them to you all!

Do consider joining us for the talk with Matt and Ian. We’ve got a raft of new fund profiles in the works, a recommendation to Morningstar to euthanize one of their long-running features, and some original research on fund trustees to share. In celebration of our fourth birthday this spring, we’ve got surprises a-brewin’ for you.

Until then, be safe!

Dear friends,

Welcome to the New Year!

And to an odd question: why is it a New Year?  That is, why January 1?  Most calendrical events correspond to something: cycles of the moon and stars, movement of the seasons, conclusions of wars or deaths of Great Men.

But why January 1?  It corresponds with nothing.

Here’s the short answer: your recent hangover and binge of bowl watching were occasioned by the scheming of some ancient Roman high priest, named a pontifex, and the political backlash to his overreach. Millennia ago, the Romans had a year that started sensibly enough, at the beginning of spring when new life began appearing. But the year also ended with the winter solstice and a year-end party that could stretch on for weeks.  December, remember? Translates as “the tenth month” out of ten.

So what happened in between the party and the planting? The usual stuff, I suppose: sex, lies, lies about sex, dinner and work.  What didn’t happen was politics: new governments, elected in the preceding year, weren’t in power until the new year began. And who decided exactly when the new year began? The pontifex. And how did the pontifex decide? Oracles, goat entrails and auguries, mostly. And also a keen sense of whether he liked the incoming government more than the outgoing one.  If the incoming government promised to be a pain in the butt, the new year might start a bit later.  If the new government was full of friends, the new year might start dramatically earlier. And if the existing government promised to be an annoyance in the meanwhile, the pontifex could declare an extended religious holiday during which time the government could not convene.

Eventually Julius Caesar and the astronomer Sosigenes got together to create a twelve month calendar whose new year commenced just after the hangover from the year-end parties faded. Oddly, the post-Roman Christian world didn’t adopt January 1 (pagan!) as the standard start date for another 1600 years.  Pope Gregory tried to fiat the new start day. Protestant countries flipped him off. In England and the early US, New Year’s Day was March 25^th, for example. Eventually the Brits standardized it in their domains in 1750.

Pagan priest examining the gall bladder of a goat. Ancient politics and hefty campaign contributions.

So, why exactly does it make sense for you to worry about how your portfolio did in 2014?  The end date of the year is arbitrary. It corresponds neither to the market’s annual flux nor to the longer seven(ish) year cycles in which the market rises and falls, much less your own financial needs and resources.

I got no clue. You?

I’d hoped to start the year by sharing My Profound Insights into the year ahead, so I wandered over to the Drawer of Clues. Empty. Nuts. The Change Jar of Market Changes? Nothing except some candy wrappers that my son stuffed in there. The white board listing The Four Funds You Must Own for 2015? Carried off by some red-suited vagrant who snuck in on Christmas Eve. (Also snagged my sugar cookies and my bottle of Drambuie. Hope he got pulled over for impaired flying.)

Oddly, I seem to be the only person who doesn’t know where things are going. The Financial Times reports that “the ‘divergence’ between the economies of the US and the rest of the world … features in almost every 2015 outlook from Wall Street strategists.” Yves Kuhn, an investment strategist from Luxembourg, notes the “the biggest consensus by any margin is to be long dollar, short euro … I have never seen such a consensus in the market.” Barron’s December survey of economists and strategists: “the consensus is ‘stick with the bull.’” James Paulsen, allowed that “There’s some really, really strong Wall Street consensus themes right now” in favor of US stocks, the dollar and low interest rates.  

Of course, the equally universal consensus in January 2014 was for rising interest rates, soaring energy prices and a crash in the bond market.

Me? I got no clue. Here’s the best I got:

• Check to see if you’ve got a plan. If not, get one. Fund an emergency account. Start investing in a conservative fund for medium time horizon needs. Work through a sensible asset allocation plan for the long-term. It’s not as hard as you want to imagine it is.
• Pursue it with some discipline. Find a sustainable monthly contribution. Set your investments on auto-pilot. Move any windfalls – whether it’s a bonus or a birthday check – into your savings. If you get a raise (I’m cheering for you!), increase your savings to match.
• Try not to screw yourself. Again. Don’t second guess yourself. Don’t obsess about your portfolio. Don’t buy because it’s been going up and you’re feeling left out. Don’t sell because your manager is being patient and you aren’t.
• Try not to let other people screw you. Really, if your fund has a letter after its name, figure out why. It means you’re paying extra. Be sure you know what exactly you’re paying and why.
• Make yourself useful, ‘cause then you’ll also make yourself happy. Get in the habit of reading again. Books. You know: the dead tree things. There’s pretty good research suggesting that the e-versions disrupt sleep and addle your mind. Try just 30 minutes in the evening with the electronics shut down, perusing Sarah Bakewell’s How to Live: A Life of Montaigne in One Question and Twenty Attempts at an Answer (2011) or Sherry Turkle’s Alone Together: Why We Expect More from Technology and Less from Each Other (2012). Read it with someone you enjoy hugging. Upgrade your news consumption: listen to the Marketplace podcasts or programs. Swear you’ll never again watch a “news program” that has a ticker constantly distracting you with unexplained 10 word snippets that pretend to explain global events. Set up a recurring contribution to your local food bank (I’ll give you the link to mine if you can’t find your own), shelter (animal or otherwise), or cause. They need you and you need to get outside yourself, to reconnect to something more important than YouTube, your portfolio or your gripes.

For those irked by sermonettes, my senior colleague has been reflecting on the question of what lessons we might draw from the markets of 2014 and offers a far more nuanced take in …

Reflections – 2014

By Edward Studzinski

The Mountains are High, and the Emperor is Far, Far Away

Chinese Aphorism

Year-end 2014 presents investors with a number of interesting conundrums. For a U.S. dollar investor, the domestic market, as represented by the S&P 500, provided a total return of 13.6%, at least for those invested in it by the proxy of Vanguard’s S&P 500 Index Fund Admiral Shares. Just before Christmas, John Authers of the Financial Times, in a piece entitled “Investment: Loser’s Game” argued that this year, with more than 90% of active managers on track to underperform their benchmarks, a tipping point may have finally been reached. The exodus of money from actively managed funds has accelerated. Vanguard is on track to take in close to $200B (yes, billion) into its passive funds this year.

And yet, I have to ask if it really matters. As I watch the postings on the Mutual Fund Observer’s discussion board, I suspect that achieving better than average investment performance is not what motivates many of our readers. Rather, there is a Walter Mittyesque desire to live vicariously through their portfolios. And every bon mot that Bill (take your pick, there are a multitude of them) or Steve or Michael or Bob drops in a print or televised interview is latched on to as a reaffirmation the genius and insight to invest early on with one of The Anointed. The disease exists in a related form at the Berkshire Hathaway Annual Circus in Omaha. Sooner or later, in an elevator or restaurant, you will hear a discussion of when that person started investing with Warren and how much money they have made. The reality is usually less that we would like to know or admit, as my friend Charles has pointed out in his recent piece about the long-term performance of his investments.

Rather than continuing to curse the darkness, let me light a few candles.

1. When are index funds appropriate for an investment program? For most of middle America, I am hard pressed to think of when they are not. They are particularly important for those individuals who are not immortal. You may have constructed a wonderful portfolio of actively-managed funds. Unfortunately, if you pass away suddenly, your spouse or family may find that they have neither the time nor the interest to devote to those investments that you did. And that assumes a static environment (no personnel changes) in the funds you are invested in, and that the advisors you have selected, if any, will follow your lead. But surprise – if you are dead, often not at the time of your choice, you cannot control things from the hereafter. Sit in trust investment committee meetings as I did for many years, and what you will most likely hear is – “I don’t care what old George wanted – that fund is not on our approved list and to protect ourselves, we should sell it, regardless of its performance or the tax consequences.”
2. How many mutual funds should one own? The interplay here is diversification and taxes. I suspect this year will prove a watershed event as investors find that their actively-managed fund has generated a huge tax bill for them while not beating its respective benchmark, or perhaps even losing money. The goal should probably be to own fewer than ten in a family unit, including individual and retirement investments. The right question to ask is why you invested in a particular fund to begin with. If you can’t remember, or the reason no longer applies, move on. In particular, retirement and 401(k) assets should be consolidated down to a smaller number of funds as you get older. Ideally they should be low cost, low expense funds. This can be done relatively easily by use of trustee to trustee transfers. And forget target date funds – they are a marketing gimmick, predicated on life expectancies not changing.
3. Don’t actively managed funds make sense in some circumstances? Yes, but you really have to do a lot of due diligence, probably more than most investment firms will let you do. Just reading the Morningstar write-ups will not cut it. I think there will be a time when actively-managed value funds will be the place to be, but we need a massive flush-out of the industry to occur first, followed by fear overcoming greed in the investing public. At that point we will probably get more regulation (oh for the days of Franklin Roosevelt putting Joe Kennedy in charge of the SEC, figuring that sometimes it makes sense to have the fox guarding the hen house).
4. Passive funds are attractive because of low expenses, and the fact that you don’t need to worry about managers departing or becoming ill. What should one look for in actively-managed funds? The simple answer is redundancy. Dodge and Cox is an ideal example, with all of their funds managed by reasonably-sized committees of very experienced investment personnel. And while smaller shops can argue that they have back-up and succession planning, often that is marketing hype and illusion rather than reality. I still remember a fund manager more than ten years ago telling me of a situation where a co-manager had been named to a fund in his organization. The CIO told him that it was to make the Trustees happy, giving the appearance of succession planning. But the CIO went on to say that if something ever happened to lead manager X, co-manager Y would be off the fund by sundown since Y had no portfolio management experience. Since learning such things is difficult from the outside, stick to the organizations where process and redundancy are obvious. Tweedy, Browne strikes me as another organization that fits the bill. Those are not meant as recommendations but rather are intended to give you some idea of what to look for in kicking tires and asking questions.

A few final thoughts – a lot of hedge funds folded in 2014, mainly for reasons of performance. I expect that trend to spread to mutual funds in 2015, especially those that are at best marginally profitable. Some of this is a function of having the usual acquiring firms (or stooges, as one investment banker friend calls them) – the Europeans – absent from the merger and acquisition trail. Given the present relationship of the dollar and the Euro, I don’t expect that trend to change soon. But I also expect funds to close just because the difficulty of outperforming in a world where events, to paraphrase Senator Warren, are increasingly rigged, is almost impossible. In a world of instant gratification, that successful active management is as much an art as a science should be self-evident. There is something in the process of human interaction which I used to refer to as complementary organizational dysfunction that produces extraordinary results, not easily replicable. And it involves more than just investment selection on the basis of reversion to the mean.

One example of genius would be Thomas Jefferson, dining alone, or Warren Buffet, sitting in his office, reading annual reports.  A different example would be the 1927 Yankees or the Fidelity organization of the 1980’s. In retrospect what made them great is easy to see. My advice to people looking for great active management today – look for organizations without self-promotion, where individuals do not seek out to be the new “It Girl” and where the organizations focus on attracting curious people with inquiring but disciplined minds, so that there ends up being a creative, dynamic tension. Avoid organizations that emphasize collegiality and consensus. In closing, let me remind you of that wonderful scene where Orson Welles, playing Harry Lime in The Third Man says,

… in Italy for 30 years under the Borgias they had warfare, terror, murder, and bloodshed, but they produced Michelangelo, Leonardo da Vinci, and the Renaissance. In Switzerland they had brotherly love – they had 500 years of democracy and peace, and what did they produce? The cuckoo clock.

Where In The World Is Your Fund Adviser?

When our esteemed colleague Ed Studzinski shares his views on an adviser or fund house, he invariably mentions location.

I’ve started to take notice.

Any place but Wall Street
Some fund advisers seem to identify themselves with their location. Smead Capital Management, Inc., which manages Smead Value Fund (SMVLX), states: ”Our compass bearings are slightly Northwest of Wall Street…” The firm is headquartered in Seattle.

SMVLX is a 5-year Great Owl sporting top quintile performance over the past 5-, 3-, and even 1-year periods (ref. Ratings Definitions):

Bill Smead believes the separation from Wall Street gives his firm an edge.

Legendary value investor Bruce Berkowitz, founder of Fairholme Capital Management, LLC seems to agree. Fortune reported that he moved the firm from New Jersey to Florida in 2006 in order to … ”put some space between himself and Wall Street … no matter where he went in town, he was in danger of running into know-it-all investors who might pollute his thinking. ’I had to get away,’ he says.”

In 2002, Charles Akre of Akre Capital Management, LLC, located his firm in Middleburg, Virginia. At that time, he was sub-advising Friedman, Billings, Ramsey & Co.’s FBR Focus Fund, an enormously successful fund. The picturesque town is in horse country. Since 2009, the firm’s Akre Focus Fund (AKREX/AKRIX) is a top-quintile performer and another 5-year Great Owl:

Perhaps location does matter?

Tales of intrigue and woe
Unfortunately, determining an adviser’s actual work location is not always so apparent. Sometimes it appears downright labyrinthine, if not Byzantine.

Take Advisors Preferred, LLC. Below is a snapshot of the firm’s contact page. There is no physical address. No discernable area code. Yet, it is the named adviser for several funds with assets under management (AUM) totaling half a billion dollars, including Hundredfold Select Alternative (SFHYX) and OnTrack Core Fund (OTRFX).

Advisors Preferred turns out to be a legal entity that provides services for sub-advisers who actually manage client money without having to hassle with administrative stuff … an “adviser” if you will by name only … an “Adviser for Hire.” To find addresses of the sub-advisers to these funds you must look to the SEC required fund documents, the prospectus or the statement of additional information (SAI).

Hunderfold Funds is sub-advised by Hunderfold Funds, LLC, which gives its sub-advisory fees to the Simply Distribute Charitable Foundation. Actually, the charity appears to own the sub-adviser. Who controls the charity? The people that control Spectrum Financial Inc., which is located, alas, in Virginia.

The SAI also reveals that the fund’s statutory trust is not administered by the adviser, Advisors Preferred, but by Gemini Funds Services, LLC. The trust itself is a so-called shared or “series trust” comprised of independent funds. Its name is Northern Lights Fund Trust II. (Ref. SEC summary.) The trust is incorporated in Delaware, like many statutory trusts, while Gemini is headquartered in New York.

Why use a series trust? According to Gemini, it’s cheaper. “Rising business costs along with the increased level of regulatory compliance … have magnified the benefits of joining a shared trust in contrast to the expenses associated with registering a standalone trust.”

How does Hundredfold pass this cost savings on to investors? SFHYX’s latest fact sheet shows a 3.80% expense ratio. This fee is not a one-time load or performance based; it is an annual expense.

OnTrack Funds is sub-advised by Price Capital Management, Inc, which is located in Florida. Per the SEC Filing, it actually is run out of a residence. Its latest fact sheet has the expense ratio for OTRFX at 2.95%, annually. With $130M AUM, this expense translates to $3.85M per year paid by investors the people at Price Capital (sub adviser), Gemini Funds (administrator), Advisors Preferred (adviser), Ceros Financial (distributer), and others.

What about the adviser itself, Advisors Preferred? It’s actually controlled by Ceros Financial Services, LLC, which is headquartered in Maryland. Ceros is wholly-owned by Ceros Holding AG, which is 95% owned by Copiaholding AG, which is wholly-owned by Franz Winklbauer.  Mr. Winklbauer is deemed to indirectly control the adviser. In 2012, Franz Winklbauer resigned as vice president of the administrative board from Ceros Holding AG. Copiaholding AG was formed in Switzerland.

Which is to say … who are all these people?

Where do they really work?

And, what do they really do?

Maybe these are related questions.

If it’s hard to figure out where advisers work, it’s probably hard to figure out what they actually do for the investors that pay them.

Guilty by affiliation
Further obfuscating adviser physical location is industry trend toward affiliation, if not outright consolidation. Take Affiliated Managers Group, or more specifically AMG Funds LLC, whose main office location is Connecticut, as registered with the SEC. It currently is the named adviser to more than 40 mutual funds with assets under management (AUM) totaling $42B, including:

• Managers Intermediate Duration Govt (MGIDX), sub advised by Amundi Smith Breeden LLC, located in North Carolina,
• Yacktman Service (YACKX), sub advised by Yacktman Asset Management, L.P. of Texas, and
• Brandywine Blue (BLUEX), sub advised by Friess Associates of Delaware, LLC, located in Delaware (fortunately) and Friess Associates LLC, located in Wyoming.

All of these funds are in process of being rebranded with the AMG name. No good deed goes unpunished?

AMG, Inc., the corporation that controls AMG Funds and is headquartered in Massachusetts, has minority or majority ownership in many other asset managers, both in the US and aboard. Below is a snapshot of US firms now “affiliated” with AMG. Note that some are themselves named advisers with multiple sub-advisers, like Aston.

AMG describes its operation as follows: “While providing our Affiliates with continued operational autonomy, we also help them to leverage the benefits of AMG’s scale in U.S. retail and global product distribution, operations and technology to enhance their growth and capabilities.”

Collectively, AMG boasts more than $600B in AUM. Time will tell whether its affiliates become controlled outright and re-branded, and more importantly, whether such affiliation ultimately benefits investors. It currently showcases full contact information of its affiliates, and affiliates like Aston showcase contact information of its sub-advisers.

Bottom line
Is Bill Smead correct when he claims separation from Wall Street gives his firm an edge? Does location matter to performance? Whether location influences fund performance remains an interesting question, but as part of your due diligence, there should be no confusion about knowing where your fund adviser (and sub-adviser) works.

Closing the capital gains season and thinking ahead

This fall Mark Wilson has launched Cap Gains Valet to help investors track and understand capital gains distributions. In addition to being Chief Valet, Mark is chief investment officer for The Tarbox Group in Newport Beach, CA. He is, they report, “one of only four people in the nation that has both the Certified Financial Planner® and Accredited Pension Administrator (APA) designations.” As the capital gains season winds down, we asked Mark if he’d put on his CIO hat for a minute and tell us what sense an investor should make of it all. Yeah, lots of folks got hammered in 2014 but that’s past. What, we asked, about 2015 and how we act in the year ahead? Here are Mark’s valedictory comments:

As 2014 comes to a close, so does capital gains season. After two straight months thinking about capital gains distributions for CapGainsValet.com, it is a great time for me to reflect on the website’s inaugural year.

At The Tarbox Group (my real job), our firm has been formally gathering capital gains estimates for the mutual funds and ETFs we use in client accounts for over 20 years. Strategizing around these distributions has been part of our year-end activities for so long I did not expect to learn much from gathering and making this information available. I was wrong. Here are some of the things I learned (or learned again) from this project:

• Checking capital gains estimates more than once is a good idea. I’m sure this has happened before, but this year we saw a number of funds “up” their estimates a more than once before their actual distribution date. Given that a handful of distributions doubled from their initial estimates, it is possible that having this more up-to-date information might necessitate a different strategy.
• Many mutual fund websites are terrible. Given the dollars managed and fees fund companies are collecting, there is no reason to have a website that looks like a bad elementary school project. Not having easily accessible capital gains estimates is excusable, but not having timely commentary, performance information, or contact information is not.
• Be wary of funds that have a shrinking asset base. This year I counted over 50 funds that distributed more than 20% of their NAV. The most common reason for the large distributions… funds that have fallen out of favor and have had huge redemptions. Unfortunately, shareholders that stick around often get stuck with the tax bill.
• Asset location is important. We found ourselves saying “good thing we own that in an IRA!” more than once this year. Owning actively managed funds in tax deferred accounts reduces stress, extra work and tax bills. Deciding which account to hold your fund can be as important a decision as which fund to hold.

CapGainsValet is “going dark” this week. Be on the lookout for our return in October or November. In the meantime, have a profitable 2015!

Fund companies explain their massive taxable distributions to us

Well, actually, most of them don’t.

I had the opportunity to chat with Jason Zweig as he prepared his year end story on how to make sense out of the recent state of huge capital gains distributions. In preparing in advance of my talk with Jason, I spent a little time gettin’ granular. I used Mark Wilson’s site to track down the funds with the most extraordinary distributions.

Cap Gains Valet identified a sort of “dirty dozen” of funds that paid out 30% or more of their NAV as taxable distributions. “Why on earth,” we innocently asked ourselves, “would they do that?” So we started calling and asking. In general, we discovered that fund advisers reacted to the question about the same way that you react to the discovery of curdled half-and-half in your coffee: with a wrinkled nose and irritated expression.

For those of you who haven’t been following the action, here’s our cap gains primer:

Capital gains are profits that result from the sales of appreciated securities in a portfolio. They come in two flavors: long-term capital gains, which result from the sale of stocks the fund has held for a while, and short-term gain gains, which usually result for the bad practice of churning the portfolio.

Even funds which have lost a lot of money can hit you with a capital gains tax bill. A fund might be down 40% year-to-date and if the only shares it sold were the Google shares it wangled at Google’s 2004 IPO, you could be hit with a tax bill for a large gain.

Two things trigger large taxable distributions: a new portfolio manager or portfolio strategy which requires cleaning out the old portfolio or forced redemptions because shareholders are bolting and the manager needs to sell stuff – often his best and most liquid stuff – to meet redemptions.

So, how did this Dirty Dozen make the list?

Neuberger Berman Large Cap Disciplined Growth (NBCIX, 53% distribution). I had a nice conversation with Neil Groom for Neuberger Berman. He was pretty clear about the problem: “we’ve struggled with performance,” and over 75% of the fund shares have been redeemed. The manager liquidates shares pro rata – that is, he sells them all down evenly – and “there are just no losses to offset those sales.” Neuberger is now underwriting the fund’s expenses to the tune of $300,000/year but remains committed to it for a couple reasons. One is that they see it as a core investment product. And the other is that the fund has had long winning streaks and long losing streaks in the past, both of which they view as a product of their discipline rather than as a failing by their manager.

We reached out to the folks at Russell LifePoints 2040 Strategy (RXLAX, 35% distribution) and Russell LifePoints 2050 Strategy (RYLRX, 33% distribution): after getting past the “what does it matter? These funds are held in tax-deferred retirement accounts” response – why is true but still doesn’t answer the question “why did this happen to you and not all target-date funds?” Russell’s Kate Stouffer reported that the funds “realized capital gains in 2014 predominantly as a result of the underlying fund reallocation that took place in August 2014.” The accompanying link showed Russell punting two weak Russell funds for two newly-launched Russell funds overseen by the same managers.

Turner Emerging Growth (TMCGX, 48% distribution), Midcap Growth (TMGFX, 42% distribution) and Small Cap Growth (TSCEX, 54% distribution): I called Turner directly and bounced around a bit before being told that “we don’t speak to the media. You’ll need to contact our media relations firm.” Suh-weet! I did. They promised to make some inquiries. Two weeks later, still no word. Two of the three funds have changed managers in the past year and Turner has seen a fair amount of asset outflows, which together might explain the problem.

Janus Forty (JDCAX, 33% distribution): about a half billion in outflows, a net loss in assets of about 75% from its peak plus a new manager in mid-2013 who might be reshaping the portfolio.

Eaton Vance Large-Cap Value (EHSTX, 29% distribution): new lead manager in mid-2014 plus an 80% decline in assets since 2010 led to it.

Nationwide HighMark Large Cap Growth (NWGLX, 42% distribution): another tale of mass redemption. The fund had $73 million in assets as of July 2013 when a new co-manager was added. The fund rose since then, but a lot less than its peers or its benchmark, investors decamped and the fund ended up with $40 million in December 2014.

Nuveen NWQ Large-Cap Value (NQCAX, 47% distribution) has been suffering mass redemptions – assets were $1.3 billion in mid-2013, $700 million in mid-2014, and $275 million at year’s end. The fund also had weak and inconsistent returns: bottom 10% of its peer group for the past 1, 3 and 5 years and far below average – about a 20% return over the current market cycle as compared to 38% for its large cap value peers – despite a couple good years.

Wells Fargo Small Cap Opportunities (NVSOX, 41% distribution) has a splendid record, low volatility, a track record for reasonably low payouts, a stable management team … and crashing assets. The fund held $700 million in October 2013, $470 million in March 2014 and $330 million in December 2014. With investment minimums of $1 million (Administrative share class) and $5 million (Institutional), the best we can say is that it’s nice to see rich people being stupid, too.

A couple of these funds are, frankly, bad. Most are mediocre. And a couple are really good but, seemingly, really unlucky. For investors in taxable accounts, their fate highlights an ugly reality: your success can be undermined by the behavior of your funds’ other investors. You really don’t want to be the last one out the door, which means you need to understand when others are heading out.

Hear “it’s a stock-pickers market”? Run quick … away

Not from the market necessarily, but from any dim bulb whose insight is limited not only by the need to repeat what others have said, but to repeat the dumbest things that others have said.

“Active management is oversold.” Run!

“Passive investing makes no sense to us or to our investors.” Run faster!

Ted, the discussion board’s indefatigable Linkster, pointed us at Henry Blodget’s recent essay “14 Meaningless Phrases That Will Make You Sound Like A Stock-Market Wizard” at his Business Insider site.  Yes, that Henry Blodget: the poster child for duplicitous stock “analysis” who was banned for life from the securities industry. He also had to “disgorge” $2 million in profits, a process that might or might not have involved a large bucket. In any case, he knows whereof he speaks.)  He pokes fun at “the trend is your friend” (phrased differently it would be “follow the herd, that’s always a wise course”) and “it’s a stockpicker’s market,” among other canards.

Chip, the Observer’s tech-crazed tech director, appreciated Blodget’s attempt but recommends an earlier essay: “Stupid Things Finance People Say” by Morgan Housel of Motley Fool. Why? “They cover the same ground. The difference is the he’s actually funny.”

Hmmm …

Blodget: “It’s not a stock market. It’s a market of stocks.” It sounds deeply profound — the sort of wisdom that can be achieved only through decades of hard work and experience. It suggests the speaker understands the market in a way that the average schmo doesn’t. It suggests that the speaker, who gets that the stock market is a “market of stocks,” will coin money while the average schmo loses his or her shirt.

Housel: “Earnings were positive before one-time charges.” This is Wall Street’s equivalent of, “Other than that, Mrs. Lincoln, how was the play?”

Blodget: “I’m cautiously optimistic.” A classic. Can be used in almost all circumstances and market conditions … It implies wise, prudent caution, but also a sunny outlook, which most people like.

Housel: “We’re cautiously optimistic.” You’re also an oxymoron.

Blodget: “Stocks are down on ‘profit taking.” …It sounds like you know what professional traders are doing, which makes you sound smart and plugged in. It doesn’t commit you to a specific recommendation or prediction. If the stock or market goes down again tomorrow, you can still have been right about the “profit taking.” If the stock or market goes up tomorrow, you can explain that traders are now “bargain hunting” (the corollary). Whether the seller is “taking a profit” — and you have no way of knowing — the buyer is at the same time placing a new bet on the stock. So collectively describing market activity as “profit taking” is ridiculous.

Housel: “The Dow is down 50 points as investors react to news of [X].” Stop it, you’re just making stuff up. “Stocks are down and no one knows why” is the only honest headline in this category.

Your pick.  Or try both for the same price!

Alternately, if you’re looking to pick up hot chicks as well as hot picks at your next Wall Street soiree, The Financial Times helpfully offered up “Strategist’s icebreakers serve up the season’s party from hell” (12/27/2014). They recommend chucking out the occasional “What’s all the fuss about the central banks?” Or you might try the cryptic, “Inflation isn’t keeping me up at night — for now.”

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 and filtered as never before. For a 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

• The plaintiff in existing fee litigation regarding ten Russell funds filed a new complaint, covering a different damages period, that additionally adds a new section 36(b) claim for excessive administrative fees. (McClure v. Russell Inv. Mgmt. Co.)

Orders

• The court consolidated ERISA lawsuits regarding “stable value funds” offered by J.P. Morgan to 401(k) plan participants. (In re J.P. Morgan Stable Value Fund ERISA Litig.)
• The court preliminarily approved a $9.475 million settlement of an ERISA class action that challenged MassMutual‘s receipt of revenue-sharing payments from unaffiliated mutual funds. (Golden Star, Inc. v. Mass Mut. Life Ins. Co.)
• The court gave its final approval to the $22.5 million settlement of Regions Morgan Keegan ERISA litigation. Plaintiffs had alleged that defendants imprudently caused and permitted retirement plans to invest in (1) Regions common stock (“despite the dire financial problems facing the Company”), (2) certain bond funds (“heavily and imprudently concentrated and invested in high-risk structured finance products”), and (3) the RMK Select Funds (“despite the fact that they incurred unreasonably expensive fees and were selected . . . solely to benefit Regions”). (In re Regions Morgan Keegan ERISA Litig.)

Briefs

• The plaintiff filed a reply brief in her appeal to the Eighth Circuit regarding gambling-related securities held by the American Century Ultra Fund. Defendants include independent directors. (Seidl v. Am. Century Cos.)
• In the ERISA class action alleging that TIAA-CREF failed to honor redemption and transfer requests in a timely fashion, the plaintiff filed her opposition to TIAA-CREF’s motion to dismiss. (Cummings v. TIAA-CREF.)

Amended Complaints

• Plaintiffs filed an amended complaint in the consolidated fee litigation regarding the Davis N.Y. Venture Fund: “The investment advisory fee rate charged to the Fund is as much as 96% higher than the rates negotiated at arm’s length by Davis with other clients for the same or substantially the same investment advisory services.” (In re Davis N.Y. Venture Fund Fee Litig.)
• Plaintiffs filed an amended complaint in the consolidated fee litigation regarding the Harbor International and and High-Yield Bond Funds: “Defendant charges investment advisory fees to each of the Funds that include a mark-up of more than 80% over the fees paid by Defendant to the Subadvisers who provide substantially all of the investment advisory services required by the Funds.” (Zehrer v. Harbor Capital Advisors, Inc.)

The Alt Perspective: Commentary and news from DailyAlts.

By Brian Haskins, editor of DailyAlts.com

As they say out here in Hollywood, that’s a wrap. Now we can close the books on 2014 and take a look at some of the trends that emerged over the year, and make a few projections about what might be in store for 2015. So let’s jump in.

Early in 2014, it was clear that assets were flowing strongly into liquid alternatives, with twelve-month growth rates hovering around 40% for most of the first half of the year. While the growth rates declined as the year went on, it was clear that 2014 was a real turning point in both asset growth and new fund launches. In total, more than $26 billion of net new assets flowed into the category over the past twelve months.

Three of the categories that garnered the most new asset flows were non-traditional bonds, long/short equity and multi-alternative strategies. Each of these makes sense, as follows:

• Non-traditional bonds provide a hedge against a rise in interest rates, so investors naturally were looking for a way to avoid what was initially thought to be a sure thing in 2014 – rising rates. As we know, that turned not to be the case, and instead we saw a fairly steady decline in rates over the year. Nonetheless, investors who flowed into these funds should be well positioned should rates rise in 2015.
• On the equity side, long/short equity provides a hedge against a decline in the equity markets, and here again investors looked to position their portfolios more conservatively given the long bull run. As a result, long/short equity funds saw strong inflows for most of the year with the exception of the $11.9 billion MainStay Marketfield Fund (MFLDX) which experienced more than $5 billion of outflows over eight straight months on the back of a difficult performance period. As my old boss would say, they have gone from the penthouse to the doghouse. But with nearly $12 billion remaining in the fund and a 1.39% management fee, their doghouse probably isn’t too bad.
• Finally, investors favored multi-alternative funds steadily during the year. These funds provide an easy one-stop-shop for making an allocation to alternatives, and for many investors and financial advisors, these funds are a solid solution since they package multiple alternative investment strategies into one fund. I would expect to see multi-alternative funds continue to play a dominant role in portfolios over the next few years while the industry becomes more comfortable with evaluating and allocating to single strategy funds.

Now that the year has come to a close, we can take a step back and look at 2014 from a big picture perspective. Here are five key trends that I saw emerge over the year:

1. The conversion of hedge funds into mutual funds – This is an interesting trend that will likely continue, and gain even more momentum in 2015. There are a few reasons why this is likely. First, raising assets in hedge funds has become more difficult over the past five years. Institutional investors allocate a bulk of their assets to well-known hedge fund managers, and performance isn’t the top criteria for making the allocations. Second, investing in hedge funds involves the review of a lot of non-standard paperwork, including fee agreements and other terms. This creates a high barrier to entry for smaller investors. Thus, the mutual fund vehicle is a much easier product to use for gathering assets with smaller investors in both the retail and institutional channels. As a result, we will see many more hedge fund conversions in the coming years. Third, the track record and the assets of a hedge fund are portable over to a mutual fund. This gives new mutual funds that convert from a hedge fund a head start over all other new funds.
2. The re-emergence of managed futures funds – A divergence in global economic policies among central banks created more opportunities for managers that look for asset prices that move in opposite directions. Managed futures managers do just that, and 2014 proved to be the first year in many where they were able to put positive, double digit returns on the board. It is likely that 2015 will be another solid year for these strategies as strong price trends will likely continue with global interest rates, currencies, commodity prices and other assets over the year.
3. More well-known hedge fund managers are getting into the liquid alternatives business – It’s hard to resist strong asset flows if you are an asset manager, and as discussed above, the asset flows into liquid alternatives have been strong. And expectations are that they will continue to be strong. So why wouldn’t a decent hedge fund manager want to get in the game and diversify their business away from institutional and high net worth assets. Some of the top hedge fund managers are recognizing this and getting into the space, and as more do, it will become even more acceptable for those who haven’t.
4. A continued increase in the use of alternative beta strategies, and the introduction of more complex alternative beta funds – Alternative beta (or smart beta) strategies give investors exposure to specific “factors” that have otherwise not been easy to obtain historically. With the introduction of alternative beta funds, investors can now fine tune their portfolio with specific allocations to low or high volatility stocks, high yielding stocks, high momentum stocks, high or low quality stocks, etc. A little known secret is that factor exposures have historically explained more of an active manager’s excess returns (returns above a benchmark) than individual stock selection. With the advent of alternative beta funds in both the mutual fund and ETF format, investors have the ability to build more risk efficient portfolios or turn the knobs in ways they haven’t been able to in the past.
5. An increase in the number of alternative ETFs – While mutual funds have a lower barrier to entry for investors than hedge funds, ETFs are even more ubiquitous. Nearly every ETF can be purchased in nearly every brokerage account. Not so for mutual funds. The biggest barrier to seeing more alternative ETFs has historically been the fact that most alternative strategies are actively managed. This is slowly changing as more systematic “hedge fund” approaches are being developed, along with alternative ETFs that invest in other ETFs to gain their underlying long and short market exposures. Expect to see this trend continue in 2015.

There is no doubt that 2015 will bring some surprises, but by definition we don’t know what those are today. We will keep you posted as the year progresses, and in the meantime, Happy New Year and all the best for a prosperous 2015!

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.

RiverPark Large Growth (RPXFX/RPXIX): it’s a discipline that works. Find the forces that will consistently drive growth in the years ahead.  Do intense research to identify great firms that are best positioned to reap enduring gains from them. Wait. Wait. Wait. Then buy them when they’re cheap. It’s worked well, except for that pesky “get investors to notice” piece.

River Park Large Growth Conference Call Highlights

On December 17th we spoke for an hour with Mitch Rubin, manager of RiverPark Large Growth (RPXFX/RPXIX), Conrad van Tienhoven, his long-time associate, and Morty Schaja, CEO of RiverPark Funds. About 20 readers joined us on the call.

Here’s a brief recap of the highlights:

• The managers have 20 years’ experience running growth portfolios, originally with Baron Asset Management and now with RiverPark. That includes eight mutual funds and a couple hedge funds.
• Across their portfolios, the strategy has been the same: identify long-term secular trends that are likely to be enduring growth drivers, do really extensive fundamental research on the firm and its environment, and be patient before buying (the target is paying less than 15-times earnings for companies growing by 20% or more) or selling (which is mostly just rebalancing within the portfolio rather than eliminating names from the portfolio).
• In the long term, the strategy works well. In the short term, sometimes less so. They argue for time arbitrage. Investors tend to underreact to changes which are strengthening firms. They’ll discount several quarters of improved performance before putting a stock on their radar screen, then may hesitate for a while longer before convincing themselves to act. By then, the stock may already have priced-in much of the potential gains. Rubin & co. try to track firms and industries long enough that they can identify the long-term winners and buy during their lulls in performance.

In the long term, the system works. The fund has returned 20% annually over the past three years. It’s four years old and had top decile performance in the large cap growth category after the first three years.

