Dear friends,

It’s spring! Sort of. Despite the steady, light snow falling outside my window, March 1 is the beginning of “meteorological spring” and I’m indisputably in the middle of Augustana’s Spring Break. (It always looked better on MTV.) Spring training, both for major leaguers and my son’s high school team, has begun. There are stirrings in my garden and a couple newly-arrived catalogs (yes, I still get real mail) are encouraging horticultural fantasies: a swath of pollinator-friendly native plants taking over the southwest corner of the yard, a new home for my towering wall of sunflowers, some experiments with carrots, replacing more of the lawn with a rain garden to reduce run-off, regrowing a full head of hair … anything’s imaginable and everything’s possible, at least until I have to figure out how to pull it off.

Sadly, as Rudyard Kipling observed, “gardens are not made by sitting in the shade.”

For one more month, at least, I focus on tidying up my financial garden. We start this month’s issue with three of the most important kind of story: ones that actually affect me.

Artisan pulls the plug

Artisan has announced the liquidation of Artisan Small Cap Value (ARTVX), my oldest holding. My first fund, purchased when I was young and dumb, was AIM Constellation, then a very good mid-cap growth fund that carried a 5.5% load. After a bit, I learned that paying sales loads without any compensating benefit was stupid, so I stopped. I sold my shares and, shortly before it closed, invested the proceeds in Artisan Small Cap (ARTSX). Shortly after Artisan launched Small Cap Value in 1997, I moved my investment over from Small Cap. The $367 million fund, down from a peak of $3 billion in 2011, will be merged into Artisan Mid Cap Value (ARTQX) in May, 2016.

After a couple withdrawals and almost 19 years of paying taxes on the account, I’m disconcerted to report that I’ll be able to report a 30% tax loss on my 2016 taxes.

What happened? The managers’ discipline (and the dictates of marketing to advisors who want to execute their own asset allocation plans) does not encompass holding significant cash. And so, despite the fact that “We’ve complained for a long time now that too much of the market is fully- or fairly valued,” they stayed fully-invested. Their discipline also pushed them toward overweighting the best-valued stocks they could find and those turned out to be in two of the market’s worst areas: energy and industrials, that latter of which “have backdoor exposure to energy.” They eventually overweighted those areas by more than 2:1. That’s, at best, a very partial explanation for the fact that the fund trailed 90% or more of its small-value peers in five of the past six years, including years with high oil prices.

The folks at Artisan position this as a simple economic decision: “a determination was made that the strategy/fund was no longer commercially viable… Given our past few years of underperformance, we have seen outflows (and passive has been an asset flow winner here). We are also hearing that fewer folks plan to use dedicated small-cap value allocations going forward.” The management team “drove the decision” and they “still believe in the asset class.”

This is the first fund liquidation in Artisan’s history.

The team manages two other funds, Mid Cap Value (ARTQX) and the large-cap oriented Value (ARTLX). Over the full market cycle, ARTQX modestly leads its peer group in performance (40 bps/year) with subdued volatility. ARTLX trails its Lipper peers (80 bps/year) with somewhat higher volatility.

Bottom line

I prefer to maintain exposure to small value stocks, so I won’t wait around for the impending transition to the team’s mid-cap value fund. I’ll book my tax loss and move on.

The finalists for this slot in my portfolio are two cash-rich, low-vol funds: John Deysher’s Pinnacle Value Fund (PVFIX) and the team-managed Intrepid Endurance Fund (ICMAX, formerly Intrepid Small Cap). Both are run by absolute value investors. They have similar expense ratios, though Intrepid is five times Pinnacle’s size. Intrepid’s about two-thirds cash right now, Pinnacle about 50%. They are, by far, the two least volatile small cap funds around. Pinnacle’s market cap and turnover are both far lower.

We profiled Pinnacle one year ago. I think we’ll try to prepare a profile of Intrepid for our April issue and see if that helps decide things.

The tough question remaining

How long should you wait before you write off a manager or a fund? My normal rule is pretty straightforward: if I haven’t changed and they haven’t changed, then we’re not going to change. That is, if my portfolio needs remain the same, the management team remains intact and true to their discipline, then I’m not going to second-guess my due diligence. This may be the first time I’ve sold a fund in a decade. Leigh Walzer’s research on stumbling funds suggests that I should have sold in mid-2014 which would have spared me about a 10% loss assuming that I’d put it in a merely average SCV fund.

Romick stares reality in the face, and turns away

My single largest non-retirement holding is FPA Crescent (FPACX), which has always struck me as the quintessence of active management. While other managers were constrained to invest in a single asset class or in a single country, or to remain fully invested or unhedged, manager Steve Romick declared himself to be “the free-range chicken” of the investing world. He’d look for firms that offered compelling advantages, would analyze their capital structure and then invest in whatever instrument – common stock, warrants, senior debt – offered the most compelling opportunities. If nothing was compelling, he sat on cash.

That strategy performed wonderfully for years. Over the past decade the fund has led its Morningstar peer group by 1.12% annually though, by freakish coincidence, Morningstar also calculates that you lost 1.12% annually to taxes over the same period. Over the past three years, the fund has either been about average (using Morningstar’s “moderate allocation” peer group) or well-above average (using Lipper’s “flexible portfolio” one). In 2015, the fund lost money and finished in the bottom third of its Morningstar peer group.

Those two things do not bother me. Two others do. First, the fund has ballooned in size with no apparent effort at gatekeeping. In 2005, it performed gloriously but had under $1 billion in assets. In 2010, it performed solidly with $2.7 billion. It hit $10 billion in 2013 and $20 billion in 2015 and remains open today. While some funds have doubtless thrived in the face of huge, continual inflows, those are rare.

Second, Romick blinked. His recently released Annual Report offered the following announcement on page two:

At first glance, it appears that we’ve declined as much as the market — down 11.71% since May 2015’s market peak against the S&P 500’s 11.30% decline — but that’s looking at the market only through the lens of the S&P 500. However, roughly half of our equity holdings (totaling almost a third of the Fund’s equity exposure) are not included in the S&P 500 index. Our quest for value has increasingly taken us overseas and our portfolio is more global than it has been in the past. We therefore consider the MSCI ACWI a pertinent alternative benchmark.

What?

“We look pretty good compared to a global all-equity benchmark”?

Uhhh … the fund is 37% cash. Morningstar reports a net exposure (11% long minus 3% short) of only 8.5% to international stocks. The most recent report on FPA’s website suggests 16% but doesn’t separate long/short. If Morningstar is right, net exposure is way less global than either its Morningstar benchmark or Morningstar peer group.

Underperformance doesn’t bother me. Obfuscation does. The irony is that it bothers Mr. Romick as well, at least when it’s being practiced by others. In a 2012 letter criticizing the Fed, he explained what we ought to demand of our leaders and ourselves:

Blind faith has gotten us into trouble repeatedly throughout history. Just consider the rogue’s gallery of false idols, dictators, and charlatans we have followed, hoping for something different, something better. That misplaced conviction corrupts and destroys. Daily life does require we put our trust in others, but we should do so judiciously.

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… 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.”

FPA once ran funds in a couple of different styles, Mr. Romick’s and the other one. They’ve now purged themselves of their quality-growth team and have renamed and repurposed those funds. In repurposing Paramount, they raised the expense ratio, ostensibly to create parity with the Perennial fund. In a private exchange I asked why they didn’t simply lower Perennial’s e.r. rather than raising it and was assured that they really needed the extra cash for as-yet undisclosed enhancements.

I’ve lost faith.

Bottom line

I’m not sure whether FPA is now being driven by investment discipline, demands for ideological purity or a rising interest in gathering assets. Regardless, I’m going. I have long respected the folks at the Leuthold Group and we recently profiled their flagship Leuthold Core Investment Fund (LCORX). Leuthold has delivered on such promises more consistently, with more discipline, for a longer period than virtually any competitor.” They’re apt to be the home for the proceeds from an FPA sale plus closing two small accounts.

Morningstar doesn’t share my reservations and FPACX retains a “Gold” analyst rating from the firm.

The tough question remaining

How do we account for cultural change in assessing a firm? Firms never admit to their internal machinations, the story is always “a long heritage and a strict discipline, honored, preserved, extended!” They say it because they must and, often, because they believe it. From the outside, it’s about impossible to test those claims and people get downright offended when you even broach the subject. Some folks have managed beautifully; Mairs and Power come to mind. Some have been disasters, Third Avenue most recently. And others, such as Royce Funds, are just now trying to navigate it. Without access to contacts within the organization or with their peers, we only see shadows and flickers, “as through a glass, darkly.”

Hate it when that happens.

Andrew Foster, Sufi master

Sell your cleverness and buy bewilderment.
Cleverness is mere opinion, bewilderment intuition.
― Rumi, Masnavi I Ma’navi,ca. 1270

I like Andrew Foster, manager of Seafarer Overseas Growth & Income (SFGIX). I also respect him. The confluence of those two is rare.

In his essay “Self Reliance,” Emerson describes “foolish consistency” as “the hobgoblin of little minds.” The rough translation is the people don’t like to admit that they’re unsure, whether it’s about what to think or what to do, even to themselves. And so they come up with procedures, policies, explanations, Great Insights and Magic Rules and claim you can stop thinking worrying now. You’ll notice this in the classroom: young teachers are terrified at losing control or losing respect while really experienced ones are comfortable admitting that they simply don’t have nearly as many answers as they’ve got questions, suspicions or possibilities.

That came to mind in reading two of Mr. Foster’s recent pieces, his Fourth Quarter 2015 Portfolio Review and his Semi-Annual Report. Between the two, you get a sense of a guy who is really sharp but not under the illusion of his own omniscience.

The short version of investing in the emerging markets over the last couple years: things have been wildly volatile and mostly negative, China’s been a concern, Seafarer’s doing better than the great majority of its peers.

Most managers, whether they’re small minded or they think you are, would have said that in about three paragraph – emphasizing their own excellence in the latter – and hit “send.”

Mr. Foster approached things differently. His analysis was more nuanced, sharper, more self-effacing and more respectful of his readers’ intelligence than almost any of what I’ve read in the professional press. You should read it, but only if you have the time to think about what you’ve read because you’ll encounter more careful speculation than illusory certainty.

Why was the market rising at the start of the fourth quarter?

Between October 1 and November 4, the benchmark index rose 9.72%. There was no obvious reason for this gain.

Okay, so what explains Seafarer’s outperformance?

The Fund’s marginal outperformance was due to selected holdings in China, Japan, Indonesia and Turkey. Those holdings had no unifying theme or idea that could explain the basis for their performance during the quarter.

Perhaps it’s because you were defensively positioned on China?

Unfortunately, my notion of “defensive” valuations proved faulty.

Oh. Dja do any better on currencies?

My prediction [there] was terribly wrong.

Ah, I see. You’ve described Seafarer as a China-centric portfolio. What’s going on there?

I wish I knew with certainty. Unfortunately, the situation is sufficiently opaque that facts are scant, and thus I can only speculate as to the cause behind the A-share market’s sudden collapse.

Well, how about a guess then? Surely you’ll do better than the bobbleheads in the media.

Unfortunately, I can only speculate as to the actual cause of the decline, so my thoughts on the matter are frankly no better than the media’s. I have very few facts to substantiate my arguments; all I can do is look at the pattern of events that has unfolded, and speculate as to the causes. 

I’m getting desperate here, Andrew. Why not just fling a wild speculation or two at us?

I would suggest two possible scenarios that might have caused the sell-off:

1. The Renminbi’s weakness is not the direct cause of the decline, but it is a precursor for a growing liquidity shortage within the Chinese financial system. The currency’s persistent weakness may indicate that one or more banks, or perhaps some portion of the “shadow banking system,” may soon experience a liquidity crisis. This explanation would suggest the currency is signaling stressed liquidity within the financial system, to which stocks have reacted swiftly and punitively.
2. The current government is unstable. Over the past three years, the government has propagated a sweeping anti-corruption campaign that has sometimes terminated in controversial political purges. The government has also introduced bold economic reforms – reforms that I largely support – but that have undoubtedly alienated powerful vested interests. Meanwhile, the current president has sought to consolidate power in a manner not seen since Mao’s era. It might be that such dramatic actions have silently eroded support for the current government among powerful factions within the Communist party. If so, the weakness in the currency and the stock market might portend a deeper source of instability.

Either scenario might have been the root cause of the volatility we observed; it is also possible that both acted in tandem.

You get the idea, I think: rather more insight than ego, important arguments made in a clear and accessible style.

In terms of portfolio positioning, he’s finding better values in Latin America and Emerging Europe than in Asia, so the portfolio is the least Asia-centered in its history. Similarly, there are intriguing opportunities in larger firms than in smaller ones right now; he’s actually been surprised at his portfolio’s small- to mid-cap positioning, but that’s where the value has been.

Bottom line

Seafarer remains a core position in my non-retirement portfolio and I’ve been adding to it steadily. Valuations in the emerging markets are compelling, with stocks trading at P/E ratios of 5 or 6. I’m tempted to sell my holdings in Matthews Asia Growth & Income (MACSX) and roll them into Seafarer, mostly as an attempt to simplify, but the two really do seem to be driven by diverse forces.

For now, I’ll continue to invest in each and, mostly, ignore the noise.

The tough question remaining

If emerging markets are simultaneously our best and our worst investment option, what on earth do we do with them? There’s a near-universal agreement that they represent the cheapest stocks and most dynamic economies in the world. And yet, collectively, over the last decade EM equity funds have made 1.3% annually with a standard deviation of 23. Run away? Pretend that investing in Nestle is the same just because they sell a lot in emerging markets? Hedge, which is tough? Hybrid? Hope? The worst case is “hire Greed and Panic to manage your investments,” though that seems awfully popular.

The Weather

By Edward Studzinski

“When we unleash the dogs of war, we must go where they take us.”

Dowager Countess of Grantham

Starting off one of these monthly discussions with a title about the weather should be indicative that this piece will perhaps be more disjointed than usual, but that is how the world and markets look to me at present. And there is very little in the way of rational explanation for why the things that are happening are happening. My friend Larry Jeddeloh, of The Institutional Strategist, would argue that this country has been on a credit cycle rather than a business cycle for more than fifteen years now. Growth in the economy is tied to the price and availability of credit. But the cost of high yield debt is rising as spreads blow out, so having lots of cheap credit available is not doing much to grow the economy. Put another way, those who need to be able to borrow to either sustain or grow their business, can’t. A friend in the investment banking business told me yesterday about a charter school that has been trying to refinance a debt package for several years now, and has not been able to (thank you, Dodd-Frank). So once again we find ourselves in a situation where those who don’t need the money can easily borrow, and those who need it, are having difficulty obtaining it. We see this in another area, where consumers, rather than spend and take on more debt, have pulled back.

Why? We truly are in a moment of deflation on the one hand (think fuel and energy costs) and the hints of inflation on the other (think food, property taxes, and prescription drug costs on the other). And the debt overload, especially public debt, has reached a point where something has to be done other than kicking the can down the road, or other major crisis. I would argue we are on the cusp of that crisis now, where illiquidity and an inability to refinance, is increasingly a problem in the capital markets. And we see that, where the business models of businesses such as energy-related master limited partnerships, premised on always being able to refinance or raise more equity, face issues.

I was reading through some old articles recently, and came across the transcript in Hermes, the Columbia Business School publication, of a seminar held in May 1985 there. The speakers were Warren Buffett, James Rogers, Jr., and Donald Kurtz. As is often the case, sifting through the older Buffett can be rewarding albeit frustrating when you realize he saw something way before its time. One of the things Buffett said then was that, based on his observations of our political system, “ … there is a small but not insignificant probability that we will lose fiscal control at some point.” His point was that given a choice, politicians will always opt for an implicit tax rather than an explicit tax. If expenditures should determine the level of explicit taxes, than taxes should cover expenditures. Instead, we have built in implicit taxation, expecting inflation to cover things without the citizens realizing it (just as you are not supposed to notice how much smaller the contents are with the packaging changes in food products – dramatically increasing your food budget).

The easier way to think of this is that politicians will always do what allows them to keep doing what they like, which is to stay in office. Hence, the bias ends up being to debase the currency through the printing presses. So you say, what’s the problem? We have more deflation than inflation at this point?

And the problem is, if you look at history, especially Weimar Germany, you see that you had bouts of severe inflation and sharp deflationary periods – things did not move in a straight line.

Now we have had many years of a bull market in stocks and other assets, which was supposed to create wealth, which would than drive increases in consumption. The wealth aspect happened, especially for the top 5%, but the consumption did not necessarily follow, especially for those lower on the economic ladder. So now we see stock and asset prices not rising, and the unspoken fear is – is recession coming?

My take on it, is that we have been in a huge jobless recovery for most of the country, that the energy patch and those industries related to it (and the banks that lent money) are now beyond entering recession, and that those effects will continue to ripple through the rest of the economy. Already we see that, with earnings estimates for the S&P 500 continuing to drift lower. So for most of you, again, my suggestion is to pay attention to what your investment time horizons and risk tolerances are.

Moving totally down a different path, I would like to suggest that an article in the February 28, 2016 New York Sunday Times Magazine entitled “Stocks & Bots” is well worth a read. The focus of the article is about the extent to which automation will eliminate jobs in the financial services industry going forward. We are not talking about clerks and order entry positions. That revolution has already taken place, with computerized trading over the last twenty years cutting by way of example, the number of employees buying and selling stock over the phone from 600 to 4 at one of the major investment banking firms. No, we are talking about the next level of change, where the analysts start getting replaced by search programs and algorithms. And it then moves on from there to the people who provide financial advice. Will the Millennials seek financial advice from programs rather than stock brokers? Will the demand grow exponentially for cheaper investment products?

I think the answer to these questions is yes, the Millennials will do things very differently in terms of utilizing financial services, and the profit margins of many of today’s investment products, such as mutual funds, will be driven much lower in the not too distant future. Anecdotally, when one has a year in the markets like 2015 and the beginning of 2016, many investment firms would push down the bonus levels and payments from the highest paid to take care of the lower ranks of employees. I was not surprised however to hear that one of the largest asset managers in the world, based in Boston, had its senior employees elect to keep the bonuses high at the “partner” levels and not take care of the next levels down this past year. They could see the handwriting on the wall.

All of which brings me back to the weather. Probably suggesting that one should read a politically incorrect writer like Mark Twain is anathema to many today, but I do so love his speech on the New England weather. For a preview for those so inclined, “The lightning there is peculiar; it is so convincing that, when it strikes a thing it doesn’t leave enough of that thing behind for you tell whether – Well, you’d think it was something valuable, and a Congressman had been there.”

At a future point I will come back for a discussion of Mr. Twain’s essay “On the Decay of the Art of Lying” which might be essential reading as this year’s elections take shape.

High Dividends, Low Volatility

From the Trapezoid Mailbag:

A financial advisor in Florida is interested in low-volatility products. With the market so choppy, he would like to dial down risk in his client’s portfolio. He wondered whether SEI Institutional Managed Trust Tax-Managed Volatility Fund (TMMAX) was a suitable choice.

As Exhibit I illustrates low-volatility has been a successful investment strategy in recent years. A good argument can be made that historically, low-volatility stocks were mispriced. Players like Berkshire Hathaway and private equity capitalized on this by levering up these firms to deliver strong risk-adjusted returns. There is a heavy overlap between the low-volatility universe and the high-dividend universe. Many high-dividend stocks have dropped assets into REITs in recent years which have fueled better returns for this sector. Low volatility has outperformed the broad market meaningfully for the past two quarters, partly due its lower beta.

Trapezoid doesn’t take a view on whether these trends will continue or whether low-volatility is the best place to hide out in a tough market. In this instance, we wonder whether the “private equity bid” which contributed to the sector’s strong performance will be as reliable as corporate credit markets tighten and whether the increasing use of REIT/MLP structures has about run its course. What Trapezoid does do is help investors, advisors, and allocators find the best instruments to express their investment strategy based on extrapolation of historic skill in relation to risk.

There are several passive strategies which express the same theme. For example, Power Shares markets an S&P 500 Low Volatility Portfolio (SPLV) and an S&P 500 High Dividend Low Volatility Portfolio (SPHD). Those two funds move virtually in lockstep, underscoring the overlap between high dividend and low volatility. The correlation between the PowerShares indices and TMMAX is 98.5% and the expense ratio is 70-75 basis points lower.

Despite the availability of good passive indices, we would nonetheless consider TMMAX. The fund’s track record has been slightly above average, making us slightly confident (53%) it is worth the added cost. SEI also manages the SEI US Managed Volatility Fund which has a 50% confidence rating (slightly lower due mainly to higher expense ratio.)

SEI relies on three subadvisors to manage the fund. The largest sleeve is managed by Analytic Investors (39%) followed by LSV (35%) and AJO. While we don’t have sleeve-level data, we can evaluate the body of work by Analytic and LSV looking at comparable sole-managed funds. Analytic’s track record the past five years on Touchstone Dynamic Equity Fund (TDELX) is good but the previous five years were poor. LSV’s record at LSV Conservative Value Equity Fund (LSVVX) and Harbor Mid-Cap Value Fund (HIMVX) was middling.

We have discussed in the past that Morningstar star ratings have some predictive value but that even a five-star rating is not sufficient to make an investment decision. The SEI funds are good examples. TMMAX, SEVIX, and SXMAX all carry five star ratings, and we agree investors are better off choosing these funds than many of the alternatives but the evidence of manager skill is inconclusive.

If the advisor is willing to expand his horizons a little, he can find similar funds which improve the odds a little. We used the Orthogonal Attribution Engine to find highly correlated funds with better confidence ratings and came up with the following.

A few observations

• T. Rowe Price Capital Appreciation Fund (PRWCX) is closed to new investors
• The two Vanguard funds attempt to outperform their benchmark indices using a quantitative strategy.
• Many of the other similar funds have higher betas, which may be a deal breaker for our advisor who wants to reduce his client’s market exposure
• Many of these funds are large blend funds, accessible to demo customers at the www.fundattribution.com website.
• Our confidence ratings are based on data through 10/30/15. In the subsequent months TMMAX’s performance lagged the lower-cost PowerShares indices. This may serve to erode our confidence that active management pays for itself. Updated data will be posted shortly

The heightened appeal of low-volatility funds might suggest something else: Advisors are more focused on extreme negative outcomes which could get them fired than extreme positive outcomes. In a choppy market, low-volatility funds have the allure of a safe haven. We don’t have a view on the wisdom of this. But we are interested in helping allocators avoid individual managers who have the potential to “blow up.” One of Trapezoid’s forthcoming new metrics hones in on this risk by focusing on the likelihood of extreme negative outcomes.

Offered without comment: Your American Funds share class options

MFO Rating Metrics

When MFO introduced its rating system in June of 2013, it chose Martin Ratio as the principal performance rating metric. Martin is a risk adjusted return metric that is the ratio between excess return, which is the compounded annualized total return above risk free T-Bill return, divided by the so-called Ulcer Index, which is a measure of extent and duration of drawdown. Our friend Peter Matin formulated the Ulcer Index as described in An Alternative Approach to the Measurement of Investment Risk & Risk-Adjusted Performance.

For each fund category, like Large Growth or Moderate Allocation, the MFO Rating system divides funds into five groups or “quintiles” based on the risk adjusted return over selected evaluation periods. Funds with the highest Martin in each category are assigned a 5, while those with the lowest receive a 1.

While this approach suits many MFO readers just fine, especially having lived through two 50 percent equity market drawdowns in the past 15 years, others like Investor on the MFO Discussion Board, were less interested in risk adjusted return and wanted to see ratings based on absolute return. Others wanted to see ratings based on the more traditional risk adjusted Sharpe Ratio. (For more definitions, see A Look A Risk Adjusted Returns.)

It took a while, but subscribers on our MFO Premium site can now choose which rating metric they prefer, including multiple rating metrics simultaneously.

For example, since the start of the current market cycle in November 2007, which Small Cap funds have delivered the best absolute return (APR) and the best Martin Ratio and the best Sharpe Ratio? To find the answer, enter the selection criteria on the MFO MultiSearch tool, as depicted below (click image to enlarge), then hit the “Submit Search” button …

A total of 28 funds appear from the more than 9,000 unique funds in the MFO database. Here are the first 10, sorted by MFO Risk and then name:

Notables include Brown Capital Mgmt Small Company (BCSIX), Champlain Small (CIPSX), Conestoga Small Cap (CCASX), and FMI Common Stock (FMIMX). The closed BCSIX is both an MFO Great Owl and Fund Alarm Honor Roll fund. It is also a Morningstar Gold Medal fund, while Silver goes to CIPSX and CCASX.

Intrepid Endurance (ICMAX) has the lowest risk rating with a MFO Risk of 3, which means this fund has historically carried volatility suited for investors with Moderate risk tolerance. Unlike other metrics in the MFO ratings system, and in fact the risk metric in Morningstar’s rating system, which assign risk relative to other funds in category, the MFO Risk metric assigns its rating based on volatility relative to the overall market.

The MFO MultiSearch tool now enables searches using more than 55 screening criteria, organized by Basic Info, Period Metrics, Composite Period Metrics, MFO Designations, Portfolio Characteristics, and Purchase Info. A list of current criteria can be found here.

The Alt Perspective: Commentary and news from DailyAlts.

Pruning Season

You can call it a cycle, a season, or even a cleansing process, but when one looks at the liquid alternatives market, it’s apparent that there is some pruning going on. Some cleaning out of the products that no longer appeal to investors, those that hit a performance patch from which it would be near impossible to recover, or just didn’t gather the requisite assets for a fund to be viable. Clean out the funds that are not producing the intended results, or just aren’t resonating with investors.

This is all a healthy process as it makes room for newer products, the next generation. It also allows for a greater investment into existing products. Interestingly, we have already seen 9 alternative funds liquidated in the first two months of the year (and at least two more schedule to be liquidated) – some announced late last year, but nonetheless, fully liquidated in 2016. And these are from some bigger names in the industry, such as Lazard, Collins, Whitebox, Virtus, Ramius and Clinton. Some seasoned hedge fund managers in there, along with seasoned asset management firms.

Four of the liquidate funds were long/short equity funds, two were multi-alternative funds, and the remaining three included market neutral, event driven and non-traditional bonds. All in all, I think we will see more pruning in the coming months as fund managers rationalize their fund lineup as markets sell off, and begin thinking about the next set of products to introduce to the market.

The pruning process is healthy and helps future growth, so don’t be surprised to see more down the road. It’s just part of the natural cycle.

Asset Flows

January saw a continuation of 2015 where investors continued to pour money into multi-alternative funds and managed futures funds (inflows of $1.2 billion and $1.5 billion, respectively), while pulling assets from non-traditional bond funds, long/short equity and market neutral (-$3 billion, -$390 million and -$340 million, respectively). Excluding non-traditional bond funds and commodities, alternative mutual funds and ETFs gathered a total of $2.4 billion in January, bringing the total 12-month haul to $18.7 billion, third of any category behind international equity and municipal bonds and 11.5% of all net asset inflows.

Commodities bounced back in January with total inflows of $3.3 billion, led primarily by flows to precious metals funds, and gold funds in particular. Non-traditional bond funds, viewed as an alternative to long-only bond funds and a protective hedge against interest rate increases, have continued to disappoint in the aggregate. As a result, investors have pulled $17.9 billion of assets from these funds over the past 12 months.

Extended Reading

What did DailyAlts readers enjoy the most this past month? The three of the most widely read articles this past month were:

• Adding Liquid Alts to DC Plans and Target-Date Funds
• Distinction Between Mutual Funds and Hedge Funds Is Eroding
• Understanding Liquid Alternatives: Ask The Right Questions

While it appears to be pruning season, that doesn’t mean it is time to stop looking for alternative funds. With Spring approaching, now is a good time to take a look across your portfolio at the risks you have exposure to, and perhaps do a bit of pruning of your own to balance risks and hedge for what might be more volatility ahead.

Have a great March, and to keep up with daily or weekly news in the liquid alts market, be sure to sign up for our newsletter.

Observer Fund Profiles: LSOFX / RYSFX

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.

LS Opportunity Fund (LSOFX): this was a really solid long/short fund that had to press the “reset” button last May when their sub-advisor decided to pack it up and call it a career. In Prospector Partners, they may have found a team that executes the same stock-by-stock discipline even more excellently than their predecessors.

Royce Global Financial Services (RYFSX): when you think “financial services,” you likely think “monstrous big banks with tendrils everywhere and eight-figure bonuses.” Royce thinks differently, and their focus on smaller firms that dominate financial niches worldwide has made a remarkable difference for their investors.

Elevator Talk: Jim Robinson, Robinson Tax-Advantaged Income (ROBAX)

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.

Jim Robinson formed Robinson Capital Management, located in Detroit’s ritzy Grosse Pointe suburb, in December, 2012. The firm manages about a quarter billion in assets for a handful of high net worth clients and advises two (soon to be three) mutual funds.

From 1987-1999, Mr. Robinson served as the Fixed Income CIO for the Munder Funds. During his stint, he grew fixed income AUM from $100 million to $20 billion. Eventually promoted to Chairman, CEO and President, he was responsible for about $38 billion in assets. He left Munder for Telemus Capital Partners, LLC, with whom his firm still has a relationship.

Robinson Capital uses a variety of strategies in their separate accounts. The Tax-Advantaged Income Fund pursues one strategy: it invests in closed-end muni bond funds. Closed-end funds (CEFs) are strange creatures, the forerunners of today’s actively-managed ETFs. They have managers and portfolios like open-end mutual funds do, but trade on exchanges like stocks and ETFs do. Such funds have several relevant characteristics:

1. They are far more likely to pursue income-oriented strategies than are open-end funds
2. They are far more likely to make extensive use of leverage and hold more illiquid securities than are open-end funds
3. Because they trade on exchanges, the managers never need to worry about meeting redemptions or closing the fund to new investors; they issue a set number of shares of the CEF during their initial public offering but after that they let buyers and sellers find each other.
4. Because they trade on exchanges, the market price of their shares changes minute-by-minute, and
5. Because they trade on exchanges, the net asset value of a share (the market value of all of the fund’s holdings divided by the number of shares outstanding) can diverge dramatically from that share’s market price (that is, the amount a potential seller can get at one particular moment for a share of the fund).

When shareholders panic, they may succumb to the temptation to sell shares of their fund for 15, 20 or even 40% less than they’re nominally worth, just because the seller really wants cash-in-hand. That’s mostly irrational. A handful of mutual fund firms – RiverNorth, Matisse, and Robinson among them – look to profit from panic. Using various metrics, they decide when to move in and buy shares that are selling at an unsustainable discount to their net asset values.

If everything goes according to plan, that strategy offers the potential for sustained, substantial, market-neutral gains: as soon as panic subsides, even if the market is still falling, a degree of rationality returns, investors start buying the discounted CEF shares, that bids up the price and the discount closes. If you invest before the crowd, you benefit when the shares you bought at, say, a 25% discount can now be sold at just a 5% discount.

Here’s a hypothetical illustration: the NAV of the Odd Income Fund is $100/share but, when rumors of dinosaurs rampaging down Wall Street rattles people, its market price drops to $75/share. Robinson moves in. In six months, the panic has passed, Odd Income’s NAV has risen a couple percent and its discount contracted to its non-panic norm of 5%. In such a scenario, Odd Income has earned 2% but folks who bought shares during the panic earned 29%.

There are distinct risks to playing this game, of course. The falling knife might continue to fall harder and faster than you’d imagined so that the 25% discount might widen to 35%. The manager of the underlying CEF might find that using leverage in a panicky market drives down the fund’s NAV as well as its market price. And, too, the CEF manager might simply do something stupid. It happens.

The folks who manage CEF-focused funds argue that downside risks are manageable through a combination of careful security selection, position-size limits and hedging. The upside can be dramatic. Here is the performance chart for ROBAX against two possible benchmarks: its Morningstar non-traditional bond peer group (orange) and long-term national muni bond group (yellow).

Here are Mr. Robinson’s 200 words on why investors concerned about income and income taxes should add ROBAX to their due-diligence list:

I generally tell people that the first three things you need to know about our fund are these:

• We pay out 40 basis points a month in tax-exempt income, on average
• We present very little credit risk; our portfolio’s credit quality is A/A+
• We hedge out interest rate risk, such that our effective duration is under a year.

There are 191 Tax-exempt closed-end funds. Today, 150 are trading at a discount to NAV. Some of those discounts are rational; if you have a poorly-managed fund buying difficult-to-price securities and misusing leverage, it should be trading at a discount. Heck, I analyze some of these funds and suspect the discount should be bigger than it is.

What we do is move money from rationally discounted funds to irrationally discounted ones. Six large fund companies – BlackRock, PIMCO, Nuveen and company – dominate the CEF space. That’s important because those companies have pretty good governance practices in place; BlackRock is aggressive about merging funds to harvest economies of scale, others do share buybacks and so on. When funds with good management, good governance and good portfolios sell at irrational discounts, we move. Bill Gross did me a big favor. Two days before we launched, he resigned from PIMCO. Gross had nothing to do with PIMCO’s CEFs but suddenly funds that always trade at a premium were available at a discount. We moved in, the discount predictably reversed, and we closed the position at a nice profit. That discount arbitrage adds about 200 bps to our performance.

The other thing we do that individual investors can’t, and that most advisors would find tough, time-consuming and expensive, is we largely hedge interest rate risk out of the portfolio. Tax-exempt CEFs tend to be long-dated and leveraged so they typically have 10-12 year weighted durations. In a year like 2013 when rates rise 1%, they lose 10-12% in principal value. Our hedge is not perfect, since Treasuries and munis don’t trade in perfect sync, but it’s pretty good.

Robinson Tax-Advantaged Income has a $2500 minimum initial investment for the “A” shares and $1,000,0000 for “I” shares. While there’s a sales load, load-waived shares are widely available. Direct expenses are capped at 1.60% on the “A” shares. Since the fund invests in other funds, you indirectly pay (through lower returns) a portion of those funds’ expenses. In 2014, that added 1.14% to ROBAX’s today expenses. The fund has about gathered about $74 million in assets since its September 2014 launch. Here’s the fund’s homepage.

Funds in Registration

Funds need to submit their prospectuses for SEC review before they’re permitted to offer the fund to the public. The SEC has 75 days in which to ponder the matter, which means that proposed new funds cool their heels for about two and a half months. During that time their prospectuses are available for review on the SEC’s website but fund advisors are forbidden to talk publicly about them. Each month Funds in Reg gives you a heads-up about what’s in the SEC pipeline.

Except for last month, when I stupidly forgot to include the file in our February issue. As a result, this month we cover the last two sets of no-load retail funds that will become available between March and May. We found 17 funds that qualify. Particularly interesting morsels include:

• 361 Domestic Long/Short Equity Fund, which will be managed by a really renowned investor – Harindra de Silva – who has a earned a great deal of respect in the industry and who already manages a number of top-ranked funds.
• Matthews Asia Credit Opportunities, which appears to be a high-yield, distressed securities version of the very fine Matthews Asia Strategic Income Fund.
• RiverPark Commercial Real Estate Fund, the latest entry in RiverPark’s quest to bring hedge fund strategies to “the mass affluent.” This fund has been running as a hedge fund for about five years now.

Sadly, there are a handful of future “Off to the Dustbin of History” nominees as well but I suppose that’s the magic of capitalism: 90% of the stuff we try fails, 9% does okay and 1% changes the world.

Uzès Grands Crus I

The French, being French, have their financial priorities in order. In February, Financière D’uzès announced the launch of their third mutual fund devoted to the investment potential of bottles of fine wine. At least 75% of the fund’s assets will be bottles of fine and their aim is “to outperform the annual rate for the five-year French treasury bond (OAT) with a minimum return of 5%.”

I reflected, very very briefly, on the investment value of the bottle of Lambrusco I bought at Trader Joe’s for $4.99, then made mid-winter sangria instead.

Manager Changes

The biggest news, by far, this month is the impending departure of Taymour R. Tamaddon from T. Rowe Price Health Sciences (PRHSX) and Donald Yacktman from his namesake funds. When Kris Jenner left the fund three years ago (how time flies!), the accepted wisdom was that nobody could live up to his legacy. Mr. Tamaddon then led the fund to 22.4% annualized returns, nearly 500 bps above his peers and good enough for a top 2% record.

Mr. Tamaddon steps down on July 1, 2016, is succeeded by Ziad Bakri then becomes manager of the $12 billion T. Rowe Price Institutional Large-Cap Growth Fund (TRLGX) on January 1, 2017.

Effective May 1, 2016, Donald A. Yacktman will transition to an advisory role and will no longer serve as a portfolio manager for AMG Yacktman (YACKX) and AMG Yacktman Focused (YAFFX) funds. The roughly corresponds with his 75^th birthday. Mr. Yacktman has been managing mutual funds since 1968, starting with Stein, Roe and the Selected American Shares before founding Yacktman Asset Management in 1992. $10,000 invested in YACKX that year would have grown to $95,000 today, which compares well to the returns on an investment in the S&P500 ($76,000) or the average large-value fund ($56,000). He was named Morningstar’s Manager of the Year in 1991 and was joined on the management team by his son, Stephen, in 2002. Stephen Yacktman and Jason Subotky will manage the funds after the transition.

Other than that, we found about 36 manager changes, a few years overdue.

Updates

Sequoia Fund (SEQUX) continues its defense of Valeant Pharmaceuticals in its Annual Report (2016) and they continued dodging the issue.

For the stock to regain credibility with long-term investors, Valeant will need to generate strong earnings and cash flow this year, make progress in paying down some of its debt, demonstrate that it can launch new drugs from its own development pipeline and avoid provoking health care payers and the government. The company has committed to doing all of these things and we are confident interim CEO Howard Schiller and interim board chairman Robert Ingram are focused on the right metrics. Before CEO J. Michael Pearson went out on an extended medical leave, he also seemed committed to this path.

“Avoid provoking health care payers.” Oh, right. That would be the predatory pricing model that attracted Sequoia to Valeant in the first place: Valeant would borrow money to buy a small pharmaceutical firm, then quintuple the price of the firm’s products. If that meant putting a few inexpensive lives at risk, well, that wasn’t Valeant’s problem.

Until it was. Before the blow-up, manager David Poppe’s tone was openly affectionate about “Mike,” Valeant’s president and almost giddy about the prospects. Valeant’s high-profile implosion cost Sequoia a lot:

As the largest shareholder of Valeant, our own credibility as investors has been damaged by this saga. We’ve seen higher-than-normal redemptions in the Fund, had two of our five independent directors resign in October and been sued by two Sequoia shareholders over our concentration in Valeant. We do not believe the lawsuit has merit and intend to defend ourselves vigorously in court. Moving along …

“Moving along”? No, it’s not time to move along, guys. Barron’s Chris Dieterich provides a nice synopsis of developments that transpired on February 29, the day Sequoia released their report:

Monday ushered in a nightmarish combination of trouble. First, Valeant said it would delay the release of its quarterly results. Then, news broke that Allergan (AGN) is challenging the patent to Xifaxan. Third, Moody’s Investors Service warned that it may need to downgrade portions of the company’s $31 billion of debt. Finally, headlines crossed the tape that Valeant faces a previously undisclosed investigation by the Securities and Exchange Commission.

All told, the stock plunged 18% to $65.80 — a fresh three-year low (“Sequoia Fund Picked A Bad Time To Stick Up For Valeant”).

The bigger, unanswered question is what does this say about you as investors? Any damage to your credibility is (a) self-inflicted and (b) deserved. You committed one third of your fund and all of your credibility to an amoral little schemer who, on his best days, stayed right at the edge of what’s legal. That’s a fact you acknowledged. Then you implicitly compared him to Warren Buffett, an investor whose moral compass, operating style and record makes him utterly incomparable.

Investors might, heck, investors must, ask: where was your brain? Were you so blinded by the prospect of easy money that you chose to ignore the hard questions? The most optimistic interpretation is that you’re not addressing such questions because you’re being sued and you can’t afford to admit to whatever idiocy led to the resignations of 40% of your board last fall. The worrisome interpretation is that Sequoia isn’t Sequoia anymore; that the clarity of thought that guided it to renown in decades past mostly now serves to mask a less exalted management.

Think it can’t happen? Check Magellan, Fidelity (FMAGX), the other Titan which has now managed to trail its peers over the past five, ten, fifteen and twenty year periods. Utterly dominant in the market cycle from 1973-1987 when it beat its peers by 1000 basis points/year, the fund hasn’t even managed consistent mediocrity since.

Morningstar doesn’t share my reservations and SEQUX retains a “Gold” analyst rating from the firm. Their equity analyst also doesn’t share my concerns about Valeant, which they rate (on 3/1/16) as a five-star stock whose shares are selling at about one-third of their fair value. Senior equity analyst Michael Waterhouse doesn’t “anticipate any major shift in our long-term thinking for the company.”

Briefly Noted . . .

SMALL WINS FOR INVESTORS

Chou has voluntarily decided to waive its entire advisory fee on the Chou Opportunity Fund (CHOEX) beginning on January 1, 2016. In addition, on February 18, 2016 Chou made a voluntary capital contribution to the Opportunity Fund in the amount of $918,468, which approximates the advisory fees retained by Chou with respect the Opportunity Fund last year. Why, you ask? The advisor describes it as “a gesture of goodwill … in recognition of the fund’s underperformance” in 2015. That’s an oblique reference to having lost 22% in 2015 and another 20% in the first two months of 2016.

The advisor to the Great Lakes Bond Fund has closed the fund’s Investor Class (GLBDX) and converted the former Investor accounts into Institutional Class (GLBNX) ones. They then lowered the minimum on the Institutional shares by 99%, from $100,000 to $1,000. Net, potential retail investors save 25 bps.

Hotchkis & Wiley Mid-Cap Value Fund (HWMAX) has reopened to new investors.

RS Partners Fund (RSPFX) reopened to new investors on March 1, 2016. None of the fund’s independent trustees have chosen to partner with you by investing in the fund. The managers’ investment in the fund ranges between “modest” and “none.”

Walthausen Small Cap Value Fund (WSCVX) reopened to new investors on March 1, 2016.

Wasatch Emerging Markets Small Cap Fund (WAEMX) has reopened to new investors. Thanks for the heads up, Openice!

CLOSINGS (and related inconveniences)

Nope, turns out “turning away money” wasn’t a popular move in February. We found no funds closing their doors.

OLD WINE, NEW BOTTLES

Armor Alternative Income Fund (AAIFX) has become Crow Point Alternative Income Fund. 

Diamond Hill Strategic Income Fund (DSIAX) has been renamed the Diamond Hill Corporate Credit Fund to better reflect what it’s up to.

Forward no more. On May 1, 2016, the name “Forward” disappears from the world of mutual funds. In general, all of the former Forward Funds will be renamed as Salient Funds, which no change other than substituting “Salient” for “Forward” in the name. There are a few exceptions,

TIAA-CREF has boldly rebranded itself as TIAA.

Straightforward. Yep. 74%. Unless you’re buying the retail share class in which case it’s nine of 33 funds excluding money markets, or 27%. 32.5% of all funds receive either four- or five-stars from Morningstar.

And about that “uncomplicated” thing? Count the number of clicks it takes you to get to any particular fund. It took me two cups of coffee before I finally got to the one I wanted.

As of May 9, 2016, Transparent Value becomes … well, insert your own snark here. In any case, the Transparent Value Funds become Guggenheim Funds.

On March 1, 2016, The Wall Street Fund (WALLX) became Evercore Equity Fund (EWMCX). The word “Equity” in the name also triggered a new promise in the prospectus that the fund, which already invests in equities, promises to invest in equities.

OFF TO THE DUSTBIN OF HISTORY

On whole, fund companies would be well-advised to extract their heads from their behinds. If you’re not willing to stick with a new fund for, say, a whole market cycle, then don’t launch the damned thing. The hypocrisy of declaring that you’re “long-term investors” and that you want to be “partners” with your investors, then closing a fund after 12-24 months, is toxic. It conveys some combination of the following three messages: (1) we’re panicked. (2) We have no ability to plan. (3) Pretty much everything we said when we launched the fund was cynical B.S. crafted by marketers who were, themselves, probably disgusted with us.

Which of those messages do you really want to be associated with?

Okay, back to the ranks of the walking dead and the dead dead after a short word of thanks to The Shadow, one of the stalwarts of our discussion board whose daily updates on the comings and goings is enormously helpful in keeping this list current.

Let’s go to Plan B: Under Plan A, Arden Alternative Strategies Fund (ARDNX) was slated to become Aberdeen Multi-Manager Alternative Strategies Fund (no ticker) on March 31, 2016. That made perfect sense since Aberdeen acquired Arden. Plan A survived for about a week when someone likely noticed that the fund wasn’t actually very good, was shrinking in size and required an annual expense subsidy from the adviser, whereupon Plan B emerged: kill it. Same date.

BPV Core Diversification Fund (BPADX) has closed and will be terminated on March 11, 2016. It’s a tiny, conservative fund that’s still managed to lose money over the past three years and trail 90% of its peers.

On February 17, 2016, the CGM Advisor Targeted Equity Fund (NEFGX, reflecting its birth name: New England Growth Fund) was liquidated. Financial Advisor magazine managed to wax nostalgic over the loss of a “venerable” and “once-vaunted” fund. Two quick notes about this: (1) the fund hasn’t earned its keep over the past 20 years. Its closing NAV was below its NAV in 1994. The 20 year performance chart is the very image of what to avoid in your investments:

And (2) you can still access the manager’s skills, if you’d like. Natixis, the fund’s sponsor, no longer has an ownership stake in CGM and so they had no interest in continuing to sponsor a fund. Mr. Heebner continues to run three other CGM funds. Their website would also win the award for the industry’s least useful.

Collins Alternative Solutions Fund (CLLAX) liquidated on February 26, 2016. The fund had about $19 million in assets and dropped 19% in its final year of operation.

Crystal Strategy Absolute Income Fund (CSTFX), Crystal Strategy Absolute Return Fund (CSRAX) and Crystal Strategy Absolute Return Plus Fund (CSLFX) will, based on the recommendation of Brinker Capital, LLC, the investment adviser, be liquidated on March 18, 2016. The funds are just past their second anniversary. Between them they have $16 million in assets and a sorrowful performance record.

Dreyfus Strategic Beta U.S. Equity Fund (DOUAX) will liquidate in mid-April.

The Fortress has fallen! Fortress Long/Short Credit Fund (LPLAX) liquidated on February 12, 2016, about three years too late. The fund lost about 25% over its lifetime. It peaked in December 2012 and its chart since then looks, for all the world, like a child’s drawing of steps leading down to the basement.

Frost International Equity Fund (FANTX) will liquidate on March 31, 2016. The announcement helpfully notes that they’ll refer to that as “the liquidation date.” I think I went on one of those in college.

Gottex Endowment Strategy Fund (GTEAX) is liquidating after about 20 months of operation. In that time it lost about 12% for its few investors.

Guidestone Real Assets Fund (GRAZX) will liquidate on April 29, 2016. It’s a tiny fund-of-funds that’s designed to protect you from inflation by investing in things that are cratering. That’s not intentional, of course, but sectors that would be durable if inflation arose – energy, natural resources, real estate – have been disasters.

The $3 million JPMorgan Asia Pacific Fund (JAPFX) will liquidate on April 6, 2016.

Investors in the Lazard Master Alternatives Portfolio (LALOX) need to find an alternative since the fund was liquidated on March 1, 2016. The fund was 14 months old.

MassMutual Barings Dynamic Allocation Fund (MLBAX) will be dissolved on July 8, 2016. It isn’t an awful tactical allocation fund but it’s tiny and misallocated in the last year, costing its investors 11.5%.

Merk Asian Currency Fund (MEAFX) liquidated on February 29, 2016. From inception in 2008 until liquidation, the fund was above water once, briefly, in 2011.

Meyers Capital Aggressive Growth Fund (MAGFX) liquidated on February 29, 2016, on about three weeks’ notice. Since the manager owns 87% of the funds’ shares, he might have seen it coming. The oddest development is the collapse of the fund’s asset base: in May, Mr. Meyers owned over $1,000,000 in fund shares. By February 2016,the fund only had $130,000 in assets.

Oberweis Asia Opportunities Fund (OBAOX) will be merged into Oberweis China Opportunities Fund (OBCHX) on or about April 29, 2016.

Philadelphia Investment Partners New Generation Fund (PIPGX), having lost 35% in the past 12 months, is now going to lose its head. The execution is March 30, 2016.

After the advisor concluded that Satuit Capital U.S. SMID Cap Fund (SATDX) was not economically viable, they decided “to close the Fund, wind up its affairs, liquidate its portfolio.” I’ve never seen “wind up its affairs,” which the announcement uses twice, in a fund liquidation filling before. Huh. The fund is not yet two years old and had attracted only a couple million, despite a really strong record. The deed is done on April 30, 2016.

Having concluded that the Smith Group Small Cap Focused Growth Fund (SGSVX) has “limited prospects for meaningful growth,” its board authorized liquidation of the fund on March 31, 2016. One can’t fault the managers for a lack of commitment: internal ownership accounted for about two-thirds of the fund’s $600,000 in assets.

Strategic Latin America Fund (SLATX) liquidated in late February, 2016. 

Touchstone Global Real Estate Fund (TGAAX) will liquidate on March 30, 2016. The board attributes the decision to “the Fund’s small size and limited growth potential.” An interim manager, apparently someone who specializes in “safeguard[ing] shareholder interests during the liquidation period,” has been appointed. It’s the sad case of a good fund not finding its audience: top 25% returns over the past five years and even better returns recently, but still only $17 million in assets.

Sometime in mid-summer Victory CEMP Multi-Asset Balanced Fund (CTMAX) will be absorbed by Victory Strategic Allocation Fund (SBALX). As is so often the case, CTMAX is larger and weaker so they’ll bury its record while tripling SBALX’s assets.

On February 5, 2016, Virtus Dynamic Trend Fund merged into Virtus Equity Trend Fund (VAPAX). I’m slightly startled to report that, despite trailing 98—99% of its peers over the intermediate term, VAPAX retains $1.5 billion in assets.

Wanger International Select (WAFFX) will liquidate at the end of March. It appears to be available only through insurance products.

WHV/EAM Emerging Markets Small Cap Equity Fund (WVEAX) and WHV/EAM International Small Cap Equity Fund (WHSAX), rather less than two years old, will liquidate on or about March 31, 2016. Both funds had very strong performance. WHV/Seizert Small Cap Value Equity Fund (WVSAX), a bit more than two years old, will liquidate a month later.

In Closing . . .

Thanks, as always, to folks who’ve supported the Observer in thought, word or deed. Welcome, especially, to Nick Burnett, long-time friend, grad school roommate and mastermind behind the CapRadioCurriculum which helps teachers connect public radio content with classroom lessons. There’s a cool one on multilingual public relations that I rather liked. Thanks, as ever to the ongoing generosity of the folks at Gardey Financial and our first subscribers, Deb and Greg. Thanks to Gary, who didn’t particularly want premium access but did want to help out. Mission accomplished, big guy! Too, to MaryRose, we’re trying to help. Welcome to Abdon Bolivar, working hard to get people to understand the role that plan administrators play in creating and sustaining bad options for investors. By coincidence, Tony Isola and the folks are Ritholtz Wealth Management are pursuing a parallel track trying to educate educators about what to do if they’re getting screwed by the 403(b). And, in a horrifying number of cases, they are.

And so, thanks to you all, not just for your support of the Observer but for all the good work you’re doing for a lot of people.

We’re waiting to talk with the folks at Otter Creek Partners, a hedge fund firm with a small long/short fund that’s performed splendidly. That conversation will let us finish up our profile of Otter Creek Long/Short Opportunity (OTCRX) and share it with you. We’ll add a look at Intrepid Endurance (ICMAX) in conjunction with my own portfolio review. We’ll look for the launch of Seafarer Overseas Value, likely around the 75^th day of 2016. We’ll look for you.

Dear friends,

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

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

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

Open confession is good for the soul.

I have two confessions.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

It’ll be a good year.

Emerging markets: About as cheap as it gets

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

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

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

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

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

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

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

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

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

This Time It Really Is Different!

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

 Kafka

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

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

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

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

China, China, China, All the Time

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

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

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

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

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

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

— by Edward A. Studzinski

Looking for Bartolo Colon

by Leigh Walzer

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

FROM THE MAILBAG:

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

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

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

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

VULCAN MIND MELD

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

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

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

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

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

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

Broadly speaking, there are three reasons:

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

Exhibit I

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

Exhibit II: Boston Partners All-Cap Value Fund

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

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

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

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

^[1] 12 months ending November 2016.

VETERAN BENEFITS

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

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

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

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

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

HOW MUCH IS ENOUGH

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

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

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

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

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

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

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

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

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

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

Why are investors so bad at picking alternatives?

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

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

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

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

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

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

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

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

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

Smallest, Shortest, Lowest

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

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

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

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

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

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

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

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

First Pacific Advisors’ FPA New Income (FPNIX)

PIMCO Income (PIMIX)

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

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

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

Queens Road Small Cap Value (QRSVX)

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

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

The Alt Perspective: Commentary and news from DailyAlts.

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

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

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

Performance Review

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

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

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

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

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

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

Overall, a mixed bag for January.

Asset Flows

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

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

Hot Topics

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

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

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

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

Observer Fund Profiles:

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

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

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

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

Launch Alert: Davenport Balanced Income (DBALX)

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

Three things worth knowing:

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

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

Manager Changes

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

Updates

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

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

Briefly Noted . . .

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

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

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

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

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

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

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

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

SMALL WINS FOR INVESTORS

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

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

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

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

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

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

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

CLOSINGS (and related inconveniences)

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

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

OLD WINE, NEW BOTTLES

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

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

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

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

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

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

OFF TO THE DUSTBIN OF HISTORY

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Rationale for liquidating the Fund

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

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

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

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

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

In Closing . . .

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

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

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

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

We’ll look for you.

Dear friends,

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

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

Annus horribilis or annus mediocris?

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

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

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

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

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

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

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

The answer, in all likelihood: Meh.

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

Stephanie Yang, writing for CNBC, half-despaired:

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

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

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

Courtesy of Leuthold Group

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

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

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

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

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

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

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

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

Good-Bye to All That

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

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

Farewell to the Whitebox Funds

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

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

So far, this is a “not.”

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

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

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

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

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

Farewell to The House of Whitman

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

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

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

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

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

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

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

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

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

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

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

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

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

Farewell to Mainstay Marketfield

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

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

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

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

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

Farewell to Sequoia’s mystique

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

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

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

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

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

We met with Mike a few weeks ago and he was telling us how with $300 million, you can get an awful lot done.

Mike can get a lot done with very little.

Mike is making a big bet.

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

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

Sequoia’s recent shareholder letter concludes by advising Valeant to start managing with “an eye on the company’s long-term corporate reputation.” It’s advice that we’d urge upon Sequoia’s managers as well.

Farewell to Irving Kahn

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

Where Are the Jedi When You Need Them?

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

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

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

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

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

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

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

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

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

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

– by Edward A. Studzinski

Quietly successful: PYGSX, RSAFX, SCLDX, ZEOIX

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

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

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

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

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

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

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

Candidates for Rookie of the Year

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

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

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

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

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

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

Herewith, the 2016 Rookie of the Year nominees:

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

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

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

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

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

Premium Site Update

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

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

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

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

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

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

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

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

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

AQR Long/Short

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

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

Whitebox Funds

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

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

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

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

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

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

Snow Tires and All-Weather portfolios

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

By Leigh Walzer

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

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

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

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

When has growth worked better than value?

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

Exhibit I

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

Exhibit II

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

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

Recent trend

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

Can growth/value switches be predicted accurately?

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

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

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

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

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

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

Exhibit IV

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

All-Weather Managers

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

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

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

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

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

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

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

The All-Season Portfolio

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

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

Bottom line:

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

The Alt Perspective: Commentary and news from DailyAlts.

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

Performance Review

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

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

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

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

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

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

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

Asset Flows

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

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

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

Hot Topics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Funds in Registration

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

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

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

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

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

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

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

Manager Changes

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

Updates

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

Briefly Noted . . .

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

SMALL WINS FOR INVESTORS

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

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

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

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

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

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

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

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

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

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

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

CLOSINGS (and related inconveniences)

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

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

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

OLD WINE, NEW BOTTLES

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

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

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

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

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

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

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

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

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

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

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

OFF TO THE DUSTBIN OF HISTORY

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The fund will liquidate on January 15, 2016.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

In Closing . . .

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

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

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

We’ll look for you.

Dear friends,

I’ve been reading two strands of research lately. One shows that simple expressions of gratitude and acts of kindness have an incredibly powerful effect on your mental and physical health. Being consciously grateful of the goodness in your life, for example, carries most of the same benefits of meditation without the need for … well, sitting on the floor and staring at candle flames. The other shows that people tend to panic when you express gratitude to them or try to do kind things for them. Apparently giving money away to strangers is a lot harder than you’d imagine.

The midwinter holidays ahead – not just Christmas but a dozen other celebrations rooted in other cultures and other traditions – are, at base, expressions of gratitude. They occur in the darkest, coldest, most threatening time of year. They occur at the moment when we most need others, and they most need us. No one thrives when they’re alone and each day brings 14 to 18 hours of darkness. And so we’ve chosen, from time immemorial, to open our hearts and our homes, our arms and our pantries, to friends and strangers alike.

Don’t talk yourself out of that impulse. Don’t worry about whether your gift is glittery (if people actually care about that, you’re sharing gifts with the wrong people) or your meal is perfect (Martha Stewart’s were and she ended up in the Big House). People most appreciate gifts that make them think of you; give a part of yourself. Follow the Grinch. Take advice from Scrooged. Tell someone they make you smile, hug them if you dare, smile and go.

Oh, by the way, you make me smile. I’m endlessly humbled (and pleased) at the realization that you’re dropping by to see what we’ve been thinking. Thanks for that!

Built on failure

Success is not built on success. It’s built on failure. It’s built on frustration. Sometimes it’s built on catastrophe. Sumner Redstone (2007)

My dad never had much tolerance of failure. Perhaps because he’d experienced more than his share. Perhaps because he judged people so harshly and assumes that others did the same to him. No matter. For him, a failed project was the sign of a failed person. And so we learned to keep our heads down, volunteer nothing, risk nothing, and never fail.

And, at the same time, we never succeeded. “In order to succeed, you have to live dangerously,” Mr. Redstone advised. The notion of taking risks came late and hesitantly.

I wish I’d risked more and failed more, perhaps even failed more joyfully. But I’m working on it. You should, too. Being comfortable with failure is good; it means that you’re less likely to sabotage yourself through timidity. It’s a human resources truism that a guy with 10% of the necessary qualifications for a job will apply for it. A woman with 90% of the qualifications will not. Both ask themselves the same question, “what’s the worst that could happen?” but give themselves strikingly different answers. Talking comfortably about failure is better; it means that you’re removing the terror from other’s minds, enabling them to take the risks that might lead to failure but that are also essential for success. You should practice both. There’s also some interesting research that suggests that people who think of themselves as “experts” get all puffed up, then become rigid and dogmatic. That’s hardly a recipe for success.

The Wall Street Journal recently published “How not to flunk at failure,” (10/25/2015) by John Danner and Mark Coopersmith. Both are faculty at UC-Berkeley’s Haas School of Business. They’ve co-authored The Other “F” Word: How Smart Leaders, Teams, and Entrepreneurs Put Failure to Work (2015). They argue that it’s more common to fail poorly than to fail well because we so horrified at the notion that we failed at all. As a result, we feel sick and learn nothing.

They offer four recommendations for failing well.

