Dear friends,

There are days in spring when I’m not sure whether what I’m hearing is ticking or dripping. My students know that the end of the school year is nigh. If they glance up from their phones, it’s to glance out the window and across Augustana’s campus. It’s always pretty here, even in November, but there are about four to six weeks when it’s absolutely stunning. For three weeks in spring, the central campus is festooned with blossoms as serviceberry, cherry, apple, and lilac erupt. Again in October the maples dominate, painting the campus crimson and gold.

Photo courtesy of Augustana Spring Photo Contest winner, Shelby Burroughs.

It’s glorious!

Unless you’re trying to get students to learn about Nazi rhetorical strategies and the parallel strategies of demonization used across cultures. If you do that, then you hear the rhythmic tick, tick, tick as they count down the final weeks of the year.

Or is it the slower drip, drip, drip as their brains leak out of their ears and their IQs puddle on the classroom floor?

And still we find joy in the occasional glimpses of the tremendous growth they’ve already experienced and in the prospect that, come fall, they’ll be back, cheerful and recharged.

At least, until those durn maples take over.

The Dry Powder Gang, revisited

“Put your trust in God but keep your powder dry.”

Oliver Cromwell, 1650, to the soldiers of the New Model Army as they prepared to forge an Irish river and head into battle.

Cromwell was a dour, humorless (or “humourless”) religious fanatic charged with squashing every Catholic and every independent thought in the British Isles because, well, that’s what God demanded. Famine, plague, deportations, mass death and deportations followed.

But even Cromwell knew that the key to victory was prudent preparation; faith did not win battles in the absence of the carefully stocked dry gunpowder that powered the army. There were times to charge ahead and there were times to gather powder.

With investing likewise: there are times to be charge ahead and times to withdraw. Most investors struggle with that decision. Why?

1. Most investment products feed our worst impulses. The investment industry has come to be dominated by passive, fully-invested products over the past five years; not coincidentally, that period has seen just one break in the upward rush. In cap-based funds, more money goes to the best performing stocks in the index so markets get driven by the momentum of fewer and fewer stocks. In 2015, for instance, just four stocks accounted for the S&P 500’s entire gain.
2. Most professional investors worry more about accumulating assets than about serving investors. By most measures, the U.S. stock market is substantially overpriced but the cash reserves at mutual funds are at their lowest levels in history. Why? Because, as Jason Zweig writes, “cash is now a sin.” Cash is a drag on short-term returns and investors fixated on 1/3/5 year returns have poured their money into funds that are fully invested all the time, both index products and the cowardly “active” managers who merely shadow them. The technical term for “skilled investors who do not attract assets to the firm” is “unemployed.”
3. Most of us are too optimistic. Most guys think of themselves as “good investors” or “above average” investors, mostly because “good” is such a vague term and almost none of us actually know how or what we’ve done. Quick quiz: what’s your personal rate of return over the last five years? How much of your portfolio was invested cautiously as the market approached its top in October 2007 and how much was invested aggressively at its bottom in March 2009? The honest answers for most of us are “dunno, dunno, dunno.”

It’s not just about investing. 95% of us think we’re above average drivers. One 1965 study of drivers responsible for car accidents that put people in the hospital found the same: the majority of those drivers rated themselves as “really good.” Jason Zweig talked through a lot of the research and its implications in chapter four of his book Your Money and Your Brain (2007). We originally linked to what turned out to be a plagiarized version of Jason’s work, masquerading as an advisor’s newsletter. (Thanks to Jason for letting us know of the goof.)

The result is that we’re tempted to take on too much risk, sublimely confident that it will all work out.

But it won’t. It never does. You need a manager who’s got your back, and you need him now. Here are three arguments in three pictures.

Argument one: stock prices are too danged high.

This chart shows valuation of the US stock market back to 1880; numbers get really sketchy before that. Valuation, on the left axis, is the CAPE P/E ratio which tries to adjust for the fact that earnings tend to be “lumpy” so it averages them over time. The “mean” line is the average value over 140 years. The adjacent red lines mark the boundaries of one standard deviation from the normal. That reflects the prices you’d expect to see in two years out of three. If you get above the two S.D. line, those are once in 20 years prices. Three standard deviation prices should occur once in 300 years.

The U.S. market went over a CAPE P/E of 24 just three times in the 20^th century; it’s lived there in the 21^st. The market’s P/E at its February 2016 bottom was still higher than the P/E at its October 2007 top.

Argument two: Price matters.

Thanks to Ryan Leggio of FPA for sharing this chart and John Hussman for creating it.

If you overpay for something, whether it’s $72 million for a “franchise quarterback” who’s only started seven NFL games ever, or 115 years’ worth of earnings for a share of Netflix stock, you’re going to be disappointed.

The chart above reflects the stock market’s valuation (measured by the value of the stock market as a percentage of the value of the “real economy,” so when the blue line is high, stocks are relatively inexpensive) overlaid with its returns over the following 12 years. With considerable consistency, price predicts future returns. By this measure, U.S. stocks are priced to return 2% a year. The only ways for that number to go up is for the U.S. economy to grow at an eye-watering rate or for prices to come down. A lot. Based on the market’s performance over the past 60 years, the folks at the Leuthold Group find that a return to the valuations seen in the average bear market would require a fall of 30-40% from where we were at the end of March. Given that earnings have deteriorated and prices have risen in the 30 days since then, you might need to add a point or two to the decline.

Argument three: Market collapses are scary

I think of this as “the icicle chart.” Ben Carlson, one of the Ritholtz managers, wrote a really thoughtful essay, rich in visuals, in April. He posted it on his Wealth of Commonsense blog under the name “180 years of market drawdowns.” He provided this graph as an antidote to those relentlessly cheerful logarithmic “mountain charts.” Those are the ones that show the stock market’s relentless climb with just niggling little “oopsies” from time to time. Losing half your portfolio is, viewed from the perspective of a few decades or a century, just a minor annoyance. Losing half your portfolio is, viewed from the perspective of a guy who needs to meet a mortgage, fund a college education and plan for the end of a teaching career, rather a bigger deal. Mr. Carlson concludes:

…stocks are constantly playing mind games with us. They generally go up but not every day, week, month or year. No one can predict what the future returns will be in the market … But predicting future risk is fairly easy — markets will continue to fluctuate and experience losses on a regular basis.

Market losses are the one constant that don’t change over time — get used to it.

Managers who’ve got your back

There are only a handful of managers left who take all of that seriously. The rest have been driven to unemployment or retirement by the relentless demand: fully invested, price be damned. They typically follow a simple model: stock by stock, determine a reasonable price for everyone in our investable universe. Recognize that stocks are risky, so buy them only when they’re selling at a healthy discount to that price. Hold them until they’re around full value, then move on regardless of whether their prices are still rising. Get out while the getting is good. If you can’t find anything worth buying today, hold cash, keep your powder dry and know that the next battle awaits.

They bear a terrible price for hewing to the discipline. Large firms won’t employ them since large firms, necessarily, value “sticky assets” above all else. 99.7% of the investment community views them as relics and their investors steadily drift away in favor of “hot hands.”

They are, in a real sense, the individual investor’s best friends. They’re the people who are willing to obsess over stocks when you’d rather obsess over the NFL draft or the Cubs’ resurgence. And they’re willing, on your behalf, to walk away from the party, to turn away from the cliff, to say “no” and go. They are the professionals who might reasonably claim …

This chart reflects every equity-oriented mutual fund that currently has somewhere between “a lot” and “the vast majority” of their portfolio in cash, awaiting the return of good values. Here’s how to read it. The first two columns are self-explanatory. The third represents how their portfolios have been repositioned between 2011 (when there are still reasonable valuations) and now. Endurance, for example, had two-thirds of its money in stocks in 2011 but only a quarter invested now. The fourth column is fund’s annual return for the period noted (full market cycle or since inception). The fifth shows the fund’s Sharpe ratio, a measure of risk-adjusted returns, against its peers. The sixth column shows you how its performed, again relative to its peer group, in bear market months. The last column is the comparison time frame. I’ve marked decisive superiority in blue, comparable performance in amber and underperformance in red. All data is month end, March 2016.

There are four funds just beyond the pale: the funds have shorter records (though the managers often have long ones in other vehicles) but have disciplined investors at the helm and lots of cash on the books. They are:

Goodhaven GOODX

Hussman Strategic Dividend Value HSDVX

Linde Hansen Contrarian Value LHVAX

Poplar Forest Outlier PFOFX

No single measure is perfect and no strategy, however sensible, thrives in the absence of a sufficiently talented, disciplined manager. This is not a “best funds” list, much less a “you must buy it now, now, now!” list.

Bottom Line: being fully invested in stocks all the time is a bad idea. Allowing greed and fear, alternately, to set your market exposure is a worse idea.  Believing that you, personally, are magically immune from those first two observations is the worst idea of all.

You should invest in stocks only when you’ll be richly repaid for the astronomical volatility you might be exposed to.  Timing in and out of “the market” is, for most of us, far less reliable and far less rewarding than finding a manager who is disciplined and who is willing to sacrifice assets rather than sacrifice you. The dozen teams listed above have demonstrated that they deserve your attention, especially now.

Garbage in, garbage out: The 1/3/5/10 follies

On whole, we are not fans of reporting a fund’s one, three, five or even ten year records. In a dyspeptic moment I might suggest that the worship of standard reporting periods is universal, lunatic, destructive, obligatory, deluding, crippling, deranged, lazy, unwise, illogical and mayhap phantasmagoric.

On whole, I’d prefer that you not do it.

The easiest analogy might be to baseball. Here’s a quick quiz. Which of these statements is most meaningful to a baseball fan?

(a) My team won the last one, three and five innings!
(b) My team won the game.

We think it’s more useful to assess how a manager has performed over a full market cycle; that is, in good time and bad. The current market cycle began in October 2007, the day that the previous cycle reached its final peak and the market began its historic tumble. This cycle has included both a 51% loss for US large caps and a 223% rise. Folks who held on through both are up about 58% since the cycle began. That’s punky compared to the cycle that dominated the 1990s (up 533%) but durned fine compared to the cycle that ended in 2007 with a tiny 14% gain over seven years.

If you don’t judge your investments by meaningful measures, you cannot make meaningful decisions. Here’s a simple illustration.

If you look at the past 12 months, the Vanguard 500 Index is up 1.8% (through the end of March) and FPA Crescent is down 2.4%. Conclusion: Crescent sucks, buy the index!

Over the past three years, the 500 is up 39% and Crescent is up 18.6%. More sucking.

Over the past five years, the 500 is up 71% and Crescent is up 38%. Maximum suckage! But so far, we’re measuring only raw performance in the good times.

Over the course of the full market cycle, including the 2007-09 crash, Crescent is up 64% to the 500’s gain of 58%. More importantly, the index subjected its investors to a 51% decline compared to Crescent’s 29% drop. In bear market months, Crescent’s investors have slipped 7%, while the index investors dropped 11%.

We weigh the balance of your risks and returns by computing measures of risk-adjusted performance, such as the Sharpe and Martin ratios. Taking both halves of the equation (risk and return) into account and measuring performance over a meaningful period (the full market cycle), Crescent clubs the index.

Three quick points:

1. It’s easy to disastrously misjudge a fund when you rely on the wrong metrics; we think that arbitrary time periods and returns without consideration of risks are the disastrously wrong metrics.
2. It’s not just that funds like Crescent serve their investors better, it’s that funds such as Crescent serve long-term investors decisively better. Over time, they allow their investors to both eat well and sleep well.
3. The key is a manager’s willingness to let money walk out the door rather than betray his investors and his standards. In the late 1990s, GMO – a staunchly contrarian bunch who would not bend to the demands of investors blinded by the market’s 50-60% annual gains – lost over half of its assets. Crescent has lost $5 billion. Centaur, Intrepid, Pinnacle – all down by 50% or more all because they’ve refused to sell out to an increasingly narrow, extraordinarily overpriced bull market that’s approaching its eighth year.

Eight years of gains. Wow.

Had I mentioned, per Leuthold, that the only other bull market to reach its eight year anniversary ended in 1929?

Who has served their investors best?

Using Charles’s fund data screener at MFO Premium, I searched among the funds that predominately invest in U.S. equities for those with the highest risk-adjusted returns over the full market cycle.

This table shows the funds with the highest Sharpe ratios, along with supplemental risk-return measures. It’s sorted by Sharpe but I’ve also highlighted the top five funds (more in the case of a tie) in each measure with Vanguard’s Total Stock Market Index added as a sort of universal benchmark.

Things that stand out:

1. Small, independent firms dominate the list. The ten largest fund complexes account for about two-thirds of the industry’s $18 trillion in assets. And yet, between them, they managed to produce two or three funds (depending on how you think about Primecap) on the list. American Century, a mid-sized firm, managed three. Intrepid, Nicholas, Parnassus and Yacktman each appeared twice and most appeared frequently on our top 50 list.
2. Active managers dominate the list. Only one index fund finished among the top 25. Only seven of the top 50 funds are passive products. If you sort by our most risk-sensitive measure, the Ulcer Index, only three passive products place in the top 50. Apparently “fully invested all the time” costs more than low fees save.
3. At most this is a place to start, not a place to end your inquiries. There are some truly excellent funds on the list and some whose presence might well be seriously misleading. Reynolds Blue Chip Growth, for instance, benefits a great deal by its decision to go entirely to cash before the market crashed in 2007. It outperformed its peers by 36% in the downturn but, other than for that one fortuitous move, has mostly trailed them in measures of both risk and return before and since.

Bottom line: The stock market, like war, is famous for “Months of boredom punctuated by moments of terror.” It’s those “moments of terror” that you’ve got to watch out for. That means you must look at how a manager serves you in both periods rather than limiting yourself to the “what have you done for me lately?” mindset.

