. . . from the archives at FundAlarm

David Snowball’s
New-Fund Page for October, 2010

Dear friends,

September: who’d have guessed? The NFL has three remarkably unlikely undefeated teams: the Pittsburgh Steelers (led by the world’s nicest fourth-string quarterback), Da Bears, and the Kansas City Chiefs (4-12 last year). The Hindenburg has moved from being an Omen back to another of history’s sad tales (press mentions of The Hindenburg Omen dropped by 60% between August and September, and the remaining coverage scoffs at all of last month’s chumps). Ninety-five percent of all mutual funds (6,100+ by count) made money this month and over 1000 returned 10% or more in September. All of that from what is, historically, the cruelest month of all for stock investors.

A Celebration of Predictably Bad Funds

The math on bad funds is irresistible. Morningstar tracks 6400 funds. By definition, 3200 of them will post below-average performances this year. If performance were determined by pure chance (hello, Mr. Bogle!), 1600 funds would post back-to-back sub-par years, while the rest of the progress is shown below.

To test that hypothesis, I counted 2010 as a complete year and then checked a database for the number of funds that have managed to turn in below average returns year after year after year.

Good news, I guess. “Continually horrible” is a bit less likely than you might guess. Two reasons suggest themselves. Fund companies either (1) bury the manager or (2) bury the fund. If you want to wander through the graveyard, check out FundAlarm’s master list of manager changes.

Highlights from the list of awful funds:

The Futile Five are Davis Government Bond “B,” Embarcadero Market Neutral (Garret Van Wagoner is back in the saddle again!), ING Emerging Countries “A”, Performance (that’s ironic)Short-Term Government Income and ProFunds Bull. Between them, they hold $465 million in assets. Two of the four funds (Davis and Performance) have had the same manager for the entire period, while Embarcadero had no manager for a number of years (it was one of the Van Wagoner zombie funds), and ING has all-new managers in 2010. I wish them well.

Over the past three years, investors in the Invesco funds, 17 of which are on three-year cold streaks, have suffered the greatest misery. Likewise 16 Fidelity, six Bridgeway and three Hennessy funds. (That probably makes it a poor time for Mr. Hennessey to pick a public fight with the Bogles, pere and fils, over fund fees and performance. Mr. Bogle the Elder recently suggested, “[Hennessy] is running an enormously profitable management company with inferior performance in these funds, in part because of the excessive fees he charges.”)

At the five-year mark, there are two Hennessy funds, five from Invesco and four from Fido. After eight years, Fidelity Growth & Income (FGRIX) is still hanging on as the $5 billion poster child for irremediable incompetence. In defense of the new manager, James Catudal, who was appointed in January 2009, the fund now consistently trails its peers and benchmark – but by less than it used to.

Permanent Portfolio: Unlikely Superstar?

I was prepared, from the outset, to dislike Jason Zweig’s recent article on the $6 billion Permanent Portfolio Fund (PRPFX) (“Unlikely Superstar: How a Forgotten Fund Got Hot in a Hurry,” WSJ, September 18-19, 2010). Mr. Z., however, produced an essay more thoughtful than the headline assigned to it.

For those unfamiliar with Permanent Portfolio, the fund holds a series of uncorrelated assets, some of which are likely to thrive regardless of the state of the market or of the economy. Harry Browne propounded the underlying notion in the 1970s. He saw the strategy as, of all things, a way to run toward the despised stock market rather than away from it. The fund’s asset allocation never changes, except in the sense that sharp market fluctuations might temporarily throw it out of whack. Give or take a little, the fund invests:

20% in gold

5% in silver

10% in Swiss francs

15% in real estate and natural resources stocks

15% in aggressive growth stocks

35% in cash and U.S. bonds

The fund has produced perfectly splendid results over the past decade, with an annualized return of 10.7% and a 2008 loss of only 8%. The fund is no-load, it takes only $1000 to get in and expenses are 0.8%.

Mr. Zweig’s article makes two points. First, much of the fund’s success is driven by mania. Bill Bernstein of Efficient Frontier Advisors wrote an essay critical of Permanent Portfolio’s newfound popularity. Fifty-five percent of the fund is in bonds and gold, which Bill Bernstein describes as being in the midst of “a non-stop beer-and-pizza party.” Those same wildly attractive assets, over the long term, have been dismal losers. Mr. Bernstein reports:

Diversifying asset classes, as Harry Browne knew well, can benefit a portfolio. The secret is deploying them before those diversifying assets shoot the lights out. Harry certainly did so by moving away from gold and into poorly performing stocks and bonds in the late 1970s. Sadly, this is the opposite of what the legions of new TPP adherents and PRPFX owners have been doing recently—effectively increasing their allocations to red-hot long Treasuries and gold. Consider: over the long sweep of financial history, the annual real return of long bonds and gold have been 2% and 0%, respectively; over the decade ending 2009, they were 5% and 11%. (“Wild About Harry“)

Second, all of the money that poured in will – just as quickly – pour out. “[M]any of its new buyers,” Zweig opines, “seem to be seeking capital appreciation – chasing this fund the same way they chased Internet funds in 1999 and 2000. They could leave just as quickly.” Mr. Bernstein is rather more pointed: “During the frothy 1990s stock market, however, investors abandoned the fund in droves.”

That is, by the way, an enormous problem for the remaining shareholders. The rush out forces the manager to sell, without regard to the wisdom of selling, just to meet redemptions.

Some of FundAlarm’s most thoughtful professional investors use Permanent Portfolio as a core position in their more conservative portfolios, providing substantial and consistent profits for their clients in the process. Despite that fact, I have never warmed up to the fund, and doubt that I ever will.

Setting aside the fact that it’s an index fund that charges 0.8%, I’m troubled by two things. First, the manager has neither closed nor even discussed the possibility of closing the fund. In most cases, responsible managers seek to dissuade a mindless inrush of (highly profitable) cash. Vanguard imposes high investment minimums, for example, $25,000 in the case of its Health Care fund (VGHCX). Oakmark restricts access through third-party vendors for several of its funds. Bridgeway, Artisan, Leuthold, Wasatch and others simply close their funds. Permanent Portfolio, instead, welcomed an additional $3,000,000,000 in the first eight months of the year – which provides an additional $24,000,000 in revenue to the advisor. In 2009, Mr. Cuggino’s firm, of which he is sole owner, received $31,286,640 in fees from the fund. In 2010, that’s likely to approach $60,000,000.

Mr. Cuggino does report “I’ve educated people right out of our fund.” Given that the fund’s website dubs it “a fund for all seasons” and the manager is a frequent speaker at money shows, it’s not clear exactly who he has talked away or how.

Second, the manager’s interests are not aligned with his investors. Though Mr. Cuggino has had a long association with the fund and has managed it since 2003, he’s been very reluctant to invest any of his own money in it. The fund’s 2006 Statement of Additional Information reports, “As of April 30, 2006, Mr. Cuggino and his immediate family members owned no shares of the Fund.” A year later that changed, but in an odd way. The SAI now reports that Mr. Cuggino ^2,3 owns “over $100,000” in fund shares. Those footnotes, though, indicate that “As of April 30, 2010, Mr. Cuggino owned shares in each of the Fund’s Portfolios through his ownership of Pacific Heights.”

Which seems to say, the company buys the shares for him. And the company likely pays him well. My favorite passage from the 2010 SAI, with emphasis added,

Pacific Heights, of which Mr. Cuggino is the manager and sole member (also its President and Chief Executive Officer), compensates Mr. Cuggino for service as the portfolio manager for each of the Fund’s Portfolios. As the manager and sole member of Pacific Heights, Mr. Cuggino is the owner of Pacific Heights and determines his own compensation. Mr. Cuggino’s compensation from Pacific Heights is in the form of a share of Pacific Heights’ total profits.

So he collects a salary (“not based directly on the performance of any of the Fund’s Portfolios or their levels of net assets”) for serving as the firm’s president and gets to allocate to himself (apparently at his discretion) a share of the firm’s considerable profits.