1. The first step: admit you’ve had failures yourself. The guys who growl that “failure is not an option” end up, they say, creating a culture of “trial and terror” rather than a healthy culture of “trial and error.”
2. Ask the right questions when the inevitable failure occurs. Abandon the witch hunt that begins with the question “who was responsible?” Instead, think “hmmm, that was the damnedest thing” and begin exploring it with the sorts of who, what, why, where, when questions familiar to journalists.
3. Borrow a page, or at least a term, from the lab. Stop talking in excited terms about mission-critical strategic imperatives and start talking about experiments. Experiments are just a tool, a means to learn something. Sometimes we learn the most when an experiment does something utterly freakish. “We’ll try this as an experiment, see what comes of it and plan from there” involves less psychological commitment and more distance.
4. Make the ending count. Your staff needs your support much less when things go right than when they go wrong. You need to celebrate the end of an experiment that went poorly with at least as much ceremony as you do when one went well. “Well, that Why don’t I take you out for a nice dinner and we’ll figure out what we’ve learned and where we go from here,” would be a spectacularly good use of your time and the corporate credit card.

Nice article. I can’t link directly to it but if you Google the title, the first result will be the article and you’ll be able to get it. (Alternately, you might, like me, subscribe to the newspaper and simply open it in your browser.)

We’ve tried a bunch of things that have failed and have learned a lot from them. Three stand out.

1. I suck as a stock investor. Suck, suck, suck. I tried it for a few years. Subscribed to Morningstar Stock Investor. Read Value Line reports. Looked carefully through three years of annual reports. Bought only deeply discounted stocks with viable business models and good managers. I still ended up owning WorldCom (which went to zero) and a bunch of stocks that inexplicably refused to go up. Ended up selling the lot of them, booking a useful tax loss and shifting the money to a diversified fund.

   What I learned was that I’m temperamentally unsuited to stock investing. Having spent months researching an investment, I expect it to do something. As in good! And now! When they staggered about like drunken sailors, I kept feeling the pressure to do something myself. That’s always a losing proposition. And I learned that a few thousand dollars in a fund bought you much better diversification than a few thousand dollars in individual securities.

2. The Best of the Web isn’t very good. You’ll find it, covered with cobwebs, under “The Best” tab up there at the top right of the screen. Our plan was to sort through a bunch of web-based resources – from fund screeners to news sources – so that you didn’t have to. It’s a worthy project give or take the cobwebs and the occasional references you might find there to President Grover Cleveland’s recent initiatives.

   What I learned was that there are limits to what we can do well. The number of hours it took to review 30 or 40 news sites or to assess the research behind various firms fund ratings, even with a former colleague doing a lot of the legwork, was enormous. The additional time to review and edit drafts was substantial. The gain to our readers was not. We’ve become much more canny about asking the hard “but then what will we stop doing?” question as we consider innovations that add to the 100 hour a month workload that many of us already accept.

3. The Utopia Funds profile was a disaster. This dates back eight years to our FundAlarm days and it still makes me wince whenever I think of it. Utopia Funds were launched by a small firm out of Michigan and I ridiculed them for the presumptuousness of the name. Imagine my surprise to be having a wonderfully pleasant conversation, a week later, to the firm’s CEO and CIO. The funds, arrayed on a risk scale from Growth to Very Conservative, invested in orphan securities: little bits and pieces that were too small to interest large investment houses and that were often underpriced. Bonds in Malaysia, apartments in Milan, microcap stocks in Austin. The CIO had been managing the strategy in separate accounts, was charming and they appealed to many of my biases (small firm, interesting portfolio, reasonable expenses, ultra-low minimum investments). I got enthused, ran two positively fawning pieces about the funds and Zach the lead manager (He’s Zachtastic!) and invested in them for myself and for family. They absolutely imploded in 2008 – Very Conservative was down about 35% by November – and were liquidated with no explanation and very short notice. I felt betrayed by the adviser and like I had betrayed my readers.

   What I learned was caution. My skeptical first reaction was correct but I let it get washed away by the CIO’s passion, attention and well-told tale. I also overlooked the fact that the strategy’s record was generated in separately-managed accounts and that the CIO was delegating day-to-day responsibility to two talented but less-experienced colleagues. Since then, I’ve changed the way I deal with managers. I now write the profile first, based on the data and the public statements on file. I identify things that cannot be ascertained from those sources and then approach the managers with a limited, targeted set of questions. That helps keep me from substituting their narrative for mine. In addition, I’ve become a lot more skeptical of track records generated in vehicles (separate accounts, SICAVs, hedge funds) other than mutual funds; the structural differences between them really matter. In each draft, I try to flag areas of concern and then share them with you. Forcing myself to ask the question “what are the soft spots here” helps maintain a sort of analytic discipline.

   Utopia’s advisers, by the way, are doing well: still in Traverse City at what appears to be a thriving firm that, true to their owner’s vision, uses part of the firm’s profits to fund a charitable foundation. Me, too: I took the proceeds from the redemption and used it to open positions in FPA Crescent (FPACX) and Matthews Asian Growth & Income (MACSX).

It’s okay to fail, if you fail well. I think that the Observer has been strengthened by my many failures and I hope it will continue to be.

For your part, you need to go find your manager’s discussion of his or her failures. Good managers take ownership of them in no uncertain terms; folks from Bridgeway, Oberweis, Polaris and Seafarer have all earned my respect for the careful, thoughtful discussions they’ve offered of their screw-ups and their responses. If you can’t find any discussion of failures, I’d worry. And if your manager is ducking responsibility (mumbly crap about “contingencies not fully anticipated”), dump him.

Speaking of the opportunity to take a risk and succeed (or fail) spectacularly, it’s time to introduce …

MFO Premium, just because “MFO Extra” sounded silly

We are pleased to announce the launch of MFO Premium. We’re offering it as a gesture of thanks to folks who have supported MFO in the past and an incentive for those who have been promising themselves to support us but haven’t quite gotten there. You can gain a year’s access for a contribution of at least $100; if there are firms that would like multiple log-ins, we’d happily talk through a package.

MFO Premium has been in development for more than a year. Its genesis lays in the tools that Charles, Ed and I rely on as we’re trying to make sense of a fund’s track record. We realized early on that the traditional reporting time frames (YTD, 1-, 3-, 5- and 10-year periods) were meaningless at best and seriously misleading at worst since they capture arbitrary periods unrelated to the rhythms of the market. As a result, we made a screener that allowed us to look at performance in up cycles, down cycles and across full cycles. We also concluded that most services have simple-minded risk measurements; while reporting standard deviation and beta are nice, they represent a small and troubled toolkit since they simplify risk down to short-term volatility. As a result, we made a screener that provides six or eight different lens (from maximum drawdown in each measurement period to recovery times, Ulcer indexes and a simple “risk group” snapshot) through which to judge what you’re getting into.

Along the way we added a tool for side-by-side comparisons of individual funds, side-by-side comparisons with ETFs, previews of our works in progress, a slowly-evolving piece on demographic change and the future of the fund world, sample screener runs (mostly recently, resilient small caps and tech funds that might best hold value in an extended bear) and a small discussion area you can use if something is goofed up.

We think it has three special characteristics:

1. It’s interesting: so far as we can tell, most of this content is not available in the tools available to “normal” folks and it’s stuff we’ve found useful.
2. It’s evolving: our current suite of tools is slated to expand as we add more functions that we, personally, have needed or wanted. Sam Lee has been meditating upon the subject since his Morningstar days and has ideas about what we might be able to offer, and I suspect you folks do, too.
3. It’s responsive: we’re trying to make our tools as useful as possible. If you can show us something that would make the site better and if it’s within our capabilities, we’ll likely do it.

To be clear: we are taking nothing away from MFO’s regular site. Not now, not ever. Nothing’s moving behind a paywall. We’re a non-profit and, more particularly, a non-profit that has a long-standing, principled dedication to helping people make sense of their options. If anything, the success of MFO Premium will allow us to expand and strengthen the offerings on MFO itself.

We operate MFO on revenues of a little more than $1,000/month, mostly from our Amazon affiliation. At 25,000 readers, that comes to income of about $0.04 per reader per month. We got two immediate and two longer-term goals for any additional contributions that the premium site engenders:

1. Pay for the data. Our Lipper data feed, which powers the premium screener and supports our other analyses, costs $1,000/month. That cost goes up if we have more than a couple thousand people using the premium screener, a problem we’re unlikely to face for a while. For the nonce, our first-year contract costs us $12,000.
2. Pay for design and programming support. As folks point out monthly, our current format – one long scrolling essay – is exceedingly cumbersome. It arose from the days of FundAlarm, where my first monthly “comments and highlights” column was about as long as your annual Christmas letter. Our plan is to switch to a template which makes MFO looks distinctly magazine-like with a table of contents and a series of separate stories and features. At the same time, we’ll continue to look like MFO. We’ve got outside professionals available to customize the template we’ve chosen and to do the design work. We’ve budgeted about $1,500 for that work.

If we end up with 140 contributions, and we’re already half way there, we can cover those expenses and contemplate the two longer-term plans:

3. Offer some compensation for the folks who write for, do programming for or manage the Observer. Currently our compensation budget in most months is zero.
4. Expand our efforts to help guide and support independent managers and boutique firms. There are an awful lot of smart, talented people out there who are working in splendid isolation from one another. We suspect that helping small fund advisers find ways to exchange thoughts and share angst might well make a difference in the breadth and quality of services that other folks receive.

Three final questions that have come up: (1) What if I’ve already contributed this year? In response to a frequently asked question, we’ve kept track of all of the folks who’ve already contributed to the Observer this year. You’re not getting left behind but it may take a couple weeks for us to catch up with you. (2) Is my contribution tax-deductible? Melissa, our attorney, has been very stern with me about how I’m allowed to answer this question so I’ll let her answer it.

Contributions are tax-deductible to the extent allowable under law. In accordance with IRS regulations, the fair market value of the online premium access of $15 is not tax-deductible. MFO is not confirming or guaranteeing that any donor can take charitable deductions; no nonprofit can do that since it depends on the individual donor’s tax situation. For example, donors can only take the deduction if they itemize and donors are subject to certain AGI limits. The nonprofit can only state that it is a 501(c)(3) organization and contributions may be tax-deductible under the law.

(3) Is there an alternative to using PayPal? Well, yes. PayPal is the default. But you do not need a PayPal account. We just use the secure PayPal portal, which allows credit or debit card payment methods. Alternately, writing a check works: Mutual Fund Observer, Inc., 5456 Marquette Street, Davenport, IA 52806. (Drop us an email when the check is in the mail and we will access you pronto.) We’re also working to activate an Amazon Pay option.

That’s about it. We think that the site is useful, the contribution target is modest and the benefits are substantial. We hope you agree and agree chip in. Too, clicking on and bookmarking our Amazon link helps us a lot, costs you nothing and minimizes your time at the mall.

Now, back to our story!

Charge of the Short-Pants Brigade

“What is youth except a man or a woman before it is ready or fit to be seen.”

Evelyn Waugh

We are now in that time of the year, December, which I will categorize as the silly season for investors, both institutional and individual. Generally things should be settling down into the holiday whirl of Christmas parties and distribution of bonus checks, at least in the world of money management. Unfortunately, things have not gone according to plan. Once again that pesky passive index, the S&P 500, is outperforming many active managers. And in some instances, it is not just outperforming, but in positive total-return territory while many active managers are in negative territory. So for the month of December, there is an unusual degree of pressure to catch-up the underperformance by year-end.

We have seen this play out in the commodities, especially the energy sector. As the price of oil has drifted downwards, bouncing but now hovering around $40 a barrel, it has been dangerous to assume that all energy stocks were alike, that leverage did not matter, and that lifting costs and the ability to get product to market did not matter. It did, which is why we see some companies on the verge of being acquired at a very low price relative to barrels of energy in the ground and others faced with potential bankruptcy. It did matter whether your reserves were shale, tar sands, deep water, or something else.

Some of you wonder why, with a career of approaching thirty years as an active value investor, I am so apparently negative on active management. I’m not – I still firmly believe that over time, value outperforms, and active management should add positive alpha. But as I have also said in past commentaries, we are in the midst of a generational shift of analysts and money managers. And it is often a shift where there is not a mentoring overlap or transition (hard to have an overlap when someone is spending much of his or her time a thousand miles away). Most of them have never seen, let alone been through, a protracted bear market. So I don’t really know how they will react. Will they panic or will they freeze? It is very hard to predict, especially from the outside looking in. But in a world of email, social media, and other forms of instantaneous communication, it is also very hard to shut out the outside noise and intrusions. I have talked to and seen managers and analysts who retreated into their offices, shut the door, and melted under the pressure.

For many of you, I think the safer and better course of action is to allocate certain assets, particularly retirement, to passively-managed products which will track the long-term returns of the asset classes in which they are invested. They too will have maximum draw-down and other bear market issues, but you will eliminate a human element that may negatively impact you at the wrong time.

The other issue of course is benchmarking and time horizons, which is difficult for non-value investors to appreciate. Value can be out of favor for a long, long period of time. Indeed it can be out of favor so long that you throw in the towel. And then, you wish you had not. The tendency towards short-termism in money management is the enemy of value investing. And many in money management who call themselves value managers view the financial consultant or intermediary as the client rather than Mr. and Mrs. Six-Pack whose money it is in the fund. They play the game of relative value, by using strategies such as regression to the mean. “See, we really are value investors. We lost less money than the other guys.”

The Real Thing

One of the high points for me over the last month was the opportunity to attend a dinner hosted by David Marcus, of Evermore Global Value, in Boston, at the time of the Schwab Conference. I would like to say that David Snowball and I attended the Schwab Conference, but Schwab does not consider MFO to be a real financial publication. They did not consider David Snowball to be a financial journalist.

I have known of David Marcus for some years, as one of the original apostles under Max Heine and Michael Price at Mutual Shares. I am unfortunately old enough to remember that the old Mutual Shares organization was something special, perhaps akin to the Brooklyn Dodgers team of 1955 that beat the Yankees in the World Series (yes, children, the Dodgers were once in Brooklyn). Mutual Shares nurtured a lot of value investing talent, many of whom you know and others, like Seth Klarman of Baupost and my friend Bruce Crystal, whom you may not.

David Snowball and I subsequently interviewed David Marcus for a profile of his fund. I remember being struck by his advice to managers thinking of starting another 1940 Act mutual fund – “Don’t start another large cap value fund just like every other large cap value fund.” And Evermore Global is not like any other fund out there that I can see. How do I know? Well, I have now listened to David Marcus at length in person, explaining what he and his analysts do in his special situation fund. And I have done what I always do to see whether what I am hearing is a marketing spiel or not. I have looked at the portfolio. And it is unlike any other fund out there that I can see in terms of holdings. Its composition tells me that they are doing what they say they are doing. And, David can articulate clearly, at length, about why he owns each holding.

What makes me comfortable? Because I don’t think David is going to morph into something different than what he is and has been. Apparently Michael Price, not known for suffering fools gladly, said that if the rationale for making an investment changed or was not what you thought it was, get rid of the investment. Don’t try and come up with a new rationale. I will not ruin your day by telling you that in many firms today the analysts and portfolio managers regularly reinvent a new rational, especially when compensation is tied to invested assets under management. I also believe Marcus when he says the number of stocks will stay at a certain level, to make sure they are the best ideas. You will not have to look back at prior semi-annual reports to wonder why the relatively concentrated fund of forty stocks became the concentrated fund of eighty stocks (well it’s active share because there are not as many as Fidelity has in their similar fund). So, I think this is a fund worth looking at, for those who have long time horizons. By way of disclosure, I am an investor in the fund.

Final Thoughts

For those of you who like history, and who want to understand what I am talking about in terms of the need for appreciating generational shifts in management when they happen, I commend to you Rick Atkinson’s first book in his WWII trilogy, An Army at Dawn.

My friend Robin Angus, at the very long-term driven UK Investment Trust Personal Assets, in his November 2015 Quarterly Report quoted Brian Spector of Baupost Partners in Boston, whose words I think are worth quoting again. “One of the most common misconceptions regarding Baupost is that most outsiders think we have generated good risk-adjusted returns despite holding cash. Most insiders, on the other hand, believe we have generated those returns BECAUSE of that cash. Without that cash, it would be impossible to deploy capital when … great opportunities became widespread.”

Finally, to put you in the holiday mood, another friend, Larry Jeddeloh of The Institutional Strategist, recently came back from a European trip visiting clients there. A client in Geneva said to Larry, “If you forget for a moment analysis, logic, reasoning and just sniff the air, one smells gunpowder.”

Not my hope for the New Year, but ….

Edward A. Studzinski

When Good Managers Go Bad

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

Continuing the theme of learning from failure… One of the toughest decisions for investors is what to do when a portfolio manager who had been performing well turns in a bad year? We can draw on our extensive database of manager skill for insight and precedents.

The Trapezoid system parses out manager skill over time. Our firm strives to understand whether past success was the result of luck or skill and determine which managers are likely to earn their fees going forward. Readers can demo the system for free at www.fundattribution.com where most of the active US equity mutual funds are modelled. The demo presents free access to certain categories with limited functionality.

To answer the question we look back in time for portfolio managers who experienced what we call a “Stumble.” Specifically, we looked for instances where a manager who had negative skill over the latest twelve months and positive skill in the preceding three years. The skill differential had to be at least 5 points. Skill in this case is a combination of Security Selection and Sector Selection. We evaluated data over the past 20 years, ignoring funds with a manager change or insufficient history.

Our goal was to see how these managers did following the Stumble. To make the comparison as fair and unbiased as possible, we compared the Stumble managers to a control group who had the same historical skill with no Stumble.

Exhibit I illustrates with two hypothetical funds. Coyote Fund had the same cumulative skill over a four year period – but investors in Roadrunner followed a much rougher path, and saw their value plummet in Year 4.

EXHIBIT I

Returns from Two Hypothetical Funds

Should holders of Roadrunner switch? Does the most recent performance suggest Roadrunner might have lost its Mojo? Does Roadrunner deserve a mulligan for an uncharacteristic year? Or should investors stick to their conviction that over the long haul Roadrunner and Coyote are equally skilled and stay the course? Or that Roadrunner is due for a bounce back?

Our database indicates that managers who stumble take approximately 30 months to regain their footing. During that thirty month period, these funds underperform by an incremental 3%. (See Exhibit II) This suggests investors would do well to switch from Roadrunner to Coyote. Note that a lot of the performance disparity occurs in the first few months after a Stumble, so close monitoring might allow investors to contain the damage. But if you don’t react quickly, there is a stronger case to stay put.

Why are managers slow to recover after a stumble? For many funds skill is partly cyclical. Cyclicality can occur because funds participate in market themes and seams of opportunity which play out over time. Strong or poor performance may affect funds flow which may further impact returns. So a Stumble may not tell investors much about the long term prognosis, but it is helpful in predicting over the short term. Our algorithms try to distinguish secular from cyclical trends and, equally important, how confident we can be in making predictions.

EXHIBIT II

Typical Skill Trend after Stumble Event

On a related note, we are sometimes asked whether managers learn from their experience and become better over time. We are sympathetic to the view that managers with a few gray hairs might do better than their younger peers, but the data doesn’t support this. In general managers with more experience don’t outperform the greenhorns, but they don’t seem to lose their fastball either.

But there is something interesting in this chart. Managers who survive a crisis do a little better than their peers in later years. One explanation is that with the battle scars come some valuable lessons which helps managers navigate the market better.

We looked for specific funds which stumbled recently. They are listed in Exhibit III. Some of these funds actually have good 3-5 year track records and have fund classes on the Trapezoid Honor Roll, which is separate from the Observer’s. Think of the Stumble Event as an early warning indicator: we are looking for funds that have lost altitude or veered off their trajectory.

EXHIBIT III

Funds with Stumble Event in the 12 Months Ending June 2015

We took a harder look at the largest fund on the list, ClearBridge Aggressive Growth (SAGYX).

EXHIBIT IV

ClearBridge Aggressive Growth Fund: Recent Performance

This $14bn fund has a 32 year history with the same lead manager in place throughout. At various times in the past it was known as Shearson, Smith Barney, or Legg Mason Aggressive Growth Fund.

We don’t have data back to inception, but over the past 20 years, the manager (Richard Freeman) has demonstrated sector selection skill of approximately 1% per year. Exhibit IV shows the recent net returns (courtesy of Morningstar). We see little or no stock picking skill. The fund is very concentrated and differentiated; the Active Index (or OAI) is 23; in general when we see scores over 18, we read it as evidence of a truly active manager). Over the past 5 years, sector selection has contributed approximately 3%/year. Based on this showing, our Orthogonal Attribution Engine (or OAE, the tool we use to parse out the effects of each of the six sources of a fund’s over- or under-performance) has enough confidence to incur expenses of roughly 1%/year. As a result, several fund classes are on our Trapezoid Honor Roll – i.e., we have 60% confidence skill justifies expenses. The fund has tripled in size in three years which is a bit of a concern. We can replicate the fund with 87% R-squared. Our “secret sauce” to replicate the fund is a blend of S&P500, small-cap, a very large dollop of biotech, and small twists of media, energy, and healthcare. The recipe doesn’t seem to have changed much over time.

Exhibit V gives a sense of the cyclicality of combined skill over time, the manager has had some periods of exceptional performance but also some slumps. The first half of 2002 was a rough period for the fund; the negative skill reflects mainly that the fund had (as always) a heavy overweight on biotech which badly underperformed the market during that timeframe.

EXHIBIT V

ClearBridge Aggressive Growth: Combined Skill from Security Selection and Sector Rotation (1995-2015)

Coming into the second half of 2014, the fund had its characteristic strong overweight on biotech. This weighting should have served the fund well. However, security selection was negative in the twelve months ended July 2014. (NB: The fund’s Fiscal Year ends August) Some of the stocks the fund had held for several years and ridden up like Biogen, SanDisk, Cree, and Weatherford did not work in this environment. We view this as negative skill, since the manager could have sold high and redeployed to other stocks in the same sector. Our math suggests the fund also incurred above average trading costs over the past year, which shows up in our model as negative skill. We asked ClearBridge to review our findings but they did not respond as of this writing.

ClearBridge Aggressive Growth re-entered Stumble territory in June. We noted earlier that funds with a Stumble event tend to lose another 2.5% before regaining their footing. In their case, that prediction has held true. We have not refreshed their skill but they have lagged the S&P500 badly. Most recently, another big biotech position they rode up, Valeant Pharmaceuticals, has come undone.

Bottom Line: Investors should consider heading to the sidelines when a fund stumbles and wait until the dust clears. We usually pay more heed to long term track record than short term blips and momentum. But a sudden drop-off in skill usually portends more pain to come. So for marginally attractive funds a Stumble Event may be a sell signal.

ClearBridge has had the conviction to remain overweight biotech for many years which has served them well. That sector now has negative momentum. We expect the poor security selection will even out over time. Investors who are neutral or positive on the sector should give the fund the benefit of the doubt.

To see additional details, please register at www.fundattribution.com and click on the Stumbles link from the Dashboard. As always, we welcome your comments at [email protected]

Quick hits: Resilient small caps and tech funds

Partly as a teaching tool, I’ve been walking folks through how to use our fund screener. Two outputs that you might find interesting:

Resilient small cap winners: which small cap funds came closest to letting you have your cake and eat it, too? That is, which were cautious enough to post both relatively limited losses in the 2007-09 bear market and to manage top tier returns across the entire market cycle (2007 – present)? Three stand out:

Intrepid Endurance (ICMAX), a cash-heavy absolute value fund once skippered by Eric Cinnamond, now of Aston River Road Independent Value (ARIVX).

Dreyfus Opportunistic Small Cap (DSCVX), a much more volatile fund whose upside has outpaced its downside. It’s closed to new investors.

Diamond Hill Small Cap (DHSCX), a star that’s set to close to new investors at the end of December.

Resilient tech: did any tech funds manage both of the past two bears, 2000-02 and 2007-09? I screened for the funds that had the lowest maximum drawdowns and Ulcer Indexes in both crashes. Turns out that risk-sensitivity persisted: four of the five most stable funds in 2002 were on the list again in 2007. The best prospect is Zachary Shafran’s Ivy Science & Tech (WSTAX). It’s more of a “great companies that use tech brilliantly” firm than a pure tech play. Paul Wick’s Columbia Seligman Communication & Information (SLMCX) was almost as good but there’s been a fair turnover in the management team lately. Two Fidelity Select sector funds, IT Services (FBSOX) and the soon-to-be-renamed Software & Computer Services (FSCSX), also repeated despite 17 manager changes between them. Chip, our IT services guru, mumbles “told you so.”

Category Averages

As promised, we’ve added a Category Averages tool on the MFO Premium page. Averages are presented for 144 categories across 10 time frames, including the five full market cycles period dating back to 1968. The display metrics include averages for Total Return, Annualized Percent Return (APR), Maximum Drawdown (MAXDD), MAXDD Recovery Time, Standard Deviation (STDEV, aka volatility), and MFO Risk Group ranking.

Which equity category has delivered the most consistently good return during the past three full market cycles? Consumer Goods. Nominally 10% per year. It’s also done so with considerably less volatility and drawdown than most equity categories.

One of the lower risk established funds in this category is Vanguard Consumer Staples Index ETF VDC. (It is also available in Admiral Shares VCSAX.) Here are its risk and return metrics for various time frames:

The new tool also enables you to examine Number of Funds used to compute the averages, as well as Fund-To-Fund Variation in APR within each category.

Morningstar anoints the “emerging, unknown, and up-and-coming”

In mid-November, Dan Culloton shared the roster of Morningstar Prospects with readers. These are funds that “emerging, unknown and up-and-coming.” They’re listed below, while the link above will take you to the Morningstar video center where a commercial and a video interview will auto-launch.

One measure of the difference between Morningstar’s universe and ours: they can see 23 year old funds as “emerging” and $10 billion ones as “unknown.” We don’t.

Farewell to FundFox

We’re saddened to report the closure of FundFox, the only service devoted exclusively to target federal litigation involving the fund industry. It was started in 2012 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. David drew an exceedingly loyal (think: 100% resubscription rate) readership that never grew enough for the service to become financially self-sustaining. David closed on Friday the 13^th of last month. David’s monthly column has run in the Observer for the past 17 months. We’ll miss him.

David’s going to take a deep breath now, enjoy the holidays and think about his next steps. One possibility would be to work in a fund compliance group; another would be to join his family’s century-old citrus business.

“Two roads diverged in a yellow wood, And sorry I could not travel both.” Diverged indeed.

Cap gains 2015: Not as bad as last year, except for those that are much worse

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.

I’ve been gathering and posting 2015 capital gain distribution estimates for CapGainsValet.com for the last two months. My database currently has distribution estimates for almost 190 fund firms. This represents 90% of the firms I’m hoping to eventually add, which means the 2015 database is nearly complete. (Hurray for me!)

I recently had a look through last year’s database to see how it compares to this year’s numbers. Here’s what I found:

• Fewer funds are distributing more than 10%. Last year I found 517 mutual funds that distributed more than 10% of their NAV. From all indications, 2014 was one of the biggest distribution years on record. For 2015, I’ve found 367 funds that are going to distribute more than 10%. My guess is that we’ll end the year in the 375-380 range.
• More BIG distributions. In 2014, I was able to find 12 funds that distributed more than 30% of their NAV. This year that number has already jumped to 19. Even though the number of 30% distributors has increased, the number of funds that are distributing between 20% and 30% of NAV is about half of what it was last season.
• Several big names in the doghouse. If you take a look at my “In the Doghouse” list, you will find that there are some of the bigger names in the actively managed funds universe. Montag & Caldwell Growth, Columbia Acorn and Fairholme will be distributing billions. Successful funds with large fund outflows are likely going to have trouble controlling future capital gains distributions.
• ETFs are still looking very tax efficient. Although CGV does not track ETF distributions, I am seeing very low capital gain numbers from ETF providers. Market-cap weighted index funds and ETFs continue to be tax efficient.
• More tax swapping opportunities. Last year’s distributions corresponded to a fairly solid year of gains – it is not looking like that will be the case this year. Last year, selling a fund before its large capital gain distribution meant little difference because the fund’s embedded gains were similar or larger. If you bought a fund this year, receiving a large distribution will likely result in a higher tax bill than if you sell the fund before its record date. At Tarbox (my day job) we have already executed a number of tax-swap trades that will save our clients hundreds to thousands of dollars on their 2015 tax return. Have a look through your holdings for these types of opportunities.

Of course, CGV is not the only site providing shortcuts to capital gain distribution estimates. MFO’s discussion board has an excellent list of capital gain distribution estimates with a number of fund firms too small for the CGV database. Check it out and provide some assistance if you can.

Mark Wilson, APA, CFP®
Chief Investment Officer, The Tarbox Group, Inc.
Chief Valet, CapGainsValet

The Alt Perspective: Commentary and news from DailyAlts.

Give Up The Funk

Every once in a while an asset category gets into a funk. Value investing was in a funk leading up to the dotcom bubble, growth stocks were in a funk following the dotcom bubble, etc. You probably know what I mean. Interestingly, active management is in a funk right now – just take a look at the below chart from Morningstar’s most recent U.S. Asset Flows report (includes both mutual funds and ETFs):

Actively managed funds have lost $136 billion in assets over the past year! Are investors taking their dollars out of funds? No. Passive funds have pulled in $457 billion over that same time period. That’s a gap of nearly $600 billion! On a net basis, investors have poured $320 billion of new dollars into mutual funds and ETFs in the past 12 months, nearly $27 billion per month on average. That’s some serious coin.

Is Active Management Dead?

So what is the story, is active management dead? No, active management is not dead, and it never will be. Part of the problem is that most actively managed funds are mutual funds, while most passive funds are ETFs. ETFs have a lower cost structure and a lower barrier to entry. Advantage passive ETFs. This will shift over time with new product development, and the pendulum will swing back, at least part way. Other factors are also at play, and just like other funks, things will change.

But in the meantime, one of the four categories of actively managed funds to garner assets over the past year, and only one of two in October, was that of Alternatives. Why? Because alternative funds offer diversification beyond traditional stock and bond portfolios. They offer investors exposure to more unconstrained forms of investing that can generate lower risk and/or provide improved portfolio diversification due to their low correlation with long-only stocks and bonds.

A recent paper by the Alternative Investment Management Association (AIMA) and the Chartered Alternative Investment Analyst Association (CAIA Association) appropriately breaks hedge funds down into two categories: Substitutes and Diversifiers. This is an important distinction since each grouping has a different role in a portfolio, and can have a different impact on overall results. Substituted replace assets that are already existing in most portfolios, such as stocks and bonds, while diversifiers are investment strategies that have a low to zero correlation with traditional asset classes. If you are considering, or even currently using alternatives, I would encourage you to read the paper.

Liquid Alts Asset Flows

So let’s take a quick look at the asset flows into, or out of, liquid alternatives for October. The picture hasn’t changed much in the past few months. Flows are going into multi-alternative funds, managed futures funds and volatility funds, while assets are flowing out of non-traditional bonds funds and bit out of other categories.

Leading up to 2015, non-traditional bond fund had significant inflows as everyone expected rates to rise. Many of these funds are designed to protect against rising rates. Here we are in late November 2015 and still no rate rise. Mediocre performance and not significant rate rise in sight, and out go investors who need income and returns more than protection.

Quick Wrap

A couple final notes of interest from the news and research categories this past month:

• Putnam published a thoughtful paper on how alternatives perform in different economic environments: Evaluating Alternatives In Four Growth and Inflation Scenarios.
• John Dolfin and Chris Maxey of Steben & Company review the Importance of Manager Selection as it relates to alternative investments.
• A new liquid form of venture capital investing is available to retail investors via a mutual fund as outlined in New Mutual Fund Aims to Democratize Access to Venture Capital.
• DailyAlts has a new column called Best and Worst where we publish a series of stories each month highlighting the best and worst performing funds in each main category of liquid alternatives.

Be sure to check out DailyAlts.com for more updates on the liquid alternatives market, and feel free to sign up for our free daily or weekly newsletter.

Observer Fund Profiles: Fidelity Total Emerging Markets

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. 

Fidelity Total Emerging Markets (FTEMX): we’ve long argued that EM investors need to find a strategy for managing volatility and that a balanced fund is the best strategy they’ve got. There’s a good argument that John Carlson’s fund is the best option for pursuing that best strategy.

Elevator Talk: Bryn Torkelson, Matisse Discounted Closed-End Fund Strategy (MDCAX/MDCEX)

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

Bryn Torkelson

Bryn Torkelson manages MDCAX, which launched at the end of October 2012. He also co-founded and owns the advisor (launched in 2010) and the sub-adviser, Deschutes Portfolio Strategies (launched in 1997). Bryn started in the investment industry in 1981 as a broker with Smith Barney and later worked with Dain Bosworth. He has a B.S. in Finance from the University of Oregon, which is helpful since some of the research underlying the strategy was conducted at the university’s Lundquist College of Business. He manages one hedge fund, Matisse Absolute Return Fund, a 5 star rated fund by Morningstar, and about 700 separate accounts, mostly for high net-worth individuals. In all, the firm manages about $900 million.

He’s headquartered in Lake Oswego, Oregon, a curiously hot spot for investment firms. It’s also home for the advisers of the Jensen and Auxier funds.

The story here’s pretty simple. Taken as a group, closed-end fund (CEF) portfolios return about what the overall market does. So if you simply invested in all the existing CEFs, you’d own an expensive index fund. CEFs, much more than other investment vehicles, are owned mostly by individual investors. Those folks are given to panic and regularly offer to sell $100 in stocks for $80; on a really bad day, they’ll trade $100 in stocks for $60 in cash. That’s irrational. Buyers move in, snap up assets at lunatic discounts and the discounts largely evaporate.

Here’s the Matisse plan: research and construct a portfolio from the 20% most discounted funds in the overall universe of income-producing CEFs, wait for the discounts to evaporate, then rebalance typically monthly to restock the portfolio with the most-discounted quintile. Research from the Securities Analysis Center at Oregon, looking back as far as they could get monthly price and discount data (1988), suggests that strategy produced 20% a year with a beta of .75. In their separate accounts which started in 2006, the strategy has produced approximately 9% net annually mostly from income and 2-3% capital gains from the contraction of the CEF discounts. Those gains are useful because they’re market neutral; that is, the discounts tend to contract over time whether the overall market is rising or falling.

Sadly, in the three years since launch, the mutual fund has returned just 3.3% a year (through late November 2015) which is better than the average tactical allocation fund but far lower than a generic balanced fund. Mr. Torkelson argues that CEF discounts reached, and have stayed at near-record levels this year which accounts for the modest gains. The folks at RiverNorth, who use a different CEF arbitrage strategy in RiverNorth Core Opportunities (RNCOX), agree with that observation. Despite “tough sledding,” Mr. T. believes the CEF market likely bottomed-out in October, which leaves him “very optimistic going forward.” He notes that, since 1988, discounts have only been wider 3% of the time – during a few months in 2008-2009, the tech bubble in 2000 and during the recession of 1990. Today his portfolios have an average discount of 17.5% and a distribution yield of 8.2%.

Here are Mr. Torkelson’s 281 words on why you should add MDCAX to your due-diligence list:

I started our fund/strategy to help investors gain access to higher income opportunities than available in ETF’s or open ended mutual funds. Today the funds distribution income is approximately 8.2%. The misunderstood market of “closed end mutual funds” (CEF’s) presents investors opportunities to buy quality income funds at 15-20% discounts to published market values. When we buy discounts our clients’ portfolios will generates substantially higher income than similar ETF’s or open ended mutual funds.

The entire CEF universe is approximately 500+ funds representing $230 billion in assets. Most of these funds are designed to pay income, often distributed monthly or quarterly. The source of the income varies on each funds objective. However, income is generated from taxable or municipal bonds, preferred stock, convertible bonds, bank loans, MLP’s, REIT’s, return of capital (ROC) or even income from “covered call writing” strategies on the portfolio.

The exciting aspect of the strategy is these CEFs trade on stock exchanges and they often trade at market values well below their published daily Net Asset Values (NAV). Our studies indicate there is a high probability for the discounts to be “mean reverting”. When this happens our clients receive both capital gains in addition to income. For example, firms like Blackrock or PIMCO manage both open ended mutual funds and closed end funds often with the same manager and or objectives. If you purchase the highly discounted vehicle of CEF’s instead of the opened ended equivalent vehicle, you’ll typically get much better returns. The other great part of our strategy is our investors get a highly diversified portfolio without any concentration worries. On a look-through basis our investors get a highly discounted income oriented global balanced portfolio.

Matisse Discounted Closed-End Fund Strategy has a $1000 minimum initial investment on its “A” shares, which bear a sales load, and $25,000 on its Institutional shares, which do not. Matisse has limited the funds expense ratio to 1.25% on the “I” shares. The pass-through costs of CEF funds in which they invest are included and a central and unavoidable contributor to the overall fees. Those pass-throughs accounted for 1.37% last year. With those fees included the expenses on the “I” shares run a stiff 2.62% while the “A” shares are 25 basis points higher. The fund has gathered about $120 million in assets since its October 2012 launch. They have $200 million the overall strategy. It just earned its initial Morningstar rating of three stars within the “tactical allocation” universe for the “I” shares and two stars for the “A” shares for investors who pay the full load.

You’ve got a sort of embarrassment of riches as far as web contacts go. In addition to the sub-adviser’s site, there are separate sites for the Matisse strategy and for the Matisse mutual fund. The former is a bit more informative about what they’re up to; the latter is better for details on the fund. Bryn’s strategy predates his mutual fund. The first six slides on this presentation gives a view of the strategy’s longer-term performance.

Launch Alert: DoubleLine Global Bond Funds

For those who can’t get enough of bondfant terrible Jeffrey Gundlach, DoubleLine Global Bond Fund (DLGBX) is arriving just in time. The fund launched on November 30, 2015 with Mr. Gundlach at the helm. This will be the 17^th fund on Mr. Gundlach’s daily to-do list which also includes nine funds on which DoubleLine is a sub-adviser and seven in-house ones. On whole he’s responsible for 50 accounts and about $70 billion in assets.

The fund’s investment objective is to seek long-term total return. The plan is to invest, mostly, in investment-grade debt issued, mostly, by G-20 countries. Once we’re past the “mostly,” things open up to include high-yield debt, swaptions, shorting, currency hedges, bank loans, corporate bonds and other creatures. They expect an average duration of 1-10 years.

In case you’re wondering if there are any particular risks to be aware of, DoubleLine offers this list:

The minimum initial investment for the retail shares is $2000 and the opening expense ratio is 0.96%.

Folks on our discussion board would urge you to consider T. Rowe Price Global Multi-Sector Bond (PRSNX) and PIMCO Total Return Active ETF (BOND) as worthy, tested, less-expensive alternatives.

Funds in Registration

We’ve reached the slow time of the year. Funds in registration now won’t be able to claim full-year returns for 2016, so there tends to be a lull in new fund releases. This month we found just five retail, no-load funds in SEC registration. Two are hedge funds undergoing conversion (LDR Preferred Income and Livian Equity Opportunity), two are edgy internationals (Frontier Silk Invest New Horizons and Harbor International Small Cap, managed by Barings) and one an ESG-oriented blue chip fund, TCW New America Premier Equities. All are them are here. 

Manager Changes

Chip tracked down 69 full or partial management changes this month, substantial but not a record. The retirement of Jason Cross, one of the founding managers and lead on their long/short trading strategy, from the Whitebox Funds is pretty consequential. Clifton Hoover is stepping away from Dreman Contrarian SCV (DRSAX) to become Dreman’s CIO. Otherwise, it’s mostly not front-page news.

Rekenthaler: “Great” funds aren’t worth the price of admission

John Rekenthaler, a guy who regularly thinks interesting thoughts, collaborated with colleague Jeff Ptak to test the truism that the best long-term strategy is to invest in “singles hitters.” That is, to invest in funds that are consistently a bit above average rather than alternately brilliant and disastrous. By at least one measure, that’s an … um, untruism. Rekenthaler and Ptak concluded that the funds with the best long-term records are ones that frequently land in their peer group’s top tier. They were home run hitters; singles hitters fell well behind.

Sadly, they also concluded that such funds (think Fairholme FAIRX or CGM Focus CGMFX) are often impossible to own. Mr. Ptak writes:

Great funds probably aren’t good. Rather, they’re intermittently amazing and horrendous. Streaky. Hard to stick with. Demanding. That would seem to match findings that the long-term standouts have often plumbed their category’s depths, owning securities that others neglect. Bad stuff routinely happens to great funds. Being merely good isn’t enough. You have to be bad … awful at times … and stick with it … and then maybe you’ll be great.

It’s an interesting, though incomplete, argument. We should think about it.

Updates: Gross, Black, Sequoia

In July 2014, after listening to Bill Gross’s disjointed maundering as a Morningstar keynote speaker, we suggested that he’d lost his marbles and that it was time either for him to go or for you to. In September 2014 he stomped off. In October 2015 he decided to sue PIMCO for succumbing to “a lust for power” in their efforts to oust him. A quarter billion or so would make him feel better. Now PIMCO has filed a motion to dismiss the suit, claiming that

The complaint, parts of which read more like a screenplay than a court pleading, uses irrelevant and false personal attacks on Mr. Gross’s former colleagues in an apparent effort to distract attention from the fundamental failings of these ‘contract’ claims.

They’ve urged him to get on with his life. Stay tuned, since I don’t see that happening. 

We reported in October, in an admirably dispassionate voice, on the sudden departure of Gary Black from Calamos Investments. In September, Calamos noted that Mr. Black was gone from the firm “effective immediately.” The company positioned it as “an evolution of the management.” He left after three years, a Calamos rep explained, because he “completed the work he was hired to do.” They had no idea of what he was going to be doing next.

Randy Diamond, writing for Pensions & Investments (11/30/2015) hints at a rather more colorful tale in his essay “Calamos continues fighting after another change at the top.”

Mr. Black lasted a little more than three years at Calamos. He joined the firm in August 2012 to replace Mr. Calamos’ nephew, Nick Calamos. Although a news release at the time said Nick Calamos “decided to step back from the day-to-day business of the firm to pursue personal interests,” sources interviewed said he left after frequent clashes with his uncle over how to fix poor investment performance in the firm’s strategies.

Sources said one reason Mr. Black left involved the team from his New York-based long-short investment business, which he sold to Calamos Investments when he joined the firm. Sources said five of the team’s seven investment professionals left this year in a dispute with John Calamos over compensation.

After the dissolution of Mr. Black’s long-short unit, the firm acquired a new long-short team, Phineus Partners LP of San Francisco.

In November 2015, we argued that the Sequoia Fund “seems in the midst of the worst screw-up in its history.” The fund, against the warnings of its board, sunk a third of its portfolio in Valeant Pharmaceuticals (VRX). The managers’ defense of Valeant’s business practices sound a lot like they were written by Valeant or by folks pressured into being cheerleaders. James Stewart, writing in the New York Times, did a really nice follow-up piece, “Huge Valeant Stake Exposes Rift at Sequoia Fund” (11/12/2015). In addition to dripping acid on Sequoia’s desperate argument that betting the farm on Valeant CEO Michael Pearson was no different than when they bet the farm on Berkshire-Hathaway CEO Warren Buffett, Stewart also managed to get some information on the arguments made by the two board members who resigned. It’s very much worth reading.

The fund lost another 1.26% in November, which places it in the bottom 1% of its peer group. Valeant dropped 22% in the same period which suggests its impact on the portfolio is dwindling. Over the past three years, it trails 98% of its peers. (Leigh Walzer might say this qualifies as “a stumble.”)

After talking with Sequoia management (“they were very cooperative”) but not with the trustees who resigned in protest, Morningstar reaffirmed Sequoia’s Gold rating.

Several of us have taken the position that we’re likely in the early stages of a bear market. The Wall Street Journal (12/01/2015) reports two troubling bits of economic data that might feed that concern: US corporate capital expenditures (capex) continue dropping and emerging market corporate debt defaults continue rising. For the first time in recent years, e.m. default rates exceed U.S. rates.

Briefly Noted . . .

One of the odder SEC filings this month: “Effective November 30, 2015, the Adaptive Allocation Fund (AAXAX) will no longer operate a website, and any references within the Prospectus and SAI to www.unusualfund.com are hereby deleted.” No idea.

BofA Global Capital Management is selling their cash asset management business to BlackRock, sometime in the first half of 2016.

Templeton Foreign Smaller Companies Fund (FINEX), Templeton Global Balanced Fund (TAGBX) and Templeton Global Opportunities Trust (TEGOX) have each added the ability to “sell (write) exchange traded and over-the-counter equity put and call options on individual securities held in its portfolio in an amount up to 10% of its net assets to generate additional income for the Fund.”

SMALL WINS FOR INVESTORS

The Fairholme Allocation Fund (FAAFX) reopened to new investors on November 18. The fund has had one great year (2013) since inception and has trailed 97% over the past three years. Assets have dropped from $379 million at the end of November 2014 to $298 million a year later.

JPMorgan Small Cap Equity Fund (VSEAX) reopened to new investors on November 16, 2015. It’s an exceptionally solid fund with a large asset base; I assume the reopening came because inflows stabilized rather than in response to outflows.

Effective January 1, 2016, Royce is dropping the management fee on Royce European Small-Cap Fund (RISCX), Global Value Fund (RIVFX), International Small-Cap Fund (RYGSX), and International Premier Fund (RYIPX) by 25 bps.

Effective November 17, 2015, the management fees of Schwab U.S. Broad Market, U.S. Large-Cap, U.S. Large-Cap Growth, and U.S. Large-Cap Value ETFs have been reduced by one basis point each. The resulting expense ratios range from 3-6 bps.

CLOSINGS (and related inconveniences)

Effective January 29, 2016, the AQR Style Premia Alternative Fund (QSPNX) and AQR Style Premia Alternative LV Fund (QSLNX) will be closed to new investors. They’re two year old institutional funds. Both have posted exceedingly strong returns with the Alternative Fund drawing $1.6 billion and Alternative LV accumulating $170 million in assets.

Effective December 31, 2015, the Diamond Hill Small Cap Fund (DHSCX) will close to most new investors. Told you so.

On December 31, 2015, the Undiscovered Managers Behavioral Value Fund (UBVAX) will institute a soft close. Shhh! Don’t tell anyone but the undiscovered managers are Russell Fuller and David Potter! And don’t tell David, but Russell is running an even-more undiscovered fund without him: Fuller & Thaler Behavioral Core Equity (FTHAX). The former is a large small cap fund, the latter is small large cap one.

OLD WINE, NEW BOTTLES

Effective October 31, 2015, Aberdeen U.S. Equity Fund became Aberdeen U.S. Multi-Cap Equity Fund.

Effective on or about January 4, 2016, Clearbridge Mid Cap Core will be renamed ClearBridge Mid Cap Fund.

Effective January 1, 2016, Fidelity Medical Delivery Portfolio will be renamed Health Care Services Portfolio and Fidelity Software and Computer Services Portfolio will be renamed Software and IT Services Portfolio.

Effective January 25, 2016, Merk Asian Currency Fund (MEAFX) becomes Merk Chinese Yuan Currency and Income Fund. The fund already reports having 98% of its portfolio in the Chinese currency (and 20.2% in Hong Kong?), so it’s largely symbolic.

On February 24, 2016, the word “Retirement” will be removed from the names of all of the T. Rowe Price Target Retirement Funds (Funds).

OFF TO THE DUSTBIN OF HISTORY

AlphaCentric Smart Money Fund (SMRTX) smartly lost 19% in 15 months of existence, which might explain why its board decided that it’s in “the best interests of the Fund and its shareholders that the Fund cease operations.” Those interests will be expressed in the fund’s liquidation, just before Christmas.

On October 27, Andrew Kerai stepped aside as manager of BDC Income Fund (ABCDX) less than a year after the fund’s launch. Six days later, the fund’s board of trustees voters to close and liquidate it. It disappeared on November 30, 2015, still short of its one-year mark.

Carne Hedged Equity Fund (CRNEX) is liquidating on December 7, 2015. The board forthrightly attributed the closure to “recent Fund performance, the inability of the Fund to garner additional assets, the relatively small asset size of the Fund, recent significant shareholder redemptions, and other factors.” The fund buys mostly household names (Gilead, PayPal, Apple, Michael Kors, IBM) and was doing well until early 2014. Since then it’s dropped 24% in a steadily rising market. Neither the fund’s shareholders nor I know what happened. The 2014 annual report contains one cryptic passage from the manager, “I looked to optimize the hedging without diverting from the core portfolio. This strategy was a poor choice.” The subsequent semi-annual report contains no text and the website offers neither commentary nor shareholder letters.

Catalyst Activist Investor Fund (AIXAX) will liquidate on December 21, 2015. The fund looked to invest in companies where the public filings, typically Form 13D, showed activity by activist investors. The idea is to follow the smart money in, and out. The strategy lost about 25% since its summer 2014 launch. If you’re intrigued by the strategy, there’s still the 13D Activist Fund (DDDAX) which has also lost money on that period but a lot less money.

CRM Global Opportunity Fund (CRMWX) has closed in advance of a December 16, 2015 liquidation.

Curian/PIMCO Income Fund has closed and will cease operations on the as-yet unannounced cessation date.

Dreyfus International Value Fund (DVLAX) merges into Dreyfus International Equity Fund (DIEAX) on January 22, 2016. DIEAX isn’t particularly good but it does have better performance and significantly lower expenses than the liquidating fund.

On December 23, 2015, Forward Tactical Enhanced Fund (FTEEX) becomes the latest attraction at Forward’s LiquidationFest. It takes a 9,956% turnover ratio with it.

Speaking of firm-wide festivities, Franklin is unleashing a bundle of liquidations. For the sake of space, I’ve stuck them in a table.

Here’s a filing written by a former philosophy major: “On November 12, 2015, Gateway International Fund was liquidated. The Fund no longer exists, and as a result, shares of the Fund are no longer available for purchase or exchange.”

JPMorgan Global Natural Resources Fund (JGNAX) will liquidate on or about December 16, 2015. Over five years, the fund turned a $10,000 initial investment into a $3,500 portfolio.

In January 2016, shareholders will vote on a proposed merger of Keeley Mid Cap Value Fund (KMCVX) into the Keeley Mid Cap Dividend Value Fund (KMDVX). They should approve.

MAI Energy Infrastructure and MLP Fund (VMLPX) will liquidate on December 23, 2015.

MFS Global Leaders Fund was terminated as of November 18, 2015.

RBC Prime Money Market Fund is closing on September 30, 2016 and liquidating shortly thereafter. The combination of zero interest and new liquidity regs are making such filings a lot more common.

SMH Representation Trust (SMHRX) liquidates on December 21, 2015. There’s been a bit of a performance slump of late.

I wonder if Morningstar ever looks at these things and thinks “perhaps labeling this chart as growth of $10,000 is a misnomer”?

Sometime in the first quarter of 2016, Templeton BRIC Fund (TABRX) will merge into Templeton Developing Markets Trust (TEDMX).

Thomas Crown Global Long/Short Equity Fund (TCLSX) liquidated on November 13, 2015 following the painful realization that “there are no meaningful prospects for growth in assets.”

Visium Event Driven Fund became driverless on November 27, 2015.

In Closing . . .

We’d like to thank all those who have contributed to MFO. That certainly includes the folks who contributed for premium access, but we’re equally grateful to the folks who made other levels of contribution. To Mitchell, Frank, John, Edward, and Charles, you’re golden!. Thank you, too, to all those who loyally use our Amazon link. It was a good month.

We wish you all a joyous holiday season. We know your families are crazy; hug them all the tighter for it. In the end they matter more than all the trinkets and all the bling and all the toys and all the square footage you’ll ever buy.

We’ll look for you in the New Year.

Dear friends,

As you read this, I’ll be wading through a drift of candy wrappers, wondering if my son’s room is still under there somewhere. Weeks ago my local retailers got into the Halloween spirit by setting up their Christmas displays and now I live in terror of the first notes of that first Christmas carol inflicted over storewide and mall-wide sound systems.

But between the two, I pause for thanksgiving and Thanksgiving. I’m thankful for all the things I don’t have: they’re mostly delusion and clutter. I’m thankful for the stores not open on Black Friday (REI most recently) just as I’m thankful for the ones not open on Sundays (Fareway grocery stores, locally); we’ve got to get past the panic and resentment that arises if there’s a whole day without shopping. I’m grateful for those who conspire to keep me young, if only through their contagious craziness. I’m grateful for gravy, for the sweet warmth of a friend hugged close, for my son’s stunning ability to sing and for all the time my phone is turned off.

And I’m grateful, most continually, for the chance to serve you. It’s a rare honor.

Had I mentioned apple pie with remarkably thick and flaky crust? If not, that’s way up on the list too.

There’s a break in the rain. Get up on the roof!

… a bear market is not the base case for most of Wall Street. Adam Shell, 9/29/15

Duh. Cheerleaders lead cheers.

Good news: the sun is out. The Total Stock Market Index (VTSMX) soared 7.84% in October, offsetting a 7.29% decline in the third quarter. It’s now above water for the year, through Halloween, with a return of 1.8%. Optimists note that we’re now in the best six months of the year for stocks, and they anticipate healthy gains.

Bad news: none of the problems underlying the third quarter decline have changed.

We have no idea of whether the market will soar, stagger or crash over the next six months. Any of those outcomes are possible, none are predictable. Morningstar’s John Rekenthaler argues that the market isn’t priced for an imminent crash (“Are US stocks overripe?” 10/30/2015). BlackRock’s chief strategist agrees. The Leuthold Group says it’s “a bear until proven otherwise” but does allow for the prospect of a nice, tradable bounce (10/7/2015).

A lot of fairly serious adults are making the same argument: crash or not, the U.S. stock market is priced for futility.

GMO estimates (as of 10/14/2015) US real returns close to zero over the next 5-7 years. They estimate that high quality stocks might make 1% a year, small caps will be flat and large caps in general will lose nearly 1% a year. Those estimates assume simple reversions to long-term average profit margins and stock prices, both of which have been goofed by the Fed’s ongoing zero rate policy.

Jack Bogle (10/14/2015, warning: another auto-launch video) likewise thinks you’ll make about zero. His calculation is a rougher version of GMO’s. Investment gains are dividends plus earnings growth. An optimist would say 2% and 6%, respectively. Bogle thinks the 6% is too optimistic and pencils-in 5%. You then inflate or deflate the investment returns by changes in valuations. He notes that a P/E of 15 is about normal, so if you buy when the P/E is below 15 you get a boost. If you buy when the P/E is above 15, you get a penalty. By his calculations, the market P/E is about 20.

So you start with a 7% investment return (2% + 5%) and begin making deductions:

• P/E contraction would cost 3% then
• inflation might easily cost 2%, and of course
• fund fees and expenses cost 1%, after which
• stupid investor behavior eats 1.5%.

That leaves you with a “real” return of about zero (which at least cuts into your tax bill).

Henry Blodget was the poster child for the abuses of the financial markets in the 1990s. He went on to launch Business Insider, which became the web most popular business news site. It (well, 88% of it) was just sold to the German publisher Axel Springer for $340 million.

Blodget published an essay (10/4/2015) which concluded that we should anticipate “weak” or “crappy” returns for the next decade. The argument is simple and familiar to folks here: stocks are “fantastically expensive relative to most of recorded history.” Vigorous government intervention prevented the phenomenal collapse that would have returned market valuations to typical bear market lows, building the base for a decades-long bull. Zero interest rates and financial engineering conspired to keep stocks from becoming appropriately loathed (though it is clear that many institutional investors are, for better or worse, making structural changes in their endowment portfolios which brings their direct equity exposure down into the single digits).

Adding fuel to the fire, Rob Arnott’s group – Research Affiliates – has entered the debate. They are, mildly put, not optimistic about US stocks. Like Leuthold and unlike Blodget, they’re actually charged with finding way to invest billions ($174 billion, in RA’s case) profitably.

Key points from their latest essay:

1. “High stock prices, just like high house prices, are harbingers of low returns.
2. Investing in price-depressed residential rental property in Atlanta is like investing in EM equities today-the future expected long-term yield is much superior to their respective high-priced alternatives.
3. Many parallels exist between the political/economic environment and the relative valuation of U.S. and EM equities in the periods from 1994 to 2002 and 2008 to 2015.
4. Our forecast of the 10-year real return for U.S. equities is 1% compared to that of EM equities at 8%, now valued at less than half the U.S. C A P E.”

Bottom line: Leuthold – bear’s at the door. GMO – pretty much zero, real, with the prospect of real ugliness after the US election. Bogle – maybe 2% real. Blodget – “crap.” Research Affiliates – 1%.

For most of us, that’s the hole in the roof.  

Recommendation One: fix it now, while the sun’s out and you’re feeling good about life. Start by looking at your Q3 losses and asking, “so, if I lost twice that much in the next year and didn’t get it back until the middle of President Trump’s second term, how much would that affect my life plans?” If you lost 3%, imagine an additional 6% and shrug, then fine. If you lost 17%, deduct another 34% from your portfolio and feel ill, get up on the roof now!  In general, simplify both your life and your portfolio, cut expenses when you can, spend a bit less, save a bit more. As you look at your portfolio, ask yourself the simple questions: what was I thinking? Why do I need that there? Glance at the glidepaths for T. Rowe Price’s retirement date funds to see how really careful folks think you should be invested. If your allocation differs a lot from theirs, you need to know why. If you don’t know your allocation or don’t have one, now would be the time to learn.

Recommendation Two: reconsider the emerging markets. Emerging markets have been slammed by huge capital outflows as investors panic over the prospect that China is broken. Over a trillion dollars in capital has fled in fear. The “in fear” part is useful to you since it likely signals an overshoot. The International Monetary Fund believes that the fears of Chinese collapse are overblown. Josh Brown, writing as The Reformed Broker, raises the prospect of that emerging markets may well have bottomed. No one doubts that another market panic in the U.S. will drive the emerging markets down again.

That having been said, there’s also evidence that the emerging markets may hold the only assets offering decent returns over the remainder of the decade. GMO estimates that EM stocks (4.6% real/year) and bonds (2.8% real/year) will be the two highest-returning asset classes over the next five-to-seven years. Research Affiliates is more optimistic, suggesting that EM stocks are priced to return 7.9% a year with high volatility, about 1.1% in the US and 5.3% in the other developed markets. Leuthold finds their valuations very tempting. Bill Bernstein (auto-launch video, sorry), an endlessly remarkable soul, allows “They are cheap; they are not good and cheap …  It’s important for small investors to realize that you can’t buy low unless you are willing to deal with bad news.”

Look for ways of decoupling from the herd, since the EM herd is a particularly volatile bunch. That means staying away from funds that focus on the largest, most liquid EM stocks since those are often commodity producers and exporters whose fate is controlled by China’s. That may point toward smaller companies, smaller markets and a domestic orientation. It certainly points toward experienced managers. We commend Driehaus Emerging Markets Small Cap Growth (DRESX), Seafarer Overseas Growth & Income (SFGIX and Matthews Asia Strategic Income (MAINX) to you.

A second approach is to consider a multi-asset or balanced fund targeting the emerging markets. We know of just a handful of such funds:

• AB Emerging Markets Multi-Asset Portfolio (ABAEX), AllianceBernstein.
• Capital Emerging Markets Total Opportunities Fund (ETOPX) – a boutique manager affiliated with the American Funds. Capital Guardian Trust Company
• Dreyfus Total Emerging Markets (DTMAX)
• Fidelity Total Emerging Markets (FTEMX)
• Lazard Emerging Markets Multi-Asset (EMMIX)
• PIMCO Emerging Multi Asset (PEAWX) The fund was liquidated on 14 July 2015.
• TCW Emerging Markets Multi-Asset Opportunities (TGMEX)
• First Trust Aberdeen Emerging Opportunities (FEO), a closed-end fund.

