Dear friends,

It’s spring.

It’s snowing.

Happy Easter.

Or Happy Eostre, if you prefer. The timing of Easter appears to be another instance of religious plagiarism, as early Christians borrowed a pagan spring festival as the (endlessly variable) date on which to celebrate the Resurrection. We don’t know that Eostre actually was a pagan goddess, since only the Venerable Bede testifies to her existence. Still, it makes sense and would be a great time to be hopeful.

So, Felices Pascuas and/or chag sameach, y’all!

One good reason to celebrate. Congratulations go to Fritz Kaegi for his electoral victory in Chicago. Fritz, who I first met when he was a high school debater for Kenwood Academy and I was Augustana’s director of debate, went on to manage Columbia Acorn Emerging Markets and, eventually, to serve as co-CIO for Columbia. He left Columbia two years ago after a coup of some sort, began to look for ways to use his powers for good and not for evil, and settled onto the prospect of running for Cook County Assessor.  It’s a powerful position affecting all of the city of Chicago, and Fritz just won a hard-fought campaign against the incumbent Joe Berrios. Neither Mr. Berrios’ Wikipedia bio nor the testimony of Chicago-area friends paints Mr. Berrios in a positive light. One giddy commentator suggested that Fritz’s win “could signal end to machine-style Chicago politics.”

Thanks to the various folks who are trying to share useful resources for you, through us.

Kirk Taylor, a long-time reader of MFO who’s lately been keeping us up to date on the last remnants of Third Avenue Focused Credit, has launched a blog, Fire Checklist, that’s begun posting interesting, thoughtful pieces on investing. On the Third Avenue matter, the advisor expects to complete liquidation by the end of June with investors receiving about 84% of their pre-liquidation capital back.

Thanks, too, to Rick Bachmann and the folks at AAII / Baltimore for sharing a Saturday morning with me. I hope it was interesting and productive!

Thanks, as ever, to the folks who support MFO.

Our special thanks, this month, to Marty for your generous donation and to John V., now joyfully retired after a long, productive career helping others manage toward retirement. Larry, Robert, Vincent, Toney, Bob Dorsey and the good folks at Ultimus, we couldn’t do it without you. To Larry P., for the support and Jonathan B. for the recommendation to investigate ACM Dynamic Opportunity (ADOIX), we thank you.

And always thanks to our trio to faithful subscribers, folks who’ve set up a steady monthly contribution to MFO. To the indefatigable Deb who might yet get me to understand how to achieve financial stability, to Brian and most especially to Greg Estey for the kind and thoughtful note that I shared with the other folks here.

In hopes that our friends in the investment management industry might have a happy week, Ed Studzinski and I agreed not to mention the recent Bloomberg Gadfly column by Mark Gilbert (“What your fund management job will look like in a decade,”3/20/2018). The essay is informed by a report by Oliver Wyman and Morgan Stanley which concludes that the firm model for the industry is unraveling, with smaller advisers driven to the wall by the commitment of larger firms to data mining and high-margin alternative investments. The key to survival is using customer relationship data and better artificial intelligence algorithms to find a way to create enduring relationships. I’ve spoken with a number of managers on this very subject. The reaction to advice to reconceive their relationship with shareholders is uniform: “don’t wanna, not gonna. I pick stocks.”

Which means it would be gratuitous to point them toward Mike Cherney’s article, “What fund managers can learn from vacuum cleaners” (WSJ, 3/29/2018). In it Andrew Formica, coCEO at Janus Henderson Group argues that the level of customer service in the investment industry is poor, but that you could learn (if you chose) from Dyson. He notes that Dyson seems manic about making sure that every customer loves every interaction with the company. When things go wrong, they go far out of their way to make it right. “No questions, no quibbles. That is client experience.” In contrast, investment managers care for their portfolios and let their clients fend for themselves.

And it would certainly be cruel to reach back to 2016, when the Financial Times interviewed Sudhir Nanda, a T. Rowe Price manager and one of their best quants (“Fund star Sudhir Nanda warns of threat to human role in finance,” 4/25/2016) for decades, the best hedge funds have used massive computing power and increasingly sophisticated programs to enact their strategies. Large fund firms “pouring money into new technology, ‘big data’ and more computer programmers to ensure they do not fall by the wayside in an increasingly ruthless investment world.” Independent firms, in contrast, often seem reluctant even to splurge on a Windows upgrade. Mr. Nanda most optimistic argument offers cold comfort, “Having a human is still important. Humans aren’t going to be completely replaced, but they will be mostly replaced.”

