Dear friends,

Welcome to our annual summer seersucker edition of Mutual Fund Observer! Lots of folks are on vacation – we got nearly 200 “I’m on vacation! Huzzah!” auto-replies to our monthly announcement – and lots of folks are coping with unprecedented heat. The triple digit temps that toasted about two-thirds of the US in mid-July are being repeated across Europe now.

American cities are poorly prepared for heat waves; European cities are far more poorly constructed for them since their summer highs used to be 10-20 degrees cooler than what’s typical in the US.

A “heat dome” over the glaciers in Greenland, which translates to highs in the 50s Fahrenheit, has dumped 180 gigatons (i.e., billion tons) of water to the oceans since July 1, about three times the norm.

Axios, a pretty solid New Media news site, published two articles recently: one on how climate change is already affecting our day-to-day lives (and portfolios) and a second on the Fed Reserve’s decision to hold its first-ever research conference on the “implications for monetary and prudential policy of climate change and its consequences.” November, 2019.

If you like your news coverage short, solid and focused, you might enjoy Axios; it’s their stock in trade.

Locally, the almost frenetic pace of building at Augustana is finally slowing and we have a few blessed weeks before the new school year picks up.  

It will be our first year operating on a semester system after at least 60 years using 10-week terms. The tumult should be fascinating. We’ve also enrolled our largest-ever cohort of international students, somewhere over 100 of our 700 incoming students. I have to admit that I’m absolutely stunned by their bravery: most of these students are coming to what is, to them, an utterly alien culture, in the middle of nearly nowhere, eight thousand miles from home with, in many cases, no prospect of seeing their families again for 10 – 20 months. Meanwhile many of the local high school grads (or, more likely, their parents) find the idea of going to school in Chicago – 150 miles east – incomprehensible.

I like the international kids. I’m looking forward to meeting a new cohort of them. I’ll let you know how it goes.

And so our summer issue, as ever, offers a bit of a breather on the investing front.

Farewell to Deb Walters

With heavy heart, I’m passing along word of the passing of Deb Walters a/k/a Slick. She’d had a long fight against multiple cancers, with good stretches and bad. Her executor, Bill Armstrong, reports that “she went peacefully and she was reasonably comfortable.”

Deb has been a constant champion of MFO, even as the events in her life made her less visible here. She was the first person to become an ongoing subscriber to MFO with a generous monthly contribution, she conceived of using year-end challenge grants to motivate support, she herself pledged two of those challenges, and she was working hard to help me find a path toward financial sustainability for MFO. Quite beyond that, she was calm and sharp, both cheerful and a cheerleader on particularly gray days.

Her interest in MFO reflected both her interest in investing (she was an active member of the AAII and met her late husband, Richard Armstrong, through that shared interest) and in helping non-profit organizations serve their communities. Before retirement she worked full-time for the YWCA and founded a transitional home for female veterans, was on the board of Albuquerque’s Domestic Violence Resource Center, served as Development Director at First Nations and was a charter member of Albuquerque Community Foundation’s Social Giving Club. She laughed freely, and raised basset hounds.

While comfort in her passing is hard to find, just now, I’ll close with the words of the poet Jane Kenyon.

Let the light of late afternoon
shine through chinks in the barn, moving
up the bales as the sun moves down.

Let the cricket take up chafing
as a woman takes up her needles
and her yarn. Let evening come.

Let dew collect on the hoe abandoned
in long grass. Let the stars appear
and the moon disclose her silver horn.

Let the fox go back to its sandy den.
Let the wind die down. Let the shed
go black inside. Let evening come.

To the bottle in the ditch, to the scoop
in the oats, to air in the lung
let evening come.

Let it come, as it will, and don’t
be afraid. God does not leave us
comfortless, so let evening come.

Debbie H. Walters, age 68, rejoined her husband, Richard Armstrong on Tuesday, July 9, 2019. Her life is being celebrated in Albuquerque in mid-August.

Jason Zweig: bidding farewell to one friend, sharing others

On July 19, Jason Zweig shared news of the passing of the person behind the @Nonrelatedsense account; out of respect for the family’s wishes, Mr. Z. declines to share the writer’s identity.  In a spectacularly rich essay, Zweig describes his departed correspondent this way:

NRS tweeted more than 117,000 times—an inimitable mix of investing insights, snarky quips, nature photographs and cocktail recipes. He exchanged what had to be thousands of direct messages with dozens, perhaps hundreds, of people who sought his opinions. (I was among them.)

NRS was blunt, cynical, often profane, but seldom cruel—even though he saw clearly that the business model of many financial companies is to pile up mountains of fees from a blizzard of flim-flam and gibberish. A financial adviser obsessed with mutual funds and income-oriented investments, he could smell baloney in a single sniff—and as soon as he detected it, he mocked it.

At the same time, his tweets and messages were infused with skeptical wisdom and profound uncertainty about how much anyone can ever know (“your confidence in this thesis is far too high to be credible”).