Of the options available, Fidelity makes a surprisingly strong showing. We’ll look into it further for you.

Sequoia: “Has anybody seen our wheels? They seem to have fallen off.”

The most famous active fund seems in the midst of the worst screw-up in its history. The fund invested over 30% of its portfolio in a single stock, Valeant Pharmaceuticals (VRX). Valeant made money by buying other pharmaceutical firms, slashing their overhead and jacking up the prices of the drugs they produced. The day after buying to rights to heart medications Nitropress or Isuprel, Valeant increased their prices by six-fold and three-fold, respectively. Hedge funds, and Sequoia, loved it! Everyone else – including two contenders for the Democratic presidential nomination – despised it.

Against the charge that Valeant’s actions are unethical (they put people’s lives at risk in order to reap a windfall profit that they didn’t earn), Sequoia obliquely promises, “When ethical concerns arise, management tends to address them forthrightly, but in the moment.” I have no idea of what “but in the moment” means.

Then, in October, after months of bleeding value, Valeant’s stock did this:

That collapse, which cost Sequoia shareholders about 6% in a single day, was pursuant to a research report suggesting that Valeant was faking sales through a “phantom pharmacy” it owned. Separately, Federal prosecutors subpoenaed documents related to Valeant’s drug pricing.

Three things stand out:

There’s a serious question about whether Sequoia management drank the Kool-Aid. One intriguing signal that they weren’t maintaining an appropriate distance from Valeant is a tendency, noted by Lewis Braham in a post to our discussion board, for the Sequoia managers to call Valeant CEO Michael D. Pearson, “Mike.” From a call transcript he pointed to:

Mike does not like to issue equity.

… not that Mike would shy away from taking a price increase.

… early on in Mike’s reign …

I think Mike said the company was going to …

We met with Mike a few weeks ago and he was telling us how with $300 million, you can get an awful lot done.

Mike can get a lot done with very little.

Mike is making a big bet.

On whole, he was “Mike” about three times more often than “Mike Pearson.” He was never “Mr. Pearson” or “the CEO.” There was no other CEO given comparable acknowledgement; in the case of their other investments, it was “Google” or “MasterCard.”

Sequoia’s research sounds a lot like Valeant’s press releases. The most serious accusation against Valeant, Sequoia insists in its opening paragraph, “is false.” That confidence rests on a single judgment: that changes in sales and changes in inventory parallel each other, so there can’t be anything amiss. Ummm … Google “manipulate inventory reporting.” The number of tricks that the accountants report is pretty substantial. The federal criminal investigation of Valeant doesn’t get mentioned. There is no evidence that Sequoia heightened its vigilance as Valeant slowly lost two-thirds of its value. Instead, they merely assert that it’s a screaming buy “at seven times the consensus estimate of 2016 cash earnings.”

Two of their independent directors resigned shortly thereafter. Rather than announcing that fact, Sequoia filed a new Statement of Additional information that simply lists three independent trustees rather than five. According to press reports, Sequoia is not interested in explaining the sudden and simultaneous departure. One director refused to discuss it with reporters; the other simply would not answer calls or letters.

Sequoia vigorously defends both Valeant’s management (“honest and extremely driven”) and its numbers. A New York Times analysis by Gretchen Morgenson is caustic about the firm’s insistence on highlighting “adjusted earnings” which distort the picture of the firm’s health. They are, Morgenson argues, “fantasy numbers.”

Sequoia’s recent shareholder letter concludes by advising Valeant to start managing with “an eye on the company’s long-term corporate reputation.” It’s advice that we’d urge upon Sequoia’s managers as well.

The Price of Everything and the Value of Nothing

By Edward Studzinski

“The pure and simple truth is rarely pure and never simple.”

                             Oscar Wilde

There are a number of things that I was thinking about writing, but given what has transpired recently at Sequoia Fund as a result of its investment in and concentration in Valeant Pharmaceuticals, I should offer some comments and thoughts to complement David’s. Mine are from the perspective of an investor (I have owned shares in Sequoia for more than thirty years), and also as a former competitor.

Sequoia Fund was started back in 1970. It came into its own when Warren Buffett, upon winding up his first investment partnership, was asked by a number of his investors, what they should do with their money since he was leaving the business for the time being. Buffett advised them to invest with the Sequoia Fund. The other part of this story of course is that Buffett had asked his friend Bill Ruane to start the Sequoia Fund so that there would be a place he could refer his investors to and have confidence in how they would be treated.

Bill Ruane was a successful value investor in his own right. He believed in concentrated portfolios, generally fewer than twenty stock positions. He also believed that you should watch those stock investments very carefully, so that the amount of due diligence and research that went into making an investment decision and then monitoring it, was considerable. The usual course of business was for Ruane, Dick Cunniff and almost the entire team of analysts to descend upon a company for a full day or more of meetings with management. And these were not the kind of meetings you find being conducted today, as a result of regulation FD, with company managements giving canned presentations and canned answers. These, according to my friend Tom Russo who started his career at Ruane, were truly get down into the weeds efforts, in terms of unit costs of raw materials, costs of manufacturing, and other variables, that could tell them the quality of a business. In terms of something like a cigarette, they understood what all the components and production costs were, and knew what that individual cigarette or pack of cigarettes, meant to a Philip Morris. And they went into plants to understand the manufacturing process where appropriate.

Fast forward to the year 2000, and yes, there is a succession plan in place at Ruane, with Bob Goldfarb and Carly Cunniff (daughter of Dick, but again, a formidable talent in her own right who would have been a super investor talent if her name had been Smith) in place as President and Executive Vice President of the firm respectively. The two of them represented a nice intellectual and personality balance, complementing or mellowing each other where appropriate, and at an equal level regardless of title.

Unfortunately, fate intervened as Ms. Cunniff was diagnosed with cancer in 2001, and passed away far too early in life, in 2005. Fate also intervened again that year, and Bill Ruane also passed away in 2005.

At that point, it became Bob Goldfarb’s firm effectively, and certainly Bob Goldfarb’s fund. At the end of 2000, according to the 12/31/2000 annual report, Sequoia had 11 individual stock positions, with Berkshire representing 35.6% and Progressive Insurance representing 6.4%. At the end of 2004, according to the 12/31/2004 annual report, Sequoia had 21 individual stock positions, with Berkshire representing 35.3% and Progressive Insurance representing 12.6% (notice a theme here). By the end of 2008, according to the 12/31/2008, Berkshire represented 22.8% of the fund, Progressive was gone totally from the portfolio, and there were 26 individual stock positions in the fund. By the end of 2014, according to the 12/31/2014 report, Sequoia had 41 individual stock positions, with Berkshire representing 12.9% and healthcare representing 21.4%.

So, clearly at this point, it is a different fund than it used to be, in terms of concentration as well as the types of businesses that it would invest in. In 2000 for instance, there was no healthcare and in 2004 it was de minimis. Which begs the question, has the number of high quality businesses expanded in recent years? The answer is probably not. Has the number of outstanding managements increased in recent years, in terms of the intelligence and integrity of those management teams? Again, that would not seem to be the case. What we can say however, is that this is a Goldfarb portfolio, or more aptly, a Goldfarb/Poppe portfolio, distinct from that of the founders.

An interesting question is, given the fund’s present composition, would Buffett, if asked today for a recommendation as to where his investors should go down the road, still suggest Sequoia? My suspicion is he would not with how the fund is presently managed and, given his public comments advocating that his wife’s money after his demise should go to an S&P 500 index fund.

A fairer question is – why have I held on to my investment at Sequoia? Well, first of all, Bob Goldfarb is 70 and one would think by this point in time he has proved whatever it was that he felt he needed to prove (and perhaps a number of things he didn’t). But secondly, there is another great investor at Ruane, and that is Greg Alexander. Those who attend the Sequoia annual meetings see Greg, because he is regularly introduced, even though he is a separate profit center at Ruane and he and his team have nothing to do with Sequoia Fund. However, Bruce Greenwald of Columbia, in a Value Walk interview in June of 2010 said Buffett had indicated there were three people he would like to have manage his money after he died (this was before the index fund comment). One of them was Seth Klarman at Baupost. Li Lu who manages Charlie Munger’s money was a second, and Greg Alexander at Ruane was the third. Greg has been at Ruane since 1985 and his partnerships have been unique. In fact, Roger Lowenstein, a Sequoia director, is quoted as saying that he knows Greg and thinks Warren is right, but that was all he would say. So my hope is that the management of Ruane as well as the outside directors remaining at Sequoia, wake up and refocus the fund to return to its historic roots.

Why is the truth never pure and simple in and of itself. We have said that you need to watch the changes taking place at firms like Third Avenue and FPA. I must emphasize that one can never truly appreciate the dynamics inside an active management firm. Has a co-manager been named to serve as a Sancho Panza or alternatively to truly manage the portfolio while the lead manager is out of the picture for non-disclosed reasons? The index investor doesn’t have to worry about these things. He or she also doesn’t have to worry about whether an investment is being made or sold to prove a point. Is it being made because it is truly a top ten investment opportunity? But the real question you need to think about is, “Can an active manager be fired, and if so, by whom?” The index investor need not worry about such things, only whether he or she is investing in the right index. But the active investor – and that is why I will discuss this subject at length down the road.

Dancing amidst the elephants: Active large core funds that earn their keep

By Leigh Walzer

Last month in these pages we reviewed actively managed utility funds. Sadly, we could not recommend any of those funds. Either they charged too much and looked too much like the cheaper index funds or they strayed far afield and failed to distinguish themselves.

We are not here to bury the actively managed fund industry. Trapezoid’s goal is to help investors and allocators identify portfolio managers who have predictable skill and evaluate whether the fees are reasonable. Fees are reasonable if investors can expect with 60% confidence a better return with an active fund than a comparable passive fund. (Without getting too technical, the comparable fund is a time-weighted replication portfolio which tries to match the investment characteristics at a low cost.)

To demonstrate how this works, we review this month our largest fund category, large blend funds. (We sometimes categorize differently than Morningstar and Lipper. We categorize for investors’ convenience but our underlying ratings process does not rely on performance relative to a peer group.)

We found 324 unique actively-managed large blend funds where the lead manager was on the job at least 3 years.

We recently posted to the www.fundattribution.com website a skill rating for each of these funds. Our “grades” are forward-looking and represent the projected skill decile for each fund over the 12 months ending July 2016.  “A” means top 10%; “J” is bottom 10%. In our back-testing, the average skill for funds rated A in the following year exceeded the skill for B-rated funds, and so on with the funds rated J ranking last. Table I presents the grades for some of the largest funds in the category.  For example, the Fidelity Puritan Fund is projected to demonstrate more skill in the coming year than 80-90% of its peer group.

MFO readers who want to see the full list can register for demo access at no cost. (The demo includes a few fund categories and limited functionality.)  Demo users can also see backtesting results.

Table I

Skill Projections for Major US Large Blend Funds

A few caveats:

• Our grades represent projected skill, not performance. Gross return reflects skill together with the manager’s positioning. Fund expenses are considered separately.
• The difference in skill level between an E and F tends to be small while at the extremes the difference between A and B or I and J is larger.
• Generally, deciles A through E have positive skill while F thru J are negative. The median fund may have skill which is slightly positive. This occurs because of survivorship bias: poorly managed funds are closed or merged out of existence
• We do not have a financial interest in any of these funds or their advisors

Of course, costs matter. So we ran 1900 large blend fund classes through our Orthogonal Attribution Engine (OAE) to get the probability the investment would outperform its replication portfolio by enough to cover expenses. The good news (for investors and the fund industry) is there are some attractive actively managed funds. Our analysis suggest the fund classes in Table II will outperform passive funds, despite their higher fees.

Table II

Highly-rated Large blend Fund Classes (based on skill through July 2015)

_{[a]   Morningstar ratings as of 10/20/15. G means gold (e.g. 5G means 5stars and “Gold”), S is silver, B is bronze}

_{[b]   For those of you who like ActiveShare, OAI provides a measure of how active each fund is.  A closet indexer should have an OAI near zero. If we can replicate the fund, even with more complicated techniques, it will also score low. Funds which are highly differentiated can score up to 100.}

_{[c]    Red funds are closed to new investors. Green are limited to institutional investors and retirement plans. Blue are limited to retirement plans}

The bad news is that top-rated fund, Vanguard PrimeCap (VPCCX), is closed to new investors. So, too, is Vulcan Value Fund (VVPLX).  Fortunately, the PRIMECAP Odyssey Stock Fund (POSKX) is open and accessible to most investors.  Investors have 66% confidence this fund will generate excess return next year after considering costs. The Primecap funds have done well by overweighting pharma and tech over utilities and financials and have rotated effectively into and out of high-dividend stocks.

In many cases only the institutional or retirement classes are good deals for investors. For example, the Fidelity Advisor New Insights Fund classes I and Z offer 70% confidence; but a new investor who incurs the higher fees/load for classes A, B, C, and T would be less than 55% confident of success. Of course investors who already paid the load should stay the course.

While all these funds are worthy, we have space today to profile just a few funds.

Sterling Capital Special Opportunities Fund (BOPIX, BOPAX, etc.) is just under $1 billion. This fund was once known as BB&T Special Opportunities Equity Fund and was rated five-stars by Morningstar. The rating of the A class later fell to 3 stars and recently regained four-stars. 

Table III

Return Attribution: Sterling Capital Special Opportunities Fund

Special Opps’ gross return was 22% before expenses over the past 3 years. (Table III) Even after fees, returns trounced the S&P500 by over 300bps for the past 3 years and over the past 10 years. The one and 5 year comparisons are less favorable but still positive. Combined skill has been consistently positive over the twelve year history of the fund.

However, that doesn’t tell the whole story. Comparing this to the S&P500 (or the Russell 1000) is neither accurate nor fair. The replicating portfolio – i.e., the one the OAE chooses as the best comparison – is approximately 90% equities (mostly the S&P500 with a smattering of small cap and hedged international which has decreased over time) plus 25% fixed income. The fixed income component surprised us at first, because the portfolio includes no bonds and does not utilize leverage. But the manager likes to write covered calls to generate extra income. We observe he sells about 5% of the portfolio on average about 10 to 20% out of the money. In this way he probably generates premium income of 25bp/yr., which the fixed income component captures well.  As always, the model evaluates the manager based on what he actually does, rather than against his stated benchmark (Russell 1000) or peer group.

Option writing helps explain why his beta is lower (We estimate .89, you will find other figures as low as .84.)  In the eyes of the Orthogonal Attribution Engine, that makes his performance more remarkable. We are not quite so impressed to pay an upfront 5.75% load for BOPAX (Class A), but BOPIX rates well. BOPAX is available no-load and NTF through Schwab and several smaller brokerages.

We had an opportunity to speak to the manager, George Shipp. Table III shows his skill derives much more from stock selection than sector rotation, a view he shared.  We can make a few observations.   He has a team of experienced generalists and a lot of continuity. His operation in Virginia Beach is separate from the other Sterling/BB&T operations in North Carolina.  He also manages Sterling Capital Equity Income (BAEIX), a much larger fund with zero historical overlap. The team follows a stable of companies, mainly industry leaders. They like to buy when the stock is dislocated and they see a catalyst.  The investment process is deliberative. That sounds like a contrarian, value philosophy, but in fact they have an even balance of growth and value investments. We reviewed his portfolio from 5 years ago, several of the top holdings trounced the market. (The exceptions were energy stocks.) Shipp noted he had good timing buying Apple when it was pummeled. He doesn’t specifically target M&A situations, but his philosophy puts the fund in a position to capture positive event risk. It is not unusual for the fund to own the same company more than once.

We also had a chance to speak to the folks at Davis Opportunity Fund (RPEAX). What jumps out about this $530mm fund is their ability to grind out excess return of 1 to 1.25% /yr. for nearly twenty years.  It is no great feat that DGOYX net returns just match the S&P500 for the past 5 years but they managed to do this despite two tailwinds: a 20% foreign allocation (partly hedged) and moderate cash balances. There is an old saw: “You can’t eat relative performance.” But when a fund shows positive relative performance for two decades with some consistency the Orthogonal model concludes the manager is skillful and some of that skill might carry over to the future.   We are willing to pay an incremental 60bp for their institutional class compared with an index fund but we cannot recommend the other share classes. A new co-manager was named in 2013, we see no drop-off in performance since then. (As with Sterling, the team manages a $15bn fund called Davis NY Venture (NYVTX) which does not rate nearly as well; there is some performance correlation between the two funds.)

Their process is geared toward global industry leaders and is somewhat thematic.  OAI of 24 indicates they run a very concentrated portfolio which cannot be easily replicated using passives. (We will talk more about OAI in the future.) Looking back at their portfolio from 5 years ago, their industry weightings were favorable and they did very well with CVS and Google but took hits from Sino Forest (ouch!) and Blount.

In general, the expected skill for a purely passive large blend fund will be close to zero and the probability will be around 50%. (There are exceptions including funds which don’t track well against our indices.)  However, there are a number of quantitatively driven and rules-based funds competing in the large blend space which show skill and some make our list

Table IV

Highly-Rated Large Blend Quantitative Funds

We are a little cautious in applying the model to quantitative funds. We know from backtesting that smart managers tend to stay smart, but there is a body of view that good quantitative strategies invite competition and have to be reinvented every few years. Nevertheless, here are the top-rated quant funds. All funds in Table IV carry five-star ratings from Morningstar except ACGOX is rated four-stars)

We had a chance to speak to the team managing American Century Legacy Large Cap (ACGOX), led by John Small and Stephen Pool in Kansas City.  Their approach is to devise models which predict what stock characteristics will work in a given market environment and load up on those stocks. There is some latitude for the managers to override the algorithms. Note this fund is rather small at $23 mm. The fund was evaluated based on data since management started in 2007.  However, the model was overhauled from 2010-2012 and has been tweaked periodically since then as market conditions change. The same team manages three other funds (Legacy Multicap, Legacy Focused, and Veedot); since 2012 they have used the same process, except they apply it to different market sectors.

Bottom Line:

If you are ready to throw in the towel on active funds, you are only 94% right.  There are a few managers who offer investors a decent value proposition. Mostly these managers have sustained good records over long periods with moderate expense levels.   Our thinking on quant funds will evolve over time. Based on our look at American Century Legacy, we suggest investors evaluate these managers based on the ability to react and adapt their quant models rather and not focus too much on the current version of the black box.   Remember to check out our fearless predictions for the entire large blend category at www.fundattribution.com (registration required)

If you have any questions, drop me a line at [email protected]

Five great overlooked little funds

Barron’s recently featured an article by journalist Lewis Braham, entitled “Five great overlooked little funds” (10/17/2015). Lewis, a frequent contributor of the Observer’s discussion board, started by screening for small (>$100 milllion), excellent (top 20% performance over five years) funds, of which he found 173. He then started doing what good journalists do: he dug around to understand when and why size matters, then started talking with analysts and managers. His final list of worthies is:

• SSgA Dynamic Small Cap(SSSDX) which has been added to Morningstar’s watchlist. A change of management in 2010 turned a perennial mutt into a greyhound. It’s beaten 99% of its peers and charged below average expenses.
• Hood River Small-Cap Growth(HRSRX) has $97 million but “its 14.1% annualized five-year return beats its peers by 2.3 percentage points a year.” The boutique fund remains small because, the manager avers, “We’re stockpickers, not marketers.”
• ClearBridge International Small Cap(LCOAX), sibling to a huge domestic growth fund, has a five-year annualized return of 8.5%, which beats 95% of its peers. It has $131 million in assets, 1% of what ClearBridge Aggressive Growth (SHRAX) holds.
• LKCM Balanced (LKBAX) holds an inexpensive, low-turnover portfolio of blue-chip stocks and high-grade bonds. It’s managed to beat 99% of its peers over the past decade while still attracting just $37 million.
• Sarofim Equity (SRFMX) is a virtual clone of Dreyfus Appreciation (DGAGX). Both buy ultra-large companies and hold them forever; in some periods, the turnover is 2%. It has a great long-term record and a sucky short-term one.

Lewis is also the author of The House that Bogle Built: How John Bogle and Vanguard Reinvented the Mutual Fund Industry(2011), which has earned a slew of positive, detailed reviews on Amazon. He is a graceful writer and lives in Pittsburgh; I’m jealous of both. Then, too, when I Googled his name in search of a small photo for the story I came up with

To which I can only say, “wow.”

Here Mr. Herro, have a smoke and a smile!

After all, science has never been able to prove that smoking is bad for you. Maureen O’Hara, for example, enjoyed the pure pleasure of a Camel:

And she passed away just a week ago (24 October 2015), cancer-free, at age 95. And the industry’s own scientists confirm that there are “no adverse effects.”

And, really, who’d be in a better position to know? Nonetheless, the Association of National Advertisers warns, this “legal product in this country for over two centuries, manufactured by private enterprise in our free market system” has faced “a fifty-year conspiracy” to challenge the very place of cigarettes in the free enterprise system. The debate has “lost all sense of rationality.”

It’s curious that the industry’s defense so closely mirrors the federal court’s finding against them. Judge Marion Kessler, in a 1700 page finding, concluded that “the tobacco industry has engaged in a conspiracy for decades to defraud or deceive the public … over the course of more than 50 years, defendants lied, misrepresented and deceived the American public … suppress[ed] research, destroyed documents, destroyed the truth and abused the legal system.”

David Herro is the famously successful manager of Oakmark International (OAKIX), as well as 13 other funds for US or European investors. Two of Mr. Herro’s recent statements give me pause.

On climate change: “pop science” and “environmental extremism”

In an interview with the Financial Times, Mr. Herro denounced the 81 corporate leaders, whose firms have a combined $5 trillion market cap, who’d signed on to the White House Climate Pledge (“Fund manager David Herro criticizes corporate ‘climate appeasers,’” 10/21/15). The pledge itself has an entirely uncontroversial premise:

…delaying action on climate change will be costly in economic and human terms, while accelerating the transition to a low-carbon economy will produce multiple benefits with regard to sustainable economic growth, public health, resilience to natural disasters, and the health of the global environment.

As part of the pledge, firms set individual goals for themselves. Coke wants to reduce its carbon footprint by 25%. Facebook promises to power its servers with power from renewables. Bloomberg would like to reduce its energy use by half while achieving an internal rate of return of 20% or more on its energy investments.

To which Mr. Herro roars: “climate appeasers!” They had decided, he charged, to “cave in to pop science and emotion.” Shareholders “should seriously question executives who appease such environmental extremism and zealotry.”

Like others on his island, he engages in a fair amount of arm-flapping. Climate change, he claims, “is not proven by the data.” The Grist.org project, “How to Talk to Climate Deniers” explains the problem of “proof” quite clearly:

There is no “proof” in science — that is a property of mathematics. In science, what matters is the balance of evidence, and theories that can explain that evidence. Where possible, scientists make predictions and design experiments to confirm, modify, or contradict their theories, and must modify these theories as new information comes in.

In the case of anthropogenic global warming, there is a theory (first conceived over 100 years ago) based on well-established laws of physics. It is consistent with mountains of observation and data, both contemporary and historical. It is supported by sophisticated, refined global climate models that can successfully reproduce the climate’s behavior over the last century.

Given the lack of any extra planet Earths and a few really large time machines, it is simply impossible to do any better than this.

But Mr. Herro has a reply at hand: “Their answer is … per cent of scientists and Big Oil. My answer is data, data, data.”

What does that even mean, other than the fact that the undergrad science requirement for business majors at Mr. Herro’s alma mater (lovely UW-Platteville) ought to be strengthened? Is he saying that he’s competent to assess climatological data? That he can’t find any data? (If so, check NASA’s “evidence” page here, sir.) That the data’s not perfect? Duh. That you’ve found the data, data, data straight from the source: talk radio and self-published newsletters? Or that there’s some additional bit not provided by the roughly 14,000 peer-reviewed studies that have corroborated the science behind global warming?

Can you imagine what would happen if you used to same criteria for assessing evidence about investments?

None of which I’d mention except for the fact that Herro decided to expand on the subject in his Financial Times interview which moves the quality of his analysis from the realm of the personal to the professional.

In my endless poking around, I came upon a clear, thoughtful, entertaining explanation of global warming that even those who aren’t big into science or the news could read, enjoy and learn from. The site is Wait But Why and it attempts to actually explain things (including sad millennials and procrastination) using, well, facts and humor.

Climate Change is a Thing

Let’s ignore all the politicians and professors and CEOs and filmmakers and look at three facts.

1. Burning Fossil Fuels Makes Atmospheric CO2 Levels Rise
2. Where Atmospheric CO2 Levels Go, Temperatures Follow
3. The Temperature Doesn’t Need to Change Very Much to Make Everything Shitty

In between our essays, you should go peek at the site. If you can understand the designs on the stuff in their gift shop, you really should drop me a note and explain it.

On emerging markets: “never again”

In an interview with the Associated Press (“answers have been edited for clarity”), Mr. Herro makes a statement that’s particularly troubling for the future of the Oakmark funds. The article, “Fund manager touts emerging-market stocks” (10/25/15), explains that much of the success of Oakmark International (OAKIX) was driven by Mr. Herro’s prescient and substantial investment in emerging markets:

If we back up to 1998 or 1999, during the Asian financial crisis, we had 25 or 26% of the portfolio in emerging markets. We built up a huge position and we benefited greatly from that the whole next decade. It was the gift that kept giving.

The position was eventually reduced as he harvested gains and valuations in the emerging markets were less attractive. The logical question is, would the fund be bold enough to repeat the decision that “benefited [them] greatly” for an entire decade. Would he ever go back to 25%.

No, no, no. It could come up to 10 or 15% … but we’ll try to cap it there because, nowadays, people use managers (who are dedicated to emerging markets). And we don’t bill ourselves as an emerging-market manager.

This is to say, his decisions are now being driven by the demands of asset gathering and retention, not by the investment rationale. He’ll cap his exposure at perhaps half its previous peak because “people” (read: large investment advisers) want their investments handled by specialists. Having OAKIX greatly overweighted in EMs, even if they were the best values available, would make the fund harder to sell. And so they won’t do it.

Letting marketability drive the portfolio is a common decision, but hardly an admirable one.

A picture for the Ultimus Client Conference folks

At the beginning of September, I had the opportunity to irritate a lot of nice people who’d gathered for the annual client conference hosted by Ultimus Fund Services. My argument about the fund industry was two-fold:

1. You’re in deep, deep trouble but
2. There are strategies that have the prospect of reversing your fortunes.

Sometimes the stuff we publish takes three or four months to come together. Our premium site has a feature called “Works in Progress.” It’s the place that we’ll share stuff that’s not ready for publication here. Between now and year’s end, we’ll be posting pieces of the “how to save yourself” essay bit-by-bit.

But that’s not what most folks at the conference wanted to talk about. No, for 12 hours after my talk, the corporate managers at various fund companies and advisers brought up the same topic: I have no idea of how to work with the Millennials in my office. They have no sense of time, urgency, deadlines or focus. What’s going on with these people? All of that was occasioned by a single, off-hand comment I’d made about the peculiar decisions made by a student of mine.

We talked through the evidence on evolving cultural norms and workplace explanations, and I promised to try to help folks find some useful guidance. I found a great explanation of why yuppies are unhappy in an essay at WaitButWhy, the folks above. After explaining why young folks are delusional, they illustrated the average Millennial’s view of their career trajectory:

If you’ve been banging your head on the desk for a while now, you should read it. You’ll feel better. Pwc, formerly Price, Waterhouse, Cooper, published an intricate analysis (Millennials at work 2015) of Millennial expectations and strategies for helping them be the best they can be. They also published a short version of their recommendations as How to manage the millennials (2015). Scholars at Harvard and the Wharton School of Business are rather more skeptical, taking the counter-intuitive position that there are few real generational differences. Their sources seem intrigued by the notion of work teams that combine people of different generations, who contrasting styles might complement and strengthen one another.

It’s worth considering.

Jack and John, Grumpy Old Men II

Occasionally you encounter essays that make you think, “Jeez, and I thought I was old and grouchy.” I read two in quick, discouraging succession.

Jack Bogle grouched, “I don’t do international.” As far as I can tell, Mr. Bogle’s argument is “the world’s a scary place, so I’m not going there.” At 86 and rich, that’s an easy and sensible personal choice. For someone at 26 or 36 or 46, it seems incredibly short-sighted. While he’s certainly right that “Outside of the U.S., you can be very disappointed,” that’s also true inside the United States. In an oddly ahistoric claim, Bogle extols our 250 year tradition of protecting shareholders rights; that’s something that folks familiar with the world before the Securities Act of 1934 would find freakishly ill-informed.

A generation Mr. Bogle’s junior, the estimable John Rekenthaler surveyed the debate concerning socially responsible investing (alternately, “sustainable” or “ESG”) and grumped, “The debate about the merits of the genre is pointless.” Why? Because, he concludes, there’s no clear evidence that ESG funds perform differently than any other fund. Exactly! We reviewed a lot of research in “It’s finally easy being green” (July 2015). The overwhelming weight of evidence shows that there is no downside to ESG investing. You lose nothing by way of performance. As a result, you can express your personal values without compromising your personal rate of return. If you’re disgusted at the thought that your retirement is dependent on addicting third world children to cigarettes or on clearing tropical forests, you can simply say “no.” We profiled clear, palatable investment choices, the number of which is rising.

The freak show behind the curtain: 25,000 funds that you didn’t even know existed

Whatever their flaws (see above), mutual funds are relatively stable vehicles that produce reasonable returns. Large cap funds, on average and after expenses, have returned 7.1% over the past 15 years which puts them 70 bps behind the S&P 500 for the same period.

But those other 25,000 funds …

Which others? ETFs? Nope. There are just about 1,800 of them – with a new, much-needed Social Media Sentiment Index ETF on the way (whew!) – controlling only $3 trillion. You already know about the 7,700 ’40 Act funds and the few hundred remaining CEFs are hardly a blip (with apologies to RiverNorth, to whom they’re a central opportunity).

No, I mean the other 24,725 private funds, the existence of which is revealed in unintelligible detail in a recent SEC staff report entitled Private Fund Statistics, 4th Quarter 2014 (October 2015). That roster includes:

• 8,625 hedge funds, up by 1100 since the start of 2013
• 8,407 private equity funds, up by 1400 in that same period
• 4,058 “other” private funds
• 2,386 Section 4 private equity funds
• 1,789 real estate funds
• 1,541 qualifying hedge funds
• 1,327 securitized asset funds
• 504 venture capital funds
• 69 liquidity funds
• 49 Section 3 liquidity funds, these latter two being the only categories in decline

The number of private funds was up by 4,200 between Q1/2013 and Q4/2014 with about 200 new advisers entering the market. They have $10 trillion in gross assets and $6.7 trillion in net assets. (Nope, I don’t know what gross assets are.) SEC-registered funds own about 1% of the shares of those private funds.

Sadly, the report explains nothing. You get tables of technical detail with nary a definition nor an explanation in sight. “Asset Weighted-Average Qualifying Hedge Fund Investor and Portfolio Liquidity” assures that that fund liquidity at seven days is about 58% while investor liquidity in that same period is about 15%. Not a word anywhere about what that means. An appendix defines about 10 terms, no one of which is related to their data reports.

A recent report in The Wall Street Journal does share one crucial bit of information: equity hedge funds don’t actually make money for their investors. The HRFX Equity Hedge Fund Index is, they report, underwater over the past decade. That is, “if you have invested … in this type of fund 10 years ago, you would have less than you started with.” An investment in the S&P 500 would have doubled (“Funds wrong-footed as Glencore, others gain,” 10/31/2015).

About a third of hedge funds fold within three years of launch; the average lifespan is just five years. Unlike the case of mutual funds, size seems no guardian against liquidation. Fortress Investment Group is closing its flagship macro fund by year’s end as major domo Michael Novogratz leaves. Renaissance Capital is closing their $1.3 billion futures fund. Bain Capital is liquidating their Absolute Return Capital fund. Many funds, including staunch investors in Valeant such as William Ackman of Pershing Square, are having their worst year since the financial crisis. As a group, they’re underwater for 2015.

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Hedge Fund, n. Expensive and exclusive funds numbering in the thousands, of which only about a hundred might be run by managers talented enough to beat the market with consistency and low risk. “The rest,” says the financial journalist Morgan Housel, “charge ten times the fees of mutual funds for half the performance of index funds, pay half the income-tax rates of taxi drivers, and have triple the ego of rock stars. Jason Zweig, The Devil’s Financial Dictionary (2015)

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Matching your funds and your time horizon

The Observer has profiled, and praised, the two RiverPark funds managed by David Sherman of Cohanzick. The more conservative, RiverPark Short Term High Yield (RPHYX/RPHIX, closed), usually makes 300-400 bps over a money market fund with scarcely more volatility. Year-to-date, through Halloween, the fund has returned a bit over 1% in a difficult market. The slightly more aggressive, RiverPark Strategic Income (RSIVX/RSIIX) might be expected to about double its sibling’s return with modest volatility, a feat that it has managed regularly. Strategic has had a performance hiccup lately; leading some of the folks on our discussion board to let us know that they’d headed for the exits.

For me, the questions are (1) is there a systemic problem with the fund? And (2) what’s the appropriate time-frame for assessing the fund’s performance? I don’t see evidence of the former, though we’re scheduled to meet Mr. Sherman in November and will talk more.

On the latter, the Observer’s fund-screener tracks “recovery times” for every fund over 20 time periods. Carl Bacon, in the book, Practical Risk Advanced Performance Measurements (2012), defines recovery time, or drawdown duration, as the time taken to recover from an individual or maximum drawdown to the original level. Recovery time helps investors approximate reasonable holding periods and also assessment periods. If funds of a particular type have recovery times of, say, 18-24 months, then (1) it would be foolish to use them for assets you might need in less than 18-24 months and (2) it would be foolish to panic if it takes them 18-24 months to recover.

Below, for comparison, are the maximum recovery times for the flexible bond funds that Morningstar considers to be the best.

Gold- and Silver-rated Flexible bond funds

The Observer has decided to license data for our fund screener from Lipper rather than Morningstar; dealing with the sales rep from Morningstar kept making my systolic soar. Within about a week the transition will be complete. The difference you’ll notice is a new set of fund categories and new peer groups for many funds. Here are the recovery times for the top “flexible income” and “multi-sector” income funds, measured by Sharpe ratio over the current full market cycle (11/2007 – present). This screens out any fund that hasn’t been around for at least eight years.

Bottom line: Before you succumb to the entirely understandable urge to do something in the face of an unexpected development, it’s essential to ask “am I being hasty?” Measures such as Recovery Time help, both in selecting an investment appropriate to your time horizon and in having reasonable criteria against which to assess the fund’s behavior.

Last fall we were delighted to welcome Mark Wilson, Chief Investment Officer for The Tarbox Group which is headquartered in Newport Beach, California. As founder and chief valet for the website CapGainsValet, Mark provided a remarkable service: free access to both thoughtful commentaries on what proved to be a horror of a tax season and timely data on hundreds of distributions. We’re more delighted that he agreed to join us again for the next few months.

Alive and kicking: The return of Cap Gains Valet

By Mark Wilson, APA, CFP®, Chief Valet

CapGainsValet.com is up and running again (and still free). CGV is designed to be the place for you to easily find mutual fund capital gains distribution information. If this concept is new to you, have a look at the Articles section of the CGV website where you’ll find educational pieces ranging from beginner concepts to more advanced tax saving strategies.

It’s quite early in the reporting season, but here are some of my initial impressions:

• Many firms have already posted 2015 estimates. The site already has over 75 firms’ estimates posted so there is already some good information available. This season I’m expecting to post estimates for over 190 fund firms. I’ll continue to cycle through missing firms and update the fund database as new information becomes available. Keep checking in.
• This year might feel more painful than last year. Based on estimates I’ve found to-date, I’m expecting total distributions to be lower than last year’s numbers. However, if fund performance ends the year near today’s (flat to down) numbers, investors can get a substantial tax bill without accompanying investment gains.
• It’s already an unusual year. My annual “In the Doghouse” list compiles funds with estimated (or actual) distributions over 20% of NAV. The list will continue to grow as fund firms post information. Already on the list is a fund that distributed over 80%, an index fund and a “tax-managed” fund – oddball stuff!
• Selling/swapping a distributing fund could save some tax dollars. If you bought almost any fund this year in a taxable account, you should consider selling those shares if the fund is going to have a substantial distribution. (No, fund companies do not want to hear this.) Tax wise, running some quick calculations can help you decide a good strategy. Be careful not to run afoul of the “wash sale” rules.

Of course, the MFO Discussion board (led by TheShadow) puts together its own list of capital gains distribution links. Be sure to check their work out as that list may have some firms that are not included on CGV due to their smaller asset base. Between the two resources, you should be well covered.

I value the input of the MFO community, so if you have any comments to share about CapGainsValet.com, feel free to contact me.

Top developments in fund industry litigation

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

Orders & Decisions

• A U.S. Magistrate Judge recommended that the court deny First Eagle‘s motion to dismiss fee litigation regarding two of its international equity funds. (Lynn M. Kennis Trust v. First Eagle Inv. Mgmt., LLC)
• In Jones v. Harris Associates—the fee litigation regarding Oakmark funds in which the U.S. Supreme Court set the legal standard for liability under section 36(b)—the Seventh Circuit denied the plaintiffs’ petition for rehearing en banc in their unsuccessful appeal of the district court’s summary judgment in favor of Harris Associates.
• J.P. Morgan Investment Management was among six firms named in SEC enforcement actions for short selling violations in advance of stock offerings. J.P. Morgan agreed to pay $1.08 million to settle the charges.
• Further extending the fund industry’s dismal losing record on motions to dismiss section 36(b) fee litigation, the court denied New York Life‘s motion to dismiss a lawsuit regarding four of its MainStay funds. The court viewed allegations that New York Life delegated “substantially all” of its responsibilities as weighing in favor of the plaintiff’s claim. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)
• After the Tenth Circuit reversed a class certification order in a prospectus disclosure case regarding Oppenheimer‘s California Municipal Bond Fund, the district court reaffirmed the order such that the litigation is once again proceeding as a certified class action. Defendants include independent directors. (In re Cal. Mun. Fund.)
• Denying Schwab defendants’ petition for certiorari, the U.S. Supreme Court declined to review the controversial Ninth Circuit decision that allowed multiple state common-law claims to proceed with respect to Schwab’s Total Bond Market Fund. Defendants include independent directors. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)
• In the same lawsuit, the district court partly denied Schwab‘s motion to dismiss, holding (among other things) that defendants had abandoned their SLUSA preclusion arguments with respect to Northstar’s breach of fiduciary duty claims. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)
• Two UBS advisory firms agreed to pay $17.5 million to settle SEC charges arising from their purported roles in failing to disclose a change in investment strategy by a closed-end fund they advised.
• By order of the court, the securities fraud class action regarding four Virtus funds transferred from C.D. Cal. to S.D.N.Y. (Youngers v. Virtus Inv. Partners, Inc.)

New Lawsuits

• Allianz Global Investors and PIMCO are targets of a new ERISA class action that challenges the selection of proprietary mutual funds for the Allianz 401(k) plan. Complaint: “the Fiduciary Defendants treat the Plan as an opportunity to promote the Allianz Family’s mutual fund business and maximize profits at the expense of the Plan and its participants.” (Urakhchin v. Allianz Asset Mgmt. of Am., L.P.)
• J.P. Morgan is the target of a new section 36(b) excessive fee lawsuit regarding five of its funds. The plaintiffs rely on comparisons to purportedly lower fees that J.P. Morgan charges to other clients. (Campbell Family Trust v. J.P. Morgan Inv. Mgmt., Inc.)
• Metropolitan West‘s Total Return Bond Fund is the subject of a new section 36(b) excessive fee lawsuit. The plaintiff relies on comparisons to purportedly lower fees that Metroplitan West charges to other clients. (Kennis v. Metro. W. Asset Mgmt., LLC.)

The Alt Perspective: Commentary and news from DailyAlts.

October proved to be less than spooky for the equity market as the S&P 500 Index rose 8.44% over the month, leading major asset classes and alternative investment categories. While bonds and commodities were relatively flat, long/short equity funds topped the list of alternative funds and returned an average of 2.88%, while bear market funds shed 11.30% over the month as stocks rallied. Managed futures funds gave back gains they had made earlier in the year with a loss of 1.82% on average, according to Morningstar, while multi-alternative funds posted gains of 1.33%.  All in all, a mixed bag for nearly everything but long-only equity.

Asset Flows

September turned out to be a month when investors decided that it was time to pull money from actively managed mutual funds and ETFs, regardless of asset class, style or strategy – except for alternatives. Every actively managed category, as reported by Morningstar saw outflows other than alternatives, which had net inflows of $719 million to actively managed funds and another $884 million to passively managed alternative mutual funds and ETFs.

As you will recall, volatility started to spike in August when the Chinese devaluated the Yuan, and the turmoil carried into September. But not all alternative categories saw positive inflows in September – in fact few did. Were it not for trading strategy funds, such as inverse funds, the overall alternatives category would be negative:

• Trading strategies, such as inverse equity funds, added $1.5 billion
• Multi-alternative funds picked up $998 million
• Managed futures funds added $744 million
• Non-traditional bond funds shed $1.3 billion
• Volatility based funds lost $551 million

New Fund Filings

AlphaCentric and Catalyst both teamed up with third parties to invest in managed futures or related strategies. AlphaCentric partnered with Integrated Managed Futures Corp for a more traditional, single manager managed futures fund while Catalyst is looking to Millburn Ridgefield Corporation to run a managed futures overlay on an equity portfolio – very institutional like!

Another interesting filing was that from a new company called Castlemaine who plans to launch five new alternative mutual funds – all managed by one individual. That’s just hard to do! Hard to criticize that this point, but we will keep an eye on the firm as they come out with new products later this year.

Research

Finally, there were a couple pieces of interesting research that we uncovered this past month, as follows:

• The Pros and Cons of Single- and Multi-Manager Alternative Funds – this is a thoughtful piece from Steben & Co. that outlines the pros and cons of investing in single and multi-manager funds. Some important points are made in the paper for anyone looking to allocate to an actively managed fund.
• Enhancing Performance With Dynamic Timing of Factor Exposures – this paper from State Street Global Advisors presents an outline for potentially enhancing returns of a static “factor” allocation portfolio. For anyone using smart beta products, this is a solid paper to read.

Have a wonderful November, and Happy Thanksgiving to all.

Observer Fund Profiles: RNCOX

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

RiverNorth Core Opportunity (RNCOX). RiverNorth turns the typical balanced strategy (boring investments, low costs) on its head. At the price of higher pass-through costs, the fund attempts to exploit the occasionally-irrational pricing of the closed-end fund market to add a market-neutral layer of returns to a flexible underlying allocation. That’s work well far more often than it hasn’t.

Launch Alert: T. Rowe Price Emerging Markets Value (PRIJX)

Price launched its Emerging Markets Value fund at the end of September. The manager is Ernest C. Yeung. He started at Price in 2003 as an analyst covering E.M. telecommunication stocks. In 2009 he became a co-manager of the International Small Cap Equity strategy (manifested in the U.S. as Price International Discovery PRIDX), where he was the lead guy on Asian stock selection. Nick Beecroft in Price’s Hong Kong office reports that at the end of 2014, “he began to manage a paper portfolio for the new T. Rowe Price Emerging Markets Value Stock Fund, which he then ran until the fund was launched publicly in September 2015. So Ernest [has] been part of our emerging markets team at T. Rowe for over 12 years.”

The fund will target 50-80 stocks and stock selection will drive both country and sector exposure. Characteristics he’ll look for:

• low valuation on various earnings, book value, sales, and cash flow metrics, in absolute terms and/or relative to the company’s peers or its own historical norm;
• low valuation relative to a company’s fundamentals;
• companies that may benefit from restructuring activity or other turnaround opportunities;
• a sound balance sheet and other positive financial characteristics;
• strong or improving position in an overlooked industry or country; and
• above-average dividend yield and/or the potential to grow dividends.

As Andrew Foster and others have pointed out, value investing has worked poorly in emerging markets. Their argument is that many EM markets, especially Asian ones, have powerful structural impediments to unlocking value. Those include interlocking directorships, control residing in founding families rather than in the corporate management, cross-ownership and a general legal disregard for the rights of minority shareholders. I asked the folks at Price what they thought had changed. Mr. Beecroft replied:

We agree that traditional, fundamental value investing can be challenging in emerging markets. Companies can destroy value for years for all the reasons that you mention. Value traps are prevalent as a result. Our approach deliberately differs from the more traditional fundamental value approach. We take a contrarian approach and actively seek stocks that are out of favour with investors or which have been “forgotten” by the market. We also look for them to have a valuation anchor in the form of a secure dividend yield or book value support. These stocks typically offer attractive valuations and with limited downside risk.

But in emerging markets, just being cheap is not enough. So, we look for a re-rating catalyst. This is where our research team comes in. Re-rating catalysts might be external to the company (e.g., industry structure change, or an improving macro environment) or internal (ROE/ROIC improvement, change in management, improved capital allocation policy, restructuring, etc.). Such change can drive a significant re-rating on the stock.

The emerging markets universe is wide and deep. We are able to find attractive upside potential in stocks that other investors are not always focused on.

The fund currently reports about a quarter million in its portfolio. The initial expense ratio, after waivers, is 1.5%. The minimum initial investment is just $1,000.

Funds in Registration

There are fifteen or so new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. The funds in registration now have a good chance of launching on December 31, which is critical to allowing them to report full-year results for 2016.

There are some interesting possibilities. Joe Huber is launching a mid-cap fund. ASTON will have an Asia dividend one. And Homestead is launching their International II fund, sub-advised by Harding Loevner.

Manager Changes

Chip tracked down 63 manager changes this month, a fairly typical tally. This month continues the trend of many more women being removed from management teams (9) than added to them (1). There were a few notable changes. The outstanding Boston Partners Long/Short Equity Fund (BPLEX) lost one of its two co-managers. Zac Wydra left Beck Mack & Oliver Partners Fund (BMPEX) to become CIO of First Manhattan Corporation. In an unusual flurry, Kevin Boone left Marsico Capital, then Marsico Capital got booted from the Marsico Growth FDP Fund (MDDDX) that Kevin co-managed, then the fund promptly became the FDP BlackRock Janus Growth Fund.

The Navigator: Fund research fast

One of the coolest resources we offer is also one of the least-used: The Navigator. It’s located on the Resources tab at the top-right of each page. If you enter a fund’s name or ticker symbol in The Navigator, it will instantly search 27 sites for information on the fund:

If you click on any of those links, it takes you directly to the site’s profile of the fund. (Did you even know The Google had fund pages? They do.)

Updates: INNAX, liquidity debate

In October we featured Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX) in our Elevator Talk. Energy-light portfolio, distinctive profile given their focus on “soft” resources like trees and cattle. Substantially above-average performance. They’d just passed their three year anniversary and seven days later they received their inaugural star rating from Morningstar. They’re now recognized as a four star fund within the natural resources group.

We’ve argued frequently that liquidity in the U.S. securities market, famously the most liquid in the world, might be drying up. The translation is: you might not be able to get a fair price for your security if you need to sell at the same time lots of other people are. The SEC is propounding rules to force funds to account for the liquidity of their holdings and to maintain a core of highly-liquid securities that would be sufficient to cover several days’ worth of panicked redemptions. The Wall Street Journal provided a nice snapshot of the potential extent of such problems even in large, conservative fixed-income funds. Using the ability to sell a security within seven days, the article “Bond funds push limits” (9/22/2015) estimates the extent of illiquid assets in five funds:

Between them, those funds hold $130 billion. The Investment Company Institute, the industry’s mouthpiece, immediately denounced the story.

It’s not quite The Satanic Verses, but ….

In October, Jason Zweig published his The Devil’s Financial Dictionary. The title, of course, draws from Ambrose Bierce’s classic The Devil’s Dictionary (1906). Critics of Wall Street still nod at entries like “Finance: the art or science of managing revenues or resources for the best advantage of the manager.”

With a combination of wit and a long career during which he incubates both insight and annoyance, Jason wrote what’s become a bedside companion for me. It’s full of short, snippy entries, each of which makes a point that bears making. I think you’d enjoy it, even if you’re the object of it.

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Financial Journalist, n. Someone who is an expert at moving words about markets around on a page or screen until they sound impressive, regardless of whether they mean anything. Until the early 20^th century, financial journalists knew exactly what they were doing, as many of them were paid overtly or covertly by market manipulators to promote or trash various investments … Nowadays, most financial journalists are honest, which is progress—and ignorant, which isn’t.

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Another thing to be thankful for: New data and our impending launch

We’ll be writing to the 6,000 or so of you on our mailing list in the next week or so with updates about our database and other analytics, as well as word of the formal launch of the “MFO premium” site, which will give all of our contributors access to all of this stuff and more.

Comparing Lipper Ratings

MFO recently started computing its risk and performance fund metrics and attendant fund ratings using the Lipper Data Feed Service for U.S. Open End funds. (See MFO Switches To Lipper Database.) These new data have now been fully incorporated on the MFO Premium beta site, and on the Great Owl, Fund Alarm, and Dashboard of Profiled Funds pages of our legacy Search Tools. (The Risk Profile and Miraculous Multi-Search pages will be updated shortly).

Last month we noted that the biggest difference MFO readers were likely to find was in the assigned classifications or categories, which are described in detail here. (Morningstar’s categories are described here,  and Lipper nicely compares the two classification methodologies here.) Some examples differences:

• Lipper uses “Core” instead of “Blend.” So, you will find Large-Cap Growth, Large-Cap Core, and Large Cap Value.
• Lipper includes a “Multi-Cap” category, in addition to Large-Cap, Medium-Cap, and Small-Cap. “Funds that, by portfolio practice, invest in a variety of market capitalization ranges …” Examples are Vanguard Total Stock Market Index Inv (VTSMX), Auxier Focus Inv (AUXFX), and Bretton (BRTNX).
• Lipper does not designate an “Asset Allocation” category type, only “Equity” and “Fixed Income.” The traditional asset allocation funds, like James Balanced: Golden Rainbow Retail (GLRBX) and Vanguard Wellesley Income Inv (VWINX) can be found in the categories “Mixed-Asset Target Allocation Moderate” and “Mixed-Asset Target Allocation Conservative,” respectively.
• Lipper used “Core Bond” instead of say “Intermediate-Term Bond” to categorize funds like Dodge & Cox Income (DODIX).
• Lipper extends data back to January 1960 versus January 1962. Number of funds still here today that were here in January 1960? Answer: 72, including T Rowe Price Growth Stock (PRGFX).

A few other changes that readers may notice with latest update:

• Ratings for funds in all the commodities categories, like Commodities Agriculture, where previously we only included “Broad Basket.”
• Ratings for funds of leveraged and short bias categories, so-called “trading” funds.
• Ratings for 144 categories versus 96 previously. We continue to not rate money market funds or funds less than 3 months old.
• No ratings for funds designated as a “variable insurance product,” which typically cannot be purchased directly by investors. Examples are certain Voya, John Hancock, and Hartford funds.
• There may be a few differences in the so-called “Oldest Share Class (OSC)” funds. MFO has chosen to define OSC as share class with earliest First Public Offering (FPO) date. (If there is a tie, then fund with lowest expense ratio. And, if tied again, then fund with largest assets under management.)

Overall, the changes appear quite satisfactory.

Briefly Noted . . .

Columbia Acorn Emerging Markets (CAGAX) has lifted the cap on what constitutes “small- and mid-sized companies,” their target universe. It has been $5 billion. Effective January 1 their limit bumps to $10 billion. That keeps their investment universe roughly in line with their benchmark’s.

Goldman Sachs Fixed Income Macro Strategies Fund (GAAMX) is making “certain enhancements” to its investment strategies. Effective November 20, 2015, the Fund will use a long/short approach to invest in certain fixed income securities. The trail of the blue line certainly suggests that “certain enhancements” might well be in order.

Here’s something I’ve not read before: “The shareholder of Leland Thomson Reuters Private Equity Index Fund (LDPAX) … approved changing the Fund’s classification from a diversified Fund to a non-diversified Fund under the Investment Company Act of 1940.”

SMALL WINS FOR INVESTORS

Not a lot to cheer for.

CLOSINGS (and related inconveniences)

The closure of the 361 Managed Futures Strategy Fund (AMFQX/ AMFZX) has been delayed “until certain administrative and other implementation matters have been completed.” The plan is to close by December 31, 2015.

The shareholders of Hennessy Cornerstone Large Growth Fund, the Hennessy Cornerstone Value Fund, and the Hennessy Large Value Fund bravely voted to screw themselves by adding 12(b)1 fees to their funds, beginning on November 1, 2015. The Hennessy folks note, in passing, that “This will increase the fees of the Investor Class shares of such Hennessy Funds.”

Invesco European Small Company Fund (ESMAX) will close to new investors on November 30, 2015. By pretty much all measures, it offers access to higher growth rates at lower valuations than the average European stock fund does. The question for most of us is whether such a geographically limited small cap fund ever makes sense. 

Effective after November 13, 2015, the RiverNorth/DoubleLine Strategic Income Fund (RNDLX) is closed to new investors.

OLD WINE, NEW BOTTLES

On December 30, the microscopic and undististinguished Alger Analyst Fund (SPEAX) will become Alger Mid Cap Focus Fund. Usually when a fund highlights Analyst in its name, it’s run by … well, the firm’s analysts. “Research” often signals the same thing. In this case, the fund has been managed since inception by CEO/CIO Dan Chung. After the name change, the fund will be managed by Alex Goldman. 

In one of those “I just want to slap someone” moves, the shareholders of City National Rochdale Socially Responsible Equity Fund (AHRAX) are voting on whether to become the Baywood SociallyResponsible Fund. The insistence of fund firms to turn two words into one word is silly but I could imagine some argument about the ability to trademark a name that’s one word (DoubleLine) that wouldn’t be available if it were two. But mashed-together with the second half officially italicized? Really, guys? The fact that the fund has trailed 97% of its peers over the past decade suggests the need to step back and ask questions more probing than this.

Effective December 31, 2015, Clearbridge Global Growth (LGGAX) becomes ClearBridge International Growth Fund.

Oppenheimer International Small Company Fund (OSMAX) becomes Oppenheimer International Small-Mid Company Fund on December 30, 2015. It’s a very solid fund except for the fact that, at $5.1 billion, is no longer targets small caps: 75% of the portfolio are mid- to large-cap stocks.

On January 11, 2016, the Rothschild U.S. Large-Cap Core Fund, U.S. Large-Cap Value, U.S. Small/Mid-Cap Core, U.S. Small-Cap Core, U.S. Small-Cap Value and U.S. Small-Cap Growth funds will become part of the Pacific Funds Series Trust. Rothschild expects that they’ll continue to manage the year-old funds with Pacific serving as the parent. The new fund names will be simpler than the old and will drop “U.S.”, though the statement of investment strategies retains U.S. as the focus. The funds will be Pacific Funds Large Cap, Large Cap Value, Small/Mid-Cap, Small-Cap, Small-Cap Value and Small-Cap Growth. It appears that the tickers will change.

On December 18, 2015, SSgA Emerging Markets Fund (SSELX) will become State Street Disciplined Emerging Markets Equity Fund, leading mayhap to speculation that it hadn’t been disciplined up until then. The fund will use quant screens “to select a portfolio that the Adviser believes will exhibit low volatility and provide competitive long-term returns relative to the Index.”

As part of a continuing series of fund adoptions, Sound Point Floating Rate Income Fund (SPRFX) will reorganize into the American Beacon Sound Point Floating Rate Income Fund.

Effective October 28, 2015, Victory Fund for Income became Victory INCORE Fund for Income. Presumably because the audience arose, applauding and calling “incore! incore!” Victory Investment Grade Convertible Fund was also rechristened Victory INCORE Investment Grade Convertible Fund.

And, too, Victory renamed all of its recently-acquired Compass EMP funds. The new names will all begin Victory CEMP. So, for example, in testing the hypothesis that no name is too long and obscure to be attractive, Compass EMP Ultra Short-Term Fixed Income Fund (COFAX) will become Victory CEMP Ultra Short Term Fixed Income Fund.

Voya Growth Opportunities Fund changed its name to Voya Large-Cap Growth Fund.

OFF TO THE DUSTBIN OF HISTORY

3D Printing, Robotics and Technology Fund (TDPNX) will liquidate on November 13, 2015. In less than two years, the managers lost 39% for their investors while the average tech fund rose 20%. The Board blamed “market conditions and economic factors” rather than taking responsibility for a fatally-flawed conception. Reaction on the Observer’s discussion board was limited to a single word: “surprised?”

Not to worry, 3D printing fans! The ETF industry has rushed in to fill the (non-existent) gap with the pending launch of the ARK 3D Printing ETF.

Acadian Emerging Markets Debt Fund (AEMDX) has closed and will liquidate on November 20, 2015. It’s a $36 million institutional fund that’s had one good year in five; otherwise, it trailed 70-98% of its peers. Performance seems to have entirely fallen off a cliff in 2015.

AllianzGI NFJ All-Cap Value Fund (PNFAX) is slated for liquidation on December 11, 2015. Their International Managed Volatility (PNIAX) and U.S. Managed Volatility (NGWAX) funds will follow on March 2, 2016. The theory says that managed volatility funds should be competitive with their benchmarks over the long term by limiting losses during downturns. The latter two funds suffered because they couldn’t consistently manage that feat.

Carne Hedged Equity Fund (CRNEX) was a small, decent long/short fund for four years. Then the recent past happened; the fund went from well above average through December 2013 to well below average since. Finally, the last week of October 2015 happened. Here’s the baffling picture:

Right: 23% loss over four days in a flat market. No word on the cause, though the liquidation filing does refer to a large redemption and anticipated future redemptions. (Ya think?) So now it’s belatedly becoming “a former fund.” Graveside services will be conducted December 30, 2015.

Forward continues … in reverse? To take one step Forward and two back? Forward Global Dividend Fund (FFLRX) will liquidate on November 17^th and the liquidation of Forward Select EM Dividend Fund will occur on December 15, 2015. Those appear to be Forward’s fifth and sixth liquidations in 2015, and the fourth since being acquired by Salient this summer.

In order “to optimize the Goldman Sachs Funds and eliminate overlap,” Goldman Sachs has (insightfully) decided to merge Goldman Sachs International Small Cap Fund (GISAX) into Goldman Sachs International Small Cap Insights Fund (GISAX). The target date is February, 2016. That’s a pretty clean win for shareholders. GISAX is, by far, the larger, stronger and cheaper option.

GuideMark® Global Real Return Fund has been liquidated and terminated and, for those of you who haven’t yet gotten the clue, “shares of the Fund are no longer available for purchase or exchange.”

JPMorgan U.S. Research Equity Plus Fund (JEPAX) liquidated after fairly short notice on October 28, 2015. It was a long/short fund of the 130/30 variety: it had a leveraged long position and a short portfolio which together equaled 100% long exposure. That’s an expensive proposition whose success relies on your ability to get three or four things (extent of leverage, target market exposure, long and short security selection) consistently and repeatedly right. Lipper helpfully classifies it as a “Lipper Alternative Active Extension Fund.” It had a few good years rather precisely offset by bad years; in the end, the fund charged a lot (2.32% despite a mystifying Morningstar report of 1.25%), churned the portfolio (178% per year) but provided nothing special (its returns exactly matched the average 100% long large cap fund).

Larkin Point Equity Preservation Fund (LPAUX), a two-year-old long/short fund of funds, will neither preserve or persevere much longer. It has closed and expects to liquidate on November 16, 2015.