My colleague Charles Boccadoro unequivocally agrees. He’s been spending a lot of time in the past year with first-tier quant managers and just returned from a conference entitled “Democratizing Quant Investing.” His report appears later in this issue.

My doctorate is in communication (dude, I teach propaganda and persuasion for pay!) and my argument just doesn’t strike me as controversial: “any fund firm that stakes its existence on its ability to generate better raw performance than a well-constructed index or AI algorithm is dead, dead, dead.” Not now, not next year and not in the next decade. But, without considerable creativity and a willingness to put the same energy into understanding your clients that you put into understanding your portfolio, there will not be a “next generation” of independent managers. (Or of fund analysts.)

All of which is true, but none of which we’ll mention just now. It’s spring, a season of hope and fertility.

In May we’ll celebrate MFO’s seventh anniversary. Our first official issue was May 1, 2011. We’ll look back to that first essay, as well as look ahead to the prospect of meeting folks at the Morningstar conference in June.

Until then, stay sane!

Roy Weitz, founder of FundAlarm and sort of godfather to MFO, annually shared his portfolio, and his reflections on it, with his readers. He owned up to his mistakes, talked through his logic and revealed his plans. When I began contributing to FundAlarm, he encouraged me to do likewise. This essay, then, is an annual “think aloud” exercise that might help you imagine how to make more informed, satisfying decisions for yourself. In constructing it, I drew on my reading and conversations with managers as well as the tools available at Morningstar and MFO Premium.

I’ve thought long and hard to create a portfolio that allows me to be dumb and lazy. My overarching goal is to have a portfolio that lets me get on with life, not one that consumes my life. I try to make good decisions, then not second-guess myself. The results of those impulses are below. I’ll work through my non-retirement and retirement portfolios, let you know what I’m planning and suggest a few things that you might consider doing in the months ahead.

Non-retirement portfolio

My asset allocation is driven by two insights: (1) I don’t like losing money and (2) the best way to make money in the long term is not losing in the short-term. As a result, I built my portfolio backward from the desire for enough decent returns without attention-grabbing volatility. Mostly, I’ve succeeded. From January 26 – February 8, 2018, the US stock market dropped about 10% and financial journalists dropped a couple extra shots of espresso into their morning coffee before taking up the “the end is nigh” screed. I have no idea of how my portfolio did during those couple weeks and, until I began writing this essay, I didn’t exactly know how it had performed in 2017. Nothing weird was happening with my funds, no one resigned, no one made headlines, no one liquidated … which was all I needed to know.

The process I rely on is simple.

1. Start with an appropriate asset allocation. I’ve written, repeatedly, about the fact that a stock-light portfolio is a far better choice in a non-retirement portfolio (i.e., one where you might reasonably need to make withdrawals this year or sometime in the next three or five years) than a stock-rich portfolio. For the sake of simplicity, I generally target 50% growth and 50% income. Within the growth sleeve, I generally target 50% foreign and 50% domestic. Within the income sleeve, I generally target 50% cash substitutes and 50% other.

   Based on a review of 65 years of returns (1949-2013), this allocation would typically return a bit over 8% annually, would lose money about one year in six but its average loss would be in the 4-5% range.

2. Find the funds that best suit my plan and me. In general, the research shows that value works, small works, cheap works, and diversified works. For me, in particular, I’m happiest when I become convinced that my managers are sensible people, with sensible approaches to risk, who are doing sensible things and have been through ugly markets before. That leads me toward value and absolute value managers who write well, have a willingness to close their funds early and have a long record. In general, I prefer funds where the manager is not locked into a single narrow asset class; multi-asset flexibility and a willingness to hold a lot of cash means they can be positioned to cope with the inevitable crash.

3. Automatically invest. I don’t trust myself to write checks to investment companies, there’s always something more tempting to do with the money. So everything I do, I do with a monthly automatic investing plan.

4. Enjoy life, seek challenges, make a difference, ignore my portfolio. The fact that two of my funds returned more than 30% last year is great, but it didn’t make the “top 10 in 2017” list in our Christmas letter: Chip’s decision to move to Iowa (and the moving adventures appertaining thereunto), my sister’s first visit in 20 years, Will’s show choir triumphs, our new rain garden and garden sculptures did. If, in 2018, two of my funds decline by 30%, it’s still not defining my year.