My colleague Charles Boccadoro has been poring over oceans of data available through our premium fund screener. In the following story, he looks beyond the realm of individual funds to look for which fund families, including some fascinating smaller entrants, get it right most consistently.

Fund Family Scorecard

We started looking at fund family performance two years ago, first in June 2014 commentary with How Good Is Your Fund Family?, and then An Update in May 2015.

Below please find our MFO Family Fund Scorecard for May 2016, which reflects fund performance through 1st quarter. As a reminder, the card measures how well each fund in a family has performed against its peers since inception (or at least back to January 1960, which starts our Lipper database). Performance is absolute total return, reflecting reinvested dividends, but inclusive of fees and maximum front load, if applicable. The card groups families by quintile. (Download pdf version here.)

Some changes to methodology since last year:

• Categories now reflect those used by Lipper versus Morningstar, as discussed in Comparing Lipper Ratings. Similarly, all categories except money market are included, even so-called trading categories.
• Reduced from five to three the number of funds required to comprise a “fund family.” These changes respond to reader feedback from last year’s score card (eg., Where’s PRIMECAP?).
• Reduced from three years to just three months the minimum age for evaluation. Reasoning here being the desire to get heads-up of which young families are beating their peers out of the gate (eg., Grandeur Peak).

The result is about 400 “fund families,” or more precisely fund management companies; distilled from the 9,350 funds overall, oldest share class only.

We recognize the card is flawed from the start. Results can be skewed by multiple factors, including survivorship-bias, share class differences, “improper” categorization, adviser and fund ownership changes, multiple sub-advisers, and inconsistent time frames … three months is too short to matter, lifetime is too long to care.  Flaws notwithstanding, there is value in highlighting families that, for example, have not had a single fund beat its category average since inception. Like our legacy Three Alarm designation, prospective investors should ask: Why is that?

Take Saratoga Capital Management who is celebrating 20 years and offers a line-up of mutual funds as “The Portfolios of the Saratoga Advantage Trust.” From its brochure: “There are over 22,000 investment management firms in the United States. How do you choose the right one? Research, research and more research.” Fourteen of the funds offered in its line-up are managed by Saratoga itself. Average age: 15.6 years. How many have beaten average return in their respective categories? None. Zero. 0.

Fact is all seventeen funds in the Saratoga Advantage line-up have underperformed category average since inception. Why is that?

On a more positive note, a closer look at a couple groupings …

Good to see: Vanguard heads list of Top Families with Largest Assets Under Management (AUM), along with other shareholder friendly firms, like Dodge & Cox.

And, a nod to the young and unbeaten … a short list of top families where every fund beats its category average.

Gotham is led by renowned investor Joel Greenblatt. As for Grandeur Peak, David has been an outspoken champion since its inception. Below are its MFO Ratings (click image to enlarge):

MFO Fund Family Scorecard will soon be a regular feature on our Premium site, updated monthly, with downloadable tables showing performance and fund information for all families, like average ER, AUM, load, and shares classes.

All That Glitters …

By Edward Studzinski

One should forgive one’s enemies, but not before they are hanged.

Heinrich Heine

So, we are one-third through another year, and things still continue to be not as they should be, at least to the prognosticators of the central banks, the Masters of the Universe on Wall Street, and those who make their livings reporting on same, at Bubblevision Cable and elsewhere. I am less convinced than I used to be that, for media commentators, especially on cable, the correct comparison is to The Gong Show. More often than not, I think a more appropriate comparison is to the skit performed by the late, great, and underappreciated Ernie Kovacs, “The Song of the Nairobi Trio.”

And lest I forget, this is the day after another of Uncle Warren’s Circuses, held in Omaha to capacity crowds. An interesting question there is whether, down the road some fifty years, students of financial and investing history discover after doing the appropriate first order original source research, that what Uncle Warren said he did in terms of his investment research methodology and what he in reality did, were perhaps two different things. Of course, if that were the case, one might wonder how all those who have made almost as good a living selling the teaching of the methodology, either through writing or university programs, failed to observe same before that. But what the heck, in a week where the NY Times prints an article entitled “Obama Lobbies for His Legacy” and the irony is not picked up on, it is a statement of the times.

The best performing asset class in this quarter has been – gold. Actually the best performing asset class has been the gold miners, with silver not too far behind. We have had gold with a mid-teen’s total return. And depending on which previous metals vehicle you have invested in, you may have seen as much as a 60%+ total return (looking at the germane Vanguard fund). Probably the second best area generically has been energy, but again, you had to choose your spots, and also distinguish between levered and unlevered investments, as well as proven reserves versus hopes and prayers.

I think gold is worth commenting on, since it is often reviled as a “barbarous relic.” The usual argument against it that it is just a hunk of something, with a value that goes up and down according to market prices, and it throws off no cash flow.

That argument changes of course in a world of negative interest rates, with central banks in Europe and one may expect shortly, parts of Asia, penalizing the holding of cash by putting a surcharge on it (the negative rate).

A second argument against it is that is often subject to governmental intervention and political manipulation. A wonderful book that I still recommend, and the subjects of whom I met when I was involved with The Santa Fe Institute in New Mexico, is The Predictors by Thomas A. Bass. A group of physicists used chaos theory in developing a quantitative approach to investing with extensive modeling. One of the comments from that book that I have long remembered is that, as they were going through various asset and commodity classes, doing their research and modeling, they came to the conclusion that they could not apply their approach to gold. Why? Because looking at its history of price movements, they became convinced that the movements reflected almost always at some point, the hand of government intervention. An exercise of interest would be to ponder how, over the last ten years, at various points it had been in the political interests of the United States and/or its allies, that the price of gold in relation to the price of the dollar, and those commodities pegged to it, such as petroleum, had moved in such a fashion that did not make sense in terms of supply and demand, but made perfect sense in terms of economic power and the stability of the dollar. I would suggest, among other things, one follow the cases in London involving the European banks that were involved in price fixing of the gold price in London. I would also suggest following the timetable involving the mandated exit of banks such as J.P. Morgan from commodity trading and warehousing of various commodities.

Exeunt, stage left. New scenario, enter our heroes, the Chinese. Now you have to give China credit, because they really do think in terms of centuries, as opposed to when the next presidential or other election cycle begins in a country like the U.S. Faced with events around 2011 and 2012 that perhaps may have seemed to be more about keeping the price of gold and other financial metrics in synch to not impact the 2012 elections here, they moved on. We of course see that they moved on in a “fool me once fashion.” We now have a Shanghai metals exchange with, as of this May, a gold price fixing twice a day. In fact, I suspect very quickly we will see whole set of unintended consequences. China is the largest miner of gold in the world, and all of its domestic supply each year, stays there. As I have said previously in these columns, China is thought to have the largest gold reserves in the world, at in excess of 30,000 tons. Russia is thought to be second, not close, but not exactly a slouch either.

So, does the U.S. dollar continue as the single reserve currency (fiat only, tied solely to our promise to pay) in the world? Or, at some point, does the Chinese currency become its equal as a reserve currency? What happens to the U.S. economy should that come to pass? Interesting question, is it not? On the one hand, we have the view in the U.S. financial press of instability in the Chinese stock market (at least on the Shanghai stock exchange), with extreme volatility. And on the other hand, we have Chinese companies, with some degree of state involvement or ownership, with the financial resources to acquire or make bids on large pieces of arable land or natural resources companies, in Africa, Australia, and Canada. How do we reconcile these events? Actually, the better question is, do we even try and reconcile these events? If you watch the nightly network news, we are so self-centered upon what is not important or critical to our national survival, that we miss the big picture.

Which brings me to the question most of you are asking at this point – what does he really think about gold? Some years ago, at a Grant’s Interest Rate Observer conference, Seth Klarman was one of the speakers and was asked about gold. And his answer was that, at the price it was at, they wanted to have some representation, not in the physical metal itself, but in some of the gold miners as a call option. It would not be more than 5% of a portfolio so that in the event it proved a mistake, the portfolio would not be hurt too badly (the opposite of a Valeant position). If the price of gold went up accordingly, the mine stocks would perhaps achieve a 5X or 10X return, which would help the overall returns of the portfolio (given the nature of events that would trigger those kinds of price movements). Remember, Klarman above all is focused on preserving capital.

And that is how I pretty much view gold, as I view flood insurance or earthquake insurance. Which, when you study flood insurance contracts you learn does not just cover flooding but also cases of extreme rain where, the house you built on the hill or mountain goes sliding down the hill in a massive mudslide. So when the catastrophic event can be covered for a reasonable price, you cover it (everyone forgets that in southern Illinois we have the New Madrid fault, which the last time it caused a major quake, made recent California or Japanese events seem like minor things). And when the prices to cover those events become extreme, recognizing the extreme overvaluation of the underlying asset, you should reconsider the ownership (something most people with coastal property should start to think about).

Twenty-odd years ago, when I first joined Harris Associates, I was assigned to cover DeBeers, the diamond company, since we were the largest shareholders in North America. I knew nothing about mining, and I knew nothing about diamonds, but I set out to learn. I soon found myself in London and Antwerp studying the businesses and meeting managements and engineers. And one thing I learned about the extractive industries is you have to differentiate the managements. There are some for whom there is always another project to consume capital. You either must expand a mine or find another vein, regardless of what the price of the underlying commodity may be (we see this same tendency with managements in the petroleum business). And there are other managements who understand that if you know the mineral is there sitting in the ground, and you have a pretty good idea of how much of it is there, you can let it sit, assuming a politically and legally stable environment, until the return on invested capital justifies bringing it out. For those who want to develop this theme more, I suggest subscribing to Grant’s Interest Rate Observer and reading not just its current issues but its library of back issues. Just remember to always apply your own circumstances rather than accept what you read or are told.

Drafting a Fixed Income Team

By Leigh Walzer

It is May 1. The time of flowers, maypoles and labor solidarity.

For football fans it is also time for that annual tradition, the NFL draft.  Representatives of every professional football team assemble in Chicago and conspire to divide up the rights to the 250 best college players.  The draft is preceded by an extensive period of due diligence.

Some teams are known to stockpile the best available talent. Other teams focus on the positions where they have the greatest need; if there are more skilled players available at other positions they try to trade up or down to get the most value out of their picks. Others focus on the players who offer the best fit, emphasizing size, speed, precision, character, or other traits.

The highly competitive world of professional sports offers a laboratory for investors selecting managers. Usually at Trapezoid we focus on finding the most skillful asset managers, particularly those with active styles who are likely to give investors their money’s worth. In the equity world, identifying skill is three quarters of the recipe for investment success.

But when we apply our principles to fixed income investing, the story is a little different.  The difference in skill between the top 10% and bottom 10% is only half as great as for the equity world. In other words, time spent looking for the next Jeff Gundlach is only half as productive as time spent looking for the next Bill Miller.

Exhibit I

That assumes you can identify the good fixed income managers.  Allocators report the tools at their disposal to analyze fixed income managers are not as good as in equities.

Some people argue that in sports, as in investing, the efficient market hypothesis rules. The blog Five-thirty-eight argues that  No Team Can Beat the Draft. General managers who were seen as geniuses at one point in their career either reverted to the mean or strayed from their discipline.

Readers might at this point be tempted to simply buy a bond ETF or passive mutual fund like VTBXX. Our preliminary view is that investors can do better. Many fixed income products are hard to reproduce in indices; and the expense difference for active management is not as great. We measure skill (see below) and estimate funds in the top ten percentile add approximately 80 basis points over the long haul; this is more than sufficient to justify the added expense.

However, investors need to think about the topic a little differently. In fixed income, skillful funds exist but they are associated with a fund which may concentrate in a specific sector, duration, and other attributes.  It is often not practical to hedge those attributes – you have to take the bundle.  Below, we identify n emerging market debt fund which shows strong skill relative to its peers; but the sector has historically been high-risk and low return which might dampen your enthusiasm. It is not unlike the highly regarded quarterback prospect with off-the-field character issues.

When selecting managers, skill has to be balanced against not only the skill and the attractiveness of the sector but also the fit within a larger portfolio. We are not football experts. But we are sympathetic to the view that the long term success of franchises like the New England Patriots is based on a similar principle: finding players who are more valuable to them than the rest of the league because the players fit well with a particular system.

To illustrate this point, we constructed an idealized fixed income portfolio. We identified 22 skilled bond managers and let our optimizer choose the best fund allocation. Instead of settling upon the manager with the best track record or highest skill, the model allocated to 8 different funds. Some of those were themselves multi-sector funds. So we ended up fairly diversified across fixed income sectors.

Exhibit  I
Sector Diversification in one Optimized Portfolio

Characteristics of a Good Bond Portfolio

We repeated this exercise a number of times, varying the choice of funds, the way we thought of skill, and other inputs. We are mindful that not every investor has access to institutional classes and tax-rates vary. While the specific fund allocations varied considerably with each iteration, we observed many similarities throughout.:

BUSINESS CREDIT: Corporate bonds received the largest allocation; the majority of that went to high yield and bank loans rather than investment grade bonds

DON’T OVERLOAD ON MUNIs. Even for taxable investors, municipal funds comprised only a minority of the portfolio.

STAY SHORT: Shorter duration funds were favored. The example above had a duration of 5.1 years, but some iterations were much shorter

DIVERSIFY, UP TO A POINT:  Five to eight funds may be enough.

Bond funds are more susceptible than equity funds to “black swan” events. Funds churn out reliable yield and NAV holds steady through most of the credit cycle until a wave of defaults or credit loss pops up in an unexpected place.  It is tough for any quantitative due diligence system to ferret out this risk, but long track records help. In the equity space five years of history may be sufficient to gauge the manager’s skill. But in fixed income we may be reluctant to trust a strategy which hasn’t weathered a credit crunch. It may help to filter out managers and funds which weren’t around in 2008. Even then, we might be preparing our portfolio to fight the last war.

