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,

We’ve always enjoyed and benefited from your reactions to the Observer. Your notes are read carefully, passed around and they often shape our work in the succeeding months. The most common reaction to our July issue was captured by one reader who shared this observation:

Dear David: I really love your writing. I just wish there weren’t so much of it. Perhaps you could consider paring back a bit?

Each month’s cover essay, in Word, ranges from 22 – 35 pages, single-spaced. June and July were both around 30 pages, a length perhaps more appropriate to the cool and heartier months of late autumn and winter. In response, we’ve decided to offer you the Seersucker Edition of Mutual Fund Observer. We, along with the U.S. Senate, are celebrating seersucker, the traditional fabric of summer suits in the South. Light, loose and casual, it is “a wonderful summer fabric that was designed for the hot summer months,” according to Mississippi senator Roger Wicker. In respect of the heat and the spirit of bipartisanship, this is the “light and slightly rumpled” edition of the Observer that “retains its fashionable good looks despite summer’s heat and humidity.”

Ken Mayer, some rights reserved

For September we’ll be adding a table of contents to help you navigate more quickly around the essay. We’ll target “Tweedy”, and perhaps Tweedy Browne, in November!

“There’ll never be another Bill Gross.” Lament or marketing slogan?

Up until July 31, the market seemed to be oblivious to the fact that the wheels seemed to be coming off the global geopolitical system. We focused instead on the spectacle of major industry players acting like carnies (do a Google image search for the word, you’ll get the idea) at the Mississippi Valley Fair.

Exhibit One is PIMCO, a firm that we lauded as having the best record for new fund launches of any of the Big Five. In signs of what must be a frustrating internal struggle:

PIMCO icon Bill Gross felt compelled to announce, at Morningstar, that PIMCO was “the happiest place in the world” to work, allowing that only Disneyland might be happier. Two notes: 1) when a couple says “our marriage is doing great,” divorce is imminent, and 2) Disneyland is, reportedly, a horrible place to work.

(Reuters, Jim King)

Gross also trumpeted “a performance turnaround” which appears not to be occurring at Gross’s several funds, either an absolute return or risk-adjusted return basis.

After chasing co-CIO Mohammed el-Erian out and convincing fund manager Jeremie Banet (a French national whose accent Gross apparently liked to ridicule) that he’d be better off running a sandwich truck, Gross took to snapping at CEO Doug Hodge for his failure to stanch fund outflows.

PIMCO insiders have reportedly asked Mr. Gross to stop speaking in public, or at least stop venting to the media. Mr. Gross threatened to quit, then publicly announced that he’s never threatened to quit.

Despite PIMCO’s declaration that the Wall Street Journal article that detailed many of these promises was “full of untruths and mischaracterizations that are unworthy of a major news daily,” they’ve also nervously allowed that “Pimco isn’t only Bill Gross” and lamented (or promised) that there will never been another PIMCO “bond king” after Gross’s departure.

Others in the industry, frustrated that PIMCO was hogging the silly season limelight, quickly grabbed the red noses and cream pies and headed at each other.

The most colorful is the fight between Morningstar and DoubleLine. On July 16, Morningstar declared that “On account of a lack of information … [DoubleLine Total Return DBLNX] is Not Ratable.” That judgment means that DoubleLine isn’t eligible for a metallic (Gold, Silver, Bronze) Analyst Rating but it doesn’t affect that fund’s five-star rating or the mechanical judgment that the $34 billion fund has offered “high” returns and “below average” risk. Morningstar’s contention is that the fund’s strategies are so opaque that risks cannot be adequately assessed at arm’s length and the DoubleLine refuses to disclose sufficient information to allow Morningstar’s analysts to understand the process from the inside. DoubleLine’s rejoinder (which might be characterized as “oh, go suck an egg!”) is that Morningstar “has made false statement about DoubleLine” and “mischaracterized the fund,” in consequence of which they’ll have “no further communication with Morningstar.com” (“How Bad is the Blood Between DoubleLine and Morningstar?” 07/18/2014).

DoubleLine declined several requests for comment on the fight and, specifically, for a copy of the reported eight page letter of particulars they’d sent to Morningstar. Nadine Youssef, speaking for Morningstar, stressed that

It’s not about refusing to answer questions—it’s about having sufficient information to assign an Analyst Rating. There are a few other fund managers who don’t answer all of our questions, but we assign an Analyst Rating if we have enough information from filings and our due diligence process.

If a fund produced enough information in shareholder letters and portfolios, we could still rate it. For example, stock funds are much easier to assess for risk because our analysts can run good portfolio analytics on them. For exotic mortgages, we can’t properly assess the risk without additional information.

It’s a tough call. Many fund managers, in private, deride Morningstar as imperious, high-handed, sanctimonious and self-serving. Others aren’t that positive. But in the immediate case Morningstar seems to be acting with considerable integrity. The mere fact that a fund is huge and famous can’t be grounds, in and of itself, for an endorsement by Morningstar’s analysts (though, admittedly, Morningstar does not have a single Negative rating on even one of the 234 $10 billion-plus funds). To the extent that this kerfuffle shines a spotlight on the larger problem of investors placing their money in funds whose strategies that don’t actually understand and couldn’t explain, it might qualify as a valuable “teachable moment” for the community.

Somewhere in there, one of the founders of DoubleLine’s equity unit quit and his fund was promptly liquidated with an explanation that almost sounded like “we weren’t really interested in that fund anyway.”

Waddell & Reed, adviser to the Ivy Funds, lost star manager Bryan Krug to Artisan.  He was replaced on Ivy High Income (IVHIX) by William Nelson, who had been running Waddell & Reed High Income (UNHIX) since 2008. On July 9^th Nelson was fired “for cause” and for reasons “unrelated to his portfolio management responsibilities,” which raised questions about the management of nearly $14 billion in high-yield assets. They also named a new president, had their stock downgraded, lost a third high-profile manager, drew huge fund inflows and blew away earnings expectations.

Recovery Time

In the book “Practical Risk-Adjusted Performance Measurement,” Carl Bacon defines recovery time or drawdown duration as the time taken to recover from an individual or maximum drawdown to the original level. In the case of maximum drawdown (MAXDD), the figure below depicts recovery time from peak. Typically, for equity funds at least, the descent from peak to valley happens more quickly than the ascent from valley to recovery level.

An individual’s risk tolerance and investment timeline certainly factor into expectations of maximum drawdown and recovery time. As evidenced in “Ten Market Cycles” from our April commentary, 20% drawdowns are quite common. Since 1956, the SP500 has fallen nearly 30% or more eight times. And, three times – a gut wrenching 50%. Morningstar advises that investors in equity funds need “investment horizons longer than 10 years.”

Since 1962, SP500’s worst recovery time is actually a modest 53 months. Perhaps more surprising is that aggregate bonds experienced a similar duration, before the long bull run.  The difference, however, is in drawdown level.

 During the past 20 years, bonds have recovered much more quickly, even after the financial crisis.

Long time MFO board contributor Bee posted recently:

MAXDD or Maximum Drawdown is to me only half of the story.

Markets move up and down. Typically the more aggressive the fund the more likely it is to have a higher MAXDD. I get that.

What I find “knocks me out of a fund” in a down market is the fund’s inability to bounce back.

Ulcer Index, as defined by Peter Martin and central to MFO’s ratings system, does capture both the MAXDD and recovery time, but like most indices, it is most easily interpreted when comparing funds over same time period. Shorter recovery times will have lower UIcer Index, even if they experience the same absolute MAXDD. Similarly, the attendant risk-adjusted-return measure Martin Ratio, which is excess return divided by Ulcer Index, will show higher levels.

But nothing hits home quite like maximum drawdown and recovery time, whose absolute levels are easily understood. A review of lifetime MAXDD and recoveries reveals the following funds with some dreadful numbers, representing a cautionary tale at least:

In contrast, some notable funds, including three Great Owls, with recovery times at one year or less:

On Bee’s suggestion, we will be working to make fund recovery times available to MFO readers.

Flash Geeks and Other Vagaries of Life …..

By Edward Studzinski

“The genius of you Americans is that you never make clear-cut stupid moves, only complicated stupid moves which make us wonder at the possibility that there may be something to them which we are missing.”

                Gamal Abdel Nasser

Some fifteen to twenty-odd years ago, before Paine Webber was acquired by UBS Financial Services, it had a superb annual conference. It was their quantitative investment conference usually held in Boston in early December. What was notable about it was that the attendees were the practitioners of what fundamental investors back then considered the black arts, namely the quants (quantitative investors) from shops like Acadian, Batterymarch, Fidelity, Numeric, and many of the other quant or quasi-quant shops. I made a point of attending, not because I thought of myself as a quant, but rather because I saw that an increasing amount of money was being managed in this fashion. WHAT I DID NOT KNOW COULD HURT BOTH ME AND MY INVESTORS.

One of the things you quickly learned about quantitative methods was that their factor-based models for screening stocks and industries, and then constructing portfolios, worked until they did not work. That is, inefficiencies that were discovered could be exploited until others noticed the same inefficiencies and adjusted their models accordingly. The beauty of this conference was that you had papers and presentations from the California Technology, MIT, and other computer geeks who had gone into the investment world. They would discuss what they had been working on and back-testing (seeing how things would have turned out). This usually gave you a pretty good snapshot of how they would be investing going forward. If nothing else, it helped you to know when you might want to step out of the way to keep from being run-over. It was certainly helpful to me in 1994. 

In late 2006, I was in New York at a financial markets presentation hosted by the Santa Fe Institute and Bill Miller of Legg Mason. It was my follow-on substitute for the Paine Webber conference. The speakers included people like Andrew Lo, who is both a brilliant scientist at MIT and the chief scientific officer of the Alpha Simplex Group. One of the other people I chanced to hear that day was Dan Mathisson of Credit Suisse, who was one of the early pioneers and fathers of algorithmic trading. In New York then on the stock exchanges people were seeing change not incrementally, but on a daily basis. The floor trading and market maker jobs which had been handed down in families from generation to generation (go to Fordham or NYU, get your degree, and come into the family business) were under siege, as things went electronic (anyone who has studied innovation in technology and the markets knows that the Canadians, as with air traffic control systems, beat us by many years in this regard). And then I returned to Illinois, where allegedly the Flat Earth Society was founded and still held sway. One of the more memorable quotes which I will take with me forever is this. “Trying to understand algorithmic trading is a waste of time as it will never amount to more than ten per cent of volume on the exchanges. One will get better execution by having” fill-in-the blank “execute your trade on the floor.” Exit, stage right.

Flash forward to 2014. Michael Lewis has written and published his book, Flash Boys. I have to confess that I purchased this book and then let it sit on my reading pile for a few months, thinking that I already understood what it was about. I got to it sitting in a hotel room in Switzerland in June, thinking it would put me to sleep in a different time zone. I learned very quickly that I did not know what it was about. Hours later, I was two-thirds finished with it and fascinated. And beyond the fascination, I had seen what Lewis talked about happen many times in the process of reviewing trade executions.

If you think that knowing something about algorithmic trading, black pools, and the elimination of floor traders by banks of servers and trading stations prepares you for what you learn in Lewis’ book, you are wrong. Think about your home internet service. Think about the difference in speeds that you see in going from copper to fiber optic cable (if you can actually get it run into your home). While much of the discussion in the book is about front-running of customer trades, more is about having access to the right equipment as well as the proximity of that equipment to a stock exchange’s computer servers. And it is also about how customer trades are often routed to exchanges that are not advantageous to the customer in terms of ultimate execution cost. 

Now, a discussion of front running will probably cause most eyes to glaze over. Perhaps a better way to think about what is going on is to use the term “skimming” as it might apply for instance, to someone being able to program a bank’s computers to take a few fractions of a cent from every transaction of a particular nature. And this skimming goes on, day in and day out, so that over a year’s time, we are talking about those fractions of cents adding up to millions of dollars.

Let’s talk about a company, Bitzko Kielbasa Company, which is a company that trades on average 500,000 shares a day. You want to sell 20,000 shares of Bitzko. The trading screen shows that the current market is $99.50 bid for 20,000 shares. You tell the trader to hit the bid and execute the sale at $99.50. He types in the order on his machine, hits sell, and you sell 100 shares of Bitzko at $99.50. The bid now drops to $99.40 for 1,000 shares. When you ask what happened, the answer is, “the bid wasn’t real and it went away.” What you learn from Lewis’ book is that as the trade was being entered, before the send/execute button was pressed, other firms could read your transaction and thus manipulate the market in that security. You end up selling your Bitzko at an average price well under the original price at which you thought you could execute.

So, how is it that no one has been held accountable for this yet? I don’t know, although there seem to be a lot of investigations ongoing. You also learn that a lot here has to do with order flow, or to what exchange a sell-side firm gets to direct your order for execution. The tragi-comic aspect of this is that mutual fund trustees spend a lot of time looking at trading evaluations as to whether best execution took place. The reality is that they have absolutely no idea on whether they got best execution because the whole thing was based on a false premise from the get-go. And the consultant’s trading execution reports reflect none of that.

Who has the fiduciary obligation? Many different parties, all of whom seem to hope that if they say nothing, the finger will not get pointed at them. The other side of the question is, you are executing trades on behalf of your client, individual or institutional, and you know which firms are doing this. Do you still keep doing business with them? The answer appears to be yes, because it is more important to YOUR business than to act in the best interests of your clients. Is there not a fiduciary obligation here as well? Yes.

I would like to think that there will be a day of reckoning coming. That said, it is not an easy area to understand or explain. In most sell-side firms, the only ones who really understood what was going on were the computer geeks. All that management and the marketers understood was that they were making a lot of money, but could not explain how. All that the buy-side firms understood was that they and their customers were being disadvantaged, but by how much was another question.

As an investor, how do you keep from being exploited? The best indicators as usual are fees, expenses, and investment turnover. Some firms have trading strategies tied to executing trades only when a set buy or sell price is triggered. Batterymarch was one of the forerunners here. Dimensional Fund Advisors follows a similar strategy today. Given low turnover in most indexing strategies, that is another way to limit the degree of hurt. Failing that, you probably need to resign yourself to paying hidden tolls, especially as a purchaser or seller of individual securities. Given that, being a long-term investor makes a good bit of sense. I will close by saying that I strongly suggest Michael Lewis’ book as must-reading. It makes you wonder how an industry got to the point where it has become so hard for so many to not see the difference between right and wrong.

What does it take for Morningstar to notice that they’re not noticing you?

Based on the funds profiled in Russ Kinnel’s July 15th webcast, “7 Under the Radar Funds,” the answer is about $400 million and ten years with the portfolio.

Let’s start with the obvious: these are pretty consistently solid funds and well worth your consideration. What most strikes me about the list is the implied judgment that unless you’re from a large fund complex, the threshold for Morningstar even to admit that they’ve been ignoring you is dauntingly high. While Don Phillips spoke at the 2013 Morningstar Investment Conference of an initiative to identify promising funds earlier in their existence, that promise wasn’t mentioned at the 2014 gathering and this list seems to substantiate the judgment that from Morningstar’s perspective, small funds are dead to them.

That’s a pity given the research that Mr. Kinnel acknowledges in his introduction…when it comes to funds, bigger is simply not better.

Investors might be beginning to suspect the same thing. Kevin McDevitt, a senior analyst on Morningstar’s manager research team (that’s what they’re calling the folks who cover mutual funds now), studied fund flows and noticed two things:

1. Starting in early 2013, investors began pouring money into “risk on” funds. “Since the start of 2013, flows into the least-volatile group of funds have basically been flat. During that same six-quarter stretch, investors poured nearly $125 billion into the most-volatile category of funds.” That is, he muses, reminiscent of their behavior in the years (2004-07) immediately before the final crisis.
2. Investors are pouring money into recently-launched funds. He writes: “What’s interesting about this recent stretch is that a sizable chunk of inflows has gone to funds without a three-year track record. If those happen to be higher-risk funds too, then people really have embraced risk once more. It’s pretty astonishing that these fledgling funds have collected more inflows over the past 12 months through June ($154 billion) than the other four quartiles (that is, funds with at least a three-year record) combined ($117 billion).”

I’ve got some serious concerns about that paragraph (you can’t just assume newer funds as “higher-risk funds too”) and I’ve sent Mr. McDevitt a request for clarification since I don’t have any ideas of what “the other four quartiles” (itself a mathematical impossibility) refers to. See “Investors Show Willingness to Buy Untested Funds,” 07/31/2014.

That said, it looks like investors and their advisors might be willing to listen. Happily, the Observer’s willing to speak with them about newer, smaller, independent funds.  Our willingness to do so is based on the research, not simple altruism. Small, nimble, independent, investment-driven rather than asset-driven works.

And so, for the 3500 funds smaller than the smallest name on Morningstar’s list and the 4100 smaller than the average fund on this list, be of good cheer! For the 141 small funds that have a better 10-year record than any of these, be brave! To the 17 unsung funds that have a five-star rating for the past three years, five years, ten years and overall, your time will come!

Thanks to Akbar Poonawala for bringing the webcast to my attention!

What aren’t you reading this summer?

If you’re like me, you have at your elbow a stack of books that you promised yourself you were going to read during summer’s long bright evenings and languid afternoons.  Mine includes Mark Miodownik’s Stuff Matters: Exploring the Marvelous Materials that Shape Our Manmade World (2013) and Sherry Turkle’s Alone Together: Why We Expect More from Technology and Less from Each Other (2012). Both remain in lamentably pristine condition.

How are yours?

Professor Jordan Ellenberg, a mathematician at Wisconsin-Madison, wrote an interesting but reasonably light-hearted essay attempting to document the point at which our ambition collapses and we surrender our pretensions of literacy.  He did it by tracking the highlights that readers embed in the Kindle versions of various books.  His thought is that the point at which readers stop highlighting text is probably a pretty good marker of where they stopped reading it.  His results are presented in “The Summer’s Most Unread Book Is…” (7/5/14). Here are his “most unread” nominees:

Thinking Fast and Slow by Daniel Kahneman : 6.8% 
Apparently the reading was more slow than fast. To be fair, Prof. Kahneman’s book, the summation of a life’s work at the forefront of cognitive psychology, is more than twice as long as “Lean In,” so his score probably represents just as much total reading as Ms. Sandberg’s does.

A Brief History of Time by Stephen Hawking: 6.6% 
The original avatar backs up its reputation pretty well. But it’s outpaced by one more recent entrant—which brings us to our champion, the most unread book of this year (and perhaps any other). Ladies and gentlemen, I present:

Capital in the Twenty-First Century by Thomas Piketty: 2.4% 
Yes, it came out just three months ago. But the contest isn’t even close. Mr. Piketty’s book is almost 700 pages long, and the last of the top five popular highlights appears on page 26. Stephen Hawking is off the hook; from now on, this measure should be known as the Piketty Index.

At the other end of the spectrum, one of the most read non-fiction works is a favorite of my colleague Ed Studzinski’s or of a number of our readers:

Flash Boys by Michael Lewis : 21.7% 
Mr. Lewis’s latest trip through the sewers of financial innovation reads like a novel and gets highlighted like one, too. It takes the crown in my sampling of nonfiction books.

What aren’t you drinking this summer?

The answer, apparently, is Coca-Cola in its many manifestations. US consumption of fizzy drinks has been declining since 2005. In part that’s a matter of changing consumer tastes and in part a reaction to concerns about obesity; even Coca-Cola North America’s president limits himself to one 8-ounce bottle a day. 

Some investors, though, suspect that the problem arises from – or at least is not being effectively addressed by – Coke’s management. They argue that management is badly misallocating capital (to, for example, buying Keurig rather than investing in their own factories) and compensating themselves richly for the effort.

Enter David Winters, manager of Wintergreen Fund (WGRNX). While some long-time Coke investors (that would be Warren Buffett) merely abstain rather than endorse management proposals, Mr. Winters loudly, persistently and thoughtfully objects. His most public effort is embodied in the website Fix Big Soda. 

David’s aged more gracefully than have I. Rich, smart, influential and youthful. Nuts.

This is far from Winters’ first attempt to influence the direction of one of his holdings. He stressed two things in a long ago interview with us: (1) the normal fund manager’s impulse to simply sell and let a corporation implode struck him as understandable but defective, and (2) the vast majority of management teams welcomed thoughtful, carefully-researched advice from qualified outsiders. But some don’t, preferring to run a corporation for the benefit of insiders rather than shareholders or other stakeholders. When Mr. Winters perceives that a firm’s value might grow dramatically if only management stopped being such buttheads (though I’m not sure he uses the term), he’s willing to become the catalyst to unlock that value for the benefit of his own shareholders. A fairly high profile earlier example was his successful conflict with the management of Florida real estate firm Consolidated-Tomoka.

You surely wouldn’t want all of your managers pursuing such a strategy but having at least one of them gives you access to another source of market-independent gains in your portfolio. So-called “special situation” or “distressed” investments can gain value if the catalyst is successful, even if the broader market is declining.

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 we profile two funds that offer different – and differently successful – takes on the same strategy. There’s a lot of academic research that show firms which are seriously and structurally devoted to innovation far outperform their rivals. These firms can exist in all sectors; it’s entirely possible to have a highly innovative firm in, say, the cement industry. Conversely, many firms systematically under-invest in innovation and the research suggests these firms are more-or-less doomed.

Why would firms be so boneheaded? Two reasons come to mind:

1. Long-term investments are hard to justify in a market that demands short-term results.
2. Spending on research and training are accounted as “overhead” and management is often rewarded for trimming unnecessary overhead.

Both of this month’s profiles target funds that are looking for ways to identify firms that are demonstrably and structurally (that is, permanently) committed to innovation or knowledge leadership. While their returns are very different, each is successful on its own terms.

GaveKal Knowledge Leaders (GAVAX) combines a search for high R&D firms with sophisticated market risks screens that force it to reduce its market exposure when markets begin teetering into “the red zone.” The result is an equity portfolio with hedge fund like characteristics which many advisors treat as a “liquid alts” option.

Guinness Atkinson Global Innovators (IWIRX) stays fully invested regardless of market conditions in the world’s 30 most innovative firms. What started in the 1990s as the Wired 40 Index Fund has been crushing its competition as an actively managed for fund over a decade. Lipper just ranked it as the best performing Global Large Cap Growth fund of the past year. And of the past three years. Also the #1 performer for the past five years and, while we’re at it, for the past 10 years as well.

Elevator Talk: Jim Cunnane, Advisory Research MLP & Energy Income Fund (INFRX/INFIX)

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.

The Observer has presented the case for investing in Master Limited Partnerships (MLPs) before, both when we profiled SteelPath Alpha (now Oppenheimer SteelPath Alpha MLPAX) and in our Elevator Talk with Ted Gardiner of Salient MLP Alpha and Energy Infrastructure II (SMLPX). Here’s the $0.50 version of the tale:

MLPs are corporate entities which typically own energy infrastructure. They do not explore for oil and they do not refine it, but they likely own the pipelines that connect the E&P firm with the refiner. Likewise they don’t mine the coal nor produce the electricity, but might own and maintain the high tension transmission grid that distributes it.

MLPs typically make money by charging for the use of their facilities, the same way that toll road operators do. They’re protected from competition by the ridiculously high capital expenses needed to create infrastructure. The rates they charge as generally set by state rate commissions, so they’re very stable and tend to rise by slow, predictable amounts.

The prime threat to MLPs is falling energy demand (for example, during a severe recession) or falling energy production.

From an investor’s perspective, direct investment in an MLP can trigger complex and expensive tax requirements. Indeed, a fund that’s too heavily invested in MLPs alone might generate those same tax headaches.

That having been said, these are surprisingly profitable investments. The benchmark Alerian MLP Index has returned 17.2% annually over the past decade with a dividend yield of 5.2%. That’s more than twice the return of the stock market and twice the income of the bond market.

The questions you need to address are two-fold. First, do these investments make sense for your portfolio? If so, second, does an actively-managed fund make more sense than simply riding an index. Jim Cunnane thinks that two yes’s are in order.

Mr. Cunnane manages Advisory Research MLP & Energy Infrastructure Fund which started life as a Fiduciary Asset Management Company (FAMCO) fund until the complex was acquired by Advisory Research. He’d been St. Louis-based FAMCO’s chief investment officer for 15 years. He’s the CIO for the MLP & Energy Infrastructure team and chair of AR’s Risk Management Committee. He also manages two closed-end funds which also target MLPs: the Fiduciary/Claymore MLP Opportunity Fund (FMO) and the Nuveen Energy MLP Total Return Fund (JMF). Here are his 200 words (and one picture) on why you might consider INFRX:

We’re always excited to talk about this fund because it’s a passion of ours. It’s a unique way to manage MLPs in an open-end fund. When you look at the landscape of US energy, it really is an exciting fundamental story. The tremendous increases in the production of oil and gas have to be accompanied by tremendous increases in energy infrastructure. Ten years ago the INGA estimated that the natural gas industry would need $3.6 billion/year in infrastructure investments. Today the estimate is $14.2 billion. We try to find great energy infrastructure and opportunistically buy it.

There are two ways you can attack investing in MLPs through a fund. One would be an MLP-dedicated portfolio but that’s subject to corporate taxation at the fund level. The other is to limit direct MLP holdings to 25% of the portfolio and place the rest in attractive energy infrastructure assets including the parent companies of the MLPs, companies that might launch MLPs and a new beast called a YieldCo which typically focus on solar or wind infrastructure. We have the freedom to move across the firms’ capital structure, investing in either debt or equity depending on what offers the most attractive return.

Our portfolio in comparison to our peers offers a lot of additional liquidity, a lower level of volatility and tax efficiency. Despite the fact that we’re not exclusively invested in MLPs we manage a 90% correlation with the MLP index.

While there are both plausible bull and bear cases to be made about MLPs, our conclusion is that risk and reward is fairly balanced and that MLP investors will earn a reasonable level of return over a 10-year horizon. To account for the recent strong performance of MLPs, we are adjusting our long term return expectation down to 5-9% per annum, from our previous estimate of 6-10%. We also expect a 10% plus MLP market correction at some point this year.

The “exciting story” that Mr. Cunnane mentioned above is illustrated in a chart that he shared:

The fund has both institutional and retail share classes. The retail class (INFRX) has a $2500 minimum initial investment and a 5.5% load.  Expenses are 1.50% with about $725 million in assets.  The institutional share class (INFIX) is $1,000,000 and 1.25%. Here’s the fund’s homepage.

Funds in Registration

The Securities and Exchange Commission requires that funds file a prospectus for the Commission’s review at least 75 days before they propose to offer it for sale to the public. The release of new funds is highly cyclical; it tends to peak in December and trough in the summer.

This month the Observer’s other David (research associate David Welsch) tracked down nine new no-load funds in registration, all of which target a September launch. It might be the time of year but all of this month’s offerings strike me as “meh.”

Manager Changes

Just as the number of fund launches and fund liquidations are at seasonal lows, so too are the number of fund manager changes.  Chip tracked down a modest 46 manager changes, with two retirements and a flurry of activity at Fidelity accounting for much of the activity.

Top Developments in Fund Industry Litigation – July 2014

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 Lawsuit

• In a copyright infringement lawsuit, the publisher of Oil Daily alleges that KA Fund Advisors (you might recognize them as Kayne Anderson) and its parent company have “for years” internally copied and distributed the publication “on a consistent and systematic basis,” and “concealed these activities” from the publisher. (Energy Intelligence Group, Inc. v. Kayne Anderson Capital Advisors, LP.)

 Order

• The court granted American Century‘s motion for summary judgment in a lawsuit that challenged investments in an illegal Internet gambling business by the Ultra Fund. (Seidl v. Am. Century Cos.)

 Briefs

• Plaintiffs filed their opposition to BlackRock‘s motion to dismiss excessive-fee litigation regarding its Global Allocation and Dividend Equity Funds. (In re BlackRock Mut. Funds Advisory Fee Litig.)
• First Eagle filed a motion to dismiss an excessive-fee lawsuit regarding its Global and Overseas Funds. (Lynn M. Kennis Trust v. First Eagle Inv. Mgmt., LLC.)
• J.P. Morgan filed a motion to dismiss an excessive- fee lawsuit regarding its Core Bond, High Yield, and Short Duration Bond Funds. (Goodman v. J.P. Morgan Inv. Mgmt., Inc.)

Answer

• Opting against a motion to dismiss, ING filed an answer in the fee lawsuit regarding its Global Real Estate Fund. (Cox v. ING Invs. LLC.)

– – –

A potentially fascinating case arose just a bit after David shared his list with us. A former Vanguard employee is suing Vanguard, alleging that they illegally dodged billions in taxes. While Vanguard itself warns that “The issues presented in the complaint are far too complex to get a full and proper hearing in the news media” (the wimps), it appears that the plaintiff has two allegations:

1. That Vanguard charges too little for their services; they charge below-market rates while the tax code requires that, for tax purposes, transactions be assessed at market rates. A simple illustration: if your parents rented an apartment to you for $300/month when anyone else would expect to pay $1000/month for the same property, the $700 difference would be taxable to you since they’re sort of giving you a $700 gift each month.
2. That Vanguard should have to pay taxes on the $1.5 billion “contingency reserve” they’ve built.

Joseph DiStephano of the Philadelphia Inquirer, Vanguard’s hometown newspaper, laid out many of the issues in “Vanguard’s singular model is under scrutiny,” 07/30/2014. If you’d like to be able to drop legalese casually at your next pool party, you can read the plaintiff’s filing in State of New York ex rel David Danon v. Vanguard Group Inc.

Updates

Aston/River Road Long-Short (ARLSX) passed its three year anniversary in May and received its first Morningstar rating recently. They rated it as a four-star fund which has captured a bit more of the upside and a bit less of the downside than has its average peer. The fund had a bad January (down more than 4%) but has otherwise been a pretty consistently above average, risk-conscious performer.

Zac Wydra, manager of Beck, Mack and Oliver Partners Fund (BMPEX), was featured in story in the Capitalism and Crisis newsletter. I suspect the title, “Investing Wisdom from Zac Wydra,” likely made Zac a bit queasy since it rather implies that he’s joined the ranks of the Old Dead White Guys (ODWGs) also with Graham and Dodd.

Here’s a major vote of confidence: Effective August 1, 2014, John Neff and Thomas Saberhagen were named as co-portfolio managers for the Akre Focus Fund. They both joined Mr. Akre’s firm in 2009 after careers at William Blair and Aegis Financial, respectively. The elevation is striking. Readers might recall that Mr. Akre was squeezed out after running FBR Focus (now Hennessy Focus HFCSX) for 13 years. FBR decided to cut Mr. Akre’s contract by about 50% (without reducing shareholder expenses), which caused him to launch Akre Focus using the same discipline. FBR promptly poached Mr. Akre’s analysts (while he was out of town) to run their fund in his place. At that point, Mr. Akre swore never to repeat the mistake and to limit analysts to analyzing rather than teaching them portfolio construction. Time and experience with the team seems to have mellowed the great man. Given the success that the rapscallions have had at HFCSX, there’s a good chance that Mr. Akre, now in his 70s, has trained Neff and Saberhagen well which might help address investor concerns about an eventual succession plan.

Seafarer Overseas Growth & Income (SFGIX) passed the $100 million AUM threshold in July and is in the process of hiring a business development director. Manager Andrew Foster reports that they received a slug of really impressive applications. Our bottom line was, and is, “There are few more-attractive emerging markets options available.” We’re pleased that folks are beginning to have faith in that conclusion.

Stewart Capital Mid Cap Fund (SCMFX) has been named to the Charles Schwab’s Mutual Fund OneSource Select List for the third quarter of 2014. It’s one of six independent mid-caps to make the list. The recognition is appropriate and overdue.  Our Star in the Shadow’s profile of the fund concluded that it was “arguably one of the top two midcap funds on the market, based on its ability to perform in volatile rising and falling markets. Their strategy seems disciplined, sensible and repeatable.” That judgment hasn’t changed but their website has; the firm made a major and welcome upgrade to it last year.

Briefly Noted . . .

Yikes. I mean, really yikes. On July 28, Aberdeen Asset Management Plc (ADN) reported that an unidentified but “very long standing” client had just withdrawn 4 billion pounds of assets from the firm’s global and Asia-Pacific region equity funds. The rough translation is $6.8 billion. Overall the firm saw over 8 billion pounds of outflow in the second quarter, an amount large enough that even Bill Gross would feel it.

We all have things that set us off. For some folks the very idea of “flavored” coffee (poor defenseless beans drenched in amaretto-kiwi goo) will do it. For others it’s the designated hitter rule or plans to descrecate renovate Wrigley Field. For me, it’s fund managers who refuse to invest in their own funds, followed closely behind by fund trustees who refuse to invest in the funds whose shareholders they represent.

Sarah Max at Barron’s published a good short column (07/12/14) on the surprising fact that over half of all managers have zero (not a farthing, not a penny, not a thing) invested in their own funds. The research is pretty clear (the more the insiders’ interests are aligned with yours, the better a fund’s risk-adjusted performance) and the atmospherics are even clearer (what on earth would convince you that a fund is worth an outsider’s money if it’s not worth an insider’s?). That’s one of the reasons that the Observer routinely reports on the manager and director investments and corporate policies for all of the funds we cover. In contrast to the average fund, small and independent funds tend to have persistently, structurally high levels of insider commitment.

SMALL WINS FOR INVESTORS

On June 30, both the advisory fee and the expense cap on The Brown Capital Management International Equity Fund (BCIIX) were reduced. The capped e.r. dropped from 2.00% to 1.25%.

Forward Tactical Enhanced Fund (FTEAX) is dropping its Investor Share class expense ratio from 1.99% to 1.74%. Woo hoo! I’d be curious to see if they drop their portfolio turnover rate from its current 11,621%.  (No, I’m not making that up.)

Perritt Ultra MicroCap Fund (PREOX) reopened to new investors on July 8. It had been closed for three whole months. The fund has middling performance at best and a tiny asset base, so there was no evident reason to close it and no reason for either the opening or closing was offered by the advisor.

CLOSINGS (and related inconveniences)

Effective at the close of business on August 15, 2014, Grandeur Peak Emerging Opportunities Fund (GPEOX/GPEIX) the Fund will close to all purchases. There are two exceptions, (1) individuals who invested directly through Grandeur Peak and who have either a tax-advantaged account or have an automatic investing plan and (2) institutions with an existing 401(k) arrangement with the firm. The fund reports about $370M in assets and YTD returns of 11.6% through late July, which places it in the top 10% of all E.M. funds. There are a couple more G.P. funds in the pipeline and the guys have hinted at another launch sooner rather than later, but the next gen funds are likely more domestic than international.

Effective as of the close of business on October 31, 2014, the Henderson European Focus Fund (HFEAX) will be closed to new purchases. The fund sports both top tier returns and top tier volatility. If you like charging toward closing doors, it’s available no-load and NTF at Schwab and elsewhere.

Parametric Market Neutral Fund (EPRAX) closed to new investors on July 11, 2014. The fund is small and slightly under water since inception. Under those circumstances, such closures are sometimes a signal of bigger changes – new management, new strategy, liquidation – on the horizon.

Citing “the lack of investment opportunities” and “high current cash levels” occasioned by the five year run-up in global stock prices, Tweedy Browne announced the impending soft close of Tweedy, Browne Global Value II (TBCUX).  TBCUX is an offshoot of Tweedy, Browne Global Value (TBGVX) with the same portfolio and managers but Global Value often hedges its currency exposure while Global Value II does not. The decision to close TBCUX makes sense as a way to avoid “diluting our existing shareholders’ returns in this difficult environment” since the new assets were going mostly to cash. Will Browne planned “to reopen the Fund when new idea flow improves and larger amounts of cash can be put to work in cheap stocks.”

Here’s the question: why not close Global Value as well?

The good folks at Mount & Nadler arranged for me to talk with Tom Shrager, Tweedy’s president. Short version: they have proportionately less  inflows into Global Value but significant net inflows, as a percentage of assets, into Global Value II. As a result, the cash level at GV II is 26% while GV sits at 20% cash. While they’ve “invested recently in a couple of stocks,” GV II’s net cash level climbed from 21% at the end of Q1 to 26% at the end of Q2. They tried adding a “governor” to the fund (you’re not allowed to buy $4 million or more a day without prior clearance) which didn’t work.

Mr. Shrager describes the sudden popularity of GV II as “a mystery to us” since its prime attraction over GV would be as a currency play and Tweedy doesn’t see any evidence of a particular opportunity there. Indeed, GV II has trailed GV over the past quarter and YTD while matching it over the past 12 months.

At the same time, Tweedy reports no particular interest in either Value (TWEBX, top 20% YTD) or High Dividend Yield Value (TBHDX, top 50% YTD), both at 11% cash.

The closing will not affect current shareholders or advisors who have been using the fund for their clients.

OLD WINE, NEW BOTTLES

Alpine Foundation Fund (ADABX) has been renamed Alpine Equity Income Fund. The rechristened version can invest no more than 20% in fixed income securities. The latest, prechange portfolio was 20.27% fixed income. Over the longer term, the fund trails its “aggressive allocation” peers by 160 – 260 basis points annually and has earned a one-star rating for the past three, five and ten year periods. At that point, I’m not immediately convinced that a slight boost in the equity stake will be a game-changer for anyone.

On October 1, the billion dollar Alpine Ultra Short Tax Optimized Income Fund (ATOAX) becomes Alpine Ultra Short Municipal Income Fund and promises to invest, mostly, in munis.

Effective October 1, SunAmerica High Yield Bond (SHNAX)becomes SunAmerica Flexible Credit. The change will free the fund of the obligation of investing primarily in non-investment grade debt which is good since it wasn’t particularly adept at investing in such bonds (one-star with low returns and above average risk during its current manager’s five-year tenure).

OFF TO THE DUSTBIN OF HISTORY

Thanks, as always, go to The Shadow – an incredibly vigilant soul and long tenured member of the Observer’s discussion community for his contributions to this section.  Really, very little gets past him and that gives me a lot more confidence in saying that we’ve caught of all of major changes hidden in the ocean of SEC filings.

Grazie!

CM Advisors Defensive Fund (CMDFX) “has terminated the public offering of its shares and will discontinue its operations effective on or about August 1, 2014.”  Uhhh … what would be eight weeks after launch?

Direxion U.S. Government Money Market Fund (DXMXX) will liquidate on August 20, 2014.  I’m less struck by the liquidation of a tiny, unprofitable fund than by the note that “the Fund’s assets will be converted to cash.”  It almost feels like a money market’s assets should be describable as “cash.”

Geneva Advisors Mid Cap Growth Fund (the “Fund”) will be closed and liquidated on August 28. 2014. That decision comes nine months after the fund’s launch. While the fund’s performance was weak and it gathered just $4 million in assets, such hasty abandonment strikes me as undisciplined and unprofessional especially when the advisor reminds its investors of “the importance of … a long-term perspective when it comes to the equity portion of their portfolio.”  The fund representatives had no further explanation of the decision.

GL Macro Performance Fund (GLMPX) liquidated on July 30, 2014.  At least the advisor gave this fund 20 months of life so that it had time to misfire with style:

The Board of Trustees of Makefield Managed Futures Strategy Fund (MMFAX) has concluded that “it is in the best interests of the Fund and its shareholders that the Fund cease operations.” Having lost 17% for its few investors since launch, the Board probably reached the right conclusion.  Liquidation is slated for August 15, 2014.

Following the sudden death of its enigmatic manager James Wang, the Board of the Oceanstone Fund (OSFDX) voted to liquidate the portfolio at the end of August. The fund had unparalleled success from 2007-2012 which generated a series of fawning (“awesome,” “the greatest investor you’ve never heard of,” “the most intriguing questions in the mutual fund world today”) stories in the financial media.  Mr. Wang would neither speak to be media nor permit his board to do so (“he will be upset with me,” fretted one independent trustee) and his shareholder communications were nearly nonexistent. His trustees rightly eulogize him as “very sincere, hard working, humble, efficient and caring.” Our sympathies go out to his family and to those for whom he worked so diligently.

Pending shareholder approval, Sentinel Capital Growth Fund (BRGRX) and Sentinel Growth Leaders Fund (BRFOX) will be merged into Sentinel Common Stock Fund (SENCX) sometime this fall. Here’s the best face I can put on the merger: SENCX isn’t awful.

Effective October 16, SunAmerica GNMA (GNMAX) gets merged into SunAmerica U.S. Government Securities (SGTAX). Both funds fall just short of mediocre (okay, they both trail 65 – 95% of their peers over the past three, five and ten year periods so maybe it’s “way short” or “well short”) and both added two new managers in July 2014.  We wish Tim and Kara well with their new charges.

With shareholder approval, the $16 million Turner All Cap Growth Fund (TBTBX) will soon merge into the Turner Midcap Growth Fund (TMGFX). Midcap has, marginally, the better record but All Cap has, massively, the greater assets so …

In Closing . . .

I’m busily finishing up the outline for my presentation to the Cohen Client Conference, which takes place in Milwaukee on August 20 and 21. The working title of my talk is “Seven things that matter, two that don’t … and one that might.” My hope is to tie some of the academic research on funds and investing into digestible snackage (it is at lunchtime, after all) that attempts to sneak a serious argument in under the cover of amiable banter. I’ll let you know how it goes.

I know that David Hobbs, Cook and Bynum’s president, will be there and I’m looking forward to a chance to chat with him. He’s offered some advice about the thrust of my talk that was disturbingly consistent with my own inclinations, which should worry at least one of us. I’ll be curious to get his reaction.

We’re also hoping to cover the Morningstar ETF Conference en masse; that is, Charles, Chip, Ed and I would like to meet there both to cover the presentations (Meb Faber, one of Charles’s favorite guys, and Eugene Fama are speaking) and to debate about ways to strengthen the Observer and better serve you folks. A lot depends on my ability to trick my colleagues into covering two of my classes that week. Perhaps we’ll see you there?

My son Will, still hobbled after dropping his iPad on a toe, has taken to wincing every time we approach the mall. It’s festooned with “back to school sale! Sale! sale!” banners which seem, somehow, to unsettle him.

Here’s a quick plug for using the Observer’s link to Amazon.com. If you’d like to spare your children, grandchildren, and yourself the agony of the mall parking lot and sound of wailing and keening, you might consider picking some of this stuff up online. The Observer receives a rebate equal to about 6% on whatever is purchased through our link. It’s largely invisible to you – if costs nothing extra and doesn’t involve any extra steps on your part – but it generates the majority of the funds that keep the lights on here.

Here are some ways to make support easy:

• Click on our Amazon link and bookmark it for easy referral.
• Look to your right, the dang thing is continually floating over there ->
• In Chrome, set us as one of your start pages.  On the upper right of your screen, click on the three horizontal bars then click “settings.”  You’ll see this option:

Click on “Set pages” then simply paste the Observer link in along with wherever else you like to start. Each time you open Chrome, it’ll launch several tabs including your regular homepage and our Amazon page.

• If, like many, you’re not comfortable with Amazon’s plan to take over everything …
  feel free to resort to PayPal or the USPS. It all helps and it’s all detailed on our Support Us page.

Finally, we offer cheerful greetings to our curiously large and diligent readership in Cebu City, Philippines; Cebu Citizens spend about a half hour on site per visit, about five times the global average. Greetings, too, to the good folks in A Coruña in the north of Spain. You’ve been one of our most persistent international audiences.  The Madrileños are fewer in number, but diligent in their reading. To our sole Ukrainian visit, Godspeed and great care.

As ever,

Dear friends,

It’s not a question of whether it’s coming.  It’s just a question of whether you’ve been preparing intelligently.

A wave struck a lighthouse in Douro River in Porto, Portugal, Monday. The wave damaged some nearby cars and caused minor injuries. Pictures of the Day, Wall Street Journal online, January 6, 2014. Estela Silva/European Pressphoto Agency

There’s an old joke about the farmer with the leaky roof that never gets fixed.  When the sun’s out, he never thinks about the leak and when it’s raining, he can’t get up there to fix it anyway.  And so the leak continues.

Our investments likewise: people who are kicking themselves for not having 100% equity exposure in March 2009 and 200% exposure in January 2013 have been pulling money steadily from boring investments and adding them to stocks.  The domestic stock market has seen its 13^th consecutive month of inflows and the S&P 500 closed February at its highest nominal level ever.

I mention this now because the sun has been shining so brightly.  March 9, 2014 marches the five-year anniversary of the current bull market.  In those five years, a $10,000 investment in the S&P500 would have grown to $30,400.  The same amount invested in the NASDAQ on March 9 would have grown to $35,900. The last remnants of the ferocious bear markets of 2000-02 and 2007-09 have faded from the ratings.  And investors really want a do-over.  All the folks hiding under their beds in 2009 and still peering out from under the blankies in 2011 feel cheated and they want in on the action, and they want it now.

Hence inflows into an overpriced market.

Our general suggestion is to learn from the past, but not to live there.  Nothing we do today can capture the returns of the past five years for us.  Sadly, we still can damage the next five.  To help build a strong prospects for our future, we’re spending a bit of time this month talking about hedging strategies – ways to get into a pricey market without quite so much heartache – and cool funds that might be better positioned for the next five than you’d otherwise find.

And, too, we get to celebrate the onset of spring!

The search for active share

It’s much easier to lose in investing than to win.  Sometimes we lose because we’re offered poor choices and sometimes we lose because we make poor ones.  Frankly, it doesn’t take many poor choices to trash the best laid plans.

Winning requires doing a lot of things right.  One of those things is deciding whether – or to what extent – your portfolio should rely on actively and passively managed funds.  A lot of actively managed funds are dismal but so too are a lot of passive products: poorly constructed indexes, trendy themes, disciplines driven by marketing, and high fees plague the index and EFT crowd.

If you are going to opt for active management, you need to be sure that it’s active in more than name alone.  As we’ve shown before, many active managers – especially those trying to deploy billions in capital – offer no advantage over a broad market index, and a lot of disadvantages. 

One tool for measuring the degree to which your manager is active is called, appropriately enough, “active share.”  Active share measures the degree to which your fund’s holdings differ from its benchmark’s.  The logic is simple: you can’t beat an index by replicating it and if you can’t beat it, you should simply buy it.

The study “How Active Is Your Manager” (2009) by Cremers and Petajitso concluded that “Funds with high active share actually do outperform their benchmarks.” The researchers originally looked at an ocean of data covering the period from 1990 to 2003, then updated it through 2009.  They found that funds with active share of at least 90% outperformed their benchmarks by 1.13% (113 basis points per year) after fees. Funds with active share below 60% consistently underperformed by 1.42 percentage points a year, after accounting for fees.

Some researchers have suggested that the threshold for active share needs to be adjusted to account for differences in the fund’s investment universe: a fund that invests in large to mega-cap names should have an active share north of 70%, midcaps should be above 80% and small caps above 90%. 

So far, we’ve only seen research validating the 60% and 90% thresholds though the logic of the step system is appealing; of the 5008 publicly-traded US stocks, there are just a few hundred large caps but several thousand small and micro-caps.

There are three problems with the active share data.  We’d like to begin addressing one of them and warn you of the other two.

Problem One: It’s not available.  Morningstar has the data but does not release it, except in occasional essays. Fund companies may or may not have it, but almost none of them share it with investors. And journalists occasionally publish pieces that include an active share chart but those tend to be an idiosyncratic, one-time shot of a few funds. Nuts.

Problem Two: Active share is only as valid as the benchmark used. The calculation of active share is simply a comparison between a fund’s portfolio and the holdings in some index. Pick a bad index and you get a bad answer. By way of simple illustration, the S&P500 stock index has an active share of 100 (woo hoo!) if you benchmark it against the MSCI Emerging Markets Index.

Fund companies might have the same incentive and the same leverage with active share providers that the buyers of bond ratings did: bond issuers could approach three ratings agencies and say “tell me how you’ll rate my bond and I’ll tell you whether we’re paying for your rating.” A fund company looking for a higher active share might simply try several indexes until they find the one that makes them look good. Here’s the warning: make sure you know what benchmark was used and make sure it makes sense.

Problem Three: You can compare active share between two funds only if they’ve chosen to use the same benchmark. One large cap might have an active share of 70 against the Mergent Dividend Achievers Index while another has a 75 against the Russell 1000 Value Index. There’s no way, from that data, to know whether one fund is actually more active than the other. So, look for comparables.

To help you make better decisions, we’ve begun gathering publicly-available active share data released by fund companies.  Because we know that compact portfolios are also correlated to higher degrees of independence, we’ve included that information too for all of the funds we could identify.  A number of managers and advisors have provided active share data since our March 1^st launch.  Thanks!  Those newly added funds appear in italics.

*        Linde Hansen notes that their active share is 98 if you count stocks and cash, 87 if you look only at the stock portion of their portfolio.  To the extent that cash is a conscious choice (i.e., “no stock in our investable universe meets our purchase standards, so we’ll buy cash”), count both makes a world of sense.  I just need to find out how other investors have handled the matter.

Who’s not on the list? 

A lot of firms, some of whose absences are in the ironic-to-hypocritical range. Firms not choosing to disclose active share include:

BlackRock – which employs Anniti Petajisto, the guy who invented active share, as a researcher and portfolio manager in their Multi-Asset Strategies group. (They do make passing reference to an “active share buyback” on the part on one of their holdings, so I guess that’s partial credit, right?)

Fidelity – whose 5 Tips to Pick a Winning Fund tells you to look for “stronger performers [which are likely to] have a high ‘active share’”.  (They do reprint a Reuters article ridiculing a competitor with a measly 56% active share, but somehow skip the 48% for Fidelity Blue Chip Growth, 47% for Growth & Income, the 37% for MegaCap Stock or the under 50% for six of their Strategic Advisers funds). (per the Wall Street Journal, Is Your Fund a Closet Index Fund, January 14, 2014).

Oakmark – which preens about “Harris Associates and Active Share” without revealing any.

Are you active?  Would you like someone to notice?

We’ve been scanning fund company sites for the past month, looking for active share reports. If we’ve missed you, we’re sorry. Help us correct the oversight  by sending us the link to where you report your active share stats. We’d be more than happy to offer a permanent home for the web’s largest open collection of active share data.

Does Size Matter?

By Edward Studzinski

“Convictions are more dangerous enemies of truth than lies.”

                    Nietzsche

One of the more interesting consequences of the performance of equities in 2013 is the ramp-up of the active investment management marketing machines to explain why their performance in many instances lagged that of inexpensive index funds. This has resulted in a manure storm media blitz with terms and phrases such as “stock picker’s market” or “active share” or “concentrated portfolios.” 

“Stock picker’s market” is generally a euphemism for active management. That is, why you should pay me 100 basis points for investing in a subset of the S&P 500, rather than pay Vanguard or some other index fund provider 5 basis points for their product. One of the rationales I used to regularly hear to justify active management fees was that the active manager will know when to get out of the market and when to get back in, whereas the small investor will always go in and out at the wrong time. The period of 2008-2009 puts paid to that argument when one looks at maximum drawdown numbers.  The question it raises however is whether the time horizon most investment managers and investors use is far too short. I think it clearly is and that rather than three years or three to five years, we should be thinking of ten years at a minimum.  Unfortunately, given personnel turnover in many investment organizations, it is difficult for the investing public to know or understand that the people who gave a fund its long-term performance, looking in the rear-view mirror, are not the ones doing the analysis or selecting the investments going forward. And if they are, often their time and attention is pulled in many other directions.  This is why I now, sitting on an endowment investment committee, appreciate why an integral part of the investment consultant’s report covers stability of personnel and succession planning at current firms invested in as well as firms proposed for consideration. Of course, if you are the average retail investor, you are far better off to focus on your risk tolerance, true time horizon, and asset allocation, again making use of low cost index products if you are not going to spend the time and effort to replicate the work of the consultants used by endowments and pension funds.

I am going to leave it to others to discuss “active share.”  I do think the question of “concentrated portfolios” is worth a few thoughts.  I once asked a friend of mine, at a large East Coast fund complex, how he managed to keep track of the two hundred or so stocks in his fund portfolio. His answer was illuminating.  He said that his firm had a very large research department and prided itself on its selection and training of analysts.  Politically then, over time he had to use an idea or two from everyone or every area. His preference would have been to have a much more concentrated portfolio.  I will refer to that then as the “ark” approach to investment management. Other firms, such as Longleaf, have tended from the get-go to have truly concentrated portfolios, say somewhere between twenty to twenty five stocks, given that the benefits of diversification run-out at a certain number of securities. Their rationale has been that rarely, when you are building a portfolio from the bottom up based on what are the most undervalued ideas, do ideas number thirty to forty have the same expected return potential as ideas number one to ten. (That is even more the case with the S&P 500 hitting new all time highs now).

There is another way to look at this which I think makes it more understandable for the average person.  In 2006, Huber Capital Managed LLC performed a study, looking at value-oriented investors, entitled “Limited Assets Under Management is a Competitive Advantage.”   The study assumed an equal weighted portfolio of 2.5% positions (forty stocks) to show how the investable universe of securities shrank at certain asset levels. It looked at the Russell 1000 Value Index and the Russell 2000 Value Index. The conclusion of the study was that as assets under management grew, portfolio managers faced increasingly unpleasant choices. One choice of course was to shrink the investment universe, what I have referred to in the past as the rule limiting investments to securities that can be bought or sold in five days average trading volume.