Here’s a quick snapshot of my team, listed from my largest position to my smallest.

2017 return is just that.

Worst-ever rolling measures the greatest loss you would have ever suffered if you held a fund for three years. We’re showing the “since inception” record, which means some funds have vastly more datapoints than others. FPACX, MASCX and RPSIX all have over 250 rolling three-year periods, RSIVX and GPROX have under 25.

Morningstar risk is their proprietary, peer-based calculation.

MFO status notes whether a fund qualifies as a Great Owl, the designation reserved for funds in the top 20% of risk-adjusted returns for every trailing period we measure.

Morningstar’s take includes two reports, current as of 3/31/2018. The first is the analyst rating, their forward-looking estimation of a fund’s prospects made either by their analysts (“Silver”) or by their new artificial intelligence engine (“Q-Silver”). The other is their backward-looking (but famous) star rating.

Snapshots of the individual funds

FPA Crescent (FPACX): manager Steve Romick has jokingly described himself as the free-range chicken of the investing world. Romick combines the absolute value discipline that infuses the FPA operation with the willingness to invest in any part of an attractive firm’s capital structure: common or hybrid equity, debt, loans or whatever.

Seafarer Growth & Income (SIGIX, closed): manager Andrew Foster just strikes me as one of the best folks I’ve met. There are lots of smart people I’ve met in the industry, but few truly thoughtful ones. In founding Seafarer, Mr. Foster announced the goal of creating a new kind of fund advisor, one smarter and more shareholder centered. He’s achieved it, through really good writing, steadily falling expenses, and an institutional share class (he’d prefer the term “universal share class”) open to small investors like me. His discipline focuses on avoiding the errors made by index creators and focusing on well-run businesses that don’t have to rely on dysfunctional local capital markets to sustain themselves. For well more than a decade, he’s practiced the art of losing at exactly the right time: his funds tend to have weak relative returns in frothy markets but excellent absolute returns. 2017 is an illustration: he trailed 86% of his peers, but made 26% for his shareholders. In a down year like 2015, he finished in the top 3% of all emerging markets funds. That’s pretty common for him.

T. Rowe Price Spectrum Income (RPSIX): this is a fund of T Rowe Price funds, including one equity fund. It returns about 6-7% annually and its losing years are rare (three in 27 years) and manageable (it dropped 9% during the 2008 meltdown). The fund has been around for 298 rolling three-year periods; its worst ever three year performance was an annualized loss of 0.5% while its average gain is 7%. Income-oriented strategies are, by nature, not tax-efficient. That simply doesn’t bother me here. I’m more than happy to pay my taxes in trade for strong, reliable returns in a portfolio I can easily access.

Intrepid Endurance (ICMAX): this fund pursues the industry’s rarest, hardest discipline. It’s a stock fund that refuses to buy irrationally-priced stocks. When its entire investable universe (small cap value, mostly) becomes irrationally-priced, it simply accumulates cash in anticipation of an eventual fire sale. That makes a world of sense to me: step one, don’t be stupid. Unfortunately, investors become hypnotized by the magic of stock markets that are going to go up forever, this time, and flee from their best hope of profiting from an eventual crash. (Mostly investors fantasize that, as soon as the market begins crashing, they’re going to invest every spare penny in it and make a killing; in reality, they do the opposite.) ICMAX sits at about 60% cash and trails nearly all of its peers over the past five years, with an annual return of 2%. Since I know that markets don’t go up forever and I believe this is one of the most grievously overvalued in history, I’m perfectly comfortable letting an experienced, talented manager hedge my portfolio by holding cash and waiting.

Artisan International Value (ARTKX, closed): I bought this fund as soon as it launched in late 2002. The managers are interested in building a compact, 50 stock portfolio of high quality, undervalued firms, frequently with much lower than average market caps. The fund’s performance has clubbed its peers and pretty much every plausible benchmark over the past 15 years. As undervalued stocks become rare, the managers have moved into larger firms and are holding a lot (15%) of cash. The fund closed to new investors to minimize the risk of bloat and my only concern is that Messrs. Samra and O’Keefe might choose to cash in their chips and retire to a nice chateau, as some other early Artisan managers have already chosen to do. As long as they stay, so do I.