On October 16, 2015, Market Vectors got out of the Quality business as they bumped off the MSCI International Quality, MSCI Emerging Markets Quality Dividend, MSCI International Quality Dividend and MSCI Emerging Markets Quality ETFs.

The Board of Trustees of The Royce Fund recently approved the fund reorganizations effective in the first half of 2016. In the first half of 2016, Royce International Premier (RIPN) will eat two of its siblings: European Small Cap (RESNX) and Global Value (RGVIX). Why does it make sense for a $9 million fund with no star rating to absorb its $22 million and $62 million siblings? Of course, Royce is burying a one-star fund that’s trailed 90% of its peers over the past five years. And, too, a one-star fund that’s trailed 100% in the same period. Yikes. Global Value averaged 0.8% annually over the past five years; its average peer pumped out ten times as much.

While they were at it, Royce’s Board of Trustees approved a plan of liquidation for Royce Micro-Cap Discovery Fund (RYDFX), to be effective on December 8, 2015. The $5 million fund is being liquidated “primarily because it has not attracted and maintained assets at a sufficient level for it to be viable.” That suggests that International Micro Cap (ROIMX) with lower returns, two stars and $6 million in assets might be next in line.

Salient MLP Fund (SAMCX) will liquidate on December 1, 2015. Investors will continue to be able to access the management team’s skills through Salient MLP & Energy Infrastructure Fund II (SMAPX) which has over a billion in assets. It’s not a particularly good fund, but it is better than SAMCX.

Schroder Global Multi-Cap Equity Fund (SQQJX) liquidated on October 27, 2015, just days short of its fifth anniversary.

Sirios Focus Fund (SFDIX) underwent “final liquidation” on Halloween, 2015. It’s another fund abandoned after two years of operation.

Tygh Capital Management has recommended the liquidation of its TCM Small-Mid Cap Growth Fund (TCMMX). That will occur just after Thanksgiving.

Touchstone Growth Allocation Fund (TGQAX) is getting absorbed by Touchstone Moderate Growth Allocation Fund (TSMAX) just before Thanksgiving. Both have pretty sad records, but Growth has the sadder of the two. At the same time, Moderate Growth brings in managers Nathan Palmer and Anthony Wicklund from Wilshire Associates. Wilshire replaces Ibbotson Associates (a Morningstar company) as the fund’s advisor. Both are funds-of-mostly-Touchstone funds. After the repositioning, Moderate Growth will offer 40% non-US exposure with 45-75% of its assets in equities. Currently Growth is entirely equities.

UBS Multi-Asset Income Fund (MAIAX) will liquidate on or about December 3, 2015.

The Virtus Disciplined Equity Style (VDEAX), Virtus Disciplined Select Bond (VDBAX) and Virtus Disciplined Select Country (VDCAX) funds will close on November 20^th and will liquidate by December 2, 2015. They share about $7 million in assets and a record of consistent underperformance.

Virtus Dynamic Trend Fund (EMNAX) will merge into Virtus Equity Trend Fund (VAPAX), they’re hoping sometime in the first quarter of 2016. I have no idea of why, since EMNAX has $600 million and a better record than VAPAX.

In Closing . . .

In a good year, nearly 40% of our Amazon revenue is generated in November and December. That’s in part because I endlessly nag people about how ridiculously simple, painless and useful it is to bookmark our Amazon link or set it as one of your tabs that opens whenever you start your favorite browser.

Please don’t make me go find some cute nagging-related image to illustrate this point. Just bookmark our Amazon link or set it as an opening tab. That would help so me. Here’s the link http://www.amazon.com/?_encoding=UTF8&tag=mutufundobse-20. Alternatively, you can click on the banner.

A quick tip of the cap to folks who made tax-deductible contributions to the Observer this month: regular subscribers, Greg and Deb; PayPal contributors, Beatrice and David; and those who preferred to mail checks, Marjorie, Tom G. and the folks at Ultimus Fund Solutions. We’re grateful to all of you.

The fund managers I’ve spoken with are nearly unanimous in their loathing of Schwab. Words like “arrogant, high-handed and extortionate” capture the spirit of their remarks. I hadn’t dealt with the folks at Schwab until now, so mostly I nodded sympathetically. I now nod more vigorously.

It’s likely that we’ll be in the vicinity of, but not at, the Schwab IMPACT conference in November. We requested press credentials and were ignored for a good while. Then after poking a couple more times, we were reminded of how rare and precious they were and were asked to submit examples of prior conference coverage. We did, on September 28^th. That’s the last we heard from them so we’ll take that as a “we’re Schwab. Go away, little man.” Drop us a note if you’re going to be there and would like to chat at some nearby coffee shop.

We’ll look for you.

Dear friends,

Welcome to fall. 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. (Also sports mascots. Don’t ask.) It’s a month famous of market crashes – 1929, 1987, 2008 – and for being the least hospitable to stocks. And it has the prospect of setting new records for political silliness and outbreaks of foot-in-mouth disease.

It’s the month of golden leaves, apple cider, backyard fires and weekend football.  (I’m a bit torn. Sam Frasco, Augie’s quarterback, broke Ken Anderson’s school record for total offense – 469 yards in a game – and lost. In the next week, he broke his own record – 575 – and lost again.) 

It’s the month where we discover that Oktoberfest 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.

Leuthold: a cyclical bear has commenced

As folks on our mailing list know, the Leuthold Group has concluded that a cyclical bear market has begun. They make the argument in the lead section of Perception for the Professional, their monthly report for paying research clients (and us). It’s pretty current, with data through September 8th. A late September update of that essay, posted on the Leuthold Group’s website, reiterates the conclusion: “We strongly suspect the decline from the September 17th intraday highs is the bear market’s second downleg, and we’d expect all major U.S. indexes to undercut their late August lows before this leg is complete.” While declines during the 3^rd quarter took some of the edge off the market’s extreme valuation, they note with concern the buoyant optimism of the “buy the dips” crowd.

Who are they?

The Leuthold Group was founded in 1981 by Steve Leuthold, who is now mostly retired to Bar Harbor, Maine. (I’m intensely jealous.) They’re an independent firm that produces financial research for institutional investors. They do unparalleled quantitative work deeply informed by historical studies that other firms simply don’t attempt. They write well and thoughtfully.

Why pay any attention?

They write well and thoughtfully. Hadn’t I mentioned? Quite beyond that, they put their research into practice through the Leuthold Core (LCORX) and Leuthold Global (GLBLX) funds. Core was a distinguished “world allocation” fund before the term existed. $10,000 entrusted to Leuthold in 1995 would have grown to $53,000 today (10/01/2015). Over that same period, an investment in the Vanguard 500 Index Fund (VFINX) would have growth to $46,000 while the average tactical allocation manager would have managed to grow it to $26,000. All of which is to say, they’re not some ivory tower assemblage of perma-bears peddling esoteric strategies to the rubes.

What’s their argument?

The bottom line is that a cyclical bear began in August and it’s got a ways to go. Their bear market targets for the S&P 500 – based on a variety of different bear patterns – are in the range of 1500-1600; it began October at about 1940. The cluster of the Russell 2000 is around 1000; the October 1 open was 1100. 

The S&P target was a composite drawn from the levels necessary to achieve:

1. a reversion to 1957-present median valuations
2. 50% retracement of gains from the October 2011 low
3. the October 2007 peak
4. the median decline in a postwar bear
5. the March 2000 secular bull market peak
6. 50% retracement of the gain from the March 2009 low
7. April 2011 market peak

Each of those represents what some technicians see as a “support level” in a typical cyclical bear. Since Leuthold recognizes that it’s not possible to be both precise and meaningful, they look for clustered values. Most of the ones about lie between 1525 and 1615, so …

They address some of the self-justificatory blather (“it’s the most hated bull market in history,” to which they reply that sales of leveraged bull market funds and equity exposure by market-timing newsletters were at records for 2014 and much of 2015 which some might think of as showin’ some lovin’), then make two arguments:

1. Market internals have been breaking down all summer.
2. After the August declines, the market’s forward P/E ratio was still higher than it was at the peaks of the last three bull markets.

In their tactical portfolios, they’ve dropped their equity exposure to 35%. Their early September asset allocation in the portfolios (such as Leuthold Core LCORX and Leuthold Global GLBLX) was:

52% long equities

21% equity hedge a/k/a short for a net long of 31%

4% EM equities, which are in addition to the long position above

20% fixed income, with both EM and TIPS eliminated in August. The rest is relatively short and higher quality.

3% cash

They seem especially chary of energy stocks and modestly positive toward consumer discretionary and health care ones.

They are torn on the emerging markets. They argue that “there must be serious fundamental problems with any asset class that commands a Normalized P/E of only 13x at the peak (in May 2015) of one of the greatest liquidity-driven bull markets in history. We now expect EM valuations will undercut their 2008 lows before the current market decline has run its course. That washout might also serve up the best stock market bargains in many years…” (emphasis in original) Valuations are already so low that they’ve discussed overriding their own models but will not abandon their discipline in favor of their guts.

The turmoil in the emerging markets has struck down saints and sinners alike. The two emerging markets funds in my personal account, Seafarer Overseas Growth & Income (SFGIX) and Grandeur Peak Emerging Opportunities (GPEOX, closed) are down about 18% from their late May highs while the EM group as a whole has declined by just over 20%. As Ed Studzinski notes, below, those declines were occasioned by a panic over Chinese stocks which triggered a trillion dollar capital flight and a liquidity crisis.

Seafarer and Grandeur Peak both have splendid records, exceptional managers and success in managing through turmoil. Given the advice that we offered readers last month – briefly put, the worst time to fix a leaky roof is in a storm – I was struck by manager Andrew Foster’s thoughtful articulation of that same perspective in the context of the emerging markets. He made the argument in a September video, in which he and Kate Jaquet discussed risk and risk management in an emerging markets portfolio.

Once a crisis begins to unfold, there’s very little we can do amid the crisis to really change how we manage the fund to somehow dampen down the risk or the exposure the fund has. .. The best way to control risk within the fund is preventative… to try and put in place a portfolio construction that anticipates different kinds of market conditions well ahead of time such that when the crisis unfolds or the volatility ensues that you’re at least reasonably well positioned for it.

The reason why it doesn’t make a great deal of sense to react substantially during a crisis is because most financial crises stem from liquidity panics or some sort of liquidity shortage. And so if you try and trade your portfolio or restructure it radically in the middle of such an event, you’re inevitably trading right into a liquidity panic. What you want to sell will be difficult to sell and you won’t realize efficient prices. What you want to buy – the stuff that might seem safe or might be able to steer you through the crisis – will inevitably be overpriced or expensive … [prices] tend to be at extremes. You’re going to manifest the risk in a more pronounced way and crystallize the loss you’re trying to avoid.

The solution he propounds is the same one you should adopt: Build an all-weather portfolio that manages to be “strong and happy” in good markets and “reasonably resilient” in bad ones.

A more striking response was offered by the good folks at Vulcan Value Partners whose Vulcan Value Partners Small Cap (VVPSX, closed) we profiled four years ago. Vulcan Value Partners does really good work (“all of our investment strategies are ranked in the top 1% of our peers since inception and both Large Cap and Focus are literally the best performing investment programs among their peers”), part and parcel of which is being really thoughtful about the risks they’re asking their partners to face. Their most recent shareholder letter is bracing:

In Small Cap, we have sold a number of positions at our estimate of fair value but have been unable to redeploy capital back into replacements at prices that provide us with a margin of safety. Consequently, cash levels are rising, and price to value ratios in the companies we do own are not as low as in Large Cap. Our investment philosophy tends to keep us fully invested most of the time. However, at extremes, cash levels can rise. We will not compromise on quality, and we will not pay fair value for anything. .. We encourage our Small Cap partners to reduce their small cap exposure in general and with us if they have better alternatives. At the very least, we strongly ask you to not add to your Small Cap allocation with us. There will be a day when we write the opposite of what we are writing today. We look forward to writing that letter, but for the time being Small Cap risks are rising and potential returns are falling. (Thanks for Press, one of the stalwarts of MFO’s discussion board, for bringing the letter to my attention.)

The Field Guide to Bears

Financial professionals tend to distinguish “cyclical” markets from “secular” ones. A secular bear market is a long-term decline that might last a decade or more. Such markets aren’t steady declines; rather, it’s an ongoing decline that’s punctuated by furious short-term market rallies – called “cyclical bulls” – that fizzle out. “Short term” is relative, of course. A short-term rally might roll on for 12-18 months before investors capitulate and the market crashes once again. As Barry Ritzholtz pointed out earlier this year, “Knowing one from the other isn’t always easy.”

There’s an old hiker’s joke that plays with the same challenge of knowing which sort of bear you’re facing:

Park visitors are advised to wear little bells on their clothes to make noise when hiking. The bell noise allows the bears to hear the hiker coming from a distance and not be startled by a hiker accidently sneaking up on them. This might cause a bear to charge. Hikers should also carry pepper spray in case they encounter a bear. Spraying the pepper in the air will irritate a bear’s sensitive nose and it will run away.

It also a good idea to keep an eye out for fresh bear scat so you’ll know if there are bears in the area. People should be able to tell the difference between black bear scat and grizzly bear scat. Black bear scat is smaller and will be fibrous, with berry seeds and sometimes grass in it. Grizzly bear scat will have bells in it and smell like pepper spray.

Some Morningstar ETF Conference Observations

Overcast and drizzling in Chicago on the day Morningstar’s annual ETF Conference opened September 29, the 6^th such event, with over 600 attendees. The US AUM is $2 trillion across 1780 predominately passive exchange traded products, or about 14% of total ETF and mutual fund assets. The ten largest ETFs , which include SPDR S&P 500 ETF (SPY) and Vanguard Total Stock Market ETF (VTI), account more for nearly $570B, or about 30% of US AUM.  Here is a link to Morningstar’s running summary of conference highlights.

Joe Davis, Vanguard’s global head of investment strategy group, gave a similarly overcast and drizzling forecast of financial markets at his opening key note, entitled “Perspectives on a low growth world.” Vanguard believes GDP growth for next 50 years will be about half that of past 50 years, because of lack of levered investment, supply constraints, and weak global demand. That said, the US economy appears “resilient” compared to rest of world because of the “blood -letting” or deleveraging after the financial crisis. Corporate balances sheets have never been stronger. Banks are well capitalized.

US employment environment has no slack, with less than 2 candidates available for every job versus more than 7 in 2008. Soon Vanguard predicts there will be just 1 candidate for every job, which is tightest environment since 1990s. The issue with employment market is that the jobs favor occupations that have been facilitated by the advent of computer and information technology. Joe believes that situation contributes to economic disparity and “return on education has never been higher.”

Vanguard believes that the real threat to global economy is China, which is entering a period of slower growth, and attendant fall-out with emerging markets. He believes though China is both motivated and has proven its ability to have a “soft landing” that relies more on sustainable growth, if slower, as it transitions to more of a consumer-based economy.

Given the fragility of the global economy, Vanguard does not see interest rates being raised above 1% for the foreseeable future. End of the day, it estimates investors can earn 3-6% return next five year via a 60/40 balanced fund.

J. Martijn Cremers and Antti Petajisto introduced a measure of active portfolio management in 2009, called Active Share, which represents the share of portfolio holdings that differ from the benchmark index holdings. A formal definition and explanation can be found here (scroll to bottom of page), extracted from their paper “How Active Is Your Fund Manager? A New Measure That Predicts Performance.”

Not everybody agrees that the measure “Predicts Performance.” AQR’s Andrea Frazzini, a principal on the firm’s Capital Management Global Stock Selection team, argued against the measure in his presentation “Deactivating Active Share.” While a useful risk measure, he states it “does not predict actual fund returns; within individual benchmarks, it is as likely to correlate positively with performance as it is to correlate negatively.” In other words, statistically indistinguishable.

AQR examined the same data as the original study and found the same quantitative result, but reached a different implication. Andrea believes the 2% higher returns versus the benchmark the original paper touted is not because of so-called high active share, but because the small cap active managers during the evaluation period happened to outperform their benchmarks. Once you break down the data by benchmark, he finds no convincing argument.

He does believe it represents a helpful risk measure. Specifically, he views it as a measure of activity.  In his view, high active share means concentrated portfolios that can have high over-performance or high under-performance, but it does not reliably predict which.

He also sees its value in helping flag closest index funds that charge high fees, since index funds by definition have zero active share.

Why is a large firm like AQR with $136B in AUM calling a couple professors to task on this measure? Andrea believes the industry moved too fast and went too far in relying on its significance.

The folks at AlphaArchitect offer up a more modest perspective and help frame the debate in their paper, ”The Active Share Debate: AQR versus the Academics.”

Charles Ellis, renowned author and founder of Greenwich Associates, gave the lunchtime keynote presentation. It was entitled “Falling Short: The Looming Problem with 401(k)s and How To Solve It.”

He started by saying he had “no intention to make an agreeable conversation,” since his topic addressed the “most important challenge to our investment world.”

The 401(k) plans, which he traces to John D. Rockefeller’s gift to his Standard Oil employees, are falling short of where they need to be to support an aging population whose life expectancy keeps increasing.

He states that $110K is the median 401(k) plus IRA value for 65 year olds, which is simply not enough to life off for 15 years, let alone 25.

The reasons for the shortfall include employers offering a “You’re in control” plan, when most people have never had experience with investing and inevitably made decisions badly. It’s too easy to opt out, for example, or make an early withdrawal.

The solution, if addressed early enough, is to recognize that 70 is the new 65. If folks delay drawing on social security from say age 62 to 70, that additional 8 years represents an increase of 76% benefit. He argues that folks should continue to work during those years to make up the shortfall, especially since normal expenses at that time tend to be decreasing.

He concluded with a passionate plea to “Help America get it right…take action soon!” His argument and recommendations are detailed in his new book with co-authors Alicia Munnell and Andrew Eschtruth, entitled “Falling Short: The Coming Retirement Crisis and What to Do About It.”

We Are Where We Are!

By Edward A. Studzinski

“Cynicism is an unpleasant way of saying the truth.”

Lillian Hellman

Current Events:

While we may be where we are, it is worth a few moments to talk about how we got here. In recent months the dichotomy between the news agendas of the U.S. financial press and the international press has become increasingly obvious. At the beginning of August, a headline on the front page of the Financial Times read, “One Trillion Dollars in Capital Flees Emerging Markets.” I looked in vain for a similar story in The Wall Street Journal or The New York Times. There were many stories about the next Federal Reserve meeting and whether they would raise rates, stories about Hillary Clinton’s email server, and stories about Apple’s new products to come, but nothing about that capital flight from the emerging markets.

We then had the Chinese currency devaluation with varying interpretations on the motivation. Let me run a theme by you that was making the rounds of institutional investors outside of the U.S. and was reported at that time. In July there was a meeting of the International Monetary Fund in Europe. One of the issues to be considered was whether or not China’s currency, the renminbi, would be included in the basket of currencies against which countries could have special drawing (borrowing) rights. This would effectively have given the Chinese currency the status of a reserve currency by the IMF. The IMF’s staff, whose response sounded like it could have been drafted by the U.S. Treasury, argued against including the renminbi. While the issue is not yet settled, the Executive Directors accepted the staff report and will recommend extending the lifespan of the current basket, now set to expire December 31, until at least September 2016. At the least, that would lock out the renminbi for another year. The story I heard about what happened next is curious but telling. The Chinese representative at the meeting is alleged to have said something like, “You won’t like what we are going to do next as a result of this.” Two weeks after the conclusion of the IMF meeting, we then had the devaluation of China’s currency, which in the minds of some triggered the increased volatility and market sell-offs that we have seen since then.

I know many of you are saying, “Pshaw, the Chinese would never do anything as irrational as that for such silly reasons.” And if you think that dear reader, you have yet to understand the concept of “Face” and the importance that it plays in the Asian world. You also do not understand the Chinese view of self – that they are a Great People and a Great Nation. And, that we disrespect them at our own peril. If you factor in a definition of long-term, measured in centuries, events become much more understandable.

One must read the world financial press regularly to truly get a picture of global events. I suggest the Financial Times as one easily accessible source. What is reported and considered front page news overseas is very different from what is reported here. It seems on occasion that the bobble-heads who used to write for Pravda have gotten jobs in public relations and journalism in Washington and Wall Street.

One example – this week the Financial Times reported the story that many of the sovereign wealth funds (those funds established by countries such as Kuwait, Norway, and Singapore to invest in stocks, bonds, and other assets, for pension, infrastructure or healthcare, among other things), have been liquidating investments. And in particular, they have been liquidating stocks, not bonds. Another story making the rounds in Europe is that the various “Quantitative Easing” programs that we have seen in the U.S., Europe, and Japan, are, surprise, having the effect of being deflationary. And in the United States, we have recently seen the three month U.S. Treasury Bill trading at negative yields, the ultimate deflationary sign. Another story that is making the rounds – the Chinese have been selling their U.S. Treasury holdings and at a fairly rapid clip. This may cause an unscripted rate rise not intended or dictated by the Federal Reserve, but rather caused by market forces as the U.S. Treasury continues to come to market with refinancing issues.

The collapse in commodity prices, especially oil, will sooner or later cause corporate bodies to float to the surface, especially in the energy sector. Counter-party (the other side of a trade) risk in hedging and lending will be a factor again, as banks start shrinking or pulling lines of credit. Liquidity, which was an issue long before this in the stock and bond markets (especially high yield), will be an even greater problem now.

The SEC, in response to warnings from the IMF and the Federal Reserve, has unanimously (which does not often happen) called for rules to prevent investors’ demands for redemptions in a market crisis from causing mutual funds to be driven out of business. Translation: don’t expect to get your money as quickly as you thought. I refer you to the SEC’s Proposal on Liquidity Risk Management Programs.

I mention that for the better of those who think that my repeated discussions of liquidity risk is “crying wolf.”

“It’s a Fine Kettle of Fish You’ve Gotten Us in, Ollie.”

I have a friend who is a retired partner from Wellington in Boston (actually I have a number of friends who are retired partners from there). Wellington is not unique in that, like Fidelity, it is very unusual for an analyst or money manager to stay much beyond the age of fifty-five.

So I asked him one day how he had his retirement investments structured, hoping I might get some perspective into thinking on the East Coast, as well as perhaps some insights into Vanguard’s products, given the close relationship between Vanguard and Wellington. His answer surprised me – “I have it all in index funds.” I asked if there were any particular index funds. Again the answer surprised me. “No bond funds, and actually only one index fund – the Vanguard S&P 500 Index Fund.” And when I asked for further color on that, the answer I got was that he was not in the business full time anymore, looking at markets and security valuations every day, so this was the best way to manage his retirement portfolio for the long-term at the lowest cost. Did he know that there were managers, that 10% or so, who consistently (or at least for a while, consistently) outperform the index? Yes, he was aware that such managers were out there. But at this juncture in his life he did not think that he either (a) had the time, interest, and energy to devote to researching and in effect “trading managers” by trading funds and (b) did not think he had any special skill set or insights that would add value in that process that would justify the time, the one resource he could not replace. Rather, he knew what equity exposure he wanted over the next twenty or thirty years (and he recognized that life expectancies keep lengthening). The index fund over that period of time would probably compound at 8% a year as it had historically with minimal transaction costs and minimal tax consequences. He could meet his needs for a diversified portfolio of equities at an expense ratio of five basis points. The rest of his assets would be in cash or cash equivalents (again, not bonds but rather insured certificates of deposit).

I have talked in the past about the need to focus on asset allocation as one gets older, and how index funds are the low cost way to achieve asset diversification. I have also talked about how your significant other may not have the same interest or ability in managing investments (trading funds) after you go on to your just reward. But I have not talked about the intangible benefits from investing in an index fund. They lessen or eliminate the danger of portfolio manager or analyst hubris blowing up a fund portfolio with a torpedo stock. They also eliminate the divergence of interests between the investment firm and investors that arises when the primary focus is running the investment business (gathering assets).

What goes into the index is determined not by the entity running the fund (although they can choose to create their own index, as some of the European banks have done, and charge fees close to 2.00%). There is no line drawn in the sand because a portfolio manager has staked his public reputation on his or her genius in investing in a particular entity. There is also no danger in an analyst recommending sale of an issue to lock in a bonus. There is no danger of an analyst recommending an investment to please someone in management with a different agenda. There is no danger of having a truncated universe of opportunities to invest in because the portfolio manager has a bias against investing in companies that have women chief executive officers. There is no danger of stock selection being tainted because a firm has changed its process by adding an undisclosed subjective screening mechanism before new ideas may be even considered. While firm insiders may know these things, it is a very difficult thing to learn them from the outside.

Is there a real life example here? I go back to the lunch I had at the time of the Morningstar Conference in June with the father-son team running a value fund out of Seattle. As is often the case, a subject that came up (not raised by me) was Washington Mutual (WaMu, a bank holding company that collapsed in 2008, trashing a bunch of mutual funds when it did). They opined how, by being in Seattle (a big small town), they had been able to observe up close and personally how the roll-up (which was what Washington Mutual was) had worked until it didn’t. Their observation was that the Old Guard, who had been at the firm from the beginning with the chair of the board/CEO had been able to remind him that he put his pants on one leg at a time. When that Old Guard retired over time, there was no one left who had the guts to perform that function, and ultimately the firm got too big relative to what had driven past success. Their assumption was that their Seattle presence gave them an edge in seeing that. Sadly, that was not necessarily the case. In the case of many an investment firm, Washington Mutual became their Stalingrad. Generally, less is more in investing. If it takes more than a few simple declarative sentences to explain why you are investing in a business, you probably should not be doing it. And when the rationale for investing changes and lengthens over time, it should serve as a warning.

I suspect many of you feel that the investment world is not this way in reality. For those who are willing to consider whether they should rein in their animal spirits, I commend to you an article entitled “Journey into the Whirlwind: Graham-and-Doddsville Revisited” by Louis Lowenstein (2006) and published by The Center for Law and Economic Studies at Columbia Law School. (Lowenstein, father of Roger Lowenstein, looks at the antics of large growth managers and conclude, “Having attracted, not investors, but speculators trying to catch the next new thing, management got the shareholders they deserved.” Snowball). When I look at the investment management profession today, as well as its lobbying efforts to prevent the imposition of stricter fiduciary standards, I question whether what they really feel in their hearts is that the sin of Madoff was getting caught.

The End

Is there anything I am going to say this month that may be useful to the long-term investor? There is at present much fear abroad in the land about investing in emerging and frontier markets today, driven by what has happened in China and the attendant ripple effect.

The question I will pose for your consideration is this. What if five years from now it becomes compellingly obvious that China has become the dominant economic force in the world? Since economic power ultimately leads to political and military power, China wins. How should one be investing a slice of one’s assets (actively-managed of course) today if one even thinks that this is a remotely possible outcome? Should you be looking for a long-term oriented, China-centric fund?

There is one other investment suggestion I will make that may be useful to the long-term investor. David has raised it once already, and that is dedicating some assets into the micro-cap stock area. Focus on those investments that are in effect too small and extraordinarily illiquid in market capitalization for the big firms (or sovereign wealth funds) to invest in and distort the prices, both coming and going. Micro-cap investing is an area where it is possible to add value by active management, especially where the manager is prepared to cap the assets that it will take under management. Look for managers or funds where the strategy cannot be replicated or imitated by an exchange traded fund. Always remember, when the elephants start to dance, it is generally not pleasant for those who are not elephants.

Edward A. Studzinski

P.S. – Where Eagles Dare

The fearless financial writer for the New York Times, Gretchen Morgenson, wrote a piece in the Sunday Times (9/27/2015) about the asset management company First Eagle Investment Management. The article covered an action brought by the SEC for allegedly questionable marketing practices under the firm’s mutual funds’ 12b-1 Plan. Without confirming or denying the allegations, First Eagle settled the matter by paying $27M in disgorgement and interest, and $12.5M in fines. With approximately $100B in assets generating an estimated $900+M in revenues annually, one does not need to hold a Tag Day for the family-controlled firm. Others have written and will write more about this event than I will.

Of more interest is the fact that Blackstone Management Partners is reportedly purchasing a 25% stake in First Eagle that is being sold by T/A Associates of Boston, another private equity firm. As we have seen with Matthews in San Francisco, investments in investment management firms by private equity firms have generally not inured to the benefit of individual investors. It remains to be seen what the purpose is of this investment for Blackstone. Blackstone had had a right-time, right-strategy investment operation with its two previously-owned closed-end funds, The Asia Tigers Fund and The India Fund, both run by experienced teams. The funds were sold to Aberdeen Asset Management, ostensibly so Blackstone could concentrate on asset management in alternatives and private equity. With this action, they appear to be rethinking that.

Other private equity firms, like Oaktree, have recently launched their own specialist mutual funds. I would note however that while the First Eagle Funds have distinguished long-term records, they were generated by individuals now absent from the firm. There is also the question of asset bloat. One has to wonder if the investment strategy and methodology could not be replicated by a much lower cost (to investors) vehicle as the funds become more commodity-like.

Which leaves us with the issue of distribution – is a load-based product, going through a network of financial intermediaries, viable, especially given how the Millennials appear to make their financial decisions? It remains to be seen. I suggest an analogy worth considering is the problem of agency-driven insurance firms like Allstate. Allstate would clearly like to not have an agency distribution system, and would make the switch overnight if it could without losing business. It can’t, because too much of the book of business would leave. And yet, when one looks at the success of GEICO and Progressive in going the on-line or 1-800 route, one can see the competitive disadvantage, especially in automobile insurance, which is the far more profitable business to capture. It remains to be seen how distribution will evolve in the investment management world, especially as pertains to funds. As fiduciary requirements change, there is the danger of the entire industry model also changing.

Why Vanguard Will Take Over the World

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

Vanguard is eating everything. It is the biggest fund company in the U.S., with over $3 trillion in assets under management as of June-end, and the second biggest asset manager in the world, after BlackRock. Size hasn’t hampered Vanguard’s growth. According to Morningstar, Vanguard took in an estimated $166 billion in U.S. ETF and mutual fund assets in the year-to-date ending in August, over three times the next closest company, BlackRock/iShares. Not only do I think Vanguard will eventually overtake BlackRock, it will eventually extend its lead to become by far the most dominant asset manager in the world.

With index funds, investors mostly care about having their desired exposure at the lowest all-in cost, the most visible component of which is the expense ratio. In other words, index funds are commodities. In a commodity industry with economies of scale, the lowest-cost producer crushes the competition. Vanguard is the lowest-cost producer. Not only that, it enjoys a first-mover advantage and possesses arguably the most trusted brand in asset management. These advantages all feed on each other in virtuous cycles.

It’s commonly known Vanguard is owned by its mutual funds, so everything is run “at cost.” (This is a bit of a fiction; some Vanguard funds subsidize others or outside ventures.) “Profits” flow back to the funds as lower expense ratios. There are no external shareholders to please, no quarterly earnings targets to hit. Many cite this as the main reason why Vanguard has been so successful. However, the mutual ownership structure has not always led to lower all-in costs or dominance in other industries, such as insurance, or even in asset management. Mutual ownership is a necessary but not a sufficient condition for Vanguard’s success.

What separates Vanguard from other mutually owned firms is that it operates in a business that benefits from strong first-mover advantages. By being the first company to offer index funds widely, it achieved a critical mass of assets and name recognition before anyone else. Assets begot lower fees which begot even more assets, a cycle that still operates today.

While Vanguard locked up the index mutual fund market, it almost lost its leadership by being slow to launch exchange-traded funds. By the time Vanguard launched its first in 2001, State Street and Barclays already had big, widely traded ETFs covering most of the major asset classes. While CEO and later chairman of the board, founder Jack Bogle was opposed to launching ETFs. He thought the intraday trading ETFs allowed would be the rope by which investors hung themselves. From a pure growth perspective, this was a major unforced error. The mistake was reversed by his successor, Jack Brennan, after Bogle was effectively forced into retirement in 1999.

In ETFs, the first-movers not only enjoy economies of scale but also liquidity advantages that allows them to remain dominant even when their fees aren’t the lowest. When given the choice between a slightly cheaper ETF with low trading volume and a more expensive ETF with high trading volume, most investors go with the more traded fund. Because ETFs attract a lot of traders, the expense ratio is small in comparison to cost of trading. This makes it very difficult for new ETFs to gain traction when an established fund has ample trading volume. The first U.S. ETF, SPDR S&P 500 ETF SPY, remains the biggest and most widely traded. In general, the biggest ETFs were also the first to come out in their respective categories. The notable exceptions are where Vanguard ETFs managed to muscle their way to the top. Despite this late start, Vanguard has clawed its way up to become the second largest ETF sponsor in the U.S.

This feat deserves closer examination. If Vanguard’s success in this area was due to one-off factors such as the tactical cleverness of its managers or missteps by competitors, then we can’t be confident that Vanguard will overtake entrenched players in other parts of the money business. But if it was due to widely applicable advantages, then we can be more confident that Vanguard can make headway against entrenched businesses.

A one-off factor that allowed Vanguard to take on its competitors was its patented hub and spoke ETF structure, where the ETF is simply a share class of a mutual fund. By allowing fund investors to convert mutual fund shares into lower-cost ETF shares (but not the other way around), Vanguard created its own critical mass of assets and trading volume.

But even without the patent, Vanguard still would have clawed its way to the top, because Vanguard has one of the most powerful brands in investing. Whenever someone extols the virtues of index funds, they are also extoling Vanguard’s. The tight link was established by Vanguard’s early dominance of the industry and a culture that places the wellbeing of the investor at the apex. Sometimes this devotion to the investor manifests as a stifling paternalism, where hot funds are closed off and “needless” trading is discouraged by a system of fees and restrictions. But, overall, Vanguard’s culture of stewardship has created intense feelings of goodwill and loyalty to the brand. No other fund company has as many devotees, some of whom have gone as far as to create an Internet subculture named after Bogle.

Over time, Vanguard’s brand will grow even stronger. Among novice investors, Vanguard is slowly becoming the default option. Go to any random forum where investing novices ask how they should invest their savings.  Chances are good at least someone will say invest in passive funds, specifically ones from Vanguard.

Vanguard is putting its powerful brand to good use by establishing new lines of business in recent years. Among the most promising in the U.S. is Vanguard Personal Advisor Services, a hybrid robo-advisor that combines largely automated online advice with some human contact and intervention. VPAS is a bigger deal than Vanguard’s understated advertising would have you believe. VPAS effectively acts like an “index” for the financial advice business. Why go with some random Edward Jones or Raymond James schmuck who charges 1% or more when you can go with Vanguard and get advice that will almost guarantee a superior result over the long run?

VPAS’s growth has been explosive. After two years in beta, VPAS had over $10 billion by the end of 2014. By June-end it had around $22 billion, with about $10 billion of that  growth from the transfer of assets from Vanguard’s traditional financial advisory unit. This already makes Vanguard one of the biggest and fastest growing registered investment advisors in the nation. It dwarfs start-up robo-advisors Betterment and Wealthfront, which have around $2.5 billion and $2.6 billion in assets, respectively.

Abroad, Vanguard’s growth opportunities look even better. Passive management’s market share is still in the single digits in many markets and the margins from asset management are even fatter. Vanguard has established subsidiaries in Australia, Canada, Europe and Hong Kong. They are among the fastest-growing asset managers in their markets.

The arithmetic of active management means over time Vanguard’s passive funds will outperform active investors as a whole. Vanguard’s cost advantages are so big in some markets its funds are among the top performers.

Critics like James Grant, editor of Grant’s Interest Rate Observer, think passive investing is too popular. Grant argues investing theories operate in cycles, where a good idea transforms into a fad that inevitably collapses under its own weight. But passive investing is special. Its capacity is practically unlimited. The theoretical limit is the point at which markets become so inefficient that price discovery is impaired and it becomes feasible for a large subset of skilled retail investors to outperform (the less skilled investors would lose even more money more quickly in such an environment—the arithmetic of active management demands it). However, passive investing can make markets more efficient if investors opting for index funds are largely novices rather than highly trained professionals. A poker game with fewer patsies means the pros have to compete with each other.

There are some problems with passive investing. Regularities in assets flows due to index-based buying and selling has created profit opportunities for clever traders. Stocks added to and deleted from the S&P 500 and Russell 2000 indexes experience huge volumes of price-insensitive trading driven by dumb, blind index funds. But these problems can be solved by smart fund management, better index construction (for example, total market indexes) or greater diversity in commonly followed indexes.

Why Vanguard May Not Take Over the World

I’m not imaginative or smart enough to think of all the reasons why Vanguard will fail in its global conquest, but a few risks pop out.

First is Vanguard’s relative weakness in institutional money management (I may be wrong on this point). BlackRock is still top dog thanks to its fantastic institutional business. Vanguard hasn’t ground BlackRock into dust because expense ratios for institutional passively managed portfolios approach zero. Successful asset gatherers offer ancillary services and are better at communicating with and servicing the key decision makers. BlackRock pays more and presumably has better salespeople. Vanguard is tight with money and so may not be willing or able to hire the best salespeople.

Second, Vanguard may make a series of strategic blunders under a bad CEO enabled by an incompetent and servile board. I have the greatest respect for Bill McNabb and Vanguard’s current board, but it’s possible his successors and future boards could be terrible.

Third, Vanguard may be corrupted by insiders. There is a long and sad history of well-meaning organizations that are transformed into personal piggybanks for the chief executive officer and his cronies. Signs of corruption include massive payouts to insiders and directors, a reversal of Vanguard’s long-standing pattern of lowering fees, expensive acquisitions or projects that fuel growth but do little to lower fees for current investors (for example, a huge ramp up in marketing expenditures), and actions that boost growth in the short-run at the expense of Vanguard’s brand.

Fourth, Vanguard may experience a severe operational failure, such as a cybersecurity hack, that damages its reputation or financial capacity.

Individually and in total, these risks seem manageable and remote to me. But I could be wrong.

Summary

• Vanguard’s rapid growth will continue for years as it benefits from three mutually reinforcing advantages: mutual ownership structure where profits flow back to fund investors in the form of lower expenses, first-mover advantage in index funds, and a powerful brand cultivated by a culture that places the investor first.
• Future growth markets are huge: Vanguard has subsidiaries in Australia, Canada, Hong Kong and Europe. These markets are much less competitive than the U.S., have higher fees and lower penetration of passive investing. Arithmetic of active investing virtually guarantees Vanguard funds will have a superior performance record over time.
• Vanguard Personal Advisor Services VPAS stands a good chance of becoming the “index” for financial advice. Due to fee advantages and brand, VPAS may be able to replicate the runaway growth Vanguard is experiencing in ETFs.
• Limits to passive investing are overblown; Vanguard still has lots of runway.
• Vanguard may wreck its campaign of global domination through several ways, including lagging in institutional money management, incompetence, corruption, or operational failure.

Needles, haystacks and grails

By Leigh Walzer, principal of Trapezoid LLC.

The Holy Grail of mutual fund selection is predictive validity. In other words, does a positive rating today predict exceptional performance in the future? Jason Zweig of The Wall Street Journal recently cited an S&P study which found three quarters of active mutual funds fail to beat their benchmark over the long haul.

We believe it’s possible, with a reasonable degree of predictive validity, to identify the likelihood a manager will succeed in the future. Trapezoid’s Orthogonal Attribution Engine (OAE) searches for the proverbial needles in a haystack: portfolio managers who exhibit predictable skill, and particularly those who justify based on a statistical analysis paying the higher freight of an active fund. In today’s case only 1 fund has predictable skill, and none justify their expenses. In general fewer than 5% of funds meet our criteria.

One of our premises is that managers who made smart decisions in the past tend to continue and vice versa. We try to break out the different types of decisions that managers have to make (e.g., selecting individual securities, sectors to overweight or currency exposure to avoid). Our system works well based on “back testing;” that is, sitting here in 2015, constructing models of what funds looked like in the past and then seeing if we could predict forward. We have published the results of back-testing, available on our website. (Go to www.fundattribution.com, demo registration required, free to MFO readers.) Using data through July 2014, historical stock-picking skill predicted skill for the subsequent 12 months with 95% confidence. Performance over the past 5 years received the most weight but longer term results (when available) were also very important. We got similar results predicting sector-rotation skills. We repeated the tests using data through July 2013 and got nearly identical results.

We are also publishing forward looking predictions (for large blend funds) to demonstrate this point.

The hard part is measuring skill accurately. The key is to analyze portfolio weightings and characteristics over time. We derive this using both historic funds holdings data and regression/inference, supported by data on individual securities.

Here’s your challenge: you need to decide how high the chances of success need to be to justify choosing a higher-cost option in your portfolio. Should managers with great track records command a higher fee? Yes, with caveats. Although the statistical relationship is solid, skill predictions tend to be fairly conservative. This is a function of the inherent uncertainty about what the future will bring.

The confidence band around individual predictions is fairly wide. The noise level varies: some funds have longer and richer history, more consistent display of skill, longer manager tenure, better data, etc. The less certain we are the past will repeat, the less we should be willing to pay a manager with a great track record. In theory we might be willing to hire a manager if we have 51% confidence he will justify his fees, but investors may want a margin of safety.

Let’s look at some concrete examples of what that means. We are going to illustrate this month with utility funds. Readers who register at the FundAttribution website will be able to query individual funds and access other data. I do not own any of the funds discussed in this piece

Active utility funds are coming off a tough year. The average fund returned only 2.2% in the year ending July 31, 2015; that’s signaled by the “gross return” for the composite at the bottom of the fourth column. Expenses consumed more than half of that. This sector has faced heavy redemptions which may intensify as the Fed begins to taper.

FundAttribution tracks 15 active utility funds. (We also follow 2 rules-based funds and 30 active energy infrastructure funds.) We informally cluster them into three groups:

TABLE 1: Active Utility Funds. Data as of July 31, 2015

*”Predict” is our extrapolation of skill for the 12 months ending July 2016

The Conservative funds tend to stick to their knitting with 70-90% exposure to traditional utilities, <10% foreign exposure, and beta of under 60%. The Aggressive funds are the most adventurous in pursuing related industries and foreign stocks; their beta is 85% (boosted for Duff & Phelps by leverage).

Without being too technical, the OAE determines a target return for each fund each period based on all its characteristics. The difference between gross return and the target equals skill. Skill can be further decomposed into components (e.g. sector selection (sR) vs security selection (sS.) For today’s discussion skill will mean the combination of sR and sS. Here’s how to read the table above: the managers at Franklin Utilities – a huge Morningstar “gold” fund – did slightly better than a passive manager over the past year (before expenses) and underperformed for the past three and five years. We anticipate that they’re going to slightly underperform a passive alternative in the year ahead. That’s better than our system predicts for, say, Fidelity, Putnam or Gabelli but it’s still no reason to celebrate.

In the aggregate these funds have below average beta, moderate non-US exposure, value tilt and a slight midcap bias. The OAE’s target return for the sector over the last year is 6.3%, so the basket of active utility funds had skill of-3.7%. Only two of the 15 funds had positive skill. Negative overall skill means that investors could have chosen other sectors with similar characteristics which produced better returns.

The 2014 energy shock was a major contributing factor. These funds allocated on average only 60-70% to regulated electric and gas generation and distribution. Much of the balance went to Midstream Energy, Merchant Power, Exploration & Production, and Telecom. Those decisions explain most of the difference among funds. Funds which stayed close to home (Icon, Franklin, Rydex, and Putnam) navigated this environment best.

Security selection moved the needle at a few funds. Prudential Jennison stuck to S&P500 components but did a good job overweighting winners. Duff & Phelps had some dreadful performers in its non-utility portfolio.

Skill last year for the two Fidelity funds was impacted by volatile returns which may reflect increased risk-taking.

We use the historic skill to predict next year’s skill. Success over the past 5 years carries the most weight, but we look at managers’ track record, consistency, and trends over their entire tenure.

The predicted skill for next year falls within a relatively tight range: Prudential has the highest skill at 0.8%, Gabelli has the lowest at -1.4%. Either the difference between best and worst in this sector is not that great or our model is not sufficiently clairvoyant.

Either way, these findings don’t excite us to pay 120bps, which is the typical expense ratio in this sector. The OAE rates the probability a fund’s skill this year will justify the freight. Cost in the chart below is the differential between the expense ratio of a fund class and the ~15bp you would pay for a passive utility fund. This analysis varies by share class, the table below shows one representative class for each fund.

We look for funds with a probability of at least 60%, and (as shown in Table 2) none of the active funds here come close. Here’s how to read the table: our system predicts that Franklin Utilities will underperform by 0.2% over the next 12 years but that number is the center of a probable performance band that’s fairly wide, so it could outperform over the next year. Given its expenses of 60 basis points, how likely are they to pull it off? They have about a 40% chance of it to which we’d say, “not good enough.”

TABLE 2

The bottom line: We can’t recommend any of these funds. Franklin might be the least bad choice based on its low fees. Prudential Jennison (PCUFX) has shown flashes of replicable stock picking skill; they would be more competitive if they reduced fees.

Duff & Phelps (DPG) merits consideration. At press time this closed end fund trades at a 15% discount to NAV. This is arguably more than required to compensate investors for the high expenses. The fund is more growth-oriented than the peer group, runs leverage of 1.28x, and maintains significant foreign exposure. There is a 9% “dividend yield;” however, performance last year and over time was dreadful, the dividend does not appear sustainable, and the prospect of rising rates adds to the negative sentiment. So, the timing may not be right.

We show the Morningstar ratings of these funds for comparison. We don’t grade on a curve and from our perspective none of the funds deserve more than 3 stars. Investors looking for such exposure might improve their odds by buying and holding Vanguard Utilities ETF (VPU) with its 0.12% expense ratio or Utilities Select Sector SPDR (XLU)

It is hard for active utility funds to generate enough skill to justify their cost structure. The conservative funds have more or less matched passive indices, so why pay an extra 60 bps. The funds which took on more risk have a mixed record, and their fee structures tend to be even higher.

 Perhaps the industry has recognized this: outflows from actively-managed utility funds have accelerated to double digits over the past 2.5 years and the share of market held by passive funds has increased steadily. A number of industry players have repositioned their utility funds as dividend income funds or merged them into other strategies.

Next month: we will apply the same techniques to large blend funds where we hope to find a few active managers worthy of your attention

Investors who want a sneak preview (of the predicted skill by fund) can register at www.fundattribution.com and click the link near the bottom of the Dashboard page.

Your feedback is welcome at [email protected].

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

• In the first case brought under the agency’s distribution-in-guise initiative, the SEC charged First Eagle and its affiliated fund distributor with improperly using mutual fund assets to pay for the marketing and distribution of fund shares. (In re First Eagle Inv. Mgmt., LLC.)
• In the purported class action by direct investors in Northern Trust‘s securities lending program, the court struck defendants’ motion for summary judgment without prejudice. (La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)
• Adopting a Magistrate Judge’s recommendation, a court granted Nuveen‘s motion to dismiss a securities fraud lawsuit regarding four closed-end bond funds affected by the 2008 collapse of the market for auction rate preferred securities. Defendants included the independent chair of the funds’ board. (Kastel v. Nuveen Invs. Inc.)

New Lawsuits

• Alleging the same fee claim but for a different damages period, plaintiffs filed a second “anniversary complaint” in the fee litigation regarding six Principal target-date funds. The litigation has previously survived defendants’ motion to dismiss. (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal Mgmt. Corp.)
• Investment adviser Sterling Capital is among the defendants in a new ERISA class action that challenges the selection of proprietary funds for its parent company’s 401(k) plan. (Bowers v. BB&T Corp.)

Briefs

• Calamos filed a reply brief in support of its motion to dismiss fee litigation regarding its Growth Fund. (Chill v. Calamos Advisors LLC.)
• In the ERISA class action regarding Fidelity‘s practices with respect to “float income” generated from transactions in retirement plan accounts, plaintiffs filed their opening appellate brief in the First Circuit, seeking to reverse the district court decision granting Fidelity’s motion to dismiss. The U.S. Secretary of Labor filed an amicus brief in support of plaintiffs, arguing that ERISA prohibits fiduciaries from using undisclosed float income obtained through plan administration for any purpose other than to benefit the ERISA-covered plan. (Kelley v. Fid. Mgmt. Trust Co.)

The Alt Perspective: Commentary and news from DailyAlts

I think it would be safe to say that most of us are happy to see the third quarter come to an end. While a variety of issues clearly remain on the horizon, it somehow feels like the potholes of the past six weeks are a bit more distant and the more joyous holiday season is closing in. Or, it could just be cognitive biases on my part.

Either way, the numbers are in. Here is a look at the 3rd Quarter performance for both traditional and alternative mutual fund categories as reported by Morningstar.

• Large Blend U.S. Equity: -7.50%
• Foreign Equity Large Blend: -10.37
• Intermediate Term Bond: 0.32%
• World Bond: -1.22%
• Moderate Allocation: -5.59%

Anything with emerging markets suffered even more. Now a look at the liquid alternative categories:

• Long/Short Equity: -4.44
• Non-Traditional Bonds: -1.96%
• Managed Futures: 0.38%
• Market Neutral: -0.26
• Multi-Alternative: -3.05
• Bear Market: 13.05%

And a few non-traditional asset classes:

• Commodities: -14.38%
• Multi-Currency: -3.35%
• Real Estate: 1.36%
• Master Limited Partnerships: -25.73%

While some media reports have questioned the performance of liquid alternatives over the past quarter, or during the August market decline, they actually have performed as expected. Long/short funds outperformed their long-only counterparts, managed futures generated positive performance (albeit fairly small), market neutral funds look fairly neutral with only a small loss on the quarter, and multi-alternative funds outperformed their moderate allocation counterparts.

The one area in question is the non-traditional bond category where these funds underperformed both traditional domestic and global bond funds. Long exposure to riskier fixed income asset would certainly have hurt many of these funds.

Declining energy prices zapped both the commodities and master limited partnerships categories, both of which had double-digit losses. Surprisingly, real estate held up well and there is even talk of developers looking to buy-back REITs due to their low valuations.

Let’s take a quick look at asset flows for August. Investors continued to pour money into managed futures funds and multi-alternative funds, the only two categories with positive inflows in every month of 2015. Volatility also got a boost in August as the CBOE Volatility Index spiked during the month. The final category to gather assets in August was commodities, surprisingly enough.

A few research papers of interest this past month:

PIMCO Examines How Liquid Alternatives Fit into Portfolios – this is a good primer on liquid alternatives with an explanation of how evaluated and use them in a portfolio.

The Path Forward for Women in Alternatives – this is an important paper that documents the success women have had in the alternative investment business. While there is much room for growth, having a study to outline the state of the current industry helps create more awareness and attention on the topic.

Investment Strategies for Tough Times – AQR provides a review of the 10 worst quarters for the market since 1972 and shows which investment strategies performed the best (and worst) in each of those quarters.

And finally, there were two regulatory topics that grabbed headlines this past month. The first was an investor alert issued by FINRA regarding “smart beta” product. Essentially, FINRA wanted to warn investors that not all smart beta products are alike, and that many different factors drive their returns. Essentially, buyer beware. The second was from the SEC who is proposing new liquidity rules for mutual funds and ETFs. One of the more pertinent rules is that having to do with maintain a three-day liquid asset minimum that would likely force many funds to hold more cash, or cash equivalents. This proposal is now in the 90-day comment period.

Have a great October and we will talk again (in this virtual way) just after Halloween! Let’s just hope the Fed doesn’t have any tricks up their sleeve in the meantime.

Elevator Talk: Michael Underhill, Capital Innovations Global Agri, Timber, Infrastructure Fund (INNAX)

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

Michael Underhill manages INNAX, which launched at the end of September 2012. Mr. Underhill worked as a real asset portfolio manager for AllianceBernstein and INVESCO prior to founding Capital Innovations in 2007. He also manages about $170 million in this same strategy through separate accounts and four funds available only to Canadian investors.

Assets can be divided into two types: real and financial. Real assets are things you can touch: gold, oil, roads, bridges, soybeans, and lumber. Financial assets are intangible; stocks, for example, represent your hypothetical fractional ownership of a corporation and your theoretical claim to some portion of the value of future earnings.

Most individual portfolios are dominated by financial assets. Most institutional portfolios, however, hold a large slug of real assets and most academic research says that the slug should be even larger than it is.

Why so? Real assets possess four characteristics that are attractive and difficult to achieve.

They thrive in environments hostile to stocks and bonds. Real assets are positively correlated with inflation, stocks are weakly correlated with inflation and bonds are negatively correlated. That is, when inflation rises, bonds fall, stocks stall and real assets rise.

They are uncorrelated with the stock and bond markets. The correlation of returns for the various types of real assets hover somewhere just above or just below zero with relation to both the stock and bond market.

They are better long term prospects than stocks or bonds. Over the past 10- and 20-year periods, real assets have produced larger, steadier returns than either stocks or bonds. While it’s true that commodities have cratered of late, it’s possible to construct a real asset portfolio that’s not entirely driven by commodity prices.

A portfolio with real assets outperforms one without. The research here is conflicted. Almost everything we’ve read suggests that some allocation to real assets improves your risk-return profile. That is, a portfolio with real assets, stocks and bonds generates a greater return for each additional unit of risk than does a pure stock/bond portfolio. Various studies seem to suggest a more-or-less permanent real asset allocation of between 20-80% of your portfolio. I suspect that the research oversimplifies the situation since some of the returns were based on private or illiquid investments (that is, someone buying an entire forest) and the experience of such investments doesn’t perfectly mirror the performance of liquid, public investments.

Inflation is not an immediate threat but, as Mr. Underhill notes, “it’s a lot cheaper to buy an umbrella on a sunny day than it is once the rain starts.” Institutional investors, including government retirement plans and university endowments, seem to concur. Their stake in real assets is substantial (14-20% in many cases) and growing (their traditional stakes, like yours, were negligible).

INNAX has performed relatively well – in the top 20% of its natural resources peer group – over the past three years, aided by its lighter-than-normal energy stake. The fund is down about 5% since inception while its peers posted a 25% loss in the same period. The fund is fully invested, so its outperformance cannot be ascribed to sitting on the sidelines.

Here are Mr. Underhill’s 200 words on why you should add INNAX to your due-diligence list:

There was no question about what I wanted to invest in. The case for investing in real assets is compelling and well-established. I’m good at it and most investors are underexposed to these assets. So real asset management is all we do. We’re proud to say we’re an inch wide and a mile deep.

The only question was where I would be when I made those investments. I’ve spent the bulk of my career in very large asset management firms and I’d grown disillusioned with them. It was clear that large fund companies try to figure out what’s going to raise the most in terms of fees, and so what’s going to bring in the most fees. The strategies are often crafted by senior managers and marketing people who are concerned with getting something trendy up and out the door fast. You end up managing to a “product delivery specification” rather than managing for the best returns.

I launched Capital Innovations because I wanted the freedom and opportunity to serve clients and be truly innovative; we do that with global, all-cap portfolios that strive to avoid some of the pitfalls – overexposure to volatile commodity marketers, disastrous tax drags – that many natural resources funds fall prey to. We launched our fund at the request of some of our separate account clients who thought it would make a valuable strategy more broadly available.

Capital Innovations Global Agri, Timber, Infrastructure Fund has a $2500 minimum initial investment which is reduced to $500 for IRAs and other types of tax-advantaged accounts. Expenses are capped at 1.50% on the investor shares and 1.25% for institutional shares, with a 2.0% redemption fee on shares sold within 90 days. There’s a 5.75% front load that’s waived on some of the online platforms (e.g., Schwab). The fund has about gathered about $7 million in assets since its September 2012 launch. Here’s the fund’s homepage. It’s understandably thin on content yet but there’s some fairly rich analysis on the Capital Innovations page devoted to the underlying strategy. Our friends at DailyAlts.com interviewed Mr. Underhill in December 2014, and he laid out the case for real assets there. An exceptionally good overview of the case for real asset investing comes from Brookfield Asset Management, in Real Assets: The New Essential (2013) though everyone from TIAA-CREF to NACUBO have white papers on the subject.

My retirement portfolio has a small but permanent niche for real assets, which T. Rowe Price Real Assets (PRAFX) and Fidelity Strategic Real Return (FSRRX) filling that slot.

Launch Alert: Thornburg Better World

Earlier this summer, we argued that “doing good” and “doing well” were no longer incompatible goals, if they ever were. A host of academic and professional research has demonstrated that sustainable (or ESG) investing does not pose a drag on portfolio performance. That means that investors who would themselves never sell cigarettes or knowing pollute the environment can, with confidence, choose investing vehicles that honor those principles.

The roster of options expanded by one on October 1, with the launch of Thornburg Better World International Fund (TBWAX).  The fund will target “high-quality, attractively priced companies making a positive impact on the world.” That differs from traditional socially-responsible investments which focused mostly on negative screens; that is, they worked to exclude evil-doers rather than seeking out firms that will have a positive impact.

They’ll examine a number of characteristics in assessing a firm’s sustainability: “environmental impact, carbon footprint, senior management diversity, regulatory and compliance track record, board independence, capital allocation decisions, relationships with communities and customers, product safety, labor and employee development practices, relationships with vendors, workplace safety, and regulatory compliance, among others.”

The fund is managed by Rolf Kelly, CFA, portfolio manager of Thornburg’s Socially Screened International Equity Strategy (SMA). The portfolio will have 30-60 names. The initial expense ratio is 1.83%. The minimum initial investment is $5000.

Funds in Registration

There are seven new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase in December.

While the number is small, many of them represent new offerings from “A” tier shops: DoubleLine Global Bond, Matthews Asia Value and two dividend-oriented international index funds from Vanguard

Manager Changes

Give or take Gary Black’s departure from Calamos, there were about 46 mostly low-visibility shifts in teams.

Thinking outside the model is hazardous to one’s wealth…

The title comes from the AlphaArchitect’s DIY Investing site, which is led by Wesley Gray. We profiled the firm’s flagship ValueShares US Quantitative Value ETF (QVAL) last December. Wes, along with Jack Vogel and David Foulke, recently published the Wiley Finance Series book, “DIY Finanical Advisor – A Simple Solution to Build and Protect Your Wealth.” It’s a great read.

It represents a solid answer to the so-called “return gap” problem described by Jason Hsu of Research Associates during Morningstar’s ETF Conference yesterday. Similar to and inspired by Morningstar’s “Investor Return” metric, Jason argues that investors’ bad decisions based on performance chasing and bad timing account for a 2% annualized short-fall between a mutual fund’s long-term performance and what investors actually receive. (He was kind enough to share his briefing with us, as well as his background position paper.)

“Investors know value funds achieve a premium, but they are too undisciplined to stay the course once the value fund underperforms the market.” It’s not just retail investors, Jason argues the poor behavior has actually been institutionalized and at some level may be worse for institutional investors, since their jobs are often based on short-term performance results.

DIY Financial Advisor opens by questioning society’s reliance on “expert opinion,” citing painful experiences of Victor Niederhoffer, Meredith Whitney, and Jon Corzine. It attempts to explain why financial experts often fail, due various biases, overconfidence, and story versus evidence-based decisions. The book challenges so-called investor myths, like…

• Buffett’s famous advice: “It’s far better to buy a wonderful company at a fair price than a fair company at the wonderful price.”
• Economic growth drives stock returns.
• Payout superstition, where observers predict that lower-dividend payout ratios imply higher earnings growth.

In order to be good investors, the book suggests that we need to appreciate our natural preference for coherent stories over evidence that conflicts with the stories. Don’t be the pigeon doing a “pellet voodoo dance.”

It advocates adoption of simple and systematic investment approaches that can be implemented by normal folks without financial background. The approaches may not be perfect, but they have been empirically validated, like the capture of value and momentum premiums, to work “for a large group of investors seeking to preserve capital and capture some upside.”