What does he do with his money, if not invest it alongside his shareholders? I don’t know, though the SAI contains the slightly-nervous warning that

Actual or apparent conflicts of interest may arise because Mr. Cuggino has day-to-day management responsibilities with respect to each of the Fund’s Portfolios and certain personal accounts. The management of the Fund’s Portfolios and these other accounts may result in Mr. Cuggino devoting unequal time and attention to the management of the Fund’s Portfolios and these other accounts.

Mr. Cuggino is subject to the Fund’s and Pacific Heights’ Amended and Restated Code of Ethics, discussed in this SAI under “Code of Ethics,” which seeks to address potential conflicts of interest that may arise in connection with Mr. Cuggino’s management of any personal accounts. There is no guarantee, however, that such procedures will detect each situation in which a potential conflict may arise.

There is no reason to believe that Mr. Cuggino has done, is doing or ever will do anything improper in his management of the fund (unless sopping up assets to generate huge fees is wrong). Nonetheless, given the tremendously foul history of the fund under its previous management (after repeated violations of SEC rules, Morningstar became so disgusted that they dropped commentary on the fund for 15 years), a far more transparent approach would seem appropriate.

Update on the best fund that doesn’t exist

A couple months ago, I pointed out the obvious hole in the fund and ETF universe: there is no emerging markets balanced fund in existence. Given that both E.M. stocks and E.M. bonds are seen as viable, perhaps imperative, investments, I can’t for the life of me figure out why no enterprising group has pursued the idea.

In the decade just passed, the storied “Lost Decade,” a perfectly sensible investment of $10,000 into Vanguard’s Total Stock Market Index (VTSMX) on the first day of the decade (January 1, 2000) would be worth $9700 on the last day of the decade (December 31, 2009).

I attempted a painfully simple, back-of-the-napkin calculation for the returns generated by a 60/40 emerging markets balanced fund over that same period. I did that by starting with T. Rowe Price’s Emerging Markets Stock (PRMSX) and Emerging Markets Bond (PREMX) funds. I placed 60% of a hypothetical $10,000 investment into stocks and 40% into bonds. On January 1 of every year thereafter, I rebalanced to 60/40. Mostly that meant selling bonds and buying stocks. Here’s how the hypothetical E.M. balanced fund (ROYX) would compare to investing all of the money into either of the Price funds:

Had the fund existed, it would have suffered two losing years in the past decade (down 9.7% in 2000 and 43.4% in 2008), while an all-stock portfolio would have had twice as many losing years including a gut-wrenching 61% drop in 2008. An all-bond portfolio would have suffered one losing year, 2008, in which it would have lost 18%.

It’s clear that a pure emerging markets bonds commitment would have been a (slightly) better bet. In reality, though, it’s a bet that almost no investor would make or would long live with.

We can also compare our hypothetical balanced fund with the best of the global funds, including the highly flexible Leuthold Core (LCORX) fund and a number of the Morningstar “analyst pick” picks which have been around for the whole decade.

The results are pretty striking, though I’m not pretending that a simple back-test provides anything more than a reason to stop and go, “hmmmmm.”

Briefly noted

David Dreman, one of those guys to whom terms like “guru” and “legend” are attached, has decided to step down as his firm’s co-CIO. The 74-year-old, who started his firm 33 years ago, will keep busy running two funds (High Opportunity and Market Overreaction), serving as chairman and writing a fifth book.

The very fine Intrepid Small Cap fund (ICMAX) lost manager Eric Cinnamond at the start of September. He’s joined institutional manager River Road Asset Manager as head of their “Independent Value strategy.” The fund remains in good hands, since the two co-managers added in 2009 also guide Intrepid Capital (ICMBX, a star in the shadows!).

Oak Value (OAKVX) just became RS Capital Appreciation. Oak Value gathered only $70 million in 17 years of operation, despite a strong record and stable management. After the acquisition, everything stays the same for this fine small fund. Except a change in name and ticker symbol (RCAPX for the “A” shares). And, oh yes, the imposition of a 4.75% front load.

Driehaus Select Credit Fund (DRSLX), which seeks “to provide positive returns under a variety of market conditions” through long and short positions in both equity and debt (primarily US) went live on September 30^th. The lead manager, K.C. Nelson, also runs Driehaus Active Income(LCMAX). The fund’s $25,000 minimum and 2.0% expenses might spook off most folks except, perhaps, those looking to add to their hedge fund collection.

In closing . . .

I want to offer a belated thanks to Stacy Havener of Havener Capital Partners LLC for recommending that I profile Evermore Global Value (EVGBX). Back in August, she mentioned that Mr. Marcus has “banded together a team of former Mutual Series people (including Jae Chung most recently PM at Davis Advisors) to start a new firm called Evermore Global Advisors. David and team are utilizing the same deep value with catalyst investment approach learned under the tutelage of Michael Price.” I was, as is too often the case, entirely clueless and deeply grateful for her perceptiveness.

Thanks to Kenster, a contributor to FundAlarm’s boisterous Discussion Board, for the New York Magazine article on hedge fund managers. The last quarter of the article includes a discussion with David Marcus, formerly of Mutual Series and now lead manager at Evermore. Mr. Marcus certainly comes across as the voice of anguished reason in a story redolent with self-important young fools.

I often stockpile reader suggestions over the summer for use in fall. I’d like to acknowledge a couple particularly good ones. First, apologies to Scott Lee, who recommended this summer a fund that I haven’t yet written about (but will). Scott writes of an “undiscovered fund manager here in Birmingham. I’m sure you’re aware of Southeastern Asset Management, the advisers behind the Longleaf Partners funds. Three years ago, Mason Hawkins’s ‘second in command,’ C.T. Fitzpatrick left Longleaf after running money there for about 20 years. . . C.T. Fitzpatrick resurfaced in his hometown of Birmingham, AL and has now started a new fund company known as Vulcan Value Partners. Thus far he has put up astounding performance numbers, with his small-cap value fund (VVPSX) ranked in top decile amongst its peer group.” Vulcan Value Partners Small Cap (VVPSX) launched in December 2009, has returned 4.6% over the first nine months of 2010. That places it in the top 4% of small core funds. The large cap Vulcan Value Partners (VVPLX) made a modest 2.5% in the same period.

Brian Young, another sensible soul, recommended that I look at two funds in the months ahead:Iron Strategic Income (IRNIX) – “a great way to get exposure to high-yield bonds without losing your shorts” – and Sierra Core Retirement (SIRIX) – “fund of funds asset allocation fund that looks more like a multisector bond fund.” Folks on the Discussion Board have had a lengthy conversation – diplomats use phrases like “frank and open” to describe the tenor of such conversations – about Sierra in late June and early July of this year. The funds are a bit larger ($500 million) than those I normally cover (under three years old and/or under $100 million), but are definitely worth a look.

Speaking of the Discussion Board, we’re quickly coming up on another milestone: our 300,000^thpost. The range of topics covered in a single day – the allure of emerging market debt funds, the growing timidity of Fidelity’s equity managers, what small cap fund might be appropriate for a college-aged investor – is remarkable. If you haven’t visited and spoken up, you should! If you have, then you’ve got a sense of the value that FundAlarm offers. Please consider using a strategy as simple to FundAlarm’s link to Amazon to help support its continued vitality.

As ever,

David

. . . from the archives at FundAlarm

David Snowball’s
New-Fund Page for November, 2010

Dear friends,

Having survived what are, historically, the two worst months for equity investors, we now enter the “sweet spot” on the calendar. The great bulk of the stock market’s annual returns since 1927 have occurred in the late fall and winter months. In theory, we should all be happy and relieved. Instead, I keep hearing Warren Buffett in the background: “Investors should remember that excitement and expenses are their enemies. . . they should try to be fearful when others are greedy and greedy when others are fearful.” And so, just as we have reason to relax, I think I’ll work a bit on being anxious.

Abetted by financial advisors who are confronting “career risk” (that is, what happens when you annoy enough clients), investors continue to sell domestic equity funds – which have seen steady outflows in each of the past six months – and buy (overpriced) bonds. About the most hopeful sign is that the rates of outflow have slowed dramatically from $7 billion/week at the start of September to just $200 million/week now.