“He remains,” Jason notes, “a model of how financial Twitter can educate investors.” In NRS’s memory, he offers six lists of Tweeters worth following. The first two:

For advice on what to read and how to think about financial decisions: @MorganHousel, @abnormalreturns, @farnamstreet, @mjmauboussin, @EconTalker, @dollarsanddata, @pcordway, @ritholtz, @AnnieDuke, @RPSeawright, @jposhaughnessy, @patrick_oshag, @BrentBeshore, @trengriffin, @RyanKruegerROI, @daniel_egan, @brianportnoy, @laurenfosternyc, @OS_Mitchell, @mikedariano.

For discussions on how to allocate assets and which investing strategies are likely to work or fail: @EconomPic, @Jesse_Livermore, @CliffordAsness, @enterprising, @syouth1, @demonetizedblog, @modestproposal1, @awealthofcs, @alphaarchitect, @choffstein, @MebFaber, @lhamtil, @bpsandpieces, @ROIChristie, @AlbertBridgeCap, @svrnco, @millerak42, @RyanPKirlin, @RA_Insights.

(Our WordPress software really didn’t want us to make these twitter links easily clickable. You’ll have to copy and paste the twitter handles to follow these accounts.)

Blessings to all with a passion for sharing, a sense of humility and thoughts worth sharing. They’re a rare bunch and deserve affirmation.

Things I learned en route to looking up other things

The word “restaurant” derives from the word, “restore.” The word is first assigned, in 1507, to “a restorative beverage.” By most reckonings, the first true restaurant (as distinguished from a tavern that served a bit of food, or wayside inn) was in France. All agreement, thereafter, ends. Most French culinary historians claim the first restaurant was opened by a chef named Boulanger (“baker”) in 1765, of whom colorful stories abound; an English historian politely points out that there’s not a shred of evidence that any such person existed. The first American restaurant was chef Jean Baptiste Gilbert Julien’s Restorator which opened in 1793 near Boston.

The profession “restaurateur,” is the Anglicized version of the French “restorer” which answers my long-time curiosity about why there’s no “N” in the word.

Chef Julien, by the way, lends his name to the technique of slicing vegetables into long, thin strips and to a very good summer soup of clear broth and julienned summer vegetables.

I owe the title of this section to Sydney Harris (1917 – 1986), a Chicago columnist and author who occasionally used this title at the head of an essay of interesting miscellany. As a young reader, I loved those columns. Harris was, in the way of all great Chicago columnists, spectacularly blunt. Fifty years ago, July 21, 1969, he wrote:

One of the most ignorant and hateful statements that a person can make is “If you don’t like it here, why don’t you leave?”

But most people who want to change conditions do like it here: they love it here. They love it so much they cannot stand to see it suffer from its imperfections, and want it to live up to its ideals. It is the people who placidly accept the corruptions and perversions and inequities in our society who do not love America; they love their status, security and special privilege.

Not surprisingly, he ended up on President Nixon’s vaunted “enemies list.”

Thanks, as always …

To Deb.

If you’re in the habit of offering thoughts on non-profit finances and would consider thinking in Deb’s stead, please feel free to contact me. If you’ve been meaning to help support MFO’s mission and Deb’s passing gives you occasion to act on that impulse, just click on the PayPal link over there – in the right hand column – or on the “support us” link at the top of this page.

As ever,

The word of the week is “Mauritius.”

For those of us who dozed through World Geography we’ve highlighted the country in question.

Google kindly offers the following snapshot: “Mauritius, an Indian Ocean island nation, is known for its beaches, lagoons and reefs. The mountainous interior includes Black River Gorges National Park, with rainforests, waterfalls, hiking trails and wildlife like the flying fox.”

The Mauritian flying fox (Pteropus niger). It’s actually a bat with a 2.5 foot wingspan.

And it’s soon-to-be known for its tax-dodging multinational investment funds.

Mauritius Leaks

In what are surely unrelated events, on July 23, 2019, the International Consortium of Investigative Journalists released a report, based on 200,000 pages of leaked documents from the Mauritius office of the Bermuda-based offshore law firm Conyers Dill & Pearman. The report was headlined: Treasure Island: Leak Reveals How Mauritius Siphons Tax From Poor Nations to Benefit Elites. Bob Geldof, of Live Aid famine-relief fame, appears to be the poster child in these stories for rich guys sucking every penny they can get out of poor countries; his investment fund, 8 Miles, long ago incorporated in the small island nation in order to dodge taxes. The report describes the deal this way:

The island, which sells itself as a “gateway” for corporations to the developing world, has two main selling points: bargain-basement tax rates and, crucially, a battery of “tax treaties” with 46 mostly poorer countries. Pushed by Western financial institutions in the 1990s, the treaties have proved a boon for Western corporations, their legal and financial advisers, and Mauritius itself — and a disaster for most of the countries that are its treaty partners.

“What Mauritius is providing is not a gateway but a getaway car for unscrupulous corporations dodging their tax obligations,” said Alvin Mosioma, executive director of the nonprofit Tax Justice Network Africa.

Geldof’s investment fund is among “hundreds of companies named in the Mauritius Leaks.” The consensus about their activities is  captured by Max de Haldevang, a former Reuters reporter who covers accounting shenanigans for Quartz, a global business news organization that originated as an offshoot of The Atlantic:

The documents had one overarching theme: Big Western multinationals reaping as much profit as possible from India and Africa, then depriving their governments of tax revenue through extraordinary accounting contortions.