Identifying Skilled Managers

The recipe for a good fixed income portfolio is to find good funds covering a number of bond sectors and mix them just right. We showed earlier that fixed income manager skill is distributed along a classic bell curve. What do we mean by skill and how do we identify the top 10%? 

The principles we apply in fixed income are the same as for equities but the methodology is the same. While the fixed income model is not yet available on our website, readers of Mutual Fund Observer may sample the equity model by registering at www.fundattribution.com.  We value strong performance relative to risk. While absolute return is important, we see value in funds which achieve good results while sitting on large cash balances – or with low correlation to their sectors. And we look for managers who have outperformed their peer group -or relevant indices – preferably over a long period of time.  We also consider the trend in skill.

For fixed income we currently rely on a fitted regression model do determine skill. A few caveats are in order. This approach isn’t quite as sophisticated as what we do with equity funds. We don’t use the holdings data to directly measure what the manager is up to, we simply infer it. We don’t break skill down into a series of components. We rely on gross performance of subsectors rather than passive indices.  We haven’t back-tested this approach to see whether it makes relevant predictions for future periods.  And we don’t try to assess the likelihood that future skill will exceed expenses.  Essentially, the funds which show up well in this screen outperformed a composite peer group chosen by an algorithm over a considerable period of time. While we call them skillful, we haven’t ruled out that some were simply lucky. Or, worse, they could be generating good performance through a strategy which back to bite them in the long term. For all the reasons noted earlier, quantitative due diligence of portfolio managers has limitations. Ultimately, it pays to know what is inside the credit “black box”

Exhibit II lists some of the top-ranking funds in some of the major fixed income categories. We culled these from a list of 2500 fixed income funds, generally seeking top-decile performance, AUM of at least $200mm, and sufficient history with the fund and manager. 

We haven’t reviewed these funds in detail. Readers with feedback on the list are welcome to contact me at [email protected]

From time to time, the media likes to anoint a single manager as the “bond king.” But we suggest that different shops seem to excel in different sectors. Four High Yield funds are included in the list led by Osterweis Strategic Income Fund (OSTIX).  In the Bank Loan Category several funds show better but Columbia Floating-Rate Fund (RFRIX) is the only fund with the requisite tenure. The multi-sector funds listed here invest in corporate, mortgage, and government obligations.  We are not familiar with Wasatch-Hoisington US Treasury Fund (WHOSX), but it seems to have outperformed its category by extending its duration.

FPA New Income Fund (FPNIX) is categorized with the Mortgage Funds, but 40% of its portfolio is in asset-backed securities including subprime auto.  Some mortgage-weighted funds with excellent five year records who show up as skillful but weren’t tested in the financial crisis or had a management change were excluded. Notable among those is TCW Total Return Bond Fund (TGLMX).

Skilled managers in the municipal area include Nuveen (at the short to intermediate end), Delaware, Franklin, and Blackrock (for High Yield Munis).

Equity

Style diversification seems less important in the equity area. We tried constructing a portfolio using 42 “best of breed” equity funds from the Trapezoid Honor Roll.  Our optimizer proposed investing 80% of the portfolio in the fund with the highest Sharpe Ratio. While this seems extreme, it does suggest equity allocators can in general look for the “best available athlete” and worry less about portfolio fit.

Bottom Line

Even though fixed income returns fall in a narrower range than their equity counterparts, funds whose skill justify their expense structure are more abundant. Portfolio fit and sector timeliness sometimes trumps skill; diversification among fixed income sectors seems to be very important; and the right portfolio can vary from client to client. If in doubt, stay short. Quantitative models are important but strive to understand what you are investing in.

The Alt Perspective: Commentary and news from DailyAlts.

April has come to a close and another Fed meeting has passed without a rate rise. At the same time, markets have continued to rally with the equity market, as measured by the S&P 500 Index, gaining another 0.39% in April, bringing the 3-month total return to 7.05%. Bonds also rallied as the Barclays U.S. Aggregated Bond Index gained 0.38% in April, and 2.02% over the past 3-months. Not bad for traditional asset classes.

Strong rallies are periods when alternative strategies lag the broad markets given that they are often hedged in their exposure to traditional asset classes. And this is what we saw in April, with managed futures funds dropping 1.76%, bear market funds losing 1.36% and market neutral funds shedding 0.40%. At the same time, long/short equity funds eked out a gain of 0.06%, multi-alternative funds gained 0.29%, non-traditional bond funds gained 1.54% and multi-currency funds added 1.57%. Not a stellar month for alternative funds, but investors can’t always make money in all areas of their portfolio – diversification has its benefits as well as its drawbacks.

News Highlights from April

• Highland Capital, who had originally filed to launch a series of 17 alternative ETFs, decided to take a different course of action and shut down the 3 hedge fund replication ETFs it launched less than a year ago. It’s unlikely any of the remaining 14 funds will see the bid or ask of a trade.
• Morningstar has made some modifications to its alternative fund classifications, creating two new alternative fund categories: Long/Short Credit and Option Writing. The changes went into effect on April 29.
• Alternative fund (mutual funds and ETFs) inflows continued to be positive in March, with nearly $2.1 billion of new assets going into the category. Managed futures funds gained just over $1 billion in assets and multi-alternative funds picked up nearly $500 million, but the big gainer was volatility based funds which added $1.5 billion as a category.
• Both Calamos and Catalyst hit the market this month with new alternative mutual funds what were converted from hedge funds. Calamos launched a global long/short equity fund managed by Phineus Partners, a firm they acquired in 2015, while Catalyst launched a hedged equity (with an alpha overlay) fund (this one is a bit more complicated on the surface) that is sub-advised by Millburn Ridgefield.
• Fidelity Investments did an about face on more than $2 billion of assets allocated to two multi-alternative mutual funds that were set up specifically, and exclusively, for their clients. One fund was managed by Blackstone, while the other by Arden Asset Management (which was recently acquired by Aberdeen).

Potential Regulatory Changes

One of the more serious issues currently on the table is a proposal by the Securities and Exchange Commission (SEC) to limit the use of derivatives and leverage in mutual funds. Keith Black, Managing Director of Curriculum and Exams for the CAIA Association, wrote a good piece for Pensions & Investments that covers some of the key issues. In the article, Black states that if the regulations are passes as is, it will “substantially alter the universe of alternative strategy funds available to investors.” While not expected to be implemented in its current form, fund managers are nevertheless concerned. The limitations proposed by the SEC would severely constrain some fund managers in their ability to implement the investment strategies they use today, and that would not be limited just to managers of alternative funds.

Greater levels of transparency and more sensible reporting are certainly needed for many funds. This is an initiative that funds should undertake themselves, rather than wait for the regulators to force their hand. But greater limits on the use of derivatives and leverage would, in many cases, go against the grain of benefiting investors.

Observer Fund Profiles: ARIVX and TILDX

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. 

Aston River Road Independent Value (ARIVX). If James Brown is the godfather of soul, then Eric Cinnamond might be thought the godfather of small cap, absolute value investing. He’s been at it since 1996 and he suspects that folks who own lots of small cap stocks today are going to want to sell them to him, for a lot less than they paid, sooner rather than later.

Centaur Total Return (TILDX). If Steppenwolf (“I like smoke and lightnin’ / Heavy metal thunder”) was born to be wild, then Zeke Ashton was born to be mild (“thoughtless risk now damages future performance”). While Steppenwolf’s name is cool, Mr. Ashton’s combination of blue chips, cash and calls has been far more profitable (and, of course, prudent).

Launch Alert: LMCG International Small Cap

LMCG International Small Cap (ISMRX/ISMIX) launched on April 1, 2016 but it’s actually a new platform for an institutional “collective trust” that’s been in operation since August 26, 2010.

LMCG Investments is a Boston-based adviser with about $7 billion of mostly institutional and high net worth individual assets. They were once “Lee Munder Capital Group” and they do subadvise some retail funds but they are not linked to the old Munder family of funds.

The fund invests primarily in international small cap stocks from developed markets, though they can invest small slices in both the US and the emerging markets. “Small cap” translates to market caps between $50 million and $7 billion with the current weighted capitalization in the portfolio at $2.9 billion. They target companies with “good growth prospects and high quality of earnings,” then buy them when they’re attractively valued. They position themselves as a quant fund with a fundamentalist’s bias; that is, they’ve constructed screens to help them identify the same attributes that other good fundamental, bottoms-up guys look for. They screen 2,500 stocks daily and are hopeful that the quantitative discipline helps them avoid a lot of human errors such as style drift and overcommittment to particular stocks. Eventually the portfolio will hold between 90-125 more-or-less equally weighted stocks.

Four things stand out about the fund:

1.   It’s cheap.

Morningstar’s benchmarking data is too cute by half since they provide separate group benchmarks for load and no-load funds, institutional and non-institutional funds and both category average and “Fee Level Comparison Group Median” numbers. In general, you’d expect to pay somewhere between 1.35% and 1.50% for a fund in this category. With an opening e.r. of 1.10%, LMCG will be one of the four cheapest options for retail investors.

2.   It’s in an arena where active managers thrive.

Standard & Poor’s SPIVA scorecards track the prospect that an active manager will outperform his benchmark. In domestic small cap core funds, the chance is about 1 in 7 over a five year period. For international small cap core, though, the chance is 1 in 2 and that’s despite the generally high expenses that the average fund carries. More to the point, funds like Vanguard FTSE All-World ex-US Small Cap Index (VFSVX) are distinctly poor performers, trailing 90% of their peers over the past three- and five-year periods.

3.   It’s got an experienced management team.

The fund is managed by Gordon Johnson, who has 23 years of experience managing global portfolios and developing quantitative investment models. Before joining LMCG in 2006 he had six years at Evergreen Investments and, before that, managed the Colonial Fund. (And, like me, he has a PhD from UMass.) Co-manager Shannon Ericson joined LMCG at the same time, also from Evergreen, and has had stints at Independence International Associates and Mellon Trust. Together they also co-manage LMCG Global Market Neutral Fund, ASTON/LMCG Emerging Markets and PACE International Emerging Markets.  They’re assisted by Daniel Getler, CFA.

4.   It’s got a strong track record.

The predecessor fund has been around since 2010 and it has outperformed its peer group and its benchmark index in each of the five calendar years of its existence.

It’s particularly interesting that the fund has been more than competitive in both up- and down-market years.

The fund’s initial expense ratio is 1.10%, after waivers, on Investor class shares and 0.85% on Institutional ones.  The minimum initial investment is $2500 for Investor shares and $100,000 for the others. 

The ISMRX homepage is, understandably, thin on the content right now. The other funds’ homepages (Global Multicap and Global Market Neutral) aren’t exactly founts of information, but they do offer the prospect for a factsheet, manager Q&A and such as forthcoming. The LMCG homepage does offer access to their monthly commentary, LMCG Unfiltered. It’s short, clear and interesting. There was an note in their March 2016 issue that over the past eight years, US corporations have accounted for a slightly higher percentage of global corporate earnings (up from 36% in 2007 and 41% in 2015) but a substantially higher percentage of global stock market capitalization (from 47% to 59%). That suggests that the US market has been underwritten by the willingness of international investors to overpay for the safe haven of US markets and raises intriguing questions about what happens when there’s no longer a safe haven premium.

Funds in Registration

Before mutual funds can offered for sale to the public, their prospectuses and related documents need to be subject to SEC review for 75 days. During the so-called “silent period,” the prospectus is available for public (and regulator) review, but the advisers are not permitted to discuss them. We try to track down no-load retail funds and actively-managed ETFs in registration that you might want to put on your radar.

There are only five funds in registration now, most set to launch by the end of June.

While it’s not likely to lead to scintillating cocktail party conversation, DoubleLine Ultra Short Bond Fund is apt to be really solid and useful. And it is run by Bonnie Baha, who once asked The Jeffrey why he was such a jerk.

AMG SouthernSun Global Opportunities Fund is a sort of global version of SouthernSun Small Cap (SSSFX). Okay, it’s a sort of smid-cap global version of Small Cap. SSSFX tends to be a high-beta fund that captures a lot more of the upside than its peers; that boldness has hurt it lately but is has serious charms.

Manager Changes

We’ve track down rather more than 55 manager changes this month, including maternity leaves, sabbaticals, retirements and quietly unexplained departures. The most noteworthy might be the departure of Daniel Martino from T. Rowe Price New America Growth Fund (PRWAX).

Updates

Welcoming Bob Cochran

It is with undisguised, and largely unrestrained, glee that we announce the addition of Robert Cochran to the Mutual Fund Observer, Inc. Board of Directors. Bob is the lead portfolio manager, Chief Compliance Officer, and a principal of PDS Planning in Columbus, Ohio.

We’ve been following Bob’s posts for the past 10 or 15 years where, as BobC, he’s been one of the most respected, thoughtful and generous contributors to our discussion board and the FundAlarm’s before that. The Observer aspires to serve two communities: the small, independent managers who are willing to stray from the herd and who are passionate about what they do (rather than about how much they can make) and the individual investors who deserve better than the timid, marketing-driven pap they’re so often fed. As we begin our sixth year, we thought that finding someone who is both active in the industry and broad in mind and spirit would allow us to serve folks better.

We believe that Bob is a great fit there. He’s been a financial professional for the past 31 years (he earned his CFP the same year I earned my PhD), writes thoughtfully and well, and had a stint teaching at Humboldt State in Arcata, a lovely town in northern California. He also serves on the Board for the Columbus Symphony (and was formerly their principal bassoonist) and Neighborhood Services, Inc., one of Ohio’s oldest food banks. Had I mentioned he’s prepping a national display garden? Me, I mostly buy extra bags of shredded hardwood mulch to bury my mistakes.

We are delighted that Bob agreed to join us, hopeful that we’ll be able to chart a useful course together, and grateful to him, and to you all, for your faith in us.