Then we spent rather a lot of time on the ugly part.

In relative terms, 2014 was wretched for the fund. The fund returned about 5.5% for the year, which meant it trailed 93% of its peers. It started the year with a spiffy five-star rating and ended with three. So, the question was, what happened?

Mitch’s answer was presented with, hmmm … great energy and conviction. There was a long stretch in there where I suspect he didn’t take a breath and I got the sense that he might have heard this question before. Still, his answer struck me as solid and well-grounded. In the short term, the time arbitrage discipline can leave them in the dust. In 2014, the fund was overweight in a number of underperforming arenas: energy E&P companies, gaming companies and interest rate victims.

• Energy firms: 13% of the portfolio, about a 2:1 overweight. Four high-quality names with underlevered balance sheets and exposure to the Marcellus shale deposits. Fortunately for consumers and unfortunately for producers, rising production, difficulties in selling US natural gas on the world market and weakening demand linked to a spillover from Russia’s travails have caused prices to crater.
  
  The fundamental story of rising demand for natural gas, abetted by better US access to the world energy market, is unchanged. In the interim, the portfolio companies are using their strong balance sheets to acquire assets on the cheap.

• Gaming firms: gaming in the US, with regards to Ol’ Blue Eyes and The Rat Pack, is the past. Gaming in Asia, they argue, is the future. The Chinese central government has committed to spending nearly a half trillion dollars on infrastructure projects, including $100 billion/year on access, in and around the gambling enclave of Macau. Chinese gaming (like hedge fund investing here) has traditionally been dominated by the ultra-rich, but gambling is culturally entrenched and the government is working to make it available to the mass affluent in China (much like liquid alt investing here). About 200 million Chinese travel abroad on vacation each year. On average, Chinese tourists spend a lot more in the casinos and a lot more in attendant high-end retail than do Western tourists. In the short term, President Xi’s anti-corruption campaign has precipitated “a vast purge” among his political opponents and other suspiciously-wealthy individuals. Until “the urge to purge” passes, high-rolling gamblers will be few and discreet. Middle class gamblers, not subject to such concerns, will eventually dominate. Just not yet.
• Interest rate victims: everyone knew, in January 2014, that interest rates were going to rise. Oops. Those continuingly low rates punish firms that hold vast cash stakes (think “Google” with its $50 billion bank account or Schwab with its huge network of money market accounts). While Visa and MasterCard’s stock is in the black for 2014, gains are muted by the lower rates they can charge on accounts and the lower returns on their cash flow.

Three questions came up:

• Dan Schein asked about the apparent tension between the managers’ commitment to a low turnover discipline and the reported 33-40% turnover rate. Morty noted that you need to distinguish between “name turnover” (that is, firms getting chucked out of the portfolio) and rebalancing. The majority of the fund’s turnover is simple internal rebalancing as the managers trim richly appreciated positions and add to underperforming ones. Name turnover is limited to two or three positions a year, with 70% of the names in the current portfolio having been there since inception.
• I asked about the extent of international exposure in the portfolio, which Morningstar reports at under 2%. Mitch noted that they far preferred to invest in firms operating under US accounting requirements (Generally Accepted Accounting Principles) and U.S. securities regulations, which made them far more reliable and transparent. On the other hand, the secular themes which the managers pursue (e.g., the rise of mobile computing) are global and so they favor U.S.-based firms with strong global presence. By their estimate, two thirds of the portfolio firms derive at least half of their earnings growth from outside the US and most of their firms derived 40-50% of earnings internationally; Priceline is about 75%, Google and eBay around 60%. Direct exposure to the emerging markets comes mainly from Visa and MasterCard, plus Schlumberger’s energy holdings.
• Finally I asked what concern they had about volatility in the portfolio. Their answer was that they couldn’t predict and didn’t worry about stock price volatility. They were concerned about what they referred to as “business case volatility,” which came down to the extent to which a firm could consistently generate free cash from recurring revenue streams (e.g., the fee MasterCard assesses on every point-of-sale transaction) without resorting to debt or leverage.

For folks interested but unable to join us, here’s the complete audio of the hour-long conversation.

The RPXFX Conference Call

As with all of these funds, we’ve created a new Featured Funds page for RiverPark Large Growth Fund, pulling together all of the best resources we have for the fund.

Conference Calls Upcoming

We anticipate three conference calls in the next three months and we would be delighted by your company on each of them. We’re still negotiating dates with the managers, so for now we’ll limit ourselves to a brief overview and a window of time.

At base, we only do conference calls when we think we’ve found really interesting people for you to talk with. That’s one of the reasons we do only a few a year.

Here’s the prospective line-up for winter.

Bernard Horn is manager of Polaris Global Value (PGVFX) and sub-adviser to a half dozen larger funds. Mr. Horn is president of Polaris Capital Management, LLC, a Boston-based global and international value equity firm. Mr. Horn founded Polaris in 1995 and launched the Global Value Fund in 1998. Today, Polaris manages more than $5 billion for 30 clients include rich folks, institutions and mutual and hedge funds. There’s a nice bio of Mr. Horn at the Polaris Capital site.

Why talk with Mr. Horn? Three things led us to it. First, Polaris Global is really good and really small. After 16 years, it’s a four- to five-star fund with just $280 million in assets. He seems just a bit abashed by that (“we’re kind of bad at marketing”) but also intent on doing right for his shareholders rather than getting rich. Second, his small cap international fund (Pear Tree Polaris Foreign Value Small Cap QUSOX) is, if anything, better and it trawls the waters where active management actually has the greatest success. Finally, Ed and I have a great conversation with him in November. Ed and I are reasonably judgmental, reasonably well-educated and reasonably cranky. And still we came away from the conversation deeply impressed, as much by Mr. Horn’s reflections on his failures as much as by his successes. There’s a motto often misattributed to the 87 year old Michelangelo: Ancora imparo, “I am still learning.” We came away from the conversation with a sense that you might say the same about Mr. Horn.

Matthew Page and Ian Mortimer are co-managers of Guinness Atkinson Global Innovators (IWIRX) and Guinness Atkinson Dividend Builder (GAINX), both of which we’ve profiled in the past year. Dr. Mortimer is trained as a physicist, with a doctorate from Oxford. He began at Guinness as an analyst in 2006 and became a portfolio manager in 2011. Mr. Page (the friendly looking one over there->) earned a master’s degree in physics from Oxford and somehow convinced the faculty to let him do his thesis on finance: “Financial Markets as Complex Dynamical Systems.” Nice trick! He spent a year with Goldman Sachs, joined Guinness in 2005 and became a portfolio co-manager in 2006.

Why might you want to hear from the guys? At one level, they’re really successful. Five star rating on IWIRX, great performance in 2014 (also 2012 and 2013), laughably low downside capture over those three years (almost all of their volatility is to the upside), and a solid, articulated portfolio discipline. In 2014, Lipper recognized IWIRX has the best global equity fund of the preceding 15 years and they still can’t attract investors. It’s sort of maddening. Part of the problem might be the fact that they’re based in London, which makes relationship-building with US investors a bit tough. At another level, like Mr. Horn, I’ve had great conversations with the guys. They’re good listeners, sharp and sometimes witty. I enjoyed the talks and learned from them.

David Berkowitz will manage the new RiverPark Focused Value Fund once it launches at the end of March. Mr. Berkowitz earned both a bachelor’s and master’s degree in chemical engineering at MIT before getting an MBA at that other school in Cambridge. In 1992, Mr. Berkowitz and his Harvard classmate William Ackman set up the Gotham Partners hedge fund, which drew investments from legendary investors such as Seth Klarman, Michael Steinhardt and Whitney Tilson. Berkowitz helped manage the fund until 2002, when they decided to close the fund, and subsequently managed money for a New York family office, the Festina Lente hedge fund (hmmm … “Make haste slowly,” the family motto of the Medicis among others) and for Ziff Brother Investments, where he was a Partner as well as the Chief Risk and Strategy Officer. He’s had an interesting, diverse career and Mr. Schaja speaks glowingly of him. We’re hopeful of speaking with Mr. Berkowitz in March.

Would you like to join in?

It’s very simple. In February we’ll post exact details about the time and date plus a registration link for each call. The calls cost you nothing, last exactly one hour and will give you the chance to ask the managers a question if you’re so moved. It’s a simple phone call with no need to have access to a tablet, wifi or anything.

Alternately, you can join the conference call notification list. One week ahead of each call we’ll email you a reminder and a registration link.

Launch Alert: Cambria Global Momentum & Global Asset Allocation

Cambria Funds recently launched two ETFs, as promised by its CIO Mebane Faber, who wants to “disrupt the traditional high fee mutual fund and hedge fund business, mostly through launching ETFs.” The line-up is now five funds with assets under management totaling more than $350M:

• Cambria Shareholder Yield ETF (SYLD)
• Cambria Foreign Shareholder Yield ETF (FYLD)
• Cambria Global Value ETF (GVAL)
• Cambria Global Momentum ETF (GMOM)
• Cambria Global Asset Allocation ETF (GAA)

We wrote about the first three in “The Existential Pleasures of Engineering Beta” this past May. SYLD is now the largest actively managed ETF among the nine categories in Morningstar’s equity fund style box (small value to large growth). It’s up 12% this year and 32% since its inception May 2013.

GMOM and GAA are the two newest ETFs. Both are fund of funds.

GMOM is based on Mebane’s definitive paper “A Quantitative Approach To Tactical Asset Allocation” and popular book “The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets.” It appears to be an in-house version of AdvisorShares Cambria Global Tactical ETF (GTAA), which Cambria stopped sub-advising this past June. Scott, a frequent and often profound contributor to our discussion board, describes GTAA in one word: “underwhelming.” (You can find follow some of the debate here.) The new version GMOM sports a much lower expense ratio, which can only help. Here is link to fact sheet.

GAA is something pretty cool. It is an all-weather strategic asset allocation fund constructed for global exposure across diverse asset classes, but with lower volatility than your typical long term target allocation fund. It is a “one fund for a lifetime” offering. (See DailyAlts “Meb Faber on the Genesis of Cambria’s Global Tactical ETF.”) It is the first ETF to have a permanent 0% management fee. Its annual expense ratio is 0.29%. From its prospectus:

Here’s is link to fact sheet, and below is snapshot of current holdings:

In keeping with the theme that no good deed goes unpunished. Chuck Jaffe referenced GAA in his annual “Lump of Coal Awards” series. Mr. Jaffe warned “investors should pay attention to the total expense ratio, because that’s what they actually pay to own a fund or ETF.” Apparently, he was irked that the media focused on the zero management fee. We agree that it was pretty silly of reporters, members of Mr. Jaffe’s brotherhood, to focus so narrowly on a single feature of the fund and at the same time celebrate the fact that Mr. Faber’s move lowers the expenses that investors would otherwise bear.

Launch Alert: ValueShares International Quantitative Value

Wesley Gray announced the launch of ValueShares International Quantitative Value ETF (IVAL) on 19 December, his firm’s second active ETF. IVAL is the international sister to ValueShares Quantitative Value ETF (QVAL), which MFO profiled in December. Like QVAL, IVAL seeks the cheapest, highest quality value stocks … within the International domain. These stocks are selected in quant fashion based on value and quality criteria grounded in investing principles first outlined by Ben Graham and validated empirically through academic research.

The concentrated portfolio currently invests in 50 companies across 14 countries. Here’s breakout:

As with QVAL, there is no sector diversification constraint or, in this case, country constraint. Japan dominates current portfolio. Once candidate stocks pass the capitalization, liquidity, and quality screens, value is king.

Notice too no Russia or Brazil.

Wesley explains: “We only trade in liquid tradeable names where front-running issues are minimized. We also look at the custodian costs. Russia and Brazil are insane on both the custodial costs and the frontrunning risks so we don’t trade ’em. In the end, we’re trading in developed/developing markets. Frontier/emerging don’t meet our criteria.”

Here is link to IVAL overview. Dr. Gray informs us that the new fund’s expense ratio has just been reduced by 20bps to 0.79%.

Launch Alert: Pear Tree Polaris Small Cap Fund (USBNX/QBNAX)

On January 1, a team from Polaris Capital assumed control of the former Pear Tree Columbia Small Cap Fund, which has now been rechristened. For the foreseeable future, the fund’s performance record will bear the imprint of the departed Columbia team.  The Columbia team had been in place since the middle 1990s and the fund has, for years, been a study in mediocrity.  We mean that in the best possible way: it rarely cratered, it rarely soared and it mostly trailed the pack by a bit. By Morningstar’s calculation, the compounding effect of almost always losing by a little ended up being monumental: the fund trailed more than 90% of its peers for the past 1, 3, 5, and 10 year periods while trailing two-thirds over them over the past 15 years.

Which is to say, your statistical screens are not going to capture the fund’s potential going forward.

We think you should look at the fund, and hope to ask Mr. Horn about it on a conference call with him.  Here are the three things you need to know about USNBX if you’re in the market for a small cap fund:

• The management team here also runs Pear Tree Polaris Foreign Value Small Cap Fund (QUSOX / QUSIX) which has earned both five stars from Morningstar and a Great Owl designation from the Observer.
• The new subadvisory agreement pays Polaris 20 basis points less than Columbia received, which will translate into lower expenses that investors pay.
• The portfolio will be mostly small cap ($100 million – $5 billion) US stocks but they’ve got a global watch-list of 500 names which are candidates for inclusion and they have the ability to hedge the portfolio. The foreign version of the fund has been remarkable in its ability to manage risk: they typically capture one-third as much downside risk as their peers while capturing virtually all of the upside.

The projected expense ratio is 1.44%. The minimum initial investment is $2500, reduced to $1000 for tax-advantaged accounts and for those set up with an automatic investing plan. Pear Tree has not, as of January 1, updated the fund’s webpage is reflect the change but you should consider visiting Pear Tree’s homepage next week to see what they have to say about the upgrade.  We’ll plan profiles of both funds in the months ahead.

Funds in Registration

Yikes. We’ve never before had a month like this: there’s only one new, no-load retail fund on file with the SEC. Even if we expand the search to loaded funds, we only get to four or five.  Hmmm …

The one fund is RiverPark Focused Value Fund. It will be primarily a large cap domestic equity fund whose manager has a particular interest in “special situations” such as spin-offs or reorganizations and on firms whose share prices might have cratered. They’ll buy if it’s a high quality firm and if the stock trades at a substantial discount to intrinsic value. It will be managed by a well-known member of the hedge fund community, David Berkowitz.

Manager Changes

This month also saw an uptick in manager turnover; 73 funds reported changes, about 50% more than the month before. The most immediately noticeable of which was Bill Frels’ departure from Mairs & Power Growth (MPGFX) and Mairs & Power Balanced (MAPOX) after 15 and 20 years, respectively. They’re both remarkable funds: Balanced has earned five stars from Morningstar for the past 3, 5, 10 and since inception periods while Growth has either four or five stars for all those periods. Both invest primarily in firms located in the upper Midwest and both have negligible turnover.

Mr. Frels’ appointment occasioned considerable anxiety years ago because he was an unknown guy replacing an investing legend, George Mairs. At the time, we counseled calm because Mairs & Power had themselves calmly and deliberately planned for the handout.  I suppose we’ll do the same today, though we might use this as an excuse for calling M&P to update our 2011 profile of the fund. That profile, written just as M&P appointed a co-manager in what we said was evidence of succession planning, concluded “If you’re looking for a core holding, especially for a smaller portfolio where the reduced minimum will help, this has to be on the short-list of the most attractive balanced funds in existence.”  We were right and we don’t see any reason to alter that conclusion now.

Updates

Andrew Foster and the folks at Seafarer Partners really are consistently better communicators than almost any of their peers.  In addition to a richly informative website and portfolio metrics that almost no one else thinks to share, they have just published a semi-annual report with substantial content.

Two arguments struck me.  First, the fund’s performance was hampered by their decision to avoid bad companies:

the Fund’s lack of exposure to small and mid-size technology companies – mostly located in Taiwan – caused it to lag the benchmark during the market’s run-up. While interesting investments occasionally surface among the sea of smaller technology firms located in and around Taipei, this group of companies in general is not distinguished by sustainable growth. Most companies make components for consumer electronics or computers, and while some grow quickly for a while, often their good fortune is not sustainable, as their products are rapidly commoditized, or as technological evolution renders their products obsolete. Their share prices can jump rapidly higher for a time when their products are in vogue. Nevertheless, I rarely find much that is worthwhile or sustainable in this segment of the market, though there are sometimes exceptions.

As a shareholder in the fund, I really do applaud a discipline that avoids those iffy but easy short-term bets.

The second argument is more interesting and a lot more important for the investing community. Andrew argues that “value investing” might finally be coming to the emerging markets.

Yet even as the near-term is murky, I believe the longer-term outlook has recently come into sharper focus. A very important structural change – one that I think has been a long time in coming – has just begun to reshape the investment landscape within the developing world. I think the consequence of this change will play out over the next decade, at a minimum.

For the past sixteen years, I have subscribed to an investment philosophy that stresses “growth” over “value.” By “value,” I mean an investment approach that places its primary emphasis on the inherent cheapness of a company’s balance sheet, and which places secondary weight on the growth prospect of the company’s income statement..

In the past, I have had substantial doubts as to whether a classic “value” strategy could be effectively implemented within the developing world – “value” seemed destined to become a “value trap.”  … In order to realize the value embedded in a cheap balance sheet, a minority investor must often invest patiently for an extended period, awaiting the catalyst that will ultimately unlock the value.

The problem with waiting in the developing world is that most countries lack sufficient legal, financial, accounting and regulatory standards to protect minority investors from abuse by “control parties.” A control party is the dominant owner of a given company. Without appropriate safeguards, minorities have little hope of avoiding exploitation while they wait; nor do they have sufficient legal clout to exert pressure on the control party to accelerate the realization of value. Thus in the past, a prospective “value” investment was more likely to be a “trap” than a source of long-term return.

Andrew’s letter outlines a series of legal and structural changes which seem to be changing that parlous state and he talks about the implications for his portfolio and, by extension, for yours. You should go read the letter.

Seafarer Growth & Income (SFGIX) is closing in on its third anniversary (February 15, 2015) with $122 million in assets and a splendid record, both in terms of returns and risk-management. The fund finished 2014 with a tiny loss but a record better than 75% of its peers.  We’re hopeful of speaking with Andrew and his team as they celebrate that third anniversary.

Speaking of third anniversaries, Grandeur Peak funds have just celebrated theirs. Their success has been amazing, at least to the folks who weren’t paying attention to their record in their preceding decade.  Eric Heufner, the firm’s president, shared some of the highlights in a December email:

… our initial Funds have reached the three-year milestone.  Both Funds ranked in the Top 1% of their respective Morningstar peer groups for the 3 years ending 10/31/14, and each delivered an annualized return of more than 20% over the period. The Grandeur Peak Global Opportunities Fund was the #1 fund in the Morningstar World Stock category and the Grandeur Peak International Opportunities Fund was the #2 fund in the Morningstar Foreign Small/Mid Growth category.  We also added two new strategies over the past year 18 months.  [He shared a performance table which comes down to this: all of the funds are top 10% or better for the available measurement periods.] 

Our original team of 7 has now grown to a team of 30 (16 full-time & 14 part-time).  Our assets under management have grown to $2.4 billion, and all four of our strategies are closed to additional investment—we remain totally committed to keeping our portfolios nimble.  We still plan to launch other Funds, but nothing is imminent.

And, too, their discipline strikes me as entirely admirable: all four of their funds have now been hard-closed in accordance with plans that they announced early and clearly. 2015 should see the launch of their last three funds, each of which was also built-in early to the firm’s planning and capacity calculations.

Finally, Matthews Asia Strategic Income (MAINX) celebrated its third anniversary and first Morningstar rating in December, 2014. The fund received a four-star rating against a “world bond” peer group. For what interest it holds, that rating is mostly meaningless since the fund’s mandate (Asia! Mostly emerging) and portfolio (just 70% bonds plus income-producing equities and convertibles) are utterly distant from what you see in the average world bond fund. The fund has crushed the one or two legitimate competitors in the space, its returns have been strong and its manager, Teresa Kong, comes across a particularly smart and articulate.

Briefly Noted . . .

Investors have, as predicted, chucked rather more than a billion dollars into Bill Gross’s new charge, Janus Unconstrained Bond (JUCAX) fund. Despite holding 75% of that in cash, Gross has managed both to lose money and underperform his peers in these opening months.  Both are silly observations, of course, though not nearly so silly as the desperate desire to rush a billion into Gross’s hands.

SMALL WINS FOR INVESTORS

Effective January 1, 2015, Perkins Small Cap Value Fund (JDSAX) reopened to new investors. I’m a bit ambivalent here. The fund looks sluggish when measured by the usual trailing periods (it has trailed about 90% of its peers over the past 3 and 5 year periods) but I continue to think that those stats mislead as often as they inform since they capture a fund’s behavior in a very limited set of market conditions. If you look at the fund’s performance over the current market cycle – from October 1 2007 to now – it has returned 78% which handily leads its peers’ 61% gain. Nonetheless the team is making adjustments which include spending down their cash (from 15% to 5%), which is a durned odd for a value discipline focused on high quality firms to do. They’re also dropping the number of names and adding staff. It has been a very fine fund over the long term but this feels just a bit twitchy.

CLOSINGS (and related inconveniences)

A couple unusual cases here.

Aegis High Yield Fund (AHYAX/AHYFX) closed to new investors in mid-December and has “assumed a temporary defensive position.” (The imagery is disturbing.) As we note below, this might well signal an end to the fund.

The more striking closure is GL Beyond Income Fund (GLBFX). While the fund is tiny, the mess is huge. It appears that Beyond Income’s manager, Daniel Thibeault (pronounced “tee-bow”), has been inventing non-existent securities then investing in them. Such invented securities might constitute a third of the fund’s portfolio. In addition, he’s been investing in illiquid securities – that is, stuff that might exist but whose value cannot be objectively determined and which cannot be easily sold. In response to the fraud, the manager has been arrested and charged with one count of fraud.  More counts are certainly pending but conviction just on the one original charge could carry a 20-year prison sentence. Since the board has no earthly idea of what the fund’s portfolio is worth, they’ve suspended all redemptions in the fund as well as all purchased. 

GL Beyond Income (it’s certainly sounding awfully ironic right now, isn’t it?) was one of two funds that Mr. Thibeault ran. The first fund, GL Macro Performance Fund (GLMPX), liquidated in July after booking a loss of nearly 50%. Like Beyond Income, it invested in a potpourri of “alternative investments” including private placements and loans to other organizations controlled by the manager.

There have been two pieces of really thoughtful writing on the crime. Investment News dug up a lot of the relevant information and background in a very solid story by Mason Braswell on December 30^th.  Chuck Jaffe approached the story as an illustration of the unrecognized risks that retail investors take as they move toward “liquid alts” funds which combine unusual corporate structures (the GL funds were interval funds, meaning that you could not freely redeem your shares) and opaque investments.

Morningstar, meanwhile, remains thoughtfully silent.  They seem to have reprinted Jaffe’s story but their own coverage of the fraud and its implications has been limited to two one-sentence notes on their Advisor site.

OLD WINE, NEW BOTTLES

Effective January 1, 2015, the name of the AIT Global Emerging Markets Opportunities Fund (VTGIX) changed to the Vontobel Global Emerging Markets Equity Institutional Fund.

American Century One Choice 2015 Portfolio has reached the end of its glidepath and is combining with One Choice In Retirement. That’s not really a liquidation, more like a long-planned transition.

Effective January 30, 2015, the name of the Brandes Emerging Markets Fund (BEMAX) will be changed to the Brandes Emerging Markets Value Fund.

At the same time that Brandes gains value, Calamos loses it. Effective March 1, Calamos Opportunistic Value Fund (CVAAX) becomes plain ol’ Calamos Opportunistic Fund and its benchmark will change from Russell 1000 Value to the S&P 500. Given that the fund is consistently inept, one could imagine calling for new managers … except for the fact that the fund is managed by the firm’s founder and The Gary Black.

Columbia Global Equity Fund (IGLGX) becomes Columbia Select Global Equity Fund on or about January 15, 2015. At that point Threadneedle International Advisers LLC takes over and it becomes a focused fund (though no one is saying how focused or focused on what?).

Effective January 1, 2015, Ivy International Growth Fund (IVINX) has changed to Ivy Global Growth Fund. Even before the change, over 20% of the portfolio was invested in the US.

PIMCO EqS^® Dividend Fund (PQDAX) became PIMCO Global Dividend Fund on December 31, 2014.

Effective February 28, 2015, Stone Ridge U.S. Variance Risk Premium Fund (VRLIX) will change its name to Stone Ridge U.S. Large Cap Variance Risk Premium Fund.

Effective December 29, 2014, the T. Rowe Price Retirement Income Fund has changed its name to the T. Rowe Price Retirement Balanced Fund.

The two week old Vertical Capital Innovations MLP Energy Fund (VMLPX) has changed its name to the Vertical Capital MLP & Energy Infrastructure Fund.

Voya Strategic Income Fund has become Voya Strategic Income Opportunities Fund. I’m so glad. I was worried that they were missing opportunities, so this reassures me. Apparently their newest opportunities lie in being just a bit more aggressive than a money market fund, since they’ve adopted the Bank of America Merrill Lynch U.S. Dollar Three-Month LIBOR Constant Maturity Index as their new benchmark. Not to say this is an awfully low threshold, but that index has returned 0.34% annually from inception in 2010 through the end of 2014.

OFF TO THE DUSTBIN OF HISTORY

Aberdeen Core Fixed Income Fund (PCDFX) will be liquidated on February 12, 2015.

Aegis High Yield Fund (AHYAX/AHYFX) hard-closed in mid-December. Given the fund’s size ($36 million) and track record, we’re thinking it’s been placed in a hospice though that hasn’t been announced. Here’s the 2014 picture:

AllianzGI Opportunity (POPAX) is getting axed. The plan is to merge the $90 million small cap fund into its $7 million sibling, AllianzGI Small-Cap Blend Fund (AZBAX). AZBAX has a short track record, mostly of hugging its index, but that’s a lot better than hauling around the one-star rating and dismal 10 year record that the larger fund’s managers inherited in 2013. They also didn’t improve upon the record. The closing date of the Reorganization is expected to be on or about March 9, 2015, although the Reorganization may be delayed.

Alpine Global Consumer Growth Fund (AWCAX) has closed and will, pending shareholder approval, be terminated in early 2015. Given that the vast majority of the fund’s shares (70% of the retail and 95% of the institutional shares) are owned by the family of Alpine’s founder, Sam Leiber, I’ve got a feeling that the shareholder vote is a done deal.

The dizzingly bad Birmiwal Oasis Fund (BIRMX) is being put out of manager Kailash Birmiwal’s misery. From 2003 – 07, the fund turned $10,000 into $67,000 and from 2007 – present it turned that $67,000 back into $21,000. All the while turning the portfolio at 2000% a year. Out of curiosity, I went back and reviewed the board of trustee’s decision to renew Mr. Birmiwal’s management contract in light of the fund’s performance. The trustees soberly noted that the fund had underperformed its benchmark and peers for the past 1-, 5-, 10-year and since inception periods but that “performance compared to its benchmark was competitive since the Fund’s inception which was reflective of the quality of the advisory services, including research, trade execution, portfolio management and compliance, provided by the Adviser.” I’m not even sure what that sentence means. In the end, they shrugged and noted that since Mr. B. owned more than 75% of the fund’s shares, he was probably managing it “to the best of his ability.”

I’m mentioning that not to pick on the decedent fund. Rather, I wanted to offer an example of the mental gymnastics that “independent” trustees frequently go through in order to reach a preordained conclusion.

The $75 million Columbia International Bond fund (CNBAX) has closed and will disappear at the being of February, 2015.

DSM Small-Mid Cap Growth Fund (DSMQZ/DSMMX) was liquidated and terminated on short notice at the beginning of December, 2014.

EP Strategic US Equity (EPUSX) and EuroPac Hard Asset (EPHAX) are two more lost lambs subject to “termination, liquidation and dissolution,” both on January 8^th, 2015.

Fidelity trustees unanimously approved the merge of Fidelity Fifty (FFTYX) into Fidelity Focused Stock (FTGQX). Not to point out the obvious but they have the same manager and near-identical 53 stock portfolios already. Shareholders will vote in spring and after baaa-ing appropriately, the reorganization will take place on June 5, 2015.

The Frost Small Cap Equity Fund was liquidated on December 15, 2014.

It is anticipated that the $500,000 HAGIN Keystone Market Neutral Fund (HKMNX) will liquidate on or about December 30, 2014 based on the Adviser’s “inability to market the Fund and that it does not desire to continue to support the Fund.”

Goldman Sachs World Bond Fund (GWRAX) will be liquidated on January 16, 2014. No reason was given. One wonders if word of the potential execution might have leaked out and reached the managers, say around June?

The $300 million INTECH U.S. Managed Volatility Fund II (JDRAX) is merging into the $100 million INTECH U.S. Managed Volatility Fund (JRSAX, formerly named INTECH U.S. Value Fund). Want to guess which of them had more Morningstar stars at the time of the merger? Janus will “streamline” (their word) their fund lineup on April 10, 2015.

ISI Strategy Fund (STRTX), a four star fund with $100 million in assets, will soon merge into Centre American Select Equity Fund (DHAMX). Both are oriented toward large caps and both substantially trail the S&P 500.

Market Vectors Colombia ETF, Latin America Small-Cap Index ETF, Germany Small-Cap ETF and Market Vectors Bank and Brokerage ETF disappeared, on quite short notice, just before Christmas.

New Path Tactical Allocation Fund (GTAAX), an $8 million fund which charges a 5% sales load and charges 1.64% in expenses – while investing in two ETFs at a time, though with a 600% turnover we can’t know for how long – has closed and will be vaporized on January 23, 2015.

The $2 million Perimeter Small Cap Opportunities Fund (PSCVX) will undergo “termination, liquidation and dissolution” on or about January 9, 2015.

ProShares is closing dozens of ETFs on January 9^th and liquidating them on January 22^nd. The roster includes:

SSgA IAM Shares Fund (SIAMX) has been closed in preparation for liquidation cover January 23, 2015. That’s just a mystifying decision: four-star rating, low expenses, quarter billion in assets … Odder still is the fund’s investment mandate: to invest in the equity securities of firms that have entered into collective bargaining agreements with the International Association of Machinists (that’s the “IAM” in the name) or related unions.

UBS Emerging Markets Debt Fund (EMFAX) will experience “certain actions to liquidate and dissolve the Fund” on or about February 24, 2015. The Board’s rationale was that “low asset levels and limited future prospects for growth” made the fund unviable. They were oddly silent on the question of the fund’s investment performance, which might somehow be implicated in the other two factors:

In Closing . . .

Jeez, so many interesting things are happening. There’s so much to share with you. Stuff on our to-do list:

• Active share is a powerful tool for weeding dead wood out of your portfolio. Lots and lots of fund firms have published articles extolling it. Morningstar declares you need to “get active or get out.” And yet neither Morningstar nor most of the “have our cake and eat it, too” crowd release the data. We’ll wave in the direction of the hypocrites and give you a heads up as the folks at Alpha Architect release the calculations for everyone.
• Talking about the role of independent trustees in the survival of the fund industry. We’ve just completed our analysis of the responsibilities, compensation and fund investments made by the independent trustees in 100 randomly-selected funds (excluding only muni bond funds). Frankly, our first reactions are (1) a few firms get it very right and (2) most of them have rigged the system in a way that screws themselves. You can afford to line your board with a collection of bobble-head dolls when times are good but, when times are tough, it reads like a recipe for failure.
• Not to call the ETF industry “scammy, self-congratulatory and venal” but there is some research pointing in that direction. We’re hopeful of getting you to think about it.
• Conference calls with amazing managers, maybe even tricking Andrew Foster into a reprise of his earlier visits with us.
• We’ve been talking with the folks at Third Avenue funds about the dramatic changes that this iconic firm has undergone. I think we understand them but we still need to confirm things (I hate making errors of fact) before we share. We’re hopeful that’s February.
• There are a couple new services that seem intent on challenging the way the fund industry operates. One is Motif Investing, which allows you to be your own fund manager. There are some drawbacks to the service but it would allow all of the folks who think they’re smarter than the professionals to test that hypothesis. The service that, if successful, will make a powerful social contribution is Liftoff. It’s being championed by Josh Brown, a/k/a The Reformed Broker, and the folks at Ritholtz Wealth Management. We mentioned the importance of automatic investing plans in December and Josh followed with a note about the role of Liftoff in extending such plans: “We created a solution for this segment of the public – the young, the underinvested and the people who’ve never been taught anything about how it all works. It’s called Liftoff … We custom-built portfolios that correspond to a matrix of answers the clients give us online. This helps them build a plan and automatically selects the right fund mix. The bank account link ensures continual allocation over time.” This whole “young and underinvested” thing does worry me. We’ll try to learn more.
• And we haven’t forgotten the study of mutual funds’ attempts to use YouTube to reach that same young ‘n’ muddled demographic. It’s coming!

Finally, thanks to you all. A quarter million readers came by in 2014, something on the order of 25,000 unique visitors each month.  The vast majority of you have returned month after month, which makes us a bit proud and a lot humbled.  Hundreds of you have used our Amazon link (if you haven’t bookmarked it, please do) and dozens have made direct contributions (regards especially to the good folks at Emerald Asset Management and to David Force, who are repeat offenders in the ‘help out MFO’ category, and to our ever-faithful subscribers). We’ll try to keep being worth the time you spend with us.

We’ll look for you closer to Valentine’s Day!

Dear friends,

The Christmas of the early American republic – of the half century following the Revolution – would be barely recognizable to us. It was a holiday so minor as to be virtually invisible to the average person. You’ll remember the famous Christmas of 1776 when George Washington crossed the Delaware on Christmas and surprised the Hessian troops who, one historian tells us, were “in blissful ignorance of local custom” and had supposed that there would be celebration rather than fighting on Christmas. Between the founding of the Republic and 1820, New England’s premier newspaper – The Hartford Courant – had neither a single mention of Christmas-keeping nor a single ad for holiday gifts. In Pennsylvania, the Harrisburg Chronicle – the newspaper of the state’s capital – ran only nine holiday advertisements in a quarter century, and those were for New Year’s gifts. The great Presbyterian minister and abolitionist orator Henry Ward Beecher, born in 1813, admitted that he knew virtually nothing about Christmas until he was 30: “To me,” he writes, “Christmas was a foreign day.” In 1819, Washington Irving, author of The Legend of Sleepy Hollow and Rip van Winkle, mourned the passing of Christmas. And, in 1821, the anonymous author of Christmas-keeping lamented that “In London, as in all great cities … the observances of Christmas must soon be lost.” Though, he notes, “Christmas is still a festival in some parts of America.”

Why? At base, Christmas was suppressed by the actions and beliefs of just two groups: the rich people . . . and the poor people.

The rich — the Protestant descendants of the founding Puritans, concentrated in the booming commercial and cultural centers of the Northeast – reviled Christmas as pagan and unpatriotic. About which they were at least half right: pagan certainly, unpatriotic . . . ehhh, debatable.

Here we seem to have a contradiction in terms: a pagan Christmas. To resolve the contradiction, we need to separate a religious celebration of Christ’s birth from a celebration of Christ’s birth on December 25^th. Why December 25^th? The most important piece of the puzzle is obscured by the fact that we use a different calendar system – the Gregorian – than the early Christians did. Under their calendar, December 25^th was the night of the winter solstice – the darkest day of the year but also the day on which light began to reassert itself against the darkness. It is an event so important that every ancient culture placed it as the centerpiece of their year. We have record of at least 40 holidays taking place on, or next to, the winter solstice. Our forebears rightly noted that the choice of December 25^th with a calculated marketing decision meant to draw pagans away from one celebration and into another.

So the Puritans were correct when they pointed out – and they pointed this out a lot – that Christmas was simply a pagan feast in Christian garb. Increase Mather found it nothing but “mad mirth…highly dishonorable to the name of Christ.” Cromwell’s Puritan parliament banned Christmas-keeping in the 1640s and the Massachusetts Puritans did so in the 1650s.

And while the legal bans on Christmas could not be sustained, the social ones largely were.

The rich, who didn’t party, were a problem. The poor, who did, were a far bigger one.