RiverPark Strategic Income (RSIVX) and RiverPark Short Term High Yield (RPHYX): both RiverPark funds are run by David Sherman of Cohanzick Asset Management. The older fund, RPHYX, has been freakishly successful as a cash alternative fund for me: it has averaged 3.2% annually since inception with a negative downside capture rate. Right, markets fall and it makes money. The fund has been around for 78 rolling 12-month periods; so far, its worst-ever loss in a 12 month period was a gain of 0.6%. In consequence, it has the highest five-year Sharpe ratio of any fund in existence. Strategic Income was positioned as one step further out on the risk-return ladder. Over the past three years it has returned about 50% more than its sibling, but with substantially greater volatility. At base, a couple individual issues blew up in 2014; with a concentrated portfolio, that was enough to put a noticeable dent in the fund.

I’m strongly committed to RPHYX, but likely to remain vigilant about Mr. Sherman’s ability to avoid repeating errors of the magnitude we saw in RSIVX’s portfolio in 2014.

Matthews Asian Growth and Income (MACSX): I began investing in this fund, which was for a long time the lowest-risk fund in one of the world’s highest-risk niches, back when Andrew Foster managed it. When he launched Seafarer, I moved half of my stake from MACSX to open my new account. Frankly, I think the fund has gone from “great” to “quite good” and I’m not sure how much longer that will warrant a place in my portfolio. Over the past 10 years, for example, it had the lowest Ulcer Index of any fund that invests in the Pacific. The Ulcer Index combines the size and duration of a fund’s worst drawdowns to estimate how much of an ulcer it will cause. Over the past decade, it’s #1. Over the past five years, it’s dropped to #8.  Over the past three years, to #12. That’s still quite good but …

Matthews Asia Strategic Income (MAINX): the argument is that the center of the financial world is ineluctably shifting from places like New York and London to places like Shanghai, and that wise income investors need to accommodate their portfolios to that shift. The fund can go anywhere within the Asian income market, including corporate (currently 50%) and government bonds, convertibles and dividend-paying stocks. The fund, led by Teresa Kong, has been growing slowly and is miscategorized by Morningstar as a “world bond” fund. The decision is entirely understandable, but it also means that star ratings and comparisons to “peer” performance as quite unreliable.

Grandeur Peak Global Reach (GPROX, closed) and Global Micro Cap (GPMCX, closed): the folks at Grandeur Peak are better at small- and micro-cap global investing than anyone else. Full stop. The founders left Wasatch after a strong run there and formed a new firm obsessive about getting investing right. They knew from the outset that they’d eventually launch seven core funds, they knew what their firm-wide capacity was and they resolved to close each fund promptly and tightly. And they have: all seven Grandeur Peak funds are now closed to new investors, including the $42 million micro cap fund that was closed on the day it opened, though their two “alumni” funds, Global Stalwarts and International Stalwarts, were opened to give loyal advisors access to the Grandeur Peak discipline in slightly larger firms. Over the years, there’s need a steady stream of folks looking to align with the firm.

The funds as a team

My final question is whether each of my funds brings something distinct to my portfolio. It wouldn’t make sense to have two funds each trying to do the same thing; I’d want to simply get rid of the weaker of the two and keep the stronger. We assess that by generating a correlation matrix, using the tools at MFO Premium. In general, I’d worry about correlations in the 90s, notice correlations in the 80s and be pleased with correlations in the 70s and below.

Grandeur Peak Global Micro Cap is too young to appear in any of the following analyses.

So now what do I do?

It’s rare that I hold a fund for less than 7-10 years, mostly because I know that change is rarely warranted if you’ve done the homework and the manager has kept the faith. Three things weigh on my mind as I think about my portfolio following this review.

1. 1. 1. I’m out of balance. The stock/bond balance is just fine at 51% – 49%. Within stocks, though, the domestic/international balance is badly off-course. It should be 50% domestic, 50% international. It’s closer to 28% domestic, 72% international. That’s the biggest imbalance ever in my portfolio. It reflects two sets of decisions: my decision not to have a “pure” domestic equity fund and my managers’ decision, wherever possible, to underweight domestic equity because valuations are so badly stretched. Two options: let it ride for another year or add a fund with strong exposure to domestic equity.

         Here is GMO’s February 2018 forecast for equity class returns over the next seven years. It’s created by simply modeling what would happen if valuations and profits regressed to roughly their historic means.

         

         From a valuation perspective, (a) things look bleak but (b) my preference for emerging markets exposure and cash-like investments – a sort of barbell – is looking more justified than forcing exposure to US equities.

