Objective and Strategy

COBYX pursues the long-term growth of capital.  They do that by assembling an exceedingly concentrated global stock portfolio.  The stocks in the portfolio must meet four criteria.

• Circle of Competence: they only invest in businesses “whose economics and future prospects” they can understand.
• Business: they only invest in “wide moat” firms, those with sustainable competitive advantages.
• People: they only invest when they believe the management team is highly competent and trustworthy.
• Price: they only buy shares priced at a substantial discount – preferably 50% – to their estimate of the share’s true value.

Within those confines, they can invest pretty much anywhere and in any amount.

Adviser

Cook & Bynum Capital Management, LLC, an independent, employee-owned money management firm established in 2001.  The firm is headquartered in Birmingham, Alabama.  It manages COBYX and two other “pooled investment vehicles.”  As of June 30, 2012, the adviser had approximately $220 million in assets under management.

Managers

Richard P. Cook and J. Dowe Bynum.  Messrs Cook and Bynum are the principals and founding partners of Cook & Bynum (are you surprised?) and have managed the fund since its inception. They have a combined 23 years of investment management experience. Mr. Cook previously managed individual accounts for Cook & Bynum Capital Management, which also served as a subadviser to Gullane Capital Partners. Prior to that, he worked for Tudor Investment Corp. in Greenwich, CT. Mr. Bynum also managed individual accounts for Cook & Bynum. Previously, he’d worked as an equity analyst at Goldman Sachs & Co. in New York.   They work alone and also manage around $140 million in two other accounts.

Management’s Stake in the Fund

As of September 30, 2011, Mr. Cook had between $100,000 and $500,000 invested in the fund, and Mr. Bynum had over $500,000 invested.  Between these investments and their investments in the firm’s private accounts, they have “substantially all of our investable net worth” in the firm’s investment vehicles.

Opening date

July 1, 2009.  The fund is modeled on a private accounts which the team has run since August 2001.

Minimum investment

$5,000 for regular accounts and $1,000 for IRA accounts.

Expense ratio

1.88%, after waivers, on assets of $82 million.  There’s also a 2% redemption fee for shares held less than 60 days.

Comments

I can explain what Cook and Bynum do.

I can explain how they’ve done.

But I have no comfortable explanation for how they’ve done it.

Messrs. Cook and Bynum are concentrated value investors in the tradition of Buffett and Munger.  They’ve been investing since before they were teens and even tried to start a mutual fund with $200,000 in seed money while they were in college.  Within a few years after graduating college, they began managing money professionally.  Now in their mid 30s, they’re on the verge of their first Morningstar rating which might well be five stars.

Their investment discipline seems straightforward: do what Warren would do.  Focus on businesses and industries that you understand, invest only with world-class management teams, research intensely, wait for a good price, don’t over-diversify, and be willing to admit your mistakes.

They are, on face, very much like dozens of other Buffett devotees in the fund world.

Their discipline led to the construction of a very distinctive portfolio.  They’ve invested in just eight stocks (as of 3/31/12) and hold about 30% in cash.  There are simply no surprises in the list:

American investors might be a bit unfamiliar with the fund’s two international holdings (Arca is a large Coca-Cola bottler serving Latin America and Tesco is the world’s third-largest retailer) but neither is “an undiscovered gem.”  With so few stocks, there’s little diversification by sector (70% of the fund is “consumer defensive” stocks) or size (85% are mega-caps).  Both are residues of bottom-up stock picking (that is, the stocks which best met C&B’s criteria were consumer-oriented multinationals) and are of no concern to the managers who remain agnostic about such external benchmarks. The fund’s turnover ratio is 25%, which is quite, if not stunningly, low.

Their performance has, however, been excellent.  Kiplinger’s (11/29/2011) reported on their long-term record: “Over the past ten years through October 31, 2011, a private account the duo have managed in the same way they manage the fund returned 8.7% annualized” which beat the S&P 500 by 6.4% per year.  COBYX just passed its third anniversary with a bang: its returns are in the top 1-5% of its large blend peer group for the past month, quarter, YTD, year and three years.  While the mutual fund trailed the vast majority of its peers in 2010, returning 11.8% versus 14.0% for its peers, that’s both very respectable and not unusual for a cash-heavy fund in a rallying market.  In 2011 the fund finished in the top 1% of its peer group and it was in the top 3% through the first seven months of 2012.

More to the point, the fund has (since inception) substantially outperformed Mr. Buffett’s Berkshire-Hathaway (BRK.A).  It is well ahead of other focus Buffettesque funds such as Tilson Focus (TILFX) and FAM Value (FAMVX) and while it has returns in the neighborhood of Tilson Dividend (TILDX), Yacktman (YACKX) and Yacktman Focused (YAFFX), it’s less volatile.