On being your own worst enemy

Chuck Jaffe, in “This is why mutual fund managers can’t beat a stock index more often” (April 14, 2016), meditated a bit upon the question of whether index funds and sliced bread belong in the same pantheon. He notes that while the easy comparisons favor index funds, there’s a strongly countervailing flow that starts with the simple recognition that 50% of funds must, by definition, underperform the group average. The question is, can you find the other 50%. Research by several large firms points in that direction. Fidelity reports that low-cost funds from large fund complexes are grrrrrrreat! American Funds reports that low cost funds with high levels of manager ownership are at least as great. My take was simpler: you need to worry less about whether your active fund is going to trail some index by 0.9% annually and worry more about whether you will, yet again, insist on being your own worst enemy:

“Your biggest risk isn’t that your manager will underperform, it’s that you’ll panic and do something stupid and self-destructive,” said David Snowball, founder of MutualFundObserver.com. “With luck, if you know what your manager is doing and why she’s doing it and if she communicates clearly and frequently, there’s at least the prospect that you’ll suppress the urge to self-immolation.”

On April 29, 2016, Morningstar added eight new fund categories, bringing their total is 122.The eight are:

They renamed 10 other categories. The most noticeable will be the replacement of conservative, moderate and aggressive allocation categories with stipulations of the degree of market exposure. The moderate allocation category, once called “balanced,” is now the “Allocation 50-70% Equity” category.

Briefly Noted . . .

With unassailable logic that Aristotle himself would affirm, we learn from a recent SEC filing that “The Aristotle Value Equity Fund has not commenced operations and therefore is currently not available for purchase.”

Effective April 1, 2016, QS Batterymarch Financial Management, Inc. merged with QS Investors, LLC, to form QS Investors, LLC. QS was an independent quant firm purchased, in 2014, by Legg Mason to run their QS Batterymarch funds.

SMALL WINS FOR INVESTORS

AMG SouthernSun Small Cap Fund (SSSFX) reopened to new investors in the first week of April.

On April 7, 2016, the Board of Trustees of Crow Point Defined Risk Global Equity Income Fund (CGHAX/CGHIX) voted to abandon the plan of liquidation for the Fund and continue the Fund’s operations.

The Board of Trustees voted to reduce the expense cap on Dean Mid Cap Value Fund (DALCX) by 1.50% to 1.10%. That includes a small drop in the management fee.

Franklin Biotechnology Discovery Fund (FBDIX) will re-open to new investors May 16, 2016. The fund’s 23% loss in the first four months of 2016 might have created some room for (well, need for) new investors.

RS Partners Fund (RSPFX) reopened to new investors on March 1, 2016, just in case you’d missed it. RS, once Robertson Stephens, has been acquired by Victory Capital, so the fund may be soon renamed Victory RS Partners.

Sequoia Fund (SEQUX) has reopened in hopes of finding new investors. I won’t be one of them. There’s the prospect of a really substantial tax hit this year. In addition, we still don’t know what happened, whether it’s been fixed and whether the folks who left – including the last of the original managers – were the cause of the mess or the scapegoats for it. Until there’s some clarity, I’d be unwilling to invest for the sake of just owning a legendary name.

WCM Investment Management has voluntarily agreed to waive all of its fees and pay all of the operating expenses for WCM Focused Global Growth Fund (WFGGX) and WCM Focused Emerging Markets Fund (WFEMX) from May 1, 2016, through April 30, 2017. “The Advisor will not seek recoupment of any advisory fees it waived or Fund expenses it paid during such period.”

CLOSINGS (and related inconveniences)

AC Alternatives® Market Neutral Value Fund (ACVQX) will close to new investors on May 25, 2016 except those who invest directly with American Century or through “certain financial intermediaries selected by American Century.” In an exceedingly odd twist, Morningstar describes it as having “average” returns, a fact belied by, well, all available evidence. In addition to beating their peers in every calendar year, the performance gap since inception is pretty substantial:

Folks closed out here and willing to consider an even more explosive take on market-neutral investing might want to look at Cognios Market Neutral Large Cap (COGIX).

Effective April 30, 2016, the Diamond Hill Small-Mid Cap Fund (DHMAX), with $1.8 billion in assets, closed to most new investors. 

OLD WINE, NEW BOTTLES

On or about May 31, 2016, each Strategic Advisers^® Multi-Manager Target Date Fund becomes a Fidelity Multi-Manager Target Date Fund.

The Primary Trend Fund has become Sims Total Return Fund (SIMFX). Sims Capital Management has been managing the fund since 2003 and just became the adviser, rather than just the sub-adviser. I wish them well, but the fact that they’ve trailed their peers in eight of the past 10 calendar years is going to make it a hard slog.

OFF TO THE DUSTBIN OF HISTORY

Appleton Group Risk Managed Growth Fund (AGPLX) has closed and will be liquidated at the close of business on June 27, 2016.

Aurora Horizons Fund (AHFAX) closed to new purchases on April 22, 2016 and will be liquidating its assets as of the close of business on May 31, 2016. As this alts fund passed its three-year mark, it was trailing 80% of its peers.

BPV Low Volatility Fund (BPLVX) has closed but “will continue to operate until on or about May 31, 2016, when it will be liquidated.” The fund is liquidating just as Morningstar is creating a category to track such option-writing strategies.

The Braver Tactical Opportunity Fund (BRAVX) has closed to new investors and will discontinue its operations effective May 27, 2016. It’s not at all a bad fund, it’s just not magical. Increasingly, it seems like that’s what it takes.

Stepping back from the edge of the grave: On March 30, 2016, the Board of Trustees of Two Roads Trust voted to abandon the plan of liquidation for the Breithorn Long/Short Fund (BRHIX) that was scheduled to occur on or about April 8, 2016. 

Fidelity Advisor Short Fixed-Income Fund (FSFAX) is merging into Fidelity Short-Term Bond Fund (FSHBX) on or about July 15, 2016. Their performance over any reasonable time frame is nearly identical and FSHBX is cheaper, so it’s a clear winner for shareholders.

Nuveen Global Growth (NGGAX) and Nuveen Tradewinds Emerging Markets (NTEAX) funds will both be liquidated after the close of business on June 24, 2016.

Oppenheimer Commodity Strategy Total Return Fund (QRAAX) will liquidate on June 29, 2016. While the fund has almost $300 million in assets, its watershed moment might have happened in 2008:

Driven by the adviser’s “its inability to market the Fund and [fact] that it does not desire to continue to support the Fund,” Outfitter Fund (OTFTX) and its fly-fishing logo will liquidate on or about May 26, 2016.

Panther Small Cap Fund (PCGSX) will be liquidated on or about May 16, 2016. Cool name, no assets, quickly deteriorating performance.

Putnam Voyager Fund (PVOYX) is merging into Putnam Growth Opportunities (POGAX) on July 15, 2016. Voyager’s performance was rightly described as “dismal” by Morningstar. Voyager’s manager was replaced in February by Growth Opportunities, after a string of bad bets: in the past six years, he mixed one brilliant year with two dismal ones and three pretty bad ones. He was appointed in late 2008 just before the market blasted off, rewarding all things risky. As soon as that phase passed, Voyager sank in the mud. To their credit, Voyager’s investors stayed with the fund and assets, still north of $3 billion, have only recently begun to slip. The new combined fund’s manager is no Peter Lynch, but he’s earning his keep.

Rivington Diversified International Equity Fund By WHV and Rivington Diversified Global Equity Fund By WHV have been closed and liquidated. “By WHV” sounds like a bad couture brand.

Stratus Government Securities (STGAX) and Growth Portfolio (STWAX) are both moving toward liquidation. Shareholders will rubberstamp the proposal on June 7, 2016.

The Board of Trustees, citing in light of “the ever-present goal of continuing to make all decisions and actions in the Best Interests of the Shareholders,” has decided to liquidate Valley Forge Fund (VAFGX). 

A queer and wonderful ride. Bernie Klawans – an aerospace engineer – ran it for decades, from 1971-2011, likely out of his garage. One-page website, no 800-number, no reports or newsletters or commentaries. Also an incredibly blurry logo that might well have been run through a mimeograph machine once or twice. Mr. Klawans brought on a successor when he was in his late 80s, worked with him for a couple years, retired in April and passed away within about six months. Then his chosen successor, Craig Arnholt, died unexpectedly within a year. The Board of Trustees actually managed the fund for six months (quite successful – they beat both their LV peers and the S&P) before finding a manager who’d run the fund for a pittance. The new guy was doing fine then … kapow! He lost 22% in September and October of 2014, when the rest of the market was essentially flat. That was a combination of a big stake in Fannie and Freddie – adverse court ruling cut their market value by half in a month – and energy exposure. He’s been staggering toward the cliff ever since.

Tocqueville Alternative Strategies Fund (TALSX) will “liquidate, dissolve and terminate [its] legal existence,” all on May 17, 2016. The fund is better than its three year record looks: it’s had two bad quarters in the last three, but often moved in the opposite direction of other alt funds and had a solid record up until Q3 2015.

William Blair Directional Multialternative Fund closed and liquidated on April 21, 2016.

William Blair Large Cap Value Fund (WLVNX) has closed and will liquidate on or about June 15, 2016. Soft performance, $3 million in assets, muerte.

In Closing . . .

Mutual Fund Observer celebrates its fifth anniversary with this issue. Our official launch was May 1, 2011 and since then we’ve enjoyed the company of nearly 800,000 readers (well, 795,688 seems like it’s near 800,000). Each month now we draw between 22,000 and 28,000 readers.

Thanks and thanks and more thanks to… David, Michael, William, and Richard. Many thanks, also, to John from California who sent a note with his donation that really brightened our day. As always, Gregory and Deb, your ongoing support is so appreciated.

If you’re grateful at the absence of ads or fees and would like to help support the Observer, there are two popular options. Simple: make a tax-deductible contribution to the Observer. Folks contributing $100 or more in a year receive access to MFO Premium, the site that houses our custom fund screener and all of the data behind our stories.

Simplest: use our link to Amazon.com. We received about 6-7% of the value of anything you purchase through that link. It costs you nothing extra and is pretty much invisible. For those of you interested in knowing a bit more about the Observer’s history, scope and mission, we’ve linked our factsheet to the thumbnail on the left.

As usual, we’ll be at the Morningstar Conference, 13-15 June. Let us know if we might see you there.

Our June issue will be just a wee bit odd for the Observer. At the end of May I’m having one of those annoying round-number birthdays. I decided that, on whole, it would be substantially less annoying if I celebrated it somewhere even nicer than the Iowa-Illinois Quad Cities. The Isle of Skye, off the west coast of Scotland, in particular. Chip saw it as an opportunity to refine her palate by trying regional varieties of haggis (and scotch), so she agreed to join me for the adventure.

That means we’ll have to finish the June issue by May 20^th, just about the time that some hundreds of students insist on graduating from our respective colleges. We’ll have the issue staged before we leave the country and will count on her IT staff to launch it. That means we’ll be out of contact for about two weeks, so we’ll have to ask for forbearance for unanswered email.

As ever,

Dear friends,

It’s spring! Sort of. Despite the steady, light snow falling outside my window, March 1 is the beginning of “meteorological spring” and I’m indisputably in the middle of Augustana’s Spring Break. (It always looked better on MTV.) Spring training, both for major leaguers and my son’s high school team, has begun. There are stirrings in my garden and a couple newly-arrived catalogs (yes, I still get real mail) are encouraging horticultural fantasies: a swath of pollinator-friendly native plants taking over the southwest corner of the yard, a new home for my towering wall of sunflowers, some experiments with carrots, replacing more of the lawn with a rain garden to reduce run-off, regrowing a full head of hair … anything’s imaginable and everything’s possible, at least until I have to figure out how to pull it off.

Sadly, as Rudyard Kipling observed, “gardens are not made by sitting in the shade.”

For one more month, at least, I focus on tidying up my financial garden. We start this month’s issue with three of the most important kind of story: ones that actually affect me.

Artisan pulls the plug

Artisan has announced the liquidation of Artisan Small Cap Value (ARTVX), my oldest holding. My first fund, purchased when I was young and dumb, was AIM Constellation, then a very good mid-cap growth fund that carried a 5.5% load. After a bit, I learned that paying sales loads without any compensating benefit was stupid, so I stopped. I sold my shares and, shortly before it closed, invested the proceeds in Artisan Small Cap (ARTSX). Shortly after Artisan launched Small Cap Value in 1997, I moved my investment over from Small Cap. The $367 million fund, down from a peak of $3 billion in 2011, will be merged into Artisan Mid Cap Value (ARTQX) in May, 2016.

After a couple withdrawals and almost 19 years of paying taxes on the account, I’m disconcerted to report that I’ll be able to report a 30% tax loss on my 2016 taxes.

What happened? The managers’ discipline (and the dictates of marketing to advisors who want to execute their own asset allocation plans) does not encompass holding significant cash. And so, despite the fact that “We’ve complained for a long time now that too much of the market is fully- or fairly valued,” they stayed fully-invested. Their discipline also pushed them toward overweighting the best-valued stocks they could find and those turned out to be in two of the market’s worst areas: energy and industrials, that latter of which “have backdoor exposure to energy.” They eventually overweighted those areas by more than 2:1. That’s, at best, a very partial explanation for the fact that the fund trailed 90% or more of its small-value peers in five of the past six years, including years with high oil prices.

The folks at Artisan position this as a simple economic decision: “a determination was made that the strategy/fund was no longer commercially viable… Given our past few years of underperformance, we have seen outflows (and passive has been an asset flow winner here). We are also hearing that fewer folks plan to use dedicated small-cap value allocations going forward.” The management team “drove the decision” and they “still believe in the asset class.”

This is the first fund liquidation in Artisan’s history.

The team manages two other funds, Mid Cap Value (ARTQX) and the large-cap oriented Value (ARTLX). Over the full market cycle, ARTQX modestly leads its peer group in performance (40 bps/year) with subdued volatility. ARTLX trails its Lipper peers (80 bps/year) with somewhat higher volatility.