Wes details how and why Harry Markowitz, who won the Nobel Prize in 1990 for his groundbreaking work in portfolio selection and modern portfolio theory, used a simple equal-weight 50/50 allocation between bond and equities when investing his own money.

The book alerts us to fear, greed, complexity, and fear tactics employed by some advisors and highlights need for DIY investors to examine fees, access/liquidity, complexity, and taxes when considering investment vehicles.

It concludes by stating that “as long as we are disciplined and committed to a thoughtful process that meets our goals, we will be successful as investors. Go forth and be one of the few, one of the proud, one of the DIY investors who took control of their hard-earned wealth. You won’t regret the decision.”

As with Wes’ previous book, Quantitative Value: A Practitioner’s Guide to Automating Intelligent Investment and Eliminating Behavioral Errors, DIY Financial Advisor is chock full of both anecdotes and analytical results. He and his team at AlphaArchitect continue to fight the good fight and we investors remain the beneficiaries.

Briefly Noted . . .

I hardly know how to talk about this one. Gary Black is “no longer a member of the investment team managing any of the series of the Calamos Investment Trust other than the Calamos Long/Short Fund … all references to Mr. Black’s position of Global Co-CIO and his involvement with all other series of the Calamos Investment Trust except for the Calamos Long/Short Fund shall be deemed deleted from the Summary Prospectuses, Prospectuses, and Statement of Additional Information of the Calamos Investment Trust.” In addition, Mr. Black ceased managing the fund that he brought to the firm, Calamos Long/Short (CALSX), on September 30, 2015. Mr. Black’s fund had about $100 million in assets and perfectly reasonable performance. The announcement of Mr. Black’s change of status was “effectively immediately,” which has rather a different feel than “effective in eight weeks after a transition period” or something similar.

Mr. Black came to Calamos after a tumultuous stint at the Janus Funds. Crain’s Chicago Business reports that Mr. Black “expanded the Calamos investment team by 50 percent, adding 25 investment professionals, and launched four funds,” but was not necessarily winning over skeptical investors.  The firm had $23.2 billion in assets under management at the end of August, 2015. That’s down from $33.4 billion on June 30, 2012, just before his hiring.

He leaves after three years, a Calamos rep explained, because he “completed the work he was hired to do. With John’s direction, he helped expand the investment teams and create specialized teams. During the past 18 months, performance has improved, signaling the evolution of the investment team is working.” Calamos, like PIMCO, is moving to a multiple CIO model. When asked if the experience of PIMCO after Gross informed their decision, Calamos reported that “We’ve extensively researched the industry overall and believe this is the best structure for a firm our size.”

“Mr. Black’s future plans,” we’ve been told, “are undecided.”

Toroso Newfound Tactical Allocation Fund (TNTAX) is a small, expensive, underperforming fund-of-ETFs. Not surprisingly, it was scheduled for liquidation. Quite surprisingly, at the investment advisor’s recommendation, the fund’s board reversed that decision and reopened the fund to new investors.  No idea of why.

Thanks, as always, to The Shadow for his help in tracking publicly announced but often little-noticed developments in the fund industry. Especially in month’s like the one just passed, it’s literally true that we couldn’t do it without his assistance. Cheers, big guy!

SMALL WINS FOR INVESTORS

Artisan Global Value Fund (ARTGX) reopened to new investors on October 1, 2015. I’m not quite sure what to make of it. Start with the obvious: it’s a splendid fund. Five stars. A Morningstar “Silver” fund. A Great Owl. Our profiles of the fund all ended with the same conclusion: “Bottom Line: We reiterate our conclusion from 2008, 2011 and 2012: ‘there are few better offerings in the global fund realm.’” That having been said, the fund is reopening with $1.6 billion in assets. If Morningstar’s report is to be trusted, assets grew by $700 million in the past 30 days. The fund is just one manifestation of Artisan’s Global Value strategy so one possible explanation is that Artisan is shifting assets around inside the $16 billion strategy, moving money from separate accounts into the fund. And given market volatility, the managers might well see richer opportunities – or might anticipate richer opportunities in the months ahead.

Effective September 15, 2015, the Westcore International Small-Cap Fund (the “Fund”) will reopen to new investors.

CLOSINGS (and related inconveniences)

Effective September 30, 361 Managed Futures Strategy Fund (AMFQX) closed to new investors.  It’s got about a billion in assets and a record that’s dramatically better than its peers’.

Artisan International Fund (ARTIX) will soft-close on January 29, 2016. The fund is having a tough year but has been a splendid performer for decades. The key is that it has tripled in size, to $18 billion, in the past four years, driven by a series of top-tier performances.

As of the close of business on October 31, 2015, Catalyst Hedged Futures Strategy Fund (HFXAX) will close to “substantially all” new investors.

Glenmede Small Cap Equity Portfolio (GTCSX) closed to new investors on September 30^th, on short notice. The closure also appears to affect current shareholders who purchased the fund through fund supermarkets.

OLD WINE, NEW BOTTLES

Aberdeen U.S. Equity Fund

Effective October 31, 2015, the name of the Aberdeen U.S. Equity Fund will change to the Aberdeen U.S. Multi-Cap Equity Fund.

Ashmore Emerging Markets Debt Fund will change its name to Ashmore Emerging Markets Hard Currency Debt Fund on or about November 8, 2015

Columbia Marsico Global Fund (COGAX) is jettisoning Marsico (that happens a lot) and getting renamed Columbia Select Global Growth Fund.

Destra Preferred and Income Securities Fund (DPIAX) has been renamed Destra Flaherty & Crumrine Preferred and Income Fund.

Dividend Plus+ Income Fund (DIVPX) has changed its name to MAI Managed Volatility Fund.

Forward Dynamic Income Fund (FDYAX) and Forward Commodity Long/Short Strategy Fund (FCOMX) have both decided to change their principal investment strategies, risks, benchmark and management team, effective November 3.

KKM U.S. Equity ARMOR Fund (UMRAX) terminated Equity Armor’s advisory contract. KKM Financial will manage the fund, now called KKM Enhanced U.S. Equity Fund (KKMAX) on its own

Effective September 10, 2015, the Pinnacle Tactical Allocation Fund change its name to the Pinnacle Sherman Tactical Allocation Fund (PTAFX).

At an August meeting, the Boards of the Wells Fargo Advantage Funds approved removing the word “Advantage” from its name, effective December 15, 2015.

Royce 100 Fund (RYOHX) was renamed Royce Small-Cap Leaders Fund on September 15, 2015. The new investment strategy is to select “securities of ‘leading’ companies—those that in its view are trading at attractive valuations that also have excellent business strengths, strong balance sheets, and/or improved prospects for growth, as well as those with the potential for improvement in cash flow levels and internal rates of return.” Chuck Royce has run the fund since 2003. It was fine through the financial crisis, and then began stumbling during the protracted bull run and trails 98% of its peers over the past five years.

Effective November 20, 2015, Worthington Value Line Equity Advantage Fund (WVLEX) becomes Worthington Value Line Dynamic Opportunity Fund. The fund invests, so far with no success, mostly in closed-end funds. It’s down about 10% since its launch in late January and the pass-through expenses of the CEFs it holds pushes the fund’s e.r. to nearly 2.5%. At that point its investment objective becomes the pursuit of “capital appreciation and current income” (income used to be “secondary”) and Liane Rosenberg gets added as a second manager joining Cindy Starke. Rosenberg is a member of the teams that manage Value Line’s other funds and, presumably, she brings fixed-income expertise to the table. The CEF universe is a strange and wonderful place, and part of the fund’s wretched performance so far (it’s lost more than twice as much since launch than the average large cap fund) might be attributed to a stretch of irrational pricing in the CEF market. Through the end of August, equity CEFs were down 12% YTD in part because their discounts steadily widened. WVLEX was also handicapped by an international stake (21%) that was five times larger than their peers. That having been said, it’s still not clear how the changes just announced will make a difference.

OFF TO THE DUSTBIN OF HISTORY

AB Market Neutral Strategy-U.S. (AMUAX) has closed and will liquidate on December 2, 2015. The fund has, since inception, bounced a lot and earned nothing: $10,000 at inception became $9,800 five years later.

Aberdeen High Yield Fund (AUYAX) is yielding to reality – it is trailing 90% of its peers and no one, including its trustees and two of its four managers, wanted to invest in it – and liquidating on October 22, 2015.

Ashmore Emerging Markets Currency Fund (ECAX), which is surely right now a lot like the “Pour Molten Lava on my Chest Fund (PMLCX), will pass from this vale of tears on October 9, 2015.

The small-and-dull, but not really bad, ASTON/TAMRO Diversified Equity Fund (ATLVX) crosses into the Great Unknown on Halloween. It’s a curious development since the same two managers run the half billion dollar Small Cap Fund (ATASX) that’s earned Morningstar’s Silver rating.

BlackRock Ultra-Short Obligations Fund (BBUSX): “On or about November 30, 2015,all of the assets of the Fund will be liquidated completely.” It’s a perfectly respectable ultra-short bond fund, with negligible volatility and average returns, that only drew $30 million. For a giant like BlackRock, that’s beneath notice.

At the recommendation of the fund’s interim investment adviser, Cavalier Traditional Fixed Income Fund (CTRNX) will be liquidated on October 5, 2015. Uhhh … yikes!

Dreyfus International Value Fund (DVLAX) is being merged into Dreyfus International Equity Fund (DIEAX). On whole, that’s a pretty clean win for the DVLAX shareholders.

Eaton Vance Global Natural Resources Fund (ENRAX) has closed and will liquidate on or about Halloween.  $4 million dollars in a portfolio that’s dropped 41% since launch, bad even by the standards of funds held hostage to commodity prices.

Shareholders have been asked to approve liquidation of EGA Frontier Diversified Core Fund (FMCR), a closed-end interval fund. Not sure how quickly the dirty deed with be done.

Fallen Angels Value Fund (FAVLX) joins the angels on October 16, 2015.

The termination and liquidation the Franklin Global Allocation Fund (FGAAX), which was scheduled to occur on or about October 23, 2015, has again been delayed due to foreign regulatory restrictions that prohibit the fund from selling one of its portfolio securities. The new liquidation target is January 14, 2016.

The $7 million Gateway International Fund (GAIAX) will liquidate on November 12, 2015. It’s an international version of the $7.7 billion, options-based Gateway Fund (GATEX) and is run by the same team. GAIAX has lost money since launch, and in two of the three years it’s been around, and trails 90% of its peers. Frankly, I’ve always been a bit puzzled by the worshipful attention that Gateway receives and this doesn’t really clear it up for me.

Inflation Hedges Strategy Fund (INHAX) has closed and will liquidate on October 22, 2015.

Janus Preservation Series – Global (JGSAX) will be unpreserved as of December 11, 2015.

Shareholders are being asked to merge John Hancock Fundamental Large Cap Core Fund (JFLAX) into John Hancock Large Cap Equity Fund TAGRX). The question will be put to them at the end of October. They should vote “yes.”

MFS Global Leaders (GLOAX) will liquidate on November 18, 2015.

Riverside Frontier Markets Fund ceased to exist on September 25, 2015 but the board assures us that the liquidation was “orderly.”

Salient Global Equity Fund (SGEAX) will liquidate around October 26, 2015.

Transamerica is proposing a rare reorganization of a closed-end fund (Transamerica Income Shares, Inc.) into one of their open-end funds, Transamerica Flexible Income (IDITX). The proposal goes before shareholders in early November.

MFO Switches To Lipper Database

In weeks ahead, MFO will begin using a Lipper provided database to compute mutual fund risk and return metrics found on our legacy Search Tools page and on the MFO Premium beta site.

Specifically, the monthly Lipper DataFeed Service provides comprehensive fund overview details, expenses, assets, and performance data for US mutual funds, ETFs, and money market funds (approximately 29,000 fund share classes).

Lipper, part of Thomson Reuters since 1998, has been providing “accurate, insightful, and timely collection and analysis of fund data” for more than 40 years. Its database extends back to 1960.

The methodologies MFO uses to compute its Great Owl funds, Three Alarm and Honor Roll designations, and Fund Dashboard of profiled funds will remain the same. The legacy search tool site will continue to be updated quarterly, while the premium site will be updated monthly.

Changes MFO readers can expect will be 1) quicker posting of updates, typically within first week of month, 2) more information on fund holdings, like allocation, turnover, market cap, and bond quality, and 3) Lipper fund classifications instead of the Morningstar categories currently used.

A summary of the Lipper classifications or categories can be found here. The more than 150 categories are organized under two main types: Equity Funds and Fixed Income Funds.

The Equity Funds have the following sub-types: US Domestic, Global, International, Specialized, Sector, and Mixed Asset. The Fixed Income Funds have: Short/Intermediate-Term U.S. Treasury and Government, Short/Intermediate-Term Corporate, General Domestic, World, Municipal Short/Intermediate, and Municipal General.

The folks at Lipper have been a pleasure to work with while evaluating the datafeed and during the transition. The new service supports all current search tools and provides opportunity for content expansion. The MFO Premium beta site in particular features:

• Selectable evaluation periods (lifetime, 20, 10, 5, 3, and 1 year, plus full, down, and up market cycles) for all risk and performance metrics, better enabling direct comparison.
• All share classes, not just oldest.
• More than twenty search criteria can be selected simultaneously, like Category, Bear Decile, and Return Group, plus sub-criteria. For example, up to nine individual categories may be selected, along with multiple risk and age characteristics.
• Compact, sortable, exportable search table outputs.
• Expanded metrics, including Peer Count, Recovery Time, and comparisons with category averages.

Planned content includes: fund rankings beyond those based on Martin ratio, including absolute return, Sharpe and Sortino ratios; fund category metrics; fund house performance ratings; and rolling period fund performance.

In Closing . . .

The Shadow is again leading the effort on MFO’s discussion board to begin cataloging capital gain’s announcements. Ten firms had year-end estimates out as of October 1. Last year’s tally on the board reached 160 funds. Mark Wilson’s Cap Gains Valet site is still hibernating. If Mark returns to the fray, we’ll surely let you know.

It’s hard to remember but, in any given month, 7000-8000 people read the Observer for the first time. Some will flee in horror, others will settle in. That’s my excuse for repeating the exhortation to bookmark MFO’s link to Amazon.com!  While we are hopeful that our impending addition of a premium site will generate a sustainable income stream to help cover the costs of our new data feed and all, Amazon still provides the bulk of our revenue. That makes our September 2015 returns, the lowest in more than two years, a bit worrisome.

The system is simple: (1) bookmark our link to Amazon. Better yet, set it as one of your browser’s “open at launch” tabs. (2) When you want to shop at Amazon, click on that link or use that tab.  You do not have to come to MFO and click on the link on your way to Amazon. You go straight there. On your address bar, you’ll see a bit of coding (encoding=UTF8&tag=mutufundobse-20) that lets Amazon know you’re using our link. (3) Amazon then contributes an amount equivalent to 5% or so of your purchase to MFO. You’re charged nothing since it’s part of their marketing budget. And we get the few hundred a month that allows us to cover our “hard” expenses.

I’m not allowed to use the link myself, so my impending purchases of Halloween candy (Tootsie Rolls and Ring Pops, mostly) and a coloring book (don’t ask), will benefit the music program at my son’s school.

Thanks especially to the folks who made contributions to the Observer this month.  That includes a cheerful wave to our subscribers, Greg and Deb, to the good folks at Cook & Bynum and at Focused Finances, to Eric E. and Sunil, both esteemed repeat offenders, as well as to Linda Who We’ve Never Met Before and Richard. To one and all, thanks! You made it a lot easier to have the confidence to sign the data agreement with Lipper.

We’ll look for you.

Dear friends,

They’re baaaaaack!

My students came rushing back to campus and, so far as I can tell, triggered some sort of stock market rout upon arrival. I’m not sure how they did it, but I’ve learned not to underestimate their energy and manic good spirits.

They’re a bright bunch, diverse in my ways. While private colleges are often seen as bastion of privilege, Augustana was founded to help the children of immigrants make their way in a new land. Really that mission hasn’t much changed in the past 150 years: lots of first-generation college students, lots of students of color, lots of kids who shared the same high school experience. They weren’t the class presidents so much as the ones who quietly worked to make sure that things got done.

It’s a challenge to teach them, not because they don’t want to learn but because the gulf between us is so wide. By the time they were born, I was already a senior administrator and a full-blown fuddy duddy. But we’re working, as always we do, to learn from each other. Humility is essential, both a sense of humor and cookies help.

Your first and best stop-loss order

The week’s events have convinced us that you all need to learn how to execute a stop-loss order to protect yourself in times like these. A stop-loss order is an automatic, pre-established command which kicks in when markets gyrate and which works to minimize your losses. Generally they’re placed through your broker (“if shares of X fall below $12/share, sell half my holdings. If it falls below $10, liquidate the position”) but an Observer Stop Loss doesn’t require one. Here’s how it works:

• On any day in which the market falls by enough to make you go “sweet Jee Zus!”
• Step Away from the Media
• Put Down your Phone
• Unhand that Mouse
• And Do Nothing for seven days.

Well, more precisely, “do nothing with your portfolio.” You’re more than welcome to, you know, have breakfast, go to the bathroom, wonder what it’s going to take for anyone to catch the Cardinals, figure out what you’re going to do with that ridiculous pile of tomatoes and all that.

My Irish grandfather told me that the worst time to fix a leaky roof is in a storm. “You’ll be miserable, you might break your neck and you’ll surely make a hames of it.” (I knew what Gramps meant and didn’t get around to looking up the “hames” bit until decades later when I was listening to the thunder and staring at a growing damp spot in the ceiling.)

The financial media loves financial cataclysm to the same extent, and for the same reason, that The Weather Channel loves superstorms. It’s a great marketing tool for them. It strokes their egos (we are important!). And it drives ratings.

Really, did you think this vogue for naming winter storms came from the National Weather Service? No, no, no.  “Winter Storm Juno” was straight from the marketing folks at TWC.

If CNBC’s ratings get any worse, I’m guessing that we’ll be subjected to Market Downturn Alan soon enough.

By and large, coverage of the market’s recent events has been relentlessly horrible. Let’s start with the obvious: if you invested $10,000 into a balanced portfolio on August 18, on Friday, August 28 you had $9,660.

That’s it. You dropped 3.4%.

(Don’t you feel silly now?)

The most frequently-invoked word in headlines? “Bloodbath.”

MarketWatch: What’s next after market’s biggest bloodbath of the year ? (Apparently they’re annual events.)

ZeroHedge: US Market Bouncing Back After Monday’s Bloodbath (hmm, maybe they’re weekly events?)

Business Insider: Six horrific stats about today’s market bloodbath. (“Oil hit its lowest level since March 2009.” The horror, the horror!)

ZeroHedge: Bloodbath: Emerging Market Assets Collapse. (Ummm … a $10,000 investment in an emerging markets balanced fund, FTEMX in this case, would have “collapsed” to $9872 over those two weeks.)

RussiaToday: It’s a Bloodbath. (Odd that this is the only context in which Russia Today is willing to apply that term.)

By Google’s count, rather more than 64,000 market bloodbaths in the media.

Those claims were complemented by a number of “yeah, it could get a lot worse” stories:

NewsMax: Yale’s Shiller, “Even bigger” plunge may follow.

Brett Arends: Dow 5,000? Yes, it could happen. (As might a civilization-ending asteroid strike or a Cubs’ World Series win.)

Those were bookended with celebratory but unsubstantiated claims (WSJ: U.S. stock swings don’t shake investors; Barry Ritholz: Mom and pop outsmart Wall Street pros) that “mom ‘n’ pop” stood firm.

Bottom line: nothing you read in the media over the past couple weeks improved either your short- or long-term prospects. To the contrary, it might well have encouraged you (or your clients) to do something emotionally satisfying and financially idiotic. The markers of panic and idiocy abound: Vanguard had to do the “all hands on deck” drill in which portfolio managers and others are pulled in to manage the phone banks, Morningstar’s site repeatedly froze, the TD Ameritrade and Scottrade sites couldn’t execute customer orders, and prices of thousands of ETFs became unmoored from the prices of the securities they held. We were particularly struck by trading volume for Vanguard’s Total Stock Market ETF (VTI).

That’s a 600% rise from its average volume.

Two points:

1. Winter is coming. Work on your roof now!

   Some argue that a secular bear market started last week. (Some always say that.) Some serious people argue that a sharp jolt this year might well be prelude to a far larger disruption later next year. Optimists believe that we are on a steadily ascending path, although the road will be far more pitted than in recent memory.

   Use the time you have now to plan for those developments. If you looked at your portfolio and thought “I didn’t know it could be this bad this fast,” it’s time to rethink.

   Questions worth considering:

   • Are you ready to give up Magical Thinking yet? Here’s the essence of Magical Thinking: “Eureka! I’ve found it! The fund that makes over 10% in the long-term and sidesteps turbulence in the short-term! And it’s mine. Mine! My Preciousssss!” Such a fund does not exist in the lands of Middle-Earth. Stop expecting your funds to act as if they do.
   • Do you have more funds in your portfolio than you can explain? Did you look at your portfolio Monday and think, honestly puzzled, “what is that fund again?”
   • Do you know whether traditional hybrid funds, liquid alt funds or a slug of low-volatility assets is working better as your risk damper? Folks with either a mordant sense of humor or stunted perspective declared last week that liquid alts funds “passed their first test with flying colors.” Often that translated to: “held up for one day while charging 2.75% for one year.”
   • Have you allocated more to risky assets than you can comfortably handle? We’re written before about the tradeoffs embedded in a stock-light strategy where 70% of the upside for 50% of the downside begins to sound less like cowardice and more like an awfully sweet deal.
   • Are you willing to believe that the structure of the fixed income market will allow your bond funds to deliver predictable total returns (current income plus appreciation) over the next five to seven years? If critics are right, a combination of structural changes in the fixed-income markets brought on by financial reforms and rising interest rates might make traditional investment-grade bond funds a surprisingly volatile option.

   If your answer is something like “I dunno,” then your answer is also something like “I’m setting myself up to fail.” We’ll try to help, but you really do need to set aside some time to plan (goals –> resources –> strategies –>tactics) with another grown-up. Bring black coffee if you’re Lutheran, Scotch if you aren’t.

2. If you place your ear tightly against the side of any ETF, you’re likely to hear ticking.

   My prejudices are clear and I’ll repeat them here. I think ETFs are the worst financial innovation since the Ponzi scheme. They are trading vehicles, not investment vehicles. The Vanguard Total Stock Market ETF has no advantage over the Vanguard Total Stock Market Index fund (the tiny expense gap is consumed in trading costs) except that it can be easily and frequently traded. The little empirical research available documents the inevitable: when given a trading vehicle, investors trade. And (the vast majority of) traders lose.

   Beyond that, ETFs cause markets to move in lockstep: all securities in an ETF – the rock solid and the failing, the undervalued and the overpriced – are rewarded equally when investors purchase the fund. If people like small cap Japanese stocks, they bid up the price of good stocks and bad, cheap and dear, which distorts the ability of vigilantes to enforce some sort of discipline.

   And, as Monday demonstrates, ETFs can fail spectacularly in a crisis because the need for instant pricing is inconsistent with the demands of rational pricing. Many ETFs, CEFs and some stocks opened Monday with 20-30% losses, couldn’t coordinate buyers and sellers fast enough and that caused a computer-spawned downward price spiral. Josh Brown makes the argument passionately in his essay “Computers are the new dumb money” and followed it up with the perhaps jubilant report that some of the “quants I know told me the link was hitting their inboxes all day from friends and colleagues around the industry. A few desk traders I talk to had some anecdotes backing my assumptions up. One guy, a ‘data scientist’, was furiously angry, meaning he probably blew himself up this week.”

   As Chris Dietrich concludes in his August 29 Barron’s article, “Market Plunge Provides Harsh Lessons for ETF Investors”

   For long-term investors unsure of their trading chops, or if uncertainty reigns, mutual funds might be better options. Mutual fund investors hand over their money and let the fund company do the trading. The difference is that you get the end-of-day price; the price of an ETF depends on when you sold or bought it during the trading day. “There are benefits of ETFs, including transparency and tax efficiency, but those come at a cost, which is that is you must be willing to trade,” says Dave Nadig, director of ETFs at FactSet Research Systems. “If you don’t want to be trading, you should not be using ETFs.”

The week’s best

Jack Bogle, Buddhist. Jack Bogle: “I’ve seen turbulence in the market. This is not real turbulence. Don’t do something. Just stand there.” (Thanks for johnN for the link.) Vanguard subsequently announced, “The Inaction Plan.”

All sound and fury, signifying nothing. Jason Zweig: “The louder and more forcefully a market pundit voices his certainty about what is going to happen next, the more likely it is that he will turn out to be wrong.”

Profiting from others’ insanity

Anyone looking at the Monday, 8/24, opening price for, say, General Electric – down 30% within the first few seconds – had to think (a) that’s insanity and (b) hmmm, wonder if there’s a way to profit from it? It turns out that the price of a number of vehicles – stocks, a thousand ETFs and many closed-end funds – became temporarily unmoored from reality. The owners of many ETFs, for example, were willing to sell $10 worth of stock for $7, just to get rid of it.

The folks at RiverNorth are experts at arbitraging such insanity. They track the historical discounts of closed-end funds; if a fund becomes temporarily unmoored, they’ll consider buying shares of it. Why? Because when the panic subsides, that 30% discount might contract by two-thirds. RiverNorth’s shareholders have the opportunity to gain from that arbitrage, whether or not the general direction of the stock market is up or down.

I spoke with Steve O’Neill, one of RiverNorth’s portfolio managers, about the extent of the market panic. Contrary to the popular stories about cool-headed investors, Steve described them as “vomiting up assets” at a level he hadn’t seen since the depth of the financial meltdown when the stability of the entire banking sector was in question.

In 2014, RiverNorth reopened their flagship RiverNorth Core Opportunity (RNCOX) fund after a three-year closure. We’ll renew our profile of this one-of-a-kind product in our October issue. In the meanwhile, interested parties really should …

RiverNorth is hosting a live webcast with Q&A on September 17, 2015 at 3:15pm CT / 4:15pm ET. Their hosts will be Patrick Galley, CIO, Portfolio Manager, and Allen Webb, Portfolio Specialist. Visit www.rivernorth.com/events to register.

Update: Finding a family’s first fund 

In August, we published a short guide to finding a family first fund. We started with the premise that lots of younger (and many not-so-younger) folks were torn between the knowledge that they should do something and the fear that they were going to screw it up. To help them out, we talked about what to look for in a first fund and proposed three funds that met our criteria: solid long term prospects, a risk-conscious approach, a low minimum initial investment and reasonable expenses.

How did the trio do in August? Not bad.

 Several readers wrote to commend Manning & Napier Pro-Blend Conservative (EXDAX) as a great “first fund” candidate as well.  We entirely agree. Unlike TIAA-CREF and Vanguard, it invests in individual securities rather than other funds. Like them, however, it has a team-managed approach that reduces the risk of a fund going awry if a single person leaves. It has a splendid 20 year record. We’ve added it to our original guide and have written a profile of the fund, which you can get to below in our Fund Profiles section.

We Are Where We Are, Or, If The Dog Didn’t Stop To Crap, He Would Have Caught The Rabbit

“I prefer the company of peasants because they have not been educated sufficiently to reason incorrectly.”

               Michel de Montaigne

At this point in time, rather than focus on the “if only” questions that tend to freeze people in their tracks in these periods of market volatility, I think we should consider what is important. For most of us, indeed, the vast majority of us, the world did not end in August and it is unlikely to end in September.  Indeed, for most Americans and therefore by definition most of us, the vagaries of the stock market are not that important.

What then is important? A Chicago Tribune columnist, Mary Schmich, recently interviewed Edward Stuart, an economics professor at Northeastern Illinois University as a follow-up to his appearance on a panel on Chicago Public Television’s “Chicago Tonight” show. Stuart had pointed out that the ownership of stock (and by implication, mutual funds) in the United States is quite unequal. He noted that while the stock market has done very well in recent years, the standard of living of the average American citizen has not done as well. Stuart thinks that the real median income for a household size of four is about $40,000 …. and that number has not changed since the late 70’s. My spin on this is rather simple – the move up the economic ladder that we used to see for various demographic groups – has stopped.

If you think about it, the evidence is before us. How many of us have friends whose children went to college, got their degrees, and returned home to live with their parents while they hunted for a job in their chosen field, which they often could not find? When one drives around city and suburban streets, how many vacancies do we see in commercial properties?  How many middle class families that used to bootstrap themselves up by investing in and owning apartment buildings or strip malls don’t now? What is needed is a growing economy that offers real job prospects that pay real wages. Stuart also pointed out that student debt is one of the few kinds of debt that one cannot expunge with bankruptcy.

As I read that piece of Ms. Schmick’s and reflected on it, I was reminded of another column I had read a few months back that talked about where we had gone off the rails collectively. The piece was entitled “Battle for the Boardroom” by Joe Nocera and was in the NY Times on May 9, 2015. Nocera was discussing the concept of “activist investors” and “shareholder value” specifically as it pertained to Nelson Peltz, Trian Investments, and a proxy fight with the management and board of DuPont.  And Nocera pointed out that Trian, by all accounts, had a good record and was often a constructive force once it got a board seat or two.

Nocera’s concern, which he raised in a fashion that went straight for the jugular, was simple. Have we really reached the point where the activist investor gets to call the tune, no matter how well run the company? What is shareholder value, especially in a company like DuPont? Trian’s argument was that DuPont was not getting a return on its spending on research and development? Yet R&D spending is what made DuPont, given the years it takes to often produce from scientific research a commercial product. Take away the R&D spending argued Nocera, and you have not just a poorer DuPont, but also a poorer United States. He closed by talking with and quoting Martin Lipton, a corporate attorney who has made a career out of disparaging corporate activists. Lipton said, “Activism has caused companies to cut R&D, capital investment, and, most significantly, employment,” he said. “It forces companies to lay off employees to meet quarterly earnings.”

“It is,” he concluded, “a disaster for the country.”

This brings me to my final set of ruminations. Some years ago, my wife and I were guests at a small dinner party at the home of a former ambassador (and patriot) living in Santa Fe.  There were a total of six of us at that dinner. One of the other guests raised the question as to whether any of us ever thought about what things would have been like for the country if Al Gore, rather than George W. Bush, had won the presidential election. My immediate response was that I didn’t think about such things as it was just far too painful to contemplate.

In like vein, having recently read Ron Suskind’s book Confidence Men, I have been forced to contemplate what it would have meant for the country if President-elect Barack Obama had actually followed through with the recommendations of his transition advisors and appointed his “A” Economic Team. Think about it – Paul Volcker as Secretary of the Treasury, the resurrection of Glass-Steagall, the break-up of the big investment banks – it too is just too painful to contemplate.  Or as the line from T.H. White’s Once and Future King goes, “I dream things that never were, and ask why not?”

Now, a few thoughts about the carnage and how to deal with it.  Have a plan and stick to it. Do not panic, for inevitably all panic does is lead to self-inflicted wounds. Think about fees, but from the perspective of correlated investments. That is, if five large (over $10B in assets) balanced funds are all positively correlated in terms of their portfolios, does it really make sense not to own the one with the lowest expense ratio (and depending on where it is held, taxes may come into play)? Think about doing things where other people’s panic does not impact you, e.g., is there a place for closed end funds in a long-term investment portfolio? And avoid investments where the bugs have not been worked out, as the glitches in pricing and execution of trades for ETF’s have shown us over the last few weeks.

There is a wonderful Dilbert cartoon where the CEO says “Asok, you can beat market averages by doing your own stock research. Asok then says, “So … You believe every investor can beat the average by reading the same information? “Yes” says the CEO. Asok then says, “Makes you wonder why more people don’t do it.” The CEO closes saying, “Just lazy, I guess.”

Edward A. Studzinski

Checking in on MFO’s 20-year Great Owls

MFO first introduced its rating system in the June 2013 commentary. That’s also when the first “Great Owl” funds were designated. These funds have consistently delivered top quintile risk adjusted returns (based on Martin Ratio) in their categories for evaluation periods 3 years and longer. The most senior are 20-year Great Owls. These select funds have received Return Group ranking of 5 for evaluation periods of 3, 5, 10, and 20 years. Only about 50 funds of the 1500 mutual funds aged 20 years or older, or about 3%, achieve the GO designation. An impressive accomplishment.

Below are the current 20-year GOs (excluding muni funds for compactness, but find complete list here, also reference MFO Ratings Definitions.)

Of the original 20-year GO list of 47 funds still in existence today, only 19 remain GOs. These include notables: Fidelity GNMA (FGMNX), PIMCO Foreign Bond – USD-Hedged I (PFORX), James Balanced: Golden Rainbow R (GLRBX), T. Rowe Price Capital Appreciation (PRWCX), Vanguard Wellington Inv (VWELX), Meridian Growth Legacy (MERDX), and Hennessy Gas Utility Investor (GASFX).

The current 20-year GOs also include 25 Honor Roll funds, based on legacy Fund Alarm ranking system. Honor Roll funds have delivered top quintile absolute returns in its category for evaluation periods of 1, 3, and 5 years. These include: AMG Managers Interm Dur Govt (MGIDX), PIMCO Foreign Bond – USD-Hedged I (PFORX), James Balanced: Golden Rainbow R (GLRBX), T. Rowe Price Capital Appreciation (PRWCX), and T. Rowe Price Mid-Cap Growth (RPMGX).

A closer look at performance of the original list of 20-year GOs, since they were introduced a little more than two years ago, shows very satisfactory performance overall, even with funds not maintaining GO designation. Below is a summary of Return Group rankings and current three-year performance.

Of the 31 funds in tables above, only 7 have underperformed on a risk adjusted basis during the past three years, while 22 have outperformed.

Some notable outperformers include: Vanguard Wellesley Income Inv (VWINX), Oakmark International I (OAKIX), Sequoia (SEQUX), Brown Capital Mgmt Small Co Inv (BCSIX), and T. Rowe Price New Horizons (PRNHX).

And the underperformers? Waddell & Reed Continental Inc A (UNCIX), AMG Yacktman (YACKX), Gabelli Equity Income AAA (GABEX), and Voya Corporate Leaders Trust (LEXCX).

A look at absolute returns shows that 10 of the 31 underperformed their peers by an average of 1.6% annualized return, while the remaining 21 beat their peers by an average of 4.8%.

Gentle reminder: MFO ratings are strictly quantitative and backward looking. No accounting for manager or adviser changes, survivorship bias, category drift, etc.

Will take a closer look at the three-year mark and make habit of posting how they have fared over time.

New Voices at the Observer: The Tale of Two Leeighs

We’re honored this month to be joined by two new contributors: Sam Lee and Leigh Walzer.

Sam is the founder of Severian Asset Management, Chicago. He is also former editor of Morningstar analyst and editor of their ETF Investor newsletter. Sam has been celebrated as one of the country’s best financial writers (Morgan Housel: “Really smart takes on ETFs, with an occasional killer piece about general investment wisdom”) and as Morningstar’s best analyst and one of their best writers (John Coumarianos: “Lee has written two excellent pieces [in the span of a month], and his showing himself to be Morningstar’s finest analyst”). Sam claims to have chosen “Severian” for its Latinate gravitas.

We’ll set aside, for now, any competing observations. For example, we’ll make no mention of the Severian Asset Management’s acronym. And certainly no reflections upon the fact that Severian was the name of the Journeyman torturer who serves as narrator in a series of Gene Wolfe’s speculative fiction. Nor that another Severian was a popular preacher and bishop. Hmmm … had I mentioned that one of Sam’s most popular pieces is “Losing My Religion”?

You get a better sense of what Sam brings to the table from his discussion of his approach to things as an investment manager:

Investing well is hard. We approach the challenge with a great deal of humility, and try to learn from the best thinkers we can identify. One of our biggest influences is Warren Buffett, who stresses that predictions about the future should be based on an understanding of economic fundamentals and human nature, not on historical returns, correlations and volatilities. He stresses that we should be skeptical of the false precision and unwarranted sense of control that come with the use of quantitative tools, such as Monte Carlo simulations and Markowitz optimizations. We take these warnings seriously.

Our approach is based on economic principles that we believe are both true and important:

• First and foremost, we believe an asset’s true worth is determined by the cash you can pull out of it discounted by the appropriate interest rate. Over the long run, prices tend to converge to intrinsic value … Where we differ with Buffett and other value investors is that we do not believe investment decisions should be made solely on the basis of intrinsic value. It is perfectly legitimate to invest in a grossly overpriced asset if one knows a sucker will shortly come along to buy it … The trick is anticipating what the suckers will do.
• Second, we believe most investors should diversify. As Buffett says, “diversification is protection against ignorance.” This should not be interpreted as a condemnation of the practice. Most investors are ignorant as to what the future holds. Because most of us are ignorant and blind, we want to maximize the protection diversification affords.
• Third, we believe risk and reward are usually, but not always, positively related … Despite equities’ attractive long-term returns, investors have managed to destroy enormous amounts of wealth while investing in them by buying high and selling low. To avoid this unfortunate outcome, we scale your equity exposure to your behavioral makeup, as well as your time horizon and goals.
• Fourth, the market makes errors, but exploiting them is hard.

We prefer to place actively managed funds (and other high-tax-burden assets) in tax-deferred accounts. In taxable accounts, we prefer tax-efficient, low-cost equities, either held directly or through mutual funds. Many exchange-traded funds are particularly tax-advantaged because they can aggressively rid themselves of low cost-basis shares without passing on capital gains to their investors.

In my experience, Sam’s writing is bracingly direct, thoughtful and evidence-driven. I think you’ll like his work and I’m delighted by his presence. Sam’s debut offering is a thoughtful and data rich profile of AQR Style Premia Alternative (QSPIX). You’ll find a summary and link to his profile under Observer Fund Profiles.

Leigh Walzer is now a principal of Trapezoid LLC and a former member of Michael Price’s merry band at the Mutual Series funds. In his long career, Leigh has brought his sharp insights and passion for data to mutual funds, hedge funds, private equity funds and even the occasional consulting firm.

We had a chance to meet during June’s Morningstar conference, where he began to work through the logic of his analysis of funds with me. Two things were quickly clear to me. First, he was doing something distinctive and interesting. As base, Leigh tried to identify the distinct factors that might qualify as types of managerial skill (two examples would be stock selection and knowing when to reduce risk exposure) and then find the data that might allow him to take apart a fund’s performance, analyze its component parts and predict whether success might persist. Second, I was in over my head. I asked Leigh if he’d be willing to share sort of bite-sized bits of his research so that folks could begin to understand his system and test the validity of its results. He agreed.

Here’s Leigh’s introduction to you all. His first analytic piece debuts next month.

Mutual Fund Observer performs a great service for the investment community. I have found information in these pages which is hard to obtain anywhere else. It is a privilege to be able to contribute.

I founded Trapezoid a few years ago after a long career in the mutual fund and hedge fund industry as an analyst and portfolio manager. Although I majored in statistics at Princeton many moons ago and have successfully modelled professional sports in the past, most of my investing was in credit and generally not quantitative in nature. As David Snowball mentioned earlier, I spent 7 years working for Mutual Shares, led by Michael Price. So the development of the Orthogonal Attribution Engine marks a return to my first passion.

I have always been interested in whether funds deliver value for investors and how accurately allocators and investors understand their managers.  My freshman economics course was taught by Burton Malkiel, author of a Random Walk Down Wall Street, who preached that the capital markets were pretty efficient. My experience in Wall Street and my work at Orthogonal have taught me this is not always true.  Sometimes a manager or a strategy can significantly outperform the market for a sustained period.  Of course, competitors react and capital flows until an equilibrium is achieved, but not nearly as quickly as Malkiel assumes.

There has been much discussion over the years about the active–passive debate.  John Bogle was generous in his time reviewing my work.  I generally agree with Jack and he is a giant in the industry to whom we all owe a great deal.  For those who are ready to throw in the towel of active investing, Bogle makes two (related) assumptions which need to be critically reviewed:

1. Even if an active manager outperforms the average, he is likely to revert to the mean.
2. Active managers with true skill (in excess of their fee structure) are hard to identify, so investors are better off with an index fund

I try to measure skill in a way which is more accurate (and multi-faceted) than Bogle’s definition and I look at skill as a statistical process best measured over an extended period of time. I try to understand how the manager is positioned at every point in time, using both holdings and regression data, and I try to understand the implications of his or her decisions.

My work indicates that the active-passive debate is less black and white than you might discern from the popular press or the marketing claims of mutual fund managers. The good news for investors is there are in fact many managers who have demonstrated skill over an extended period of time. Using statistical techniques, it is possible to identify managers likely to outperform in the future. There are some funds whose expected return over the next 12 months justifies what they charge. There are many other managers who show investment skill, but not enough to justify their expense structure.

Feel free to check out the website at www.fundattribution.com which is currently in beta test. Over 30,000 funds are modelled; users who register for demo access can see certain metrics measuring historic manager skill and likelihood of future success on a subset of the fund universe.

I look forward to sharing with you insights on specific funds in the coming months and provide MFO readers a way to track my results. Equally important, I hope to give you new insights to help you think about the role of actively managed funds in your portfolio and how to select funds. My research is still a work in process. I invite the readership of MFO to join me in my journey and invite feedback, suggestions, and collaboration.  You may contact me at [email protected].

We’re very much looking forward to October and Leigh’s first essay. Thanks to both. I think you’ll enjoy their good spirits and insight.

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.

Court Decisions & Orders

• In the shareholder litigation regarding gambling-related securities held by the American Century Ultra Fund, the Eighth Circuit affirmed the district court’s grant of summary judgment in favor of American Century, agreeing that the shareholder could not bring suit against the fund adviser because the fund had declined to do so in a valid exercise of business judgment. Defendants included independent directors. (Seidl v. Am. Century Cos.)
• Setting the stage for a rare section 36(b) trial (assuming no settlement), a court denied parties’ summary judgment motions in fee litigation regarding multiple AXA Equitable funds. The court cited only “reasons set forth on the record.” (Sanford v. AXA Equitable Funds Mgmt. Group, LLC; Sivolella v. AXA Equitable Life Ins. Co.)
• A court gave its final approval to (1) a $24 million partial settlement of the state-law class action regarding Northern Trust‘s securities lending program, and (2) a $36 million settlement of interrelated ERISA claims. The state-law class action is still proceeding with respect to plaintiffs who invested directly in the program. (Diebold v. N. Trust Invs., N.A.; La. Firefighters’ Ret. Sys. v. N. Trust Invs., N.A.)
• In the long-running fee litigation regarding Oakmark funds that had made it all the way to the U.S. Supreme Court, the Seventh Circuit affirmed a lower court’s grant of summary judgment for defendant Harris Associates. The appeals court cited the lower court’s findings that (1) “Harris’s fees were in line with those charged by advisers for other comparable funds” and (2) “the fees could not be called disproportionate in relation to the value of Harris’s work, as the funds’ returns (net of fees) exceeded the norm for comparable investment vehicles.” Plaintiffs have filed a petition for rehearing en banc. (Jones v. Harris Assocs.)
• Extending the fund industry’s dismal record on motions to dismiss section 36(b) litigation, a court denied PIMCO‘s motion to dismiss an excessive-fee lawsuit regarding the Total Return Fund. Court: “Throughout their Motion, Defendants grossly exaggerate ‘the specifics’ needed to survive a 12(b)(6) motion, essentially calling for Plaintiff to prove his case now, before discovery.” (Kenny v. Pac. Inv. Mgmt. Co.)
• A court granted the motion to dismiss a state-law and RICO class action alleging mismanagement by a UBS investment adviser, but without prejudice to refile the state-law claims as federal securities fraud claims. (Knopick v. UBS Fin. Servs., Inc.)

The Alt Perspective: Commentary and news from DailyAlts.

As we all now know, August was anything but calm. Despite starting that way, the month delivered some tough love in the last two weeks, just when we were all supposed to be relaxing with family and friends. Select Morningstar mutual fund categories finished the month with the following returns:

• Large Blend (US Equity): -6.07%
• Intermediate-Term Bond: -0.45%
• Long/Short Equity: -3.57%
• Nontraditional Bonds: -0.91%
• Managed Futures: -2.52%

The one surprise of the five categories above is Managed Futures. This is a category that typically does well when markets are in turmoil and trending down. August proved to be an inflection point, and turned out to be challenging in what was otherwise a solid year for the strategies.

However, let’s take a look at balanced portfolio configurations. Using the above category returns, at traditional long-only 60/40 blend portfolio (60% stocks / 40% bonds) would have returned -3.82% in August, while an alternative balanced portfolio of 50% long/short equity, 30% nontraditional bonds and 20% managed futures would have returned -2.56%. Compare these to the two categories below:

• Moderate Allocation: -4.17%
• Multialternative: -2.22%

Moderate Allocation funds, which are relatively lower risk balance portfolios, turned in the lowest of the balanced portfolio configurations. The Multialternative category of funds, which are balanced portfolios made up of mostly alternative strategies, performed the best, beating the traditional 60/40 portfolio, the 50/30/20 alternative portfolio and the Moderate Allocation category. Overall, it looks like alternatives did their job in August.

August Highlights

Believe it or not, Vanguard launched its second alternative mutual fund in August. The new Vanguard Alternative Strategies Fund will invest across several alternative investment strategies, including long/short equity and event driven, and will also allocate some assets to currencies and commodities. Surprisingly, Vanguard will be managing the fund in-house, but does that the ability to outsource some or all of the management of the fund. Sticking with its low cost focus, Vanguard will charge a management fee of 0.18% – a level practically unheard of in the liquid alternatives space.

In a not quite so surprising move, Catalyst Funds converted its fourth hedge fund into a mutual fund in August with the launch of the Catalyts/Auctos Multi Strategy Fund. In this instance, the firm did go one step beyond prior conversions and actually acquired the underlying manager, Auctos Capital Management. One key benefit of the hedge fund conversion is the fact that the fund can retain its performance track record, which dates back to 2008.

Finally, American Century (yes, that conservative, mid-western asset management firm) launched a new brand called AC Alternatives under which it will manage a series of alternative mutual funds. The firm currently has three funds under the new brand, with two more in the works. Similar to Vanguard, the firm launched a market neutral fund back in 2005, and a value tilted version in 2011. The third fund, an alternative income fund, is new this year.

Let’s Get Together

Two notable acquisitions occurred in August. The first is the acquisition of Arden Asset Management, a long-time institutional fund-of-hedge funds manager, by Aberdeen. The latter has been on the acquisition trail over the past several years, with a keen eye on alternative investment firms. Through the transaction, Arden will get global distribution, while Aberdeen will pick up very specific hedge fund due diligence, manager research and portfolio construction capabilities. Looks like a win-win.

The second transaction was the acquisition of 51% of the Australian-based unconstrained fixed income shop Kapstream Capital by Janus for a cool $85 million. Janus also has the right to purchase the remainder of the firm, which has roughly $6 billion under management. Good for Kapstream as the valuation appears to be on the high end, but perhaps Bill Gross needed some assistance managed his unconstrained portfolios.

The Fall

A lot happens in the Fall. Back to school. Football. Interest rate hike. Changing leaves. Halloween. Thanksgiving. Federal debt ceiling. Maybe there is enough for us all to take our minds off the markets for just a bit and let things settle down. Time will tell, but until next month, enjoy the Labor Day weekend and the beginning of a new season.

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. 

AQR Style Premia Alternative (QSPIX). AQR’s new long-short multi-strategy fund takes factor investing to its logical extreme: It applies four distinct strategies–value, momentum, carry, and defensive–across stock, bond, commodity, and currency markets. The standard version of the fund targets a 10% volatility and a 0.7 Sharpe ratio while maintaining low to no correlation with conventional portfolios. In its short life, the fund has delivered in spades. Please note, this profile was written by our colleague, Sam Lee.

Manning & Napier Pro-Blend Conservative (EXDAX): this fund has been navigating market turbulences for two decades now. Over the course of the 21^st century, it’s managed to outperform the Total Stock Market Index with only one-third of the stocks and one-third of the volatility. And you can start with just $25!  

TCW/Gargoyle Hedged Value (TFHVX/TFHIX):  if you understand what you’re getting – a first-rate value fund with one important extra – you’re apt to be very happy. If you see “hedged” and think “tame,” you’ve got another thing coming.

Launch Alert: Falcon Focused SCV (FALCX)

The fact that newly-launched Falcon Focused SCV has negligible assets (it’s one of the few funds in the world where I could write a check and become the fund’s largest shareholder) doesn’t mean that it has negligible appeal.

The fund is run by Kevin Silverman whose 30 year career has been split about equally between stints on the sell side and on the buy side.  He’s a graduate of the University of Wisconsin’s well-respect Applied Securities Analysis Program . Early in his career he served as an analyst at Oakmark and around the turn of the century was one of the managers of ABN AMRO Large Cap Growth Fund. He cofounded Falcon Capital Management in April 2015 and is currently one of the folks responsible for a $100 million small cap value strategy at Dearborn Partners in Chicago. They’ve got an audited 14 year record.

I’m endlessly attracted to the potential of small cap value investing. The research, famously French and Fama’s, and common sense concur: this should be the area with the greatest potential for profits. It’s huge. It’s systemically mispriced because there’s so little analyst coverage and because investors undervalue value stocks. Growth stocks are all cool and sexy and you want to own them and brag to all your friends about them. Value stocks are generally goofed up companies in distressed industries. They’re boring and a bit embarrassing to own; on whole, they’re sort of the midden heap of the investing world.

The average investor’s unwillingness or inability to consider them raises the prospect that a really determined investor might find exceptional returns. Kevin and his folks try to build 5 to 10 year models for all of their holdings, then look seriously at years four and five. The notion is that if they can factor emotion out of the process (they invoke the pilot’s mantra, “trust your instruments”) and extend their vision beyond the current obsession with this quarter and next quarter, they’ll find opportunities that will pay off handsomely a few years from now. Their target is to use their models to construct a portfolio that has the prospect for returns “in the mid-20s over the next three years.” Mathematically, that works out to a doubling in just over three years.

I’m not sure that the guys can pull it off but they’re disciplined, experienced and focused. That puts them ahead of a lot of their peers.

The initial expense ratio, after waivers, is 1.25%. The no-load Institutional shares carry a $10,000 minimum, which is reduced to $5000 for tax-advantaged accounts and those set up with an automatic investing plan. The fund’s website is still pretty sparse (okay, just under “pretty sparse”), but you can find a bit more detail and one pretty panorama at the adviser’s website.

Launch Alert: Grandeur Peak Global Stalwarts Fund (GGSOX/GGSYX)

Grandeur Peak launched two “alumni” funds on September 1, 2015. Grandeur Peak’s specialty is global micro- and small-cap stocks, generally at the growth end of the spectrum. If they do a good job, their microcap stocks soon become small caps, their small caps become midcaps, and both are at risk of being ejected from the capitalization-limited Grandeur Peak funds.

Grandeur Peak was approached by a large investor who recognized the fact that many of those now-larger stocks were still fundamentally attractive, and asked about the prospect of a couple “alumni” funds to hold them. Such funds are attractive to advisors since you’re able to accommodate a much larger asset base when you’re investing in $10 billion stocks than in $200 million ones.

One investor reaction might be to label Grandeur Peak as sell-outs. They’ve loudly touted two virtues: a laser-like focus and a firm-wide capacity cap at $3 billion, total. With the launch of the Stalwarts funds, they’re suddenly in the mid-cap business and are imagining firmwide AUM of about $10 billion.

Grandeur Peak, however, provided a remarkable wide-ranging, thoughtful defense of their decision. In a letter to investors, dated July 15, they discuss the rationale for and strategies embodied by three new funds:

Grandeur Peak Global Micro Cap Fund (GPMCX): A micro-cap strategy primarily targeting companies in the $50M-350M market cap range across the globe; very limited capacity.

Grandeur Peak Global Stalwarts Fund (GGSOX/GGSYX): A small/mid-cap (SMID) strategy focused on companies above $1.5B market cap across the globe.

Grandeur Peak International Stalwarts Fund (GISOX/GISYX): A small/mid-cap strategy focused on companies above $1.5B market cap outside of the U.S.

They argue that they’d always imagined Stalwarts funds, but didn’t imagine launching them until the firm’s second decade of operation. Their success in identifying outstanding stocks and drawing assets brought high returns, a lot of attention and a lot of money. While they hoped to be able to soft-close their funds, controlling inflows forced a series of hard closes instead which left some of their long-time clients adrift. By adding the Stalwarts funds as dedicated vehicles for larger cap names (the firm already owns over 100 stocks in the over $1.5 billion category), they’re able to provide continuing access to their investors without compromising the hard limits on the micro- and nano-cap products. Here’s their detail:

As you know, capacity is a very important topic to us. We believe managing capacity appropriately is another critical competitive advantage for Grandeur Peak. We plan to initially close the Global Micro Cap Fund at around $25 million. We intend to keep it very small in order to allow the Fund full access to micro and nanocap companies …

Looking carefully at the market cap and liquidity of our holdings above $1.5 billion in market cap, the math suggests that we could manage up to roughly $7 billion across the Stalwarts family without sacrificing our investment strategy or desired position sizes in these names. This $7 billion is in addition to the roughly $3 billion that we believe we can comfortably manage below $1.5 billion in market cap.

Our existing strategies will remain hard closed as we are committed to protecting these strategies and their ability to invest in micro-cap and small-cap companies. We are very aware that many good small cap firms lose their edge by taking in too many assets and being forced to adjust their investment style. We will not do this! We are taking a more unique approach by partitioning the lower capacity, less liquid names and allowing additional assets in the higher capacity, liquid stocks where the impact will not be felt by the smaller-cap funds.

The minimum initial investment is $2000 for the Investor share class, which will be waived if you establish the account with an automatic investment plan. Unlike Global Micro Cap, there is no waiver of the institutional minimum available for the Stalwarts. Each fund will charge 1.35%, retail, after waivers. You might want to visit the Global Stalwarts or International Stalwarts homepages for details.

Funds in Registration

There are 17 new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase in November.

Two of the funds will not be available for direct purchase: T. Rowe Price is launching Mid Cap and Small Cap index funds to use with 529 plans, funds-of-funds and so on. Of the others, there are new offerings from two solid boutiques: Driehaus Turnaround Opportunities will target “distressed” investing and Brown Advisory Equity Long/Short Fund will do about what you expect except that the filings bracket the phrase Equity Long/Short. That suggests that the fund’s final name might be different. Harbor is launching a clone of Vanguard Global Equity. A little firm named Gripman is launched a conservative allocation fund (I wish them well) and just one of the funds made my eyes roll. You’ll figure it out.

Manager Changes

We tracked down 60 or 70 manager changes this month; the exact number is imprecise because one dude was leaving a couple dozen Voya funds which we reduced to just a single entry. We were struck by the fact that about a dozen funds lost women from the management teams, but it appears only two funds added a female manager.

Sympathies to Michael Lippert, who is taking a leave from managing Baron Opportunity (BIOPX) while he recovers from injuries sustained in a serious bicycle accident. We wish him a speedy recovery.

Updates

A slightly-goofed SEC filing led us to erroneously report last month that Osterweis Strategic Investment (OSTVX) might invest up to 100% in international fixed-income. A “prospectus sticker” now clarifies the fact that “at the fund level OSTVX is limited to 50% foreign.” Thanks to the folks at Osterweis for sharing the update with us. Regrets for any confusion.

Morningstar giveth: In mid-August, Morningstar initiated coverage of two teams we’ve written about. Vanguard Global Minimum Volatility (VMVFX) received a Bronze rating, mostly because it’s a Vanguard fund. Morningstar praises the low expenses, Vanguard culture and the “highly regarded–and generally successful–quantitative equity group.” The fund’s not quite two years old but has a solid record and has attracted $1.1 billion in assets.

Vulcan Value Partners (VVPLX) was the other Bronze honoree. Sadly, Morningstar waited until after the fund had closed before recognizing it. The equally excellent Vulcan Value Partners Small Cap (VVPSX) fund is also closed, though Morningstar has declined to recognize it as a medalist fund.

Morningstar taketh away: Fidelity Capital Appreciation (FDCAX) is no longer a Fanny Fifty Fund: it has been doing too well. There’s an incentive fee built into the fund’s price structure; if performance sucks, the e.r. drops. If performance soars, the e.r. rises.

Rewarding good performance sounds to the novice like a good idea. Nonetheless, good performance has had the effect of disqualifying FDCAX as a “Fantastic” fund. Laura Lutton explains why, in “These Formerly ‘Fantastic’ Funds Now Miss the Mark.”

In 2013, the fund outpaced that index by 2.47 percentage points, upping the expense ratio by 4 basis points to 0.81%. This increase moved the fund’s expenses beyond the category’s cheapest quintile…

Uhhh … yup. 247 basis points of excess return in exchange for 4 basis points of expense is clearly not what we expect of Fantastic funds. Out!

From Ira’s “What the hell is that?” file: A rare T Rowe flub

Ira Artman, a long-time friend of the Observer and consistently perceptive observer himself, shared the following WTF performance chart from T. Rowe Price:

Good news: T. Rowe Price Latin America (PRLAX) is magic! It’s volatility-free emerging market fund.

Bad news: the chart is rigged. The vertical axis is compressed so eliminate virtually all visible volatility. There’s a sparky discussion of the chart on our discussion board that provides both uncompressed versions of the chart and the note that the other T. Rowe funds did not receive similarly scaled axes. Consensus on the board: someone deserves a spanking for this one.

Thanks to Ira for catching and sharing.

Briefly Noted . . .

CRM Global Opportunity Fund (CRMWX) is becoming CRM Slightly-Less-Global Opportunity Fund, in composition if not in name. Effective October 28, the fund is changing its principal investment strategy from investing “a majority” of its assets outside the US to investing “at least 40%” internationally, less if markets get ugly. Given that the fund’s portfolio is just 39% global now (per Morningstar), I’m a little fuzzy on why the change will make a difference.

SMALL WINS FOR INVESTORS

Seafarer’s share class model is becoming more common, which is a good thing. Seafarer, like other independent funds, needs to be available on brokerage platforms like Schwab and Scottrade; those platforms allow for lower cost institutional shares so long as the minimum exceeds $100,000 and higher cost retail shares with baked-in 12(b)1 fees to help pay Schwab’s platform fees. Seafarer complied but allows a loophole: they’ll waive the minimum on the institutional shares if you (a) buy it directly from them and (b) set up an automatic investing plan so that you’re moving toward the $100,000 minimum. Whether or not you reach it isn’t the consideration. Seafarer’s preference is to think of their low-cost institutional class as their “universal share class.”

Grandeur Peak is following suit. They intend to launch their new Global Micro Cap Fund by year’s end, then to close it as soon as assets hit $25 million. That raises the real prospect of the fund being available for a day or two. During that time, though, they’ll offer institutional shares to retail investors who invest directly with them. They write:

We want the Global Micro Cap Fund to be available to both our retail and institutional clients, but without the 0.25% 12b-1 fee that comes with the Investor share class. Our intention is to make the Institutional class available to all investors, and waive the minimum to $2000 for regular accounts and $100 for UTMA accounts.

Invesco International Small Company Fund will reopen to all investors on September 11, 2015. Morningstar has a lot of confidence in it (the fund is “Silver”) and it has a slender asset base right now, $330 million, down from its peak of $700 million before the financial crisis. The fund has been badly out of step with the market in recent years, which is reflected in the fact that it has one of its peer group’s best ten-year record and worst five-year records. Since neither the team nor the strategy has changed, Morningstar remains sanguine.

Matthews Pacific Tiger Fund (MAPTX) has reopened to new investors.