There was, by long European tradition, a period of wild festivity to celebrate New Year’s. Society’s lowest classes – slaves or serfs or peasants or blue collar toilers – temporarily slipped their yokes and engaged in a period of wild revelry and misrule.

In America, the parties were quite wild. Really quite wild.

Think: Young guys.

Lots of them.

With guns.

Drunk.

Ohhh . . . way drunk, lots of alcohol, to . . . uh, drive the cold winter away.

And a sense of entitlement – a sense that their social betters owed them good food, small bribes and more alcohol.

Then add lots more alcohol.

Roving gangs, called “callithumpian bands,” roamed night after night – by a contemporary account “shouting, singing, blowing trumpets and tin horns, beating on kettles, firing crackers … hurling missiles” and demanding some figgy pudding. Remember?

Oh, bring us a figgy pudding and a cup of good cheer

We won’t go until we get some;

We won’t go until we get some;

We won’t go until we get some, so bring some out here

Back then, that wasn’t a song. It was a set of non-negotiable demands.

In a perverse way, what saved Christmas was its commercialization. Beginning in New York around 1810 or 1820, merchants and civic groups began “discovering” old Dutch Christmas traditions (remember New York started as New Amsterdam) that surrounded family gatherings, communal meals and presents. Lots of presents. The commercial Christmas was a triumph of the middle class. Slowly, over a generation, they pushed aside old traditions of revelry and half-disguised violence. By creating a civic holiday which helped to bridge a centuries’ old divide between Christian denominations – the Christmas-keepers and the others – and gave people at least an opportunity to offer a fumbling apology, perhaps in the form of a Chia pet, for their idiocy in the year past and a pledge to try better in the year ahead.

I might even give it a try, minus regifting my Chia thing.

Harness the incomparable power of lethargy!

We are lazy, inconstant, wavering and inattentive. It’s time to start using it to our advantage. It’s time to set up a low minimum/low pain account with an automatic investment plan.

About a third of us have saved nothing. The reasons vary. Some of us simply can’t; about 60 million of us – the bottom 20% of the American population – are getting by (or not) on $21,000/year. Over the past 40 years, that group has actually seen their incomes decline by 1%. Folks with just high school diplomas have lost about 20% in purchasing power over that same period. NPR’s Planet Money team did a really good report on how the distribution of wealth in the US has changed over the past 40 years.

A rather larger group of us could save, or could save more, but we’re thwarted by the magnitude of the challenge. Picking funds is hard, filling out forms is scary and thinking about how far behind we are is numbing. So we sort of panic and freeze. That reaction is only so-so in possums; it pretty much reeks in financial planning.

Fortunately, you’ve got an out: low minimum accounts with automatic investment plans. That’s not the same as a low minimum mutual fund account. The difference is that low minimum accounts are a bad idea and an economic drain to all involved; when I started maintaining a list of funds for small investors in the 1990s, there were over 600 no-load options. Most of those are gone now because fund advisers discovered an ugly truth: small accounts stay small. Full of good intentions people would invest the required $250 or $500 or whatever, then bravely add $100 in the next month but find that cash was a bit tight in the next month and that the cat needed braces shortly thereafter. Fund companies ended up with thousands of accounts containing just a few hundred dollars each; those accounts might generate just $3 or 4 a year in fees, far below what it cost to keep them open. Left to its own a $250 account would take 20 years to reach $1,000, a nice amount but not a meaningful one.

But what if you could start small then determinedly add a pittance – say $50 – each month? Over that same 20 year period, your $250 account with a $50 monthly addition would grow to $29,000. Which, for most of us, is really meaningful.

Would you like to start moving in that direction? Here’s how.

If you do not have an emergency fund or if you mostly want to sleep well at night, make your first fund one that invests mostly in cash and bonds with just a dash of stocks. As we noted last month, such a stock-light portfolio has, over the past 65 years, captured 60% of the stock market’s gains with only 25% of its risks. Roughly 7% annual returns with a minimal risk of loss. That’s not world-beating but you don’t want world-beating. For a first fund or for the core of your emergency fund, you want steady, predictable and inflation-beating.

Consider one of these two:

TIAA-CREF Lifestyle Income Fund (TSILX). TIAA-CREF is primarily a retirement services provider to the non-profit world. This is a fund of other TIAA-CREF funds. About 20% of the fund is invested in dividend-paying stocks, 40% in short-term bonds and 40% in other fixed-income investments. It charges 0.83% per year in expenses. You can get started for just $100 as long as you set up an automatic investment of at least $100/month from your bank account. Here’s the link to the account application form. You’ll have to print off the pdf and mail it. Sorry that they’re being so mid-90s about it.

Manning & Napier Strategic Income, Conservative Series (MSCBX). Manning & Napier is a well-respected, cautious investment firm headquartered in Fairport, NY. Their funds are all managed by the same large team of people. Like TSILX, it’s a fund-of-funds and invests in just five of M&N’s other funds. About 30% of the fund is invested in stocks and 70% in bonds. The bond portfolio is a bit more aggressive than TSILX’s and the stock portfolio is larger, so this is a slightly more-aggressive choice. It charges 0.88% per year in expenses. You can get started for just $25 (jeez!) as long as you set up a $25 AIP. Do yourself a favor a set a noticeably higher bar than that, please. Here’s the direct link to the fund application form. Admittedly it’s a poorly designed one, where they stretch two pages of information they need over about eight pages of noise. Be patient with them and with yourself, it’s just not that hard to complete and you do get to fill it out online.

Where do you build from there? The number of advisers offering low or waived minimums continues to shrink, though once you’re through the door you’re usually safe even if the firm ups their requirement for newcomers.

Here’s a quick warning: Almost all of the online lists of funds with waived or reduced minimum contain a lot of mistakes. Morningstar, for instance, misreports the results for Artisan (which does waive its minimum) as well as for DoubleLine, Driehaus, TCW and Vanguard (which don’t). Others are a lot worse, so you really want to follow the “trust but verify” dictum.

Here are some of your best options for adding funds to your monthly investing portfolio:

Do you have a fund family that really should be on this list but we missed? Sorry ‘bout that! But we’ll fix it if only you’ll let us know!

Correcting our misreport of FPA Paramount’s (FPRAX) expense ratio

In our November profile of FPRAX, we substantially misreported FPRAX’s expense ratio. The fund charges 1.26%, not 0.92% as we reported. . Morningstar, which had been reporting the 0.92% charge until late November, now reports a new figure. The annual report is the source for the 1.06% number, the prospectus gives 1.26%.  The difference is that one is backward-looking, the other forward looking.

Where did the error originate? Before the fall of 2013, Paramount operated as a domestic small- to mid-cap fund which focused on high quality stocks. At that point the expense ratio was 0.92%. That fall FPA changed its mandate so that it now focuses on a global, absolute value portfolio.  Attendant to that change, FPA raised the fund’s expense ratio from 0.92 to 1.26%. We didn’t catch it. Apologies for the error.

The next question: why did FPA decide to charge Paramount’s shareholders an extra 37%? I’ve had the opportunity to chat at some length with folks from FPA, including Greg Herr, who serves as one of the managers for Paramount. The shortest version of the explanation came in an email:

… the main reasons we sought a change in fees was because [of] the increased scope of the mandate and comparable fees charged by other world stocks funds.

FPA notes that the fund’s shareholders voted overwhelmingly to raise their fees. The proxy statement adds a bit of further detail:

FPA believes that the proposed fee would be competitive with other global funds, consistent with fees charged by FPA to other FPA Funds (and thus designed to create a proper alignment of internal incentives for the portfolio management team), and would allow FPA to attract and retain high quality investment and trading personnel to successfully manage the Fund into the future.

Based on our conversations and the proxy text, here’s my best summary of the arguments in favor of a higher expense ratio:

• It’s competitive with what other companies charge
• The fund has higher costs now
• The fund may have higher costs in the future, for example higher salaries and larger analyst teams
• FPA wants to charge the same fee to all of our shareholders

Given the fund’s current size ($304 million), the additional 34 bps translates to an additional $1.03 million/year transferred from shareholders to the adviser.

Let’s start with the easy part. Even after the repricing, Paramount remains competitively priced. We screened for all retail, no-load global funds with between $100-500 million in their portfolios, and then made sure to add the few other global funds that the Observer already profiled. There are 35 such funds. Twelve are cheaper than Paramount, 21 are more expensive. Great Owls appear in highlighted blue rows, while profiled funds have links to their MFO profiles.

Unfortunately other people’s expenses are a pretty poor explanation for FPA’s prices.

There are two ways of reading FPA’s decision:

1. We’re going to charge what the market will bear. Welcome to capitalism. The cynical reading starts with the suspicion that the fund’s expenses haven’t risen by a million dollars. While FPA cites research, trading, settlement and compliance expenses that are higher in a global fund than in a domestic fund, the fact that every international stock in Paramount’s portfolio was already in International Value’s means that the change required no additional analysts, no additional research trips, no additional registrations, certifications or subscriptions. While Paramount’s shareholders might need to share the cost of those reports with International Value’s (which lowers the cost of running International Value), at best it’s a wash: International Value’s expenses should fall as Paramount’s rise.
2. We need to raise fees a lot in the short term to be sure we can do right by our shareholders in the long term. There are increased expenses, they were fully disclosed to the fund’s board, and that the board acted thoughtfully and in good faith in deciding to propose a higher expense ratio. They also argue that it makes sense that Paramount and International Value’s shareholders should pay the same rate for their manager’s services, the so-called management fee, since they’ve got the same managers and objectives. Before the change, FPIVX shareholders paid 1% and FPRAX shareholders paid 0.65%. The complete list of FPA management fees:
   

   FPA New Income	Non-traditional bond	0.50
   FPA Capital	Mid-cap value	0.65
   FPA Perennial	Mid-cap growth	0.65
   FPA Crescent	Free-range chicken	1.00
   FPA International Value	International all-cap	1.00
   FPA Paramount	Global	1.00

   Finally, the new expenses create a sort of war-chest or contingency fund which will give the adviser the resources to address opportunities that are not yet manifest.

So what do we make of all this? I don’t know. I respect and admire FPA but this decision is disquieting and opaque. I’m short on evidence, which is frustrating.

That, sadly, is where we need to leave it.

Whitney George and the Royce Funds part ways

We report each month on manager changes, primarily at equity and balanced funds. All told, nearly 700 funds have reported changes so far in 2014. Most of those changes have a pretty marginal effect. Of the 68 manager changes we reported in our November issue, only 12 represented house cleanings. The remainder were simply adding a new member to an existing team (20 instances) or replacing part of an existing team (36 funds).

Occasionally, though, manager departures are legitimate news and serious business, both for a fund’s shareholders and the larger investing community.

And so it is with the departure of Whitney George from Royce Funds.

Mr. George has been with Royce Funds for 23 years, both as portfolio manager and with founder Charles Royce, co-Chief Investment Officer. He manages the $65 million Royce Privet hedge fund (‘cause “privet” is a kind of hedge, you see) and the $170 million Royce Focus Trust (FUND), an all-cap, closed-end fund. On November 10, Royce announced that Mr. George was leaving to join Toronto-based Sprott Asset Management and that, pending shareholder approval, Privet and Focus were going with him. At the same time he stepped aside from the management (sole, co- or assistant) of five open-end funds: Royce Global Value (RIVFX), Low-Priced Stock (RYLPX), Premier (RPFFX), SMid-Cap Value (RMVSX) and Value (RYVFX). They are all, by Morningstar’s reckoning, one- or two-star funds. As of May 2014, Mr. George was connected with the management of more than $15 billion in assets.

Why? The firm’s leadership was contemplating long term succession planning for Chuck and decided on an executive transition that did not include Whitney. The position of president went to Chris Clark. Sometime thereafter, he concluded that his greatest contributions and greatest natural strengths lay in managing investments for Canadians and began negotiating a separation. He’ll remain with Royce through the end of the first quarter of 2015, and will remain domiciled in New York City rather than moving to Toronto and feigning an interest in the Maple Leafs, Blue Jays, Rock, Raptors or round bacon.

What’s worth knowing?

• The media got it wrong. In 2009, Mr. George was named co-chief investment officer along with Chuck Royce. At the time Royce was clear that this was not succession planning (this was “not in preparation for Mr. Royce retiring at some point”); which is to say, Mr. George was not being named heir apparent. Outsiders knew better: “The succession plan has become clearer recently: Whitney George was promoted to co-chief investment officer in 2009, and for now he serves alongside Chuck Royce” Karen Anderson, Morningstar, 12/01/10.
• Succession is clearer now. Royce’s David Gruber allowed that the 2009 move was contingency planning, not succession planning. There now are succession plans: the firm has created a management committee to help Mr. Royce, who is 75, run the firm. While Mr. Royce has no plans on retiring, they “would rather make these decisions now than when Chuck is 85” and imagine that “Chris Clark will become CEO in the next several years.” Mr. Clark has been with Royce for over seven years, has been a manager for them and used to be a hedge fund manager. He’s now their co-CIO.
• The change will make a difference in the funds. David Nadel, an international equity specialist for them, will take over the international sleeve of Global Value. Mr. Royce assumes the lead on Premier, his 13^th Most significantly, James Stoeffel intends to reorient the Low-Priced Stock portfolio toward, well, low-priced stocks. The argument is that low-priced stocks are inefficiently priced stocks. They have limited interest to institutions for some reason, especially those priced below $10. Stocks priced below $5 cannot be purchased on margin, which further limits their market. Mr. Stoeffel intends to look more closely now at stocks priced near $10 rather than those in the upper end of the allowable range ($25). Up until the last three years, RLPSX has stayed step-for-step with Joel Tillinghast and the remarkable Fidelity Low-Priced Stock Fund (FLPSX). If they can regain that traction, it would be a powerful addition to Royce’s lagging lineup.
• Royce is making interesting decisions. Messrs. George and Royce served as co-CIOs from 2009 to the end of 2013. At that point, the firm appointed Chris Clark and Francis Gannon to the role. The argument strikes me as interesting: Royce does not want their senior portfolio managers serving as CIOs (or, for that matter, as CEO). They believe that the CIO should complement the portfolio managers, rather than just being managers. The vision is that Clark and Gannon function as the firm’s lead risk managers, trying to understand the bigger picture of threats and challenges and working with a new risk management committee to find ways around them. And the CEO should have demonstrated business management skills, rather than demonstrated investment management ones. That’s rather at odds with the prevailing “great man” ideology. And, frankly, being at odds with the prevailing ideology strikes me as fundamentally healthy.

Succession is an iffy business, especially when a firm’s founder was a titanic personality. We learned that in the barely civil transition from Jack Bogle to John Brennan and some fear that we’re seeing it as Marty Whitman becomes marginalized at Third Avenue. We’ll follow-up on the Third Avenue transition in our January issue and, for now, continue to watch Royce Funds to see if they’re able to regain their footing in the year ahead.

Top developments in fund industry litigation – November 2014

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 and filtered as never before.

“We built Fundfox from the ground up for mutual fund insiders,” says attorney-founder David M. Smith. “Directors and advisory personnel now have easier and more affordable access to industry-specific litigation intelligence than even most law firms had before.”

The core offering is a database of case information and primary court documents for hundreds of industry cases filed in federal courts from 2005 through the present. A Premium Subscription also includes robust database searching—by fund family, subject matter, claim, and more.

Orders

• In a win for Fidelity, the U.S. Supreme Court denied a certiorari petition in an ERISA class action regarding the float income generated by transactions in plan accounts. (Tussey v. ABB Inc.)
• Extending the fund industry’s losing streak, the court denied Harbor’s motion to dismiss excessive fee litigation regarding the subadvised International Fund: “Although it is far from clear that Zehrer [the plaintiff-shareholder] will be able to meet the high standard for liability under § 36(b), he has alleged sufficient facts specific to the fees paid to Harbor Capital to survive a motion to dismiss.” (Zehrer v. Harbor Capital Advisors, Inc.)
• The court dismissed Nuveen from an ERISA class action regarding services rendered by FAF Advisors, holding that the contract for Nuveen’s purchase of FAF “unambiguously indicates that Nuveen did not assume any liability that FAF may have had” with respect to the plan at issue. (Adedipe v. U.S. Bank, N.A.)

Briefs

• Genworth filed a motion for summary judgment in the class action alleging that defendants misrepresented the role that Robert Brinker played in the management of the BJ Group Services portfolio. (Goodman v. Genworth Fin. Wealth Mgmt., Inc.)
• SEI Investments filed a motion to dismiss an amended complaint challenging advisory and transfer agent fees for five funds. (Curd v. SEI Invs. Mgmt. Corp.)
• In the ERISA class action regarding TIAA-CREF’s account closing procedures, defendants filed a motion seeking dismissal of interrelated state-law claims as preempted by ERISA. (Cummings v. TIAA-CREF.)

Amended Complaint

• Plaintiffs filed an amended complaint in a consolidated class action regarding an alleged Ponzi scheme related to “TelexFree Memberships.” Defendants include a number of investment service providers, including Waddell & Reed. (Abdelgadir v. TelexElectric, LLLP.)

Supplemental Complaint

• In the class action regarding Northern Trust’s securities lending program, a pension fund’s board of trustees filed a supplemental complaint asserting individual non-class claims. (La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)

The Alt Perspective: Commentary and news from DailyAlts.

Brian Haskin publishes and edits the DailyAlts site, which is devoted to the fastest-growing segment of the fund universe, liquid alternative investments. Here’s his quick take on the DailyAlts mission:

Our aim is to provide our readers (investment advisors, family offices, institutional investors, investment consultants and other industry professionals) with a centralized source for high quality news, research and other information on one of the most dynamic and fastest growing segments of the investment industry: liquid alternative investments.

Brian offers this as his take on the month just past.

NO PLACE TO HIDE

Asset flows into and out of mutual funds and ETFs provide the market with insights about investor behavior, and in this past month it was clear that investors were not happy about active management and underperformance. While the data is lagged a month (October flow data becomes available in November, for instance), asset flows out of alternative mutual funds and ETFs exceeded inflows for the first time in…. well quite a while.

As noted in the table below, alternatives suffered $2.8 billion in outflows across both active and passive strategies. This is a stark change from previous months whereby the category generated consistent positive inflows. Of the $2.8 billion in outflows however, the MainStay Marketfield Fund, a long/short equity fund, contributed $2.2 billion. Market neutral funds also suffered outflows, while managed futures, multi-alternative and commodity funds all saw reasonable inflows.

However, alternatives were not the only category hit in October. Actively managed funds were hit to the tune of $31 billion in outflows, while passive funds recorded $54 billion in inflows. Definitely a shift in investor preferences as active funds in general struggle to keep up with their passive counterparts.

NEW FUND LAUNCHES IN NOVEMBER

Year to date, we have seen 80 new alternative funds hit the market, and six of those were launched in November (this may be revised upward in the next few days; see List of New Funds for more information). Both the global macro and managed futures categories had two new entrants, while other new funds fell into the long/short equity and mutli-alternative categories. Two notable new funds are as follows:

• Neuberger Berman Global Long Short Fund – There are not many pure global long/short funds, yet a larger opportunity set creates more potential for value added. The portfolio manager is new to Neuberger Berman, but not new to global investing. With its global mandate, this fund has the potential to work well alongside a US focused long/short fund.
• Eaton Vance Global Macro Capital Opportunities Fund – This fund is also global but looks for opportunities across multiple asset classes including equity and fixed income securities. The fund carries a moderate fee relative to other multi-alternative funds, and Eaton Vance has had longer-term success with other global macro funds.

FUND REGISTRATIONS IN NOVEMBER

October was the final month to register a fund and still get it launched in 2014, and as a result, November only saw eight new alternative funds enter the registration process, all of which fall into the alternative fixed income or multi-alternative categories. Two of these that look promising are:

• Franklin Mutual Recovery Fund – If you like distressed fixed income, then keep an eye out for the launch of this fund. This fund goes beyond junk and looks for bonds and other fixed income securities of distressed or bankrupt companies.
• Collins Long/Short Credit Fund – If interest rates ever rise, long/short credit funds can help get out of the way of volatile fixed income markets. The sub-advisor of this new fund has a record of delivering fairly steady returns over past several years while beating the Barclays Aggregate Bond Index.

NOVEMBER’S TOP RESEARCH / EDUCATIONAL ARTICLES

Education is critical when it comes to newer and more complex investment approaches, and liquid alternatives fit that description. The good news is that asset managers, investment consultants and other thought leaders in the industry publish a wide range of research papers that are available to the public. At DailyAlts, we provide summaries of these papers, along with links to the full versions. The top three research related articles in November were:

• The Sharpe Ratio is Not the Best Metric for Maximizing Portfolio Efficiency
• MLP Investment Guide for Taxable and Non-Taxable Investors
• The Free Lunch Effect: The Value of Decoupling Diversification and Risk

OTHER NEWS

Probably the most interesting news during the month was the SEC’s approval of Eaton Vance’s proposal to launch Exchange Traded Managed Funds, which essentially combines the intra-day trading, brokerage account availability and lower operating costs of exchange traded funds (ETFs) with the less frequent transparency (at least quarterly disclosure of holdings) of mutual funds. Think of actively managed mutual funds in an ETF wrapper.

Why is this significant? The ETF market is growing at a much faster rate than the mutual fund market, and so far most of the flows into ETFs have been into indexed ETFs. Now the door is open for actively managed ETFs with less transparency than a typical ETF, so expect to see over the next few years a long line of active fund management companies shift gears away from mutual funds and prepping new ETMF structures on the heels of Eaton Vance’s approval from the SEC. Many active fund managers that have wanted to tap the growth of the ETF market now have a mechanism to do so, assuming they can either create their own structure without violating patents held by Eaton Vance, or license the technology directly from Eaton Vance.

Visit us at DailyAlts.com for ongoing news and information about liquid alternatives.

Dodging the tax bullet

We’re entering capital gains season, a time when funds make the distributions that will come back to bite you around April 15^th. Because funds operate as pass-through vehicles for tax purposes, investors can end up paying taxes in two annoying circumstances: when they haven’t sold a single share of a fund and when the fund is losing money. The sooner you know about a potential hit, the better you’re able to work on offsetting strategies. We’re offering two short-term resources to help you sort through.

Our colleague The Shadow, one of our discussion board’s most vigilant members, has assembled links to the announced distributions for over 160 fund families. If you want to go directly there, let your mouse hover over the Resources tab at the top of this page and the link will appear.

Beyond that, Mark Wilson has launched Cap Gains Valet to help you. In addition to being Chief Valet, Mark is chief investment officer for The Tarbox Group in Newport Beach, CA. He is, they report, “one of only four people in the nation that has both the Certified Financial Planner® and Accredited Pension Administrator (APA) designations.” Mark’s site, which is also free and public, offers a nice search engine, interpretive articles and a list of funds with the most horrifyingly large distributions. Here’s a friendly suggestion to any of you invested in the Turner Funds: go now! There’s a good chance that you’re going to say something that rhymes with “oh spit.”

We asked Mark what advice he could offer to avoid taking another hit next year. Here’s his year-end planning list for you:

Keeping More of What You Make

Between holiday shopping, decorating and goodie eating there is more than enough going on this time of year without worrying about the tax consequences from mutual fund capital gain distributions.

I have already counted over 450 funds that will distribute more than 10% of their net asset value (NAV) this year, and 50 of these are expected to distribute in excess of 20%! Mutual fund information providers, fund marketers, and most fund managers focus on total investment returns, so they do not care much about taxable distributions. Of course, total returns are very important, but it is not what you make, it is what you keep! After-tax returns are what are most important for the taxable investor.

You can keep more of what you make by considering these factors before you make your investment:

• Use funds with embedded losses or low potential capital gains exposures. Are there really quality funds that have little/no gains? Yes, and Mutual Fund Observer (MFO) is a great site to find these opportunities. The most likely situations are when an experienced manager opens his/her own shop or when one takes over a failing fund and makes it their own.
• Use funds with low turnover and with a long-term investment philosophy. Paying taxes on annual long-term capital gains is not pleasant; however, it is the short-term gains that are the real killer. Short-term gains are taxed at your ordinary income tax rates. Worse yet, short-term capital gains distributions are not offset by other types of capital losses, as these are reported on a completely different tax schedule. Fund managers who trade frequently might have attractive returns, but their returns have to be substantially higher than tax-efficient managers to offset the higher tax bite they are generating.
• Think about asset location. Putting your most tax-inefficient holdings in your tax-deferred accounts will help you avoid these issues. Funds that typically have significant taxable income, high turnover, or mostly short-term gains should be placed in your IRA, Roth IRA, etc. High yield funds, REIT funds and many alternative strategies are usually ideal funds to place in tax-deferred accounts.
• Use index funds or broad based indexed ETFs. I know MFO is not an index fund site, but it is clear that it is not easy to choose funds that beat comparable broad based, low cost index funds or ETFs. When taxes are added to the equation, the hurdle gets even higher. Using index-based holdings in taxable accounts and active fund managers in tax-deferred accounts can make for a great compromise.

I hope considering these strategies will leave you with a little more to spend on the holidays in 2015. Mark.

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.

Polaris Global Value (PGVFX) Polaris sports one of the longer records among global stock funds, low expenses, excellent tax efficiency, dogged independence and excellent long term returns. Well, no wonder they have such a small fund!

RiverPark Structural Alpha (RSAFX) Structural Alpha starts with a simple premise: people are consistently willing to overpay in order to hedge their risks. That makes the business of selling insurance to them consistently profitable if you know what you’re doing and don’t get greedy. Justin and Jeremy have proven over the course of years that (1) they do and (2) they don’t, much to their investors’ gain. For folks disgusted with bonds and overexposed to stocks, it’s an interesting alternative.

ValueShares US Quantitative Value (QVAL) We don’t typically profile ETFs, but our colleague Charles Boccadoro has been in an extended conversation with Wesley Gray, chief architect of Alpha Architect, and he offers an extended profile with a wealth of unusual detail for this quant’s take on buying “the cheapest, highest quality value stocks.”

Conference call with Mitch Rubin, CIO and PM, RiverPark Large Growth Fund, December 17th, 7:00 Eastern

We’d be delighted if you’d join us on Wednesday, December 17^th, for a conversation with Mitch Rubin, chief investment officer for the RiverPark Funds. Over the past several years, the Observer has hosted a series of hour-long conference calls between remarkable investors and, well, you. The format’s always the same: you register to join the call. We share an 800-number with you and send you an emailed reminder on the day of the call. We divide our hour together roughly in thirds: in the first third, our guest talks with us, generally about his or her fund’s genesis and strategy. In the middle third I pose a series of questions, often those raised by readers. Here’s the cool part, in the final third you get to ask questions directly to our guest; none of this wimpy-wompy “you submit a written question in advance, which a fund rep rewords and reads blankly.” Nay nay. It’s your question, you ask it.

The stability of the Chinese economy has been on a lot of minds lately. Between the perennial risks of the unregulated shadow banking sector and speculation fueled by central bank policies to the prospect of a sudden crackdown on whatever the bureaucrats designate as “corruption,” the world’s second largest stock market – and second largest economy – has been excessively interesting.

Mr. Rubin and his fund have a fair amount of exposure to China. In the second week of December, he and his team will embark on a research trip to the region. They’ve agreed to speak with us about the trip and the positioning of his fund almost immediately after the jet lag has passed.

RiverPark’s president Morty Schaja is coordinating the call and offers this explanation from why you might want to join it.

Given the planned openings of new casinos and the expected completion of the bridge from Hong Kong to Macau, Mitch and his team believe that the current stock weakness presents an unusual opportunity for investors.

Generally speaking Mitch is excited about the opportunity for the Fund post a period of relative underperformance. This year many of the fund’s positions – relative to both the market and, more importantly, to their expected growth – are now as inexpensive as they have been in some time. The Fund is trading at a weighted average price-earnings ratio (PE) of about 13x 2016 earnings, a discount to the market as a whole. This valuation is, in Mitch’s view, especially compelling given that their holdings have demonstrated substantially faster earnings growth of 15-20% or more as compared with the 7% historical earnings growth for the market. Given these valuations and the team’s continued confidence in the long-term earnings growth of the companies, they believe the Fund is especially well positioned going into year end.

It will be an interesting opportunity to talk with Mitch about how he thinks about the vicissitudes of “relative performance” (three excellent years are being followed by one poor one) and shareholder twitchiness.

HOW CAN YOU JOIN IN?

If you’d like to join in, just click on register and you’ll be taken to the Chorus Call site. In exchange for your name and email, you’ll receive a toll-free number, a PIN and instructions on joining the call. If you register, I’ll send you a reminder email on the morning of the call.

Remember: registering for one call does not automatically register you for another. You need to click each separately. Likewise, registering for the conference call mailing list doesn’t register you for a call; it just lets you know when an opportunity comes up. 

WOULD AN ADDITIONAL HEADS UP HELP?

Over two hundred readers have signed up for a conference call mailing list. About a week ahead of each call, I write to everyone on the list to remind them of what might make the call special and how to register. If you’d like to be added to the conference call list, just drop me a line.

Funds in registration

There were remarkably few funds in registration with the SEC this month, just four and a half. That reflects, in part, the fact that advisers wanted to get new funds launched by December 30^th and the funds in registration now won’t be available until February. It might also reflect a loss of confidence within the fund industry, since it’s the lowest total we’ve recorded in nine years. That said, several of the new registrations will end up being solid and useful offerings: T. Rowe Price is launching a global high income bond fund and a global unconstrained bond fund while Vanguard will offer an ultra-short bond fund for the ultra-nervous. They’re all detailed on the Funds in Registration page.

Manager changes

This month also saw a modest level of manager turnover; 53 funds reported changes, the most immediately noticeable of which was Mr. George’s departure from various Royce funds. More-intriguing changes include the appointment of former Janus manager and founding partner of Arrowpoint Minyoung Sohn to manage Meridian Equity Income (MEIFX). At about the same time, Bernard Horn and Polaris Capital were appointed to manage Pear Tree Columbia Small Cap Fund (USBNX) which I assume will become Pear Tree Polaris Small Cap Fund on January 1. Polaris already subadvises Pear Tree Polaris Foreign Value Small Cap Fund (QUSOX / QUSIX) which has earned both five stars from Morningstar and a Great Owl designation from the Observer.

We know you’re communicating in new ways …

But why don’t you communicate in simple ones? It turns out that fund firms are, with varying degrees of conviction, invading the world of cat videos. A group called Corporate Insights maintains a series of Mutual Fund Monitor reports, the most recent of which is “Fund Films Go Viral: The Diverse Strategies of Fund Firms on YouTube.” They were kind enough to share a copy and a quick reading suggests that firms have a long way to go if they intend to use sites like YouTube to reach younger prospective investors. We’ll talk with the report’s authors in December and pass along what we learn.

In the meanwhile: all fund firms have immediate access to a simple technology that could dramatically increase the number of people noticing what you’ve written and published. And you’re not using it. Why is that?

Chip, our technical director and founding partner, has been looking at the possibility of aggregating interesting content from fund advisers and making it widely available.  The technology to acquire that content is called Real Simple Syndication, or RSS for short. At base the technology simply pushes your new content out to folks who’ve already expressed an interest in it; the Observer, for example, subscribes to the New York Times RSS feed for mutual funds. When they write it there, it pops up here.

Journalists, analysts, investors and advisers could all receive your analyses automatically, without needing to remember to visit your site, in their inboxes. And yet, Chip discovered, almost no one uses the feed (or, in at least one case, made a simple coding mistake that made their feed ineffective).

If you work with or for a fund company, would you let us know why? And if you don’t know, would you ask someone in web services?  In either case, drop Chip a note to let her know what’s up. We’d be happy to foster the common good by getting more people to notice high-quality independent shops, but we’d need your help. Thanks!

Briefly noted . . .

If you ever wondered I look like, you’re in luck. The Wall Street Journal ran a nice interview with me, entitled, “Mutual Funds’ Professor Can Flunk Them.” Embarrassed that the only professional pictures of me were from my high school graduation, I duped a very talented colleague into taking a new set, one of which appears in the Journal article. Pieces of the article, though not the radiant portrait, were picked up by Ben Carlson, at A Wealth of Common Sense; Cullen Roche, at Pragmatic Capitalism; and Joshua Brown, at The Reformed Broker.

A reader has requested that we share word of Seafarer‘s upcoming conference call. Here it is:

SMALL WINS FOR INVESTORS

DuPont Capital Emerging Markets Fund (DCMEX) reopened to new investors on December 1, 2014. It sports a $1 million minimum, $348 million portfolio and record that trails 96% of its peers over the past three years. On the upside, the fund appointed two additional managers in mid-October.

Guggenheim Alpha Opportunity Fund (SAOAX) reopens to new and existing investors on January 28^th. At the same time they’ll get a new long/short strategy and management team. Okay, I’m baffled. Here’s the fund’s performance under its current strategy and managers (blue line) versus long/short benchmark (orange line):

If you’d invested $10,000 in the average long/short fund on the day the SAOAX team came on board, your account would have grown by 25%. If you’d given your money to the SAOAX team, it would have grown by 122%. That’s rarely grounds for kicking the scoundrels out. Admittedly the fund has a minuscule asset base ($11 million after 11 years) but that seems like a reason to change the marketing team, doesn’t it?

As a guy who likes redemption fees since they benefit long-term fund holders at the expense of traders, I’m never sure of whether their elimination qualifies as a “small win” or a “small loss.” In the holiday spirit, we’ll classify the elimination of those fees from four Guinness Atkinson funds (Inflation-Managed Dividend, Global Innovators, Alternative Energy, Global Energy and Alternative Energy) as “wins.” After the New Year, though, we’re back to calling them losses.

Invesco European Small Company Fund (ESMAX) has reopened to existing investors though it remains closed to new ones. It’s the best open-end fund in its space, but then it’s almost the only open-end mutual fund in its space. Its two competitors are Royce European Smaller-Companies (RESNX) and DFA Continental Small Company (DFCSX). ESMAX handily outperforms either. There are a couple ETF alternatives to it, the best being WisdomTree Europe SmallCap Dividend ETF (DFE). DFE’s a bit more volatile but a lot cheaper (58 bps versus 146), available and has posted near-identical returns over the past five years.

Loomis Sayles gives new meaning to “grandfathered-in.” While several Loomis Sayles funds (notably Small Cap Growth and Small Cap Value) remain closed to new investors, as of November 19, 2014 they became available to Natixis employees … and to their grandparents. Also grandkids. Had I mentioned mothers-in-law? The institutional share classes of a half dozen funds are available to family members without a minimum investment requirement. Yes, indeed, if your wretched son-in-law (really, none of us have any idea of what your daughter saw in that ne’er do well) works for Natixis you can at least comfort yourself with your newly gained access to first-rate investment management.

Market Vectors lowered the expense cap on Market Vectors Investment Grade Floating Rate ETF (NYSE Arca: FLTR) from 0.19% to 0.14%. As the release discusses, FLTR is an interesting option for income investors looking to decrease interest rate sensitivity in their portfolios. The fund was recently recognized by Morningstar at the end of September with a 5-star overall rating. 

CLOSINGS (and related inconveniences)

None that I could find. I’m not sure what to make of the fact that the Dow has had 29 record closes through late November, and still advisers aren’t finding cause to close any funds. It might be that stock market records aren’t translating to fund flows, or it might be that advisers are seeing flows but are loathe to close the doors.

OLD WINE, NEW BOTTLES

Effective January 28, 2015, AQR is renaming … well, pretty much everything.

The ticker symbols remain the same.

Effective December 19, 2014, a handful of BMO funds add the trendy “allocation” moniker to their names:

On January 14, 2015, Cloud Capital Strategic Large Cap Fund (CCILX) is becoming Cloud Capital Strategic All Cap Fund. It will be as strategic as ever, but now will be able to ply that strategy on firms with capitalizations down to $169 million.

Effective December 30, 2014, the name of the CMG Managed High Yield Fund (CHYOX) will be changed to CMG Tactical Bond Fund. And “high yield bond” will disappear from the mandate. Additionally, effective January 28, 2015, the Fund will no longer have a non-fundamental policy of investing at least 80% of its assets in fixed income securities.

Crystal Strategy Leveraged Alternative Fund has become the Crystal Strategy Absolute Return Plus Fund (CSLFX). That change occurred less than a year after launch but that fund has attracted only $5 million, which might be linked to high expenses (2.3%), a high sales load and losing money while their multi-alternative peers were making it. It’s another instance where “change the name” doesn’t seem to be the greatest imperative.