Bottom line

I prefer to maintain exposure to small value stocks, so I won’t wait around for the impending transition to the team’s mid-cap value fund. I’ll book my tax loss and move on.

The finalists for this slot in my portfolio are two cash-rich, low-vol funds: John Deysher’s Pinnacle Value Fund (PVFIX) and the team-managed Intrepid Endurance Fund (ICMAX, formerly Intrepid Small Cap). Both are run by absolute value investors. They have similar expense ratios, though Intrepid is five times Pinnacle’s size. Intrepid’s about two-thirds cash right now, Pinnacle about 50%. They are, by far, the two least volatile small cap funds around. Pinnacle’s market cap and turnover are both far lower.

We profiled Pinnacle one year ago. I think we’ll try to prepare a profile of Intrepid for our April issue and see if that helps decide things.

The tough question remaining

How long should you wait before you write off a manager or a fund? My normal rule is pretty straightforward: if I haven’t changed and they haven’t changed, then we’re not going to change. That is, if my portfolio needs remain the same, the management team remains intact and true to their discipline, then I’m not going to second-guess my due diligence. This may be the first time I’ve sold a fund in a decade. Leigh Walzer’s research on stumbling funds suggests that I should have sold in mid-2014 which would have spared me about a 10% loss assuming that I’d put it in a merely average SCV fund.

Romick stares reality in the face, and turns away

My single largest non-retirement holding is FPA Crescent (FPACX), which has always struck me as the quintessence of active management. While other managers were constrained to invest in a single asset class or in a single country, or to remain fully invested or unhedged, manager Steve Romick declared himself to be “the free-range chicken” of the investing world. He’d look for firms that offered compelling advantages, would analyze their capital structure and then invest in whatever instrument – common stock, warrants, senior debt – offered the most compelling opportunities. If nothing was compelling, he sat on cash.

That strategy performed wonderfully for years. Over the past decade the fund has led its Morningstar peer group by 1.12% annually though, by freakish coincidence, Morningstar also calculates that you lost 1.12% annually to taxes over the same period. Over the past three years, the fund has either been about average (using Morningstar’s “moderate allocation” peer group) or well-above average (using Lipper’s “flexible portfolio” one). In 2015, the fund lost money and finished in the bottom third of its Morningstar peer group.

Those two things do not bother me. Two others do. First, the fund has ballooned in size with no apparent effort at gatekeeping. In 2005, it performed gloriously but had under $1 billion in assets. In 2010, it performed solidly with $2.7 billion. It hit $10 billion in 2013 and $20 billion in 2015 and remains open today. While some funds have doubtless thrived in the face of huge, continual inflows, those are rare.

Second, Romick blinked. His recently released Annual Report offered the following announcement on page two:

At first glance, it appears that we’ve declined as much as the market — down 11.71% since May 2015’s market peak against the S&P 500’s 11.30% decline — but that’s looking at the market only through the lens of the S&P 500. However, roughly half of our equity holdings (totaling almost a third of the Fund’s equity exposure) are not included in the S&P 500 index. Our quest for value has increasingly taken us overseas and our portfolio is more global than it has been in the past. We therefore consider the MSCI ACWI a pertinent alternative benchmark.

What?

“We look pretty good compared to a global all-equity benchmark”?

Uhhh … the fund is 37% cash. Morningstar reports a net exposure (11% long minus 3% short) of only 8.5% to international stocks. The most recent report on FPA’s website suggests 16% but doesn’t separate long/short. If Morningstar is right, net exposure is way less global than either its Morningstar benchmark or Morningstar peer group.

Underperformance doesn’t bother me. Obfuscation does. The irony is that it bothers Mr. Romick as well, at least when it’s being practiced by others. In a 2012 letter criticizing the Fed, he explained what we ought to demand of our leaders and ourselves:

Blind faith has gotten us into trouble repeatedly throughout history. Just consider the rogue’s gallery of false idols, dictators, and charlatans we have followed, hoping for something different, something better. That misplaced conviction corrupts and destroys. Daily life does require we put our trust in others, but we should do so judiciously.

Nobody has all the answers. Genius fails. Experts goof. Rather than blind faith, we need our leaders to admit failure, learn from it, recalibrate, and move forward with something better… As the author Malcolm Gladwell so eloquently said, “Incompetence is the disease of idiots. Overconfidence is the mistake of experts…. Incompetence irritates me. Overconfidence terrifies me.”

FPA once ran funds in a couple of different styles, Mr. Romick’s and the other one. They’ve now purged themselves of their quality-growth team and have renamed and repurposed those funds. In repurposing Paramount, they raised the expense ratio, ostensibly to create parity with the Perennial fund. In a private exchange I asked why they didn’t simply lower Perennial’s e.r. rather than raising it and was assured that they really needed the extra cash for as-yet undisclosed enhancements.

I’ve lost faith.

Bottom line

I’m not sure whether FPA is now being driven by investment discipline, demands for ideological purity or a rising interest in gathering assets. Regardless, I’m going. I have long respected the folks at the Leuthold Group and we recently profiled their flagship Leuthold Core Investment Fund (LCORX). Leuthold has delivered on such promises more consistently, with more discipline, for a longer period than virtually any competitor.” They’re apt to be the home for the proceeds from an FPA sale plus closing two small accounts.

Morningstar doesn’t share my reservations and FPACX retains a “Gold” analyst rating from the firm.

The tough question remaining

How do we account for cultural change in assessing a firm? Firms never admit to their internal machinations, the story is always “a long heritage and a strict discipline, honored, preserved, extended!” They say it because they must and, often, because they believe it. From the outside, it’s about impossible to test those claims and people get downright offended when you even broach the subject. Some folks have managed beautifully; Mairs and Power come to mind. Some have been disasters, Third Avenue most recently. And others, such as Royce Funds, are just now trying to navigate it. Without access to contacts within the organization or with their peers, we only see shadows and flickers, “as through a glass, darkly.”

Hate it when that happens.

Andrew Foster, Sufi master

Sell your cleverness and buy bewilderment.
Cleverness is mere opinion, bewilderment intuition.
― Rumi, Masnavi I Ma’navi,ca. 1270

I like Andrew Foster, manager of Seafarer Overseas Growth & Income (SFGIX). I also respect him. The confluence of those two is rare.

In his essay “Self Reliance,” Emerson describes “foolish consistency” as “the hobgoblin of little minds.” The rough translation is the people don’t like to admit that they’re unsure, whether it’s about what to think or what to do, even to themselves. And so they come up with procedures, policies, explanations, Great Insights and Magic Rules and claim you can stop thinking worrying now. You’ll notice this in the classroom: young teachers are terrified at losing control or losing respect while really experienced ones are comfortable admitting that they simply don’t have nearly as many answers as they’ve got questions, suspicions or possibilities.

That came to mind in reading two of Mr. Foster’s recent pieces, his Fourth Quarter 2015 Portfolio Review and his Semi-Annual Report. Between the two, you get a sense of a guy who is really sharp but not under the illusion of his own omniscience.

The short version of investing in the emerging markets over the last couple years: things have been wildly volatile and mostly negative, China’s been a concern, Seafarer’s doing better than the great majority of its peers.

Most managers, whether they’re small minded or they think you are, would have said that in about three paragraph – emphasizing their own excellence in the latter – and hit “send.”

Mr. Foster approached things differently. His analysis was more nuanced, sharper, more self-effacing and more respectful of his readers’ intelligence than almost any of what I’ve read in the professional press. You should read it, but only if you have the time to think about what you’ve read because you’ll encounter more careful speculation than illusory certainty.

Why was the market rising at the start of the fourth quarter?

Between October 1 and November 4, the benchmark index rose 9.72%. There was no obvious reason for this gain.

Okay, so what explains Seafarer’s outperformance?

The Fund’s marginal outperformance was due to selected holdings in China, Japan, Indonesia and Turkey. Those holdings had no unifying theme or idea that could explain the basis for their performance during the quarter.

Perhaps it’s because you were defensively positioned on China?

Unfortunately, my notion of “defensive” valuations proved faulty.

Oh. Dja do any better on currencies?

My prediction [there] was terribly wrong.

Ah, I see. You’ve described Seafarer as a China-centric portfolio. What’s going on there?

I wish I knew with certainty. Unfortunately, the situation is sufficiently opaque that facts are scant, and thus I can only speculate as to the cause behind the A-share market’s sudden collapse.

Well, how about a guess then? Surely you’ll do better than the bobbleheads in the media.

Unfortunately, I can only speculate as to the actual cause of the decline, so my thoughts on the matter are frankly no better than the media’s. I have very few facts to substantiate my arguments; all I can do is look at the pattern of events that has unfolded, and speculate as to the causes. 

I’m getting desperate here, Andrew. Why not just fling a wild speculation or two at us?

I would suggest two possible scenarios that might have caused the sell-off:

1. The Renminbi’s weakness is not the direct cause of the decline, but it is a precursor for a growing liquidity shortage within the Chinese financial system. The currency’s persistent weakness may indicate that one or more banks, or perhaps some portion of the “shadow banking system,” may soon experience a liquidity crisis. This explanation would suggest the currency is signaling stressed liquidity within the financial system, to which stocks have reacted swiftly and punitively.
2. The current government is unstable. Over the past three years, the government has propagated a sweeping anti-corruption campaign that has sometimes terminated in controversial political purges. The government has also introduced bold economic reforms – reforms that I largely support – but that have undoubtedly alienated powerful vested interests. Meanwhile, the current president has sought to consolidate power in a manner not seen since Mao’s era. It might be that such dramatic actions have silently eroded support for the current government among powerful factions within the Communist party. If so, the weakness in the currency and the stock market might portend a deeper source of instability.

Either scenario might have been the root cause of the volatility we observed; it is also possible that both acted in tandem.

You get the idea, I think: rather more insight than ego, important arguments made in a clear and accessible style.

In terms of portfolio positioning, he’s finding better values in Latin America and Emerging Europe than in Asia, so the portfolio is the least Asia-centered in its history. Similarly, there are intriguing opportunities in larger firms than in smaller ones right now; he’s actually been surprised at his portfolio’s small- to mid-cap positioning, but that’s where the value has been.

Bottom line

Seafarer remains a core position in my non-retirement portfolio and I’ve been adding to it steadily. Valuations in the emerging markets are compelling, with stocks trading at P/E ratios of 5 or 6. I’m tempted to sell my holdings in Matthews Asia Growth & Income (MACSX) and roll them into Seafarer, mostly as an attempt to simplify, but the two really do seem to be driven by diverse forces.

For now, I’ll continue to invest in each and, mostly, ignore the noise.

The tough question remaining

If emerging markets are simultaneously our best and our worst investment option, what on earth do we do with them? There’s a near-universal agreement that they represent the cheapest stocks and most dynamic economies in the world. And yet, collectively, over the last decade EM equity funds have made 1.3% annually with a standard deviation of 23. Run away? Pretend that investing in Nestle is the same just because they sell a lot in emerging markets? Hedge, which is tough? Hybrid? Hope? The worst case is “hire Greed and Panic to manage your investments,” though that seems awfully popular.

The Weather

By Edward Studzinski

“When we unleash the dogs of war, we must go where they take us.”

Dowager Countess of Grantham

Starting off one of these monthly discussions with a title about the weather should be indicative that this piece will perhaps be more disjointed than usual, but that is how the world and markets look to me at present. And there is very little in the way of rational explanation for why the things that are happening are happening. My friend Larry Jeddeloh, of The Institutional Strategist, would argue that this country has been on a credit cycle rather than a business cycle for more than fifteen years now. Growth in the economy is tied to the price and availability of credit. But the cost of high yield debt is rising as spreads blow out, so having lots of cheap credit available is not doing much to grow the economy. Put another way, those who need to be able to borrow to either sustain or grow their business, can’t. A friend in the investment banking business told me yesterday about a charter school that has been trying to refinance a debt package for several years now, and has not been able to (thank you, Dodd-Frank). So once again we find ourselves in a situation where those who don’t need the money can easily borrow, and those who need it, are having difficulty obtaining it. We see this in another area, where consumers, rather than spend and take on more debt, have pulled back.

Why? We truly are in a moment of deflation on the one hand (think fuel and energy costs) and the hints of inflation on the other (think food, property taxes, and prescription drug costs on the other). And the debt overload, especially public debt, has reached a point where something has to be done other than kicking the can down the road, or other major crisis. I would argue we are on the cusp of that crisis now, where illiquidity and an inability to refinance, is increasingly a problem in the capital markets. And we see that, where the business models of businesses such as energy-related master limited partnerships, premised on always being able to refinance or raise more equity, face issues.

I was reading through some old articles recently, and came across the transcript in Hermes, the Columbia Business School publication, of a seminar held in May 1985 there. The speakers were Warren Buffett, James Rogers, Jr., and Donald Kurtz. As is often the case, sifting through the older Buffett can be rewarding albeit frustrating when you realize he saw something way before its time. One of the things Buffett said then was that, based on his observations of our political system, “ … there is a small but not insignificant probability that we will lose fiscal control at some point.” His point was that given a choice, politicians will always opt for an implicit tax rather than an explicit tax. If expenditures should determine the level of explicit taxes, than taxes should cover expenditures. Instead, we have built in implicit taxation, expecting inflation to cover things without the citizens realizing it (just as you are not supposed to notice how much smaller the contents are with the packaging changes in food products – dramatically increasing your food budget).

The easier way to think of this is that politicians will always do what allows them to keep doing what they like, which is to stay in office. Hence, the bias ends up being to debase the currency through the printing presses. So you say, what’s the problem? We have more deflation than inflation at this point?

And the problem is, if you look at history, especially Weimar Germany, you see that you had bouts of severe inflation and sharp deflationary periods – things did not move in a straight line.