Sniping at the Absolute Return crowd

The pressure to find something new to say, pretty much every day, occasionally produces spectacularly weak arguments. Such was the case with Daisy Maxey’s recent dismissal of absolute return funds in the Wall Street Journal(“Absolute-Return Funds: Low Risk, Low Return,” October 29 2010). Ms. Maxey analyzes three funds (only one of which is an absolute return fund) and quotes as her authorities the manager of a small wealth management firm (albeit one that offers you “a business plan for life”) and a young man who just made the leap from “summer intern” to “new employee” at a well-respected financial research corporation. Her conclusion, unsupported by data or testimony, was that “such funds tend to minimize risk but aren’t likely to consistently deliver positive returns.” There are 16 funds with “Absolute Return” in their names, though she notes that there is no “absolute return” category or peer group in systems such as Morningstar’s, that many de facto absolute return funds don’t use the phrase in their names and that funds whose marketers have chosen the phrase “absolute return” often have nothing in common. Her one source does sniff that “a lot of absolute-return funds [are] coming out that will be what I call ‘no-return funds'” but that’s about it for evidence.

Ms. Maxey’s concern is either that the funds produce “low returns” or that they won’t “consistently deliver positive returns,” which are two very different complaints. I’ll take them in turn as we look at funds (in Morningstar’s system, market neutral, long/short, conservative allocation) whose goal is something like absolute returns.

First, most absolute return funds don’t promise high returns. They attempt to provide something greater than zero (that’s the “absolute” part), regardless of the market environment. Most of the managers I’ve spoken with would be very happy if they could produce consistent gains in the 5 to 7% range. It’s hardly a knock on the funds that they don’t produce something they never claim to produce.

The more serious objection is that they don’t produce absolute returns either. Unfortunately, the market crisis of 2008 – the worst mess in more than three –quarters of a century – makes it hard to generalize since pretty much everything except Treasuries cratered. By way of illustration, there are 422 funds that have produced positive returns in each of the past five years, of which 416 are bond funds. If you change the criteria to “four years of gains and no worse than single-digit losses in 2008,” you get a much more positive picture. Two dozen no-load funds pass the test.

Among the funds that use absolute return strategies, such as shorting the market, a handful survived 2008 and went on to produce gains in both 2009 and 2010. They are:

None of the other no-load “Absolute Return” funds qualify under this screen.

Three funds with exceedingly broad mandates – a little stock with precious metals, bonds and cash – have made a case for themselves. Midas Perpetual Portfolio (PRPFX) and Mr. Hussman’s less ambitious Total Return fund, first profiled here in early 2008, are among the few funds never to have lost money in a calendar year. Both have strategies reflecting the Permanent Portfolio (PRPFX ) approach. PRPFX is a fund which makes me slightly crazy (see Permanent Portfolio: Unlikely Superstar? in the September 2010 essay), but which has made its investors a lot of money.

Another fine year for The Fund Morningstar Loves to Hate

Let’s say you had a mutual fund that posted the following returns:

And let’s assume that the fund had a substantially below-average expense ratio, and a five-star rating. Add to our fantasy: above average returns in 11 of the past 12 years and top 5% returns about two-thirds of the time. And, what the heck, high tax-efficiency.

How might the good folks at Morningstar react? Oh, about the same way you react when, in a darkened room in the middle of the night you step on something squishy. Which is to say, with disgust.

The fund in question is Fidelity Canada (FICDX) and its record has been spectacular. The tiny handful of international funds with comparable 15-year records include First Eagle Global (SGENX), Matthews Asian Growth & Income(MACSX), First Eagle Overseas (SGOVX) and Janus Overseas (JAOSX). Which leads Morningstar to observe:

• This is one of two funds focused on Canada. If we had to pick, we’d choose the other one. (2009)
• Approach this mutual fund with caution. (2007)
• Do you really need a Canada fund, especially now? (2006) Answer: no, “it’s unnecessary and risky.”
• This mutual fund has been on a hot streak, but cool north winds could easily prevail. (2005)
• A reversal of fortune. (2004)
• Should you be looking at this chart-topper? (2003) Answer: no, “it’s hard to justify owning” it.
• Beating its index-tracking rival handily. (2002) Nonetheless, “it’s a tough sell.”
• This fund’s purpose can be questioned, but not its execution. (2001)
• Fidelity Canada has shown resilience in the face of adversity. (2001) Though the fund still “doesn’t have broad appeal.”
• Fidelity Canada’s high return doesn’t make it a compelling choice. (2001) “It’s hard to make a case for buying this fund.”
• Even the most loyal Canadian would have a tough time defending Fidelity Canada Fund. (1998)
• Fidelity Canada Fund is unusual, but it’s not clear if its appeal goes beyond that. (1997)
• Fidelity Canada Fund looks–and acts–a lot like a natural-resources offering. (1997)
• Fidelity Canada Fund’s sector bets are giving it a bad case of frostbite. (1997)
• Fidelity Canada Fund looks more like Siberia. (1996)
• Fidelity Canada Fund makes about as much sense as a spring break in Saskatoon (1996)

Morningstar’s latest complaint: the manager Doug Lober “isn’t introspective enough.” I think this is the first time I’ve seen Morningstar complain about a manager’s mental acuity. The dim bulb has, by the way, placed the fund in the top 5% of international large-core funds in 2010.

In the meanwhile, Greg Frasier, who managed Fidelity Diversified International (FDIVX) and who was described by Morningstar as “a legend,” attributed his fund’s consistent outperformance to two factors: the wise use of ADRS, and a willingness to invest in Canada. The case for investing in Canada might not be a slam-dunk, but it’s surely better than “spring break in Saskatoon.”

Small, newer funds can be good investments!

Well duh.

Two new studies prove the obvious: old and large aren’t requirements for investment success.

Northern Trust, based in Chicago, specializes in picking fund managers rather than picking individual securities. Their recent study of large-cap manager performance and size, No Contest: Emerging Managers Lap Investment Elephants, concludes that smaller investment firms have better five-year records than either managers at larger firms or the S&P 500, have better performance during bear markets, and are more likely than larger managers to end up in the top quarter of funds.

Lipper reached the same conclusion earlier this year. Their study of Europe-based funds, Ruling Out New Funds? Wrong Decision, finds “[n]o evidence . . . that funds with long track records enjoy better performance or incur less risk than new funds. On the contrary, the empirical data suggest that newly- launched funds post higher average total returns and lower risk data.”

Fund managers respond to charge: “We are not a stegosaurus”

Barron’s writer Tom Sullivan just announced, “It’s Adapt or Die for Fund Businesses” (October 30, 2010). Drawing on a survey of 1000 “distribution professionals” conducted by Strategic Insight, a New York-based research and consulting firm, Sullivan reports that equity funds – which used to draw 65% of inflows – now draw only 25%. The brands of many larger firms have suffered damage that will take years to undo, while smaller and midsized firms have a competitive advantage.

Fund companies seem to be endorsing Mr. Sullivan’s prognosis. One sign of that: the number of long-only equity managers who are suddenly enamored of funky global strategies. Among the funds, newly-launched or still in registration, are:

Aston/River Road Long-Short Fund, in registration and likely to launch around year’s end.

Causeway Global Absolute Return Fund, likewise in registration.

Fairholme Allocation Fund, which will invest in anything, anywhere, in any direction.

Forward Commodity Long/Short Strategy Fund which tracks the Credit Suisse Momentum and Volatility Enhanced Return Strategy Index.

GRT Absolute Return Fund, run by three brilliant equity investors.

Navigator Equity Hedged, which will buy ETFs and put options.

River Park/Gravity Long-Biased Fund, one of five new funds from an advisor founded by Baron Asset alumni.