The sums involved are colossal. Back in 2013, America’s biggest venture capital firm, Sequoia Capital, boasted it had routed $1.2 billion into Indian startups via the tiny island, which offers an effective 3% tax rate for foreign multinationals. It’s unclear how much tax Sequoia avoided, but the files show it taking “pretty aggressive”—and head-spinningly complex—measures stretching all the way to Singapore.

Such machinations lose poorer countries up to $100 billion per year—or around 6% of Subsaharan Africa’s GDP. (“Accounting Contortions: The Mauritius Leaks show the West profiting from poor nations while depriving them of tax revenue,” July 27, 2019)

Invesco exits

One day later, on July 24, 2019, Invesco India ETF (PIN) filed the following notice with the SEC on

On July 19, 2019, the board of directors of Invesco Mauritius, the wholly owned subsidiary of the Fund organized in the Republic of Mauritius (the “Subsidiary”) through which the Fund previously obtained exposure to Indian equity securities, voted to liquidate and wind up the Subsidiary.

Mauritius lives under the hood of India ETFs

Invesco might be ahead of the curve in distancing itself from this particular swamp, albeit after having benefited from it for some time. We used the MFO Premium fund screener to sort India funds and ETFs by AUM. Here’s a rundown of the ten largest.

In summary, all of the largest ETFs use – or have used – a Mauritius subsidiary while only one of the four largest mutual funds do.

This strategy manifests itself in other ways. Predictably, private partnerships such as Pegasus Capital Advisors, Sequoia Capital, a VC fund, Nalanda India Equity Fund Ltd, and Greenland Global Fund II, L.P. all utilized the strategy.

A quick search of July 2019 SEC filings shows iShares providing their trustees a compensation bump in order to cover Mauritian taxes : “Each Independent Trustee that served as a director of subsidiaries of the Exchange-Traded Fund Complex is paid an additional annual retainer of $10,000 (plus an additional $1,765 paid annually to compensate for taxes due in the Republic of Mauritius in connection with such Trustee’s service on the boards of certain Mauritius-based subsidiaries).”

Similarly, it seems to creep into the strategies offered to high net worth individuals. Goldman Sachs has a service for private clients built around the GS Momentum Builder^® Multi-Asset 5S ER Index. They report that one of the underlying ETFs “invests all of its assets that are invested in India in a wholly owned subsidiary located in the Republic of Mauritius.”

Bottom Line

To be clear, the activities of these firms appear to be legal, if rapacious. The conscientious attempt to dodge taxes and deepen the poverty of many through exploiting treaties that benefit wealthy corporations and the self-serving politicians that cozen up to them has, at least, an acrid moral flavor. In an era where the most powerful investment trend targets socially responsible and/or sustainable and/or ESG funds – those which, on principle, try to avoid screwing people on their way to profit – the use of these subsidiaries feels, at best, like a relic  and, as worst, like an ongoing repudiation of firm’s increasingly pious public stances.

Not every India fund relies on this tax dodge. Kudos, in particular, to Matthews India (MINDX, four stars from Morningstar), Wasatch Emerging India (WAINX, five stars) and Eaton Vance Greater Index (EGIIX, four stars) for strong performance and first-rate stewardship.

One of the charms of our country is all of the stuff we don’t ask. Our federal census does not, and has not since the 1950s (quick thanks to David Moran for his insight into census history), asked people about their religious preference or practices. That’s good because it’s none of the guvmint’s damned business. It’s also bad because religion is an important element of our individual and collective culture; in the absence of official estimations, a host of (sometimes laughably inept) unofficial calculations substitute.

The Pew Research Center (2018) estimates that there are “3.45 million Muslims of all ages living in the U.S. in 2017, and that Muslims made up about 1.1% of the total U.S. population.” Pew is both professional and cautious, and their explanation of their methodology struck me as clear and reasonable so I’m willing to take it as a decent ballpark estimate.

Faithful Muslim investors are constrained to follow sharia law in selecting their investments. While the term “sharia” immediately triggers negative associations in most Americans’ minds – black burkas, oppression, extremism and all that – as an investing discipline its remarkably sensible and benign:

• Avoid investing in morally offensive activities, including businesses that sell porn, violent video games, alcohol and so on.
• Avoid gambling with your money, which means no short-selling, no high-turnover strategies and no weird derivatives
• Avoid usury, which means you can’t loan money and charge people interest on it
• Avoid deeply indebted, economically suspect companies, which led Enron and WorldCom to get booted from sharia-compliant indexes long before they could hurt investors.

As a philosophical matter, it’s simple and straightforward.  Khalique Zahir, a plastic surgeon from McLean, Va. Describes it as “Basically just safe, intelligent investing. With halal investing, you’re investing in a company that has at least 50 percent of its value in hard cash. It’s not in some hypothetical dot-com kind of thought processes. It doesn’t matter if you’re Muslim or non-Muslim — you just don’t like to lose your capital.” (Retirement Savings, the Muslim Way, New York Times, 6/30/2017) Conservative ESG investors, regardless of issues of religion, would generally feel at home.