Another alternative was to increase the number of stocks held in the portfolio. You can see whether your manager has done this by going back five or ten years and looking at annual reports.  When the fund was $5B in asset size, did it own thirty stocks? Do you really believe that with the fund at $10B or $15B in asset size, that it has found another twenty or thirty undervalued stocks?  Look also to see if the number of research analysts has increased materially. Are roughly the same number of analysts covering more names? 

The third choice was to make the fund very concentrated or even non-diversified by SEC standards, with individual positions greater than five per cent. That can work, but it entails taking on career risk for the analysts and fund managers, and enterprise risk for the management company. A fund with $10B in assets under management has available only 50% of the investable set of stocks to invest in, assuming it is going to continue to focus on liquidity of the investment as an implicit criteria. That is why you see more and more pension funds, endowments, and family office managers shifting to low-cost index or ETF vehicles for their large cap investments. The incremental return is not justified by the incremental fee over the low-cost vehicle. And with a long-term time horizon, the compounding effect of that fee differential becomes truly important to returns.

My thanks to Huber Capital Manangement LLC for doing this study, and to Long Short Advisors for making me aware of it in one of their recent reports. Both firms are to be commended for their integrity and honesty. They are truly investment managers rather than asset gatherers. 

On the impact of fund categorization: Morningstar’s rejoinder

Morningstar’s esteemed John Rekenthaler replied to MFO’s February commentary on categorization, although officially “his views are his own.” His February 5 column is entitled How Morningstar Categorizes Funds.

Snowball’s gloss: John starts with a semantic quibble (Charles: “Morningstar says OSTFX is a mid-cap blend fund,” John: “Morningstar does not say what a fund is,” just what category it’s been assigned to), mischaracterizes Charles’s article as “a letter to MFO” (which I mention only because he started the quibble-business) and goes on to argue that the assignment of OSTFX to its category is about as reasonable a choice as could be made. Back to Charles:

Mr. R. uses BobC’s post to frame an explanation of what Morningstar does and does not do with respect to fund categorization. In his usual thoughtful and self-effacing manner, he defends the methodology, while admitting some difficulty in communicating. Fact is, he remains one of Morningstar’s best communicators and Rekenthaler Report is always a must read.

I actually agree with his position on Osterweis. Ditto for his position on not having an All Cap category (though I suspect I’m in the minority here and he actually admits he may be too). He did not address the (mis-)categorization of River Park Short Term High Yield Fund (RPHYX/RPHIX, closed). Perhaps because he is no longer in charge of categorization at Morningstar.

The debate on categorization is never-ending, of course, as evidenced by the responses to his report and the many threads on our own board. For the most part, the debate remains a healthy one. Important for investors to understand the context, the peer group, in which prospective funds are being rated.

In any case and as always, we very much appreciate Mr. Rekenthaler taking notice and sharing his views.

Snowball’s other gloss: geez, Charles is a lot nicer than I am. I respect John’s work but frankly I don’t really tingle at the thought that he “takes notice.” Well, except maybe for that time at the Morningstar conference when he swerved at the last minute to avoid crashing into me. I guess there was a tingle then.

Snowball’s snipe: at the sound of Morningstar’s disdain, MFWire did what MFWire does. They raised high the red-and-white banner, trumpeting John’s argument and concluding with a sharp “grow up, already!” I would have been much more impressed with them if they’d read Charles’s article beforehand. They certainly might have, but there’s no evidence in the article that they felt that need.

One of the joys of writing for the Observer is the huge range of backgrounds and perspectives that our readers bring to the discussion. A second job is the huge range of backgrounds and perspectives that my colleagues bring. Charles, in particular, can hear statistics sing. (He just spent a joyful week in conference studying discounted cash-flow models.) From time to time he tries, gently, to lift the veil of innumeracy from my eyes. The following essay flows from our extended e-mail exchanges in which I struggled to understand the vastly different judgments of particular funds implied by different ways of presenting their risk-adjusted statistics. 

We thought some of you might like to overhear that conversation.  

Morningstar’s Risk Adjusted Return Measure

Central to any fund rating system is the performance measure used to determine percentile rank order. MFO uses Martin ratio, as described Rating System Definitions. Morningstar developed its own risk adjusted return (MRAR), which Nobel Laureate William Sharpe once described as a measure that “…differs significantly from more traditional ones such as various forms of the Sharpe ratio.” While the professor referred to an earlier version of MRAR, the same holds true today.

Here is how Morningstar describes MRAR on its Data FAQ page: Morningstar adjusts for risk by calculating a risk penalty for each fund based on “expected utility theory,” a commonly used method of economic analysis. Although the math is complex, the basic concept is relatively straightforward. It assumes that investors are more concerned about a possible poor outcome than an unexpectedly good outcome and that those investors are willing to give up a small portion of an investment’s expected return in exchange for greater certainty. A “risk penalty” is subtracted from each fund’s total return, based on the variation in its month-to-month return during the rating period, with an emphasis on downward variation. The greater the variation, the larger the penalty. If two funds have the exact same return, the one with more variation in its return is given the larger risk penalty.

For the curious and mathematically inclined, the detailed equations are well documented in The Morningstar Rating Methodology. The following figure illustrates how MRAR behaves for three hypothetical funds over a 3 year period ending Dec 2013:

Each fund in the illustration delivers the same total return, but with varying levels of volatility. The higher the volatility, the lower the risk adjusted return. Fund 0 delivers consistent returns every month with zero volatility; consequently, it receives the highest MRAR, which in this case is the fund’s annualized total return minus the risk-free T-Bill (i.e., it’s the annualized “excess” return).

Morningstar computes MRAR for all funds over equivalent periods, and then percentile ranks them within their respective categories to assign appropriate levels, 1 star for those funds in the lowest group and the coveted 5 star rating for the highest.

It also computes a risk measure MRisk and performs a similar ranking to designate “low” to “high” risk funds within each category. MRisk is simply the difference between the annualized excess return of the fund and its MRAR.

The following figure provides further insight into how MRAR behaves for funds of varying volatility. This time, fund total returns have been scaled to match their category averages, again for the 3 year period ending Dec 2013. The figure includes results from several categories showing MRAR versus the tradition volatility measure, annualized standard deviation.

Once again we see that funds with higher volatility generally receive lower MRARs and that the highest possible MRAR is equal to a fund’s annualized excess return, which occurs at zero standard deviation.

A consequence of Morningstar’s methodology is that low volatility funds with below average returns can quite possibly be out-ranked by average volatility funds with average returns. Put another way, the methodology generally penalizes funds with high volatility more so than it rewards funds with low volatility, since with the latter the benefit is “capped.”

This behavior is different from other risk adjusted return measures based on say Sharpe ratio, as can be seen in the figure below. Here the same funds from above are plotted against Sharpe, but now funds with low volatility are rewarded handsomely, even if they have below average total returns.

Revisiting the Morningstar risk measure MRisk, one finds another observation: it appears to correlate rather satisfactorily against a simple function based on standard deviation (up to about 30% for funds of positive total return without load):

Which means that Morningstar’s risk adjusted return can be estimated from the following:

This simple approximation may come in handy, like when David wonders: “Why do RPHIX and ICMYX, which have superior 3 year Sharpe ratios, rate a very inferior 1 star by Morningstar?” He can use the above calculation to better understand, as illustrated here:

While both do indeed have great 3 year Sharpe ratios – RPHIX is highest of any US fund – they both have below average total returns relative to their current peer group, as represented by say VWEHX, a moderate risk and average returning high yield bond “reference” fund.

Their low volatilities simply get no love from Morningstar’s risk adjusted return measure.

27Feb2014/Charles

Celebrating one-starness

I was having a nice back-channel conversation with a substantially frustrated fund manager this week. He read Charles’s piece on fund categorization and wrote to express his own dismay with the process. He’s running a small fund. It hit its three-year mark and earned five stars. People noticed. Then Morningstar decided to recategorize the fund (into something he thinks he isn’t). And it promptly became one star. And, again, people – potential investors – noticed, but not in a good way.

Five to one, with the stroke of a pen? It happens, but tends not to get trumpeted. After all, it rather implies negligence on Morningstar’s part if they’ve been labeling something as, say, a really good conservative allocation fund for years but then, on further reflection, conclude that it’s actually a sucky high-yield bond or preferred stock fund.

Here’s what Morningstar’s explanation for such a change looks like in practice:

Morningstar Alert

Osterweis Strategic Income Fund OSTIX

12-03-13 01:00 PM

Change in Morningstar Fund Star Rating: The Morningstar Star Rating for this fund has changed from 4 stars to 2 stars. For details, go to http://quicktake.morningstar.com/Fund/RatingsAndRisk.asp?Symbol=OSTIX.

Sadly, when you go to that page there are no details that would explain an overnight drop of that magnitude. On the “performance” page, you will find the clue:

I don’t have an opinion on the appropriateness of the category assignment but it would be an awfully nice touch, given the real financial consequences of such a redesignation, if Morningstar would take three sentences to explain their rationale at the point that they make the change.

Which got me to thinking about my own favorite one-star fund (RiverPark Short Term High Yield RPHYX and RPHIX, which is closed) and Charles’s favorite one-shot stat on a fund’s risk-adjusted returns (its Sharpe ratio).

And so, here’s the question: how many funds have a higher (i.e., better) Sharpe ratio than does RPHYX?

And, as a follow-up, how many have a Sharpe ratio even half as high as RiverPark’s?

That would be “zero” and “seven,” respectively, out of 6500 funds.

Taking up Rekenthaler’s offer

In concluding his response to Charles’s essay, John writes:

A sufficient critique is one that comes from a fund that truly does not behave like others in its category, that contains a proposal for a modification to the existing category system, that does not lead to rampant category proliferation, and that results in a significantly closer performance comparison between the fund and its new category. In such cases, Morningstar will consider the request carefully–and sometimes make the suggested change.

Ummm … short-term high-yield? In general, those are funds that are much more conservative than the high-yield group. The manager at RiverPark Short-Term High Yield (RPHYX) positions the fund as a “cash management” account. The managers at Intrepid Income (ICMYX) claim to be “absolute return” investors. Wells Fargo Advantage Short-Term High-Yield Bond (STHBX) seems similarly positioned. All are one-star funds (as of February 2014) when judged against the high-yield universe.

“Does not behave like others in its category” but “results in a significantly closer performance comparison [within] its new category.” The orange line is the high-yield category. That little cluster of parallel, often overlapping lines below it are the three funds.

“Does not lead to rampant category proliferation.” You mean, like creating a “preferred stock” category with seven funds? That sort of proliferation? If so, we’re okay – there are about twice as many short-term high-yield candidates as preferred stock ones.

I’m not sure this is a great idea. I am pretty sure that dumping a bunch of useful, creative funds into this particular box is a pretty bad one.

Next month’s unsought advice will highlight emerging markets balanced (or multi-asset) funds. We’re up to a dozen of them now and the same logic that pulled US balanced funds out of the equity category and global balanced funds out of the international equity category, seems to be operating here.

Two things you really should read

In general, most writing about funds has the same problem as most funds do: it’s shallow, unoriginal, unreflective. It contributes little except to fill space and get somebody paid (both honorable goals, by the way). Occasionally, though, there are pieces that are really worth some of our time, thought and reflection. Here are two.

I’m not a great fan of ETFs. They’ve always struck me as trading vehicles, tools for allowing hedge funds and others to “make bets” rather than to invest. Chuck Jaffe had a really solid piece entitled “The growing case against ETFs” (Feb. 23, 2014) that makes the argument that ETFs are bad for you. Why? Because the great advantage of ETFs are that you can trade them all day long. And, as it turns out, if you give someone a portfolio filled with ETFs that’s precisely – and disastrously – what they do.

The Observer was founded on the premise that small, independent, active funds are the only viable alternative to a low-cost indexed portfolio. As funds swell, two bad things happen: their investable universe shrinks and the cost of making a mistake skyrockets, both of which lead to bad investment choices. There’s a vibrant line of academic research on the issue. John Rekenthaler began dissecting some of that research – in particular, a recent study endorsing younger managers and funds – in a four-part series of The Rekenthaler Report. At this writing, John had posted two essays: “Are Young Managers All That?” (Feb. 27, 2014) and “Has Your Fund Become Too Large, Or Is Industry Size the Problem?” (Feb. 28, 2014).  The first essay walks carefully through the reasons why older, larger funds – even those with very talented managers – regress. To my mind, he’s making a very strong case for finding capacity-constrained strategies and managers who will close their funds tight and early. The second picks up an old argument made by Charles Ellis in his 1974 “The Loser’s Game” essay; that the growth and professionalization of the investment industry is so great that no one – certainly not someone dragging a load – can noticeably outrun the crowd. The problem is less, John argues, the bloat of a single fund as the effect of “$3 trillion in smart money chasing the same ideas.”  

Regardless of whether you disdain or adore ETFs, or find the industry’s difficulties located at the level of undisciplined funds or an unwieldy industry, you’ll come away from these essays with much to think about.

RiverPark Strategic Income: Another set of ears

I’m always amazed by the number of bright and engaging folks who’ve been drawn to the Observer, and humbled by their willingness to freely share some of their time, insights and experience with the rest of us. One of those folks is an investor and advisor named “Mark” who is responsible for extended family money, a “multi-family office” if you will. He had an opportunity to spend some time chatting with David Sherman in mid-January as he contemplated a rather sizeable investment in RiverPark Strategic Income (RSIVX) for some family members who would benefit from such a strategy. Herewith are some of the reflections he shared over the course of a series of emails with me.

Where he’s coming from

Mark wrote that to him it’s important to understand the “context” of RSIVX. Mr. Sherman manages private strategies and hedge fund monies at Cohanzick Management, LLC. He cut his teeth at Leucadia National (whose principal Ian Cumming is sometimes referred to as Canada’s Warren Buffett) and is running some sophisticated and high entry strategies that have big risks and big rewards. His shop is not as large as some, sure, but Mr. Sherman seems to prefer it that way.

Some of what Mr. Sherman does all day “informs” RSIVX. He comes across an instrument or an idea that doesn’t fit in one strategy but may in another. It has the risk/reward characteristics that he wants for a particular strategy and so he and his team perform their due diligence on it. More on that later.

Where he is

RSIVX only exists, according to Mr. Sherman, because it fills a need. The need is for an annuity like stream of income at a rate that “his mother could live off” and he did not see such a thing in the marketplace. (In 2007 you could park money at American Express Bank in a jumbo CD at 5.5%. No such luck today.) He saw many other total return products out there in the high yield space where an investor can get a bit higher returns than what he envisions. But some of those returns will be from capital appreciation, i.e., returns from in essence trading. Mr. Sherman did not want to rely on that. He wants a lower duration portfolio (3-4 years) that he can possibly but not necessarily hold to get nice, safe, relatively high coupons from. As long as his investor has that timeframe, Mr. Sherman believes he can compound the money at 6-8% annually, and the investor gets his money back plus his return.

Shorter timeframes, because of impatience or poor timing choices, carry no such assurances. It’s not a CD, it’s not a guaranteed annuity from an insurer, but it’s what is available and what he is able to get for an investor.

How? Well, one inefficiency he hopes to exploit is in the composition of SPDR Barclays High Yield Bond (JNK) and iShares High Yield Corporate Bond (HYG). He doesn’t believe they reflect the composition of high yield space accurately with their necessary emphasis on the most liquid names. He will play in a different sandbox with different toys. And he believes it’s no more risky and thinks it is less so. In addition, when the high yield market moves, especially down, those names move fast.

Mark wrote that he asked David whether the smoothness of his returns exhibited in RPHYX and presumably in RSIVX in the future was due or would be due to a laddering strategy that he employed. He said that it was not – RSIVX’s portfolio was more of a barbell presently- and he did not want to be pigeonholed into a certain formula or strategy. He would do whatever it took to produce the necessary safe returns and that may change from time to time depending upon the market.

What changing interest rates might mean

What if rates fall? If rates fall then, sure, the portfolio will have some capital appreciation. What if rates rise? Well, every day and every month, David said, the investor will grind toward the payday on the shorter duration instruments he is holding. Mark-to-market they will be “worth” less. The market will be demanding higher interest rates and what hasn’t rolled off yet will not be as competitive as the day he bought them. The investor will still be getting a relatively high 6-8% return and as opportunities present themselves and with cash from matured securities and new monies the portfolio will be repopulated over time in the new interest rate environment. Best he can do. He does not intend to play the game of hedging. 

Where he might be going

Mark said he also asked about a higher-risk follow-on to RSIVX. He said that David told him that if he doesn’t have something unique to bring that meets a need, he doesn’t want to do it. He believes RPHYX and RSIVX to be unique. He “knew” he could pull off RPHYX, that he could demonstrate its value, and then have the credibility to introduce another idea. That idea is the Strategic Income Fund.

He doesn’t see a need for him to step out on the spectrum right now. There are a hundred competitors out there and a lot of overlap. People can go get a total return fund with more risk of loss. Returns from them will vary a lot from year to year unless conditions are remarkably stable. This [strategy] almost requires a smaller, more nimble fund and manager. Here he is. Here it is. So the next step out isn’t something he is thinking [immediately] about, but he continually brings ideas to Morty.

Mark concludes: “We discussed a few of his strategies that had more risk. They are fascinating but definitely not vanilla or oatmeal and a few I had to write out by hand the mechanics afterward so I could “see” what he was doing. One of them took me about an hour to work through where the return came from and where it could go possibly wrong.

But he described it to me because working on it gave him the inspiration for a totally different situation that, if it came to pass, would be appropriate for RSIVX. It did, is much more vanilla and is in the portfolio. Very interesting and shows how he thinks. Would love to have a beer with this guy.”

Mark’s bottom line(s)

Mark wanted me to be sure to disclose that he and his family have a rather large position in RiverPark Strategic Income now, and will be holding it for an extended period assuming all goes well (years) so, yeah, he may be biased with his remarks. He says “the strategy is not to everyone’s taste or risk tolerance”. He holds it because it exactly fills a need that his family has.

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.

Driehaus Emerging Markets Small Cap Growth (DRESX): There’s a lot to be said for EM small caps. They provide powerful diversification and performance benefits for a portfolio. The knock of them is that they’re too hot to handle. Driehaus’s carefully constructed, hedged portfolio seems to have cooled the handle by a lot.

Guinness Atkinson Inflation Managed Dividend (GAINX): It’s easy to agree that owning the world’s best companies, especially if you buy them on the cheap, is a really good strategy. GAINX approaches the challenge of constructing a very compact, high quality, low cost portfolio with quantitative discipline and considerable thought.

Intrepid Income (ICMUX): What’s not to like about this conservative little short-term, high-yield fund. It’s got it all: solid returns, excellent risk management and that coveted one-star rating! Intrepid, like almost all absolute value investors, is offering an object lesson on the important of fortitude in the face of frothy markets and serial market records.

RiverPark Gargoyle Hedged Value (RGHVX): The short story is this. Gargoyle’s combination of a compact, high quality portfolio and options-based hedging strategy has, over time, beaten just about every reasonable comparison group. Unless you anticipate a series of 20 or 30% gains in the stock market over the rest of the decade, it might be time to think about protecting some of what you’ve already made.

Elevator Talk: Ted Gardner, Salient MLP & Energy Infrastructure II (SMLPX)

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.

Master limited partnerships (MLPs) are an intriguing asset class which was, until very recently, virtually absent from both open-end fund and ETF portfolios.

MLPs are a form of business organization, in the same way corporations are a form of organization. Their shares trade on US exchanges (NYSE and NASDAQ) and they meet the same SEC security registration requirements as corporations do. They were created in the 1980s primarily as a tool to encourage increased energy production in the country and the vast majority of MLPs (75% or so) are in the energy sector.

MLPs are distinct from corporations in a number of ways:

• They’re organized around two groups: the limited partners (i.e., investors) and the general partners (i.e., managers). The limited partners provide capital and receive quarterly distributions.
• MLPs are required, by contract, to pay minimum quarterly distributions to their limited partners. That means that they produce very consistent streams of income for the limited partners.
• MLPs are required, by law, to generate at least 90% of their income from “qualified sources.” Mostly that means energy production and distribution.

The coolest thing about MLPs is the way they generate their income: they operate hugely profitable, economically-insensitive monopolies whose profits are guaranteed by law. A typical midstream MLP might own a gas or oil pipeline. The MLP receives a fee for every gallon of oil or cubic foot of gas moving through the pipe. That rate is set by a federal agency and that rate rises every year by the rate of inflation plus 1.3%. It doesn’t matter whether the price of oil soars or craters; the MLP gets its toll regardless. And it doesn’t really matter whether the economy soars or craters: people still need warm homes and gas to get to work. At worst, bad recessions eliminate a year’s demand rise but haven’t yet caused a net demand decrease. As the population grows and energy consumption rises, the amount moving through the pipelines rise and so does the MLPs income.

Those profits are protected by enormously high entry barriers: building new pipelines cost billions, require endless hearings and permits, and takes years. As a result, the existing pipelines function as de facto a regional monopoly, which means that the amount of material traveling through the pipeline won’t be driven down by competition for other pipelines.

Quick highlights of the benchmark Alerian MLP index:

• From inception through early 2013, the index returned 16% annually, on average.
• For that same period, it had a 7.1% yield which grew 7% annually.
• There is a low correlation – 50 – between the stock market and the index. REITs say at around 70 and utility stocks at 25, but with dramatically lower yield and returns.

Only seven of the 17 funds with “MLP” in their names have been around long enough to quality for a Morningstar rating; all seven are four- or five-star funds, measured against an “energy equity” peer group. Here’s a quick snapshot of Salient (the blue line) against the two five-star funds (Advisory Research MLP & Energy Income INFIX and MLP & Energy Infrastructure MLPPX) and the first open-end fund to target MLPs (Oppenheimer SteelPath MLP Alpha MLPAX):

The quick conclusion is that Salient was one of the best MLP funds until autumn 2013, at which point it became the best one. I did not include the Alerian MLP index or any of the ETFs which track it because they lag so far behind the actively-managed funds. Over the past year, for example, Salient has outperformed the Alerian MLP Index – delivering 20% versus 15.5%.

High returns and substantial diversification. Sounds perfect. It isn’t, of course. Nothing is. MLP took a tremendous pounding in the 2007-09 meltdown when credit markets froze and dropped again in August 2013 during a short-lived panic over changes in MLP’s favorable tax treatment. And it’s certainly possible for individual MLPs to get bid up to fundamentally unattractive valuations.

Ted Gardner is the co‐portfolio manager for Salient’s MLP Complex, one manifestation of which is SMLPX. He oversees and coordinates all investment modeling, due diligence, company visits, and management conferences. Before joining Salient he was both Director of Research and a portfolio manager for RDG Capital and a research analyst with Raymond James. Here are his 200 words on why you should consider getting into the erl bidness:

Our portfolio management team has many years of experience with MLP investing, as managers and analysts, in private funds, CEFs and separate accounts. We considered both the state of the investment marketplace and our own experiences and thought it might translate well into an open-end product.

As far as what we saw in the marketplace, most of the funds out there exist inside a corporate wrapper. Unfortunately C-Corp funds are subject to double taxation and that can create a real draw on returns. We felt like going the traditional mutual fund, registered investment company route made a lot of sense.

We are very research-intensive, our four analysts and I all have a sell side background. We take cash flow modeling very seriously. It’s a fundamental modeling approach, modeling down to the segment levels to understand cash flows. And, historically, our analysts have done a pretty good job at it.

We think we do things a bit differently than many investors. What we like to see is visible growth, which means we’re less yield-oriented than others might be. We typically like partnerships that have a strategic asset footprint with a lot of organic growth opportunities or those with a dropdown story, where a parent company drops more assets into a partnership over time. We tend to avoid firms dependent on third-party acquisitions for growth. And we’ve liked investing in General Partners which have historically grown their dividends at approximately twice the rate of the underlying MLPs.

The fund has both institutional and retail share classes. The retail classes (SMAPX, SMPFX) nominally carry sales loads, but they’re available no-load/NTF at Schwab. The minimum for the load-waived “A” shares is $2,500. Expenses are 1.60% on about $630 million in assets. Here’s the fund’s homepage, but I’d recommend that you click through to the Literature tab to grab some of the printed documentation.

River Park/Gargoyle Hedged Value Conference Call Highlights

On February 12th we spoke for an hour with Alan Salzbank and Josh Parker, both of the Gargoyle Group, and Morty Schaja, CEO of RiverPark Funds. Here’s a brief recap of the highlights:

Alan handles the long portfolio. Josh, a securities lawyer by training, handles the options portfolio. He’s also an internationally competitive bridge player (Gates, Buffett, Parker…) and there’s some reason to believe that the habits of mind that make for successful bridge play also makes for successful options trading. They have 35 and 25 years of experience, respectively, and all of the investment folks who support them at Gargoyle have at least 20 years of experience in the industry. Morty has been investigating buy-write strategies since the mid-1980s and he described the Gargoyle guys as “the team I’ve been looking for for 25 years.”

The fund combines an unleveraged long portfolio and a 50% short portfolio, for a steady market exposure of 50%. The portfolio rebalances between those strategies monthly, but monitors and trades its options portfolio “in real time” throughout the month.

The long portfolio is 80-120 stocks, and stock selection is algorithmic. They screen the 1000 largest US stocks on four valuation criteria (P/B, P/E, P/CF, P/S) and then assign a “J score” to each stock based on how its current valuation compares with (1) its historic valuation and (2) its industry peers’ valuation. They then buy the 100 more undervalued stocks, but maintain sector weightings that are close to the S&P 500’s.

The options portfolio is a collection of index call options. At base, they’re selling insurance policies to nervous investors. Those policies pay an average premium of 2% per month and rise in value as the market falls. That 2% is a long-term average, during the market panic in the fall of 2008, their options were generating 8% per month in premiums.

Why index calls? Two reasons: (1) they are systematically mispriced, and so they always generate more profit than they theoretically should. In particular, they are overpriced by about 35 basis points/month 88% of the time. For sellers, that means something like a 35 bps free lunch. And (2) selling calls on their individual stocks – that is, betting that the stocks in their long portfolio will fall – would reduce returns. They believe that their long portfolio is a collection of stocks superior to any index and so they don’t want to hedge away any of their upside.

And it works. Their long portfolio has outperformed the S&P 500 by an average of 5% per year for 15 years. The entire strategy has outperformed the S&P in the long-term and has matched its returns, with less volatility, in the shorter term. Throughout, it has sort of clubbed its actively-managed long-short peers. It also anticipates clubbing the emerging bevy of buy-write ETFs.

The guys identify two structural advantages they have over an ETF: (1) they buy stocks superior to those in broad indexes and (2) they manage their options portfolio moment by moment, while the ETF just sits and takes hits for 29 out of 30 days each month.

There’s evidence that they’re right. The ETFs are largely based on the CBOE S&P Buy-Write Index (BXM). Between 2000-12, the S&P 500 returned 24% and the BXM returned 52%; the options portion of the Gargoyle portfolio returned 110% while the long portfolio crushed the S&P.

Except not so much in 2008. The fund’s maximum drawdown was 48%, between 10/07 and 03/08. The guys attributed that loss to the nature of the fund’s long portfolio: it buys stocks in badly dented companies when the price of the stock is even lower than the company’s dents would warrant. Unfortunately in the meltdown, those were the stocks people least wanted to own so they got killed. The fund’s discipline kept them from wavering: they stayed 100% invested and rebalanced monthly to buy more of the stocks that were cratering. The payback comes in 2009 when they posted a 42% return against the S&P’s 26% and again in 2010 when they made 18% to the index’s 15%.

The managers believe that ’08 was exceptional, and note that the strategy actually made money from 2000-02 when the market suffered from the bursting of the dot-com bubble.

In general, the strategy fares poorest when the market has wild swings. It fares best in gently rising markets, since both the long and options portfolios can make money if the market rises but less than the strike price of the options – they can earn 2% a month on an option that’s triggered if the market rises by more than 1%. If the market rises but by less than 1%, they pay out nothing, pocket the 2% and pocket the capital appreciation from their long portfolio.

What’s the role of the fund in a portfolio? They view it as a substitute for a large-cap value investment; so if your asset allocation plan is 20% LCV, then you could profitably invest up to 20% of your portfolio in Gargoyle. For the guys, it’s 100% of their US equity exposure.

Morty Speaks!  The rationale for hedging a long-term portfolio.

The Gargoyle call sparked – here’s a surprise – considerable commentary on our discussion board. Some were impressed with Josh and Alan’s fortitude in maintaining their market exposure during the 2007-09 meltdown but others had a more quizzical response. “Expatsp” captured it this way: “Though this seems the best of the long/short bunch, I just don’t see the appeal of long/short funds for anyone who has a long-term horizon.”

No. Not Morty.

There’s a great scene in Big Bang Theory where the brilliant but socially-inept Sheldon clears up a misunderstanding surrounding a comment he made about his roommate: “Ah, I understand the confusion. Uh, I have never said that you are not good at what you do. It’s just that what you do is not worth doing.” Same theme.

Morty Schaja, RiverPark’s president, is in an interesting position to comment on the question. His firm not only advises a pure long/short fund (RiverPark Long/Short Opportunity RLSFX) and a long hedged with options fund (RiverPark Gargoyle), but it also runs a very successful long-only fund (RiverPark Large Cap Growth RPXFX, which he describes as “our five-star secret weapon”).

With the obvious disclaimer that Morty has a stake in the success of all of the RiverPark funds (and the less-obvious note that he has invested deeply in each), we asked him the obvious question: Is it worth doing?

Since RiverPark is one of the very few investment advisors to offer the whole range of hedged funds, I asked Morty to share a quick snapshot of each to illustrate how the different strategies are likely to play out in various sets of market conditions.

Let’s start with the RiverPark Long/Short Opportunity Fund.

How does this compare with the RiverPark/Gargoyle Hedged Value Fund?

And finally, tell us about the new Structural Alpha Fund.

Is the Structural Alpha Fund an absolute return strategy?

Conference Call Upcoming

We haven’t scheduled a call for March. We only schedule calls when we can offer you the opportunity to speak with someone really interesting and articulate.  No one has reached that threshold this month, but we’ll keep looking on your behalf.

Conference call junkies might want to listen in on the next RiverNorth call, which focuses on the RiverNorth Managed Volatility Fund (RNBWX). Managed Volatility started life as RiverNorth Dynamic Buy-Write Fund. Long/short funds comes in three very distinct flavors, but are all lumped in the same performance category. For now, that works to the detriment of funds like Managed Volatility that rely on an options-based hedging strategy. The fund trails the long/short peer group since inception but has performed slightly better than the $8 billion Gateway Fund (GATEX). If you’re interested in the potential of an options-hedged portfolio, you’ll find the sign-up link on RiverNorth’s Events page.  The webcast takes place March 13, 2014 at 3:15 Central.

Launch Alert: Conestoga SMid Cap (CCSMX)

On February 28, 2014, Conestoga Mid Cap (CCMGX) ceased to be. Its liquidation was occasioned by negative assessments of its “asset size, strategic importance, current expenses and historical performance.” It trailed its peers in all seven calendar quarters since inception, in both rising and falling periods. With under $2 million in assets, its disappearance is not surprising.

Two things are surprising, however. First, its poor relative performance is surprising given the success of its sibling, Conestoga Small Cap (CCASX). CCASX is a four-star fund that received a “Silver” designation from Morningstar’s analysts. Morningstar lauds the stable management team, top-tier long-term returns, low volatility (its less volatile than 90% of its peers) and disciplined focus on high quality firms. And, in general, small cap teams have had little problem in applying their discipline successfully to slightly-larger firms.

Second, Conestoga’s decision to launch (on January 21, 2014) a new fund – SMid Cap – in virtually the same space is surprising, given their ability simply to tweak the existing fund. It smacks of an attempt to bury a bad record.

My conclusion after speaking with Mark Clewett, one of the Managing Directors at Conestoga: yeah, pretty much. But honorably.

Mark made two arguments.

1. Conestoga fundamentally mis-fit its comparison group. Conestoga targeted stocks in the $2 – 10 billion market cap range. Both its Morningstar peers and its Russell Midcap Growth benchmark have substantial investments in stocks up to $20 billion. The substantial exposure to those large cap names in a mid-cap wrapper drove its peer’s performance.

   The evidence is consistent with that explanation. It’s clear from the portfolio data that Conestoga was a much purer mid-cap play that either its benchmark or its peer group.

   Portfolio	Conestoga Mid Cap	Russell Mid-cap Growth	Mid-cap Growth Peers
   % large to mega cap	0	35	23
   % mid cap	86	63	63
   % small to micro cap	14	2	14
   Average market cap	5.1M	10.4M	8.4M

    By 2013, over 48% of the Russell index was stocks with market caps above $10 billion.

   Mark was able to pull the attribution data for Conestoga’s mid-cap composite, which this fund reflects. The performance picture is mixed: the composite outperformed its benchmark in 2010 and 2011, then trailed in 2013 and 2013. The fund’s holdings in the $2-5 billion and $5–10 billion bands sometimes outperformed their peers and sometimes trailed badly.

2. Tweaking the old fund would not be in the shareholders’ best interest.  The changes would be expensive and time-consuming. They would, at the same time, leave the new fund with the old fund’s record; that would inevitably cause some hesitance on the part of prospective investors, which meant it would be longer before the fund reached an economically viable size.

The hope is that with a new and more appropriate benchmark, a stable management team, sensible discipline and clean slate, the fund will achieve some of the success that Small Cap’s enjoyed.  I’m hopeful but, for now, we’ll maintain a watchful, sympathetic silence.

Funds in Registration

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

Funds in registration this month are eligible to launch in late April or early May 2014 and some of the prospectuses do highlight that date.

This month David Welsch battled through wicked viruses and wicked snowstorms to track down eight funds in registration, one of the lowest totals since we launched three years ago.

The clear standout in the group is Dodge & Cox Global Bond, which the Dodge & Cox folks ran as “a private fund” since the end of December 2012.  It did really well in its one full year of operation – it gained 2.6% while its benchmark lost the same amount – and it comes with D&C’s signature low minimum, low expenses, low drama, team management.

Three other income funds are at least mildly interesting: Lazard Emerging Markets Income, Payden Strategic Income and Whitebox Unconstrained Income.

Manager Changes

On a related note, we also tracked down 50 sets of fund manager changes. The most intriguing of those include fallout from the pissing match at Pimco as Marc Seidner, an El-Erian ally, leaves to become GMO’s head of fixed-income operations.

Updates: The Observer here and there

I had a long conversation with a WSJ reporter which led to a short quotation in “Infrastructure funds are intriguing, but ….” The Wall Street Journal, Feb. 4 2014.  My bottom line was “infrastructure funds appear to be an incoherent mish-mash, with no two funds even agreeing on what sectors are worth including much less what stocks.  I don’t see any evidence of them adding value to a portfolio,” an observation prompted in part by T. Rowe Price’s decision to close their own Global Infrastructure fund. The writer, Lisa Ward, delicately quotes me as saying “you probably already own these same stocks in your other funds.” 

I was quoted as endorsing Artisan Global Small Cap (ARTWX) in Six promising new funds (though the subtitle might have been: “five of which I wouldn’t go near”), Kiplinger’s, Feb. 12 2014.  ARTWX draws on one of the most storied international management teams around, led by Mark Yockey.  The other funds profiled include three mutual funds and two ETFs.  The funds are Miller Income Opportunity (I’ve written elsewhere that “The whole enterprise leaves me feeling a little queasy since it looks either like Miller’s late-career attempt to prove that he’s not a dinosaur or Legg’s post-divorce sop to him”), Fidelity Event-Driven (FARNX: no record that Fido can actually execute with new funds anymore, much less with niche funds and untested managers), and Vanguard Global Minimum Volatility (VMVFX: meh – they work backward from a target risk level to see what returns they can generate).  The ETFs are two of the “smart beta” sorts of products, iShares MSCI USA Quality Factor (QUAL) and Schwab Fundamental U.S. Broad Market (FNDB). 

Finally, there was a very short piece entitled “Actively managed funds with low volatility,” in Bottom Line, Feb. 15 2014.  The publication is not online, at least not in an accessible form.  The editors were looking for funds with fairly well-established track records that have a tradition of low volatility.  I offered up Cook & Bynum Fund (COBYX, I’ve linked to our 2013 profile of them), FPA Crescent (FPACX, in which I’m invested) and Osterweis Fund (OSTWX).

Updates: Forbes discovers Beck, Mack & Oliver Partners (BMPEX)

Forbes rank a nice article on BMPEX, “Swinging at Strikes,” in their February 10, 2014 issue. Despite the lunacy of describing a $175 million fund as “puny” and “tiny,” the author turns up some fun facts to know and tell (the manager, Zac Wydra, was a premed student until he discovered that the sight of blood made him queasy) and gets the fund’s basic discipline right. Zac offers some fairly lively commentary in his Q4 shareholder letter, including a nice swipe at British haughtiness and a reflection on the fact that the S&P 500 is at an all-time high at the same time that the number of S&P 500 firms issuing negative guidance is near an all-time high.

Briefly Noted . . .

BlackRock has added the BlackRock Emerging Markets Long/Short Equity Fund (BLSAX) and the BlackRock Global Long/Short Equity Fund (BDMAX) as part of the constituent fund lineup in its Aggressive Growth, Conservative , Growth and Moderate Prepared Portfolios, and its Lifepath Active-Date series. Global has actually made some money for its investors, which EM has pretty much flatlined while the emerging markets have risen over its lifetime.  No word on a target allocation for either.

Effective May 1, Chou Income (CHOIX) will add preferred stocks to the list of their principal investments: “fixed-income securities, financial instruments that provide exposure to fixed-income securities, and preferred stocks.” Morningstar categorizes CHOIX as a World Bond fund despite the fact that bonds are less than 20% of its current portfolio and non-U.S. bonds are less than 3% of it.

Rydex executed reverse share splits on 13 of its funds in February. Investors received one new share for between three and seven old shares, depending on the fund.

Direxion will follow the same path on March 14, 2014 with five of their funds. They’re executing reverse splits on three bear funds and splits on two bulls.  They are: 

 SMALL WINS FOR INVESTORS

Auxier Focus (AUXIX) is reducing the minimum initial investment for their Institutional shares from $250,000 to $100,000. Investor and “A” shares remain at $5,000. The institutional shares cost 25 basis points less than the others.

TFS Market Neutral Fund (TFSMX) reopened to new investors on March 1, 2014.

At the end of January, Whitebox eliminated its Advisor share class and dropped the sales load on Whitebox Tactical. Their explanation: “The elimination of the Advisor share class was basically to streamline share classes … eliminating the front load was in the best interest of our clients.” The first makes sense; the second is a bit disingenuous. I’m doubtful that Whitebox imposed a sales load because it was “in the best interest of our clients” and I likewise doubt that’s the reason for its elimination.

CLOSINGS (and related inconveniences)

Artisan Global Value (ARTGX) closed on Valentine’s Day.

Grandeur Peak will soft close the Emerging Markets Opportunities (GPEOX) and hard close the Global Opportunities (GPGOX) and International Opportunities (GPIOX) strategies on March 5, 2014.

 Effective March 5, 2014, Invesco Select Companies Fund (ATIAX) will close to all investors.

Vanguard Admiral Treasury Money Market Fund (VUSSX) is really, really closed.  It will “no longer accept additional investments from any financial advisor, intermediary, or institutional accounts, including those of defined contribution plans. Furthermore, the Fund is no longer available as an investment option for defined contribution plans. The Fund is closed to new accounts and will remain closed until further notice.”  So there.

OLD WINE, NEW BOTTLES

Effective as of March 21, 2014, Brown Advisory Emerging Markets Fund (BIAQX) is being changed to the Brown Advisory – Somerset Emerging Markets Fund. The investment objective and the investment strategies of the Fund are not being changed in connection with the name change for the Fund and the current portfolio managers will continue. At the same time, Brown Advisory Strategic European Equity Fund (BIAHX) becomes Brown Advisory -WMC Strategic European Equity Fund.

Burnham Financial Industries Fund has been renamed Burnham Financial Long/Short Fund (BURFX).  It’s a tiny fund (with a sales load and high expenses) that’s been around for a decade.  It’s hard to know what to make of it since “long/short financial” is a pretty small niche with few other players.

Caritas All-Cap Growth Fund has become Goodwood SMID Cap Discovery Fund (GAMAX), a name that my 13-year-old keeps snickering at.  It’s been a pretty mediocre fund which gained new managers in October.

Compass EMP Commodity Long/Short Strategies Fund (CCNAX) is slated to become Compass EMP Commodity Strategies Enhanced Volatility Weighted Fund in May. Its objective will change to “match the performance of the CEMP Commodity Long/Cash Volatility Weighted Index.”  It’s not easily searchable by name at Morningstar because they’ve changed the name in their index but not on the fund’s profile.

Eaton Vance Institutional Emerging Markets Local Debt Fund (EELDX) has been renamed Eaton Vance Institutional Emerging Markets Debt Fund and is now a bit less local.

Frost Diversified Strategies and Strategic Balanced are hitting the “reset” button in a major way. On March 31, 2014, they change name, objective and strategy. Frost Diversified Strategies (FDSFX) becomes Frost Conservative Allocation while Strategic Balanced (FASTX) becomes Moderate Allocation. Both become funds-of-funds and discover a newfound delight in “total return consistent with their allocation strategy.” Diversified currently is a sort of long/short, ETFs, funds and stocks, options mess … $4 million in assets, high expense, high turnover, indifferent returns, limited protection. Strategic Balanced, with a relatively high downside capture, is a bit bigger and a bit calmer but ….

Effective on or about May 30, 2014, Hartford Balanced Allocation Fund (HBAAX) will be changed to Hartford Moderate Allocation Fund.

At the same time, Hartford Global Research Fund (HLEAX) becomes Hartford Global Equity Income Fund, with a so far unexplained “change to the Fund’s investment goal.” 

Effective March 31, 2014, MFS High Yield Opportunities Fund (MHOAX) will change its name to MFS Global High Yield Fund.

In mid-February, Northern Enhanced Large Cap Fund (NOLCX) became Northern Large Cap Core Fund though, at last check, Morningstar hadn’t noticed. Nice little fund, by the way.

Speaking of not noticing, the folks at Whitebox have accused of us ignoring “one of the most important changes we made, which is Whitebox Long Short Equity Fund is now the Whitebox Market Neutral Equity Fund.” We look alternately chastened by our negligence and excited to report such consequential news.

OFF TO THE DUSTBIN OF HISTORY

BCM Decathlon Conservative Portfolio, BCM Decathlon Moderate Portfolio and BCM Decathlon Aggressive Portfolio have decided that they can best serve their shareholders by liquidating.  The event is scheduled for April 14, 2014.

BlackRock International Bond Portfolio (BIIAX) has closed and will liquidate on March 14, 2014.  A good move given the fund’s dismal record, though you’d imagine that a firm with BlackRock’s footprint would want a fund of this name.

Pending shareholder approval, City National Rochdale Diversified Equity Fund (AHDEX) will merge into City National Rochdale U.S. Core Equity Fund (CNRVX) of the Trust. I rather like the honesty of their explanation to shareholders:

This reorganization is being proposed, among other reasons, to reduce the annual operating expenses borne by shareholders of the Diversified Fund. CNR does not expect significant future in-flows to the Diversified Fund and anticipates the assets of the Diversified Fund may continue to decrease in the future. The Core Fund has significantly more assets [and] … a significantly lower annual expense ratio.

Goldman Sachs Income Strategies Portfolio merged “with and into” the Goldman Sachs Satellite Strategies Portfolio (GXSAX) and Goldman Sachs China Equity Fund with and into the Goldman Sachs Asia Equity Fund (GSAGX) in mid-February.

Huntington Rotating Markets Fund (HRIAX) has closed and will liquidate by March 28, 2014.

Shareholders of Ivy Asset Strategy New Opportunities Fund (INOAX) have been urged to approve the merger of their fund into Ivy Emerging Markets Equity Fund (IPOAX).  The disappearing fund is badly awful but the merger is curious because INOAX is not primarily an emerging markets fund; its current portfolio is split between developed and developing.

The Board of Trustees of the JPMorgan Ex-G4 Currency Strategies Fund (EXGAX) has approved the liquidation and dissolution of the Fund on or about March 10, 2014.  The “strategies” in question appear to involve thrashing around without appreciable gain.

After an entire year of operation (!), the KKR Board of Trustees of the Fund approved a Plan of Liquidation with respect to KKR Alternative Corporate Opportunities Fund (XKCPX) and KKR Alternative High Yield Fund (KHYZX). Accordingly, the Fund will be liquidated in accordance with the Plan on or about March 31, 2014 or as soon as practicable thereafter. 

Loomis Sayles Mid Cap Growth Fund (LAGRX) will be liquidated on March 14^th, a surprisingly fast execution given that the Board approved the action just the month before.

On February 13, 2014, the shareholders of the Quaker Small Cap Growth Tactical Allocation Fund (QGASX) approved the liquidation and dissolution of the Fund. 

In Closing . . .

We asked you folks, in January, what made the Observer worthwhile.  That is, what did we offer that brought you back each month?  We poured your answers into a Wordle in hopes of capturing the spirit of the 300 or so responses.

Three themes recurred:  (1) the Observer is independent. We’re not trying to sell you anything.  We’re not trying to please advertisers. We’re not desperate to write inflated drivel in order to maximize clicks. We don’t have a hidden agenda. 

(2) We talk about things that other folks do not. There’s a lot of appreciation for our willingness to ferret out smaller, emerging managers and to bring them to you in a variety of formats. There’s also some appreciate of our willingness to step back from the fray and try to talk about important long-term issues rather than sexy short-term ones.

(3) We’re funny. Or weird. Perhaps snarky, opinionated, cranky and, on a good day, curmudgeonly.

And that helps us a lot.  As we plan for the future of the Observer, we’re thinking through two big questions: where should we be going and how can we get there? We’ll write a bit next time about your answer to the final question: what should we be doing that we aren’t (yet)?

We’ve made a couple changes under the hood to make the Observer stronger and more reliable.  We’ve completed our migration to a new virtual private server at Green Geeks, which should help with reliability and allow us to handle a lot more traffic.  (We hit records again in January and February.)  We also upgraded the software that runs our discussion board.  It gives the board better security and a fresher look.  If you’ve got a bookmarked link to the discussion board, we need you to reset your link to http://www.mutualfundobserver.com/discuss/discussions.  If you use your old bookmark you’ll just end up on a redirect page.  

In April we celebrate our third anniversary. Old, for a website nowadays, and so we thought we’d solicit the insights of some of the Grand Old Men of the industry: well-seasoned, sometimes storied managers who struck out on their own after long careers in large firms. We’re trying hard to wheedle our colleague Ed, who left Oakmark full of years and honors, to lead the effort. While he’s at that, we’re planning to look again at the emerging markets and the almost laughable frenzy of commentary on “the bloodbath in the emerging markets.”  (Uhh … Vanguard’s Emerging Market Index has dropped 8% in a year. That’s not a bloodbath. It’s not even a correction. It’s a damned annoyance. And, too, talking about “the emerging markets” makes about as much analytic sense as talking about “the white people.”  It’s not one big undifferentiated mass).  We’ve been looking at fund flow data and Morningstar’s “buy the unloved” strategy.  Mr. Studzinski has become curious, a bit, about Martin Focused Value (MFVRX) and the arguments that have led them to a 90% cash stake. We’ll look into it.

Please do bookmark our Amazon link.  Every bit helps! 

 As ever,

Dear friends,

Given the intensity of the headlines, you’d think that Black Monday had revisited us weekly or, perhaps, that Smaug had settled his scaly bulk firmly atop our portfolios.  But no, the market wandered down a few percent for the month.  I have the same reaction to the near-hysterical headlines about the emerging markets (“rout,” “panic” and “sell-off” are popular headline terms). From the headlines, you’d think the emerging markets had lost a quarter of their value and that their governments were back to defaulting on debts and privatizing companies. They haven’t and they aren’t.  It makes you wonder how ready we are for the inevitable sharp correction that many are predicting and few are expecting.

Where are the customers’ yachts: The power of asking the wrong question

In 1940, Fred Schwed penned one of the most caustic and widely-read finance books of its time.  Where Are the Customers’ Yachts, now in its sixth edition, opens with an anecdote reportedly set in 1900 and popular on Wall Street in the 1920s.

That’s an almost irresistibly attractive tale since it so quickly captures the essence of what we all suspect: finance is a game rigged to benefit the financiers, a sort of reverse Robin Hood scheme in which we eagerly participate. Disclosure of rampant manipulation of the London currency exchanges is just the most recent round in the game.

As charming as it is, it’s also fundamentally the wrong question.  Why?  Because “buying a yacht” was not the goal for the vast majority of those customers.  Presumably their goals were things like “buying a house” or “having a rainy day cushion,” which means the right question would have been “where are the customer’s houses?”

We commit the same fallacy today when we ask, “can your fund beat the market?”  It’s the question that drives hundreds of articles about the failure of active management and of financial advisors more generally.  But it’s the wrong question.  Our financial goals aren’t expressed relative to the market; they’re expressed in terms of life goals and objectives to which our investments might contribute.

In short, the right question is “why does investing in this fund give me a better chance of achieving my goals than I would have otherwise?”  That might redirect our attention to questions far more important than whether Fund X lags or leads the S&P500 by 50 bps a year.  Those fractions of a percent are not driving your investment performance nearly as much as other ill-considered decisions are.  The impulse to jump in and out of emerging markets funds (or bond funds or U.S. small caps) based on wildly overheated headlines are far more destructive than any other factor.

Morningstar calculates “investor returns” for hundreds of funds. Investor returns are an attempt to answer the question, “did the investors show up after the party was over and leave as things got dicey?”  That is, did investors buy into something they didn’t understand and weren’t prepared to stick with? The gap between what an investor could have made – the fund’s long-term returns – and what the average investor actually seems to have made – the investor returns – can be appalling.  T. Rowe Price Emerging Market Stock (PRMSX) made 9% over the past decade, its average investor made 4%. Over a 15 year horizon the disparity is worse: the fund earned 10.7% while investors were around for 4.3% gains.  The gap for Dodge & Cox Stock (DODGX) is smaller but palpable: 9.2% for the fund over 15 years but 7.0% for its well-heeled investors. 

My colleague Charles has urged me to submit a manuscript on mutual fund investing to John Wiley’s Little Book series, along with such classics as The Little Book That Makes You Rich and The Little Book That Beats the Market. I might. But if I do, it will be The Little Book That Doesn’t Beat the Market: And Why That’s Just Fine. Its core message will be this:

If you spend less time researching your investments than you spend researching a new kitchen blender, you’re screwed.  If you base your investments on a belief in magical outcomes, you’re screwed.  And if you think that 9% returns will flow to you with the smooth, stately grace of a Rolls Royce on a country road, you’re screwed.

But if you take the time to understand yourself and you take the time to understand the strategies that will be used by the people you’re hiring to provide for your future, you’ve got a chance.

And a good, actively managed mutual fund can make a difference but only if you look for the things that make a difference.  I’ll suggest four:

Understanding: do you know what your manager plans to do?  Here’s a test: you can explain it to your utterly uninterested spouse and then have him or her correctly explain it back?  Does your manager write in a way that draws you closer to understanding, or are you seeing impenetrable prose or marketing babble?  When you have a question, can you call or write and actually receive an intelligible answer?

Alignment: is your manager’s personal best interests directly tied to your success?  Has he limited himself to his best ideas, or does he own a bit of everything, everywhere?  Has he committed his own personal fortune to the fund?  Have his Board of Directors?  Is he capable of telling you the limits of his strategy; that is, how much money he can handle without diluting performance? And is he committed to closing the fund long before you reach that sad point?

Independence: does your fund have a reason to exist? Is there any reason to believe that you couldn’t substitute any one of a hundred other strategies and get the same results? Does your fund publish its active share; that is, the amount of difference between it and an index? Does it publish its r-squared value; that is, the degree to which it merely imitates the performance of its peer group? 

Volatility: does your manager admit to how bad it could get? Not just the fund’s standard deviation, which is a pretty dilute measure of risk. No, do they provide their maximum drawdown for you; that is, the worst hit they ever took from peak to trough.  Are the willing to share and explain their Sharpe and Sortino ratios, key measures of whether you’re getting reasonably compensated for the hits you’ll inevitable take?  Are they willing to talk with you in sharply rising markets about how to prepare for the sharply falling ones?

The research is clear: there are structural and psychological factors that make a difference in your prospects for success.  Neither breathless headlines nor raw performance numbers are among them.

Then again, there’s a real question of whether it could ever compete for total sales with my first book, Continuity and Change in the Rhetoric of the Moral Majority (total 20-year sales: 650 copies).