That’s in addition to Third Avenue’s decision to launch an unconventional income fund (Third Avenue Focused Credit), Fairholme’s to launch a Focused Income fund, and Driehaus’s to buy an “active income” fund in 2009 and to give the same team a second fund (Driehaus Select Credit). Even some “alternative” managers are branching out, as in the case of Arbitrage Event-Driven or RiverNorth/DoubleLine Strategic Income Fund.

Two questions that potential investors had better answer before opening their wallets: (1) is there any reason to believe that success in long-only equity investing translates to success anywhere else (answer: not particularly) and (2) is there reason to be concerned that adding the obligation to manager complex new vehicles may over-extend the managers and weaken their performance across the board (answer: no one is sure, would you like to figure it out with your money?).

Briefly Noted:

Move over, Geico gecko, here comes Jerry Jordan. Mr. Jordan is now running TV commercials for his five-star Jordan Opportunity (JORDX) fund. The spots, airing on Bloomberg TV, reported show an investor using Morningstar.com and finding Jordan Opportunity. Why Morningstar rather than FundAlarm for the spot? “[I]f you’re quoting Morningstar,” the ad agency’s president opines, “you’re basically quoting the Bible.” (I knew I shouldn’t have brought my copy of The Satanic Verses to our last staff meeting!)

Hakan Castegren, manager of the Harbor International Fund and Morningstar’s International Stock Fund Manager of the Year award for 1996 and 2007, passed away October 2, one week shy of his 76^th birthday. He was, by all accounts, a good man and a phenomenal manager. His firm, Northern Cross, will continue to sub-advise the Harbor fund.

On October 7, Reuters reported “AQR seeks smaller investors.” Ten days later Investment News updated the search for smaller investors: “Retail investors will no longer be able to buy mutual funds from AQR.” AQR is, of course, AQR Capital Management, a $29 billion institutional quant investor which launched a line of retail funds in 2009. Apparently the numbers weren’t looking good, and the company shifted all of its sales to the advisor-sold channel.

The Board of Trustees approved the liquidation of a slug of PowerShares ETFs, with the executions to occur just before Christmas. The walking dead include

• Dynamic Healthcare Services Portfolio (PTJ)
• Dynamic Telecommunications & Wireless Portfolio (PTE)
• FTSE NASDAQ Small Cap Portfolio (PQSC)
• FTSE RAFI Europe Portfolio (PEF)
• FTSE RAFI Japan Portfolio (PJO)
• Global Biotech Portfolio (PBTQ)
• Global Progressive Transportation Portfolio (PTRP)
• NASDAQ-100 BuyWrite Portfolio (PQBW)
• NXQ Portfolio (PNXQ)
• Zacks Small Cap Portfolio (PZJ)

Standard & Poor’s recently announced finalists for its U.S. Mutual Fund Excellence Awards Program. Three funds were designated as “new and notable.” They are Dodge & Cox Global (DODWX), Northern Global Sustainability Index Fund(NSRIX) and T. Rowe Price US Large-Cap Core (TRULX).

Those folks at Mutual Fund Wire need to get out more. Writer Hung Tran trumpeted the fact that “[r]ookie mutual fund shop Simple Alternatives is making headlines with its first product: a mutual fund of hedge funds.” The great advantage of their fund (called “S1”) is that it offers “mutual fund-like liquidity terms and fees. The new fund, which debuted on Monday, reportedly charges just 2.95 percent and offers daily redemptions without notice.” Earth to MFWire: 2.95% is extortionate and shouldn’t be preceded by the word “just.” Out of 6250 mutual funds, only 30-odd have expenses this high and they’re generally sad little fly-specks.

The folks at Ironclad Investments (“ironclad” as in the Civil War era navy vessels) just launched two risk-managed funds which use the popular institutional strategy of buying and selling options to limit their volatility while still participating in the market. Ironclad Managed Risk Fund (IRONX, precariously close to IRONY) sells covered put options on a variety of indexes while Ironclad Defined Risk Fund (CLADX) purchases of call options and sells call and put options on ETFs and equity indexes. Both are run by Rudy Aguilera and Jon Gold, both charge 1.25% and have $2500 investment minimums. Since I’d missed them in the “Coming Attractions,” it felt right to acknowledge them here.

In closing . . .

We celebrate the passing of a milestone. FundAlarm’s discussion board recorded its 300,000th message late in October (ironically, one asking about the 300,000th message), then quickly tagged on another 500 messages as folks sorted through their options for finding funds invested in “high quality” American companies and ones holding “rare earth metals” stocks. The board is wonderfully dynamic and diverse. If you haven’t visited, you should. If you have visited but consigned yourself to lurking, speak up, dude! It’s not a discussion without you.

David

. . . from the archives at FundAlarm

David Snowball’s
New-Fund Page for December, 2010

Dear friends,

Multiple stories in the past month (“Hedged mutual funds on the ascent,” “Here come the ‘hedged’ mutual funds”), complemented by a series of high profile fund launches, are heralding hedge funds as the future of mutual funds. So, despite their questionable performance, expensive strategies, secretive nature, frantic trading and tendency to be liquidated by the thousands, it appears that

It’s Hedge-Mania Time!

There are three ways in which we discuss “hedges” in regard to mutual funds: currency hedging by international funds, hedge fund-like strategies adopted by mutual funds, or mutual funds that attempt to replicate the performance of the hedge fund universe.

Currency hedging

The oldest, least expensive and least controversial practice is currency hedging by international funds. Currency hedges are a sort of insurance which, for a price, can largely nullify the effect of changing currency values on an international fund’s performance.

The simplest way to measure the effects of currency changes is to compare the performance of Tweedy, Browne Global Value (TBGVX), which does hedge its currency exposure, with Tweedy, Browne Global Value II (TBCUX) which is identical except that it doesn’t purchase currency hedges.

Over the past twelve months, the hedged version of the fund has earned its investors 12.85%, which places it in the top 1% of its peer group. The unhedged version (same stocks, same manager, same expenses) has returned 4.75%. Tweedy’s managers believe that, in the long term, neither currency strategy has an inherit advantage: the hedges cost some money but moderate short term volatility.

Hedge fund strategies

The second strategy, which has been around for a decade or more, has been the importation of hedge fund strategies into mutual fund portfolios. While the extent of those strategies is limited by federal regulation, such funds might sell securities shorts in order to benefit from their falling values, use leverage to over-expose themselves to a market, or use derivatives to hedge various risks. All of which is expensive: the average long-short fund charges 2.04% in expenses, with the worst of them charging over 5% annually for their services. With considerable confidence and absolutely no evidence, Alistair Barr and Sam Mamudi of The Wall Street Journal recently (11/15/10) assured readers that “Hedged mutual funds provide stock-like returns with less volatility.” Oddly, the only fund they point to – Thesis Flexible Fund (TFLEX) – had lost 0.4% since inception while the S&P was up 10%. Of all 562 “alternative” mutual funds tracked by Morningstar, only 86 managed “stock-like returns” in 2010. Nonetheless, the Journal’s sources pronounce us in “the very early stages of a multitrillion-dollar wave that’s going to wash over” the fund industry.

Whether “multi-trillion” or not, it’s clear that more and more long-established equity managers – recently Turner, Fairholme, Aston, Causeway, GRT, plus the bond guys at DoubleLine – have committed to new hedge-like funds.

Hedge fund replication

The most recent manifestation of hedge mania are the so-called “hedge fund replication” funds. Operating under the assumption that hedge funds are, by definition, good, these funds use complex mathematical modeling to construct portfolios of traditional investments (for example, convertible bonds) whose performance matches the risk and return profile of some part of the hedge fund universe. In theory, they offer all of the advantages of hedge fund investing with none of the pesky fees, minimums and liquidity problems.

The fact that they don’t work seems secondary. I compared the returns since inception for all of the “hedge fund replication” funds that I could identify with the returns of the simplest, blandest and cheapest alternative I could identify: Vanguard’s Balanced Index fund (VBINX). The Balanced Index charges next to nothing (0.08 – 0.25%, depending on share class) and offers a very simple 60/40 stock/bond split.