Deutsche International Fund (SUIAX) has changed its name to Deutsche CROCI® International Fund and Deutsche Equity Dividend (KDHAX) has become Deutsche CROCI® Equity Dividend Fund. Oddly the name change does not appear to be accompanied by any explanation of what’s up with the CROCI (cash return on capital invested??) thing. CROCI was part of Deutsche Bank’s research operation until late 2013.

Effective December 8, 2014, Guinness Atkinson Asia Pacific Dividend Fund (GAADX) will be renamed Guinness Atkinson Asia Pacific Dividend Builder Fund with this strategy clarification:

The Advisor uses fundamental analysis to assess a company’s ability to maintain consistent, real (after inflation) dividend growth. The Advisor seeks to invest in companies that have returned a real cash flow return on investment of at least 8% for each of the last eight years, and, in the opinion of the Advisor, are likely to grow their dividend over time.

At the same time, Guinness Atkinson Inflation Managed Dividend Fund (GAINX) becomes Guinness Atkinson Inflation Managed Dividend Builder Fund.

RESQ Absolute Income Fund has become the RESQ Strategic Income Fund (RQIAX). It now “seeks income with an emphasis on total return and capital preservation as a secondary objective.” “Capital appreciation” is out; “total return” is in. And again, the fund has been around for less than a year so changing the name and strategy doesn’t seem like evidence of patience and planning. Oh, too, RESQ Absolute Equity Fund is now RESQ Dynamic Allocation Fund (RQEAX). It appears to be heightening the visibility of international equities in the investment plan and adding popular words to the name.

Orion/Monetta Intermediate Bond Fund is now Varsity/Monetta Intermediate Bond Fund (MIBFX). Sorry, Orion, you’ve been chopped!

Effective November 12, 2014, Virtus Mid-Cap Value Fund became Virtus Contrarian Value Fund (FMIVX). By the end of January 2015, the principle investment strategy be tweaked but in reading the old and new text side-by-side, I couldn’t quite figure out what was changing. A performance chart of the fund suggests that it’s pretty much a mid-cap value index fund with slightly elevated volatility and noticeably elevated expenses.

OFF TO THE DUSTBIN OF HISTORY

Aberdeen Global Select Opportunities Fund (BJGQX), formerly Artio Select Opportunities, formerly Artio Global Equity, formerly Julius Baer Global Equity Fund, is disappearing. Either shareholders will approve a merger with Aberdeen Global Equity Fund or the trustees will liquidate it. Note from the Observer: vote for the merger. Global Equity has been a dramatically better fund.

AIS Tactical Asset Allocation Portfolio (TAPAX) has closed and will liquidate by December 15, 2014.

AllianceBernstein Global Value Fund (ABAGX) will liquidate and dissolve around January 16, 2015. Not to be picking on the decedent, but don’t “liquidate” and “dissolve” conjure the exact same image, sort of what happened to the witch in The Wizard of Oz?

In distinction to most such actions, the Board of Trustees of the ALPS ETF Trust ordered “an orderly liquidation” of the VelocityShares Emerging Markets DR ETF, VelocityShares Russia Select DR ETF and VelocityShares Emerging Asia DR ETF. All are now “former options.”

BMO Pyrford Global Strategic Return Fund (BPGAX) and BMO Global Natural Resources Fund (BAGNX) are both scheduled to be liquidated on December 23, 2014, perhaps part of an early Christmas present to their investors. BAGNX has, in six short months of existence, parlayed a $1,000 investment into an $820 portfolio, rather more dismal than even its average peer.

BTS Bond Asset Allocation Fund (BTSAX) will be merging into the BTS Tactical Fixed Income Fund (BTFAX) on December 12, 2014.

DSM Small-Mid Cap Growth Fund (DSMQX) will liquidate on December 2, 2014.

Eaton Vance Asian Small Companies Fund (EVASX) bites the dust on or about January 23, 2015. Despite the addition of How Teng Chiou as a co-manager in March (I’m fascinated by that name), the fund has drawn neither assets nor kudos.

Huntington Income Generation Fund (HIGAX) is another victim of poor planning, impatience and the redundant “dissolve and liquidate” fate. The fund launched in January 2014, performed miserably, for which reason the D&L is scheduled for December 19, 2014.

MassMutual Premier Focused International Fund was dissolved, liquidated and terminated, all on November 14^th. We’re not sure of the order of occurrence.

The 20 year old, $150 million Victory Special Value Fund (SSVSX) has merged into the two year old, $8 million Victory Dividend Growth Fund (VDGAX). Cynics would suggest an attempt to bury Special Value’s record of trailing 85% of its peers by merging into a tiny fund run by the same manager. We wouldn’t, of course. Only cynics would say that.

Virginia Equity Fund decided to liquidate before it launched. Here’s the official word: “the Fund’s investment adviser, recommended to the Board to approve the Plan based on the inability to raise sufficient capital necessary to commence operations. As a result, the Board of Trustees has concluded that it is in the best interest of the sole shareholder to liquidate the Fund.”

Wright Total Return Bond Fund (WTRBX) disappears at the same moment that 2014 does.

In Closing . . .

In November we picked up about 1500 new registrants for our monthly email notification. Greetings to you all and, especially, to the nice folks at Smart Chicken. Love your work! Welcome to one and all.

A number of readers deserve thanks for their support in the month just passed. And so to the amazing Madame Nadler: “thanks! We’re not going anywhere.” To the folks at Gaia Capital: cool logo, though I’m still not sure that “proactive” is a word. To Jason, Matt and Tyler: “thanks” are in the mail! (Soon, anyway.) For Jason and our other British readers, by the way, we are trying to extend the Amazon partnership to Amazon UK. Finally thanks, as always, to our two stalwart subscribers, Deb and Greg. Do let us know how we can make the beta version of the premium site better.

November also saw us pass the 30,000 “unique visitors” threshold for the first time. Thanks to you all, but dropping by and imagining possibilities smarter and better than behemoth funds and treacherous, trendy trading products.

Finally, I promise I won’t mention this again (in 2014): Frankly it would help a lot if folks who haven’t already done so would take a moment to bookmark our Amazon link. Our traffic has grown by almost 80% in the past 12 months and that extra traffic increases our operating expenses by a fair bit. At the same time our Amazon revenue for November grew by (get ready!) $1.48 from last year, a full one-third of one percent. While we’re grateful for the extra $1.48, it doesn’t quite cover the added hosting and mail expenses.

The Amazon thing is remarkably quick, painless and helpful. The short story is that Amazon will rebate to us an amount equivalent to about 6% of whatever you purchase through our Associates link. It costs you nothing, since it’s built into Amazon’s marketing budget. It adds no steps to your shopping. And it doesn’t require that you come to the Observer to use it. Just set it as a bookmark, use it as your homepage or use it as one of the opening tabs in your browser. Okay, here’s our link. Click on it then click on the star on the address bar of your browser – they all use the same symbol now to signal “make a bookmark!” If you want to Amazon as your homepage or use it as one of your opening tabs but don’t know how, just drop me a note with your browser’s name and we’ll send off a paragraph.

There are, in addition, way cool smaller retailers that we’ve come across but that you might not have heard of. The Observer has no financial stake in any of this stuff but I like sharing word of things that strike me as really first-rate.

Some guys wear ties rarely enough that they need to keep that little “how to tie a tie” diagram taped to their bathroom mirrors. Other guys really wish that they had a job where they wore ties rarely enough that they needed to keep that little “how to tie a tie” diagram taped up.

Duluth sells clothes, and accessories, for them. I own rather a lot of it. Their stuff is remarkably well-made and, more importantly, thoughtfully made. Their clothes are designed, for example, to allow a great deal of freedom of motion; they accomplish that by adding panels where other folks just have seams. Admittedly they cost more than department store stuff. Their sweatshirts, by way of example, are $45-50 when they’re not on sale. JCPenney claims that their sweatshirts are $55 but on perma-sale for $20 or so. The difference is that Duluth’s are substantially better: thicker fabric, longer cut, with thoughtful touches like expandable/stretchy side panels.

QuoteArts.com is a small shop that consistently offers a bunch of the most attractive, best written greeting cards (and refrigerator magnets) that I’ve seen. Steve Metivier, who runs the site, shared one of his favorites:

The text reads “’tis not too late to seek a newer world.” The original cards are, of course, sharper and don’t have the copyright watermark. Steve writes that “we’ve found that a number of advisors and other professionals buy our cards to keep in touch with their clients throughout the year. So, we offer a volume discount of 100 or more cards. The details can be found on our specials page.”

We hope it’s a joyful holiday season for you all, and we look forward to seeing you in the New Year.

Dear friends,

In a college with more trees than students, autumn is stunning. Around the campus pond and along wooded paths, trees begin to erupt in glorious color. At first the change is slow, more teasing than apparent. But then we always have a glorious reign of color … followed by a glorious rain of leaves. It’s more apparent then than ever why Augustana was recognized as having one of America’s 25 most beautiful campuses.

Every morning, teaching schedule permitting, I park my car near Old Main then conspire to find the longest possible route into the building. Instead of the simple one block walk east, I head west, uphill and through the residential neighborhoods or south, behind the natural sciences building and up a wooded hillside. I generally walk unencumbered by technology, purpose or companions. 

Kicking the leaves is not optional.

photo courtesy of Augustana Photo Bureau

I listen to the crunching of acorns underfoot and to the anxious scouring of black squirrels. I look at the architecture of the houses, some well more than a century old but still sound and beautiful. I breathe, sniffing for the hint of a hardwood fire. And I left my mind wander where it wants to, too.  Why are some houses enduringly beautiful, while others are painful before they’re even complete?  How might more volatile weather reshape the landscape? Are my students even curious about anything? Would dipping their phones in epoxy make a difference? Maybe investors don’t want to know what their managers actually do? Where would we be if folks actually did spend less? Heck, most of them have already been forced to. I wonder if folks whose incomes and wealth are rapidly rising even think about the implications of stagnation for the rest of us? Why aren’t there any good donut shops anymore?  (Nuts.)

You might think of my walks as a luxury or a harmless indulgence by a middle-aged academic. You’d be wrong. Very wrong.

The world has conspired to heap so many demands upon our attention than we can barely focus long enough to button our shirts. Our attention is fragmented, our time is lost (go on, try to remember what you actually did Friday) and our thinking extends no further than the next interruption. It makes us sloppy, unhappy and unimaginative.

Have you ever thought about including those characteristics in a job description: “We’re hoping to find sloppy, unhappy and unimaginative individuals to take us to the next level!  If you have the potential to become so distracted by minutiae and incessant interruption that you can’t even remember any other way, we have the position for you.”

Go take a walk, dear friends. Go take a dozen. Take them with someone who makes you want to hold a hand rather than a tablet. The leaves beckon and you’ll be better for it. 

On the discreet charm of a stock light portfolio

All the signs point to stocks. The best time of the year to buy stocks is right after Halloween. The best time in the four year presidential cycle to be in stocks is just after the midterm elections. Bonds are poised for a bear market. Markets are steadying. Stocks are plowing ahead; the Total Stock Market Index posted gains of 9.8% through the first 10 months of 2014.

And yet, I’m not plowing into stocks. That’s not a tactical allocation decision, it’s strategic. My non-retirement portfolio, everything outside the 403(b), is always the same: 50% equity, 50% income. Equity is 50% here, 50% there, as well as 50% large and 50% small. Income tends to be the same: 50% short duration/cash-like substances, 50% riskier assets, 50% domestic, 50% international. It is, as a strategy, designed to plod steadily.

My asset allocation has some similarities to Morningstar’s “conservative retirement saver” portfolio, which they gear “toward still-working individuals who expect to retire in 2020 or thereabouts.”  Both portfolios are about 50% in equities and both have a medium term time horizon of around 7-10 years.  On whole, though, I appear to be both more aggressive and more conservative than Morningstar’s model.  I’ve got a lot more exposure to international and, particularly, emerging markets stocks (through Seafarer, Grandeur Peak and Matthews) and bonds (through Matthews and Price) than they do.  I favor managers who have the freedom to move opportunistically between asset classes (FPA Crescent is the show piece, but managers at eight of my 10 funds have more than one asset class at their disposal).  At the same time, I’ve got a lot more exposure to short-term and cash-management strategies (through Price and two fine RiverPark funds).  My funds are cheaper than average (I’m not cheap, I’m rationally cost-conscious) though pricier than Morningstar’s, which reflects their preference for large (no, I didn’t called them “bloated”) funds.

You might benefit from thinking about whether a more diversified stock-light portfolio might help you better balance your personal goals (sleeping well) with your financial ones (eating well). There’s good evidence to guide us.

T. Rowe Price is one of my favorite fund companies, in part because they treat their investors with unusual respect. Price’s publications depart from the normal marketing fluff and generally provide useful, occasionally fascinating, information.

I found two Price studies, in 2004 and again in 2010, particularly provocative. Price constructed a series of portfolios representing different levels of stock exposure and looked at how the various portfolios would have played out over the past 50-60 years.

The original study looked at portfolios with 20, 40, 60, 80 and 100% stocks. The update dropped the 20% portfolio and looked at 0, 40, 60, 80, and 100%. Price updated their research for us and allowed us to release it here.

T. Rowe Price, October 30 2014. Used with permission.

Over the last 65 years, periods which included devastating bear markets for both stocks and bonds, a stock-light portfolio returned 6.8% annually. That translates to receiving about 60% of the returns of an all-equity portfolio with about 25% of the volatility. Going from 20% stocks to 100% increases the chance of having a losing year by 350%, increases the average loss in down years by 1400% and nearly quadruples volatility.

On face, that’s not a compelling case for a huge slug of equities. The findings of behavioral finance research nibbles away at the return advantage of a stock-heavy portfolio by demonstrating that, on average, we’re not capable of holding assets which are so volatile. We run at the wrong time and hide too long. Morningstar’s “Mind the Gap 2014” research suggests that equity investors lose about 166 basis points a year to their ill-timed decisions. Over the past 15 years, S&P 500 investors have lost nearly 200 basis points a year.

Here’s the argument: you might be better with slow and steady, even if that means saving a bit more or expecting a bit less. For visual learners, here’s a picture of what the result might look like:

The blue line represents the performance, since January 2000, of T. Rowe Price Spectrum Income (RPSIX) which holds 80% or so in a broadly diversified income portfolio and 20% or so in dividend-paying stocks. The orange line is Vanguard 500 Index (VFINX). I’m happy to admit that maxing-out the graph, charting the funds for 25 years rather than 14, gives a major advantage to the 500 Index. But, as we’re already noted, investors don’t act based on a 25 year horizon.

I know what you’re going to say: (1) we need stocks for the long-run and (2) the bear is about to maul the bond world. Both are true, in a limited sort of way.

First, the mantra “stocks for the long-term” doesn’t say “how much stock” nor does it argue for stocks at any particular juncture; that is, it doesn’t justify stocks now. I’m profoundly sympathetic to the absolute value investors’ argument that you’re actually being paid very poorly for the risks you’re taking. GMO’s latest asset class projections have the broad US market with negative real returns over the next seven years.

Second, a bear market in bonds doesn’t look like a bear market in stocks. A bear market in stocks looks like 25 or 35 or 45% down. Bonds, not so much. A bear market in bonds is generally triggered by rising interest rates. When rates rise, two things happen: the market value of existing low-rate bonds falls while the payouts available from newly issued bonds rises.

The folks at Legg Mason looked at 90 years of bond market returns and graphed them against changes in interest rates. The results were published in Rate-Driven Bond Bear Markets (2013) and they look like this:

The vertical axis is you, gaining or losing money. The horizontal axis measures rising or falling rates. In the 41 years in which rates have risen, the bond index fell on only nine occasions (the lower right quandrant). In 34 other years, rising rates were accompanied by positive returns, fed by the income payouts of the newly-issued bonds. And even when bonds fall, they typically lose 2-3%. Only 1994 registered a hefty 9% loss.

Price’s research makes things even a bit more positive. They argue that simply using a monolithic measure (intermediate Treasuries, the BarCap aggregate or whatever) underestimates the potential of diversifying within fixed income. Their most recent work suggests that a globally diversified portfolio, even without resort to intricate derivative strategies or illiquid investments, might boost the annual returns of a 60/40 portfolio. A diversified 60/40 portfolio, they find, would have beaten a vanilla one by 130 basis points or so this century. (See “Diversification’s Long-Term Benefits,” 2013.)

This is not an argument against owning stocks or stock funds. Goodness, some of my best friends (the poor dears) own them or manage them. The argument is simpler: fix the roof when it’s not raining. Think now about what’s in your long-term best interest rather than waiting for a sickened panic to make the decision for you. One of the peculiar signs of my portfolio’s success is this: I have no earthly idea of how it’s doing this year.  While I do read my managers’ letters eagerly and even talk with them on occasion, I neither know nor care about the performance over the course of a few months of a portfolio designed to serve me over the course of many years. 

And as you think about your portfolio’s shape for the year ahead or reflect on Charles’ and Ed’s essays below, you might find the Price data useful. The original 2004 and 2010 studies are available at the T. Rowe Price website.

Mediocrity and frustration

I’ve been fully invested in the market for the past 14 years with little to show for it, except frustration and proclamations of even more frustration ahead. During this time, basically since start of 21st century, my portfolio has returned only 3.9% per year, substantially below historical return of the last century, which includes among many other things The Great Depression.

I’ve suffered two monster drawdowns, each halving my balance. I’ve spent 65 months looking at monthly statements showing retractions of at least 20%. And, each time I seem to climb-out, I’m greeted with headlines telling me the next big drop is just around the corner (e.g., “How to Prepare for the Coming Bear Market,” and “Are You Prepared for a Stock Selloff ?“)

I have one Nobel Prize winner telling me the market is still overpriced, seeming every chance he gets. And another telling me that there is nothing I can do about it…that no amount of research will help me improve my portfolio’s performance.

Welcome to US stock market investing in the new century…in the new millennium.

The chart below depicts S&P 500 total return, which includes reinvested dividends, since December 1968, basically during the past 46 years. It uses month-ending returns, so intra-day and intra-month fluctuations are not reflected, as was done in a similar chart presented in Ten Market Cycles. The less frequent perspective discounts, for example, bear sightings from bear markets.

The period holds five market cycles, the last still in progress, each cycle comprising a bear and bull market, defined as a 20% move opposite preceding peak or trough, respectively. The last two cycles account for the mediocre annualized returns of 3.9%, across 14-years, or more precisely 169 months through September 2014.

Journalist hyperbole about how “share prices have almost tripled since the March 2009 low” refers to the performance of the current bull market, which indeed accounts for a great 21.9% annualized return over the past 67 months. Somehow this performance gets decoupled from the preceding -51% return of the financial crisis bear. Cycle 4 holds a similar story, only investors had to suffer 40 months of protracted 20% declines during the tech bubble bear before finally eking out a 2% annualized return across its 7-year full cycle.

Despite advances reflected in the current bull run, 14-year annualized returns (plotted against the secondary axis on the chart above) are among the lowest they been for the S&P 500 since September 1944, when returns reflected impacts of The Great Depression and World War II.

Makes you wonder why anybody invests in the stock market.

I suspect all one needs to do is see the significant potential for upside, as witnessed in Cycles 2-3. Our current bull pales in comparison to the truly remarkable advances of the two bull runs of 1970-80s and 1990s. An investment of $10,000 in October 1974, the trough of 1973-74, resulted in a balance of $610,017 by August 2000 – a 6000% return, or 17.2% for nearly 26 years, which includes the brief bear of 1987 and its coincident Black Monday.

Here’s a summary of results presented in the above graph, showing the dramatic differences between the two great bull markets at the end of the last century with the first two of the new century, so far:

But how many funds were around to take advantage 40 years ago? Answer: Not many. Here’s a count of today’s funds that also existed at the start of the last five bull markets:

Makes you wonder whether the current mediocrity is simply due to too many people and perhaps too much money chasing too few good ideas?

The long-term annualized absolute return for the S&P 500 is 10%, dating back to January 1926 through September 2014, about 89 years (using database derived from Goyal and Shiller websites). But the position held currently by many value oriented investors, money-managers, and CAPE Crusaders is that we will have to suffer mediocre returns for the foreseeable future…at some level to make-up for excessive valuations at the end of the last century. Paying it seems for sins of our fathers.

Of course, high valuation isn’t the only concern expressed about the US stock market. Others believe that the economy will face significant headwinds, making it hard to repeat higher market returns of years past. Rob Arnott describes the “3-D Hurricane Force Headwind” caused by waves of Deficit spending, which artificially props-up GDP, higher than published Debt, and aging Demographics.

Expectations for US stocks for the next ten years is very low, as depicted in the new risk and return tool on Research Affiliates’ website (thanks to Meb Faber for heads-up here). Forecast for large US equities? Just 0.7% total return per year. And small caps? Zero.

Good grief.

What about bonds?

Plotted also on the first chart presented above is 10-year average T-Bill interest rate. While it has trended down since the early 1980’s, if there is a correlation between it and stock performance, it is not obvious. What is obvious is that since interest rates peaked in 1981, US aggregate bonds have been hands-down superior to US stocks for healthy, stable, risk-adjusted returns, as summarized below:

Sure, stocks still triumphed on absolute return, but who would not take 8.7% annually with such low volatility? Based on comparisons of absolute return and Ulcer Index, bonds returned more than 70% of the gain with just 10% of the pain.

With underlining factors like 33 years of declining interest rates, it is no wonder that bond funds proliferated during this period and perhaps why some conservative allocation funds, like the MFO Great Owl and Morningstar Gold Metal Vanguard Wellesley Income Fund (VWINX), performed so well. But will they be as attractive the next 33 years, or when interest rates rise?

As Morningstar’s Kevin McDevitt points out in his assessment of VWINX, “the fund lagged its average peer…from July 1, 1970, through July 1, 1980, a period of generally rising interest rates.” That said, it still captured 85% of the S&P500 return over that period and 76% during the Cycle 2 bull market from October 1974 through August 1987.

Of course, predicting interest rates will rise and interest rates actually rising are two different animals, as evidenced in bond returns YTD. In fact, our colleague Ed Studzinski recently pointed out the long term bonds have done exceptionally well this year (e.g., Vanguard Extended Duration Treasury ETF up 26.3% through September). Who would have figured?

I’m reminded of the pop quiz Greg Ip presents in his opening chapter of “Little Book of Economics”: The year is 1990. Which of the following countries has the brighter future…Japan or US? In 1990, many economists and investors picked Japan. Accurately predicting macroeconomics it seems is very hard to do. Some say it is simply not possible.

Similarly, the difficulty mutual funds have to consistently achieve top-quintile performance, either across fixed time periods or market cycles, or using absolute or risk-adjusted measures, is well documented (e.g., The Persistence Scorecard – June 2014, Persistence is a Killer, In Search of Persistence, and Ten Market Cycles). It does not happen. Due to the many underlying technical and psychological variables of the market place, if not the shear randomness of events.

In his great book “The Most Important Thing,” Howard Marks describes the skillful defensive investor as someone who does not lose much when the market goes down, but gains a fair amount when the market goes up. But this too appears very hard to do consistently.

Vanguard’s Convertible Securities Fund (VCVSX), sub-advised by OakTree Capital Management, appears to exhibit this quality to some degree, typically capturing 70-100% of upside with 70-80% of downside across the last three market cycles.

Since bull markets tend to last much longer than bear markets and produce returns well above the average, capturing a “fair amount” does not need to be that high. Examining funds that have been around for at least 1.5 cycles (since October 2002, oldest share class only), the following delivered 50% or more total return during bull markets, while limiting drawdowns to 50% during bear markets, each relative to S&P 500. Given the 3500 funds evaluated, the final list is pretty short.

VWINX is the oldest, along with Lord Abbett Bond-Debenture Fund (LBNDX) . Both achieved this result across the last four full cycles. As a check against performance missing the 50% threshold during out-of-cycle or partial-cycle periods, all funds on this list achieved the same result over their lifetimes.

For moderately conservative investors, these funds have not been mediocre or frustrating at all, quite the contrary. For those with an appetite for higher returns and possess the attendant temperament and investing horizon, here is a link to similar funds with higher thresholds: MFO Pain-To-Gain Funds.

We can only hope to have it so good going forward.

I fear that Charles and I may have driven poor Ed over the edge.  After decades of outstanding work as an investment professional, this month he’s been driven to ask …

Investing – Why?

By Edward Studzinski

“The most costly of all follies is to believe passionately in the palpably not true.  It is the chief occupation of mankind.”

          H.L. Mencken

I will apologize in advance, for this may end up sounding like the anti-mutual fund essay. Why do people invest, and specifically, why do they invest in mutual funds?  The short answer is to make money. The longer answer is hopefully more complex and covers a multitude of rationales. Some invest for retirement to maintain a standard of living when one is no longer working full-time, expecting to achieve returns through diversified portfolios and professional management above and beyond what they could achieve by investing on their own. Others invest to meet a specific goal along the path of life – purchase a home, pay for college for the children, be able to retire early. Rarely does one hear that the goal of mutual fund investing is to become wealthy. In fact, I can’t think of any time I have ever had anyone tell me they were investing in mutual funds to become rich. Indeed if you want to become wealthy, your goal should be to manage a mutual fund rather than invest in one. 

How has most of the great wealth been created in this country? It has been created by people who started and built businesses, and poured themselves (and their assets) into a single-minded effort to make those businesses succeed, in many instances beyond anyone’s wildest expectations. And at some point, the wealth created became solidified as it were by either selling the business (as the great philanthropist Irving Harris did with his firm, Toni Home Permanents) or taking it public (think Bill Gates or Jeff Bezos with Microsoft and Amazon). And if one goes further back in time, the example of John D. Rockefeller with the various Standard Oil companies would loom large (and now of course, we have reunited two of those companies, Standard Oil Company of New Jersey aka Exxon and Standard Oil Company of New York aka Mobil as Exxon-Mobil, but I digress).

So, this begs the question, can one become wealthy by investing in a professionally-managed portfolio of securities, aka a mutual fund? The answer is – it depends. If one wants above-average returns and wealth creation, one usually has to concentrate one’s investments. In the mutual fund world you do this by investing in a concentrated or non-diversified fund. The conflict comes when the non-diversified fund grows beyond a certain size of assets under management and number of investments.  It then morphs from an opportunistic investment pool into a large or mega cap investment pool. The other problem arises with the unlimited duration of a mutual fund. Daily fund pricing and daily fund flows and redemptions do have a cost. For those looking for a real life example (I suspect I know the answer but I will defer to Charles to provide the numbers in next month’s MFO), contrast the performance over time of the closed-end fund, Source Capital (SOR) run by one of the best value investment firms, First Pacific Advisors with the performance over time of the mutual funds run by the same firm, some with the same portfolio managers and strategy. 

The point of this is that having a fixed capital structure lessens the number of issues with which an investment manager has to deal (focus on the investment, not what to do with new money or what to sell to meet redemptions). If you want a different real life example, take a look at the long-term performance of one of the best investment managers to come out of Harris Associates, whom most of you have never heard of, Peter B. Foreman, and his partnership Hesperus Partners, Ltd.

Now the point of this is not to say that you cannot make money by investing in a mutual fund or a pool of mutual funds. Rather, as you introduce more variables such as asset in-flows, out-flows, pools of analysts dedicated to an entire fund group rather than one investment product, and compensation incentives or disincentives, it becomes harder to generate consistent outperformance. And if you are an individual investor who keeps increasing the number of mutual funds that he or she has invested in (think Noah and the Ark School of Personal Investment), it becomes even more difficult

A few weeks ago it struck me that in the early 1980’s, when I figured out that I was a part of the sub-species of investor called value investor (not “value-oriented investor” which is a term invented by securities lawyers for securities lawyers), I made my first investment in Berkshire Hathaway, Warren Buffett’s company. That was a relatively easy decision to make back then. I recently asked my friend Greg Jackson if he could think of a handful of investments, stocks like Berkshire (which has in effect been a closed-end investment portfolio) that today one could invest in that were one-decision investments. Both of us are still thinking about the answer to that question. 

Has something changed in the world in investing in the last fifteen or twenty years? Yes, it is a different world, in terms of information flows, in terms of types of investments, in terms of derivatives, in terms of a variety of things. What it also is is a different world in terms of time horizons and patience.  There is a tremendous amount of slippage that can eat into investment returns today in terms of trading costs and taxes (even at capital gains rates). And as a professional investment manager you have lots of white noise to deal with – consultants, peer pressure both internal and external, and the overwhelming flow of information that streams by every second on the internet. Even sitting in Omaha, the net of modern communications still drops over everything. 

So, how does one improve the odds of superior long-term performance? One has to be prepared to step back and stand apart. And that is increasingly a difficult proposition. But the hardest thing to do as an investment manager, or in dealing with one’s own personal portfolio, is to sometimes just do nothing. And yes, Pascal the French philosopher was right when he said that most of men’s follies come from not being able to sit quietly in one room. Even more does that lesson apply to one’s investment portfolio. More in this vein at some future date, but those are the things that I am musing about now.

“ … if you want to become wealthy, your goal should be to manage a mutual fund rather than invest in one.”  It’s actually fairer to say, “manage a large firm’s mutual fund” since many of the managers of smaller, independent funds are actually paying for the privilege of investing your money: their personal wealth underwrites some of the fund’s operations while they wait for performance to draw enough assets to cross the financial sustainability threshold.  One remarkably successful manager of a small fund joked that “you and I are both running non-profits.  The difference is that I hadn’t intended to.”

In the Courts: 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 and filtered as never before.

“We built Fundfox from the ground up for mutual fund insiders,” says attorney-founder David M. Smith. “Directors and advisory personnel now have easier and more affordable access to industry-specific litigation intelligence than even most law firms had before.”

The core offering is a database of case information and primary court documents for hundreds of industry cases filed in federal courts from 2005 through the present. A Premium Subscription also includes robust database searching—by fund family, subject matter, claim, and more.

Settlement

• Fidelity settled a six-year old whistleblower case that had been green-lighted by the U.S. Supreme Court earlier this year. (Zang v. Fid. Mgmt. & Research Co.)

Briefs

• American Century defendants filed their opening appellate brief (under seal) in a derivate action regarding the Ultra Fund’s investments in gambling-related securities. Defendants include independent directors. (Seidl v. Am. Century Cos.)
• Fidelity filed a motion to dismiss a consolidated ERISA class action that challenges Fidelity’s practices with respect to “redemption float” (i.e., the cash held to pay checks sent to 401(k) plan participants who have withdrawn funds from their 401(k) accounts). (In re Fid. ERISA Float Litig.)
• First Eagle filed a reply brief in support of its motion to dismiss fee litigation regarding two international equity funds: “Plaintiffs have not identified a single case in which a court allowed a § 36(b) claim to proceed based solely on a comparison of the adviser’s fee to a single, unknown fee that the adviser receives for providing sub-advisory services to another client.” (Lynn M. Kennis Trust v. First Eagle Inv. Mgmt., LLC.)

Amended Complaints

• Plaintiffs filed an amended complaint in the excessive-fee litigation regarding five SEI funds, adding a new claim regarding the level of transfer agent fees. (Curd v. SEI Invs. Mgmt. Corp.)
• ERISA class-action plaintiffs filed an amended complaint alleging that TIAA-CREF failed to honor customer requests to pay out funds in a timely fashion. (Cummings v. TIAA-CREF.)

Answer

Having lost its motion to dismiss, Principal filed an answer in excessive-fee litigation regarding six of its LifeTime Funds. (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal.

For a 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.

The Alt Perspective:  Commentary and News from DailyAlts.

PREPARE FOR VOLATILITY

The markets delivered investors both tricks and treats in October. Underlying the modestly positive top-line U.S. equity and bond market returns for the month was a 64% rise, and subsequent decline, in the CBOE Volatility Index, otherwise known as VIX. This dramatic rise in the VIX coincided with a sharp, mid-month decline in equity markets. But with Halloween looming, the market goblins wanted to deliver some treats, and in fact did so as they pushed the VIX down to end the month 12.3% lower than it started. In turn, the equity markets rallied to close the month at all-time highs on Halloween day.

But as volatility creeps back into the markets, opportunities arise. Investment strategies that rely on different segments of the market behaving differently, such as managed futures and global macro, can thrive as global central bank policies diverge. And indeed they have. The top three managed futures funds have returned an average of 14.7% year-to-date through Oct. 31, according to data from Morningstar.

Other strategies that rely heavily on greater dispersion of returns, such as equity market neutral strategies, are also doing well this year. Whereas managed futures and global macro strategies take advantage of diverging prices at a macro level (U.S equities vs. Japanese equities, or Australian dollar vs. the Euro), market neutral funds take advantage of differences in individual stock price performance. And many of these funds have done just that this year. Through October 31, the three best performing equity market neutral funds have an average return of 11.9% year-to-date, according to data from Morningstar.

All three of these strategies generate returns by investing both long and short, generally in equal amounts, and maintain low levels of net exposure to individual markets. As a result, they can be used to effectively diversify portfolios away from stocks and bonds. And as volatility picks up, these funds have a greater opportunity to add value.  

NEW FUND LAUNCHES IN OCTOBER

As of this writing, seven new alternative funds have been launched in October, and like last month when four new funds launched on the last day of the month, we expect to add a few more to the October count. Five of the new funds are packaged as mutual funds, and two are ETFs, while five are multi-strategy funds, one is long/short, one is managed futures and one is market neutral. Two notable launches that dovetail on the discussion above are as follows:

• ProShares Managed Futures Strategy Fund (FUTS) – This is a low cost, systematic managed futures fund that invests across multiple asset classes.
• AQR Equity Market Neutral Fund (QMNIX) – This is a pure equity market neutral fund that will target a beta of 0 relative to the US equity markets.

NEW FUNDS REGISTERED IN OCTOBER

October saw 13 new alternative funds register with the S.E.C. covering a wide swath of strategies including multi-strategy, long/short equity, arbitrage, global macro and managed futures. Two notable funds are:

• Balter Discretionary Global Macro Fund – This is the second mutual fund from Balter Liquid Alternatives and will provide investors with exposure to Willowbridge Associates, a discretionary global macro manager that was formed in 1988.
• PIMCO Multi-Strategy Alternative Fund – This fund will be sub-advised by Research Affiliates and will invest in a range of alternative mutual funds and ETFs managed and offered by PIMCO.

OTHER NOTABLE NEWS

• The SEC rejected two proposals for non-transparent ETFs (exchange traded funds that don’t have to disclose their holdings on a daily basis). This is a setback for this new product structure that may ultimately bring more alternative strategies to the ETF marketplace.
• Education continues to be a hot topic among advisors and other investors looking to use alternative mutual funds and ETFs. The two most viewed articles on DailyAlts in October had to do with investor education and related research articles: AllianceBernstein Provides Thought Leadership on Liquid Alts and Neuberger Berman Calls Alts ‘The New Traditionals’.
• The S.E.C. continues to examine liquid alternative funds, and potentially has an issue with some fund disclosures. Norm Champ, the S.E.C. director leading the investigations, spoke recently at an industry event and noted that there appears to be some discrepancies between what funds are permitted to do per their prospectuses, and what is actually being done in the funds. Interestingly, he noted that prospectuses sometimes disclose more strategies than are actually being used in the funds.

Have a joyful Thanksgiving, and feel free to stop by DailyAlts.com for more updates on the liquid alternatives market.

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.

FPA Paramount (FPRAX): Paramount has just completed Year One under its new global, absolute value discipline.  If it weren’t for those danged emerging markets (non) consumers and anti-corruption drives, the short term results would likely have been as bright as the long-term promise.

Launch Alert: US Quantitative Value (QVAL)

My colleague Charles Boccadoro has been in conversation with Wesley Gray and the folks at Alpha Architect.  While ETFs are not our traditional interest, the rise of actively managed ETFs and the recently thwarted prospect for non-transparent, actively managed ETFs, substantially blurs the line between them and open-end mutual funds.  When we encounter particularly intriguing active ETF options, we’re predisposed to share them with you. Based on the investing approach detailed in his highly praised 2013 book Quantitative Value, this fund qualifies. Wesley Gray launched the U.S. Quantitative Value ETF (QVAL) on 22 October 2014.

Dr. Gray gave an excellent talk at the recent Morningstar conference with a somewhat self-effacing title borrowed from Warren Buffet: Beware of Geeks Bearing Formulas. His background includes serving as a US Marine Corps intelligence officer and completing both an MBA and a PhD from the University of Chicago’s Booth School of Business. He appears well prepared to understand and ultimately exploit financial opportunities created by behavioral biases and inefficiencies in the market.