      2. I need to reconsider MACSX. The correlation with Seafarer, which has Mr. Foster and more global flexibility, is high enough to warrant eliminating it. I could add a fund with greater domestic equity, I suppose, or shift the money to Matthews Strategic Income. Ms. Kong’s fund has, since inception, had a fair correlation (low 80s) with MACSX, offered higher returns (4% versus 3% over 5 years) and far lower volatility (5.2% SD versus 10.3%).
      3. I need to step up my monthly investment. My broker has been Scottrade, recently absorbed by TD Ameritrade. There was an administrative screw-up (uhhh … miscommunication, I’m told) that discontinued my monthly transfer from my bank account a year or so ago. While I’m adding steadily to my non-retirement portfolio through auto-investing in Seafarer, T Rowe Price and Grandeur Peak, the amount should probably rise at least a bit from my current level of several hundred a month.

My retirement portfolio

My retirement portfolio consists of a 403(b) plan administered by my employer, Augustana College, and a small Roth IRA. The 403(b) part is split between TIAA-CREF (the college’s contribution went there), T. Rowe Price and Fidelity. As part of a retirement plan reform that I helped manage, we’ve effectively shut down my ability to add to the Fidelity or T Rowe portfolios. Our new state-of-the-art system offers fewer choices (CREF funds and accounts, lifecycle funds as a default, and exactly one actively managed outside fund in each asset class) but has vastly higher employee participation. I really wanted to keep my old setup, but knew that it wasn’t in the best interest of the vast majority of college employees.

Each of the three providers has a stand-alone portfolio that’s about 70% equities. The relentless rise of the US stock market and the inconvenience of managing the old accounts through the new system, has allowed my domestic equity exposure to get far too high at about 50% more than international equity.

That said, the returns were just fine last year – 23% or so – driven by all things growth. Expenses across the portfolio come to 0.55%.

So now what do I do?

Three changes are coming in the near future.

1. 1. 1. I am liquidating my Fidelity portfolio and transferring the proceeds to T. Rowe Price. I’m worried that Fidelity is becoming a bit frayed, with reports of sexual harassment, changes in the roles of managers, fund mergers and no clear evidence of a healthy, innovative culture. For the sake of sanity and simplicity, I’d rather one “locked” portfolio than two and I am substantially more confident in Price than in Fido.
      2. I will simplify things at Price. My plan is to maintain my overweights (small / value / emerging) but I’ll do it with fewer funds. I’m apt to move the bulk of my assets into T Rowe Price Retirement 2025 (TRRHX) then use smaller positions in a few funds to tilt it. Price also has a Target 2025 Fund (TRRVX) with the same manager but a more cautious asset allocation. I’ll ponder it, but lean toward the other.
      3. I will review my asset allocation. I’m not sure that I want to ratchet back.

So what should you do?

As little as possible, but as much as necessary.

1. 1. Consider contributing, then using the ever-evolving tools at MFO Premium. The contribution part is $100 a year, tax-deductible (mostly). The tools are easy to use and Charles, our colleague and maestro of the Premium site, is an infinitely kind and engaging teacher for those who have questions.
   2. Consider whether you’re comfortable with the risks you’ve built into your portfolio. You might glance at our 2014 and 2017 articles (here, here, and here) on the implications of asset allocation for risk and return, to see whether you’re aware of the broad risks you face. You might try the lifeboat drill we offered: multiply your funds’ maximum drawdown during the 2007-09 financial crisis by their percentage weight in your portfolio. The result will give you a decent guesstimate of how much your portfolio might fall in a similar meltdown. In my case, the non-retirement loss would likely be in the low 20s. If you look and think, “good gravy, I wouldn’t be able to sleep or eat if I lost that much,” you could act to change your risk profile now by shifting to a lower risk allocation or to more risk-sensitive managers.
   3. Reduce the clutter, in your life and portfolio both. We don’t have an infinite ability to pay attention to things, much less to enjoy them. If you discover six nearly-identical funds in your portfolio, simplify. If you’re glancing at Facebook and Twitter more than at the faces of your family, simplify. If you’ve structured your day so that you have time neither to learn nor wonder, simplify. (I’m struck by the fact that we’re so sure that even though Gates and Buffett and Musk have lifelong commitments to learning and thinking, such activities don’t warrant our own time.)