Absolute value’s sudden charm

Jeremy Grantham often speaks of “career risk” as one of the great impediments to investment success. The fact that managers know they’re apt to be fired for doing the right thing at the wrong time is a powerful deterrent to them. For a great many, “the right thing” is refusing to buy overvalued stocks. Nonetheless, when confronted by a sharply rising market and investor ebullience, most conclude that it’s “the wrong time” to act on principle. In short, they buy when they know  they probably shouldn’t.

A handful of brave souls have refused to succumb to the pressure. In general, they’re described as “absolute value” investors. That is, they’ll only buy stocks that are selling at a substantial discount to their underlying value; the mere fact that they’re “the best of a bad lot” isn’t enough to tempt them.

And, in general, they got killed – at least in relative terms – in 2013. We thought it would be interesting to look at the flip side, the performance of those same funds during January 2014 when the equity indexes dropped 3.5 – 4%.  While the period is too brief to offer any major insights, it gives you a sense of how dramatically fortunes can reverse.

THE ABSOLUTE VALUE GUYS

Motion, not progress

Cynic, n.  A blackguard whose faulty vision sees things as they are, not as they ought to be.

                                                                                                         Ambrose Bierce

One of the joys of having entered the investment business in the 1980’s is that you came in at a time when the profession was still populated by some really nice and thoughtful people, well-read and curious about the world around them.  They were and are generally willing to share their thoughts and ideas without hesitation. They were the kind of people that you hoped you could keep as friends for life.  One such person is my friend, Bruce, who had a thirty-year career on the “buy side” as both an analyst and a director of research at several well-known money management firms. He retired in 2008 and divides his time between homes in western Connecticut and Costa Rica.

Here in Chicago in January, with snow falling again and the wind chill taking the temperature below zero, I see that Bruce, sitting now in Costa Rica, is the smart one.  Then I reflected on a lunch we had on a warm summer day last August near the Mohawk Trail in western Massachusetts.  We stay in touch regularly but this was the first time the two of us had gotten together in several years. 

The first thing I asked Bruce was what he missed most about no longer being active in the business.  Without hesitation he said that it was the people. For most of his career he had interacted daily with other smart investors as well as company management teams.  You learned how they thought, what kind of people they were, whether they loved their businesses or were just doing it to make money, and how they treated their shareholders and investors. Some of his best memories were of one-on-one meetings or small group dinners.  These were events that companies used to hold for their institutional shareholders.  That ended with the implementation of Regulation FD (full disclosure), the purpose of which was to eliminate the so-called whisper number that used to be “leaked” to certain brokerage firm analysts ahead of earnings reporting dates. This would allow those analysts to tip-off favored clients, giving them an edge in buying or selling a position. Companies now deal with this issue by keeping tight control on investor meetings and what can be said in them, tending to favor multi-media analyst days (timed, choreographed, scripted, and rehearsed events where you find yourself one of three hundred in a room being spoon-fed drivel), and earnings conference calls (timed, choreographed, scripted, and rehearsed events where you find yourself one of a faceless mass listening to reporting without seeing any body language).  Companies will still visit current and potential investors by means of “road shows” run by a friendly brokerage firm coincidentally looking for investment banking business.  But the exchange of information can be less than free-flowing, especially if the brokerage analyst sits in on the meeting.  And, to prevent accidental disclosure, the event is still heavily scripted.  It has however created a new sideline business for brokerage firms in these days of declining commission rates.  Even if you are a large existing institutional shareholder, the broker/investment bankers think you should pay them $10,000 – $15,000 in commissions for the privilege of seeing the management of a company you already own.  This is apparently illegal in the United Kingdom, and referred to as “pay to play” there.  Here, neither the SEC nor the compliance officers have tumbled to it as an apparent fiduciary violation.

Next I asked him what had been most frustrating in his final years. Again without hesitation he said that it was difficult to feel that you were actually able to add value in evaluating large cap companies, given how the regulatory environment had changed. I mentioned to him that everyone seemed to be trying to replace the on-site leg work part of fundamental analysis with screening and extensive earnings modeling, going out multiple years. Unfortunately many of those using such approaches appear to have not learned the law of significant numbers in high school chemistry. They seek exactitude while in reality adding complexity.  At the same time, the subjective value of sitting in a company headquarters waiting room and seeing how customers, visitors, and employees are treated is no longer appreciated.

Bruce, like many value investors, favors private market value as the best underpinning for security valuation. That is, based on recent transactions to acquire a comparable business, what was this one worth? But you need an active merger & acquisition market for the valuation not to be tied to stale inputs. He mentioned that he had observed the increased use of dividend discount models to complement other valuation work. However, he thought that there was a danger in a low interest-rate environment that a dividend discount model could produce absurd results. One analyst had brought him a valuation write-up supported by a dividend discount model. Most of the business value ended up being in the terminal segment, requiring a 15 or 16X EBITDA multiple to make the numbers work.  Who in the real world pays that for a business?  I mentioned that Luther King, a distinguished investment manager in Texas with an excellent long-term record, insisted on meeting as many company managements as he could, even in his seventies, as part of his firm’s ongoing due diligence. He did not want his investors to think that their investments were being followed and analyzed by “three guys and a Bloomberg terminal.”  And in reality, one cannot learn an industry and company solely through a Bloomberg terminal, webcasts, and conference calls. 

Bruce then mentioned another potentially corrupting factor. His experience was that investment firms compensate analysts based on idea generation, performance of the idea, and the investment dollars committed to the idea. This can lead to gamesmanship as you get to the end of the measurement period for compensation. E.g., we tell corporate managements they shouldn’t act as if they were winding up and liquidating their business at the end of a quarter or year. Yet, we incent analysts to act that way (and lock in a profitable bonus) by recommending sale of an idea much too early. Or at the other extreme, they may not want to recommend sale of the idea when they should. I mentioned that one solution was to eliminate such compensation performance assessments as one large West Coast firm is reputed to have done after the disastrous 2008 meltdown. They were trying to restore a culture that for eighty years had been geared to producing the best long-term compounding investment ideas for the clients. However, they also had the luxury of being independent.      

Finally I asked Bruce what tipped him over the edge into retirement. He said he got tired of discussions about “scalability.” A brief explanation is in order. After the dot-com disaster at the beginning of the decade, followed by the debacle years of 2008-2009, many investment firms put into place an implicit policy. For an idea to be added to the investment universe, a full investment position had to be capable of being acquired in five days average trading volume for that issue. Likewise, one had to also be able to exit the position in five days average trading volume. If it could not pass those hurdles, it was not a suitable investment. This cuts out small cap and most mid-cap ideas, as well as a number of large cap ideas where there is limited investment float. While the benchmark universe might be the S&P 500, in actuality it ends up being something very different. Rather than investing in the best ideas for clients, one ends up investing in the best liquid ideas for clients (I will save for another day the discussion about illiquid investments consistently producing higher returns long-term, albeit with greater volatility). 

From Bruce’s perspective, too much money is chasing too few good ideas. This has resulted in what we call “style drift”.  Firms that had made their mark as small cap or mid cap investors didn’t want to kill the goose laying the golden eggs by shutting off new money, so they evolved to become large cap investors. But ultimately that is self-defeating, for as the assets come in, you either have to shut down the flows or change your style by adding more and larger positions, which ultimately leads to under-performance.

I mentioned to Bruce that the other problem of too much money chasing too few good new ideas was that it tended to encourage “smart guy investing,” a term coined by a mutual friend of ours in Chicago. The perfect example of this was Dell. When it first appeared in the portfolios of Southeastern Asset Management, I was surprised. Over the next year, the idea made its way in to many more portfolios at other firms. Why? Because originally Southeastern had made it a very large position, which indicated they were convinced of its investment merits. The outsider take was “they are smart guys – they must have done the work.” And so, at the end of the day after making their own assessments, a number of other smart guys followed. In retrospect it appears that the really smart guy was Michael Dell.

A month ago I was reading a summary of the 2013 annual investment retreat of a family office investment firm with an excellent reputation located in Vermont. A conclusion reached was that the incremental value being provided by many large cap active managers was not justified by the fees being charged. Therefore, they determined that that part of an asset allocation mix should make use of low cost index funds. That is a growing trend. Something else that I think is happening now in the industry is that investment firms that are not independent are increasingly being run for short-term profitability as the competition and fee pressures from products like exchange traded funds increases. Mike Royko, the Chicago newspaper columnist once said that the unofficial motto of Chicago is “Ubi est meum?” or “Where’s mine?” Segments of the investment management business seemed to have adopted it as well. As a long-term value investor in New York recently said to me, short-termism is now the thing. 

The ultimate lesson is the basic David Snowball raison d’etre for the Mutual Fund Observer. Find yourself funds that are relatively small and independent, with a clearly articulated philosophy and strategy. Look to see, by reading the reports and looking at the lists of holdings, that they are actually doing what they say they are doing, and that their interests are aligned with yours. Look at their active share, the extent to which the holdings do not mimic their benchmark index. And if you cannot be bothered to do the work, put your investments in low cost index vehicles and focus on asset allocation.  Otherwise, as Mr. Buffet once said, if you are seated at the table to play cards and don’t identify the “mark” you should leave, as you are it.

Edward Studzinski    

Impact of Category on Fund Ratings

The results for MFO’s fund ratings through quarter ending December 2013, which include the latest Great Owl and Three Alarm funds, can be found on the Search Tools page. The ratings are across 92 fund categories, defined by Morningstar, and include three newly created categories:

Corporate Bond. “The corporate bond category was created to cull funds from the intermediate-term and long-term bond categories that focused on corporate bonds,” reports Cara Esser.  Examples are Vanguard Interm-Term Invmt-Grade Inv (VFICX) and T. Rowe Price Corporate Income (PRPIX).

Preferred Stock. “The preferred stock category includes funds with a majority of assets invested in preferred stock over a three-year period. Previously, most preferred share funds were lumped in with long-term bond funds because of their historically high sensitivity to long-term yields.” An example is iShares US Preferred Stock (PFF).

Tactical Allocation. “Tactical Allocation portfolios seek to provide capital appreciation and income by actively shifting allocations between asset classes. These portfolios have material shifts across equity regions and bond sectors on a frequent basis.” Examples here are PIMCO All Asset All Authority Inst (PAUIX) and AQR Risk Parity (AQRIX).

An “all cap” or “all style” category is still not included in the category definitions, as explained by John Rekenthaler in Why Morningstar Lacks an All-Cap Fund Category. The omission frustrates many, including BobC, a seasoned contributor to the MFO board:

Osterweis (OSTFX) is a mid-cap blend fund, according to M*. But don’t say that to John Osterweis. Even looking at the style map, you can see the fund covers all of the style boxes, and it has about 20% in foreign stocks, with 8% in emerging countries. John would tell you that he has never managed the fund to a style box. In truth he is style box agnostic. He is looking for great companies to buy at a discount. Yet M* compares the fund with others that are VERY different.

In fairness, according to the methodology, “for multiple-share-class funds, each share class is rated separately and counted as a fraction of a fund within this scale, which may cause slight variations in the distribution percentages.” Truth is, fund managers or certainly their marketing departments are sensitive to what category their fund lands-in, as it can impact relative ratings for return, risk, and price.

As reported in David’s October commentary, we learned that Whitebox Funds appealed to the Morningstar editorial board to have its Tactical Opportunities Fund (WBMIX) changed from aggressive allocation to long/short equity. WBMIX certainly has the latitude to practice long/short; in fact, the strategy is helping the fund better negotiate the market’s rough start in 2014. But its ratings are higher and price is lower, relatively, in the new category.

One hotly debated fund on the MFO board, ASTON/River Road Independent Small Value (ARIVX), managed by Eric Cinnamond, would also benefit from a category change. As a small cap, the fund rates a 1 (bottom quintile) for 2013 in the MFO ratings system, but when viewed as a conservative or tactical allocation fund – because of significant shifts to cash – the ratings improve. Here is impact on return group rank for a couple alternative categories:

Of course, a conservative tactical allocation category would be a perfect antidote here (just kidding).

Getting It Wrong. David has commented more than once about the “wildly inappropriate” mis-categorization of Riverpark Short Term High Yield Fund (RPHIX), managed by David Sherman, which debuted with just a single star after its first three years of operation. The MFO community considers the closed fund more of a cash alternative, suited best to the short- or even ultrashort-term bond categories, but Morningstar placed it in the high yield bond category.

Exacerbating the issue is that the star system appears to rank returns after deducting for a so-called “risk penalty,” based on the variation in month-to-month return during the rating period. This is good. But it also means that funds like RPHIX, which have lower absolute returns with little or no downside, do not get credit for their very high risk-adjusted return ratios, like Sharpe, Sortino, or Martin.

Below is the impact of categorization, as well as return metrics, on its performance ranking. The sweet irony is that its absolute return even beat the US bond aggregate index!

RPHIX is a top tier fund by just about any measure when placed in a more appropriate bond category or when examined with risk-adjusted return ratios. (Even Modigliani’s M2, a genuinely risk-adjusted return, not a ratio, that is often used to compare portfolios with different levels of risk, reinforces that RPHIX should still be top tier even in the high yield bond category.) Since Morningstar states its categorizations are “based strictly on portfolio statistics,” and not fund names, hopefully the editorial board will have opportunity to make things right for this fund at the bi-annual review in May.

A Broader View. Interestingly, prior to July 2002, Morningstar rated funds using just four broad asset-class-based groups: US stock, international stock, taxable bond, and municipal bonds. It switched to (smaller) categories to neutralize market tends or “tailwinds,” which would cause, for example, persistent outperformance by funds with value strategies.

A consequence of rating funds within smaller categories, however, is more attention goes to more funds, including higher risk funds, even if they have underperformed the broader market on a risk-adjusted basis. And in other cases, the system calls less attention to funds that have outperformed the broader market, but lost an occasional joust in their peer group, resulting in a lower rating.

Running the MFO ratings using only the four board legacy categories reveals just how much categorization can alter the ratings. For example, the resulting “US stock” 20-year Great Owl funds are dominated by allocation funds, along with a high number of sector equity funds, particularly health. But rate the same funds with the current categories (Great Owl Funds – 4Q2013), and we find more funds across the 3 x 3 style box, plus some higher risk sector funds, but the absence of health funds.

Fortunately, some funds are such strong performers that they appear to transcend categorization. The eighteen funds listed below have consistently delivered high excess return while avoiding large drawdown and end-up in the top return quintile over the past 20, 10, 5, and 3 year evaluation periods using either categorization approach:

 Roy Weitz grouped funds into only five equity and six specialty “benchmark categories” when he established the legacy Three Alarm Funds list. Similarly, when Accipiter created the MFO Miraculous Multi-Search tool, he organized the 92 categories used in the MFO rating system into 11 groups…not too many, not too few. Running the ratings for these groupings provides some satisfying results:

A more radical approach may be to replace traditional style categories altogether! For example, instead of looking for best performing small-cap value funds, one would look for the best performing funds based on a risk level consistent with an investor’s temperament. Implementing this approach, using Risk Group (as defined in ratings system) for category, identifies the following 20-year Great Owls:

Bottom Line. Category placement can be as important to a fund’s commercial success as its people, process, performance, price and parent. Many more categories exist today on which peer groups are established and ratings performed, causing us to pay more attention to more funds. And perhaps that is the point. Like all chambers of commerce, Morningstar is as much a promoter of the fund industry, as it is a provider of helpful information to investors. No one envies the enormous task of defining, maintaining, and defending the rationale for several dozen and ever-evolving fund categories. Investors should be wary, however, that the proliferation may provide a better view of the grove than the forest.

28Jan2014/Charles

Our readers speak!

And we’re grateful for it. Last month we gave folks an opportunity to weigh-in on their assessment of how we’re doing and what we should do differently. Nearly 350 of you shared your reactions during the first week of the New Year. That represents a tiny fraction of the 27,000 unique readers who came by in January, so we’re not going to put as much weight on the statistical results as on the thoughts you shared.

We thought we’d share what we heard. This month we’ll highlight the statistical results.  In March we’ll share some of your written comments (they run over 30 pages) and our understanding of them.

Who are you?

80% identified themselves as private investors, 18% worked in the financial services industry and 2% were journalists, bloggers and analysts.

How often do you read the Observer?

The most common answer is “I just drop by at the start of the month” (36%). That combines with “I drop by once every month, but not necessarily at the start”) (14%) to explain about half of the results. At the same time, a quarter of you visit four or more times every month. (And thanks for it!)

Which features are most (or least) interesting to you?

By far, the greatest number of “great, do more!” responses came under “individual fund profiles.” A very distant second and third were the longer pieces in the monthly commentary (such as Motion, Not Progress and Impact of Category on Fund Ratings) and the shorter pieces (on fund liquidations and such) in the commentary. Folks had the least interest in our conference calls and funds in registration.

Hmmm … we’re entirely sympathetic to the desire for more fund profiles. Morningstar has an effective monopoly in the area and their institutional biases are clear: of the last 100 fund analyses posted, only 13 featured funds with under one billion in assets. Only one fund launched since January 2010 was profiled. In response, we’re going to try to increase the number of profiles each month to at least four with a goal of hitting five or six. 

We’re not terribly concerned about the tepid response to the conference calls since they’re useful in writing our profiles and the audience for them continues to grow. If you haven’t tried one, perhaps it might be worthwhile this month?

And so, in response to your suggestion, here’s the freshly expanded …

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. 

ASTON/River Road Long Short (ARLSX): measured in the cold light of risk-return statistics, ARLSX is as good as it gets. We’d recommend that interested parties look at both this profile and at the conference call highlights, below.

Artisan Global Small Cap (ARTWX): what part of “phenomenally talented, enormously experienced management team now offers access to a poorly-explored asset class” isn’t interesting to you?

Grandeur Peak Emerging Opportunities (GPEOX): ditto!

RiverNorth Equity Opportunity (RNEOX): ditto! Equity Opportunity is a redesigned and greatly strengthened version of an earlier fund.  This new edition is all RiverNorth and that is, for folks looking for buffered equity exposure, a really interesting option.

We try to think strategically about which funds to profile. Part of the strategy is to highlight funds that might do you well in the immediate market environment, as well as others that are likely to be distinctly out of step with today’s market but very strong additions in the long-run. We reached out in January to the managers of two funds in the latter category: the newly-launched Meridian Small Cap Growth (MSGAX) and William Blair Emerging Markets Small Cap (WESNX). Neither has responded to a request for information (we were curious about strategy capacity, for instance, and risk-management protocols). We’ll continue reaching out; if we don’t hear back, we’ll profile the funds in March with a small caution flag attached.

RiverNorth conference call, February 25 2014

RiverNorth’s opportunistic CEF strategy strikes us as distinctive, profitable and very crafty. We’ve tried to explain it in profiles of RNCOX and RNEOX. Investors who are intrigued by the opportunity to invest with RiverNorth should sign up for their upcoming webcast entitled RiverNorth Closed-End Fund Strategies: Capitalizing on Discount Volatility. While this is not an Observer event, we’ve spoken with Mr. Galley a lot and are impressed with his insights and his ability to help folks make sense of what the strategy can and cannot do.

Navigate over to http://www.rivernorthfunds.com/events/ for free registration.

Conference Call Highlights:  ASTON River Road Long/Short (ARLSX)

We spoke with Daniel Johnson and Matt Moran, managers for the River Road Long-Short Equity strategy which is incorporated in Aston River Road Long-Short Fund (ARLSX). Mike Mayhew, one of the Partners at Aston Asset, was also in on the call to answer questions about the fund’s mechanics. About 60 people joined in.

The highlights, for me, were:

the fund’s strategy is sensible and straightforward, which means there aren’t a lot of moving parts and there’s not a lot of conceptual complexity. The fund’s stock market exposure can run from 10 – 90% long, with an average in the 50-70% range. The guys measure their portfolio’s discount to fair value; if their favorite stocks sell at a less than 80% of fair value, they increase exposure. The long portfolio is compact (15-30), driven by an absolute value discipline, and emphasizes high quality firms that they can hold for the long term. The short portfolio (20-40 names) is stocked with poorly managed firms with a combination of a bad business model and a dying industry whose stock is overpriced and does not show positive price momentum. That is, they “get out of the way of moving trains” and won’t short stocks that show positive price movements.

the fund grew from $8M to $207M in a year, with a strategy capacity in the $1B – 1.5B range. They anticipate substantial additional growth, which should lower expenses a little (and might improve tax efficiency – my note, not theirs). Because they started the year with such a small asset base, the expense numbers are exaggerated; expenses might have been 5% of assets back when they were tiny, but that’s no longer the case. 

shorting expenses were boosted by the vogue for dividend-paying stocks, which  drove valuations of some otherwise sucky stocks sharply higher; that increases the fund’s expenses because they’ve got to repay those dividends but the managers believe that the shorts will turn out to be profitable even so.

the guys have no client other than the fund, don’t expect ever to have one, hope to manage the fund until they retire and they have 100% of their liquid net worth in it.

their target is “sleep-at-night equity exposure,” which translates to a maximum drawdown (their worst-case market event) of no more than 10-15%. They’ve been particularly appalled by long/short funds that suffered drawdowns in the 20-25% range which is, they say, not consistent with why folks buy such funds.

they’ve got the highest Sharpe ratio of any long-short fund, their longs beat the market by 900 bps, their shorts beat the inverse of the market by 1100 bps and they’ve kept volatility to about 40% of the market’s while capturing 70% of its total returns.

A lot of the Q&A focused on the fund’s short portfolio and a little on the current state of the market. The guys note that they tend to generate ideas (they keep a watchlist of no more than 40 names) by paging through Value Line. They focus on fundamentals (let’s call it “reality”) rather than just valuation numbers in assembling their portfolio. They point out that sometimes fundamentally rotten firms manage to make their numbers (e.g., dividend yield or cash flow) look good but, at the same time, the reality is that it’s a poorly managed firm in a failing industry. On the flip side, sometimes firms in special situations (spinoffs or those emerging from bankruptcy) will have little analyst coverage and odd numbers but still be fundamentally great bargains. The fact that they need to find two or three new ideas, rather than thirty or sixty, allows them to look more carefully and think more broadly. That turns out to be profitable.

Bottom Line: this is not an all-offense all the time fund, a stance paradoxically taken by some of its long-short peers.  Neither is it a timid little “let’s short an ETF or two and hope” offering.”  It has a clear value discipline and even clearer risk controls.  For a conservative equity investor like me, that’s been a compelling combination.

Folks unable to make the call but interested in it can download or listen to the .mp3 of the call, which will open in a separate window.

As with all of these funds, we have a featured funds page for ARLSX which provides a permanent home for the mp3 and highlights, and pulls together all of the best resources we have for the fund.

Would An Additional Heads Up Help?

Over 220 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.

Conference Call Upcoming:  Joshua B. Parker and Alan Salzbank, RiverPark / Gargoyle Hedged Value

Josh Parker and Alan Salzbank, Co-Portfolio Managers of the RiverPark/Gargoyle Hedged Value Fund (RGHVX) and Morty Schaja, RiverPark’s CEO; are pleased to join us for a conference call scheduled for Wednesday, February 12 from 7:00 – 8:00 PM Eastern. We profiled the fund in June 2013, but haven’t spoken with the managers before.  

Why speak with them now?  Three reasons.  First, you really need to have a strategy in place for hedging the substantial gains booked by the stock market since its March 2009 low. There are three broad strategies for doing that: an absolute value strategy which will hold cash rather than overpriced equities, a long-short equity strategy and an options-based strategy. Since you’ve had a chance to hear from folks representing the first two, it seems wise to give you access to the third. Second, RiverPark has gotten it consistently right when it comes to both managers and strategies. I respect their ability and their record in bringing interesting strategies to “the mass affluent” (and me). Finally, RiverPark/Gargoyle Hedged Value Fund ranks as a top performing fund within the Morningstar Long/Short category since its inception 14 years ago. The Fund underwent a conversion from its former partnership hedge fund structure in April 2012 and is managed using the same approach by the same investment team, but now offers daily liquidity, low  minimums and a substantially lower fee structure for shareholders.

I asked Alan what he’d like folks to know ahead of the call. Here’s what he shared:

Alan and Josh have spent the last twenty-five years as traders and managers of options-based investment strategies beginning their careers as market makers on the option floor in the 1980’s. The Gargoyle strategy involves using a disciplined quantitative approach to find and purchase what they believe to be undervalued stocks. They have a unique approach to managing volatility through the sale of relatively overpriced index call options to hedge the portfolio. Their strategy is similar to traditional buy/write option strategies that offer reduced volatility and some downside protection, but gains an advantage by selling index rather single stock options. This allows them to benefit from both the systemic overpricing of index options while not sacrificing the alpha they hope to realize on their bottom-up stock picking, 

The Fund targets a 50% net market exposure and manages the option portfolio such that market exposure stays within the range of 35% to 65%. Notably, using this conservative approach, the Fund has still managed to outperform the S&P 500 over the last five years. Josh and Alan believe that over the long term shareholders can continue to realize returns greater than the market with less risk. Gargoyle’s website features an eight minute video “The Options Advantage” describing the investment process and the key differences between their strategy and a typical single stock buy-write (click here to watch video).

That call is scheduled for Wednesday, February 12, from 7:00 – 8:00 Eastern. We’ll provide additional details in our February issue.  

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.

Funds in Registration

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

Funds in registration this month are eligible to launch in late March or early April 2014, and some of the prospectuses do highlight that date.

This month David Welsch celebrated a newly-earned degree from SUNY-Sullivan and still tracked down 18 no-load retail funds in registration, which represents our core interest.

Four sets of filings caught our attention. First, DoubleLine is launching two new and slightly edgy funds (the “wherever I want to go” Flexible Income Fund managed by Mr. Gundlach and an emerging markets short-term bond fund). Second, three focused value funds from Pzena, a well-respected institutional manager. Third, Scout Equity Opportunity Fund which will be managed by Brent Olson, a former Aquila Three Peaks Opportunity Growth Fund (ATGAX) manager. While I can’t prove a cause-and-effect relationship, ATGAX vastly underperformed its mid-cap growth peers for the decade prior to Mr. Olson’s arrival and substantially outperformed them during his tenure. 

Finally, Victory Emerging Markets Small Cap Fund will join the small pool of EM small cap funds. I’d normally be a bit less interested, but their EM small cap separate accounts have substantially outperformed their benchmark with relatively low volatility over the past five years. The initial expense ratio will be 1.50% and the minimum initial investment is $2500, reduced to $1000 for IRAs.

Manager Changes

On a related note, we also tracked down 39 sets of fund manager changes. The most intriguing of those include what appears to be the surprising outflow of managers from T. Rowe Price, Alpine’s decision to replace its lead managers with an outsider and entirely rechristen one of their funds, and Bill McVail’s departure after 15 years at Turner Small Cap Growth.

Updates

We noted a couple months ago that DundeeWealth was looking to exit the U.S. fund market and sell their funds. Through legal maneuvers too complicated for me to follow, the very solid Dynamic U.S. Growth Fund (Class II, DWUHX) has undergone the necessary reorganization and will continue to function as Dynamic U.S. Growth Fund with Noah Blackstein, its founding manager, still at the helm. 

Briefly Noted . . .

Effective March 31 2014, Alpine Innovators Fund (ADIAX) transforms into Alpine Small Cap Fund.  Following the move, it will be repositioned as a domestic small cap core fund, with up to 30% international.  Both of Innovator’s managers, the Liebers, are being replaced by Michael T. Smith, long-time manager of Lord Abbett Small-Cap Blend Fund (LSBAX).  Smith’s fund had a very weak record over its last five years and was merged out of existence in July, 2013; Smith left Lord Abbett in February of that year.

Effective April 1, 2014, the principal investment strategy of the Green Century Equity Fund (GCEQX) will be revised to change the index tracked by the Fund, so as to exclude the stocks of companies that explore for, process, refine or distribute coal, oil or gas. 

The Oppenheimer Steelpath funds have decided to resort to English. It’s kinda refreshing. The funds’ current investment Objectives read like this:

The investment objective of Oppenheimer SteelPath MLP Alpha Fund (the “Fund” or “Alpha Fund”) is to provide investors with a concentrated portfolio of energy infrastructure Master Limited Partnerships (“MLPs”) which the Advisor believes will provide substantial long-term capital appreciation through distribution growth and an attractive level of current income.

As of February 28, it becomes:

The Fund seeks total return.

SMALL WINS FOR INVESTORS

The Board of Trustees of the Fund has approved an increase in the Congressional Effect Fund’s (CEFFX) expense cap from 1.50% to 3.00%. Since I think their core strategy – “go to cash whenever Congress is in session” – is not sensible, a suspicion supported by their 0.95% annual returns over the past five years, becoming less attractive to investors is probably a net good.

Driehaus Mutual Funds’ Board approved reductions in the management fees for the Driehaus International Discovery Fund (DRIDX) and the Driehaus Global Growth Fund (DRGGX) which became effective January 1, 2014.  At base, it’s a 10-15 bps drop. 

Effective February 3, 2014, Virtus Emerging Markets Opportunities Fund (HEMZX) will be open to new investors. Low risk, above average returns but over $7 billion in the portfolio. Technically that’s capped at “two cheers.”

CLOSINGS (and related inconveniences)

Effective February 14, 2014, American Beacon Stephens Small Cap Growth Fund (STSGX) will act to limit inflows by stopping new retirement and benefit plans from opening accounts with the fund.

Artisan Global Value Fund (ARTGX) will soft-close on February 14, 2014.  Its managers were just recognized as Morningstar’s international-stock fund managers of the year for 2013. We’ve written about the fund four times since 2008, each time ending with the same note: “there are few better offerings in the global fund realm.”

As of the close of business on January 28, 2014, the GL Macro Performance Fund (GLMPX) will close to new investments. They don’t say that the fund is going to disappear, but that’s the clear implication of closing an underperforming, $5 million fund even to folks with automatic investment plans.

Effective January 31, the Wasatch International Growth Fund (WAIGX) closed to new investors.

OLD WINE, NEW BOTTLES

Effective February 1, 2014, the name of the CMG Tactical Equity Strategy Fund (SCOTX) will be changed to CMG Tactical Futures Strategy Fund.

Effective March 3, 2014, the name of the Mariner Hyman Beck Portfolio (MHBAX) has been changed to Mariner Managed Futures Strategy Portfolio.

OFF TO THE DUSTBIN OF HISTORY

On January 24, 2014, the Board of Trustees approved the closing and subsequent liquidation of the Fusion Fund (AFFSX, AFFAX).

ING will ask shareholders in June 2014 to approve the merger of five externally sub-advised funds into three ING funds.   

The Board of Trustees of iShares voted to close and liquidate ten international sector ETFs, effective March 26, 2014.  The decedents are:  

• iShares MSCI ACWI ex U.S. Consumer Discretionary ETF (AXDI)
• iShares MSCI ACWI ex U.S. Consumer Staples ETF (AXSL)
• iShares MSCI ACWI ex U.S. Energy ETF (AXEN)
• iShares MSCI ACWI ex U.S. Financials ETF (AXFN)
• iShares MSCI ACWI ex U.S. Healthcare ETF (AXHE)
• iShares MSCI ACWI ex U.S. Industrials ETF (AXID)
• iShares MSCI ACWI ex U.S. Information Technology ETF (AXIT)
• iShares MSCI ACWI ex U.S. Materials ETF (AXMT)
• iShares MSCI ACWI ex U.S. Telecommunication Services ETF (AXTE) and
• iShares MSCI ACWI ex U.S. Utilities ETF (AXUT)

The Nomura Funds board has authorized the liquidation of their three funds:

• Nomura Asia Pacific ex Japan Fund (NPAAX)
• Nomura Global Emerging Markets Fund (NPEAX)
• Nomura Global Equity Income Fund (NPWAX)

The liquidations will occur on or about March 19, 2014.

On January 30, 2014, the shareholders of the Quaker Akros Absolute Return Fund (AARFX) approved the liquidation of the Fund which has banked five-year returns of (0.13%) annually. 

The Vanguard Growth Equity Fund (VGEQX)is to be reorganized into the Vanguard U.S. Growth Fund (VWUSX) on or about February 21, 2014. The Trustees helpfully note: “The reorganization does not require shareholder approval, and you are not being asked to vote.”

Virtus Greater Asia ex Japan Opportunities Fund (VGAAX) is closing on February 21, 2014, and will be liquidated shortly thereafter.  Old story: decent but not stellar returns, no assets.

In Closing . . .

Thanks a hundred times over for your continued support of the Observer, whether through direct contributions or using our Amazon link.  I’m a little concerned about Amazon’s squishy financial results and the risk that they’re going to go looking for ways to pinch pennies. Your continued use of that program provides us with about 80% of our monthly revenue.  Thanks, especially, to the folks at Evergreen Asset Management and Gardey Financial Advisors, who have been very generous over the years; while the money means a lot, the knowledge that we’re actually making a difference for folks means even more.

The next month will see our migration to a new, more reliable server, a long talk with the folks at Gargoyle and profiles of four intriguing small funds.  Since you make it all possible, I hope you join us for it all.

As ever,

Dear friends,

Welcome to the New Year.  At least as we calculate it.  The Year of the Horse begins January 31, a date the Vietnamese share.  The Iranians, like the ancient Romans, sensibly celebrate the New Year at the beginning of spring.  A bunch of cultures in South Asia pick mid-April. Rosh Hashanah (“head of the year”) rolls around in September.  My Celtic ancestors (and a bunch of modern Druidic wannabees) preferred Samhain, at the start of November.

Whatever your culture, the New Year is bittersweet.  We seem obsessed with looking back in regret at all the stuff we didn’t do, as much as we look forward to all of the stuff we might yet do.

My suggestion: can the regrets, get off yer butt, and do the stuff now that you know you need to do.  One small start: get rid of that mutual fund.  You know the one.  You’ve been regretting it for years.  You keep thinking “maybe I’ll wait to let it come back a bit.”  The one that you tend to forget to mention whenever you talk about investments.

Good gravy.  Dump it!  It takes about 30 seconds on the phone and no one is going to hassle you about it; it’s not like the manager is going to grab the line and begin pleading for a bit more time.  Pick up a lower cost replacement.  Maybe look into a nice ETF or index fund. Track down a really good fund whose manager is willing to put his own fortune and honor at risk along with yours.

You’ll feel a lot better once you do.

We can talk about your gym membership later.

Voices from the bottom of the well

THESE are the times that try men’s souls. The summer soldier and the sunshine patriot will, in this crisis, shrink from the service of their country; but he that stands by it now, deserves the love and thanks of man and woman. Tyranny, like hell, is not easily conquered; yet we have this consolation with us, that the harder the conflict, the more glorious the triumph. What we obtain too cheap, we esteem too lightly: it is dearness only that gives every thing its value. Heaven knows how to put a proper price upon its goods; and it would be strange indeed if so celestial an article as FREEDOM should not be highly rated.

Thos. Paine, The Crisis, 23 December 1776

Investors highly value managers who are principled, decisive, independent, active and contrarian.  Right up to the moment that they have one. 

Then they’re appalled.

There are two honorable approaches to investing: relative value and absolute value.  Relative value investors tend to buy the best-priced securities available, even if the price quoted isn’t very good.  They tend to remain fully invested even when the market is pricey and have, as their mantra, “there’s always a bull market in something.”  They’re optimistic by nature, enjoy fruity wines and rarely wear bowties.

Absolute value investors tend to buy equities only when they’re selling for cheap.  Schooled in the works of Graham and Dodd, they’re adamant about having “a margin of safety” when investing in an inherently risk asset class like stocks.  They tend to calculate the fair value of a company and they tend to use cautious assumptions in making those calculations.  They tend to look for investments selling at a 30% discount to fair value, or to firms likely to produce 10% internal returns of return even if things turn ugly.  They’re often found sniffing around the piles that trendier investors have fled.  And when they find no compelling values, they raise cash.  Sometimes lots of cash, sometimes for quite a while.  Their mantra is, “it’s not ‘different this time’.”  They’re slightly-mournful by nature, contemplate Scotch, and rather enjoyed Andy Rooney’s commentaries on “60 Minutes.”

If you’re looking for a shortcut to finding absolute value investors today, it’s a safe bet you’ll find them atop the “%age portfolio cash” list.  And at the bottom of the “YTD relative return” list.  They are, in short, the guys you’re now railing against.

But should you be?

I spent a chunk of December talking with guys who’ve managed five-star funds and who were loved by the crowds but who are now suspected of having doubled-up on their intake of Stupid Pills.  They are, on whole, stoic. 

Take-aways from those conversations:

1. They hate cash.  As a matter of fact, it’s second on their most-hated list behind only “risking permanent impairment of capital”.
2. They’re not perma-bears. They love owning stocks. These are, by and large, guys who sat around reading The Intelligent Investor during recess and get tingly at the thought of visiting Omaha. But they love them for the prospect of the substantial, compounded returns they might generate.  The price of those outsized returns, though, is waiting for one of the market’s periodic mad sales.
3. They bought stocks like mad in early 2009, around the time that the rest of us were becoming nauseated at the thought of opening our 401(k) statements. Richard Cook and Dowe Bynum, for example, were at 2% cash in March 2009.  Eric Cinnamond was, likewise, fully invested then.
4. They’ve been through this before though, as Mr. Cinnamond notes, “it isn’t very fun.”  The market moves in multi-year cycles, generally five years long more or less. While each cycle is different in composition, they all have similar features: the macro environment turns accommodative, stocks rise, the fearful finally rush in, stocks overshoot fair value by a lot, there’s an “oops” and a mass exit for the door.  Typically, the folks who arrived late inherit the bulk of the pain.
5. And they know you’re disgusted with them. Mr. Cinnamond, whose fund has compounded at 12% annually for the past 15 years, allows “we get those long-term returns by looking very stupid.”  Richard Cook agrees, “we’re going to look silly, sometimes for three to five years at a stretch.”  Zac Wydra admits that he sometimes looks at himself in the mirror and asks “how can you be so stupid?”

And to those investors who declare, “but the market is reasonably priced,” they reply: “we don’t buy ‘the market.’  We buy stocks.  Find the individual stocks that meet the criteria that you hired us to apply, and we’ll buy them.”

What do they think you should do now?  In general, be patient.  Mr. Cook points to Charlie Munger’s observation:

I think the [Berkshire Hathaway’s] record shows the advantage of a peculiar mind-set – not seeking action for its own sake, but instead combining extreme patience with extreme decisiveness. It takes character to sit there with all that cash and do nothing. I didn’t get to where I am by going after mediocre opportunities.

Which is hard.  Several of the guys pointed to Seth Klarman’s decision to return $4 billion in capital to his hedge fund investors this month. Klarman made the decision in principle back in September, arguing that if there were no compelling investment opportunities, he’d start mailing out checks.  Two things are worth noting about Klarman: (1) his hedge funds have posted returns in the high teens for over 30 years and (2) he’s willing to sit at 33-50% cash for a long time if that’s what it takes to generate big long-term returns.

Few managers have Klarman’s record or ability to wait out markets.  Mr. Cinnamond noted, “there aren’t many fund managers with a long track record doing this because you’re so apt to get fired.”  Jeremy Grantham of GMO nods, declaring that “career risk” is often a greater driver of a manager’s decisions than market risk is.

In general, the absolute value guys suggest you think differently about their funds than you think about fully-invested relative value ones.  Cook and Bynum’s institutional partners think of them as “alternative asset managers,” rather than equity guys and they regard value-leaning hedge funds as their natural peer group.  John Deysher, manager of Pinnacle Value (PVFIX), recommends considering “cash-adjusted returns” as a viable measure, though Mr. Cinnamond disagrees since a manager investing in unpopular, undervalued sectors in a momentum driven market is still going to look inept.

Our bottom line: investors need to take a lot more responsibility if they’re going to thrive.  That means we’ve got to look beyond simple return numbers and ask, instead, about what decisions led to those returns.  That means actually reading your managers’ commentaries, contacting the fund reps with specific questions (if your questions are thoughtful rather more than knee-jerk, you’d be surprised at the quality of answers you receive) and asking the all-important question, “is my manager doing precisely what I hired him to do: to be stubbornly independent, fearful when others are greedy and greedy when others are fearful?” 

Alternately: buy a suite of broadly diversified, low-cost index funds.  There are several really solid funds-of-index-funds that give you broad exposure to market risk with no exposure to manager risk.  The only thing that you need to avoid at all costs is the herd: do not pay active management prices for the services of managers whose only goal is to be no different than every other timid soul out there.

The Absolute Value Guys

* FPACX’s “moderate allocation” competitors were caught holding bonds this year, dumber even than holding cash.

Don’t worry, relative value guys.  Morningstar’s got your back.

Earnings at S&P500 companies grew by 11% in 2013, through late December, and they paid out a couple percent in dividends.  Arguably, then, stocks are worth about 13% more than they were in January.  Unfortunately, the prices paid for those stocks rose by more than twice that amount.  Stocks rose by 32.4% in 2013, with the Dow setting 50 all-time record highs in the process. One might imagine that if prices started at around fair value and then rose 2.5 times as much as earnings did, valuations would be getting stretched.  Perhaps overvalued by 19% (simple subtraction of the earnings + dividend rise from the price + dividend rise)?

Not to worry, Morningstar’s got you covered.  By their estimation, valuations are up only 5% on the year – from fully valued in January to 5% high at year’s end.  They concluded that it’s certainly not time to reconsider your mad rush into US equities.  (Our outlook for the stock market, 12/27/2013.) While the author, Matthew Coffina, did approvingly quote Warren Buffett on market timing:

Charlie and I believe it’s a terrible mistake to try to dance in and out of it based upon the turn of tarot cards, the predictions of “experts,” or the ebb and flow of business activity. The risks of being out of the game are huge compared to the risks of being in it.

He didn’t, however, invoke what Warren Buffett terms “the three most important words in all of investing,” margin of safety.  Because you can’t be sure of a firm’s exact value, you always need to pay less than you think it’s worth – ideally 30 or 40% less – in order to protect your investors against your own fallible judgment. 

Quo Vadis Japan

I go out of the darkness

Onto a road of darkness

Lit only by the far off

Moon on the edge of the mountains.

Izumi

One of the benefits of having had multiple careers and a plethora of interests is that friends and associates always stand ready with suggestions for you to occupy your time. In January of 2012, a former colleague and good friend from my days with the Navy’s long-range strategic planning group suggested that I might find it interesting to attend the Second China Defense and Security Conference at the Jamestown Foundation. That is how I found myself seated in a conference room in February with roughly a hundred other people. My fellow attendees were primarily from the various alphabet soup governmental agencies and mid-level military officers. 

The morning’s presentations might best be summed up as grudging praise about the transformation of the Chinese military, especially their navy, from a regional force to one increasingly able to project power throughout Asia and beyond to carry out China’s national interests. When I finally could not stand it any longer, after a presentation during Q&A, I stuck my hand up and asked why there was absolutely no mention of the 600 pound gorilla in the corner of the room, namely Japan and the Japanese Maritime Self-Defense Force. The JMSDF was and is either the second or third largest navy in the world. It is considered by many professional observers to be extraordinarily capable. The silence that greeted my question was akin to what one would observe if I had brought in a dog that had peed on the floor. The moderator muttered a few comments about the JMSDF having fine capabilities. We then went on with no mention of Japan again. At that point I realized I had just learned the most important thing that I was going to take from the conference, that Japan (and its military) had become the invisible country of Asia. 

The New Year is when as an investor you reflect back on successes and mistakes. And if one is especially introspective, one can ponder why. For most of 2013, I was banging the drum on two investment themes that made sense to me:  (a) the Japanese equity market and (b) the Japanese currency – the yen – hedged back into U.S. dollars. The broad Japanese market touched highs this month not seen before this century. The dollar – yen exchange rate moved from 89.5 at the beginning of the year to 105.5. In tandem, the themes have proven to be quite profitable. Had an investment been made solely in the Wisdom Tree: Japan Hedged Equity ETF, a total return of 41.8% would have been achieved by the U.S. dollar investor. So, is this another false start for both the Japanese stock market and economy? Or is Japan on the cusp of an economic and political transformation?   

When I mention to institutional investors that I think the change in Japan is real, the most common response I get is a concern about “Abenomics.” This is usually expressed as “They are printing an awful lot of money.”  Give me a break.  Ben Bernanke and his little band of merry Fed governors have effectively been printing money with their various QE efforts. Who thinks that money will be repaid or the devaluation of the U.S. dollar will be reversed?  The same can be said of the EU central bankers.  If anything, the U.S. has been pursuing a policy of beggar thy creditor, since much of our debt is owed to others.  At least in Japan, they owe the money to themselves. They have also gone through years of deflation without the social order and fabric of society breaking down. One wonders how the U.S. would fare in a similar long-term deflationary environment. 

I think the more important distinction is to emphasize what “Abenomics” is not.  It is not a one-off program of purchasing government bonds with a view towards going from a multi-year deflationary spiral to generating a few points of inflation.  It is a comprehensive program aimed at reversing Japan’s economic, political, and strategic slide of the past twenty years. Subsumed under the rubric of “Abenomics” are efforts to increase and widen the acceptance of child care facilities to enable more of Japan’s female talent pool to actively participate in the workforce, a shift in policy for the investments permitted in pension funds to dramatically increase domestic equity exposure, and incentives to transform the Japanese universities into research and resource engines. Similarly, the Japanese economy is beginning to open from a closed economy to one of free trade, especially in agriculture, as Japan has joined the Trans Pacific Partnership. Finally, public opinion has shifted dramatically to a willingness to contemplate revision of Japan’s American-drafted post-war Constitution. This would permit a standing military and a more active military posture. It would normalize Japan as a global nation, and restore a balance of interests and power in East Asia. The ultimate goal then is to restore the self-confidence of the Japanese nation.  So, what awakened Japan and the Japanese?

Strangely enough, the Chinese did it. I have been in Japan four times in the last twenty-two months, which does not make me an expert on anything. But it has allowed me to discern a shift in the mood of the country. Long-time Japan hands had told me that when public opinion in Japan shifts, it shifts all at once and moves together in the same direction. Several months ago, I asked a friend and investment manager who is a long-time resident of Tokyo what had caused that shift in opinion. His response was that most individuals, he as well, traced it to the arrest and detention by the Japanese Coast Guard, of a Chinese fishing vessel and its captain who had strayed into Japanese waters. China responded aggressively, embargoing rare earth materials that the Japanese electronics and automobile industries needed, and made other public bellicose noises. Riots and torching of Japanese plants in China followed, with what seemed to be the tacit approval of the Chinese government. Japan released the ship and its captain, and in Asian parlance, lost face. As my friend explained it, the Japanese public came to the conclusion that the Chinese government was composed of bad people whose behavior was unacceptable. Concurrently, Japan Inc. began to relocate its overseas investment away from China and into countries such as Vietnam, Indonesia, Thailand, and Singapore.

From an investment point of view, what does it all mean? First, one should not look at Prime Minister Abe, Act II (remember that he was briefly in office for 12 months in 2006-2007) in a vacuum. Like Reagan and Churchill, he used his time in the “wilderness years” to rethink what he wanted to achieve for Japan and how he would set about doing it. Second, one of the things one learns about Japan and the Japanese is that they believe in their country and generally trust their government, and are prepared to invest in Japan. This is in stark contrast to China, where if the rumors of capital flows are to be believed, vast sums of money are flowing out of the country through Hong Kong and Singapore. So, after the above events involving China, Abe’s timing in return to office was timely. 

While Japanese equities have surged this year, that surge has been primarily in the large cap liquid issues that are easily studied and invested in by global firms. Most U.S. firms follow the fly-by approach. Go to Tokyo for a week of company meetings, and invest accordingly. Few firms make the commitment of having resources on the ground. That is why if you look at most U.S.-based Japan specialist mutual funds, they all own pretty much the same large cap liquid names, with only the percentages and sector weightings varying. There are tiers of small and mid-cap companies that are under-researched and under-invested in.  If this is the beginning of a secular bull market, as we saw start in the U.S. in 1982, Japan will just be at the beginnings of eliminating the value gap between intrinsic value and the market price of securities, especially in the more inefficiently-traded and under-researched companies. 

So, as Lenin once famously asked, “What is to be done?”  For most individuals, individual stock investments are out of the question, given the currency, custody, language, trading, and tax issues. For exposure to the asset class, there is a lot to be said for a passive approach through an index fund or exchange-traded fund, of which there are a number with relatively low expense ratios. Finally, there are the fifteen or so Japan-only mutual funds. I am only aware of three that are small-cap vehicles – DFA, Fidelity, and Hennessy. There are also two actively-managed closed end funds. I will look to others to put together performance numbers and information that will allow you to research the area and draw your own conclusions.  

Finally, it should be obvious that Japan does not lend itself to simple explanations. As Americans, we are often in a time-warp, thinking that with the atomic bombs, American Occupation and force-fed Constitution, we successfully transformed Japan into a pacifist democratically-styled Asian theme park.  My conclusion is rather that what you see in Japan is not reality (whatever that is) but what they are comfortable with you seeing. I think for instance of the cultural differences with China in a business sense.  With the Chinese businessman, a signed contract is in effect the beginning of the negotiation.  For the Japanese businessman, a signed contract is a commitment to be honored to the letter.

I will leave you with one thing to ponder shared with me by a Japanese friend. She told me that the samurai have been gone for a long time in Japan. But, everyone in Japan still knows who the samurai families are and everyone knows who is of those families and who is not. And she said, everyone from those families still tends to marry into other samurai families.  So I thought, perhaps they are not gone after all.  

Edward Studzinski

From Day One …

… the Observer’s readers were anxious to have us publish lists of Great Funds, as FundAlarm did with its Honor Roll funds.  For a long time I demurred because I was afraid folks would take such a list too seriously.  That is, rather than viewing it as a collection of historical observations, they’d see it as a shopping list. 

After two years and unrelenting inquires, I prevailed upon my colleague Charles to look at whether we could produce a list of funds that had great track records but, at the same time, highlight the often-hidden data concerning those funds’ risks.  With that request and Charles’s initiative, the Great Owl Funds were launched.

And now Charles returns to that troubling original question: what can we actually learn about the future from a fund’s past?

In Search of Persistence

It outperformed nearly 3/4ths of the time, while it under-performed only 5%. NAINX essentially equaled or beat its peers 194 out of 205 periods. Encouraged, the investor purchases the fund making a long-term commitment to buy-and-hold.

It’s now 2013, twenty years later. How has NAINX performed? To the investor’s horror, Virtus Tactical Allocation underperformed 3/4ths of the time since purchased! And the fund that outperformed most persistently? Mairs & Power Balanced (MAPOX), of course.

Back to 1993. This time a more aggressive investor applies the same methodology to the large growth category and finds an extraordinary fund, named Fidelity Magellan (FMAGX).  This fund outperformed nearly 100% of the time across 205 rolling 3-year periods over 20 years versus 31 other long-time peers. But during the next 20 years…? Not well, unfortunately. This investor would have done better choosing Fidelity Contrafund (FCNTX). How can this be? Most industry experts would attribute the colossal shift in FMAGX performance to the resignation of legendary fund manager Peter Lynch in 1990.

MJG, one of the heavy contributors to MFO’s discussion board, posts regularly about the difficulty of staying on top of one’s peer group, often citing results from Standard & Poor’s Index Versus Active Indexing (SPIVA) reports. Here is the top lesson-learned from ten years of these reports:

“Over a five-year horizon…a majority of active funds in most categories fail to outperform indexes. If an investing horizon is five years or longer, a passive approach may be preferable.”

The December 2013 SPIVA “Persistence Scorecard” has just been published, which Joshua Brown writes insightfully about in “Persistence is a Killer.” The scorecard once again shows that only a small fraction of top performing domestic equity mutual funds remain on top across any 2, 3, or 5 year period.

What does mutual fund non-persistence look like across 40 years? Here’s one depiction:

The image (or “mural”) represents monthly rank by color-coded quintiles of risk-adjusted returns, specifically Martin Ratio, for 101 funds across five categories. The funds have existed for 40 years through September 2013. The calculations use total monthly returns of oldest share class only, ignoring any load, survivor bias, and category drift.  Within each category, the funds are listed alphabetically.

There are no long blue/green horizontal streaks. If anything, there seem to be more extended orange/red streaks, suggesting that if mutual fund persistence does exist, it’s in the wrong quintiles! (SPIVA actually finds similar result and such bottom funds tend to end-up merged or liquated.)

Looking across the 40 years of 3-year rolling risk-adjusted returns, some observations:

• 98% of funds spent some periods in every rank level…top, bottom, and all in-between
• 35% landed in the bottom two quintiles most of the time…that’s more than 1/3^rd of all funds
• 13% were in the top two bottom quintiles…apparently harder to be persistently good than bad
• Sequoia (SEQUX) was the most persistent top performer…one of greatest mutual funds ever
• Wall Street (WALLX) was the most persistent cellar dweller…how can it still exist?

The difference in overall return between the most persistent winner and loser is breathtaking: SEQUX delivered 5.5 times more than SP500 and 16 times more than WALLX. Put another way, $10K invested in SEQUX in October 1973 is worth nearly $3M today. Here’s how the comparison looks:

So, while attaining persistence may be elusive, the motivation to achieve it is clear and present.

