Dear friends,

It’s the BOJ’s fault. Or the price of oil’s. Perhaps the Fed. Probably China. Possibly Putin. Likely ISIL (or Assad). Alternately small investors. (ETF.com assures us it’s definitely not the effect of rapid, block-trading of ETFs on the market, though.) It’s all an overreaction or, occasionally, a lagging one. Could be fears of recession or even fears of fears.

We don’t like randomness. That’s why conspiracy theories are so persistent: they offer simple, satisfying explanations for otherwise inexplicable occurrences. We want explanations and, frankly, the financial media are addicted to offering them. The list in that opening paragraph captures just some of the explanations offered by talking heads to explain January’s turbulence. Those same sages have offered prognostications for the year ahead, ranging from a “cataclysmic” 40% decline and advice to “sell everything” to 7-11% gains, the latter from folks who typically foresee 7-11% gains.

As I drove to campus the other day, watching a huge flock of birds take wing and wheel and listening to financial analysis, it occurred to me that these guys had about as much prospect of understanding the market as they do of understanding the birds’ ballet.

Open confession is good for the soul.

I have two confessions.

First, I can’t find the source of the quotation that serves as the title of this essay. I keep hitting a wall as “Scottish proverb,” with no further discussion. All too often that translates to “some hack at The Reader’s Digest in 1934 made it up and added ‘Scottish proverb’ to dignify the insight.”

Second, until I began this essay, I had only the vaguest idea of how my portfolio had done in 2015. I preach a single doctrine: make a good plan, execute the plan, get on with your life.

Make a good plan: My retirement portfolio is largely hostage to Augustana College. As part of a Retirement Plan Redesign task force a few years ago, we discovered that the college’s plan was too complicated (it offered over 800 funds) and too lax (under 30% of our employees contributed anything beyond the college’s 10% contribution).  The research was clear and we followed it: we dramatically reduced the fund of investment choices so that in each asset class folks had one active fund and one passive fund, installed a lifecycle fund as the default option, the college went from a flat contribution to a modestly more generous one based on a matching system, we auto-enrolled everyone in a payroll deduction which started at 4%, and automatically escalated their contributions annually until they reached 10%. It was, of course, possible to opt out but we counted on the same laziness that kept folks from opting in to keep them from opting out.

We were right. Ninety-some percent of employees now contribute to their own retirements, the amount of money sitting in money markets for years is dramatically reduced, the savings rate is at a record and more accounts seem to contain a mix of assets.

Yay for everyone but me! In pursuit of the common good, I helped strip out my own access to the Fidelity and T. Rowe Price funds that were central to my plan. Those funds are now in a “can’t add more” account and continue to do quite well. Both growth funds (Fidelity Growth Discovery, T. Rowe Price Blue Chip Growth) and international small caps (Fidelity Japan Smaller Companies, T. Rowe Price International Discovery) were thriving, while my substantial emerging markets exposure and a small inflation hedge hurt. In these later years of my career at the college, the vast bulk of my retirement contributions are going into a combination of the CREF Stock Account (60% of my portfolio, down 0.9% in 2015, up 10.5% annually over the past three years), TIAA Real Estate Account (25% of my portfolio, up 8% in 2015, up 10% annually over the past three years) and a TIAA-CREF Retirement Income fund (15% of the portfolio, flat in 2015, up 4.5% over three years) for broad-based fixed income exposure.

My non-retirement account starts with a simple asset allocation:

• 50% growth / 50% income
• Within growth, 50% domestic equities, 50% foreign
• Within domestic, 50% smaller companies, 50% larger
• Within foreign, 50% developed, 50% emerging
• Within income, 50% conservative, 50% venturesome.

I know that I could optimize the allocation by adjusting the exact levels of exposure to each class, but I don’t need the extra complexity in my life. In most of my funds, the managers have some wiggle room so that they’re not locked into a single narrow asset class. That makes managing the overall asset allocation a bit trickier, but manageable.

The roster of funds, ranked from my largest to smallest positions:

Execute the plan. So what did I do in 2015? Added Grandeur Peak Global Microcap and set up a monthly auto-invest. I also (finally!) transferred my Seafarer holdings from Scottrade directly to Seafarer where I took advantage of their offer to make lower-cost institutional shares available to retail investors who met the retail minimum and established an auto-investing plan. Otherwise, it was mostly stay the course and invest monthly.

What’s up for 2016? Artisan Small Cap Value is on the chopping block. Assets in the fund are down nearly 90% from peak, reflecting year after wretched year of underperformance. This is one of my oldest holdings, I’ve owned it since the late 1990s and have substantial embedded capital gains. Three issues are pushing me toward the door:

1. The managers seem to have fallen into a value trap. Their discipline is explicitly designed to avoid “value traps,” but their dogged commitments to energy and industrials seem to have ensnared them.
2. They don’t seem to be able to get out. Perhaps I’m jaundiced, but their shareholder communications haven’t been inspiring. The theme is “we’re not going to change our discipline just because it’s not working right now.” My fear is that “disciplined” transitions too easily into “bunkered down.” I experienced something similar with Ron Muhlenkamp of Muhlenkamp Fund (MUHLX), which was brilliant for 15 years then rigidly rotten for a decade. Mr. Muhlenkamp’s mantra was “we’re not sacrificing our long-term discipline for short-term gains” which sounded grand and worked poorly. I know of few instances where once-great funds rebound from several consecutive years in the basement. The question was examined closely by Leigh Walzer of Trapezoid in his December 2015 essay, When Good Managers Go Bad.
3. Lead manager Scott Satterwhite is retiring in October. The transition has been underway for a long while now but (a) it’s still epochal and (b) performance during the transition has not been noticeable better.

I may surrender to Ed’s desire to have me simplify my portfolio. (Does he simplify his? No, not so far as I can tell.) That might mean moving the MACSX money into Seafarer. Maybe closing out a couple smaller holdings because they’re not financially consequential. My asset allocation is a bit overweight in international stocks right now, so I’m probably going to move some into domestic smaller caps. (Yes, I know. I’ve read the asset class projections but my time horizon is still longer than five to seven years.) And making some progress in debt reduction (I took out a home equity loan to handle some fairly-pressing repairs) would be prudent.

Get on with life. I’m planning on resuming my War on Lawns this spring. I’m having a Davenport firm design a rain garden, an area designed to slow the rush of water off my property during storms, for me and I’ll spend some weeks installing it. I’ll add a bunch of native plants, mostly pollinator-friendly, to another corner once overrun by lawn. Together, I think they’ll make my space a bit more sustainable. Baseball season (which my son interprets as “I need expensive new stuff” season) impends. I really need to focus on strengthening MFO’s infrastructure, now that more people are depending on it. And my academic department continues to ask, “how can we change our teaching to help raise diverse, first-generation college students to that same level of achievement that we’ve traditionally expected?” That’s exhausting but exciting because I think, done right, we can make a huge difference in the lives of lots of bright kids who’ve been poorly served in some of their high schools. As a kid whose parents never had the opportunity to finish high school (World War Two interrupted their teen years), my faith in the transformative power of teaching remains undimmed.

It’ll be a good year.

Emerging markets: About as cheap as it gets

In the course of our conversation about Leuthold Core Investment (LCORX), Doug Ramsay shared the observation that emerging markets stocks are painfully cheap. Leuthold’s chart, below, shows the price/earnings ratio based on five-year normalized earnings for E.M. stocks from 2004 to now. Valuations briefly touched a p/e of 31 in 2007 then fell to 8 within a year. As we end January 2016, prices for E.M. stocks hover within a point of their market-crisis lows.

And still Leuthold’s not investing in them. Their E.M. exposure in Core and Global (GLBLX) are both near all-time lows because their analytics don’t (yet) show signs of a turnaround. Still, Mr. Ramsay notes, “they look impossibly cheap.”

Investing in five-star funds? It’s not as daft as you’d think

We asked the good folks at Morningstar if they’d generate a list of all five-star funds from ten years ago, then update their star ratings from five years ago and today. I’d first seen this data several years ago when it had been requested by a Wall Street Journal reporter and shared with us. The common interpretation is “it’s not worth it, since five-star funds aren’t likely to remain five-star funds.”

I’ve always thought that was the wrong concern. Really, I’m less concerned about whether my brilliant manager remains absolutely brilliant than whether he turns wretched. Frankly, if my funds kept bouncing between “reasonable,” “pretty good” and “really good,” I’d be thrilled. That is, if they stay in the three- to five-star range over time, that’s perfectly respectable.

Chip took the data and converted it into a pivot table. (Up until then, I thought “pivot table” was just another name for a “lazy Susan.” Turns out it’s actually a data visualization tool. Who knew?)

Here’s how to read it. There were 354 five-star funds in 2005. Of those, only 16 fell to one-star by 2010. You can see that in the top-center box. Of those 16 one-star funds, none rebounded to five stars by 2015 and only two made it back to four stars. On the upside, 187 of the original 354 remained four- or five-star funds across the whole time period and 245 of 354 never dropped below three stars.

We clearly need to do some refinement of the data to see whether a few categories are highly resilient (for example, single-state muni bond funds might never change their star ratings) and, thus, skewing the results. On whole, though, it seems clear that “first to worst” is a pretty low probability outcome and “first to kinda regrettable” isn’t hugely more likely.

The original spreadsheet is in the Commentary section at MFO Premium, for what interest that holds.

This Time It Really Is Different!

“Every revolution evaporates and leaves behind only the slime of a new bureaucracy.”

 Kafka

So, time now for something of a follow-up to my suggestion of a year ago that a family unit should own no more than ten mutual funds. As some will recall, I was instructed by “She Who Must Be Obeyed” to follow my own advice and get our own number of fund investments down from the more than twenty-five where it had been. We are now down to sixteen, which includes money market funds. My first observation would be that this is not as easy to do as I thought it would be, especially when you are starting from something of an ark approach (one of these, two of those). It is far easier to do when you start to build your portfolio from scratch, when you can be ruthless about diversification. That is, you don’t really need two large cap growth or four value funds. You may only add a new fund if you get rid of an old fund. You are quite specific about setting out the reasons for investing in a fund, and you are equally disciplined about getting rid of it when the reasons for owning it change, e.g. asset bloat, change in managers, style drift, no fund managers who are in Boston, etc., etc.

Which brings me to a point that I think will be controversial – for most families, mutual fund ownership should be concentrated in tax-exempt (retirement accounts) if taxes matter. And mutual fund ownership in retirement accounts should emphasize passive investments to maximize the effects of lower fees on compounding. It also lessens the likelihood of an active manager shooting himself or herself in the foot by selling the wrong thing at the wrong time because of a need to meet redemptions, or dare I suggest it, panic or depression overwhelm the manager’s common sense in maintaining an investment position (which often hits short seller specialists more than long only investors, but that is another story for another day).

The reasons for this will become clearer as holdings come out for 12/31 and 3/31, as well as asset levels (which will let you know what redemptions are – the rumor is that they are large). It will also become pretty clear as you look at your tax forms from your taxable fund accounts and are wondering where the money will come from to pay the capital gains that were triggered by the manager’s need to raise funds (actually they probably didn’t need to sell to meet redemptions as they all have bank lines of credit in place to cover those periods when redemptions exceed cash on hand, but …..).

The other thing to keep in mind about index funds that are widely diversified (a total market fund for instance) – yes, it will lag on the upside against a concentrated fund that does well. But it will also do better on the downside than a concentrated fund that does not do well. Look at it this way – a fifty stock portfolio that has a number of three and four per cent positions, especially in the energy or energy services sector this past year, that has seen those decline by 50% or more, has a lot of ground to make up. A total stock market portfolio that has a thousand or more positions – one or two or twenty or thirty bad stocks, do not cripple it. And in retirement accounts, it is the compounding effect that you want. The other issue of course is that the index funds will stay fully invested in the indices, rather than be caught out underinvested because they were trying to balance out exiting positions with adding positions with meeting redemptions. The one exception here would be for funds where the inefficiencies of an asset class can lead to a positive sustainable alpha by a good active manager – look for that manager as one to invest with in either taxable or tax-exempt accounts.

China, China, China, All the Time

In both the financial print press and the financial media on television and cable, much of the “blame” for market volatility is attributed to nervousness about the Chinese economy, the Chinese stock market, in fact everything to do with China. There generally appear to be two sorts of stories about China these days. One recurring theme is that they are novices at capital markets, currencies, as well as dealing with volatility and transparency in their markets, and that this has exacerbated trends in the swings in the Shanghai market, which has spread to other emerging markets. Another element of this particular them is that China’s economy is slowing and was not transparent to begin with, and that lack of growth will flow through and send the rest of the world into recession. Now, mind you, we are talking about economic growth that by most accounts, has slowed from high single digits recently (above 7%) to what will be a range going forward of low to still mid-single digits (4 – 7%).

I think a couple of comments are in order about this first theme. One, the Shanghai market has very much been intended as a punter’s market, where not necessarily the best companies are listed (somewhat like Vancouver in Canada twenty-odd years ago). The best companies in China are listed on the Hong Kong market – always have been, and will continue to be for the foreseeable future. The second thing to be said is that if you think things happen in China by accident or because they have lost control, you don’t understand very much about China and its thousands of years of history. Let’s be realistic here – the currency is controlled, interest rates are controlled, the companies are controlled, the economy is controlled – so while there may be random events and undercurrents going on, they are probably not the ones we are seeing or are worried about.

This brings me to the second different theme you hear about China these days, which is that China and the Chinese economy have carried the global economy for the last several years, and that even last year, their contribution to the world economy was quite substantial. I realize this runs counter to stories that you hear emanating from Washington, DC these days, but much that you hear emanating from Washington now is quite surreal. But let’s look at a few things. China still has $3 trillion dollars of foreign exchange reserves. China does not look to be a debtor nation. China has really not a lot of places left to spend money domestically since they have a modern transportation infrastructure and, they have built lots of ghost cities that could be occupied by a still growing population. And while China has goods that are manufactured that they would like to export, the rest of the world is not in a buying mood. A rumor which I keep hearing, is that they have more than 30,000 metric tons of gold reserves with which to back their currency, should they so choose (by comparison, the US as of October 2014 was thought to have about 4,200 metric tons in Fort Knox).

For those familiar with magic shows and sleight of hand tricks, I think this is what we are seeing now. Those who watch the cable financial news shows come away with the impression that the world is ending in the Chinese equity markets, and that will cause the rest of the world to end as well. So while you are watching that, let’s see what you are missing. We have a currency that has become a second reserve currency to the world, supplanting the exclusive role of the U.S. dollar as countries that are commodity economies now price their commodities and do trade deals in Chinese currency. And, notwithstanding that, the prices of commodities have fallen considerably, we continue to see acquisition and investment in the securing of commodities (at fire sale prices) by China. And finally, we have a major expansion by China in Africa, where it is securing arable land to provide another bread basket for itself for the future, as well as an area to send parts of it population.

And let me suggest in passing that the one place China could elect to spend massively in their domestic economy is to build up their defense establishment far beyond what they have done to date. After all, President Reagan launched a massive arms build-up by the US during his terms in office, which in effect bankrupted the Soviets as they tried to keep up. One wonders whether we would or could try to keep up should China elect to do the same to us at this point.

So, dear readers, I will leave it to you to figure out which theme you prefer, although I suspect it depends on your time horizon. But let me emphasize again – looking at the equity markets in China means looking at the wrong things. By the end of this year, we should have a better sense of whether the industrial economy is China has undergone a rather strong recovery, driven by the wealth of a growing middle class (which is really quite entrepreneurial, and which to put it into context, should be approaching by the end of this year, 400M in size). And it will really also become clear that much of the capital that has been rumored to be “fleeing” China has to be split out to account for that which is investment in other parts of the world. Paying attention to those investment outflows will give you some insight as to why China still thinks of and refers to itself as, “The Middle Kingdom.”

— by Edward A. Studzinski

Looking for Bartolo Colon

by Leigh Walzer

Bartolo Colon is a baseball pitcher; he is the second oldest active major leaguer.  Ten years ago he won the coveted Cy Young award. Probably no investment firm has asked Colon for an endorsement but maybe they should. More on this shortly.

FROM THE MAILBAG:

A reader in Detroit who registered but has not yet logged into www.Fundattribution.com  writes: “We find little use for back tested or algorithmic results [and prefer an] index-based philosophy for clients.” 

Index funds offer a great approach for anyone who lacks the time or inclination to do their homework. We expect they will continue to gain share and pressure the fees of active managers.

Trapezoid does not advocate algorithmic strategies, as the term is commonly used. Nor do we oppose them. Rather, we rigorously test portfolio managers for skill. Our “null hypothesis” is that a low-cost passive strategy is best. We look for managers which demonstrate their worth, based on skill demonstrated over a sufficient period of time. Specifically, Honor Roll fund classes must have a 60% chance of justifying their expenses. Less than 10% of the fund universe satisfies this test.  Trapezoid does rate some quantitative funds, and we wrote in the November edition of Mutual Fund Observer about some of the challenges of evaluating them.

We do rely on quantitative methods, including back testing, to validate our tests and hone our understanding of how historic skill translates into future success.

VULCAN MIND MELD

A wealth manager (and demo client) from Denver asks our view of his favorite funds, Vulcan Value Partners (VVPLX). Vulcan was incepted December 2009.Prior to founding Vulcan, the manager, C.T. Fitzpatrick, worked for many years at Southeastern under famed value investor O. Mason Hawkins.  Currently it is closed to new investors.

VVPLX has performed very well in its 6 years of history. By our measure, investors accumulated an extra 20% compared to index funds based on the managers’ stock selection skill alone. We mentioned it favorably in the October edition of MFO.

Vulcan’s expense structure is 1.08%, roughly 90bps higher than an investor would require to hold a comparable ETF. Think of that as the expense premium to hire an active manager. Based on data through October, we assigned VVPLX a 55% probability of justifying its active expense premium. (This is down from 68% based on our prior evaluation using data through July 2015 and places them outside the Honor Roll.)

The wealth manager questioned why we classify VVPLX as large blend?  Vulcan describes itself as a value manager and the portfolio is heavily weighted toward financial services.

VVPLX is classified as large blend because, over its history, it has behaved slightly more like the large blend aggregate than large value. We base this on comparisons to indices and active funds. One of our upcoming features identifies the peer funds, both active and passive, which most closely resemble a given fund. For a majority of our funds, we supplement this approach by looking at historic holdings. We currently consider factors like the distribution of forward P/E ratios over time. Our categorization and taxonomy do not always conform to services like Morningstar and Lipper, but we do consider them as a starting point, along with the manager’s stated objective.  We frequently change classifications and welcome all input. While categories may be useful in screening for managers, we emphasize that the classifications have no impact on skill ratings, since we rely 100% on objective criteria such as passive indices.

The client noted we identified a few managers following similar strategies to VVPLX who were assigned higher probabilities. How is this possible considering VVPLX trounced them over its six-year history?

Broadly speaking, there are three reasons:

• Some of the active managers who beat out VVPLX had slightly lower expenses.
• While VVPLX did very well since 2010, some other funds have proven themselves over much longer periods. We have more data to satisfy ourselves (and our algorithms) that the manager was skillful and not just lucky. 
• VVPLX’s stock selection skill was not entirely consistent which also hurts its case. From April to October, the fund recorded negative skill of approximately 4%. This perhaps explain why management felt compelled to close the fund 4/22/15.

Exhibit I

1. Annualized contribution from stock selection or sector rotation over manager tenure
2. Expenses increased recently by 10bps as BPAIX’s board curtailed the fee waiver
3. Closed to new investors

Exhibit II: Boston Partners All-Cap Value Fund

Exhibit I compares VVPLX to Boston Partners All-Cap Value Fund. BPAIX is on the cusp of value and blend, much like VVPLX. Our model sees a 56.1% chance that the fund’s skill over the next 12 months will justify its expense structure. According to John Forelli, Senior Portfolio Analyst, the managers screen from a broader universe using their own value metrics. They combine this with in-depth fundamental analysis. As a result, they are overweight sectors like international, financials, and pharma relative to the Russell 3000 (their avowed benchmark.) Boston Partners separately manages approximately $10 billion of institutional accounts which closely tracks BPAIX.

Any reader with the www.fundattribution.com demo can pull up the Fund Analysis for VVPLX.  The chart for BPAIX is not available on the demo (because it is categorized in Large Value) so we present it in Exhibit II.  Exhibit III presents a more traditional attribution against the Russell 3000 Value Fund. Both exhibits suggest Boston Partners are great stock pickers. However, we attribute much less skill to Allocation because our “Baseline Return” construes they are not a dyed-in-the-wool value fund.

VVPLX has shown even more skill over the manager’s tenure than BPAIX and is expected to have more skill next year^[1]. But even if VVPLX were open, we would prefer BPAIX due to a combination of cost and longer history. (BPAIX investors should keep an eye on expenses: the trustees recently reduced the fee waiver by 10bps and may move further next year.)

Trapezoid has identified funds which are more attractive than either of these funds. The Trapezoid Honor Roll consists of funds with at least 60% confidence. The methodology behind these findings is summarized at here.

^[1] 12 months ending November 2016.

VETERAN BENEFITS

Our review of VVPLX raises a broader question. Investors often have to choose between a fund which posted stellar returns for a short period against another whose performance was merely above average over a longer period.

For those of you who watched the World Series a few months ago, the NY Mets had a number of very young pitchers with fastballs close to 100 miles per hour.  They also had some veteran pitchers like John Niese and the 42-year-old ageless wonder Bartolo Colon who couldn’t muster the same heat but had established their skill and consistency over a long period of time. We don’t know whether Bartolo Colon drank from the fountain of youth; he served a lengthy suspension a few years ago for using a banned substance. But his statistics in his 40s are on par with his prime ten year ago.  

Unfortunately, for every Bartolo Colon, there is a Dontrelle Willis. Willis was 2003 NL Rookie of the year for the Florida Marlins and helped his team to a World Series victory. He was less effective his second year but by his third year was runner up for the Cy Young award. The “D-Train” spent 6 more years in the major leagues; although his career was relatively free of injuries, he never performed at the same level.

Extrapolating from a few years of success can be challenging. If consistency is so important to investors, does it follow that a baseball team should choose the consistent veterans over the promising but less-tested young arms?

Sometimes there is a tradeoff between expected outcome (∆) and certitude (±).  The crafty veteran capable of keeping your team in the game for five innings may not be best choice in the seventh game of the World Series; but he might be the judicious choice for a general manager trying to stretch his personnel budget. The same is true for investment managers. Vulcan may have the more skillful management team. But considering its longevity, consistency, and expense Boston Partners is the surer bet.

HOW MUCH IS ENOUGH

How long a track record is needed before an investor can bet confident in a portfolio manager? This is not an easy question to answer.

In the December edition of MFO (When_Good_Managers_Go_Bad) we profiled the Clearbridge Aggressive Growth fund which rode one thesis successfully for 20 years. Six years of data might tell us less about them than a very active fund.   

Here is one stab at answering the question.  We reviewed the database to see what percentage of fund made the Trapezoid Honor Roll as a function of manager tenure. 

Recall the Trapezoid Honor Roll consists of fund classes for which we have 60% confidence that future skill will justify expense structure.  In Exhibit IV the Honor Roll fund classes are shown in blue while the funds we want no part of are in yellow.  16% of those fund classes where the manager has been on the job for twenty-five years make the Honor Roll compared with just 2% for those on the job less than three years.  The relationship is not a smooth line, but generally managers with more longevity give us more data points allowing us to be more confident of their skill.. or more likely persuade us they lack sufficient skill. 

There is an element of “survivorship” bias in this analysis. Every year 6% of funds disappear; generally, they are the smallest or worst performers. “All-stars” managers are more likely to survive for 20 years. But surprisingly a lot of “bad” managers survive for a long time. The percentage of yellow funds increases just as quickly as the blue.

It seems reasonable to ask why so many “bad” managers survive in a Darwinian business. We surveyed the top 10. (Exhibit V) We find that in the aggregate they have a modicum of skill, but nowhere sufficient to justify what they charge.  We can say with high confidence all these investors would be better off in index funds or (ideally) the active managers on the Trapezoid honor roll.

We haven’t distinguished between a new manager who takes over an old fund and a brand new fund. Should investors abandon all their confidence when a good manager retires and passes the baton? Should investors give the fund a mulligan when a poor performer is replaced?  Probably not.  From a review of 840 manager changes with sufficient data (Exhibit VI), strong performers tend to remain strong which suggests we may gain confidence by considering the track record of the previous manager.

The “rookie confidence” problem is a challenge for investors. The average manager tenure is about six years and only a quarter of portfolio managers have been on the job longer than 10 years. It is also a challenge for asset managers marketing a new fund or a new manager of an existing fund.  Without a long track record, it is hard to tell if a fund is good – investors have every incentive to stick with the cheaper index fund.  Asset managers incubate funds to give investors a track record but studies suggest investors shouldn’t take much comfort from incubated track records. (Richard Evans, CFA Digest, 2010.) We see many sponsors aggressively waiving fees for their younger funds.  Investors will take comfort when the individuals have a prior track record at another successful fund.  C.T. Fitzpatrick’s seventeen years’ experience under Mason Hawkins seems to have carried over to Vulcan.

BOTTOM LINE:  It is hard to gain complete trust that any active fund is better than an index fund. It is harder when a new captain takes the helm, and harder yet for a brand new fund. The fund with the best five-year record is not necessarily the best choice. Veteran managers are over represented in the Trapezoid Honor Roll — for good reason.

Unlike investing, baseball will always have rookies taking jobs from the veterans. But in 2016 we can still root for Bartolo Colon.

Why are investors so bad at picking alternatives?

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

Gateway (GATEX) is the $8 billion behemoth of the long-short equity mutual fund category, and one of the biggest alternative mutual funds. I’ve long marveled at this fund’s size given its demonstrable lack of merit as a portfolio diversifier. Over the past 10 years the fund has behaved like an overpriced, underperforming 40% stock, 60% cash portfolio. Its R-squared over this period to the U.S. stock market index is 0.85.