Morningstar’s analysts can cover a limited number of funds, “those investments that are most relevant to investors and that hold a significant portion of industry assets.” When analysts cover a fund, they issue a forward-looking rating based on five research-driven “pillars.” Those ratings are described by medal assignments: Gold, Silver, Bronze, Neutral and Negative. The analyst ratings are distinct from the iconic star ratings; the star ratings are backward looking (they tell you how a fund did based on risk and return measures) while the analyst ratings are forward-looking (they aspire to tell you how a fund will do based on a broader set of factors).

As a practical matter, few smaller, newer, independent funds qualify. In response to concerns from clients who believe that Morningstar’s assessment is an important part of their compliance and due-diligence efforts for every fund they consider, Morningstar has unveiled a second tier of ratings. These ratings are driven by a machine-learning algorithm that has been studying two sets of data: the last five years’ worth of analyst ratings and the ocean of data Morningstar has on the components and metrics of fund performance. The goal was to produce ratings for all “analogous to” those produced by Morningstar analysts. Like the analyst ratings, they would could in Gold/Silver/Bronze and so on. Unlike the analyst ratings, they would be based purely on quantitative inputs (so the observation “he’s an utter sleazeball and a lying sack of poop” might influence the analyst’s judgment but would be unavailable to the machine). Here are the methodological details.

On March 28, 2018, I had to chance to speak with Jeff Ptak and Tim Strauts about the system and its implications. Jeff is Morningstar’s global director of manager research, Tim is their director of quantitative research and one of the brains behind the new system. We played around with three topics.

Is the machine good?

Performance in the back tests, they aver, “is pretty good.” The rough translation is that the machine has roughly the same level of predictive ability as do the human analysts.

Does the machine get to replace the humans?

Of course not.  (If I had a nickel for …) The machine and the humans do not always agree, in part because they’re focused on slightly different sets of inputs. The humans factor conversations into their judgment of the “People” pillar, for instance, while the machine factors in Sharpe ratio as part of “People.” For now the machine and the humans agree on the exact rating about 80% of the time; it could be higher, but Tim argues that he didn’t want to “overfit” the model. The more important point, in their minds, is that they’re largely avoided “the very bad problem” that would result if the machine issued a “negative” rating on the same fund where the analysts assigned a positive one. That occurs in “much less” than 1% of the ratings.

Beyond that, the machine learns from the analysts’ rating decisions. They need to keep making new decisions in order for it to become more sophisticated.

Is there a way to see the machine’s outputs? That is, can we quickly find where the machine found bits of gold or silver that the analysts missed?

Nope. Jeff and Tim are going to check with the Product team and the Prospects team, but they neither knew of any particular cool finds made by the machine nor of any way for outsiders to search the ratings just now.

The ratings are available, fund by fund, on Morningstar’s new (low profile) fund pages. When you pull up a fund’s profile, you see a simple link to the alternate profile page.

If you click on the link in the colored bar, you see

Out of curiosity, I ran a screen for all five-star domestic equity funds with under $1 billion in assets, then clicked through each profile. About half of the funds have a neutral rating and just two have negative ratings. Excluding a few funds available just through insurance products, here’s the list of “non-neutral” funds with the links to their MFO profiles when available. Many of these are purely institutional funds or the institutional share classes of funds, which reflects the effect of expenses on a fund’s ratings.

Update: Jeffrey Ptak updates us via Twitter

Gold

Glenmede Total Market Portfolio GTTMX

Silver

Fuller & Thaler Behavioral Small-Cap Equity FTHFX – an MFO “Great Owl” fund. Great Owls, a term derived from the Great Horned Owl which inspired MFO’s logo, are fund’s that are in the top 20% of their peer group, based on risk-adjusted returns, for every trailing measurement period.

Hartford Schroders US Small/Mid-Cap Opportunities Fund Class I SMDIX – “Great Owl”

Jackson Square SMID-Cap Growth Fund IS Class DCGTX – “Great Owl”

Johnson Enhanced Return Fund JENHX – “Great Owl”

Lord Abbett Micro Cap Growth Fund Class I LMIYX

Nationwide Small Company Growth Fund Institutional Service Class NWSIX – “Great Owl”

Nationwide Ziegler NYSE Arca Tech 100 Index Fund Class A NWJCX

Shelton Capital Management Nasdaq-100 Index Fund Direct Shares NASDX

Tributary Small Company Fund Institutional Class FOSCX – “Great Owl”