The implication of a lack of persistence strikes at the core of all fund rating methodologies that investors try to use to predict future returns, at least those based only on historical returns. It is, of course, why Kiplinger, Money, and Morningstar all try to incorporate additional factors, like shareholder friendliness, experience, and strategy, when compiling their Best Funds lists. An attempt, as Morningstar well states, to identify “funds with the highest potential of success.”

The MFO rating system was introduced in June 2013. The current 20-year Great Owls, shown below for moderate allocation and large growth categories, include funds that have achieved top performance rank over the past 20, 10, 5, and 3 year evaluation periods. (See Rating Definitions.)

But will they be Great Owls next year? The system is strictly quantitative based on past returns, which means, alas, a gentle and all too ubiquitous reminder that past performance is not a guarantee of future results. (More qualitative assessments of fund strategy, stewardship, and promise are provided monthly in David’s fund profiles.) In any case and in the spirit of SPIVA, we will plan to publish periodically a Great Owl “Persistence Scorecard.”

31Dec2013/Charles

It’s not exciting just because the marketers say it is

Most mutual funds don’t really have any investment reason to exist: they’re mostly asset gathering tools that some advisor created in support of its business model. Even the funds that do have a compelling case to make often have trouble receiving a fair hearing, so I’m sympathetic to the need to find new angles and new pitches to try to get journalists’ and investors’ attention.

But the fact that a marketer announces it doesn’t mean that journalists need to validate it through repetition. And it doesn’t mean that you should just take in what we’ve written.

Case in point: BlackRock Emerging Markets Long/Short Fund (BLSAX).  Here’s the combination of reasonable and silly statements offered in a BlackRock article justifying long/short investing:

For example, our access to information relies on cutting edge infrastructure to compile vast amounts of obvious and less-obvious sources of publicly available information. In fact, we consume a massive amount of data from more than 25 countries, with a storage capacity 4 times the Library of Congress and 8 times the size of Wikipedia. We take that vast quantity of publicly available information and filter and identify relevant pieces.

Reasonable statement: we do lots of research.  Silly statement: we have a really big hard drive on our computer (“a storage capacity of…”).  Why on earth would we care?  And what on earth does it mean?  “4 times the Library of Congress”?  The LoC digital collection – a small fraction of its total collection – holds three petabytes of data, a statement that folks immediately recognize as nonsensical.  3,000,000 gigabytes.  So the BlackRock team has a 12 petabyte hard drive?  12 petabytes of data?  How’s it used?  How much is reliable, consistent, contradictory or outdated?  How much value do you get from data so vast that you’ll never comprehend it?

NSA’s biggest “data farm” consumes 65 megawatts of power, has melted down 10 times, and – by the fed’s own reckoning – still hasn’t produced demonstrable security gains.  Data ≠ knowledge.

The Google, by the way, processes 20 petabytes of user-generated content per day.

Nonetheless, Investment News promptly and uncritically gloms onto the factoid, and then gets it twice wrong:

The Scientific Active Equity team takes quantitative investing to a whole new level. In fact, the team has amassed so much data on publicly traded companies that its database is now four times the size of Wikipedia and eight times the size of the Library of Congress (Jason Kephart, Beyond black box investing: Fund uses database four times the size of Wikipedia, 12/26/13).

Error 1: reversing the LoC and the Wikipedia.  Error 2: conflating “storage capacity” with “data.” (And, of course, confusing “pile o’ data” with “something meaningful.”)

MFWire promptly grabs the bullhorn to share the errors and the credulity:

This Fund Uses the Data of Eight Libraries of Congress (12/26/13, Boxing Day for our British friends)

The team managing the fund uses gigantic amounts of data — four times the size of Wikipedia and eight times the size of the Library of Congress — on public company earnings, analyst calls, news releases, what have you, to gain on insights into different stocks, according to Kephart.

Our second, perhaps larger, point of disagreement with Jason (who, in fairness, generally does exceptionally solid work) comes in his enthusiasm for one particular statistic:

That brings us to perhaps the fund’s most impressive stat, and the one advisers really need to keep their eyes on: its correlation to global equities.

Based on weekly returns through the third quarter, the most recent data available, the fund has a correlation of just 0.38 to the MSCI World Index and a correlation of 0.36 to the S&P 500. Correlations lower than 0.5 lead to better diversification and can lead to better risk-adjusted returns for the entire portfolio.

Uhhh.  No?

Why, exactly, is correlation The Golden Number?  And why is BlackRock’s correlation enough to make you tingle?  The BlackRock fund has been around just one year, so we don’t know its long-term correlation.  In December, it had a net market exposure of just 9% which actually makes a .36 correlation seem oddly high. BlackRock’s correlation is not distinctively low (Whitebox Long/Short WBLSX has a three-year correlation of 0.33, for instance). 

Nor is low correlation the hallmark of the best long-term funds in the group.  By almost any measure, the best long/short fund in existence is the closed Robeco Boston Partners L/S Equity Fund (BPLEX).  BPLEX is a five-star fund, a Lipper Leader, a Great Owl fund, with returns in the top 4% of its peer group over the past decade. And its long term correlation to the market: 75.  Wasatch Long/Short (FMLSX), another great fund with a long track record: 90. Marketfield (MFLDX), four-star, Great Owl: 67.

The case for BlackRock EM L/S is it’s open. It’s got a good record, though a short one.  In comparison to other, more-established funds, it substantially trails Long-Short Opportunity (LSOFX) since inception, is comparable to ASTON River Road (ARLSX) and Wasatch Long Short (FMLSX), while it leads Whitebox Long-Short (WBLSX), Robeco Boston Partners (BPLEX) and RiverPark Long/Short Opportunity (RLSFX). The fund has nearly $400 million in assets after one year and charges 2% expenses plus a 5.25% front load.  That’s more than ARLSX, WBLSX or FMLSX, though cheaper than LSOFX. 

Bottom Line: as writers, we need to guard against the pressures created by deadlines and the desire for “clicks.”  As readers, you need to realize we have good days and bad and you need to keep asking the questions we should be asking: what’s the context of this number?  What does it mean?  Why am I being given it? How does it compare?  And, as investors, we all need to remember that magic is more common in the world of Harry Potter than in the world we’re stuck with.

Wells Fargo and the Roll Call of the Wretched

Our Annual Roll Call of the Wretched highlights those funds which consistently, over a period of many years, trail their benchmark.  We noted that inclusion on the list signaled one of two problems:

• Bad fund or
• Bad benchmark.

The former problem is obvious.  The latter takes a word of explanation.  There are 7055 distinct mutual funds, each claiming – more or less legitimately – to be different from all of the others.   For the purpose of comparison, Morningstar and Lipper assign them to one of 108 categories.  Some funds fit easily and well, others are laughably misfit.  One example is RiverPark Short-Term High Yield Fund (RPHYX), which is a splendid cash management fund whose performance is being compared to the High-Yield group which is dominated by longer-duration bonds that carry equity-like risks and returns.

You get a sense of the mismatch – and of the reason that RPHYX was assigned one-star – when you compare the movements of the fund to the high-yield group.

That same problem afflicts Wells Fargo Advantage Short-Term High Yield Bond (SSTHX), an entirely admirable fund that returns around 4% per year over the long term in a category that delivers 50% greater returns with 150% greater volatility.  In Morningstar’s eyes, one star.

Joel Talish, one of the managing directors at Wells Fargo Advisors, raised the entirely reasonable objection that SSTHX isn’t wretched – it’s misclassified – and it shouldn’t be in the Roll Call at all. He might well be right. Our strategy has been to report all of the funds that pass the statistical screen, then to highlight those whose performance is better than the peer data suggest.  We don’t tend to remove funds from the list just because we believe that the ratings agencies are wrong. We’ve made that decision consciously: investors need to read these ubiquitous statistical screens more closely and more skeptically.  A pattern of results arises from a series of actions, and they’re meaningful only if you take the time to understand what’s going on. By highlighting solid funds that look bad because of a rater’s unexplained assignments, we’re trying to help folks learn how to look past the stars.

It might well be the case that highlighting and explaining SSTHX’s consistently one-star performance did a substantial disservice to the management team. It was a judgment call on our part and we’ll revisit it as we prepare future features.  For now, we’re hopeful that the point we highlighted at the start of the list: 

Use lists like the Roll Call of the Wretched or the Three Alarm Funds as a first step, not a final answer.  If you see a fund of yours on either list, find out why.  Call the adviser, read the prospectus, try the manager’s letter, post a question on our board.  There might be a perfectly good reason for their performance, there might be a perfectly awful one.  In either case, you need to know.

Observer Fund Profile

Each month the Observer provides in-depth profiles of notable funds that you’d otherwise not hear of.  Our “Most Intriguing New Funds” are funds launched within the past couple years that most frequently feature experienced managers leading innovative newer funds.  “Stars in the Shadows” are older funds that have attracted far less attention than they deserve. 

RiverPark Strategic Income (RSIVX): RSIVX sits at the core of Cohanzick’s competence, a conservative yet opportunistic strategy that they’ve pursued for two decades and that offers the prospect of doubling the returns of its very fine Short-Term High Yield Fund.

Elevator Talk: Oliver Pursche, GMG Defensive Beta Fund (MPDAX)

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. 

The traditional approach to buffering the stock market’s volatility without entirely surrendering the prospect of adequate returns was to divide the portfolio between (domestic, large cap) stocks and (domestic, investment grade) bonds, at a ratio of roughly 60/40.  That strategy worked passably well as long as stocks could be counted on to produce robust returns and bonds could be counted on to post solid though smaller gains without fail.  As the wheels began falling off that strategy, advisors began casting about for alternative strategies. 

Some, like the folks at Montebello Partners, began drawing lessons from the experience of hedge funds and institutional alternatives managers.  Their conclusion was that each asset class had one or two vital contributions to make to the health of the portfolio, but that exposure to those assets had to be actively managed if they were going to have a chance of producing equity-like (perhaps “equity-lite”) returns with substantial downside protection.

Their strategy is manifested in GMG Defensive Beta, which launched in the summer of 2009.  Its returns have generally overwhelmed those of its multi-alternative peers (top 3% over the past three years, substantially higher returns since inception) though at the cost of substantially higher volatility.  Morningstar rates it as a five-star fund, while Lipper gives it four stars for both Total Return and Consistency of Return and five stars for Capital Preservation.

Oliver Pursche is the president of Gary M Goldberg Financial Services (hence GMG) one of the four founding co-managers of MPDAX.  Here are his 218 words (on whole, durn close to target) on why you should consider a multi alternative strategy:

Markets are up, and as a result, so are the risks of a correction. I don’t think that a 2008-like crash is in the cards, but we could certainly see a 20% correction at some point. If you agree with me, protecting your hard fought gains makes all the sense in the world, which is why I believe low-volatility and multi-alternative funds like our GMG Defensive Beta Fund will continue to gain favor with investors. The problem is that most of these new funds have no, or only a short track-record, so it’s difficult to know how they will actually perform in a prolonged downturn. One thing is certain, in the absence of a longer-term track record, low fees and low turnover tend to be advantageous to investors. This is why our fund is a no-load fund and we cap our fees at 1.49%, well below most of our peers, and our cap gain distributions have been minimal.

From my perspective, if you’re looking to continue to have market exposure, but don’t want all of the risks associated with investing in the S&P 500, our fund is ideally suited. We’re strategic and tactical at the same time and have demonstrated our ability to remain disciplined, which is (I think) why Morningstar has awarded us a 5 Star ranking.

MPDAX is a no-load fund with a single share class.  The minimum initial investment is $1,000.   Expenses are 1.49% on about $27 million in assets.

The fund’s website is functional but spare.  You get the essential information, but there’s no particular wealth of insight or commentary on this strategy.  There’s a Morningstar reprint available but you should be aware that the file contains one page of data reporting and five pages of definitions and disclaimers.

Our earlier Elevator Talks were:

1. February 2013: Tom Kerr, Rocky Peak Small Cap Value (RPCSX), whose manager has a 14 year track record in small cap investing and a passion for discovering “value” in the intersection of many measures.  We’re saddened to report that Tom chose to liquidate the fund.
2. March 2013: Dale Harvey, Poplar Forest Partners (PFPFX and IPFPX), a concentrated, contrarian value stock fund that offers “a once-in-a-generation opportunity to invest with a successful American Funds manager who went out on his own.”
3. April 2013: Bayard Closser, Vertical Capital Income Fund (VCAPX), “a closed-end interval fund, VCAPX invests in whole mortgage loans and first deeds of trust. We purchase the loans from lenders at a deep discount and service them ourselves.”
4. May 2013: Jim Hillary, LS Opportunity Fund (LSOFX), a co-founder of Marsico Capital Management whose worry that “the quality of research on Wall Street continues to decline and investors are becoming increasingly concerned about short-term performance” led to his faith in “in-depth research and long-term orientation in our high conviction ideas.”
5. July 2013: Casey Frazier, Versus Capital Multi-Manager Real Estate Income Fund (VCMRX), a second closed-end interval fund whose portfolio “includes real estate private equity and debt, public equity and debt, and broad exposure across asset types and geographies. We target a mix of 70% private real estate with 30% public real estate to enhance liquidity, and our objective is to produce total returns in the 7 – 9% range net of fees.”
6. August 2013: Brian Frank, Frank Value Fund (FRNKX), a truly all-cap value fund with a simple, successful discipline: if one part of the market is overpriced, shop elsewhere.
7. August 2013: Ian Mortimer and Matthew Page of Guinness Atkinson Inflation Managed Dividend (GAINX), a global equity fund that pursues firms with “sustainable and potentially rising dividends,” which also translates to firms with robust business models and consistently high return on capital.
8. September 2013: Steven Vannelli of GaveKal Knowledge Leaders (GAVAX), which looks to invest in “the best among global companies that are tapping a deep reservoir of intangible capital to generate earnings growth,” where “R&D, design, brand and channel” are markers of robust intangible capital. From launch through the end of June, 2013, the fund modestly outperformed the MSCI World Index and did so with two-thirds less volatility
9. October 2013: Bashar Qasem of Wise Capital (WISEX), which provides investors with an opportunity for global diversification in a fund category (short term bonds) mostly distinguished by bland uniformity.
10. November 2013: Jeffrey Ringdahl of American Beacon Flexible Bond (AFXAX) gives teams from Brandywine Global, GAM and PIMCO incredible leeway wth which to pursue “positive total return regardless of market conditions.” Since inception the fund has noticeably outrun its “nontraditional bond” peers with reasonable volatility.

Conference Call Highlights

On December 9^th, about 50 of us spent a rollicking hour with David Sherman of Cohanzick Asset Management, discussing his new fund: RiverPark Strategic Income Fund (RSIVX).  I’m always amazed at how excited folks can get about short-term bonds and dented credits.  It’s sort of contagious.

David’s first fund with RiverPark, the now-closed Short Term High Yield (RPHYX), was built around Cohanzick’s strategy for managing its excess cash.  Strategic Income represents their seminal, and core, strategy to fixed-income investing.  Before launching Cohanzick in 1996, David was a Vice President of Leucadia National Corporation, a holding company that might be thought of as a mini-Berkshire Hathaway. His responsibilities there included helping to manage a $3 billion investment portfolio which had an opportunistic distressed securities flair.  When he founded Cohanzick, Leucadia was his first client.  They entrusted him with $150 million, this was the strategy he used to invest it.

Rather than review the fund’s portfolio, which we cover in this month’s profile of it (below), we’ll highlight strategy and his response to listener questions.

The fund focuses on “money good” securities.  Those are securities where, if held to maturity, he’s confident that he’ll get his entire principal and all of the interest due to him.  They’re the sorts of securities where, if the issuer files for bankruptcy, he still anticipates eventually receiving his principal and interest plus interest on his interest.  Because he expects to be able to hold securities to maturity, he doesn’t care about “the taper” and its effects – he’ll simply hold on through any kerfuffle and benefit from regular payments that flow in much like an annuity stream.  These are, he says, bonds that he’d have his mother hold.

Given that David’s mother was one of the early investors in the fund, these are bonds his mother holds.  He joked that he serves as a sort of financial guarantor for her standard of living (if her portfolio doesn’t produce sufficient returns to cover her expenses, he has to reach for his checkbook), he’s very motivated to get this right.

While the fund might hold a variety of securities, they hold little international exposure and no emerging markets debt. They’re primarily invested in North American (77%) and European(14%)  corporate debt, in firms where the accounting is clear and nations where the laws are. The fund’s investment mandate is very flexible, so they can actively hedge portfolio positions (and might) and they can buy income-producing equities (but won’t).

The portfolio focuses on non-investment grade securities, mostly in the B – BB range, but that’s consistent with his intention not to lose his investors’ money. He values liquidity in his investments; that is to say, he doesn’t get into investments that he can’t quickly get out of.  The fund has been letting cash build, and it’s now about 30% of the portfolio.  David’s general preference is to get out too early and lose some potential returns, rather than linger too long and suffer the risk of permanent impairment.

There were rather more questions from callers than we had time to field.  Some of the points we did get to talk about:

David is not impressed with the values available in one- to three-year bonds, they’ve been subject to too much buying by the anxious herd.  He’s currently finding better values in three- to five-year bonds, especially those which are not included in the major bond indexes.  There is, he says, “a lot of high yield value outside of indexed issues.”

About 50% of the corporate bond market qualifies as “high yield,” which gives him lots of opportunities.

This could function as one’s core bond portfolio.  While there will be more NAV volatility because of mark-to-market rules (that is, you have to ask “what would I get if I stupidly decided to sell my entire portfolio in the midst of a particular day’s market panic”), the risk of permanent impairment of capital occurs only if he’s made a mistake.

Munis are a possibility, but they’re not currently cheap enough to be attractive.

If there’s a limited supply of a security that would be appropriate for both Short-Term and here, Short-Term gets dibs.

Cohanzick is really good at pricing their portfolio securities.  At one level, they use an independent pricing service.  At another, getting the price right has been a central discipline since the firm’s founding and he’s comfortable with his ability to do so even with relatively illiquid names.

At base, David believes the fund can generate returns in the 7-8% range with minimal risk of capital loss.  Given his record with Cohanzick and RPHYX, we are confident that he’s capable of delivering on that promise.  By way of full disclosure: In aligning our mouths and our money, both Chip and I added RSIVX to our personal portfolios this fall.  Once we work out all of the Observer’s year-end finances, we also intend to transfer a portion of the money now in MFO’s credit union savings account into an investment in this fund.

For folks interested but unable to join us, here’s the complete audio of the hour-long conversation.

The RSIVX conference call

As with all of these funds, we’ve created a new featured funds page for the RiverPark Strategic Income Fund, pulling together all of the best resources we have for the fund.

January Conference Call: Matt Moran, ASTON River Road Long/Short

Last winter we spent time talking with the managers of really promising hedged funds, including a couple who joined us on conference calls.  The fund that best matched my own predilections was ASTON River Road Long/Short (ARLSX), extensive details on which appear on our ARLSX Featured Fund Page.   In our December 2012 call, manager Matt Moran argued that:

1. The fund might outperform the stock market by 200 bps/year over a full, 3-5 year market cycle.
2. The fund can maintain a beta at 0.3 to 0.5, in part because of their systematic Drawdown Plan.
3. Risk management is more important than return management, so all three of their disciplines are risk-tuned.

I was sufficiently impressed that I chose to invest in the fund.  That does not say that we believe this is “the best” long/short fund (an entirely pointless designation), just that it’s the fund that best matched my own concerns and interests.  The fund returned 18% in 2013, placing it in the top third of all long/short funds.

Matt and co-manager Dan Johnson have agreed to join us for a second conversation.  That call is scheduled for Wednesday, January 15, from 7:00 – 8:00 Eastern.  Please note that this is one day later than our original announcement. Matt has been kicking around ideas for what he’d like to talk about.  His short-list includes:

• How we think about our performance in 2013 and, in particular, why we’re satisfied with it given our three mandates (equity-like returns, reduced volatility, capital preservation)
• Where we are finding value on the long side.  It’s a struggle…
• How we’re surviving on the short side.  It’s a huge challenge.  Really, how many marginal businesses can keep hanging on because of the Fed’s historic generosity?  Stocks must ultimately earn what underlying business earns and a slug of these firms are earning …
• But, too, our desire not to be carried out in body bags on short side.
• The fact that we sleep better at night with Drawdown Plan in place.  

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. 

For those of you new to our conference calls, here’s the short version: we set up an audio-only phone conversation, you register and receive an 800-number and a PIN, our guest talks for about 20 minutes on his fund’s genesis and strategy, I ask questions for about 20, and then our listeners get to chime in with questions of their own.  A couple days later we post an .mp3 of the call and highlights of the conversation. 

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.

February Conference Call: Joshua B. Parker and Alan Salzbank, RiverPark / Gargoyle Hedged Value

We extend our conversation with hedged fund managers in a conversation with Messrs. Parker and Salzbank, whose RiverPark / Gargoyle Hedged Value (RGHVX) we profiled last June, but with whom we’ve never spoken. 

Gargoyle is a converted hedge fund.  The hedge fund launched in 1999 and the strategy was converted to a mutual fund on April 30, 2012.  Rather than shorting stocks, the strategy is to hold a diversified portfolio mid- to large-cap value stocks, mostly domestic, and to hedge part of the stock market risk by selling a blend of index call options. That value focus is both distinctive and sensible; the strategy’s stock portfolio has outperformed the S&P500 by 4.5% per year over the past 23 years. The options overlay generates 1.5 – 2% in premium income per month. The fund ended 2013 with a 29% gain, which beat 88% of its long/short peers.

That call is scheduled for Wednesday, February 12, from 7:00 – 8:00 Eastern.  We’ll provide additional details in our February issue.  

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.

Launch Alert: Vanguard Global Minimum Volatility Fund (VMVFX)

Vanguard Global Minimum Volatility Fund (VMVFX) launched on December 12, 2013.  It’s Vanguard’s answer to the craze for “smart beta,” a strategy that seemingly promises both higher returns and lower risk over time.  Vanguard dismisses the possibility with terms like “new-age investment alchemy,” and promise instead to provide reasonable returns with lower risk than an equity investor would otherwise be subject to.  They are, they say, “trying to deliver broadly diversified exposure to the equity asset class, with lower average volatility over time than the market. We will use quantitative models to assess the expected volatility of stocks and correlation to one another.”  They also intend to hedge currency risk in order to further dampen volatility. 

Most portfolios are constructed with an eye to maximizing returns within a set of secondary constraints (for example, market cap).  Volatility is then a sort of fallout from the system.  Vanguard reverses the process here by working to minimize the volatility of an all-equity portfolio within a set of secondary constraints dealing with diversification and liquidity.  Returns are then a sort of fallout from the design.  Vanguard recently explained the fund’s distinctiveness in Our new fund offering: What it is and what it isn’t.

The fund will be managed by James D. Troyer, James P. Stetler, and Michael R. Roach.  They are members of the management teams for about a dozen other Vanguard funds.

The Investor share class has a $3,000 minimum initial investment.  The opening expense ratio is 0.30%.

MFS made its first foray into low-volatility investing this month, launching MFS Low Volatility Equity (MLVAX) and MFS Low Volatility Global Equity (MVGAX) just one week before Vanguard. The former will target a volatility level that is 20% lower than that of the S&P 500 Index over a full market cycle, while the latter will target 30% less volatility than the MSCI All Country World Index.  The MFS funds charge about four times what Vanguard does.

Launch Alert II: Meridian Small Cap Growth Advisor (MSGAX)

Meridian Small Cap Growth Fund launched on December 16^th.  The prospectus says very little about what the managers will be doing: “The portfolio managers apply a ‘bottom up’ fundamental research process in selecting investments. In other words, the portfolio managers analyze individual companies to determine if a company presents an attractive investment opportunity and if it is consistent with the Fund’s investment strategies and policies.”

Nevertheless, the fund warrants – and will receive – considerable attention because of the pedigree of its managers.  Chad Meade and Brian Schaub managed Janus Triton (JATTX) together from 2006 – May 2013.  During their tenure, they managed to turn an initial $10,000 investment into $21,400 by the time they departed; their peers would have parlayed $10,000 into just over $14,000.  The more remarkable fact is that the managed it with a low turnover (39%, half the group average), relatively low risk (beta = .80, S.D. about 3 points below their peers) strategy.  Understandably, the fund’s assets soared to $6 billion and it morphed from focused on small caps to slightly larger names.  Regrettably, Janus decided that wasn’t grounds for closing the fund.

Messrs Meade and Schaub joined Arrowpoint Partners in May 2013.  Arrowpoint famously is the home of a cadre of Janus alumni (or escapees, depending):  David Corkins, Karen Reidy, Tony Yao, Minyoung Sohn and Rick Grove.  Together they managed over $2 billion.  In June, they purchased Aster Investment Management, advisor to the Meridian funds, adding nearly $3 billion more in assets.  We’ll reach out to the Arrowpoint folks early in the new year.

The Advisor share class is available no-load and NTF through brokerages like Scottrade, with a $2,500 minimum initial investment.  The opening expense ratio is 1.60%.

Funds in Registration

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

Funds in registration this month are eligible to launch in March, 2014 and some of the prospectuses do highlight that date.

And there were a lot of funds targeting a year-end launch. Every day David Welsch, firefighter/EMT/fund researcher, scours new SEC filings to see what opportunities might be about to present themselves. This month he tracked down 15 no-load retail funds in registration, which represents our core interest. That number is down from what we’d normally see because these funds won’t launch until February 2014; whenever possible, firms prefer to launch by December 30^th and so force a lot of funds into the pipeline in October.

Interesting entries this month include:

Artisan High Income Fund will invest in high yield corporate bonds and debt.  There are two major distinctions here.  First, it is Artisan’s first fixed-income fund.  Second, Artisan has always claimed that they’re only willing to hire managers who will be “category-killers.”  If you look at Artisan’s returns, you’ll get a sense of how very good they are at that task.  Their new high-yield manager, and eventual head of a new, autonomous high-yield team, is Bryan C. Krug who ran the $10 billion, five star Ivy High Income Fund (WHIYX) for the past seven years.  The minimum initial investment will be $1000 for Investor shares and $250,000 for Advisor shares.  The initial expense ratio will be 1.25% for both Investor and Advisor shares.

Brown Advisory Japan Alpha Opportunities Fund will pursue total return by investing principally in Japanese stocks.  The fund will be constructed around a series of distinct “sleeves,” each with its own distinct risk profile but they don’t explain what they might be. They may invest in common and preferred stock, futures, convertibles, options, ADRs and GDR, REITs and ETFs.  While they advertise an all-cap portfolio, they do flag small cap and EM risks.  The fund will be managed by a team from Wellington Management.  The minimum initial investment will be $5000.  The initial expense ratio will be 1.36%. 

Perritt Low Priced Stock Fund will pursue long-term capital appreciation by investing in small cap stocks priced at $15 or less.  I’m a bit ambivalent but could be talked into liking it.  The lead manager also runs Perritt Microcap (PRCGX) and Ultra MicroCap (PREOX), both of which are very solid funds with good risk profiles.  Doubtless he can do it here.  That said, the whole “under $15” thing strikes me as a marketing ploy and a modestly regrettable one. What benefit does that stipulation really offer the investors?  The minimum initial investment will be $1000, reduced to $250 for all sorts of good reasons, and the initial expense ratio will be 1.5%. 

Manager Changes

On a related note, we also tracked down 40 fund manager changes.  The most intriguing of those include what appears to be the abrupt dismissal of Ken Feinberg, one of the longest-serving managers in the Davis/Selected Funds, and PIMCO’s decision to add to Bill Gross’s workload by having him fill in for a manager on sabbatical.

Updates

There are really very few emerging markets investors which whom I’d trust my money.  Robert Gardiner and Andrew Foster are at the top of the list.  There are notable updates on both this month.

Grandeur Peak Emerging Opportunities (GPEOX) launched two weeks ago, hasn’t released a word about its portfolio, has earned one half of one percent for its investors . . . and has drawn nearly $100 million in assets.  Mr. Gardiner and company have a long-established plan to close the fund at $200 million.  I’d encourage interested parties to (quickly!) read our review of Grandeur Peak’s flagship Global Reach fund.  If you’re interested in a reasonably assertive, small- to mid-cap fund, you may have just a few weeks to establish your account before the fund closes.  The advisor does not intend to market the fund to the general public until February 1, by which time it might well be at capacity.

Investors understandably assume that an e.m. small cap fund is necessarily, and probably substantially, riskier than a more-diversified e.m. fund. That assumption might be faulty. By most measures (standard deviation and beta, for example) it’s about 15% more volatile than the average e.m. fund, but part of that volatility is on the upside. In the past five years, emerging markets equities have fallen in six of 20 quarters.   We can look at the performance of DFA’s semi-passive Emerging Markets Small Cap Fund (DEMSX) to gauge the downside of these funds. 

The same pattern is demonstrated by Templeton E.M. Small Cap (TEMMX): higher beta but surprising resilience in declining quarters.  For aggressive investors, a $2,000 foot-in-the-door position might well represent a rational balance between the need for more information and the desire to maintain their options.

Happily, there’s an entirely-excellent alternative to GPEOX and it’s not (yet) near closing to new investors.

Seafarer Overseas Growth & Income (SFGIX and SIGIX) is beginning to draw well-earned attention. Seafarer offers a particularly risk-conscious approach to emerging markets investing.  It offers a compact (40 names), all-cap portfolio (20% in small- and microcap names and 28% in mid-caps, both vastly higher than its peers) that includes both firms domiciled in the emerging markets (about 70%) and those headquartered in the developing world but profiting from the emerging one (30%). It finished 2013 up 5.5%, which puts it in the top tier of all emerging markets funds. 

That’s consistent with both manager Andrew Foster’s record at his former charge (Matthews Asian Growth & Income MACSX which was one of the two top Asian funds in existence through his time there) and Seafarer’s record since launch (it has returned 20% since February 2012 while its average peer made less than 4%). Assets had been growing briskly through the fund’s first full year, plateaued for much of 2013 then popped in December: the fund moved from about $40 million in AUM to $55 million in a very short period. That presumably signals a rising recognition of Seafarer’s strength among larger investors, which strikes me as a very good thing for both Seafarer and the investors.

On an unrelated note, Oakseed Opportunity (SEEDX) has added master limited partnerships to its list of investable securities. The guys continue negotiating distribution arrangements; the fund became available on the Fidelity platform in the second week of December, 2013. They were already available through Schwab, Scottrade, TDAmeritrade and Vanguard.

Briefly Noted . . .

The Gold Bullion Strategy Fund (QGLDX) has added a redemption fee of 2.00% for shares sold within seven days of purchase because, really, how could you consider yourself a long-term investor if you’re not willing to hold for at least eight days?

Legg Mason Capital Management Special Investment Trust (LMSAX) will transition from being a small- and mid-cap fund to a small cap and special situations fund. The advisor warns that this will involve an abnormal turnover in the portfolio and higher-than-usual capital gains distributions. The fund has beaten its peers precisely twice in the past decade, cratered in 2007-09, got a new manager in 2011 and has ascended to … uh, mediocrity since then. Apparently “unstable” and “mediocre” is sufficient to justify someone’s decision to keep $750 million in the fund. 

PIMCO’s RealRetirement funds just got a bit more aggressive. In an SEC filing on December 30, PIMCO shifted the target asset allocations to increase equity exposure and decrease real estate, commodities and fixed income.  Here’s the allocation for an individual with 40 years until retirement

Real estate and commodities are an inflation hedge (that’s the “real” part of RealRetirement) and PIMCO’s commitment to them has been (1) unusually high and (2) unusually detrimental to performance.

SMALL WINS FOR INVESTORS

Effective January 2, 2014, BlackRock U.S. Opportunities Portfolio (BMEAX) reopened to new investors. Skeptics might note that the fund is large ($1.6 billion), overpriced (1.47%) and under-performing (having trailed its peers in four of the past five years), which makes its renewed availability a distinctly small win.

Speaking of “small wins,” the Board of Trustees of Buffalo Funds has approved a series of management fees breakpoints for the very solid Buffalo Small Cap Fund (BUFSX).  The fund, with remains open to new investors despite having nearly $4 billion in assets, currently pays a 1.0% management fee to its advisor.  Under the new arrangement, the fee drops by five basis points for assets from $6 to $7 billion, another five for assets from $7-8 and $8-9 then it levels out at 80 bps for assets over $9 billion.  Those gains are fairly minor (the net fee on the fund at $7 billion is $69.5 million under the new arrangement versus $70 million under the old) and the implication that the fund might remain open as it swells is worrisome.

Effective January 1, 2014, Polaris Global Value Fund (PGVFX) has agreed to cap operating expenses at 0.99%.  Polaris, a four-star fund with a quarter billion in assets, currently charges 1.39% so the drop will be substantial. 

The investment minimum for Institutional Class shares of Yacktman Focused Fund (YAFFX) has dropped from $1,000,000 to $100,000.

Vanguard High-Yield Corporate Fund (VWEHX) has reopened to new investors.  Wellington Management, the fund’s advisor, reports that  “Cash flow to the fund has subsided, which, along with a change in market conditions, has enabled us to reopen the fund.”

CLOSINGS (and related inconveniences)

Driehaus Select Credit Fund (DRSLX) will close to most new investors on January 31, 2014. The strategy capacity is about $1.5 billion and the fund already holds $1 billion, with more flowing in, so they decided to close it just as they closed its sibling, Driehaus Active Income (LCMAX). You might think of it as a high-conviction, high-volatility fixed income hedge fund.

Hotchkis & Wiley Mid-Cap Value (HWMIX) is slated to close to new investors on March 1, 2014. Ted, our board’s most senior member, opines “Top notch MCV fund, 2.8 Billion in assets, and superior returns.”  I nod.

Sequoia (SEQUX) closed to new investors on December 10^th. Their last closure lasted 25 years.

Vanguard Capital Opportunity Fund (VHCOX), managed by PRIMECAP Management Company, has closed again. It closed in 2004, opened the door a crack in 2007 and fully reopened in 2009.  Apparently the $2 billion in new assets generated a sense of concern, prompting the reclosure.

OLD WINE, NEW BOTTLES

Aberdeen Diversified Income Fund (GMAAX), a tiny fund distinguished more for volatility than for great returns, can now invest in closed-end funds.  Two other Aberdeen funds, Dynamic Allocation (GMMAX) and Diversified Alternatives (GASAX), are also now permitted  to invest, to a limited extent, in “certain direct investments” and so if you’ve always wanted exposure to certain direct investments (as opposed to uncertain ones), they’ve got the funds for you.

American Independence Core Plus Fund (IBFSX) has changed its name to the American Independence Boyd Watterson Core Plus Fund, presumably in the hope that the Boyd Watterson name will work marketing magic.  Not entirely sure why that would be the case, but there it is.

Effective December 31, 2013, FAMCO MLP & Energy Income Fund became Advisory Research MLP & Energy Income Fund. Oddly, the announcement lists two separate “A” shares with two separate ticker symbols (INFIX and INFRX).

In February Compass EMP Long/Short Fixed Income Fund (CBHAX) gets rechristened Compass EMP Market Neutral Income Fund and it will no longer be required to invest at least 80% in fixed income securities.  The change likely reflects the fact that the fund is underwater since its November 2013 inception (its late December NAV was $9.67) and no one cares (AUM is $28 million).

In yet another test of my assertion that giving yourself an obscure and nonsensical name is a bad way to build a following (think “Artio”), ING reiterated its plan to rebrand itself as Voya Financial.  The name change will roll out over the first half of 2014.

As of early December, Gabelli Value Fund became Gabelli Value 25 Fund (GABVX). And no, it does not hold 25 stocks (the portfolio has nearly 200 names).  Here’s their explanation: “The name change highlights the Fund’s overweighting of its core 25 equity positions and underscores the upcoming 25^th anniversary of the Fund’s inception.” And yes, that does strike me as something that The Mario came up with and no one dared contradict.

GMO, as part of a far larger fund shakeup (see below), has renamed and repurposed four of its institutional funds.  GMO International Core Equity Fund becomes GMO International Large/Mid Cap Equity Fund, GMO International Intrinsic Value Fund becomes GMO International Equity Fund, GMO International Opportunities Equity Allocation Fund becomes GMO International Developed Equity Allocation Fund, and GMO World Opportunities Equity Allocation Fund morphs (slightly) into GMO Global Developed Equity Allocation Fund, all on February 12, 2014. Most of the funds tweaked their investment strategy statements to comply with the SEC’s naming rules which say that if you have a distinct asset class in your name (large/midcap equity), you need to have at least 80% of your portfolio in that class. 

Effective February 28, MainStay Intermediate Term Bond Fund (MTMAX) becomes MainStay Total Return Bond Fund.

Nuveen NWQ Flexible Income Fund (NWQIX), formerly Nuveen NWQ Equity Income Fund has been rechristened as Nuveen NWQ Global Equity Income Fund, with James Stephenson serving as its sole manager.  If you’d like to get a sense of what “survivorship bias” looks like, you might check out Nuveen’s SEC distributions filing and count the number of funds with lines through their names.

Old Westbury Global Small & Mid Cap Fund (OWSMX) has been rechristened as Old Westbury Small & Mid Cap Fund. It’s no longer required to have a global portfolio, but might.  It’s been very solid, with about 20% of its portfolio in ETFs and the rest in individual securities.

At the meeting on December 3, 2013, the Board approved a change in Old Westbury Global Opportunities Fund’s (OWGOX) name to Old Westbury Strategic Opportunities Fund.  Let’s see: 13 managers, $6 billion in assets, and a long-term record that trails 70% of its peers.  Yep, a name change is just what’s needed!

OFF TO THE DUSTBIN OF HISTORY

Jeez, The Shadow is just a wild man here.

On December 6, 2013, the Board of the Conestoga Funds decided to close and liquidate the Conestoga Mid Cap Fund (CCMGX), effective February 28, 2014.  At the same time, they’re launched a SMid cap fund with the same management team.  I wrote the advisor to ask why this isn’t just a scam to bury a bad track record and get a re-do; they could, more easily, just have amended Mid Cap’s principal investment strategy to encompass small caps and called it SMid Cap.  They volunteered to talk then reconsidered, suggesting that they’d be freer to walk me through their decision once the new fund is up and running. I’m looking forward to the opportunity.

Dynamic Energy Income Fund (DWEIS), one of the suite of former DundeeWealth funds, was liquidated on December 31, 2013.

Fidelity has finalized plans for the merger of Fidelity Europe Capital Appreciation Fund (FECAX) into Fidelity Europe Fund (FIEUX), which occurs on March 21.

The institutional firm Grantham, Mayo, van Otterloo (GMO) is not known for precipitous action, so their December announcement of a dozen fund closures is striking.  One set of funds is simply slated to disappear:

In addition, the Board has approved the termination of GMO Asset Allocation International Small Companies Fund and GMO International Large/Mid Cap Value Fund, neither of which had commenced operations.

They then added two sets of fund mergers: GMO Debt Opportunities Fund into GMO Short-Duration Collateral Fund (with the freakish coda that “GMO Short-Duration Collateral Fund is not pursuing an active investment program and is gradually liquidating its portfolio” but absorbing Debt Opportunities gives it reason to live) and GMO U.S. Flexible Equities Fund into GMO U.S. Core Equity Fund, which is expected to occur on or about January 24, 2014.

Not to be outdone, The Hartford Mutual Funds announced ten fund mergers and closures themselves.  Hartford Growth Fund (HGWAX) is merging with Hartford Growth Opportunities Fund (HGOAX), Hartford Global Growth (HALAX) merges with Hartford Capital Appreciation II (HCTAX) and Hartford Value (HVFAX) goes into Hartford Value Opportunities (HV)AX), all effective April 7, 2014. None of which, they note, requires shareholder approval. I have real trouble seeing any upside for the funds’ investors, since most going from one sub-par fund into another and will see expenses drop by just a few basis points. The exceptions are the value funds, both of which are solid and economically viable on their own. In addition, Hartford is pulling the plug on its entire target-date retirement line-up. The funds slated for liquidation are Hartford Target Retirement 2010 through 2050. That dirty deed will be done on June 30, 2014. 

Highbridge Dynamic Commodities Strategy Fund (HDSAX) is slated to be liquidated and dissolved (an interesting visual image) on February 7, 2014. In the interim, it’s going to cash.

John Hancock Sovereign Investors Fund (SOVIX) will merge into John Hancock Large Cap Equity Fund (TAGRX), on or about April 30, 2014.

Principal SmallCap Growth Fund II (PPMIX) will be absorbed by SmallCap Growth Fund I (PGRTX) on or about April 25, 2014.

It’s with some sadness that we bid adieu to Tom Kerr and his Rocky Peak Small Cap Value Fund (RPCSX), which liquidated on December 30.  The fund sagged from “tiny” to “microscopic” by the end of its run, with under a million in assets.  Its performance in 2013 was pretty much calamitous, which was both curious and fatal.  Tom was an experienced manager and sensible guy who will, we hope, find a satisfying path forward. 

In a sort of three-for-one swap, Pax World International Fund (PXIRX) and Pax MSCI EAFE ESG Index ETF (EAPS) are merging to form the Pax World International ESG Index Fund.

On October 21, 2013, the Board of Directors of the T. Rowe Price Summit GNMA Fund (PRSUX) approved a proposed merger with, and into, T. Rowe Price GNMA Fund (PRGMX).

The Vanguard Managed Payout Growth Focus Fund (VPGFX) and Vanguard Managed Payout Distribution Focus Fund (VPDFX) are each to be reorganized into the Vanguard Managed Payout Growth and Distribution Fund (VPGDX) on or about January 17, 2014.

W.P. Stewart & Co. Growth Fund (WPSGX) is merging into the AllianceBernstein Concentrated Growth Fund (WPCSX), which has the same manager, investment discipline and expenses of the WPS fund.  Alliance acquired WPS in December, so the merger was a sort of foregone conclusion.

Wegener Adaptive Growth Fund (WAGFX) decided, on about three days’ notice, to close and liquidate at the end of December, 2013.  It had a couple very solid years (2008 and 2009) then went into the dumper, ending with a portfolio smaller than my retirement account.

A small change

Our navigation menu is growing. If you look along the top of our page, you’ll likely notice that “Featured Funds” is no longer a top-level menu item. Instead the “Featured Funds” category can now be found under the “Fund” or “The Best” menus. Replacing it as a new top-level menu is “Search Tools”, which is the easiest way to directly access new search functionality that Accipiter, Charles, and Chip have been working on for the past few months.

Under Search Tools, you’ll find:

1. Risk Profile – designed to help you understand the different measures of a fund’s risk profile. No one measure of risk captures the full picture and most measures of risk are not self-explanatory. Our Risk Profile reporter allows you to enter a single ticker symbol for any fund and it will generate a short, clear report, in simple, conversational English, that walks you through the various means of risk and returns and will provide you with the profiles for a whole range of possible benchmarks. Alternatively, entering multiple ticker symbols will return a tabular results page, making side-by-side comparisons more convenient.
2. Great Owls – allows you to screen our Great Owl Funds – those which have top tier performance in every trailing period of three years or more – by category or profile. We know that past performance should never be the primary driver of your decision-making, but working from a pool of consistently superior performers and learning more about their risk-return profile strikes us as a sensible place to start.
3. Fund Dashboard – a snapshot of all of the funds we’ve profiled, is updated monthly and is available both as a .pdf and as a searchable and sortable search.
4. Miraculous Multi-Search – Accipiter’s newest screening tool helps us search Charles’ database of risk elements. Searches are available by fund name, category, risk group and age group. There’s even an option to restrict the results to GreatOwl funds. Better yet, you can search on multiple criteria and further refine your results list by choosing to hide certain results.

In Closing . . .

Thank you, dear friends.  It’s been a remarkable year.  In December of 2012, we served 9000 readers.  A year later, 24,500 readers made 57,000 visits to the Observer in December – a gain of 150%.  The amount of time readers spend on site is up, too, by about 50% over last year.  The percentage of new visitors is up 57%.  But almost 70% of visits are by returning readers.

It’s all the more striking because we’re the antithesis of a modern news site: our pieces tend to be long, appear once a month and try to be reflective and intelligent.  NPR had a nice piece that lamented the pressure to be “first, loud and sensational” (This is (not) the most important story of the year, 12/29/2013).  The “reflective and intelligent” part sort of reflects our mental image of who you are. 

We’ve often reminded folks of their ability to help the Observer financially, either through our partnership with Amazon (they rebate us about 7% of the value of items purchased through our link) or direct contributions.  Those are both essential and we’re deeply grateful to the dozens of folks who’ve acted on our behalf.  This month we’d like to ask for a different sort of support, one which might help us make the Observer better in the months ahead.

Would you tell us a bit about who you are and why you’re here?  We do not collect any information about you when you visit. The cosmically-talented Chip found a way to embed an anonymous survey directly in this essay, so that you could answer a few questions without ever leaving the comfort of your chair.  What follows are six quick questions.  We’re setting aside questions about our discussion board for now, since it’s been pretty easy to keep in touch with the folks there.  Complete as many as you’re comfortable with.

We’ll share as soon as we hear back from you.

Thanks to Deb (the first person ever to set up an automatic monthly contribution to the site, which was really startling when we found out), to David and the other contributors scattered (mostly) in warm states (and Indianapolis), and to friends who’ve shared books, cookies, well-wishes and holiday cheer.

Finally, thanks to the folks whose constant presence makes the Observer happen: the folks who’ve spent this entire century supporting the discussion board (BobC, glampig, rono, Slick, the indefatigable Ted, and Whakamole among them) and the hundred or so folks regularly on the board; The Shadow, who can sense the presence of interesting SEC filings from a mile away; Accipiter, whose programming skills – generally self-taught – lie behind our fund searches; Ed, who puzzles and grumbles; Charles, who makes data sing; and the irreplaceable Chip, friend, partner and magician.  I’m grateful to you all and look forward to the adventures of the year ahead.

As ever,

Dear friends,

Occasionally Facebook produces finds that I’m at a loss to explain.  Ecce:

(Thanks to Nina K., a really first-rate writer and first-rate property/insurance lawyer in the Bay State for sharing Mr. Takei’s post with us. Now if I could just get her to restrain the impulse to blurt out, incredulous, “you really find this stuff interesting?”)

Let’s see.  Should I be more curious about the fact that Mr. Takei (iconically Ensign Sulu on Star Trek) manages just a basso profundo “oh myyy” on his post or the fact that he was recently lounging in a waiting room at the University of Iowa Hospitals, a bit west of here?  Perhaps it would be better to let his friends weigh in?

Chip’s vote was to simply swipe her favorite image from the thread, one labeled “a real hedge fund.”

Which is to say, a market that tacks on 29% in a year makes it easy to think of investing as fun and funny again. 

Now if only that popular sentiment could be reconciled with the fact that a bunch of very disciplined, very successful managers are quietly selling down their stocks and building their cash reserves again.

Here’s today’s “know your Morningstar!” quiz.  

Here are the total return charts for two short-term bond funds.  One is the sole Morningstar Gold Medalist in the group, representing “one of the industry’s best managers, and one of the category’s best funds.”  The other is a lowly one-star fund unworthy of Morningstar’s notice 

Question: do you …know your Morningstar!?  Which is the golden child?  Is it blue or orange?

Would it help to know that one of these funds is managed by a multi-trillion dollar titan and the other by a small, distinctive boutique?  Or that one of the funds invests quite conventionally and fits neatly into a style-box while the other is one-of-a-kind?

If you know your Morningstar, you’ll know that “small, distinctive and hard to pigeonhole” is pretty much the kiss of death.  The orange (or gold) line represents PIMCO Low Duration, “D” shares (PLDDX).  It’s a $24 billion “juggernaut” (Morningstar’s term) that’s earned four stars and a Gold designation.  It tends to be in the top quarter of the short-term bond group, though not at its top, and is a bit riskier than average.

The blue line represents RiverPark Short Term High Yield (RPHYX), an absolutely first-rate cash management fund about which we’ve written a lot. And which Morningstar just designated as a one-star fund. Why so?  Because Morningstar classifies it as a “high yield bond” fund and benchmarks it against an investment class that has outperformed the stock market over the past 15 years but with the highest volatility in the fixed-income universe. To be clear: there is essentially no overlap between RiverPark’s portfolio and the average high-yield bond funds and they have entirely different strategies, objectives and risk profiles. Which is to say, Morningstar has managed a classic “walnuts to lug nuts” comparison.

Here’s the defense Morningstar might reasonably make: “we had to put it somewhere.  It says ‘high yield.’  We put it there.”

Here’s our response: “that’s a sad and self-damning answer.  Yes, you had to put it somewhere.  But having put it in a place that you know is wildly inappropriate, you also need to accept the responsibility – to your readers, to RiverPark’s investors and to yourselves – to address your decision.  You’ve got the world’s biggest and best supported corps of analysts in the world. Use them! Don’t ignore the funds that do well outside of the comfortable framework of style boxes, categories and corporate investing! If the algorithms produce palpably misleading ratings, speak up.”

But, of course, they didn’t.

The problem is straightforward: Morningstar’s ratings are most reliable when you least need them. For funds with conventional, straightforward, style-pure disciplines – index funds and closet index funds – the star ratings probably produce a fair snapshot across the funds. But really, how hard is it – even absent Morningstar’s imprimatur – to find the most solid offering among a gaggle of long-only, domestic large cap, growth-at-a-reasonable price funds? You’ll get 90% of the way there with three numbers: five year returns, five year volatility and expense ratio. Look for ones where the first is higher and the second two are lower.

When funds try not to follow the herd, when the manager appears to have a brain and to be using it to pursue different possibilities, is when the ratings system is most prone to misleading readers. That’s when you need to hear an expert’s analysis. 

So why, then, deploy your analysts to write endless prose about domestic large cap funds? Because that’s where the money is.

Morningstar ETF Invest: Rather less useful content than I’d imagined

Morningstar hosted their ETF-focused conference in Chicago at the beginning of October.  The folks report that the gathering has tripled in size over the last couple years, turned away potential registrants and will soon need to move to a new space.  After three days there, though, I came away with few strong reactions.  I was struck by the decision of one keynote speaker to refer to active fixed-income managers as “the enemy” (no, dude, check the mirror) and the apparent anxiety around Fidelity’s decision to enter the ETF market (“Fidelity is coming.  We know they’re coming.  It’s only a matter of time,” warned one).

My greatest bewilderment was at the industry’s apparent insistence on damaging themselves as quickly and thoroughly as possible.  ETFs really have, at most, three advantages: they’re cheap, transparent and liquid.  The vogue seems to be for frittering that away.  More and more advisors are being persuaded to purchase the services of managed portfolio advisors who, for a fee, promise to custom-package (and trade) dozens of ETFs.  I spoke with representatives of a couple index providers, including FTSE, who corroborated Morningstar’s assertion that there are likely two million separate security indexes in operation with more being created daily. And many of the exchange-traded products rely in derivatives to try to capture the movements of those 2,000,000.  On whole, it feels like a systematic attempt to capture the most troubling features of the mutual fund industry – all while preening about your Olympian superiority to the mutual fund industry.

Odd.

The most interesting presentation at the conference was made by Austan Goolsbee, a University of Chicago economist and former chief of the President’s Council of Economic Advisers, who addressed a luncheon crowd. It was a thoroughly unexpected performance: there’s a strong overtone of Jon Stewart from The Daily Show, an almost antic energy. The presentation was one-third Goolsbee family anecdotes (“when I’d complain about a problem, gramma would say ‘80% of us don’t care. . . and the other 20% are glad about it'”), one-third White House anecdotes and one-third economic arguments.

The short version:

• The next 12-18 months will be tough because the old drivers of recovery aren’t available this time. Over the last century, house prices appreciated by 40 basis points annually for the first 90 years. From 2000-08, it appreciated 1350 bps annually. In the future, 40 bps is likely about right which means that a recovery in the housing industry won’t be lifting all boats any time soon.
• We’ll know the economy is recovering when 25 year olds start moving out of their parents’ basements, renting little apartments, buying futons and cheap pots and pans. (Technically, an uptick in household formation. Since the beginning of the recession, the US population has grown by 10 million but the number of households has remained flat.) One optimistic measure that Goolsbee did not mention but which seems comparable: the number of Americans choosing to quit their jobs (presumably for something better) is rising.
• The shutdown is probably a good thing, since it will derail efforts to create an unnecessary crisis around the debt ceiling.
• In the longer term, the US will recover and grow at 3.5% annually, driven by a population that’s growing (we’ll likely peak around 400 million while Japan, Western Europe and Russia contract), the world’s most productive workforce and relatively light taxation. While Social Security faces challenges, they’re manageable. Given the slow rolling crisis in higher education and the near collapse of new business launches over the past decade, I’m actually somewhere between skeptical and queasy on this one.
• The Chinese economic numbers can’t be trusted at all. The US reports quarterly economic data after a 30 day lag and frequently revises the numbers 30 days after that. China reports their quarterly numbers one day after the end of the quarter and has never revised any of the numbers. A better measure of Chinese activity is derivable from FedEx volume (it’s way down) since China is so export driven.