Not only is its past performance damning, but little in the substance of the strategy suggests performance will radically change. Gateway owns a basket of stocks designed to track the S&P 500, with a slight dividend tilt. On this portfolio the managers sell calls on the S&P 500, capping the potential upside of the fund in exchange for a premium up front, and simultaneously buy puts, capping the potential downside of the fund at the cost of a premium up front. By implementing this “collar” strategy, the managers protect the portfolio from extreme ups and downs.

There is another way to soften volatility: Own less equities and more cash—which is pretty much what this fund achieves in a roundabout manner.

Portfolio theory says that an investment is only attractive to the extent that it improves the risk-adjusted return of a portfolio. That means three things matter for each asset: expected return, expected volatility, and expected correlation with other assets in the portfolio. The first two are intuitive, but many investors neglect the correlation piece. A low return, high volatility asset can be an excellent investment if it has a low enough correlation with the rest of the portfolio.

Consider an asset that’s expected to return 0% with stock-like volatility and a perfectly negative correlation to the stock market (meaning it moves in the opposite direction of the market without fail). Many investors, looking at the asset’s standalone returns and volatility, would be turned off. Someone fluent in portfolio theory would salivate. Assume the expected excess return of the stock market is 5%. If you own the stock market and the negatively correlated asset in equal measure, the portfolio’s expected excess return halves to 2.5% and its expected volatility drops to 0%. Apply some leverage to double the portfolio’s return and you end up with a 5% expected excess return with no volatility.

In practice, many investors do not assess assets from the portfolio perspective. They fixate on standalone return and volatility. Much of the time this is a harmless simplification. But it can go wrong when assessing alternatives, such as with Gateway. Judged by its Sharpe ratio and other risk-adjusted measures, Gateway looks like a reasonable investment. Judged by its ability to enhance a portfolio’s risk-adjusted return, it falls flat.

I don’t believe individual investors are responsible for Gateway’s size. If anything, institutional investors (particularly RIAs) are to blame. You would think that supposedly sophisticated investors would not fall into this trap. But they do. A large part of the blame belongs to committee-driven investment processes, which dominate institutional money management. When a committee is responsible for a portfolio, they often hire consultants. These consultants in turn promise to help members of the committee avoid getting fired or sued.

In this context, the consultants like to create model portfolios that have predefined allocations to investment types—X% in large growth, Y% in small-cap value, Z% in long-short equity, and so on—and then find suitable managers within those categories. When picking those managers, they tend to focus on return and volatility as well as performance relative to peers. If not done carefully, a fund like Gateway gets chosen, despite its utter lack of diversifying power.

Smallest, Shortest, Lowest

David invariably cuts to the chase when it comes to assessing mutual funds. It’s a gift he shares with us each month.

So, in evolving the MFO Premium site, he suggested we provide lists of funds satisfying interesting screening criteria to help users get the most from our search tools.

Last month we introduced two such lists: “Best Performing Rookie Funds” and “Dual Great Owl & Honor Roll Funds.”

This month our MultiSearch screener incorporates three more: “Smallest Drawdown Fixed Income Funds,” “Shortest Recovery Time Small Caps,” and “Lowest Ulcer Moderate Allocation Funds.”

Smallest Drawdown Fixed Income Funds generates a list of Fixed Income (e.g., Bond, Muni) funds that have experienced the smallest levels of Maximum Drawdown (MAXDD) in their respective categories. More specifically, they are in the quintile of funds with smallest MAXDD among their peers.

Looking back at performance since the November 2007, which represents the beginning of the current full market cycle, we find 147 such funds. Two top performing core bond funds are TCW Core Fixed-Income (TGCFX) and RidgeWorth Seix Total Return (SAMFX). The screen also uncovered notables like First Pacific Advisors’ FPA New Income (FPNIX) and Dan Ivascyn’s PIMCO Income (PIMIX).

Here are some risk/return metrics for these Fixed Income funds (click on images to enlarge):

TCW Core Fixed-Income (TGCFX) and RidgeWorth Seix Total Return (SAMFX)

First Pacific Advisors’ FPA New Income (FPNIX)

PIMCO Income (PIMIX)

Shortest Recovery Time Small Caps generates a list of Small Cap (Small Core, Small Value, Small Growth) funds that have incurred shortest Recovery Times (number of months a fund retracts from previous peak) in their respective categories.

For Full Cycle 5, this screen produces 62 such funds through December 2015. Among the best performing funds with shortest Recovery Times, under 30 months, only one remains open and/or accessible: Queens Road Small Cap Value (QRSVX). It was profiled by David in April 2015.

Here’s a short list and risk/return numbers for QRSVX across various timeframes:

Queens Road Small Cap Value (QRSVX)

Lowest Ulcer Moderate Allocation Funds generates a list of Mixed Asset Moderate Allocation funds that have incurred the lowest Ulcer Indices in their respective categories. 

Topping the list (fund with lowest UI) is James Balanced: Golden Rainbow (GLRBX), profiled last August :

The Alt Perspective: Commentary and news from DailyAlts.

We can all be thankful that January 2016 is over. I am at a point in my life where I don’t really enjoy rollercoaster rides, of any sort, as much as I did when I was younger. And this past month has been nothing short of a financial rollercoaster. In many ways, however, it shouldn’t have been a surprise that investors decided to take some air out of the balloon.

In a grand experiment, the central banks around the world have been pumping hot air into the global market balloon since November 2008. But the U.S. Fed officially took its foot off the gas pedal and applied a bit of light pressure to the brakes with its scant rate rise in December. And on top of that, China’s slowdown has raised concerns of contagion, and its equity markets have taken the brunt of that concern.

With all of the re-adjustments of market expectations and valuations currently taking place, 2016 may turn out to be quite a good year to be invested in alternatives.

Performance Review

Let’s start with traditional asset classes for the month of January 2015, where the average mutual fund for all of the major equity markets (per Morningstar) delivered negative performance in the month:

• Large Blend U.S. Equity: -6.95%
• Small Blend U.S. Equity: -9.18%
• Foreign Equity Large Blend: -7.32%
• Diversified Emerging Markets: -6.46%
• Intermediate Term Bond: 0.94%
• World Bond: -0.03%
• Moderate Allocation: -4.36%

Now a look at the liquid alternative categories, per Morningstar’s classification. Only Managed Futures and Bear Market funds generated positive returns in January, as one would expect. Long/Short Equity was down more than expected, but with small cap stocks being down just over 9%, it is not a surprise. Multi-alternative funds held up well, as did market neutral funds.

• Long/Short Equity: -4.18%
• Non-Traditional Bonds: -1.15%
• Managed Futures: 2.34%
• Market Neutral: -0.22%
• Multi-Alternative: -1.65%
• Bear Market: 11.92%

And a few non-traditional asset classes, where none escaped January’s downdraft:

• Commodities: -3.01%
• Multi-Currency: -0.49%
• Real Estate: -5.16%
• Master Limited Partnerships: -9.77%

Overall, a mixed bag for January.

Asset Flows

One of the more surprising aspects of 2015 was the concentration of asset flows into multi-alternative funds and managed futures funds. All other categories of funds, except for volatility funds, experienced outflows over the full twelve months of 2015, as documented in the below chart:

And despite the massive outflows from non-traditional bonds, the category remains the largest with more than $135 billion in assets. This compares to commodities at $67 billion and multi-alternative at $56 billion.

Hot Topics

Only six new liquid alternative funds were launched in January – four were long/short equity funds, one was a managed futures fund and the sixth was a non-traditional bond fund. Of the six funds, two were ETFs, and fairly innovative ETFs at that. We wrote about their structure in an article titled, Reality Shares Builds Suite of Dividend-Themed ETFs.

On the research front, we published summaries of two important research papers in January, both of which have been popular with readers:

• Using Active Share to Evaluate High-Yield Bond Portfolios – An interesting look at how to use active share to evaluate fixed income portfolios.
• Using Momentum and Hedge Funds to Build a Better Portfolio – It is often documented how hedge funds can help a traditionally allocated portfolio, but this article takes a look at a research paper that proposes something a bit different.

If you would like to keep up with all the news from DailyAlts, feel free to sign up for our daily or weekly newsletter.

I’ll be back next month, and until then, let’s hope the rollercoaster ride that started in January has come to an end.

Observer Fund Profiles:

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

Cognios Market Neutral Large Cap (COGMX): this tiny fund does what its category is supposed to do, but never has. It makes good money even when the market stinks.

Leuthold Core Investment (LCORX): We celebrate the 20^th anniversary of Leuthold Core, a singularly disciplined and adaptive fund. Just one more year and it will be old enough to drink! We’re hopeful that the markets don’t give it, or us, reason to.

RiverNorth Opportunities (RIV): This is the closed-end fund for serious investors who know there’s a lot of money to be made in the irrational pricing of closed-end funds, but who don’t have the time or expertise to construct such a portfolio on their own.

Launch Alert: Davenport Balanced Income (DBALX)

Most folks haven’t heard of the Davenport Funds, which is understandable but also too bad. Davenport & Company is an employee-owned investment adviser that’s headquartered in Richmond, VA. They’ve been around since 1863 and now “custodies more than $20 billion in assets.” They manage five no-load funds, all somewhere in the solid-to-excellent range. Their newest fund, Davenport Balanced Income, launched on December 30, 2015.

Three things worth knowing:

1. The equity portion of the portfolio mirrors the holdings of the Davenport Value and Income Fund (DVIPX). All Davenport funds target firms with exceptionally high levels of insider equity ownership. Value & Income, in particular, targets three investment themes: Dividend Aristocrats, High Yielders with Capital Appreciation Potential and deep-value Contrarian/Special Situations.
2. Value and Income has performed exceedingly well. The fund just celebrated its fifth anniversary. Morningstar places it in the top 4% of all large value funds since inception. Perhaps more importantly, it significantly outperformed its peers in 2015 and again in 2016’s choppy first month. Since inception, its returns have been about a third higher than its equity income peers while all measures of its volatility have been lower. Based on the conventional measures of risk-adjusted return (Sharpe, Martin and Sortino ratios or Ulcer Index), it’s a Top 20 equity income fund.
3. The equity allocation is fluid, ranging from 25 to 75% of assets. The balance between the two sleeves is determined by the managers’ analysis of “economic trends, changes in the shape of the yield curve and sector analysis.” The income portion of the portfolio is invested for stability rather than appreciation.

John Ackerly, one of Davenport’s directors, claims they have “a long history of developing funds that manage downside risk and produce positive returns … over full market cycles.” The equity portion of the fund is managed by Davenport’s Investment Policy Committee; the fixed-income portion by two of the guys who manage their fixed-income separate accounts. Their managers have, on average, 30 years of experience. Expenses are capped at 1.25%. The minimum initial investment is $5,000 for regular accounts and $2,000 for tax-advantaged ones. More details are at Davenport Asset Management, with the funds linked under the Strategies tab.

Manager Changes

There’s always churn in the manager ranks. This month we tracked down changes at 67 equity or balanced funds. While no cry out “sea change!”, three fairly well-known Fidelity managers – Peter Saperstone, Adam Kutas and Charles Myers – are having their responsibilities changed. Mr. Kutas drops Latin America to focus on EMEA. Mr. Myers takes a six-month leave of absence starting in March. Mr. Saperstone has been steadily moving away for months. I also discovered that I don’t recognize the names of any of the Janus managers (except, of course, Mr. Gross).

Updates

Speaking of Mr. Gross, his Janus Unconstrained Bond (JUCAX) fund’s performance chart looks like this:

So far the fund has been above water for about one month, April 2015, since Mr. Gross came on board. That said, it certainly shows a dogged independence compared to its nontraditional bond peers (the orange line). And it does look a lot better than Miller Income Opportunity Fund (LMCJX), Legg Mason’s retirement gift to former star Bill Miller. Mr. Miller co-manages the fund with his son. Together they’ve managed to lose about 24% for their investors in the same period that Mr. Gross dropped two or three.

Briefly Noted . . .

There was a great thread on our discussion board about the fate of the Berwyn Funds. The Berwyn funds are advised by The Killen Group. The founder, Robert E. Killen, turned 75 and has chosen to sell his firm to the Chartwell Investment Partners. The fear is that Chartwell will use this as an opportunity to vacuum up assets. Their press release on the acquisition reads, in part:

“This transaction creates an investment management firm with annual revenues approaching $50 million and more than $10 billion in assets under management, as part of our well-defined strategy for growing our Chartwell Investment Partners business into a world-class asset manager,” TriState Capital Chief Executive Officer James F. Getz said. “We have an exceptional opportunity to combine Killen’s highly credible investment performance, particularly by the Morningstar five-star rated Berwyn Income Fund, with our proven national financial services distribution model to meaningfully accelerate growth in client assets….”

The fate of Berwyn’s small no-load shareholders seems unresolved.

Thanks, in passing but as always, to The Shadow, the indomitable Ted and the folks on our discussion board. They track down more cool stuff, and think more interesting thoughts, than about any group I know. I browse their work daily and learn a lot.

GoodHaven Fund (GOODX) is reorganizing itself. The key change is that it will have a new board of trustees, rather than relying on a board provided by the Professionally Managed Portfolios trust.

Effective at the end of January, 2016, the Innealta Capital Country Rotation (ICCNX) and Capital Sector Rotation (ICSNX) funds no longer include “consistent with the preservation of capital” as part of their investment objectives.

Manning & Napier has agreed to acquire a majority interest in Rainier Investment Management, the investment adviser to the Rainier Funds. 

Effective February 1, 2016, the T. Rowe Price Mid-Cap Index Fund and the T. Rowe Price Small-Cap Index Fund were added as options for all of the T. Rowe Price Retirement Fund. 

SMALL WINS FOR INVESTORS

Buffalo Emerging Opportunities Fund (BUFOX) and the Buffalo Small Cap Fund (BUFSX) have re-opened to new investors. They were closed for three and six years, respectively. Both funds posted wretched performance in 2014 and 2015 which might be a sign of disciplined investors out of step with an undisciplined market.

The Fairholme Focused Income (FOCIX) and Allocation (FAAFX) funds have reduced their minimum initial investment from $25,000 to $10,000.

Effective January 29, 2016, the redemption fee for the TCM Small Cap Growth Fund (TCMSX) was removed and the fund reduced its minimum initial investment from $100,000 to $2,500. It’s actually a pretty solid little small-growth fund.

Tweedy, Browne Global Value Fund II -Currency Unhedged (the “Fund”) reopened to new investors on February 1, 2016.

Effective as of January 1, 2016, the Valley Forge Fund’s (VAFGX) advisor, Boyle Capital Management, LLC, has voluntarily agreed to waive the full amount of its management fee. The voluntary waiver may be discontinued at any time. It was always a cute, idiosyncratic little fund run by a guy named Bernie Klawans. The sort of fund that had neither a website nor an 800 number. Bernie passed away at age 90, having run the fund until the last six months of his life. His handpicked successor died within the year. The Board of Trustees actually ran the fund for six months. Their eventual choice for a new manager did okay for a year, then performance fell off a cliff in the middle of 2014.

It’s never recovered and the fund is down to $7 million in assets, down by two-thirds since Mr. Klawan’s passing.

Vanguard Treasury Money Market Fund (VUSXX) has re-opened to all investors without limitations. It’s been charging four basis points and returning one basis point a year for the past three.

CLOSINGS (and related inconveniences)

AQR Style Premia Alternative Fund and AQR Style Premia Alternative LV Fund will both close to new investors on March 31, 2016. AQR’s Diversified Arbitrage Risk Parity and Multi-Strategy Alternative funds closed in 2012 and 2013. Sam Lee did a really strong analysis of the two Style Premia funds in our September 2015 issue.

Ziegler Strategic Income Fund (ZLSCX) has liquidated its Investor share class and has converted the existing Investor Class accounts into institutional accounts.

OLD WINE, NEW BOTTLES

The American Independence funds announced five name changes, including shortening American Independence to AI.

Aston Small Cap Fund (ATASX) – formerly Aston TAMRO Small Cap – is soon-to-be AMG GW&K Small Cap Growth Fund.

On January 28, 2016, Centre Global Select Equity Fund became Centre Global ex-U.S. Select Equity Fund (DHGRX). Not entirely sure why “Global ex-US” isn’t “International,” but maybe they had some monogrammed stationery that they didn’t want to throw out.

Effective on February 19, 2016, Columbia Intermediate Bond Fund (LIBAX) becomes Columbia Total Return Bond Fund. 

On February 1, 2016, Ivy Global Real Estate Fund (IREAX) became Ivy LaSalle Global Real Estate Fund, and Ivy Global Risk-Managed Real Estate Fund changed to Ivy LaSalle Global Risk-Managed Real Estate Fund (IVRAX). For the past three years, both funds have been sub-advised by Lasalle Investment Management. IVRAX has performed splendidly; IREAX, not so much.

Silly reader. You thought it was Touchstone Small Cap Core Fund. Actually it’s just Touchstone Small Cap Fund (TSFAX). Now, anyway.

OFF TO THE DUSTBIN OF HISTORY

“Because of the difficulty encountered in distributing the Fund’s shares,” 1492 Small Cap Core Alpha Fund (FNTSX) will liquidate on February 26, 2016. The fact that it’s not very good probably contributed to the problem.

American Beacon Retirement Income and Appreciation Fund and American Beacon Treasury Inflation Protected Securities Fund ( ) will be liquidated and terminated on March 31, 2016. Presumably that’s part of the ongoing house-cleaning as American Beacon tries to reposition itself as a sort of alternatives manager.

Anfield Universal Fixed Income Fund (AFLEX) liquidated two of its share classes (A1 and R) on February 1, 2016. Rather than moving those investors into another share class, they received a check in the mail and a tax bill. Odd. 

ASTON/TAMRO International Small Cap Fund (AROWX) liquidated on February 1, 2016. On the one hand, it only had $2 million in assets. On the other, the adviser pulled the plug after just a year. The manager, Waldemar Mozes, is a bright guy with experience at Artisan and Capital Group. He jokingly described himself as “the best fund manager ever to come from Transylvania.” We wish him well.

Columbia Global Inflation-Linked Bond Plus Fund liquidated after very short notice, on January 29, 2016.

Gator Opportunities Fund (GTOAX) thought it had to hang on until March 21, 2016. The board has discovered that a swifter execution would be legal, and now it’s scheduled to disappear on February 15, 2016.

Hodges Equity Income Fund (HDPEX) will merge into Hodges Blue Chip Equity Income Fund (currently named the Hodges Blue Chip 25 Fund HDPBX) at the end of March, 2016.

Its board simultaneously announced new managers for, and liquidation of, KF Griffin Blue Chip Covered Call Fund (KFGAX). The former occurred on January 6, the latter is slated for February 16, 2016.

Madison Large Cap Growth Fund (MCAAX) merges into Madison Investors (MNVAX) on February 29, 2016,

Don’t blink: McKinley Non-U.S. Core Growth Fund (MCNUX) will be gone by February 5, 2016. It was an institutional fund with a minimum investment of $40 million and assets of $37 million, so ….

Midas Magic (MISEX) and Midas Perpetual Portfolio (MPERX) are both slated to merge into Midas Fund (MIDSX). In reporting their taxable distributions this year, Midas announced that “One of Midas’ guiding principles is that we will communicate with our shareholders and prospective investors as candidly as possible because we believe shareholders and prospective investors benefit from understanding our investment philosophy and approach.” That makes it ironic that there’s no hint about why they’ve folding a diversified equity fund and a tactical allocation fund into a gold portfolio with higher fees than either of the other two.

We previously noted the plan to merge the Royce European Small-Cap and Global Value funds into Royce International Premier, pending shareholder approval. The sheep baa’ed shareholders approved the mergers, which will be executed sometime in February, 2016.

On March 24, 2016, Sentinel Mid Cap Fund (SNTNX) will be absorbed by Sentinel Small Company Fund (SAGWX), which have “identical investment objectives and similar investment strategies.” That’s a clear win for the investors, give or take any actual interest in investing in mid-caps. At the same time, Sentinel Sustainable Mid Cap Opportunities Fund (WAEGX) will be absorbed into Sentinel Sustainable Core Opportunities Fund (MYPVX).

TeaLeaf Long/Short Deep Value Fund (LEFAX) closed on January 25 and liquidated on January 29, 2016.

I’m okay with the decision to liquidate UBS U.S. Equity Opportunity Fund (BNVAX): it’s a tiny fund that’s trailed 98% of its peers over the past decade. The UBS board decided you needed to hear their reasoning for the decision, which they included in a section entitled:

Rationale for liquidating the Fund

Based upon information provided by UBS Asset Management (Americas) Inc., the Fund’s investment advisor, the Board determined that “it is in the best interests of the Fund and its shareholders to liquidate and dissolve the Fund pursuant to a Plan of Liquidation (the “Plan”). To arrive at this decision, the Board considered factors that have adversely affected, and will continue to adversely affect, the ability of the Fund to conduct its business and operations in an economically viable manner.”

Quick note to the board: that’s not a rationale. It’s a conclusion (“it’s in your best interest”) and a cryptic passage about the process “we considered factors.”

The Board of Trustees of Monetta Trust has concluded “that it would be in the best interests of the Fund and its shareholders” to liquidate Varsity/Monetta Intermediate Bond Fund (MIBFX), which will occur on February 18, 2016.

Vivaldi Orinda Hedged Equity Fund (OHEAX) is victim of its advisor’s “strategic decision to streamline its product offerings.” The fund will liquidate on February 26, 2016.

Voya Emerging Markets Equity Dividend Fund (IFCAX) will liquidate on April 8, 2016.

In Closing . . .

Please do double-check to see if you’ve set our Amazon link as a bookmark or starting tab in your browser. From Christmas 2014 to Christmas 2015, Amazon’s sales rose 60% but our little slice of the pie fell by 15% in the same period. We try not to be too much of a pesterance on the subject, but the Amazon piece continues as a financial mainstay so it helps to mention it.

If you’re curious about how the Amazon Associates program works, here’s the short version: if you enter Amazon using our link, an invisible little piece of text (roughly: “for the benefit of MFO”) follows you. When you buy something, that tag is attached to your order and we receive an amount equivalent to 6% or so of the value of the stuff ordered. It’s invisible and seamless from your perspective, and costs nothing extra. Sadly the tag expires after a day so if you put something in your cart on Guy Fawkes Day and places the order on Mardi Gras, the link will have expired.

Thanks, too, to the folks whose ongoing support makes it possible for us to keep the lights on (and even to upgrade them to LEDs!). That includes the growing cadre of folks using MFO Premium but also Paul R and Jason B, our most faithful subscribers Deb and Greg, the good folks at Andrei Financial and Gardey Financial and Carl R. (generous repeat offenders in the “keep MFO going” realm).

We’re about 90% done on a profile of the “new” LS Opportunity Fund (LSOFX), so that’s in the pipeline for March. Readers and insiders both have been finding interesting options for us to explore which, with Augustana’s spring break occurring in February, I might actually have time to!

We’ll look for you.

Dear friends,

Talk about sturm und drang. After 75 days with in which the stock market rose or fell by 1% or more, the Vanguard Total Stock Market Index managed to roar ahead to a gain … of 0.29%. Almost 3000 mutual funds hung within two percentage points, up or down, of zero. Ten managed the rare feat of returning precisely zero. Far from a Santa Claus rally, 2015 couldn’t even manage a Grinchy Claus one.

And the Steelers lost to the Ravens. Again! Just rip my heart out, why doncha?

Annus horribilis or annus mediocris?

In all likelihood, the following three statements described your investment portfolio: your manager lost money, you suspect he’s lost touch with the market, and you’re confused.

Welcome to the club! 2015 saw incredibly widespread disappointment for investors. Investors saw losses in:

• 8 of 9 domestic equity categories, excluding large growth
• 17 of 17 asset allocation categories, from retirement income to tactical allocation
• 8 of 15 international stock categories
• 14 of 15 taxable bond categories and
• 6 of 6 alternative or hedged fund categories.

Anything that smacked of “real assets” (energy, MLPs, natural resources) or Latin America posted 20-30% declines. Foreign and domestic value strategies, regardless of market cap, trailed their growth-oriented peers by 400-700 basis points. The average hedge fund finished the year down about 4% and Warren Buffett’s Berkshire-Hathaway dropped 11.5%. The Masters of the Universe – William Ackman, David Einhorn, Joel Greenblatt, and Larry Robbins among them – are all spending their holidays penning letters that explain why 10-25% losses are no big deal. The folks at Bain, Fortress Investments and BlackRock spared themselves the bother by simply closing their hedge funds this year.

And among funds I actually care about (a/k/a “own”), T. Rowe Price Spectrum Income (RPSIX) lost money for just the third time in its 25 year history. As in 1994, it’s posting an annual loss of about 2%.

What to make of it? Opinions differ. Neil Irwin, writing in The New York Times half-celebrated:

Name a financial asset — any financial asset. How did it do in 2015?

The answer, in all likelihood: Meh.

It might have made a little money. It might have lost a little money. But, barring any drastic moves in the final trading days of 2015, the most widely held classes of assets, including stocks and bonds across the globe, were basically flat … While that may be disappointing news for people who hoped to see big returns from at least some portion of their portfolio, it is excellent news for anyone who wants to see a steady global economic expansion without new bubbles and all the volatility that can bring. (“Financial markets were flat in 2015. Thank goodness.” 12/30/2015)

Stephanie Yang, writing for CNBC, half-despaired:

It’s been a really, really tough year for returns.

According to data from Societe Generale, the best-performing asset class of 2015 has been stocks, whose meager 2 percent total return (that is, including dividends) still surpasses those of long-term bonds, short-term Treasury bills and commodities. These minimal gains make 2015 the worst year for finding returns since 1937, when the cash-like 3-month Treasury bill beat out other major asset classes with a return of 0.3 percent. (“2015 was the hardest year to make money in 78 years,” 12/31/2015).

Thirty-one liquid alts funds subsequently liquidated, the most ever (“The Year the Hedge-Fund Model Stalled on Main Street,” WSJ, 12/31/2015).

Courtesy of Leuthold Group

The most pressing question is whether 2015 is a single bad year or the prelude to something more painful than “more or less flat.” The folks at the Leuthold Group, advisers to the Leuthold funds as well as good institutional researchers, make the argument that the global equity markets have topped out. In support of that position, they break the market out into both component parts (MSCI Emerging Markets or FTSE 100) and internal measures (number of new 52-week highs in the NYSE or the ratio of advancing to declining stocks). With Leuthold’s permission, we’ve reproduced their timeline here.