To date, every hedge fund replicant, from inception to late November 2010, trails the returns of the VBINX. Here’s the comparison of what you’d get it you’d place $10,000 either in a hedge replicating fund on the day it opened or in the balanced index on that same day. All results are rounded to the nearest $100:

While it’s true that the records of these funds are too short (between one and 30 months) to offer a great test, the fact that none of them have outperformed a simple alternative does remind us of Occam’s Razor. William of Ockham was a 14^th century logician and friar, who embraced the minimalist notion that “entities must not be multiplied beyond what is necessary.” His “Razor” is generally rendered as “the simplest explanation is more likely the correct one” or “when you have two competing theories that make exactly the same predictions, the simpler one is the better.” The same, perhaps, might be said of investing: “if two different investments get you to the same spot, the simpler one is the better.”

Shaving USAA Total Return Strategy with Occam’s Razor

“Scott,” an active and cheerful contributor to FundAlarm’s discussion board, made a sharp-eyed observation about the USAA Total Return Strategy (USTRX) fund: “it has 70% in SPY [an ETF which tracks the S&P 500]. I’ve never seen a mutual fund with 70% of its weighted portfolio in one position. . . For the record, the performance combined with the expenses of the fund are not attractive. In its worst year it lost almost twice as much as it gained in its best year. Have you ever seen a fund with almost 75% in one ETF?”

Actually, Scott, not until now.

USAA is a financial services company open to “anyone who has ever served honorably in the military,” a restriction you could dodge by investing through one of the several fund supermarkets who offer the funds NTF. Since they restrict information about their funds to members, outsiders need to work through SEC filings to get much detail.

The Total Return portfolio is divided into three parts. There’s a tiny market-neutral sleeve, which invests long and short in equities. There’s a tiny, bizarre sleeve invested in a hedge fund. Here’s their attempt to explain it:

[We employ] a global tactical asset allocation overlay strategy (GTAA) by investing in hedge or other funds that invests in short-term money market instruments and long and short positions in global equity and fixed-income exchange-traded futures, currency forward contracts, and other derivative instruments such as swaps.

But 92% of the portfolio consists of SPY (70%) and “Currency United States” (at 21% and somehow distinct from “cash”). The strategy is to sell index calls or buy puts in an “attempt to create a collar on our stock market exposure that effectively limits downside (and upside) potential and gives us the flexibility to quickly change the Fund’s risk.”

Which would be nice except for the fact that it doesn’t actually do anything. $10,000 invested in the fund nearly six years ago has grown to $10,100. The same investment in the bland Vanguard Balanced Index grew to $12, 900. (The fund trails its Lipper Flexible Portfolio Funds peer group by a comparable amount.) And the Balanced Index imposed virtually the same degree of volatility (a five-year standard deviation of 11.27 versus USTRX’s 10.84), had virtually the same downside (down 22% in 2008 versus 21% for USTRX) and charges one-fifth as much.

And in the background, one hears the good Friar Ockham intoning, “don’t make it unnecessarily complicated, ye sinners.”

Silly advice of the month: “Why You Must ‘Time’ This Market”

Levisohn & Kim’s lead story in The Wall Street Journal’s “Weekend Investor” section (11/13/10) begins: “Forget ‘buy and hold.’ It’s time to time the stock market.”

You can’t imagine how much of a headache these stories give me. The story begins with the conspiratorial insight, if timing “sounds like sacrilege, it may be because mutual-fund firms have spent decades persuading you to keep your money in their stock funds through thick and thin so they could collect bigger profits.” The depth of the conspiracy is illustrated by a hypothetical $1 million doing investment (because bigger numbers are, well, bigger) in the S&P 500 made on December 24 1998. Since then, you’d have made nuthin’.

The solution? Tactical allocation funds which “have the flexibility to jump into and out of asset classes to avoid market losses.”

There are three problems with Levisohn and Kim’s advice:

First, it tells you what might have worked 12 years ago, which is a lot different than telling you what will work in the years ahead. Did the WSJ advocate market timing in 1998 (or 2002, for that matter)? Nope, not so far as I can find in the paper’s archive. Why not? Because they had no idea of what the next decade in the market would be like. Nor do Levisohn and Kim have any particular evidence of insight into the decade ahead.

Second, it relies on your ability to time the market. “And,” they assure us, “it turns out sometimes you can.” Sometimes, it turns out, is a dangerous notion. Their faith depends on knowing that you’re “stuck in a trading range for an extended period” (the same assumption made by the folks selling you day-trading software). Unfortunately, the market of the past 12 years hasn’t been stuck in a trading range: it’s had two catastrophic collapses and two enormous rallies.

Third, most of the solution seems to come down to the fact that two funds have done well. The authors point to the sparkling performance of FPA Crescent(FPACX) and Ivy Asset Strategy (WASAX). Of the remaining 82 funds in the “world allocation” category, three-quarters either haven’t made it to their fifth anniversary, or have made it and still trail the modest returns of Vanguard’s Total Stock Market Index (VTSMX).

“Transparent” is relative

“Ira Artman,” a long-time reader and thoughtful guy, wrote one of the shortest and most provocative notes that Roy and I have lately received. Here, in its entirety, is Ira’s note concerning the Transparent Value family of funds:

“transparent”?

Which got me to thinking: “what’s up, Ira?”

Might it be that the actual names of the funds are longer than some summary prospectuses, as in: Transparent Value Dow Jones RBP® U.S. Large-Cap Aggressive Index Fund (Class F-1 shares)? The name’s long enough that you can’t search for “Transparent Value” at Morningstar, which squeezed the name to Transparent Val DJ RBP US LC Agr Idx F-1.

Or that the funds’ “Principal Investment Strategies” appear to have been penned by an irascible French historian?

The Aggressive Index consists of common stock of companies in the Dow Jones U.S. Large-Cap Total Stock Market Index^SMthat Dow Jones Indexes has selected for inclusion in the Index by applying Required Business Performance® (RBP®) Probability scores (as defined below), as further described in the “Index Construction” section on page 22 of this prospectus. Dow Jones Indexes is part of CME Group Index Services LLC, a joint-venture company which is owned 90% by CME Group and 10% by Dow Jones (“Dow Jones Indexes”). The RBP® Probability scores are derived from a quantitative process of Transparent Value, LLC.

Might he wonder about the claim that the fund offers “High RBP, weighted by RBP”?

Perhaps even that the fund tracks its index by investing in stuff not included in the index?

The Fund also may invest up to 20% of its net assets in securities not included in the Index, but which the Adviser, after consultation with the Sub-Adviser, believes will help the Fund track the Index . . .

He might be worried about his difficulty in “seeing through” management’s decision to charge 1.50% (after waivers) for an index fund that has, so far, done nothing more than track the S&P 500.

The fact that Morningstar has cross-linked all of Tamarack Value’s (TVAAX) analyst reports with Transparent Value’s fund profile doesn’t materially help.

Doubtless, Ira will clear it all up for us!

Searching for “perfect” mutual funds

Warren Boroson has been writing about personal finance for several decades now. (He has also written about blondes, dueling, and Typhoid Mary – though not in the same column.) Lately he decided to go “In search of ‘perfect’ mutual funds” (10/18/2010), which he designates as “six star funds.” That is, funds which combine a current five-star rating from Morningstar with a “high” rating for return and a “low” rating for risk. In addition to funds that his readers certainly have heard of, Boroson found three “intriguing newcomers, funds that may become the Fidelity Magellans, Vanguard Windsors, or Mutual Series funds of tomorrow.” They are:

• Appleseed (APPLX) which he describes as “a mid-cap value fund.” One might note that it’s a socially responsible investor with no particular commitment to midcaps and a 15% gold stake
• Pinnacle Value (PVFIX), “a small-cap fund, run by John Deysher, a protégé of Charles Royce . . . 47% in cash.” Actually Mr. Deysher is 57% in cash as of his last portfolio report which is absolutely typical for the fund. The fund has held 40-60% in cash every year since launch.
• Intrepid Small Cap (ICMAX), “a value fund . . . [r]un by Eric Cinnamond . . . Up an amazing 12.24%-a-year over three years.”