One highlight was his report of a headline from The Onion: “recession-plagued nation demands a new bubble to invest in … so we can get the economy going again. We need a concrete way to create illusory wealth in the near future.”

One of the great things about having Messrs Studzinski and Boccadoro contributing to the Observer is that they’re keen, experienced observers and very good writers.  The other great thing about it is that I no longer have to bear the label, “the cranky one.” In the following essay, Ed Studzinkski takes on one of the beloved touchstones of shareholder-friendly management: “skin in the game.”  Further down, Charles Boccadoro casts a skeptical eye, in a data-rich piece, on the likelihood that an investor’s going to avoid permanent loss of capital.

Skin in the Game, Part Two

The trouble with our times is that the future is not what it used to be.

Paul Valery

Nassim Nicholas Taleb, the author of The Black Swan as well as Antifragile: Things That Gain from Disorder, has recently been giving a series of interviews in which he argues that current investment industry compensation practices lead to subtle conflicts of interest, that end up inuring to the disadvantage of individual investors. Nowhere is this more apparent than when one looks at the mutual fund complexes that have become asset gatherers rather than investment managers.

By way of full disclosure I have to tell you that I am an admirer of Mr. Taleb’s. I was not always the most popular boy in the classroom as I was always worrying about the need to consider the potential for “Black Swan” or outlier events. Unfortunately all one has to have is one investment massacre like the 2008-2009 period. This gave investors a lost decade of investment returns and a potentially permanent loss of capital if they panicked and liquidated their investments. To have a more in-depth appreciation of the concept and its implications, I commend those of you with the time to a careful study of the data that the Mutual Fund Observer has compiled and begun releasing regularly. You should pay particular attention to a number called the “Maximum Drawdown.” There you will see that as a result of that dark period, looking back five years it is a rarity to find a domestic fund manager who did not lose 35-50% of his or her investors’ money. The same is to be said for global and international fund managers who likewise did not distinguish themselves, losing 50-65% of investors’ capital, assuming the investors panicked and liquidated their investments, and many did.

A number of investment managers that I know are not fans of Mr. Taleb’s work, primarily because he has a habit of bringing attention to inconvenient truths. In Fooled by Randomness, he made the case that given the large number of people who had come into the investment management business in recent years, there were a number who had to have generated good records randomly. They were what he calls “spurious winners.” I would argue that the maximum drawdown numbers referred to above confirm that thesis.

How then to avoid the spurious winner? Taleb argues that the hedge fund industry serves as a model, by truly having managers with “skin in the game.” In his experience a hedge fund manager typically has twenty to fifty times the exposure of his next biggest client. That of necessity makes them both more careful and as well as aware of the consequences if they have underinvested in the necessary talent to remain competitive. Taleb quite definitively states, “You don’t get that with fund managers.”

I suspect the counterargument I am going to hear is that fund managers are now required to disclose, by means of reporting within various ranges, the amount of money they have invested in the fund they are managing. Just go to the Statement of Additional Information, which is usually found on a fund website. And if the SAI shows that the manager has more than $1 million invested in his or her fund, then that is supposed to be a good sign concerning alignment of interests. Like the old Hertz commercial, the real rather than apparent answer is “not exactly.”

The gold standard in this regard has been set by Longleaf Partners with their funds. Their employees are required to limit their publicly offered equity investments to funds advised by Southeastern Asset Management, Longleaf’s advisor, unless granted a compliance exception. Their trustees also must obtain permission before making a publicly offered equity investment. That is rather unique in the fund industry, since what you usually see in the marketing brochures or periodic fund reports is something like “the employees and families of blah-blah have more than $X million invested in our funds.” If you are lucky this may work out to be one percent of assets under management in the firm, hardly hedge-fund like metrics. At the same time, you often find trustees of the fund with de minimis investments.

The comparison becomes worse when you look at a fund with $9 billion in assets and the “normal” one percent investment management fee, which generates $90 million in revenue. The fund manager may tell you that his largest equity investment is in the fund and is more than $1 million. But if his annual compensation runs somewhere between $1million and $10 million, and this is Taleb’s strongest point, the fund manager does not have a true disincentive for losing money. The situation becomes even more blurred where compliance policy allows investment in ETF’s or open-ended mutual funds, which in today’s world will often allow a fund manager to construct his own personal market neutral or hedged portfolio, to offset his investment in the fund he is managing.

Is there a solution? Yes, a fairly easy one – adopt as an industry standard through government regulation the requirement that all employees in the investment firm are required to limit their publicly offered equity investments to the funds in the complex. To give credit where credit is due, just as we have a Volcker rule, we can call it the “Southeastern Asset Management” rule. If that should prove too restrictive, I would suggest as an alternative that the SEC add another band of investment ranges above the current $1 million limit, at perhaps $5 million. That at least would give a truer picture for the investor, especially given the money flows now gushing into a number of firms, which often make a $1 million investment not material to the fund manager. Such disclosure will do a better job of attuning investment professionals to what should be their real concern – managing risk with a view towards the potential downside, rather than ignoring risk with other people’s money.

Postscript:

What does it say when such well known value managers as Tweedy, Browne and First Pacific Advisors are letting cash positions rise in their portfolios as they sell and don’t replace securities that have reached their target valuations? Probably the same thing as when one of the people I consider to be one of the outstanding money managers of our time, Seth Klarman at Baupost Partners, announces that he will be returning some capital to his partnership investors at year end. Stay tuned.

So, if it’s “the best,” why can’t people just agree on what it is?

Last month David pointed out how little overlap he found between three popular mutual fund lists: Kiplinger 25, Money 70, and Morningstar’s Fantastic 51. David mused: “You’d think that if all of these publications shared the same sensible goal – good risk-adjusted returns and shareholder-friendly practices – they’d also be stumbling across the same funds. You’d be wrong.”

He found only one fund, Dodge & Cox International Fund DODFX, on all three lists. Just one! Although just one is a statistically better outcome than randomly picking three such lists from the 6600 or so mutual funds and 1000 ETFs, it does seem surprisingly small. 

Opening up the field a little, by replacing the Fantastic 51 with a list of 232 funds formed from Morningstar’s current “Gold-Rated Funds” and “Favorite ETFs,” the overlap does not improve much. Just two funds appear in all three publications: DODFX and Habor Bond Institutional HABDX. Just two!

While perhaps not directly comparable, the table below provides a quick summary of the criteria used by each publication. Money 70 criteria actually include Morningstar’s so-called stewardship grade, which must be one of the least maintained measures. For example, Morningstar awarded Bruce Berkowitz Fund Manager of the Decade, but it never published a stewardship grade for Fairholme.

Overall, however, the criteria seem quite similar, or as David described “good risk-adjusted returns and shareholder-friendly practices.”  Add in experienced managers for good measure and one would expect the lists to overlap pretty well. But again, they don’t.

How do the “forward-looking” recommendations in each of these lists fare against Morningstar’s purely quantitative “backward-looking” performance rating system? Not as well as you might think. There are just seven 5-star funds on Money’s list, or 1-in-10. Kiplinger does the best with six, from a percentage perspective, or almost 1-in-4. (They must have peeked.) Morningstar’s own list includes 44 5-star funds, or about 1-in-5. So, as well intentioned and “forward looking” as these analysts certainly try to be, only a small minority of their “best funds” have delivered top-tier returns.

On the other hand, they each do better than picking funds arbitrarily, if not unwittingly, since Morningstar assigns 5 stars to only about 1-in-17 funds. Neither of the two over-lapping funds that appear on all three lists, DODFX and HABDX, have 5 stars. But both have a commendable 4 stars, and certainly, that’s good enough.

Lowering expectations a bit, how many funds appear on at least two of these lists? The answer: 38, excluding the two trifectas. Vanguard dominates with 14. T. Rowe Price and American Funds each have 4. Fidelity has just one. Most have 4 stars, a few have 3, like SLASX, probably the scariest.

But there is no Artisan. There is no Tweedy. There is no Matthews. There is no TCW or Doubleline. There are no PIMCO bond funds. (Can you believe?) There is no Yacktman. Or Arke. Or Sequoia. There are no funds less than five years old. In short, there’s a lot missing.

There are, however, nine 5-star funds among the 38, or just about 1-in-4. That’s not bad. Interestingly, not one is a fixed income fund, which is probably a sign of the times. Here’s how they stack-up in MFO’s own “backward looking” ratings system, updated through September:

Four are moderate allocation funds: FPACX, PRWCX, VWELX, and TRRBX. Three are Vanguard funds: VWELX, VDIGX, and VASVX. One FMI fund FMIHX and one Oakmark fund OAKIX. Hard to argue with any of these funds, especially the three Great Owls: PRWCX, VWELX, and OAKIX.

These lists of “best funds” are probably not a bad place to start, especially for those new to mutual funds. They tend to expose investors to many perfectly acceptable, if more mainstream, funds with desirable characteristics: lower fees, experienced teams, defensible, if not superior, past performance.

They probably do not stress downside potential enough, so any selection needs to also take risk tolerance and investment time-frame into account. And, incredulously, Morningstar continues to give Gold ratings to loaded funds, about 1-in-7 actually.

The lists produce surprisingly little overlap, perhaps simply because there are a lot of funds available that satisfy the broad screening criteria. But within the little bit of overlap, one can find some very satisfying funds.

Money 70 and Kiplinger 25 are free and online. Morningstar’s rated funds are available for a premium subscription. (Cheapest path may be to subscribe for just one month each year at $22 while performing an annual portfolio review.)

As for a list of smaller, less well known mutual funds with great managers and intriguing strategies? Well, of course, that’s the niche MFO aspires to cover.

23Oct2013/Charles

The Great Owl search engine has arrived

Great Owls are the designation that my colleague Charles Boccadoro gives to those funds which are first in the top 20% of their peer group for every trailing period of three years or more. Because we know that “risk” is often more durable and a better predictor of investor actions than “return” is, we’ve compiled a wide variety of risk measures for each of the Great Owl funds.

Up until now, we’ve been limited to publishing the Great Owls as a .pdf while working on a search engine for them. We’re pleased to announce the launch of the Great Owl Search, 1.0. We expect in the months ahead to widen the engine’s function and to better integrate it into the site. We hope you like it.

For JJ and other fans of FundAlarm’s Three-Alarm and Most Alarming fund lists, we’re working to create a predefined search that will allow you to quickly and reliable identify the most gruesome investments in the fund world. More soon!

Who do you trust for fund information?

The short answer is: not fund companies.  On October 22, the WSJ’s Karen Damato hosted an online poll entitled Poll: The Best Source of Mutual-Fund Information? 

Representing, as I do, Column Three, I should be cheered.  Teaching, as I do, Journalism 215: News Literacy, I felt compelled to admit that the results were somewhere between empty (the margin of error is 10.89, so it’s “somewhere between 16% and 38% think it’s the fund company’s website and marketing materials”) and discouraging (the country’s leading financial newspaper managed to engage the interest of precisely 81 of its readers on this question).

Nina Eisenman, President of Eisenman Associates which oversees strategic communications for corporations, and sometime contributor to the Observer

Asking which of the 3 choices individual investors find “most useful” generates data that creates an impression that they don’t use the other two at all when, in fact, they may use all 3 to varying degrees. It’s also a broad question. Are investors responding based on what’s most useful to them in conducting their initial research or due diligence? For example, I may read about a fund in the Mutual Fund Observer (“other website”) and decide to check it out but I would (hopefully) look at the fund’s website, read the manager’s letters and the fund prospectus before I actually put money in.

When I surveyed financial advisors and RIAs on the same topic, but gave them an option to rate the importance of various sources of information they use, the vast majority used mutual funds’ own websites to some extent as part of their due diligence research. [especially for] fund-specific information (including the fund prospectus which is generally available on the website) that can help investors make educated investment decisions.

Both Nina’s own research and the results of a comparable Advisor Perspectives poll can be found at FundSites, her portal for addressing the challenges and practices of small- to medium sizes fund company websites.

The difference between “departures” and “succession planning”

Three firms this month announced the decisions of superb managers to move on. Happily for their investors, the departures are long-dated and seem to be surrounded by a careful succession planning process.

Mitch Milias will be retiring at the end of 2013

Primecap Management was founded by three American Funds veterans. That generation is passing. Howard Schow has passed away at age 84 in April 2012. Vanguard observer Dan Weiner wrote at the time that “To say that he was one of the best, and least-known investors would be a vast understatement.”  The second of the triumvirate, Mitch Milias, retires in two months at 71.  That leaves Theo Kolokotrones who, at 68, is likely in the latter half of his investing career.  Milias has served as comanager of four Gold-rated funds: Vanguard Primecap  (VPMCX) Vanguard Primecap Core (VPCCX), Primecap Odyssey Growth (POGRX), and  Primecap Odyssey Stock (POSKX).

Neil Woodford will depart Invesco in April, 2014

British fund manager Neil Woodford is leaving after 25 years of managing Invesco Perpetual High Income Fund and the Invesco Perpetual Income Fund. Mr. Woodford apparently is the best known manager in England and described as a “hero” in the media for his resolute style.  He’s decided to set up his own English fund company.  In making the move he reports:

My decision to leave is a personal one based on my views about where I see long-term opportunities in the fund management industry.  My intention is to establish a new fund management business serving institutional and retail clients as soon as possible after 29th April 2014.

His investors seem somehow less sanguine: they pulled over £1 billion in the two weeks after his announcement.  Invesco’s British president describes that reaction as “calm.”

Given Mr. Woodford’s reputation and the global nature of the securities market, I would surely flag 1 May 2014 as a day to peer across the Atlantic to see what “long-term opportunities” he’s pursuing.

Scott Satterwhite will be retiring at the end of September, 2016

Scott Satterwhite joined Artisan from Wachovia Securities in 1997 and was the sole manager of Artisan Small Cap Value (ARTVX) from its launch. ARTVX is also the longest-tenured fund in my non-retirement portfolio; I moved my Artisan Small Cap (ARTSX) investment into Satterwhite’s fund almost as soon as it launched and I’ve never had reason to question that decision.  Mr. Satterwhite then extended his discipline into Artisan Mid Cap Value (ARTQX) and the large cap Artisan Value (ARTLX).  All are, as is typical of Artisan, superb.

Artisan has a really strong internal culture and focus on creating coherent, self-sustaining investment teams.  Three years after launch, Satterwhite’s long-time analyst Jim Kieffer became a co-manager.  George Sertl was added six years after that and Dan Kane six years later.  Mr. Kane is now described as “the informal lead manager” with Satterwhite on ARTVX.  This is probably one of the two most significant manager changes in Artisan’s history (the retirement of its founder was the other) but the firm seems exceptionally well-positioned both to attract additional talent and to manage the required three year transition.

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. 

T. Rowe Price Global Allocation (RPGAX): T. Rowe is getting bold, cautiously.  Their newest and most innovative fund offers a changing mix of global assets, including structural exposure to a single hedge fund, is also broadly diversified, low-cost and run by the team responsible for their Spectrum and Personal Strategy Funds.  So far, so good!

Oops! The fund profile is slightly delayed. Please check back tomorrow.

Elevator Talk: Jeffrey K. Ringdahl of American Beacon Flexible Bond (AFXAX)

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.

In a fundamentally hostile environment, investors need to have a flexible approach to income investing. Some funds express that flexibility by investing in emerging market bonds, financial derivatives such as options, or illiquid securities (think: “lease payments from the apartment complex we just bought”).

American Beacon’s decision was to target “positive total return regardless of market conditions” in their version.  Beacon, like Harbor, positions itself as “a manager of managers” and assembles teams of institutional sub-advisors to manage the actual portfolio.  In this case, they’ve paired Brandywine Global, GAM and PIMCO and have given the managers extraordinarily leeway in pursuing the fund’s objective.  One measure of that flexibility is the fund’s duration, a measure of interest rate sensitivity.  They project a duration of anything from negative five years (effectively shorting the market) to plus eight years (generally the preferred spot for long-term owners of bond funds).  Since inception the fund has noticeably outrun its “nontraditional bond” peers with reasonable volatility.

Jeff Ringdahl is American Beacon’s Chief Operating Officer and one of the primary architects of the Flexible Bond Strategy. He’s worked with a bunch of “A” tier management firms including Touchstone Investments, Fidelity and State Street Global Advisors.   Here are his 245 words (I know, he overshot) on why you should consider a flexible bond strategy:

In building an alternative to a traditional bond fund, our goal was to stay true to what we consider the three tenets of traditional bond investing: current income, principal preservation and equity diversification.  However, we also sought to protect against unstable interest rates and credit spreads.

The word “unconstrained” is often used to describe similar strategies, but we believe “flexible” is a better descriptor for our approach. Many investors associate the word “unconstrained” with higher risk.  We implemented important risk constraints which help to create a lower risk profile. Our multi-manager structure is a key distinguishing characteristic because of its built-in risk management. Unconstrained or flexible bond funds feature a great degree of investment flexibility. While investment managers may deliver compelling risk-adjusted performance by using this enhanced flexibility, there may be an increased possibility of underperformance because there are fewer risk controls imposed by many of our peer funds. In our opinion, if you would ever want to diversify your managers you would do so where the manager had the greatest latitude. We think that this product style is uniquely designed for multi-manager diversification.

Flexible bond investing allows asset managers the ability to invest long and short across the global bond and currency markets to capitalize on opportunities in the broad areas of credit, currencies and yield curve strategies. We think focusing on the three Cs: Credit, Currency and Curve gives us an advantage in seeking to deliver positive returns over a complete market cycle.

The fund has five share classes. The minimum initial investment for the no-load Investor class is $2,500.   Expenses are 1.27% on about $300 million in assets.

The fund’s website is functional but spare.  You get the essential information, but there’s no particular wealth of insight or commentary on this strategy (and there is one odd picture of a bunch of sailboats barely able to get out of one another’s way).

Our earlier Elevator Talks were:

1. February 2013: Tom Kerr, Rocky Peak Small Cap Value (RPCSX), whose manager has a 14 year track record in small cap investing and a passion for discovering “value” in the intersection of many measures: discounted cash flows, LBO models, M&A valuations and traditional relative valuation metrics.
2. March 2013: Dale Harvey, Poplar Forest Partners (PFPFX and IPFPX), a concentrated, contrarian value stock fund that offers “a once-in-a-generation opportunity to invest with a successful American Funds manager who went out on his own.”
3. April 2013: Bayard Closser, Vertical Capital Income Fund (VCAPX), “a closed-end interval fund, VCAPX invests in whole mortgage loans and first deeds of trust. We purchase the loans from lenders at a deep discount and service them ourselves.”
4. May 2013: Jim Hillary, LS Opportunity Fund (LSOFX), a co-founder of Marsico Capital Management whose worry that “the quality of research on Wall Street continues to decline and investors are becoming increasingly concerned about short-term performance” led to his faith in “in-depth research and long-term orientation in our high conviction ideas.”
5. July 2013: Casey Frazier, Versus Capital Multi-Manager Real Estate Income Fund (VCMRX), a second closed-end interval fund whose portfolio “includes real estate private equity and debt, public equity and debt, and broad exposure across asset types and geographies. We target a mix of 70% private real estate with 30% public real estate to enhance liquidity, and our objective is to produce total returns in the 7 – 9% range net of fees.”
6. August 2013: Brian Frank, Frank Value Fund (FRNKX), a truly all-cap value fund with a simple, successful discipline: if one part of the market is overpriced, shop elsewhere.
7. August 2013: Ian Mortimer and Matthew Page of Guinness Atkinson Inflation Managed Dividend (GAINX), a global equity fund that pursues firms with “sustainable and potentially rising dividends,” which also translates to firms with robust business models and consistently high return on capital.
8. September 2013: Steven Vannelli of GaveKal Knowledge Leaders (GAVAX), which looks to invest in “the best among global companies that are tapping a deep reservoir of intangible capital to generate earnings growth,” where “R&D, design, brand and channel” are markers of robust intangible capital. From launch through the end of June, 2013, the fund modestly outperformed the MSCI World Index and did so with two-thirds less volatility
9. October 2013: Bashar Qasem of Wise Capital (WISEX), which provides investors with an opportunity for global diversification in a fund category (short term bonds) mostly distinguished by bland uniformity.

Conference Call Highlights: Zac Wydra of Beck, Mack & Oliver Partners

We looked for a picture of Zac Wydra on the web but found Wydra the Otter instead. We decided that Zac is cute but Wydra is cuter, so… If we can find a t-shirt with Wydra’s picture on it, we might send it along to Zac with our best wishes.

In mid-October we spoke for about an hour with Zac Wydra of Beck, Mack & Oliver Partners Fund (BMPEX). There were about 30 other participants on the call. I’ve elsewhere analogized Beck, Mack to Dodge & Cox: an old money, white shoe firm whose core business is helping the rich stay rich. In general, you need a $3 million minimum investment to engage with them. Partners was created in 1991 as a limited partnership to accommodate the grandkids or staff of their clients, folks who might only have a few hundred thousand to commit. (Insert about here: “Snowball gulps”) The “limited” in limited partnership signals a maximum number of investors, 100. The partnership filled up and prospered. When the managing partner retired, Zac made a pitch to convert the partnership to a ’40 fund and make it more widely available. He argued that he thought there was a wider audience for a disciplined, concentrated fund.

He was made the fund’s inaugural manager. He’s 41 and anticipates running BMPEX for about the next quarter century, at which point he’ll be required – as all partners are – to move into retirement and undertake a phased five year divestment of his economic stake in the firm. His then-former ownership stake will be available to help attract and retain the best cadre of younger professionals that they can find. Between now and retirement he will (1) not run any other pooled investment vehicle, (2) not allow BMPEX to get noticeably bigger than $1.5 billion – he’ll return capital to investors first – and (3) will, over a period of years, train and oversee a potential successor.

In the interim, the discipline is simple:

1. never hold more than 30 securities – he can hold bonds but hasn’t found any that offer a better risk/return profile than the stocks he’s found.
2. only invest in firms with great management teams, a criterion that’s met when the team demonstrates superior capital allocation decisions over a period of years
3. invest only in firms whose cash flows are consistent and predictable. Some fine firms come with high variable flows and some are in industries whose drivers are particularly hard to decipher; he avoids those altogether.
4. only buy when stocks sell at a sufficient discount to fair value that you’ve got a margin of safety, a patience that was illustrated by his decision to watch Bed, Bath & Beyond for over two and a half years before a short-term stumble triggered a panicky price drop and he could move in. In general, he is targeting stocks which have the prospect of gaining at least 50% over the next three years and which will not lose value over that time.
5. ignore the question of whether it’s a “high turnover” or “low turnover” strategy. His argument is that the market determines the turnover rate. If his holdings become overpriced, he’ll sell them quickly. If the market collapses, he’ll look for stocks with even better risk/return profiles than those currently in the portfolio. In general, it would be common for him to turn over three to five names in the portfolio each year, though occasionally that’s just recycling: he’ll sell a good firm whose stock becomes overvalued then buy it back again once it becomes undervalued.

Two listener questions, in particular, stood out:

Kevin asked what Zac’s “edge” was. A focus on cash, rather than earnings, seemed to be the core of it. Businesses exist to generate cash, not earnings, and so BM&O’s valuations were driven by discounted cash flow models. Those models were meaningful only if it were possible to calculate the durability of cash flows over 5 years. In industries where cash flows have volatile, it’s hard to assign a meaningful multiple and so he avoids them.

Seth asked what mistakes have you made and what did you learn from them? Zac hearkened back to the days when the fund was still a private partnership. They’d invested in AIG which subsequently turned into a bloody mess. Ummm, “not an enjoyable experience” was his phrase. He learned from that that “independent” was not always the same as “contrary.” AIG was selling at what appeared to be a lunatic discount, so BM&O bought in a contrarian move. Out of the resulting debacle, Zac learned a bit more respect for the market’s occasionally unexplainable pricings of an asset. At base, if the market says a stock is worth twenty cents a share, you’d better than remarkably strong evidence in order to act on an internal valuation of twenty dollars a share.

Bottom Line: On whole, it strikes me as a remarkable strategy: simple, high return, low excitement, repeatable, sustained for near a quarter century and sustainable for another.

For folks interested but unable to join us, here’s the complete audio of the hour-long conversation.

The BMPEX Conference Call

As with all of these funds, we’ve created a new featured funds page for Beck, Mack & Oliver Partners Fund, pulling together all of the best resources we have for the fund, including a brand new audio profile in .mp3 format.

When you click on the link, the file will load in your browser and will begin playing after it’s partially loaded. If the file downloads, instead, you may have to double-click to play it.

As promised, my colleague Charles Boccadoro weighs in on your almost-magical ability to turn a temporary loss of principal into a …

Permanent Loss of Capital

The father of value investing, Benjamin Graham, employed the concept of “Margin of Safety” to minimize risk of permanent loss. His great student, Warren Buffett, puts it like this: “Rule No. 1: never lose money; rule No. 2: don’t forget rule No. 1.”

Zachary Wydra, portfolio manager of the 5-star Beck Mack & Oliver Partners (BMPEX) fund, actually cited Mr. Buffett’s quote during the recent MFO conference call.

But a look at Berkshire Hathaway, one of the great stocks of all time, shows it dropped 46% between December 2007 and February of 2009. And, further back, it dropped about the same between June 1998 and February 2002. So, is Mr. Buffett not following his own rule? Similarly, a look at BMPEX shows an even steeper decline in 2009 at -54%, slightly worse than the SP500.

The distinction, of course, is that drawdown does not necessarily mean loss, unless one sells at what is only a temporary loss in valuation – as opposed to an unrecoverable loss, like experienced by Enron shareholders. Since its 2009 drawdown, BMPEX is in fact up an enviable 161%, beating the SP500 by 9%.

Robert Arnott, founder of Research Associates, summarizes as follows: “Temporary losses of value are frequent; at times they can become so frightening that they become permanent—for those that sell.” Distinguishing between temporary drawdown and permanent loss of capital (aka “the ultimate risk”) is singularly the most important, if unnerving, aspect of successful value investing.

Mr. Wydra explains his strategy is to target stocks that have an upside potential over the next three years of at least 50% and will not lose value over that time. Translation: “loss,” as far as BMPEX is concerned, equates to no drawdown over a three year period. A very practical goal indeed, since any longer period would likely not be tolerated by risk averse investors.

And yet, it is very, very hard to do, perhaps even impossible for any fund that is primarily long equities.

Here is downside SP500 total return performance looking back about 52 years:

It says that 3-year returns fall below zero over nearly 30% of the time and the SP500 shows a loss of 20% or more in 15% of 3-year returns. If we compare returns against consumer price index (CPI), the result is even worse. But for simplicity (and Pete’s) sake, we will not. Fact is, over this time frame, one would need to have invested in the SP500 for nearly 12 years continuously to guarantee a positive return. 12 years!

How many equity or asset allocation funds have not experienced a drawdown over any three year period? Very few. In the last 20 years, only four, or about 1-in-1000. Gabelli ABC (GABCX) and Merger (MERFX), both in the market neutral category and both focused on merger arbitrage strategies. Along with Permanent Portfolio (PRPFX) and Midas Perpetual Portfolio (MPREX), both in the conservative allocation category and both with large a percentage of their portfolios in gold. None of these four beat the SP500. (Although three beat bonds and GABCX did so with especially low volatility.)

So, while delivering equity-like returns without incurring a “loss” over a three year period may simply prove too high a goal to come true, it is what we wish was true.

29Oct2013/Charles

Conference Call Upcoming: John Park and Greg Jackson, Oakseed Opportunity, November 18, 7:00 – 8:00 Eastern

On November 18, Observer readers will have the opportunity to hear from, and speak to John Park and Greg Jackson, co-managers of Oakseed Opportunity Fund (SEEDX and SEDEX). John managed Columbia Acorn Select for five and a half years and, at his 2004 departure, Morningstar announced “we are troubled by his departure: Park had run this fund since its inception and was a big driver behind its great long-term record. He was also the firm’s primary health-care analyst.” Greg co-managed Oakmark Global (OAKGX) for over four years and his departure in 2003 prompted an Eeyore-ish, “It’s never good news when a talented manager leaves.”

The guys moved to Blum Capital, a venture capital firm.  They did well, made money but had less fun than they’d like so they decided to return to managing a distinctly low-profile mutual fund.

Oakseed is designed to be an opportunistic equity fund.  Its managers are expected to be able to look broadly and go boldly, wherever the greatest opportunities present themselves.  It’s limited by neither geography, market cap nor stylebox.   John Park laid out its mission succinctly: “we pursue the maximum returns in the safest way possible.”

I asked John where he thought they’d focus their opening comments.  Here’s his reply:

We would like to talk about the structure of our firm and how it relates to the fund at the outset of the call.  I think people should know we’re not the usual fund management company most people think of when investing in a fund. We discussed this in our first letter to shareholders, but I think it’s worthwhile for our prospective and current investors to know that Oakseed is the only client we have, primarily because we want complete alignment with our clients from not only a mutual investment perspective (“skin in the game”), but also that all of our time is spent on this one entity. In addition, being founders of our firm and this fund, with no intentions of ever starting and managing a new fund, there is much less risk to our investors that one or both of us would ever leave. I think having that assurance is important.

Our conference call will be Monday, November 18, from 7:00 – 8:00 Eastern.  It’s free.  It’s a phone call.

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?

Nearly 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.

Conference Call Queue: David Sherman, RiverPark Strategic Income, December 9, 7:00 – 8:00 Eastern

On Monday, December 9, from 7:00 – 8:00 Eastern, you’ll have a chance to meet David Sherman, manager of RiverPark Short Term High Yield (RPHYX) and the newly-launched RiverPark Strategic Income Fund (RSIVX). David positions RSIVX as the next step out on the risk-return ladder from RPHYX: capable of doubling its sibling’s returns with entirely manageable risk.  If you’d like to get ahead of the curve, you can register for the call with David though I will highlight his call in next month’s issue.

Launch Alert: DoubleLine Shiller Enhanced CAPE

On October 29, DoubleLine Shiller Enhanced CAPE (DSEEX and DSENX) launched. The fund will use derivatives to try to outperform the Shiller Barclays CAPE US Sector Total Return Index.  CAPE is an acronym for “cyclically-adjusted price/earnings.”  The measure was propounded by Nobel Prize winning economist Robert Shiller as a way of taking some of the hocus-pocus out of the calculation of price/earnings ratios.  At base, it divides today’s stock price by the average, inflation-adjusted earnings from the past decade.  Shiller argues that current earnings are often deceptive since profit margins tend over time to regress to the mean and many firms earnings run on three to five year cycles.  As a result, the market might look dirt cheap (high profit margins plus high cyclical earnings = low conventional P/E) when it’s actually poised for a fall.  Looking at prices relative to longer-term earnings gives you a better chance of getting sucked into a value trap.

The fund will be managed by The Gundlach and Jeffrey Sherman. Messrs Gundlach and Sherman also work together on the distinctly disappointing Multi-Asset Growth fund (DMLAX), so the combination of these guys and an interesting idea doesn’t translate immediately into a desirable product.  The fact that it, like many PIMCO funds, is complicated and derivatives-driven counsels for due caution in one’s due diligence. The “N” share class has a $2000 minimum initial investment and 0.91% expense ratio.  The institutional shares are about one-third cheaper.

Those interested in a nice introduction to the CAPE research might look at Samuel Lee’s 2012 CAPE Crusader essay at Morningstar. There’s a fact sheet and a little other information on the fund’s homepage.

Funds in Registration (The New Year’s Edition)

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

And there were a lot of funds targeting a year-end launch. Every day David Welsch, firefighter/EMT/fund researcher, scours new SEC filings to see what opportunities might be about to present themselves.  This month he tracked down 24 no-load retail funds in registration, which represents our core interest.  But if you expand that to include ETFs, institutional funds, reorganized funds and load-bearing funds, you find nearly 120 new vehicles scheduled for Christmas delivery.

Close readers might find the answers to four funds in reg quiz questions:

1. Which manager of a newly-registered fund had the schmanciest high society wedding this year?
2. Which fund in registration gave Snowball, by far, the biggest headache as he tried to translate their prose to English?
3. Which hedge fund manager decided that the perfect time to launch a mutual fund was after getting bludgeoned on returns for two consecutive years?
4. Which managers seem most attuned to young investors, skippering craft that might be described as Clifford the Big Red Mutual Fund and the Spongebob Fund?

Manager Changes

On a related note, we also tracked down 51 fund manager changes.

Updates

One of the characteristics of good managers is their ability to think clearly and one of the best clues to the existence of clear thinking is clear writing. Here’s a decent rule: if they can’t write a grocery list without babbling, you should avoid them. Contrarily, clear, graceful writing often reflects clear thinking.

Many managers update their commentaries and fund materials quarterly and we want to guide you to the most recent discussions and data possible for the funds we’ve written about. The indefatigable Mr. Welsch has checked (and updated) every link and linked document for every fund we’ve profiled in 2013 and for most of 2012. Here’s David’s summary table, which will allow you to click through to a variety of updated documents.

Briefly Noted 

A big ol’ “uhhh” to Advisory Research Emerging Markets All Cap Value Fund (the “Fund”) which has changed both manager (“Effective immediately, Brien M. O’Brien is no longer a portfolio manager of the Fund”) and name (it will be Advisory Research Emerging Markets Opportunities Fund), both before the fund even launched.  A few days after that announcement, AR also decided that Matthew Dougherty would be removed as a manager of the still-unlaunched fund.  On the bright side, it didn’t close to new investors before launch, so that’s good.  Launch date is November 1, 2013.

In a singularly dark day, Mr. O’Brien was also removed as manager of Advisory Research Small Micro Cap Value Fund, which has also not launched and has changed its name: Advisory Research Small Company Opportunities Fund.”

A Centaur arises!  The Tilson funds used to be a two-fund family: the one that Mr. Tilson ran and the one that was really good. After years of returns that never quite matched the hype, Mr. Tilson liquidated his Tilson Focus (TILFX) fund in June 2013.  That left behind the Tilson-less Tilson Dividend Fund (TILDX) which we described as “an awfully compelling little fund.”

Effective November 1, Tilson Dividend became Centaur Total Return Fund (TILDX), named after its long-time sub-adviser, Centaur Capital Partners.  Rick Schumacher, the operations guy at the Centaur funds, elaborates:

Since Tilson is no longer involved in the mutual fund whatsoever, and since the Dividend Fund has historically generated as much (if not more) income from covered call premiums rather than pure dividends, we felt that it was a good time to rebrand the fund.  So, effective today, our fund is now named the Centaur Total Return Fund.  We have kept the ticker (TILDX), as nothing’s really changed as far as the investment objective or strategy of the fund, and besides, we like our track record.  But, we’re very excited about our new Centaur Mutual Funds brand, as it will provide us with potential opportunities to launch other strategies under this platform in the future.

They’ve just launched a clean and appropriate dignified website that both represents the new fund and archives the analytic materials relevant to its old designation.  The fund sits at $65 million in assets with cash occupying about a quarter of its portfolio.  All cap, four stars, low risk. It’s worth considering, which we’ll do again in our December issue.

Laudus Growth Investors U.S. Large Cap Growth Fund is having almost as much fun.  On September 24, its Board booted UBS Global Asset Management as the managers of the fund in favor of BlackRock.  They then changed the name (to Laudus U.S. Large Cap Growth Fund) and, generously, slashed the fund’s expense ratio by an entire basis point from 0.78% to 0.77%.

But no joy in Mudville: the shareholder meeting being held to vote on the merger of  Lord Abbett Classic Stock Fund (LRLCX) into Lord Abbett Calibrated Dividend Growth Fund (LAMAX) has been adjourned until November 7, 2013 for lack of a quorum.

Scout Funds are sporting a redesigned website. Despite the fact that our profiles of Scout Unconstrained Bond and Scout Low Duration don’t qualify as “news” for the purposes of their media list (sniffles), I agree with reader Dennis Green’s celebration of the fact the new site is “thoughtful, with a classy layout, and—are you sitting down?— their data are no longer stale and are readily accessible!”  Thanks to Dennis for the heads-up.

Snowball’s portfolio: in September, I noted that two funds were on the watchlist for my own, non-retirement portfolio.  They were Aston River Road Long Short (ARLSX) and RiverPark Strategic Income (RSIVX). I’ve now opened a small exploratory position in Aston (I pay much more attention to a fund when I have actual money at risk) as I continue to explore the possibility of transferring my Northern Global Tactical Asset Allocation (BBALX) investment there.  The Strategic Income position is small but permanent and linked to a monthly automatic investment plan.

For those interested, John Waggoner of USA Today talked with me for a long while about the industry and interesting new funds.  Part of that conversation contributed to his October 17 article, “New Funds Worth Mentioning.”

SMALL WINS FOR INVESTORS

Eaton Vance Asian Small Companies Fund (EVASX) will eliminate its danged annoying “B” share class on November 4, 2013. It’s still trying to catch up from having lost 70% in the 2007-09 meltdown. 

Green Owl Intrinsic Value Fund (GOWLX) substantially reduced its expense cap from 1.40% to 1.10%. It’s been a very solid little large cap fund since its launch in early 2012.

Invesco Balanced-Risk Commodity Strategy Fund (BRCAX) will reopen to new investors on November 8, 2013. The fund has three quarters of a billion in assets despite trailing its peers and losing money in two of its first three years of existence.

As of December, Vanguard Dividend Appreciation Index (VDAIX) will have new Admiral shares with a 0.10% expense ratio and a $10,000 minimum investment. That’s a welcome savings on a fund currently charging 0.20% for the Investor share class.

At eight funds, Vanguard will rename Signal shares as Admiral shares and will lower the minimum investment to $10,000 from $100,000.

Zeo Strategic Income Fund (ZEOIX) dropped its “institutional” minimum to $5,000.  I will say this for Zeo: it’s very steady.

CLOSINGS (and related inconveniences)

The Brown Capital Management Small Company Fund (BCSIX) closed to new investors on October 18, 2013.

Buffalo Emerging Opportunities Fund (BUFOX) formally announced its intention to close to new investors when the fund’s assets under management reach $475 million. At last check, they’re at $420 million.  Five star fund with consistently top 1% returns.  If you’re curious, check quick!

GW&K Small Cap Equity Fund (GWETX) is slated to close to new investors on November 1, 2013.

Matthews Pacific Tiger Fund (MAPTX) closed to new investors on October 25, 2013.

Oakmark International (OAKIX) closed to most new investors as of the close of business on October 4, 2013

Templeton Foreign Smaller Companies (FINEX) will close to new investors on December 10^th.  I have no idea of why: it’s a small fund with an undistinguished but not awful record. Liquidation seems unlikely but I can’t imagine that much hot money has been burning a hole in the managers’ pockets.

Touchstone Merger Arbitrage Fund (TMGAX), already mostly closed, will limit access a bit more on November 11, 2013.  That means closing the fund to new financial advisors.

OLD WINE, NEW BOTTLES

Advisory Research Emerging Markets All Cap Value Fund has renamed itself, before launch, as Advisory Research Emerging Markets Opportunities Fund.

Aegis Value Fund (AVALX) has been reorganized as … Aegis Value Fund (AVALX), except with a sales load (see story above).

DundeeWealth US, LP (the “Adviser”) has also changed its name to “Scotia Institutional Investments US, LP” effective November 1, 2013.

The Hatteras suite of alternative strategy funds (Hatteras Alpha Hedged Strategies, Hedged Strategies Fund, Long/Short Debt Fund, Long/Short Equity Fund and Managed Futures Strategies Fund) have been sold to RCS Capital Corporation and Scotland Acquisition, LLC.  We know this because the SEC filing avers the “Purchaser will purchase from the Sellers and the Sellers will sell to the Purchaser, substantially all the assets related to the business and operations of the Sellers and … the “Hatteras Funds Group.” Morningstar has a “negative” analyst rating on the group but I cannot find a discussion of that judgment.

Ladenburg Thalmann Alternative Strategies Fund (LTAFX) have been boldly renamed (wait for it) Alternative Strategies Fund.  It appears to be another in the expanding array of “interval” funds, whose shares are illiquid and partially redeemable just once a quarter. Its performance since October 2010 launch has been substantially better than its open-ended peers.

Effective October 7, 2013, the WisdomTree Global ex-US Growth Fund (DNL) became WisdomTree Global ex-US Dividend Growth Fund.

U.S. Global Investors MegaTrends Fund (MEGAX) will, on December 20, become Holmes Growth Fund

OFF TO THE DUSTBIN OF HISTORY

On-going thanks to The Shadow for help in tracking the consequences of “the perennial gale of creative destruction” blowing through the industry.  Shadow, a member of the Observer’s discussion community, has an uncanny talent for identifying and posting fund liquidations (and occasionally) launches to our discussion board about, oh, 30 seconds after the SEC first learns of the change.  Rather more than three dozen of the changes noted here and elsewhere in Briefly Noted were flagged by The Shadow.  While my daily reading of SEC 497 filings identified most of the them, his work really does contribute a lot. 

And so, thanks, big guy!

On October 16, 2013, the Board of Trustees of the Trust approved a Plan of Liquidation, which authorizes the termination, liquidation and dissolution of the 361 Absolute Alpha Fund. In order to effect such liquidation, the Fund is closed to all new investment. Shareholders may redeem their shares until the date of liquidation. The Fund will be liquidated on or about October 30, 2013.

City National Rochdale Diversified Equity Fund (the “Diversified Fund”) has merged into City National Rochdale U.S. Core Equity Fund while City National Rochdale Full Maturity Fixed Income Fund was absorbed by City National Rochdale Intermediate Fixed Income Fund

Great-West Ariel Small Cap Value Fund (MXSCX) will merge into Great-West Ariel Mid Cap Value Fund (MXMCX) around Christmas, 2013.  That’s probably a win for shareholders, since SCV has been mired in the muck while MCV has posted top 1% returns over the past five years.

As we suspected, Fidelity Europe Capital Appreciation Fund (FECAX) is merging into Fidelity Europe Fund (FIEUX). FECAX was supposed to be the aggressive growth version of FIEUX but the funds have operated as virtually clones for the past five years.  And neither has particularly justified its existence: average risk, average return, high r-squared despite the advantages of low expenses and a large analyst pool.

The Board of the Hansberger funds seems concerned that you don’t quite understand the implications of having a fund liquidated.  And so, in the announcement of the October 18 liquidation of Hansberger International Fund they helpfully explain: “The Fund no longer exists, and as a result, shares of the Fund are no longer available for purchase.”

Highland Alpha Trend Strategies Fund (HATAX), formerly Pyxis Alpha Trend Strategies Fund, will close on November 20, 2013.  With assets not much greater than my retirement account (and performance vastly below it), I’m not sure that even the manager will notice the disappearance.

Huntington Income Equity (HUINX) will merge into Huntington Dividend Capture Fund (HDCAX) at the end of the first week of December.  It’s never a good sign when the winning fund – the more attractive of the two – trails 80% of its peers.

The JPMorgan Global Opportunities Fund was liquidated and dissolved on or about October 25, 2013. Given that they’re speaking in the past tense, don’t you think that they’d know whether it was “on” or “about”?

Update on the JPMorgan Value Opportunities Fund: an attempt to merge the fund out of existence in September failed because the Board couldn’t get enough shareholders to vote one way or the other.  On October 10, though, they reached a critical mass and folded the fund into JPMorgan Large Cap Value Fund (OLVAX) on October 18^th.

So long to LONGX! Longview Tactical Allocation Fund (LONGX) has closed and will liquidate on November 15, 2013.  700% turnover which might well have led to a joke about their ability to take the long view except for the fact that they’ve joined the zombie legion of walking dead funds.

In a determinedly “WTF?” move, the Mitchell Capital’s Board of Trustees has determined to liquidate the Mitchell Capital All-Cap Growth Fund (MCAEX) “due to the adviser’s business decision that it no longer is economically viable to continue managing the Fund because of the Fund’s small size, the increasing costs associated with managing the Fund, and the difficulty encountered in distributing the Fund’s shares.”  Huh?  “No longer economically viable”?  They only launched this sucker on March 1, 2013.  Seven months, guys?  You hung on seven months and that’s it?  What sort of analytic abilities are on display here, do you suppose?

On October 15, Nomura Partners Funds closed all of its remaining five mutual funds to purchases and exchanges.  They are The Japan Fund (NPJAX), Nomura Partners High Yield (NPHAX), Nomura Partners Asia Pacific Ex Japan (NPAAX), Nomura Partners Global Equity Income (NPWAX), and Nomura Partners Global Emerging Markets (NPEAX).  Here’s a sentence you should take seriously: “The Board will consider the best interests of the investors in each of the Funds and may decide to liquidate, merge, assign the advisory contract or to take another course of action for one or more of the Funds.”  The NPJAX board has acted boldly in the past.  In 2002, it fired the fund’s long-standing adviser, Scudder,Stevens, and turned the fund over to Fidelity to manage.  Then, in 2008, they moved it again from Fidelity to Nomura.  No telling what they might do next.

The firm also announced that it, like DundeeWealth, is planning to get out of the US retail fund business.

The liquidations of Nuveen Tradewinds Global Resources Fund and Nuveen Tradewinds Small-Cap Opportunities Fund are complete.  It’s an ill wind that blows …

Oppenheimer SteelPath MLP and Infrastructure Debt Fund went the way of the wild goose on October 4.

Transamerica is bumping off two sub-advised funds in mid-December: Transamerica International Bond (TABAX), subadvised by J.P. Morgan, and Transamerica International Value Opportunities Fund, subadvised by Thornburg but only available to other Transamerica fund managers.

UBS Global Frontier Fund became UBS Asset Growth Fund (BGFAX) on October 28.  Uhhh … doesn’t “Asset Growth” strike you as pretty much “Asset Gathering”?  Under the assumption that “incredibly complicated” is the magic strategy, the fund will adopt a managed volatility objective that tries to capture all of the upside of the MSCI World Free Index with a standard deviation of no more than 15.  On the portfolio’s horizon: indirect real estate securities, index funds, options and derivatives with leverage of up to 75%. They lose a couple managers and gain a couple in the process.

U.S. Global Investors Global Emerging Markets Fund closed on October 1 and liquidated on Halloween.  If you were an investor in the fund, I’m hopeful that you’d already noticed.  And considered Seafarer as an alternative.

Vanguard plans to merge two of its tax-managed funds into very similar index funds.  Vanguard Tax-Managed International (VTMNX) is merging into Vanguard Developed Markets Index (VDMIX) and Vanguard Tax-Managed Growth & Income (VTMIX) will merge into Vanguard 500 Index (VFINX). Since these were closet index funds to begin with – they have R-squared values of 98.5 and 100(!) – the merger mostly serves to raise the expenses borne by VTMNX investors from 10 basis points to 20 for the index fund.

Vanguard Growth Equity (VGEQX) is being absorbed by Vanguard US Growth (VWUSX). Baillie Gifford, managers of Growth Equity, will be added as another team for US Growth.

Vanguard Managed Payout Distribution Focus (VPDFX) and Vanguard Managed Payout Growth Focus (VPGFX) are slated to merge to create a new fund, Vanguard Managed Payout Fund. At that time, the payout in question will decrease to 4% from 5%.

WHV Emerging Markets Equity Fund (WHEAX) is suffering “final liquidation”  on or about December 20, 2013.  Okay returns, $5 million in assets.

In Closing . . .

As Chip reviewed how folks use our email notification (do they open it?  Do they click through to MFO?), she discovered 33 clicks from folks in Toyko (youkoso!), 21 in the U.K. (uhhh … pip pip?), 13 in the United Arab Emirates (keep cool, guys!) and 10 scattered about India (Namaste!).  Welcome to all.

Thanks to the kind folks who contributed to the Observer this month.  I never second guess folks’ decision to contribute, directly or through PayPal, but I am sometimes humbled by their generosity and years of support.  And so thanks, especially, to the Right Reverend Rick – a friend of many years – and to Andrew, Bradford, Matt, James (uhh… Jimmy?) and you all.  You make it all possible.

Thanks to all of the folks who bookmarked or clicked on our Amazon link.   Here’s the reminder of the easiest way to support the Observer: just use our Amazon link whenever you’d normally be doing your shopping, holiday or other, on Amazon anyway.  They contribute an amount equal to about 7% of the value of all stuff purchased through the link.  It costs you nothing (the cost is already built into their marketing budget) and is invisible.  If you’re interested in the details, feel free to look at the Amazon section under “Support.”  

Remember to join us, if you can, for our upcoming conversations with John, Greg and David.  Regardless, enjoy the quiet descent of fall and its seasonal reminder to slow down a bit and remember all the things you have to be grateful for rather than fretting about the ones you don’t have (and, really, likely don’t need and wouldn’t enjoy).

Cheers!

Welcome to October, the time of pumpkins.

October’s a month of surprises, from the first morning that you see frost on the grass to the appearance of ghosts and ghouls at month’s end.  It’s a month famous of market crashes – 1929, 1987, 2008 – and for being the least hospitable to stocks. And now it promises to be a month famous for government showdowns and shutdowns, when the sales of scary Halloween masks (Barackula, anyone?) take off.

It’s the month of golden leaves, apple cider, backyard fires and weekend football.  (Except possibly back home in Pittsburgh, where some suspect a zombie takeover of the beloved Steelers backfield.)  It’s the month that the danged lawnmower gets put away but the snowblower doesn’t need to be dragged out.

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

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

Better make that “The Fantastic 48,” Russ

Russel Kinnel, Morningstar’s chief fund guy, sent out an email on September 16^th, touting his “Fantastic 51,” described as “51 Funds You Should Know About.”  And if you’ll just pony up the $125 for a Fund Investor subscription, it’s yours!

 Uhhh … might have to pare that back to the Fantastic 48, Russ.  It turns out that a couple of the funds hyped in the email underwent critical changes between the time Mr. Kinnel published that article in May and the time Morningstar’s marketers began pushing it in September.

Let’s start by looking at Mr. K’s criteria, then talking about the flubbed funds and finish by figuring out what we might learn from the list as a whole.

Here are the criteria for being Fantastic this year:

Last year I shared the “Fantastic 46” with you. This year I raised the bar on my tests and still reached 51 funds. Here’s what I want:

1. A fund with expenses in the cheapest quintile
2. Returns that beat the benchmark over the course of the manager’s tenure (minimum five years)
3. Manager investment of at least $500,000
4. A Positive Parent rating
5. A medalist Morningstar Analyst Rating

Sub-text: Fantastic funds are large or come from large fund complexes.  Of the 1150 medalist funds, only 53 have assets under $100 million.  Of those 53, only five or six are the products of independent or boutique firms.  The others are from Fido, MFS, PIMCO or another large firm.  Typically an entire target-date series gets medalized, including the Retirement 2075 fund with $500,003 in it.  By way of comparison, there are 2433 funds with under $100 million in assets.

And it’s certainly the case that the Fantastic 51 is The Corporate Collection: 10 American Funds, 10 Price and nine Vanguard.  Russel holds out the LKCM funds as examples of off-the-radar families, which would be more credible if LKCM Small Cap Equity (LKSCX) didn’t already have $1.1 billion in assets.

And what about the funds touted in the promotional email.  Two stand out: FPA Paramount and Janus Triton.

Morningstar’s take on FPA Paramount

The Mutual Fund Observer’s reply:

Great recommendation, except that the managers you’re touting left the fund and its strategy has substantially changed.  Eric and Steve’s unnamed and unrecognized co-managers are now in charge of the fund and are working to transition it from a quality-growth to an absolute-value portfolio.  Both of those took place in August 2013. 

The MFO recommendation: if you like Eric and Steve’s work, invest in FPA Perennial (FPPFX) which is a fund they actually run, using the strategy that Mr. Kinnel celebrates.

Morningstar’s take on Janus Triton

The Observer’s reply:

Uhhh … a bigger worry here is that Chad and Brian left in early May, 2013. The new manager’s tenure is 14 weeks.  Morningstar’s analysts promptly downgraded the fund to “neutral.” And Greg Carlson fretted that the “manager change leaves Janus Triton with uncertain prospects” because Mr. Coleman has not done a consistently excellent job in his other charges. That would be four months before the distribution of this email promo.

The MFO recommendation: if you’re impressed by Chad and Brian’s work (an entirely reasonable conclusion) check Meridian Growth Legacy Fund (MERDX), or wait until November and invest in their new Meridian Small Cap Growth Fund.

The email did not highlight, but the Fantastic 51 does include, T. Rowe Price New America Growth (PRWAX), whose manager resigned in May 2013.   Presumably these funds ended up in the letter because, contrary to appearances, Mr. Kinnel neither wrote, read nor approved its content (his smiling face and first-personal singular style notwithstanding).  That work was likely all done by a marketer who wouldn’t know Triton from Trident.

The bigger picture should give you pause about the value of such lists.   Twenty-six percent of the funds that were “fantastic” last year are absent this year, including the entire contingent of Fidelity funds.  Thirty-three percent of the currently fantastic funds were not so distinguished twelve months ago.  If you systematically exclude large chunks of the fund universe from consideration (those not medalized) and have a list that’s both prosaic (“tape the names of all of the Price funds to the wall, throw a dart, find your fantasy fund!”) and unstable, you wonder how much insight you’re being offered.