Two things stand out. First, it appears that “the market’s” gains, if any, are being driven by fewer and fewer stocks. That’s suggested by the fact the number of 52-week highs peaked in 2013 and the number of advancing stocks peaked in spring 2015. The equal-weight version of the S&P 500 (represented by the Guggenheim S&P 500 Equal Weight ETF RSP) trailed the cap-weighted version by 370 basis points. The Value Line Arithmetic Index, which tracks the performance of “the average stock” by equally weighting 1675 issues, is down 11% from its April peak. Nearly 300 of the S&P 500 stocks will likely finish the year in the red. Second, many of the components followed the same pattern: peak in June, crash in August, partially rally in September then fade. The battle cry “there’s always a bull market somewhere!” seems not to be playing out just now.

The S&P 500 began 2015 at 2058. The consensus of market strategists in Barron’s was that it would finish 2015 just north of 2200. It actually ended at 2043. The new consensus is that it will finish 2016 just north of 2200.

The Leuthold Group calculates that, if we were to experience a typical bear market over the next year, the S&P 500 would drop to somewhere between 1500-1600.

By most measures, US stocks remain overpriced. There’s not much margin for safety in the bond market right now with US interest rates near zero and other major developing markets cutting theirs. Those interest rate cuts reflect concerns about weak growth and the potential for a China-led recession. The implosion of Third Avenue Focused Credit (TFCVX) serves as a reminder that liquidity challenges remain unresolved ahead of potentially disruptive regulations contemplated by the SEC.

The path forward is not particularly clear to me because we’ve never managed such a long period of global economic weakness and zero to negative interest rates before. My plan is to remind myself that I need to care about 2026 more than about 2016, to rebalance soon, and to stick with my discipline which is, roughly put, “invest regularly and automatically in sensible funds that execute a reasonable plan, ignore the market and pay attention to the moments, hours and days that life presents me.” On whole, an hour goofing around with my son or the laughter of dinner guests really does make a much bigger difference in my life than anything my portfolio might do today.

As Sergeant Phil Esterhaus used to remind the guys at Hill Street station as they were preparing to leave on patrol, “Hey, let’s be careful out there.”

For those seeking rather more direct guidance, our colleague Leigh Walzer of Trapezoid offers guidance, below, on the discipline of finding all-weather managers. Helpfully enough, he names a couple for you.

Good-Bye to All That

I cribbed the title from Robert Graves’ 1929 autobiography, one of a host of works detailing the horrors of fighting the Great War and the British military’s almost-criminal incompetence.

We bid farewell, sometimes with sadness, to a host of friends and funds.

Farewell to the Whitebox Funds

The Whitebox Advisors come from The Land of Giants. From the outside, I could never tell whether their expression was “swagger” or “sneer” but I found neither attractive. Back in 2012 readers urged us to look into the funds, and so we did. Our first take was this:

There are some funds, and some management teams, that I find immediately compelling.  Others not.

So far, this is a “not.”

Here’s the argument in favor of Whitebox: they have a Multi-Strategy hedge fund which uses some of the same strategies and which, per a vaguely fawning article in Barron’s, returned 15% annually over the past decade while the S&P returned 5%. I’ll note that the hedge fund’s record does not get reported in the mutual fund’s, which the SEC allows when it believes that the mutual fund replicates the hedge. 

Here’s the reservation: their writing makes them sound arrogant and obscure.  They advertise “a proprietary, multi-factor quantitative model to identify dislocations within and between equity and credit markets.”  At base, they’re looking for irrational price drops.  They also use broad investment themes (they like US blue chips, large cap financials and natural gas producers), are short both the Russell 2000 (which is up 14.2% through 9/28) and individual small cap stocks, and declare that “the dominant theories about how markets behave and the sources of investment success are untrue.”  They don’t believe in the efficient market hypothesis (join the club).

I’ll try to learn more in the month ahead, but I’ll first need to overcome a vague distaste.

I failed to overcome it. The fact that their own managers largely avoided the funds did not engender confidence.

In the face of poor performance and shrinking assets, they announced the closure of their three liquid alts funds in December. My colleague Charles offers a bit of further reflection on the closure, below.

Farewell to The House of Whitman

Marty Whitman become a fund manager at age 60 and earned enormous respect for his outspokenness and fiercely independent style. Returns at Third Avenue Value Fund (TAVFX) were sometimes great, sometimes awful but always Marty. Somewhere along the way, he elevated David Barse to handle all the business stuff that he had no earthly interest in, got bought by AMG, promised to assemble at least $25 billion in assets and built a set of funds that, save perhaps Third Avenue Real Estate Value (TAREX), never quite matched the original. It’s likely that his ability to judge people, or perhaps the attention he was willing to give to judging them, matched his securities analysis. The firm suffered and Mr. Whitman, in his 80s, either drifted or was pushed aside. Last February we wrote:

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

Many outsiders noted not just the departure of long-tenured members of the Third Avenue community, but also the tendency to replace some those folks with outsiders … Industry professionals we talked with spoke of “a rolling coup,” the intentional marginalization of Mr. Whitman within the firm he created and the influx of outsiders. Understandably, the folks at Third Avenue reject that characterization.

Mr. Barse was, reportedly, furious about our story. An outstanding bit of reporting by Gregory Zuckerman and Matt Wirz from The Wall Street Journal in the wake of the collapse of Third Avenue Focused Credit revealed that “furious” was a more-or-less constant state for him.

Mr. Barse also harangued other fund managers who grew disgruntled. Mr. Whitman took no public steps to rein in the CEO, the people said, preferring to focus on investing.

The dispute boiled over in the fall of 2011, when about 50 employees gathered in the firm’s largest conference room after an annual meeting with investors. Mr. Barse screamed at Mr. Whitman, inches from his face, demanding better performance, according to people who were in the room.

Mr. Whitman “was pounding the table so hard with his fist it was shaking,” said another person at the meeting. Mr. Whitman eventually withdrew money from the Value Fund and quit running it to focus on investing for himself, while remaining chairman of the firm.

As most of Third Avenue’s funds underperformed relevant benchmarks … Mr. Barse seemed to become more irritated, the people said.

Staff stopped using the conference room adjoining Mr. Barse’s office because sometimes he could be heard shouting through the walls.

Most employees received part of their pay on a deferred basis. After 2008, Mr. Barse began personally determining compensation for most personnel, often without explaining his decision, one of the people said. (“How the Third Avenue Fund Melted Down,” 12/23/2015).

Yikes. The Focused Credit fund, Mr. Barse’s brainchild, came into the summer of 2015 with something like one third of its assets invested in illiquid securities, so-called “Level 3 securities.” There are two things you need to know about illiquid securities: you probably can’t sell them (at least not easily or quickly) and you probably can’t know what they’re actually worth (which is defined as “what someone is willing to buy it for”). A well-documented panic ensued when it looked like Focused Credit would need to hurriedly sell securities for which there were no buyers. Mr. Barse ordered the fund’s assets moved to a “liquidating trust,” which meant that shareholders (a) no longer knew what their accounts were worth and (b) no longer could get to the money. The plan, Third Avenue writes, is to liquidate the illiquid securities whenever they find someone willing to pay a decent price for them. Investors will receive dribs and drabs as that process unfolds.

We wrote Third Avenue to ask whether the firm would honor the last-published NAV for their fund and whether the firm had a commitment to “making whole” their investors. Like The Wall Street Journal reporters, we found that folks were unwilling to talk.

And so now investors wait. How long might they wait? Oh, could be eight or ten years. The closest analogue we have is the 2006 blowup of the Amaranth Advisors hedge fund. Amaranth announced that they’d freeze redemptions for two months. That’s now stretched to ten years with the freeze extended until at least December 2016. (“Ten Years After Blowup, Amaranth Investors Waiting to Get Money Back,” WSJ, 12/30/2015). In the interim, it’s hard to understand why investment advisors wouldn’t follow Mr. Whitman out the door.

Farewell to Mainstay Marketfield

Marketfield (MFLDX) was an excellent small no-load liquid alts fund that aspired to be more. It aspired to be a massive liquid alts fund, a goal achieved by selling themselves to New York Life and becoming Mainstay Marketfield. New York Life adopted a $1.7 billion overachiever in 2012 and managed to jam another $20 billion in assets into the fund in two years. The fund hasn’t been the same since. Over the past three years, it’s earned a one-star rating from Morningstar and lost almost 90% of its assets while trailing 90% of its peers.

On December 15, 2015, Mainstay announced an impending divorce:

At a meeting held on December 8-10, 2015, the Board of Trustees of MainStay Funds Trust approved an Agreement and Plan of Reorganization [which] provides for the reorganization of the Fund into the Marketfield Fund (the “New Fund”) …

Prior to the Reorganization, which is expected to occur on or about March 23, 2016, Marketfield Asset Management, LLC, the Fund’s current subadvisor, will continue to manage the Fund … The New Fund will have the same investment objective, principal investment strategies and investment process.

There are very few instances of a fund recovering from such a dramatic fall, but we wish Mr. Aronstein and his remaining investors the very best.

Farewell to Sequoia’s mystique

The fact that Sequoia (SEQUX) lost money in 2015 should bother no one. The fact that they lost their independence should bother anyone who cares about the industry. Sequoia staked its fate to the performance of Valeant Pharmaceuticals, a firm adored by hedge fund managers and Sequoia – which plowed over a third of its portfolio into the stock – for its singular strategy: buy small drug companies with successful niche medicines, then skyrocket the price of those drugs. One recent story reported:

The drugstore price of a tube of Targretin gel, a topical treatment for cutaneous T cell lymphoma, rose to about $30,320 this year from $1,687 in 2009. Most of that increase appears to have occurred after Valeant acquired the drug early in 2013. A patient might need two tubes a month for several months, Dr. Rosenberg said.

The retail price of a tube of Carac cream, used to treat precancerous skin lesions called actinic keratoses, rose to $2,865 this summer from $159 in 2009. Virtually all of the increase occurred after 2011, when Valeant acquired the product. (“Two Valeant drugs lead steep price increases,” 11/25/2015)

Remember that Valeant didn’t do anything to discover or create the drugs; they simply gain control of them and increase the price by 1800%.

Sequoia’s relationship to Valeant’s CEO struck me as deeply troubling: Valeant’s CEO Michael Pearson was consistently “Mike” when Sequoia talked about him, as in “my buddy Mike.”

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.

The Sequoia press releases about Valeant sound like they were written by Valeant, two members of the board of trustees resigned in protest, a third was close to following them and James Stewart, writing for The New York Times, described “Sequoia’s infatuation with Valeant.” In a desperate gesture, Sequoia’s David Poppe tried to analogize Sequoia’s investment in Valeant with a long-ago bet on Berkshire Hathaway. Mr. Stewart drips acid on the argument.

Sequoia’s returns may well rebound. Their legendary reputation, built over decades of principled decision-making, will not. Our November story on Sequoia ended this way:

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.

Farewell to Irving Kahn

Mr. Kahn died at his home in February 2015. At age 109, he was the nation’s oldest active professional investor. He began trading in the summer of 1929, made good money by shorting overvalued stock at the outset of the Crash, and continued working steadily for 85 more years. He apprenticed with Benjamin Graham and taught, at Graham’s behest, at the Columbia Business School. At 108, he still traveled to his office three days a week, weather permitted. His firm, Kahn Brothers Group, manages over a billion dollars.

Where Are the Jedi When You Need Them?

“In present-day America it’s very difficult, when commenting on events of the day, to invent something so bizarre that it might not actually come to pass while your piece is still on the presses.”

Calvin Trillin, remarking on the problems in writing satire today.

So, the year has ended and again there is no joy in Mudville. The investors have no yachts or NetJet cards but on a trailing fee basis, fund managers still got rich. The S&P 500, which by the way has 30-35% of the earnings of its component companies coming from overseas so it is internationally diversified, trounced most active managers again. We continued to see the acceleration of the generational shift at investment management companies, not necessarily having anything to do with the older generation becoming unfit or incompetent. After all, Warren Buffett is in his 80’s, Charlie Munger is even older, and Roy Neuberger kept working, I believe, well into his 90’s. No, most such changes have to do with appearances and marketing. The buzzword of the day is “succession planning.” In the investment management business, old is generally defined as 55 (at least in Boston at the two largest fund management firms in that town). But at least it is not Hollywood.

One manager I know who cut his teeth as a media analyst allegedly tried to secure a place as a contestant on “The Bachelor” through his industry contacts. Alas, he was told that at age 40 he was too old. Probably the best advice I had in this regard was a discussion with a senior infantry commander, who explained to me that at 22, a man (or woman) was probably too old to be in the front lines in battle. They no longer believed they couldn’t be killed. The same applies to investment management, where the younger folks, especially when dealing with other people’s money, think that this time the “new, new thing” really is new and this time it really is different. That is a little bit of what we have seen in the energy and commodity sectors this year, as people kept doubling down and buying on the dips. This is not to say that I am without sin in this regard myself, but at a certain point, experience does cause one to stand back and reassess. Those looking for further insight, I would advise doing a search on the word “Passchendaele.” Continuing to double down on investments especially where the profit of the underlying business is tied to the price of a commodity has often proved to be a fool’s errand.

The period between Christmas and New Year’s Day is when I usually try to catch up on seeing movies. If you go to the first showing in the morning, you get both the discounted price and, a theater that is usually pretty empty. This year, we saw two movies. I highly recommend both of them. One of them was “The Big Short” based on the book by Michael Lewis. The other was “Spotlight” which was about The Boston Globe’s breaking of the scandal involving abusive priests in the Archdiocese of Boston.

Now, I suspect many of you will see “The Big Short” and think it is hyped-up entertainment. That of course, the real estate bubble with massive fraud taking place in the underwriting and placement of mortgages happened in 2006-2008 but ….. Yes, it happened. And a very small group of people, as you will see in the story, saw it, thought something did not make sense, asked questions, researched, and made a great deal of money going against the conventional wisdom. They did not just avoid the area (don’t invest in thrifts or banks, don’t invest in home building stocks, don’t invest in mortgage guaranty insurers) but found vehicles to invest in that would go up as the housing market bubble burst and the mortgages became worthless. I wish I could tell you I was likewise as smart to have made those contrary investments. I wasn’t. However, I did know something was wrong, based on my days at a bank and on its asset-liability committee. When mortgages stopped being retained on the books by the institutions that had made them and were packaged to be sold into the secondary market (and then securitized), it was clear that, without ongoing accountability, underwriting standards were being stretched. Why? With gain-on-sale accounting, profits and bonuses were increased and stock options went into the money. That was one of the reasons I refused to drink the thrift/bank Kool-Aid (not the only time I did not go along to get along, but we really don’t change after the age of 8). One food for thought question – are we seeing a replay event in China, tied as their boom was to residential construction and real estate?

One of the great scenes in “The Big Short” is when two individuals from New York fly down to Florida to check on the housing market and find unfinished construction, mortgages on homes being occupied by renters, people owning four or five homes trying to flip them, and totally bogus underwriting on mortgage lending. The point here is that they did the research – they went and looked. Often in fund management, a lot of people did not do that. After all, fill-in-the blank sell-side firm would not be recommending purchase of equities in home builders or mortgage lenders, without actually doing the real due diligence. Leaving aside the question of conflicts of interest, it was not that difficult to go look at the underlying properties and check valuations out against the deeds in the Recorder’s Office (there is a reason why there are tax stamps on deeds). So you might miss a few of your kid’s Little League games. But what resonates most with me is that no senior executive that I can remember from any of the big investment banks, the big thrifts, the big commercial banks was criminally charged and went to jail. Instead, what seems to have worked is what I will call the “good German defense.” And another aside, in China, there is still capital punishment and what are capital crimes is defined differently than here.

This brings me to “Spotlight” where one of the great lines is, “We all knew something was going on and we didn’t do anything about it.” And the reason it resonates with me is that you see a similar conspiracy of silence in the financial services industry. Does the investor come first or the consultant? Is it most important that the assets grow so the parent company gets a bigger return on its investment, or is investment performance most important? John Bogle, when he has spoken about conflicts of interest, is right when he talks about the many conflicts that came about when investment firms were allowed to sell themselves and basically eliminate personal responsibility.

This year, we have seen the poster child for what is wrong with this business with the ongoing mess at The Third Avenue Funds. There is a lot that has been written so far. I expect more will be written (and maybe even some litigation to boot). I commend all of you to the extensive pieces that have appeared in the Wall Street Journal. But what they highlight that I don’t think has been paid enough attention to is the problem of a roll-up investment (one company buying up and owning multiple investment management firms) with absentee masters. In the case of Third Avenue, we have Affiliated Managers Group owning, as reported by the WSJ, 60% of Third Avenue, and those at Third Avenue keeping a 40% stake (to incentivize them). With other companies from Europe, such as Allianz, the percentages may change but the ownership is always majority. So, 60% of the revenues come off the top, and the locals are left to grow the business, reinvest in it by hiring and retaining talent, focus on investment performance, etc., with their percentage. Unfortunately, when the Emperor is several states, or an ocean away, one often does not know what is really going on. You get to see numbers, you get told what you want to hear (ISIS has been contained, Bill Gross is a distraction to the other people), and you accept it until something stops working.

So I leave you with my question for you all to ponder for 2016. Is the 1940 Act mutual fund industry, the next big short? Investors, compliments of Third Avenue, have now been reminded that daily liquidity and redemption is that until it is not. As I have mentioned before, this is an investment class with an unlimited duration and a mismatch of assets and liabilities. This is perhaps an unusual concern for a publication named “Mutual Fund Observer.” But I figure if nothing else, we can always start a separate publication called “Mutual Fund Managers Address Book” so you can go look at the mansions and townhouses in person.

– by Edward A. Studzinski

Quietly successful: PYGSX, RSAFX, SCLDX, ZEOIX

Amidst the turmoil, a handful of the funds we’re profiled did in 2015 exactly what they promised. They made a bit of money with little drama and, sadly, little attention. You might want to glance in their direction if you’ve found that your managers were getting a little too creative and stretching a little too far in their pursuit of “safe” income.

Payden Global Low Duration (PYGSX): the short-term global bond fund made a modest 0.29% in 2015 while its peers lost about 4.6%. In our 2013 profile we suggested that “flexibility and opportunism coupled with experienced, disciplined management teams will be invaluable” and that Payden offered that combo.

Riverpark Structural Alpha (RSAFX): this tiny fund used a mix of options which earned their investors 1.3% while its “market neutral” peers lost money. The fund, we suggested, was designed to answer the question, “where should investors who are horrified by the prospects of the bond market but are already sufficiently exposed to the stock market turn for stable, credible returns?” It’s structurally exposed to short-term losses but also structurally designed to rebound, automatically and quickly, from them. In the last five years, for example, it’s had four losing quarters but has never had back-to-back losing quarters.

Scout Low Duration Bond Fund (SCLDX): this flexible, tiny short-term bond tiny fund made a bit of money in 2015 (0.6%), but it’s more impressive that the underlying strategy also made money (1.4%) during the 2008 meltdown. Mr. Eagan, the lead manager, explained it this way: “Many short-term bond funds experienced negative returns in 2008 because they were willing to take on what we view as unacceptable risks in the quest for incremental yield or income …When the credit crisis occurred, the higher risks they were willing to accept produced significant losses, including permanent impairment. We believe that true risk in fixed income should be defined as a permanent loss of principle. Focusing on securities that are designed to avoid this type of risk has served us well through the years.”

Zeo Strategic Income (ZEOIX): this short-term, mostly high-yield fund made 2.0% in 2015 while its peers dropped 4.1%. It did a particularly nice job in the third quarter, making a marginal gain as the high-yield market tanked. Positioned as a home for your “strategic cash holdings,” we suggested that “Modestly affluent folks who are looking to both finish ahead of inflation and sleep at night should likely make the effort to reach out and learn more.”

RiverPark Short-Term High Yield (RPHYX) likewise posted a gain – 0.86% – for the year but remains closed to new investors. PIMCO Short Asset Investment (PAIUX) which provides the “cash” strategy for all the PIMCO funds, eked out a 0.25% gain, modestly ahead of its ultra-short peers. 

These are very different strategies, but are unified by the presence of thoughtful, experienced managers who are exceedingly conscious of market risk.

Candidates for Rookie of the Year

We’ve often asked, by journalists and others, which are the young funds to keep an eye on. We decided to search our database for young funds that have been exceptionally risk-sensitive and have, at the same time, posted strong returns over their short lives. We used our premium screener to identify funds that had several characteristics:

They were between 12 and 24 months old; that is, they’d completed at least one full year of existence but were no more than two. I suspect a few funds in the 2-3 year range slipped through, but it should be pretty few.

They had a Martin Ratio greater than one; the Martin Ratio is a variation of the Sharpe ratio which is more sensitive to downward movements

They had a positive Sharpe ratio and had one of the five highest Sharpe ratios in their peer group.

Hence: young, exceptional downside sensitivity so far and solid upside. We limited our search to a dozen core equity categories, such as Moderate Balanced and Large Growth.

In all of these tables, “APR vs Peer” measures the difference in Annual Percentage Return between a fund’s lifetime performance and its average peers. A fund might have a 14 month record which the screener annualizes; that is, it says “at this rate, you’d expect to earn X in a year.” That’s important because a fund with a scant 12 month record is going to look a lot worse than one at 20 or 24 months since 2015, well, sucked.

Herewith, the 2016 Rookie of the Year nominees:

Hmmm … you might notice that the large cap list is dominated by ETFs, two active and two passive. There were a larger number of active funds on the original list but I deleted Fidelity funds (three of them) that were only available for use by other Fidelity managers.

This is another category where we had to dump a bunch of internal-only Fidelity funds. It’s interesting that no passive fund was even near the top of the list, perhaps because the ability to move between size ranges is active and useful?

At the other end of the spectrum, it was durn tough to find strong performance among “rookie” international funds. In the emerging markets arena, for example, just one fund had a positive Martin Ratio: Brown Advisory Emerging Markets Small-Cap (BIANX). Everyone else was down a deep, deep hole.

While we’re not endorsing any of these funds just yet, they’ve distinguished themselves with creditable starts in tough markets. In the months ahead, we’ll be trying to learn more about them on your behalf.

For the convenience of MFO Premium members who are interesting in digging into rookie funds more deeply, Charles created a preset screen for high-achieving younger funds. He offers dozens of data points on each of those funds where we only have room, or need, for a handful here.

Premium Site Update

New to MFO Premium this month are several additions to the MultiSearch Tool, which now can screen our monthly fund database with some 44 performance metrics and other parameters. (Here are links to current Input and Output MultiSearch Parameter Lists.) The new additions include SubType (a kind of super category), exchange-traded fund (ETF) flag, Profiled Funds flag, and some initial Pre-Set Screens.

SubType is a broad grouping of categories. Lipper currently defines 144 categories, excluding money market funds. MFO organizes them into 9 subtypes: U.S. Equity, Mixed Asset, Global Equity, International Equity, Sector Equity, Commodity, Alternative & Other, Bond, and Municipal Bond funds. The categories are organized further into broader types: Fixed Income, Asset Allocation, and Equity funds. The MultiSearch Tool enables screening of up to 9 categories, 3 subtypes, or 2 types along with other criteria.

The Profiled Funds flag enables screening of funds summarized monthly on our Dashboard (screenshot here). Each month, David (and occasionally another member of MFO’s staff), typically provides in-depth analysis of two to four funds, continuing a FundAlarm tradition. Through November 2015, 117 profiles are available on MFO legacy site Funds page. “David’s Take” precariously attempts to distill the profile into one word: Positive, Negative, or Mixed.

The ETF flag is self-explanatory, of course. How many ETFs are in our November database? A lot! 1,716 of the 9,034 unique (aka oldest share class) funds we cover are ETFs, or nearly 19%. The most populated ETF subtype is Sector Equity with 364, followed by International Equity with 343, US Equity with 279, and Bonds with 264. At nearly $2T in assets under management (AUM), ETFs represent 12% of the market. Our screener shows 226 ETFs with more than $1B in AUM. Here is a summary of 3-year performance for top ten ETFs by AUM (click on image to enlarge):

The Pre-Set Screen option is simply a collection of screening criteria. The two initial screens are “Best Performing Rookie Funds” and “Both Great Owl and Honor Roll Funds.” The former generates a list of 160 funds that are between the age of 1 and 2 years old and have delivered top quintile risk adjusted return (based on Martin Ratio) since their inception. The latter generates a list of 132 funds that have received both our Great Owl distinction as well as Honor Roll designation. Here is a summary of 3-year performance for top ten such funds, again by AUM (click on image to enlarge) … it’s an impressive list:

Other Pre-Screens David has recommended include “moderate allocation funds with the best Ulcer Index, small caps with the shortest recovery times, fixed-income funds with the smallest MAXDD …” Stay tuned.

Along with the parameters above, new options were added to existing criteria in the MultiSearch Tool. These include 30, 40, and 50 year Age groups; a “Not Three Alarm” rating; and, a “0% Annual or More” Absolute Return setting.

Using the new “0% Annual or More” criterion, we can get a sense of how tough the past 12 months have been for mutual funds. Of the 8,450 funds across all categories at least 12 months old through November 2015, nearly 60% (4,835) returned less than 0% for the year. Only 36 of 147 moderate allocation funds delivered a positive return, which means nearly 75% lost money … believe it or not, this performance was worse than the long/short category.

A closer look at the long/short category shows 56 of 121 funds delivered positive absolute return. Of those, here are the top five based on risk adjusted return (Martin Ratio) … click on image to enlarge:

AQR Long/Short

AQR’s rookie Long/Short Equity I (QLEIX) has been eye-watering since inception, as can be seen in its Risk Profile (click on images to enlarge):

While I’ve always been a fan of Cliff Asness and the strategies at AQR, I’m not a fan of AQR Funds, since experiencing unfriendly shareholder practices, namely lack of disclosure when its funds underperform … but nothing speaks like performance.

Whitebox Funds

I have also always been a fan of Andrew Redleaf and Whitebox Funds, which we featured in the March 2015 Whitebox Tactical Opportunities 4Q14 Conference Call and October 2013 Whitebox Tactical Opportunities Conference Call. David has remained a bit more guarded, giving them a “Mixed” profile in April 2013 Whitebox Market Neutral Equity Fund, Investor Class (WBLSX), April 2013.