Victory RS Small Cap Equity Fund Class A GPSCX

William Blair Small Cap Growth Fund Class I WBSIX

Bronze

AT Disciplined Equity Fund Institutional Class AWEIX 

Conestoga SMip Cap CCSMX

Glenmede Strategic Equity GTCEX

Government Street Mid-Cap Fund GVMCX – “Great Owl”

Manning & Napier Disciplined Value Series Class I MNDFX

Morgan Stanley Institutional Fund, Inc. Advantage Portfolio Class I MPAIX

Morgan Stanley Institutional Fund, Inc. Insight Portfolio Class I

Pin Oak Equity Fund POGSX

T. Rowe Price Capital Opportunity Fund PRCOX

T. Rowe Price Institutional U.S. Structured Research Fund TRISX

Negative

Catalyst Buyback Strategy Fund BUYIX – negative on parent, price, and people

Salient US Dividend Signal Fund Institutional Class FDYTX – negative on price, process and people

It was ridiculously easy to make 15% total returns in 2017. 3,406 funds managed the feat.

And it was not particularly hard to hold 15% cash in 2017, though it was certainly unpopular with investors. 970 funds held that level of cash, either as collateral on derivative purchases, as a defensive move, or from the inability to find suitable investments.

Making 15% is good. It’s about 50% above the stock market’s historic rate of return and is a bit better than most balanced funds.

Holding 15% cash is good. The stock market is teetering. Its valuations are at or near all-time highs by a variety of measures. Washington is somewhat unhinged. People, and machines, are primed for a panic. And the best way to survive a panic is to have a clear plan and cash on hand to move in when others are giving away their shares.

Holding 15% cash and still finding a way to make 15% last year – that is, having both dry powder to profit in a crash while not sitting out the market’s rise – is rare, difficult and desirable.

Finding such funds is tricky because “cash” has many forms and functions. For our purposes, we’re looking at “cash” as a source of liquidity: money guaranteed to be there in the midst of a crash, so that a manager might move aggressively. So we started with all funds that nominally held 15% or more in cash, then stripped out those who used cash as collateral, or those whose cash included highly volatile cryptocurrencies. As a further safeguard, we tried to strip away highly volatile funds. We also screened for trailing three year returns of at least 5% to minimize the number of one hit wonders.

Finally, we tried to identify funds that were still open and accessible to the average retail investor. That left us with just over 15 15/15 funds.

Investors looking for a portfolio hedge, but who aren’t immediately drawn to complicated and costly hedging strategies, might want to start here.

A different approach was inspired by a recent article by Jeff Ptak at Morningstar (Slow and Steady Wins the Race–in the Land of Make-Believe, 3/20/2018). For reasons unclear, he decided to direct his disdain toward a suggestion that Oaktree’s Howard Marks made in a memo 28 years ago. Marks quotes the manager as saying:

We have never had a year below the 47th percentile over that period or, until 1990, above the 27th percentile. As a result, we are in the fourth percentile for the 14-year period as a whole.

In the following two paragraphs, we learn that slow and steady is “a mirage,” that the manager cited was “a unicorn or a mermaid,” the search for slow and steady is “largely misguided” and that we’d be looking for “Puff the Magic Portfolio Manager.” Mr. Ptak constructs several tests that everyone fails. He concludes that most investors should buy an index fund or, alternately, pick “managers who know the true meaning of slow but steady, as evidenced by a strong commitment to the investment process, a supportive, shareholder-friendly parent, and competitive fees that give the strategy a fighting chance of succeeding over the long haul.”

Sadly, he offers no suggestions for how to find such managers. Here’s one place to start: we searched for equity managers who had not fallen in their category’s bottom third in any of the past ten years. I focused only on funds that Morningstar flags as “core” holdings, which eliminates pretty much all of the smaller, newer funds which comprise MFO’s coverage universe. All of the funds turn out to have received four- or five-star ratings from Morningstar and are medalists of various shades.

This list excluded target-date funds and those not easily accessible to small investors.

If these results were merely random, we’d expect to see one-third of the list drop out each year; that is, one third of a random group of funds would end up the bottom third of their peer group. That’s not the pattern here, funds drop out at about 40% of the predicted rate.

Bottom Line: It is possible to change your portfolio’s risk-return profile. It doesn’t require blowing things up, but it doesn’t benefit from blind deference to the magic of market cap-weighted index funds either. Investors who ask reasonable questions, proceed from an understanding of what risks their portfolio faces and do a little poking around while the weather’s still relatively calm, can make things better for themselves and their families.