As a practical matter, it’s really complicated. What do you do with a company that’s 98% to the good, 2% to the bad? What happens if the ratio is 90/10? How do you harness the good part of lending – providing capital to towns, colleges or businesses – without running afoul of rules that forbid predatory activity?

In the US, the investment industry has largely catered to the needs of high net worth investors. There are a bunch of sharia-compliant separately managed accounts to accommodate the needs of your average neurosurgeon or successful entrepreneur.

For normal folks, though, the options have been incredibly slim. If you go to Morningstar’s UK website and enter “sharia” or “Islamic” in the search bar, you’ll find 13 funds and 10 ETFs available to European investors. In the US, the same search – until recently – returned zero and zero.

While options for American retail investors interested in a sharia-compliant investment vehicles are limited, the roster has slowly expanded and has always included some exceptionally strong choices. The most prominent family of sharia-compliant funds are the Amana Funds, run by the same advisor who provides the Sextant and Saturna funds. The newest entrant is the only ETF available to American Muslim investors, Wahed FTSE USA Shariah ETF (HLAL) which launched on July 15, 2019.

Two things strike me as I review these funds:

1. Their ratings – star and otherwise – are not particularly reliable. Morningstar and Lipper have to put these funds in some peer group, but having a fund which doesn’t invest in bonds placed in a short-term bond group, is inherently suspect. Likewise, an equity fund that structurally avoids the most speculative parts of the market is going to look weak during periods of froth and high valuations.
2. Their investors tend to be abnormally loyal. While investors have fled in droves from active income and equity funds, the flows into Islamic funds have typically been somewhere between steadily positive to just slightly negative. The ban on “speculation” means that investors want managers who buy-and-hold and are, themselves, held to a similar standard. That discipline is good for investors and advisors alike.

Nine funds for Muslim (and other risk conscious ESG) investors

Amana Growth (AMAGX): the oldest, largest and best equity option available. The general constraints we outlined above translated to a portfolio that has no basic materials, real estate, telecom, energy, or utilities (because they typically are high debt companies), a lot of technology stocks, and a bias toward quality. As part of the “don’t speculate” restriction, the fund went into the 2008 market collapse holding 30% cash which helped a lot. The only red flag: long-time manager Nick Kaiser is 70 and has been slowly handing responsibility over to a new generation. Whether they meet his high standard is yet to be seen. Four-star rating from Morningstar, a “Bronze” analyst rating, $2.2 billion in assets, $250 minimum initial investment.

Amana Developing World (AMDWX): launched in September 2009, we were really enthused about it as an option for cautious investors interested in tapping into the emerging markets. Good news: it’s by far the least volatile emerging markets equity fund in existence. Bad news: it’s made no money for its investors over the decade; annual returns have averaged just 0.1%. Why? First, it often holds five times as much cash as its peers. Second, it’s forbidden from investing in the financial sector, the largest sector in the EM indexes. One star from Morningstar, a “Neutral” analyst rating, $33 million in assets.

Amana Participation (AMAPX): launched in September 2015, AMAPX tries to generate non-equity income through investing in sukuk. Sukuk are bond-like structures which don’t run afoul of the “no interest!” stricture; globally, there’s a $250 billion industry. Since sukuk are only used in Islamic finance, it functions something like a short-duration emerging market bond fund. Since inception it has returned an average of 2.2% annually with low volatility, a standard deviation of 1.7%. One star from Morningstar, a “Neutral” analyst rating, $85 million in assets.

Amana Income (AMANX):  launched in August 1986, AMANX invests in large, steady, dividend-paying companies. Lipper categorizes it as an “equity income” fund, which seems fair. It has the same manager and most of the same strictures as Amana Growth. In the short term, it tends to have just slightly higher or just slightly lower returns and volatility than its peers; over the long term (for periods ranging from full market cycles to 10- and 20-year windows), it tends to handsomely outperform by blunting the effects of sustained bear markets. Two stars from Morningstar as a “large blend” fund, a “Bronze” analyst rating, $1.4 billion in assets.

Arabesque Systematic USA Institutional (ASUIX): launched in May 2017, this is a quant fund – that is, one whose portfolio choices are driven by machine intelligence – that invests in ESG-stocks and cash. The goal is decent returns with below benchmark risks; one explicit sub-goal is “to limit maximum drawdowns to less than 25%.” It has a strong record over its first couple years: up 9.6% annually against 1.5% for its Lipper peer group. It won’t receive its first Morningstar star rating until June 2020, a “Neutral” analyst rating, $41 million in assets. The major downside is a $50,000 minimum initial investment.

Azzad Ethical (ADJEX): launched in December 2000, the managers describe it as an “enhanced index fund that invests in mid-sized growth stocks.” It’s sub-advised by Ziegler Capital Management of Chicago. The fund tends to trail its peers by a point or two (for example, it’s returned 13.5% a year over the past decade while its peers clocked in at 14.8%) but also tends to have noticeably lower volatility. Two stars from Morningstar as a “mid growth” fund, a “negative” analyst rating, $92 million in assets, $1,000 minimum initial investment.