The fund employs a Benjamin Graham value philosophy, which Dr. Gray has been studying since his 12th birthday, when his late grandmother gave him a copy of The Intelligent Investor. In quant-fashion, the fund attempts to implement the value strategy in systematic fashion to help protect against behavioral errors. Behaviors, for example, that led to the worst investor returns for the past decade’s best performing fund – CGM Focus Fund (2000-09). “We are each our own worst enemy,” Dr. Gray writes.

The fund uses academically-based and empirically-validated approaches to identify quality and price. In this way, Dr. Gray has actually challenged a similar strategy, called “The Magic Formula,” made popular by Joel Greenblatt’s book The Little Book That Beats the Market. The issue appears to be that The Magic Formula systematically forces investors to pay too high for quality. Dr. Gray argues that price is actually a bigger determinant of ultimate return than quality.

QVAL currently holds 40 stocks so we classify it as a concentrated portfolio, though not technically non-diversified. Its expense ratio is 0.79%, substantially less than the former Formula Investing funds (now replaced by even more expensive Gotham funds). The fund has quickly collected $8M in AUM. An international version (IVAL) is pending. We plan to do an in-depth profile of QVAL soon.

Alpha Shares maintains separate sites for its Alpha Shares advisory business and its Value Shares active ETFs.  Folks trying to understand the evidence behind the strategy would be well-advised to start with the QVAL factsheet, which provides the five cent tour of the strategy, then look at the research in-depth on the “Our Ideas” tab on the advisor’s homepage

Funds in Registration

The intrepid David Welsch, spelunker in the SEC database, tracked down 23 new no-load, retail funds in registration this month. In general, these funds will be available for purchase at the very end of December.  Advisors really want to have a fund live by December 30^th or reporting services won’t credit it with “year to date” results for all of 2015. A number of the prospectuses are incredibly incomplete (not listing, for example, a fund manager, minimums, expenses or strategies) which suggests that they’re panicked about having something on file.

Highlights among the registrants:

• Arbitrage Tactical Equity Fund will inexplicably do complicated things in pursuit of capital appreciation. Given that all of the Arbitrage funds could be described in the same way, and all of them are in the solid-to-excellent range, that’s apparently not a bad thing. 
• Greenhouse MicroCap Discovery Fund will pursue long-term capital appreciation by investing in 50-100 microcaps “run by disciplined management teams possessing clear strategies for growth that … trade at a discount to intrinsic value.” The fund intrigues me because Joseph Milano is one of its two managers. Milano managed T. Rowe Price New America Growth Fund (PRWAX) quite successfully from 2002-2013. PRWAX is a large growth fund but a manager’s disciplines often seem transferable across size ranges.
• Intrepid International Fund will seek long-term capital appreciation by investing in foreign stocks but it is, by prospectus, bound to invest only 40% of its portfolio overseas. Curious. The Intrepid funds are all built around absolute value disciplines: if the case for risky assets isn’t compelling, they won’t buy them.  That’s led to some pretty strong records across full market cycles, and pretty disappointing ones if you look only at little slices of time.  One of the managers of Intrepid Income was handle the reins here.

Manager Changes

This month saw 67 manager changes including the departures of several high profile professionals, including Abhay Deshpande of the First Eagle Funds.

Updates

PIMCO has been punted from management of Forward Investment Grade Fixed-Income Fund (AITIX) and Principal Global Multi-Strategy Fund (PMSAX). I’m afraid that the folks at the erstwhile “happiest place on earth” must be a bit shell-shocked. Since Mr. Gross stomped off, they’ve lost contracts – involving either the Total Return Fund or all of their services – with the state retirement systems in New Hampshire and Florida, the teachers’ retirement system in Arkansas, Ford Motor’s 401(k), Advanced Series Trust, Massachusetts Mutual Life Insurance Co., Alabama’s and California’s 529 College Savings accounts, Russell Investments, British wealth manager St. James Place, Schwab’s Target Date funds and a slug of city retirement plans. Consultant DiMeo Schneider & Associates, whose clients have about a billion in PIMCO Total Return, has issued “a universal sell recommendation” on PIMCO and Schwab reportedly is saying something comparable to its private clients.

Three short reactions:

The folks firing PIMCO are irresponsible.  The time to dump PIMCO would have been during the period that Gross was publicly unraveling. Leaving after you replace the erratic titan with a solid, professional team suggests either they weren’t being diligent or they’re grabbing for headlines or both.

PIMCO crisis management appears inept. “We are PIMCO (dot com)!” Really? I don’t tweet but enormous numbers of folks do and PIMCO’s Twitter feed is lame. One measure of impact is retweeting and only three of the past 20 tweets have been retweeted 10 or more times. There appears to be no coherent focus or intensity, just clutter and business-as-usual as the wobble gets worse.

Financial writers should be ashamed. In the months leading up to Gross’s departure, I found just three or four people willing to state the obvious. Now many stories, if not virtually every story, about PIMCO being sacked pontificates about the corrosive effect of months of increasingly erratic behavior. Where we these folks when their readers needed them? Oh right, hiding behind “the need to maintain access.”

By the way, the actual Pontiff seems to be doing a remarkably good job of pontificating. He seems an interesting guy. It will be curious to see whether his efforts are more than just a passing ripple on a pond, since the Vatican specializes in enduring, absorbing then forgetting reformist popes.

Grandeur Peak Global Opportunities (GPGOX) and Grandeur Peak International Opportunities (GPIOX) have now changed their designation from “non-diversified” to “diversified” portfolios. Given that they hold more than 200 stocks each, that seems justified.

photo courtesy of Augustana Photo Bureau

Briefly Noted . . .

Kent Gasaway has resigned as president of the Buffalo Funds, though he’ll continue to co-manage Buffalo Small Cap Fund (BUFSX) and the Buffalo Mid Cap Fund (BUFMX).

At about the same time, Abhay Deshpande has resigned as manager of the First Eagle Global (SGENX), Overseas (SGOVX) and US Value (FEVAX) funds. It’s curious that his departure, described as “amicable,” has drawn essentially no notice given his distinguished record and former partnership with Jean-Marie Eveillard.

Chou America makes it definite. According to their most recent SEC filing, the unexplained changes that might happen on December 6 now definitely will happen on December 6:

Robeco Boston Partners Long/Short Research Fund (BPRRX) is closed to new investors, which is neither news (it happened in spring) nor striking (Robeco has a long record of shuttering funds). What is striking is their willingness to announce the trigger that will lead them to reopen the fund:

Robeco reserves the right to reopen the Fund to new investments from time to time at its discretion, should the assets of the Fund decline by more than 5% from the date of the last closing of the Fund. In addition, if Robeco reopens the Fund, Robeco has discretion to close the Fund thereafter should the assets of the Fund increase by more than 5% from the date of the last reopening of the Fund.

Portfolio 21 Global Equity Fund (PORTX) “is excited to announce” that it’s likely to be merge with Trillium Asset Management and that its president, John Streur, has resigned.

Wasatch Funds announced the election of Kristin Fletcher to their board of trustees. I love it when funds have small, highly qualified boards. Ms. Fletcher surely qualifies, with over 35 years in the industry including a stint as the Chairman and CEO of ABN AMRO, and time at First Interstate Bank, Standard Chartered Bank, Export-Import Bank of the U.S., and Wells Fargo Bank.

SMALL WINS FOR INVESTORS

Aristotle International Equity (ARSFX) and Aristotle/Saul Global Opportunities Fund (ARSOX) have reduced their initial purchase minimum from $25,000 to $2,500 and their subsequent investment minimum to $100. Both funds have been cellar-dwellers over their short lives; presumably rich folks have enough wretched opportunities in hedge funds and so weren’t drawn here.

Effective November 1, Forward trimmed five basis points of the management fee for the various classes of Forward Emerging Markets Fund (PGERX). The fund is tiny, mediocre and running at a loss of .68%, so this is a marketing move rather than an adjustment to the economies of scale.

The trustees for O’Shaughnessy Enhanced Dividend (OFDAX/OFDCX) and O’Shaughnessy Small/Mid Cap Growth Fund (OFMAX) voted to eliminate the fund’s “A” and “C” share classes and transitioning those investors into the lower-cost Institutional share class. Neither makes a compelling case for itself.

On October 9, 2014, the Board of Trustees of Philadelphia Investment Partners New Generation Fund (PIPGX) voted to remove the fund’s sales charge. The fund has earned just under 5% per year for the past three years, handily trailing its long-short peer group.

Break out the bubbly! PSP Multi-Manager Fund (CEFFX/CEFIX) has slashed its expenses – exclusive of a long list of exceptions – from 3.0% to 2.64%. The fund inherits its predecessor Congressional Effect Fund’s dismal record, so don’t hold bad long-term returns against the current team. They’ve only been on-board since late August 2014. If you’d like, you’re more than welcome to hold a 2.64% e.r. against them instead.

Hartford Total Return Bond Fund (HABDX) has dropped its management fee by 12 basis points. I’m not certain that the reduction is related to the departure of the $200 Million Man, manager Bill Gross, but the timing is striking.

As of October 1, 2014, the investment advisory fee paid to Charles Schwab for the Laudus Mondrian International Equity Fund (LIEQX) was dropped by 10 basis points to 0.75%.

Each of the Litman Gregory Masters Fund’s Investor Class shares is eliminating its redemption fee.

PIMCO Emerging Markets Bond Fund (PAEMX) has dropped its management charge by 5 basis points to 50 basis points.

Similarly, RBC Global Asset Management will see its fees reduced by 10 basis points for the RBC BlueBay Emerging Market Corporate Bond Fund (RECAX) and by 5 basis points for the RBC BlueBay Emerging Market Select Bond Fund (RESAX), RBC BlueBay Global High Yield Bond Fund (RHYAX) and RBC BlueBay Global Convertible Bond Fund.

CLOSINGS (and related inconveniences)

The American Beacon International Equity Index Fund (AIIIX) will close to new investors on December 31, 2014. Uhhh … why? It’s an index fund tracking the largest international index.

Effective December 1, 2014, American Century One Choice 2015 Portfolio (ARFAX) will be closed to new investors. One presumes that the fund is in the process of liquidating as it reaches its target date, which its assets transferring to a retirement income fund.

OLD WINE, NEW BOTTLES

Just before Christmas, the AllianzGI Wellness Fund (RAGHX) will change its name to the AllianzGI Health Sciences Fund and it will begin investing in, well, health sciences-related companies. Currently it also invests in “wellness companies,” those promoting a healthy lifestyle. Not to dismiss the change, but pretty much all of the top 25 holdings are health-sciences companies already and Morningstar places 98% of its holdings in the healthcare field.

Effective January 15, 2015, Calvert High Yield Bond Fund (CYBAX) will shift its principal investment strategy from investing in bonds with intermediate durations to those “with varying durations,” with the note that “duration and maturity will be managed tactically.” At the same time Calvert Global Alternative Energy Fund (CGAEX) will be renamed Calvert Global Energy Solutions Fund, presumably because “alternative energy” is “so Obama.” I’ll note in passing that I really like the clarity of Calvert’s filings; they make it ridiculously easy to understand exactly what they do now and what they’ll be doing in the future. Thanks for that.

Effective December 30, 2014, CMG Managed High Yield Fund (CHYOX) will be renamed CMG Tactical Bond Fund. It appears as if the fund’s adviser decided to change its name and principal strategy within two weeks of its initial launch. They had filed to launch this fund in April 2013, appeared to have delayed for nearly 20 months, launched it and then immediately questioned the decision. Why am I not finding this reassuring?

Equinox EquityHedge U.S. Strategy Fund is chucking its “let’s hire lots of star sub-advisers” strategy in favor of investing in derivatives and ETFs on their own. Following the change, the investment advisory fee drops from 1.95% to 0.95% but “the Board also approved a decrease in the fee waiver and expense reimbursement arrangements with the Adviser to correspond with the decreased advisory fee.” The new system caps “A” share expenses at 1.45% except for a long list of uncapped items which might push the total substantially higher.

First Pacific Low Volatility Fund (LOVIX) has been renamed Lee Financial Tactical Fund. Headquartered in Honolulu. I feel a field trip coming on.

On October 1, Forward announced plans to reposition Forward Global Dividend Fund (FFLRX) as Forward Foreign Equity Fund on December 1. The new investment strategy statement is unremarkable, except for the absence of the word “dividend” anywhere in it. Two weeks later Forward filed an indefinite suspension of the change, so FFLRX lives on but conceivably on borrowed time.

Goldman Sachs Municipal Income Fund becomes Goldman Sachs Strategic Municipal Income Fund in December. The strategy in question involves permitting investments in high yield munis and in a 2-8 year duration band.

Effective December 17, Janus’s INTECH subsidiary will be “applying a managed volatility approach” to four of INTECH’s funds, at which point their names will change:

Laudus Mondrian Institutional Emerging Markets (LIEMX) and Laudus Mondrian Institutional International Equity (LIIEX) funds are pursuing one of those changes that make sense primarily to the fund’s accountants and lawyers. Instead of being the Institutional EM Fund, it will become the Institutional share class Laudus Mondrian Emerging Markets (LEMIX). Likewise with International Equity.

photo courtesy of Augustana Photo Bureau

OFF TO THE DUSTBIN OF HISTORY

Aberdeen Global Select Opportunities Fund (BJGQX) is going to merge into the Aberdeen Global Equity Fund (GLLAX) following what the adviser refers to as “the completion of certain conditions” a/k/a approval by shareholders. Neither fund is particularly good and they have overlapping management teams, but Select is microscopic and pretty much doomed.

Boston Advisors Broad Allocation Strategy Fund (BABAX) will be liquidated come December 18, 2014. It’s a small, overpriced fund-of-funds that’s managed to lag in both up markets and down markets over its short life.

HNP Growth and Preservation Fund (HNPKX) is slated for liquidation in mid-November. It was a reasonably conservative managed futures fund that was hampered by modest returns and high expenses. We wrote a short profile of it a while ago.

iShares isn’t exactly cleaning house, but they did bump off 18 ETFs in late October. The descendants include their entire Target Date lineup plus a couple real estate, emerging market sector and financial ETFs. The full list is:

• iShares Global Nuclear Energy ETF (NUCL)
• iShares Industrial/Office Real Estate Capped ETF (FNIO)
• iShares MSCI Emerging Markets Financials ETF (EMFN)
• iShares MSCI Emerging Markets Materials ETF (EMMT)
• iShares MSCI Far East Financials ETF (FEFN)
• iShares NYSE 100 ETF (NY)
• iShares NYSE Composite ETF (NYC)
• iShares Retail Real Estate Capped ETF (RTL)
• iShares Target Date Retirement Income ETF (TGR)
• iShares Target Date 2010 ETF (TZD)
• iShares Target Date 2015 ETF (TZE)
• iShares Target Date 2020 ETF (TZG)
• iShares Target Date 2025 ETF (TZI)
• iShares Target Date 2030 ETF (TZL)
• iShares Target Date 2035 ETF (TZO)
• iShares Target Date 2040 ETF (TZV)
• iShares Target Date 2045 ETF (TZW)
• iShares Target Date 2050 ETF (TZY)

Lifetime Achievement Fund (LFTAX) “has concluded that it is in the best interests of the Fund and its shareholders that the Fund cease operations.” The orderly dissolution of the fund will take until March 31, 2015.

Effective October 13, 2014, the Nationwide Enhanced Income Fund and the Nationwide Short Duration Bond Fund were reorganized into the Nationwide HighMark Short Term Bond Fund (NWJSX).

QS LEGG MASON TARGET RETIREMENT 2015,

Speaking of mass liquidations, Legg Mason decided to bump off its entirely target-date lineup, except for Target Retirement 2015 (LMFAX), effective mid-November.

• QS Legg Mason Target Retirement 2020,
• QS Legg Mason Target Retirement 2025,
• QS Legg Mason Target Retirement 2030,
• QS Legg Mason Target Retirement 2035,
• QS Legg Mason Target Retirement 2040,
• QS Legg Mason Target Retirement 2045,
• QS Legg Mason Target Retirement 2050
• QS Legg Mason Target Retirement Fund.

Robeco Boston Partners International Equity Fund merged into John Hancock Disciplined Value International Fund (JDIBX) on September 26, 2014.

Symons Small Cap Institutional Fund (SSMIX) has decided to liquidate, done in by “the Fund’s small asset size and the increasing regulatory and operating costs borne by the adviser.” Trailing 98-99% of its peers over the past 1, 3 and 5 year periods probably didn’t help its case.

Effective immediately, the USFS Funds Limited Duration Government Fund (USLDX) is closed to new purchases, its manager has left and all references to him in the Fund’s Summary Prospectus, Prospectus and SAI have been “deleted in their entirety.” Given that the fund is small and sad, and the adviser’s website doesn’t even admit it exists, I’m thinking the “closed to new investors and the manager’s out the door” might be a prelude to a watery grave.

The Japan Fund (SJPNX) just became The Former Japan Fund as it ended a long and rambling career by being absorbed into the Matthews Japan Fund (MJFOX, as in Michael J. Fox). The Japan Fund, launched in the late 1980s as Scudder Japan, was one of the first funds to target Japan – at just about the time Japan’s market peaked.

Effective October 20, 2014, three Virtus Insight money market funds (Government Money Market, Money Market and Tax-Exempt Money Market) were liquidated.

Bon Voya-age: Voya Global Natural Resources Fund (LEXMX – another of the old Lexington funds, along with our long-time favorite Lexington Corporate Leaders LEXCX) is merging in Voya International Value Equity (NAWGX). LEXMX has led its peers in four of the past five years but seems not to have drawn enough assets to satisfy the adviser’s needs. In the interim, International Value will be rechristened Voya Global Value Advantage.

In Closing . . .

One of our greatest challenges each month is balancing the needs and interests of our regular readers with those of the folks who are encountering us for the first time. Of the 25,000 folks who’ve read the Observer in the past 30 days, 40% ~ say, 10,000 ~ were first-time visitors. That latter group might reasonably be wondering things like “who on earth are these people?” and “where are the ads?” The following is for them and for anyone who’s still wondering “what’s up here?”

photo courtesy of Carolyn Yaschur, Augustana College

Who is the Observer?

The Mutual Fund Observer operates as a public service, a place for individuals to interact, grow, learn and gain confidence. It is a free, independent, non-commercial site, financially supported by folks who value its services. We write for intellectually curious, serious investors – managers, advisers, and individuals – who need to get beyond marketing fluff and computer-generated recommendations.

We have about 25,000 readers, 95% of whom are resident in the US.

The Observer is published by David Snowball, a Professor of Communication Studies and former Director of Debate at Augustana College in Rock Island, Illinois. While I might be the “face” of the Observer, I’m also only one piece of it. The strength of the Observer is the strength of the people it has drawn. There is a community of folks, fantastically successful in their own rights, who provide us with an incredibly powerful advantage. Some (Charles and Edward, as preeminent examples) write for us, some write to us (mostly in private emails) and some (David Smith at Fundfox and Brian Haskin at DailyAlts) share their words and expertise with us. They all share a common passion: to teach and hence to learn. Their presence, and yours, makes this infinitely more than Snowball 24/7.

What’s our mission?

We’ll begin with the obvious: about 80% of all mutual funds could shut their doors today and not be missed.  If I had to describe them, I’d use words like

• Large
• Unimaginative
• Undistinguished
• Asset sponges

They thrive by never being bad enough to dump and so, year after year, their numbers swell. By one estimate, 30% of all mutual fund money is invested in closet index funds – nominally active funds whose strategy and portfolio is barely distinguishable from an index. One of Russel Kinnel’s sharper lines of late was, “New funds tend to be mediocre because fund companies make them that way” (“New Funds Generate More Excitement Than Results,” 10/16/14). Add “larger” in front of “fund companies” and I’d nod happily. The situation is worse in ETF-land where the disappearance of 90% of offerings would likely improve the performance of 99% of investor portfolios.

Sadly those are the funds that win analyst coverage and investor attention.  The structure of the investment company industry is such that the funds you should consider most seriously are the ones about which you hear the least: small, nimble, independent entities with skilled managers who – in many cases – have left major firms in disgust at the realization that the corporation’s needs were going to trump their investors’ needs. Where the mantra at large companies is “let’s not do anything weird,” the mantra at smaller firms seems to be “let’s do the right thing for our investors.”

That’s who we write about, convinced that there are opportunities there that you really should recognize and consider with all seriousness.

How can you best use it?

Give yourself time and go beyond the obvious.

We tend to publish longer pieces that most sites and many of those essays assume that you’re smart, interested and thoughtful. We don’t do fluff though we celebrate quirky. The essays that Charles posts tend to be incredibly data-rich. Ed’s essays tend to be driven by a sharply trained, deeply inquisitive mind and decades of experience; he understands more about what’s going on just under the surface or behind closed doors than most of us could ever aspire to. They bear re-reading.

We have a lot of resources not immediately evident in the monthly update you’ve just read. I’ll highlight four and suggest you click around a bit on the top menu bar.

1. We share content from, and link to, people who impress us. David Smith and FundFox do an exceptional job of following and organizing the industry’s legal travails; it strikes me as an indispensable tool for trustees, reporters and folks whose names are followed by the letters J and D.  Brian Haskin and the folks are DailyAlts are dedicated to comprehensive tracking of the industry’s fastest growing, most complex corner.  Both offer resources well beyond our capacity and strike us as really worth following.
2. We offer tools that do cool things. Want detailed, current, credible risk measures for any fund? Risk Profile Search. A searchable list of every fund whose risk-adjusted returns beat its peers in every trailing period?  Great Owls.  A quick way to generate lists of candidates for a portfolio?  Miraculous Multi-Search.  Every manager change at an equity, balanced or alts fund over the past three years.  Got it.  Chip’s Manager Changes master list. Most of them are under the Search Tools tab, but the Navigator – which links you directly to any specified fund’s page on a dozen credible news and rating sites – is a Resource. 
3. We have profiles of over 100 funds, generally small, new and distinctive. Charles’s downloadable dashboard gives you quick access to updated risk and return information on each. There are archived audio interviews with the managers of some of the most intriguing of them. We present the active share calculations for every fund we profile and host one of the web’s largest collections of current active share data.
4. We have searchable editorial and analytic content back to our inception. Curious about everything we’ve reported on Seafarer Growth & Income (SFGIX) since its inception?  It’s there.  Our discussion of the fall o’ Fidelity funds? 

Quite independent of which (fiercely independent of which, I dare say) is the Observer’s mutual fund discussion board, which has had 1600 users and 65,000 posts.

We also answer our mail.

How do we pay for it?

Because the folks most in need of a quiet corner and reasonable people are those least able to pay a subscription, we’ve never charged one. When readers wish to support the Observer, they have four pretty simple, entirely voluntary channels:

1. They can use our Amazon.com link for their online shopping. On average, Amazon rebates to us an amount equivalent to about 7% of your purchase. Hint! Hint! There are holidays coming. If you’re one of those people who participate in “holiday shopping”, use this link. It costs you nothing. There really are no strings attached.
2. They can contribute directly through PayPal.
3. They can become de facto subscribers through an automatic monthly contribution through PayPal.
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All of that is laid out on our Support Us page.

Our goal each month is not to be great. It’s to be a bit better than we were last month. Frankly, the more you help – with ideas, encouragement, criticism and support – the likelier that is to occur.

Speaking of de facto subscribers, the number has doubled in the last month. Thanks Greg, Deb appreciates the company!  Charles is developing a remarkably sophisticated fund search function; in thanks and in hopes of getting feedback, we’ve extended access to our subscribers. If our recent rate of subscriber growth (i.e., doubling monthly) keeps up, we’ll crack 8200 in a year and I think we’d hit 16,777,216 by the end of the following year. Charles, the energetic one among us, has promised to greet each of you at the door.

I’m sure by now that you’ve set your clocks back.  But what about your other fall chores?  Change the batteries in your smoke detectors.  If you don’t have spare batteries on hand, leave a big Post-It note on the door to the garage so you remember to buy some.  If your detector predates the Obama administration, it’s time for a change.  And when was the last time you called your mom, changed your furnace filters or unwrapped that mysterious aluminum foil clad nodule in the freezer?  Time to get to it, friends!

For December, we’ll profile three new funds and think with you about the results of our latest research project focusing on the extent to which fund trustees are willing to entrust their own money to the funds they oversee.  We’ve completed reviews of 80 of our target 100 funds and, so far, 515 trustees might have a bit of explaining to do. 

Also coming in December, our pilot episode of the soon-to-be-hit reality TV show: So you think you can be an equity fund manager!  It’ll be hosted by some cheeky chick from Poughkeepsie who sports a faux British accent.

It looks so easy.  And so profitable.  Our British confreres boiled the attraction down in a single three minute video.

Wealth Management Parody from SCM on Vimeo. Thanks to Ted, one of the discussion board’s senior members, for bringing it to our attention.

In December we’ll look at Motif, a service mentioned to us by actual fund managers who are intrigued by it and which would let you run your own mutual fund (or six), in real time with real money.

Your money.

See you then!

Dear friends,

If it weren’t for everything else I’ve read in the news this week (a “blood feud” between DoubleLine and Morningstar? Blood feud? Really? “Pa! Grab your shotgun. Ah dun seen one a them filthy Mansuetos down by the crik!”), the silliest story of the week would be the transformation of candidate’s mutual fund portfolios into attack fodder. And not even attacks for the right reasons!

Republican U.S. Senate candidate Terri Lynn Land attacked her opponent for owning shares of the French firm Total SA. Three weeks later Democrat Gary Peters struck back after discovering that Land (the wretch!) owned “C” shares of Well Fargo Absolute Return (WARCX)and WARCX in turn owns GMO Benchmark-Free Allocation which owns five other GMO funds, one of which has 3% of its portfolio invested in Total SA stock. “She got her hand caught in the cookie jar,” quoth the Democrat.

Land’s total profit from WARCX was between $200-1000. Total SA represented 4% of a fund that was itself 14% of another fund. Hmmm … maybe 0.5% of her perhaps $200 windfall was Total SA so, yup, the issue came down to $1 worth of cookie.

Of course, it wasn’t about the money. It was about the principle. As politics so often are.

Also in Michigan Democrat Mark Schauer attacked the Republican governor’s tax break which benefited companies “even if they send jobs overseas.” The Republican struck back after discovering that Schauer owned shares of Growth Fund of America (AGTHX) which “has a portfolio of companies that make goods overseas, such as Apple.” Here in the Quad Cities, the Democrat candidate for Congress has been attacked for her investment in Janus Overseas (JAOSX), whose 7% holding in Li and Fung Enterprises raised Republican hackles. Congressional candidate Martha Robertson was attacked for owning stock in the treacherous, border-jumping, tax-inverting Burger King – which turns out to be held in the portfolio of a mutual fund she bought 36 years ago. Minnesota senator Al Franken was found to own Lazard, the parent company of a somehow objectionable company, via shares in a socially responsible mutual fund.

Yup. That sure would have been the craziest story of the month except for …

Notes on The Greatest (ill-timed mutual fund manager transition) Story Ever Told

Bill Gross arriving at Janus

Making sense of Mr. Gross’s departure from PIMCO is the very epitome of an “above my pay grade and outside my circle of competence” story. I don’t know why he left. I don’t know whether PIMCO has a toxic environment or, if so, whether he was the source or the firewall. And I certainly don’t know who, among the many partisans furiously spinning their stories, is even vaguely close to speaking the truth.

Here are, however, seven things that I do believe to be true.

If your adviser has recommended moving out of PIMCO funds, you should fire him. If your endowment consultant has advised moving out of PIMCO funds, fire them. If your newsletter editor has rushed out a special bulletin urging you to run, cancel your subscription, demand a refund and send the money to us. (We’ll buy chocolate.) If your spouse is planning on selling PIMCO shares, fir … distract him with pie and that adorable story about a firefighter giving oxygen to baby hamsters. (Also switch him to decaf and consider changing the password on your brokerage account.)

At base, Mr. Gross made some contribution to his core fund’s long-term outperformance, which is in the range of 100-200 basis points/year. In the long term, say over the course of decades, that’s huge. For the immediate future, it’s utterly trivial and irrelevant.

Note to PIMCO (from academe): Thank you! Thank you! Thank you! On behalf of all of us who teach Crisis Communications, Strategic Comm, Media Relations or Public Relations, thanks. Your handling of the story has been manna and will be the source of case studies for years.

For those of you without the time to take a crisis communications course, let me share the five word version of it: Get ahead of the story. Play it, don’t let it play you. Mr. Gross’s departure was absolutely predictable, even if the precise timing wasn’t. The probability of his unhappy departure was exceedingly high, even if the precise trigger was unknown. The firm’s strategists have either known it, or had a responsibility to know it, for the past six months. You could have been planning positive takes. You could have been helping journalists, long in advance, imagine positive frames for the story.

As is, you appeared to be somewhere between scrambling and flailing. About the most positive coverage you could generate was a whiny headline, “Bill Gross relied on us,” and a former employee’s human interest assessment, “El-Erian: PIMCO’s new CIO is one of the most considerate and decent people I know.”

We’d been living off BP’s mishandling of the Gulf oil disaster for years, but it was endless and getting stale. Roger Goodell has certainly offered himself up (latest: he’s got bodyguards and they assault photographers) but it’s great to have a Menu of Misses and Messes to work with.

Note (1) to Janus: You don’t have a Global Unconstrained Bond Fund. Or didn’t at the point that you announced that Mr. Gross was running it:

You might blame the “Global” slip-up on your IT team. It turns out that it’s not just the low-level gnomes. Janus president Richard Weil also invoked the non-existent Global Unconstrained Fund:

Morningstar echoed the confusion:

I called a Janus phone rep, who affirmed that of course they had a Global Unconstrained Fund, followed by a bunch of tapping, a “that’s odd,” an “uh-oh” and a “I’ll have to refer this up the line.” Two hours later Janus filed the name change announcement with the SEC.

Dudes: you were at the top of the news cycle. Everyone was looking. This was just chance to prove to everyone that you were relevant. Why deflect the story with careless goofs? You could have filed a two sentence SEC notice, with no mention of Mr. Gross, the week before. You didn’t. Why, too, does the fund have an eight page summary prospectus with five pages of text, two pages labeled “Intentionally Blank” and another page also blank (even blanker than the two preceding pages with writing on them), but apparently unintentionally so?

Note (2) to Janus: That’s the best picture of Mr. Gross that you could find? Really? Uhhh … that’s not a fund manager. That’s the Grinch.

Note to the ETF zealots, dancing around a bonfire and attempting to howl like wolves: Stop it, you’re embarrassing.

If you actually believed the credo that you so piously pronounce, there’d be about three ETFs in existence, each with a trillion in assets. They’d be overseen by a nonprofit corporation (hi, Jack!) which would charge one basis point. All the rest of you would be off somewhere, hawking nutraceuticals and testosterone supplements for a living. We’ll get to you later.

Note to pundits tossing around 12 figure guesstimates about PIMCO outflows: Stop it, you’re not helping anyone. I know you want to get headlines and build your personal brand. That’s fine, go date a Kardashian. There are a bunch of them available and apparently their standards are pretty … uhhh, flexible. Making up scary pronouncements with blue sky numbers (“we anticipate as much as $400 billion in outflows…”) does nothing more than encourage people to act poorly.

Note to our readers and other PIMCO investors: this is likely the best news you’ve had in a year. PIMCO has been twisting itself in knots over this issue. It’s been a daily distraction and a source of incredible tension and anxiety for dozens upon dozens of management and investment professionals. The situation had been steadily worsening. And now it’s done.

We don’t much cover PIMCO funds. Like the American Funds, they’re way too big to be healthy or interesting. That said, PIMCO has launched innovative and successful new funds over the past five years. Their collective Morningstar performance ratings (4.4 stars for the average domestic equity fund, 3.8 stars for taxable bond funds, 3.6 for international stocks and 1.9 for muni bonds) are well above average.

There is, I suspect, a real prospect of very healthy outcomes for PIMCO and their investors from all this. I suspect that a lot of people may start to look forward to coming to work again. That it will be a lot easier to attract and retain talent. And that a lot of folks will hear the call to step up and take up the slack. You might want to give them to chance to do just that.

Ever wonder what Mr. Gross did when he wasn’t prognosticating?

When I explained to Chip, overseer of our manager changes data, that Mr. Gross was moving on and that his departure affected a six page, single-spaced list of funds (accounting for all of the share classes and versions), she threatened to go all Air France on us and institute a work stoppage. Shuddering, I promised to share the master list of Gross changes with you in the cover essay.  The manager changes page will reflect just some of the higher-profile funds in his portfolio.

Here’s a partial list, courtesy of Morningstar, of the funds he was responsible for:

• PIMCO Total Return, the quarter trillion dollar beast he was famous for

And the other 34:

• MassMutual Select PIMCO Total Return
• PIMCO Emerging Markets Fundamental IndexPLUS Absolute Return Strategy
• JHFunds2 Total Return
• Target Total Return Bond
• AMG Managers Total Return Bond
• PIMCO GIS Total Return Bond
• PIMCO Worldwide Fundamental Advantage Absolute Return Strategy, the fund with the highest buzzwords-to-content ratio of any.
• Transamerica Total Return
• 37 iterations of PIMCO GIS Unconstrained Bond
• Consulting Group Core Fixed-Income
• Harbor Unconstrained Bond
• PIMCO Unconstrained Bond
• PIMCO Total Return IV
• Principal Core Plus Bond
• PL Managed Bond
• PIMCO Fundamental Advantage Absolute Return Strategy
• VY PIMCO Bond
• PIMCO International StocksPLUS® Absolute Return Strategy
• PIMCO Small Cap StocksPLUS® Absolute Return Strategy
• PIMCO Fundamental IndexPLUS Absolute Return
• PIMCO StocksPLUS Absolute RETURN Short Strategy
• PIMCO GIS Low Average Duration
• PIMCO StocksPLUS Absolute Return
• Old Mutual Total Return
• PIMCO GIS StocksPlus
• PIMCO Moderate Duration
• PIMCO StocksPLUS
• PIMCO Low Duration III
• PIMCO Total Return II
• PIMCO Low Duration II
• PIMCO Total Return III
• Harbor Bond
• PIMCO Low Duration
• Prudential Income Builder

As we note with PIMCO GIS Unconstrained (the GIS standing for “global investor series”), there can be literally dozens of manifestations of the same portfolio, denominated in different currencies and hedged and unhedged forms, offers to investors in a dozen different nations.

Morningstar ETF Conference Notes

By Charles Boccadoro

The pre-autumnal weather was perfect. Blue skies. Warm days. Cool nights. Vibrant city scene. New construction. Breath-taking architecture. Diverse eateries, like Lou Malnati’s deep dish pizza. Stylist bars and coffee shops. Colorful flower boxes on The River Walk. Shopping galore. An enlightened public metro system that enables you to arrival at O’Hare and 45 minutes later be at Clark/Lake in the heart of downtown. If you have not visited The Windy City since say when the Sears Tower was renamed the Willis Tower, you owe yourself a walk down The Magnificent Mile.

At the opening keynote, Ben Johnson, Morningstar’s director responsible for coverage of exchange traded funds (ETFs) and conference host, noted that ETFs today hold $1.9T in assets versus just $700M only five years ago, during the first such conference. He explained that 72% is new money, not just appreciation.

The conference had a total of 671 attendees, including 470 registered attendees (mostly financial advisors, but this number also includes PR people and individual attendees), 123 sponsor attendees, 43 speakers, and 35 journalists, but not counting a very helpful M* staff and walk-ins. Five years ago? Just shy of 300 attendees.

The Dirty Words of Finance

AQR’s Ronen Israel spoke of Style Premia, which refers to source of compelling returns generated by certain investment vehicle styles, specifically Value, Momentum, Carry (the tendency for higher-yielding assets to provide higher returns than lower-yielding assets), and Defensive (the tendency for lower-risk and higher-quality assets to generate higher risk-adjusted returns). He argues that these excess returns are backed by both theory, be it efficient market or behavioral science, and “decades of data across geographies and asset groups.”

He presented further data that indicate these four styles have historically had low correlation. He believes that by constructing a portfolio using these styles across multiple asset classes investors will yield more consistent returns versus say the tradition 60/40 stocks/bond balanced portfolio. Add in LSD, which stands for leverage, shorting and derivatives, or what Mr. Israel jokingly calls “the dirty word of finance,” and you have the basic recipe for one of AQR’s newest fund offerings: Style Premia Alternative (QSPNX). The fund seeks long-term absolute (positive) returns.