This past month the Minneapolis-based shop decided to close its three open-end funds, which were based on its hedge-fund strategies, less than four years after launch. A person familiar with the adviser offered: “They were one large redemption away from exposing remaining investors to too great a concentration risk … so, the board voted to close the funds.” AUM in WBMIX had grown to nearly $1B, before heading south. According to the same person, Whitebox hedge funds actually attracted $2B additional AUM the past two years and that was where they wanted to concentrate their efforts.

The fund enjoyed 28 months (about as long as QLEIX is old) of strong performance initially, before exiting the Mr. Market bus. Through November 2015, it’s incurred 19 consecutive months of drawdown and a decline from its peak of 24.2%. Depicting its rise and fall, here is a Morningstar growth performance plot of WBMIX versus Vanguard’s Balanced Fund Index (VBINX), as well as the MFO Risk Profile (click on images to enlarge):

Ultimately, Mr. Redleaf and company failed to deliver returns across the rather short life span of WBMIX consistent with their goal of “the best endowments.” Ultimately, they also failed to deliver performance consistent with the risk tolerance and investment timeframe of its investors. Ultimately and unfortunately, there was no “path to victory” in the current market environment for the fund’s “intelligent value” strategy, as compelling as it sounded and well-intended as it may have been.

As always, a good discussion can be found on the MFO Board Whitebox Mutual Funds Liquidating Three Funds, along with news of the liquidations.

Year-end MFO ratings will be available on or about 4th business day, which would be January 7^th on both our premium and legacy sites.

Snow Tires and All-Weather portfolios

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

By Leigh Walzer

Readers of a certain age will remember when winter meant putting on the snow tires. All-season tires were introduced in 1978 and today account for 96% of the US market. Not everyone is sure this is a good idea; Edmunds.com concludes “snow and summer tires provide clear benefits to those who can use them.”

As we begin 2016, most of the country is getting its first taste of winter weather. “Putting on the snow tires” is a useful metaphor for investors who are considering sacrificing performance for safety. Growth stocks have had a great run while the rest of the market sits stagnant. Fed-tightening, jittery credit markets, tight-fisted consumer, commodity recession, and sluggishness outside the US are good reasons for investor caution.

Some clients have been asking if now is a good time to dial back allocations to growth. In other words, should they put the snow tires on their portfolio.

The dichotomy between growth and value and the debate over which is better sometimes approaches theological overtones. Some asset allocators are convinced one or the other will outperform over the long haul. Others believe each has a time and season. There is money to be made switching between growth and value, if only we had 20/20 hindsight about when the business cycle turns.

When has growth worked better than value?

Historically, the race between growth and value has been nearly a dead heat. Exhibit 1 shows the difference in the Cumulative return of Growth and Value strategies over the past twenty years. G/V is a measure of the difference in return between growth and value in a given period Generally speaking, growth performed better in the 90s, a period of loose money up to the internet bust. Value did better from 2000-2007. Since 2007, growth has had the edge despite a number of inflections. Studies going back 50 years suggest value holds a slight advantage, particularly during the stagflation of the 1970s.

Exhibit I

Growth tends to perform better in up-markets. This relationship is statistically valid but the magnitude is almost negligible. Over the past twenty years Trapezoid’s US Growth Index had a beta of 1.015 compared with 0.983 for Value.

Exhibit II

The conventional wisdom is that growth stocks should perform better early to mid-cycle while value stocks perform best late in the business cycle and during recession. That might loosely describe the 90s and early 2000s. However, in the run up the great recession, value took a bigger beating as financials melted down. And when the market rebounded in April 2009, value led the recovery for the first six months.

Value investors expect to sacrifice some upside capture in order to preserve capital during declining markets. Exhibit III, which uses data from Morningstar.com about their Large Growth (“LG”) and Large Value (“LV”) fund categories, shows the reality is less clear. In 2000-2005 LV lived up to its promise: it captured 96% of LG’s upside but only 63% of its downside. But since 2005 LV has actually participated more in the downside than LG.

Recent trend

In 2015 (with the year almost over as of this writing), value underperformed growth by about 5%. Value funds are overweight energy and underweight consumer discretionary which contributed to the shortfall.

Can growth/value switches be predicted accurately?

In the long haul, the two strategies perform nearly equally. If the weatherman can’t predict the snow, maybe it makes sense to leave the all-season tires on all year.

We can look through the historical Trapezoid database to see which managers had successfully navigated between growth and value. Recall that Trapezoid uses the Orthogonal Attribution Engine to attribute the performance of active equity managers over time to a variety of skills. Trapezoid calculates the contribution to portfolio return from overweighting growth or value in a given period. We call this sV.

Bear in mind that Trapezoid LLC does not call market turns or rate sectors for timeliness. And Trapezoid doesn’t try to forecast whether growth or value will work better in a given period. But we do try to help investors make the most of the market. And we look at the historic and projected ability of money managers to outperform the market and their peer group based on a number of skills.

The Trapezoid data does identify managers who scored high in sV during particular periods. Unfortunately, high sV doesn’t seem to carry over from period to period. As Professor Snowball would say, sV lacks predictive validity; the weatherman who excelled last year missed the big storm this year. However, the data doesn’t rule out the possibility that some managers may have skill. As we have seen, growth or value can dominate for many years, and few managers have sufficient tenure to draw a strong conclusion.

We also checked whether market fundamentals might help investors allocate between growth and value. We are aware of one macroeconomic model (Duke/Fuqua 2002) which claims to successfully anticipate 2/3 of growth and value switches over the preceding 25 years.

One hypothesis is that value excels when valuations are stretched while growth excels when the market is not giving enough credit to earnings growth. In principle this sounds almost tautologically correct. However, implementing an investment strategy is not easy. We devised an index to see how much earnings growth the market is pricing in a given time (S&P500 E/P less 7-year AAA bond yield adjusted for one year of earning growth). When the index is high, it means either the equity market is attractive relative bonds or that the market isn’t pricing in much earnings growth. Conversely, when the index is low it means valuations of growth stocks are stretched and therefore investors should load up on value. We looked at data from 1995-2015 and compared the relative performance of growth and value strategies over the following 12 months. We expected that when the index is high growth would do better.

Exhibit IV

There are clearly times when investors who heeded this strategy would have correctly anticipated investing cycles. We found the index was directionally correct but not statistically significant. Exhibit IV shows the Predictor has been trending lower in 2015 which would suggest that the growth cycle is nearly over.

All-Weather Managers

Since it is hard to tell when value will start working, investors could opt for all-weather managers, i.e. managers with a proven ability to thrive during value and growth periods.

We combed our database for active equity managers who had an sV contribution of at least 1%/year in both the growth era since 1q07 and the value market which preceded it. Our filter excludes a large swath of managers who haven’t been around 9 years. Only six funds passed this screen – an indication that skill at navigating between growth and value is rare. We knocked out four other funds because, using Trapezoid’s standard methodology, projected skill is low or expenses are high. This left just two funds.

Century Shares Trust (CENSX), launched in 1928, is one of the oldest mutual funds in the US. The fund tracks itself against the Russell 1000 Growth Index but does not target a particular sector mix and apply criteria like EV/EBITDA more associated with value. Expenses run 109bps. CENSX’s performance has been strong over the past three years. Their long-term record selecting stocks and sectors is not sufficient for inclusion in the Trapezoid Honor Roll.

Does CENSX merit extra consideration because of the outstanding contribution from rotating between growth and value? Serendipity certainly plays a part. As Exhibit V illustrates, the current managers inherited in 1999 a fund which was restricted by its charter to financials, especially insurance. That weighting was very well-suited to the internet bust and recession which followed. They gradually repositioned the portfolio towards large growth. And he has made a number of astute switches. Notably, he emphasized consumer discretionary and exited energy which has worked extremely well over the past year. We spoke to portfolio manager Kevin Callahan. The fund is managed on a bottom-up fundamentals basis and does not have explicit sector targets. But he currently screens for stocks from the Russell 1000 Growth Index and seem reluctant to stray too far from its sector weightings, so we expect growth/value switching will be much more muted in the future.

The other fund which showed up is Cohen & Steers Global Realty Fund (CSSPX). The entire real estate category had positive sV over the past 15-20 years; real estate (both domestic and global) clobbered the market during the value years, gave some back in the run-up to the financial crisis, and has been a market performer since then.

We are not sure how meaningful it is that CSSPX made this list over some other real estate funds with similar focus and longevity. Investors may be tempted to embrace real estate as an all-weather sector. But over the longer haul real estate has had a more consistent market correlation with beta averaging 0.6 which means it participated equally in up and down markets.

More complete information can be found at www.fundattribution.com. MFO readers can sign up for a free demo. Please click the link from the Model Dashboard (login required) to the All-Weather Portfolio.

The All-Season Portfolio

Since we are not sure that good historic sV predicts future success and managers with a good track record in this area are scarce, investors might take a portfolio approach to all-season investing.

1. Find best of breed managers. Use Trapezoid’s OAE to find managers with high projected skill relative to cost. While the Trapezoid demo rates only Large Blend managers (link to the October issue of MFO), the OAE also identifies outstanding managers with a growth or value orientation.
2. Strike the right balance. Many thoughtful investors believe “value is all you need” and some counsel 100% allocation to growth. Others apply age-based parameters. Based on the portfolio-optimization model I consulted and my dataset, the recommended weighting of growth and value is nearly 50/50. In other words: snow tires on the front, summer tires on the back. (Note this recommendation is for your portfolio, for auto advice please ask a mechanic.) I used 20 years of data; using a longer time frame, value might look better.

Bottom line:

It is hard to predict whether growth or value will outperform in a given year. Demonstrable skill shifting between growth and value is surprisingly scarce. Investors who are content to be passive can just stick to funds which index the entire market. A better strategy is to identify skillful growth and value managers and weight them evenly.

The Alt Perspective: Commentary and news from DailyAlts.

As they say out here in Los Angeles, that’s a wrap. 2015 has come to a close and we begin anew. But before we get too far into 2016, let’s do a quick recap of some of the activity in the liquid alternatives market that occurred over the past year, starting with a performance review.

Performance Review

Let’s start with traditional asset classes for the full year of 2015, where the average mutual fund for all of the major asset classes (per Morningstar) delivered negative performance on the year:

• Large Blend U.S. Equity: -1.06%
• Foreign Equity Large Blend: -1.56%
• Diversified Emerging Markets: -13.83%
• Intermediate Term Bond: -0.35%
• World Bond: -4.09%
• Moderate Allocation: -1.96%

Now a look at the liquid alternative categories, per Morningstar’s classification. As with the traditional asset classes, none of the alternative categories escaped a negative return on the year:

• Long/Short Equity: -2.08%
• Non-Traditional Bonds: -1.84%
• Managed Futures: -1.06%
• Market Neutral: -0.39%
• Multi-Alternative: -2.48%
• Bear Market: -3.16%

And a few non-traditional asset classes, where real estate generated a positive return:

• Commodities: -24.16%
• Multi-Currency: -0.62%
• Real Estate: 2.39%
• Master Limited Partnerships: -35.12%

Overall, a less than impressive year across the board with energy leading the way to the bottom.

Asset Flows

Flows into alternative mutual funds and ETFs remained fairly constant over the year in terms of where the flows were directed, with a total of $20 billion of new assets being allocated to funds in Morningstar’s alternative categories. However, non-traditional bond funds, which are not included in Morningstar’s alternatives categories, saw nearly $10 billion of outflows through November.

While the flows appeared strong, only three categories had net positive flows over the past twelve months: Multi-alternative funds, managed futures funds and volatility based funds. The full picture is below (data source: Morningstar):

This concentration is not good for the industry, but just as we saw a shift from 2014 to 2015 (non-traditional bond funds were the largest asset gatherer in 2014), the flows will likely shift in 2016. I would expect managed futures to continue to see strong inflows, and both long/short equity and commodities could see a turn back to the positive.

Hot Topics

While there have been a slew of year-end fund launches (we will cover those next month), a dominant theme coming into the end of the year was fund closures. While the Third Avenue Focused Credit Fund announced an abrupt closure of its mutual fund due to significant outflows, the concentration of asset flows to alternative funds is causing a variety of managers to liquidate funds. Most recently, the hedge fund firm Whitebox Advisors decided to close three alternative mutual funds, the oldest of which was launched in 2011. This is a concerning trend, but reminds us that performance still rules.

On the research front, we published summaries of three important research papers in December, all three of which have been popular with readers:

• Will Retiring Baby Boomers Continue the Liquid Alts Boom? – Approximately 10,000 baby boomers turn 65 every day. Where will they invest their nest eggs when they retire? Liquid alternatives can provide a low volatility solution to keeping their wealth.
• Goldman Sachs Outlines the Case for a Multimanager Approach to Alternatives – While individual strategies can top the charts in any one year, mixing multiple strategies and allocating assets across multiple managers can provide more consistent results over time.
• AQR Puts Risk Parity Performance into Perspective – While risk parity strategies have had lackluster performance over the past few years, it doesn’t mean they need to be tossed aside.

If you would like to keep up with all the news from DailyAlts, feel free to sign up for our daily or weekly newsletter.

All the best for 2016! Have a happy, safe and prosperous year.

Elevator Talk: Randy Swan, Swan Defined Risk (SDRAX/SDRIX)

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.

Randy Swan manages SDRAX, which launched at the end of July 2012. He founded Swan Capital Management, which uses this strategy in their separately managed accounts in 1997. Before then, Mr. Swan was a CPA and senior manager for KPMG’s Financial Services Group, primarily working with insurance companies and risk managers. Mr. Swan manages about $27 million in other accounts, including the new Swan Defined Risk Emerging Markets (SDFAX).

“Stocks for the long term” is an attractive claim, give or take two small problems. First, investors live in the short term; their tolerance for pain is somewhere between three days and three years with most sitting toward the shorter end of that range. Second, sharp losses in the short term push the long-term further off; many of the funds that suffered 50% losses in the 2007-09 debacle remain underwater seven years later.

Bright investors know both of those things and try to hedge their portfolios against risk. The questions become (1) what risk do you try to hedge out? and (2) what tools do you choose? The answers include “everything conceivable and several inconceivable risks” and “balanced portfolios” to “expensive, glitch, inexplicably complicated black box schemes.”

Mr. Swan’s answers are (1) the risk of grinding bear markets but not short-term panics and (2) cheap, value-oriented equity exposure and long-dated options. The strategy is, he says, “always invested, always hedged.”

It’s nice to note that the strategy has outperformed both pure equity and balanced strategies, net of fees, since inception. $10,000 invested with Swan in 1997 has now grown to roughly $44,000 while a comparable investment in the S&P500 climbed to $30,300 and a balanced portfolio would have reached $25,000. I’m more struck, though, by the way that Swan generated those returns. The graphic below compares the variability in returns of the S&P and Swan’s strategy over the nearly 19 years he’s run the strategy. Each line represents the performance for one 10-year period (1998-2007, 1999-2008 and so on).

The consistency of Swan’s returns are striking: in his worst 10-year run, he averaged 7.5% annually while the best run generated 9%. The S&P returns are, in contrast, highly variable, unpredictable and lower.

Here are Mr. Swan’s 222 words on why you should add SDRAX to your due-diligence list:

We’ve managed this strategy since 1997 as a way of addressing the risks posed by bear markets. We combine tax-efficient, low-cost exposure to the U.S. stock market with long-dated options that protect against bears rather than corrections. We’re vulnerable to short-term declines like August’s correction but we’ve done a great job protecting against bears. That’s a worthwhile tradeoff since corrections recover in months (August’s losses are pretty much wiped out already) but bears take years.

Most investors try to manage risk with diversification but you can’t diversify market risk away. Instead, we choose to directly attack market risk by including assets that have an inverse correlation to the markets. At the same time, we maintain a stock portfolio that equally weights all nine sectors through the Select SPDR ETFs which we rebalance regularly. In the long-term, all of the research we’ve seen says an equal-weight strategy will outperform a cap-weighted one because it forces you to continually buy undervalued sectors. That strategy underperforms at the end of a bull market when index gains are driven by a handful of momentum-driven stocks, but over full market cycles it pays off.

Our maxim is KISS: keep it simple, stupid. Low-cost market exposure, reliable hedges against bear markets, no market timing, no attempts at individual security selection. It’s a strategy that has worked for us.

The fund lost about 4% in 2015. Over the past three years, the fund has returned 5.25% annually, well below the S&P 500’s 16%. With the fund’s structural commitment to keeping 10% in currently-loathed sectors such as energy, utilities and basic materials, that’s neither surprising nor avoidable.

Swan Defined-Risk has a $2500 minimum initial investment on its “A” shares, which bear a sales load, and $100,000 on its Institutional shares, which do not. Expenses on the “A” shares run a stiff 1.58% on assets of $1.4 billion, rather below average, while the institutional shares are 25 basis points less. Load-waived access to the “A” shares is available through Schwab, Fidelity, NFS, & TD Ameritrade. Pershing will be added soon.

Here’s the fund’s homepage. Morningstar also wrote a reasonably thoughtful article reflecting on the difference in August 2015 performance between Swan and a couple of apparently-comparable funds. A second version of the article features an annoying auto-launch video.

Funds in Registration

There are 14 new no-load funds in the pipeline. Most will be available by late February or early March. While the number is not extraordinarily high, their parentage is. This month saw filings on behalf of American Century (three funds), DoubleLine, T. Rowe Price (three) and Vanguard (two).

The most intriguing registrant, though, is a new fund from Seafarer. Seafarer Overseas Value Fund will invest in an all-cap EM stock portfolio. Beyond the bland announcement that they’ll use a “value” approach (“investing in companies that currently have low or depressed valuations, but which also have the prospect of achieving improved valuations in the future”), there’s little guidance as to what the fund’s will be doing.

The fund will be managed by Paul Espinosa. Mr. Espinosa had 15 years as an EM equity analyst with Legg Mason, Citigroup and J.P. Morgan before joining Seafarer in May, 2014. Seafarer’s interest in moving in the direction of a value fund was signaled in November, with their publication of Mr. Espinosa’s white paper entitled On Value in the Emerging Markets. It notes the oddity that while emerging markets ought to be rife with misvalued securities, only 3% of emerging markets funds appear to espouse any variety of a value investing discipline. That might reflect Andrew Foster’s long-ago observer that emerging markets were mostly value traps, where corporate, legal and regulatory structures didn’t allow value to be unlocked. More recently he’s mused that those circumstances might be changing.

In any case, after a detailed discussion of what value investing might mean in the emerging markets, the paper concludes:

This exploration discovered a large value opportunity set with an aggregate market capitalization of $1.4 trillion, characterized by financial metrics that strongly suggest the pervasive presence of discounts to intrinsic worth.

After examining most possible deterrents, this study found no compelling reason that investors would forgo value investing in the emerging markets. On the contrary, this paper documented a potential universe that was both large and compelling. The fact that such an opportunity set remains largely untapped should make it all the more attractive to disciplined value practitioners.

The initial expense ratio has not yet been set, though Seafarer is evangelical about providing their services at the lowest practicable cost to investors, and the minimum initial investment is $2,500.

Manager Changes

Fifty-six funds saw partial or complete turnover in their management teams in the past month. Most of the changes seemed pretty modest though, in one case, a firm’s president and cofounder either walked out, or was shown, the door. Curious.

Updates

Back in May, John Waggoner took a buyout offer from USA Today after 25 years as their mutual funds guru. Good news: he’s returning to join InvestmentNews as a senior contributor and mutual funds specialist. Welcome back, big guy!

Briefly Noted . . .

At a Board meeting held on December 11, 2015, RiskX Investments, LLC (formerly American Independence Financial Services, LLC), the adviser to the RX Dynamic Stock Fund (IFCSX formerly, the American Independence Stock Fund), recommended to the Trustees of the Board that the Fund change its investment strategy from value to growth. On whole, that seems like a big honkin’ shift if you were serious about value in the first place but they weren’t: the fund’s portfolio – which typically has a turnover over 200% a year – shifted from core to value to core to value to growth over five consecutive years. That’s dynamic!

SMALL WINS FOR INVESTORS

“The closure of the 361 Managed Futures Strategy Fund (AMFQX) to investment by new investors that was disclosed by the Fund in Supplements dated September 9, 2015, and September 30, 2015, has been cancelled.” Well, okay then!

On December 31^st, Champlain Emerging Markets Fund (CIPDX) announced that it was lowering its expense ratio from 1.85% to 1.60%. With middle-of-the-road performance and just $2 million in assets, it’s worth trying.

It appears that AMG Frontier Small Cap Growth Fund (MSSGX) and AMG TimesSquare Mid Cap Growth Fund (TMDIX) reopened to new investors on January 1. Their filings didn’t say that they reopening; they said, instead, that “With respect to the sub-section ‘Buying and Selling Fund Shares’ in the section ‘Summary of the Funds’ for the Fund, the first paragraph is hereby deleted in its entirety.” The first paragraph explained that the funds were soft-closed.

Effective January 1, ASTON/Cornerstone Large Cap Value Fund (RVALX) will reduce its expense ratio from 1.30% to 1.14% on its retail shares. Institutional shares will see a comparable drop.

Effective as of February 1, 2016, the Columbia Acorn Emerging Markets Fund (CAGAX) and Columbia Small Cap Growth Fund (CGOAX) will be opened to new investors and new accounts.

Effective January 1, 2016, Diamond Hill reduced its management fee for the four-star Diamond Hill Large Cap Fund (DHLAX) from an annual rate of 0.55% to 0.50%.

Effective immediately, the minimum initial investment requirements for the Class I Shares of Falcon Focus SCV Fund (FALCX) are being lowered to $5,000 for direct regular accounts and $2,500 for direct retirement accounts, automatic investment plans and gift accounts for minors.

Here’s why we claim to report nothing grander than “small wins” for investors: the board of Gotham Absolute 500 Fund (GFIVX) has graciously agreed to reduce the management fee from 2.0% to 1.5% and the expense cap from 2.25% to 1.75%. All of this on an institutional long/short fund with high volatility and a $250,000 minimum. The advisor calculates that it actually costs them 5.42% to run the fund. The managers both have over $1 million in each of their four funds.

Grandeur Peak has reduced fees on two of its funds. Grandeur Peak Emerging Markets Opportunities Fund (GPEOX) to 1.95% and 1.70% and Grandeur Peak Global Reach Fund (GPGRX) to 1.60% and 1.35%.

Effective January 4, 2016, Royce Premier Fund (RYPRX) and Royce Special Equity Fund (RYSEX) will reopen to new shareholders. Why, you ask? Each fund’s assets have tumbled by 50% since 2013 as Premier trailed 98% of its peers and Special trailed 92%. Morningstar describes Special as “a compelling small-cap option” and gives it a Gold rating.

Teton Westwood Mid-Cap Equity Fund (WMCRX) has reduced the expense cap for Class I shares of the Fund to 0.80%.

CLOSINGS (and related inconveniences)

Effective as of the close of business on December 31, 2015, Emerald Growth Fund (HSPGX) closed to new investors

The Class A shares of Hatteras Managed Futures Strategies Fund were liquidated in mid-December. The institutional class (HMFIX) remains in operation for now. Given that there’s a $1 million minimum initial investment and far less than $1 million in assets in the fund, I suspect we’ll continue thinning out of liquid-alts category soon.

Effective as of the close of business on January 28, 2016, Vontobel International Equity Institutional (VTIIX) and Vontobel Global Equity Institutional Fund (VTEIX) will soft close. Given that the funds have only $30 million between them, I suspect that they’re not long for this world. 

OLD WINE, NEW BOTTLES

At the end of February, Aberdeen Small Cap Fund (GSXAX) becomes Aberdeen U.S. Small Cap Equity Fund. Two bits of good news: (1) it’s already a very solid performer and (2) it already invests 93% of its money in U.S. small cap equities, so it’s not likely that that’s going to change. At the same time, Aberdeen Global Small Cap Fund (WVCCX) will become Aberdeen International Small Cap Fund. The news here is mixed: (1) the fund kinda sucks and (2) it already invests more than 80% of its money in international small cap equities, so it’s not likely that that’s going to change either.

Sometime in the first quarter of 2016, Arden Alternative Strategies Fund (ARDNX) becomes Aberdeen Multi-Manager Alternative Strategies Fund, following Aberdeen’s purchase of Arden Asset Management.

Effective on February 1, 2016: AC Alternatives Equity Fund, which hasn’t even launched yet, will change its name to AC Alternatives Long Short Fund. After the change, the fund will no longer be required to invest at least 80% of its portfolio in equities.

As of February 27, 2016, Balter Long/Short Equity Fund (BEQRX) becomes Balter L/S Small Cap Equity Fund.

At an as-yet unspecified date, Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX) will become RidgeWorth Capital Innovations Global Resources and Infrastructure Fund. Interesting little fund, the subject of an Elevator Talk several months ago.

Gator Opportunities Fund (GTOAX) is on its way to becoming BPV Small Cap Fund, likely by the beginning of summer, 2016. The fund will shed its mid-cap holdings in the process.

At the end of January 2016, Marsico Growth FDP Fund (MDDDX) will become FDP BlackRock Janus Growth Fund. Which is to say, yes, Marsico lost another sub-advisory contract.

Effective December 31, 2015, the Meeder Strategic Growth Fund (FLFGX) changed its name to Global Opportunities Fund.

On February 24, 2016, the T. Rowe Price Diversified Small-Cap Growth Fund (PRDSX) will change its name to the T. Rowe Price QM U.S. Small-Cap Growth Equity Fund. The addition of “QM” in the fund’s name reflects the concept that the fund employs a “quantitative management” strategy.

On March 1, Transamerica Asset Management will make a few tweaks to Transamerica Growth Opportunities (ITSAX). The managers will change (from Morgan Stanley to Alta Capital); likewise the “fund’s investment objective, principal investment strategies, principal risks, benchmark index, portfolio managers [and] name, will change. The fund will also have a lower advisory fee schedule.” The reborn fund will be named Transamerica Multi-Cap Growth.