Interested parties might choose to compare last year’s Fantastic 46 list with 2013’s new and improved Fantastic 51. 

About the lack of index funds in the Fantastic 51

Good index funds – ones with little tracking error – can’t beat their benchmarks over time because their return is the benchmark minus expenses.  A few bad index funds – ones with high tracking error, so they’re sometimes out of step with their benchmark – might beat it from time to time, and Gus Sauter was pretty sure that microscopic expenses and canny trade execution might allow him to eke out the occasional win.  But the current 51 has no passive funds.

The authors of S&P Indices Versus Active Funds (SPIVA®) Scorecard would argue that’s a foolish bias.  They track the percentage of funds in each equity category which manage to outperform their benchmark, controlling for survivorship bias.  The results aren’t pretty.  In 17 of 17 domestic equity categories they analyzed, active funds trailed passive.  Not just “most active funds.”  No, no.  The vast majority of active funds.  Over the past five years, 64.08% of large value funds trailed their benchmark and that’s the best performance by any of the 17 groups.  Overall, 72.01% trailed.  Your poorest odds came in the large cap growth, midcap growth and multicap growth categories, where 88% of funds lagged. 

In general, active funds lag passive ones by 150-200 basis points year.  That’s a problem, since that loss is greater than what the fund’s expense ratios could explain.  Put another way: even if actively managed funds had an expense ratio of zero, they’d still modestly trail their passive peers.

There is one and only one bright spot in the picture for active managers: international small cap funds, nearly 90% of which outperform a comparable index. Which international small caps qualify as Fantastic you might ask? That would be, none.

If you were looking for great prospects in the international small cap arena, the Observer recommends that you check Grandeur Peak Global Reach (GPROX) or wait for the launch of one of their next generation of purely international funds. Oberweis International Opportunities (OBIOX), profiled this month, would surely be on the list. Fans of thrill rides might consider Driehaus International Small Cap Growth (DRIOX). Those more interested in restrained, high-probability bets might look at the new Artisan Global Small Cap Fund (ARTWX), a profile of which is forthcoming.

How much can you actually gain by picking a good manager?

It’s hard to find a good manager. It takes time and effort and it would be nice to believe that you might receive a reward commensurate with all your hard work. That is, spending dozens of hours in research makes a lot more sense if a good pick actually has a noticeably pay-off. One way of measuring that pay-off is by looking at the performance difference between purely average managers and those who are well above average. 

The chart below, derived from data in the S&P 2013 SPIVA analysis shows how much additional reward a manager in the top 25% of funds provides compared to a purely average manager.

What might this suggest about where to put your energy?  First and foremost, a good emerging markets manager makes a real difference – the average manager lost money for you, the top tier of guys kept you in the black. Likewise with diversified international funds.  The poorest investment of your time might be in looking for a large cap and especially large cap value manager. Not only do they rarely beat an index fund when they do, the margin of victory is slim. 

The group where good active manager appears to have the biggest payoff – small caps across the board –  is muddied a bit by the fact that the average return was so high to begin with. The seemingly huge 231 bps advantage held by top managers represents just a 28% premium over the work of mediocre managers. In international small caps, the good-manager premium is far higher at 41%.  Likewise, top global managers returned about 42% more than average ones.

The bottom line: invest your intellectual resources where your likeliest to see the greatest reward.  In particular, managers who invest largely or exclusively overseas seem to have the prospect of making a substantial difference in your returns and probably warrant the most careful selection.  Managers in what’s traditionally the safest corner of the equity style box – large core, large  value, midcap value – don’t have a huge capacity to outperform either indexes or peers.  In those areas, cheap and simple might be your mantra.

The one consensus pick: Dodge & Cox International (DODFX)

There are three lists of “best funds” in wide circulation now: the Kiplinger 25, the Fantastic 51, and the Money 70.  You’d think that if all of these publications shared the same sensible goal – good risk-adjusted returns and shareholder-friendly practices – they’d also be stumbling across the same funds.

You’d be wrong. There’s actually just one fund that they all agree on: Dodge & Cox International (DODFX). The fund is managed by the same team that handles all of Dodge & Cox. It’s dragging around $45 billion in assets but, despite consistently elevated volatility, it’s done beautifully. It has trailed its peers only twice in the past decade, including 2008 when all of the D&C funds made a mistimed bet that the market couldn’t get much cheaper.  They were wrong, by about six months and 25% of their assets.

The fund has 94% of its assets in large cap stocks, but a surprisingly high exposure to the emerging markets – 17% to its peers 7%.

My colleague Charles is, even as you read this, analyzing the overlap – and lack of overlap – between such “best funds” lists.  He’ll share his findings with us in November.

Tealeaf Long/Short Deep Value Fund?

Really guys?

Really?

You’ve got a business model that’s predicated upon being ridiculed before you even launch?

The fate of the Palantir (“mystical far-seeing eye”) Fund (PALIX) didn’t raise a red flag?  Nor the Oracle Fund (ORGAX – the jokes there were too dangerous), or the Eye of Zohar Fund (okay, I made that one up)?  It’s hard to imagine investment advisors wanting to deal with their clients’ incredulity at being placed in a fund that sounds like a parody, and it’s harder to imagine that folks like Chuck Jaffe (and, well, me) won’t be waiting for you to do something ridiculous.

In any case, the fund’s in registration now and will eventually ask you for 2.62 – 3.62% of your money each year.

The art of reading tea leaves is referred to as tasseography.  Thought you’d like to know.

A new Fidelity fund is doing okay!

Yeah, I’m surprised to hear me saying that, too.  It’s a rarity.  Still FidelityTotal Emerging Markets (FTEMX) has made a really solid start.  FTEMX is one of the new generation of emerging markets balanced or hybrid funds.  It launched on November 1, 2011 and is managed by a seven-person team.  The team is led by John Carlson, who has been running Fidelity New Markets Income (FNMIX), an emerging markets bond fund, since 1995.  Mr. Carlson’s co-managers in general are young managers with only one other fund responsibility (for most, Fidelity Series Emerging Markets, a fund open only to other Fidelity funds).

The fund has allocated between 60-73% of its portfolio to equities and its equity allocation is currently at a historic high.

Since there’s no “emerging markets balanced” peer group or benchmark, the best we can do is compare it to the handful of other comparable funds we could find.  Below we report the fund’s expense ratios and the amount of money you’d have in September 2013 if you’d invested $10,000 in each on the day that FTEMX launched.

The only fund with even modestly better returns is the closed-end First Trust Aberdeen Emerging Opportunities, about which we wrote a short, positive profile.  That fund’s shares are selling, as of October 1, at a 9.2% discount to its actual net asset value which is a bit more than its 8.9% average discount over the past five years and substantially more than its 7.4% discount over the past three.

Microscopic by Fidelity standard, the fund has just $80 million in assets.  The minimum initial investment is $2500, reduced to $500 for IRAs.

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.

Frank Value Fund (FRNKX) is not “that other Frank Fund” (John Buckingham’s Al Frank fund VALUX). It’s a concentrated, all-cap value fund that’s approaching its 10^th anniversary. It’s entirely plausible that it will celebrate its 10^thanniversary with returns in the top 10% of its peer group.

Oberweis International Opportunities (OBIOX) brings a unique strategy grounded in the tenets of behavioral finance to the world of international small- and mid-cap growth investing.  The results (top decile returns in three of the past four years) and the firm’s increasingly sophisticated approach to risk management are both striking.

Elevator Talk #9: Bashar Qasem of Wise Capital (WISEX)

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.

Wise Capital (WISEX) provides investors with an opportunity for diversification in a fund category (short term bonds) mostly distinguished by bland uniformity: 10% cash, one equity security thrown in for its thrill-value, about 90% of the bond portfolio would be US with a dribble of Canadian and British issues, 90% A-AAA rated and little distance between the fund and its peers. 

We began searching, late last year, from short-term income funds that offered some prospect of offering atypical returns in a bad environment: negative real short-term rates for now and the prospect of a market overreaction when US rates finally began to rise.  Our touchstones were stable management, a distinctive strategy, and a record of success.  A tiny handful of funds survived the cull.  Among them, PIMCO Short Asset (PAUIX ), Payden Global Low Duration (PYGSX), RiverPark Short Term High Yield (RPHYX), Scout Low Duration (SCLDX) … and Azzad Wise Capital.

WISEX draws on a fundamentally different asset set than any other US fixed-income fund.  Much of the fund’s portfolio is invested in the Islamic world, in a special class of bank deposits and bond-equivalents called Sukuks.  The fund is not constrained to invest solely in either asset class, but its investments are ethically-screened, Shariah-compliant and offers ethical exposure to emerging markets such as Turkey, Indonesia, Malaysia and the Gulf.

Azzad was founded in 1997 by Bashar Qasem, a computer engineer who immigrated to the United States from Jordan at the age of 23.  Here’s Mr. Qasem’s 200 words making his case:

I started Azzad Asset Management back 1997 because I was disappointed with the lack of investment options that aligned with my socially responsible worldview. For similar reasons, I traveled across the globe to consult with scholars and earned licenses to teach and consult on compliance with Islamic finance. I later trained and became licensed to work in the investment industry.

We launched the Azzad Wise Capital Fund in 2010 as a response to calls from clients asking for a fund that respects the Islamic prohibition on interest but still offers a revenue stream and risk/return profile similar to a short-term bond fund. WISEX invests in a variety of Sukuk (Islamic bonds) and Islamic bank deposits involved in overseas development projects. Of course, it’s SEC-registered and governed by the Investment Company Act of 1940. Although it doesn’t deal with debt instruments created from interest-based lending, WISEX shares in the profits from its ventures.

And I’m particularly pleased that it appeals to conservative, income-oriented investors of all backgrounds, Muslim or not. We hear from financial advisors and individual shareholders of all stripes who own WISEX for exposure to countries like Turkey, Malaysia, and Indonesia, as well as access to an alternative asset class like Sukuk.

The fund has a single share class. The minimum initial investment is $4,000, reduced to $300 for accounts established with an automatic investing plan (always a good idea with cash management accounts). Expenses are capped at 1.49% through December, 2018.

For those unfamiliar with the risk/return profile of these sorts of investments, Azzad offers two resources.  First, on the Azzad Funds website, they’ve got an okay (not but great) white paper on Sukuks.  It’s under Investor Education, then White Papers.  Second, on October 23^rd, Mr. Quesam and portfolio manager Jamal Elbarmil will host a free webinar on Fed Tapering and Sukuk Investing.  Azzad shared the announcement with us but I can’t, for the life of me, find it on either of their websites so here’s a .pdf explaining the call.

Our earlier Elevator Talks were:

1. February 2013: Tom Kerr, Rocky Peak Small Cap Value (RPCSX), whose manager has a 14 year track record in small cap investing and a passion for discovering “value” in the intersection of many measures: discounted cash flows, LBO models, M&A valuations and traditional relative valuation metrics.
2. March 2013: Dale Harvey, Poplar Forest Partners (PFPFX and IPFPX), a concentrated, contrarian value stock fund that offers “a once-in-a-generation opportunity to invest with a successful American Funds manager who went out on his own.”
3. April 2013: Bayard Closser, Vertical Capital Income Fund (VCAPX), “a closed-end interval fund, VCAPX invests in whole mortgage loans and first deeds of trust. We purchase the loans from lenders at a deep discount and service them ourselves.”
4. May 2013: Jim Hillary, LS Opportunity Fund (LSOFX), a co-founder of Marsico Capital Management whose worry that “the quality of research on Wall Street continues to decline and investors are becoming increasingly concerned about short-term performance” led to his faith in “in-depth research and long-term orientation in our high conviction ideas.”
5. July 2013: Casey Frazier, Versus Capital Multi-Manager Real Estate Income Fund (VCMRX), a second closed-end interval fund whose portfolio “includes real estate private equity and debt, public equity and debt, and broad exposure across asset types and geographies. We target a mix of 70% private real estate with 30% public real estate to enhance liquidity, and our objective is to produce total returns in the 7 – 9% range net of fees.”
6. August 2013: Brian Frank, Frank Value Fund (FRNKX), a truly all-cap value fund with a simple, successful discipline: if one part of the market is overpriced, shop elsewhere.
7. August 2013: Ian Mortimer and Matthew Page of Guinness Atkinson Inflation Managed Dividend (GAINX), a global equity fund that pursues firms with “sustainable and potentially rising dividends,” which also translates to firms with robust business models and consistently high return on capital.
8. September 2013: Steven Vannelli of GaveKal Knowledge Leaders (GAVAX), which looks to invest in “the best among global companies that are tapping a deep reservoir of intangible capital to generate earnings growth,” where “R&D, design, brand and channel” are markers of robust intangible capital. From launch through the end of June, 2013, the fund modestly outperformed the MSCI World Index and did so with two-thirds less volatility

During the summer hiatus on Observer conference calls, my colleague Charles Boccadoro and I have been listening-in on calls sponsored by some of the more interesting fund companies.  We report this month on the highlights of the calls concerning the reopening of RiverNorth/DoubleLine Strategic Income (David) and the evolution of the intriguing Whitebox Tactical Opportunities (Charles) funds.

Conference Call Highlights: RiverNorth/DoubleLine Strategic Income (RNDLX)

Strategic Income was launched on December 30, 2010 and our profile of the fund described it as “compelling.”  We speculated that if an investor were planning to hold only three funds over the long haul, “given its reasonable expenses, the managers’ sustained successes, innovative design and risk-consciousness, this might well be one of those three.”  Both popular ($1.1 billion in the portfolio) and successful (it has outperformed its “multisector bond” peers since inception and in seven of 10 quarters), the fund closed to new investors at the end of March. 2012.  Faced with a substantial expansion in their opportunity set, RiverNorth decided to reopen the fund to new investors 17 months later, at the end of August 2013, with the understanding that it was subject to re-closure if there was a pressing mismatch between the fund’s resources and the opportunities available.

On September 18, 2013, co-managers Jeffrey Gundlach of DoubleLine and Patrick Galley of RiverNorth spoke with interested parties about their decision to re-open the fund and its likely evolution.

By happenstance, the call coincided with the fed’s announcement that they’d put plans to reduce stimulus on hold, an event which led Mr. Gundlach to describe it as “a pivotal day for investor attitudes.” The call addressed three issues:

• The fund’s strategy and positioning.  The fund was launched as an answer to the question, how do income-oriented investors manage in a zero-rate environment?  The answer was, by taking an eclectic and opportunistic approach to exploiting income-producing investments.  The portfolio has three sleeves: core income, modeled after Doubleline’s Core Income Fund, opportunistic income, a mortgage-backed securities strategy which is Doubleline’s signature strength, and RiverNorth’s tactical closed-end income sleeve which seeks to profit from both tactical asset choices and the opportunities for arbitrage gains when the discounts on CEFs become unsustainably large.

  The original allocation was 50% core, 25% opportunistic and 25% tactical CEF.  RiverNorth’s strategy is to change weightings between the sleeves to help the portfolio manage changes in interest rates and volatility; in a highly volatile market, they might reallocate toward the more conservative core strategy while a rising interest rate regime might move them toward their opportunistic and tactical sleeves.  Before closing, much of the tactical CEF money was held in cash because opportunities were so few. 

• The rationale for reopening. Asset prices often bear some vague relation to reality.  But not always.  Opportunistic investors look to exploit other investors’ irrationality.  In 2009, people loathed many asset classes and in 2010 they loathed them more selectively.  As the memory of the crash faded, greed began to supplant fear and CEFs began selling at historic premiums to their NAVs.  That is, investors were willing to pay $110 for the privilege of owning $100 in equities.  Mr. Galley reported that 60% of CEFs sold at a premium to their NAVs in 2012.  2013 brought renewed anxiety, an anxious departure from the bond market by many and the replacement of historic premiums on CEFs with substantial discounts.  As of mid-September, 60% of CEFs were selling at discounts of 5% or more.  That is, investors were willing to sell $100 worth of securities for $95.

  As a whole, CEFs were selling at a 6.5% discount to NAV.  That compared to a premium the year before, an average 1% discount over the preceding three years and an average 3% discount over the preceding decade.

  

  The lack of opportunities in the fixed-income CEF space, a relatively small place, forced the fund’s closure.  The dramatic expansion of those opportunities justified its reopening.  The strategy might be able to accommodate as much as $1.5 billion in assets, but the question of re-closing the fund would arise well before then.

• Listener concerns.  Listeners were able to submit questions electronically to a RiverNorth moderator, an approach rather more cautious than the Observer’s strategy of having callers speak directly to the managers.  Some of the questions submitted were categorized as “repetitive or not worth answering” (yikes), but three issues did make it through. CEFs are traded using an algorithmic trading system developed by RiverNorth. It is not a black box, but rather a proprietary execution system used to efficiently trade closed-end funds based off of discount, instead of price. The size of the fund’s investable CEF universe is about 300 funds, out of 400 extant closed-end fixed-income funds. The extent of leverage in the portfolio’s CEFs was about 20%.

Bottom Line: the record of the managers and the fund deserves considerable respect, as does the advisor’s clear commitment to closing funds when doing so is in their investors’ best interest. The available data clearly supports the conclusion that, even with dislocations in the CEF space in 2013, active management has added considerable value here. 

The data-rich slides are already available by contacting RiverNorth. A transcript of the broadcast will be available on the RiverNorthFunds.com website sometime in October. 

Update: The webcast is now available at https://event.webcasts.com/viewer/event.jsp?ei=1021309 You will be required to register, but you’ll gain access immediately.

Conference Call Highlights: Whitebox Tactical Opportunities Fund (WBMAX and WBMIX)

Portfolio managers Andrew Redleaf and Dr. Jason Cross, along with Whitebox Funds’ President Bruce Nordin, hosted the 2^nd quarter conference call for their Tactical Opportunities Fund (WBMIX) on September 10. Robert Vogel, the fund’s third manager, did not participate. The call provided an opportunity to take a closer look at the fund, which is becoming hard to ignore.

Background

WBMIX is the more directionally oriented sibling of Whitebox’s market-neutral Long Short Equity Fund (WBLFX), which David profiled in April. Whitebox is preparing to launch a third mutual fund, named Enhanced Convertible Fund (WBNIX), although no target date has been established.

Whitebox Advisors, founded by Mr. Redleaf in 1999, manages its mutual funds with similar staff and strategies as its hedge funds. Mr. Redleaf is a deep contrarian of efficient market theory. He works to exploit market irrationalities and inefficiencies, like “mispriced securities that have a relationship to each other.” He received considerable attention for successfully betting against mortgages in 2008.

The Tactical Opportunities Fund seeks to provide “a combination of capital appreciation and income that is consistent with prudent investment management.” It employs the full spectrum of security classes, including stocks, bonds, and options. Its managers reject the notion that investors are rewarded for accepting more risk. “We believe risk does not create wealth, it destroys wealth.” Instead, they identify salient risks and adjust their portfolio “to perform at least tolerably well in multiple likely scenarios.”

The fund has attracted $205M AUM since its inception in December 2011 ­– on the day of the conference call, Morningstar showed AUM at $171M, an increase of $34M in less than three weeks. All three managers are also partners and owners in the firm, which manages about $2.4B in various types of investment accounts, but the SAI filed February 2013 showed none invested in the fund proper. Since this filing, Whitebox reports Mr. Redleaf has become a “significant owner” and that most of its partners and employees are invested in its funds through the company’s 401k program.

Morningstar recently re-categorized WBMIX from aggressive allocation to long-short after Whitebox management successfully appealed to the editorial board. While long-short is currently more appropriate, the fund’s versatility makes it an awkward fit in any category. It maintains two disparate benchmarks, S&P 500 Price Index SPX (excludes dividends) and Barclay’s Aggregate U.S. Bond Total Return Index. Going forward, Whitebox reports it will add S&P 500 Total Return Index as a benchmark.

Ideally, Mr. Redleaf would prefer the fund’s performance be measured against the nation’s best endowment funds, like Yale’s or Havard’s. He received multiple degrees from Yale in 1978. Dr. Cross holds an MBA from University of Chicago and a Ph.D. in Statistics from Yale.

Call Highlights

Most of its portfolio themes were positive or flat for the quarter, resulting in a 1.3% gain versus 2.9% for SP500 Total Return, 2.4% SP500 Price Return, 0.7% for Vanguard’s Balanced Index , and -2.3% for US Aggregate Bonds. In short, WBMIX had a good quarter.

Short Bonds. Whitebox has been sounding warning bells for sometime about overbought fixed income markets. Consequently, it has been shorting 20+ year Treasuries and high-yield bond ETFs, while being long blue-chip equities. If 1Q was “status quo” for investors, 2Q saw more of an orderly rotation out of low yielding bonds and into quality stocks. WBMIX was positioned to take advantage.

Worst-Case Hedge. It continues to hold out-of-money option straddles, which hedge against sudden moves up or down, in addition to its bond shorts. Both plays help in the less probable scenario that “credit markets crack” due to total loss of confidence in bonds, rapid rate increase and mass exodus, taking equities down with them.

Bullish Industrials. Dr. Cross explained that in 2Q they remained bullish on industrials and automakers. After healthy appreciation, they pared back on airlines and large financials, focusing instead on smaller banks, life insurers, and specialty financials. They’ve also been shorting lower yielding apartment REITS, but are beginning to see dislocations in higher yielding REITs and CEFs.

Gold Miner Value. Their one misstep was gold miners, at just under 5% of portfolio; it detracted 150 basis points from 2Q returns. Long a proxy for gold, miners have been displaced by gold ETFs and will no longer be able to mask poor business performance with commodity pricing. Mr. Redleaf believes increased scrutiny on these miners will lead to improved operations and a closure in the spread, reaping significant upside. He cited that six CEOs have retired or been replaced recently. This play is signature Whitebox. The portfolio managers do not see similar inefficiencies in base metal miners.

Large vs Small. Like its miss with gold miners, its large cap versus small cap play has yet to pan-out. It believes small caps are systematically overpriced, so they have been long on large caps while short on small caps. Again, “value arbitrage” Whitebox. The market agreed last quarter, but this theme has worked against the fund since 2Q12.

Heading into 3Q, Whitebox believes equities are becoming overbought, if temporarily, given their extended ascent since 2009. Consequently, WBMIX beta was cut to 0.35 from 0.70. This move appears more tactical than strategic, as they remain bullish on industrials longer term. Mr. Redleaf explains that this is a “game with no called strikes…you never have to swing.” Better instead to wait for your pitch, like winners of baseball’s Home Run Derby invariably do.

Whitebox has been considering an increase to European exposure, if it can find special situations, but during the call Mr. Redleaf stated that “emerging markets is a bit out of our comfort zone.”

Performance To-Date

The table below summaries WBMIX’s return/risk metrics over its 20-month lifetime. The comparative funds were suggested by MFO reader and prolific board contributor “Scott.” (He also brought WBMIX to community attention with his post back in August 2012, entitled “Somewhat Interesting Tiny Fund.”) Most if not all of the funds listed here, at some point and level (except VBINX), tout the ability to deliver balanced-like returns with less risk than the 60/40 fixed balanced portfolio.

While Whitebox has delivered superior returns (besting VBINX, Mr. Aronstein’s Marketfield and Mr. Romick’s Crescent, while trouncing Mr. Arnott’s All Asset and AQR’s Risk Parity), it’s generally done so with higher volatility. But the S&P 500 has had few drawdowns and low downside over this period, so it’s difficult to conclude if the fund is managing risk more effectively. That said, it has certainly played bonds correctly.

Other Considerations

When asked about the fund’s quickly increasing AUM, Dr. Cross stated that their portfolio contains large sector plays, so liquidity is not an issue. He believes that the fund’s capacity is “immense.”

Whitebox provides timely and thoughtful quarterly commentaries, both macro and security specific, both qualitative and quantitative. These commentaries reflect well on the firm, whose very name was selected to highlight a “culture of transparency and integrity.” Whitebox also sponsors an annual award for best financial research. The $25K prize this year went to authors of the paper “Time Series Momentum,” published in the Journal of Financial Economics.

Whitebox Mutual Funds offers Tactical Opportunities in three share classes. (This unfortunate practice is embraced by some houses, like American Funds and PIMCO, but not others, like Dodge & Cox and FPA.) Investor shares carry an indefensible front-load for purchases below $1M. Both Investor and Advisor shares carry a 12b-1 fee. Some brokerages, like Fidelity and Schwab, offer Advisor shares with No Transaction Fee. (As is common in the fund industry, but not well publicized, Whitebox pays these brokerages to do so – an expensive borne by the Advisor and not fund shareholders.) Its Institutional shares WBMIX are competitive currently at 1.35 ER, if not inexpensive, and are available at some brokerages for accounts with $100,000 minimum.

During the call, Mr. Redleaf stated that its mutual funds are cheaper than its hedge funds, but the latter “can hold illiquid and obscure securities, so it kind of balances out.” Perhaps so, but as Whitebox Mutual Funds continues to grow through thoughtful risk and portfolio management, it should adopt a simpler and less expensive fee structure: single share class, no loads or 12b-1 fees, reasonable minimums, and lowest ER possible. That would make this already promising fund impossible to ignore.

Bottom Line

At the end of the day, continued success with the fund will depend on whether investors believe its portfolio managers “have behaved reasonably in preparing for the good and bad possibilities in the current environment.” The fund proper is still young and yet to be truly tested, but it has the potential to be one of an elite group of funds that moderate investors could consider holding singularly – on the short list, if you will, for those who simply want to hold one all-weather fund.

A transcript of the 2Q call should be posted shortly at Whitebox Tactical Opportunities Fund.

27Sept2013/Charles

Conference Call Upcoming: Zachary Wydra, Beck, Mack & Oliver Partners (BMPEX), October 16, 7:00 – 8:00 Eastern

On October 16, Observer readers will have the opportunity to hear from, and speak to Zachary Wydra, manager of Beck, Mack & Oliver Partners (BMPEX).  After review of a lot of written materials on the fund and its investment discipline, we were impressed and intrigued.  After a long conversation with Zac, we were delighted.  Not to put pressure on the poor guy, but he came across as smart, insightful, reflective, animated and funny, often in a self-deprecating way.  We were more delighted when he agreed to spend an hour talking with our readers and other folks interested in the fund.

Mr. Wydra will celebrate having survived both the sojourn to Nebraska and participation in The Last Blast Triathlon by opening with a discussion of the  structure, portfolio management approach and stock selection criteria that distinguish BMPEX from the run-of-the-mill large cap fund, and then we’ll settle in to questions (yours and mine).

Our conference call will be Wednesday, October 16, from 7:00 – 8:00 Eastern.  It’s free.  It’s a phone call.

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?

Nearly 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.

The Conference Call Queue

We have two other calls on tap.  On Monday, November 18, from 7:00 – 8:00 Eastern, you’ll have a chance to meet John Park and Greg Jackson, co-managers of Oakseed Opportunity (SEEDX and SEDEX).  John and Greg have really first-rate experience as mutual fund managers and in private equity, as well.  Oakseed is a focused equity fund that invests in high quality businesses whose managers interests are aligned with their shareholders.  As we note in the Updates section below, they’re beginning to draw both high-quality investors and a greater range of media attention.  If you’d like to get ahead of the curve, you can register for the call with John and Greg though I will highlight their call in next month’s issue.

In early December we’ll give you a chance to speak with the inimitable duo of Sherman and Schaja on the genesis and early performance of RiverPark Strategic Income, the focus of this month’s Launch Alert.

Launch Alert: RiverPark Strategic Income (RSIVX, RSIIX)

There are two things particularly worth knowing about RiverPark Short-Term High Yield (RPHYX): (1) it’s splendid and (2) it’s closed.  Tragically mischaracterized as a high-yield bond fund by Morningstar, it’s actually a cash management fund that has posted 3-4% annual returns and negligible volatility, which eventually drew almost a billion to the fund and triggered its soft close in June.  Two weeks later, RiverPark placed its sibling in registration. That fund went live on September 30, 2013.

Strategic Income will be managed by David Sherman of Cohanzick Management, LLC.  David spent ten years at Leucadia National Corporation where he was actively involved high yield and distressed securities and rose to the rank of vice president.  He founded Cohanzick in 1996 and Leucadia became his first client.  Cohanzick is now a $1.3 billion dollar investment adviser to high net worth individuals and corporations.   

Ed Studzinski and I had a chance to talk with Mr. Sherman and Morty Schaja, RiverPark’s president, for an hour on September 18^th.  We wanted to pursue three topics: the relation of the new fund to the older one, his portfolio strategy, and how much risk he was willing to court. 

RPHYX represented the strategies that Cohanzick uses for dealing with in-house cash.  It targets returns of 3-4% with negligible volatility.  RSIVX represents the next step out on the risk-return continuum.  David believes that this strategy might be reasonably expected to double the returns of RPHYX.  While volatility will be higher, David is absolutely adamant about risk-management.  He intends this to be a “sleep well at night” fund in which his mother will be invested.  He refuses to be driven by the temptation to shoot for “the best” total returns; he would far rather sacrifice returns to protect against loss of principal.  Morty Schaja affirms the commitment to “a very conservative credit posture.”

The strategy snapshot is this.  He will use the same security selection discipline here that he uses at RPHYX, but will apply that discipline to a wider opportunity set.  Broadly speaking, the fund’s investments fall into a half dozen categories:

1. RPHYX overlap holdings – some of the longer-dated securities (1-3 year maturities) in the RPHYX portfolio will appear here and might make up 20-40% of the portfolio.
2. Buy and hold securities – money good bonds that he’s prepared to hold to maturity. 
3. Priority-based debt – which he describes as “above the fray securities of [firms with] dented credit.”  These are firms that “have issue” but are unlikely to file for bankruptcy any time soon.  David will buy higher-order debt “if it’s cheap enough,” confident that even in bankruptcy or reorganization the margin of safety provided by buying debt at the right price at the peak of the creditor priority pyramid should be money good.
4. Off-the-beaten-path debt – issues with limited markets and limited liquidity, possibly small issues of high quality credits or the debt of firms that has solid business prospects but only modestly-talented management teams.  As raters like S&P contract their coverage universe, it’s likely that more folks are off the major firm’s radar.
5. Interest rate resets – uhhh … my ears started ringing during this part of the interview; I had one of those “Charlie Brown’s teacher” moments.  I’m confident that the “cushion bonds” of the RPHYX portfolio, where the coupon rate is greater than the yield-to maturity, would fall into this category.  Beyond that, you’re going to need to call and see if you’re better at following the explanation than I was.
6. And other stuff – always my favorite category.  He’s found some interesting asset-backed securities, fixed income issues with equity-like characteristics and distressed securities, which end up in the “miscellaneous” basket.

Mr. Sherman reiterates that he’s not looking for the highest possible return here; he wants a reasonable, safe return.  As such, he anticipates underperforming in silly markets and outperforming in normal ones.

The minimum initial investment in the retail class is $1,000.  The expense ratio is capped at 1.25%.  The fund is available today at TD and Fidelity and is expected to be available within the next few days at Schwab. More information is available at RiverPark’s website.  As I noted in September’s review of my portfolio, this is one of two funds that I’m almost certain to purchase before year’s end.

Funds in Registration

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

Every day David Welsch, firefighter/EMT/fund researcher, scours new SEC filings to see what opportunities might be about to present themselves.  This month he tracked down 10 no-load funds in registration, one of the lowest levels in a year (compare it to 26 last month), but it does contain three offerings from first-rate, veteran teams:

361 Multi-Strategy Fund, 361’s fourth alternatives fund, guided by Brian Cunningham (a hedge fund guy), Thomas Florence (ex-Morningstar Investment Management), Blaine Rollins (ex-Janus) and Jeremy Frank.

Croft Focus, which transplants the discipline that’s guided Croft Value for 18 years into a far more concentrated global portfolio.

RSQ International Equity, which marks the re-emergence of Rudolph Riad-Younes and Richard Pell from the ashes of the Artio International crash.

In addition, two first-tier firms (Brookfield and First Eagle) have new funds managed by experienced teams.

Funds in registration this month won’t be available for sale until, typically, the end of November or early December 2013.

Manager Changes

On a related note, we also tracked down 39 fund manager changes.

Updates

The good folks at Oakseed Opportunity (SEEDX and SEDEX) are getting their share of favorable notice.  The folks at Bloomberg featured them in A Fund’s Value: Having Skin in the Game (Sept 6, 2013) while, something called Institutional Imperative made them one of Two Funds on which to Build a Portfolio (Sept 10, 2013).  At last report, they were holding more cash, more international exposure and smaller firms than their peers, none of which has been positive in this year’s market. Somehow the fact that the managers have $10 million of their own money in the fund, and that two phenomenally talented international investors (David Herro of Oakmark and David Samra of Artisan) are also invested in the fund does rather make “weak relative returns in 2013” sound rather like background noise.  Thanks to the indefatigable Denny Baran for sharing both of those links and do consider the opportunity to speak with the Oakseed managers during our November conference call.

Morningstar declared Poplar Forest Partners Fund (PFPFX and IPFPX) to be an Undiscovered Manager (uhhh … okay) and featured them in a Morningstar Advisor Magazine article, “Greener Pastures” (August/September, 2013).  Rob Wherry makes the argument that manager Dale Harvey walked away from managing a $20 billion fund because it was – for reasons he couldn’t control – a $20 billion fund.  “I had to put the money to work. I was managing $20 billion, but I didn’t have $20 billion [worth of] good ideas . . . I had 80 investments, but I only wanted 30.”  It’s a good piece.

Briefly Noted . . .

Since DundeeWealth US, LP, has opted to get out of the US mutual fund business they’re looking for a buyer for their Dynamic Energy Income Fund (DWEIX/DWEJX/DWEKX), Dynamic U.S. Growth Fund (DWUGX/DWUHX/DWUIX) and Mount Lucas U.S. Focused Equity Fund (BMLEX) funds. Failing that, they’re likely to liquidate them. My suggestion for eBaying them was not received warmly (hey, it worked for William Shatner’s $25,000 kidney stone!). If you’re looking for a handful of $50 million funds – one of which, US Growth, is remarkably good – you might give them a call.

Fidelity Global Balanced Fund (FGBLX) manager Ruben Calderon has taken a leave of absence for an unspecified reason.  His co-manager, Geoff Stein, will take sole control.   A chunk of my retirement accounts are, and have for a long time been, invested in the fund and I wish Mr. Calderon all the best with whatever has called him away.

JPMorgan Value Opportunities Fund (JVOAX) isn’t dead yet.  The Board is appalled.  The Board convened a meeting on September 10, 2013, for the purpose of merged Value Opps into JPMorgan Large Cap Value.  Unfortunately, they have not received enough ballots to meet their quorum requirement and the meeting dissolved.  They’ve resolved to try again with the following stern warning to non-voting shareholders:

However, recognizing that it is neither feasible nor legally permitted for the Value Opportunities Fund to conduct a proxy solicitation indefinitely, the Board approved in principle the liquidation of the Value Opportunities Fund if shareholders do not approve the merger when the Meeting is reconvened on October 10, 2013. If the Value Opportunities Fund is liquidated, the Fund’s liquidation may be taxable to a shareholder depending on the shareholder’s tax situation; as a result, the tax-free nature of the merger may be more beneficial to shareholders.

Translation: (a) vote (b) the way we want you to, or we’ll liquidate your fund and jack up your taxes.

Litman Gregory giveth and Litman Gregory taketh away.  The firm has eliminated the redemption fee on its Institutional Class shares, but then increased the minimum investment for Institutional shares of their Equity (MSEFX) and International (MSILX) funds from $10,000 to $100,000.

Vanguard 500 Index Fund ETF Shares (VOO) has announced an odd reverse share split.  As of October 24, 2013, the fund will issue one new share for every two current ones.  Good news: Vanguard expects somewhat lower transaction costs as a result, savings which they’ll pass along to investors.  Bad news: “As a result of the split, VOO shareholders could potentially hold fractional shares. These will be redeemed for cash and sent to the broker of record, which may result in the realization of modest taxable gains or deductible losses for some shareholders.”

Virtus Dynamic AlphaSector Fund (EMNAX), on the other hand, mostly taketh away.  Virtus discontinued the voluntary limit on “Other Expenses” of the fund.  The fund, categorized as a long/short fund though it currently has no reported short positions, charges a lot for modest achievement: Class A Shares, 2.56%; Class B Shares, 3.31%; Class C Shares, 3.31%; and Class I Shares, 2.31%.   Virtus may also recapture fees previously waived. 

SMALL WINS FOR INVESTORS

The Board for Altegris Equity Long Short Fund (ELSAX) voted to reduce Altegris’s management fee from 2.75% to 2.25% of assets.   This qualifies as a small win since that’s still about 50% higher than reasonable.  Aston River Road Long/Short (ARLSX) investors, for example, pays a management fee of 1.20% for considerably stronger performance.  Wasatch Long/Short (FMLSX) investors pay 1.10%.

Altegris Futures Evolution Strategy Fund  (EVOAX) has capped its management fee at 1.50%.

Calamos Convertible Fund (CCVIX) reopened to new investors on September 6^th.

CSC Small Cap Value Fund (CSCSX) has been renamed Cove Street Capital Small Cap Value Fund.  They’ve eliminated their sales loads and reduced the minimum initial investment to $1,000 for Investor class shares and $10,000 for Institutional class shares.   The manager here was part of the team that had fair success at the former CNI Charter RCB Small Cap Value Fund.

CLOSINGS (and related inconveniences)

ASTON/Fairpointe Mid Cap Fund (ABMIX) is set to close on October 18, 2013.  About $5 billion in assets.  Consistently solid performance.  I’m still not a fan of announcing a closing four weeks ahead of the actual event, as happened here.

BMO Small-Cap Growth Fund (MRSCX) is closing effective November 1, 2013.  The closure represents an interesting reminder of the role of invisible assets in capacity limits.  The fund has $795 million in it, but the advisor reports that assets in the small-cap growth strategy as a whole are approaching approximately $1.5 billion.

Invesco European Small Company Fund (ESMAX) closes to new investors on October 4, 2013.  Invesco’s to be complimented on their decision to close the fund while it was still small, under a half billion in assets.

Touchstone Sands Capital Select Growth Fund (TSNAX) instituted a soft-close on April 8, 2013.  That barely slowed the inrush of money and the fund is now up to $5.5 billion in assets.  In response, the advisor will institute additional restrictions on October 21, 2013. In particular, existing RIA’s already using the fund can continue to use the fund for both new and existing clients.  They will not be able to accept any new RIA’s after that date.

Virtus Emerging Markets Opportunities Fund (HEMZX), a four-star medalist run by Morningstar’s International Stock Fund Manager of the Year Rajiv Jain, has closed to new investors.

OLD WINE, NEW BOTTLES

FMI Focus (FMIOX) will reorganize itself into Broadview Opportunity Fund in November.  It’s an exceedingly solid small-cap fund (four stars, “silver” rated, nearly a billion in assets) that’s being sold to its managers.

Invesco Disciplined Equity Fund (AWEIX) will, pending shareholder approval on October 17, become AT Disciplined Equity Fund.

Meridian Value (MVALX) is Meridian Contrarian Fund.  Same investment objective, policies, strategies and team. 

Oppenheimer Capital Income Fund (OPPEX) has gained a little flexibility; it can now invest 40% in junk bonds rather than 25%.  The fund was crushed during the meltdown in 2007-09.  Immediately thereafter its managers were discharged and it has been pretty solid since then.

Effective October 1, 2013, Reaves Select Research Fund (RSRAX) became Reaves Utilities and Energy Infrastructure Fund, with all of the predictable fallout in its listed investment strategies and risks.

Smith Group Large Cap Core Growth Fund (BSLGX) will, pending shareholder approval, be reorganized into an identical fund of the same name in early 2014. 

Tilson Dividend Fund (TILDX) has been sold to its long-time subadviser, Centaur Capital Partners, LP, presumably as part of the unwinding of the other Tilson fund.

U.S. Global Investors Government Securities Savings Fund (UGSCX) is being converted from a money market fund to an ultra-short bond fund, right around Christmas.

OFF TO THE DUSTBIN OF HISTORY

American Century announced that it will merge American Century Vista Fund (TWVAX) into American Century Heritage (ATHAX).  Both are multibillion dollar midcap growth funds, with Heritage being far the stronger. The merger will take place Dec. 6, 2013.

EGA Emerging Global ordered the liquidation of a dozen of emerging markets sector funds, all effective October 4, 2013.  The dearly departed:

• EGShares GEMS Composite ETF (AGEM)
• EGShares Basic Materials GEMS ETF (LGEM)
• EGShares Consumer Goods GEMS ETF (GGEM)
• EGShares Consumer Services GEMS ETF (VGEM)
• EGShares Energy GEMS ETF (OGEM)
• EGShares Financials GEMS ETF (FGEM)
• EGShares Health Care GEMS ETF (HGEM)
• EGShares Industrials GEMS ETF (IGEM)
• EGShares Technology GEMS ETF (QGEM)
• EGShares Telecom GEMS ETF (TGEM)
• EGShares Utilities GEMS ETF (UGEM)
• EGShares Emerging Markets Metals & Mining ETF (EMT)

FCI Value Equity Fund (FCIEX) closed September 27, on its way to liquidation.  The Board cited “the Fund’s small size and the increasing costs associated with advising a registered investment company” but might have cited, too, the fact that it trails 97% of its peers over the past five years and tended to post two awful years for every decent one.

Natixis Hansberger International Fund (NEFDX) will liquidate on October 18, 2013, a victim of bad returns, high risk, high expenses, wretched tax efficiency … all your basic causes.

Loomis Sayles Multi-Asset Real Return Fund (MARAX) liquidates at the end of October, 2013.  The fund drew about  $25 million in assets and was in existence for fewer than three years.  “Real return” funds are designed to thrive in a relatively high or rising inflation rate environment.  Pretty much any fund bearing the name has been thwarted by the consistent economic weakness that’s been suppressing prices.

I really like Manning & Napier.  They are killing off three funds that were never a good match for the firm’s core strengths.  Manning & Napier Small Cap (MNSMX), Life Sciences (EXLSX), and Technology (EXTCX) will all cease to exist on or about January 24, 2014.  My affection for them comes to mind because these funds, unlike the vast majority that end up in the trash heap, were all economically viable.  Between them they have over $600 million in assets and were producing $7 million/year in revenue for M&N.  The firm’s great strength is risk-conscious, low-cost, team-managed diversified funds.  Other than a real estate fund, they offer almost no niche products really.  Heck, the tech fund even had a great 10-year record and was no worse than mediocre in shorter time periods.  But, it seems, they didn’t make sense given M&N’s focus. 

Metzler/Payden European Emerging Markets Fund (MPYMX) closed on September 30, 2013.  It actually outperformed the average European equity fund over the past decade but suffered two cataclysm losses – 74% from June 2008 to March 2009 and 33% in 2011 – that surely sealed its fate.  We reviewed the fund favorably as a fascinating Eurozone play about seven years ago. 

Nuveen International (FAIAX) is slated to merge into Nuveen International Select (ISACX), which is a case of a poor fund with few assets joining an almost-as-poor fund with more assets (and, not coincidentally, the same managers). 

PIA Moderate Duration Bond Fund (PIATX) “will be liquidating its assets on October 31, 2013.  You are welcome, however, to redeem your shares before that date.”  As $30 million in assets, it appears that most investors didn’t require the board’s urging before getting out.

U.S. Global Investors Tax Free Fund (USUTX) will merge with a far better fund, Near-Term Tax Free (NEARX) on or about December 13, 2013.

U.S. Global Investors Treasury Securities Cash (USTXX) vanishes on December 27, 2013.

Victoria 1522 Fund (VMDAX) has closed and will liquidate on October 10, 2013.  Nice people, high fees, weak performance, no assets. 

Westcore Small-Cap Opportunity Fund (WTSCX) merges into the Westcore Small-Cap Value Dividend Fund (WTSVX) on or about November 14, 2013.  It’s hard to make a case for the surviving fund (it pays almost no dividend and trails 90% of its peers) except to say it’s better than WTSCX.  Vanguard has an undistinguished SCV index fund that would be a better choice than either.

In Closing . . .

At the beginning of October, we’ll be attending Morningstar’s ETF Invest Conference in Chicago, our first tentative inquiry, made in hopes of understanding better the prospects of actively-managed ETFs.  I don’t tweet (I will never tweet) but I will try to share daily updates and insights on our discussion board.  We’ll offer highlights of the conference presentations in our November issue.

Thanks to all of the folks who bookmarked or clicked on our Amazon link.  There was a gratifyingly sustained uptick in credit from Amazon, on the order of a 7-8% rise from our 2013 average.  Thanks especially to those who’ve supported the Observer directly (Hi, Joe!  It’s a tough balance each month: we try to be enjoyable without being fluffy, informative without being plodding.  Glad you think we make it.) or via our PayPal link (Thanks, Ken!  Thanks, Michelle.  Sorry I didn’t extend thanks sooner.  And thanks, especially, to Deb.  You make a difference).  It does make a difference.

We’ll see you just after Halloween.  If you have little kids who enjoy playing on line, one of Chip’s staff made a little free website that lets kids decorate jack-o-lanterns.  It’s been very popular with the seven-and-under set. 

Take care!

David

Dear friends,

My colleagues in the English department are forever yammering on about this Shakespeare guy.I’m skeptical. First, he didn’t even know how to spell his own name (“Wm Shakspē”? Really?). Second, he clearly didn’t understand seasonality of the markets. If you listen to Gloucester’s famous declamation in Richard III, you’ll see what I mean:

Now is the winter of our discontent
Made glorious summer by this sun of York;
And all the clouds that lour’d upon our house
In the deep bosom of the ocean buried.
Now are our brows bound with victorious wreaths;
Our bruised arms hung up for monuments;
Our stern alarums changed to merry meetings,
Our dreadful marches to delightful measures.

It’s pretty danged clear that we haven’t had anything “made glorious summer by the sun of [New] York.” By Morningstar’s report, every single category of bond and hybrid fund has lost money over the course of the allegedly “glorious summer.” Seven of the nine domestic equity boxes have flopped around, neither noticeably rising nor falling.

And now, the glorious summer passed, we enter what historically are the two worst months for the stock market. To which I can only reply with three observations (The Pirates are on the verge of their first winning season since 1992! The Steelers have no serious injuries looming over them. And Will’s fall baseball practices are upon us.) and one question:

Is it time to loathe the emerging markets? Again?

Yuh, apparently. A quick search in Google News for “emerging markets panic” turns up 3300 stories during the month of August. They look pretty much like this:

With our preeminent journalists contributing:

Many investors have responded as they usually do, by applying a short-term perspective to a long-term decision. Which is to say, they’re fleeing. Emerging market bond funds saw a $2 billion outflow in the last week of August and $24 billion since late May (Emerging Markets Fund Flows Investors Are Dumping Emerging Markets at an Accelerating Pace, Business Insider, 8/30/13). The withdrawals were indiscriminate, affecting all regions and both local currency and hard currency securities. Equity funds saw $4 billion outflows for the week, with ETFs leading the way down (Emerging markets rout has investors saying one word: sell, Marketwatch, 8/30/13).

In a peculiar counterpoint, Jason Kepler of Investment News claims – using slightly older data – that Mom and pop can’t quit emerging-market stocks. And that’s good (8/27/13). He finds “uncharacteristic resiliency” in retail investors’ behavior. I’d like to believe him. (The News allows a limited number of free article views; if you’d exceeded your limit and hit a paywall, you might try Googling the article title. Or subscribing, I guess.)

We’d like to make three points.

• Emerging markets securities are deeply undervalued
• Those securities certainly could become much more deeply undervalued.
• It’s not the time to be running away.

Emerging markets securities are deeply undervalued

Wall Street Ranter, an anonymous blogger from the financial services industry and sometime contributor to the Observer’s discussion board, shared two really striking bits of valuation data from his blog.

The first, “Valuations of Emerging Markets vs US Stocks” (7/20/13) looks at a PIMCO presentation of the Shiller PE for the emerging markets and U.S., then at how such p/e ratios have correlated to future returns. Shiller adjusts the market’s price/earnings ratio to eliminate the effect of atypical profit margins, since those margins relentlessly regress to the mean over time. There’s a fair amount of research that suggests that the Shiller PE has fair predictive validity; that is, abnormally low Shiller PEs are followed by abnormally high market returns and vice versa.

Here, with Ranter’s kind permission, is one of the graphics from that piece:

At June 30, 2013 valuations, this suggests that US equities were priced for 4% nominal returns (2-3% real), on average, over the next five years while e.m. equities were priced to return 19% nominal (17% or so real) over the same period. GMO, at month’s end, reached about the same figure for high quality US equities (3.1% real) but a much lower estimate (6.8%) for emerging equities. By GMO’s calculation, emerging equities were priced to return more than twice as much as any other publicly traded asset class.

Based on recent conversations with the folks at GMO, Ranter concludes that GMO suspects that changes in the structure of the Chinese economy might be leading them to overstate likely emerging equity returns. Even accounting for those changes, they remain the world’s most attractive asset class:

While emerging markets are the highest on their 7 year forecast (approx. 7%/year) they are treating it more like 4%/year in their allocations . . . because they believe they need to account for a longer-term shift in the pace of China’s growth. They believe the last 10 years or so have skewed the mean too far upwards. While this reduces slightly their allocation, it still leaves Emerging Markets has one of their highest forecasts (but very close to International Value … which includes a lot of developed European companies).

Ranter offered a second, equally striking graphic in “Emerging Markets Price-to-Book Ratio and Forward Returns (8/9/13).”

At these levels, he reports, you’d typically expect returns over the following year of around 55%. That data is available in his original article. 

In a singularly unpopular observation, Andrew Foster, manager of Seafarer Overseas Growth & Income (SFGIX/SIGIX), one of the most successful and risk-alert e.m. managers (those two attributes are intimately connected), notes that the most-loathed emerging markets are also the most compelling values:

The BRICs have underperformed to such an extent that their aggregate valuation, when compared to the emerging markets as a whole, is as low as it has been in eight years. In other words, based on a variety of valuation metrics (price-to-book value, price-to-prospective-earnings, and dividend yield), the BRICs are as cheap relative to the rest of the emerging markets as they have been in a long time. I find this interesting. . . for the (rare?) subset of investors contemplating a long-term (10-year) allocation to EM, just as they were better off to avoid the BRICs over the past 5 years when they were “hot,” they are likely to be better off over the next 10 years emphasizing the BRICs now they are “not.”

Those securities certainly could become much more deeply undervalued.

The graphic above illustrates the ugly reality that sometimes (late ’98, all of ’08), but not always (’02, ’03, mid ’11), very cheap markets become sickeningly cheap markets before rebounding. Likewise, Shiller PE for the emerging markets occasionally slip from cheap (10-15PE) to “I don’t want to talk about it” (7 PE). GMO mildly notes, “economic reality and investor behavior cause securities and markets to overshoot their fair value.”

Andrew Foster gently dismisses his own predictive powers (“my record on predicting short-term outcomes is very poor”). At the same time, he finds additional cause for short-term concern:

[M]y thinking on the big picture has changed since [early July] because currencies have gotten into the act. I have been worried about this for two years now — and yet even with some sense it could get ugly, it has been hard to avoid mistakes. In my opinion, currency movements are impossible to predict over the short or long term. The only thing that is predictable is that when currency volatility picks up, is likely to overshoot (to the downside) in the short run.

It’s not the time to be running away.

There are two reasons driving that conclusion. First, you’ve already gotten the timing wrong and you’re apt to double your error. The broad emerging markets index has been bumping along without material gain for five years now. If you were actually good at actively allocating your portfolio, you’d have gotten out in the summer of 2007 instead of thinking that five consecutive years of 25%+ gains would go on forever. And you, like the guys at Cook and Bynum, would have foregone Christmas presents in 2008 in order to plow every penny you had into an irrationally, shockingly cheap market. If you didn’t pull it off then, you’re not going to pull it off this time, either.

Second, there are better options here than elsewhere. These remain, even after you adjust down their earnings and adjust them down again, about the best values you’ll find. Ranter grumbles about the thoughtless domestic dash:

Bottom line is I fail to see, on a relative basis, how the US is more tempting looking 5 years out. People can be scared all they want of catching a falling knife…but it’s a lot easier to catch something which is only 5 feet in the air than something that is 10 feet in the air.

If you’re thinking of your emerging markets stake as something that you’ll be holding or building over the next 10-15 years (as I do), it doesn’t matter whether you buy now or in three months, at this level or 7% up or down from here. It will matter if you panic, leave and then refuse to return until the emerging markets feel “safe” to you – typically around the top of the next market cycle.

It’s certainly possible that you’re systemically over-allocated to equities or emerging equities. The current turbulence might well provide an opportunity to revisit your long-term plan, and I’d salute you for it. My argument here is against actions driven by your gut.