Or not. Mr. Cinnamond resigned from the fund six weeks before Mr. Boroson’s endorsement, and now works for River Road Asset Management. The fund’s lead manager, Jayme Wiggins, returned to the company from b-school just weeks before taking over the Small Cap fund. Wiggins was a small cap analyst at the turn of the century, but his last assignment before leaving for school was to run the firm’s bond fund. He’s assisted by the team that handles Intrepid Capital (ICMBX), which I described as “a fund that offers most of the stock market’s thrills with only a fraction of its chills.”

All of which raises the question: should you follow Mr. Cinnamond out the door? He was clearly a “star manager” and his accomplishments – though, go figure, not his departure – are celebrated at Intrepid’s website. One way to answer that question is to look at the fate of funds which lost their stars. I’ve profiled seven funds started by star managers stepping out on their own. Two of those funds are not included in the comparison below: Presidio (PRSDX) was splendid, but manager Kerry O’Boyle lost interest in liquidated the fund. And the River Park Small Cap Growth fund, at only a month, is too new. Here’s the performance of the five remaining funds, plus a first look at the decade’s highest-profile manager defection (Jeff Gundlach from TCW).

What are the odds? The managers new fund has outperformed his previous charge four times out of six (Wintergreen was a touch ahead before rounding). But the old funds continue to perform solidly: three of the six beat their peer group while another two were pretty close. The only substantial loser is BlackRock Mid-Cap Value (BMCAX) which is only a distant echo of Mr. Kluiber’s State Street Aurora fund.

Briefly noted . . .

Oops! They may have done it again! The folks at Janus are once again attracting the interest of Federal enforcement agencies. According to the New York Times, “SAC Capital Advisors, the hedge fund giant run by the billionaire investor Steven A. Cohen, received an ‘extraordinarily broad’ subpoena from federal authorities” while Wellington Management Company and the Janus Capital Group were among the fund companies which received subpoena requests seeking “a wide range of information.” Coincidentally or not, the subpoenas were revealed the day after the feds raided the offices of three hedge funds. This is part of a year-long investigation in which the funds are suspected of insider trading. Wellington and Janus, I presume, became implicated because they’re clients of John Kinnucan, a principal at Broadband Research, who is suspected of passing insider information to his clients. The WSJ quotes BU law professor Tamar Frankel as concluding that the investigation is building a picture of a vast “closed market in insider information.”

In a letter filed with the SEC, Janus’s CFO, Greg Frost, announced that Janus “intends to cooperate fully with that inquiry [but] does not intend to provide any further updates concerning this matter unless and until required by applicable law.”

As some of you may recall, Janus was knee-deep in the market-timing scandals from several years ago, and afterward the firm underwent a self-described transformation of its corporate culture. Note to Janus: In the area of “disclosing more than the bare minimum required by law,” it looks like you have a bit more work to do.

Repeat after Jack: “All men are mortal. Bruce Berkowitz is a man. Therefore…” In a recent interview, Vanguard founder Jack Bogle explained away Bruce Berkowitz’s inconvenient success. Mr. Berkowitz’s Fairholme Fund (FAIRX) has crushed his peers by turning $10,000 into $30,000 over the course of “the lost decade.” Mr. Bogle rather skirted the prospect that this performance qualifies as evidence of skill on Mr. Berkowitz part (“he seems like an intelligent manager” was about as good as it got) and focused on the real issue: “investors who start out in their 20s today could end up investing for 70 years, since people are living longer. Well, Bruce Berkowitz is not going to be around managing funds 70 years from now.” On the other hand, at 51, Mr. Berkowitz could be managing funds for another quarter century or more. For most people, that’s likely a good consolation prize.

TIAA-CREF seems to be steadily slipping. The Wall Street Journal reports (11/17) that T-C led all providers in sales of variable annuities in 2008, with $14.4 billion sold. In 2009 they slipped to third, with $13.9 in sales. During the first three quarters of 2010, they finished fourth with sales of $10.4 billion. That might reflect investor disenchantment (Morningstar’s ratings for their variable annuities, with the exception of Social Choice, reflect respectable mediocrity), or simply more competent competition.

Susan Bryne and the nice people at the Westwood Holdings Group just acquired McCarthy Multi-Cap Stock fund (MGAMX) to add to their family. It’s a solid little fund: $65 million in assets, mostly mid- to large-cap, mostly value-tilted, mostly domestic. The fund won’t quite compete with Ms. Bryne’s own WHG LargeCap Value (WHGLX), which has a substantially higher market cap and a slightly greater value tilt. On whole, it’s not good to compete with your new boss and downright bad to beat her (which MGAMX does, while both funds far outstrip their Morningstar peer group).

Fidelity Canada (FICDX), the fund Morningstar loves to hate, has posted top percentile returns in 2010 (through 11/26). Which isn’t unusual. FICDX has returns in the top 1% for the week, month, year, five year, ten year and fifteen year periods.

Driehaus International Small Cap Growth Fund (DRIOX ) will close to new investors on the last day of 2010. In my original profile of the fund, I concluded that “for investors with $10,000 to spare and a high tolerance for risk, this might be as good as bet for sheer, pulse-pounding, gut-wrenching, adrenaline-pumping performance as you’re going to find.” That’s still true: $10,000 invested in the fund at launch (August 2002) has grown to $53,000 versus $28000 for international small cap peers. The fund holds about a third of its assets in emerging markets, roughly twice its peers’ stake. Despite above average volatility, it has trailed peers only once, ever, and spent four of its eight years in the top 10% of international small cap funds. It remains, for 30 days, an intriguing option for the bold.

The launch of the Market Vectors Kuwait Index ETF is been delayed until, at least, the week before Christmas. Dang, I’d been so looking forward to investing in an exchange with “an independent judicial personality with the right of litigation in a mode facilitating the performance of its functions for the purpose of realizing the objectives of its organization in the best manner within the scope of regulations and laws governing the Stock Exchange operations.” So saith the Kuwaiti Stock Exchange. Likewise RiverFront Strategic Income has been delayed.

The former Dreman Contrarian Large Cap Value (DRLVX) morphed into an institutional fund Dreman High Opportunity with loaded retail shares in 2010, so it’s being dropped from our Archive listings.

In closing . . .

For most folks, the “fourth quarter holiday retail season” (4QHRS) is the easiest time of year to help support FundAlarm. Folks spend, on average, $400 on gifts, and another $800 on entertaining and decorations, over next four weeks. As many of you know, if you choose to shop using FundAlarm’s link to Amazon, FundAlarm receives an amount equivalent to about 7% of your purchase that Roy uses to defray the cost of servers and bandwidth and such.

Many folks think of Amazon as a bookseller, but my own holiday purchases highlight the breadth of its opportunities. Among other things, I’ve recently squirreled away are a case of herbal tea, an iPod and a smart phone, a really nice chef’s knife (8″ Victorinox Fibrox, wonderfully light, wickedly sharp), a hospital quality air cleaner, four movies, a dozen books and a videogame.

For bookish Bogleheads, one new book stands out: Goldie and Murray’s Investment Answer Book. Mr. Murray is a former Goldman Sachs institutional bond seller and Managing Director at Lehman Brothers. He discovered, only after retirement, that most of his professional life – spent trying to beat the market – was wasted. He became a consultant to Dimensional Fund Advisers and then discovered he was dying of a brain tumor. Last summer he ceased his medical treatments and worked to complete a readable, short book that reduces your investment plan to five decisions, the fourth of which is whether you want to continue pouring your money down the rathole of actively managed investing. (His sentiments, not mine.) Mr. Murray hopes to see Christmas, but has little prospect of experiencing another spring. By all accounts, the book is readable, sensible and useful.