Effective January 31, 2016, the principal investment strategy of Turner Emerging Growth Fund (TMCGX) shifts from focusing on “small and very small” cap stocks to “small and mid-cap” ones. The fund will also change its name to the Turner SMID Cap Growth Opportunities Fund. 

OFF TO THE DUSTBIN OF HISTORY

All Terrain Opportunity Fund (TERAX) liquidated on December 4, 2015. Why? It was only a year old, had $30 million in assets and respectable performance.

Big 4 OneFund (FOURX) didn’t make it to the New Years. The fund survived for all of 13 months before the managers despaired for the “inability to market the Fund.” It was a fund of DFA funds (good idea) which lost 12% in 12 months and trailed 94% of its peers. One wonders if the adviser should have ‘fessed up the “the inability to manage a fund that was worth buying”?

BPV Income Opportunities Fund liquidated on December 22, 2015, on about a week’s notice.

The Board of Trustees of Natixis Funds determined that it would be in the best interests of CGM Advisor Targeted Equity Fund (NEFGX) that it be liquidated, which will occur on February 17, 2016. Really, they said that: “it’s in the fund’s best interests to die.” The rest of the story is that CGM is buying itself back from Natixis; since Natixis won’t accept outside managers, the fund needed either to merge or liquidate. Natixis saw no logical place for it to merge, so it’s gone.

C Tactical Dynamic Fund (TGIFX) liquidated on December 31, 2015.

Clinton Long Short Equity Fund (WKCAX) liquidates on January 8, 2016.

Columbia has proposed merging away a half dozen of its funds, likely by mid-2016 though the date hasn’t yet been settled.

On or about March 31, 2016, the ESG Managers Growth Portfolio (PAGAX) will be consolidated into the ESG Managers Growth and Income Portfolio (PGPAX), which will then be renamed Pax Sustainable Managers Capital Appreciation Fund. At the same time, ESG Managers Balanced Portfolio (PMPAX) will be consolidated into the ESG Managers Income Portfolio (PWMAX) which will then be known as Pax Sustainable Managers Total Return Fund. The funds are all sub-advised by Morningstar staff.

Fortunatus Protactical New Opportunity Fund (FPOAX) liquidated on December 31, 2015. Why? The fund launched 12 months ago, had respectable performance and had drawn $40 million in assets. Perhaps combining the name of a 15^th century adventurer (and jerk) with an ugly neologism (protactical? really?) was too much to bear.

Foundry Small Cap Value Fund liquidated on December 31, 2015.

Frost Cinque Large Cap Buy-Write Equity Fund (FCBWX) will cease operations and liquidate on or about February 29, 2016.

The tiny, one-star Franklin All Cap Value Fund (FRAVX), a fund that’s about 60% small caps, is slated to merge with huge, two-star Franklin Small Cap Value Fund (FRVLX), pending shareholder approval. That will likely occur at the beginning of April.

Back in 2008, if you wanted to pick a new fund that was certain to succeed, you’d have picked GRT Value. It combined reasonable expenses, a straightforward discipline and the services of two superstar managers (Greg Frasier, who’d been brilliant at Fidelity Diversified International and Rudy Kluiber who beat everyone as manager of State Street Research Aurora). Now we learn that GRT Value Fund (GRTVX) and GRT Absolute Return Fund (GRTHX) will liquidate on or about January 25, 2016. What happened? Don’t know. The fund rocketed out of the gate then, after two years, began to wobble, then spiral down. Both Value and its younger sibling ended up as tiny, failed shells. Perhaps the managers’ attention was riveted on their six hedge funds or large private accounts? Presumably the funds’ fate was sealed by GRT’s declining business fortunes. According to SEC filing, the firm started 2015 with $950 million in AUM, which dropped by $785 million by June and $500 million by September. The declining size of their asset base was accompanied by a slight increase in the number of accounts they were managing, which suggests the departure of a few major clients and a scramble to replace them with new, smaller accounts.

The folks behind the Jacobs/Broel Value Fund (JBVLX) have decided to liquidate the fund based on “its inability to market the Fund and the Adviser’s indication that it does not desire to continue to support the Fund.” Nearly all of the assets in the fund are the managers’ own money, perhaps because others wondered about paying 1.4% for:

The fund will liquidate on January 15, 2016.

On or around January 28, 2016, JOHCM Emerging Markets Small Mid Cap Equity Fund Service Class shares (JOMIX) will liquidate.

The Board of Directors of the Manning & Napier Fund, Inc. has voted to completely liquidate the Focused Opportunities Series (MNFSX) on or about January 25, 2016.

HSBC Growth Fund (HOTAX) will cease its investment operations and liquidate on or about February 12, 2016. Apparently the combination of consistently strong results with a $78 million asset base was not compelling.

McKinley Diversified Income Fund (MCDRX) is merging with Innovator McKinley Income Fund (IMIFX), pending shareholder approval. The reorganization will occur January 29, 2016.

Leader Global Bond Fund (LGBMX) will close, cease operations, redeem all outstanding shares and liquidate, all on January 29, 2016.

Madison Large Cap Growth Fund (MCAAX) merges with and into the Madison Investors Fund (MNVAX) on February 29, 2016. The Board mentions the identical objectives, strategies, risk profile and management as reason for why the merger is logical.

The Newmark Risk-Managed Opportunistic Fund (NEWRX) liquidated on December 31, 2015. The Board attributed the decision to the fund’s small size, rather than to the underlying problem: consistently bad short- and long-term performance.

Nile Frontier and Emerging Fund (NFRNX) liquidated, on about three weeks’ notice, on December 31, 2015.

QES Dynamic Fund (QXHYX) liquidated on December 17, 2015, after a week’s notice.

On January 29, 2016, Redmont Resolute Fund I (RMREX) becomes Redmont Dissolute Fund as it, well, dissolves.

Royce has now put the proposals to merge Royce European Small-Cap Fund (RESNX) and Global Value (RIVFX) into Royce International Premier Fund (RYIPX) to their shareholders. The proposal comes disturbingly close to making the argument that, really, there isn’t much difference among the Royce funds. Here is Royce’s list of similarities:

• the same objective;
• the same managers;
• the same investment approach;
• the same investment universe, small-cap equities;
• the same sort of focused portfolio;
• all provide substantial exposure to foreign securities;
• the same policy on hedging;
• the same advisory fee rates;
• the same restrictions on investments in developing country securities; and
• almost identical portfolio turnover rates.

Skeptics have long suggested that that’s true of the Royce funds in general; they have pretty much one or two funds that have been marketed in the guise of 20 distinct funds.

Third Avenue Focused Credit Fund (TFCVX) nominally liquidated on December 9, 2015. As a practical matter, cash-on-hand was returned to shareholders and the remainder of the fund’s assets were placed in a trust. Over the next year or so, the adviser will attempt to find buyers for its various illiquid holdings. The former fund’s shareholders will receive dribs and drabs as individual holdings are sold “at reasonable prices.”

Valspresso Green Zone Select Tactical Fund liquidated on December 30, 2015.

On December 2, 2015, Virtus Disciplined Equity Style, Virtus Disciplined Select Bond and Virtus Disciplined Select Country funds were liquidated.

Whitebox is getting out of the mutual fund business. They’ve announced plans to liquidate their Tactical Opportunities (WBMAX), Market Neutral Equity (WBLSX) and Tactical Advantage (WBIVX) funds on or about January 19, 2016.

In Closing . . .

In case you sometimes wonder, “Did I learn anything in the past year?” Josh Brown offered a great year-end compendium of observations from his friends and acquaintances, fittingly entitled “In 2015, I learned that …” Extra points if you can track down the source of “Everything’s amazing and nobody’s happy.”

And as for me, thanks and thanks and thanks! Thanks to the 140 or so folks who’ve joined MFO Premium as a way of supporting everything we’re doing. Thanks to the folks who’ve shared books, both classic (Irrational Exuberance, 3e) and striking (Spain: The Centre of the World, 1519-1682) and chocolates. I’m so looking forward to a quiet winter’s evening to begin them. Thanks to the folks who’ve read us and written to us, both the frustrated and the effusive. Thanks to my colleagues, Charles, Ed and Chip, who do more than I could possibly deserve. Thanks to the folks on the discussion board, who keep it lively and civil and funny and human. Thanks to the folks who’ve volunteered to help me learn to be halfway a businessperson, Sisyphus had it easier.

And thanks, especially, to all of you who’ll be here again next month.

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 the dog days.

“Dog days” didn’t originally have anything to do with dogs, of course. It derived from the ancient belief shared by Egyptians, Greeks and Romans that summer weather was controlled by Sirius, the Dog Star. Why? Because Sirius rises just at dawn in the hottest, most sultry months of the year.

FreeImages.com/superburg

In celebration of the fact that the dog days of summer have arrived and you should be out by the pool with family, we’re opening our annual summer-weight issue with some good news.

MFO is a charity case

And you just thought we were a basket case!

As a matter of economic and administrative necessity, the Observer has always been organized as a sole proprietorship. We’re pleased to announce that, in June, our legal status changed. On June 29, we became a non-profit corporation (Mutual Fund Observer, Inc.) under Iowa law. On July 6, the Internal Revenue Service “determined that [we’re] exempt from federal income tax under Internal Revenue Code Section 501(c)(3).”

Why does that matter?

1. It means that all contributions to the Observer are now tax-deductible. We’ve always taken a moment to send hand-written thanks to folks for their support; going forward, we’ll include a card for their tax records.
2. It means that any contribution made on or after May 27, 2015 is retroactively tax deductible. After this issue is live and we’ve handled the monthly cleanup chores, we’ll begin sending the appropriate documents to the folks involved.
3. It means we’re finding ways to become a long-term source of commentary and analysis.

It’s no secret that the Observer’s annual operating budget is roughly equivalent to what some … hmmmm, larger entities in the field spend on paperclips. That works as long as highly talented individuals work pro bono (technically pro bono publico, literally, “for the public good”). As we turn more frequently to outsiders, whether for access to fund data or programming services, we’ll need to strengthen our finances. These changes are part of that effort.

Other changes in the media environment lead us to conclude that there’s an increasingly important role for an independent, authoritative public voice speaking for (and to) smaller investors and smaller fund firms. At the June Morningstar conference, there was quiet, nervous conversation about the prospect that The Wall Street Journal staff had been forced to re-apply for their own jobs. The editors of the Journal announced, in June, a plan to reduce personal finance coverage in the paper:

We will be scaling back significantly our personal finance team, though we will continue to provide high quality reporting and commentary on topics of personal financial interest to our readers.

These closures and realignments do not reflect on the quality of the work done by these teams but simply speak to the pressing need to become more focused as a newsroom on areas we believe are ripe for growth.

We will be better-equipped and better able to exploit the opportunities that exist in the fastest growing parts of our business: with enhanced and improved coverage of the news that we know translates into additional circulation and long-term growth. 

Details of the restructuring emerged in July. At base, resources are being moved from serving individual investors to serving financial advisors. While that’s good for the Journal’s profits and might be good for the 300,000 or so financial advisers in the country (a number that’s dropping steadily), it represents a further shift from serious service to the rest of us. (Thanks to Ari Weinberg for leading us to good coverage of these changes.)

Being a non-profit makes sense for us. It allows us to maintain our independence and focus (a nonprofit corporation is legally owned by all the people of a state and chartered to serve the public interest).

The Observer has always tried to act responsibly and our new legal status reflects that commitment. In addition to that whole “giving voice to the voiceless” thing, we consciously try to act as good stewards. By way of examples:

We work hard to minimize the stress we place on the planet and its systems. We travel very little and, when we do, we purchase carbon offsets through Carbonfund. Carbonfund allows individuals or businesses to calculate the amount of carbon released by their activities and to offset them with investments in a variety of climate-friendly projects from building renewable power systems to recapturing the methane produced in landfills and helping farmers control the effects of animal containment facilities. They’re a non-profit, seem to generate consistently high ratings from folks who assess their operations and write sensibly. In general, we tend to be carbon-negative.

The Observer is hosted by GreenGeeks. They host over 300,000 sites and are distinguished for the environmental commitment. They promise “if we pull 1X of power from the grid we purchase enough wind energy credits to put back into the grid 3X of power having been produced by wind power. Your website hosted with GreenGeeks will be powered by 300% wind energy, making your website’s carbon footprint negative.”

We think of food banks as something folks need mid-winter, which misses the fact that many children receive their only hot meal of the day (sometimes, only meal of the day) as part of their school’s breakfast and lunch programs. That’s led some charities to characterize summer as “the hungriest time of the year” for children. There’s a really worthy federal summer meals program, but it only reaches 15% of the kids who are fed during the regular school year.

We use the same approach here as we do in investing: make a commitment and automate it. On the last day of every month, there’s an automatic transfer from our checking to the River Bend FoodBank. It’s a good group that spends under 3% on administration. Our contribution is not major – enough to provide 150 meals for hungry families – but it’s the sort of absolutely steady inflow that allows an organization to help folks and do a meaningful planning.

All of which is, by the way, exciting and terrifying.

If you’d like to support the Mutual Fund Observer, you have two options:

1. To make a tax deductible contribution, please use our PayPal button on the right, or visit our Support Us page for our address to mail a check. You’ll receive a thank you with a receipt for your tax records.
2. We also strongly encourage everyone who shops at Amazon, now America’s largest retailer (take that Walmart!), to bookmark our Amazon link. Every time you buy anything at Amazon, using our link, we get a small percentage of the sale, and it costs you nothing.

Finding a family’s first fund

I suspect that very few of our readers need advice on selecting a “first fund.” But I’m very certain that you know people who are, or should be, starting their first investment account. Our faithful research associate David Welsch is starting down that road: first “real” job, the prospect of his first modest apartment and the need for starting to put money aside. The contractor who did a splendid job rebuilding my rotted deck admitted that up until now he’s had to spend everything he’s made to support his family and company, but now is in a place to start (just start) thinking about the future. A friend had a passing conversation with a grocery cashier (we’re in the Midwest, this sort of stuff happens a lot) who was saddened by an elderly friend struggling with money in his 70s; my friend suggested that the young lady ought to begin a small account for her own sake. “I know,” she sighed, “I knooow.” For the young men and women serving in the armed forces and making $20,000-30,000 a year, the challenge is just as great.

Mostly they think it’s hard, don’t know where to start, don’t know who to ask and can’t imagine it will make a difference. And you’re feeling a bit guilty because you haven’t been as much help as you’d like.

Here’s what to do. Read the article below. Print it out (we’ve even created a nice .pdf of it for you). Hand it to a young friend with the simple promise, “this will make it easy to get started.”

“The journey of a thousand miles begins …

with one step.” Lao-Tzu.

Good news: you’re ready to take that step and we’re here to help make it happen. We’re going to guide you through the process of setting up your first investment account. There are only two things you need to know:

It’s easy and

It will make a big difference. You’ll be glad you did it.

It’s easy. A mutual fund is simply a way of sharing with others in the costs of hiring a professional to make investments on your behalf. Mostly your manager will invest in either stocks or bonds. Stocks give you part-ownership in a company (Apple, Google, Ford); if the value of the company rises, the value of your shares will rise too. Some companies will soar; others will crash so it’s wiser for investors to invest broadly in a bunch of companies than to try to find individual winners. Bonds are ways for governments or companies to borrow money and pay it back, with interest, over time. “Iffy” borrowers have to pay a bit more in interest, so you earn a bit more on loans to them; high quality borrowers pay you a bit less but you can be pretty sure that they’ll repay their borrowings promptly and fully.

Over very long periods, stocks make more money than bonds but, over shorter periods, stocks can lose a lot more money than bonds.  Your best path is to own some of each, rather than betting entirely on one or the other. If you look back over the last 65 years, you can see the pattern: stocks provide the most long-term gain but also the greatest short-term pain.

How do you read the table? As you double your exposure to stocks, going from 40% to 80%, you add 2.4% to your average annual return. That’s good, though the gain is not huge. At the same time, you increase by 30% the chance of finishing a year in the red and you triple the size of the loss you might expect.  

We searched through about 7000 mutual funds on your behalf, looking for really good first funds. We looked for four virtues:

• They can handle stormy weather. All investments rise and fall; we found ones that won’t fall far and long.
• They can handle sunny weather. Over time, things get better. The world’s economy grows, people have better lives and the world’s a richer place. We found funds that earned good returns over time so you could benefit from that growth.
• They don’t overcharge you. Your mutual fund is a business with bills to pay; as a shareholder in the fund you help pay those bills. Paying under 1% a year is reasonable. While 1% doesn’t seem like a lot, if your fund only makes 6% gains, you’d be returning 17% of those profits to the manager.
• They require only a small investment to get started. As low as $50 a month seemed within reach of folks who were determined to get started.

Getting the account set up requires about 20 minutes, a two page form and knowing your checking account numbers.

It will make a difference. How much can $50 a month get you? In one year, not so much. Over time, a surprising lot. Here’s how much your account might grow using three pretty conservative rates of return (5-7% per year) and four holding periods.

You read that correctly: if you’re a young investor able to put $50 a month away between now and retirement, just that contribution might translate to $100,000 or more.

Two things to remember: (1) Patience is your ally. Markets can be scary; sometimes they’re going down and you think they’ll never go up again. But they do. Always have. Here’s how to win: set up your account with a small automatic monthly investment, check in on it every year or so, add a bit more as your finances improve and go enjoy your life. (2) Small things add up over time. In the example above, if your fund pays you just 1% more it makes a 30% difference in how much you’ll have over the long term. Buying a fund with low expenses can make that 1% difference all by itself, and so can a small increase in the percentage of your account invested in stocks.

Three funds to consider. The August 2015 issue of Mutual Fund Observer, available free on-line, provides a more complete discussion of each of these funds. In addition to our own explanation of them, we’ve provided links to the form you’d need to complete to open an account, the most recent fact sheet provided by the fund company (it’s a two page “highlights of our fund” document) and a link to the fund’s homepage.

James Balanced: Golden Rainbow (ticker symbol: GLRBX). The fund invests about half of its money in stocks and half in bonds, though the managers have the ability to become much more cautious or much more daring if the situation calls for it. Mostly they’ve been cautious, successful investors; they’ve made about 6.9% per year over the past decade, with less risk than their peers. During the very bad period in 2008, the stock market fell about 40% while Golden Rainbow lost less than 6%. The fund’s operating expenses average 1.01% per year, which is low. Starting an account requires a monthly investment of $500 or a one-time investment of $2,000.

Why consider it? Very low starting investment, very cautious managers, very solid returns.

TIAA-CREF Lifestyle Conservative (TSCLX). TIAA-CREF’s traditional business has been providing low cost, conservatively managed investment accounts for people working at hospitals, universities and other non-profit organizations.  Today they manage about $630 billion for investors. The Lifestyle Conservative Fund invests about 40% of its money in stocks and 60% in bonds. It does that by investing in other TIAA-CREF mutual funds that specialize in different parts of the stock or bond market. This fund has only been around for four years but most of the funds in which it invests have long, solid records. The fund’s operating expenses average 0.87% per year, well below average. Starting an account requires a monthly investment of $100 or a one-time investment of $2,500.

Why consider it? The most conservative stock-bond mix in the group, solid lineup of funds it invests in, low expenses and a rock-solid advisor.

Vanguard STAR (VGSTX). Vanguard has a unique corporate structure; it’s owned by the shareholders in its funds. As a result, it has been famous for keeping its expenses amazingly low and its standards consistently high. They now manage over $3 trillion, which represents a powerful vote of confidence on the part of millions of investors. STAR is designed to be Vanguard’s first fund for beginning investors. STAR invests about 60% of its money in stocks and 40% in bonds. It does that by investing in other Vanguard funds. Over the past 10 years, it has earned about 6.8% per year and it lost 25% in 2008. The fund’s operating expenses are 0.34% per year, which is very low. Starting an account requires a one-time investment of $1,000.

Why consider it? The lowest expenses in the group, one-stop access to many of the best funds offered by the firm many consider the best in the world.

We’re targeting funds for you whose portfolios are somewhere around 40-60% stocks. Why so cautious? You might be thinking, “hey, these are Old People funds! I’m young. I’ve got time.  I want to invest in stocks, exciting 3D printing stocks!” Owning too many stocks is bad for your financial health. Imagine that you were really good, invested steadily and built a $10,000 portfolio. How would you feel if someone broke in, stole $5,000 from it and the police said that they thought it might take five to ten years to solve the crime and get your money back? In the meantime, you were out of luck. That’s essentially what happens from time to time in the stock market and it’s really discouraging. Those 3D printing stocks that seem so exciting? They’ve lost two-thirds of their value in the past year, many will never recover.

If you balance your portfolio, you get much better odds of success. Remember Table One, which gives you the tradeoff?  Balancing gives you a really good bargain, especially for the first step in your journey.

So what’s the next step? It’s easy. Pick the one that makes the most sense to you. Take 20 minutes to fill out a short account set-up form online. Tell them if you want to start by investing a little money or a lot. Fill it out, choose the option that says “reinvest my gains, please!” and go back to doing the stuff you really enjoy.

Two bits of follow-up for our regular readers. You might ask, why didn’t we tell folks to start with a six-month emergency fund? Two reasons. First, they are many good personal finance steps folks need to take: build a savings account, avoid eating out frequently, pay down high interest rate credit card debt and all. Since we’re not personal finance specialists, we decided to start where we could add value. Second, a conservative fund can act as a supplement to a savings account; if you’ve got a conservative $5,000 that will still hold $4,000-4,500 at the trough of a bear does provide emergency backup. In my own portfolio, I use T. Rowe Price Spectrum Income (RPSIX) and RiverPark Short-Term High Yield (RPHYX, closed) as my cash-management accounts. Both can lose money but both thump CDs and other “safe” choices most years while posting manageable losses in the worst of times.

Second, there may be other funds out there which would fit our parameters and provide a more-attractive profile than one of the three we’ve highlighted. If so, let us know at [email protected]! I’d love to follow-up next month with suggestions for other ways to help young folks who have neither the confidence nor the awareness to seek out a fully qualified financial advisor. One odd side-note: there are several “Retirement Income” funds with really good profiles; I didn’t mention them because I figured that 99% of young folks would reject them just for the name alone.

Where else might small investors turn for a second or third fund?

Once upon a time, the fund industry had faith in the discipline of average investors so they offered lots of funds with minuscule initial investments. The hope was that folks would develop the discipline of investing regularly on their own.

Oops. Not even I can manage that feat. As the industry quickly and painfully learned, if it’s not on auto-pilot, it’s not getting funded.

That’s a real loss, even if a self-inflicted one, for small investors.  Nonetheless, there remain about 130 funds accessible to folks with modest budgets and the willingness to make a serious commitment to improving their finances.  By my best reading, there are thirteen smaller fund families still taking the risk of getting stiffed by undisciplined investors.  The families willing to waive their normal investment minimums are:

Potpourri

by Edward A. Studzinski

Some men are born mediocre, some men achieve mediocrity, and some men have mediocrity thrust upon them.

       Joseph Heller

We are now at the seven month mark. All would not appear to be well in the investing world. But before I head off on that tangent, there are some housekeeping matters to address.

First, at the beginning of the year I suggested that the average family unit should own no more than ten mutual funds, which would cover both individual and retirement assets. When my long-suffering spouse read that, the question she asked was how many we had. I stopped counting when I got to twenty-five, and told her the results of my search. I was then told that if I was going to tell others they should have ten or less per family unit, we should follow suit. I am happy to report that the number is now down to seventeen (exclusive of money market funds), and I am aiming to hit that ten number by year-end.

Obviously, tax consequences play a big role in this process of consolidation. One, there are tax consequences you can control, in terms of whether your ownership is long-term or short-term, and when to sell. Two, there are tax consequences you can’t control, which are tied in an actively-managed fund, to the decision by the portfolio manager to take some gains and losses in an effort to manage the fund in a tax-efficient manner. At least that is what I hope they are doing. There are other tax consequences you cannot control when the fund in question’s performance is bad, leading to a wave of redemptions. The wave of redemptions then leads to forced selling of equity positions, either en masse or on a pro rata basis, which then triggers tax issues (hopefully gains but sometimes not). The problem with these unintended or unplanned for tax consequences, is that in non-retirement accounts, you are often faced with a tax bill that you have not planned for at filing time, and need to come up with a check to pay the taxes due. A very different way to control the tax consequences, especially if you are of a certain age, is to own passive index funds, whose portfolios won’t change except for those issues going into or leaving the index. Turnover and hence capital gains distributions, tend to be minimized. And since they do tend to own everything as it were, you will pick up some of the benefit of merger and acquisition activity. However, index funds are not immune to an investor panic, which leads to forced selling which again triggers tax consequences.

In this consolidation process, one of the issues I am wrestling with is what to do with money market funds, given that later this year unless something changes again, they will be allowed to “break the buck” or no longer have a constant $1 share price. My inclination is to say that cash reserves for individuals should go back into bank certificates of deposit, up to the maximum amounts of the FDIC insurance. That will work until or unless, like Europe, the government through the banks decides to start charging a negative interest rate on bank deposits. The other issue I am wrestling with is the category of balanced funds, where I am increasingly concerned that the three usual asset classes of equities, fixed income, and cash, will not necessarily work in a complementary manner to reduce risk. The counter argument to that of course, is that most people investing in a balanced (or equity fund for that matter) investment, do not have a sufficiently long time horizon, ten years perhaps being the minimum commitment. If you look at recent history, it is extraordinary how many ten year returns both for equity funds and balanced funds, tend to cluster around the 8% annualized mark.

Morningstar, revisited:

One of the more interesting lunch meetings I had around the Morningstar conference that I did not attend, was with a Seattle-based father-son team with an outstanding record to date in their fund. One of the major research tools used was, shock of shock, the Value Line. But that should not surprise people. Many of Buffet’s own personal investments were, as he relates it, arrived at by thumbing through things like a handbook of Korean stocks. I have used a similar handbook to look at Japanese stocks. One needs to understand that in many respects, the purpose of hordes of analysts, producing detailed models and exhaustive reports is to provide the cover of the appearance of adequate due diligence. Years ago, when I was back in the trust investment world, I used to have various services for sale by the big trust banks (think New York and Philadelphia) presented to me as necessary. Not necessary to arrive at good investment decisions, but necessary to have as file drawer stuffers when the regulators came to examine why a particular equity issue had been added to the approved list. Now of course with Regulation FD, rather than individual access to managements and the danger of selective disclosure of material information, we have big and medium sized companies putting on analyst days, where all investors – buy side, sell side, and retail, get access to the same information at the same time, and what they make of it is up to them.