Shorting is used to neutralize market risk, while exposing the Style Premia. Leverage is used to amplify absolute returns at defined portfolio volatility. Derivatives provide most efficient vehicles for exposure to alternative classes, like interest rates, currencies, and commodities.

When asked if using LSD flirted with disaster, Mr. Israel answered it could be managed, alluding to drawdown controls, liquidity, and transparency.

(My own experience with a somewhat similar strategy at AQR, known as Risk Parity, proved to be highly correlated and anything but transparent. When bonds, commodities, and EM equities sank rapidly from May through June 2013, AQR’s strategy sank with them. Its risk parity flagship AQRNX drew down 18.1% in 31 trading days…and the fund house stopped publishing its monthly commentary.)

When asked about the size style, he explained that their research showed size not to be that robust, unless you factored in liquidity and quality, alluding to a future paper called “Size Matters If You Control Your Junk.”

When asked if his presentation was available on-line or in-print, he answered no. His good paper “Understanding Style Premia” was available in the media room and is available at Institutional Investor Journals, registration required.

Launched in October 2013, the young fund has generated nearly $300M in AUM while slightly underperforming Vanguard’s Balanced Index Fund VBINX, but outperforming the rather diverse multi-alternative category.

QSPNX er is 2.36% after waivers and 1.75% after cap (through April 2015). Like all AQR funds, it carries high minimums and caters to the exclusivity of institutional investors and advisors, which strikes me as being shareholder unfriendly. Today, AQR offers 27 funds, 17 launched in the past three years. They offer no ETFs.

In The Shadow of Giants

PIMCO’s Jerome Schneider took over the short-term and funding desk from legendary Paul McCulley in 2010. Two years before, he was at Bear Stearns. Today, think popular active ETF MINT. Think PAIUX.

During his briefing, he touched on 2% being real expected growth rate. Of new liquidly requirements for money market funds, which could bring potential for redemption gates and fees, providing more motivation to look at low duration bonds as an alternative to cash. He spoke of 14 year old cars that needed to be replaced and expected US housing recovery.

He anticipates capital expenditure will continue to improve, people will get wealthier, and for US to provide a better investment outlook than rest of world, which was a somewhat contrarian view at the conference. He mentioned global debt overhang, mostly in the public sector. Of working age population declining. And, of geopolitical instability. He believes bonds still play a role in one’s portfolio, because historically they have drawn down much less than equities.

It was all rather disjointed.

Mostly, he talked about the extraordinary culture of active management at PIMCO. With time tested investment practices. Liquidity sensitivity. Risk management. Credit research capability, including 45 analysts across the globe that he begins calling at 03:45…the start of his work day. He touted PIMCO’s understanding of tools of the trade and trading acumen. “Even Bill Gross still trades.” He displayed a picture of himself that folks often mistook for a young Paul McCulley.

Cannot help but think what an awkward time it must be for the good folks at PIMCO. And be reminded of another giant’s quote: “Only when the tide goes out do you discover who’s been swimming naked.”

Youthful Hosts

Surely, it is my own graying hair, wrinkled bags, muddled thought processes, and inarticulate mannerisms that makes me notice something extraordinary about the people hosting and leading the conference’s many panels, workshops, luncheons, keynotes, receptions, and sidebars. They all look very young! In addition to being clear thinkers, articulate public speakers, helpful and gracious hosts.

It would not be too much of a stretch to say that the combined ages of M*’s Ben Johnson, Ling-Wei Hew, and Samuel Lee together add up to one Eugene Fama. Indeed, when Mr. Johnson sat across from Nobel laureate Professor Fama, during a charming lunch time keynote/interview, he could have easily been an undergraduate from University of Chicago.

Is it because the ETF industry itself is young? Or, is it as a colleague explains: “Morningstar has hard time holding on to good talent because it is a stepping stone to higher paying jobs at places like BlackRock.”

Whatever the reason, if we were all as knowledgeable about investing as Mr. Lee and the rest of the youthful staff, the world of investing would be a much better place.

Damp & Disappointing

That’s how JP Morgan’s Dr. David Kelly, Chief Global Strategist, describes our current recovery. While I did not agree with everything, it was hands-down the best talk of the conference. At one point he said that he wished he could speak for another hour. I wished he could have too.

“Damp and disappointing, like an Irish summer,” he explained.

Short term US prospects are good, but long term not good. “In the short run, it’s all about demand. But in the long run, it’s all about supply, which will be adversely impacted by labor and productivity.” The labor force is not growing. Baby boomers are retiring en masse. He also showed data that productivity was likely not growing, blaming lack of capital expenditure. (Hard to believe since we seem to work 24/7 these days thanks to amazing improvements communications, computing, information access, manufacturing technology, etc. All the while, living longer.)

Dr. Kelly offered up fixes: 1) corporate tax reform, including 10% flat rate, and 2) immigration reform, that allows the world’s best, brightest, and hardest working continued entry to the US. But since congress only acts in crisis, he concedes his forecast prepares for slowing US growth longer term.

Greater opportunity for long term growth is overseas. Manufacturing momentum is gaining around world. Cyclical growth will be higher than US while valuations remain lower and work force is younger. Simply put, they have more room to grow. Unfortunately, US media bias “always gives impression that the rest of the world is in flames…it shows only bad news.”

JP Morgan remains underweight fixed income, since monetary policy remains abnormal, and cautiously over weight US equities. The thing about Irish summers is…everything is green. Low interest rates. Higher corporate margins. Normal valuation. Although he takes issue with the phrase “All the easy money has been made in equities.” He asks “When was it ever easy?”

Alpha Architect

Dr. Wesley Gray is a former US Marine Captain, a former assistant and now adjunct professor at Drexel University, co-author of Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, and founder of AlphaArchitect, LLC.

He earned his MBA and Finance PhD from University of Chicago, where Professor Fama was on his doctoral committee. He offers a fresh perspective in the investment community. Straight talking and no holds barred. My first impression – a kind of amped-up, in-your-face Mebane Faber. (They are friends.)

In fact, he starts his presentation with an overview of Mr. Faber’s book “The Ivy Portfolio,” which at its simplest form represents an equal allocation strategy across multiple and somewhat uncorrelated investment vehicles, like US stocks, world stocks, bonds, REITS, and commodities.

Dr. Gray argues that simple, equal allocation remains tough to beat. No model works all the time; in fact, the simple equal allocation strategy has under-performed the past four years, but precisely because forces driving markets are unstable, the strategy will reward investors with satisfactory returns over the long run. “Complexity does not add value.”

He seems equally comfortable talking efficient market theory and how to maximize a portfolio’s Sharpe ratio as he does explaining why the phycology of dynamic loss aversion creates opportunities in the market.

When Professor Fama earlier in the day dismissed a question about trend-following, answering “No evidence that this works,” Dr. Gray wished he would have asked about the so-called “Prime anomaly…momentum. Momentum is pervasive.”

When Dr. Gray was asked, “Will your presentation would be made available on-line?” He answered “Absolutely.” Here is link to Beware of Geeks Bearing Formulas.

His firm’s web site is interesting, including a new tools page, free with an easy registration. They launch their first ETF aptly called Alpha Architect’s Quantitative Value (QVAL) on 20 October, which will follow the strategy outlined in the book. Basically, buy cheap high-quality stocks that Wall Street hates using systematic decision making in a transparent fashion. Definitively a candidate MFO fund profile.

Trends Shaping The ETF Market

Ben Johnson hosted an excellent overview ETF trends. The overall briefings included Strategic Beta, Active ETFs (like BOND and MINT), and ETF Managed Portfolios.

Points made by Mr. Johnson:

1. Active vs passive is a false premise. Today’s ETFs represent a cross-section of both approaches.

2. “More assets are flowing into passive investment vehicles that are increasingly active in their nature and implementation.”

3. Smart beta is a loaded term. “They will not look smart all the time” and investors need to set expectations accordingly.

4. M* assigns the term “Strategic Beta” to a growing category of indexes and exchange traded products (ETPs) that track them. “These indexes seek to enhance returns or minimize risk relative to traditional market cap weighted benchmarks.” They often have tilts, like low volatility value, and are consistently rules-based, transparent, and relatively low-cost.

5. Strategic Beta subset of ETPs has been explosive in recent years with 374 listed in US as of 2Q14 or 1/4 of all ETPs, while amassing $360M, or 1/5th of ETP AUM. Perhaps more telling is that 31% of new cash flows for ETPs in 2013 went into Strategic Beta products.

6. Reduction or fees and a general disillusionment with active managers are two of several reasons behind the growth in these ETFs.  These quasi active funds charge a fraction of traditional fees. A disillusionment with active managers is evidenced in recent surveys made by Northern Trust and PowerShares.

M* is attempting to bring more neutral attention to these ETFs, which up to now has been driven by product providers. In doing so, M* hopes to help set expectation management, or ground rules if you will, to better compare these investment alternatives. With ground rules set, they seek to highlight winners and call out losers. And, at the end of the day, help investors “navigate this increasingly complex landscape.”

They’ve started to develop the following taxonomy that is complementary to (but not in place of) existing M* categories.

Honestly, I think their coverage of this area is M* at its best.

Welcomed Moderation

Mr. Koesterich gave the conference opening keynote. He is chief investment strategist for BlackRock. The briefing room was packed. Several hundred people. Many standing along wall. The reception afterward was just madness. His briefing was entitled “2014 Mid-Year Update – What to Know / What to Do.”

He threaded a somewhat cautiously reassuring middle ground. Things aren’t great. But, they aren’t terrible either. They are just different. Different, perhaps, because the fed experiment is untested. No one really knows how QE will turn out. But in mean time, it’s keeping things together.

Different, perhaps, because this is first time in 30-some years where investors are facing a rising interest rate environment. Not expected to be rapid. But rather certain. So bonds no longer seem as safe and certainly not as high yield as in recent decades.

To get to the punch-line, his advice is: 1) rethink bonds – seek adaptive strategies, look to EM, switch to terms less interest rate sensitive, like HY, avoiding 2-5 year maturities, look into muni’s on taxable accounts, 2) generate income, but don’t overreach – look for flexible approaches, proxies to HY, like dividend equities, and 3) seek growth, but manage volatility – diversify to unconstrained strategies

More generally, he thinks we are in a cyclical upswing, but slower than normal. Does not expect US to achieve 3.5% annual GDP growth (post WWII normal) for next decade. Reasons: high debt, aging demographics, and wage stagnation (similar to Rob Arnott’s 3D cautions).

He cited stats that non-financial debt has actually increased 20-30%, not decreased, since financial crisis. US population growth last year was zero. Overall wages, adjusted for inflation, same as late ’90s. But for men, same as mid ‘70s. (The latter wage impact has been masked by more credit availability, more women working, and lower savings.) All indicative of slower growth in US for foreseeable future, despite increases in productivity.

Lack of volatility is due to fed, keeping interest rates low, and high liquidity. Expects volatility to increase next year as rates start to rise. He believes that lower interest rates so far is one of year’s biggest surprises. Explains it due to pension funds shifting out of equities and into bonds and that US 10 year is pretty good relative to Japan and Europe.

On inflation, he believes tech and aging demographics tend to keep inflation in check.

BlackRock continues to like large cap over small cap. Latter will be more sensitive to interest rate increases.

Anything cheap? Stocks remain cheaper than bonds, because of extensive fed purchases during QE. Nothing cheap on absolute basis, only on relative basis. “All asset classes above long term averages, except a couple niche areas.”

“Should we all move to cash?” Mr. Koesterich answers no. Just moderate our expectations going forward. Equities are perhaps 10-15% above long term averages. But not expensive compared to prices before previous drops.

One reason is company margins remain high. For couple of same reasons: low credit interest and low wages. Plus higher productivity, which later appeared contrary to JP Morgan’s perspective.

He advises investors be selective in equities. Look for value. Like large over small. More cyclical companies. He likes tech, energy, manufacturing, financials going forward. This past year, folks have driven up valuations of “safe” equities like utilities, staples, REITS. But those investments tend to work well in recessions…not so much in rising interest rate environment. EM relatively inexpensive, but fears they are cheap for reason. Lots of divided arguments here at BlackRock. Japan likely good trade for next couple years due to Japanese pension funds shifting to organic assets.

He closed by stating that only New Zealand is offering a 10 year sovereign return above 4%. Which means, bond holders must take on higher risk. He suggests three places to look: HY, EM, muni’s.

Again, a moderate presentation and perhaps not much new here. While I personally remain more cautiously optimistic about US economy, compared to mounting predictions of another big pull-back, it was a welcomed perspective.

Beta Central

I’m hard-pressed to think of someone who has done more to enlighten investors about the benefits of ETF vehicles and opportunities beyond buy-and-hold US market cap than Mebane Faber. At this conference especially, he represents a central figure helping shape investment opportunities and strategies today.

He was kind enough to spend a few minutes before his panel on dividend investing and ETFs, which he held with Morningstar’s Josh Peters and Samuel Lee.

He shared that Cambria recently completed a funding campaign to expand its internal operations using the increasingly popular “Crowd Funding” approach. They did not use one of the established shops, like EquityNet, simply because of cost.  A couple hundred “accredited investors” quickly responded to Cambria’s request to raise $1-2M. The investors now have a private stake in the company. Mebane says they plan to use the funds to increase staff, both research and marketing. Indeed, he’s hiring: “If you are an A+ candidate, incredibly sharp, gritty, and super hungry, come join us!”

The new ETF Global Momentum (GMOM), which we mentioned in the July commentary, is due out soon, he thinks this month. Several others are in pipeline: Global Income and Currency Strategies ETF (FXFX), Emerging Shareholder Yield ETF (EYLD), Sovereign High Yield Bond ETF (SOVB), and Value and Momentum ETF (VAMO), which will make for a total of eight Cambria ETFs. The initial three ETFs (SYLD, FYLD, and GVAL) have attracted $365M in their young lives.

He admitted being surprised that Mark Yusko of Morgan Creek Funds agreed to take over AdvisorShares Global Tactical ETF GTAA, which now has just $20M AUM.

He was also surprised and disappointed to read about the SEC’s probe in F2 Investments, which alleges overstated performance results. F2 specializes in strategies “designed to protect investors from severe losses in down markets while providing quality participation in rising markets” and they sub-advise several Virtus ETFs. When WSJ reported that F2 received a so-called Wells notice, which portends a civil case against the company, Mebane posted “first requirement for anyone allocating to separate account investment advisor – GIPS audit. None? Move on.” I asked, “What’s GIPS?” He explains it stands for Global Investment Performance Standards and was created by the CFA Institute.

Mebane continues to write, has three books in work, including one on top hedge funds. Speaking of insight into hedge funds, subscribers joining his The Idea Farm after 31 December will pay a much elevated $499 annually.

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 funds call into two broad categories: The Fallen Titans Funds and Stealthy Funds from “A” Tier Teams.

Le roi est mort, vive le roi’s new fund

Janus Unconstrained Bond (JUCAX) On October 6, Bill Gross, The Bond King, completes the transition from running 34 funds and $1.8 trillion in assets to managing a single $13 million portfolio. Like a Walmart at dawn on Black Friday, the fund is sure is see a huge crush of anxious, half-unhinged shoppers jammed against the doors.

Miller Income Opportunity (LMCJX) On February 26, Bill Miller, The Guy Who Bested the S&P 15 Years in a Row, partnered with his son to manage a new fund with a slightly misleading name (the portfolio produces little income) and hedge fund like freedom (and fees).

Quiet funds from “A” tier teams

Meridian Small Cap Growth (MSAGX) Small growth stocks have been described as “a failed asset class” because of the inability of most professional investors to control the sector’s downside well enough to benefit from its upside. Fortunately Chad Meade and Brian Schaub didn’t know that it was impossible to profit handsomely by limiting a small growth portfolio’s downside and so, for the past seven years, they’ve been doing exactly that. After moving from Janus to Meridian, they get to do it with a small, nimble fund.

Sarofim Equity (SRFMX) Have you ever looked at a large fund with a sensible strategy, solid management team and fine long-term record and thought to yourself “sure wish they were running a small, new fund doing the exact same thing for noticeably less money”? If so, the management team behind Dreyfus Appreciation has an opportunity for you to consider.

Elevator Talk: Justin Frankel, RiverPark Structural Alpha (RSAFX/RSAIX)

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

Justin Frankel (presumably not the JF described as “the world’s most dangerous geek”) co-manages Structural Alpha with his colleague Jeremy Berman. RiverPark launched the fund in June 2013, but the strategy’s public record is considerably longer. It began life in September 2008 as Wavecrest Partners Fund, LP which the guys ran alongside separate accounts for rich folks. Justin and I spent some time discussing the fund over warm drinks in lovely Milwaukee this August.

Structural Alpha embodies an options-based strategy. Every time I write that, my head begins to hurt because I struggle to explain them even to myself. Investors use options as a sort of portfolio insurance. The managers here sell options because those options are structurally overpriced; that is, there’s a predictable excess profit for the sellers built into the market just as you pay more for your insurance policies than you’ll ever get out of them.

The portfolio has four components – long-dated options which tend to move in the direction of the stock market, short-dated options which tend to be market independent, a permanent hedge which buffers the long options’ downside risk and a huge amount of cash which serves as collateral on the options they’ve sold. The guys invest that cash in short-term securities which produce income for the fund. As market conditions change, the managers adjust the size of the options components to keep the fund’s risk exposure within predetermined limits. That is, there are times when their market indicators show that the long-dated portion is carrying the potential for too much downside and so they’ll dial back that component.

Here’s what that performance looks like, including the strategy’s time as a hedge fund. RiverPark is the blue line, its painfully inept peer group is on the orange line and the S&P 500 is green.

Over the better part of a full market cycle, the Structural Alpha strategy captured the 80% of the stock index’s returns – the strategy gained about 70% while the S&P rose 87% – while largely sidestepping any sustained losses. On average, it captures about 20% of the market’s down market performance and 40% of its up market. The magic of compounding then works in their favor – by minimizing their losses in falling markets, they have little ground to make up when markets rally and so, little by little, they catch up with a pure equity portfolio.

Justin Frankel

It’s clear that they might substantially lag in sustained, low volatility rallies but it’s also clear that they’ll make money for their investors even then.

Here are Justin’s 200 words on how you might buy some insurance:

The RiverPark Structural Alpha Fund is a market-neutral, hedged equity strategy. Our goal is to generate equity-like returns with fixed-income like volatility. We use a consistent and systematic investment process that focuses first on the management of risk, and then on the management of return.

The core of our investment philosophy is that excessive returns are rarely realized, and therefore should be traded for the opportunity to generate more stable returns, protect against some market declines, and reduce overall portfolio volatility. Secondarily, we believe that index options are overpriced, and by systematically selling these options we can generate positive returns without market exposure. This is why we use the term Structural Alpha in the fund’s name.

Jeremy Berman

Importantly, we have no view of the market and do not change our holdings or market exposure based on market conditions. Specifically, we use options to set zones of protection and to allow the fund to perform in up markets while maintaining a constant hedge to help protect the fund in down markets. The non-linear profile of options makes them ideally suited to implement our philosophy. Our portfolio naturally gets more exposed to the market as it declines (which means that we are constantly buying lower), and gets less exposed to the market when it rises (which means we are constantly selling higher).

Over the long run, the fund is slightly long-biased. Therefore, we believe it should perform better in rising markets. In our opinion, small and consistent gains over time, when compounded, will yield above average risk-adjusted returns for our shareholders. We believe our structural approach to investing gives the strategy a high probability for success across a range of different market environments.

RiverPark Structural Alpha has a $1000 minimum initial investment. Expenses are capped at 2.0% on the investor shares and the fund has about gathered about $7 million in assets since its June 2013 launch. Here’s the fund’s homepage, which has a funny video of the guys talking through the strategy. It’s a sort of homemade ten minute video and has much of the unprepossessing charm of Sheldon Cooper’s “Fun with flags” videos on The Big Bang Theory. Spoiler alert: the first two minutes are the managers sharing their biographies and the last seven minutes are soundless images of slides and disclaimers (I feel the compliance group’s hand here). If you’d like to listen to a précis of the strategy, start listening at about the 4:00 minute mark through to about 6:50. They make a complex strategy about as clear as anyone I’ve yet heard.

Launch Alert: T. Rowe Price International Concentrated Equity (PRCNX)

It’s rare that a newly launched fund receives both a “Great Owl” (top quintile risk-adjusted returns in all trailing periods longer than a year) and Morningstar five star rating, but Price’s International Concentrated Equity Fund (PRCNX) managed the trick. On August 22, 2014, T. Rowe released a retail version of its outstanding Institutional International Concentrated Equity Fund (RPICX). That fund launched in July 2010. Federico Santilli, who has managed the RPICX since inception, will manage the new fund. He claims to be style, sector and region-agnostic, willing to go wherever the values are best. He targets “companies that have solid positions in attractive industries, have an ability to generate visible and durable free cash flow, and can create shareholder value over time.”

The portfolio holds 60 large cap names, weighting them equally but turning them over with alarming speed, about 150% per year. The portfolio offers little direct exposure to the emerging markets but the multinationals that dominate the portfolio (Royal Bank of Scotland, Sony, drug maker Glaxo, Honda) derive much of their earnings from consumers in those newer markets.

The fund has performed well. It has been in or near the top 10% of foreign large blend funds each year. $10,000 invested there at inception would have grown to $15,700 (as of late September, 2014) while its average peer would have generated $13,700 with noticeably higher volatility. It has been the second-strongest performer among all the T. Rowe Price international funds, trailing only International Discovery (PRIDX), whose lead is tiny.

PRCNX is not merely a share class of RPICX. It is a separate fund, managed by the same guy using the same discipline. Nonetheless, the portfolios may show significant differences depending on what names are attractive when money flows into each fund.

The expense ratio is capped at 0.90%, barely higher than the Institutional fund’s 0.75%, under February 2017. The minimum initial investment is $2500, reduced to $1000 for IRAs. The fund’s homepage is here but the institutional fund’s homepage has a far greater array of information and strategy detail. Price would urge me to remind you that the information about the institutional fund is designed to inform qualified investors and analysts and it’s not aimed to persuading you to buy the retail fund.

Funds in Registration

Our colleague David Welsch tracked down 12 new no-load, retail funds in registration this month. In general, these funds will be available for purchase by late November. A number of the prospectuses are incredibly incomplete (not listing, for example, a fund manager) which suggests that they’re just gearing up for the traditional year-end rush to launch new funds. Highlights among the registrants:

• 361 Global Long/Short Equity Fund, which will feature a global long/short portfolio. Its most notable for its cast of managers, including Blaine Rollins from 361 Capitals and Harindra de Silva from Analytic Investors. Mr. Rollins ran Janus Fund at the height of its popularity (sadly, that would be around the year 2000), left investing in 2006 but has since returned to cofound 361, a liquid alts firm that’s dedicated to trying to prevent the sorts of losses the Janus funds suffered. Mr. Silva has roots going back to the PBHG Funds in the 1990s. The fund is no-load with a $2500 minimum, but we don’t yet know the expenses.
• American Century Multi-Asset Income Fund, which will primarily seek income with a conservative balanced portfolio. You might anticipate 40% dividend-paying stocks and 60% bonds. It will be team-managed with a reasonable 0.91% e.r. and $2,000 minimum.
• DoubleLine Long Duration Total Return Bond Fund, which will sport an effective average duration of 10 years or more. That’s a fascinating launch since long duration funds are highly interest rate sensitive and most observers anticipate rising rates (eventually). The Other Bond King and Vitaliy Liberman will manage the fund. The expenses aren’t yet set. The minimum initial investment will be $2,000 for “N” shares.

Manager Changes

Yikes.  This month saw 93 manager changes without accounting for the full extent of the turmoil caused by Mr. Gross’s change of employment. 

Top Developments in Fund Industry Litigation – September 2014

Fundfox is the only intelligence service to focus exclusively on litigation involving U.S.-registered investment companies, their directors and advisers. Each month editor David Smith shares word of the month’s litigation-related highlights. Folks whose livelihood ride on such matters need to visit FundFox and chat a bit with David about the service.

New Lawsuit

• Harbor was hit with new excessive-fee litigation, alleging that it charges advisory fees to its International and High-Yield Bond Funds that include a mark-up of more than 80% over the fees paid by Harbor to unaffiliated subadvisers who do most of the work. (Tumpowsky v. Harbor Capital Advisors, Inc.)

Orders

• The court consolidated a pair of fee lawsuits regarding the Davis N.Y. Venture Fund. (In re Davis N.Y. Venture Fund Fee Litig.)
• In a pair of ERISA lawsuits regarding a J.P. Morgan pooled stable value investment fund, the court transferred venue to the S.D.N.Y. (Adams v. J.P. Morgan Ret. Plan Servs., LLC; Ashurst v. J.P. Morgan Ret. Plan Servs. LLC.)
• The court denied defendants’ motion to dismiss excessive-fee litigation regarding six Principal LifeTime funds: “[W]hile Plaintiff has included some generalized statements regarding the mutual fund industry in its complaint, Plaintiff is not relying solely on speculation and has included some specific factual allegations regarding Defendants and their practices.” (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal Mgmt. Corp.)
• The court gave its final approval to a $19.5 million settlement of an ERISA class action regarding TIAA-CREF‘s procedures for closing retirement plan accounts. (Bauer-Ramazani v. TIAA-CREF.)

Brief

• The plaintiff filed her opening brief in an appeal concerning American Century‘s liability for the Ultra Fund’s investments in off-shore Internet gambling businesses. Defendants include independent directors. (Seidl v. Am. Century Cos.)

Amended Complaint

• After surviving a motion to dismiss, a plaintiff filed an amended complaint alleging Securities Act violations in connection with four closed-end Morgan Keegan bond funds (n/k/a Helios funds). (Small v. RMK High Income Fund, Inc.)

For a 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.

Liquid Alternative Observations

Brian Haskin publishes and edits the DailyAlts site, which is devoted to the fastest-growing segment of the fund universe, liquid alternative investments. Here’s his quick take on the DailyAlts mission:

Our aim is to provide our readers (investment advisors, family offices, institutional investors, investment consultants and other industry professionals) with a centralized source for high quality news, research and other information on one of the most dynamic and fastest growing segments of the investment industry: liquid alternative investments.

I like the site for a couple reasons. The writing is clean, the stories are fresh and the content seems thoughtful. Beyond that, one of the ways that the Observer tries to help folks is by linking them to the resources they need. There are really important areas that are outside our circle of competence and beyond our resources, and we’re deeply grateful for folks like David Smith at FundFox and Brian for their generous willingness to share leads and insights.

Brian offers this as his take on the month just past.

A Key Turning Point

September 2014 may be a month to remember – jot it down in the depths of your memory as it may be a useful data point some time down the road. Why? Because it was the point at which the largest pension fund in the United States, the California Public Employee Retirement System (CalPERS), decided not to push forward with a larger allocation to hedge funds, and instead reversed course and cut their allocation to zero.

Citing costs and complexity, it is easy to see why the prior would be a problem for the taxpayer funded pension system. As James B. Stewart stated in his article for The New York Times, “the fees CalPERS paid [to hedge funds] would have soared to $1.35 billion” if they increased their hedge fund program to a meaningful allocation of their portfolio (~10-15%).

That’s clearly not a number that would make any investment committee member comfortable. The “CalPERS Decision” may be the real turning point for liquid alternatives, which are essentially hedge funds without performance fees wrapped in mutual fund or exchange traded fund wrappers.

By eliminating the performance fee, which generally is equal to 20% of annual returns, investors will reap the short- and long-term benefit of substantially lower costs. This lower cost will be attractive not only to individual investors and their advisors, but also to a much broader universe of investors that includes family offices, endowments, foundations and pension funds. Hedge funds are a key source of diversification for many of these investors already, and as more high quality mutual fund and ETF choices become available, investors will shift assets from higher cost hedge funds to lower cost liquid alternative vehicles.

It should be noted that most, but not all, alternative mutual funds do not incur a performance fee similar to a hedge fund performance fee. However, certain structures within mutual funds do allow for the mutual fund to indirectly purchase limited partnerships (i.e. hedge funds) that charge traditional hedge fund fees, including a performance fee.

New Fund Launches

As of this writing, September saw only six new alternative fund launches, with five of those being mutual funds. Additional launches often occur on the last day of the month, so others may be near, including a long/short equity fund from Goldman Sachs and a multi-alternative fund from Lazard. Two notable new funds that have launched are as follows:

• AQR Style Premia Alternative LV Fund (QSLIX) – this is a low volatility version of an existing AQR fund, but is interesting because it takes a leveraged market neutral approach to investing across multiple asset classes using a factor based investment approach. With a targeted volatility level similar to intermediate term bonds, this fund could be a good substitute for long-only fixed income if rates start to rise.
• Eaton Vance Richard Bernstein Market Opportunities Fund (ERMIX) – this new global macro fund is managed by the former Chief Investment Strategist at Merrill Lynch and the fund’s namesake, Richard Bernstein. The market environment is getting better for global macro funds as the Fed eases up on QE and more natural market trends re-emerge. Keep an eye on this one.

A full list of new funds can be found on the DailyAlts’ New Fund Listing.

New Fund Registrations

We tracked ten new alternative mutual fund filings in September, which means that the end of the year will be flush with new funds. Four of the filings are for long/short equity, which has been a recipient of significant inflows over the past year. Two of the notable filings outside of long/short equity include the following:

o  State Street Global Macro Absolute Return Fund – another go-anywhere global macro fund that will invest across global markets and asset classes. As with the new Eaton Vance fund above, the timing could be good and the universe for global macro funds is relatively small.

o   Palmer Square Long Short Credit Fund – just in time for rising interest rates, this new fund comes from a boutique asset management firm with a highly experienced fixed income team. The fund has a wide range of credit oriented securities that it can use on both a long and short basis to generate absolute (positive) returns over full market cycles.

Other Items of Interest

• On the ETF front, First Trust launched an actively managed long/short equity ETF. We’ll keep an eye on this low cost vehicle to see how well a long/short strategy can do in an ETF wrapper.
• HedgeCo launched HedgeCoVest, a managed accounts platform available to individual investors for as little as $30,000. Investors can get a hedge fund managed in their own brokerage account with full liquidity and transparency. This could be a real market disruptor.
• TFS marked the 10-year anniversary of their TFS Market Neutral Fund (TFSMX). Quite an accomplishment, especially when (in hindsight) being “market neutral” over the past five years has not been a desirable bet. But as we know, the next five years won’t be like the past five years. Congrats to TFS.

We look forward to bringing readers of the Mutual Fund Observer monthly insights on the evolving market for alternative mutual funds.

Meh. Just meh.

From time to time, I come across what strikes me as an extraordinarily cool website or online retailer. In the past those have included the DailyAlts site and the Duluth Trading Company. When that happens, I’m predisposed to share word about the site with you, for your sake and for theirs.

I still remember a sign in the hot dog shop’s window from when I was in grad school: “eat here or we’ll both go hungry.” It’s sort of like that.

I have lately been delighted with the little online shop, meh. If we were Vikings, that would be “meh son of woot” or “meh wootson.” Woot was an online shop launched in 2004. The founders worked as wholesalers and looked at the challenge of selling what I think of as “orphan goods.” That is, stuff where the quantity available is substantial but too small to be profitably distributed through a mainline retailer. Woot was distinguished by two characteristics: (1) a one-deal-one-day business model in which shoppers were offered one deeply discounted item each day and at the day’s end, the item vanished. And (2) a snarky dismissiveness of their own offerings.

It was sufficiently cool that Amazon.com bought it in 2010 and messed it up by, oh, 2011. Instead of advertising one great deal, Amazon thought they should offer one deal in each of ten categories, plus Side Deals and Woot!Plus deals and miscellaneous sale items from Amazon’s own site and goodness knows what else.

Woot’s founders decided to try again (presumably after the expiration of non-compete agreements) and, with the help of Kickstarter funding, launched meh. Like the original Woot!, meh offers precisely one deal for no more than 24 hours. The site is tantalizing for two reasons: (1) the stuff is always cheap and sometimes outstanding and (2) checking each day takes me about 30 seconds since there’s, well, just one thing.

What sort of “one thing”? 40 AA Panasonic batteries for $5. Two refurbished 39” Emerson LCD TVs for $300 (not $300 each, $300 for the pair). A Phillips Blu-ray player for $15. Down alternative comforters for $18-20. (I bought two for my son’s bed, under the assumption that 14-year-olds will eventually spot, stain or shred pretty much anything within reach.) A padded laptop, a refurbished Dyson DC41 vacuum, Bluetooth keyboards for your tablet. Stuff.

It’s a small operation. Shipping tends to be slow. They charge $5 per item to ship unless you join their Very Mediocre Person service where you get unlimited free shipping for $5/month. A lot, but not all, of the stuff is refurbished. Neither bells nor whistles are in evidence. On whole they are, I guess, sort of “meh.”

That said, they’re also worth visiting. (And no, we have no relationship of any sort with them. You’re so suspicious.) meh.

Briefly Noted . . .

Effective November 1, 2014, Catalyst/Lyons Hedged Premium Return Fund (CLPAX/ CLPFX) will pursue “long-term capital appreciation and income with less downside volatility than the equity market.” That’s a bold departure from the current promise to seek “long-term capital appreciation and income with low volatility and low correlation to the equity market.”

On October 1^st, FTSE and Research Affiliates rolled out a new set of low-volatility indexes. As with many RAFI products, the stocks in the index are weighted using fundamental factors, as opposed to market capitalization. Jason Hsu, one of the RA co-founders, describes it as “a next generation approach that produces a low volatility core universe which is valuation-aware, without uncomfortable country or sector active bets.” Given that there’s $60 billion in funds, ETFs and separate accounts benchmarked against the existing FTSE RAFI indexes, you might reasonably expect the product launches to commence in the near future.

Matthews raised the expense ratio on Matthews China Fund (MCHFX) by one basis point at the end of September, netting them a cool $110,000 on a $1.1 billion fund. MCHFX and Matthews Asia Dividend have both qualified for access to Chinese “A” shares, expenses relating to which apparently triggered the one bp bump.

In another odd development, the Board of Trustees of the Value Line Core Bond Fund (VAGIX) approved a 3:1 reverse stock split on or about October 17, 2014. It’s incredibly rare for a fund to execute a split or a reverse split because the fund’s NAV has absolutely no relevance to its operation. With stocks, share prices that are too low might trigger a delisting alert and shares prices that are too high (think Berkshire Hathaway Cl A shares) might impede trading. Funds have no such excuse. When I spoke with a fund rep, she dutifully read Value Line’s one-sentence rationale to me: “It will realign our fund’s NAV with their peers’ and daily performance would be more appropriately reported.” Neither she nor I nor why the former was important or how the latter occurred, so I rack it up to “it’s Value Line. They do that sort of thing.”

Seafarer adds capacity

As Seafarer Overseas Growth & Income (SFGIX) grows steadily in size, it’s now over $117 million, and approaches its third anniversary, Andrew Foster has taken the opportunity to add to his analyst corps.  The estimable Kate Jacquet (Morningstar keeps misspelling her name as “Jacque”) is joined by Paul Espinosa and Sameer Agarwal.   Paul was a London-based analyst who has worked for Legg Mason, JP Morgan, Citigroup and Salomon Brothers.  He’s got some interesting experience in small cap and market neutral strategies.  Sameer grew up in India and worked for an India-based mutual fund before joining Royal Bank of Scotland and later Cartica Management, LLC.  Cartica is a sort of liquid alts manager focusing on the emerging markets.  I’ll ask Andrew in the month ahead how the guys’ work with what appear to be hedged products might contribute to Seafarer’s famously risk-conscious approach.

Seafarer reduced its expenses again, to 1.25% for Investor shares, though Morningstar continues to report a higher cost. 

SMALL WINS FOR INVESTORS

Appleseed (APPLX/APPIX) is lowering their expenses for both investor and institutional classes. Manager Joshua Strauss writes: “As we begin a new fiscal year Oct. 1, we will be trimming four basis points off Appleseed Fund Investor shares, resulting in a 1.20% net expense ratio. At the same time, we will be lowering the net expense ratio on Institutional shares by four basis points, to 0.95%.” It’s a risk-conscious, go-anywhere sort of fund that Morningstar has recognized as one of the few smaller funds that’s impressed them.