Now we have had many years of a bull market in stocks and other assets, which was supposed to create wealth, which would than drive increases in consumption. The wealth aspect happened, especially for the top 5%, but the consumption did not necessarily follow, especially for those lower on the economic ladder. So now we see stock and asset prices not rising, and the unspoken fear is – is recession coming?

My take on it, is that we have been in a huge jobless recovery for most of the country, that the energy patch and those industries related to it (and the banks that lent money) are now beyond entering recession, and that those effects will continue to ripple through the rest of the economy. Already we see that, with earnings estimates for the S&P 500 continuing to drift lower. So for most of you, again, my suggestion is to pay attention to what your investment time horizons and risk tolerances are.

Moving totally down a different path, I would like to suggest that an article in the February 28, 2016 New York Sunday Times Magazine entitled “Stocks & Bots” is well worth a read. The focus of the article is about the extent to which automation will eliminate jobs in the financial services industry going forward. We are not talking about clerks and order entry positions. That revolution has already taken place, with computerized trading over the last twenty years cutting by way of example, the number of employees buying and selling stock over the phone from 600 to 4 at one of the major investment banking firms. No, we are talking about the next level of change, where the analysts start getting replaced by search programs and algorithms. And it then moves on from there to the people who provide financial advice. Will the Millennials seek financial advice from programs rather than stock brokers? Will the demand grow exponentially for cheaper investment products?

I think the answer to these questions is yes, the Millennials will do things very differently in terms of utilizing financial services, and the profit margins of many of today’s investment products, such as mutual funds, will be driven much lower in the not too distant future. Anecdotally, when one has a year in the markets like 2015 and the beginning of 2016, many investment firms would push down the bonus levels and payments from the highest paid to take care of the lower ranks of employees. I was not surprised however to hear that one of the largest asset managers in the world, based in Boston, had its senior employees elect to keep the bonuses high at the “partner” levels and not take care of the next levels down this past year. They could see the handwriting on the wall.

All of which brings me back to the weather. Probably suggesting that one should read a politically incorrect writer like Mark Twain is anathema to many today, but I do so love his speech on the New England weather. For a preview for those so inclined, “The lightning there is peculiar; it is so convincing that, when it strikes a thing it doesn’t leave enough of that thing behind for you tell whether – Well, you’d think it was something valuable, and a Congressman had been there.”

At a future point I will come back for a discussion of Mr. Twain’s essay “On the Decay of the Art of Lying” which might be essential reading as this year’s elections take shape.

High Dividends, Low Volatility

From the Trapezoid Mailbag:

A financial advisor in Florida is interested in low-volatility products. With the market so choppy, he would like to dial down risk in his client’s portfolio. He wondered whether SEI Institutional Managed Trust Tax-Managed Volatility Fund (TMMAX) was a suitable choice.

As Exhibit I illustrates low-volatility has been a successful investment strategy in recent years. A good argument can be made that historically, low-volatility stocks were mispriced. Players like Berkshire Hathaway and private equity capitalized on this by levering up these firms to deliver strong risk-adjusted returns. There is a heavy overlap between the low-volatility universe and the high-dividend universe. Many high-dividend stocks have dropped assets into REITs in recent years which have fueled better returns for this sector. Low volatility has outperformed the broad market meaningfully for the past two quarters, partly due its lower beta.

Trapezoid doesn’t take a view on whether these trends will continue or whether low-volatility is the best place to hide out in a tough market. In this instance, we wonder whether the “private equity bid” which contributed to the sector’s strong performance will be as reliable as corporate credit markets tighten and whether the increasing use of REIT/MLP structures has about run its course. What Trapezoid does do is help investors, advisors, and allocators find the best instruments to express their investment strategy based on extrapolation of historic skill in relation to risk.

There are several passive strategies which express the same theme. For example, Power Shares markets an S&P 500 Low Volatility Portfolio (SPLV) and an S&P 500 High Dividend Low Volatility Portfolio (SPHD). Those two funds move virtually in lockstep, underscoring the overlap between high dividend and low volatility. The correlation between the PowerShares indices and TMMAX is 98.5% and the expense ratio is 70-75 basis points lower.

Despite the availability of good passive indices, we would nonetheless consider TMMAX. The fund’s track record has been slightly above average, making us slightly confident (53%) it is worth the added cost. SEI also manages the SEI US Managed Volatility Fund which has a 50% confidence rating (slightly lower due mainly to higher expense ratio.)

SEI relies on three subadvisors to manage the fund. The largest sleeve is managed by Analytic Investors (39%) followed by LSV (35%) and AJO. While we don’t have sleeve-level data, we can evaluate the body of work by Analytic and LSV looking at comparable sole-managed funds. Analytic’s track record the past five years on Touchstone Dynamic Equity Fund (TDELX) is good but the previous five years were poor. LSV’s record at LSV Conservative Value Equity Fund (LSVVX) and Harbor Mid-Cap Value Fund (HIMVX) was middling.

We have discussed in the past that Morningstar star ratings have some predictive value but that even a five-star rating is not sufficient to make an investment decision. The SEI funds are good examples. TMMAX, SEVIX, and SXMAX all carry five star ratings, and we agree investors are better off choosing these funds than many of the alternatives but the evidence of manager skill is inconclusive.

If the advisor is willing to expand his horizons a little, he can find similar funds which improve the odds a little. We used the Orthogonal Attribution Engine to find highly correlated funds with better confidence ratings and came up with the following.

A few observations

• T. Rowe Price Capital Appreciation Fund (PRWCX) is closed to new investors
• The two Vanguard funds attempt to outperform their benchmark indices using a quantitative strategy.
• Many of the other similar funds have higher betas, which may be a deal breaker for our advisor who wants to reduce his client’s market exposure
• Many of these funds are large blend funds, accessible to demo customers at the www.fundattribution.com website.
• Our confidence ratings are based on data through 10/30/15. In the subsequent months TMMAX’s performance lagged the lower-cost PowerShares indices. This may serve to erode our confidence that active management pays for itself. Updated data will be posted shortly

The heightened appeal of low-volatility funds might suggest something else: Advisors are more focused on extreme negative outcomes which could get them fired than extreme positive outcomes. In a choppy market, low-volatility funds have the allure of a safe haven. We don’t have a view on the wisdom of this. But we are interested in helping allocators avoid individual managers who have the potential to “blow up.” One of Trapezoid’s forthcoming new metrics hones in on this risk by focusing on the likelihood of extreme negative outcomes.

Offered without comment: Your American Funds share class options

MFO Rating Metrics

When MFO introduced its rating system in June of 2013, it chose Martin Ratio as the principal performance rating metric. Martin is a risk adjusted return metric that is the ratio between excess return, which is the compounded annualized total return above risk free T-Bill return, divided by the so-called Ulcer Index, which is a measure of extent and duration of drawdown. Our friend Peter Matin formulated the Ulcer Index as described in An Alternative Approach to the Measurement of Investment Risk & Risk-Adjusted Performance.

For each fund category, like Large Growth or Moderate Allocation, the MFO Rating system divides funds into five groups or “quintiles” based on the risk adjusted return over selected evaluation periods. Funds with the highest Martin in each category are assigned a 5, while those with the lowest receive a 1.

While this approach suits many MFO readers just fine, especially having lived through two 50 percent equity market drawdowns in the past 15 years, others like Investor on the MFO Discussion Board, were less interested in risk adjusted return and wanted to see ratings based on absolute return. Others wanted to see ratings based on the more traditional risk adjusted Sharpe Ratio. (For more definitions, see A Look A Risk Adjusted Returns.)

It took a while, but subscribers on our MFO Premium site can now choose which rating metric they prefer, including multiple rating metrics simultaneously.

For example, since the start of the current market cycle in November 2007, which Small Cap funds have delivered the best absolute return (APR) and the best Martin Ratio and the best Sharpe Ratio? To find the answer, enter the selection criteria on the MFO MultiSearch tool, as depicted below (click image to enlarge), then hit the “Submit Search” button …

A total of 28 funds appear from the more than 9,000 unique funds in the MFO database. Here are the first 10, sorted by MFO Risk and then name:

Notables include Brown Capital Mgmt Small Company (BCSIX), Champlain Small (CIPSX), Conestoga Small Cap (CCASX), and FMI Common Stock (FMIMX). The closed BCSIX is both an MFO Great Owl and Fund Alarm Honor Roll fund. It is also a Morningstar Gold Medal fund, while Silver goes to CIPSX and CCASX.

Intrepid Endurance (ICMAX) has the lowest risk rating with a MFO Risk of 3, which means this fund has historically carried volatility suited for investors with Moderate risk tolerance. Unlike other metrics in the MFO ratings system, and in fact the risk metric in Morningstar’s rating system, which assign risk relative to other funds in category, the MFO Risk metric assigns its rating based on volatility relative to the overall market.

The MFO MultiSearch tool now enables searches using more than 55 screening criteria, organized by Basic Info, Period Metrics, Composite Period Metrics, MFO Designations, Portfolio Characteristics, and Purchase Info. A list of current criteria can be found here.

The Alt Perspective: Commentary and news from DailyAlts.

Pruning Season

You can call it a cycle, a season, or even a cleansing process, but when one looks at the liquid alternatives market, it’s apparent that there is some pruning going on. Some cleaning out of the products that no longer appeal to investors, those that hit a performance patch from which it would be near impossible to recover, or just didn’t gather the requisite assets for a fund to be viable. Clean out the funds that are not producing the intended results, or just aren’t resonating with investors.

This is all a healthy process as it makes room for newer products, the next generation. It also allows for a greater investment into existing products. Interestingly, we have already seen 9 alternative funds liquidated in the first two months of the year (and at least two more schedule to be liquidated) – some announced late last year, but nonetheless, fully liquidated in 2016. And these are from some bigger names in the industry, such as Lazard, Collins, Whitebox, Virtus, Ramius and Clinton. Some seasoned hedge fund managers in there, along with seasoned asset management firms.

Four of the liquidate funds were long/short equity funds, two were multi-alternative funds, and the remaining three included market neutral, event driven and non-traditional bonds. All in all, I think we will see more pruning in the coming months as fund managers rationalize their fund lineup as markets sell off, and begin thinking about the next set of products to introduce to the market.

The pruning process is healthy and helps future growth, so don’t be surprised to see more down the road. It’s just part of the natural cycle.

Asset Flows

January saw a continuation of 2015 where investors continued to pour money into multi-alternative funds and managed futures funds (inflows of $1.2 billion and $1.5 billion, respectively), while pulling assets from non-traditional bond funds, long/short equity and market neutral (-$3 billion, -$390 million and -$340 million, respectively). Excluding non-traditional bond funds and commodities, alternative mutual funds and ETFs gathered a total of $2.4 billion in January, bringing the total 12-month haul to $18.7 billion, third of any category behind international equity and municipal bonds and 11.5% of all net asset inflows.

Commodities bounced back in January with total inflows of $3.3 billion, led primarily by flows to precious metals funds, and gold funds in particular. Non-traditional bond funds, viewed as an alternative to long-only bond funds and a protective hedge against interest rate increases, have continued to disappoint in the aggregate. As a result, investors have pulled $17.9 billion of assets from these funds over the past 12 months.

Extended Reading

What did DailyAlts readers enjoy the most this past month? The three of the most widely read articles this past month were:

• Adding Liquid Alts to DC Plans and Target-Date Funds
• Distinction Between Mutual Funds and Hedge Funds Is Eroding
• Understanding Liquid Alternatives: Ask The Right Questions

While it appears to be pruning season, that doesn’t mean it is time to stop looking for alternative funds. With Spring approaching, now is a good time to take a look across your portfolio at the risks you have exposure to, and perhaps do a bit of pruning of your own to balance risks and hedge for what might be more volatility ahead.

Have a great March, and to keep up with daily or weekly news in the liquid alts market, be sure to sign up for our newsletter.

Observer Fund Profiles: LSOFX / RYSFX

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.

LS Opportunity Fund (LSOFX): this was a really solid long/short fund that had to press the “reset” button last May when their sub-advisor decided to pack it up and call it a career. In Prospector Partners, they may have found a team that executes the same stock-by-stock discipline even more excellently than their predecessors.

Royce Global Financial Services (RYFSX): when you think “financial services,” you likely think “monstrous big banks with tendrils everywhere and eight-figure bonuses.” Royce thinks differently, and their focus on smaller firms that dominate financial niches worldwide has made a remarkable difference for their investors.

Elevator Talk: Jim Robinson, Robinson Tax-Advantaged Income (ROBAX)

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.

Jim Robinson formed Robinson Capital Management, located in Detroit’s ritzy Grosse Pointe suburb, in December, 2012. The firm manages about a quarter billion in assets for a handful of high net worth clients and advises two (soon to be three) mutual funds.

From 1987-1999, Mr. Robinson served as the Fixed Income CIO for the Munder Funds. During his stint, he grew fixed income AUM from $100 million to $20 billion. Eventually promoted to Chairman, CEO and President, he was responsible for about $38 billion in assets. He left Munder for Telemus Capital Partners, LLC, with whom his firm still has a relationship.

Robinson Capital uses a variety of strategies in their separate accounts. The Tax-Advantaged Income Fund pursues one strategy: it invests in closed-end muni bond funds. Closed-end funds (CEFs) are strange creatures, the forerunners of today’s actively-managed ETFs. They have managers and portfolios like open-end mutual funds do, but trade on exchanges like stocks and ETFs do. Such funds have several relevant characteristics:

1. They are far more likely to pursue income-oriented strategies than are open-end funds
2. They are far more likely to make extensive use of leverage and hold more illiquid securities than are open-end funds
3. Because they trade on exchanges, the managers never need to worry about meeting redemptions or closing the fund to new investors; they issue a set number of shares of the CEF during their initial public offering but after that they let buyers and sellers find each other.
4. Because they trade on exchanges, the market price of their shares changes minute-by-minute, and
5. Because they trade on exchanges, the net asset value of a share (the market value of all of the fund’s holdings divided by the number of shares outstanding) can diverge dramatically from that share’s market price (that is, the amount a potential seller can get at one particular moment for a share of the fund).