Azzad Wise Capital (WISEX): launched in May 2010, it describes itself as “the first halal, socially responsible fixed income fund in the United States” and is managed by Federated Investment Management, a huge firm based in Pittsburgh. (Huzzah!)  The fund has averaged 2.0% a year with a standard deviation of 1.7%, which is quite low. Three stars from Morningstar as a short-term bond fund, a “neutral” analyst rating, $143 million in assets and a $4,000 minimum initial investment.

Iman K (IMANX): launched in June 2000, Iman invests primarily in large US stocks with predictable overweights in technology and healthcare and no exposure to utilities or financials. It has been modestly outperforming its peers over the past 1-, 3- and 5-year periods after having modestly underperformed them in the past 10-year and since inception timeframes. High active share and a surprisingly high portfolio turnover (72%). Three stars from Morningstar as a large-growth fund, a “neutral” analyst rating, $125 million in assets and a $250 minimum initial investment.

Wahed FTSE USA Shariah ETF (HLAL): launched in July 2019, HLAL is a passive ETF which will track the FTSE USA Shariah Index. The index has a noticeable overweight in oil & gas, as well as the predictable overweight in tech and healthcare. The expense ratio is a perfectly reasonable 0.5%.

Active management, as a discipline, is hard.

Active management, as a sustainable business, is harder.

Active management, as a sustainable business run by an independent investment boutique, no matter how skilled, is crazy hard, getting crazier and getting harder.

When, on top of all that, it feels like a megalithic corporation has it out for you, you’d surely feel like it’s time to surrender and put Sisyphus on the management team.

Remember Sisyphus? Woven into the Iliad and the Odyssey but brought to life for many college-educated folks of a certain generation by Albert Camus, The Myth of Sisyphus (1942). King of Corinth. By all accounts, pretty much a bastard. But, also, by all accounts, the smartest and trickiest guy ever. Got a reputation for being able to trick the gods of Olympus. That was jolly in the short term, hellacious in the long term (by which I mean “for all eternity”). Zeus sentenced him to an eternity in Hades, with the sole hope that if he could roll a boulder to the top of a hill, he could get out. Or not: enchanted boulder that always slipped from his grasp a foot from the top and rolled all the way back down.

Steven Vanelli, manager of KL Allocation (GAVIX), suspects that that’s where he’s at.

We profiled his fund in 2014, when it was called GaveKal Knowledge Leaders Fund (GAVAX/GAVIX). We described it as “a very solid, mildly-mannered portfolio” but “not a fund for investors seeking unwaveringly high exposure to the global equities market. Its cautious, nearly absolute-return, approach has led many advisors to slot it in as part of their “nontraditional/liquid alts” allocation.” In March 2015, the fund was renamed GaveKal Knowledge Leaders Allocation Fund, then GaveKal KL Allocation and finally (May 2017) KL Allocation Fund.

On July 30, 2019, he published a short white paper entitled, Are There Inefficiencies in Mutual Fund Ratings?  (2019). The teaser text for the piece was clear:

Morningstar wiped GAVIX’s first five years of history from the star-ratings system and called it a “significant restructure” in 2015. We believe this action may be misleading investors about the fund’s history. Our appeal to correct it was declined. We believe it’s time to provide investors with a fuller performance and asset allocation history.

The short version of the argument is that by calculating only the last 36 months of performance and excluding the 70 months before that, Morningstar creates a short-sighted and unfairly negative capsule of the fund’s performance.

Here’s the current Morningstar snippet:

The good news is encapsulated in the designation Bronze^Q  where “Bronze” signals “above average prospects” and “Q” means the judgment was made by Morningstar’s artificial intelligence program. Most of the pillars are positive, which helps explain the medal.

The bad news is the one-star rating, which is driven by the fund’s performance since January 2015.

The three-year return is, effectively, dead last in its category but the five-year number is substantially above average. Mr. V. notes:

Using third-party data pulled from Morningstar Direct, of which we are subscribers, Morningstar ranks the fund’s total return in the top 19th percentile of 381 peer funds in the World Allocation Category, as of 6/30/19.

Looking at Morningstar’s report on risk-adjusted total return, the KL Allocation Fund appreciated at a 2.57% annualized rate over the last five years. According to Morningstar, this puts the fund in the top 15th percentile among 381 peers in the Morningstar World Allocation category, as of 6/30/19.

Using five-year data, KL is in the top 5-15% for alpha generation, beta, upside/downside capture differential and Sharpe ratio. The three-year data is far bleaker.

Mr. Vannelli doesn’t dispute the shorter-term stats; he just argues that it’s malpractice to direct investors’ attention to the short term when data for the same strategy for the longer-term is relevant and readily available.

And there’s the rub: is it the same strategy?

On face, the fund documents suggest a substantial repositioning at the start of 2015. Here’s the prospectus language before 2015 and since.

Pre-2015: GaveKal Knowledge Leaders Fund (GAVIX), January 1, 2015 prospectus:

The investment objectives of the GaveKal Knowledge Leaders Fund are to seek long-term growth of capital and to exceed the performance of the MSCI World Index.

Principal Investment Strategies

Under normal market conditions, the Fund invests primarily in common stock of companies of any size located throughout the world, including the United States. … The Fund also may invest in exchange-traded funds (“ETFs”). ETFs are investment companies that invest in portfolios of securities designed to track particular market segments or indices and whose shares are bought and sold on securities exchanges. The Fund invests primarily in companies included in the MSCI World Index.