Effective July 1, 2015 the shareholder servicing fee for the Investor Class Shares of each of the Meridian Funds was reduced from 0.25% to 0.05%. Somehow I missed it. Sorry for the late notice. The Investor shares continue to sport their bizarre $99,999 minimum initial investment.

Wells Fargo Advantage Index Fund (WFILX) reopens to new investors on October 1. It’s an over-priced S&P 500 Index fund. Assuming you can dodge the front load, the 0.56% expense ratio is a bit more than triple Vanguard’s (0.17% for Investor shares of Vanguard 500, VFINX). That difference adds up: over 10 years, a $10,000 investment in WFILX would have grown to $19,800 while the same money in VFINX grew to $20,700.

CLOSINGS (and related inconveniences)

Acadian Emerging Markets (AEMGX) is slated to close to new investors on October 1. The adviser is afraid that the fund’s ability to execute its strategy will be impaired “if the size of the Fund is not limited.” The fund has lost an average of 3.7% annually for the current market cycle, through July 2015. You’d almost think that losing money, trailing the benchmark and having higher-than-normal volatility would serve as automatic brakes limiting the size of the portfolio.” Apparently not so much.

M.D. Sass 1-3 Year Duration U.S. Agency Bond Fund (MDSHX) is closing the fund’s retail share class and converting them to institutional shares. It’s an okay fund in a low return category, which means expenses matter. Over the past three years, the retail shares trail 60% of their peer group while the institutional shares lead 60% of the group. The conversion will give existing retail shareholders a bit of a boost and likely cut the adviser’s expenses by a bit.

OLD WINE, NEW BOTTLES

Effective August 27, 2015 361 Global Managed Futures Strategy Fund (AGFQX) became the 361 Global Counter-Trend Fund. I wish them well, but the new prospectus language is redolent of magic wands and sparkly dust: “counter-trend strategy follows an investment model designed to perform in volatile markets, regardless of direction, by taking advantage of fluctuations.  Using a combination of market inputs, the model systematically identifies when to purchase and sell specific investments for the Fund.” What does that mean? What fund isn’t looking to identify when to buy or sell specific investments?

American Independence Laffer Dividend Growth Fund (LDGAX) has … laughed its last laff? Hmmm. Two year old fund run by Laffer Investments, brainchild of Arthur B. Laffer, the genius behind supply-side economics. Not, as it turns out, a very good two year old fund.  At the end of July, American Independence merged with FolioMetrix LLC to form RiskX Investments. Somewhere in the process, the fund was declared to be surplus.

Effective September 1, 2015, the name of the Anchor Alternative Income Fund (AAIFX) will be changed to Armor Alternative Income Fund.

Effective August 7, 2015, Eaton Vance Tax-Managed Small-Cap Value Fund became Eaton Vance Tax-Managed Global Small-Cap Fund (ESVAX).

The Hartford Emerging Markets Research Fund is now Hartford Emerging Markets Equity Fund (HERAX) while The Hartford Small/Mid Cap Equity Fund has become Hartford Small Cap Core Fund (HSMAX).  HERAX is sub-advised by Wellington. Back in May they switched out managers, with the new guy bringing a more-driven approach so they’ve also added “quantitative investing” as a risk factor in the prospectus.  For HSMAX, midcaps are now out.

In mid-November, three Stratton funds add “Sterling Capital” to their names: Stratton Mid Cap Value (STRGX) becomes Sterling Capital Stratton Mid Cap Value. Stratton Real Estate (STMDX) and Stratton Small Cap Value (STSCX) get the same additions.

Effective September 17, 2015, ROBO-STOX^TM Global Robotics and Automation Index ETF (ROBO) will be renamed ROBO Global^TM Robotics and Automation Index ETF. If this announcement affects your portfolio, consider getting therapy and a Lab puppy.

OFF TO THE DUSTBIN OF HISTORY

American Beacon is pretty much cleaning out the closet. They’ve announced liquidation of their S&P 500 Index Fund, Small Cap Index Fund, International Equity Index Fund, Emerging Markets Fund, High Yield Bond Fund, Intermediate Bond Fund, Short-Term Bond Fund and Zebra Global Equity Fund (AZLAX). With regard to everything except Zebra, the announcement speaks of “large redemptions which are expected to occur by the end of 2015” that would shrink the funds by so much that they’re not economically viable. American Beacon started as the retirement plan for American Airlines, was sold to one private equity firm in 2008 and then sold again in 2015. It appears that they lost the contract for running a major retirement plan and are dumping most of their vanilla funds in favor of their recent ventures into trendier fare. The Zebra Global Equity Fund was a perfectly respectable global equity fund that drew just $5 million in assets.

In case you’re wondering whatever happened to the Ave Maria Opportunity Fund, it was eaten by the Ave Maria Catholic Values Fund (AVEMX) at the end of July.

Eaton Vance announced liquidation of its U.S. Government Money Market Fund, around about Halloween, 2015. As new SEC money market regs kick in, we’ve seen a lot of MMFs liquidate.  

Eaton Vance Hexavest U.S. Equity Fund (EHUAX) is promoted to the rank of Former Fund on or about September 18, 2015, immediately after they pass their third anniversary.  What is a “hexavest,” you ask? Perhaps a protective garment donned before entering the magical realms of investing? Hmmm … haven’t visited WoW lately, so maybe. Quite beyond that it’s an institutional equity investment firm based in Montreal that subadvises four (oops, three) funds for Eaton Vance.  Likely the name derived from the fact that the firm had six founders (Greek, “hex”) who wore vests.

Rather more quickly, Eaton Vance also liquidated Parametric Balanced Risk Fund (EAPBX). The Board announced the liquidation on August 11; it was carried out August 28. And you could still say they might have been a little slow on the trigger:

The Eudora Fund (EUDFX) has closed and will liquidate on September 10, 2015.

Hundredfold Select Equity Fund (SFEOX) has closed and will discontinue its operations effective October 30, 2015. It’s the sort of closure about which I think too much. On the one hand, the manager (described on the firm’s Linked-In page as “an industry visionary”) is a good steward: almost all of the money in the fund is his own (over $1 million of $1.8 million), he doesn’t get paid to manage it, his Simply Distribute Foundation helps fund children’s hospitals and build orphanages. On the other hand, it’s a market-timing fund of funds will an 1100% turnover which has led the fund to consistently capture much more of the downside, and much less of the upside, than its peers. And, in a slightly disingenuous move, the Hundredfold Select website has already been edited to hide the fact that the Select Equity fund even exists.

Ticker symbols are sometimes useful time capsules, helping you unpack a fund’s evolution. Matthews Asian Growth and Income is “MACSX” because it once was their Asian Convertible Securities fund. Hundredfold Select is “SFEOX” because it once was the Direxion Spectrum Funds: Equity Opportunity fund.

KKM Armor Fund (RMRAX) was not, it appears, bullet-proof. Despite a 30% gain in August 2015, the 18 month old, $8 million fund has closed and will liquidate on September 24, 2015. RMRAX was one of only two mutual funds in the “volatility” peer group. The other is Navigator Sentry Managed Volatility (NVXAX). I bet you’re wondering, “why on earth would Morningstar create a bizarre little peer group with only two funds?” The answer is that there are a slug of ETFs that allow you to bet changes in the level of market volatility; they comprise the remainder of the group. That also illustrates why I prefer funds to ETFs: encouraging folks to speculate on volatility changes is a fool’s errand.

The Modern Technology Fund (BELAX) has closed and will liquidate on September 25, 2015.

There’s going to be one less BRIC in the wall: Goldman Sachs has announced plans to merge Goldman Sachs BRIC Fund (GBRAX) into their Emerging Markets Equity Fund (GEMAX) sometime in October.  The Trustees unearthed a new euphemism for “burying this dog.” They want “to optimize the Goldman Sachs Funds.” The optimized line-up removes a fund that, over the past five years, turned $10,000 into $8,500 by moving its assets into a fund that turned $10,000 into $10,000.

In an interesting choice of words, the Board of Directors authorized the “winding down” Keeley Alternative Value Fund (KALVX) and the Keeley International Small Cap Value Fund (KISVX). By the time you read this, the funds will already have been quite unwound. The advisor gave Alternative Value about four years to prove its … uhh, alternative value (it couldn’t). It gave International Small Cap all of eight months. Founder John Keeley passed away in June at age 75. The firm had completed their transition planning just a month before his passing.

PIMCO Tax Managed Real Return Fund (PXMDX) will be liquidated on or about October 30, 2015.  In addition, three PIMCO ETFs are getting deposited in the circular file: 3-7 Year U.S. Treasury Index (FIVZ), 7-15 Year U.S. Treasury Index (TENZ) and Foreign Currency Strategy Active (FORX) ETFs all disappear on September 30, 2015. “This date may be changed without notice at the discretion of the Trust’s officers.” Their average daily trading volume was just a thousand or two shares.

Ramius Hedged Alpha Fund (RDRAX) will undergo “termination, liquidation and dissolution,” all on September 4, 2015.

A reminder to all muddled Lutherans: your former Aid Association for Lutherans (AAL) Funds and/or your former Lutheran Brother Funds, which merged to become your Thrivent Funds, aren’t exactly thriving. The latest evidence is the decision to merge Small Value and Small Growth into Thrivent Small Cap, Mid Cap Value and Mid Cap Growth into Thrivent Mid Cap Stock and Natural Resources and Technology into Thrivent Large Cap Growth

Toroso Newfound Tactical Allocation Fund (TNTAX) has closed and will liquidate at the end of September, 2015.  The promise of riches driven by “a proprietary, volatility-adjusted and momentum driven model” never quite panned out for this tiny fund-of-ETFs.

In Closing . . .

Warren Buffett turned 85 on Sunday. I can only hope that we all have his wits and vigor when we reach a similar point in our lives. To avoid copyright infringement and the risk of making folks ears bleed, I didn’t sing “happy birthday” but I celebrate his life and legacy.

As you read this, I’m boring at bunch of nice folks in Cincinnati to tears. I was asked to chat with the folks at the Ultimus Fund Services conference about growth in uncertain times. It’s a valid concern and I’ll try to share in October the gist of the argument. In late August, a bright former student of mine, Jonathon Woo, had me visit with some of his colleagues in the mutual fund research group at Edward Jones. I won’t tell you what I said to them (it was all Q&A and I rambled) but what I should have said about how to learn (in this case about the prospect of an individual mutual fund) from talking with others. And, if the market doesn’t scramble things up again, we’ll finally run the stuff that’s been in the pipeline for two months.

We’re grateful to the folks who continue to support the Observer, both financially and with an ongoing stream of suggestions. Thanks to Tyler for his recent advice, and to Rick, Kirk, William, Beatrice, Courtney, Thaddeus, Kevin, Virginia, Sunil, and Ira (a donor advised fund – that’s so cool) for their financial support. You guys rock! A number of planning firms have also reaching out with support, kind words and suggestions. So thanks to Wealth Care, LLC, Evergreen Asset Management, and Integrity Financial Planning.  I especially need to track down our friends at Evergreen Asset Management for some beta testing questions. Too, we can’t forget the folks whose support comes from the use of our Amazon Affiliate link. Way to go on finding those back-to-school supplies!

I don’t mean to frighten anyone before Halloween, but historically September and October are the year’s most volatile months. Take a deep breath, try to do a little constructive planning on quiet days, pray for the Cubs (as I write, they’re in third place but with a record that would have them leading four of the six MLB divisions), cheer for the Pirates, laugh at the dinner table and remember that we’re thinking of you.

As ever,

Dear friends,

Welcome to the dog days.

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

FreeImages.com/superburg

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

MFO is a charity case

And you just thought we were a basket case!

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

Why does that matter?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Finding a family’s first fund

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

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

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

“The journey of a thousand miles begins …

with one step.” Lao-Tzu.

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

It’s easy and

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Potpourri

by Edward A. Studzinski

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

       Joseph Heller

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

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

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

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

Morningstar, revisited:

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

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

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

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

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

What’s coming?

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

Top developments in fund industry litigation

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

New Lawsuit

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

Orders

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

Briefs

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

The Alt Perspective: Commentary and news from DailyAlts.

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

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

Asset Flows

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

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

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

Trends and Research

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

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

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

Educational Videos

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

Observer Fund Profiles

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

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

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

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

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

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

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

Launch Alert

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

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

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

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

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

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

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

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

Funds in Registration

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

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

Manager Changes

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

Updates

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

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

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

Briefly Noted . . .

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

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

SMALL WINS FOR INVESTORS

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

CLOSINGS (and related inconveniences)

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

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

OLD WINE, NEW BOTTLES

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

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

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

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

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

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

OFF TO THE DUSTBIN OF HISTORY

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

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

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

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

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

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

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

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

Rationale for liquidating the Fund

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

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

In Closing . . .

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

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

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

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

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

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

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

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

We’ll look for you.

Dear friends,

We really hope you enjoy the extra start-of-summer profundity that we’ve larded (excuse the expression) into this issue. We took advantage of the extra time afforded by the June 30^th leap second and the extra light generated that night by the once-in-two-millennia conjunction of Venus and Jupiter to squeeze in a family-sized portion of insight into this month’s issue.

And it all started with Morningstar.

Mania at the McCormick!

Morningstar’s annual investor conference is always a bit of a zoo. Two thousand people jam together in a building the size of a shopping mall, driven by a long schedule and alternating doses of caffeine (6:00 a.m. to 6:00 p.m.) and alcohol (thereafter). There are some dozens of presentations, ranging from enormously provocative to freakish, mostly by folks who have something to sell but, for the sake of decorum, are trying not to mention that fact.

Okay: the damned thing’s a lot bigger than any shopping mall except the Mall of America. MoA has about 4.2 million square feet total, McCormick is around 3.4 million. We were in the West Building, whose main ballroom alone runs to 100,000 square feet. 500,000 square feet of exhibition space, 250,000 of meeting space, with something like 60 meeting rooms. That building alone cost about $900 million, and McCormick has three others.

What follows are three sets of idiosyncratic observations: mine, Charles and Ed’s. I’ve linked to Morningstar’s video, where available. The key is that their videos auto-launch, which can be mightily annoying. Be ready for it.

Jeremy Grantham: The World Will End, You’ve Just Got to be Patient for a Bit

Grantham, one of the cofounders of GMO, a highly respected institutional investment firm originally named Grantham, Mayo, van Otterloo, is regularly caricatured as a perma-bear. He responds to the charge by asserting “I’m not a pessimist. You’re simply optimists.”

Grantham argues that we’re heading for a massive stock market crash (something on the order of a 60% fall), just not for a while yet. GMO’s study of asset bubbles found that asset prices regularly become detached from reality but they’re not subject to crashing until they exceed their normal levels by about two standard deviations.  Roughly speaking, that translates to asset prices that are higher than they are 95% of the time. Right now, we’re about 1.5 standard deviations above average. If current trends continue – and Grantham does expect stocks to follow the path of least resistance, higher – then we’ll reach the two standard deviation mark around the time of the presidential election.

Merely being wildly overvalued doesn’t automatically trigger a crash (in the UK, home prices reached a three standard deviation peak – 99.7% – before imploding) but it’s extremely rare for such a market not to find a reason to crash. And when the crash comes, the market typically falls at about twice the rate that it rose.

As an aside, Grantham also notes that no stock market crash has occurred until after average investors have been dragged into the party’s frenzied last hours, too late to make much money but just in time to have their portfolios gutted (again). While optimism, measured by various investor attitude surveys, is high, it’s not manic. Yet.

So, we’ve got a bit to savor ill-garnered gains and to reassure ourselves that this time we’ll be sharp, discerning and well on our way to safety ere the crash occurs.

Oddly, Grantham expects a crash because capitalism does work, but regulation (mostly) does not. Under capitalism, capital flows to the area of greatest opportunity: if your lemonade stand is able to draw a million in revenue today, you can be pretty much guaranteed that there will be a dozen really cool lemonade stands in your neighborhood within the week. As a result, your profit will decline. More stands will be built, and profits will continue declining, until capitalists conclude that there’s nothing special in the lemonade stand biz and they resume the search for great opportunities. Today’s record corporate profit margins must draw new competitors in to drive those excess profits down, or capitalism is failing.

Grantham argues that capitalism is failing for now. He blames the rise of “stock option culture” and a complicit U.S. fed for the problem. Up to 80% of executive compensation now flows from stock options, which are tied to short-term performance of a company’s stock rather than long-term performance of the company. People respond to the incentives they’re given, so managers tend toward those actions which increase the value of their stock options. Investing in the company is slow, uncertain and risky, and so capital expenditures (“capex”) by publicly-traded firms is falling. Buying back stock (overpriced or not) and issuing dividends is quick, clean and safe, and so that sort of financial engineering expands. Interest rates at or near zero even encourage the issuance of debt to fund buybacks (“Peter, meet Paul”). It would be possible to constrain the exercise of options, but we choose not to. And so firms are not moving capital into new ventures or into improving existing capabilities which, in the short run, continues to underwrite record profit margins.

David Marcus: We’re in the Bottom of the Third

All value investing starts with fundamentally, sometimes appallingly, screwed-up companies that have the potential to do vastly better than they’ve been doing. The question is whether anything will unleash those potential gains. That’s not automatically true; 50 to a hundred publicly-traded companies go bankrupt each year as do something like 30,000 private ones.

On whole, investors would prefer that the firms they invest in not go belly up. In the U.S., they’ve got great leverage to encourage corporate restructurings – spinoffs, mergers, acquisitions, division closures – which might serve to release that locked-up potential. We also have a culture that, for better and worse, endorses the notion of maximizing shareholder (rather than stakeholder or community) value.

Traditionally the U.S. has been one of the few places that countenanced, much less encouraged, frequent corporate dislocations. Europeans encourage a stakeholder model focused on workers’ interests and Asians have a tradition of intricately interwoven corporate interests where corporations share a web of directorships and reciprocal investments in each other.

David Marcus manages Evermore Global Value (EVGBX) and tries to do so in the spirit of his mentor, Michael Price. As one of Price’s Mutual Series managers, he specialized in “special situations” investing, a term that describes the whole array of “rotten company teetering between damnation and salvation” thing. Later, as a private investor in Europe, he saw the beginnings of a change in corporate culture; the first intimations that European managers were willing to make tentative moves toward a shareholder-focused culture. In December 2009, he launched the Evermore funds to exploit that unrecognized change.

The first three years were trying: his flagship fund lost 10% over the period and trailed 95% of its peers. When we spoke several years ago, Mr. Marcus was frustrated but patient: he likened his portfolio to a spring that’s already been compressed a lot but, instead of releasing, was getting compressed even more. In the past three years, the spring rebounded: top third relative returns, 15% annualized ones, with two stretches at the very top of the global equity heap.

Mr. Marcus’s portfolio remains Euro-centric, about 66% against his peers’ 30%, but he foresees a rotation. The 2008 financial meltdown provided an opportunity for European corporate insiders to pursue a reform agenda. International members started appearing on corporate boards, for instance, and managers were given leeway to begin reducing inefficiency. ThyssenKrupp AG, a German conglomerate, had 27 separate IT departments operating with inconsistent policies and often incompatible software. They’ve whittled that down to five and are pursuing the crazy dream of just one IT department. Such moves create a certain momentum: at first, restructuring seems impossible, then a minor restructuring frees up a billion in capital and managers begin to imagine additional work that might reap another billion and a half. As the great Everett Dirksen once reflected, “A billion here, a billion there, and pretty soon you’re talking about real money.” Mr. Marcus believes that Europeans are pursuing such reforms with greater vigor but without wasting capital “on crappy IPOs” that continue to dog the U.S. market.

A bigger change might be afoot in Asia and, in particular, in Japan. Corporate executives are, for the first time, beginning to unwind the complex web of cross-ownership which had traditionally been a one-way move: you invest in another corporation but never, ever sell your stake. Increasingly, managers see those investments as “cash cows,” the source of additional capital that might be put to better use.

Ironically, the same social forces that once held capital captive might now be working to free it. Several new Japanese stock indexes attempt to recognize firms that are good stewards of shareholder capital. The most visible is the Nikkei 400 ROE index, which tracks companies “with high appeal for investors, which meet requirements of global investment standards, such as efficient use of capital and investor-focused management perspectives.” Failure to qualify for inclusion has been deeply embarrassing for some management teams, which subsequently reoriented their capital allocations. Nomura Securities launched a competing index focusing on companies that use dormant cash to repurchase shares, though the effects of that are not yet known.

Mr. Marcus’s sense that the ground might be shifting is shared by several outstanding managers. Andrew Foster of Seafarer (SFGIX) has speculated that conditions favorable to value investing (primarily institutions that might serve as catalysts to unlock value) are evolving in the emerging markets. Messrs. Lee and Richyal at JOHCM International Select Fund (JOHAX) have directly invoked the significance of the Nikkei ROE Index in their Japan investing. Ralf Scherschmidt at Oberweis International Opportunities (OBIOX) has made a career of noticing that investors fail to react promptly to such changes; he tries to react to news promptly then wait patiently for others to begin believing that change is really. All three are five-star funds.

I’ll continue my reviews in August. For now, here are Charles’s quick takes.

Morningstar Investment Conference 2015 Notes

In contrast to the perfect pre-autumnal weather of last year’s ETF conference, Chicago was hot and muggy this past week, where some 2000 attendees gathered for Morningstar’s Investment Conference located at the massive, sprawling, and remote McCormick Place.

Morningstar does a great job of quickly publishing conference highlights and greatly facilitates press … large press room wired with high-speed internet, ample snacks and hot coffee, as well as adjacent media center where financial reporters can record fund managers and speakers then quickly post perspectives, like Chuck Jaffe’s good series of audio interviews.

On the MFO Discussion Board, David attempts to post nightly his impressions and linkster Ted relays newly published conference articles. To say the event is well covered would be a colossal understatement.

Nonetheless, some impressions for inclusion in this month’s commentary …

If you are a financial adviser not catering to women and millennials, your days are numbered.

On women. Per Sallie Krawcheck, former president of BAC’s Global Wealth division and currently chair of the Ellevate network, which is dedicated to economic engagement of women worldwide, women live six to eight years longer than men … 80% of men die married, while 80% of women die unmarried … 70% of widows leave their financial advisers within a year of their husband’s death.

While women will soon account for majority of US millionaires, most financials advisors don’t include spouses in the conversation. The issue extends to the buy side as well. In a pre-conference session entitled, “Do Women Investors Behave Differently Than Men,” panels cited that women control 51% investable wealth and currently account for 47% of high net worth individuals, yet professional women money managers account for only 5% of assets under management. How can that be?

The consequence of this lack of inclusion is “lack of diversification, higher risk, and money left on table.” Women, they state, value wealth preservation many times more than men. One panelist actually argues that women are better suited to handle the stress hormone cortisol since they need not suffer adverse consequences of interaction with testosterone.

While never said explicitly, I could not help but wonder if the message or perhaps question here is: If women played a greater role in financial institutions and at the Fed in years leading up to 2007, would we have avoided the financial or housing crises?  

On millennials. Per Joel Brukenstein of Financial Planning Magazine and creator of Technology Tools for Today website, explains that the days of financial advisors charging 1% annual fee for maintaining a client portfolios of four or five mutual funds are no longer sustainable … replaced with a proliferation of robo-advisors, like Schwab Intelligent Portfolios, which charges “no advisory fees, no account service fees, no commissions, period.”

Ditto, if your services are not available on a smart phone. Millennials are beyond internet savvy and mobile … all data/tools must be accessible via the cloud.

Mr. Brukenstein went so far as to suggest that financial advisors not offering services beyond portfolio management should consider exiting the business.

Keynote highlights. Jeremy Grantham, British-born co-founder of Boston-based asset management firm GMO, once again reiterated his belief that US stocks are 30 – 60% overvalued, still paying for overvaluation sins of our fathers … the great bull run of 1990, which started in 1987, finished in 2000, and was right on the heels of the great bull run of the 1980s. No matter that investors have suffered two 50% drawdowns the past 15 years with the S&P 500 and only received anemic returns, “it will take 25 years to get things right again.” So, 10 more years of suffering I’m afraid.

He blames Greenspan, Bernanke, and Yellen for distorting valuations, the capital markets, the zero interest rate policy … leading to artificially inflated equity prices and a stock-option culture that has resulted in making leaders of publically traded companies wealthy at the expense of capital investment, which would benefit the many. “No longer any room for city or community altruism in today’s capitalism … FDR’s social contract no more.”

All that said he does not see the equity bubble popping just yet … “no bubble peaks before abnormal buyers and deals come to market.” He predicts steady raise until perhaps coming presidential election.

Mr. Grantham is not a believer in efficient market theory. He views the cycles of equity expansion and contraction quite inefficiently driven by career risk (never be wrong on your own …), herding, momentum, extrapolation, excursions from replacement value, then finally, arbitrage and mean reversion at expense of client patience. Round and round it goes.

David Kelly, JP Morgan’s Chief Global Strategist whose quarterly “Guide To Markets” now reaches 169 thousand individuals in 25 countries, also does not see a bear market on horizon, which he believes would be triggered by one or more of these four events/conditions: recession, commodity spike, aggressive fed tightening, and/or extreme valuation. He sees none of these.

He sees current situation in Greece as a tragedy … Germany was too tough during recession. Fortunately, 80% of Greek debt is held by ECB, not Euro banks, so he sees no lasting domino effect if it defaults.

On the US economy, he sees it “not booming, but bouncing back.” Seven years into recovery, which represents the fourth longest expansion dating back to 1900. “Like a Yankees/Red Sox game … long because it is slow.”

He disputes Yellen’s position that there is slack in the economy, citing that last year 60 million people were hired … an extraordinary amount. (That is the gross number; subtract 57 million jobs left, for a net of 3 million.) The biggest threat to continued expansion is lack of labor force, given retiring baby boomers, 12.5% of population with felony convictions, scores addicted to drug, and restrictions on foreign nationals, which he calls the biggest tragedy: “We bring them in. They want to be here. We educate them. They are top of class. Then, we send them home. It’s crazy. We need immigration reform to allow skilled workers to stay.”

Like Grantham, he does see QE helping too much of the wrong thing at this point: “Fertilizer for weeds.”

On oil, which he views like potatoes – a classic commodity: “$110 is too much, but $40 is too low.” Since we have “genetically evolved to waste oil,” he believes now is good time to get in cause “prices have stabilized and will gradually go up.”

Like last fall, he continues to see EM cheap and good long term opportunity. Europe valuations ok … a mid-term opportunity.

He closed by reminding us that investors need courage during bear markets and brains during bull markets.

Breakout sessions. Wasatch’s Laura Geritz was stand-out panelist in break-out session “Are Frontier Markets Worth Pursuing?” She articulates her likes (“Active manager’s dream asset class … capital held dear by phenomenal FM management teams … investments by strong subsidiaries, like Nestle … China’s investment in FM … ”) and dislikes (“No practical index … current indices remain too correlated due to lack of diversification … lack of market liquidity …”). She views FM as strictly long-term investment proposition with lots of ups and downs, but ultimately compelling. If you have not listened to her interview with Chuck Jaffe, you should.

Another break-out session, panelists discussed the current increasing popularity of “ESG Investing.” (ESG stands for environmental, social, and governance. ESG funds, currently numbering more than 200, apply these criteria in their investments.) “Ignore increasingly at your own peril … especially given that women and millennials represent the biggest demographic on horizon.” Interestingly, data suggest such funds do just as well if not slightly better than the overall market.

Lengthening Noses

By Edward Studzinski

“A sign of celebrity is that his name is often worth more than his services.”

Daniel J. Boorstin

So the annual Morningstar Conference has come and gone again, with couple thousand attendees in town hoping to receive the benefit of some bit of investment or business wisdom. The theme of this year’s conference appears to have been that the world of investors now increasingly is populated by and belongs to “Gen X’ers” and “Millennials.” Baby Boomers such as yours truly, are a thing of the past in terms of influence as well as a group from whom assets are to be gathered. Indeed, according to my colleagues, advisors should be focused not on the current decision maker in a client family but rather the spouse (who statistically should outlive) or the children. And their process of decision making will most likely be very different than that of the patriarch. We can see that now, in terms of how they desire to communicate, which is increasingly less by the written word or in face to face meetings.

In year’s past, the conference had the flavor of being an investment conference. Now it has taken on the appearance of a marketing and asset allocation advice event. Many a person told me that they do not come to attend the conference and hear the speakers. Rather, they come because they have conveniently assembled in one place a large number of individuals that they have been interested either in meeting or catching up with. My friend Charles’ observation was that it was a conference of “suits” and “skirts” in the Exhibitors’ Hall. Unfortunately I have the benefit of these observations only second and third hand, as for the first part of the week I was in Massachusetts and did not get back to Chicago until late Wednesday evening. And while I could have made my way to events on Thursday afternoon and Friday morning, I have found it increasingly difficult to take the whole thing seriously as an investment information event (although it is obviously a tremendous cash cow for Morningstar). Given the tremendous success of the conference year in and year out, one increasingly wonders what the correct valuation metric is to be applied to Morningstar equity. Is it the Google of the investment and financial services world? Nonetheless, given the focus of many of the attendees on the highest margin opportunities in the investment business and the way to sustain an investment management franchise, I wonder if, notwithstanding how she said it, whether Senator Elizabeth Warren is correct when she says that “the game is rigged.”

Friday apparently saw two value-oriented investors in a small panel presenting and taking Q&A. One of those manages a fund with $20 Billion in assets, which is a larger amount of money than he historically has managed. Charging a 1% fee on that $20B, his firm is picking up $200 Million in revenue from that one fund alone, notwithstanding that they have other funds. Historically he has been more of a small-midcap manager, with a lot of special situations but not to worry, he’s finding lots of things to invest in, albeit with 40% or so in cash or cash equivalents. The other domestic manager runs two domestic funds as the lead manager, with slightly more than $24 Billion in assets, and for simplicity’s sake, let’s call it a blended rate of 90 basis points in fees. His firm is seeing than somewhat in excess of $216 Million in revenue from the two funds. Now let me point out that unless the assets collapse, these fees are recurring, so in five years, there has been a billion dollars in revenue generated at each firm, more than enough to purchase several yachts. The problem I have with this is it is not a serious discussion of the world we are in at present. Valuation metrics for stocks and bonds are at levels approaching if not beyond the two standard deviation warning bells. I suppose some of this is to be expected, as if is a rare manager who is going to tell you to keep your money. However, I would be hard pressed at this time if running a fund, to have it open. I am actually reminded of the situation where a friend sent me to her family’s restaurant in suburban Chicago, and her mother rattled off the specials of the evening, one of which was Bohemian style duck. I asked her to go ask the chef how the duck looked that night, and after a minute she came back and said, “Chef says the duck looks real good tonight.” At that point, one of the regulars at the bar started laughing and said, “What do you think? The chef’s going to say, oh, the duck looks like crap tonight?”

Now, if I could make a suggestion in Senator Warren’s ear, it would be that hearings should be held about what kind of compensation in the investment management field is excessive. When the dispersion between the lowest paid employee and the highest results in the highest compensated being paid two hundred times more than the lowest, it seems extreme. I suppose we will hear that not all of the compensation is compensation, but rather some reflects ownership and management responsibilities. The rub is that many times the so-called ownership interests are artificial or phantom.

It just strikes that this is an area ripe for reform, for something in the nature of an excess profits tax to be proposed. After all, nothing is really being created here that redounds to the benefit of the U.S. economy, or is creating jobs (and yes Virginia, carried interest for hedge funds as a tax advantage should also be eliminated).

We now face a world where the can increasingly looks like it cannot be kicked down the road financially for either Greece or Puerto Rico. And that doesn’t even consider the states like Illinois and Rhode Island that have serious underfunded pension issues, as well as crumbling infrastructures. So, I say again, there is a great deal of risk in the global financial system at present. One should focus, as an investor, in not putting any more at risk than one could afford to write off without compromising one’s standard of living. Low interest rates have done more harm than good, for both the U.S. economy and the global economy. And liquidity is increasingly a problem, especially in the fixed income markets but also in stocks. Be warned! Don’t be one of the investors who has caught the disease known as FOMO or “Fear of Missing Out.”

It’s finally easy being green

The most widely accepted solution to Americans’ “retirement crisis” – our lifelong refusal to forego the joy of stuff now in order to live comfortably later – is pursuing a second (or third or fifth) career after we’ve nominally retired. Some of us serve as school crossing guards, greeters, or directors of mutual fund boards, others as consultants, carpenters and writers. Honorable choices, all.

But what if you could make more money another way, by selling cigarettes directly to adolescents in poor countries?  There’s a booming market, the U.S. Chamber of Commerce is working globally to be sure that folks keep smoking, and your customers do get addicted. A couple hours a day with a stand near a large elementary school or junior high and you’re golden.

Most of us would say “no.” Many of us would say “HELL NO.” The thought of imperiling the lives and health of others to prop up our own lifestyle just feels horribly wrong.

The question at hand, then, is “if you aren’t willing to participate directly in such actions, why are you willing to participate indirectly in them through your investments?” Your decision to invest in, for example, a tobacco company lowers their cost of capital, increases their financial strength and furthers their business. There’s no real dodging the fact: you become a part-owner of the corporation, underwrite its operations and expect to be well compensated for it.

And you are doing it. In the case of Phillip Morris International (PM), for example, 30% of the firm’s stock is owned by ten investment companies:

Capital World & Capital Research are the advisors to the American Funds. Barrow sub-advises funds for, among others, Vanguard and Touchstone.

That exercise can be repeated with a bunch of variations: what role would you like to play in The Sixth Great Extinction, the impending collapse of the Antarctic ice sheet, or the incineration of young people in footwear factories? In the past, many of us defaulted to one of two simple positions: I don’t have a choice or I can’t afford to be picky.

The days when socially-responsible investing was the domain of earnest clergy and tree-hugging professors are gone. How gone?  Here’s a quick quiz to help provide context: how many dollars are invested through socially-screened investment vehicles?

1. A few hundred million
2. A few billion
3. A few tens of billions
4. A few hundred billion
5. A few trillion
6. Just enough to form a really satisfying plug with which to muffle The Trump.

The answer is “E” (though I’d give credit, on principle, for “F”). ESG-screened investments now account for about one-sixth of all of the money invested in the U.S. —over $6.5 trillion— up by 76% since 2012. In the U.S. alone there are over 200 open-end funds and ETFs which apply some variety of environmental, social and governance screens on their investors’ behalf.

There are four reasons investors might have for pursuing, or avoiding, ESG-screened investments. They are, in brief:

1. It changes my returns. The traditional fear is that by imposing screening costs and limiting one’s investable universe, SRI funds were a financial drag on your portfolio. There have been over 1200 academic and professional studies published on the financial effects, and a dozen or so studies of the studies (called meta-analyses). The uniform conclusion of both academic and professional reviews is that SRI screens do not reduce portfolio returns. There’s some thin evidence of improved performance, but I wouldn’t invest based on that.
2. It changes my risk profile. The traditional hope is that responsible firms would be less subject to “headline risk” and less frequently involved in litigation, which might make them less risky investments. At least when examining SRI indexes, that’s not the case. TIAA-CREF examined a quarter century’s worth of volatility data for five widely used indexes (Calvert Social Index, Dow Jones Sustainability U.S. Index, FTSE4Good US Index, MSCI KLD 400 Social Index, and MSCI USA IMI ESG Index) and concluded that there were no systematic differences between ESG-screened indexes and “normal” ones.
3. It allows me to foster good in the world. The logic is simple: if people refuse to invest in a company, its cost of doing business rises, its products become less economically competitive and fewer people buy them. Conversely, if you give managers access to lots of capital, their cost of capital falls and they’re able to do more of whatever you want them to do. In some instances, called “impact investing,” you actually direct your manager to put money to work for the common ground through microfinance, underwriting housing construction in economically-challenged cities and so on.
4. It’s an expression of an important social value. In its simplest form, it’s captured by the phrase “I’m not giving my money to those bastards. Period.” Some critics of SRI have made convoluted arguments in favor of giving your money to the bastards on economic grounds and then giving other money to social causes or charities. The argument for investing in line with your beliefs seems to have resonated most strongly with Millennials (those born in the last two decades of the 20^th century) and with women. Huge majorities in both groups want to align their portfolio with their desires for a better world.

Our bottom line is this: you can invest honorably without weakening your future returns. There is no longer any credible doubt about it. The real problems you face are (1) sorting through the welter of funds which might impose both positive and negative screens on a conflicting collection of 20 different issues and (2) managing your investment costs.

We’ve screened our own data to help you get started. We divided funds into two groups: ESG Stalwarts, funds with long records and stable teams, and Most Intriguing New ESG Funds, those with shorter records, smaller asset bases and distinctly promising prospects. We derived those lists by looking for no-load options open to retail investors, then looking for folks with competitive returns, reasonable expenses and high Sharpe ratios over the full market cycle that began in October 2007.

In addition, we recommend that you consult the exceedingly cool, current table of SRI funds maintained by the Forum for Sustainable and Responsible Investment. The table, which is sadly not sortable, provides current performance data and screening criteria for nearly 200 SRI funds. In addition, it has a series of clear, concise summaries of each fund on the table.

ESG Stalwarts

Most intriguing new ESG funds

In the wings, socially responsible funds still in registration with the Securities and Exchange Commission which will be available by early autumn include:

Thornburg Better World Fund will seek long-term capital growth. The plan is to invest in international “companies that demonstrate one or more positive environmental, social and governance characteristics.” Details in this month’s Funds in Registration feature.

TIAA-CREF Social Choice International Equity Fund will seek a favorable long-term total return, reflected in the performance of ESG-screened international stocks. MSCI will provide the ESG screens and the fund will target developed international markets. This fund, and the next, will be managed by Philip James (Jim) Campagna and Lei Liao. The managers’ previous experience seems mostly to be in index funds.

TIAA-CREF Social Choice Low Carbon Equity Fund will seek a favorable long-term total return, reflected in the performance of ESG-screened US stocks. MSCI will provide the ESG screens, which will be supplemented by screens looking for firms with “demonstrate leadership in managing and mitigating their current carbon emissions and (2) have limited exposure to oil, gas, and coal reserves.”

Trillium All Cap Fund will seek long term capital appreciation by investing in an all-cap portfolio of “stocks with high quality characteristics and strong environmental, social, and governance records.” Up to 20% of the portfolio might be overseas. The fund will be managed by Elizabeth Levy and Stephanie Leighton of Trillium Asset Management. Levy managed Winslow Green Large Cap from 2009-11, Leighton managed ESG money at SunLife of Canada and Pioneer.

Trillium Small/Mid Cap Fund will seek long term capital appreciation by investing in a portfolio of small- to mid-cap “stocks with high quality characteristics and strong environmental, social, and governance records.” Small- to mid- is defined as stocks comparable in size to those in the S&P 1000, a composite of the S&P’s small and mid-cap indexes. Up to 20% of the portfolio might be overseas. The fund will be managed by Laura McGonagle and Matthew Patsky of Trillium Asset Management. Trillium oversees about $2.2 billion in assets. McGonagle was previously a research analyst at Adams, Harkness and Hill and is distantly related to Professor Minerva McGonagall. Patsky was Director of Equity Research for Adams, Harkness & Hill and a manager of the Winslow Green Solutions Fund.

We, now more than ever in human history, have a chance to make a difference. Indeed, we can’t avoid making a difference, for good or ill. In our daily lives, that might translate to helping our religious community, coaching youth sports, serving meals at a center for the marginally secure or turning our backs on that ever-so-manly Cadillac urban assault vehicle, the Escalade.

That’s all inconvenient, a bit limiting and utterly right, and so we do it. ESG advocates argue that we’ve reached the point where we can do the same things with our portfolios: we can make a difference, encourage good behavior and affirm important personal values, all with little or no cost to ourselves. It seems like a deal worth considering.

The league’s top rebounders

Even the best funds decline in value during either a correction or a bear market. Indeed, many of the best decline more dramatically than their peers because the high conviction, high independence portfolios that are signs of their distinction also can leave them exposed when things turn bad. The disastrous performance of the Dodge & Cox funds during the 2007-09 crash is a case in point.

The real question isn’t “will it fall?” We know the answer. The real question is “will the fall be so bad that I’ll get stupid and insist on selling at a painful loss (again), probably just before a rebound?” Two rarely discussed statistics address that question. The first is recovery time, which simply measures the number of months that it’s taken each fund to recover from its single worst drawdown. The second is the Ulcer Index, one of Charles’s favorite metrics if only because of the name, which was designed by Peter Martin to factor–in both the depth and duration of a fund’s drawdown.

For those casting about for tummy-calming options, we screened for funds that had been around for a full market cycle, then looked at funds which have the shortest recovery times and, separately, the lowest Ulcer Indexes over the current market cycle. That cycle started in October 2007 when the broad market peaked and includes both the subsequent brutal crash and ferocious rebound. Our general sense is that looking at performance across such a cycle is better than focusing on some arbitrary number of years (e.g., 5, 10 or 15 year results).

The first table highlights the funds with the fastest rebounders in each of six popular categories.

The rebound or recovery time doesn’t directly account for the depth of the drawdown. It’s possible, after all, for an utterly nerve-wracking fund to power dive then immediately rocket skyward again, leaving your stomach and sleep behind.  The Ulcer Index figures that in: two funds might each dive, swoop and recover in two months but the one dove least earned a better (that is, lower) Ulcer Index score.

Again, these calculations are looking at performance over the course of the current market cycle only.

How much difference does paying attention to risk make? Fully half of all international large cap funds are still underwater; 83 months after the onset of the crash, they have still not made their investors whole. That roster includes all of the funds indexed to the MSCI EAFE, the main index of large cap stocks in the developed world, as well as actively-managed managed funds from BlackRock, Goldman Sachs, Janus, JPMorgan and others.

In domestic large caps, both the median fund on the list and all major market index funds took 57 months to recover.

Bottom Line: the best time to prepare for the rain is while the sun is still shining. While you might not feel that a portfolio heavy on cash or short-term bonds meets your needs, it makes sense for you to investigate – within whatever asset classes you choose to pursue – funds likely to inflict only manageable amounts of pain. Metrics like recovery time and Ulcer Index should help guide those explorations.

FPA Perennial: Time to Go.

FPA Perennial (FPPFX) closed to new investors on June 15, 2015. The fund that re-opens to new investors at the beginning of October will bear no resemblance to it. If you are a current Perennial shareholder, you should leave now.

Perennial and its siblings, FPA Paramount (FPRAX) and the closed-end Source Capital (SOR), were virtual clones, managed by Steve Geist and Eric Ende. While the rest of FPA were hard-core absolute value guys, G&E ran splendid small- to mid-cap growth funds, fully invested in very high-quality companies, negligible turnover, drifting between small and mid, growth and blend. Returns were consistent and solid. Greg Herr was added to the team several years ago.

In 2013, FPA made the same transition at Paramount that’s envisaged here: the managers left, a new strategy was imposed and the portfolio was liquidated. Domestic growth became global value. Only the name remained the same.

With Perennial, not even the name will remain.

1. All of the managers are going. Mr. Geist retired in 2014 and Ende, at age 70, is moving toward the door. Mr. Herr is leaving to focus on Paramount. They are being replaced by Greg Nathan. Mr. Nathan is described as “the longest serving analyst for the Contrarian Value Strategy, including FPA Crescent Fund (FPACX).”
2. The strategy is going. Geist and Ende were small- to mid-cap growth. The new fund will be all-cap value. It will be the US equity manifestation of the stock-picking strategy used in Crescent, Paramount and International Value. It is a perfectly sensible strategy, but it bears no resemblance to the one for which the fund is known.
3. The portfolio is going. FPA warns that the change “will result in significant long-term capital gains.” Take that warning seriously.  Morningstar calculates your potential capital gains exposure at 63%, that is, 63% of the fund’s NAV is a result of so far untaxed capital gains. If the portfolio is liquidated, you could see up to $36/share in taxable distributions.  

   How likely is a hit of that magnitude? We can compare Paramount’s portfolio before and after the 2013 transition. Of the 31 stocks in Paramount’s portfolio:

   27 positions were entirely eliminated
   2 positions (WABCO and Zebra Technologies) were dramatically reduced
   1 position (Aggreko plc) was dramatically expanded
   1 position (Maxim Integrated Products) remained roughly equal

   During that transition, the fund paid out about 40% of its NAV in taxable gains including two large distributions over the course of two weeks at year’s end.

   Certainly the tax hit will vary based on your cost basis, but if your cost basis is high – $35/share or more – you might be better getting out before the big tax hit comes.

4. The name is going. The new fund will be named FPA S. Value Fund.

I rather like FPA’s absolute value orientation and FPA U.S. Value may well prove itself to be an excellent fund in the long-term. In the short term, however, it’s likely to be a tax nightmare led in an entirely new direction by an inexperienced manager. If you bought FPPFX because you likely want what Geist & Ende did, you might want to look at Motley Fool Great America (TMFGX). It’s got a similar focus on quality growth, low turnover and small- to mid-cap domestic stocks. It’s small enough to be nimble and we’ve identified it as a Great Owl Fund for its consistently excellent risk-adjusted returns.

The mills of justice turn slowly, but grind exceedingly fine.

The SEC this month announced sanctions against two funds for misdeeds that took place five to seven years ago while a third fund worked to get ahead of SEC concerns about its advisor.

On June 17, 2015, the SEC issued penalties to Commonwealth Capital Management and three former three independent members of its mutual fund board. The basic argument is that, between 2008 and 2010, the adviser fed crap to the board and they blindly gobbled it up. (Why does neither half of their equation surprise me?) The SEC’s exact argument is that the board provided misleading information about the fund to the directors and the independent directors failed to exercise reasonable diligence in examining the evidence before approving a new investment contract. The fund in question was small and bad; it quickly added “extinct” to its list of attributes.

On June 22, 2015, the Board of Trustees of the Vertical Capital Income Fund (VCAPX) terminated the investment advisory agreement with Vertical Capital Asset Management, LLC. The fund’s auditor has also resigned. The Board’s vaguely phrased concern is that VCAM “lacks sufficient resources to meet its obligations to the Fund, and failed to adequately monitor the actions of its affiliate Vertical Recovery Management in its duties as the servicing agent of the mortgage notes held by the Fund.”

On June 23, 2015, the SEC reached a settlement with Pekin Singer Strauss Asset Management (PSS), advisor to the Appleseed Fund (APPLX) and portfolio managers William Pekin and Joshua Strauss.  The SEC found “that the securities laws were violated in 2009 and 2010 when PSS did not conduct timely internal annual compliance reviews or implement and enforce certain policies and procedures.” PSS also failed to move clients from the higher-cost investor shares to the lower-cost institutional ones. No one admits or denies anything, though PSS were the ones who detected and corrected the share class issue on their own.

Morningstar, once a fan of the fund, has placed them “under review” as they sort out the implications. That’s got to sting since Appleseed so visibly positions itself as a socially-responsible fund.

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.

Order

• The court gave its final approval to a $9.475 million settlement in the ERISA class action that challenged MassMutual‘s receipt of revenue-sharing payments from third-party mutual funds. (Golden Star, Inc. v. Mass Mut. Life Ins. Co.)

Briefs

• Calamos filed a motion to dismiss excessive-fee litigation regarding its Growth Fund. Brief: “Plaintiffs advance overwrought policy critiques of the entire mutual fund industry, legally inapt comparisons between services rendered to a retail mutual fund (such as the [Growth] Fund) and those provided to an institutional account or as sub-adviser, and conclusory assertions that the Fund grew over time but did not reduce its fees that are just the sort of allegations that courts in this Circuit have consistently dismissed for more than 30 years.” (Chill v. Calamos Advisors LLC.)
• Parties filed dueling motions for summary judgment in fee litigation regarding eight Hartford mutual funds. Plaintiffs’ section 36(b) claims, first filed in 2011, previously survived Hartford’s motion to dismiss. The summary judgment briefs are unavailable on PACER. (Kasilag v. Hartford Inv. Fin. Servs. LLC; Kasilag v. Hartford Funds Mgmt. Co.)
• New York Life filed a motion to dismiss excessive-fee litigation regarding four of its MainStay funds. Brief: Plaintiffs’ complaint “asserts in conclusory fashion that Defendant New York Life Investment Management LLC (‘NYLIM’) received excessive fees for management of four mutual funds, merely because NYLIM hired subadvisors to assist with its duties and paid them a portion of the total management fee. But NYLIM’s employment of this manager/subadvisor structure—widely utilized throughout the mutual fund industry and endorsed by NYLIM’s regulator—cannot itself constitute a breach of NYLIM’s fiduciary duty under Section 36(b) of the Investment Company Act . . . .” (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

The Alt Perspective: Commentary and news from DailyAlts.

Survey Says…

The spring is the season for surveys and big opinion pieces. Perhaps it is the looming summer vacations of readers that prompt companies to survey the market for opinions and views on particular topics before everyone heads out of the office for a long break. Regardless, the survey results are in, the results have been tallied and in the world of liquid alternatives, it appears that the future looks good.

Two industry surveys that were completed recently are cited in the articles below. The first provides the results of a survey of financial advisors about their allocations to alternative investments, and notes that more than half of the financial advisors surveyed think that their clients should allocate between 6% and 15% to alternative investments – a significant increase from today’s levels.

The second report below provides big picture industry thinking from Citi’s Business Advisory Services unit, and projects the market for liquid alternatives to double over the next five years, increasing to more than $1.7 trillion in assets.

• Majority of Advisors Plan to Continue Recommending Alternatives
• Citi Sees Boom in Unconstrained Long, Smart Beta and Liquid Alts

While industry surveys and big picture industry reports can often over-project the optimism and growth of a particular product group, the directional trends are important to watch. And in this case, the trends continue to be further growth of the liquid alternatives market, both here in the U.S. and abroad.

Monthly Liquid Alternative Flows

Consistent with the reports above, investors continued to allocate to alternative mutual funds and ETFs in May of this year. Investors allocated a net total of $2 billion to the space in May, a healthy increase from April’s level of $723 million, and a return to levels we saw earlier in the year.

While only two categories had positive inflows last month, this month has four categories with positive inflows. Once again, multi-alternative funds that combine multiple styles of investing, and often multiple asset managers, all into a single fund had the most significant inflows. These funds pulled in $1.8 billion in net new assets. Managed futures are once again in second place with just over $520 million in new inflows.

While the outflows from long/short equity funds have moved closer to $0, they have yet to turn positive this year. With equity market conditions as they are, this has the potential to shift to net inflows over the coming months. Commodity funds continued to struggle in May, but investors kicked it up a notch and increased the net outflows to more than $1.5 billion, more than a double from April’s level.

Diversification and one stop shopping continue to be an important theme for investors. Multi-alternative fund and managed futures funds provide both. Expect asset flows to liquid alternatives to continue on their current course of strong single-digit to low double-digit growth. Should the current Greek debt crisis or other global events cause the markets to falter, investors will look to allocate more to liquid alternatives.

New Fund Launches

We have seen 66 new funds launched this year, up from 53 at the end of April. This includes alternative beta funds as well as non-traditional bond funds, both of which provide investors with differentiated sources of return. In May, we logged 13 new funds, with nearly half being alternative beta funds. The remaining funds cut across multi-alternative, non-traditional bonds and hedged equity.

Two of the funds that were launched in May were unconstrained bond funds, one of the more popular categories for asset inflows in 2014. This asset category is meant to shield investors from the potential rise in interest rates and the related negative impact of bond prices. Both Virtus and WisdomTree placed a bet on the space in May with their new funds that give the portfolio managers wide latitude to invest across nearly all areas of the global fixed income market on a long and short basis.

While significant assets have flowed into this category of funds over the past several years, the rise in interest rates has yet to occur. This may change come September, and at that point we will find out if the unconstrained nature of these funds is helpful.

For more details on new fund launches, you can visit our New Funds 2015 page.

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. 

Eventide Healthcare & Life Sciences (ETNHX): Morningstar’s 2015 conference included a laudatory panel celebrating “up and coming” funds, including the five star, $2 billion Eventide Gilead. At yet as I talked with the Eventide professionals the talk kept returning to the fund that has them more excited, Healthcare. The fund looks fascinating and profitable. Unfortunately, we need answers to two final questions before publishing the profile. We’re hopeful of having those answers in the first couple days of July; we’ll notify the 6000 members of our mailing list as soon as the profile goes live

Launch Alert

Thornburg Developing World (THDAX) is one of the two reasons for being excited about Artisan Developing World (ARTYX). Artisan’s record for finding and nurturing outstanding management teams is the other.

Lewis Kaufman managed Thornburg Developing World from inception through early 2015. During that time, he amassed a remarkable record for risk-sensitive performance.  A $10,000 investment at inception would have grown to $15,700 on the day of Mr. Kaufman’s departure, while his peers would have earned $11,300. Morningstar’s only Gold-rated emerging markets fund (American Funds New World Fund NEWFX) would have clocked in at $13,300, a gain about midway between mediocre and Mr. Kaufmann.

By all of the risk and risk/return measures we follow, he achieved those gains with lower volatility than did his peers.

Mr. Kaufman pursues a compact, primarily large-cap portfolio. He’s willing to invest in firms tied to, but not domiciled in, the emerging markets. And he has a special interest in self-funding companies; that is, firms that generate free cash flow sufficient to cover their operating and capital needs. That allows the firms insulate themselves from both the risk of international capital flight and dysfunctional capital markets that are almost a defining feature of the emerging markets. Andrew Foster of Seafarer Overseas Growth & Income (SFGIX) shares that preference for self-funding firms and it has been consistently rewarding.

There are, of course, two caveats. First, Thornburg launched after the conclusion of the 2007-09 market crisis. That means that it only dealt with one sharply down quarter (3Q2011) and it trailed the pack then. Second, Thornburg’s deep analyst core doubtless contributed to Mr. Kaufmann’s success. It’s unclear how reliance on a smaller team will affect him.

In general, Artisan’s new funds have performed exceptionally well (the current E.M. product, which wasn’t launched in the retail market, is the exception). Artisan professes only ever to hire “category killers,” then gives them both great support and great autonomy. That process has worked exceptionally well. I suggested on our discussion board “that immediately upon launch, our short-list of emerging markets funds quite worth your money’ will grow by one.” I’m pretty comfortable with that prediction.

Artisan Developing World (ARTYX) has a 1.5% initial expense ratio and a $1,000 investment minimum.

Funds in Registration

There are eight new funds in registration this month. Funds in registration with the SEC are not available for sale to the public and the advisors are not permitted to talk about them, but a careful reading of the filed prospectuses gives you a good idea of what interesting (and occasionally appalling) options are in the pipeline. Funds currently in registration will generally be available for purchase in September or early October.

Two funds sort of pop out:

RiverNorth Marketplace Lending Fund will invest in loans initiated by peer-to-peer lenders such as LendingClub and Prosper.com. It’s structured as a non-listed closed-end fund which will likely offer only periodic liquidity; that is, you might be able to get out just once a month or so. The portfolio’s characteristics should make it similar to high-yield bonds, offering the chance for some thrills and interest rate insulation plus high single-digit returns. It’s a small market; about $7 billion in loans were made last year, which makes it most appropriate to a specialist boutique firm like RiverNorth.

Thornburg Better World will be an international fund with strong ESG screens. Thornburg’s international funds are uniformly in the solid-to-outstanding range, though the departure of Lewis Kaufmann and some of his analysts for Artisan certainly make a dent. That said, Thornburg’s analyst core is large and well-respected and socially-responsible investing has established itself as an entirely mainstream strategy.

Manager Changes

This month there were only 38 funds reporting partial or complete changes in their management teams. This number is slightly inflated by the departure of Wayne Crumpler from eleven American Beacon funds. The most notable changes include Virginie Maisonneuve’s departure from another PIMCO fund, and Thomas Huber stepping down from T. Rowe Price Growth & Income. The good news is that he’s remaining at T. Rowe Price Dividend Growth where he’s had a longer record and more success.

Updates

In May we ran The Dry Powder Gang, a story highlighting successful funds that are currently holding exceptionally high levels of cash. After publication, we heard from two advisors who warned that their funds’ cash levels were dramatically lower than we’d reported: FMI International (FMIJX) and Tocqueville International Value (TIVFX).

The error came from, and remains in, the outputs from Morningstar’s online fund screener.  Here is Morningstar’s report of the most cash-heavy international funds, based on a June 30 2015 screening:

Cool, except for the fact the Brown is 9% cash, not 66%; FMI is 20%, not 62%; AQR is 7%, not 56% … down to Tocqueville which is 6%, not 38%.

Where do those lower numbers come from? Morningstar, of course, on the funds’ “quote” and “portfolio” pages.

We promptly corrected our misreport and contacted Morningstar. Alexa Auerbach, a kind and crafty wizard there, explained the difficulty: the cash levels reported in the screener are “long rescaled” numbers. If a fund has both long and short positions, which is common in international funds which are hedging their currency exposures, Morningstar recalculates the cash position as a percentage of the fund’s long portfolio. “So,” I asked, “if a fund was 99% short and 1% long, including a 0.3% cash position, the screener would report a 30% cash stake?” Yep.

When I mentioned that anomaly to John Rekenthaler, Morningstar’s resident thunderer and former head of research, he was visibly aroused. “Long-rescaled? I thought I’d killed that beast five years ago!” And, grabbing a cudgel, he headed off again in the direction of IT.

I’ll let you know how the quest goes. In the interim, we will, and you should be a bit vigilant in checking curious outputs from the software.

Trust but Verify

On December 9, 2014, BlackRock president Larry Fink told a Bloomberg TV interviewer, “I am absolutely convinced we will have a day, a week, two weeks where we will have a dysfunctional market. It’s going to create some sort of panic, create uncertainty again.” That’s pretty much the argument that Ed and I have made, in earlier months, about ongoing liquidity constraints and an eventual crisis. It’s a reasonably widespread topic of conversation about serious investment professionals, as well as the likes of us.

Fink’s solution was electronic bond trading and his fear was not the prospect of the market crisis but, rather, of regulators reacting inappropriately. In the interim, BlackRock applied for permission to do inter-fund lending: if one of their mutual funds needed cash to meet redemptions, they could take a short-term loan from a cash-rich BlackRock fund in lieu of borrowing from the banks or hastily selling part of the portfolio. It is a pretty common provision.

Which you’d never know from one gold bug’s conclusion that Fink sounded “BlackRock’s Warning: Get Your Money Out Of All Mutual Funds.” It’s the nature of the web that that same story, generally positioned as “What They Don’t Want You to Know,” appeared on a dozen other websites, some with remarkably innocuous names. Those stories stressed that the problem would last “days or even weeks,” which is not what Fink said.

Briefly Noted . . .

On June 4, 2015, John L. Keeley, Jr., the president and founder of Keeley Asset Management and a portfolio manager to several of the Keeley funds passed away at a still-young 75. He’s survived by his wife of 50+ years and a large family. His rich life, good works and premature departure remind us all of the need to embrace our lives while we can, rather than dully plodding through them.

Conestoga SMid Cap Fund (CCSMX) just gained, with shareholder approval, a 12(b)1 fee. (Shareholders are a potentially valuable source of lanolin.) Likewise, the Hennessy Funds are asking shareholders to raise their costs via a 12(b)1 fee on the Investor Class of the Hennessy Funds.

In the “let’s not be too overt about this” vein, Janus quietly added a co-manager to Janus Unconstrained Global Bond (JUCAX).  According to the WSJ, Janus bought the majority stake in an Australian bond firm, Kapstream Capital Pty Ltd., then appointed Kapstream’s founder to co-manage Unconstrained Bond.  Kumar Palghat, the co-manager in question, is a former PIMCO executive who managed a $22 billion bond portfolio for PIMCO’s Australian division. He resigned in 2006, reportedly to join a hedge fund.