Happily, there are a number of first rate options available for folks seeking risk-conscious exposure to the emerging markets. My own choice, discussed more fully below, is Seafarer. I’ve added to my (small investor-sized) account twice since the market began turning south in late spring. I have no idea of whether those dollars with be worth a dollar or eighty cents or a plugged nickel six months from now. My suspicion is that those dollars will be worth more a decade from now having been invested with a smart manager in the emerging markets than they would have been had I invested them in domestic equities (or hidden them away in a 0.01% bank account). But Seafarer isn’t the only “A” level choice. There are some managers sitting on large war chests (Amana Developing World AMDWX), others with the freedom to invest across asset classes (First Trust/Aberdeen Emerging Opportunities FEO) and even some with both (Lazard Emerging Markets Multi-Strategy EMMOX).

To which Morningstar says, “If you’ve got $50 million to spend, we’ve got a fund for you!”

On August 22^nd, Morningstar’s Fund Spy trumpeted “Medalist Emerging-Markets Funds Open for Business,” in which they reviewed their list of the crème de la crème emerging markets funds. It is, from the average investor’s perspective, a curious list studded with funds you couldn’t get into or wouldn’t want to pay for. Here’s the Big Picture:

Our take on those funds follows.

Our recommendations differ from theirs, given our preference for smaller funds that are actually available to the public. Our shortlist:

Amana Developing World (AMDWX): offers an exceedingly cautious take on an exceedingly risky slice of the world. Readers were openly derisive of Amana’s refusal to buy at any cost, which led the managers to sit on a 50% cash stake while the market’s roared ahead. As those markets began their swoon in 2011, Amana began moving in and disposing of more than half of its cash reserves. Still cash-rich, the fund’s relative performance is picking up and its risks remain very muted.

First Trust/Aberdeen Emerging Opportunity (FEO): one of the first emerging markets balanced funds, it’s performed very well over the long-term and is currently selling at a substantial discount to NAV: 12.6%, about 50% greater than its long-term average. That implies that investors might see something like a 5% arbitrage gain once the current panic abates, above and beyond whatever the market provides.

Grandeur Peak Emerging Markets Opportunities (GPEOX): the Grandeur Peak team has been brilliantly successful both here and at Wasatch. Their intention is to create a single master fund (Global Reach) and six subsidiary funds whose portfolios represent slices of the master profile. Emerging Markets has already cleared the SEC registration procedures but hasn’t launched. The Grandeur Peak folks say two factors are driving the delay. First, the managers want to be able to invest directly in Indian equities which requires registration with that country’s equity regulators. They couldn’t begin the registration until the fund itself was registered in the US. So they’re working through the process. Second, they wanted to be comfortable with the launch of Global Reach before adding another set of tasks. Give or take the market’s current tantrum (one manager describes it as “a taper tantrum”), that’s going well. With luck, but without any guarantees, the fund might be live sometime in Q4.

Seafarer Overseas Growth & Income (SFGIX): hugely talented manager, global portfolio, risk conscious, shareholder-centered and successful.

Wasatch Frontier Emerging Small Countries (WAFMX): one of the very few no-load, retail funds that targets the smaller, more dynamic markets rather than markets with billions of people (India and China) or plausible claim to be developed markets (e.g., Korea). The manager, Laura Geritz, has been exceedingly successful. Frontier markets effectively diversify emerging markets portfolios and the fund has drawn nearly $700 million. The key is that Wasatch is apt to close the fund sooner rather than later.

Snowball’s portfolio

Some number of folks have, reasonably enough, asked whether I invest in all of the funds I profile (uhhh … there have been over 150 of them, so no) or whether I have found The Secret Formula (presumably whatever Nicholas Cage has been looking for in all those movies). The answer is less interesting than the question.

I guess my portfolio construction is driven by three dictums:

1. Don’t pretend to be smarter than you are
2. Don’t pretend to be braver than you are
3. There’s a lot of virtue in doing nothing

Don’t pretend to be smarter than you are. If I knew which asset classes were going to soar and which were going to tank in the next six months or year or two, two things would happen. First, I’d invest in the winners. Second, I’d sell my services to ridiculously rich people and sock them with huge and abusive fees that they’d happily pay. But, I don’t.

As a result, I tend to invest in funds whose managers have a reasonable degree of autonomy about investing across asset classes, rather than ones pigeonholed into a small (style) box. That’s a problem: it makes benchmarking hard, it makes maintaining an asset allocation plan hard and it requires abnormally skilled managers. My focus has been on establishing a strategic objective (“increasing exposure to fast growing economies”) and then spending a lot of time trying to find managers whose strategies I trust, respect and understand.

Don’t pretend to be braver than you are. Stocks have a lot in common with chili peppers. In each case, you get a surprising amount of benefit from a relatively small amount of exposure. In each case, increasing exposure quickly shifts the pleasure/pain balance from pleasantly piquant to moronically painful. Some readers think of my non-retirement asset allocation is surprisingly timid: about 50% stocks, 30% bonds, 20% cash equivalents. They’re not much happier about my 70% equity stake in retirement funds. But, they’re wrong.

T. Rowe Price is one of my favorite fund companies, in part because they treat their investors with unusual respect. I found two Price studies, in 2004 and again in 2010, particularly provocative. Price constructed a series of portfolios representing different levels of stock exposure and looked at how the various portfolios would have played out over the past 50-60 years.

The original study looked at portfolios with 20/40/60/80/100% stocks. The update dropped the 20% portfolio and looked at 0/40/60/80/100%. Below I’ve reproduced partial results for three portfolios. The original 2004 and 2010 studies are available at the T. Rowe Price website.

 Over a 10 year period – reasonable for a non-retirement account – a portfolio that’s 20% stocks would grow from $10,000 to $21,000. A 100% stock portfolio would grow to $28,000. Roughly speaking, the conservative portfolio ends up at 75% of the size of the aggressive one but a pure stock portfolio increases the probability of losing money by 400% (from a 6% chance to 23%), increases the size of your average loss by 2500% (from 0.5% to 12.5%) and triples your volatility. Somewhere in there, it will face the real prospect of a 51% loss, which is the average maximum drawdown for large core stock funds that have been around 20 years or more. Sadly, there’s no way of knowing whether the 51% loss will occur in Year One (where you might have some recovery time) or Year Ten (where you’d be toast).

At 50% equities, I might capture 80% of the market’s gain with 50% of its volatility. If domestic bonds weren’t in such dismal straits, a smaller stock exposure might be justifiable. But they suck so I’m stuck.

There’s a lot of virtue in doing nothing. Our action tends to be a lot more costly than our inaction, so I change my target allocation slowly and change my fund line-up slowly. I’ve held a few retirement plan funds (e.g., Fidelity Low Priced Stock FLPSX) for decades and a number of non-retirement funds since their inception. In general, I’ll only add a fund if it represents an entirely new opportunity set or if it’s replacing an existing fund. On average, I might change out one fund every year or two.

My retirement portfolio is dominated by the providers in Augustana’s 403(b) plan: Fidelity, T. Rowe Price and TIAA-CREF. The college contribution to retirement goes exclusively into TIAA-CREF. CREF Stock accounts for 68%, TIAA Real Estate holds 22% and the rest is in a target-date fund. The Fidelity and Price allocations mirror one another: 33% domestic stock (with a value bias), 33% international stock (with an emerging markets bias) and 33% income (of the eclectic Spectrum Income/Global High Income sort).

My non-retirement portfolio is nine funds and some cash waiting to be deployed.

Is anyone likely to make it into my portfolio in 2013-14? There are two candidates:

ASTON/River Road Long-Short (ARLSX). We’ve both profiled the fund and had a conference call with its manager, both of which are available on the Observer’s ARLSX page. I’m very impressed with the quality and clarity of their risk-management disciplines; they’ve left little to chance and have created a system that forces them to act when it’s time. They’ve performed well since inception and have the prospect of outperforming the stock market with a fraction of its risk. If this enters the portfolio, it would likely be as a substitute for Northern Global Tactical since the two serve the same risk-dampening function.

RiverPark Strategic Income (not yet launched). This fund will come to market in October and represents the next step out on the risk-return spectrum from the very successful RiverPark Short Term High Yield (RPHYX). I’ve been impressed with David Sherman’s intelligence and judgment and with RPHYX’s ability to deliver on its promises. We’ll be doing fairly serious inquiries in the next couple months, but the new fund might become a success to T. Rowe Price Spectrum Income.

Sterling Capital hits Ctrl+Alt+Delete

Sterling Capital Select Equity (BBTGX) has been a determinedly bad fund for years. It’s had three managers since 1993 and it has badly trailed its benchmark under each of them. The strategy is determinedly nondescript. They’ve managed to return 3.2% annually over the past 15 years. That’s better – by about 50 bps – than Vanguard’s money market fund, but not by much. Effective September 3, 2013, they’re hitting “reformat.”

The fund’s name changes, to Sterling Capital Large Cap Value Diversified Fund.

The strategy changes, to a “behavioral financed” based system targeting large cap value stocks.

The benchmark changes, to the Russell 1000 Value

And the management team changes, to Robert W. Bridges and Robert O. Weller. Bridges joined the firm in 2008 and runs the Sterling Behavioral Finance Small Cap Diversified Alpha. Mr. Weller joined in 2012 after 15 years at JPMorgan, much of it with their behavioral finance team.

None of which required shareholders’ agreement since, presumably, all aspects of the fund are “non-fundamental.” 

One change that they should pursue but haven’t: get the manager to put his own money at risk. The departing manager was responsible for five funds since 2009 and managed to find nary a penny to invest in any of them. As a group, Sterling’s bond and asset allocation team seems utterly uninterested in risking their own money in a lineup of mostly one- and two-star funds. Here’s the snapshot of those managers’ holdings in their own funds:

You’ll notice the word “none” appears 32 times. Let’s agree that it would be silly to expect a manager to own tax-free bonds anywhere but in his home jurisdiction. That leaves 26 decisions to avoid their own funds out of a total of 27 opportunities. Most of the equity managers, by contrast, have made substantial personal investments.

Warren Buffett thinks you’ve come to the right place

Fortune recently published a short article which highlighted a letter that Warren Buffett wrote to the publisher of the Washington Post in 1975. Buffett’s an investor in the Post and was concerned about the long-term consequences of the Post’s defined-benefit pension. The letter covers two topics: the economics of pension obligations in general and the challenge of finding competent investment management. There’s also a nice swipe at the financial services industry, which most folks should keep posted somewhere near their phone or monitor to review as you reflect on the inevitable marketing pitch for the next great financial product.

I particularly enjoy the “initially.” Large money managers, whose performance records were generally parlous, “felt obliged to seek improvement or at least the approach of improvement” by hiring groups “with impressive organizational charts, lots of young talent … and a record of recent performance (pg 8).” Unfortunately, he notes, they found it.

The pressure to look like you were earning your keep led to high portfolio turnover (Buffett warns against what would now be laughably low turnover: 25% per annum). By definition, most professionals cannot be above average but “a few will succeed – in a modest way – because of skill” (pg 10). If you’re going to find them, it won’t be by picking past winners though it might be by understanding what they’re doing and why:

The key: abandon all hope ye who invest in behemoths:

For those interested in Buffett’s entire reflection, Chip’s embedded the following:

Warren Buffett Katharine Graham Letter

And now for something completely different …

We can be certain of some things about Ed Studzinski. As an investor and co-manager of Oakmark Equity & Income (OAKBX), he was consistently successful in caring for other people’s money (as much as $17 billion of it), in part because he remained keenly aware that he was also caring for their futures. $10,000 entrusted to Ed and co-manager Clyde McGregor on the day Ed joined the fund (01 March 2000) would have grown to $27,750 on the day of his departure (31 December 2011). His average competitor (I’m purposefully avoiding “peer” as a misnomer) would have managed $13,900.

As a writer and thinker, he minced no words.

The Equity and Income Fund’s managers have both worked in the investment industry for many decades, so we both should be at the point in our careers where dubious financial-industry innovations no longer surprise us. Such an assumption, however, would be incorrect.

For the past few quarters we have repeatedly read that the daily outcomes in the securities markets are the result of the “Risk On/Risk Off” trade, wherein investors (sic?) react to the most recent news by buying equities/selling bonds (Risk On) or the reverse (Risk Off). As value investors we think this is pure nonsense. 

Over the past two years, Ed and I have engaged in monthly conversations that I’ve found consistently provocative and information-rich. It’s clear that he’s been paying active attention for many years to contortions of his industry which he views with equal measures of disdain and alarm. 

I’ve prevailed upon Ed to share a manager’s fuss and fulminations with us, as whim, wife and other obligations permit. His first installment, which might also be phrased as the question “Whose skin in the game?” follows.

“Skin in the Game, Part One”

One of the more favored sayings of fund managers is that they like to invest with managements with “skin in the game.” This is another instance where the early Buffett (as opposed to the later Buffett) had it right. Managements can and should own stock in their firms. But they should purchase it with their own money. That, like the prospect of hanging as Dr. Johnson said, would truly clarify the mind. In hind sight a major error in judgment was made by investment professionals who bought into the argument that awarding stock options would beneficially serve to align the interests of managements and shareholders. Never mind that the corporate officers should have already understood their fiduciary obligations. What resulted, not in all instances but often enough in the largest capitalization companies, was a class of condottieri such as one saw in Renaissance Italy, heading armies that spent their days marching around avoiding each other, all the while being lavishly paid for the risks they were NOT facing. This sub-set of managers became a new entitled class that achieved great personal wealth, often just by being present and fitting in to the culture. Rather than thinking about truly long-term strategic implications and questions raised in running a business, they acted with a short-duration focus, and an ever-present image of the current share price in the background. Creating sustainable long-term business value rarely entered into the equation, often because they had never seen it practiced.

I understood how much of a Frankenstein’s monster had been created when executive compensation proposals ended up often being the greater part of a proxy filing. A particularly bothersome practice was “reloading” options annually. Over time, with much dilution, these programs transferred significant share ownership to management. You knew you were on to something when these compensation proposals started attracting negative vote recommendations. The calls would initially start with the investor relations person inquiring about the proxy voting process. Once it was obvious that best practices governance indicated a “no” vote, the CFO would call and ask for reconsideration.

How do you determine whether a CEO or CFO actually walks the walk of good capital allocation, which is really what this is all about? One tip-off usually comes from discussions about business strategy and what the company will look like in five to ten years. You will have covered metrics and standards for acquisitions, dividends, debt, share repurchase, and other corporate action. Following that, if the CEO or CFO says, “Why do you think our share price is so low?” I would know I was in the wrong place. My usual response was, “Why do you care if you know what the business value of the company is per share? You wouldn’t sell the company for that price. You aren’t going to liquidate the business. If you did, you know it is worth substantially more than the current share price.” Another “tell” is when you see management taking actions that don’t make sense if building long-term value is the goal. Other hints also raise questions – a CFO leaves “because he wants to enjoy more time with his family.” Selling a position contemporaneously with the departure of a CFO that you respected would usually leave your investors better off than doing nothing. And if you see the CEO or CFO selling stock – “our investment bankers have suggested that I need to diversify my portfolio, since all my wealth is tied up in the company.” That usually should raise red flags that indicate something is going on not obvious to the non-insider.

Are things improving? Options have gone out of favor as a compensation vehicle for executives, increasingly replaced by the use of restricted stock. More investors are aware of the potential conflicts that options awards can create and have a greater appreciation of governance. That said, one simple law or regulation would eliminate many of the potential abuses caused by stock options. “All stock acquired by reason of stock option awards to senior corporate officers as part of their compensation MAY NOT BE SOLD OR OTHERWISE DISPOSED OF UNTIL AFTER THE EXPIRATION OF A PERIOD OF THREE YEARS FROM THE INDIVIDUAL’S LAST DATE OF SERVICE.” Then you might actually see the investors having a better chance of getting their own yachts.

Edward A. Studzinski

If you’d like to reach Ed, click here. An artist’s rendering of Messrs. Boccadoro and Studzinski appears below.

Introducing Charles’ Balcony

Since his debut in February 2012, my colleague Charles Boccadoro has produced some exceedingly solid, data-rich analyses for us, including this month’s review of the risk/return profiles of the FundX family of funds. One of his signature contributions was “Timing Method Performance Over Ten Decades,” which was widely reproduced and debated around the web.

We’re pleased to announce that we’ve collected his essays in a single, easy-to-access location. We’ve dubbed it “Charles’ Balcony” and we even stumbled upon this striking likeness of Charles and the shadowy Ed Studzinski in situ. I’m deeply hopeful that from their airy (aerie or eery) perch, they’ll share their sharp-eyed insights with us for years to come.

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. 

Advisory Research Strategic Income (ADVNX): you’ve got to love a 10 month old fund with a 10 year track record and a portfolio that Morningstar can only describe as 60% “other.” AR converted a successful limited partnership into the only no-load mutual fund offering investors substantial access to preferred securities.

Beck, Mack and Oliver Partners (BMPEX): we think of it as “Dodge and Cox without the $50 billion in baggage.” This is an admirably disciplined, focused equity fund with a remarkable array of safeguards against self-inflicted injuries.

FPA Paramount (FPRAX): some see Paramount as a 60-year-old fund that seeks out only the highest-quality mid-cap growth stocks. With a just-announced change of management and philosophy, it might be moving to become a first-rate global value fund (with enough assets under management to start life as one of the group’s most affordable entries).

FundX Upgrader (FUNDX): all investors struggle with the need to refine their portfolios, dumping losers and adding winners. In a follow-up to his data-rich analysis on the possibility of using a simple moving average as a portfolio signal, associate editor Charles Boccadoro investigated the flagship fund of the Upgrader fleet.

Tributary Balanced (FOBAX): it’s remarkable that a fund this consistently good – in the top tier of all balanced funds over the past five-, ten-, and fifteen-year periods and a Great Owl by my colleague Charles’ risk/return calculations – hasn’t drawn more attention. It will be more remarkable if that neglect continues despite the recent return of the long-time manager who beat pretty much everyone in sight.

Elevator Talk #8: Steven Vannelli of GaveKal Knowledge Leaders (GAVAX)

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.

Steven Vannelli, Manager

GaveKal Knowledge Leaders (GAVAX) believes in investing only in firms that are committed to being smart, so where did the dumb name come from? GaveKal is a portmanteau formed from the names of the firm’s founders: Charles Gave, Anatole Kaletsky and Louis-Vincent Gave. Happily it changed the fund’s original name from GaveKal Platform Company Fund (named after its European counterpart) to Knowledge Leaders. 

GaveKal, headquartered in Hong Kong, started in 2001 as a global economics and asset allocation research firm. Their other investment products (the Asian Balanced Fund – a cool idea which was rechristened Asian Absolute Return – and Greater China Fund) are available to non-U.S. investors as, originally, was Knowledge Leaders. They opened a U.S. office in 2006. In 2010 they deepened their Asia expertise by acquiring Dragonomics, a China-focused research and advisory firm.

Knowledge Leaders has generated a remarkable record in its two-plus years of U.S. operation. They look to invest in “the best among global companies that are tapping a deep reservoir of intangible capital to generate earnings growth,” where “R&D, design, brand and channel” are markers of robust intangible capital. From launch through the end of June, 2013, the fund modestly outperformed the MSCI World Index and did so with two-thirds less volatility. Currently, approximately 30% of the portfolio is in cash, down from 40% earlier in summer.

Manager Steven Vannelli researches intangible capital and corporate performance and leads the fund’s investment team. Before joining GaveKal, he spent a decade at Alexander Capital, a Denver-based investment advisor. Here’s Mr. Vannelli’s 200 words making his case:

We invest in the world’s most innovative companies. Decades of academic research show that companies that invest heavily in innovation are structurally undervalued due to lack of information on innovative activities. Our strategy capitalizes on this market inefficiency.

To find investment opportunities, we identify Knowledge Leaders, or companies with large stores of intangible assets. These companies often operate globally across an array of industries from health care to technology, from consumer to capital goods. We have developed a proprietary method to capitalize a company’s intangible investments, revealing an important, invisible layer of value inherent to intangible-rich companies. 

The Knowledge Leaders Strategy employs an active strategy that offers equity-like returns with bond-like risk. Superior risk-adjusted returns with low correlation to market indices make the GaveKal Knowledge Leaders Strategy a good vehicle for investors who seek to maximize their risk and return objectives.

The genesis of the strategy has its origin in the 2005 book, Our Brave New World, by GaveKal Research, which highlights knowledge as a scare asset.

As a validation of our intellectual foundation, in July, the US Bureau of Economic Analysis began to capitalize R&D to measure the contribution of innovation spending on growth of the US economy.

The minimum initial investment on the fund’s retail shares is $2,500. There are also institutional shares (GAVIX) with a $100,000 minimum (though they do let financial advisors aggregate accounts in order to reach that threshold). The fund’s website is clean and easily navigated. It would make a fair amount of sense for you to visit to “Fund Documents” page, which hosts the fund’s factsheet and a thoughtful presentation on intangible capital. 

Our earlier Elevator Talks were:

1. February 2013: Tom Kerr, Rocky Peak Small Cap Value (RPCSX), whose manager has a 14 year track record in small cap investing and a passion for discovering “value” in the intersection of many measures: discounted cash flows, LBO models, M&A valuations and traditional relative valuation metrics.
2. March 2013: Dale Harvey, Poplar Forest Partners (PFPFX and IPFPX), a concentrated, contrarian value stock fund that offers “a once-in-a-generation opportunity to invest with a successful American Funds manager who went out on his own.”
3. April 2013: Bayard Closser, Vertical Capital Income Fund (VCAPX), “a closed-end interval fund, VCAPX invests in whole mortgage loans and first deeds of trust. We purchase the loans from lenders at a deep discount and service them ourselves.”
4. May 2013: Jim Hillary, LS Opportunity Fund (LSOFX), a co-founder of Marsico Capital Management whose worry that “the quality of research on Wall Street continues to decline and investors are becoming increasingly concerned about short-term performance” led to his faith in “in-depth research and long-term orientation in our high conviction ideas.”
5. July 2013: Casey Frazier, Versus Capital Multi-Manager Real Estate Income Fund (VCMRX), a second closed-end interval fund whose portfolio “includes real estate private equity and debt, public equity and debt, and broad exposure across asset types and geographies. We target a mix of 70% private real estate with 30% public real estate to enhance liquidity, and our objective is to produce total returns in the 7 – 9% range net of fees.”
6. August 2013: Brian Frank, Frank Value Fund (FRNKX), a truly all-cap value fund with a simple, successful discipline: if one part of the market is overpriced, shop elsewhere.
7. August 2013: Ian Mortimer and Matthew Page of Guinness Atkinson Inflation Managed Dividend (GAINX), a global equity fund that pursues firms with “sustainable and potentially rising dividends,” which also translates to firms with robust business models and consistently high return on capital.

Upcoming conference call: A discussion of the reopening of RiverNorth Strategy Income (RNDLX)

The folks at RiverNorth will host a conference call between the fund’s two lead managers, Patrick Galley of RiverNorth and Jeffrey Gundlach of DoubleLine, to discuss their decision to reopen the fund to new investors at the end of August and what they see going forward (the phrase “fear and loathing” keeps coming up). 

The call will be: Wednesday, September 18, 3:15pm – 4:15pm CDT

To register, go to www.rivernorthfunds.com/events/

The webcast will feature a Q&A with Messrs. Galley and Gundlach.

RNDLX (RNSIX for the institutional class), which the Observer profiled shortly after launch, has been a very solid fund with a distinctive strategy. Mr. Gundlach manages part of his sleeve of the portfolio in a manner akin to DoubleLine Core Fixed Income (DLFNX) and part with a more opportunistic income strategy. Mr. Galley pursues a tactical fixed-income allocation and an utterly unique closed-end fund arbitrage strategy in his slice. The lack of attractive opportunities in the CEF universe prompted the fund’s initial closure. Emily Deter of RiverNorth reports that the opening “is primarily driven by the current market opportunity in the closed-end fund space. Fixed-income closed-end funds are trading at attractive discounts to their NAVs, which is an opportunity we have not seen in years.” Investment News reported that fixed-income CEFs moved quickly from selling at a 2% premium to selling at a 7% discount. 

That’s led Mr. Galley’s move from CEFs from occupying 17% of the portfolio a year ago to 30% today and, it seems, he believes he could pursue more opportunities if he had more cash on hand.

Given RiverNorth’s ongoing success and clear commitment to closing funds well before they become unmanageable, it’s apt to be a good use of your time.

The Observer’s own series of conference calls with managers who’ve proven to be interesting, sharp, occasionally wry and successful, will resume in October. We’ll share details in our October issue.

Funds in Registration

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

Every day David Welsch, an exceedingly diligent research assistant at the Observer, scours new SEC filings to see what opportunities might be about to present themselves. David tracked down nearly 100 new funds and ETFs. Many of the proposed funds offer nothing new, distinctive or interesting. Some were downright mystifying. (Puerto Rico Shares? Colombia Capped ETF? The Target Duration 2-month ETF?) There were 26 no-load funds or actively-managed ETFs in registration with the SEC this month. 

Funds in registration this month won’t be available for sale until, typically, the end of October or early November 2013.

There are probably more interesting products in registration this month than at any time in the seven years we’ve been tracking them. Among the standouts:

Brown Advisory Strategic European Equity Fund which will be managed by Dirk Enderlein of Wellington Management. Wellington is indisputably an “A-team” shop (they’ve got about three-quarters of a trillion in assets under management). Mr. Enderlein joined them in 2010 after serving as a manager for RCM – Allianz Global Investors in Frankfurt, Germany (1999-2009). Media reports described him as “one of Europe’s most highly regarded European growth managers.”

DoubleLine Shiller Enhanced CAPE will attempt to beat an index, Shiller Barclays CAPE® US Sector TR USD Index, which was designed based on decades of research by the renowned Robert Shiller. The fund will be managed by Jeffrey Gundlach and Jeffrey Sherman.

Driehaus Micro Cap Growth Fund, a converted 15 year old hedge fund

Harbor Emerging Markets Equity Fund, which will be sub-advised by the emerging markets team at Oaktree Capital Management. Oaktree’s a first-tier institutional manager with a very limited number of advisory relationships (primarily with Vanguard and RiverNorth) in the mutual fund world. 

Meridian Small Cap Growth, which will be the star vehicle for Chad Meade and Brian Schaub, who Meridian’s new owner hired away from Janus. Morningstar’s Greg Carlson described them as “superb managers” who were “consistently successful during their nearly seven years at the helm” of Janus Triton.

Plus some innovative offerings from Northern, PIMCO and T. Rowe Price. Details and the list of all of the funds in registration are available at the Observer’s Funds in Registration page or by clicking “Funds” on the menu atop each page.

Manager Changes

On a related note, we also tracked down a record 85 fund manager changes. Investors should take particular note of Eric Ende and Stephen Geist’s exit from FPA Paramount after a 13 year run. The change is big enough that we’ve got a profile of Paramount as one of the month’s Most Intriguing New Funds.

Updates

Bretton Fund (BRTNX) is now available through Vanguard. Manager Stephen Dodson writes that after our conference call, several listeners asked about the fund’s availability and Stephen encouraged them to speak directly with Vanguard. Mirabile dictu, the Big V was receptive to the idea.

Stephen recently posted his most recent letter to his shareholders. He does a nice job of walking folks through the core of his investing discipline with some current illustrations. The short version is that he’s looking for firms with durable competitive advantages in healthy industries whose stocks are selling at a substantial discount. He writes:

There are a number of relevant and defensible companies out there that are easily identifiable; the hard part is finding the rare ones that are undervalued. The sweet spot for us continues to be relevant, defensible businesses at low prices (“cheap compounders”). I continue to spend my waking hours looking for them.

Q2 2013 presented slim pickin’s for absolute value investors (Bretton “neither initiated nor eliminated any investments during the quarter”). For all of the market’s disconcerting gyrations this summer, Morningstar calculates that valuations for its Wide Moat and Low Business Uncertainty groups (surrogates for “high quality stocks”) remains just about where they were in June: undervalued by about 4% while junkier stocks remain modestly overvalued.

Patience is hard.

Briefly Noted . . .

Calamos loses another president

James Boyne is resigning as president and chief operating officer of Calamos Investments effective Sept. 30, just eight months after being promoted to president. The firm has decided that they need neither a president nor a chief operating officer. Those responsibilities will be assumed “by other senior leaders” at the firm (see: Black, Gary, below). The preceding president, Nick P. Calamos, decided to “step back” from his responsibilities in August 2012 when, by coincidence, Calamos hired former Janus CEO Gary Black. To describe Black as controversial is a bit like described Rush Limbaugh as opinionated.

They’re not dead yet!

Back in July, the Board of Caritas All-Cap Growth (CTSAX): “our fund is tiny, expensive, bad, and pursues a flawed investment strategy (long stocks, short ETFs).” Thereupon they reached a sensible conclusion: euthanasia. Shortly after the fund had liquidated all of its securities, “the Board was presented with and reviewed possible alternatives to the liquidation of the Fund that had arisen since the meeting on July 25, 2013.”

The alternative? Hire Brenda A. Smith, founder of CV Investment Advisors, LLC, to manage the fund. A quick scan of SEC ADV filings shows that Ms. Smith is the principal in a two person firm with 10 or fewer clients and $5,000 in regulated AUM. 

(I don’t know more about the firm because they have a one page website.)

At almost the same moment, the same Board gave Ms. Smith charge of the failing Presidio Multi-Strategy Fund (PMSFX), an overpriced long/short fund that executes its strategy through ETFs. 

I wish Ms. Smith and her new investors all the luck in the world, but it’s hard to see how a Board of Trustees could, with a straight face, decide to hand over one fund and resuscitate another with huge structural impediments on the promise of handing it off to a rookie manager and declare that both moves are in the best interests of long-suffering shareholders.

Diamond Hill goes overseas, a bit

Effective September 1, 2013, Diamond Hill Research Opportunities Fund (DHROX) gains the flexibility to invest internationally (the new prospectus allows that it “may also invest in non-U.S. equity securities, including equity securities in emerging market countries”) and the SEC filing avers that they “will commence investing in foreign securities.” The fund has 15 managers; I’m guessing they got bored. As a hedge fund (2009-2011), it had a reasonably mediocre record which might have spurred the conversion to a ’40 fund. Which has also had a reasonably mediocre lesson, so points to the management for consistency!

Janus gets more bad news

Janus investors pulled $2.2 billion from the firm’s funds in July, the worst outflows in more than three years. A single investor accounted for $1.3 billion of the leakage. The star managers of Triton and Venture left in May. And now this: they’re losing business to Legg Mason.

The Board of Trustees of Met Investors Series Trust has approved a change of subadviser for the Janus Forty Portfolio from Janus Capital Management to ClearBridge Investments to be effective November 1, 2013 . . . Effective November 1, 2013, the name of the Portfolio will change to ClearBridge Aggressive Growth Portfolio II.

Matthews chucks Taiwan

Matthews Asia China (MCHFX), China Dividend (MCDFX) and Matthews and China Small Companies (MCSMX) have changed their Principal Investment Strategy to delete Taiwan. The text for China Dividend shows the template:

Under normal market conditions, the Matthews China Dividend Fund seeks to achieve its investment objective by investing at least 80% of its net assets, which include borrowings for investment purposes, in dividend-paying equity securities of companies located in China and Taiwan.

To:

Under normal market conditions, the Matthews China Dividend Fund seeks to achieve its investment objective by investing at least 80% of its nets assets, which include borrowings for investment purposes, in dividend-paying equity securities of companies located in China.

A reader in the financial services industry, Anonymous Dude, checked with Matthews about the decision. AD reports

T. Rowe tweaks

Long ago, as a college administrator, I was worried about whether the text in a proposed policy statement might one day get us in trouble. I still remember college counsel shaking his head confidently, smiling and saying “Not to worry. We’re going to fuzz it up real good.” One wonders if he works for T. Rowe Price now? Up until now, many of Price’s funds have had relatively detailed and descriptive investment objectives. No more! At least five of Price’s funds propose new language that reduces the statement of investment objectives to an indistinct mumble. T. Rowe Price Growth Stock Fund (PRGFX) goes from

The fund seeks to provide long-term capital growth and, secondarily, increasing dividend income through investments in the common stocks of well-established growth companies.

To

The fund seeks long-term capital growth through investments in stocks.

Similar blandifications are proposed for Dividend Growth, Equity Income, Growth & Income and International Growth & Income.

Wasatch redefines “small cap”

A series of Wasatch funds, Small Growth, Small Value and Emerging Markets Small Cap are upping the size of stocks in their universe from $2.5 billion or less to $3.0 billion or less. The change is effective in November.

Can you say whoa!? Or WOA?

The Board of Trustees of an admittedly obscure little institutional fund, WOA All Asset (WOAIX), has decided that the best way to solve what ails the yearling fund is to get it more aggressive.

The Board approved certain changes to the Fund’s principal investment strategies. The changes will be effective on or about September 3, 2013. . . the changes in the Fund’s strategy will alter the Fund’s risk level from balanced strategy with a moderate risk level to an aggressive risk level.

Here’s the chart of the fund’s performance since inception against conservative and moderate benchmarks. While that might show that the managers just need to fire up the risk machine, I’d also imagine that addressing the ridiculously high expenses (1.75% for an institutional balanced fund) and consistent ability to lag in both up and down months (11 of 16 and counting) might actually be a better move. 

WOA’s Trustees, by the way, are charged with overseeing 24 funds. No Trustee has a dollar invested in any of those funds.

SMALL WINS FOR INVESTORS

The Board of Trustees of the Direxion Funds and Rafferty Asset Management have decided to make it cheaper for you to own a bunch of funds that you really shouldn’t own. They’re removed the 25 bps Shareholder Servicing Fee from

• Direxion Monthly S&P 500® Bull 2X Fund
• Direxion Monthly S&P 500® Bear 2X Fund
• Direxion Monthly NASDAQ-100® Bull 2X Fund
• Direxion Monthly Small Cap Bull 2X Fund
• Direxion Monthly Small Cap Bear 2X Fund
• Direxion Monthly Emerging Markets Bull 2X Fund
• Direxion Monthly Latin America Bull 2X Fund
• Direxion Monthly China Bull 2X Fund
• Direxion Monthly Commodity Bull 2X Fund
• Direxion Monthly 7-10 Year Treasury Bull 2X Fund
• Direxion Monthly 7-10 Year Treasury Bear 2X Fund
• Dynamic HY Bond Fund and
• U.S. Government Money Market Fund.

Because Eaton Vance loves you, they’ve decided to create the opportunity for investors to buy high expense “C” class shares of Eaton Vance Bond (EVBCX). The new shares will add a 1.00% back load for sales held less than a year and a 1.70% expense ratio (compared to 0.7 and 0.95 for Institutional and A, respectively). 

The Fairholme Fund (FAIRX) reopened to new investors on August 19, 2013. The other Fairholme family funds, not so much.

The Advisor Class shares of Forward Select Income Fund (FSIMX) reopened to new investors at the end of August.

The Board of Directors of the Leuthold Global Industries Fund (LGINX) has agreed to reduce the Fund’s expense cap from 1.85% to 1.60%.

JacksonPark Capital reduced the minimum initial investment on Oakseed Opportunity Institutional shares (SEDEX) from $1 million to $10,000. Given the 18% lower fees on the institutional class (capped at 1.15% versus 1.40% for retail shares), reasonably affluent retail investors ought to seriously consider pursuing the institutional share class. That said, Oakseed’s minimum investment for the retail shares, as low as $100 for accounts set up with an AIP, are awfully reasonable.

RiverNorth DoubleLine Strategic Income (RNDLX/RNSIX) reopened to new investors at the end of August. Check the “upcoming conference calls” feature, above, for more details.

Westcore Blue Chip Dividend Fund (WTMVX ) lowered the expense ratio on its no-load retail shares from 1.15% to 0.99%, effective September 1. They also changed from paying distributions annually to paying them quarterly. It’s a perfectly agreeable, mild-mannered little fund: stable management, global diversified, reasonable expenses and very consistently muted volatility. You do give up a fair amount of upside for the opportunity to sleep a bit more quietly at night.

CLOSINGS (and related inconveniences)

American Beacon Stephens Small Cap Growth Fund (STSGX) will close to new investors, effective as of September 16, 2013. The no-class share class has returned 11.8% while its peers made 9.3% and it did so with lower volatility. The fund is closing at a still small $500 million.

Neither high fees nor mediocre performance can dim the appeal of AQR Multi-Strategy Alternative Fund (ASANX/ASAIX). The fund has drawn $1.5 billion and has advertised the opportunity for rich investors (the minimum runs between $1 million and $5 million) to rush in before the doors swing shut at the end of September. It’s almost always a bad sign that a fund feels the need to close and the need to put up a flashing neon sign six weeks ahead.

Morgan Stanley Institutional Global Franchise (MSFAX) will close to new investors on Nov. 29, 2013. The current management team came on board four years ago (June 2009) and have posted very good risk-adjusted returns since then. Investors might wonder why a large cap global fund with a small asset base needs to close. The answer is that the mutual fund represents just the tip of the iceberg; this team actually manages almost $17 billion in this strategy, so the size of the separate accounts is what’s driving the decision.

OLD WINE, NEW BOTTLES

At the end of September Ariel International Equity Fund (AINTX) becomes Ariel International Fund and will no longer be required to invest at least 80% of its assets in equities. At the same time, Ariel Global Equity Fund (AGLOX) becomes Ariel Global Fund. The advisor avers that it’s not planning on changing the funds’ investment strategies, just that it would be nice to have the option to move into other asset classes if conditions dictate.

Effective October 30, Guggenheim U.S. Long Short Momentum Fund (RYAMX) will become plain ol’ Guggenheim Long-Short Fund. In one of those “why bother” changes, the prospectus adds a new first sentence to the Strategy section (“invest, under normal circumstances, at least 80% of its assets in long and short equity or equity-like securities”) but maintains the old “momentum” language in the second and third sentences. They’ll still “respond to the dynamically changing economy by moving its investments among different industries and styles” and “allocates investments to industries and styles according to several measures of momentum. “ Over the past five years, the fund has been modestly more volatile and less profitable than its peers. As a result, they’ve attracted few assets and might have decided, as a marketing matter, that highlighting a momentum approach isn’t winning them friends.

As of October 28, the SCA Absolute Return Fund (SCARX) will become the Granite Harbor Alternative Fund and it will no longer aim to provide “positive absolute returns with less volatility than traditional equity markets.” Instead, it’s going for the wimpier “long-term capital appreciation and income with low correlation” to the markets. SCA Directional Fund (SCADX) will become Granite Harbor Tactical Fund but will no longer seek “returns similar to equities with less volatility.” Instead, it will aspire to “long term capital appreciation with moderate correlation to traditional equity markets.” 

Have you ever heard someone say, “You know, what I’m really looking for is a change for a moderate correlation to the equity markets”? No, me neither.

Thomas Rowe Price, Jr. (the man, 1898-1983) has been called “the father of growth investing.” It’s perhaps then fitting that T. Rowe Price (the company) has decided to graft the word “Growth” into the names of many of its funds effective November 1.

T. Rowe Price Institutional Global Equity Fund becomes T. Rowe Price Institutional Global Focused Growth Equity Fund. Institutional Global Large-Cap Equity Fund will change its name to the T. Rowe Price Institutional Global Growth Equity Fund. T. Rowe Price Global Large-Cap Stock Fund will change its name to the T. Rowe Price Global Growth Stock Fund.

Effective October 28, 2013, USB International Equity Fund (BNIEX) gets a new name (UBS Global Sustainable Equity Fund), new mandate (invest globally in firms that pass a series of ESG screens) and new managers (Bruno Bertocci and Shari Gilfillan). The fund’s been a bit better under the five years of Nick Irish’s leadership than its two-star rating suggests, but not by a lot.

Off to the dustbin of history

There were an exceptionally large number of funds giving up the ghost this month. We’ve tracked 26, the same as the number of new no-load funds in registration and well below the hundred or so new portfolios of all sorts being launched. I’m deeply grateful to The Shadow, one of the longest-tenured members of our discussion board, for helping me to keep ahead of the flood.

American Independence Dynamic Conservative Plus Fund (TBBIX, AABBX) will liquidate on or about September 27, 2012.

Dynamic Canadian Equity Income Fund (DWGIX) and Dynamic Gold & Precious Metals Fund (DWGOX), both series of the DundeeWealth Funds, are slated for liquidation on September 23, 2013. Dundee bumped off Dynamic Contrarian Advantage Fund (DWGVX) and announced that it was divesting itself of three other funds (JOHCM Emerging Markets Opportunities Fund JOEIX, JOHCM International Select Fund JOHIX and JOHCM Global Equity Fund JOGEX), which are being transferred to new owners.

Equinox Commodity Strategy Fund (EQCAX) closed to new investors in mid-August and will liquidate on September 27^th.

The Evolution Funds face extinction! Oh, the cruel irony of it.

Evolution Managed Bond (PEMVX) Evolution All-Cap Equity (PEVEX), Evolution Market Leaders (PEVSX) and Evolution Alternative Investment (PETRX) have closed to all new investment and were scheduled to liquidate by the end of September. Given their disappearance from Morningstar, one suspects the end came more quickly than we knew.

Frontegra HEXAM Emerging Markets Fund (FHEMX) liquidates at the end of September.

The Northern Lights Board of Trustees has concluded that “based on, among other factors, the current and projected level of assets in the Fund and the belief that it would be in the best interests of the Fund and its shareholders to discontinue the Hundredfold Select Global Fund (SFGPX).”

Perhaps the “other factors” would be the fact that Hundredfold trailed 100% of its peers over the past three- and five-year periods? The manager was unpaid and quite possibly the fund’s largest shareholder ($50-100k in a $2M fund). His Hundredfold Select Equity (SFEOX) is almost as woeful as the decedent, but Hundredfold Select Alternative (SFHYX) is in the top 1% of its peer group for the same period that the others are bottom 1%. That raises the spectre that luck, rather than skill, might be involved.

JPMorgan is cleaning house: JPMorgan Credit Opportunities Fund (JOCAX), JPMorgan Global Opportunities Fund (JGFAX) and JPMorgan Russia Fund (JRUAX) are all gone as of October 4.

John Hancock intends to merge John Hancock High Income (JHAQX) into John Hancock High Yield (JHHBX). I’m guessing at the fund tickers because the names in the SEC filing don’t quite line up with the Morningstar ones.

Legg Mason Esemplia Emerging Markets Long-Short Fund (SMKAX) will be terminated on October 1, 2013. Let’s see: hard-to-manage strategy, high risk, high expenses, high front load, no assets . . . sounds like Legg.

Leuthold Asset Allocation Fund (LAALX) is merging into Leuthold Core Investment Fund (LCORX). The Board of Directors approved a proposal for the Leuthold Asset Allocation to be acquired by the Leuthold Core, sometime in October 2013. Curious. LAALX, with a quarter billion in assets, modestly lags LCORX which has about $600 million. Both lag more mild-mannered funds such as Northern Global Tactical Asset Allocation (BBALX) and Vanguard STAR (VGSTX) over the course of LAALX’s lifetime. This might be less a story about LAALX than about the once-legendary Leuthold Core. Leuthold’s funds are all quant-driven, based on an unparalleled dataset. For years Core seemed unstoppable: between 2003 and 2008, it finished in the top 5% of its peer group four times. But for 2009 to now, it has trailed its peers every year and has bled $1 billion in assets. In merging the two, LAALX investors get a modestly less expensive fund with modestly better performance. Leuthold gets a simpler administrative structure. 

I halfway admire the willingness of Leuthold to close products that can’t distinguish themselves in the market. Clean Tech, Hedged Equity, Undervalued & Unloved, Select Equities and now Asset Allocation have been liquidated.

MassMutual Premier Capital Appreciation Fund (MCALX) will be liquidated, but not until January 24, 2014. Why? 

New Frontiers KC India Fund (NFIFX) has closed and began the process of liquidating their portfolio on August 26^th. They point to “difficult market conditions in India.” The fund’s returns were comparable to its India-focused peers, which is to say it lost about 30% in 18 months.

Nomura Partners India Fund (NPIAX), Greater China Fund (NPCAX) and International Equity Fund (NPQAX) will all be liquidated by month’s end.

Nuveen Quantitative Enhanced Core Equity (FQCAX) is slated, pending inevitable shareholder approval, to disappear into Nuveen Symphony Low Volatility Equity Fund (NOPAX, formerly Nuveen Symphony Optimized Alpha Fund)

Oracle Mutual Fund (ORGAX) has “due to the relatively small size of the fund” underwent the process of “orderly dissolution.” Due to the relatively small size? How about, “due to losing 49.5% of our investors’ money over the past 30 months, despite an ongoing bull market in our investment universe”? To his credit, the advisor’s president and portfolio manager went down with the ship: he had something between $500,000 – $1,000,000 left in the fund as of the last SAI.

Quantitative Managed Futures Strategy Fund (QMFAX) will “in the best interests of the Fund and its shareholders” redeem all outstanding shares on September 15^th.

The directors of the United Association S&P 500 Index Fund (UASPX/UAIIX) have determined that it’s in their shareholders’ best interest to liquidate. Uhhh … I don’t know why. $140 million in assets, low expenses, four-star rating …

Okay, so the Oracle Fund didn’t seem particularly oracular but what about the Steadfast Fund? Let’s see: “steadfast: firmly loyal or constant, unswerving, not subject to change.” VFM Steadfast Fund (VFMSX) launched less than one year ago and gone before its first birthday.

In Closing . . .

Interesting stuff’s afoot. We’ve spoken with the folks behind the surprising Oberweis International Opportunities Fund (OBIOX), which was much different and much more interesting that we’d anticipated. Thanks to “Investor” for poking us about a profile. In October we’ll have one. RiverPark Strategic Income is set to launch at the end of the month, which is exciting both because of the success of the other fund (the now-closed RiverPark Short Term High Yield Fund RPHYX) managed by David Sherman and Cohanzick Asset Management and because Sherman comes across as such a consistently sharp and engaging guy. With luck, I’ll lure him into an extended interview with me and a co-conspirator (the gruff but lovable Ed Studzinski, cast in the role of a gruff but lovable curmudgeon who formerly managed a really first-rate mutual fund, which he did).

MFO returns to Morningstar! Morningstar is hosting their annual ETF Invest Conference in Chicago, from October 2 – 4. While, on whole, we’d rather drop by their November conference in Milan, Italy it was a bit pricey and I couldn’t get a dinner reservation at D’O before early February 2014 so we decided to pass it up. While the ETF industry seems to be home to more loony ideas and regrettable business practices than most, it’s clear that the industry’s maturing and a number of ETF products offer low cost access to sensible strategies, some in areas where there are no tested active managers. The slow emergence of active ETFs blurs the distinction with funds and Morningstar does seem do have arranged both interesting panels (skeptical though I am, I’ll go listen to some gold-talk on your behalf) and flashy speakers (Austan Goolsbee among them). With luck, I’ll be able to arrange a couple of face-to-face meetings with Chicago-based fund management teams while I’m in town. If you’re going to be at the conference, feel free to wave. If you’d like to chat, let me know.

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The Sufi poet Attar records the fable of a powerful king who asks assembled wise men to create a ring that will make him happy when he is sad, and vice versa. After deliberation the sages hand him a simple ring with the words “This too will pass.” That’s also true of whatever happens to the market and your portfolio in September and October.

Be brave and we’ll be with you in a month!

Dear friends,

As most of you know, my day job is as a professor at Augustana College in Rock Island, Illinois. We have a really lovely campus (one prospective student once joked that we’re the only college he’d visited that actually looked like its postcards) and, as the weather has warmed, I’ve returned to taking my daily walk over the lunch hour.

We have three major construction projects underway, a lot for a school our size. We’re renovating Old Main, which was built in 1884, originally lit gas lanterns and warmed by stoves in the classrooms. After a century of fiddling with it, we finally resolved to strip out a bunch of “improvements” from days gone by, restore some of its original grandeur and make it capable of supporting 21^st century classes.

We’re also building Charles D. Lindberg Stadium, where our football team will finally get to have a locker room and seating for 1800. It’s emblematic that our football stadium is actually named for a national debate champion; we’re kind of into the whole scholar-athlete ethos. (We have the sixth greatest number of Academic All-Americans of any school in the country, just behind Stanford and well ahead of Texas.)

And we’re creating a Center for Student Life, which is “fused” to the 4^th floor of our library. The Center will combine dining, study, academic support and student activities. It’s stuff we do now but that’s scattered all over creation.

Two things occurred to me on my latest walk. One is that these buildings really are investments in our future. They represent acts of faith that, even in turbulent times, we need to plan and act prudently now to create the future we imagine. And the other is that they represent a remarkable balance: between curricular, co-curricular and extra-curricular, between mind, body and spirit, between strengthening what we’ve always had and building something new.

On one level, that’s just about one college and one set of hopes. But, at another, it strikes me as surprisingly useful guidance for a lot more than that: plan, balance, act, dare.

Oh! So that’s what a Stupid Pill looks like!

In a widely misinterpreted March 25^th column, Chuck Jaffe raises the question of whether it’s time to buy a bear market fund.  Most folks, he argues, are addicted to performance-chasing.  What better time to buy stocks than after they’ve doubled in price?  What better time to hedge your portfolio than after they’re been halved?  That, of course, is the behavior of the foolish herd.  We canny contrarians are working now to hedge our gains with select bets against the market, right?  

Talk to money managers and the guys behind bear-market funds, however, and they will tell you their products are designed mostly to be a hedge, diversifying risks and protecting against declines. They say the proper use of their offerings involves a small-but-permanent allocation to the dark side, rather than something to jump into when everything else you own looks to be in the tank.

They also say — and the flows of money into and out of bear-market issues shows — that investors don’t act that way.

At base, he’s not arguing for the purchase of a bear-market fund or a gold fund. He’s using those as tools for getting folks to think about their own short time horizons and herding instincts.

He generously quotes me as making a more-modest observation: that managers, no matter the length or strength of their track records, are quickly dismissed (or ignored) if they lag their peers for more than a quarter. Our reaction tends to be clear: the manager has taken stupid pills and we’re leaving.  Jeff Vinik at Magellan: Manager of the Year in 1993, Stupid Pill swallower in ’95, gone in ’96.  (Started a hedge fund, making a mint.) Bill Nygren at Oakmark Select: intravenous stupid drip around 2007.  (Top 1% since then on both his funds.)  Bruce Berkowitz at Fairholme: Manager of the Decade, slipped off to Walgreen’s in 2011 for stupid pills, got trashed and saw withdrawals of a quarter billion dollars a week. (Top 1% in 2012, closed his funds to new investments, launching a hedge fund now). 

By way of example, one of the most distinguished small cap managers around is Eric Cinnamond who has exercised the same rigorous absolute-return discipline at three small cap funds: Evergreen, Intrepid and now Aston/River Road.  His discipline is really simple: don’t buy or hold anything unless it offers a compelling, absolute value.  Over the period of years, that has proven to be a tremendously rewarding strategy for his investors. 

When I spoke to Eric late in March, he offered a blunt judgment: “small caps overall appear wildly expensive as people extrapolate valuations from peak profits.” That is, current valuations make sense only if you believe that firms experiencing their highest profits won’t ever see them drop back to normal levels.  And so he’s selling stuff as it becomes fully valued, nibbling at a few things (“hard asset companies – natural gas, precious metals – are getting treated as if they’re in a permanent depression but their fundamentals are strong and improving”), accumulating cash and trailing the market.  By a mile.  Over the twelve months ending March 29, 2013, ARIVX returned 7.5% – which trailed 99% of his small value peers. 

The top SCV fund over that period?  Scott Barbee’s microcap Aegis Value (AVALX) fund with a 32% return and absolutely no cash on the books.  As I noted in a FundAlarm profile, it’s perennially a one- or two-star fund with more going for it than you’d imagine.

Mr. Cinnamond seemed acquainted with the sorts of comments made about his fund on our discussion board: “I bailed on ARIVX back in early September,” “I am probably going to bail soon,” and “in 2012 to the present the funds has ranked, in various time periods, in the 97%-100% rank of SCV… I’d look at other SCV Funds.”  Eric nods: “there are investors better suited to other funds.  If you lose assets, so be it but I’d rather lose assets than lose my shareholders’ capital.”  John Deysher, long-time manager of Pinnacle Value (PVFIX), another SCV fund that insists on an absolute rather than relative value discipline, agrees, “it’s tough holding lots of cash in a sizzling market like we’ve seen . . . [cash] isn’t earning much, it’s dry powder available for future opportunities which of course aren’t ‘visible’ now.”

One telling benchmark is GMO Benchmark-Free Allocation IV (GBMBX). GMO’s chairman, Jeremy Grantham, has long argued that long-term returns are hampered by managers’ fear of trailing their benchmarks and losing business (as GMO so famously did before the 2000 crash).  Cinnamond concurs, “a lot of managers ‘get it’ when you read their letters but then you see what they’re doing with their portfolios and wonder what’s happening to them.” In a bold move, GMO launched a benchmark-free allocation fund whose mandate was simple: follow the evidence, not the crowd.  It’s designed to invest in whatever offers the best risk-adjusted rewards, benchmarks be damned.  The fund has offered low risks and above-average returns since launch.  What’s it holding now?  European equities (35%), cash (28%) and Japanese stocks (17%).  US stocks?  Not so much: just under 5% net long.