When shareholders panic, they may succumb to the temptation to sell shares of their fund for 15, 20 or even 40% less than they’re nominally worth, just because the seller really wants cash-in-hand. That’s mostly irrational. A handful of mutual fund firms – RiverNorth, Matisse, and Robinson among them – look to profit from panic. Using various metrics, they decide when to move in and buy shares that are selling at an unsustainable discount to their net asset values.

If everything goes according to plan, that strategy offers the potential for sustained, substantial, market-neutral gains: as soon as panic subsides, even if the market is still falling, a degree of rationality returns, investors start buying the discounted CEF shares, that bids up the price and the discount closes. If you invest before the crowd, you benefit when the shares you bought at, say, a 25% discount can now be sold at just a 5% discount.

Here’s a hypothetical illustration: the NAV of the Odd Income Fund is $100/share but, when rumors of dinosaurs rampaging down Wall Street rattles people, its market price drops to $75/share. Robinson moves in. In six months, the panic has passed, Odd Income’s NAV has risen a couple percent and its discount contracted to its non-panic norm of 5%. In such a scenario, Odd Income has earned 2% but folks who bought shares during the panic earned 29%.

There are distinct risks to playing this game, of course. The falling knife might continue to fall harder and faster than you’d imagined so that the 25% discount might widen to 35%. The manager of the underlying CEF might find that using leverage in a panicky market drives down the fund’s NAV as well as its market price. And, too, the CEF manager might simply do something stupid. It happens.

The folks who manage CEF-focused funds argue that downside risks are manageable through a combination of careful security selection, position-size limits and hedging. The upside can be dramatic. Here is the performance chart for ROBAX against two possible benchmarks: its Morningstar non-traditional bond peer group (orange) and long-term national muni bond group (yellow).

Here are Mr. Robinson’s 200 words on why investors concerned about income and income taxes should add ROBAX to their due-diligence list:

I generally tell people that the first three things you need to know about our fund are these:

• We pay out 40 basis points a month in tax-exempt income, on average
• We present very little credit risk; our portfolio’s credit quality is A/A+
• We hedge out interest rate risk, such that our effective duration is under a year.

There are 191 Tax-exempt closed-end funds. Today, 150 are trading at a discount to NAV. Some of those discounts are rational; if you have a poorly-managed fund buying difficult-to-price securities and misusing leverage, it should be trading at a discount. Heck, I analyze some of these funds and suspect the discount should be bigger than it is.

What we do is move money from rationally discounted funds to irrationally discounted ones. Six large fund companies – BlackRock, PIMCO, Nuveen and company – dominate the CEF space. That’s important because those companies have pretty good governance practices in place; BlackRock is aggressive about merging funds to harvest economies of scale, others do share buybacks and so on. When funds with good management, good governance and good portfolios sell at irrational discounts, we move. Bill Gross did me a big favor. Two days before we launched, he resigned from PIMCO. Gross had nothing to do with PIMCO’s CEFs but suddenly funds that always trade at a premium were available at a discount. We moved in, the discount predictably reversed, and we closed the position at a nice profit. That discount arbitrage adds about 200 bps to our performance.

The other thing we do that individual investors can’t, and that most advisors would find tough, time-consuming and expensive, is we largely hedge interest rate risk out of the portfolio. Tax-exempt CEFs tend to be long-dated and leveraged so they typically have 10-12 year weighted durations. In a year like 2013 when rates rise 1%, they lose 10-12% in principal value. Our hedge is not perfect, since Treasuries and munis don’t trade in perfect sync, but it’s pretty good.

Robinson Tax-Advantaged Income has a $2500 minimum initial investment for the “A” shares and $1,000,0000 for “I” shares. While there’s a sales load, load-waived shares are widely available. Direct expenses are capped at 1.60% on the “A” shares. Since the fund invests in other funds, you indirectly pay (through lower returns) a portion of those funds’ expenses. In 2014, that added 1.14% to ROBAX’s today expenses. The fund has about gathered about $74 million in assets since its September 2014 launch. Here’s the fund’s homepage.

Funds in Registration

Funds need to submit their prospectuses for SEC review before they’re permitted to offer the fund to the public. The SEC has 75 days in which to ponder the matter, which means that proposed new funds cool their heels for about two and a half months. During that time their prospectuses are available for review on the SEC’s website but fund advisors are forbidden to talk publicly about them. Each month Funds in Reg gives you a heads-up about what’s in the SEC pipeline.

Except for last month, when I stupidly forgot to include the file in our February issue. As a result, this month we cover the last two sets of no-load retail funds that will become available between March and May. We found 17 funds that qualify. Particularly interesting morsels include:

• 361 Domestic Long/Short Equity Fund, which will be managed by a really renowned investor – Harindra de Silva – who has a earned a great deal of respect in the industry and who already manages a number of top-ranked funds.
• Matthews Asia Credit Opportunities, which appears to be a high-yield, distressed securities version of the very fine Matthews Asia Strategic Income Fund.
• RiverPark Commercial Real Estate Fund, the latest entry in RiverPark’s quest to bring hedge fund strategies to “the mass affluent.” This fund has been running as a hedge fund for about five years now.

Sadly, there are a handful of future “Off to the Dustbin of History” nominees as well but I suppose that’s the magic of capitalism: 90% of the stuff we try fails, 9% does okay and 1% changes the world.

Uzès Grands Crus I

The French, being French, have their financial priorities in order. In February, Financière D’uzès announced the launch of their third mutual fund devoted to the investment potential of bottles of fine wine. At least 75% of the fund’s assets will be bottles of fine and their aim is “to outperform the annual rate for the five-year French treasury bond (OAT) with a minimum return of 5%.”

I reflected, very very briefly, on the investment value of the bottle of Lambrusco I bought at Trader Joe’s for $4.99, then made mid-winter sangria instead.

Manager Changes

The biggest news, by far, this month is the impending departure of Taymour R. Tamaddon from T. Rowe Price Health Sciences (PRHSX) and Donald Yacktman from his namesake funds. When Kris Jenner left the fund three years ago (how time flies!), the accepted wisdom was that nobody could live up to his legacy. Mr. Tamaddon then led the fund to 22.4% annualized returns, nearly 500 bps above his peers and good enough for a top 2% record.

Mr. Tamaddon steps down on July 1, 2016, is succeeded by Ziad Bakri then becomes manager of the $12 billion T. Rowe Price Institutional Large-Cap Growth Fund (TRLGX) on January 1, 2017.

Effective May 1, 2016, Donald A. Yacktman will transition to an advisory role and will no longer serve as a portfolio manager for AMG Yacktman (YACKX) and AMG Yacktman Focused (YAFFX) funds. The roughly corresponds with his 75^th birthday. Mr. Yacktman has been managing mutual funds since 1968, starting with Stein, Roe and the Selected American Shares before founding Yacktman Asset Management in 1992. $10,000 invested in YACKX that year would have grown to $95,000 today, which compares well to the returns on an investment in the S&P500 ($76,000) or the average large-value fund ($56,000). He was named Morningstar’s Manager of the Year in 1991 and was joined on the management team by his son, Stephen, in 2002. Stephen Yacktman and Jason Subotky will manage the funds after the transition.

Other than that, we found about 36 manager changes, a few years overdue.

Updates

Sequoia Fund (SEQUX) continues its defense of Valeant Pharmaceuticals in its Annual Report (2016) and they continued dodging the issue.

For the stock to regain credibility with long-term investors, Valeant will need to generate strong earnings and cash flow this year, make progress in paying down some of its debt, demonstrate that it can launch new drugs from its own development pipeline and avoid provoking health care payers and the government. The company has committed to doing all of these things and we are confident interim CEO Howard Schiller and interim board chairman Robert Ingram are focused on the right metrics. Before CEO J. Michael Pearson went out on an extended medical leave, he also seemed committed to this path.

“Avoid provoking health care payers.” Oh, right. That would be the predatory pricing model that attracted Sequoia to Valeant in the first place: Valeant would borrow money to buy a small pharmaceutical firm, then quintuple the price of the firm’s products. If that meant putting a few inexpensive lives at risk, well, that wasn’t Valeant’s problem.

Until it was. Before the blow-up, manager David Poppe’s tone was openly affectionate about “Mike,” Valeant’s president and almost giddy about the prospects. Valeant’s high-profile implosion cost Sequoia a lot:

As the largest shareholder of Valeant, our own credibility as investors has been damaged by this saga. We’ve seen higher-than-normal redemptions in the Fund, had two of our five independent directors resign in October and been sued by two Sequoia shareholders over our concentration in Valeant. We do not believe the lawsuit has merit and intend to defend ourselves vigorously in court. Moving along …

“Moving along”? No, it’s not time to move along, guys. Barron’s Chris Dieterich provides a nice synopsis of developments that transpired on February 29, the day Sequoia released their report:

Monday ushered in a nightmarish combination of trouble. First, Valeant said it would delay the release of its quarterly results. Then, news broke that Allergan (AGN) is challenging the patent to Xifaxan. Third, Moody’s Investors Service warned that it may need to downgrade portions of the company’s $31 billion of debt. Finally, headlines crossed the tape that Valeant faces a previously undisclosed investigation by the Securities and Exchange Commission.

All told, the stock plunged 18% to $65.80 — a fresh three-year low (“Sequoia Fund Picked A Bad Time To Stick Up For Valeant”).

The bigger, unanswered question is what does this say about you as investors? Any damage to your credibility is (a) self-inflicted and (b) deserved. You committed one third of your fund and all of your credibility to an amoral little schemer who, on his best days, stayed right at the edge of what’s legal. That’s a fact you acknowledged. Then you implicitly compared him to Warren Buffett, an investor whose moral compass, operating style and record makes him utterly incomparable.

Investors might, heck, investors must, ask: where was your brain? Were you so blinded by the prospect of easy money that you chose to ignore the hard questions? The most optimistic interpretation is that you’re not addressing such questions because you’re being sued and you can’t afford to admit to whatever idiocy led to the resignations of 40% of your board last fall. The worrisome interpretation is that Sequoia isn’t Sequoia anymore; that the clarity of thought that guided it to renown in decades past mostly now serves to mask a less exalted management.

Think it can’t happen? Check Magellan, Fidelity (FMAGX), the other Titan which has now managed to trail its peers over the past five, ten, fifteen and twenty year periods. Utterly dominant in the market cycle from 1973-1987 when it beat its peers by 1000 basis points/year, the fund hasn’t even managed consistent mediocrity since.

Morningstar doesn’t share my reservations and SEQUX retains a “Gold” analyst rating from the firm. Their equity analyst also doesn’t share my concerns about Valeant, which they rate (on 3/1/16) as a five-star stock whose shares are selling at about one-third of their fair value. Senior equity analyst Michael Waterhouse doesn’t “anticipate any major shift in our long-term thinking for the company.”

Briefly Noted . . .

SMALL WINS FOR INVESTORS

Chou has voluntarily decided to waive its entire advisory fee on the Chou Opportunity Fund (CHOEX) beginning on January 1, 2016. In addition, on February 18, 2016 Chou made a voluntary capital contribution to the Opportunity Fund in the amount of $918,468, which approximates the advisory fees retained by Chou with respect the Opportunity Fund last year. Why, you ask? The advisor describes it as “a gesture of goodwill … in recognition of the fund’s underperformance” in 2015. That’s an oblique reference to having lost 22% in 2015 and another 20% in the first two months of 2016.

The advisor to the Great Lakes Bond Fund has closed the fund’s Investor Class (GLBDX) and converted the former Investor accounts into Institutional Class (GLBNX) ones. They then lowered the minimum on the Institutional shares by 99%, from $100,000 to $1,000. Net, potential retail investors save 25 bps.

Hotchkis & Wiley Mid-Cap Value Fund (HWMAX) has reopened to new investors.

RS Partners Fund (RSPFX) reopened to new investors on March 1, 2016. None of the fund’s independent trustees have chosen to partner with you by investing in the fund. The managers’ investment in the fund ranges between “modest” and “none.”

Walthausen Small Cap Value Fund (WSCVX) reopened to new investors on March 1, 2016.

Wasatch Emerging Markets Small Cap Fund (WAEMX) has reopened to new investors. Thanks for the heads up, Openice!

CLOSINGS (and related inconveniences)

Nope, turns out “turning away money” wasn’t a popular move in February. We found no funds closing their doors.

OLD WINE, NEW BOTTLES

Armor Alternative Income Fund (AAIFX) has become Crow Point Alternative Income Fund. 

Diamond Hill Strategic Income Fund (DSIAX) has been renamed the Diamond Hill Corporate Credit Fund to better reflect what it’s up to.

Forward no more. On May 1, 2016, the name “Forward” disappears from the world of mutual funds. In general, all of the former Forward Funds will be renamed as Salient Funds, which no change other than substituting “Salient” for “Forward” in the name. There are a few exceptions,

TIAA-CREF has boldly rebranded itself as TIAA.

Straightforward. Yep. 74%. Unless you’re buying the retail share class in which case it’s nine of 33 funds excluding money markets, or 27%. 32.5% of all funds receive either four- or five-stars from Morningstar.

And about that “uncomplicated” thing? Count the number of clicks it takes you to get to any particular fund. It took me two cups of coffee before I finally got to the one I wanted.

As of May 9, 2016, Transparent Value becomes … well, insert your own snark here. In any case, the Transparent Value Funds become Guggenheim Funds.

On March 1, 2016, The Wall Street Fund (WALLX) became Evercore Equity Fund (EWMCX). The word “Equity” in the name also triggered a new promise in the prospectus that the fund, which already invests in equities, promises to invest in equities.