It’s intriguing that Gross, who once managed $1.8 trillion, is struggling with one-tenth of one percent of that amount. Janus Unconstrained is volatile and underwater since launch. Its performance trails that of PIMCO Unconstrained (PFIUX), the BarCap Aggregate, its non-traditional bond peer group, and most other reasonable measures.

PIMCO has announced reverse share-splits of 2:1 or 3:1 for a series of its funds: PIMCO Commodity Real Return Strategy Fund (PCRAX), PIMCO RAE Fundamental Advantage PLUS Fund (PTFAX), PIMCO Real Estate Real Return Strategy Fund (PETAX) and PIMCO StocksPLUS Short Fund (PSSAX). Most of the funds have NAVs in the neighborhood of $2.50-4.00. At that level, daily NAV changes of under 0.25% don’t get reflected (they round down to zero) until a couple consecutive unreported changes pile up and trigger an unusually large one day move.

O Canada! Your home and native land!! Vanguard just noticed that Canada exists and that it is (who knew?) a developed market. As a result, the Vanguard Developed Markets Index Fund will now track the FTSE Developed All Cap ex US Index rather than the FTSE Developed ex North America Index. The board has also approved the addition of the Canadian market to the Fund’s investment objective. Welcome, o’ land of pines and maples, stalwart sons and gentle maidens!

Vanguard’s Emerging Markets, Pacific and European stock index funds will also get new indexes, some time late in 2015. Vanguard’s being intentionally vague on the timing of the transition to try to prevent front-running by hedge funds and others. In each case, the new index will include a greater number of small- to mid-cap names. The Emerging Markets index will, in addition, include Chinese “A” shares. One wonders if recent events are causing them to reconsider?

Villere Balanced Fund (VILLX) and Villere Equity Fund (VLEQX) may, effective immediately, lend securities – generally, that means “to short sellers” – “in order to generate return.”

SMALL WINS FOR INVESTORS

AMG Yacktman (YACKX) and AMG Yacktman Focused (YAFFX) both reopened to new investors on June 22, 2015. The reopening engendered a lively debate on our discussion board. One camp pointed out that these are top 1% performers over the past 10- and 15-year periods. The other mentioned that they’re bottom 10% performers over the past 3- and 5-year periods. The question of asset bloat (about $20 billion between them) came up as did the noticeable outflows ($4 billion between them) in the last several years. There was a sense that the elder Mr. Yacktman was brilliant and a phenomenally decent man but, really, moving well into the “elder” ranks. Son Steve, who has been handling the funds’ day-to-day operations for 15 years is … hmmm, well, a piece of work.

The Barrow Funds, Barrow Value Opportunity Fund (BALAX/BALIX) and Barrow Long/Short Opportunity Fund (BFLSX/BFSLX) are converting from two share classes to one. The investor share class closed to new purchases on June 2 and merged into the institutional share class on June 30. At that same time, the minimum investment requirement for the institutional shares dropped from $250,000 to $2,500.  The net effect is that Barrow gets administrative simplicity and their investors, current and potential, get a price break.

Effective immediately, the name of the Hatteras Hedged Strategies Fund has changed to Hatteras Alternative Multi-Manager Fund (HHSIX).  Here’s the “small wins” part: they’ve sliced their minimum initial investment from $150 million to $1 million! Woo hoo! And here’s the tricky part: the fund has only $97 million in assets which implies that the exalted minimum was honored mostly in the breach.

The Royce Funds reduced their advisory fees for their European Smaller-Companies Fund, Global Value, International Smaller-Companies, International Micro-Cap and International Premier funds on July 1, 2015. The reductions are about 15 basis points, which translates to a drop in the funds’ expense ratios of about 10%.

Nota bene: the Royce Funds make me crazy. After a series of liquidations in April, there are 22 funds left which will drop to 21 in a couple of months. Of those, two have above average returns for the past five years while 16 trail at least 80% of their peers. The situation over the past decade is better, but not much. If you screen out the sucky, high risk and economically unviable Royce funds, you get down to about five: Global Financial Services and a bunch that existed before Legg Mason bought the firm and got them to start churning out new funds.

Effective June 1, 2015, the Schroder U.S. Opportunities Fund (SCUIX), which had been closed to new investors, will become available for purchase by investors generally. Actually with a $250,000 investment minimum, it “became available for purchase by really rich investors generally.”

CLOSINGS (and related inconveniences)

Effective as of the close of business on July 15, 2015, Brown Advisory Small-Cap Fundamental Value Fund (BIAUX) will stop accepting new purchases through most broker-dealer firms.

Eaton Vance Atlanta Capital Horizon Growth Fund (EXMCX) announced its plan to close to new investors on July 13, 2015. I wouldn’t run for your checkbook just yet. The fund has only $34 million in assets and has trailed pretty much everybody in its peer group, pretty much forever:

INTECH U.S. Core Fund (JDOAX) closed to new investors on June 30, 2015. Why, you ask? Good question. It’s a small fund that invests in large companies with a doggedly mediocre record. Not “bad,” “mediocre.” Over the past decade, it’s trailed the S&P 500 by 0.11% annually with no particular reduction of volatility. The official reason: “because Janus Capital and the Trustees believe continued sales are not in the best interests of the Fund.”

OLD WINE, NEW BOTTLES

The Calvert Social Index Fund is now Calvert U.S. Large Cap Core Responsible Index Fund (CSXAX). At the same time, the adviser reduced the fund’s expense ratio by nearly one-third, from 0.75% down to 0.54% for “A” shares.  

Effective June 2, 2015, Columbia LifeGoal Growth Portfolio, a fund of funds, became Columbia Global Strategic Equity Fund (NLGIX). At the same time the principal investment strategies were revised (good plan! It trails 90% of its peers over the past 1, 3 and 5 years) to eliminate a lot of the clutter about how much goes into which Columbia fund. The proviso that the fund will invest at least “40% of its net assets in foreign currencies, and equity and debt securities” implies a currency-hedged portfolio.

FPA Perennial (FPPFX) has closed for a few months while it becomes an entirely different fund using the same name.

Effective immediately, the name of the Hatteras Hedged Strategies Fund has changed to Hatteras Alternative Multi-Manager Fund (HHSIX). 

On August 31, 2015: iShares MSCI USA ETF (EUSA) becomes iShares MSCI USA Equal Weighted ETF. We’ll leave it to you to figure out how they might be changing the portfolio.

Natixis Diversified Income Fund (IIDPX) becomes Loomis Sayles Multi-Asset Income Fund on August 31, 2015. The investment strategy gets tweaked accordingly.

-er, don’t panic! A handful of Royce funds have lost their –ers. On June 15, Royce International Smaller-Companies Fund became Royce International Small-Cap Fund (RYGSX), European Smaller-Companies Fund became European Small-Cap Fund (RISCX) and Royce Financial Services Fund became Royce Global Financial Services Fund (RYFSX). In the former two cases, the managers wanted to highlight the fact that they focused on a stock’s capitalization rather than the size of the underlying firm. In the latter case, RYFSX has about five times the international exposure of its peers. Given that excellent performance (top 2% over the past decade) and a distinctive portfolio (their market cap is one-twentieth of their peers) hasn’t drawn assets, I suppose they’re hoping that a new name will. At the very least, with eight funds – over a third of their lineup – renamed in the past three months, that’s the way they’re betting.

Oppenheimer Flexible Strategies Fund (QVOPX) becomes Oppenheimer Fundamental Alternatives Fund on August 3, 2015. There’s no change in the fund’s operation, so apparently “strategies” are “alternatives,” just not trendy alternatives.

On June 22, 2015, the Sterling Capital Strategic Allocation Conservative Fund (BCGAX) morphed into Sterling Capital Diversified Income Fund. Heretofore it’s been a fund of Sterling funds. With the new name comes the ability to invest in other funds as well.

In case you hadn’t noticed, on June 18, 2015, the letters “TDAM” were replaced by the word “Epoch” in the names of a bunch of funds: Epoch U.S. Equity Shareholder Yield Fund, Epoch U.S. Large Cap Core Equity Fund, Epoch Global Equity Shareholder Yield Fund, Epoch Global All Cap Fund, and Epoch U.S. Small-Mid Cap Equity Fund. The funds, mostly bad, have two share classes each and have authorization to launch eight additional share classes. Except for U.S. Small-Mid Cap, they have $3-6 million in assets.

Effective July 31, 2015 Virtus Global Dividend Fund (PGUAX), a perfectly respectable fund with lots of global infrastructure exposure, becomes Virtus Global Infrastructure Fund.

Effective August 28, 2015, the West Shore Real Return Income Fund (NWSFX) becomes West Shore Real Return Fund. They’re also changing their objective from “capital growth and current income” to “preserving purchasing power.” They’ve pretty much completely rewritten their “principal strategies” text so that it’s hard to know how exactly the portfolio will change, though the addition of a risk statement concerning the use of futures and other derivatives does offer a partial answer. I’ve been genially skeptical of the fund for a long while. Their performance chart doesn’t materially reduce that skepticism:

At a reader’s behest, I spoke at length with one of the managers whose answers seemed mostly circular and who was reluctant to share information about the fund. He claimed that they have a great record as a private strategy, that they’ve shown to the board, but that they’re not interested in sharing with others. His basic argument was: “we don’t intend to make information about the fund, our strategies or insights available on the web. Our website is just a pick-up point for the prospectus. We expect that people will either know us already or will follow our success and be drawn.” At the end of the call, he announced that he and co-manager James Rickards were mostly the public faces of the fund and that the actual work of managing it fell to the third member of the trio. Mr. Rickards has since left to resume his career as doom-sayer.

OFF TO THE DUSTBIN OF HISTORY

Aftershock Strategies Fund (SHKIX/SHKNX) has closed and will discontinue its operations effective July 6, 2015.

You’ll need to find an alternative to AMG FQ Global Alternatives Fund (MGAAX), which is in the process of liquidating. Apparently they’re liquidating (or solidifying?) cash:

Final shutdown should occur by the end of July.

Elessar SCV Fund has morphed into the Emerald Small Cap Value Fund (ELASX)

Franklin Templeton has delayed by a bit the liquidation of Franklin Global Allocation Fund (FGAAX). The original date of execution was June 30 but “due to delays in liquidating certain portfolio securities,” they anticipate waiting until October 23. That’s a fascinating announcement since it implies liquidity problems though that’s not listed as an investment risk in the prospectus.

Guggenheim Enhanced World Equity Fund “ceased operations, liquidated its assets, and distributed the liquidation proceeds to shareholders of record at the close of business on June 26, 2015.”

Salient recently bought the Forward Funds complex “in an effort to build scale in the rapidly growing liquid alternatives space.” The brilliance of the deal is debatable (Forward favors liquid alts investing, but only three of its 30 funds – Select Emerging Markets Dividend, Credit Analysis Long/Short (whose founding managers were sacked a year ago) and High Yield Bond – have outperformed their peers since inception). As it turns out, Forward Small Cap Equity Fund (FFSCX) and Forward Income & Growth Allocation Fund (AOIAX) fell into neither of those camps: good or alternative. Both are scheduled to be liquidated on August 12, 2015.

HSBC RMB Fixed Income Fund (HRMBX), an exceptionally strong EM bond fund with no investors, will be liquidated on or about July 21, 2015.

MainStay ICAP Global Fund (ICGLX) will be liquidated on or about September 30, 2015. Small, middling performer, culled from the herd.

Sometimes a picture is worth a thousand words. Other times a picture leaves me speechless. Such is the case with the YTD price chart for Merk Currency Enhanced U.S. Equity Fund (MUSFX).

Yuh. That’s a one-day spike of about 60%, followed by a 60% fall the next day for a net loss of a third over two days, at which point the fund was no longer “pursuing its investment objective.” The fund is scheduled to be liquidated July 15.

Montibus Small Cap Growth Fund (SGWAX) joins the legion of the dearly departed on August 24, 2015.

Nationwide HighMark Balanced Fund (NWGDX) will, pending shareholder approval, vanish on or about October 23, 2015. At about the same time Nationwide HighMark Large Cap Growth (NWGLX) is slated to merge into Nationwide Large Cap Core Equity while Nationwide HighMark Value (NWGTX) gets swallowed by Nationwide Fund (NWFAX). The latter has been rallying after getting a new manager in 2013, so we’ll be hopeful that this is a gain for shareholders.

At the end of July, shareholders will vote on a proposal to merge the small and sad Royce Select Fund (RYSFX) into the much larger and sadder Royce 100 (RYOHX). The proxy assures investors that “the Funds have identical investment objectives, employ substantially similar principal investment strategies to pursue those investment objectives, and have the same portfolio managers,” which raises the question of why they launched Select in the first place.

The previously announced liquidation of the half million dollar Rx Tax Advantaged Fund (FMERX) has been delayed until July 31, 2015. 

On or about August 25, 2015, the Vantagepoint Model Portfolio All-Equity Growth Fund (VPAGX) becomes Vantagepoint Model Portfolio Global Equity Growth Fund and increases its equity exposure to non-U.S. securities by adding an international index fund to its collection. The fund has about a billion in assets. Who knew?

Relationships come and relationships go. One of the few proprieties that my students observe is, if you’ve actually met and gone out in person, you should be willing to break up in person. Breaking up by text is, they agreed, cruel and cowardly. I suspect that they’re unusually sympathetic with the managers of Wells Fargo Advantage Emerging Markets Local Bond Fund (WLBAX) and Wells Fargo Advantage Emerging Markets Equity Select Fund (WEMTX). “At a telephonic meeting held on June 15, 2015, the Board of Trustees unanimously approved the liquidation of the Funds.” Cold, dude. If you’d like to extend your sympathies, best send the text before July 17, 2015.

Wilmington Mid-Cap Growth Fund (AMCRX) will liquidate on or about August 3, 2015. Being “not very good” (they’ve trailed two-thirds of their peers for the past five and ten years) didn’t stop them from accumulating a quarter billion in assets but somehow the combination wasn’t enough to keep them around. Wilmington Small-Cap Strategy Fund (WMSIX), a small institutional fund with a pretty solid record and stable management, goes into the vortex that same day.

In Closing . . .

Thank you, once again, to those whose support keeps the lights on at the Observer. To Diane & Tom, Allen & Cleo, Hjalmar, Ed (cool and mysterious email address, sir!): we appreciate you!  A great, big thanks to those who use the Observer’s Amazon link for all their Amazon purchases. Your consistency, and occasional exuberant purchase, continues to help us beat our normal pattern of declining revenue in the summer months. We’d also be remiss if we forgot to thank the faithful Deborah and Greg, our honorary subscribers and PayPal monthly contributors. Many thanks to you both.

Lots to do for August. We’ve been watching the folks at the Turner Funds thrash about, both in court and in the marketplace. We’ll try to give you some perspective on what some have called The Fall of the House of Turner. In addition, we’d like to look at the question, “where should you start out?” That is, if you or a young friend of yours is a 20-something with exceedingly modest cash flow but a determination to build a sensible, durable foundation, which funds might serve as your (or their) best first investment: conservative, affordable, sensible.

And, too, I’ve got to prepare for a couple presentations: a talk with some of the young analysts at Edward Jones in St. Louis and with the folks attending Ultimus Fund Solution’s client conference at the end of August and beginning of September. If I find something fun, you’ll be the second to know!

As ever,

Dear friends,

They’re gone. Five hundred and twenty-six Augie students who we’ve jollied, prodded, chided, praised, despaired of and delighted in for the past four years have been launched on the rest of you. They’re awfully bright-eyed, occasionally in reflection of the light coming from their cell phone screens. You might suspect that they’re not listening, but if you text them, they’ll perk right up.

This is usually the time for graduation pictures but I’ve never found those engaging since they reflect the dispersion of our small, close-knit community. I celebrate rather more the moments of our cohesion; the times when small and close were incredibly powerful.

Augie’s basketball team finished second in the nation in 2015, doing rather better in our division than the Kentucky Mildcats did in theirs, eh? We did not play in a grand arena but instead in a passionate one: Carver Gymnasium, home of the Carver Crazies. It was a place where the football team (the entire football team) jammed the sidelines of every game, generally shoulder to shoulder with the women’s basketball team and the choir, all shouting … hmmm, deprecations at opposing players.

When the team boarded buses at 5:00 a.m. for the trip east to compete in the Final Four, they were cheered off by hundreds of students and staff who stood in happy gaggles in the dark. A day later, hundreds more boarded buses and jammed in cars to follow them east. And when they came home, one win shy of a championship, they were greeted with the sound of trumpets and cheers.

And while the basketball players won’t go to the NBA, a fair number – over half of our juniors – will go to med school. And so perhaps we’ll yet meet the Kentuckians at an NBA contest as our guys patch together theirs.

I rather like kids, maddened though we make each other.

MFO on FOMO

No, FOMO is not that revolutionary white spray foam that’s guaranteed to remove the toughest pet stains from your carpet; neither is it a campaign rallying cry (“FOMO years! FOMO years!”).

FOMO is “fear of missing out” and it’s one of the more plausible explanations for the market’s persistent rise. There’s an almost-universal agreement that financial assets are, almost without exception, overpriced. Some (bonds) are more badly overpriced than others (small Japanese stocks), but that’s about the best defense that serious investors make of current conditions: they’re finding pockets of relative value rather than much by way of absolute value.

The question is: why are folks hanging around when they know this is going to end badly (again)? The surprising answer is, because everyone else is hanging around. It’s a logic reminiscent of those anxious moments back in our early high school years. We’d get invited to a party (surprise!), it would be great for a while then it would begin to drag. But really, you couldn’t be the first kid to leave. First off, everyone would notice and brand you as a wuss, or worse. Second, while it was late, all the cool kids were still around and that meant, you know, that something cool might happen.

And so you lingered until just after that kid from the football team threw up near the food, one of the girls used “the F word” kinda in your face and someone – no one knows who – knocked over the nice table lamp which really pissed off Emily’s dad. Then everyone was anxious to squeeze as quickly through the door as possible. On whole, the night would have been a lot better if you’d left just a little earlier but still …

It’s like that for professional investors, too. Reuters columnist James Saft points to research that shows professionals falling victim to the same pressures:  

Call it status anxiety, call it greed or just call it clever momentum trading, but the fear of missing out is an under-appreciated force in financial markets. No one likes to miss out on a good thing, especially when they see their friends, neighbors and rivals cashing in.

Much of this may be driven by concerns about relative wealth, or how much you have compared to those in your group, a force explored in a 2007 paper by Peter DeMarzo and Ilan Kramer of Stanford University and Ron Kaniel of Duke University. They found that even when traders understand that prices are too high they may stay in the market because they fear losing out as the overvaluation persists and extends.

Investors want to keep pace with their peers, and fear not having as much wealth. That raises, in a certain way, the risk of selling into a bubble. That status and group-motivated anxiety can blind investors towards other, seemingly obvious risks. (“The power of the fear of missing out,” 05/29/2015.)

You might think of it as a financial manifestation of Newton’s first law of motion: “unless acted upon by an outside force, an object in motion tends to stay in motion in the same direction and speed.” It’s sometimes called “the law of inertia.” One technical analyst, looking at the “pattern we have seen for much of 2015, namely choppy with a slight upward bias,” opined that despite “an increasing number of clouds gathering on the horizon  …  the path of least resistance likely remains to the upside.”

And so the smart money people remain, anxiously, present. Business Insider reporter Linette Lopez, covering the huge SALT Las Vegas hedge fund conference, observes that leading hedge fund strategists:

Across the board … believe asset prices are too high. Mostly bonds, sometimes stocks. Still, everyone is long the market. No one wants to be the first person out of the market as long as they’re making money. This is a huge issue on Wall Street, and everyone at this conference is now looking for a warning signal. (“We’ve already seen the beginning of the quake that could be coming,” 05/06/2015) – didn’t discuss h.f. fees (steadily rising) or h.f. performance (steadily lagging)…

In the same week that the hedgies were meeting in Las Vegas, the Buffett Believers gathered in Omaha. There renowned value investors, such as Jean-Marie Eveillard, now a senior advisor to First Eagle funds, fret that the market was overvalued, kept alive by artificial stimulus that’s coming to an end. Eveillard says investors don’t seem to be factoring that in. “Either everyone is thinking I will just keep dancing until the music stops, or they don’t see the risks that I do.” (“At Berkshire annual meeting, Warren Buffett hosts cautious investors,” 05/02/2015.)

In an interview with Reuters, Joel Tillinghast – one of Fidelity’s two best managers – captured the yin and yang of it:

“I think [the level of the financial markets are] colossally artificial, but I don’t see it ending. How long can we party with our bad selves?” Mr. Tillinghast asked. “You want to know so you can party on until five minutes before it ends.” (“Top Fidelity stockpicker: Financial markets are ‘colossally artificial,’” 05/26/2015)

We raised last month the notion of a “roach motel,” where getting in is easy and getting out is impossible. In the case of bugs, the problem is stickum. In the case of investors, it’s liquidity. At base, you may find that there’s no one willing to pay anything even vaguely like what you think your holdings are worth. Kevin Kinsella, president of a venture capital firm, notes that investors have been making 30% per quarter on privately traded shares, like Uber.

Given the various stratospheric private valuations some of these unicorn companies are reaching, there will be no trade buyers, and it is doubtful whether a sane investment bank would take such companies public at these market caps.

Investors historically delude themselves by concocting rationales as to why the insanity will continue, why it is completely reasonable and why an implosion won’t happen to them. They are always wrong. 

How will it end? When interest rates ultimately start to tick up and vast pools of capital begin to shift toward fixed income away from equities. It’s a historic cyclical shift. When the music stops and everyone needs to scramble for their chair, there will be a lot of fannies left hanging out there.

Predicting that this will happen is easy; predicting exactly when, not so easy. But my prediction is that it is not far off. (“Tech Boom 2015: What’s Driving Investor Insanity?” Forbes, 05/21/2015)

Michael Novogratz, head of the $67 billion Fortress hedge fund operation, shared that concern at the SALT gathering:

“I’m going to argue that I think something has fundamentally changed.” He is worried because even though managers know assets are expensive, they are still long. This is a recipe for a difficult exit once all they want to close their positions. The liquidity will disappear and assets will reprice. As legendary trader Stanley Druckenmiller said, assets need a lot of volume and money to go up and much less to crash.  (Michael Novogratz CEO of Fortress Investments Is Worried About The Markets)

The question is, what’s a fund investor to do? Five things come to mind:

1. Do a quick check on your asset allocation and risk exposure. Any idea of how long a core equity fund might remain underwater; that is, how many months it takes for a fund to rebound from a bad decline? I scanned MFO’s premium fund screener for large-cap core funds that had been around 10 years or more. The five best funds took, on average, over two years to rebound. The average large cap fund took 58 months, on average, to recover from their maximum drawdown. Here’s the test: look at your portfolio value today and ask whether you’re capable of waiting until April, 2020 to ever see a number that high again. That’s the worst case for a large cap stock portfolio. For a conservative asset allocation, the recovery time is a year or two. For a moderate portfolio, three or so years. At base, decide now how long you can wait and adjust accordingly.
2. Join the Dry Powder Gang. We profiled, last month, a couple dozen entirely admirable funds that are holding substantial cash stakes. Some have been badly punished for their caution, both by investors and raters, but all have strong, stable management teams, coherent strategies and a record of deploying cash when prices get juicy.
3. Allocate some to funds that have won in up and down markets. They’re rare. Daren Fonda at Barron’s recommends “[f]unds such as FPA Crescent (FPACX) and First Eagle Global (SGENX) have flexible strategies and defensive-minded managers.”  Charles identified a handful of long-term stalwarts in his April 2015 essay “Identifying Bear-Market Resistant Funds During Good Times.” Among the notable funds (not all open to new investors) he highlighted:
   
4. Cautiously approach the alt-fund space. There are some alt funds which have a plausible claim to thrive on volatility. We’ve profiled RiverPark Structural Alpha (RSAFX), for instance, and our colleagues at DailyAlts.com regularly highlight intriguing options.
5. Try to leave when everyone else heads out, too. The Latin word for those massive exits was “vomitaria” which would make you …

Liquidity Problem – What Liquidity Problem?

By Edward A. Studzinski

“Moon in a barrel: you never know just when the bottom will fall out.”

 Mabutsu

So as David Snowball mentioned in his May commentary, I have been thinking about the potential consequences of illiquidity in the fixed income market. Obviously, if you have a portfolio in U.S. Treasury issues, you assume you can turn it into cash overnight. If you can’t, that’s a potential problem. That appears to be a problem now – selling $10 or $20 million in Treasuries without moving the market is difficult. Part of the problem is there are not a lot of natural buyers, especially at these rates and prices. QE has given the Federal Reserve their fill of them. Banks have to hold them as part of the Dodd-Frank capital requirements, but are adding to their holdings only when growing their assets. And those people who always act in the best interests of the United States, namely the Chinese, have been liquidating their U.S. Treasury portfolio. Why? As they cut rates to stimulate their economy, they are trying to sterilize their currency from the effects of those rate cuts by selling our bonds, part of their foreign reserve holdings. Remember, the goal of China is to supplant, with their own currency, the dollar as a reserve currency, especially in Asia and the developing world. And our Russian friends have similarly been selling their Treasury holdings, but in that instance using the proceeds to purchase gold bullion to add to their reserves.

Who is there to buy bonds today? Bond funds? Not likely. If you are a fund manager and thought a Treasury bond was a cash equivalent, it is not. But if there are redemptions from your fund, there is a line of credit to use until you can sell securities to cover the redemptions, right? And it is a committed line of credit, so the bank has to lend on it, no worries! In the face of a full blown market panic, with the same half dozen banks in the business of providing lines of credit to the fund industry, where will your fund firm fall in the pecking order of mutual fund holding companies, all of whom have committed lines of credit? It now becomes more understandable why the mutual fund firms with a number of grey hairs still around, have been raising cash in their funds, not just because they are running out of things to invest in that meet their parameters. It also gives you a sense as to who understands their obligations to their shareholder investors.

We also saw this week, through an article in The Wall Street Journal, that there is a liquidity problem in the equity markets as well. There are trading volumes at the open. There are trading volumes, usually quite heavy, at the end of the day. The rest of the time – there is no volume and no liquidity. So if you thought you had protected yourself from another tsunami by having no position in your fund composed of more than three days average volume of a large or mega cap stock, surprise – you have again fought the last war. And heaven help you if you decide to still sell a position when the liquidity is limited and you trigger one or more parameters for the program and quant traders.

As Lenin asked, “What is to be done?” Jason Zweig, whom I regard as the Zen Philosopher King of financial columnists, wrote a piece in the WSJ on May 23, 2015 entitled “Lessons From A Buffett Believer.” It is a discussion about the annual meeting of Markel Corporation and the presentation given by its Chief Investment Officer, Tom Gayner. Gayner, an active manager, has compiled a wonderful long-term investment record. However, he also has a huge competitive advantage. Markel is a property and casualty company that consistently underwrites at a profitable combined ratio. Gayner is always (monthly) receiving additional capital to invest. He does not appear to trade his portfolio. So the investors in Markel have gotten a double compounding effect both at the level of the investment portfolio and at the corporation (book value growth). And it has happened in a tax-efficient manner and with an expense ratio in investing that Vanguard would be proud of in its index funds.

I recently was speaking with a friend in Japan, Alex Kinmont, who has compiled a very strong record as a deep value investor in the Japanese market, in particular the small cap end of the market. We were discussing the viability of a global value fund and whether it could successfully exist with an open-ended mutual fund as its vehicle. Alex reminded me of something that I know but have on occasion forgotten in semi-retirement, which is that our style of value can be out of favor for years. Given the increased fickleness today of mutual fund investors, the style may not fit the vehicle. Robert Sanborn used to say the same thing about those occasions when value was out of favor (think dot.com insanity). But Robert was an investment manager who was always willing to put the interests of his investors above the interests of the business.

Alex made another point which is more telling, which is that Warren Buffett has been able to do what is sensible in investing successfully because he has permanent capital. Not for him the fear of redemptions. Not for him the need to appear at noon on the Gong Show on cable to flog his investment in Bank America as a stroke of genius. Not for him the need to pander to colleagues or holding company managers more worried about their bonuses than their fiduciary obligations. Gayner at Markel has the same huge competitive advantage. Both of them can focus on the underlying business value of their investments over the long term without having to worry about short-term market pricing volatility.

What does this mean for the average fund investor? You have to be very careful, because what you think you are investing in is not always what you are getting. You can see the whole transformation of a fund organization if you look carefully at what Third Avenue was and how it invested ten years ago. And now look at what its portfolios are invested in with the departure of most of the old hands.

The annual Morningstar Conference happens in a few weeks here in Chicago. Steve Romick of FPA Advisors and the manager of FPA Crescent will be a speaker, both at Morningstar and at an Investment Analysts Society of Chicago event. Steve now has more than $20B in assets in Crescent. If I were in a position to ask questions, one of them would be to inquire about the consequences of style drift given the size of the fund. Another would be about fees, where the fee breakpoints are, and will they be adjusted as assets continue to be sought after.

I believe in 2010, Steve’s colleague Bob Rodriguez did a well-deserved victory lap as a keynote speaker at Morningstar and also as well at another Investment Analysts Society of Chicago meeting. And what I heard then, both in the presentation and in the q&a by myself and others then has made me wonder, “What’s changed?” Of course, this was just before Bob was going on a year’s sabbatical, leaving the business in the hands of others. But, he said we should not expect to see FPA doing conference calls, or having a large marketing effort. And since all of their funds at that time, with the exception of Crescent, were load funds I asked him why they kept them as load funds? Bob said that that distribution channel had been loyal to them and they needed to be loyal to it, especially since it encouraged the investors to be long term. Now all the FPA Funds are no load, and they have marketing events and conference calls up the wazoo. What I suspect you are seeing is the kind of generational shift that occurs at organizations when the founders die or leave, and the children or adopted children want to make it seem like the success of the organization and the investment brilliance is solely due to them. For those of us familiar with the history of Source Capital and FPA, and the involvement of Charlie Munger, Jim Gipson, and George Michaelis, this is to say the least, disappointing.

Does Your Fund Manager Consistently Beat the Stock Market?

I saw the headline at Morningstar and had two immediate thoughts: (1) uhh, no, and (2) why on earth would I care since “beating the stock market” is not one of my portfolio objectives?

Then I read the sub-title: “Probably not–but you shouldn’t much care.”

“Ah! Rekenthaler!” I thought. And I was right.

John recounts a column by Chuck Jaffe, lamenting the demise of the star fund manager.  Rekenthaler’s questions are (1) are they actually gone? And (2) should you care? The answers are “yes” and “no, not much,” respectively.

Morningstar researchers looked to determine how long “winning streaks” last; that is, for how many consecutive years might a fund manager beat his or her benchmark. Over the past 10 years, none of the 1000 U.S. stock funds have beaten the S&P500 for more than six years. Ten funds managed six year streaks, but four of those were NASDAQ 100 index funds. Worse yet, active managers performed worse than simple luck would dictate.

Outliers

“At the extreme outer edge of what is statistically plausible” is how Malcom Gladwell defines an outlier in his amazing book, Outliers: The Story of Success (2008).

The MFO Rating System ranks funds based on risk adjusted return within their respective categories across various evaluation periods. The rankings are by quintile. Those in the top 20 percentile are assigned a 5, while those in the bottom 20 percentile are assigned a 1.

The percentile is not determined from simple rank ordering. For example, say there are 100 funds in the Large Growth category. The 20 funds with the highest risk adjusted return may not necessarily all be given a 5. That’s because our methodology assumes fund performance will be normally distributed across the category, which means terms like category mean and standard deviation are taken into account.

It’s similar to grading tests in school using a bell curve and, rightly or wrongly, is in deference to the random nature of returns. While not perfect, this method produces more satisfactory ranking results than the simple rank order method because it ensures, for example, that the bottom quintile funds (Return Group 1) have returns that are so many standard deviations below the mean or average returning funds (Return Group 3). Similarly, top quintile funds (Return Group 5) will have returns that are so many standard deviations above the mean.

All said, there remain drawbacks. At times, returns can be anything but random or “normally” distributed, which was painfully observed when the hedge fund Long-Term Capital Management (LTCM) collapsed in 1998. LTCM used quant models with normal distributions that underestimated the potential for extreme under performance. Such distributions can be skewed negatively, creating a so-called “left tail” perhaps driven by a market liquidity crunch, which means that the probability of extreme under-performance is higher than depicted on the left edge of the bell curve above.

Then there are outliers. Funds that over- or under-perform several standard deviations away from the mean. Depending on the number of funds in the category being ranked, these outliers can meaningfully alter the mean and standard deviation values themselves. For example, if a category has only 10 funds and one is an outlier, the resulting rankings could have the outlier assigned Return Group 5 and all others relegated to Return Group 1.

The MFO methodology removes outliers, anointing them if you will to bottom or top quintile, then recalculates rankings of remaining funds. It keeps track of the outliers across the evaluation periods ranked. Below please find a list of positive outliers, or extreme over-performers, based on the latest MFO Ratings of some 8700 funds, month ending April 2015.

The list contains some amazing funds and warrants a couple observations:

• Time mitigates outliers, which seems to be a manifestation of reversion to the mean, so no outliers are observed presently for periods beyond 205 or so months, or about 17 years.
• Outliers rarely repeat across different time frames, sad to say but certainly not unexpected as observed in In Search of Persistence.
• Outliers typically protect against drawdown, as evidenced by low Bear Decile score and Great Owl designations (highlighted in dark blue – Great Owls are assigned to funds that have earned top performance rank based on Martin for all evaluation periods 3 years or longer).

The following outliers have delivered extreme over-performance for periods 10 years and more (the tables depict 20 year or life metrics, as applicable):

Here are the outliers for periods 5 years and more (the tables depict 10 year or life metrics, as applicable):

Finally, the outliers for periods 3 years and more (the tables depict 5 year or life metrics, as applicable):

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.

Order

The Tenth Circuit vacated a district court’s order that had granted class certification in the prospectus disclosure lawsuit regarding the Oppenheimer California Municipal Bond Fund, finding that “[t]he district court’s class certification order at issue here did not analyze either the Rule 23(a) or 23(b) factors.” Defendants include independent directors. (In re Cal. Mun. Fund.)

New Lawsuits

A new securities fraud class action targets four Virtus funds, alleging that defendants misrepresented the performance track record of the funds’ “AlphaSector” strategy (created by an unaffiliated sub-adviser). Defendants include independent directors. (Youngers v. Virtus Inv. Partners, Inc.)

A new antitrust lawsuit alleges that Waddell & Reed and Ivy Funds “financed and aided” Al Haymon’s illegal efforts to monopolize professional boxing. (Golden Boy Promotions LLC v. Haymon.)

Briefs

Davis filed a reply brief in support of its motion to dismiss fee litigation regarding its New York Venture Fund. (In re Davis N.Y. Venture Fund Fee Litig.)

PIMCO filed a reply brief in support of its motion to dismiss fee litigation regarding its Total Return Fund (Kenny v. Pac. Inv. Mgmt. Co.)

Having lost in district court, plaintiffs filed their opening appellate brief defending their state-law claims regarding investments of Vanguard mutual fund assets in foreign gambling businesses. Defendants include independent directors. (Hartsel v. Vanguard Group, Inc.)

Amended Complaint

Plaintiffs filed a second amended complaint in fee litigation regarding four MainStay funds issued by New York Life. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

Answer

Having lost on appeal, Putnam filed an answer to fraud and negligence claims, filed by the insurer of a swap transaction, regarding Putnam’s collateral management services to a CDO. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)

The Alt Perspective: Commentary and news from DailyAlts

Every month Brian J. Haskin, founder, publisher and editor of DailyAlts shares news, perspective and commentary on the alt-space with the Observer’s readers. DailyAlts is the only website with a sole focus on liquid alternative investments.  They seek to provide a centralized source for high quality news, research and other information on one of the most dynamic and fastest growing segments of the investment industry. We’re always grateful for Brian’s commentary and he welcomes folks to drop by DailyAlts for more news in great depth. For now, the highlights:

The Access Revolution

There is an access revolution taking place in today’s investment world, especially with alternative investments. It started a number of years ago with platforms such as Kickstarter and Kiva, where everyday citizens could help others get their new idea off the ground. Today, individual investors can access a broad array of investments with just a few clicks of the mouse:

• Private equity via closed-end mutual funds
• Real estate lending and investing through crowdsourcing platforms
• Angel investing via online venture capital portals
• Private lending via online lending platforms

The list goes on, but the good news is that individual investors have far greater choice today than they did just a few years ago.

Much of the change taking place is due to changes in securities regulations that permit advertising and public promotion of private investment offerings. Other changes are driven by capital flowing to new technology-driven platforms and the broader use of existing investment vehicles.

Just this past month we had two new private equity offerings come to market in closed-end interval funds, one from Altegris / StepStone / KKR and the other from Pomona Capital / Voya:

• New Altegris Fund Gives Accredited Investors Exposure to Private Equity
• Pomona Capital and Voya Team Up on New Private Equity Fund

While these are not pure liquid alternatives (they don’t have daily liquidity, thankfully), they fall into the “near” liquid grouping. And furthermore, they give the mass-affluent access to investments that have never been available for as little as $25,000.

Expect to see more products such as these from the big name financial firms, as well as more access to alternatives through online investment portals. There is a revolution taking place.

Now, onto the liquid part of the alternatives market.

Monthly Liquid Alternative Flows

Investors allocated a total of $982 million to actively managed alternative mutual funds and ETFs in April, according to Morningstar’s most recent asset flows report, but pulled $259 million from passively managed alternative funds. Net flows totaled $723 million for the month, down from the healthy $2.8 billion of net new asset flows seen in March.

Interestingly, only two categories had positive flows in April: Multi-alternative funds and managed futures. Clearly a sign that advisors and investors are looking for either a one-stop shop for an alternatives allocation, or are looking to allocate to wholly uncorrelated strategies alongside equity and fixed income allocations. Managed futures strategies are generally expected to perform well during times of crisis, such as during the 2008 credit crisis, and when there are strong directional trends in markets, such as those we have seen in the past year with oil prices and the US dollar.

Last year was the year of non-traditional bonds, while 2015 is looking much stronger for several other strategies. Volatility based funds topped the charts for 12-month growth rates, with managed futures and multi-alternative funds not too far behind. And despite strong growth in 2014, non-traditional bond funds are only modestly keeping their head above water with a 12-month growth rate of 2.6%.

Based on growth rates and asset flows, diversification appears to be the primary focus of investors and allocators. In 2014, long/short equity fought against the $7.8 billion of outflows from the MainStay Marketfield Fund and still posted $6.4 billion of net inflows for the year. 2015 is looking quite different. Year-to-date, the long/short equity category is down $1.5 billion. While market neutral strategies can provide low levels of correlation with the equity markets, investors appear to be moving away from these strategies in favor of managed futures, volatility and multi-alternative funds.

Expect asset flows to liquid alternatives to continue on their current course of strong single-digit to low double-digit growth. Should markets falter, investors will look to allocate more to liquid alternatives.

New Fund Launches

We have seen 53 new funds launched this year, including alternative beta funds. In May, we logged 12 new funds, with nearly half being alternative beta funds. The remaining funds cut across multi-alternative, market neutral, non-traditional bonds, volatility and commodities. 

Two intriguing funds in the volatility space came to market in May:

• AccuShares Spot CBOE VIX Up Shares (VXUP)
• AccuShares Spot CBOE VIX Down Shares (VXDN)

These two funds are different because they provide direct exposure to the VIX Index, whereas other VIX related products are indexed to futures contracts on the VIX, and thus can have very high holding costs over the course of a month. Some time is needed on the new AccuShares ETFs, but if VIX is your game, these are worth keeping an eye on.

For more details, you can visit our New Funds 2015 page to see a full listing.

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.

JOHCM International Select II (JOHAX): it’s the single best performing international large growth fund in existence over the past 1, 3 and 5 years. It’s got five stars. It’s a Great Owl. You’ve probably never heard of it and it’s closing in mid-July. Now does any of that offer a compelling reason to add it to your portfolio?

Elevator Talk: Jon Angrist, Cognios Market Neutral Large Cap

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.

Market-neutral funds are, on whole, dumb investments. They’re funds with complex strategies, high expenses and low returns which provide questionable protection for their investors. By way of simple illustration, the average market-neutral fund charges 1.70% while returning 1.25% annually over the past five years. Right: 60% of the portfolio’s (modest) returns go to the adviser in the form of fees, 40% go to you.

About the best you can say for them is that, as a group, they lost only a little money in 2008: about 0.3%. The worst you can say is that they also lost a little money in 2009. And then a little more in 2010. And yet again in 2011 before their … uh, ferocious rebound led to a 0.18% gain in 2012.

Into the mess steps Jon Angrist, Brian J. Machtley and the folks at Cognios Capital. In 2008, Messrs. Angrist and Machtley co-founded Cognios (from the Latin for “to learn” or “to inquire”) which manages about $325 million, mostly for high net worth individuals. Mr. Angrist, the lead manager, has experience managing investments through limited partnerships (Helzberg Angrist Capital), private equity firms (Harvest Partners) and mutual funds (Buffalo Microcap Fund, now called Buffalo Emerging Opportunities BUFOX).

Cognios argues that most market-neutral managers misconstruct their portfolios. Most managers simply balance their short and long books: if 5% gets invested in an attractively valued car company then another 5% is devoted to shorting an unattractively valued car company. The problem is that an over-priced company might well be more volatile than an underpriced one, which means that the portfolio ceases to be market-neutral. The twist at Cognios, then, is to use quant tools to construct an attractive large cap portfolio while changing the relative sizes of the long and short books to neutralize beta. Cognios Market Neutral Large Cap describes itself as providing a “beta-adjusted market neutral” portfolio.

In a Beta-adjusted market neutral portfolio the size of the short book can be larger or smaller than the size of the long book. If the Beta of the long book is higher than the Beta of the short book, the short book needs to be larger than the size of the long book in order to remove all of the market’s broad movements (i.e., to remove the market’s Beta) … Even though the portfolio will be net short on an absolute dollar basis in [this] example (i.e., more shorts than longs) … [it] both would be market neutral on a Beta-adjusted basis.

So far, this seems to be a profitable strategy. Below is the comparative performance of Cognios (blue line) since inception, against its market neutral peer group.

Here are Jon’s 264 words on why this might become a standout strategy:

Brian and I have been working in value investing for most of our careers and about three years ago, as we looked at the mutual fund universe, we saw a huge gap in market neutral offerings for individual investors. Even today, there are less than 40 market neutral mutual funds (not share classes). In today’s market environment, I believe a market neutral allocation, beta market neutral in particular, is a critical diversification tool in an investor’s overall asset allocation as it is the only strategy that strives to remove the impact of the market and macro events from the return of the strategy. Unlike most market neutral strategies that target risk-free rates of return, our fund targets equity-like returns over full market cycles because, in my opinion, if an investor wants Treasury-like returns why wouldn’t he/she just buy Treasuries?

There was a real need in the market for which our strategy could provide a solution if packaged in a mutual fund wrapper and because we only invest in large, liquid companies in the S&P 500, we didn’t have to change our strategy in order to deploy it in a mutual fund. Investors and their advisors are looking for strategies that seek to reduce volatility, standard deviation and downside risk in a portfolio, which is the primary objective of our fund. This fund has made it possible for a wide range of investors to access the same strategy that we provide to our institutional clients in other structures. As investors in our own fund, we have a very strong conviction about what we are doing.

Cognios Market Neutral Large Cap (COGMX/COGIX) has a $1000 minimum initial investment for its retail class and $100,000 for the institutional class. Both are modest in comparison to the $25 million minimum for a separately managed account. Expenses are capped at 1.95% on the investor shares, at least through early 2016. The fund has about gathered about $16 million in assets since its December 2012 launch. More information can be found at the fund’s homepage. There’s also a quick slideshow on a third-party website that walks through the basics of the fund’s strategy.

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 July or August and some of the prospectuses do highlight that date.

This month our research associate David Welsch tracked down eight no-load retail funds in registration, which represents our core interest. Of those, four carry ESG screens (two from TIAA-CREF and two from Trillium) and three represent absolute value or absolute return strategies, while one is a short-term bond index. Interesting cluster of interests.

Manager Changes

This month 66 funds reported partial or complete changes in their management teams, a number slightly inflated by a dozen partial team changes in the AB (formerly AllianceBernstein) retirement date funds. The most striking were the imminent departures of PIMCO’s global equities CIO Virginie Maisonneuve plus several equity managers and analysts as PIMCO pulls back on their attempt to make a mark in pure equity investing. There was, in addition, announcement of the planned departure of Robert Mohn, Domestic Chief Investment Officer of Columbia Wanger Asset Management and Vice President of Wanger Advisors Trust who will step down in the fourth quarter of 2015. The change was announced for Wanger USA (WUSAX) but will presumably ripple through a series of Columbia Acorn funds eventually. In addition, Matt Paschke of the Leuthold Funds is taking a leave of absence to pursue personal interests for a bit. He’s a good and level-headed guy and we wish him well.

Updates

Andrew Foster, manager of Seafarer Overseas Growth & Income (SFGIX), was the guest on a sort-of video interview with Morningstar’s Jason Stipp in mid-May. The interview, entitled “Seeking Sustainable Growth in Emerging Markets,” covers much of the same ground as our recent conference call with Mr. Foster. One difference is that he spoke at greater length about China in his conversation with Mr. Stipp. I’ve designed it as a “sort of” video call because Jason was on-camera while Andrew was on a phone, with his picture superimposed on the screen.

Seafarer, with a three year record and five star rating, seems to have found its footing in the marketplace. The fund now boasts over a quarter billion in well-deserved assets.

Briefly Noted . . .

Ted, The Linkster and long-time stalwart of our discussion board, cheers for Dodge & Cox shareholders. He shared a USA Today story “3 AOL Investors Bag a Quick $200M” that calculates the gain to D&C shareholders from Verizon’s bid to acquire AOL. The Dodge & Cox funds own 15% of the outstanding shares of AOL, which netted them $95,000,000 in a single day. Sadly, the D&C funds are so big that AOL contributed just a fraction of a percent to returns that day. Iridian Asset Management and BlackRock finished second and third in total gains.

Ted also reports that the famously frugal Vanguard Group decided to chuck $200,000 at Bill Clinton in exchange for a 2012 speech for Vanguard’s institutional clients. That’s not an exceptional amount to hear from the former First Saxophonist; The Washington Post shows Bill pocketing $105 million for 542 speeches from the time he left the White House until the time Hilary Rodham-Clinton left the State Department. That comes to an average of $194,000 which suggests that Vanguard might have gotten just a bit flabby on their cost containment with this talk. The record might have been $300,000 paid by Dell that same year.

SMALL WINS FOR INVESTORS

Hmmm … does “nothing really bad has happened yet” qualify as a win? Other than that, we’ve got the reopening of BlackRock Event Driven Equity Fund (BALPX) on or about July 27, 2015. Bad news: BALPX is tiny, expensive and sucks. Good news: they brought in a new manager in early May, 2015. Mark McKenna left Harvard’s endowment team and joined BlackRock last year to run an event-driven hedge fund. He’s now been moved here. The other bad news: Harvard’s performance was surprisingly poor during McKenna’s tenure, which doesn’t say McKenna was responsible for the poor performance, just that he didn’t live up to the vaunted Harvard standard. As a result, this is a small win.

CLOSINGS (and related inconveniences)

American Century Small Cap Value Fund sort of closed on May 1. In an increasingly common move, the adviser left the door open for those who invest directly with the fund and for “certain financial intermediaries selected by American Century.”

ASTON/River Road Dividend All Cap Value Fund (ARDEX) and ASTON/Fairpointe Mid Cap Fund (CHTTX) have each been soft-closed. Each management team has a second fund still open.

Effective June 12, 2015, $4.2 billion Diamond Hill Long-Short Fund (DIAMX) will close to most new investors. The fund has exceptional returns for an exceptional period. Its 3-, 5- and 10-year records cluster around the 25^th percentile of all long-short funds. Potential investors need to take two factors into consideration when deciding whether to jump in: (1) performance is driven primarily by the strength of its long portfolio and (2) the lead manager for the long portfolio, Chuck Bath, is stepping aside. He’ll remain as a sort of backup manager but wants to focus his attention on Diamond Hill Large Cap. There’s no easy way of guessing how much his reorientation will cost the fund, so proceed thoughtfully if at all.

Effective as of the close of business on July 15, 2015, the $2.8 billion, five-star JOHCM International Select Fund (JOHIX) will be soft-closed. As friend Marjorie Pannell points out, the fund is an MFO Great Owl with eye-popping performance:

1 year – top 1% – (1 out of 339 funds) 
3 year – top 1% – (1 out of 293 funds) 
5 year – top 1% – (1 out of 277 funds)

Vulcan Value Partners (VVLPX) closed on June 1, rather later than originally planned. Out of respect for manager C.T. Fitzpatrick’s excellent long-term record here and at the Longleaf Funds, we sent out a notice of the extended window of opportunity to the 6000 or so folks on our email list.The $14 billion T. Rowe Price Health Sciences Fund (PRHSX) closed to new investors on June 1, 2015. Morningstar covered the fund avidly until the departure of star manager Kris Jenner. Over 13 years, Jenner nearly doubled the annualized returns of his benchmark. He left with two analysts, leaving the remaining analyst to take the reins. There was about $6 billion in the fund when Jenner (and Morningstar) left. Since then the fund has been much more T. Rowe Price-like: it has converted consistent, modest outperformance and risk consciousness into a fine record under manager Taymour Tamaddon.

OLD WINE, NEW BOTTLES

Barrow All-Cap Core Fund (BALAX) is now Barrow Value Opportunity Fund and Barrow All-Cap Long/Short Fund (BFLSX) has been renamed Barrow Long/Short Opportunity Fund. Morningstar hasn’t caught up with the change yet.

Brown Capital Management Mid-Cap Fund is now Brown Capital Management Mid Company Fund (BCSMX). Rather than investing in mid-cap stocks, the fund will target mid-sized companies: those with total operating revenues of $500 million to $10 billion.

Catalyst Absolute Total Return Fund, will undergo a name and objective change to Catalyst Intelligent Alternative Fund in July.

Over the course of the past month, The Hartford Emerging Markets Research Fund (HERAX) was … uhh, tweaked a bit so that it has a new investment mandate, lower management fee (though no break on the bottom line expense ratio), new manager (Cheryl Duckworth is out, David Elliott of Wellington is in) and new name, Hartford Emerging Markets Equity Fund. One striking element of the change was the introduction of a new “related accounts performance” table, which shows how Mr. Elliott’s other EM porfolios perform before and after deductions for Hartford’s sales charges and expenses. Since inception, Elliott’s portfolio has returned 6.9% which crushes his benchmark’s 3.6%. Deduct sales charges and expenses and investors would pocket only 3.9%. That is, 56% of the manager’s raw performance gets routed to The Hartford and 44% goes to his investors. Other than for that, it was pretty much status quo in Hartford.

Roxbury/Mar Vista Strategic Growth Fund was recently rechristened as the Mar Vista Strategic Growth Fund (MVSGX) while Roxbury/Hood River Small-Cap Growth Fund became Hood River Small-Cap Growth Fund (HRSMX). Both are tiny but have really solid records. Heck, in Hood River’s case, it has a top tier 3-, 5- and 10 year record

On July 1, 2015, the T. Rowe Price Strategic Income Fund (PRSNX) will change its name to the T. Rowe Price Global Multi-Sector Bond Fund.

Effective May 30, 2015, the name of Turner Spectrum Fund was changed to Turner Titan II Fund. . Under its new dispensation, the fund “invests primarily in equity securities of companies with large capitalization ranges across major industry sectors using a long/short strategy in seeking to capture alpha, reduce volatility, and preserve capital in declining markets.”

On May 1, 2015, the European Equity Fund (VEEEX) became the Global Strategic Income Fund. Morningstar continues its membership in the European equity peer group despite the fact that, well, it ain’t.

OFF TO THE DUSTBIN OF HISTORY

It was a bad month for both alternative strategy and bond funds. Of the 23 funds that went extinct this month, five pursued alternative strategies, four were fixed-income funds – mostly international – and two were stock/bond hybrids.

361 Market Neutral Fund (ALSQX) underwent “termination, liquidation and dissolution” on May 29, 2015. The fund had an all-star management team, spotty record and trivial asset base.

As of March 9, 2015, AllianzGI Opportunity Fund merged into AllianzGI Small-Cap Blend Fund (AZBAX). The topic came up in a mid-May SEC filing, so I thought I’d mention.

Ancora Equity Fund (ANQIX) will be liquidated and dissolved on or about June 26, 2015.

Ave Maria Opportunity Fund (AVESX), a tiny small-value fund with a lot of faith in energy stocks, will merge into Ave Maria Catholic Values Fund (AVEMX) at the end of July.

Catalyst Event Arbitrage Fund (CEAAX), which was a good hedge fund and a bad mutual fund, will be liquidated on June 15, 2015.

Clear River Fund (CLRVX) will liquidate on June 30, 2015. No, I’ve never heard of it, either. The closest to a fun fact about the fund is that it never managed to finish any calendar year with above-average returns relative to its Morningstar peer group.

A new speed record: The Trustees of Context Capital Funds launched the Context Alternative Strategies Fund (CALTX) with two managers and seven sub-advisers in March, 2014. Performance started out as mediocre but by December turned ugly. Having been patient for more than a year(!), the Trustees dismissed their two managers on May 18, then filed a prospectus supplement on Friday, May 29, 2015 that announced the liquidation of the fund on the next business day, Monday, June 1, 2015. That liquidation leaves Context with one fund, Context Macro Opportunities (CMOTX), which nominally launched in December, hasn’t traded yet, has $100,000 in assets and a $1,000,000 minimum.

Encompass Fund (ENCPX) liquidated on May 27, 2015. They launched about seven years ago, convinced that it was time to focus on materials stocks. They were right, then they were very wrong; the fund tended to finish in the top 1% or the bottom 1% of its noticeably volatile natural resources peer group. At the end, they had $2 million in AUM and were dead last in their peer group. The managers and trustees, to their great credit if not to their personal gain, held about half of the fund’s total assets.

That said, the managers wrote a thoughtful and appropriate eulogy for the fund in their last letter to shareholders.

We want the shareholders to know that we resigned with a keen sense of disappointment. After posting exceptional returns in 2009 and 2010, we were optimistic that the Fund’s overweight in precious and industrial metals would continue to enable Encompass to excel. However, the last 4 years were difficult ones for resource companies and the Fund has underperformed. We did increase exposure to the energy sector in late 2013 and early 2014. Those stocks performed very well until oil prices shocked investors by declining more than 50% in the second half of 2014.

More recently we increased the Fund’s exposure to the health care, cybersecurity and airline industries with good results. However, the resource companies have continued to weigh on overall portfolio performance even though exposure to metals has been significantly reduced.

When we launched Encompass in mid-2006, we believed the time was right for a diversified mutual fund that emphasized resource companies. For several years we were proven right, but despite fundamentals that historically have been good for metals companies, the last few years have been very challenging. The Fund has not been able to grow and thus we came to the very difficult decision that we should resign as Manager. The Fund’s independent Trustees considered various alternatives and concluded that the Fund should be liquidated.

We have begun liquidating the Fund’s holdings, and intend to complete the process in the next couple of weeks. Of course, we are attempting to maximize the proceeds for the benefit of shareholders.

Guggenheim Enhanced World Equity Fund (GEEWX) will liquidate on June 26, 2015. $6 million in assets with a 600% annual turnover which, I presume, is the “enhancement” implied by the name.

Innealta Capital Global All Asset Opportunity Fund (ROMAX) will discontinue operations on June 19^th. The fund managed to rake in just about $3 million in its two years of high expense/high turnover/low returns operations.

In mid-July, Jamestown Balanced Fund (JAMBX) will ask its shareholders for permission to merge into Jamestown Equity Fund (JAMEX). The rationale is that the funds have “similar investment objectives, investment strategies and risk factors,” which is true give or take the nearly 50% higher volatility that investors in the equity fund experience over investors in the balanced one.

The trustees of the fund have authorized the liquidation of the Pioneer Emerging Markets Local Currency Debt Fund (LCEMX) which will occur on August 7, 2015. To put the decision in context: over the past couple years, investing in emerging markets bonds (the orange line) has been a bad idea, investing in EM bonds denominated in local currencies (green) has been a worse idea and investing in the Pioneer fund (blue) has been a thorough disaster.

On the upside, with only $10 million in assets, no one much was hurt. As of the last SAI, the manager hadn’t invested a single dinar, rupee or pataca in the fund so his portfolio was pretty much unscathed.

The Listed Private Equity Plus Fund become unlisted on May 18, 2015.

On May 15, 2015, the Loomis Sayles International Bond Fund was liquidated. A subsequent SEC filing helpfully notes: “The Fund no longer exists, and as a result, shares of the Fund are no longer available for purchase or exchange.”

PIMCO is retreating from the equity business with the liquidation of PIMCO Emerging Multi-Asset (PEAAX), PIMCO EqS^® Emerging Markets (PEQAX) and PIMCO EqS Pathfinder (PATHX) funds, all on July 14, 2015. Pathfinder, with nearly $900 million in assets, was supposed to be a vehicle to showcase the talents of two Franklin Mutual Series managers who defected to PIMCO. That didn’t play out during the fund’s five year history, arguably because it was better positioned for down markets than for rising ones. PEAAX was a small, sucky fund of PIMCO funds. PEQAX was a slightly less small, slightly less sucky fund that was supposed to be the star vehicle for an imported GSAM team. Oops.

Rx Tax Advantaged Fund (FMERX) will liquidate soon. It managed to parlay high expenses and a low-return asset class (muni bonds) into a tiny, money-losing proposition.

Templeton Constrained Bond Fund (FTCAX) goes the way of the dodo bird on August 27, 2015 which “may be delayed if unforeseen circumstances arise.” I can’t for the life of me figure out what the “constraint” in the fund name referred to. The prospectus announces:

Under normal market conditions, the Fund invests at least 80% of its net assets in “bonds.” Bonds include debt obligations of any maturity, such as bonds, notes, bills and debentures.

The constraint is that the bond fund must buy “bonds”? The last portfolio report shows them at 90% cash in a $10 million portfolio.

Touchstone International Fixed Income Fund (TIFAX), in recognition of “its small size and limited growth potential,” will liquidate on July 21, 2015. “An overweight to peripheral and speculative issuers” helped performance, right up to the moment when it didn’t:

Okay, they really, really mean it this time: The Turner Funds determined to close and liquidate the Turner Titan Fund (TTLFX), effective on or about June 19, 2015. The Fund had previously been scheduled to close and liquidate on or about June 1, 2015. That’s followed its closure at the end of 2014 and previously announced plans to liquidate in mid-March and late April.

V2 Hedged Equity Fund (VVHEX/VVHIX), responding to “an anticipated decline in Fund assets,” liquidated in early May.

I appreciate thoroughness: “Effective April 30, 2015, the Virtus Global Commodities Stock Fund … was liquidated. The Fund has ceased to exist and is no longer available for sale. Accordingly, the prospectus and SAI are no longer valid.” Any questions?

In Closing . . .

Thanks, as always, to the folks who support the Observer. To Binod, greetings and good luck with the rising waters in Houston. We feel for you! Thanks to Joe for the thumbs-up on our continuing redesign of the Observer’s site; it’s always good to get an endorsement from a pro! Tom, thank you, we’re so glad that you find our site useful. Thanks, finally, to the folks who’ve bookmarked the Observer’s link to Amazon. Normally our Amazon revenue tails off dramatically at mid-year. So far this season, it’s held up reasonably well and we’re grateful.