Starting with 2015: GaveKal Knowledge Leaders Allocation Fund (GAVIX), January 30, 2015 prospectus

The investment objective of the GaveKal Knowledge Leaders Allocation Fund is to seek long-term capital appreciation with an emphasis on capital preservation.

Principal Investment Strategies

The Fund invests primarily in equity securities, fixed income securities and exchange-traded funds. Using a tactical allocation strategy focused on companies with significant intangible capital, or “Knowledge Leaders,” the Fund’s advisor shifts the Fund’s allocation among asset types, equity sectors and geographies to pursue the Fund’s objective. This flexibility is key to the Fund’s investment strategy. The proportion the Fund invests in each asset type at any given time depends on the Fund advisor’s analysis of market factors, including economic growth, inflation, credit spreads and relative valuations.

The Fund invests primarily in equity securities of companies included in the MSCI All Country World Index. …The Fund also invests in fixed income securities and in ETFs, including fixed income, money market and alternative ETFs that invest in government, municipal and mortgage-related fixed income securities, and related investments.

The folks at Morningstar, understandably, read those as fundamental changes in strategy:

During our investigation of the strategy change, we reviewed the fund literature. The name change accompanied with the investment strategy language in the prospectus led us to assign a significant restructure tag upon the change to prospectus. This decision was reviewed by senior members of both our methodology and manager research teams.

Mr. Vannelli argues that the 2015 language did not reflect a change in investment behavior, it simply clarified what the fund had been doing all along.

The team did not make an “abrupt” portfolio shift, in our opinion. We did not sell most of the fund’s holdings or have any new holdings that were of “substantially different character than the old holdings.” There was no change in the fund’s legal structure. In short, there was no significant restructuring event in our view, as the holdings breakdown below shows. Furthermore, portfolio holdings suggest the fund has been an allocation fund from its inception.  (emphasis in the original)

He offers this snapshot of the portfolio’s asset allocation before and after the prospectus change:

He laments “questionable and arbitrary categorizations, measurements and data methodologies from the largest provider of mutual fund data for investors.” Morningstar argues that they’re doing their honest best:

Successful appeals are not uncommon; the recent average of successful appeals is approximately 70%. Successful appeals are of a mixed variety; common themes are: the appeal notifies Morningstar of strategy investment changes, which Morningstar substantiates generally through two portfolio disclosures; the appeal elucidates a strategy that may not be born out adequately by Morningstar’s holdings-based statistical calculation (particularly for alternative strategies); and funds that share attributes with multiple categories and request a review to see which is their best peer-group.

Bottom Line

GAVIX’s current one-star rating is driven by two factors: (1) it’s based on only three years’ worth of data and (2) one of those three years – 2018 – was the worst in the fund’s history. Long-term investors, as is their wont, reacted to short-term adversity by fleeing.

In both the short and long term, the fund has stayed true to its concern for capital preservation. Because the fund screener at MFO Premium is far more flexible than what’s usually available to individual investors, we were able to generate the relevant performance of GAVIX against its Lipper “flexible portfolio” peers for nine different time windows. We’ve shaded a cell green whenever GAVIX outperformed its peers and red (well, pink) whenever it underperformed them.

All data is from the Lipper Global Data Feed, as of 6/30/2019

In most trailing periods, GAVIX had a lower volatility portfolio than its peers; even when it had above-average volatility, the difference was minor. The key driver is falling returns: the portfolio is now just  10% US equities and 28% international equities, roughly half its historic weighting. With the US equity market up 21% YTD (through 7/29/2019), against international equities up 13% and bonds up 6%, the fund’s 10% gain is reasonable, understandable … any still behind 70% of its Morningstar peers.

Should you look beyond the one-star rating? Hell, yeah. Even Morningstar, with its forward-looking Bronze designation, does. The “flexible portfolio” or “world allocation” business is harder than most, because you’ve got to both get your asset allocation right and get security selection right, and then survive being benchmarked against a bunch of funds that have nothing in common except for a refusal to color within the lines. That requires substantially more research and better understanding of what the manager is doing – and why – than a simple star or pile of stars can capture.

If you’re going to go there, read carefully and focus on whether the manager is doing what you hired them to do, not on an external snapshot.

Investors are pulled by three competing forces just now.

Force One: The market is going to crash soon enough.

Longest bull market in US history. Valuations, based on 10-year CAPE or Shiller average, have only been higher twice in market history: 1929 and 2000. Record earnings, which make stocks look cheaper, are starting to wobble. Economic policy is being made by tweet by a guy still in his jammies. Trade war. Brexit. $1,200,000,000,000 federal budget deficit this year.

Force Two: There still could be a heck of a party before that happens.

The Fed just cut interest rates for the first time in 3,878 days; rate cuts during past expansions have triggered six month market gains of 11% or so, which would be on top of the 20% YTD gain we’ve already booked.

To be clear: I am not predicting a melt-up and I’m not celebrating what appears to be the Fed’s craven response to political pressures. I’m just trying to fairly reflect factors that seem to be on investors’ minds.