CLOSINGS (and related inconveniences)

Grandeur Peak Global Reach (GPROX), which was already soft closed to new investors, imposed a hard close on virtually all investors on September 30^th.

“Effective immediately, and until further notice” Guggenheim Alpha Opportunity Fund (SAOAX) has closed to all investors. That’s odd. It’s an exceedingly solid long/short fund with negligible assets. There’s been some administrative reshuffling going on but no clear indication of the fund’s future.

OLD WINE, NEW BOTTLES

The Absolute Opportunities Fund has been renamed the Absolute Credit Opportunities Fund (AOFOX). Its prospectus is being revised to reflect a focus on credit-related strategies. At the same time, the fund’s expense ratio is dropping from a usurious 2.75% down to a high 1.60%.

Chilton Realty Income & Growth Fund (REIAX) has become West Loop Realty Fund.

Effective on September 2, 2014, Dreyfus Select Managers Long/Short Equity Fund (DBNAX) became Dreyfus Select Managers Long/Short Fund (DBNAX). Dropping the word “equity” from the name allows the managers to invest more than 20% of the portfolio in non-equity securities but it’s not clear that any great change is in the works. The new prospectus still relegates non-equity securities to one line at the end of paragraph four: “The fund may invest, to a limited extent, in bonds and other fixed-income securities.”

Effective October 1, 2014, Mellon Capital Management Corporation replaced PVG Asset Management Corporation as sub-adviser to the Dunham Loss Averse Equity Income Fund (DAAVX),which was then re-named the Dunham Dynamic Macro Fund.

John Hancock China Emerging Leaders Fund (JCHLX) is rethinking the whole “China” thing and has become just the John Hancock Emerging Leaders Fund. The change allows them to invest across the emerging markets. DFA will still manage the fund.

Effective at the close of business on October 15, 2014, Loomis Sayles Capital Income Fund (LSCAX) becomes Loomis Sayles Dividend Income Fund. The investment strategies change to stipulate the fact that they’ll be investing, mostly, in equities.

Effective September 16, 2014, Market Vectors Wide Moat ETF (MOAT) became Market Vectors Morningstar Wide Moat ETF.

Pioneer is planning to find Solutions for you. Effective mid November, all of the Pioneer Ibbotson Allocation funds will jettison Ibbotson and gain Solutions. So, for example, Pioneer Ibbotson Growth Allocation Fund (GRAAX) will be Pioneer Solutions: Growth Fund. Moderate Allocation (PIALX) will become Solutions: Balanced and Conservative Allocation (PIAVX) will become Solutions: Conservative. Some as-yet undisclosed strategy and manager changes will accompany the name changes.

In that same “let’s add the name of someone well-known to our fund’s name” vein, what was Ramius Trading Strategies Managed Futures Fund (RTSRX) is now State Street/Ramius Managed Futures Strategy Fund. SSgA replaced Horizon Cash Management LLC as manager.

OFF TO THE DUSTBIN OF HISTORY

Dreyfus Emerging Asia Fund (DEAAX) becomes Dreyfus Submerging Asia Fund on or about October 30, 2014. The decision to liquidate caps a sorry seven year run for the tiny, volatile fund which made a ton of money for investors in 2009 (130%) but was unrelievedly bad the rest of the time.

Driehaus Global Growth Fund (DRGGX)is slated to liquidate on October 20, 2014. Cycling through a half dozen managers in a half dozen years certainly didn’t solve the fund’s performance problems and might well have deepened them.

Forward Managed Futures Strategy Fund (FUTRX) no longer has a future, a fact which will be formalized with the fund’s liquidation on October 31, 2014. The fund has lost about 12% since launch in 2012. The whole managed futures universe has performed so abysmally that you have to wonder if regression to the mean is about to rescue some of the surviving funds.

Huntington International Equity Fund (HIEAX) is merging into Huntington Global Select Markets Fund (HGSAX). Effectively both funds are being liquidated. HEIAX disappears entirely and HGSAX transforms from an underperforming equity markets stock fund to a global balanced fund with no particular tilt toward the Ems. The same management team that struggled with these as international equity funds will be entrusted with the new incarnation of Global Select. The best news is a new expense cap of 1.21% on Select. The worst news is that much of the combined portfolio might have to be liquidated to complete the transition.

Morgan Stanley Global Infrastructure Fund (UTLAX)will be absorbed by its institutional sibling, MSIF Select Global Infrastructure (MTIPX). They’re essentially the same fund, except for the fact that the surviving fund is much smaller and charges more. And, too, they’re both really good funds.

Nationwide International Value Fund (NWVAX)will be liquidated on December 19^th for all the usual reasons.

Effective November 14, 2014, Northern Large Cap Growth Fund (NOEQX) will merge into Northern Large Cap Core Fund (NOLCX). The Growth Fund shareholders get a major win out of the deal, since they’re joining a far stronger, larger, cheaper fund. The reorganization does not require a shareholder vote.

Perimeter Small Cap Growth Fund (PSCGX/PSIGX) has closed to new investors in anticipation of being liquidated on Halloween. The fund’s redemption fee has been waived, just in case you want to get out early.

On or about November 14, 2014, Pioneer Ibbotson Aggressive Allocation Fund (PIAAX) merges into Pioneer Ibbotson Growth Allocation Fund (GRAAX) At the same time, Growth Allocation changes its name to Pioneer Solutions – Growth Fund.

This is kind of boring, but here’s word that PNC Pennsylvania Tax Exempt Money Market Fund and PNC Ohio Municipal Money Market Fund both liquidate in early October.

QuantShares U.S. Market Neutral Momentum Fund (MOM) and QuantShares U.S. Market Neutral Size Fund (SIZ) are under threat of delisting. “The staff of NYSE Regulation, Inc. recently advised the Trust that the Funds’ shares currently are not in compliance with NYSE Arca, Inc.’s continued listing standards with respect to the number of record or beneficial holders. Therefore, commencing on or about September 16, 2014, NYSE Arca will attach a “below compliance” (.BC) indicator to each Fund’s ticker symbol … Should the Staff determine to delist a Fund, or should the Adviser conclude that a Fund cannot be brought into compliance with NYSE Arca’s continued listing standards, the Adviser will recommend the Fund’s liquidation to the Fund’s Board of Trustees and attempt to provide shareholders with advance notice of the liquidation.”

Pending shareholder approval, Sentinel Capital Growth Fund (BRGRX – it’d read as “Boogers” if it were a license plate) and Sentinel Growth Leaders Fund (BRFOX) will merge into Sentinel Common Stock Fund (SENCX). The shareholder meeting will nominally occur in lovely Montpelier, Vermont, on November 14^th. It wouldn’t be unusual for the merger to then occur by year’s end.

TCW Growth Fund (TGGYX) will liquidate around Halloween, 2014.

Turner Large Growth Fund (TCGFX) will soon merge into Turner Midcap Growth Fund (TMGFX), pending shareholder approval. I’ve never really gotten the Turner Funds. They always feel like holdovers from the run and gun ‘90s to me. The fact that Midcap Growth suffered a 56% drawdown during the financial crisis and is routinely a third more volatile than its peers fits with that impression.

Wade Tactical L/S Fund (WADEX) plans to cease and desist around the middle of October.

The Board of Directors for Western Asset Global Multi-Sector Fund (WALAX)has determined that “it is in the best interests of the fund and its shareholders to terminate the fund.” It seemed they long ago also determined it was in shareholders’ best interest not to invest in the fund:

The fund is expected to cease operations on or about November 14, 2014.

On January 30, 2015, Wilmington Short Duration Government Bond Fund (ASTTX) will be merged into the Wilmington Short-Term Corporate Bond Fund (MVSAX). Likewise the Wilmington Maryland Municipal Bond Fund (ARMRX) will be merged into the Wilmington Municipal Bond Fund (WTABX). The latter, muni into muni, makes more sense on face than the former.

The WY Core Fund (SGBFX/SGBYX) disappeared on September 30^th, just in case you were wondering why there’s an empty seat at the table.

In Closing . . .

As I sat in my study, 11:30 p.m. CDT on the last day of September, finishing this essay, my internet connection disappeared.  Then the lights flickered, flashed then failed.  Nuts.  The MidAmerican Energy outage map shows that I was one of precisely two customers to lose power.  This is the second time since moving to my new home in May that the power disappeared just as we were trying to finishing an update.  The first time it happened we were in a world of hurt, both having lost a bunch of writing and having the rest of the new issue trapped inside an inert machine.

This time we were irked and modestly inconvenienced. The difference is that after the first major outage, Chip identified and I bought a really good uninterruptible power supply (UPS) for us. While it’s not an industrial grade unit, it allowed me to save everything, move it for safekeeping to an external solid-state drive and finish the story I was working on before shutting the system down. We resumed work a bit before dawn and finished everything roughly on time.

All of which is to say thank you! to all the folks who’ve supported the Observer.  I was deeply grateful that we had the resources at hand to react, quickly and frugally, to resolve the problems caused by the first outage.  Thanks to all the folks who use our Amazon link (feel free to share it!), to Joe and Bladen (cool old English name, linked to a village in Oxfordshire) who contributed to our resources this month but most especially to Deb who, in an odd sense, is the Observer’s only subscriber.  Deb arranged a monthly auto-transfer from her PayPal account which provides us with a modest, very welcome stipend at the beginning of each month.

The other project that you helped support this month was the first ever face-to-face meeting of the folks who write for you each month.  Charles, Chip, Ed and I gathered in Chicago in the immediate aftermath of the Morningstar ETF Conference to discuss (some would say “plot”) the Observer’s future.  Among our first priorities coming out of the meeting is to formalize the Observer as a legal enterprise: incorporation, pursue of 501(c)3 tax-exempt organization status, better liability and intellectual property protection and so on.  None of that will immediately change the Observer but it all lays the foundation for a more sustainable future.  So thanks for your help in covering the expenses there, too.

Take care and enjoy October.  It tends to be a rough and tumble month in the markets, but a fine time for visiting orchards with your family and starting the holiday fruitcakes.

As ever,

Dear friends,

They’re baaaaack!

The summer silence has been shattered. My students have returned in endlessly boisterous, hormonally-imbalanced, self-absorbed droves. They’re glued to their phones and to their preconceptions, one about as maddening as the other.

The steady rhythm of the off-season (deal with something else falling off the house, talk to a manager, mow, think, read, write, kvetch) has been replaced by getting up at 5:30 and bolting through days, leaving a blur behind.

Somewhere in the background, Putin threatens war, the market threatens a swoon, horrible diseases spread, politicians debate who among them is the most dysfunctional and someone finds time to think Deep Thoughts about the leaked nekkid pitchers of semi-celebrities.

On whole, it’s good to be back.

Seven things that matter, two that don’t … and one that might

I spoke on August 20^th to about 200 folks at the Cohen Fund client conference in Milwaukee. Interesting gathering, surprisingly attractive city, consistently good food (thanks guys!) and decent coffee. My argument was straightforward and, I hope, worth repeating here: if you don’t start thinking and acting differently, you’re doomed. A version of that text follows.

Your apparent options: dead, dying or living dead

From the perspective of most journalists, many advisors and a clear majority of investors, this gathering of mutual fund managers and of the professionals who make their work possible looks to be little more than a casting call for the Zombie Apocalypse. You are seen, dear friends, as “the walking dead,” a group whose success is predicated upon their ability to do … what? Eat their neighbors’ brains which are, of course, tasty but, and this is more important, once freed of their brains these folks are more likely to invest in your funds.

CBS News declared you “a losing bet.” TheStreet.com declared that you’re dead.  Joseph Duran asked, curiously, “are you a dinosaur?” Schwab declared that “a great question!” Ric Edelman, a major financial advisor, both widely quoted and widely respected, declares, “The retail mutual fund industry is a dinosaur and won’t exist in 10 or 15 more years, as investors are realizing the incredible opportunity to lower their cost, lower their risks and improve their disclosure through low-cost passive products.” When asked what their parents do for a living, your kids desperately wish they could say “my dad writes apps and mom’s a paid assassin.” Instead they mumble “stuff.” In short, you are no longer welcome at the cool kids’ table.

Serious data underlies those declarations. The estimable John Rekenthaler reports that only one-third of new investment money flows to active funds, one third to ETFs and one third to index funds. Drop target-date funds out of the equation and the amount of net inflows to funds is reduced by a quarter. The number of Google searches for the term “mutual funds” is down 80% over the past decade.

Funds liquidate or merge at the rate of 400-500  per year. Of the funds that existed 15 years ago, Vanguard found that 46% have been liquidated or merged. The most painful stroke might have been delivered by Morningstar, a firm whose fortunes were built on covering the mutual fund industry. Two weeks ago John Rekenthaler, vice president and resident curmudgeon, asked the question “do have funds have a future?”  He answered his own question with “to cut to the chase: apparently not much.”

Friends, I feel your pain. Not that zombies actually feel pain. You know if Mr. Cook accidentally rips Mr. Bynum’s arm off and bludgeons him with it, “it’s all good.” But if you did feel pain, I’d be right there with you since in a Zombies Anonymous sort of way I’m obliged to say “Hello. My name is Dave and I’m a liberal arts professor.”

The parallel experience of the liberal arts college

I teach at Augustana College – as school known only to those of you blessed with a Scandinavian Lutheran heritage or to fans of the history of college football.

We operate in an industry much like yours – higher education is in crisis, buffeted by changing demographics – a relentless decline in the number of 17 year old high school graduates everywhere except in a band of increasingly sunbaked states – changing societal demands and bizarre new competitors whose low cost models have caught the attention of regulators, journalists and parents.

You might think, “yeah, but if you’re good – if you’re individually excellent – you’ll do fine.”  “Emerson was wrong, wrong, wrong: being excellent does not imply you’ll be noticed, much less be successful.” 

Remember that “build a better mousetrap and people will beat a path to your door” promise. Nope.  Not true, even for mousetraps. There have been over 4400 patents for mousetraps (including a bunch labeled “better mousetrap”) issued since 1839. There are dozens of different subclasses, including “Electrocuting and Explosive,” “Swinging Striker,” “Choking or Squeezing,” and 36 others. One device, patented in 1897, controls 60% of the market and a modification of it patented in 1903 controls another 15-20%. About 0.6% of patented mousetraps were able to attract a manufacturer.

The whole “succeed in the market because you’re demonstrably better” thing is certainly not true for small colleges. Let me try an argument out with you: Augustana is the best college you’ve never heard of. The best. What’s the evidence?

• We’re #6 among all colleges in the number of Academic All-Americans we’ve produced, #2 behind only MIT as a Division 3 school.
• We were in the top 50 schools in the 20^th century for the number of our graduates who went on to earn doctorates.
• National Survey of Student Engagement (NSSE) and the Wabash National Study both singled us out for the magnitude of gains that our students made over their four years.
• The Teagle Foundation identified use as one of the 12 colleges that define the “Gold Standard” in American higher education based on our ability to vastly outperform given the assets available to us.

And yet, we’re not confident of our future. We’re competing brilliantly, but we’re competing to maintain our share of a steadily shrinking pie. Fewer students each year are willing to even consider a small school as families focus more on price rather than value or on “name” rather than education. Most workers expect to enjoy their peak earnings in their late 40s and 50s.  For college professors entering the profession today, peak lifetimes earnings might well occur in Year One.  After that, they face a long series of pay freezes or raises that come in just below the CPI.  Bain & Company estimate that one third of all US colleges and universities are financially unsustainable; they spend more than the take in and collect debt faster than they build equity. While some colleges will surely fold, the threat for most is less closure than permanent stagnation and increasing irrelevance.

Curious problem: by all but one measures (name recognition), we’re better for students than the household names but no one believes us and few will even consider attending. We’re losing to upstart competitors with inferior products and lumbering behemoths. 

And you are too.

“The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings.”

Half of that is our own fault. We tend to be generic and focused on ourselves, without material understanding of the bigger picture. And half of your problem is your fault: 80% of mutual funds could disappear without any noticeable loss of investors. They don’t matter. There are 500 domestic large core funds. I’d be amazed if anyone could make a compelling case for keeping 90% of them open. More correctly, those don’t matter to anyone but the advisor who needs them for business development purposes.

Here’s the test: would anyone pay good money to buy the fund from you? Get serious: half of all funds can’t draw even a penny’s investment from their own managers (Sarah Max, Fund managers who invest elsewhere). The level of fund trustee investment in the funds they oversee on behalf of the rest of us is so low, especially in the series trusts common among smaller funds, as to represent an embarrassment.

The question is: can you do anything? Will anything you do matter? In order to answer that question, it would help to understand what matters, what doesn’t … and what might.

Herewith: seven things that matter, two that don’t … and one that might.

Seven things that matter.

1. Independence matters. Whether measured by r-squared, tracking error or active share, researchers have generated a huge body of evidence that independent thinking is a prerequisite to outstanding performance. Surprisingly, that’s true on the downside as much as the upside: higher active managers perform better in falling markets than herd-huggers do. But herding behavior is increasing. Where two-thirds of the industry’s assets were once housed in “highly active” funds, that number is now 25% and falling.
2. Size matters. There is no evidence to suggest that “bigger is better” in the mutual fund world, at least once a fund passes the threshold of economic viability. Large funds face two serious constraints. First, their investable universes collapse; that is, if you have $10 billion to invest, there are literally thousands of small companies whose stocks become utterly meaningless to you and your forced to seek a competitive advantage against a few hundred competitors all looking at the same few hundred larger names. Second, larger funds become cash cows generating revenue essential to the adviser’s business. The livelihoods of dozens or hundreds of coworkers depend on having the manager not lose assets, much more than they depend on investment excellence. But money flows to “safe” bloated funds.
3. Alignment of interest matters. Almost all of us know that there’s a lot of research showing that good things happen when fund managers stake their personal fortunes on the success of their funds; in particular, risk-adjusted returns rise. Fewer people know that there appears to be an even stronger effect from substantial ownership by a fund’s trustees: high trustee ownership is linked to lower risk, higher active share and less tolerance of inept management. But, Morningstar reports, something like 500 firms have funds with negligible insider ownership.
4. Risk matters. Investors are far more risk-averse than they know. That’s one of the most frequently observed findings in the behavioral finance literature. No amount of upside offsets a tendency to crash. The sad consequence of misjudged risk is reflected in the Dalbar’s widely quoted calculations showing that investors might pocket as little as one-quarter of their funds’ returns largely because of excess confidence, excess trading and a tendency to run away as the worst possible time.
5. Focus matters. If the goal is to provide better (not necessarily higher, but perhaps steadier, more explicable, less volatile) returns than a broad market index, then you need to look as little like the index as possible. Too many folks become “fund collectors” with sprawling portfolios, just as too many fund managers to commit to marginal ideas.
6. Communication matters. I need to mention this because I’m, well, a professor of communication studies and we know it to be true. In general, communication from mutual funds to their investors (how to put this politely?) sucks. Websites get built for the sake of having a pretty side. Semi-annual reports get written because the SEC says to (but doesn’t say that you actually need to write anything to your investors, and many don’t). Shareholder letters get written to a template and conference calls are managed to assure that there’s no risk of anything interesting or informative breaking out. (If I hear the term “slide deck,” as in “on page 157 of your slide deck,” I’ll scream.) We know that most investors don’t understand why they’re invested or what their funds do. We know that when investors “get it,” they stay (look at Jared Peifer’s “Fund loyalty among socially responsible investors” for a study of folks who really think about their investments before making them). 
7. Relationships matter. Managers mumbling the mousetrap mantra believe that great performance will have the world beating a path to their door. It won’t. A fascinating study by the folks at Gerstein Fisher (“Mutual fund outperformance and growth,” Journal of Investment Management, 2014) offered an entirely maddening conclusion: good performance draws assets if you’re large, but has no effect on assets if you have under a quarter billion in assets. So how do smaller funds prosper? At least from our experience, it is by having a story that makes sense to investors and a nearly evangelical advocate to tell that story, face to face, over and over. Please flag this thought: it’s not whether you’re impressed with your story. It’s not whether it makes sense to you. It’s whether it makes enough sense to investors that, once you’re gone, they can explain it with conviction to other people.

Two things that don’t. 

1. Great returns don’t matter. Beating the market doesn’t matter. Beating your peers doesn’t matter. It’s impossible to do consistently (“peer beating” is, by definition, zero sum), it doesn’t draw assets and it doesn’t necessarily serve your investors’ needs. Consistent returns, consistently explained, might matter.
2. Morningstar doesn’t matter. A few of you might yet win the lottery and get analyst coverage from Morningstar, but you should depend on that about the way you depend on winning the Powerball. Recent feature on “Under the Radar” funds gives you a view of Morningstar’s basement: these seven funds were consistently excellent, averaged $400 million in assets and 12 years of manager tenure – and they were still “under the radar.” In reality, Morningstar doesn’t even know that you exist. More to the point: the genius of independent funds is that they’re not cookie-cutters, but Morningstar is constrained to use a cookie-cutter. The more independent you are, the more likely that Morningstar will give you a silly peer group.

This is not, by the way, a criticism of Morningstar. I like a lot of the folks there and I know they often work like dogs to get it right. It’s simply a reflection on their business model and the complexity of the task before them. In attempting to do the greatest good for the greatest number (and to serve their shareholders), they’re inevitably drawn to the largest, most popular funds.

The one thing that might matter? 

I might say “the Observer” does.  We’ve got 26,000 readers and we’ve had the opportunity to work with dozens of journalists.  We’ve profiled over 125 smaller funds, exceeding the number of Morningstar’s small fund profiles by, well, 120.  We know you’re there and know your travails.  We’re working really hard to help folks think more clearly about small, independent funds in general and by a hundred of so really distinguished smaller funds in particular.

But a better answer is: you might matter.

But do you want to?

It is clear that we can all do our jobs without mattering.  We can attend quarterly meetings, read thick packets, listen thoughtfully to what we’ve been told, ask a trenchant question (just to prove that we’ve been listening) … and still never make six cents worth of difference to anyone. 

There may have been a time, perhaps in the days of “a rising tide,” when firms could afford to have folks more interested in getting along than in making a difference.  Those days are passed.  If you aren’t intent on being A Person Who Matters, you need to go.

How might you matter?

1. Figure out whether you have a reason to exist.  Ask “what’s the story supposed to be?”  Look at the prospect that “your” story is so painfully generic or agonizingly technical than it means nothing to anyone.  And if you’ve got a good story, tell it passionately and well. 
2. Align your walking and your talking.  First, pin your personal fortune on the success of your funds.  Second, get in place a corporate policy that ensures everyone does likewise.  There are several fine examples of such policies that you might borrow from your peers.  Third, let people know what your policy is and why it matters to them.
3. Help people succeed.  Very few of the journalists who might share your message actually know enough to do it well.  And they often know it and they’d like to do better.  Great!  Find the time to help them succeed.  Become a valuable source of honest assessment, suggest story possibilities, notice when they do well.  That ethos is not limited to aiding journalists.   Help other independent funds succeed, too.  Tell people about the best of them.  Tell them what’s worked for you.  They’re not your enemies and they’re not your competitors.  They might, however, become part of a community that can help you survive.
4. Climb out of your silo.  Learn stuff you don’t need to know.  I know compliance is tough. I know those board packets are thick. But that’s not an excuse.  Bill Bernstein earned a PhD in chemistry, then MD in neurology, pursued the active practice of medicine, started writing about asset allocation and the efficient frontier, then advising, then writing books on topics well afield of his specialties. Bill writes:  “As Warren Buffett famously observed, investing is not a game in which the person with an IQ of 160 beats the persons with an IQ of 130.  Rather, it’s a game best played by those with a broad set of skills that are rich not only in quantitative ability but also in deep historical knowledge, all deployed with an Asperger’s-like emotional detachment.”  Those of us in the liberal arts love this stuff.
5. Build relationships, perhaps in odd ways.  Trustees: you were elected to represent the fund’s shareholders so why are you hiding from them?  Put your name and address on the website and let them know that if they have a concern, you’ll listen. Send a handwritten card to every new investor, at least those who invest directly with the fund.  Tell them they matter to you.  Heck, send them an anniversary card a year after they first invest, signed by you all.  When they go, ask “why?”  This is the only industry I’ve ever worked with that has precisely zero interest in customer loyalty.
6. Be prepared to annoy people.  Frankly, you’re going to be richly rewarded, financially and interpersonally, for your willingness to go away.  If you try to change things, you’re going to upset at least some of the people in every room.  You’re going to hear the same refrain, over and over: “But no one does that.”
7. Stop hiring pretty good people. Hire great ones, or no one. The hallmark of dynamic, rising institutions is their insistence on bringing in people who are so good it kind of scares the folks who are already there. That’s been the ethos of my academic department for 20 years. It is reflected in the Artisan Fund’s insistence that they will hire in only “category killers.” They might, they report, interview several dozen management teams a year and still make only one hire every two or three years. Check their record of performance and market success and draw your own conclusion. Achieving this means that you have to be a great place to work. You have to know why it’s a great place, and you have to have a strategy for making outsiders realize it, too.

Which is precisely the point. Independence is not merely a matter of portfolio construction. It’s a matter of innovation, responsibility and stewardship. It requires that you look beyond safety, look beyond asset gathering and short-term profit maximization to answer the larger question: is there any reason for us to exist?

It’s your decision. It is clear to me that business as usual will not work, but neither will hunkering down and hoping that it all goes away. Do you want to matter, or do you want to hold on – hoping that you’ll make it through despite the storm?  Like the faculty near retirement. Like Louis XV who declared, “Après moi, le déluge”. Mr. Rekenthaler concludes that “active funds retreat further into silence.” Do you want to prove him right or wrong?

If you want to make a difference, start today. Start here. Start today. Take the opportunity to listen, to talk, to learn and to decide. To decide to make all the difference you can. Which might be all the difference in the world.

From Charles’s Balcony: Why Am I Rebalancing?

Long-time MFO discussion board member AKAFlack emailed me recently wondering how much investors have underperformed during the current bull market due to the practice of rebalancing their portfolios.

For those that rebalance annually, the answer is…almost 12% in total return from March 2009 through June 2014. Not huge given the healthy gains, but certainly noticeable. The graph below compares performance for a buy & hold and an annually rebalanced portfolio, assuming an initial investment of $10,000 allocated 60% to stocks and 40% to bonds.

So why rebalance?

According to a good study by Vanguard, entitled “Best practices for portfolio rebalancing,” the answer is not to maximize return. “If the sole objective is to maximize return regardless of risk, then the investor should select a 100% equity portfolio.”

The purpose of rebalancing, whether done periodically or by threshold deviation, is to keep a portfolio risk composition consistent with an investor’s tolerance, as defined by their target allocation. Otherwise, investors “can end up with a portfolio that is over-weighted to equities and therefore more vulnerable to equity-market corrections, putting the investors’ portfolios at risk of larger losses compared with their target portfolios.” This situation is evidenced in the allocation shown above for the buy & hold portfolio, which is now at nearly 80/20 stocks/bonds.

In this way, rebalancing is one way to keep loss aversion in check and the attendant consequences of selling and buying at all the wrong times, often chronicled in Morningstar’s notorious “Investor Return” tracking metric.

Balancing makes up ground, however, when equities are temporarily undervalued, like was the case in 2008. The same comparison as above but now across the most current full market cycle, beginning in November 2007, shows that annual balancing actually slighted outperformed the buy & hold portfolio.

In his book “The Ivy Portfolio,” Mebane Faber presents additional data to support that “there is a clear advantage to rebalancing sometime rather than letting the portfolio drift. A simple rebalance can add 0.1 to 0.2 to the Sharpe Ratio.”

If your first investment priority is risk management, occasional rebalancing to your target allocation is one way to help you sleep better at night, even if it means underperforming somewhat during bull markets.

Edward, Ex Cathedra: Money money money money money money

“The mystery of the world is the visible, not the invisible.”

                                                                    Oscar Wilde

This has been an interesting month in the world of mutual funds and fund managers. First we have Charles D. Ellis, CFA with another landmark (and land mine) article in the Financial Analysts Journal entitled “The Rise and Fall of Performance Investing.” For some years now, starting with his magnum opus for institutional investors entitled “Winning the Loser’s Game,” Ellis has been arguing that institutional (and individual) investors would be better served by using passive index funds for their investments, rather than hiring active managers who tend to underperform the index funds. By way of disclosure, Mr. Ellis founded Greenwich Associates and made his fortune selling services to those active managers that he now writes about with the zeal of a convert.

Nonetheless the numbers he presents are fairly compelling, and for that reason difficult to accept. I am reminded of one of my former banking colleagues who was always looking for the pony that he was convinced was hidden underneath the manure in the room. I can see the results of this thinking by scanning some of the discussions on the Mutual Fund Observer bulletin board. Many of those discussions seem more attuned with how smart or lucky one was to invest with a particular manager before his or her fund closed, rather than how the investment has actually performed. And I am not talking about the performance numbers put out by the fund companies, which are artificial results for artificial investors. No, I’m talking about the real results obtained by putting the moneys invested and time periods into one’s HP12C calculator to figure out the returns. Most people really do not want to know those numbers, otherwise they become forced to think about Senator Warren’s argument that “the game is rigged.”

Ellis however makes a point that he has made before and that I have covered before. However I feel it is so important that it is worth noting again. Most mutual fund advertising or descriptions involving fees consist of one word and a number. The fee is “only” 1% (or less for most institutional investors). The problem is that that is a phrase worthy of Don Draper, as the 1% is related to the assets the investor has given to the fund company. Yet the investor already owns the assets. What is being promised then? The answer is returns. And if one accepts the Ibbotson return histories for large cap common stocks in the U.S. as running at 8 – 10% per year over a fifty-year period, we are talking about a fee running from 10 – 12.5% a year based on returns. 

Taking this concept one step further Ellis suggests what you really should be looking at in assessing fees are the “incremental fee as a percentage of incremental returns after adjusting for risk.” And using those criteria, we would see something very different given that most active investment managers are underperforming their benchmark indices, namely that the incremental fees are above 100% Ellis goes on to raise a number of points in his article. I would like to focus on just one of them for the remainder of this commentary. One of Ellis’ central questions is “When will our clients decide that continuing to take all the risks and pay all the costs of striving to beat the market with so little success is no longer a good deal for them?”

My assessment is that we have finally hit the tipping point, and things are moving inexorably in that direction. Two weeks ago roughly, it was announced that Vanguard now has more than $3 trillion worth of assets, much of it in passive products. Jason Zweig recently wrote an article for The Wall Street Journal suggesting that the group of fund and portfolio managers in their 30’s and 40’s should start thinking about alternative careers, possibly as financial planners giving asset allocation advice to clients. The Financial Times suggests in an article detailing the relationship between Bill Gross at PIMCO and the analyst that covered him at Morningstar that they had become too close. The argument there was that Morningstar analysts had become co-opted by the fund industry to write soft criticism in return for continued access to managers. My own observational experience with Morningstar was that their mutual fund analysts had been top shelf when they were interviewing me and both independent and objective. I can’t speak now as to whether the hiring and retention criteria have changed. 

My own anecdotal observations are limited to things I see happening in Chicago. My conclusion is that the senior managers at most of the Chicago money management firms are moving as fast as they can to suck as much money out of their businesses as quickly as possible. In some respects, it has become a variation on musical chairs and that group hears the music slowing. So you will see lots of money in bonus payments. Sustainability of the business will be talked about, especially as a sop to absentee owners, but the businesses will be under-invested in, especially with regard to personnel. What do I base that on? Well, at one firm, what I will call the boys from Winnetka and Lake Forest, I was told every client meeting now starts with questions about fees. Not performance, but fees are what is primary in the client minds. The person who said this indicated he is fighting a constant battle to see that his analyst pool is being paid commensurate with the market notwithstanding an assumption by senior management that the talent is fungible and could easily be replaced at lower prices. At another firm, it is a question of preserving the “collegiality” of the fund group’s trustees when they are adding new board members. As one executive said to me about an election, “Thank God they had two candidates and picked the less problematic one in terms of our business and causing fee issues for us.”

The investment management business, especially the mutual fund business, is a wonderful business with superb returns. But to use Mr. Ellis’ phrase, is it anything more now than a “crass commercial business?” How the industry behaves going forward will offer us a clue. Unfortunately, knowing as many of the players as well as I do leads me to conclude that greed will continue to be the primary motivator. Change will not occur until it is forced upon the industry.

I will leave you with a scene from a wonderful movie, The Freshman (with Marlon Brando and Matthew Broderick) to ponder.

“This is an ugly word, this scam.  This is business, and if you want to be in business, this is what you do.”

                               Carmine Sabatini as played by Marlon Brandon

Categories Morningstar doesn’t recognize: Short-term high-yield income

There are doubtless a million ways to slice and dice the seven or eight thousand extant funds into categories. Morningstar has chosen to create 105 categories in hopes of (a) creating meaningful peer comparisons and (b) avoid mindless proliferation of categories. We’re endlessly sympathetic with their desire to maintain a disciplined, manageable system. That said, the Observer tracks some categories of funds that Morningstar doesn’t recognize, including short-term high yield, emerging markets balanced and absolute value equity.

We think that these funds have two characteristics that might be obscured by Morningstar’s assignment of them to a larger category of fundamentally different funds. First, it causes funds to be misjudged if their risk profiles vary dramatically from the group’s. Short-term high yield, for example, are doomed to one- and two-star ratings. That’s not because they fail. It’s because they succeed in a way that’s fundamentally different from the majority of their peer group. In general, high yield funds have risk profiles similar to stock funds. Short-term high yield funds have dramatically lower volatility and returns closer to a short term bond fund’s than a high yield fund’s.

[High yield/orange, ST high yield blue, ST investment grade green]

Morningstar’s risk-adjusted returns calculation is far less sensitive to risk than the Observer’s is; as a risk, the lower risk is blanketed by the lower returns and the funds end up with an undeservedly wretched rating.

Bottom line: investors who need to earn more than the payout of a money market fund (0.01% ytd) or certificates of deposit (currently 1.1% annually) might take the risk of a conventional short-term bond fund (in the hopes of making 1-2%) or might be lured by the appeal of a complex market neutral derivatives strategy (paying 2% to make 3%). Another path that might reasonably consider are short-term high yield funds that take on greater risk but whose managers generally recognize that fact and have risk-management tools at hand.

The Observer has profiled three such funds: Intrepid Income, RiverPark Short-Term High Yield (now closed to new investors) and Zeo Strategic Income.

Short-term, high Income peer group, as of 9/1/14

Over the next several months we’ll be reviewing the performance of some of these unrecognized peer groups, in hopes of having folks look beyond the stars. 

To the New Castle County executives: I know your intentions were good, but …

Shortly after taking office, the new county executive for New Castle County, Delaware, made a shocking discovery: someone has nefariously invested the taxpayers’ money in two funds that (gasp!) earned one-star from Morningstar and were full of dangerous high yield investments. The executive in question, not pausing to learn anything about what the funds actually do, snapped into action. He rushed “to protect the County reserves from the potential of significant financial loss and undo risk by directing the funds to be placed in an account representing the financial security values associated with taxpayer dollars” by giving the money to UBS (a firm fined $1.5 billion two years ago in a “rogue trading” scandal). And then he, or the county staff, wrote a congratulatory press release (New Castle County Executive Acted Quickly to Protect Taxpayer Reserves).

The funds in question were RiverPark Short-Term High Yield (RPHYX) which is one of the least volatile funds in existence and which has posted the industry’s best Sharpe ratio, and FPA New Income (FPNIX), which Morningstar celebrates as an ultra-conservative choice in the face of deteriorating markets: “thanks to its super-low volatility, its five-year Sharpe ratio, a measure of risk-adjusted returns, bests all it but one of its competitors’ in both groups.”

The press release doesn’t mention how or where UBS will be investing the taxpayer’s dollars but it does sound like UBS has decided to work for free: enviable savings resulted from the fact that New Castle County “does not pay investment management fees to UBS.”

Due diligence requires going beyond a cursory reading. It turns out that The Tale of Two Cities is not a travelogue and that Animal Farm really doesn’t offer much guidance on animal husbandry, titles notwithstanding. And it turns out that the county has sold two exceptionally solid, conservative funds – funds with about the best risk-adjusted returns possible – based on a cursory reading and spurious concerns.

Observer Fund Profiles: AKREX and MAINX

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. 

Akre Focus (AKREX): the only question about Akre Focus is whether it can be as excellent in the future has it, and its predecessors, have been for the past quarter century. 