So how does one improve the decision making process, or rather, get an investment edge? The answer is, it depends on the industry and what you are defining as your circle of competency. Let’s assume for the moment it is property and casualty reinsurance. I would submit that one would want to make a point of attending the industry meetings, held annually, in Monte Carlo and Baden-Baden. If you have even the most rudimentary of social skills, you will come away from those events with a good idea as to how pricing (rate on line) is going to be set for categories of business and renewals. You will get an idea as to whose underwriting is conservative and whose is not. And you will get an idea as to who is under-reserved for prior events and who is not. You will also get a sense as to how a particular executive is perceived.

Is this the basis for an investment decision alone? No, but in the insurance business, which is a business of estimates to begin with, the two most critical variables are the intelligence and integrity of management (which comes down from the top). What about those wonderfully complex models, forecasting interest rates, pricing, catastrophic events leading to loss ratios and the like? It strikes me that fewer and fewer people have taken sciences in high school or college, where they have learned about the Law of Significant Numbers. Or put another way, perhaps appropriately cynical, garbage in/garbage out.

Now, many of you are sitting there thinking that it really cannot be this simple. And I will tell you that the finest investment analyst I have ever met, a contemporary of mine, when he was acting as an analyst, used to do up his research ideas by hand, on one or one and a half sheets of 8 ½ by 11 paper.

There would be a one or two sentence description of the company and lines of business, a simple income statement going out maybe two years beyond this year, several bullet points as to what the investment case was, with what could go right (and sometimes what could go wrong), and that was generally it, except for perhaps a concluding “Reasons to Own. AND HIS RETURNS WERE SPECTACULAR FOR HIS IDEAS! People often disbelieve me when I tell them that, so luckily I have saved one of those write-ups. My point is this – the best ideas are often the simplest ideas, capable of being presented and explained in one or two declarative sentences.

What’s coming?

And finally, for a drop of my usual enthusiasm for the glass half empty. There is a lot of strange stuff going on in the world at the moment, much of it not going according to plan, for governments, central banks, and corporations as one expected in January. Commodity prices are collapsing. Interest rates look to go up in this country, perhaps sooner rather than later. China may or may not have lost control of its markets, which would not augur well for the rest of us. I will leave you with something else to ponder. The “dot.com” crash in 2000 and the financial crisis of 2007-2008-2009 were water-torture events. Most of the people running money now were around for them, and it represents their experiential reference point. The October 1987 crash was a very different animal – you came in one day, and things just headed down and did not stop. Derivatives did not work, portfolio insurance did not work, and there was no liquidity as everyone panicked and tried to go through the door at once. Very few people who went through that experience are still actively running money. I bring this up, because I worry that the next event (and there will be one), will not necessarily be like the last two, where one had time to get out in orderly fashion. That is why I keep emphasizing – do not put at risk more than you can afford to lose without impacting your standard of living. Investors, whether professional or individual, need to guard mentally against always being prepared to fight the last war.

Top developments in fund industry litigation

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

New Lawsuit

• A new excessive-fee lawsuit targets five State Farm LifePath target-date funds. Complaint: “The nature and quality of Defendant’s services to the LifePath Funds in exchange for close to half of the net management fee are extremely limited. Indeed, it is difficult to determine what management services, if any, [State Farm] provides to the LifePath Funds, since virtually all of the investment management functions of the LifePath Funds are delegated” to an unaffiliated sub-adviser. (Ingenhutt v. State Farm Inv. Mgmt. Corp.)

Orders

• A court gave its final approval to the $27.5 million settlement of an ERISA class action that had challenged the selection of proprietary Columbia and RiverSource funds for Ameriprise retirement accounts. (Krueger v. Ameriprise Fin., Inc.)
• In a decision on motion to dismiss, a court allowed a plaintiff to add new Morgan Keegan defendants to previously allowed Securities Act claims regarding four closed-end funds, rejecting the new defendants’ statute-of-limitations argument. (Small v. RMK High Income Fund, Inc.)
• Further extending the fund industry’s losing streak, a court allowed excessive-fee allegations regarding five SEI funds to proceed past motion to dismiss: “While the allegations in the Amended Complaint may well not survive summary judgment, they are sufficient to survive the motion-to-dismiss stage.” (Curd v. SEI Invs. Mgmt. Corp.)
• A court mostly denied the motion by Sterling Capital to dismiss a fraud lawsuit filed by its affiliated bank’s customer. (Bowers v. Branch Banking & Trust Co.)
• A court consolidated excessive-fee litigation regarding the Voya Global Real Estate Fund. (In re Voya Global Real Estate Fund S’holder Litig.)

Briefs

• Parties filed their oppositions to dueling motions for summary judgment in fee litigation regarding eight Hartford mutual funds. Plaintiffs’ section 36(b) claims, first filed in 2011, previously survived Hartford’s motion to dismiss. The summary judgment papers are unavailable on PACER. (Kasilag v. Hartford Inv. Fin. Servs. LLC; Kasilag v. Hartford Funds Mgmt. Co.)

The Alt Perspective: Commentary and news from DailyAlts.

Despite being the summer, there was no slowdown in activity around liquid alternatives in July. Seven new alternative mutual funds and ETFs came to market, bringing the year to date total to 79. And in addition to the new fund launches, private equity titans Apollo and Carlyle both announced plans to launch alternative mutual funds later this year. For Carlyle, this is their second time to the dance and this time they have picked TCW as their partner. Carlyle purchased a majority interest in TCW early 2013 and will wisely be leveraging the firm’s distribution into the retail market. In a similar vein, Apollo has partnered with Ivy and will look to Ivy for distribution leadership.

Apollo and Carlyle’s plans follow on the heals of KKR’s partnership with Altegris for the launch of a private equity offering for the “mass affluent” earlier this year, and Blackstone’s partnership with Columbia on a multi-alternative fund, also announced earlier this year. Distribution is key, and the private equity shops are starting to figure that out.

Asset Flows

Asset flows into liquid alternative funds (mutual funds and ETFs combined) continued on their positive streak for the sixth consecutive month, with total flows in June of more than $2.2 billion according to Morningstar’s June 2015 U.S. Asset Flows Update report.

For the fifth consecutive month, multi-alternative funds have dominated inflows into liquid alternatives as investors look for a one-stop shop for their alternatives allocation. Both long/short equity and market neutral have experienced outflows every month in 2015, while non-traditional bonds has had outflows in 5 of 6 months this year. Quite a change from 2014 when both long/short equity and non-traditional bonds ruled the roost.

Twelve month flows look fairly consistent with June’s flows with multi-alternative and managed futures funds leading the way, and long/short equity, market neutral and non-traditional bonds seeing the largest outflows.

Trends and Research

There were several worthwhile publications distributed in July that provide more depth to the liquid alts conversation. The firsts is the annual Morningstar / Barron’s survey of financial advisors, which notes that advisors are more inclined to allocate to liquid alternatives than they were last year. A summary of the results can be found here: Morningstar and Barron’s Release National Alternatives Survey Results.

In addition to the survey, both Morgan Stanley and Goldman Sachs published research papers on liquid alternatives. Both papers are designed to help investors better understand the category of investments and how to use them in a portfolio:

• Morgan Stanley Publishes Liquid Alts Investment Primer
• Goldman Sachs: Viewing Liquid Alternatives Through a Hedge Fund Lens

Educational Videos

Finally, we published a series of video interviews with several portfolio managers of leading alternative mutual funds, as well as a three part series with Keith Black, Managing Director of Exams and Curriculum of the CAIA Association. All of the videos can be viewed here: DailyAlts Videos. More will be on the way over the next couple weeks, so check back periodically.

Observer Fund Profiles

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

This month’s profiles are unusual, in that they’re linked to our story on “first funds.” Two of the three are much larger and older than we normally cover, but they make a strong case for themselves.

James Balanced: Golden Rainbow (GLRBX). The fund invests about half of its money in stocks and half in bonds, though the managers have the ability to become much more cautious or much more daring if the situation calls for it. Mostly they’ve been cautious. Their professed goal is “to seek to grow our clients’ assets…while stressing the preservation of principal, and the reduction of risk.” With a loss of just 6% in 2008, they seem to be managing that balance quite well. FYI, this profile was written by our colleague Charles Boccadoro and is substantially more data-rich than most.

TIAA-CREF Lifestyle Conservative (TSCLX). TIAA-CREF’s traditional business has been providing low cost, conservatively managed investment accounts for people working at hospitals, universities and other non-profit organizations.  Lifestyle Conservative is a fund-of-funds with about 40% of its money in stocks and 60% in bonds. They’ve got a short track record, but substantially below-average expenses and a solid lineup of funds in which to invest.

Vanguard STAR (VGSTX). STAR is designed to be Vanguard’s first fund for beginning investors. It invests only in Vanguard’s actively-managed funds, with a portfolio that’s about 60% of its money in stocks and 40% in bonds. The fund’s operating expenses are 0.34% per year, which is very low. The combination of Vanguard + low minimum has always had it on my short-list of funds for new investors.

We delayed publication of July’s fund profile while we finished some due diligence. Sorry ‘bout that but we’d rather get the facts right than rush to print.

Eventide Healthcare & Life Sciences (ETNHX): Morningstar’s 2015 conference included a laudatory panel celebrating “up and coming” funds, including the five star, $2 billion Eventide Gilead. And yet as I talked with the Eventide professionals the talk kept returning to the fund that has them more excited, Healthcare & Life Sciences. The fund’s combination of a strong record with a uniquely qualified manager compels a closer look.

Launch Alert

Triad Small Cap Value Fund (TSCVX) launched on June 29, 2015. Triad promises a concentrated but conservative take on small cap investing.

The fund is managed by John Heldman and David Hutchison, both of Triad Investment Management. The guys both have experience managing money for larger firms, including Bank of America, Deutsche Bank and Neuberger Berman. They learned from the experience, but one of the things they learned was that “we’d had enough of working for larger firms … having our own shop means we have a much more flexible organization and we’ll be able do what’s right for our investors.” Triad manages about $130 million for investors, mostly through separate accounts.

The Adviser analyzes corporate financial statements, management presentations, specialized research publications, and general news sources specifically focused on three primary aspects of each company: the degree of business competitive strength, whether management is capable and co-invested in the business, and the Adviser’s assessment of the attractiveness of a security’s valuation.

The guys approach is similar to Bernie Horn and the Polaris team: invest only where you think you can meaningfully project a firm’s future, look for management that makes smart capital allocation decisions, make conservative assumptions and demand a 50% discount to fair value.

That discipline means that some good companies are not good investments. Firms in technology and biotech, for example, are subject to such abrupt disruption of their business models that it’s impossible to have confidence in a three to five year projection. Other fundamentally attractive firms have simply been bid too high to provide any margin of safety.

They’re looking for 30-45 names in the portfolio, most of which they’ve followed for years. The tiny fund and the larger private strategy are both fully invested now despite repeated market highs. While they agree that “there aren’t hundreds of great opportunities, not a huge amount at all,” the small cap universe is so large that they’re still finding attractive opportunities.

The minimum initial purchase is $5,000. The opening expense ratio is 1.5% with a 2.0% redemption fee on shares held under 90 days.

The fund’s website is still pretty rudimentary but there’s a good discussion of their Small Cap Equity strategy available on the advisor’s site. For reasons unclear, Mornignstar’s profile of the fund aims you to the homepage of the Wireless Fund (WIREX). Don’t go there, it won’t help.

Funds in Registration

There are 17 new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase right around the end of September, which would allow the new funds to still report a full quarter’s worth of results in 2015.

The most important new registrations are a series of alternatives funds about to be launched by TCW. They’ve partnered with several distinguished sub-advisers, including our friends at Gargoyle who, at our first reading of the filings, are offered the best options including both Gargoyle Hedged Value and, separately, the unhedged Gargoyle long portfolio as a free-standing fund.

Manager Changes

There are 45 manager changes, at least if you don’t mind a bit of cheating on our part. Wyatt Lee’s arrival as co-manager marginally affected all the funds in the T. Rowe Price retirement series but we called that just one change. None are game-changers.

Updates

The Board at LS Opportunity Fund (LSOFX) just announced their interim plan for dealing with the departure of the fund’s adviser. Jim Hillary of Independence Capital Asset Partners and formerly of Marsico Capital, LLC ran LSOFX side-by-side with his ICAP hedge fund from 2010-2015. It’s been an above-average performer, though not a stunning one. DailyAlts reports that Mr. Hillary has decided to retire and return the hedge fund’s assets to its investors. The LS Board appointed Prospector Partners LLC to sub-advise the fund for now; come fall, they’ll ask shareholders for authority to add sub-advisors.

The Prospector folks come with excellent credentials but a spotty record. The managers have a lot of experience managing funds for White Mountains Insurance, T. Rowe Price (both Capital Appreciation and Growth Stock) and Neuberger Berman (Genesis). Prospector Capital Appreciation (PCAFX) was positioned as a nimbler version of T. Rowe Price Capital Appreciation (PRWCX), run by Cap App’s long-time manager. The fund did well during the meltdown but has trailed 99% of its peers since. Prospector Opportunity (POPFX) has done better, also by limiting losses in down markets at the price of losing some of the upside in rising ones.

The Board of Trustees has approved a change Zeo Strategic Income’s investment objective. Right now the fund seeks “income and moderate capital appreciation.” Effective August 31, 2015, the Fund’s investment objective will be to seek “low volatility and absolute returns consisting of income and moderate capital appreciation.” From our conversations with the folks at Zeo, that’s not a change; it’s an editorial clarification and a symbolic affirmation of their core values.

Briefly Noted . . .

Effective August 1, Value Line is imposing a 0.40% 12(b)1 fee on a fund that hasn’t been launched yet (Centurion) but then offers a 0.13% 12(b)1 waiver for a net 12(b)1 fee of 0.27%. Why? At the same time, they’ve dropped fees on their Core Bond Fund (VAGIX) by two basis points (woo hoo!). Why? Because the change drops them below the 1.0% expense threshold (to 0.99%), which might increase the number of preliminary fund screens they pass. Hard to know whether that will help: over the five years under its current management, the fund has been a lot more volatile (bigger maximum drawdown but much faster recovery) and more profitable than its peers; the question is whether, in uncertain times, investors will buy that combo – even after the generous cost reduction.

Thanks, as always, to The Shadow’s irreplaceable assistance on tracking down the following changes!

SMALL WINS FOR INVESTORS

Effective August 1, 2015, Aspiriant Risk-Managed Global Equity Fund’s (RMEAX) investment advisory fee will be reduced from 0.75% to 0.60%.

CLOSINGS (and related inconveniences)

Invesco International Growth Fund (AIIEX) will close to new investors on October 1, 2015. Nothing says “we’re serious” quite like offering a two-month window for hot money investors to join the fund. The $9 billion fund tends to be a top-tier performer when the market is falling and just okay otherwise.

Tweedy, Browne Global Value Fund II (TBCUX) has closed to new investors. Global Value II is the sibling to Global Value (TBGVX). The difference between them is that Global Value hedges its currency exposure and Global Value II does not. I don’t anticipate an extended closure. Global II has only a half billion in assets, against $9.3 billion in Global, so neither the size of the portfolio nor capacity constraints can explain the closure. A likelier explanation is the need to manage a large anticipated inflow or outflow caused, conceivably, by gaining or losing a single large institutional client.

OLD WINE, NEW BOTTLES

Effective July 9, 2015, the 3D Printing and Technology Fund (TDPNX) becomes the 3D Printing, Robotics and Technology Fund. The fact that General Electric is the fund’s #6 holding signals the essential problem: there simply aren’t enough companies whose earnings are driven by 3D printing or robotics to populate a portfolio, so firms where such earnings are marginal get drawn in.

Effective September 9, 2015, Alpine Accelerating Dividend Fund (AAADX) is getting renamed Alpine Rising Dividend Fund. The prospectus will no longer target “accelerating dividends” as an investment criterion. It’s simultaneously fuzzier and clearer on the issue of portfolio turnover: it no longer refers to the prospect of 150% annual turnover (the new language is “higher turnover”) but is clear that the strategy increases transaction costs and taxable short-term gains.

Calvert Tax-Free Bond Fund (CTTLX) has become Calvert Tax-Free Responsible Impact Bond Fund. “Impact investing” generally refers to the practice of buying the securities of socially desirable enterprises, for example urban redevelopment administrations, as a way of fostering their mission. At the start of September, Calvert Large Cap Value (CLVAX) morphs into Calvert Global Value Fund. The globalization theme continues with the change of Calvert Equity Income Fund (CEIAX) to Calvert Global Equity Income Fund. Strategy tweaks follow.

On September 22, 2015, Castlerigg Equity Event and Arbitrage Fund (EVNTX) becomes Castlerigg Event Driven and Arbitrage Fund. In addition to the name change, Castlerigg made what appear to be mostly editorial changes to the statement of investment strategies. It’s not immediately clear that either will address this:

Eaton Vance Small-Cap Value Fund has been renamed Eaton Vance Global Small-Cap Fund (EAVSX). Less value, more global. The fund trails more than 80% of its peers over pretty much every trailing measurement period. They’ve added Aidan M. Farrell as a co-manager. Good news: he’s managed Goldman Sachs International Small Cap (GISSX). Bad news: it’s not very good, either.

Effective July 13, 2015 Innovator Matrix Income® Fund became Innovator McKinley Income Fund (IMIFX), with the appointment of a new sub-advisor, McKinley Capital Management, LLC. The fund’s strategy was to harvest income primarily from high income securities which included master limited partnerships and REITs. The “income” part worked and the fund yields north of 10%. The “put the vast majority of your money into energy and real estate” has played out less spectacularly. The new managers bring a new quantitative model and modest changes in the investment strategy, but the core remains “income from equities.”

OFF TO THE DUSTBIN OF HISTORY

Effective October 23, 2015, Alpine Equity Income Fund (the “Fund”) and Alpine Transformations Fund (the “Fund”) will both be absorbed by Alpine Accelerating Dividend Fund. At the same time Alpine Cyclical Advantage Property Fund (the “Fund”) disappears into Alpine Global Infrastructure Fund (the “Acquiring Fund”).

Fidelity Fifty merged into Fidelity Focused Stock Fund (FTQGX) on July 24, 2015, just in case you missed it.

Forward is liquidating their U.S. Government Money Fund by the end of August.

MassMutual Select Small Company Growth Fund will be liquidated by September 28, 2015.

Neuberger Berman Global Thematic Opportunities Fund will disappear around August 21, 2015.

RiverNorth Managed Volatility Fund (RNBWX) is scheduled for a quick exit, on August 7, 2015.

The $1.2 million Stone Toro Long/Short Fund (STVHX) will be liquidated on or about August 19, 2015 following the manager’s resignation from the advisor.

UBS Equity Long-Short Multi-Strategy Fund (BMNAX) takes its place in history alongside the carrier pigeon on September 24, 2015. Advisors don’t have to explain why they’re liquidating a fund. In general, either the fund sucks or nobody is buying it. No problem. I do think it’s bad practice to go out of your way to announce that you’re about to explain your rationale and then spout gibberish.

Rationale for liquidating the Fund

Based upon information provided by UBS … the Board determined that it is in the best interests of the Fund and its shareholders to liquidate and dissolve the Fund pursuant to a Plan of Liquidation. To arrive at this decision, the Board considered factors that have adversely affected, and will continue to adversely affect, the ability of the Fund to conduct its business and operations in an economically viable manner.

Our rationale is that we “considered factors that have adversely affected, and will continue to adversely affect” the fund. Why is that even worth saying? The honest statement would be “we’re in a deep hole, the fund has been losing money for the advisor for five year and even the stronger performance of the past 18 months hasn’t made a difference so we’re cutting our losses.”

In Closing . . .

In the months ahead we’ll add at least a couple new voices to the Observer’s family. Sam Lee, a principal of Severian Asset and former editor of Morningstar’s ETF Investor, would like to profile a fund for you in September. Leigh Walzer, a principal of Trapezoid LLC and a former member of Michael Price’s merry band at the Mutual Series funds, will join us in October to provide careful, sophisticated quantitative analyses of the most distinguished funds in a core investment category.

We’ve mentioned the development of a sort of second tier at the Observer, where we might be able to provide folks with access to some interesting data, Charles’s risk-sensitive fund screener and such. We’re trying to be very cautious in talking about any of those possibilities because we hate over-promising. But we’re working hard to make good stuff happen. More soon!

Our September issue will start with the following argument: it’s not time to give up on managers who insist on investing in Wall Street’s most despised creature: the high-quality, intelligently managed U.S. corporation. A defining characteristic of a high-quality corporation is the capital allocation decisions made by its leaders. High-quality firms invest intelligently, consistently, successfully, in their futures. Those are “capital expenditures” and investors have come to loathe them because investing in the future thwarts our desire to be rich, rich, rich, now, now, now. In general I loathe the editorial pages of The Wall Street Journal since they so often start with an ideologically mandated conclusion and invent the necessary supporting evidence. William Galston’s recent column, “Hillary gets it right on short-termism” (07/29/2015) is a grand exception:

Too many CEOs are making decisions based on short-term considerations, regardless of their impact on the long-run performance of their firms.

Laurence Fink is the chairman of BlackRock … expressed his concern that “in the wake of the financial crisis, many companies have shied away from investing in the future growth of their companies,” choosing instead to reduce capital expenditures in favor of higher dividends and increased stock buybacks.

His worries rest on a sound factual foundation. For the 454 companies listed continuously in the S&P 500 between 2004 and 2013, stock buybacks consumed 51% of net income and dividends an additional 35%, leaving only 14% for all other purposes.

It wasn’t always this way. As recently as 1981, buybacks constituted only 2% of the total net income of the S&P 500. But when economist William Lazonick examined the 248 firms listed continuously in this index between 1984 and 2013, he found an inexorable rise in buybacks’ share of net income: 25% in the 1984-1993 decade; 37% in 1994-2003; 47% in 2004-13. Between 2004 and 2013, some of America’s best-known corporations returned more than 100% of their income to shareholders through buybacks and dividends.

He cites a 2005 survey of CEOs, 80% of whom would cut R&D and 55% would avoid long-term capex if that’s what it took to meet their quarterly earnings expectations. We’ve been talking with folks like David Rolfe of Wedgewood, Zac Wydra of Beck, Mack and others who are taking their lumps for refusing to play along. We’ll share their argument as well as bring our modestly-delayed story on the Turner funds, Sam’s debut, and Charles’ return.

We’ll look for you.

Dear friends,

Investing by aphorism is a tricky business.

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

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

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

And Gore, accepting the Nobel Prize:

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

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

Weiji, Will Robinson! Weiji!

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

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

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

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

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

Snowball and the power of positive stupidity

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

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

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

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

It’s a nice feeling. 

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

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

Pure equity:

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

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

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

Pure income

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

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

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

Impure funds

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

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

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

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

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

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

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

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

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

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

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

Strange doings, currency wars, and unintended consequences

By Edward A. Studzinski

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Genius, succession and transition at Third Avenue

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Where are they now?

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

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

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

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

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

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

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

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

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

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

Top developments in fund industry litigation

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

Decision

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

Settlement

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

Briefs

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

Answer

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

The Alt Perspective: Commentary and news from DailyAlts.

By Brian Haskin, editor of DailyAlts.com

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

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

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

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

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

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

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

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

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

Observer Fund Profiles

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

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

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

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

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

Conference Call Highlights: Bernie Horn, Polaris Global Value

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

Highlights:

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

A couple caller questions struck me as particularly helpful:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

HOW CAN YOU JOIN IN?

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

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

WOULD AN ADDITIONAL HEADS UP HELP?

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

Funds in Registration

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

Manager Changes

About 50 funds changed part or all of their management teams in the past month. An exceptional number of them were part of the continuing realignment at PIMCO. A curious and disappointing development was the departure of founding manager Michael Carne from the helm of Nuveen NWQ Flexible Income Fund (NWQAX). He built a very good, conservative allocation fund that holds stocks, bonds and convertibles. We wrote about the fund a while ago: three years after launch it received a five-star rating from Morningstar, celebration followed until a couple weeks later Morningstar reclassified it as a “convertibles” fund (it ain’t) and it plunged to one-star, appealed the ruling, was reclassified and regained its stars. It has been solid, disciplined and distinctive, which makes it odd that Nuveen chose to switch managers.

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

Briefly Noted . . .

On December 1, 2014, Janus Capital Group announced the acquisition of VS Holdings, parent of VelocityShares, LLC. VelocityShares provides both index calculation and a suite of (creepy) leveraged, reverse leveraged, double leveraged and triple leveraged ETNs.

Fidelity Strategic Income (FSICX) is changing the shape of the barbell. They’ve long described their portfolio as a barbell with high yield and EM bonds on the one end and high quality US Treasuries and corporates on the other. They’re now shifting their “neutral allocation” to inch up high yield exposure (from 40 to 45%) and drop investment grade (from 30 to 25%).

GaveKal Knowledge Leaders Fund (GAVAX/GAVIX) is changing its name to GaveKal Knowledge Leaders Allocation Fund. The fund has always had an absolute value discipline which leads to it high cash allocations (currently 25%), exceedingly low risk … and Morningstar’s open disdain (it’s currently a one-star large growth fund). The changes will recognize the fact that it’s not designed to be a fully-invested equity fund. Their objective changes from “long-term capital appreciation” to “long-term capital appreciation with an emphasis on capital preservation” and “fixed income” gets added as a principal investment strategy.

SMALL WINS FOR INVESTORS

Palmer Square Absolute Return Fund (PSQAX/PSQIX) has agreed to a lower management fee and has reduced the cap on operating expenses by 46 basis points to 1.39% and 1.64% on its institutional and “A” shares.

Likewise, State Street/Ramius Managed Futures Strategy Fund (RTSRX) dropped its expense cap by 20 basis points, to 1.90% and 1.65% on its “A” and institutional shares.