For those interested in other managers who’ve followed Mr. Cinnamond’s prescription, I sorted through Morningstar’s database for a list of equity and hybrid managers who’ve chosen to hold substantial cash stakes now.  There’s a remarkable collection of first-rate folks, both long-time mutual fund managers and former hedge fund guys, who seem to have concluded that cash is their best option.

This list focuses on no-load, retail equity and hybrid funds, excluding those that hold cash as a primary investment strategy (some futures funds, for example, or hard currency funds).  These folks all hold over 25% cash as of their last portfolio report.  I’ve starred the funds for which there are Observer profiles.

(We’re not endorsing all of those funds.  While I tried to weed out the most obvious nit-wits, like the guy who was 96% cash and 4% penny stocks, the level of talent shown by these managers is highly variable.)

Mr. Deysher gets to the point this way: “As Buffett says, Rule 1 is ‘Don’t lose capital.’   Rule 2 is ‘Don’t forget Rule 1.’”  Steve Romick, long-time manager of FPA Crescent (FPACX), offered both the logic behind FPA’s corporate caution and a really good closing line in a recent shareholder letter:

At FPA, we aspire to protect capital, before seeking a return on it. We change our mind, not casually, but when presented with convincing evidence. Despite our best efforts, we are sometimes wrong. We take our mea culpa and move on, hopefully learning from our mistakes. We question our conclusions constantly. We do this with the approximately $20 billion of client capital entrusted to us to manage, and we simply ask the same of our elected and appointed officials whom we have entrusted with trillions of dollars more.

Nobody has all the answers. Genius fails. Experts goof.  Rather than blind faith, we need our leaders to admit failure, learn from it, recalibrate, and move forward with something better. Although we cannot impose our will on this Administration as to Mr. Bernanke’s continued role at the Fed, we would at least like to make our case for a Fed chairman more aware (at least publicly) of the unintended consequences of ultra-easy monetary policy, and one with less hubris. As the author Malcolm Gladwell so eloquently said, “Incompetence is the disease of idiots. Overconfidence is the mistake of experts…. Incompetence irritates me. Overconfidence terrifies me.”

It’s clear that over-confidence can infest pessimists as well as optimists, which was demonstrated in a March Business Insider piece entitled “The Idiot-Maker Rally: Check Out All Of The Gurus Made To Look Like Fools By This Market.”  The article is really amusing and really misleading.  On the one hand, it does prick the balloons of a number of pompous prognosticators.  On the other, it completely fails to ask what happened to invalidate – for now, anyway – the worried conclusions of some serious, first-rate strategists?

Triumph of the optimists: Financial “journalists” and you

It’s no secret that professional journalism seems to be circling a black hole: people want more information, but they want it now, free and simple. That’s not really a recipe for thoughtful, much less profitable, reporting. The universe of personal finance journals is down to two (the painfully thin Money and Kiplinger’s), CNBC’s core audience viewership is down 40% from 2008, the PBS show “Nightly Business Report” has been sold to CNBC in a bid to find viewers, and collectively newspapers have cut something like 40% of their total staff in a decade.

One response has been to look for cheap help: networks and websites look to publish content that’s provided for cheap or for free. Often that means dressing up individuals with a distinct vested interest as if they were journalists.

Case in point: Mellody Hobson, CBS Financial Analyst

I was astounded to see the amiable talking heads on the CBS Morning News turn to “CBS News Financial Analyst Mellody Hobson” for insight on how investors should be behaving (Bullish, not a bubble, 03/18/2013). Ms. Hobson, charismatic, energetic, confident and poised, received a steady stream of softball pitches (“Do you see that there’s a bubble in the stock market?” “I know people are saying we’re entering bubble territory. I don’t agree. We’re far from it. It’s a bull market!”) while offering objective, expert advice on how investors should behave: “The stock market is not overvalued. Valuations are really pretty good. This is the perfect environment for a strong stock market. I’m always a proponent of being in the market.” Nods all around.

The problem isn’t what CBS does tell you about Ms. Hobson; it’s what they don’t tell you. Hobson is the president of a mutual fund company, Ariel Investments, whose only product is stock mutual funds. Here’s a snippet from Ariel’s own website:

Should CBS mention this to you? The Code of Ethics for the Society of Professional Journalists kinda hints at it:

Journalists should be free of obligation to any interest other than the public’s right to know.

Journalists should:

• Avoid conflicts of interest, real or perceived.
• Remain free of associations and activities that may compromise integrity or damage credibility.
• Refuse gifts, favors, fees, free travel and special treatment, and shun secondary employment, political involvement, public office and service in community organizations if they compromise journalistic integrity.
• Disclose unavoidable conflicts.

CBS’s own 2012 Business Conduct Statement exults “our commitment to the highest standards of appropriate and ethical business behavior” and warns of circumstances where “there is a significant risk that the situation presented is likely to affect your business judgment.” My argument is neither that Ms. Hobson was wrong (that’s a separate matter) nor that she acted improperly; it’s that CBS should not be presenting representatives of an industry as disinterested experts on that industry. They need to disclose the conflict. They failed to do so on the air and don’t even offer a biography page for Hobson where an interested party might get a clue.

MarketWatch likewise puts parties with conflicts of interest center-stage in their Trading Deck feature which lives in the center column of their homepage, but at least they warn people that something might be amiss:

That disclaimer doesn’t appear on the homepage with the teasers, but it does appear on the first page of stories written by people who . . . well, probably shouldn’t be taken at face value.

The problem is complicated when a publisher such as MarketWatch mixes journalists and advocates in the same feature, as they do at The Trading Deck, and then headline writers condense a story into eight or ten catchy, misleading words. 

The headline says “This popular mutual fund type is losing you money.”  The story says global stock funds could boost their returns by up to 2% per year through portfolio optimization, which is a very different claim.

The author bio says “Roberto Rigobon is the Society of Sloan Fellows Professor of Applied Economics at MIT’s Sloan School of Management.”  He is a first-class scholar.  The bio doesn’t say “and a member of State Street Associates, which provides consulting on, among other things, portfolio optimization.”

The other response by those publications still struggling to hold on is adamant optimism.

In the April 2013 issue of Kiplinger’s Personal Finance, editor Knight Kiplinger (pictured laughing at his desk) takes on Helaine Olen’s Pound Foolish: Exposing the Dark Side of the Personal Finance Industry (2012). She’s a former LA Times personal finance columnist with a lot of data and a fair grasp of her industry. She argues “most of the financial advice published and dished out by the truckload is useless” – its sources are compromised, its diagnosis misses the point and its solutions are self-serving. To which Mr. Kiplinger responds, “I know quite a few longtime Kiplinger readers who might disagree with that.” That’s it. Other than for pointing to Obamacare as a solution, he just notes that . . . well, she’s just not right.

Skipping the stories on “How to Learn to Love (Stocks) Again” and “The 7 Best ETFs to Buy Now,” we come to Jane Bennett Clark’s piece entitled “The Sky Isn’t Falling.” The good news about retirement: a study by the Investment Company Institute says that investment companies are doing a great job and that the good ol’ days of pensions were an illusion. (No mention, yet again, of any conflict of interest that the ICI might have in selecting either the arguments or the data they present.) The title claim comes from a statement of Richard Johnson of the Employee Retirement Benefit Institute, whose argument appears to be that we need to work as long as we can. The oddest statement in the article just sort of glides by: “43% of boomers … and Gen Xers … are at risk of not having enough to cover basic retirement expenses and uninsured health costs.” Which, for 43% of the population, might look rather like their sky is falling.

April’s Money magazine offered the same sort of optimistic take: bond funds will be okay even if interest rates rise, Japan’s coming back, transportation stocks are signaling “full steam ahead for the market,” housing’s back and “fixed income never gets scary.”

Optimism sells. It doesn’t necessarily encourage clear thinking, but it does sell.

Folks interested in examples of really powerful journalism might turn to The Economist, which routinely runs long and well-documented pieces that are entirely worth your time, or the radio duo of American Public Media (APM) and National Public Radio (NPR). Both have really first rate financial coverage daily, serious and humorous. The most striking example of great long-form work is “Unfit for Work: The startling rise of disability in America,” the NPR piece on the rising tide of Americans who apply for and receive permanent disability status. 14 million Americans – adults and children – are now “disabled,” out of the workforce (hence out of the jobless statistics) and unlikely ever to hold a job again. That number has doubled in a generation. The argument is that disability is a last resort for older, less-educated workers who get laid off from a blue collar job and face the prospect of never being able to find a job again. The piece stirred up a storm of responses, some of which are arguable (telling the story of hard-hit Hale County makes people think all counties are like that) and others seem merely to reinforce the story’s claim (the Center for Budget and Policy Priorities says most disabled workers are uneducated and over 50 – which seems consistent with the story’s claim).

Who says mutual funds can’t make you rich?

Forbes magazine published their annual list of “The Richest People on the Planet” (03/04/2013), tracking down almost 1500 billionaires in the process. (None, oddly, teachers by profession.)

MFWire scoured the list for “The Richest Fundsters in the Game” (03/06/2013). They ended up naming nine while missing a handful of others. Here’s their list with my additions in blue:

• Charles Brandes, Brandes funds, #1342, $1.0 billion
• Thomas Bailey, Janus founder, #1342, $1.0 billion
• Mario Gabelli, Gamco #1175, $1.2 billion
• Michael Price, former Mutual Series mgr, #1107, $1.3 billion
• Fayez Sarofim, Dreyfus Appreciation mgr, #1031, $1.4 billion
• Ron Baron, Baron Funds #931, $1.6 billion
• Howard Marks, TCW then Oaktree Capital, #922, $1.65 billion
• Joe Mansueto, Morningstar #793, $1.9 billion
• Ken Fisher, investment guru and source of pop-up ads, #792, $1.9 billion
• Bill Gross, PIMCO, #641, $2.3 billion
• Charles Schwab (the person), Charles Schwab (the company) #299, $4.3 billion
• Paul Desmarais, whose Power Financial backs Putnam #276, $4.5 billion
• Rupert Johnson, Franklin Templeton #215, $5.6 billion
• Charles Johnson, Franklin Templeton #211, $5.7 billion
• Ned Johnson, Fidelity #166, worth $7 billion
• Abby Johnson, Fidelity #74, $12.7 billion

For the curious, here’s the list of billionaire U.S. investors, which mysteriously doesn’t include Bill Gross. He’s listed under “finance.”

The thing that strikes me is how much of these folks I’d entrust my money to, if only because so many became so rich on wealth transfer (in the form of fees paid by their shareholders) rather than wealth creation.

Two new and noteworthy resources: InvestingNerd and Fundfox

I had a chance to speak this week with the folks behind two new (one brand-new, one pretty durn new) sites that might be useful to some of you folks.

InvestingNerd (a little slice of NerdWallet)

NerdWallet launched in 2010 as a tool to find the best credit card offers.  It claimed to be able to locate and sort five times as many offers as its major competitors.  With time they added other services to help consumers save money. For example the TravelNerd app to help travelers compare costs related to their travel plans, like finding the cheapest transportation to the airport or comparing airport parking prices, the NerdScholar has a tool for assessing law schools based on their placement rates. NerdWallet makes its money from finder’s fees: if you like one of the credit card offers they find for you and sign up for that card, the site receives a bit of compensation. That’s a fairly common arrangement used, for example, by folks like BankRate.com.

On March 27, NerdWallet launched a new site for its investing vertical, InvestingNerd. It brings together advice (TurboTax vs H&R Block: Tax Prep Cost Comparison), analysis (Bank Stress Test Results: How Stressful Were They?) and screening tools.

I asked Neda Jafarzadeh, a public relations representative over at InvestingNerd, what she’d recommend as most distinctive about the site.  She offered up three features that she thought would be most intriguing for investors in particular: 

• InvestingNerd recently rolled out a new tool – the Mutual Fund Screener. This tool allows investors to find, search and compare over 15,000 funds. In addition, it allows investors to filter through funds based on variables like the fund’s size, minimum required investment, and the fund’s expense ratio. Also, investors can screen funds using key performance metrics such as the fund’s risk-adjusted return rate, annual volatility, market exposure and market outperformance.
• In addition, InvestingNerd has a Brokerage Comparison Tool which provides an unbiased comparison of 69 of the most popular online brokerage accounts. The tool can provide an exact monthly cost for the investor based on their individual trading behavior.
• InvestingNerd also has a blog where we cover news on financial markets and the economy, release studies and analyses related to investing, in addition to publishing helpful articles on various other investment and tax related topics.

Their fund screener is . . . interesting.  It’s very simple and updates a results list immediately.  Want an equity fund with a manager who’s been around more than 10 years?  No problem.  Make it a small cap?  Sure.  Click.  You get a list and clickable profiles.  There are a couple problems, though.  First, they have incomplete or missing explanations of what their screening categories (“outperformance”) means.  Second, their results list is inexplicably incomplete: the same search in Morningstar turns up noticeably more funds.   Finally, they offer a fund rating (“five stars”) with no evidence of what went into it or what it might tell us about the fund’s future.  When I ask with the folks there, it seemed that the rating was driven by risk-adjusted return (alpha adjusted for standard deviation) and InvestingNerd makes no claim that their ratings have predictive validity.

It’s worth looking at and playing with.  Their screener, like any, is best thought of as a tool for generating a due diligence list: a way to identify some funds worth digging into.  Their articles cover an interesting array of topics (considering a gray divorce?  Shopping tips for folks who support gay rights?) and you might well use one of their tools to find the free checking account you’ve always dreamed of.

Fundfox

Fundfox is a site for those folks who wake in the morning and ask themselves, “I wonder who’s been suing the mutual fund industry this week?” or “I wonder what the most popular grounds for suing a fund company this year is?”

Which is to say fund company attorneys, compliance folks, guys at the SEC and me.

It was started by David Smith, who used to work for the largest liability insurance provider to the fund industry, as a simpler, cleaner, more specialized alternative to services such as WestLaw or Lexis. It covers lawsuits filed against mutual funds, period. That really reduces the clutter. The site does include a series of dashboards (what fund types are most frequently the object of suits?) and some commentary.

You can register for free and get a lot of information a la Morningstar or sign up for a premium membership and access serious quantities of filings and findings. There’s a two week trial for the premium service and I really respect David’s decision to offer a trial without requiring a credit card. Legal professionals might well find the combination of tight focus, easy navigation and frequent updates useful.

Introducing: The Elevator Talk

The Elevator Talk is a new feature which began in February. 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.

Elevator Talk #3: Bayard Closser, Vertical Capital Income Fund (VCAPX)

Mr. Closser is president of the Vertical Capital Markets Group and one of the guys behind Vertical Capital Income Fund (VCAPX), which launched on December 30, 2011. VCAPX is structured as an interval fund, a class of funds rare enough that Morningstar doesn’t even track them. An interval fund allows you access to your investment only at specified intervals and only to the extent that the management can supply redemptions without disrupting the portfolio. The logic is that certain sorts of investments are impossible to pursue if management has to be able to accommodate the demands of investors to get their money now. Hedge funds, using lock-up periods, pursue the exact same logic. Given the managers’ experience in structuring hedge funds, that seems like a logical outcome. They do allow for the possibility that the fund might, with time, transition over to a conventional CEF structure:

Vertical chose an interval fund structure because we determined that it is the best delivery mechanism for alternative assets. It helps protect shareholders by giving them limited liquidity, but also provides the advantages of an open-end fund, including daily pricing and valuation. In addition, it is easy to convert an interval fund to a closed-end fund as the fund grows and we no longer want to acquire assets.

Here’s what Bayard has to say (in a Spartan 172 words) about VCAPX:

A closed-end interval fund, VCAPX invests in whole mortgage loans and first deeds of trust. We purchase the loans from lenders at a deep discount and service them ourselves through our sister company Vertical Recovery Management, which can even restructure loans for committed homeowners to help them keep current on monthly payments.

Increasingly, even small investors are seeking alternative investments to increase diversification. VCAPX can play that role, as its assets have no correlation or a slight negative correlation with the stock market.

While lenders are still divesting mortgages at a deep discount, the housing market is improving, creating a “Goldilocks” effect that may be “just right” for the fund.

VCAPX easily outperformed its benchmark in its first year of operation (Dec. 30, 2011 through Dec. 31, 2012), with a return of 12.95% at net asset value, compared with 2.59% for the Barclays U.S. Mortgage-Backed Securities (MBS) Index.

At the fund’s maximum 4.50% sales charge, the return was 7.91%. The fund also declared a 4.01% annualized dividend (3.54% after the sales charge).

The fund’s minimum initial investment is $5,000 for retail shares, reduced to $1,000 for IRAs. There’s a front sales load of 4.5% but the fund is available no-load at both Schwab and TDAmeritrade. They offer a fair amount of background, risk and performance information on the fund’s website. You might check under the “Resource Center” tab for copies of their quarterly newsletter.

The Cook and Bynum Fund, Conference Call Highlights

Recently published research laments the fact that actively-managed funds have become steadily less active and more index-like over time.

The changing imperatives of the fund industry have led many managers to become mediocre by design. Their response is driven by the anxious desire for so-called “sticky” assets. The strategy is simple: design a product to minimize the risk that it will ever spectacularly trail its peer group. If you make your fund very much like its benchmark, you will never be a singular disaster and so investors (retirement plan investors, particularly) will never be motivated to find something better. The fact that you never excel is irrelevant. The result is a legion of large, expensive, undistinguished funds who seek safety in the herd.

The Cook and Bynum Fund (COBYX) strikes me as the antithesis of those. Carefully constructed, tightly focused, and intentionally distinct. On Tuesday, March 5, we spoke with Richard Cook and Dowe Bynum in the first of three conversations with distinguished managers who defy that trend through their commitment to a singular discipline: buy only the best. For Richard and Dowe, that translates to a portfolio with only seven holdings and a 34% cash stake. Since inception (through early March, 2013), they managed to capture 83% of the market’s gains with only 50% of its volatility; in the past twelve months, Morningstar estimates that they captured just 7% of the market’s downside.

Among the highlights of the call for me:

1. The guys are willing to look stupid. There are times, as now, when they can’t find stocks that meet their quality and valuation standards. The rule for such situations is simply: “When compelling opportunities do not exist, it is our obligation not to put capital at risk.” They happily admit that other funds might well reap short-term gains by running with the pack, but you “have to be willing to look stupid.” Their current cash stake is about 34%, “the highest cash level ever in the fund.” That’s not driven by a market call; it’s a simple residue of their inability to find great opportunities.
2. The guys are not willing to be stupid. Richard and Dowe grew up together and are comfortable challenging each other. Richard knows the limits of Dowe’s knowledge (and vice versa), “so we’re less likely to hold hands and go off the cliff together.” In order to avoid that outcome, they spend a lot of time figuring out how not to be stupid. They relegate some intriguing possibilities to the “too hard pile,” those businesses that might have a great story but whose business model or financials are simply too hard to forecast with sufficient confidence. They think about common errors (commitment bias, our ability to rationalize why we’re not going to stop doing something once we’ve started, chief among them) and have generated a set of really interesting tools to help contain them. They maintain, for example, a list all of the reasons why they don’t like their current holdings. In advance of any purchase, they list all of the conditions under which they’d quickly sell (“if their star CEO leaves, we do too”) and keep that on top of their pile of papers concerning the stock.
3. They’re doing what they love. Before starting Cook & Bynum (the company), both of the guys had high-visibility, highly-compensated positions in financial centers. Richard worked for Tudor Investments in Stamford, CT, while Dowe was with Goldman Sachs in New York. The guys believe in a fundamental, value- and research-driven, stock-by-stock process. What they were being paid to do (with Tudor’s macro event-driven hedge fund strategies for Richard) was about as far from what they most wanted as they could get. And so they quit, moved back to Alabama and set up their own shop to manage their own money and the investments of high net-worth individuals. They created Cook & Bynum (the fund) in response to an investor’s request for a product accessible to family and friends.  The $250 million invested with them (about $100 million in the fund) includes 100% of their own liquid net worth, with their investment split between the fund and the partnerships. Since both sets of vehicles use the same fees and structure, there’s no conflict between the two.
4. They do prodigious research without succumbing to the “gotta buy something” impulse. While they spend the majority of their time in their offices, they’re also comfortable with spending two or three weeks at a time on the road. Their argument is that they’ve got to understand the entire ecosystem in which a firm operates – from the quality of its distribution network to the feelings of its customers – which they can only do first-hand. Nonetheless, they’ve been pretty good at resisting “deal momentum.”  They spent, for example, some three weeks traveling around Estonia, Poland and Hungary. Found nothing compelling. Traveled Greece and Turkey and learned a lot, including how deeply dysfunctional the Greek economy is, but bought nothing.
5. They’re willing to do what you won’t. Most of us profess a buy low / buy the unloved / break from the herd / embrace our inner contrarian ethos. And most of us are deluded. Cook and Bynum seem rather less so: they’re holding cash now while others buy stocks after the market has doubled and profits margins hit records but in the depth of the 2008 meltdown they were buyers. (They report having skipped Christmas presents in 2008 in order to have extra capital to invest.) As the market bottomed in March 2009, the fund was down to 2% cash.

Bottom Line: the guys seem to be looking for two elusive commodities. One is investments worth pursuing. The other is investing partners who share their passion for compelling investments and their willingness to let other investors charge off in a herd. Neither is as common as you might hope.

For folks interested but unable to join us, here’s the complete audio of the hour-long conversation.

The COBYX conference call

When you click on the link, the file will load in your browser and will begin playing after it’s partially loaded. If the file downloads, instead, you may have to double-click to play it.

We periodically invite our colleague, Charles Boccadoro, to share his perspectives on funds which were the focus of our conference calls. Charles’ ability to apprehend and assess tons of data is, we think, a nice complement to my strengths which might lie in the direction of answering the questions (1) does this strategy make any sense? And (2) what’s the prospect that they can pull it off? Without further ado, here’s Charles on Cook and Bynum

Inoculated By Value

To describe Richard P. Cook and J. Dowe Bynum (C&B) as value investors would be accurate, but certainly not adequate. Their website is rich with references to value investment principles championed by Benjamin Graham, John Burr Williams, Charlie Munger, and Warren Buffet. “The value investing inoculation took immediately,” C&B explain, after reading Mr. Buffett’s biography in high school. They have been investing together literally since childhood and at age 23 they actually tried to start their own mutual fund. That did not happen, but years later in 2001 they established Cook & Bynum Capital Management and in mid-2009 they launched their namesake The Cook & Bynum Fund COBYX, which turned out to be perfect timing.

Like many experienced investors on MFO, C&B do not view volatility as risk, but as opportunity. That said, the lack of volatility in 43 months of COBYX performance through February 2013 is very alluring and likely helped propel the fund’s popularity, now with $102M AUM. Its consistent growth rate resembles more a steady bond fund, say PONDX, than an equity fund. The fund received a 5-Star Morningstar Rating for the 3-year period ending mid-2012.

Other than strictly adhering to the three most important words of value investing (“Margin of Safety”) when assessing stock price against inherent value, C&B do not impose explicit drawdown control or practice dynamic allocation, like risk-parity AQRNX or long-short ARLSX. They try instead to buy wonderful businesses at discounted prices. To quote Mr. Buffett: “If you’re right about what, you don’t have to worry about when very much.”

Fortunately, history is on their side. The chart below depicts drawdowns for the last 50 years, comparing value versus growth large cap fund averages. Value funds indeed generally suffer smaller and shorter drawdowns. But not always. The term “value trap” became ubiquitous during the financial collapse of 2008, when many highly respected, long established, and top performing value funds (prime example DODGX) were simply hammered. And, when the forest is burning, all the trees go with it.

While Mr. Cook and Mr. Bynum must have managed their private accounts through such turbulent times, COBYX has enjoyed bull market conditions since its inception. (Perhaps a reluctant bull, but nonetheless…) Still, when the market dipped 7% in May 2012, COBYX did not drop at all. In September 2011, SP500 dropped 16%, COBYX dipped only 5%. Its biggest drawdown was June 2010 at 9% versus 13% for the market. The tame behavior is due partly to C&B’s propensity to hold cash. Not as a strategy, they explain, but as residual to value opportunities available. They unloaded Kraft, for example, shortly after the company split its international and domestic businesses. Here is an excerpt from COBYX’s 2012 annual report explaining their move:

Despite neither of the companies’ fundamental business prospects changing one iota, the market reacted to the news by trading both of the stocks higher. We used this opportunity to liquidate our stake in both companies. It is popular, even within our value discipline, for investors to advocate various financial engineering strategies in an attempt to drive near-term stock price appreciation rather than to focus on a company’s long-term cash flows – where real value resides.

C&B take pride in not being “closet indexers” to their benchmarks SP500 and MSCI All Country World Index (ACWI). So far they have tended to hold consumer defensive stocks, like Wal-Mart, Procter & Gamble, and Coca-Cola. Although more recently, they own Microsoft, which accounts for 16% of the portfolio. COBYX’s lifetime correlation to SP500 is 66% and its beta is only 0.47.

The strategy has delivered handsomely. Just how good is it? Below compares COBYX with several other Morningstar 5 star funds, including Charles Akre’s AKREX, Steven Romick’s FPA Crescent Fund, Donald Yacktman’s YAFFX, Sequoia Fund (perhaps the greatest fund ever), plus landmark Berkshire Hathaway.

Since COBYX inception, it has produced the highest risk adjusted returns, based on both Sharpe and Sortino Ratios, with the lowest standard and downside volatilities. It has delivered more than 90% of SP500 total return with less than 60% of its volatility. Interestingly, all of these top-performing mutual funds have low beta against SP500, like COBYX, but again for the record, C&B reject metrics like beta: “Risk is not volatility.”

COBYX is also highly concentrated. As of December 2012, it held only seven equities. C&B’s strategy is to focus only on companies whose businesses they can understand – depth of insight is the edge they seek. They employ Kelly Criterion to size positions in their portfolio, which represents an implicit form of risk management. John Kelly developed it in 1950s at AT&T’s Bell Labs to optimize transmission rate through long distance phone lines. Edward Thorpe then famously employed the technique to “Beat the Dealer” and later to help optimize his hedge fund investments at Princeton/Newport Partners. In C&B’s implementation, Kelly is edge over odds, or expected returns over range of outcomes. What is currently their biggest position? Cash at 34%.

Bottom-line: Hard not to love this young fund, performance to date, and philosophy employed by its managers. High ER, recently dropped from 1.88 to 1.49, has been its one detractor. Hopefully, ER reduction continues with AUM growth, since world-stock fund median is already a hefty 1.20 drag.

(Thank you, sir! David)

Conference Call Upcoming: RiverPark Wedgewood Growth, April 17

Large-cap funds, and especially large large-cap funds, suffer from the same tendency toward timidity and bloat that I discussed above. On average, actively-managed large growth funds hold 70 stocks and turn over 100% per year. The ten largest such funds hold 311 stocks on average and turn over 38% per year.

The well-read folks at Wedgewood see the path to success differently. Manager David Rolfe endorses Charles Ellis’s classic essay, “The Losers Game” (Financial Analysts Journal, July 1975). Reasoning from war and sports to investing, Ellis argues that losers games are those where, as in amateur tennis:

The amateur duffer seldom beats his opponent, but he beats himself all the time. The victor in this game of tennis gets a higher score than the opponent, but he gets that higher score because his opponent is losing even more points.

Ellis argues that professional investors, in the main, play a losers game by becoming distracted, unfocused and undistinguished. Mr. Rolfe and his associates are determined not to play that game. They position themselves as “contrarian growth investors.” In practical terms, that means:

1. They force themselves to own fewer stocks than they really want to. After filtering a universe of 500-600 large growth companies, Wedgewood holds only “the top 20 of the 40 stocks we really want to own.” Currently, 55% of the fund’s assets are in its top ten picks.
2. They buy when other growth managers are selling. Most growth managers are momentum investors, they buy when a stock’s price is rising. Wedgewood would rather buy during panic than during euphoria.
3. They hold far longer once they buy. The historical average for Wedgewood’s separate accounts which use this exact discipline is 15-20% turnover and the fund is around 25%.
4. And then they spend a lot of time watching those stocks. “Thinking and acting like business owners reduces our interest to those few businesses which are superior,” Rolfe writes, and he maintains a thoughtful vigil over those businesses.

David is articulate, thoughtful and successful. His reflections on “out-thinking the index makers” strike me as rare and valuable, as does his ability to manage risk while remaining fully invested.

Our conference call will be Wednesday, April 17, from 7:00 – 8:00 Eastern.

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.

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 lineup features:

The Cook and Bynum Fund (COBYX): an updated profile of this concentrated value fund.

Whitebox Long Short Equity (WBLSX): the former hedge fund has a reasonably distinctive, complicated strategy and I haven’t had much luck in communicating with fund representatives over the last month or so about the strategy. Given a continued high level of reader interest in the fund, it seemed prudent to offer, with this caveat, a preliminary take on what they do and how you might think about it.

Launch Alert: BBH Global Core Select (BBGRX)

There are two things particularly worth knowing about BBH (for Brown Brothers Harriman) Core Select (BBTRX): (1) it’s splendid and (2) it’s closed. It’s posted a very consistent pattern of high returns and low risk, which eventually drew $5 billion to the fund and triggered its soft close in November. At the moment that BBH closed Core Select, they announced the launch of Global Core Select. That fund went live on March 28, 2013.

Global Core Select will be co-managed by Regina Lombardi and Tim Hartch, two members of the BBH Core Select investment team. Hartch is one of Core Select’s two managers; Lombardi is one of 11 analysts. The Fund is the successor to the BBH private investment partnership, BBH Global Funds, LLC – Global Core Select, which launched on April 2, 2012. Because the hedge fund had less than a one year of operation, there’s no performance record for them reported. The minimum initial investment in the retail class is $5,000. The expense ratio is capped at 1.50% (which represents a generous one basis-point sacrifice on the adviser’s part).

The strategy snapshot is this: they’ll invest in 30-40 mid- to large-cap companies in both developed and developing markets. They’ll place at least 40% outside the US. The strategy seems identical to Core Select’s: established, cash generative businesses that are leading providers of essential products and services with strong management teams and loyal customers, and are priced at a discount to estimated intrinsic value. They profess a “buy and own” approach.

What are the differences: well, Global Core Select is open and Core Select isn’t. Global will double Core’s international stake. And Global will have a slightly-lower target range: its investable universe starts at $3 billion, Core’s starts at $5 billion.

I’ll suggest three reasons to hesitate before you rush in:

1. There’s no public explanation of why closing Core and opening Global isn’t just a shell game. Core is not constrained in the amount of foreign stock it owns (currently under 20% of assets). If Core closed because the strategy couldn’t handle the additional cash, I’m not sure why opening a fund with a nearly-identical strategy is warranted.
2. Expenses are likely to remain high – even with $5 billion in a largely domestic, low turnover portfolio, BBH charges 1.25%.
3. Others are going to rush in. Core’s record and unavailability is going to make Global the object of a lot of hot money which will be rolling in just as the market reaches its seasonal (and possibly cyclical) peak.

That said, this strategy has worked elsewhere. The closed Oakmark Select (OAKLX) begat Oakmark Global Select (OAKWX) and closed Leuthold Core (LCORX) led to Leuthold Global (GLBLX). In both cases, the young fund handily outperformed its progenitor. Here’s the nearly empty BBH Global Core Select homepage.

Launch Alert: DoubleLine Equities Small Cap Growth Fund (DLESX)

DoubleLine continues to pillage TCW, the former home of its founder and seemingly of most of its employees. DoubleLine, which manages more than $53 billion in mostly fixed income assets, has created a DoubleLine Equity LP division. The unit’s first launch, DoubleLine Equities Small Cap Growth Fund, occurs April 1, 2013. Growth Fund (DLEGX) and Technology Fund (DLETX) are close behind in the pipeline.

Husam Nazer, who oversaw $4-5 billion in assets in TCW’s Small and Mid-Cap Growth Equities Group, will manage the new fund. DoubleLine hired Nazer’s former TCW investing partner, Brendt Stallings, four stock analysts and a stock trader. Four of the new hires previously worked for Nazer and Stallings at TCW.

The fund will invest mainly in stocks comparable in size to those in the Russell US Growth index (which tops out at around $4 billion). They’ll invest mostly in smaller U.S. companies and in foreign small caps which trade on American exchanges through ADRs. The manager professes a “bottom up” approach to identify investment. He’s looking for a set of reasonable and unremarkable characteristics: consistent and growing earnings, strong balance sheet, good competitive position, good management and so on. The minimum initial investment in the retail class is $2,000, reduced to $500 for IRAs. The expense ratio is capped at 1.40%.

I’ll suggest one decent reason to hesitate before you bet that DoubleLine’s success in bonds will be matched by its success in stocks:

Mr. Nazer’s last fund wasn’t really all that good. His longest and most-comparable charge is TCW Small Cap Growth (TGSNX). Morningstar rates it as a two-star fund. In his eight years at the fund, Mr. Nazer had a slow start (2005 was weak) followed by four very strong years (2006-2009) and three really bad ones (2010-2012). The fund’s three-year record trails 97% of its peers. It has offered consistently above-average to high volatility, paired with average to way below-average returns. Morningstar’s generally-optimistic reviews of the fund ended in July 2011. Lipper likewise rates it as a two-star fund over the past five years.

The fund might well perform brilliantly, assuming that Mr. Gundlach believed he had good reason to import this team. That said, the record is not unambiguously positive.

Funds in Registration

New mutual funds must be registered with the Securities and Exchange Commission before they can be offered for sale to the public. The SEC has a 75-day window during which to call for revisions of a prospectus; fund companies sometimes use that same time to tweak a fund’s fee structure or operating details. Every day we scour new SEC filings to see what opportunities might be about to present themselves. Many of the proposed funds offer nothing new, distinctive or interesting. Some are downright horrors of Dilbertesque babble (see “Synthetic Reverse Convertibles,” below).

Funds in registration this month won’t be available for sale until, typically, the beginning of June 2013. We found a handful of no-load, retail funds in the pipeline, notably:

Robeco Boston Partners Global Long/Short Fund will offer a global take on Boston Partner’s highly-successful long/short strategy. They expect at least 40% international exposure, compared to 10% in their flagship Long/Short Equity Fund (BPLEX) and 15% in the new Long/Short Research Fund (BPRRX). There are very few constraints in the prospectus on their investing universe. The fund will be managed by Jay Feeney, an original Boston Partner, co-CEO and CIO-Equities, and Christopher K. Hart, Equity Portfolio Manage. The minimum initial investment in the retail class is $2,500. The expense ratio will be 3.77% after waivers. Let me just say: “Yikes.” At the risk of repeating myself, “Yikes!” With a management fee of 1.75%, this is likely to remain a challenging case.

T. Rowe Price Global Allocation Fund will invest in stocks, bonds, cash and hedge funds. Yikes! T. Rowe is getting you into hedge funds. They’ll active manage their asset allocation. The baseline is 30% US stocks, 30% international stocks, 20% US bonds, 10% international bonds and 10% alternative investments. A series of macro judgments will allow them to tweak those allocations. The fund will be managed by Charles Shriver, lead manager for their Balanced, Personal Strategy and Spectrum funds. The minimum initial purchase is $2500, reduced to $1000 for IRAs. Expense ratio will be 1.05%.

Details on these funds and the list of all of the funds in registration are available at the Observer’s Funds in Registration page or by clicking “Funds” on the menu atop each page.

Manager Changes: Two giants begin to step back

On a related note, we also tracked down 71 fund manager changes. Those include decisions by two fund company founders to begin lightening their loads. Nicholas Kaiser, president of Saturna Investments which advises the Sextant and Amana funds, no longer co-manages Sextant Growth (SSGFX) and John Kornitzer, founder of Kornitzer Capital which advises the Buffalo funds, stepped back from Buffalo Dividend Focus (BUFDX) four months after launch.

Snowball on the transformative power of standing around, doing little

I’m occasionally asked to contribute 500 words to Amazon’s Money & Markets blog. Amazon circulates a question (in this case, “how should investors react to sequestration?”) and invites responses. I knew they won’t publish “oh, get real,” so I wrote something just slightly longer.

Don’t Just Do Something. Stand There.

When exactly did the old midshipman’s rule, “When in danger or in doubt, run in circles, scream and shout,” get enshrined as investing advice?

There are just three things we don’t know about sequestration: (1) what will happen, (2) how long it will last and (3) what will follow. Collectively, they tell you that the most useful thing a stock investor might do in reaction to the sequestration is, nothing. Whatever happens will certainly roil the markets but stock markets are forever being roiled. This one is no different than all of the others. Go check your portfolio and ask four things:

1. Do I have an adequate reserve in a cash-management account to cover my basic expenses – that is, to maintain a normal standard of living – if I need six months to find a new job?
2. Do I have very limited stock exposure (say, under 20%) in the portion of the portfolio that I might reasonably need to tap in the next three or five years?
3. Do I have a globally diversified portfolio in the portion that I need to grow over a period of 10 years or more?
4. Am I acting responsibly in adding regularly to each?

If yes, the sequestration is important, but not to your portfolio. If no, you’ve got problems to address that are far more significant than the waves caused by this latest episode of our collective inability to manage otherwise manageable problems. Address those, as promptly and thoughtfully as you can.

The temptation is clear: do something! And the research is equally clear: investors who reactively do something lose. Those who have constructed sensible portfolios and leave them be, win.

Be a winner: stand there.

Happily, the other respondents were at least as sensible. There’s the complete collection.

Briefly Noted ….

Vanguard is shifting

Perhaps you should, as well? Vanguard announced three shifts in the composition of income sleeve of their Target Retirement Funds.

• They are shifting their bond exposure from domestic to international. Twenty percent of each fund’s fixed income exposure will be reallocated to foreign bonds through investment in Vanguard Total International Bond Index Fund.
• Near term funds are maintaining their exposure to TIPS but are shifting all of their allocation to the Short-Term Inflation-Protected Securities Index Fund rather than Vanguard Inflation-Protected Securities Fund.
• The Retirement Income and Retirement 2010 funds are eliminating their exposure to cash. The proceeds will be used to buy foreign bonds.

PIMCO retargets

As of March 8, 2013 the PIMCO Global Multi-Asset Fund changed its objective from “The Fund seeks total return which exceeds that of a blend of 60% MSCI World Index/40% Barclays U.S. Aggregate Index” to “The Fund seeks maximum long-term absolute return, consistent with prudent management of portfolio volatility.” At the same time, the Fund’s secondary index is the 1 Month USD LIBOR Index +5% which should give you a good idea of what they expect the fund to be able to return over time.

PIMCO did not announce any change in investment policies but did explain that the new, more conservative index “is more closely aligned with the Fund’s investment philosophy and investment objective” than a simple global stock/bond blend would be.

Capital Group / American Funds is bleeding

Our recent series on new fund launches over the past decade pointed out that, of the five major fund groups, the American Funds had – by far – the worst record. They managed to combine almost no innovation with increasingly bloated funds whose managers were pleading for help. A new report in Pensions & Investments (Capital Group seeking to rebuild, 03/18/2013) suggests that the costs of a decade spent on cruise control were high: the firm’s assets under management have dropped by almost a half-trillion dollars in six years with the worst losses coming from the institutional investment side.

Matthews and the power of those three little words.

Several readers have noticed that Matthews recently issued a supplement to the Strategic Income Fund (MAINX) portfolio. The extent of the change is this: the advisor dropped the words “and debt-related” from a proviso that at least 50% of the fund’s portfolio would be invested in “debt and debt-related securities” which were rated as investment-grade.

In talking with folks affiliated with Matthews, it turns out that the phrase “and debt-related” put them in an untenable bind. “Debt-related securities” includes all manner of derivatives, including the currency futures contracts which allow them to hedge currency exposure. Such derivatives do not receive ratings from debt-rating firms such as Fitch meaning that it automatically appeared as if the manager was buying “junk” when no such thing was happening. That became more complicated by the challenge of assigning a value to a futures contract: if, hypothetically, you buy $1 million in insurance (which you might not need) for a $100 premium, do you report the value of $100 or $1 million?

In order to keep attention focused on the actual intent of the proviso – that at least 50% of the debt securities will be investment grade – they struck the complicating language.

Good news and bad for AllianzGI Opportunity Fund shareholders

Good news, guys: you’re getting a whole new fund! Bad news: it’s gonna cost ya.

AllianzGI Opportunity Fund (POPAX) is a pretty poor fund. During the first five years of its lead manager’s ten year tenure, it wasn’t awful: two years with well above average returns, two years below average and one year was a draw. The last five have been far weaker: four years way below average, with 2013 on course for another. Regardless of returns, the fund’s volatility has been consistently high.

The clean-up began March 8 2013 with the departure of co-manager Eric Sartorius. On April 8 2013, manager Mike Corelli departs and the fund’s investment strategy gets a substantial rewrite. The current strategy “focuses on bottom-up, fundamental analysis” of firms with market caps under $2 billion. Ironically, despite the “GI” designation in the name (code for Growth & Income, just as TR is Total Return and AR is Absolute Return), the prospectus assures us that “no consideration is given to income.” The new strategy will “utilize a quantitative process to focus on stocks of companies that exhibit positive change, sustainability, and timely market recognition” and the allowable market cap will rise to $5.3 billion.

Two bits of bad news. First, it’s likely to be a tax headache. Allianz warns that “the Fund will liquidate a substantial majority of its existing holdings” which will almost certainly trigger a substantial 2013 capital gains bill. Second, the new managers (Mark Roemer and Jeff Parker) aren’t very good. I’m sure they’re nice people and Mr. Parker is CIO for the firm’s U.S. equity strategies but none of the funds they’ve been associated with (Mr. Roemer is a “managed volatility” specialist, Mr. Parker focuses on growth) have been very good and several seem not to exist anymore.

Direxion splits

A bunch of Direxion leveraged index and reverse index products split either 2:1 or 3:1 at the close of business on March 28, 2013. They were

Small Wins for Investors

Effective April 1, 2013, Advisory Research International Small Cap Value Fund’s (ADVIX) expense ratio is capped at 1.25%, down from its current 1.35%. Morningstar will likely not reflect this change for a while

Aftershock Strategies Fund (SHKNX) has lowered its expense cap, from 1.80 to 1.70%. Their aim is to “preserve capital in a challenging investment environment.” Apparently the absence of a challenging investment environment inspired them to lose capital: the fund is down 1.5% YTD, through March 29, 2013.

Good news: effective March 15, 2013, Clearwater Management increased its voluntary management fee waiver for three of its Clearwater Funds (Core, Small Companies, Tax-Exempt Bond). Bad news, I can’t confirm that the funds actually exist. There’s no website and none of the major the major tracking services now recognizes the funds’ ticker symbols. Nothing posts at the SEC suggests cessation, so I don’t know what’s up.

Fidelity is offering to waive the sales loads on an ever-wider array of traditionally load-only funds through its supermarket. I learned of the move, as I learn of so many things, from the folks at MFO’s discussion board. The list of load-waived funds is detailed in msf’s thread, entitled Fidelity waives loads. A separate thread, started by Scott, with similar good news announces that T. Rowe Price funds are available without a transaction fee at Ameritrade.

Vanguard is dropping expenses on two more funds including the $69 billion Wellington (VWELX) fund. Wellington’s expenses have been reduced in three consecutive years.

Closings

American Century Equity Income (TWEAX) closed to new investors on March 29, 2013. The fund recently passed $10 billion in assets, a hefty weight to haul. The fund, which has always been a bit streaky, has trailed its large-value peers in five of the past six quarters which might have contributed to the decision to close the door.

The billion-dollar BNY Mellon Municipal Opportunities Fund (MOTIX) closed to new investors on March 28, 2013.

Effective April 30, 2013 Cambiar Small Cap Fund (CAMSX) will close to new investors. It’s been a very strong performer and has drawn $1.4 billion in assets.

Prudential Jennison Mid Cap Growth (PEEAX) will close to new investors on April 8, 2013. The fund’s assets have grown substantially over the past three years from under $2 billion at the beginning of 2010 to over $8 billion as of February 2013. While some in the media describe this as “a shareholder-friendly decision,” there’s some question about whether Prudential friended its shareholders a bit too late. The fund’s 10 year performance is top 5%, 5-year declines to top 20%, 3 year to top 40% and one year to mediocre.

Effective April 12, 2013, Oppenheimer Developing Markets Fund (ODMAX) closed to both new and existing shareholders. In the business jargon, that’s a “hard close.”

Touchstone Sands Capital Select Growth (PTSGX) and Touchstone Sands Institutional Growth (CISGX), both endorsed by Morningstar’s analysts, will close to new investors effective April 8, 2013. Sands is good and also subadvises from for GuideStone and MassMutual.

Touchstone has also announced that Touchstone Merger Arbitrage (TMGAX), subadvised by Longfellow Investment Management, will close to new investors effective April 8. The two-year old fund has about a half billion in assets and management wants to close it to maintain performance.

Effective April 29, 2013, Westcore International Small-Cap Fund (WTIFX) will close to all purchase activity with the exception of dividend reinvestment. That will turn the current soft-close into a hard-close.

Old Wine in New Bottles

On or about May 31, 2013. Alger Large Cap Growth Fund (ALGAX) will become Alger International Growth Fund, but its investment objective to seek long-term capital appreciation will not change. The Fund will be managed by Pedro V. Marcal. At the same time, Alger China-U.S. Growth Fund (CHUSX) will become Alger Global Growth Fund, but its investment objective to seek long-term capital appreciation will not change. The Fund will continue to be managed by Dan Chung and Deborah Vélez Medenica, with the addition of Pedro V. Marcal. These are both fundamentally sorrowful funds. About the only leads I have on Mr. Marcal is that he’s either a former Olympic fencer for Portugal (1960) or the author of a study on market timing and technical analysis. I’m not sure which set of skills would contribute more here.

Effective April 19, BlackRock S&P 500 Index (MASRX) will merge into BlackRock S&P 500 Stock (WFSPX). Uhhh … they’re both S&P500 index funds. The reorganization will give shareholders a tiny break in expenses (a drop from 13 bps to 11) but will slightly goof with their tax bill.

Buffalo Micro Cap Fund (BUFOX) will become Buffalo Emerging Opportunities Fund, around June 3, 2013. That’s a slight delay in the scheduled renaming, which should have already taken place under the original plan. The renamed beast will invest in “domestic common stocks, preferred stocks, convertible securities, warrants and rights of companies that, at the time of purchase by the Fund, have market capitalizations of $1 billion or less.

Catalyst Large Cap Value Fund (LVXAX) will, on May 27 2013, become Catalyst Insider Buying Fund. The fund will no longer be constrained to invest in large cap value stocks.

Effective April 1, 2013, Intrepid All Cap Fund (ICMCX) changed its name to Intrepid Disciplined Value Fund. There was a corresponding change to the investment policies of the fund to allow it to invest in common stocks and “preferred stocks, convertible preferred stocks, warrants and foreign securities, which include American Depositary Receipts (ADRs).”

PIMCO Worldwide Fundamental Advantage TR Strategy (PWWIX) will change its name to PIMCO Worldwide Fundamental Advantage AR Strategy. Also, the fund will change from a “total return” strategy to an “absolute return” strategy, which has more flexibility with sector exposures, non-U.S. exposures, and credit quality.

Value Line changed the names of Value Line Emerging Opportunities Fund to the Value Line Small Cap Opportunities Fund (VLEOX) and the Value Line Aggressive Income Trust to the Value Line Core Bond Fund (VAGIX).

Off to the Dustbin of History

AllianzGI Focused Opportunity Fund (AFOAX) will be liquidated and dissolved on or about April 19, 2013.

Armstrong Associates (ARMSX) is merging into LKCM Equity Fund (LKEQX) effective on or about May 10, 2013. C.K. Lawson has been managing ARMSX for modestly longer – 45 years – than many of his peers have been alive.

Artio Emerging Markets Local Debt (AEFAX) will liquidate on April 19, 2013.

You thought you invested in what? The details of db X-trackers MSCI Canada Hedged Equity Fund will, effective May 31 2013, be tweaked just a bit. The essence of the tweak is that it will become db X-trackers MSCI Germany Hedged Equity Fund (DBGR).

The Forward Focus and Forward Strategic Alternatives funds will be liquidated pursuant to a Board-approved Plan of Liquidation on or around April 30, 2013.

The Guardian Fund (LGFAX) guards no more. It is, as of March 28, 2013, a former fund.

ING International Value Choice Fund (IVCAX) will merge with ING International Value Equity Fund (NIVAX, formerly ING Global Value Choice Fund), though the date is not yet set.

Janus Global Research Fund merged into Janus Worldwide Fund (JAWWX) effective on March 15, 2013.

In a minor indignity, Dreman has been ousted as the manager of MIST Dreman Small Cap Value Portfolio, an insurance product distributed by MET Investment Series Trust (hence “MIST”) and replaced by J.P. Morgan Investment Management. Effective April 29, 2013, the fund becomes JPMorgan Small Cap Value Portfolio. No-load investors can still access Mr. Dreman’s services through Dreman Contrarian Small Cap Value (DRSVX). Folks with the attention spans of gnats and a tendency to think that glancing at the stars is the same as due diligence, will pass quickly by. This small fund has a long record of outperformance, marred by 2010 (strong absolute returns, weak relative ones) and 2011 (weak relative and absolute returns). 2012 was so-so and 2013, through March, has been solid.

Munder Large-Cap Value Fund was liquidated on March 25, 2013.

JPMorgan is planning a leisurely merger JPMorgan Value Opportunities (JVOIX) into JPMorgan Large Cap Value (HLQVX), which won’t be effective until Oct. 31, 2014. The funds share the same manager and strategy and . . . . well, portfolio. Hmmm. Makes you wonder about the delay.

Lord Abbett Stock Appreciation Fund merged into Lord Abbett Growth Leaders Fund (LGLAX) on March 22, 2013.

Pioneer Independence Fund is merging into Pioneer Disciplined Growth Fund (SERSX) which is expected to occur on or about May 17, 2013. The Disciplined Growth management team, fees and record survives while Independence’s vanishes.

Effective March 31, 2013 Salient Alternative Strategies Fund, a hedge fund, merged into the Salient Alternative Strategies I Fund (SABSX) because, the board suddenly discovered, both funds “have the same investment objectives, policies and strategies.”

Sentinel Mid Cap II Fund (SYVAX) has merged into the Sentinel Mid Cap Fund (SNTNX).

Target Growth Allocation Fund would like to merge into Prudential Jennison Equity Income Fund (SPQAX). Shareholders consider the question on April 19, 2013 and approval is pretty routine but if they don’t agree to merge the fund away, the Board has at least resolved to firm Marsico as one of the fund’s excessive number of sub-advisers (10, currently).

600,000 visits later . . .

609,000, actually. 143,000 visitors since launch. About 10,000 readers a month nowadays. That’s up by 25% from the same period a year ago. Because of your support, either direct contributions (thanks Leah and Dan!) or use of our Amazon link (it’s over there, on the right), we remain financially stable. And a widening circle of folks are sharing tips and leads with us, which gives us a chance to serve you better. And so, thanks for all of that.

The Observer celebrates its second anniversary with this issue. We are delighted and honored by your continuing readership and interest. You make it all worthwhile. (And you make writing at 1:54 a.m. a lot more manageable.) We’re in the midst of sprucing the place up a bit for you. Will, my son, clicked through hundreds of links to identify deadsters which Chip then corrected. We’ve tweaked the navigation bar a bit by renaming “podcasts” as “featured” to better reflect the content there, and cleaned out some dead profiles. Chip is working to track down and address a technical problem that’s caused us to go offline for between two and 20 minutes once or twice a week. Anya is looking at freshening our appearance a bit, Junior is updating our Best of the Web profiles in advance of adding some new, and a good friend is looking at creating an actual logo for us.

Four quick closing notes for the months ahead:

1. We are still not spam! Some folks continue to report not receiving our monthly reminders or conference call updates. Please check your spam folder. If you see us there, just click on the “not spam” icon and things will improve.
2. Morningstar is coming. Not the zombie horde, the annual conference. The Morningstar Investor Conference is June 12-14, in Chicago. I’ll be attending the conference on behalf of the Observer. I had the opportunity to spend time with a dozen people there last year: fund managers, media relations folks, Observer readers and others. If you’re going to be there, perhaps we might find time to talk.
3. We’re getting a bit backed-up on fund profiles, in several cases because we’ve had trouble getting fund reps to answer their mail. Our plan for the next few months will be to shorten the cover essay by a bit in order to spend more time posting new profiles. If you have folks who strike you as particularly meritorious but unnoticed, drop me a note!
4. Please do use the Amazon link, if you don’t already. We’re deeply grateful for direct contributions but they tend to be a bit unpredictable (many months end up in the $50 range while one saw many hundreds) while the Amazon relationship tends to produce a pretty predictable stream (which makes planning a lot easier). It costs you nothing and takes no more effort than clicking and hitting the “bookmark this page” button in your browser. After that, it’s automatic and invisible.

Take great care!