OFF TO THE DUSTBIN OF HISTORY

On whole, fund companies would be well-advised to extract their heads from their behinds. If you’re not willing to stick with a new fund for, say, a whole market cycle, then don’t launch the damned thing. The hypocrisy of declaring that you’re “long-term investors” and that you want to be “partners” with your investors, then closing a fund after 12-24 months, is toxic. It conveys some combination of the following three messages: (1) we’re panicked. (2) We have no ability to plan. (3) Pretty much everything we said when we launched the fund was cynical B.S. crafted by marketers who were, themselves, probably disgusted with us.

Which of those messages do you really want to be associated with?

Okay, back to the ranks of the walking dead and the dead dead after a short word of thanks to The Shadow, one of the stalwarts of our discussion board whose daily updates on the comings and goings is enormously helpful in keeping this list current.

Let’s go to Plan B: Under Plan A, Arden Alternative Strategies Fund (ARDNX) was slated to become Aberdeen Multi-Manager Alternative Strategies Fund (no ticker) on March 31, 2016. That made perfect sense since Aberdeen acquired Arden. Plan A survived for about a week when someone likely noticed that the fund wasn’t actually very good, was shrinking in size and required an annual expense subsidy from the adviser, whereupon Plan B emerged: kill it. Same date.

BPV Core Diversification Fund (BPADX) has closed and will be terminated on March 11, 2016. It’s a tiny, conservative fund that’s still managed to lose money over the past three years and trail 90% of its peers.

On February 17, 2016, the CGM Advisor Targeted Equity Fund (NEFGX, reflecting its birth name: New England Growth Fund) was liquidated. Financial Advisor magazine managed to wax nostalgic over the loss of a “venerable” and “once-vaunted” fund. Two quick notes about this: (1) the fund hasn’t earned its keep over the past 20 years. Its closing NAV was below its NAV in 1994. The 20 year performance chart is the very image of what to avoid in your investments:

And (2) you can still access the manager’s skills, if you’d like. Natixis, the fund’s sponsor, no longer has an ownership stake in CGM and so they had no interest in continuing to sponsor a fund. Mr. Heebner continues to run three other CGM funds. Their website would also win the award for the industry’s least useful.

Collins Alternative Solutions Fund (CLLAX) liquidated on February 26, 2016. The fund had about $19 million in assets and dropped 19% in its final year of operation.

Crystal Strategy Absolute Income Fund (CSTFX), Crystal Strategy Absolute Return Fund (CSRAX) and Crystal Strategy Absolute Return Plus Fund (CSLFX) will, based on the recommendation of Brinker Capital, LLC, the investment adviser, be liquidated on March 18, 2016. The funds are just past their second anniversary. Between them they have $16 million in assets and a sorrowful performance record.

Dreyfus Strategic Beta U.S. Equity Fund (DOUAX) will liquidate in mid-April.

The Fortress has fallen! Fortress Long/Short Credit Fund (LPLAX) liquidated on February 12, 2016, about three years too late. The fund lost about 25% over its lifetime. It peaked in December 2012 and its chart since then looks, for all the world, like a child’s drawing of steps leading down to the basement.

Frost International Equity Fund (FANTX) will liquidate on March 31, 2016. The announcement helpfully notes that they’ll refer to that as “the liquidation date.” I think I went on one of those in college.

Gottex Endowment Strategy Fund (GTEAX) is liquidating after about 20 months of operation. In that time it lost about 12% for its few investors.

Guidestone Real Assets Fund (GRAZX) will liquidate on April 29, 2016. It’s a tiny fund-of-funds that’s designed to protect you from inflation by investing in things that are cratering. That’s not intentional, of course, but sectors that would be durable if inflation arose – energy, natural resources, real estate – have been disasters.

The $3 million JPMorgan Asia Pacific Fund (JAPFX) will liquidate on April 6, 2016.

Investors in the Lazard Master Alternatives Portfolio (LALOX) need to find an alternative since the fund was liquidated on March 1, 2016. The fund was 14 months old.

MassMutual Barings Dynamic Allocation Fund (MLBAX) will be dissolved on July 8, 2016. It isn’t an awful tactical allocation fund but it’s tiny and misallocated in the last year, costing its investors 11.5%.

Merk Asian Currency Fund (MEAFX) liquidated on February 29, 2016. From inception in 2008 until liquidation, the fund was above water once, briefly, in 2011.

Meyers Capital Aggressive Growth Fund (MAGFX) liquidated on February 29, 2016, on about three weeks’ notice. Since the manager owns 87% of the funds’ shares, he might have seen it coming. The oddest development is the collapse of the fund’s asset base: in May, Mr. Meyers owned over $1,000,000 in fund shares. By February 2016,the fund only had $130,000 in assets.

Oberweis Asia Opportunities Fund (OBAOX) will be merged into Oberweis China Opportunities Fund (OBCHX) on or about April 29, 2016.

Philadelphia Investment Partners New Generation Fund (PIPGX), having lost 35% in the past 12 months, is now going to lose its head. The execution is March 30, 2016.

After the advisor concluded that Satuit Capital U.S. SMID Cap Fund (SATDX) was not economically viable, they decided “to close the Fund, wind up its affairs, liquidate its portfolio.” I’ve never seen “wind up its affairs,” which the announcement uses twice, in a fund liquidation filling before. Huh. The fund is not yet two years old and had attracted only a couple million, despite a really strong record. The deed is done on April 30, 2016.

Having concluded that the Smith Group Small Cap Focused Growth Fund (SGSVX) has “limited prospects for meaningful growth,” its board authorized liquidation of the fund on March 31, 2016. One can’t fault the managers for a lack of commitment: internal ownership accounted for about two-thirds of the fund’s $600,000 in assets.

Strategic Latin America Fund (SLATX) liquidated in late February, 2016. 

Touchstone Global Real Estate Fund (TGAAX) will liquidate on March 30, 2016. The board attributes the decision to “the Fund’s small size and limited growth potential.” An interim manager, apparently someone who specializes in “safeguard[ing] shareholder interests during the liquidation period,” has been appointed. It’s the sad case of a good fund not finding its audience: top 25% returns over the past five years and even better returns recently, but still only $17 million in assets.

Sometime in mid-summer Victory CEMP Multi-Asset Balanced Fund (CTMAX) will be absorbed by Victory Strategic Allocation Fund (SBALX). As is so often the case, CTMAX is larger and weaker so they’ll bury its record while tripling SBALX’s assets.

On February 5, 2016, Virtus Dynamic Trend Fund merged into Virtus Equity Trend Fund (VAPAX). I’m slightly startled to report that, despite trailing 98—99% of its peers over the intermediate term, VAPAX retains $1.5 billion in assets.

Wanger International Select (WAFFX) will liquidate at the end of March. It appears to be available only through insurance products.

WHV/EAM Emerging Markets Small Cap Equity Fund (WVEAX) and WHV/EAM International Small Cap Equity Fund (WHSAX), rather less than two years old, will liquidate on or about March 31, 2016. Both funds had very strong performance. WHV/Seizert Small Cap Value Equity Fund (WVSAX), a bit more than two years old, will liquidate a month later.

In Closing . . .

Thanks, as always, to folks who’ve supported the Observer in thought, word or deed. Welcome, especially, to Nick Burnett, long-time friend, grad school roommate and mastermind behind the CapRadioCurriculum which helps teachers connect public radio content with classroom lessons. There’s a cool one on multilingual public relations that I rather liked. Thanks, as ever to the ongoing generosity of the folks at Gardey Financial and our first subscribers, Deb and Greg. Thanks to Gary, who didn’t particularly want premium access but did want to help out. Mission accomplished, big guy! Too, to MaryRose, we’re trying to help. Welcome to Abdon Bolivar, working hard to get people to understand the role that plan administrators play in creating and sustaining bad options for investors. By coincidence, Tony Isola and the folks are Ritholtz Wealth Management are pursuing a parallel track trying to educate educators about what to do if they’re getting screwed by the 403(b). And, in a horrifying number of cases, they are.

And so, thanks to you all, not just for your support of the Observer but for all the good work you’re doing for a lot of people.

We’re waiting to talk with the folks at Otter Creek Partners, a hedge fund firm with a small long/short fund that’s performed splendidly. That conversation will let us finish up our profile of Otter Creek Long/Short Opportunity (OTCRX) and share it with you. We’ll add a look at Intrepid Endurance (ICMAX) in conjunction with my own portfolio review. We’ll look for the launch of Seafarer Overseas Value, likely around the 75^th day of 2016. We’ll look for you.

Dear friends,

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

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

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

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

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

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

Duh. Cheerleaders lead cheers.

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

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

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

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

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

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

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

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

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

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

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

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

Key points from their latest essay:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Three things stand out:

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

Mike does not like to issue equity.

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

… early on in Mike’s reign …

I think Mike said the company was going to …

We met with Mike a few weeks ago and he was telling us how with $300 million, you can get an awful lot done.

Mike can get a lot done with very little.

Mike is making a big bet.

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

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

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

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

Sequoia’s recent shareholder letter concludes by advising Valeant to start managing with “an eye on the company’s long-term corporate reputation.” It’s advice that we’d urge upon Sequoia’s managers as well.

The Price of Everything and the Value of Nothing

By Edward Studzinski

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

                             Oscar Wilde

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

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

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

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

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

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

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

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

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

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

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

By Leigh Walzer

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

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

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

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

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

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

Table I

Skill Projections for Major US Large Blend Funds

A few caveats:

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

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

Table II

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

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

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

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

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

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

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

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

Table III

Return Attribution: Sterling Capital Special Opportunities Fund

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

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

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

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

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

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

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

Table IV

Highly-Rated Large Blend Quantitative Funds

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

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

Bottom Line:

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

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

Five great overlooked little funds

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

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

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

To which I can only say, “wow.”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Climate Change is a Thing

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

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

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

On emerging markets: “never again”

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

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

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

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

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

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

A picture for the Ultimus Client Conference folks

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

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

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

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

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

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

It’s worth considering.

Jack and John, Grumpy Old Men II

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

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

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

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

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

But those other 25,000 funds …

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

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

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

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

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

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

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

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

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Matching your funds and your time horizon

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

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

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

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

Gold- and Silver-rated Flexible bond funds

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

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

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

Alive and kicking: The return of Cap Gains Valet

By Mark Wilson, APA, CFP®, Chief Valet

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

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

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

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

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

Top developments in fund industry litigation

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

Orders & Decisions

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

New Lawsuits

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

The Alt Perspective: Commentary and news from DailyAlts.

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

Asset Flows

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

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

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

New Fund Filings

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

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

Research

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

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

Have a wonderful November, and Happy Thanksgiving to all.

Observer Fund Profiles: RNCOX

Each month the Observer provides in-depth profiles of between two and four funds. Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds. “Stars in the Shadows” are older funds that have attracted far less attention than they deserve.

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

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

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

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

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

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

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

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

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

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

Funds in Registration

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

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

Manager Changes

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

The Navigator: Fund research fast

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

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

Updates: INNAX, liquidity debate

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

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

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

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

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

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

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

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

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

Comparing Lipper Ratings

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

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

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

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

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

Overall, the changes appear quite satisfactory.

Briefly Noted . . .

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

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

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

SMALL WINS FOR INVESTORS

Not a lot to cheer for.

CLOSINGS (and related inconveniences)

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

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

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

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

OLD WINE, NEW BOTTLES

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

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

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

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

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

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

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

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

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

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

OFF TO THE DUSTBIN OF HISTORY

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In Closing . . .

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

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

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

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

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

We’ll look for you.

Dear friends,

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

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

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

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

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

Leuthold: a cyclical bear has commenced

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

Who are they?

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

Why pay any attention?

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

What’s their argument?

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

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

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

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

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

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

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

52% long equities

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

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

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

3% cash

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

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

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

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

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

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

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

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

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

The Field Guide to Bears

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

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

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

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

Some Morningstar ETF Conference Observations

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

We Are Where We Are!

By Edward A. Studzinski

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

Lillian Hellman

Current Events:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The End

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

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

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

Edward A. Studzinski

P.S. – Where Eagles Dare

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

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

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

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

Why Vanguard Will Take Over the World

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Why Vanguard May Not Take Over the World

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

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

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

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

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

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

Summary

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

Needles, haystacks and grails

By Leigh Walzer, principal of Trapezoid LLC.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

TABLE 2

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

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

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

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

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

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

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

Your feedback is welcome at [email protected].

Top developments in fund industry litigation

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

Orders

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

New Lawsuits

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

Briefs

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

The Alt Perspective: Commentary and news from DailyAlts

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

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

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

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

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

And a few non-traditional asset classes:

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

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

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

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

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

A few research papers of interest this past month:

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

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

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

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

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

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

Since the number of funds we can cover in-depth is smaller than the number of funds worthy of in-depth coverage, we have decided to offer one or two managers each month the opportunity to make a 200 word pitch to you. That’s about the number of words a slightly-manic elevator companion could share in a minute and a half. In each case, I’ve promised to offer a quick capsule of the fund and a link back to the fund’s site. Other than that, they’ve got 200 words and precisely as much of your time and attention as you’re willing to share. These aren’t endorsements; they’re opportunities to learn more.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Launch Alert: Thornburg Better World

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

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

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

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

Funds in Registration

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

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

Manager Changes

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

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

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

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

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

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

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

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

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

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

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

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

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

Briefly Noted . . .

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

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

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

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

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

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

SMALL WINS FOR INVESTORS

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

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

CLOSINGS (and related inconveniences)

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

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

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

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

OLD WINE, NEW BOTTLES

Aberdeen U.S. Equity Fund

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

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

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

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

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

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

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

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

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

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

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

OFF TO THE DUSTBIN OF HISTORY

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

MFO Switches To Lipper Database

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

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

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

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

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

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

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

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

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

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

In Closing . . .

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

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

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

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

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

We’ll look for you.