BTW: Our current budget deficit is $1.2 trillion/year. A decade hence, government and private economists estimate that the federal government will be paying $1 trillion/year in debt payments.

Force Three: Investors love them their ETFs!

Fund flows, market dominance, active funds are dinosaurs. Got it.

Here’s the one thing you need to understand: market-weighted indexes work only when the market is rising. If the market falls, you’re toast; first, because you’re developed an almost-religious belief in them and, second, because they fail when you need them most.

We used the MFO Premium screener to look at the performance of all equity and balanced funds and ETFs during the 2007-2009 market decline. Of the 100 investment vehicles with the highest Sharpe ratio, none were ETFs and none were passive funds. Of the 200 best performers, only four were ETFs. Five of the 10 worst performers, by contrast, were passive.

Finding funds to balance your competing desires

MFO maintains two separate ratings systems for mutual funds.

Our main designation is for the Great Owl funds, designated GO in our screener. Here’s the definition: “A fund that has delivered top quintile risk-adjusted returns, based on Martin Ratio, in its category for evaluation periods of 3, 5, 10, and 20 years, as applicable. An MFO 10-year Great Owl (GO) fund, for example, has delivered top quintile risk-adjusted returns for evaluation periods of 3, 5, and 10 years.” The key to understanding the Great Owls is that they are consistently excellent judged by a very conservative risk-return metric.  That means you get a lot of return for the risk you’re exposed to, which doesn’t automatically mean you’re getting a lot of return period.

Our second designation was inherited from our predecessor, FundAlarm. From 1996 on, FundAlarm famously tracked “Alarming” and “Most Alarming” funds based on how consistently miserable their trailing returns were but FundAlarm also maintained an Honor Roll of funds (HR in the screener). Honor Roll funds have returns in the top quintile of their categories in the past 1, 3, and 5 years. That is, Honor Roll funds have consistently high absolute returns, a judgment made without regard to the level of risk they expose their investors to.

In the late parts of a cycle, investors who are unwilling to downshift their asset allocation to include more cash (“dry powder” for use in an eventual fire sale) might want to consider funds that are both Great Owls and Honor Roll members. The following funds:

• Invest in US stocks or a stock/bond blend
• Have been around for 12 years or more
• Have consistently excellent long-term risk-adjusted returns (i.e., are Great Owls)
• Have consistently excellent short- and mid-term absolute returns (i.e., are Honor Rollees)
• Are available to retail investors (i.e., have minimums of no more, and generally much less, than $10,000)

As a comparison, we’ve included both Vanguard STAR, a fund of actively managed funds with a 60/40 allocation, and Vanguard Total Stock Market, an ultra-cheap option for getting a bit of everything.

There are 1944 funds and ETFs that have been around for the full market cycle and invest either in US stocks or in a stock/bond blend. Only 13 of those funds – 0.06% – have earned a place on the list below.

The Thirteen Overachieving Defenders

Of the funds listed, Franklin Convertible Securities Fund, Virtus KAR Small-Cap Core, Virtus KAR Small-Cap Growth, T. Rowe Price New Horizons and T. Rowe Price Capital Appreciation are closed to new investors. Of them, only New Horizons has seen sustained outflows (which might presage re-opening) but New Horizons lost its long-time manager in March, 2019. Other than for investigating the new Virtus KAR Small-Mid Cap Core Fund (VKSAX), the prospect of backdoors and re-openings both seem limited.

Many thanks to MFO reader John Hawrylak, another Western Pennsylvanian, for catching the fact that so many of the best funds are still closed and recommending that we flag them!

MFO Premium search: Sub-type = US equity or mixed asset, Great Owl = yes, Honor Roll = yes, Period = Full Cycle 5 (2007-present), Minimum purchase < $10,000. Data current as of 6/30/2019. Sorted by Sharpe ratio.

Here’s a one-time special offer: if you’d like more detail on any of the Defensive Overachievers, drop us a note and let us know. If any fund interests more than two readers, we’ll produce a full profile of the fund for you!

But wait, there’s more! We’ll happily share word of, and thoughts behind, your nomination of the fund with next month’s readers. It’s like being famous without the hassle of paparazzi!

I’m inured to stupid stories (“12% annual returns from a three-stock portfolio allow smart investors to retire at age 24 with $12 million!”) originating from “financial journalists” that no one has ever heard of. Those folks exist because the news hole has become a black hole.

The “news hole” is the amount of space, in a newspaper or magazine, or time, in a news broadcast, available for the news of the day. It used to be a constraining factor: if you only have 23 minutes (or 400 column inches) a day available, you had to make editorial judgments about what was important, true and timely.

The launch of CNN changed all that. CNN needed to fill 24 hours a day with “news.” That forced a change from “sifting the wheat from the chaff” to “scrounging around for anything we can put on camera.” The iconic story for them is the coverage of a hostage-taking: a camera points resolutely at the front of a building (where there’s nothing to be seen) while a reporter resolutely tells us “we’re heard nothing from the police on-scene” … for three hours at a stretch.

With The Internet representing a virtually infinite news hole, we need a virtually infinite amount of stuff to occupy it each day. And still I’m surprised when “A” list folks get caught up in the “write something, quick!” imperative.