CLOSINGS (and related inconveniences)

Effective as of the close of business on February 27, 2015, BNY Mellon Municipal Opportunities Fund (MOTIX) will be closed to new and existing investors. It’s a five-star fund with $1.1 billion in assets and five-year returns in the top 1% of its peer group.

Franklin Small Cap Growth Fund (FSGRX) closes to new investors on February 12, 2015. It’s a very solid fund that had a very ugly 2014, when it captured 240% of the market’s downside.

OLD WINE, NEW BOTTLES

Stand back! AllianceBernstein is making its move: all AllianceBernstein funds are being rebranded as AB funds.

OFF TO THE DUSTBIN OF HISTORY

Ascendant Natural Resources Fund (NRGAX) becomes only a fond memory as of February 27, 2015.

AdvisorShares International Gold and AdvisorShares Gartman Gold/British Pound ETFs liquidated at the end of January.

Cloumbia is cleaning out a bunch of funds at the beginning of March: Columbia Masters International Equity Portfolio, Absolute Return Emerging Markets Macro Fund,Absolute Return Enhanced Multi-Strategy Fund and Absolute Return Multi-Strategy Fund. Apparently having 10-11 share classes each wasn’t enough to save them. The Absolute Return funds shared the same management team and were generally mild-mannered under-performers with few investors.

Direxion/Wilshire Dynamic Fund (DXDWX) will be dynamically spinning in its grave come February 20^th.

Dynamic Total Return Fund (DYNAX/DYNIX) will totally return to the dust whence it came, effective February 20^th. Uhhh … if I’m reading the record correctly, the “A” shares never launched, the “I” shares launched in September 2014 and management pulled the plug after three months.

Loeb King Alternative Strategies (LKASX) and Loeb King Asia Fund (LKPAX) are being liquidated at the end of February because, well, Loeb King doesn’t want to run mutual funds anymore and they’re getting entirely out of the business. Both were pricey long/short funds with minimal assets and similar success.

New Path Tactical Allocation Fund became liquid on January 13, 2015.

In “consideration of the Fund’s asset size, strategic importance, current expenses and historical performance,” Turner’s board of directors has pulled the plug on Turner Titan Fund (TTLFX). It wasn’t a particularly bad fund, it’s just that Turner couldn’t get anyone (including one of the two managers and three of the four trustees) to invest in it. Graveside ceremonies will take place on March 13, 2015 in the family burial plot.

In Closing . . .

I try, each month, to conclude this essay with thanks to the folks who’ve supported us, by reading, by shopping through our Amazon link and by making direct, voluntary contributions. Part of the discipline of thanking folks is, oh, getting their names right. It’s not a long list, so you’d think I could manage it.

Not so much. So let me take a special moment to thank the good folks at Evergreen Asset Management in Washington for their ongoing support over the years. I misidentified them last month. And I’d also like to express intense jealousy over what appears to be the view out their front window since the current view out my front window is

With extra careful spelling, thanks go out to the guys at Gardey Financial of Saginaw (MI), who’ve been supporting us for quite a while but who don’t seem to have a particularly good view from their office, Callahan Capital Management out of Steamboat Springs (hi, Dan!), Mary Rose, our friends Dan S. and Andrew K. (I know it’s odd, but just knowing that there are folks who’ve stuck with us for years makes me feel good), Rick Forno (who wrote an embarrassingly nice letter to which we reply, “gee, oh garsh”), Ned L. (who, like me, has professed for a living), David F., the surprising and formidable Dan Wiener and the Hastingses. And, as always, to our two stalwart subscribers, Greg and Deb. If we had MFO coffee mugs, I’d sent them to you all!

Do consider joining us for the talk with Matt and Ian. We’ve got a raft of new fund profiles in the works, a recommendation to Morningstar to euthanize one of their long-running features, and some original research on fund trustees to share. In celebration of our fourth birthday this spring, we’ve got surprises a-brewin’ for you.

Until then, be safe!

Dear friends,

They’re baaaaack!

The summer silence has been shattered. My students have returned in endlessly boisterous, hormonally-imbalanced, self-absorbed droves. They’re glued to their phones and to their preconceptions, one about as maddening as the other.

The steady rhythm of the off-season (deal with something else falling off the house, talk to a manager, mow, think, read, write, kvetch) has been replaced by getting up at 5:30 and bolting through days, leaving a blur behind.

Somewhere in the background, Putin threatens war, the market threatens a swoon, horrible diseases spread, politicians debate who among them is the most dysfunctional and someone finds time to think Deep Thoughts about the leaked nekkid pitchers of semi-celebrities.

On whole, it’s good to be back.

Seven things that matter, two that don’t … and one that might

I spoke on August 20^th to about 200 folks at the Cohen Fund client conference in Milwaukee. Interesting gathering, surprisingly attractive city, consistently good food (thanks guys!) and decent coffee. My argument was straightforward and, I hope, worth repeating here: if you don’t start thinking and acting differently, you’re doomed. A version of that text follows.

Your apparent options: dead, dying or living dead

From the perspective of most journalists, many advisors and a clear majority of investors, this gathering of mutual fund managers and of the professionals who make their work possible looks to be little more than a casting call for the Zombie Apocalypse. You are seen, dear friends, as “the walking dead,” a group whose success is predicated upon their ability to do … what? Eat their neighbors’ brains which are, of course, tasty but, and this is more important, once freed of their brains these folks are more likely to invest in your funds.

CBS News declared you “a losing bet.” TheStreet.com declared that you’re dead.  Joseph Duran asked, curiously, “are you a dinosaur?” Schwab declared that “a great question!” Ric Edelman, a major financial advisor, both widely quoted and widely respected, declares, “The retail mutual fund industry is a dinosaur and won’t exist in 10 or 15 more years, as investors are realizing the incredible opportunity to lower their cost, lower their risks and improve their disclosure through low-cost passive products.” When asked what their parents do for a living, your kids desperately wish they could say “my dad writes apps and mom’s a paid assassin.” Instead they mumble “stuff.” In short, you are no longer welcome at the cool kids’ table.

Serious data underlies those declarations. The estimable John Rekenthaler reports that only one-third of new investment money flows to active funds, one third to ETFs and one third to index funds. Drop target-date funds out of the equation and the amount of net inflows to funds is reduced by a quarter. The number of Google searches for the term “mutual funds” is down 80% over the past decade.

Funds liquidate or merge at the rate of 400-500  per year. Of the funds that existed 15 years ago, Vanguard found that 46% have been liquidated or merged. The most painful stroke might have been delivered by Morningstar, a firm whose fortunes were built on covering the mutual fund industry. Two weeks ago John Rekenthaler, vice president and resident curmudgeon, asked the question “do have funds have a future?”  He answered his own question with “to cut to the chase: apparently not much.”

Friends, I feel your pain. Not that zombies actually feel pain. You know if Mr. Cook accidentally rips Mr. Bynum’s arm off and bludgeons him with it, “it’s all good.” But if you did feel pain, I’d be right there with you since in a Zombies Anonymous sort of way I’m obliged to say “Hello. My name is Dave and I’m a liberal arts professor.”

The parallel experience of the liberal arts college

I teach at Augustana College – as school known only to those of you blessed with a Scandinavian Lutheran heritage or to fans of the history of college football.

We operate in an industry much like yours – higher education is in crisis, buffeted by changing demographics – a relentless decline in the number of 17 year old high school graduates everywhere except in a band of increasingly sunbaked states – changing societal demands and bizarre new competitors whose low cost models have caught the attention of regulators, journalists and parents.

You might think, “yeah, but if you’re good – if you’re individually excellent – you’ll do fine.”  “Emerson was wrong, wrong, wrong: being excellent does not imply you’ll be noticed, much less be successful.” 

Remember that “build a better mousetrap and people will beat a path to your door” promise. Nope.  Not true, even for mousetraps. There have been over 4400 patents for mousetraps (including a bunch labeled “better mousetrap”) issued since 1839. There are dozens of different subclasses, including “Electrocuting and Explosive,” “Swinging Striker,” “Choking or Squeezing,” and 36 others. One device, patented in 1897, controls 60% of the market and a modification of it patented in 1903 controls another 15-20%. About 0.6% of patented mousetraps were able to attract a manufacturer.

The whole “succeed in the market because you’re demonstrably better” thing is certainly not true for small colleges. Let me try an argument out with you: Augustana is the best college you’ve never heard of. The best. What’s the evidence?

• We’re #6 among all colleges in the number of Academic All-Americans we’ve produced, #2 behind only MIT as a Division 3 school.
• We were in the top 50 schools in the 20^th century for the number of our graduates who went on to earn doctorates.
• National Survey of Student Engagement (NSSE) and the Wabash National Study both singled us out for the magnitude of gains that our students made over their four years.
• The Teagle Foundation identified use as one of the 12 colleges that define the “Gold Standard” in American higher education based on our ability to vastly outperform given the assets available to us.

And yet, we’re not confident of our future. We’re competing brilliantly, but we’re competing to maintain our share of a steadily shrinking pie. Fewer students each year are willing to even consider a small school as families focus more on price rather than value or on “name” rather than education. Most workers expect to enjoy their peak earnings in their late 40s and 50s.  For college professors entering the profession today, peak lifetimes earnings might well occur in Year One.  After that, they face a long series of pay freezes or raises that come in just below the CPI.  Bain & Company estimate that one third of all US colleges and universities are financially unsustainable; they spend more than the take in and collect debt faster than they build equity. While some colleges will surely fold, the threat for most is less closure than permanent stagnation and increasing irrelevance.

Curious problem: by all but one measures (name recognition), we’re better for students than the household names but no one believes us and few will even consider attending. We’re losing to upstart competitors with inferior products and lumbering behemoths. 

And you are too.

“The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings.”

Half of that is our own fault. We tend to be generic and focused on ourselves, without material understanding of the bigger picture. And half of your problem is your fault: 80% of mutual funds could disappear without any noticeable loss of investors. They don’t matter. There are 500 domestic large core funds. I’d be amazed if anyone could make a compelling case for keeping 90% of them open. More correctly, those don’t matter to anyone but the advisor who needs them for business development purposes.

Here’s the test: would anyone pay good money to buy the fund from you? Get serious: half of all funds can’t draw even a penny’s investment from their own managers (Sarah Max, Fund managers who invest elsewhere). The level of fund trustee investment in the funds they oversee on behalf of the rest of us is so low, especially in the series trusts common among smaller funds, as to represent an embarrassment.

The question is: can you do anything? Will anything you do matter? In order to answer that question, it would help to understand what matters, what doesn’t … and what might.

Herewith: seven things that matter, two that don’t … and one that might.

Seven things that matter.

1. Independence matters. Whether measured by r-squared, tracking error or active share, researchers have generated a huge body of evidence that independent thinking is a prerequisite to outstanding performance. Surprisingly, that’s true on the downside as much as the upside: higher active managers perform better in falling markets than herd-huggers do. But herding behavior is increasing. Where two-thirds of the industry’s assets were once housed in “highly active” funds, that number is now 25% and falling.
2. Size matters. There is no evidence to suggest that “bigger is better” in the mutual fund world, at least once a fund passes the threshold of economic viability. Large funds face two serious constraints. First, their investable universes collapse; that is, if you have $10 billion to invest, there are literally thousands of small companies whose stocks become utterly meaningless to you and your forced to seek a competitive advantage against a few hundred competitors all looking at the same few hundred larger names. Second, larger funds become cash cows generating revenue essential to the adviser’s business. The livelihoods of dozens or hundreds of coworkers depend on having the manager not lose assets, much more than they depend on investment excellence. But money flows to “safe” bloated funds.
3. Alignment of interest matters. Almost all of us know that there’s a lot of research showing that good things happen when fund managers stake their personal fortunes on the success of their funds; in particular, risk-adjusted returns rise. Fewer people know that there appears to be an even stronger effect from substantial ownership by a fund’s trustees: high trustee ownership is linked to lower risk, higher active share and less tolerance of inept management. But, Morningstar reports, something like 500 firms have funds with negligible insider ownership.
4. Risk matters. Investors are far more risk-averse than they know. That’s one of the most frequently observed findings in the behavioral finance literature. No amount of upside offsets a tendency to crash. The sad consequence of misjudged risk is reflected in the Dalbar’s widely quoted calculations showing that investors might pocket as little as one-quarter of their funds’ returns largely because of excess confidence, excess trading and a tendency to run away as the worst possible time.
5. Focus matters. If the goal is to provide better (not necessarily higher, but perhaps steadier, more explicable, less volatile) returns than a broad market index, then you need to look as little like the index as possible. Too many folks become “fund collectors” with sprawling portfolios, just as too many fund managers to commit to marginal ideas.
6. Communication matters. I need to mention this because I’m, well, a professor of communication studies and we know it to be true. In general, communication from mutual funds to their investors (how to put this politely?) sucks. Websites get built for the sake of having a pretty side. Semi-annual reports get written because the SEC says to (but doesn’t say that you actually need to write anything to your investors, and many don’t). Shareholder letters get written to a template and conference calls are managed to assure that there’s no risk of anything interesting or informative breaking out. (If I hear the term “slide deck,” as in “on page 157 of your slide deck,” I’ll scream.) We know that most investors don’t understand why they’re invested or what their funds do. We know that when investors “get it,” they stay (look at Jared Peifer’s “Fund loyalty among socially responsible investors” for a study of folks who really think about their investments before making them). 
7. Relationships matter. Managers mumbling the mousetrap mantra believe that great performance will have the world beating a path to their door. It won’t. A fascinating study by the folks at Gerstein Fisher (“Mutual fund outperformance and growth,” Journal of Investment Management, 2014) offered an entirely maddening conclusion: good performance draws assets if you’re large, but has no effect on assets if you have under a quarter billion in assets. So how do smaller funds prosper? At least from our experience, it is by having a story that makes sense to investors and a nearly evangelical advocate to tell that story, face to face, over and over. Please flag this thought: it’s not whether you’re impressed with your story. It’s not whether it makes sense to you. It’s whether it makes enough sense to investors that, once you’re gone, they can explain it with conviction to other people.

Two things that don’t. 

1. Great returns don’t matter. Beating the market doesn’t matter. Beating your peers doesn’t matter. It’s impossible to do consistently (“peer beating” is, by definition, zero sum), it doesn’t draw assets and it doesn’t necessarily serve your investors’ needs. Consistent returns, consistently explained, might matter.
2. Morningstar doesn’t matter. A few of you might yet win the lottery and get analyst coverage from Morningstar, but you should depend on that about the way you depend on winning the Powerball. Recent feature on “Under the Radar” funds gives you a view of Morningstar’s basement: these seven funds were consistently excellent, averaged $400 million in assets and 12 years of manager tenure – and they were still “under the radar.” In reality, Morningstar doesn’t even know that you exist. More to the point: the genius of independent funds is that they’re not cookie-cutters, but Morningstar is constrained to use a cookie-cutter. The more independent you are, the more likely that Morningstar will give you a silly peer group.

This is not, by the way, a criticism of Morningstar. I like a lot of the folks there and I know they often work like dogs to get it right. It’s simply a reflection on their business model and the complexity of the task before them. In attempting to do the greatest good for the greatest number (and to serve their shareholders), they’re inevitably drawn to the largest, most popular funds.

The one thing that might matter? 

I might say “the Observer” does.  We’ve got 26,000 readers and we’ve had the opportunity to work with dozens of journalists.  We’ve profiled over 125 smaller funds, exceeding the number of Morningstar’s small fund profiles by, well, 120.  We know you’re there and know your travails.  We’re working really hard to help folks think more clearly about small, independent funds in general and by a hundred of so really distinguished smaller funds in particular.

But a better answer is: you might matter.

But do you want to?

It is clear that we can all do our jobs without mattering.  We can attend quarterly meetings, read thick packets, listen thoughtfully to what we’ve been told, ask a trenchant question (just to prove that we’ve been listening) … and still never make six cents worth of difference to anyone. 

There may have been a time, perhaps in the days of “a rising tide,” when firms could afford to have folks more interested in getting along than in making a difference.  Those days are passed.  If you aren’t intent on being A Person Who Matters, you need to go.

How might you matter?

1. Figure out whether you have a reason to exist.  Ask “what’s the story supposed to be?”  Look at the prospect that “your” story is so painfully generic or agonizingly technical than it means nothing to anyone.  And if you’ve got a good story, tell it passionately and well. 
2. Align your walking and your talking.  First, pin your personal fortune on the success of your funds.  Second, get in place a corporate policy that ensures everyone does likewise.  There are several fine examples of such policies that you might borrow from your peers.  Third, let people know what your policy is and why it matters to them.
3. Help people succeed.  Very few of the journalists who might share your message actually know enough to do it well.  And they often know it and they’d like to do better.  Great!  Find the time to help them succeed.  Become a valuable source of honest assessment, suggest story possibilities, notice when they do well.  That ethos is not limited to aiding journalists.   Help other independent funds succeed, too.  Tell people about the best of them.  Tell them what’s worked for you.  They’re not your enemies and they’re not your competitors.  They might, however, become part of a community that can help you survive.
4. Climb out of your silo.  Learn stuff you don’t need to know.  I know compliance is tough. I know those board packets are thick. But that’s not an excuse.  Bill Bernstein earned a PhD in chemistry, then MD in neurology, pursued the active practice of medicine, started writing about asset allocation and the efficient frontier, then advising, then writing books on topics well afield of his specialties. Bill writes:  “As Warren Buffett famously observed, investing is not a game in which the person with an IQ of 160 beats the persons with an IQ of 130.  Rather, it’s a game best played by those with a broad set of skills that are rich not only in quantitative ability but also in deep historical knowledge, all deployed with an Asperger’s-like emotional detachment.”  Those of us in the liberal arts love this stuff.
5. Build relationships, perhaps in odd ways.  Trustees: you were elected to represent the fund’s shareholders so why are you hiding from them?  Put your name and address on the website and let them know that if they have a concern, you’ll listen. Send a handwritten card to every new investor, at least those who invest directly with the fund.  Tell them they matter to you.  Heck, send them an anniversary card a year after they first invest, signed by you all.  When they go, ask “why?”  This is the only industry I’ve ever worked with that has precisely zero interest in customer loyalty.
6. Be prepared to annoy people.  Frankly, you’re going to be richly rewarded, financially and interpersonally, for your willingness to go away.  If you try to change things, you’re going to upset at least some of the people in every room.  You’re going to hear the same refrain, over and over: “But no one does that.”
7. Stop hiring pretty good people. Hire great ones, or no one. The hallmark of dynamic, rising institutions is their insistence on bringing in people who are so good it kind of scares the folks who are already there. That’s been the ethos of my academic department for 20 years. It is reflected in the Artisan Fund’s insistence that they will hire in only “category killers.” They might, they report, interview several dozen management teams a year and still make only one hire every two or three years. Check their record of performance and market success and draw your own conclusion. Achieving this means that you have to be a great place to work. You have to know why it’s a great place, and you have to have a strategy for making outsiders realize it, too.

Which is precisely the point. Independence is not merely a matter of portfolio construction. It’s a matter of innovation, responsibility and stewardship. It requires that you look beyond safety, look beyond asset gathering and short-term profit maximization to answer the larger question: is there any reason for us to exist?

It’s your decision. It is clear to me that business as usual will not work, but neither will hunkering down and hoping that it all goes away. Do you want to matter, or do you want to hold on – hoping that you’ll make it through despite the storm?  Like the faculty near retirement. Like Louis XV who declared, “Après moi, le déluge”. Mr. Rekenthaler concludes that “active funds retreat further into silence.” Do you want to prove him right or wrong?

If you want to make a difference, start today. Start here. Start today. Take the opportunity to listen, to talk, to learn and to decide. To decide to make all the difference you can. Which might be all the difference in the world.

From Charles’s Balcony: Why Am I Rebalancing?

Long-time MFO discussion board member AKAFlack emailed me recently wondering how much investors have underperformed during the current bull market due to the practice of rebalancing their portfolios.

For those that rebalance annually, the answer is…almost 12% in total return from March 2009 through June 2014. Not huge given the healthy gains, but certainly noticeable. The graph below compares performance for a buy & hold and an annually rebalanced portfolio, assuming an initial investment of $10,000 allocated 60% to stocks and 40% to bonds.

So why rebalance?

According to a good study by Vanguard, entitled “Best practices for portfolio rebalancing,” the answer is not to maximize return. “If the sole objective is to maximize return regardless of risk, then the investor should select a 100% equity portfolio.”

The purpose of rebalancing, whether done periodically or by threshold deviation, is to keep a portfolio risk composition consistent with an investor’s tolerance, as defined by their target allocation. Otherwise, investors “can end up with a portfolio that is over-weighted to equities and therefore more vulnerable to equity-market corrections, putting the investors’ portfolios at risk of larger losses compared with their target portfolios.” This situation is evidenced in the allocation shown above for the buy & hold portfolio, which is now at nearly 80/20 stocks/bonds.

In this way, rebalancing is one way to keep loss aversion in check and the attendant consequences of selling and buying at all the wrong times, often chronicled in Morningstar’s notorious “Investor Return” tracking metric.

Balancing makes up ground, however, when equities are temporarily undervalued, like was the case in 2008. The same comparison as above but now across the most current full market cycle, beginning in November 2007, shows that annual balancing actually slighted outperformed the buy & hold portfolio.

In his book “The Ivy Portfolio,” Mebane Faber presents additional data to support that “there is a clear advantage to rebalancing sometime rather than letting the portfolio drift. A simple rebalance can add 0.1 to 0.2 to the Sharpe Ratio.”

If your first investment priority is risk management, occasional rebalancing to your target allocation is one way to help you sleep better at night, even if it means underperforming somewhat during bull markets.

Edward, Ex Cathedra: Money money money money money money

“The mystery of the world is the visible, not the invisible.”

                                                                    Oscar Wilde

This has been an interesting month in the world of mutual funds and fund managers. First we have Charles D. Ellis, CFA with another landmark (and land mine) article in the Financial Analysts Journal entitled “The Rise and Fall of Performance Investing.” For some years now, starting with his magnum opus for institutional investors entitled “Winning the Loser’s Game,” Ellis has been arguing that institutional (and individual) investors would be better served by using passive index funds for their investments, rather than hiring active managers who tend to underperform the index funds. By way of disclosure, Mr. Ellis founded Greenwich Associates and made his fortune selling services to those active managers that he now writes about with the zeal of a convert.

Nonetheless the numbers he presents are fairly compelling, and for that reason difficult to accept. I am reminded of one of my former banking colleagues who was always looking for the pony that he was convinced was hidden underneath the manure in the room. I can see the results of this thinking by scanning some of the discussions on the Mutual Fund Observer bulletin board. Many of those discussions seem more attuned with how smart or lucky one was to invest with a particular manager before his or her fund closed, rather than how the investment has actually performed. And I am not talking about the performance numbers put out by the fund companies, which are artificial results for artificial investors. No, I’m talking about the real results obtained by putting the moneys invested and time periods into one’s HP12C calculator to figure out the returns. Most people really do not want to know those numbers, otherwise they become forced to think about Senator Warren’s argument that “the game is rigged.”

Ellis however makes a point that he has made before and that I have covered before. However I feel it is so important that it is worth noting again. Most mutual fund advertising or descriptions involving fees consist of one word and a number. The fee is “only” 1% (or less for most institutional investors). The problem is that that is a phrase worthy of Don Draper, as the 1% is related to the assets the investor has given to the fund company. Yet the investor already owns the assets. What is being promised then? The answer is returns. And if one accepts the Ibbotson return histories for large cap common stocks in the U.S. as running at 8 – 10% per year over a fifty-year period, we are talking about a fee running from 10 – 12.5% a year based on returns. 

Taking this concept one step further Ellis suggests what you really should be looking at in assessing fees are the “incremental fee as a percentage of incremental returns after adjusting for risk.” And using those criteria, we would see something very different given that most active investment managers are underperforming their benchmark indices, namely that the incremental fees are above 100% Ellis goes on to raise a number of points in his article. I would like to focus on just one of them for the remainder of this commentary. One of Ellis’ central questions is “When will our clients decide that continuing to take all the risks and pay all the costs of striving to beat the market with so little success is no longer a good deal for them?”

My assessment is that we have finally hit the tipping point, and things are moving inexorably in that direction. Two weeks ago roughly, it was announced that Vanguard now has more than $3 trillion worth of assets, much of it in passive products. Jason Zweig recently wrote an article for The Wall Street Journal suggesting that the group of fund and portfolio managers in their 30’s and 40’s should start thinking about alternative careers, possibly as financial planners giving asset allocation advice to clients. The Financial Times suggests in an article detailing the relationship between Bill Gross at PIMCO and the analyst that covered him at Morningstar that they had become too close. The argument there was that Morningstar analysts had become co-opted by the fund industry to write soft criticism in return for continued access to managers. My own observational experience with Morningstar was that their mutual fund analysts had been top shelf when they were interviewing me and both independent and objective. I can’t speak now as to whether the hiring and retention criteria have changed. 

My own anecdotal observations are limited to things I see happening in Chicago. My conclusion is that the senior managers at most of the Chicago money management firms are moving as fast as they can to suck as much money out of their businesses as quickly as possible. In some respects, it has become a variation on musical chairs and that group hears the music slowing. So you will see lots of money in bonus payments. Sustainability of the business will be talked about, especially as a sop to absentee owners, but the businesses will be under-invested in, especially with regard to personnel. What do I base that on? Well, at one firm, what I will call the boys from Winnetka and Lake Forest, I was told every client meeting now starts with questions about fees. Not performance, but fees are what is primary in the client minds. The person who said this indicated he is fighting a constant battle to see that his analyst pool is being paid commensurate with the market notwithstanding an assumption by senior management that the talent is fungible and could easily be replaced at lower prices. At another firm, it is a question of preserving the “collegiality” of the fund group’s trustees when they are adding new board members. As one executive said to me about an election, “Thank God they had two candidates and picked the less problematic one in terms of our business and causing fee issues for us.”

The investment management business, especially the mutual fund business, is a wonderful business with superb returns. But to use Mr. Ellis’ phrase, is it anything more now than a “crass commercial business?” How the industry behaves going forward will offer us a clue. Unfortunately, knowing as many of the players as well as I do leads me to conclude that greed will continue to be the primary motivator. Change will not occur until it is forced upon the industry.