Matthews Asia Strategic Income (MAINX): against all the noise in the markets and in the world news, Teresa Kong remains convinced that your most important sources of income in the decades ahead will increasingly be centered in Asia.  She’ll doing an exceptional job of letting you tap that future today.

Elevator Talk: Brent Olsen, Scout Equity Opportunity (SEOFX)

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

Brent Olson is the lead portfolio manager of the Scout Equity Opportunity Fund. He joined the firm in 2013 and has more than 17 years of professional investment experience. Prior to joining Scout, Brent was director of research and a portfolio manager with Three Peaks Capital Management, LLC. From 2010-2013, Brent comanaged Aquila Three Peaks Opportunity Growth (ATGAX) and Aquila Three Peaks High Income (ATPAX) with Sandy Rufenacht. Before that, he served as an equity analyst for Invesco and both a high-yield and equity analyst for Janus.

Scout Equity Opportunity proposes to invest in leveraged companies. Leveraged companies are firms that have accumulated, or are accumulating, a noticeable level of debt on their books. These are firms that are, or were, dependent on borrowing to finance operations. Many equity investors, particularly those interested in “high quality stocks,” look askance at the practice. They’re interested in firms with low debt-to-equity ratios and the ability to finance operations internally.

Nonetheless, leveraged company stock offers the prospect for outsized gains. Tom Soviero of Fidelity Leveraged Company Stock Fund (FLVCX) captured more than 150% of the S&P 500’s upside over the course of a decade (2003-2013). The Credit Suisse Leveraged Equity Index substantially outperformed the S&P500 over the same period. Why so? Three reasons come to mind:

1. Debt adds complexity, which increases the prospects for mispricing. Beyond the simple fact that most equity investors are not comfortable analyzing the other half of a firm’s capital structure, there are also several different kinds of debt, each of which adds its own complexity.
2. Debt can be used wisely, which allows firms to increase their return on equity, especially when the cost of debt is low and the stock market is already rising.
3. Indebtedness increases a firm’s accountability and transparency, since they gain the obligation to report to creditors, and to pay them regularly. They are, as a result, less free to make dumb decisions than managers deploying internally-generated capital.

The downside to leveraged equity investing is, well, the downside to leveraged equity investing.  When the market falls, leveraged company stocks can fall harder and faster than most.  By way of illustration, Fidelity Leverage Company dropped 55% in 2008. That makes it hard for many investors to hold on; indeed, by Morningstar’s calculations, Mr. Soveiro’s invested managed to pocket less than a third of his fund’s excellent returns because they tended to bail when the pain got too great.

Brent Olson knows the tale, having co-managed for three years a fund with a similar discipline.  He recognizes the importance of risk control and thinks that he and the folks at Scout have found a way to manage some of the strategy’s downside.

Here are Brent’s 200 words on what a manager sensitive to high-yield fixed-income metrics brings to equity investing:

We believe superior risk-adjusted relative performance can be achieved through long-term ownership of a diversified portfolio of levered stocks. We recognize debt metrics as a leading indicator for equity performance – our adage is “credit leads, equity follows” – and so we use this as the basis for our disciplined investment process. That perspective allows us to identify companies that we believe are undervalued and thus attractive for investors.

We focus our attention on stable industries with lots of free cash flow.  Within those industries, we’re looking at companies that are either using credit improvement through de-levering their balance sheet, though debt paydown or refinancing, or ones that are reapplying leverage to transform themselves, perhaps through growth or acquisitions. At the moment there are 68 names in the portfolio. There are roughly 50 other names that we’re actively monitoring with about 10 that are getting close.

We’ve thought a lot about risk management. One of the most attractive aspects of working at Scout is the deep analyst bench, and especially the strength of our fixed income team at Reams Asset Management. That gives me access to lots of data and first-rate analysis. We also can move 20% of the portfolio into fixed income in order to dampen volatility, the onset of which might be signaled by wider high-yield spreads. Finally, we can raise the ratings quality of our portfolio names.

Scout Equity Opportunity has a $1000 minimum initial investment which is reduced to a really friendly $100 for IRAs and accounts established with an automatic investing plan. Expenses are capped at 1.25% and the fund has about gathered about $7 million in assets since its March 2014 launch. Here’s the fund’s homepage. Investors intrigued by the characteristics of leveraged equity might benefit from reading Tom Soveiro’s white paper, Opportunities in Leveraged Equity Investing (2014).

Launch Alert: Touchstone Large Cap Fund (TLCYX)

On July 9, Touchstone Investments launched the Touchstone Large Cap Fund, sub-advised by The London Company. The London Company is Virginia-based RIA with over $8.7 billion in assets under management. The firm subadvises several other US-domiciled funds including:

Hennessy Equity and Income (HEIFX), since 2007. HEIFX is a $370 million, five-star LCV fund that The London Company jointly manages with FCI Advisors.

Touchstone Small Cap Core (TSFYX), since 2009. TSFYX is an $830 million, four-star SCB fund.

Touchstone Mid Cap (TMCPX), since 2011. TMCPX is a $460 million, three-star mid-cap blend fund.

American Beacon The London Company Income Equity (ABCYX), since 2012. It’s another LCV fund with about $275 million in assets.

The fund enters the most crowded part of the equity universe: large cap domestic stock.  Depending on how you count, there are 466 large blend funds. The new Touchstone fund proposes to invest in 30-40 US large cap stocks.  In particular they’re looking for financially stable firms that will compound returns over time.  Rather than looking at earnings per share, they “pay strict attention to each company’s sustainability of return on capital and resulting free cash flow and balance sheet to derive its strategic value.”  The argument is that EPS bounces, is subject to gaming and is not predictive.  Return on capital tends to be a stable predictor of strong future performance.  They target buying those firms at a 30-40% discount to intrinsic value and holding them for relatively long periods.

It’s a sound and attractive strategy.  Still, there are hundreds of funds operating in this space and dozens that might lay plausible claim to a comparable discipline. Touchstone’s president, Steve Graziano, allows that this looks like a spectacularly silly move:

If I wasn’t looking under the hood and someone came to me to launch a large cap core fund, I’d say “you must be crazy.”  It’s an overpopulated space, a stronghold of passive investing.

The reason to launch, Mr. Graziano argues, is TLC’s remarkable discipline.  They’ve used this same strategy for over 15 years in its private accounts.  Their large core composite has returned 9.7% annually over the last decade through June 30, 2014. During the same time, the S&P500 returned 7.8%.  They’ve beaten the S&P500 over the past 3, 5, 10 and 15 year periods.  The margin of victory has ranged from 130-210 bps, depending on the time period.

The firm argues that much of the strategy’s strength comes from its downside protection: “[Our] large cap core strategy focuses on investing primarily in conservative, low‐beta, large cap equities with above average downside protection.”  Over the past five years, the strategy captured 62% of the market’s downside and 96% of its upside.  That’s also reflected in the strategy’s low beta (0.77, which is striking for a fully-invested equity strategy) and low standard deviation (12.6, about 300 bps below the market’s).

Of the 500 or so large cap blend funds, only 23 can match the 9.7% annualized10-year returns for The London Company’s Large Core Strategy. Of those, only one (PIMCO StocksPlus Absolute Return PSPTX) can also match its five-year returns of 20.7%.

The minimum initial investment in the retail class is $2500, reduced to $1000 for IRAs. The expenses are capped at 1.49%. Here’s the fund’s homepage.  While it reflects the performance of the separate accounts rather than the mutual fund’s, TLC’s Large Cap Core quarterly report contains a lot of useful information on the strategy’s historic profile.

Pre-launch Alert: PSP Multi-Manager (CEFFX)

In a particularly odd development, the legal husk of the Congressional Effect Fund is being turned to good use.  As you might recall, Congressional Effect (CEFFX) was (along with the Blue Funds) another of a series of political gestures masquerading as investment vehicles. Congressional Effect went to cash whenever (evil, destructive) Congress was in session and invested in stocks otherwise. Right: out of stocks during the high-return months and in stocks over the summer and at holidays. Good.

The fund’s legal structure has been purchased by Pulteney Street Capital Management, LLC and is soon to be relaunched as the PSP Multi-Manager Fund (ticker unknown). The plan is to hire experienced managers who specialize in a set of complementary alternative strategies (long/short equity, event-driven, macro, market neutral, capital structure arbitrage and distressed) and give each of them a slice of the portfolio.  The management teams represent EastBay Asset Management, Ferro Investment Management, Riverpark Advisors, S.W. Mitchell Capital, and Tiburon Capital Management. The good news is that the fund features solid managers and a low minimum initial investment ($1000). The bad news is that the expenses (north of 3%) are near the level charged by T’ree Fingers McGurk, my local loan shark sub-prime lender.

Funds in Registration

Our colleague David Welsch tracked down 17 new no-load, retail funds in registration this month.  In general, these funds will be available for purchase by around Halloween.  (Caveat emptor.) They include new offers from several A-tier families including BBH, Brown Advisory,and Causeway.  Of special interest is the new Cambria Global Asset Allocation ETF (GAA), a passive fund tracking an active index.  Charles is working to arrange an interview with the manager, Mebane Faber, during the upcoming Morningstar ETF conference.

Manager Changes

Chip reports a huge spike in the number of announced manager or management team changes this month, with 73 recorded changes, about 30 more than we’ve being seeing over the summer months. A bunch are simple games of musical chairs (Ivy and Waddell & Reed are understandably re-allocating staff) and about as many are additions of co-managers to teams, but there are a handful of senior folks who’ve announced their retirements.

Top Developments in Fund Industry Litigation – August2014

Fundfox is the only intelligence service to focus exclusively on litigation involving U.S.-registered investment companies, their directors and advisers. Publisher David Smith has agreed to share highlights with us. For a 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 Lawsuits

• Davis was hit with a new excessive-fee lawsuit regarding its N.Y. Venture Fund (the same fund already involved in another pending fee litigation). (Chill v. Davis Selected Advisers, L.P.)
• Alleging the same fee claim but for a different damages period, plaintiffs filed an “anniversary complaint” in the excessive-fee litigation regarding six Principal LifeTime funds. (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal Mgmt. Corp.)

Order

• The court partly denied motions to dismiss a shareholder’s lawsuit regarding four Morgan Keegan closed-end funds, allowing misrepresentation claims under the Securities Act to proceed. (Small v. RMK High Income Fund, Inc.)

Certiorari Petition

• Plaintiffs have filed a writ of certiorari seeking Supreme Court review of the Eighth Circuit’s ruling in an ERISA class action that challenged Fidelity‘s use of the float income generated by transactions in retirement plan accounts. (Tussey v. ABB, Inc.)

Briefs

• Davis filed a motion to dismiss excessive-fee litigation regarding its N.Y. Venture Fund. (Hebda v. Davis Selected Advisers, L.P.)
• Putnam filed its opening brief in the appeal of a fraud lawsuit regarding its collateral management services to a CDO; and the plaintiff filed a reply. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)
• Plaintiffs filed their opposition to Vanguard‘s motion to dismiss a lawsuit regarding investments by two funds in offshore online gambling businesses; and Vanguard filed its reply brief. (Hartsel v. Vanguard Group, Inc.)

David Hobbs, president of Cook & Bynum, and I were talking at the Cohen Fund conference about the challenges facing fund trustees.  David mentioned that he encourages his trustees to follow David Smith’s posts here since they represent a valuable overview of new legal activity in the field.  That struck me as a thoughtful initiative and so I thought I’d pass David H’s suggestion along.

A cool resource for folks seeking “liquid alts” funds

The folks at DailyAlts maintain a list of all new hedge fund like mutual funds and ETFs. The list records 52 new funds launched between January and August 2014 and offers a handful of useful data points as well as a link to a cursory overview of the strategy.

I stumbled upon the site in pursuit of something else. It struck me as a cool and useful resource and led me to a fair number of funds that were entirely new to me. Kudos to Editor Brian Haskin and his team for the good work.

Briefly Noted . . .

Arrowpoint Asset Management LLC has increased its stake in Destra Capital Management, adviser to the Destra funds, to the point that it’s now the majority owner and “controlling person” of the firm.

Causeway’s bringing it home: pending shareholder approval, Causeway International Opportunities Fund (CIOVX) will be restructured from a “fund of funds” to “a fund making direct investments in securities.” The underlying funds in question are institutional shares of Causeway’s two other international funds – Emerging Markets (CEMIX) and International Opportunities Value(CIVIX) – so it’s hard to see how much gain investors might expect. The downside: the fund needs to entirely liquidate its portfolio which will trigger “a significantly higher taxable distribution” than investors are used to. In a slightly-stern note, Causeway warns “taxable investors receiving the distributions should be prepared to pay taxes on them.” The effect of the change on the fund’s expense ratio is muddled at the moment. Morningstar’s reported e.r. for the fund, .36%, doesn’t include the expense ratios of the underlying funds. With the new fund’s expense ratio not set, we have no idea about whether the investors are likely to see their expenses rise or fall. 

Morningstar, due to their somewhat confused reporting on the expense ratios of funds-of-funds, derides the 36 basis point fee as “high”, when they should be providing the value of the expense ratio of both the fund and it’s underlying holdings. (Thanks, Ira!)

Effective August 21, FPA Crescent Fund (FPACX) became free to invest more than 50% of its assets overseas.  Direct international exposure was previously capped at 50%.  No word yet as to why.  Or, more pointedly, why now?

Jeffrey Gundlach, DoubleLine’s founder, is apparently in talks about buying the Buffalo Bills. I’m not sure if anyone mentioned to him that E.J. Manuel (“Buffalo head coach Doug Marrone already is lowering the bar of expectation considerably for the team’s 2013 first-round pick”) is all they’ve got for a QB, unless of course The Jeffrey is imagining himself indomitably under center. That’s far from the oddest investment by a mutual fund billionaire. That honor might go to Ned Johnson’s obsessive pursuit of tomato perfection through his ownership of Backyard Farms.

On or about November 3, 2014, the principal investment strategies of the Manning Napier Real Estate and Equity Income will change to permit the writing (selling) of options on securities.

Another tough month for Marsico.  With the departure (or dismissal) of James Gendelman,  Marsico International Opportunities (MIOFX) loses its founding manager and Marsico Global (MGBLX)loses the second of its three founding managers. On the same day they lost their sub-advisory role at Litman Gregory Masters International Fund (MNILX).  Five other first-rate teams remain with the fund, whose generally fine record is marred by substantially losses in 2011.  In April 2012, one of the management teams – from Mastholm Asset Management – was dropped and performance on other sides of 2011 has been solid.

Royce Special Equity Multi-Cap Fund (RSMCX) has declared itself, and its 30 portfolio holdings, “non-diversified.”

T. Rowe Price Spectrum Income (RPSIX) is getting a bit spicy. Effective September 1, 2014, the managers may invest between 0 – 10% of the fund’s assets in T. Rowe Price Emerging Markets Local Currency Bond Fund, Floating Rate Fund, Inflation Focused Bond Fund, Inflation Protected Bond Fund, and U.S. Treasury Intermediate Fund.

SMALL WINS FOR INVESTORS

Effective immediately, 361 Global Macro Opportunity, Managed Futures Strategy and Global Managed Futures Strategy fund will no longer impose a 2% redemption fee.

That’s a ridiculously small number of wins for our side.

CLOSINGS (and related inconveniences)

On September 19, 2014, Eaton Vance Multi-Cap Growth Fund (EVGFX) will be soft-closed.  One-star rating, $162 million in assets, regrettable tendency to capture more downside (108%) than upside (93%), new manager in November 2013 with steadily weakening performance since then.  This might be the equivalent of a move into hospice care.

Effective September 5, 2014, Nationwide International Value Fund (NWVAX) will close to new investors.  One star rating, $22 million in assets, a record the trails 87% of its peers: Hospice!

OLD WINE, NEW BOTTLES

Effective October 1, 2014, Dunham Loss Averse Equity Income Fund (DAAVX/DNAVX) will be renamed Dunham Dynamic Macro Fund.  The revised fund will use “a dynamic macro asset allocation strategy” which might generate long or short exposure to pretty much any publicly-traded security.

Effective October 31, 2014, Eaton Vance Large-Cap Growth Fund (EALCX) gets renamed Eaton Vance Growth Fund.  The change seems to be purely designed to dodge the 80% rule since the principle investment strategies remain unchanged except for the “invests 80% of its assets in large” piece.  The fund comes across as modestly overpriced tapioca pudding: there’s nothing terribly objectionable about it but, really, why bother?  At the same time Eaton Vance Large-Cap Core Research Fund (EAERX) gains a bold new name: Eaton Vance Stock Fund.  With an R-squared that’s consistently over 98 but returns that trailed the S&P in four of the past five calendar years, it might be more accurately renamed Eaton Vance “Wouldn’t You Be Better in a Stock Index Fund?” Fund.

Oh, I know why that would be a bad name.  Because, the prospectus declares “Particular stocks owned will not mirror the S&P 500 Index.” Right, though the portfolio as a whole will.

Eaton Vance Balanced Fund (EVIFX) has become a fund of two Eaton Vance Funds: Growth and Investment Grade Income.  It’s a curious decision since the fund has had substantially above-average returns over the past five years.

Effective on October 1, 2014. Goldman Sachs Core Plus Fixed Income Fund becomes Goldman Sachs Bond Fund

On or around October 21, 2014, JPMorgan Multi-Sector Income Fund (the “Fund”) becomes the JPMorgan Unconstrained Debt Fund. Its principal investment strategy is to invest in (get ready!) “debt.” The list of allowable investments offers a hint, in listing two sorts of bank loans first and bonds fifth.

OFF TO THE DUSTBIN OF HISTORY

If you’ve ever wondered how big the dustbin of history is, here’s a quick snapshot of it from the Investment Company Institute’s latest Factbook. In broad terms, 500 funds disappear and 600 materialize in the average year. The industry generally sees healthy shakeouts in the year following a market crash.

Ron Rowland, founder of Invest With an Edge and editor of AllStarInvestor.com, maintains the suitably macabre ETF Deathwatch which each month highlights those ETFs likeliest to be described as zombies: funds with both low assets and low trading volumes.  The August Deathwatch lists over 300 ETFs that soon might, and perhaps ought to, become nothing more than vague memories.

This month’s entrants to the dustbin include AMF Intermediate Mortgage Fund (ASCPX)and AMF Ultra Short Fund (AULTX), both slated to liquidate on September 26, 2014.

AllianceBernstein International Discovery Equity (ADEAX) and AllianceBernstein Market Neutral Strategy — Global (AANNX)will be liquidated and dissolved (how are those different?) on October 10, 2014.

Around December 19^th, Clearbridge Equity Fund (LMQAX) merges into ClearBridge Large Cap Growth Fund (SBLGX).  LMQAX has had the same manager since 1995.

On Aug. 20, 2014, the Board of Trustees of Voyageur Mutual Funds unanimously voted and approved a proposal to liquidate and dissolve Delaware Large Cap Core Fund (DDCAX), Delaware Core Bond Fund (DPFIX) and Delaware Macquarie Global Infrastructure Fund (DMGAX). The euthanasia will occur by late October but they did not specify a date.

Direxion Indexed CVT Strategy Bear Fund (DXCVX) and Direxion Long/Short Global Currency Fund (DXAFX)are both slated to close on September 8^th and liquidate on September 22^nd.  Knowing that you were being eaten alive by curiosity, I checked: DXCVX seeks to replicate the inverse of the daily returns of the QES Synthetic Convertible Index. At base, it shorts convertible bonds.  Morningstar designates the fund as Direxion Indxd Synth Convert Strat Bear, for reasons not clear, but does give a clue as to its demise: it has $30,000 in AUM and has fallen a sprightly 15% since inception in February.

Horizons West Multi-Strategy Hedged Income Fund (HWCVX) will liquidate on October 6, 2014, just six months after launch.  In the interim, Brenda A. Smith has replaced Steven M. MacNamara as the fund’s president and principal executive officer.

The $100 million JPMorgan Strategic Preservation Fund (JSPAX) is slated for liquidation on September 29^th.  The manager may have suffered from excessive dedication to the goal of preservation: throughout its life the fund never had more than a third of its assets in stocks.  That gave it a minimal beta (about 0.20) but also minimal appeal in generally rising markets.

Oddly, the fund’s prospectus warns that “The Fund’s total allocation to equity securities and convertible bonds will not exceed 60% of the Fund’s total assets except for temporary defensive positions.”  They never explain when moving out of cash and into stocks qualifies as a defensive move.

Parametric Market Neutral Fund (EPRAX) ceases to exist on September 19, 2014.

PIMCO, the world’s biggest bond fund shop and happiest employer, is trimming out its ETF roster: Australia Bond, Build America Bond, Canada Bond and Germany Bond disappear on or about October 1, 2014.  “This date,” PIMCO gently reminds us, “may be changed without notice at the discretion of the Trust’s officers.”  At the same time iShares, the biggest issuer of ETFs, plans to close 18 small funds with a combined asset base of a half billion dollars.  That includes 10 target-date funds plus several EM and real estate niche funds.

Prudential International Value Fund (PISAX), run by LSV, will be merged into Prudential International Equity Fund (PJRAX).  Both funds are overpriced and neither has a consistent record of adding much value, though PJRAX is slightly less overpriced and has strung through a decent run lately.

PTA Comprehensive Alternatives Fund (BPFAX) liquidates on September 15, 2014. I didn’t even know the PTA had funds, though around here they certainly have fund-raisers.

In Closing . . .

Thanks, as always, to all of you who’ve supported the Observer either by using our Amazon link (which costs you nothing but earns us 6-7% of the value of whatever you buy using it) or making a direct contribution by check or through PayPal (which costs you … well, something admittedly).  Nuts.  I really owe Philip A. a short note of thanks.  Uhhh … sorry, big guy!  The card is in the mail (nearly).

For the first time ever, the four of us who handle the bulk of the Observer’s writing and administrative work – Charles, Chip, Ed and me – are settling down to a face-to-face planning session at the end of the upcoming Morningstar ETF Conference. Which also means that we’ll be wandering around the conference. If you’re there and would like to chat with any of us, drop me a note and we’ll get it set up.

Talk to you soon, think of you sooner!

Dear friends,

We’ve always enjoyed and benefited from your reactions to the Observer. Your notes are read carefully, passed around and they often shape our work in the succeeding months. The most common reaction to our July issue was captured by one reader who shared this observation:

Dear David: I really love your writing. I just wish there weren’t so much of it. Perhaps you could consider paring back a bit?

Each month’s cover essay, in Word, ranges from 22 – 35 pages, single-spaced. June and July were both around 30 pages, a length perhaps more appropriate to the cool and heartier months of late autumn and winter. In response, we’ve decided to offer you the Seersucker Edition of Mutual Fund Observer. We, along with the U.S. Senate, are celebrating seersucker, the traditional fabric of summer suits in the South. Light, loose and casual, it is “a wonderful summer fabric that was designed for the hot summer months,” according to Mississippi senator Roger Wicker. In respect of the heat and the spirit of bipartisanship, this is the “light and slightly rumpled” edition of the Observer that “retains its fashionable good looks despite summer’s heat and humidity.”

Ken Mayer, some rights reserved

For September we’ll be adding a table of contents to help you navigate more quickly around the essay. We’ll target “Tweedy”, and perhaps Tweedy Browne, in November!

“There’ll never be another Bill Gross.” Lament or marketing slogan?

Up until July 31, the market seemed to be oblivious to the fact that the wheels seemed to be coming off the global geopolitical system. We focused instead on the spectacle of major industry players acting like carnies (do a Google image search for the word, you’ll get the idea) at the Mississippi Valley Fair.

Exhibit One is PIMCO, a firm that we lauded as having the best record for new fund launches of any of the Big Five. In signs of what must be a frustrating internal struggle:

PIMCO icon Bill Gross felt compelled to announce, at Morningstar, that PIMCO was “the happiest place in the world” to work, allowing that only Disneyland might be happier. Two notes: 1) when a couple says “our marriage is doing great,” divorce is imminent, and 2) Disneyland is, reportedly, a horrible place to work.

(Reuters, Jim King)

Gross also trumpeted “a performance turnaround” which appears not to be occurring at Gross’s several funds, either an absolute return or risk-adjusted return basis.

After chasing co-CIO Mohammed el-Erian out and convincing fund manager Jeremie Banet (a French national whose accent Gross apparently liked to ridicule) that he’d be better off running a sandwich truck, Gross took to snapping at CEO Doug Hodge for his failure to stanch fund outflows.

PIMCO insiders have reportedly asked Mr. Gross to stop speaking in public, or at least stop venting to the media. Mr. Gross threatened to quit, then publicly announced that he’s never threatened to quit.

Despite PIMCO’s declaration that the Wall Street Journal article that detailed many of these promises was “full of untruths and mischaracterizations that are unworthy of a major news daily,” they’ve also nervously allowed that “Pimco isn’t only Bill Gross” and lamented (or promised) that there will never been another PIMCO “bond king” after Gross’s departure.

Others in the industry, frustrated that PIMCO was hogging the silly season limelight, quickly grabbed the red noses and cream pies and headed at each other.

The most colorful is the fight between Morningstar and DoubleLine. On July 16, Morningstar declared that “On account of a lack of information … [DoubleLine Total Return DBLNX] is Not Ratable.” That judgment means that DoubleLine isn’t eligible for a metallic (Gold, Silver, Bronze) Analyst Rating but it doesn’t affect that fund’s five-star rating or the mechanical judgment that the $34 billion fund has offered “high” returns and “below average” risk. Morningstar’s contention is that the fund’s strategies are so opaque that risks cannot be adequately assessed at arm’s length and the DoubleLine refuses to disclose sufficient information to allow Morningstar’s analysts to understand the process from the inside. DoubleLine’s rejoinder (which might be characterized as “oh, go suck an egg!”) is that Morningstar “has made false statement about DoubleLine” and “mischaracterized the fund,” in consequence of which they’ll have “no further communication with Morningstar.com” (“How Bad is the Blood Between DoubleLine and Morningstar?” 07/18/2014).

DoubleLine declined several requests for comment on the fight and, specifically, for a copy of the reported eight page letter of particulars they’d sent to Morningstar. Nadine Youssef, speaking for Morningstar, stressed that

It’s not about refusing to answer questions—it’s about having sufficient information to assign an Analyst Rating. There are a few other fund managers who don’t answer all of our questions, but we assign an Analyst Rating if we have enough information from filings and our due diligence process.

If a fund produced enough information in shareholder letters and portfolios, we could still rate it. For example, stock funds are much easier to assess for risk because our analysts can run good portfolio analytics on them. For exotic mortgages, we can’t properly assess the risk without additional information.

It’s a tough call. Many fund managers, in private, deride Morningstar as imperious, high-handed, sanctimonious and self-serving. Others aren’t that positive. But in the immediate case Morningstar seems to be acting with considerable integrity. The mere fact that a fund is huge and famous can’t be grounds, in and of itself, for an endorsement by Morningstar’s analysts (though, admittedly, Morningstar does not have a single Negative rating on even one of the 234 $10 billion-plus funds). To the extent that this kerfuffle shines a spotlight on the larger problem of investors placing their money in funds whose strategies that don’t actually understand and couldn’t explain, it might qualify as a valuable “teachable moment” for the community.

Somewhere in there, one of the founders of DoubleLine’s equity unit quit and his fund was promptly liquidated with an explanation that almost sounded like “we weren’t really interested in that fund anyway.”

Waddell & Reed, adviser to the Ivy Funds, lost star manager Bryan Krug to Artisan.  He was replaced on Ivy High Income (IVHIX) by William Nelson, who had been running Waddell & Reed High Income (UNHIX) since 2008. On July 9^th Nelson was fired “for cause” and for reasons “unrelated to his portfolio management responsibilities,” which raised questions about the management of nearly $14 billion in high-yield assets. They also named a new president, had their stock downgraded, lost a third high-profile manager, drew huge fund inflows and blew away earnings expectations.

Recovery Time

In the book “Practical Risk-Adjusted Performance Measurement,” Carl Bacon defines recovery time or drawdown duration as the time taken to recover from an individual or maximum drawdown to the original level. In the case of maximum drawdown (MAXDD), the figure below depicts recovery time from peak. Typically, for equity funds at least, the descent from peak to valley happens more quickly than the ascent from valley to recovery level.

An individual’s risk tolerance and investment timeline certainly factor into expectations of maximum drawdown and recovery time. As evidenced in “Ten Market Cycles” from our April commentary, 20% drawdowns are quite common. Since 1956, the SP500 has fallen nearly 30% or more eight times. And, three times – a gut wrenching 50%. Morningstar advises that investors in equity funds need “investment horizons longer than 10 years.”

Since 1962, SP500’s worst recovery time is actually a modest 53 months. Perhaps more surprising is that aggregate bonds experienced a similar duration, before the long bull run.  The difference, however, is in drawdown level.

 During the past 20 years, bonds have recovered much more quickly, even after the financial crisis.

Long time MFO board contributor Bee posted recently:

MAXDD or Maximum Drawdown is to me only half of the story.

Markets move up and down. Typically the more aggressive the fund the more likely it is to have a higher MAXDD. I get that.

What I find “knocks me out of a fund” in a down market is the fund’s inability to bounce back.

Ulcer Index, as defined by Peter Martin and central to MFO’s ratings system, does capture both the MAXDD and recovery time, but like most indices, it is most easily interpreted when comparing funds over same time period. Shorter recovery times will have lower UIcer Index, even if they experience the same absolute MAXDD. Similarly, the attendant risk-adjusted-return measure Martin Ratio, which is excess return divided by Ulcer Index, will show higher levels.

But nothing hits home quite like maximum drawdown and recovery time, whose absolute levels are easily understood. A review of lifetime MAXDD and recoveries reveals the following funds with some dreadful numbers, representing a cautionary tale at least:

In contrast, some notable funds, including three Great Owls, with recovery times at one year or less:

On Bee’s suggestion, we will be working to make fund recovery times available to MFO readers.

Flash Geeks and Other Vagaries of Life …..

By Edward Studzinski

“The genius of you Americans is that you never make clear-cut stupid moves, only complicated stupid moves which make us wonder at the possibility that there may be something to them which we are missing.”

                Gamal Abdel Nasser

Some fifteen to twenty-odd years ago, before Paine Webber was acquired by UBS Financial Services, it had a superb annual conference. It was their quantitative investment conference usually held in Boston in early December. What was notable about it was that the attendees were the practitioners of what fundamental investors back then considered the black arts, namely the quants (quantitative investors) from shops like Acadian, Batterymarch, Fidelity, Numeric, and many of the other quant or quasi-quant shops. I made a point of attending, not because I thought of myself as a quant, but rather because I saw that an increasing amount of money was being managed in this fashion. WHAT I DID NOT KNOW COULD HURT BOTH ME AND MY INVESTORS.

One of the things you quickly learned about quantitative methods was that their factor-based models for screening stocks and industries, and then constructing portfolios, worked until they did not work. That is, inefficiencies that were discovered could be exploited until others noticed the same inefficiencies and adjusted their models accordingly. The beauty of this conference was that you had papers and presentations from the California Technology, MIT, and other computer geeks who had gone into the investment world. They would discuss what they had been working on and back-testing (seeing how things would have turned out). This usually gave you a pretty good snapshot of how they would be investing going forward. If nothing else, it helped you to know when you might want to step out of the way to keep from being run-over. It was certainly helpful to me in 1994. 

In late 2006, I was in New York at a financial markets presentation hosted by the Santa Fe Institute and Bill Miller of Legg Mason. It was my follow-on substitute for the Paine Webber conference. The speakers included people like Andrew Lo, who is both a brilliant scientist at MIT and the chief scientific officer of the Alpha Simplex Group. One of the other people I chanced to hear that day was Dan Mathisson of Credit Suisse, who was one of the early pioneers and fathers of algorithmic trading. In New York then on the stock exchanges people were seeing change not incrementally, but on a daily basis. The floor trading and market maker jobs which had been handed down in families from generation to generation (go to Fordham or NYU, get your degree, and come into the family business) were under siege, as things went electronic (anyone who has studied innovation in technology and the markets knows that the Canadians, as with air traffic control systems, beat us by many years in this regard). And then I returned to Illinois, where allegedly the Flat Earth Society was founded and still held sway. One of the more memorable quotes which I will take with me forever is this. “Trying to understand algorithmic trading is a waste of time as it will never amount to more than ten per cent of volume on the exchanges. One will get better execution by having” fill-in-the blank “execute your trade on the floor.” Exit, stage right.

Flash forward to 2014. Michael Lewis has written and published his book, Flash Boys. I have to confess that I purchased this book and then let it sit on my reading pile for a few months, thinking that I already understood what it was about. I got to it sitting in a hotel room in Switzerland in June, thinking it would put me to sleep in a different time zone. I learned very quickly that I did not know what it was about. Hours later, I was two-thirds finished with it and fascinated. And beyond the fascination, I had seen what Lewis talked about happen many times in the process of reviewing trade executions.

If you think that knowing something about algorithmic trading, black pools, and the elimination of floor traders by banks of servers and trading stations prepares you for what you learn in Lewis’ book, you are wrong. Think about your home internet service. Think about the difference in speeds that you see in going from copper to fiber optic cable (if you can actually get it run into your home). While much of the discussion in the book is about front-running of customer trades, more is about having access to the right equipment as well as the proximity of that equipment to a stock exchange’s computer servers. And it is also about how customer trades are often routed to exchanges that are not advantageous to the customer in terms of ultimate execution cost. 

Now, a discussion of front running will probably cause most eyes to glaze over. Perhaps a better way to think about what is going on is to use the term “skimming” as it might apply for instance, to someone being able to program a bank’s computers to take a few fractions of a cent from every transaction of a particular nature. And this skimming goes on, day in and day out, so that over a year’s time, we are talking about those fractions of cents adding up to millions of dollars.

Let’s talk about a company, Bitzko Kielbasa Company, which is a company that trades on average 500,000 shares a day. You want to sell 20,000 shares of Bitzko. The trading screen shows that the current market is $99.50 bid for 20,000 shares. You tell the trader to hit the bid and execute the sale at $99.50. He types in the order on his machine, hits sell, and you sell 100 shares of Bitzko at $99.50. The bid now drops to $99.40 for 1,000 shares. When you ask what happened, the answer is, “the bid wasn’t real and it went away.” What you learn from Lewis’ book is that as the trade was being entered, before the send/execute button was pressed, other firms could read your transaction and thus manipulate the market in that security. You end up selling your Bitzko at an average price well under the original price at which you thought you could execute.

So, how is it that no one has been held accountable for this yet? I don’t know, although there seem to be a lot of investigations ongoing. You also learn that a lot here has to do with order flow, or to what exchange a sell-side firm gets to direct your order for execution. The tragi-comic aspect of this is that mutual fund trustees spend a lot of time looking at trading evaluations as to whether best execution took place. The reality is that they have absolutely no idea on whether they got best execution because the whole thing was based on a false premise from the get-go. And the consultant’s trading execution reports reflect none of that.

Who has the fiduciary obligation? Many different parties, all of whom seem to hope that if they say nothing, the finger will not get pointed at them. The other side of the question is, you are executing trades on behalf of your client, individual or institutional, and you know which firms are doing this. Do you still keep doing business with them? The answer appears to be yes, because it is more important to YOUR business than to act in the best interests of your clients. Is there not a fiduciary obligation here as well? Yes.

I would like to think that there will be a day of reckoning coming. That said, it is not an easy area to understand or explain. In most sell-side firms, the only ones who really understood what was going on were the computer geeks. All that management and the marketers understood was that they were making a lot of money, but could not explain how. All that the buy-side firms understood was that they and their customers were being disadvantaged, but by how much was another question.

As an investor, how do you keep from being exploited? The best indicators as usual are fees, expenses, and investment turnover. Some firms have trading strategies tied to executing trades only when a set buy or sell price is triggered. Batterymarch was one of the forerunners here. Dimensional Fund Advisors follows a similar strategy today. Given low turnover in most indexing strategies, that is another way to limit the degree of hurt. Failing that, you probably need to resign yourself to paying hidden tolls, especially as a purchaser or seller of individual securities. Given that, being a long-term investor makes a good bit of sense. I will close by saying that I strongly suggest Michael Lewis’ book as must-reading. It makes you wonder how an industry got to the point where it has become so hard for so many to not see the difference between right and wrong.

What does it take for Morningstar to notice that they’re not noticing you?

Based on the funds profiled in Russ Kinnel’s July 15th webcast, “7 Under the Radar Funds,” the answer is about $400 million and ten years with the portfolio.