For the merely perverse, my favorite travel book ever, The Clumsiest People in Europe: Or, Mrs. Mortimer’s Bad-Tempered Guide to the Victorian World, has been rereleased in paperback. Mrs. Mortimer, a wildly popular Victorian travel writer, seems never to have ventured five miles from home. Nonetheless she offers up sober, unintentionally ridiculous descriptions of two dozen nations from Ireland (“there are no huts in the world so miserable as Irish cottages”) or China (“All the religions of China are bad, but of the three, the religion of Confucius is least foolish”). It’s at least as delightful as Michael Bell’s Scouts in Bondage: And Other Violations of Literary Propriety or Catherine Price’s 101 Places Not to See Before You Die. All worthy whimsies to lighten a winter’s eve.

Oh, and those of you who had the good sense to respond to our profiles of Wasatch Emerging Markets Small Cap (WAEMX) or Walthausen Small Cap Value (WSCVX) — both up 35% this year — well, you might choose the simpler route of a direct contribution through PayPal.

Wishing you all a wonderful 4QHRS,

David

. . . from the archives at FundAlarm

David Snowball’s
New-Fund Page for January, 2011

Dear friends,

Welcome to the New Year! Having survived The Death Cross and the Hindenburg Omen, as well as Elliott Wave theorists’ prediction of a civil war, we enter a new year heartened by a New York Times’ prediction that “most of the good news is already behind us” (“Why Investor Optimism May Be a Red Flag,” 12/25/10). Before embracing the cover stories that tell us “Where to Invest in 2011” (Kiplinger’s) or direct us to “Make Money in 2011” (Money), I thought we might take a look at the decade just passed.

This just in: sometimes academics are right!

Academic researchers seem comfortable with a series of conclusions: over time, small beats large, value beats growth, cheap beats costly, focused beats unfocused, and so on. The combination of our miserable communication skills (“Ex ante asset pricing models provide the normative basis for the commonly used ex post estimation models”) and overweening sense of self-importance (see Robert Arnott) sometimes masks the fact that researchers can have useful things to say. So here’s a quick decennial perspective on the research.

Researcher’s say, expect small to outperform large, value to outperform growth, small value is optimal.

Hey, it did!

Morningstar’s “investment radar” offers a really striking visual representation of the effect. If you set the radar to show all domestic funds, then to show ten-year returns, you’ll see a thousand colored dots each representing one fund. The funds are divided by deciles (top 10% of all funds, next 10%…). If you turn off the middle 80%, leaving only the best 10% and the worst, a striking visual pattern emerges: there’s an almost perfect dividing line from the northwest corner down to the southeast corner. Virtually everything on the left of the line (smaller, lower priced) is bright green, virtually everything on the right (larger, growthier) is bright red.

Almost nothing that favored smaller and cheaper failed. The only wretched funds in that half of the universe were NYSA (NYSAX) whose website has vanished, ING Small Cap Opportunities (five share classes), PFW Water (PFWCX) which used to be the really bad Bender Growth fund before becoming the really bad Water fund, Oberweis Small Cap Opportunity (OBSOX) and Maxim Small Cap Growth(MXSGX) whose manager claims to run “top performing institutional small cap growth portfolios.”

A nearly identical number of funds represented the few bright spots on the larger, growth side. These include Baron Opportunity(BIOPX) and Wasatch Small Growth (WAAEX) are the growthiest survivors. Yacktman (YACKX), Yacktman Focused(YAFFX),Fairholme (FAIRX), MassMutual Select Focused Value(five share classes) and Columbia Strategic (CSVFX) are the large cap winners.

The most striking difference between the winners and the losers: with the exception of the Water fund (constrained by the limited number of watery stocks available) the losers traded at two- to ten-times (125-250% turnover) the rate of the winners (8-75% turnover), and had substantially more expansive portfolios (150 for losers versus 50 for winners).

Researchers say, expect the slow, steady advantages of index funds to win out in the long run

One simple test is to ask how, over the long term, Vanguard’s index funds have fared against the actively-managed universe. Of 23 Vanguard index funds with a record of 10 years or more, 18 have posted average (S&P500, Extended Market) or better (16 others) performance. That is, about 77% are okay to excellent. The laggards in the group are a motley collection: Value, Small Value, Europe, Pacific, and Social Choice.

The second test, though, is to look at Vanguard’s index funds against their comparable actively-managed funds. For this test, I focused on what might be considered “core” funds in a portfolio. Vanguard has 13 actively-managed large cap domestic equity funds and six index funds in the same space. Ten of the 13 actively-managed funds, about 77% by coincidence, have outperformed their indexed counterparts over the past decade. On average, the active funds returned 2.2% per year while the indexes earned 1.4%.

Vanguard’s active fund charge between 0.3 – 0.45% in expenses. If they charged the more-typical 1.25%, their advantage over the indexes would have been lost. So, if it’s not a game of inches, it’s certainly a game of pennies.

Researchers say, Expect focus to win out over diversified.

And it did.

The best test I have is to compare sibling funds. In four instances, a particular manager runs too nearly identical funds, one diversified and one focused. If the researchers are right, the managers’ focused funds should prevail over his more diffuse portfolios. The four sets of funds are Mainstay ICAP Equity and Select, Marsico Growth and Focus, Oakmark and Select, Yacktman and Focused. In every case, the focused fund outperformed the diversified one, though often by fractions of a percent per year.

Researchers say: don’t buy based on past returns. It’s such a powerful temptation that the SEC requires funds to tell investors that a fund’s past performance does not necessarily predict future results.

I looked at the top large cap core funds of the 1990s, and tracked their performance over the past 10 years. Here are their subsequent absolute returns and performance relative to their peers.

The odds are unlikely to improve. The 25 best funds of the 2000s clocked over 20% annual returns through “the lost decade,” but did it by investing in gold and dictatorships (primarily Russia and China, though I lumped emerging markets in general into this category). While it’s not impossible that one asset class and two countries will rise 750% over the next decade – the outcome of 20% or better growth – it seems vanishingly unlikely.

284 funds beat the 10% threshold that defines the long-term returns of the US stock market. The best diversified equity funds in the bunch were Bridgeway Ultra-Small (BRUSX at 15.6%), CGM Focus (CGMFX, 15%), FBR Focus (FBRVX, 15%), Satuit Microcap(SATMX, 14.7%), Perritt Microcap (PRCGX, 14.5%) and Heartland Value Plus (HRVIX, 14.4%). For the record, that’s four microcap funds, one mid-cap fund whose star manager was squeezed out (and now runs Akre Focus, AKREX) and one fund so volatile (about twice the market’s standard deviation and a 500% annual turnover rate) that is has virtually no long-term investors.

One good strategy is to avoid the previous decade’s biggest losers, a simple notion that has evaded millions of investors.

Vanguard’s worst diversified loser of the decade: Vanguard U.S. Growth (VWUSX), which is closer to Vanguard U.S. Decline with an annualized loss of 3.7%. And $4 billion in assets. Fidelity contributes Fidelity Decline Strategies . . . sorry, Fidelity Growth Strategies(FDEGX), formerly Fidelity Too-Aggressive Growth and Fidelity Submerging Growth, to the list with 5.4% annual losses and over $2 billion in assets. American Century Select (TCWIX) pares $2 billion assets with a half-percentage annual loss. The Janus Fund(JANDX) has dropped 1.1% per year while Legg Mason All Cap (SPAAX) holds a half billion while steadily shrinking by 2.5% per annum.

Legg Mason added Bill Miller to the management team here at the start of 2009, and the fund rallied mightily. At the same time, Miller announced his own successor at the flagship Legg Mason Capital Management Value “C” class shares (LMVTX, formerly just Legg Mason Value). Remarkably low returns remain paired there with remarkably high fees.

Less venturesome folks might have done with boring ol’ planners and scholars suggested: diversify across asset classes, rebalance periodically, keep your expenses down. Funds that followed that simple discipline, and which I’ve used as benchmarks, had an okay decade:

Vanguard Balanced Index (VBINX): up 4.2%

Fidelity Global Balanced (FGLBX) : up 6.7%

Vanguard STAR (VGSTX): up 5.3%

T. Rowe Price Capital Appreciation (PRWCX): up 8.9%

Another possible hedge against this disturbing reality is to consider investing some of your portfolio with companies that get it right. There are a set of boutique firms which have consistently by sticking to their discipline and building stable, supportive management teams. Among the fund companies whose products we’ve profiled, there are a number whose funds beat their benchmarks consistently over the long term. Below are four such companies. Artisan Partners hires only experienced teams of risk-conscious managers and has a tradition of shareholder friendly practices (low minimums, falling expenses, closing funds). Matthews knows Asia better than anyone.Harris Associates understands value. Royce does small and value with passion and discipline. Here’s a recap of their funds’ performance:

The poorest Royce funds are only a year or two old. The poorest Matthews ones are single country funds.