I will leave you with a scene from a wonderful movie, The Freshman (with Marlon Brando and Matthew Broderick) to ponder.

“This is an ugly word, this scam.  This is business, and if you want to be in business, this is what you do.”

                               Carmine Sabatini as played by Marlon Brandon

Categories Morningstar doesn’t recognize: Short-term high-yield income

There are doubtless a million ways to slice and dice the seven or eight thousand extant funds into categories. Morningstar has chosen to create 105 categories in hopes of (a) creating meaningful peer comparisons and (b) avoid mindless proliferation of categories. We’re endlessly sympathetic with their desire to maintain a disciplined, manageable system. That said, the Observer tracks some categories of funds that Morningstar doesn’t recognize, including short-term high yield, emerging markets balanced and absolute value equity.

We think that these funds have two characteristics that might be obscured by Morningstar’s assignment of them to a larger category of fundamentally different funds. First, it causes funds to be misjudged if their risk profiles vary dramatically from the group’s. Short-term high yield, for example, are doomed to one- and two-star ratings. That’s not because they fail. It’s because they succeed in a way that’s fundamentally different from the majority of their peer group. In general, high yield funds have risk profiles similar to stock funds. Short-term high yield funds have dramatically lower volatility and returns closer to a short term bond fund’s than a high yield fund’s.

[High yield/orange, ST high yield blue, ST investment grade green]

Morningstar’s risk-adjusted returns calculation is far less sensitive to risk than the Observer’s is; as a risk, the lower risk is blanketed by the lower returns and the funds end up with an undeservedly wretched rating.

Bottom line: investors who need to earn more than the payout of a money market fund (0.01% ytd) or certificates of deposit (currently 1.1% annually) might take the risk of a conventional short-term bond fund (in the hopes of making 1-2%) or might be lured by the appeal of a complex market neutral derivatives strategy (paying 2% to make 3%). Another path that might reasonably consider are short-term high yield funds that take on greater risk but whose managers generally recognize that fact and have risk-management tools at hand.

The Observer has profiled three such funds: Intrepid Income, RiverPark Short-Term High Yield (now closed to new investors) and Zeo Strategic Income.

Short-term, high Income peer group, as of 9/1/14

Over the next several months we’ll be reviewing the performance of some of these unrecognized peer groups, in hopes of having folks look beyond the stars. 

To the New Castle County executives: I know your intentions were good, but …

Shortly after taking office, the new county executive for New Castle County, Delaware, made a shocking discovery: someone has nefariously invested the taxpayers’ money in two funds that (gasp!) earned one-star from Morningstar and were full of dangerous high yield investments. The executive in question, not pausing to learn anything about what the funds actually do, snapped into action. He rushed “to protect the County reserves from the potential of significant financial loss and undo risk by directing the funds to be placed in an account representing the financial security values associated with taxpayer dollars” by giving the money to UBS (a firm fined $1.5 billion two years ago in a “rogue trading” scandal). And then he, or the county staff, wrote a congratulatory press release (New Castle County Executive Acted Quickly to Protect Taxpayer Reserves).

The funds in question were RiverPark Short-Term High Yield (RPHYX) which is one of the least volatile funds in existence and which has posted the industry’s best Sharpe ratio, and FPA New Income (FPNIX), which Morningstar celebrates as an ultra-conservative choice in the face of deteriorating markets: “thanks to its super-low volatility, its five-year Sharpe ratio, a measure of risk-adjusted returns, bests all it but one of its competitors’ in both groups.”

The press release doesn’t mention how or where UBS will be investing the taxpayer’s dollars but it does sound like UBS has decided to work for free: enviable savings resulted from the fact that New Castle County “does not pay investment management fees to UBS.”

Due diligence requires going beyond a cursory reading. It turns out that The Tale of Two Cities is not a travelogue and that Animal Farm really doesn’t offer much guidance on animal husbandry, titles notwithstanding. And it turns out that the county has sold two exceptionally solid, conservative funds – funds with about the best risk-adjusted returns possible – based on a cursory reading and spurious concerns.

Observer Fund Profiles: AKREX and MAINX

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

Akre Focus (AKREX): the only question about Akre Focus is whether it can be as excellent in the future has it, and its predecessors, have been for the past quarter century. 

Matthews Asia Strategic Income (MAINX): against all the noise in the markets and in the world news, Teresa Kong remains convinced that your most important sources of income in the decades ahead will increasingly be centered in Asia.  She’ll doing an exceptional job of letting you tap that future today.

Elevator Talk: Brent Olsen, Scout Equity Opportunity (SEOFX)

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

Brent Olson is the lead portfolio manager of the Scout Equity Opportunity Fund. He joined the firm in 2013 and has more than 17 years of professional investment experience. Prior to joining Scout, Brent was director of research and a portfolio manager with Three Peaks Capital Management, LLC. From 2010-2013, Brent comanaged Aquila Three Peaks Opportunity Growth (ATGAX) and Aquila Three Peaks High Income (ATPAX) with Sandy Rufenacht. Before that, he served as an equity analyst for Invesco and both a high-yield and equity analyst for Janus.

Scout Equity Opportunity proposes to invest in leveraged companies. Leveraged companies are firms that have accumulated, or are accumulating, a noticeable level of debt on their books. These are firms that are, or were, dependent on borrowing to finance operations. Many equity investors, particularly those interested in “high quality stocks,” look askance at the practice. They’re interested in firms with low debt-to-equity ratios and the ability to finance operations internally.

Nonetheless, leveraged company stock offers the prospect for outsized gains. Tom Soviero of Fidelity Leveraged Company Stock Fund (FLVCX) captured more than 150% of the S&P 500’s upside over the course of a decade (2003-2013). The Credit Suisse Leveraged Equity Index substantially outperformed the S&P500 over the same period. Why so? Three reasons come to mind:

1. Debt adds complexity, which increases the prospects for mispricing. Beyond the simple fact that most equity investors are not comfortable analyzing the other half of a firm’s capital structure, there are also several different kinds of debt, each of which adds its own complexity.
2. Debt can be used wisely, which allows firms to increase their return on equity, especially when the cost of debt is low and the stock market is already rising.
3. Indebtedness increases a firm’s accountability and transparency, since they gain the obligation to report to creditors, and to pay them regularly. They are, as a result, less free to make dumb decisions than managers deploying internally-generated capital.

The downside to leveraged equity investing is, well, the downside to leveraged equity investing.  When the market falls, leveraged company stocks can fall harder and faster than most.  By way of illustration, Fidelity Leverage Company dropped 55% in 2008. That makes it hard for many investors to hold on; indeed, by Morningstar’s calculations, Mr. Soveiro’s invested managed to pocket less than a third of his fund’s excellent returns because they tended to bail when the pain got too great.

Brent Olson knows the tale, having co-managed for three years a fund with a similar discipline.  He recognizes the importance of risk control and thinks that he and the folks at Scout have found a way to manage some of the strategy’s downside.

Here are Brent’s 200 words on what a manager sensitive to high-yield fixed-income metrics brings to equity investing:

We believe superior risk-adjusted relative performance can be achieved through long-term ownership of a diversified portfolio of levered stocks. We recognize debt metrics as a leading indicator for equity performance – our adage is “credit leads, equity follows” – and so we use this as the basis for our disciplined investment process. That perspective allows us to identify companies that we believe are undervalued and thus attractive for investors.

We focus our attention on stable industries with lots of free cash flow.  Within those industries, we’re looking at companies that are either using credit improvement through de-levering their balance sheet, though debt paydown or refinancing, or ones that are reapplying leverage to transform themselves, perhaps through growth or acquisitions. At the moment there are 68 names in the portfolio. There are roughly 50 other names that we’re actively monitoring with about 10 that are getting close.

We’ve thought a lot about risk management. One of the most attractive aspects of working at Scout is the deep analyst bench, and especially the strength of our fixed income team at Reams Asset Management. That gives me access to lots of data and first-rate analysis. We also can move 20% of the portfolio into fixed income in order to dampen volatility, the onset of which might be signaled by wider high-yield spreads. Finally, we can raise the ratings quality of our portfolio names.

Scout Equity Opportunity has a $1000 minimum initial investment which is reduced to a really friendly $100 for IRAs and accounts established with an automatic investing plan. Expenses are capped at 1.25% and the fund has about gathered about $7 million in assets since its March 2014 launch. Here’s the fund’s homepage. Investors intrigued by the characteristics of leveraged equity might benefit from reading Tom Soveiro’s white paper, Opportunities in Leveraged Equity Investing (2014).

Launch Alert: Touchstone Large Cap Fund (TLCYX)

On July 9, Touchstone Investments launched the Touchstone Large Cap Fund, sub-advised by The London Company. The London Company is Virginia-based RIA with over $8.7 billion in assets under management. The firm subadvises several other US-domiciled funds including:

Hennessy Equity and Income (HEIFX), since 2007. HEIFX is a $370 million, five-star LCV fund that The London Company jointly manages with FCI Advisors.

Touchstone Small Cap Core (TSFYX), since 2009. TSFYX is an $830 million, four-star SCB fund.

Touchstone Mid Cap (TMCPX), since 2011. TMCPX is a $460 million, three-star mid-cap blend fund.

American Beacon The London Company Income Equity (ABCYX), since 2012. It’s another LCV fund with about $275 million in assets.

The fund enters the most crowded part of the equity universe: large cap domestic stock.  Depending on how you count, there are 466 large blend funds. The new Touchstone fund proposes to invest in 30-40 US large cap stocks.  In particular they’re looking for financially stable firms that will compound returns over time.  Rather than looking at earnings per share, they “pay strict attention to each company’s sustainability of return on capital and resulting free cash flow and balance sheet to derive its strategic value.”  The argument is that EPS bounces, is subject to gaming and is not predictive.  Return on capital tends to be a stable predictor of strong future performance.  They target buying those firms at a 30-40% discount to intrinsic value and holding them for relatively long periods.

It’s a sound and attractive strategy.  Still, there are hundreds of funds operating in this space and dozens that might lay plausible claim to a comparable discipline. Touchstone’s president, Steve Graziano, allows that this looks like a spectacularly silly move:

If I wasn’t looking under the hood and someone came to me to launch a large cap core fund, I’d say “you must be crazy.”  It’s an overpopulated space, a stronghold of passive investing.

The reason to launch, Mr. Graziano argues, is TLC’s remarkable discipline.  They’ve used this same strategy for over 15 years in its private accounts.  Their large core composite has returned 9.7% annually over the last decade through June 30, 2014. During the same time, the S&P500 returned 7.8%.  They’ve beaten the S&P500 over the past 3, 5, 10 and 15 year periods.  The margin of victory has ranged from 130-210 bps, depending on the time period.

The firm argues that much of the strategy’s strength comes from its downside protection: “[Our] large cap core strategy focuses on investing primarily in conservative, low‐beta, large cap equities with above average downside protection.”  Over the past five years, the strategy captured 62% of the market’s downside and 96% of its upside.  That’s also reflected in the strategy’s low beta (0.77, which is striking for a fully-invested equity strategy) and low standard deviation (12.6, about 300 bps below the market’s).

Of the 500 or so large cap blend funds, only 23 can match the 9.7% annualized10-year returns for The London Company’s Large Core Strategy. Of those, only one (PIMCO StocksPlus Absolute Return PSPTX) can also match its five-year returns of 20.7%.

The minimum initial investment in the retail class is $2500, reduced to $1000 for IRAs. The expenses are capped at 1.49%. Here’s the fund’s homepage.  While it reflects the performance of the separate accounts rather than the mutual fund’s, TLC’s Large Cap Core quarterly report contains a lot of useful information on the strategy’s historic profile.

Pre-launch Alert: PSP Multi-Manager (CEFFX)

In a particularly odd development, the legal husk of the Congressional Effect Fund is being turned to good use.  As you might recall, Congressional Effect (CEFFX) was (along with the Blue Funds) another of a series of political gestures masquerading as investment vehicles. Congressional Effect went to cash whenever (evil, destructive) Congress was in session and invested in stocks otherwise. Right: out of stocks during the high-return months and in stocks over the summer and at holidays. Good.

The fund’s legal structure has been purchased by Pulteney Street Capital Management, LLC and is soon to be relaunched as the PSP Multi-Manager Fund (ticker unknown). The plan is to hire experienced managers who specialize in a set of complementary alternative strategies (long/short equity, event-driven, macro, market neutral, capital structure arbitrage and distressed) and give each of them a slice of the portfolio.  The management teams represent EastBay Asset Management, Ferro Investment Management, Riverpark Advisors, S.W. Mitchell Capital, and Tiburon Capital Management. The good news is that the fund features solid managers and a low minimum initial investment ($1000). The bad news is that the expenses (north of 3%) are near the level charged by T’ree Fingers McGurk, my local loan shark sub-prime lender.

Funds in Registration

Our colleague David Welsch tracked down 17 new no-load, retail funds in registration this month.  In general, these funds will be available for purchase by around Halloween.  (Caveat emptor.) They include new offers from several A-tier families including BBH, Brown Advisory,and Causeway.  Of special interest is the new Cambria Global Asset Allocation ETF (GAA), a passive fund tracking an active index.  Charles is working to arrange an interview with the manager, Mebane Faber, during the upcoming Morningstar ETF conference.

Manager Changes

Chip reports a huge spike in the number of announced manager or management team changes this month, with 73 recorded changes, about 30 more than we’ve being seeing over the summer months. A bunch are simple games of musical chairs (Ivy and Waddell & Reed are understandably re-allocating staff) and about as many are additions of co-managers to teams, but there are a handful of senior folks who’ve announced their retirements.

Top Developments in Fund Industry Litigation – August2014

Fundfox is the only intelligence service to focus exclusively on litigation involving U.S.-registered investment companies, their directors and advisers. Publisher David Smith has agreed to share highlights with us. For a complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

New Lawsuits

• Davis was hit with a new excessive-fee lawsuit regarding its N.Y. Venture Fund (the same fund already involved in another pending fee litigation). (Chill v. Davis Selected Advisers, L.P.)
• Alleging the same fee claim but for a different damages period, plaintiffs filed an “anniversary complaint” in the excessive-fee litigation regarding six Principal LifeTime funds. (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal Mgmt. Corp.)

Order

• The court partly denied motions to dismiss a shareholder’s lawsuit regarding four Morgan Keegan closed-end funds, allowing misrepresentation claims under the Securities Act to proceed. (Small v. RMK High Income Fund, Inc.)

Certiorari Petition

• Plaintiffs have filed a writ of certiorari seeking Supreme Court review of the Eighth Circuit’s ruling in an ERISA class action that challenged Fidelity‘s use of the float income generated by transactions in retirement plan accounts. (Tussey v. ABB, Inc.)

Briefs

• Davis filed a motion to dismiss excessive-fee litigation regarding its N.Y. Venture Fund. (Hebda v. Davis Selected Advisers, L.P.)
• Putnam filed its opening brief in the appeal of a fraud lawsuit regarding its collateral management services to a CDO; and the plaintiff filed a reply. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)
• Plaintiffs filed their opposition to Vanguard‘s motion to dismiss a lawsuit regarding investments by two funds in offshore online gambling businesses; and Vanguard filed its reply brief. (Hartsel v. Vanguard Group, Inc.)

David Hobbs, president of Cook & Bynum, and I were talking at the Cohen Fund conference about the challenges facing fund trustees.  David mentioned that he encourages his trustees to follow David Smith’s posts here since they represent a valuable overview of new legal activity in the field.  That struck me as a thoughtful initiative and so I thought I’d pass David H’s suggestion along.

A cool resource for folks seeking “liquid alts” funds

The folks at DailyAlts maintain a list of all new hedge fund like mutual funds and ETFs. The list records 52 new funds launched between January and August 2014 and offers a handful of useful data points as well as a link to a cursory overview of the strategy.

I stumbled upon the site in pursuit of something else. It struck me as a cool and useful resource and led me to a fair number of funds that were entirely new to me. Kudos to Editor Brian Haskin and his team for the good work.

Briefly Noted . . .

Arrowpoint Asset Management LLC has increased its stake in Destra Capital Management, adviser to the Destra funds, to the point that it’s now the majority owner and “controlling person” of the firm.

Causeway’s bringing it home: pending shareholder approval, Causeway International Opportunities Fund (CIOVX) will be restructured from a “fund of funds” to “a fund making direct investments in securities.” The underlying funds in question are institutional shares of Causeway’s two other international funds – Emerging Markets (CEMIX) and International Opportunities Value(CIVIX) – so it’s hard to see how much gain investors might expect. The downside: the fund needs to entirely liquidate its portfolio which will trigger “a significantly higher taxable distribution” than investors are used to. In a slightly-stern note, Causeway warns “taxable investors receiving the distributions should be prepared to pay taxes on them.” The effect of the change on the fund’s expense ratio is muddled at the moment. Morningstar’s reported e.r. for the fund, .36%, doesn’t include the expense ratios of the underlying funds. With the new fund’s expense ratio not set, we have no idea about whether the investors are likely to see their expenses rise or fall. 

Morningstar, due to their somewhat confused reporting on the expense ratios of funds-of-funds, derides the 36 basis point fee as “high”, when they should be providing the value of the expense ratio of both the fund and it’s underlying holdings. (Thanks, Ira!)

Effective August 21, FPA Crescent Fund (FPACX) became free to invest more than 50% of its assets overseas.  Direct international exposure was previously capped at 50%.  No word yet as to why.  Or, more pointedly, why now?

Jeffrey Gundlach, DoubleLine’s founder, is apparently in talks about buying the Buffalo Bills. I’m not sure if anyone mentioned to him that E.J. Manuel (“Buffalo head coach Doug Marrone already is lowering the bar of expectation considerably for the team’s 2013 first-round pick”) is all they’ve got for a QB, unless of course The Jeffrey is imagining himself indomitably under center. That’s far from the oddest investment by a mutual fund billionaire. That honor might go to Ned Johnson’s obsessive pursuit of tomato perfection through his ownership of Backyard Farms.

On or about November 3, 2014, the principal investment strategies of the Manning Napier Real Estate and Equity Income will change to permit the writing (selling) of options on securities.

Another tough month for Marsico.  With the departure (or dismissal) of James Gendelman,  Marsico International Opportunities (MIOFX) loses its founding manager and Marsico Global (MGBLX)loses the second of its three founding managers. On the same day they lost their sub-advisory role at Litman Gregory Masters International Fund (MNILX).  Five other first-rate teams remain with the fund, whose generally fine record is marred by substantially losses in 2011.  In April 2012, one of the management teams – from Mastholm Asset Management – was dropped and performance on other sides of 2011 has been solid.

Royce Special Equity Multi-Cap Fund (RSMCX) has declared itself, and its 30 portfolio holdings, “non-diversified.”

T. Rowe Price Spectrum Income (RPSIX) is getting a bit spicy. Effective September 1, 2014, the managers may invest between 0 – 10% of the fund’s assets in T. Rowe Price Emerging Markets Local Currency Bond Fund, Floating Rate Fund, Inflation Focused Bond Fund, Inflation Protected Bond Fund, and U.S. Treasury Intermediate Fund.

SMALL WINS FOR INVESTORS

Effective immediately, 361 Global Macro Opportunity, Managed Futures Strategy and Global Managed Futures Strategy fund will no longer impose a 2% redemption fee.

That’s a ridiculously small number of wins for our side.

CLOSINGS (and related inconveniences)

On September 19, 2014, Eaton Vance Multi-Cap Growth Fund (EVGFX) will be soft-closed.  One-star rating, $162 million in assets, regrettable tendency to capture more downside (108%) than upside (93%), new manager in November 2013 with steadily weakening performance since then.  This might be the equivalent of a move into hospice care.

Effective September 5, 2014, Nationwide International Value Fund (NWVAX) will close to new investors.  One star rating, $22 million in assets, a record the trails 87% of its peers: Hospice!

OLD WINE, NEW BOTTLES

Effective October 1, 2014, Dunham Loss Averse Equity Income Fund (DAAVX/DNAVX) will be renamed Dunham Dynamic Macro Fund.  The revised fund will use “a dynamic macro asset allocation strategy” which might generate long or short exposure to pretty much any publicly-traded security.

Effective October 31, 2014, Eaton Vance Large-Cap Growth Fund (EALCX) gets renamed Eaton Vance Growth Fund.  The change seems to be purely designed to dodge the 80% rule since the principle investment strategies remain unchanged except for the “invests 80% of its assets in large” piece.  The fund comes across as modestly overpriced tapioca pudding: there’s nothing terribly objectionable about it but, really, why bother?  At the same time Eaton Vance Large-Cap Core Research Fund (EAERX) gains a bold new name: Eaton Vance Stock Fund.  With an R-squared that’s consistently over 98 but returns that trailed the S&P in four of the past five calendar years, it might be more accurately renamed Eaton Vance “Wouldn’t You Be Better in a Stock Index Fund?” Fund.

Oh, I know why that would be a bad name.  Because, the prospectus declares “Particular stocks owned will not mirror the S&P 500 Index.” Right, though the portfolio as a whole will.

Eaton Vance Balanced Fund (EVIFX) has become a fund of two Eaton Vance Funds: Growth and Investment Grade Income.  It’s a curious decision since the fund has had substantially above-average returns over the past five years.

Effective on October 1, 2014. Goldman Sachs Core Plus Fixed Income Fund becomes Goldman Sachs Bond Fund

On or around October 21, 2014, JPMorgan Multi-Sector Income Fund (the “Fund”) becomes the JPMorgan Unconstrained Debt Fund. Its principal investment strategy is to invest in (get ready!) “debt.” The list of allowable investments offers a hint, in listing two sorts of bank loans first and bonds fifth.

OFF TO THE DUSTBIN OF HISTORY

If you’ve ever wondered how big the dustbin of history is, here’s a quick snapshot of it from the Investment Company Institute’s latest Factbook. In broad terms, 500 funds disappear and 600 materialize in the average year. The industry generally sees healthy shakeouts in the year following a market crash.

Ron Rowland, founder of Invest With an Edge and editor of AllStarInvestor.com, maintains the suitably macabre ETF Deathwatch which each month highlights those ETFs likeliest to be described as zombies: funds with both low assets and low trading volumes.  The August Deathwatch lists over 300 ETFs that soon might, and perhaps ought to, become nothing more than vague memories.

This month’s entrants to the dustbin include AMF Intermediate Mortgage Fund (ASCPX)and AMF Ultra Short Fund (AULTX), both slated to liquidate on September 26, 2014.

AllianceBernstein International Discovery Equity (ADEAX) and AllianceBernstein Market Neutral Strategy — Global (AANNX)will be liquidated and dissolved (how are those different?) on October 10, 2014.

Around December 19^th, Clearbridge Equity Fund (LMQAX) merges into ClearBridge Large Cap Growth Fund (SBLGX).  LMQAX has had the same manager since 1995.

On Aug. 20, 2014, the Board of Trustees of Voyageur Mutual Funds unanimously voted and approved a proposal to liquidate and dissolve Delaware Large Cap Core Fund (DDCAX), Delaware Core Bond Fund (DPFIX) and Delaware Macquarie Global Infrastructure Fund (DMGAX). The euthanasia will occur by late October but they did not specify a date.

Direxion Indexed CVT Strategy Bear Fund (DXCVX) and Direxion Long/Short Global Currency Fund (DXAFX)are both slated to close on September 8^th and liquidate on September 22^nd.  Knowing that you were being eaten alive by curiosity, I checked: DXCVX seeks to replicate the inverse of the daily returns of the QES Synthetic Convertible Index. At base, it shorts convertible bonds.  Morningstar designates the fund as Direxion Indxd Synth Convert Strat Bear, for reasons not clear, but does give a clue as to its demise: it has $30,000 in AUM and has fallen a sprightly 15% since inception in February.

Horizons West Multi-Strategy Hedged Income Fund (HWCVX) will liquidate on October 6, 2014, just six months after launch.  In the interim, Brenda A. Smith has replaced Steven M. MacNamara as the fund’s president and principal executive officer.

The $100 million JPMorgan Strategic Preservation Fund (JSPAX) is slated for liquidation on September 29^th.  The manager may have suffered from excessive dedication to the goal of preservation: throughout its life the fund never had more than a third of its assets in stocks.  That gave it a minimal beta (about 0.20) but also minimal appeal in generally rising markets.

Oddly, the fund’s prospectus warns that “The Fund’s total allocation to equity securities and convertible bonds will not exceed 60% of the Fund’s total assets except for temporary defensive positions.”  They never explain when moving out of cash and into stocks qualifies as a defensive move.

Parametric Market Neutral Fund (EPRAX) ceases to exist on September 19, 2014.

PIMCO, the world’s biggest bond fund shop and happiest employer, is trimming out its ETF roster: Australia Bond, Build America Bond, Canada Bond and Germany Bond disappear on or about October 1, 2014.  “This date,” PIMCO gently reminds us, “may be changed without notice at the discretion of the Trust’s officers.”  At the same time iShares, the biggest issuer of ETFs, plans to close 18 small funds with a combined asset base of a half billion dollars.  That includes 10 target-date funds plus several EM and real estate niche funds.

Prudential International Value Fund (PISAX), run by LSV, will be merged into Prudential International Equity Fund (PJRAX).  Both funds are overpriced and neither has a consistent record of adding much value, though PJRAX is slightly less overpriced and has strung through a decent run lately.

PTA Comprehensive Alternatives Fund (BPFAX) liquidates on September 15, 2014. I didn’t even know the PTA had funds, though around here they certainly have fund-raisers.

In Closing . . .

Thanks, as always, to all of you who’ve supported the Observer either by using our Amazon link (which costs you nothing but earns us 6-7% of the value of whatever you buy using it) or making a direct contribution by check or through PayPal (which costs you … well, something admittedly).  Nuts.  I really owe Philip A. a short note of thanks.  Uhhh … sorry, big guy!  The card is in the mail (nearly).

For the first time ever, the four of us who handle the bulk of the Observer’s writing and administrative work – Charles, Chip, Ed and me – are settling down to a face-to-face planning session at the end of the upcoming Morningstar ETF Conference. Which also means that we’ll be wandering around the conference. If you’re there and would like to chat with any of us, drop me a note and we’ll get it set up.

Talk to you soon, think of you sooner!