Ken Fisher: Everyone’s scared, and everyone knows that’s the best time to buy!

Mr. Fisher is rich, famous and nearly ubiquitous. He also likely holds a Guinness world record for number of appearances in pop-up ads. But this advice (Special to the USA Today, July 7, 2019) is freakish. Here’s his thesis: all bad news is priced into the market and we’re already at maximum pessimism, so any development short of an apocalypse will be a relief and the markets will skyrocket.

Quoth Fisher: “Warren Buffett famously preached: Be fearful when others are greedy – and greedy when others are fearful.”

Ummm … Mr. Buffett is sitting on $112 billion in cash, 34% of his investment portfolio. On July 9, two days after Mr. Fisher’s piece, the ratio between the Wilshire 5000 and US GDP, which Mr. Buffett described as “probably the best single measure of where valuations stand at any given moment,” reached 146.1% which implied an annual market return of  -2.2% (Warren Buffett’s market indicator exceeds 145%, GuruFocus).

My best understanding of Mr. Buffett’s adage is this: you can make money when other people panic and get stupid, so long as you do neither of those things. While I’m confident that investors will oblige Mr. Buffett eventually, a market at historic highs seems hardly the time to plunge in.

Mark Hulbert: if you’re not in the top 25% year after year, you’re dirt.

Mr. Hulbert, long-time publisher of the Hulbert Financial Digest, reads, digests and explains more financial research than just about anybody. Smart guy, independent thinker.

And still we get this freakish fetish about judging investments by whether they finish in the top XX% for XX consecutive years. There is no stupider or more destructive obsession in the investing world than this: so how often does your guy beat the market? This is the fantasy football version of investing: we win not by winning but by adding together a bunch of random, unconnected data points and declaring the person with the biggest piles o’ points won.

Earth to Investors: Fantasy Football is Fantasy. It’s not a model for managing your money. In personal finance, you win if and only if the sum of your resources is equal to or greater than the sum of your needs.

If you beat the market 10 years in a row and the sum of your resources is less than the sum of your needs, you lose.

If you trail the market 10 years in a row and the sum of your resources is greater than the sum of your needs, you win.

Our guess is that winning requires investments that you understand and can stick with in the long term, ideally calibrated to a calculation of your long term needs. In my case, for example, I win if my retirement portfolio returns 6% per year. If my 6% returns “trail the market,” I still win. If I “beat the market” but make less than 6%, I lose.

Back to Mr. Hulbert:

S&P Dow Jones Indices is out with its latest “Persistence Scorecard” on mutual fund performance, and its findings are just as depressing as they always have been.

That’s because, as has been the case with every other of those reports over the years, almost no top-performing actively managed mutual funds are able to repeat their winning ways from year to year.

The results certainly are devastating. (Opinion: This statistically inferior strategy can make investors more money over the long haul, MarketWatch, July 22, 2019)

He is, in particular, concerned about the inability of actively-managed funds be to in the top 25% of their peer group year after year. “On the assumption of pure randomness, you’d expect 6.25% of the original group of funds to be in the top quartile for three straight years. The actual percentage: 0.9%.” Here’s the accompanying graphic:

Ummm …. Two problems. First, this is meaningless data driven by the aforementioned stupid and destructive obsession.

Second, by this metric, passive index funds are four times worse than active mutual funds!  0.9% of active funds pass Mr. Hulbert’s three-year test … but only 0.2% of passive funds do. Using the Morningstar fund screener, we first identified all passive domestic equity funds that existed in 2016 and calculated what percentage finished in the top quartile of their peer groups that year: 104 of 406 funds, 25.6% of the total. We then asked what percentage repeated that achievement in 2017 (3 funds, 0.7%) and what percentage managed three consecutive years (1 fund, 0.2%).

This ineluctably leads us to one of two conclusions: (1) index funds suck! or (2) this metric sucks!

Your choice.

Mr. Hulbert redeems himself in the article’s second half when he warns that all of the gains made during a market’s upcycle can be undone if you panic and get stupid (get the discussion above) when the market begins to fall, as it will.

A statistically inferior strategy can nevertheless make you more money, provided you’re willing to follow it over the long haul. And I mean the long haul. Through thick and thin. Not bailing out in the middle of a bear market.

Engage in honest self-reflection on what your tolerance level is for bear-market losses. If you truly are able to tolerate being invested in an index fund during a major bear market, then by all means go with it.

But if you don’t have that tolerance level—and there is no shame in realizing that you don’t—then find a mutual fund or adviser with which you can live through that bear market.

He is, as so often is true, very right about that.

Bottom Line

Having a strategy that’s well thought out and that you can stick with, in good markets and bad, is your best hope for winning. “Beating the market” is irrelevant, at best. “Timing the market” is suicidal, at best. Our argument has always been: start with an asset allocation that gives you about the returns you need with risks you can tolerate (in my case, 50% stocks in my non-retirement portfolio, 65% in retirement), pick a small group of investment vehicles that you’ve taken the time to understand, fund the plan, get on with life.

This month’s feature, Defensive Overachievers, highlights the 13 funds that have managed both risk-conscious excellence and total return excellence over the 12 years of the current market cycle. They’re a good starting point for many.