There are no guarantees. Ten years ago I might have (though, in truth, wasn’t) writing about Oak Associates or Janus. But there are ways to at least tilting the odds in your favor.

The research says so!

2010: the cloudy crystal ball

It’s the time of year when every financial publication promises to make you rich as Croesus in the year ahead. As a reality check just ahead of that exercise, you might want to consider the one thing the publications rarely mention: the track record of their set of “best funds for 2010.”

For each of four major publications, I created an equally weighted portfolio of their 2010 fund picks and compared it to the simplest-available benchmark: a balanced index for portfolios with balance, and a stock or bond index otherwise. They appear in rank-order, by performance. Performance is as of 12/20/2010.

• Kiplingers. Steven Goldberg, “The 5 Best Stock Funds for 2010,” Kiplinger.com December 18, 2009

Comments: good recovery, Mr. G! His 2009 picks including Primecap and Price Emerging Markets, but also two terribly disappointing funds: CGM Focus and Bridgeway Aggressive Investors I. He seems to have dialed-back the risk for 2010, and profited from it.

• Morningstar. “Where to Invest, 2010.”

This is a long Morningstar stand-alone document, including both market analyses and individual equity recommendations as well as the industry’s longest list of fund recommendations.

Comments: a nicely-done, T. Rowe Price-ish sort of performance. The collection succeeds less by picking a few “shoot out the lights” stars and more by avoiding silly risks. When your two worst funds are rock-solid, risk-conscious gems, you’re doing good.

• Money. “Make Money in 2010,” Money magazine, December 2009

Comments: The folks at Money assumed that high-quality investments – blue chip multinationals, AA bonds – were finally due for their day in the sun. “Don’t hold your breath waiting for gains much beyond 6% in either stocks or bonds for 2010. …The key to surviving is to go for high quality, in both stocks and bonds.” Off by 300% on stocks – the Total Stock Market Index (VTSMX) was up near 18% in late December – but close on bonds. And wrong, for the moment, on quality: Morningstar’s index of high-quality stocks returned about 8% while junkier small-growth stocks returned four times as much.

• Smart Money. “Where to Invest 2010,” Smart Money, January 2010.

Comments: I despaired of this particular essay last year, claiming that “It’s hard to imagine a more useless article for the average investor.” The difficulty is that Smart Money offered four broad scenarios with no probabilities. “If you think that we’ll plod along, then…” without offering their expert judgment on whether plodding would occur. Thanks, Dow Jones!

The funds, above, come from elsewhere in the “Where to” issue and received positive reviews there.

The Strange Life and Quiet Death of Satuit Small Cap

Readers of FundAlarm’s discussion board pointed out, recently, that I failed to eliminate the archived profile of Satuit Small Cap. Sorry ‘bout that!

In reality, Small Cap turned out to be the firm’s lonely step-child. It was an adopted child, have begun life as the Genomics Fund,world’s first and only mutual fund specializing in investing in the dynamic, new genomics industry!” After years of wretched performance, Satuit Microcap’s manager took over the fund and, eventually, rebranded it as Satuit Small Cap. I could do so because an exciting genomics fund is virtually identical to a diversified small cap one with virtually no genomics investments. We know that’s true because the fund solemnly attested to the fact: “The Fund was reorganized as a separate series of the Satuit Capital Management Trust on November 1, 2007. The Fund has the same investment strategy as the Predecessor Fund.” Similarly, PFW Water fund (ridiculed above) had the same strategy as Bender Growth, give or take investing in water.

The firm’s passion for the fund seemed limited from the start: there was little information about it at Satuit’s website, the website continued to refer to Microcap as if it were the firm’s only product, and the manager declined the opportunity to invest it in. There’s limited information about the new fund on the website. For example, most of the site’s text says “the” fund when referring to Satuit Microcap.

The manager’s last letter to his few investors (the fund had under $2 million, down by more than 60%) was full of . . . uh, full of . . . optimism!

I began writing this letter on Tuesday September 15th, 2009.  What a difference a year makes.  Last year I was writing about Monday September 15^th, 2008.  It was the day that Lehman Bros filed for Chapter 11 Bankruptcy and Bank of America bought Merrill Lynch. And I said, “My sense is that by the time you read this letter, those events will be water-under-the-bridge, much like the JP Morgan acquisition of Bear Stearns and the Treasury take-over of Fannie Mae and Freddie Mac are today.”  Fortunately, these events are water under a very high bridge.  I’m glad it’s all behind us!

Sincerely,

Robert J. Sullivan

Chief Investment Officer

Portfolio Manager, SATSX

Eight weeks late, the Board – presumably at Mr. Sullivan’s recommendation – liquidated the fund. There was no explanation for why the fund wasn’t simply merged into its successful sibling.

Briefly noted:

• Causeway has added an “investor” share class to their Global Value (CGVIX) fund. Up until now, Global Value has required a $1 million minimum. The fund is not quite two years old and has been a respectable but unspectacular performer. The new share class charges 1.35% with a $5000 investment minimum.
• Brett Favre is not the only weary warrior leaving the field one last (?) time. Michael Fasciano decided in October to liquidate the new Aston/Fasciano SmallCap Fund (AFASX). Mike explained it as a matter of simple economics: despite respectable returns in its first three quarters of operation, Aston was able to attract very little interest in the fund. Under the terms of his operating agreement, Mike had to underwrite half the cost of operating AFASX. Facing a substantial capital outflow and no evidence that assets would be growing quickly, he made the sensible, sad, painful decision to pull the plug. The fund ends its short life having made a profit for its investors, a continuation of a quarter-century tradition of which Mike is justifiably proud.
• When a door closes, a window opens. Just as Aston/Fasciano liquidates, Aston/River Road Independent Value (ARIVX) launches! Eric Cinnamond, the founding manager of Intrepid Small Cap (ICMAX) left to join River Road in September. He’s been heading River Road’s “Independent Value” team and has just opened his new Independent Value fund. The fund focuses on high-quality small- to mid-cap stocks. The initial expense ratio is 1.41% with a $2500 investment minimum, which exactly match the terms and conditions of his former fund. Given Mr. Cinnamond’s top 1% returns, consistently low risk scores and string of five-star ratings from Morningstar, fans of his work have reason to be intrigued by the chance to access Mr. Cinnamond’s skills tied to a tiny asset base. With luck, we’ll profile his new fund in the months ahead.

In closing . . .

Ten years ago, the FundAlarm discussion board was abuzz. In his December “Highlights and Commentary,” Roy reviewed the recent scandal in Strong’s bond funds, which would eventually doom the firm, and lambasted a remarkable collection of sad-sack Internet funds (Monument Digital Technology or de Leon Internet 100, anybody?) Bob C warned of the imminent closing of Scudder Funds’ no-load shares. Roy offered T. Rowe Price Science & Tech as a stocking stuffer, which was certainly a better idea than most of the other options circulating on the board: Firsthand E-Commerce, IPS Millennium, Strong Enterprise . . . Happily, most of the comments about those funds were deeply cautionary and much of the discussion center on tax-management, portfolio allocations and strong management teams. Ten years, and 280,000 posts (!) later, we’d like to recognize the good and thoughtful folks who have been sharing their reflections, now and over the decade past.

Below is a Wordle, a visual representation of data frequency generated at Wordle.net. I sampled the names appearing on our current discussion threads and added those prominent in December 2005 and December 2000. To you all, and to them all, thanks for making FundAlarm what it is!

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A blessed New Year to all!

David