We’ll look for you at Morningstar. I’ll be the one dressed like a small oak. It’s a ploy! John Rekenthaler (Bavarian for “thunder talker,” I think) recently mused “I don’t actually get invited to parties, but if I did, I’d be chatting with the potted plants.” I figure that with proper foliage I might lure the Great Man into amiable conversation.

If any of you would like to join Hedda, Jake, (maybe) Tadas and the good folks from the Queens Road funds (they’ve promised me fresh peanuts) in diverting my attention and saving John from my interminable prattle, please do drop us a note and we’ll set up a time to meet. The Observer folks should be around the conference from early Wednesday until well past its Friday close.

As always, we’ll post daily conference highlights on MFO’s discussion board. (No, I don’t tweet and you can’t make me.) If you miss them there, we’ll share them in our July issue. In addition, we have profiles of some new ESG/green funds – equity, income and hybrid – on tap. We’ll explain why in July!

As ever,

Dear friends,

It’s May, a sweet and anxious time at college. The End is tantalizingly close; just two weeks remain in the academic year and, for many, in their academic career.  Both the trees on the Quad and summer wardrobes are bursting out. The days remaining and the brain cells remaining shrink to a precious few. We all wonder where another year (my 31^st here) went, holding on to its black-robed closing days even as we long for the change of pace and breathing space that summer promises.

For investors too summer holds promise, for days away and for markets unhinged. Perhaps thinking a bit ahead while the hinges remain intact might be a prudent course and a helpful prologue to lazy, hazy and crazy.

The Dry Powder Crowd

A bunch of fundamentally solid funds have been hammered by their absolute value orientation; that is, their refusal to buy stocks when they believe that the stock’s valuations and the underlying corporation’s prospects simply do not offer a sufficient margin of safety for the risks they’re taking, much less compelling opportunities. The mere fact that a fund sports just one lonely star in the Morningstar system should not disqualify it from serious consideration. Many times a low star rating reflects the fact that a particular style or perspective is out-of-favor, but the managers were unwilling to surrender their discipline to play to what’s popular.

That strikes us as admirable.

Sometimes a fund ends up with a one-star rating simply because it’s too independent to fit into one of Morningstar’s or Lipper’s predetermined boxes.

We screened for one-star equity funds with over 20% cash. From that list we looked for solid, disciplined funds whose Morningstar ratings have taken a pounding. Those include:

Frankly, any one of the funds above has the potential to be the best performer in your portfolio over the next five years especially if interest rates and valuations begin to normalize.

The challenge of overcoming cash seems so titanic that it’s worth noting, especially, the funds whose managers have managed to marry substantial cash strong with ongoing strong absolute and relative returns. These funds all have at least 20% cash and four- or five-star ratings from Morningstar, as of April 2015.

Fans of large funds (or Goodhaven) might want to consult Morningstar’s recommended list of “Cash-Heavy Funds for the Cautious Investor” which includes five names:

It’s time for an upgrade

The story was all over the place on the morning of April 20^th:

• Reuters: “Carlyle to shutter its two mutual funds”
• Bloomberg: “Carlyle to close two mutual funds in liquid alts setback”
• Ignites: “Carlyle pulls plug on two mutual funds”
• ValueWalk: “Carlyle to liquidate a pair of mutual funds”
• Barron’s: “Carlyle closing funds, gold slips”
• MFWire dutifully linked to three of them in its morning link list

Business Insider gets it closest to right: “Private equity giant Carlyle Group is shutting down the two mutual funds it launched just a year ago,” including Carlyle Global Core Allocation Fund.

What’s my beef? 

1. Carlyle doesn’t have two mutual funds, they have one. They have authorization to launch the second fund, but never have. It’s like shuttering an unbuilt house. Reuters, nonetheless, solemnly notes that the second fund “never took off [and] will also be wound down,” implying that – despite Carlyle’s best efforts, it was just an undistinguished performer.
2. The fund they have isn’t the one named in the stories. There is no such fund as Carlyle Global Core Allocation Fund, a fund mentioned in every story. Its name is Carlyle Core Allocation Fund(CCAIX/CCANX). It’s rather like the Janus Global Unconstrained Bond Fund that, despite Janus’s insistence, didn’t exist at the point that Mr. Gross joined the team. “Global” is a description but not in the name.
3. The Carlyle fund is not newsworthy. It’s less than one year old, it has a trivial asset base ($50 million) and has not yet made a penny ($10,000 at inception is now $9930).

If folks wanted to find a story here, a good title might be “Another big name private investor trawls the fund space for assets, doesn’t receive immediate gratification and almost immediately loses interest.” I detest the practice of tossing a fund into the market then shutting it in its first year; it really speaks poorly of the adviser’s planning, understanding and commitment but it seems distressingly common.

What’s my solution?

Upgrade. Most news outlets are no longer capable of doing that for you; they simply don’t have the resources to do a better job or to separate press release from self-serving bilge from news so you need to do it for yourself.

Switch to Bloomberg TV from, you know, the screechy guys. If it’s not universally lauded, it does seem broadly recognized as the most thoughtful of the financial television channels.

Develop the habit of listening to Marketplace, online or on public radio. It’s a service of American Public Media and I love listening to Kai Ryssdal and crew for their broad, intelligent, insightful reporting on a wide range of topics in finance and money.

Read the Saturday Wall Street Journal, which contains more sensible content per inch than any other paper that lands on my desk. Jason Zweig’s column alone is worth the price of admission. His most recent weekend piece, “A History of Mutual-Fund Doors Opening and Closing,” is outstanding, if only because it quotes me.  About 90% of us would benefit from less saturation with the daily noise and more time to read pieces that offer a bit of perspective.

Reward yourself richly on any day when your child’s baseball score comes immediately to mind but you can honestly say you have no earthly clue what the score of the Dow Jones is. That’s not advice for casual investors, that’s advice for professionals: the last thing on earth that you want is a time horizon that’s measured in hours, days, weeks or months. On that scale the movement of markets is utterly unpredictable and focusing on those horizons will damage you more deeply and more consistently than any other bad habit you can develop.

Go read a good book and I don’t mean financial porn. If your competitive advantage is seeing things that other people (uhh, the herd) don’t see, then you’ve got to expose yourself to things other people don’t experience. In a world increasingly dominated by six inch screens, books – those things made from trees – fit the bill. Bill Gates recommends The Bully Pulpit, by Doris Kearns Goodwin. Goodwin “studies the lives of America’s 26th and 27th presidents to examine a question that fascinates me: How does social change happen?” That is, Teddy Roosevelt and William Taft. Power down your phone while you’re reading. The aforementioned Mr. Zweig fusses that “you can’t spend all day reading things that train your brain to twitch” and offers up Daniel Kahneman’s Thinking, Fast and Slow. Having something that you sip, rather than gulp, does help turn reading from an obligation to a calming ritual. Nina Kallen, a friend, insurance coverage lawyer in Boston and one of the sharpest people we know, declares Roger Fisher and William Ury’s Getting to Yes: Negotiating Agreement Without Giving In to be “life-changing.” In her judgment, it’s the one book that every 18-year-old should be handed as part of the process of becoming an adult. Chip and I have moved the book to the top of our joint reading list for the month ahead. Speaking of 18-year-olds, it wouldn’t hurt if your children actually saw you reading; perhaps if you tell them they wouldn’t like it, they’d insist on joining you.

How Good Is Your Fund Family? An Update…

Baseball season has started. MLB.TV actually plays more commercials than it used to, which sad to say I enjoy more than the silent “Commercial Break In Progress” screen, even if they are repetitive.

One commercial is for The Hartford Funds. The company launched a media campaign introducing a new tagline, “Our benchmark is the investor℠,” and its focus on “human-centric investing.”

Its website touts research they have done with MIT on aging, and its funds are actually sub-advised by Wellington Management.

A quick look shows 66 funds, each with some 6 share classes, and just under $100B AUM. Of the 66, most charge front loads up to 5.5% with an average annual expense ratio of just over 1%, including 12b-1 fee. And, 60 have been around for more than 3 years, averaging 15 years in fact.

How well have their funds performed over their lifetimes? Just average … a near even split between funds over-performing and under-performing their peers, including expenses.

We first started looking at fund family performance last year in the piece “How Good Is Your Fund Family?” Following much the same methodology, with all the same qualifications, below is a brief update. Shortly, we hope to publish an ongoing tally, or “Fund Family Score Card” if you will, because … during the next commercial break, while watching a fund family’s newest media campaign, we want to make it easier for you to gauge how well a fund family has performed against its peers.

The current playing field has about 6200 US funds packaged and usually marketed in 225 families. For our tally, each family includes at least 5 funds with ages 3 years or more. Oldest share class only, excluding money market, bear, trading, and specialized commodity funds. Though the numbers sound high, the field is actually dominated by just five families, as shown below:

It is interesting that while Vanguard represents the largest family by AUM, with nearly twice its nearest competitor, its average annual ER of 0.22% is less than one third either Fidelity or American Funds, at 0.79% and 0.71%, respectively. So, even without front loads, which both the latter use to excess, they are likely raking in much more in fees than Vanguard.

Ranking each of the 225 families based on number of funds that beat their category averages produces the following score card, by quintile, best to worst:

Of the five families, four are in top two quintiles: Vanguard, American Funds, Fidelity, and T. Rowe Price.  In fact, of Vanguard’s 145 funds, 119 beat their peers. Extraordinary. But BlackRock is just average, like Hartford.

The difference in average total return between top and bottom fund families on score card is 3.1% per year!

The line-ups of some of the bottom quintile families include 100% under-performers, where every fund has returned less than its peers over their lifetimes: Commonwealth, Integrity, Lincoln, Oak Associates, Pacific Advisors, Pacific Financial, Praxis, STAAR. Do you think their investors know? Do the investors of Goldman Sachs know that their funds are bottom quintile … written-off to survivorship bias possibly?

Visiting the website of Oberweis, you don’t see that four of its six funds under-performed. Instead, you find: TWO FUNDS NAMED “BEST FUND” IN 2015 LIPPER AWARDS. Yes, its two over-performers.

While the line-ups of some top quintile families include 100% over-performers: Cambiar, Causeway, Dodge & Cox, First Eagle, Marsico, Mirae, Robeco, Tocqueville.

Here is a summary of some of the current best and worst:

While not meeting the “five funds” minimum, some other notables: Tweedy Browne has 4 of 4 over-performers, and Berwyn, FMI, Mairs & Power, Meridian, and PRIMECAP Odyssey all have 3 of 3.

(PRIMECAP is an interesting case. It actually advises 6 funds, but 3 are packaged as part of the Vanguard family. All 6 PRIMECAP advised funds are long-term overperformers … 3.4% per year across an average of 15 years! Similarly with OakTree. All four of its funds beat their peers, but only 2 under its own name.)

As well as younger families off to great starts: KP, 14 of 14 over-performers, Rothschild 7 of 7, Gotham 5 of 5, and Grandeur Peak 4 of 4. We will find a way to call attention to these funds too on the future “Fund Family Score Card.”

Ed is on assignment, staking out a possible roach motel

Our distinguished senior colleague Ed Studzinski is a deep-value investor; his impulse is to worry more about protecting his investors when times turn dark than in making them as rich as Croesus when the days are bright and sunny. He’s been meditating, of late, on the question of whether there’s anything a manager today might do that would reliably protect his investors in the case of a market crisis akin to 2008.

Ed is one of a growing number of investors who are fearful that we might be approaching a roach motel; that is, a situation where it’s easy to get into a particular security but where it might be impossible to get back out of it when you urgently want to.

Structural changes in the market and market regulations have, some fear, put us at risk for a liquidity crisis. In a liquidity crisis, the ability of market makers to absorb the volume of securities offered for sale and to efficiently match buyers and sellers disappears. A manager under pressure to sell a million dollars’ worth of corporate bonds might well find that there’s only a market for two-thirds of that amount, the remaining third could swiftly become illiquid – that is, unmarketable – securities.

David Sherman, president of Cohanzick Asset Management and manager of two RiverPark’s non-traditional bond funds addressed the issue in his most recent shareholder letter. I came away from it with two strong impressions:

There may be emerging structural problems in the investment-grade fixed-income market. At base, the unintended consequences of well-intended reforms may be draining liquidity from the market (the market makers have dramatically less cash and less skin in the game than they once did) and making it hard to market large fixed-income sales. An immediate manifestation is the problem in getting large bond issuances sold.

Things might get noticeably worse for folks managing large fixed-income portfolios. His argument is that given the challenges facing large bond issues, you really want a fund that can benefit from small bond issues. That means a small fund with commitments to looking beyond the investment-grade universe and to closing before size becomes a hindrance.

Some of his concerns are echoed on a news site tailored for portfolio managers, ninetwentynine.com. An article entitled “Have managers lost sight of liquidity risk?” argues:

A liquidity drought in the bond space is a real concern if the Fed starts raising rates, but as the Fed pushes off the expected date of its first hike, some managers may be losing sight of that danger. That’s according to Fed officials, who argue that if a rate hike catches too many managers off their feet, the least they can expect is a taper tantrum similar to 2013, reports Reuters. The worst-case-scenario is a full-blown liquidity crisis.

The most recent investor letter from the managers of Driehaus Active Income Fund (LCMAX) warns that recent structural changes in the market have made it increasingly fragile:

Since the end of the credit crisis, there have been a number of structural changes in the credit markets, including new regulations, a reduced size of broker dealer trading desks, changes in fund flows, and significant growth of larger index-based mutual funds and ETFs. The “new” market environment and players have impacted nearly all aspects of the market, including trading liquidity. The transfer of risk is not nearly as orderly as it once was and is now more expensive and volatile … one thing nearly everyone can agree on is that liquidity in the credit markets has decreased materially since the credit crisis.

The federal Office of Financial Research concurs: “Markets have become more brittle because liquidity may be less available in a downturn.” Ben Inker, head of GMO’s asset allocation group, just observed that “the liquidity in [corporate credit] markets has become shockingly poor.”

More and more money is being stashed in a handful of enormous fixed income funds, active and passive. In general, those might be incredibly regrettable places to be when liquidity becomes constrained:

Generally speaking, you’re going to need liquidity in your bond fund when the market is stressed. When the market is falling apart, the ETFs are the worst place to be, as evidenced by their underperformance to the index in 2008, 2011 and 2013. So yes, you will have liquidity, but it will be in something that is cratering.

What does this mean for you?

1. Formerly safe havens won’t necessarily remain safe.
2. You need to know what strategy your portfolio manager has for getting ahead of a liquidity crunch and for managing during it. The Driehaus folks list seven or eight sensible steps they’ve taken and Mr. Sherman walks through the structural elements of his portfolio that mitigate such risks.
3. If your manager pretend not to know what the concern is or suggests you shouldn’t worry your pretty little head about it, fire him.

In the interim, Mr. Studzinski is off worrying on your behalf, talking with other investors and looking for a safe(r) path forward. We’re hoping that he’ll return next month with word of what he’s found.

Top developments in fund industry litigation

Fundfox, launched in 2012, is the mutual fund industry’s only litigation intelligence service, delivering exclusive litigation information and real-time case documents neatly organized and filtered as never before. For 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

• The SEC charged BlackRock Advisors with breaching its fiduciary duty by failing to disclose a conflict of interest created by the outside business activity of a top-performing portfolio manager. BlackRock agreed to settle the charges and pay a $12 million penalty.
• In a blow to Putnam, the Second Circuit reinstated fraud and negligence-based claims made by the insurer of a swap transaction. The insurer alleges that Putnam misrepresented the independence of its management of a collateralized debt obligation. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)

New Appeals

• Plaintiffs have appealed the lower court’s dismissal of an ERISA class action regarding Fidelity‘s practices with respect to the so-called “float income” generated from plan participants’ account transactions. (In re Fid. ERISA Float Litig.)

Briefs

• Plaintiffs filed their opposition to Davis‘s motion to dismiss excessive-fee litigation regarding the New York Venture Fund. Brief: “Defendants’ investment advisory fee arrangements with the Davis New York Venture Fund . . . epitomize the conflicts of interest and potential for abuse that led Congress to enact § 36(b). Unconstrained by competitive pressures, Defendants charge the Fund advisory fees that are as much as 96% higher than the fees negotiated at arm’s length by other, independent mutual funds . . . for Davis’s investment [sub-]advisory services.” (In re Davis N.Y. Venture Fund Fee Litig.)
• Plaintiffs filed their opposition to PIMCO‘s motion to dismiss excessive-fee litigation regarding the Total Return Fund. Brief: “In 2013 alone, the PIMCO Defendants charged the shareholders of the PIMCO Total Return Fund $1.5 billion in fees, awarded Ex-head of PIMCO, Bill Gross, a $290 million bonus and his second-in-command a whopping $230 million, and ousted a Board member who dared challenge Gross’s compensation—all this despite the Fund’s dismal performance that trailed 70% of its peers.” (Kenny v. Pac. Inv. Mgmt. Co.)
• In the purported class action regarding alleged deviations from two fundamental investment objectives by the Schwab Total Bond Market Fund, the Investment Company Institute and Independent Directors Council filed an amici brief in support of Schwab’s petition for rehearing (and rehearing en banc) of the Ninth Circuit’s 2-1 decision allowing the plaintiffs’ state-law claims to proceed. Brief: “The panel’s decision departs from long-standing law governing mutual funds and creates confusion and uncertainty nationwide.” Defendants include independent directors. (Northstar Fin. Advisors, Inc. v. Schwab Invs.)

Amended Complaint

• Plaintiffs filed a new complaint in the fee litigation against New York Life, adding a fourth fund to the case: the MainStay High Yield Opportunities Fund. (Redus-Tarchis v. N.Y. Life Inv. Mgmt., LLC.)

Answer

• P. Morgan filed an answer in an excessive-fee lawsuit regarding three of its bond funds. (Goodman v. J.P. Morgan Inv. Mgmt., Inc.)

The Alt Perspective: Commentary and News from Daily Alts

The spring has brought new life into the liquid alternatives market with both March and April seeing robust activity in terms of new fund launches and registrations, as well as fund flows. Touching on new fund flows first, March saw more than $2 billion of new asset flow into alternative mutual funds and ETFs, while US equity mutual funds and ETFs had combined outflows of nearly $6 billion.

At the top of the inflow rankings were international equity and fixed income, which provides a clear indication that investors were seeking both potentially higher return equity markets (non-US equity) and shelter (fixed income and alternatives). With increased levels of volatility in the markets, I wouldn’t be surprised to see this cash flow trend continue on into April and May.

New Funds Launched in April

We logged eight new liquid alternative funds in April from firms such as Prudential, Waycross, PowerShares and LoCorr. No particular strategy stood out as being dominant among the eight funds as they ranged from long/short equity and alternative fixed income strategies, to global macro and multi-strategy. A couple highlights are as follows:

1) LoCorr Multi-Strategy Fund – To date, LoCorr has done a thoughtful job of brining high quality managers to the liquid alts market, and offers funds that cover managed futures, long/short commodities, long/short equity and alternative income strategies. In this new fund, they bring all of these together in a single offering, making it easier for investors to diversify with a single fund.

2) Exceed Structured Shield Index Strategies Fund – This is the first of three new mutual funds that provide investors with a structured product that is designed to protect downside volatility and provide a specific level of upside participation. The idea of a more defined outcome can be appealing to a lot of investors, and will also help advisors figure out where and how to use the fund in a portfolio.

New Funds Registered in April

Fund registrations are where we see what is coming a couple months down the road – a bit like going to the annual car show to see what the car manufacturers are going to be brining out in the new season. And at this point, it looks like June/July will be busy as we counted 9 new alternative fund registration in April. A couple interesting products are listed below:

1) Hatteras Market Neutral Fund – Hatteras has been around the liquid alts market for quite some time, and with this fund will be brining multiple managers in as sub-advisors. Market neutral strategies are appealing at times when investors are looking to take risk off the table yet generate returns that are better than cash. They can also serve as a fixed income substitute when the outlook is flat to negative for the fixed income market.

2) Franklin K2 Long Short Credit Fund – K2 is a leading fund of hedge fund manager that works with large institutional investors to invest in and manage portfolios of hedge funds. The firm was acquired by Franklin Templeton back in 2012 and has so far launched one alternative mutual fund. The fund will be managed by multiple sub-advisors and will allocate to several segments of the fixed income market. 

Debunking Active Share

High active share does not equal high alpha. I’ll say that again. High active share does not equal high alpha. This is the finding in a new AQR white paper that essentially proves false two of the key tenents of a 2009 research paper (How Active is Your Fund Manager? A New Measure That Predicts Performance) by Martijn Cremers and Antti Petajisto. These two tenents are:

1) Active Share predicts fund performance: funds with the highest Active Share significantly outperform their benchmarks, both before and after expenses, and they exhibit strong performance persistence.

2) Non-index funds with the lowest Active Share underperform their benchmarks.

AQR explains that other factors are in play, and those other factors actually explain the outperformance that Cremers and Petajisto found in their work. You can read more here: AQR Deactivates Active Share in New White Paper.

And finally, for anyone considering the old “Sell in May and Go Away” strategy this month, be sure to have a read of this article, or watch this video. Or, better yet, just make a strategic allocation to a few solid alternative funds that have some downside protection built into them.

Feel free to stop by DailyAlts.com for more coverage of liquid alternatives.

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.

Seafarer Overseas Growth & Income (SFGIX/SIGIX): Our contention has always been that Seafarer represents one of the best possible options for investors interested in approaching the emerging markets. A steadily deepening record and list of accomplishments suggests that we’re right.

Towle Deep Value Fund (TDVFX): This fund positions itself a “an absolute value fund with a strong preference for staying fully invested.” For the past 33 years, Mr. Towle & Co. have been consistently successful at turning over more rock – in under covered small caps and international stocks alike – to find enough deeply undervalued stocks to populate the portfolio and produce eye-catching results.

Conference Call Highlights: Seafarer Overseas Growth & Income

Here are some quick highlights from our April 16^th conversation with Andrew Foster of Seafarer.

Seafarer’s objective: Andrew’s hope is to outperform his benchmark (the MSCI EM index) “slowly but steadily over time.” He describes the approach as a “relative return strategy” which pursues growth that’s more sustainable than what’s typical in developing markets while remaining value conscious.

Here’s the strategy: you need to start by understanding that the capital markets in many EM nations are somewhere between “poorly developed” and “cruddy.” Both academics and professional investors assume that a country’s capital markets will function smoothly: banks will make loans to credit-worthy borrowers, corporations and governments will be able to access the bond market to finance longer-term projects and stocks will trade regularly, transparently and at rational expense.

None of that may safely be assumed in the case of emerging markets; indeed, that’s what might distinguish an “emerging” market from a developed one. The question becomes: what are the characteristics of companies that might thrive in such conditions.

The answer seems to be (1) firms that can grow their top line steadily in the 7-15% per annum range and (2) those that can finance their growth internally. The focus on the top line means looking for firms that can increase revenues by 7-15% without obsessing about similar growth in the bottom line. It’s almost inevitable that EM firms will have “stumbles” that might diminish earnings for one to three years; while you can’t ignore them, you also can’t let them drive your investing decisions. “If the top line grows,” Andrew argues, “the bottom line will follow.” The focus on internal financing means that the firms will be capable of funding their operations and plans without needing recourse to the unreliable external sources of capital.

Seafarer tries to marry that focus on sustainable moderate growth “with some current income, which is a key tool to understanding quality and valuation of growth.” Dividends are a means to an end; they don’t do anything magical all by themselves. Dividends have three functions. They are:

An essential albeit crude valuation tool – many valuation metrics cannot be meaningfully applied across borders and between regions; there’s simply too much complexity in the way different markets operate. Dividends are a universally applicable measure.

A way of identifying firms that will bounce less in adverse market conditions – firms with stable yields that are just “somewhat higher than average” tend to be resilient. Firms with very high dividend yields are often sending out distress signals. 

A key and under-appreciated signal for the liquidity and solvency of a company – EMs are constantly beset by liquidity and credit shocks and unreliable capital markets compound the challenge. Companies don’t survive those shocks as easily as people imagine. The effects of liquidity and credit crunches range from firms that completely miss their revenue and earnings forecasts to those that drown themselves in debt or simply shutter. Against such challenges dividends provide a clear and useful signal of liquidity and solvency.

It’s certainly true that perhaps 70% of the dispersion of returns over a 5-to-10 year period are driven by macro-economic factors (Putin invades-> the EU sanctions-> economies falter-> the price of oil drops-> interest rates fall) but that fact is not useful because such events are unforecastable and their macro-level impacts are incalculably complex (try “what effect will European reaction to Putin’s missile transfer offer have on shadow interest rates in China?”). 

Andrew believes he can make sense of the ways in which micro-economic factors, which drive the other 30% of dispersion, might impact individual firms. He tries to insulate his portfolio, and his investors, from excess volatility by diversifying away some of the risk, imagining a “three years to not quite forever” time horizon for his holdings and moving across a firm’s capital structure in pursuit of the best risk-return balance.

While Seafarer is classified as an emerging markets equity fund, common stocks have comprised between 70-85% of the portfolio. “There’s way too much attention given to whether a security is a stock or bond; all are cash flows from an issuer. They’re not completely different animals, they’re cousins. We sometimes find instruments trading with odd valuations, try to exploit that.” As of January 2015, 80% of the fund is invested directly in common stock; the remainder is invested in ADRs, hard- and local-currency convertibles, government bonds and cash. The cash stake is at a historic low of 1%.

Thinking about the fund’s performance: Seafarer is in the top 3% of EM stock funds since launch, returning a bit over 10% annually. With characteristic honesty and modesty, Andrew cautions against assuming that the fund’s top-tier rankings will persist in the next part of the cycle:

We’re proud of performance over the last few years. We have really benefited from the fact that our strategy was well-positioned for anemic growth environments. Three or four years ago a lot of people were buying the story of vibrant growth in the emerging markets, and many were willing to overpay for it. As we know, that growth did not materialize. There are signs that the deceleration of growth is over even if it’s not clear when the acceleration of growth might begin. A major source of return for our fund over 10 years is beta. We’re here to harness beta and hope for a little alpha.

That said, he does believe that flaws in the construction of EM indexes makes it more likely that passive strategies will underperform:

I’m actually a fan of passive investing if costs are low, churn is low, and the benchmark is soundly constructed. The main EM benchmark is disconnected from the market. The MSCI EM index imposes filters for scalability and replicability in pursuit of an index that’s easily tradable by major investors. That leads it to being not a really good benchmark. The emerging markets have $14 trillion in market capitalization; the MSCI Core index captures only $3.8 trillion of that amount and the Total Market index captures just $4.2 trillion. In the US, the Total Stock Market indexes capture 80% of the market. The comparable EM index captures barely 25%.

Highlights from the questions:

As a practical matter, a 4-5% position is “huge for us” though he has learned to let his winners run a little longer than he used to, so the occasional 6% position wouldn’t be surprising.

A focus on dividend payers does not imply a focus on large cap stocks. There are a lot of very stable dividend-payers in the mid- to small-cap range; Seafarer ranges about 15-20% small cap and 35-50% midcap.

The fundamental reason to consider investing in emerging markets is because “they are really in dismal shape, sometimes the horrible things you read about them are true but there’s an incredibly powerful drive to give your kids a better life and to improve your life. People will move mountains to make things better. I followed the story of one family who were able to move from a farmhouse with a dirt floor to a comfortable, modern townhouse in one lifetime. It’s incredibly inspiring, but it’s also incredibly powerful.”

With special reference to holdings in Eastern Europe, you need to avoid high-growth, high-expectation companies that are going to get shell-shocked by political turmoil and currency devaluation. It’s important to find companies that have already been hit and that have proved that they can survive the shock.

Bottom line: Andrew has a great track record built around winning by not losing. His funds have posted great relative returns in bad markets and very respectable absolute returns in frothy ones. While he is doubtless correct in saying that the fund was unique well-suited to the current market and that it won’t always be a market leader, it’s equally correct to say that this is one of the most consistently risk-conscious, more consistently shareholder-sensitive and most consistently rewarding EM funds available. Those are patterns that I’ve found compelling.

We’ve also updated our featured fund page for Seafarer.

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 June and some of the prospectuses do highlight that date.

This month our research associate David Welsch tracked down 14 no-load retail funds in registration, which represents our core interest. By far the most interest was stirred by the announcement of three new Grandeur Peak funds:

• Global Micro Cap
• International Stalwarts
• Global Stalwarts

The launch of Global Micro Cap has been anticipated for a long time. Grandeur Peak announced two things early on: (1) that they had a firm wide strategy capacity of around $3 billion, and (2) they had seven funds in the works, including Global Micro, which were each allocated a set part of that capacity. Two of the seven projected funds (US Opportunities and Global Value) remain on the drawing board. President Eric Huefner remarks that “Remaining nimble is critical for a small/micro cap manager to be world-class,” hence “we are terribly passionate about asset capping across the firm.” 

The surprise comes with the launch of the two Stalwarts funds, whose existence was previously unanticipated. Folks on our discussion board reacted with (thoughtful) alarm. Many of them are GP investors and they raised two concerns: (1) this might signal a change in corporate culture with the business managers ascendant over the asset managers, and (2) a move into larger capitalizations might move GP away from their core area of competence.

Because they’re in a quiet period, Eric was not able to speak about these concerns though he did affirm that they’re entirely understandable and that he’d be able to address them directly after launch of the new funds.

Mr. Gardiner, Guardian Manager, at work

While I am mightily amused by the title GUARDIAN MANAGER given to Robert Gardiner to explain his role with the new funds, I’m not immediately distressed by these developments. “Stalwarts” has always been a designation for one of the three sorts of stocks that the firm invests in, so presumably these are stocks that the team has already researched and invested in. Many small cap managers find an attraction in these “alumni” stocks, which they know well and have confidence in but which have outgrown their original fund. Such funds also offer a firm the ability to increase its strategy capacity without compromising its investment discipline. I’ll be interested in hearing from Mr. Heufner later this summer and, perhaps, in getting to tap of Mr. Gardiner’s shield.

Manager Changes

A lot of funds were liquidated this month, which means that a lot of managers changed from “employed” to “highly motivated investment professional seeking to make a difference.” Beyond that group, 43 funds reported partial or complete changes in their management teams. The most striking were:

• The departure of Independence Capital Asset Partners from LS Opportunity Fund, about which there’s more below.
• The departure of Robert Mohn from both Columbia Acorn Fund (ACRNX) and Columbia Acorn USA (AUSAX) and from his position as their Domestic CIO. Mr. Mohn joined the fund in late 2003 shortly after the retirement of the legendary Ralph Wanger. He initially comanaged the fund with John Park (now of Oakseed Opportunity SEEDX) and Chuck McQuaid (now manager of Columbia Thermostat (CTFAX). Mr. Mohn is being succeeded by Zachary Egan, President of the adviser, and the estimable Fritz Kaegi, one of the managers of Columbia Acorn Emerging Markets (CAGAX). They’ll join David Frank who remained on the fund.

Updates

Centaur Total Return (TILDX) celebrated its 10-year anniversary in March, so I wish we’d reported the fact back then. It’s an interesting creature. Centaur started life as Tilson Dividend, though Whitney Tilson never had a role in its management. Mr. Tilson thought of himself (likely “thinks of himself”) as a great value investor, but that claim didn’t play out in his Tilson Focus Fund so he sort of gave up and headed to hedge fund land. (Lately he’s been making headlines by accusing Lumber Liquidators, a company his firm has shorted, of deceptive sales practices.) Mr. Tilson left and the fund was rechristened as Centaur.

Centaur’s record is worth puzzling over.  Morningstar gives it a ten-year ranking of five stars, a three-year ranking of one star and three stars overall. Over its lifetime it has modestly better returns and vastly lower risks than its peers which give it a great risk-adjusted performance.

Mostly it has great down market protection and reasonable upmarket performance, which works well if the market has both ups and downs. When the market has a whole series of strong gains, conservative value investors end up looking bad … until they look prescient and brilliant all over again.

There’s an oddly contrarian indicator in the quick dismissal of funds like Centaur, whose managers have proven adept and disciplined. When the consensus is “one star, bunch of worthless cash in the portfolio, there’s nothing to see here,” there might well be reason to start thinking more seriously as folks with a bunch of …

In any case, best anniversary wishes to manager Zeke Ashton and his team.

Briefly Noted . . .

American Century Investments, adviser to the American Century Funds, has elected to support the America’s Best Communities competition, a $10 million project to stimulate economic revitalization in small towns and cities across the country. At this point, 50 communities have registered first round wins. The ultimate winner will receive a $3 million economic development grant from a consortium of American firms.

In the interim, American Century has “adopted” Wausau, Wisconsin, which styles itself “the Chicago of the north.” (I suspect many of you think of Chicago as “the Chicago of the north,” but that’s just because you’re winter wimps.) Wausau won $35,000 which will be used to develop a comprehensive plan for economic revival and cultural enrichment. American Century is voluntarily adding another $15,000 to Wausau’s award and will serve as a sort of consultant to the town as they work on preparing a plan. It’s a helpful gesture and worthy of recognition.

LS Opportunity Fund (LSOFX) is about to become … well, something else but we don’t know what. The fund has always been managed by Independence Capital Asset Partners in parallel with ICAP’s long/short hedge fund. On April 23, 2015, the fund’s board terminated ICAP’s contract because of “certain portfolio management changes expected to occur within the sub-adviser.” On April 30, the board named Prospector Partners LLC has the fund’s interim manager, presumably with the expectation that they’ll be confirmed in June as the permanent replacement for ICAP. Prospector is described as “an investment adviser registered with the Securities and Exchange Commission with its principal offices [in] Guilford, CT. Prospector currently provides investment advisory services to corporations, pooled investment vehicles, and retirement plans.” Though they don’t mention it, Prospector also serves as the adviser to two distinctly unexciting long-only mutual funds: Prospector Opportunity (POPFX) and Prospector Capital Appreciation (PCAFX). LSOFX is a rated by Morningstar as a four-star fund with $170 million in assets, which makes the change both consequential and perplexing. We’ll share more as soon as we can.

Northern Global Tactical Asset Allocation Fund (BBALX) has added hedging via derivatives to the list of its possible investments: “In addition, the Fund also may invest directly in derivatives, including but not limited to forward currency exchange contracts, futures contracts and options on futures contracts, for hedging purposes.”

Gargoyle is on the move. RiverPark Funds is in the process of transferring control of RiverPark Gargoyle Hedged Value Fund (RGHVX) to TCW where it will be renamed … wait for it … TCW/Gargoyle Hedged Value Fund. It’s a solid five star fund with $73 million in assets. That latter number is what has occasioned the proposed move which shareholders will still need to ratify.

RiverPark CEO Morty Schaja notes that the strategy has spectacular long-term performance (it was a hedge fund before becoming a mutual fund) but that it’s devilishly hard to market. The fund uses two distinct strategies: a quantitatively driven relative value strategy for its stock portfolio and a defensive options overlay. While the options provide income and some downside protection, the fund does not pretend to being heavily hedged much less market neutral. As a result, it has a lot more downside volatility than the average long-short fund (it was down 34% in 2008, for example, compared with 15% for its peers) but also a more explosive upside (gaining 42% in 2009 against 10% for its peers). That’s not a common combination and RiverPark’s small marketing team has been having trouble finding investors who understand and value the combination. TCW is interested in developing a presence in “the liquid alts space” and has a sales force that’s large enough to find the investors that Gargoyle is seeking.

Expenses will be essentially unchanged, though the retail minimum will be substantially higher.

Zacks Small-Cap Core Fund (ZSCCX) has raised its upper market cap limit to $10.3 billion, which hardly sounds small cap at all.  That’s the range of stocks like Staples (SPLS) and L-3 Communications (LLL) which Morningstar classifies as mid-caps.

SMALL WINS FOR INVESTORS

Touchstone Merger Arbitrage Fund (TMGAX) has reopened to a select subset of investors: RIAs, family offices, institutional consulting firms, bank trust departments and the like. It’s fine as market-neutral funds go but they don’t go very far: TMGAX has returned under 2% annually over the past three years.  On whole, I suspect that RiverPark Structural Alpha (RSAFX) remains the more-attractive choice.

CLOSINGS (and related inconveniences)

Effective May 15, 2015, Janus Triton (JGMAX) and Janus Venture (JVTAX) are soft closing, albeit with a bunch of exceptions. Triton fans might consider Meridian Small Cap Growth, run by the team that put together Triton’s excellent record.

Effective at the close of business on May 29, 2015, MFS International Value Fund (MGIAX) will be closed to new investors

Effective June 1, 2015, the T. Rowe Price Health Sciences Fund (PRHSX) will be closed to new investors. 

Vulcan Value Partners (VVLPX) has closed to new investors. The firm closed its Small Cap strategy, including its small cap fund, in November of 2013, and closed its All Cap Program in early 2014. Vulcan closed, without advance notice, its Large Cap Programs – which include Large Cap, Focus and Focus Plus in late April. All five of Vulcan Value Partners’ investment strategies are ranked in the top 1% of their respective peer groups since inception.

OLD WINE, NEW BOTTLES

Effective April 30, 2015, American Independence Risk-Managed Allocation Fund (AARMX) was renamed the American Independence JAForlines Risk-Managed Allocation Fund. The objective, strategies and ticker remained the same. Just to make it unsearchable, Morningstar abbreviates it as American Indep JAFrl Risk-Mgd Allc A.

Effective on June 26, 2015 Intrepid Small Cap Fund (ICMAX) becomes Intrepid Endurance Fund and will no longer to restricted to small cap investing. It’s an understandable move: the fund has an absolute value focus, there are durned few deeply discounted small cap stocks currently and so cash has built up to become 60% of the portfolio. By eliminating the market cap restriction, the managers are free to move further afield in search of places to deploy their cash stash.

Effective June 15, 2015, Invesco China Fund (AACFX) will change its name to Invesco Greater China Fund.

Effective June 1, 2015, Pioneer Long/Short Global Bond Fund (LSGAX) becomes Pioneer Long/Short Bond Fund. Since it’s nominally not “global,” it’s no longer forced to place at least 40% outside of the U.S. At the same time Pioneer Multi-Asset Real Return Fund (PMARX) will be renamed Pioneer Flexible Opportunities.

As of May 1, 2015 Royce Opportunity Select Fund (ROSFX) became Royce Micro-Cap Opportunity Fund. For their purposes, micro-caps have capitalizations up to $1 billion. The Fund will invest, under normal circumstances, at least 80% of its net assets in equity securities of companies with stock market capitalizations up to $1 billion. In addition, the Fund’s operating policies will prohibit it from engaging in short sale transactions, writing call options, or borrowing money for investment purposes.

At the same time, Royce Value Fund (RVVHX) will be renamed Royce Small-Cap Value Fund and will target stocks with capitalizations under $3 billion. Royce Value Plus Fund (RVPHX) will be renamed Royce Smaller-Companies Growth Fund with a maximum market cap at time of purchase of $7.5 billion.

OFF TO THE DUSTBIN OF HISTORY

AlphaMark Small Cap Growth Fund (AMSCX) has been terminated; the gap between the announcement and the fund’s liquidation was three weeks. It wasn’t a bad fund at all, three stars from Morningstar, middling returns, modest risk, but wasn’t able to gain enough distinction to become economically viable. To their credit, the advisor stuck with the fund for nearly seven years before succumbing.

American Beacon Small Cap Value II Fund (ABBVX) will liquidate on May 12. The advisor cites a rare but not unique occurrence to explain the decision: “after a large redemption which is expected to occur in April 2015 that will substantially reduce the Fund’s asset size, it will no longer be practicable for the Manager to operate the Fund in an economically viable manner.”

Carlyle Core Allocation Fund (CCAIX) and Enhanced Commodity Real Return (no ticker) liquidate in mid-May.  

The Citi Market Pilot 2030 (CFTYX) and 2040 (CFTWX) funds each liquidated on about one week’s notice in mid-April; the decision was announced April 9 and the portfolio was liquidated April 17. They lasted just about one year.

The Trustees have voted to liquidate and terminate Context Alternative Strategies Fund (CALTX) on May 18, 2015.

Contravisory Strategic Equity Fund (CSEFX), a tiny low risk/low return stock fund, will liquidate in mid-May. 

Dreyfus TOBAM Emerging Markets Fund (DABQX) will be liquidated on or about June 30, 2015.

Franklin Templeton is thinning down. They merged away one of their closed-end funds in April. They plan to liquidate the $38 million Franklin Global Asset Allocation Fund (FGAAX) on June 30. Next the tiny Franklin Mutual Recovery Fund (FMRAX) is looking, with shareholder approval, to merge into the Franklin Mutual Quest Fund (TEQIX) likely around the end of August.

The Jordan Fund (JORDX) is merging into the Meridian Equity Income Fund (MRIEX), pending shareholder approval. The move is more sensible than it looks. Mr. Jordan has been running the fund for a decade but has little to show for it. He had five strong years followed by five lean ones and he still hasn’t accumulated enough assets to break even. Minyoung Sohn took over MRIEX last October but has only $26 million to invest; the JORDX acquisition will triple the fund’s size, move it toward financial equilibrium and will get JORDX investors a noticeable reduction in fees.

Leadsman Capital Strategic Income Fund (LEDRX) was liquidated on April 7, 2015, based on the advisor’s “representations of its inability to market the Fund and the Adviser’s indication that it does not desire to continue to support the Fund.” They lost interest in it? Okay, on the one hand there was only $400,005 in the fund. On the other hand, they launched it exactly six months before declaring failure and going home. I’m perpetually stunned by advisors who pull the plug after a few months or a year. I mean, really, what does that say about the quality of their business planning, much less their investment acumen?

I wonder if we should make advisers to new funds post bail? At launch the advisor must commit to running the fund for no less than a year (or two or three). They have to deposit some amount ($50,000? $100,000?) with an independent trustee. If they close early, they forfeit their bond to the fund’s investors. That might encourage more folks to invest in promising young funds by hedging against one of the risks they face and it might discourage “let’s toss it against the wall and see if anything sticks” fund launches.

Manning & Napier Inflation Focus Equity Series (MNIFX) will liquidate on May 11, 2015.

Merk Hard Currency ETF (formerly HRD) has liquidated. Hard currency funds are, at base, a bet against the falling value of the US dollar. Merk, for example, defines hard currencies as “currencies backed by sound monetary policy.” That’s really not been working out. Merk’s flagship no-load fund, Merk Hard Currency (MERKX), is still around but has been bleeding assets (from $280M to $160M in a year) and losing money (down 2.1% annually for the past five years). It’s been in the red in four of the past five years and five of the past ten. Here’s the three-year picture.

Presumably if investors stop fleeing to the safe haven of US Treasuries there will be a mighty reversal of fortunes. The question is whether investors can (or should) wait around until then. Can you say “Grexit”?

Effective May 1, 2015, Royce Select Fund I (RYSFX) will be closed to all purchases and all exchanges into the Fund in anticipation of the fund being absorbed into the one-star Royce 100 Fund (ROHHX). Mr. Royce co-manages both but it’s still odd that they buried a three-star small blend fund into a one-star one.

The Turner Funds will close and liquidate the Turner Titan Fund (TTLFX), effective on or about June 1, 2015. It’s a perfectly respectable long/short fund in which no one had any interest.

The two-star Voya Large Cap Growth Fund (ILCAX) is slated to be merged into the three-star Voya Growth Opportunities Fund (NLCAX). Same management team, same management fee, same performance: it’s pretty much a wash.

In Closing . . .

The first issue of the Observer appeared four years ago this month, May 2011. We resolved from the outset to try to build a thoughtful community here and to provide them with insights about opportunities and perspectives that they might never otherwise encounter. I’m not entirely sure of how well we did, but I can say that it’s been an adventure and a delight. We have a lot yet to accomplish and we’re deeply hopeful you’ll join us in the effort to help investors and independent managers alike. Each needs the other.

Thanks, as ever, to the folks – Linda, who celebrates our even temperament, Bill and James – who’ve clicked on our elegantly redesigned PayPal link. Thanks, most especially, to Deb and Greg who’ve been in it through thick and thin. It really helps.

A word of encouragement: if you haven’t already done so, please click now on our Amazon link and either bookmark it or set it as one of the start pages in your browser. We receive a rebate equivalent to 6-7% of the value of anything you purchase (books, music, used umbrellas, vitamins …) through that link. It costs you nothing since it’s part of Amazon’s marketing budget and if you bookmark it now, you’ll never have to think about it again.

We’re excited about the upcoming Morningstar conference. All four of us – Charles, Chip, Ed and I – will be around the conference and at least three of us will be there from beginning to end, and beyond. Highlights for me:

• The opportunity to dine with the other Observer folks at one of Ed’s carefully-vetted Chicago eateries.
• Two potentially excellent addresses – an opening talk by Jeremy Grantham and a colloquy between Bill Nygren and Steve Romick
• A panel presentation on what Morningstar considers off-the-radar funds: the five-star Mairs & Power Small Cap (MSCFX, which we profiled late in 2011), Meridian Small Cap Growth (MSGAX, which we profiled late in 2014) and the five-star Eventide Gilead Fund (ETAGX, which, at $1.6 billion, is a bit beyond our coverage universe).
• A frontier markets panel presented by some “A” list managers.
• The opportunity to meet and chat with you folks. If you’re going to be at Morningstar, as exhibitor or attendee, and would like a chance to chat with one or another of us, drop me a note and we’ll try hard to set something up. We’d love to see you.

As ever,

Dear friends,

What a difference a month makes. When I wrote to you last month, it was 18 degrees below zero. Right now it’s 90 … 100 degrees warmer … and my students have noticed. Not only is there spring finery on display, but attendance at late afternoon classes seems to be just a bit iffy. All for good reason, of course: horrible contagious hacking coughs, migraines, spontaneously-combusting roommates, all the usual signs of spring.

I admit to a profound ambivalence about the weather. I visited Lake Mead, the reservoir behind Boulder Dam, a couple weeks ago. The water level is 100’ below capacity and neither the recorded audio nor the tour guides really wanted to talk about why or what it might mean. As I flew home, I noticed mountains with virtually no snow pack. California today imposed the first statewide water restrictions in the state’s history as they faced the prospect of absolute rather than just relative shortage. Geologists have discovered rivers flowing under Antarctica’s “grounded ice” and oceanographers note that the Atlantic oceans currents are slowing.

I worry that all too many of us think something like, “the worst-case is too awful to imagine, so I’m not going to think about this stuff.” Meanwhile, members of the U.S. Congress excuse their refusal to take it seriously with the carefully-rehearsed excuse, “I’m not a scientist,” as if that had some meaning greater than “I don’t want to offend either donors or primary voters, so I think I’ve found a slick way to dodge my responsibilities.”

I worry, too, that my efforts (a garden that needs little by way of watering or chemicals, a carefully insulated house that sips electric, carbon offsets for my travel, a small car matched with a tendency to walk where I need to go) and the Observer’s (we’ve got a very small carbon footprint, in part because we use a “green” hosting service) are trivial. All of which puts me in a state to cry:

The End is coming! The End is coming!

Soon … er.

Or later. That is, the stock market is going to crash.

I don’t really know when. Okay, fine: I haven’t got an earthly clue. Then again, neither does anyone else. I looked back at the financial media in the months before the market crash in 2007. The Lexis-Nexis database contains around 800 stock market stories for the three months immediately before the worst collapse in three-quarters of a century. By limiting the search to U.S. sources, I got it down to a nearly-manageable 400 or so which I proceeded to scan.

Here’s what I discovered: almost without exception, the public statements of major financial media outlets, mutual fund managers and hedge fund managers were stunningly clueless. Almost without exception, the story was that other than for one or two little puffy clouds in the distance, the skies were clear, you should have a song in your heart and a buy order in your hands.

Kiplinger’s led that parade with “Why Stocks Will Keep Going Up” (July). BusinessWeek urged us, “Don’t Be Afraid of the Dark” (August 13). Money asked “Is This Bull Ready to Leave” (July) and concluded that the market was undervalued and that large cap growth stocks had “a strong outlook.” Fortune did some fortune-telling and found “A Sunny Second Half” (July 9); relying on “a hedge fund superstar,” they promised “This Bull Has Legs” (August 20). John Rogers of the Ariel Funds declared “Subprime Risks: Overblown … [it’s] time to buy” (September 17). Standard & Poor’s thought “equities could register nice gains by the end of the year” (September 20) as the result of a Fed-fueled breakout.

Only GMO’s Jeremy Grantham stood out:

Even if the credit crunch passes without a major catastrophe, the prices of stocks, bonds, and real estate have a long way to fall

Credit crises have always been painful and unpredictable. The current one is particularly hair-raising because it’s occurring amid the first truly global bubble in asset pricing. It is also accompanied by a plethora of new and ingenious financial instruments. These are designed overtly to spread risk around and to sell fee-bearing products that are in great demand. Inadvertently (to be generous), they have been constructed to hide risk and confuse buyers. How this credit crisis works out and what price we end up paying has to be largely unknowable, depending as it does on hundreds of interlocking and often novel factors and how they in turn affect animal spirits. In the end it is, of course, the management of animal spirits that makes and breaks credit crises. “Danger: Steep Drop Ahead” (Fortune, September 17).

My scan excludes results for The Wall Street Journal, since neither the Journal’s own archive search nor the Lexis database cover the Journal’s articles for the period so it’s possible that the clear-eyed Jason Zweig was standing on the parapet crying “beware!”

We do know that, in general, markets are more apt to fall when valuations get out of hand and the market encounters an exogenous shock. That is, some cataclysmic event outside of the market; for example, in 2013 Fed chair Ben Bernanke allowed that “we could take a step down in our pace of purchase” of Treasury securities. The subsequent “taper tantrum” saw US bond markets drop 3% in three months. Ummm … that would be a trillion dollar setback.

If we can’t know when the crash will come, can we at least figure out whether the market is overvalued?

Ummm … no, though heaven knows we’ve tried. Here’s a sampling:

• Morningstar suggests that the market is overvalued by 4% (as of 3/23), which seems modest until you notice that the market seems to correct when it hits 5% overvalued. It hit 5% in May 2011 and the market dropped about 19% by the beginning of August. The market reached 10-14% overvalued in late 2004 and 2005, during which time it surged 17%. Other than for that stretch, market overvaluation hasn’t exceeded 5-7% before correcting. Matt Coffina, StockInvestor editor, agrees that “we see little margin of safety and few opportunities in current stock prices… Investors in common stocks must have a long time horizon and the patience and discipline to ride out volatility.” He identified industrials, technology, health care, consumer defensive, and utilities as the most overvalued sectors. 
• Mark Hulbert argues that, “based on six well-known and time-tested indicators, equities are more overvalued today than they’ve been between 69% and 89% of the past century’s bull-market tops.”
• Doug Short, one of the guys behind Advisor Perspectives, worries that, “Based on the latest S&P 500 monthly data, the market is overvalued somewhere in the range of 64% to 98%, depending on the indicator, up from the previous month’s 60% to 94%.” He does allow that markets can remain overvalued for years, though today’s high valuations translate to tomorrow’s tepid returns.
• Jim Paulsen, chief investment strategist at Wells Capital Management, finds that the median stock in the NYSE trades, based on its price/earnings and price/cash flow ratios, at post WW2 highs. Why look at the median? Because most stock indices are cap-weighted, the valuations of the few largest stocks can materially change the entire index’s weight; he admits the S&P500 appears “slightly above average but not excessive.” By looking at the median stock, he’s trying to gauge whether the market is broadly overvalued.
• Doug Ramsey, chief investment officer for the Leuthold Group and co-manager of the outstanding Leuthold Core Investment Fund (LCORX), in an email exchange, notes that “We have a composite Intrinsic Value reading for the stock market based on 25 different measures, with weightings based on the long-term correlation of each measure with subsequent 3-, 5- and 10-yr. total returns … The composite of our 25 measures finds U.S. stocks moderately overvalued, but the situation is different than peaks like 2000 and 2007 because we find the overvaluation to be very broad-based. In other words, valuation measures on the median or ‘typical’ U.S. stock are even higher than seen at 2000 or 2007. This phenomenon isn’t fully captured by valuation measures on the cap-weighted indexes.”

Even when high valuations aren’t followed by crashes, they tend to predict weak future returns. GMO’s forward-looking asset class forecast is among the glummest I’ve seen: they anticipate negative real returns over the next 5-7 years in nine of the 12 asset classes they track:

(3.5%) Int’l bonds (currency hedged)
(3.4%) US small cap
(2.4%) US large cap
(1.0%) US bonds
(0.5%) TIPs
(0.3%) Cash
(0.2%) Int’l small cap
(0.1%) US high quality
0.0% Int’l large cap
2.6% EM bonds
2.9% EM equity
5.4% Managed timber

AQR, a global investment management firm “built at the intersection of financial theory and practical application” advises the AQR funds and manages about $120 billion. Their projections for the next five to ten years, courtesy of our friends at DailyAlts.com, are more optimistic than Leuthold’s, but nothing it celebrate:

AQR’s current estimate of U.S. stocks’ long-term real (above inflation) returns is just 3.8%. European, Australian, Canadian, and emerging market stocks are all projected to outperform the U.S., with respective long-term real returns of 5.5%, 6.1%, 4.6%, and 6.6%. U.K. stocks are expected to generate long-term real returns of 6.2%, also besting the U.S.; while only Japanese stocks are expected to underperform American equities, with returns of 3.5% above inflation.

So, 3.8 – 6.6% real returns. That’s not far from Leuthold’s estimate: “For investors who’ve missed the entire bull market to this point, we’d advise strongly against jumping into stocks with both feet; long-term (5- to 10-yr.) total returns are almost assured to be depressed (on the order of 3 to 5%, we would estimate).”

At the other end, several recent analyses by serious investors have reached the opposite conclusion: that the market is no more than modestly pricey, if that. After warning folks not to base their conclusions on a single valuation measure, the estimable Barry Ritholtz identifies a single valuation measure (enterprise value to EBITDA) as the most probative and concludes from it that the market is modestly valued.

… what has been considered the best-performing measure of markets suggests that U.S. stocks are not expensive — are indeed priced fairly. This strongly suggests that the expected future returns for U.S. equities will be about their historic average.

Ritholtz’s faith in EV:EBITDA derives, in part, from research by Wesley Gray. We contacted Mr. Gray who was busily crunching numbers in response to Mr. Ritzholtz’s piece. In a mid-March essay, he too concluded that there was no cause for concern:

The metrics aren’t screaming “overvalued:” P/E, P/B, TEV/EBITDA, and TEV/GP are all in the 50-75 percentile; TEV/FCF is actually in the 2 to 25 percentile. In fact, adjusted for the current interest rate environment (much lower than it was in the past), the argument that the market is extremely overvalued is far-fetched.

Here’s where that leaves us: the stock market has recorded double-digit gains in five of the past six years, the Vanguard Total Stock Market Index Fund (VTSMX) is up 230% in six years (though, Charles hastens to remind us, only 4.6% annualized over the past 15 years dating back to the last days of the 1990s bubble), but we have no idea of whether a correction (or worse) is imminent nor even whether conditions are right for a major correction.

So what’s an investor to do? Your two most common reactions are:

1. Do nothing until the storm hits, utterly confident in your ability to diagnose and smoothly adjust to the storm when it comes (the technical term here is “delusional thinking”) or
2. Panic, needlessly churning your portfolio in hopes of finding The One Safe Spot.

As it turns out, we endorse neither. For almost every investor, success is the product of patience. And patience is the product of a carefully considered plan and a thorough understanding of the managers and funds that you’re entrusting to execute that plan.

To be plain: if you have only half a clue about what you’re invested in, and why, you have much less than half a chance of succeeding. That’s graphically illustrated in data on 20-year asset class and investor returns:

Some pundits, fearful that we don’t quite understand the significance of life on the far right of the chart clarify it for us:

The Observer tries to help. We’re one of the few places that treat risk-conscious managers with respect, even when sticking with their principles costs them dearly in relative performance and investor assets. We know that some of the funds we’ve profiled recently have not been at the top of the recent charts; in many cases, we view that as a very good thing. We explain how you might think about investing and give you the chance to speak directly with really good managers on our conference calls. Within the next few months we’ll make our fund screener more widely available; it’s distinguished by the fact that it focuses on risk as much as returns and on meaningful time periods (entire market cycles, as well as up- and down-market phases) rather than random periods (uhhh, “last week”? Why on earth would you care?).

We’re grateful for your support and we’d really like to encourage you to take more advantage of the rich archive and tools here. There’s a lot that can help, crash or no.

Identifying Bear-Market Resistant Funds During Good Times

It’s easy enough to look back at the last bear market to see which funds avoided massive drawdown. Unfortunately, portfolio construction of those same funds may not defend against the next bear, which may be driven by different instabilities.

Dodge & Cox Balanced Fund (DODBX) comes to mind. In the difficult period between August 2000 and September 2002, it only drew down 11.6% versus the S&P 500’s -44.7% and Vanguard’s Balanced Index VBINX -22.4%. Better yet, it actually delivered a healthy positive return versus a loss for most balanced funds.

Owners of that fund (like I was and remain) were disappointed then when during the next bear market from November 2007 to February 2009, DODBX performed miserably. Max drawdown of -45.8%, which took 41 months to recover, and underperformance of -6.9% per year versus peers. A value-oriented fund house, D&C avoided growth tech stocks during the 2000 bubble, but ran head-on into the financial bubble of 2008. Indeed, as the saying goes, not all bear markets are the same.

Similarly, funds may have avoided or tamed the last bear by being heavy cash, diversifying into uncorrelated assets, hedging or perhaps even going net short, only to underperform in the subsequent bull market. Many esteemed fund managers are in good company here, including Robert Arnott, John Hussman, Andrew Redleaf, Eric Cinnamond to name a few.

Morningstar actually defines a so-called “bear-market ranking,” although honestly this metric must be one of least maintained and least acknowledged on its website. “Bear-market rankings compare how funds have held up during market downturns over the past five years.” The metric looks at how funds have performed over the past five years relative to peers during down months. Applying the methodology over the past 50 years reveals just how many “bear-market months” investors have endured, as depicted in the following chart:

The long term average shows that equity funds experience a monthly drop below 3% about twice a year and fixed income funds experience a drop below 1% about three times every two years. There have been virtually no such drops this past year, which helps explain the five-year screening window.

The key question is whether a fund’s performance during these relatively scarce down months is a precursor to its performance during a genuine bear market, which is marked by a 20% drawdown from previous peak for equity funds.

Taking a cue from Morningstar’s methodology (but tailoring it somewhat), let’s define “bear market deviation (BMDEV)” as the downside deviation during bear-market months. Basically, BMDEV indicates the typical percentage decline based only on a fund’s performance during bear-market months. (See Ratings System Definitions and A Look at Risk Adjusted Returns.)

The bull market period preceding 2008 was just over five years, October 2002 through October 2007, setting up a good test case. Calculating BMDEV for the 3500 or so existing funds during that period, ranking them by decile within peer group, and then assessing subsequent bear market performance provides an encouraging result … funds with the lowest bear market deviation (BMDEV) well out-performed funds with the highest bear market deviation, as depicted below.

Comparing the same funds across the full cycle reveals comparable if not superior absolute return performance of funds with the lowest bear market deviation. A look at the individual funds includes some top performers:  

The correlation did not hold up in all cases, of course, but it is a reminder that the superior return often goes hand-in-hand with protecting the downside.

Posturing then for the future, which funds have the lowest bear-market deviation over the current bull market? Evaluating the 5500 or so existing funds since March 2009 produces a list of about 450 funds. Some notables are listed below and the full list can be downloaded here. (Note: The full list includes all funds with lowest decile BMDEV, regardless of load, manager change, expense ratio, availability, min purchase, etc., so please consider accordingly.)