Having read about everything written by or about the fund and having spoken at length with David Hobbs, Cook & Bynum’s president, I’m still not sure why they do so well.  What stands out from that conversation is the insane amount of fieldwork the managers do before initiating and while monitoring a position.  By way of example, the fund invested in Wal-Mart de Mexico (Walmex) from 2007-2012.  Their interest began while they were investigating another firm (Soriana), whose management idolized Walmex.  “We visited Walmex’s management the following week in Mexico City and were blown away … Since then we have made hundreds of store visits to Walmex’s various formats as well as to Soriana’s and to those of other competitors…”  They concluded that Walmex was “perhaps the finest large company in the world” and its stock was deeply discounted.  They bought.   The Walmex position “significantly outperformed our most optimistic expectation over the last six years,” with the stock rising high enough that it no longer trades at an adequate discount so they sold it.

In talking with Mr. Hobbs, it seems that a comparable research push is taking place in emerging Europe.  While the team suspects that the Eurozone might collapse, such macro calls don’t drive their stock selection and so they’re pursuing a number of leads within the zone.  Given their belief in a focused portfolio, Hobbs concluded “if we can find two or three good ideas, it’s been a good year.”

Potential investors need to cope with three concerns.  First, a 1.88% expense ratio is high and is going to be an ongoing drag on returns.  Second, their incessant travel carries risks.  In psychology, the problem is summed up in the adage, “seek and ye shall find, whether it’s there or not.”  In acoustical engineering, it’s addressed as the “signal-to-noise ratio.”  If you were to spend three weeks of your life schlepping around central Europe, perusing every mini-mart from Bratislava to Bucharest, you’d experience tremendous internal pressure to conclude that you’d gained A Great Insight from all that effort. Third, it’s not always going to work.  For all their care and skill, someone will slip Stupid Pills into their coffee one morning.  It happened to Donald Yacktman, a phenomenally talented guy who trailed his peers badly for three consecutive years (2004-06).  It happened to Bill Nygren whose Oakmark Select (OAKLX) crushed for a decade then trailed the pack, sometimes dramatically, for five consecutive years (2003-07).  Over 30 years it happens repeatedly to Marty Whitman at Third Avenue Value (TAVFX). And it happened to a bunch of once-untouchable managers (Jim Oelschlager at White Oak Growth WOGSX, Auriana and Utsch at Kaufmann KAUFX, Ron Muhlenkamp at Muhlenkamp Fund MUHLX) whose former brilliance is now largely eclipsed.  The best managers stumble and recover.  The best focused portfolio managers stumble harder, and recover.  The best shareholders stick with them.

Bottom Line

It’s working.  Cook and Bynum might well be among the best.  They’re young.  The fund is small and nimble.  Their discipline makes great sense.  It’s not magic, but it has been very, very good and offers an intriguing alternative for investors concerned by lockstep correlations and watered-down portfolios.

Fund website

The Cook & Bynum Fund.  The C&B website was recently recognized as one of the two best small fund websites as part of the Observer’s “Best of the Web” feature.

Objective and Strategy

FPA International Value tries to provide above average capital appreciation over the long term while minimizing the risk of capital losses.  Their strategy is to identify high-quality companies, invest in a quite limited number of them and only when they’re selling at a substantial discount to FPA’s estimation of fair value, and then to hold on to them for the long-term.  In the absence of stocks selling at compelling discounts, FPA is willing to hold a lot of cash for an extended period.  They’re able to invest in both developed and developing markets, but recognize that the bulk of their exposure to the latter might be achieved indirectly through developed market firms with substantial emerging markets footprints.

Adviser

FPA, formerly First Pacific Advisors, which is located in Los Angeles.  The firm is entirely owned by its management which, in a singularly cool move, bought FPA from its parent company in 2006 and became independent for the first time in its 50 year history.  The firm has 25 investment professionals and 66 employees in total.  Currently, FPA manages about $20 billion across four equity strategies and one fixed income strategy.  Each strategy is manifested in a mutual fund and in separately managed accounts; for example, the Contrarian Value strategy is manifested in FPA Crescent (FPACX), in nine separate accounts and a half dozen hedge funds.

Managers

Pierre O. Py.  Mr. Py joined FPA in September 2011. Prior to that, he was an International Research Analyst for Harris Associates, adviser to the Oakmark funds, from 2005 to 2010.  At this writing (July 30 2012), Mr. Py was looking for a couple of analysts to assist in running the fund.

Management’s Stake in the Fund

Mr. Py, his former co-manager Eric Bokota and FPA’s partners are the fund’s largest investors.  Mr. Bokota estimated that he and Mr. Py had invested about two to three times their annual salary in the fund.  That reflects FPA’s corporate commitment to “co-investment” in which “Partners invest alongside our clients and have a majority of their investable net worth committed to the firm’s products and investments. We encourage all other members of the firm to invest similarly.”

Opening date

December 1, 2011.

Minimum investment

$1,500, reduced to $100 for IRAs or accounts with automatic investing plans

Expense ratio

1.35% on assets of $8 million

Comments

Few fund companies get it consistently right.  By “right” I don’t mean “in step with current market passions” or “at the top of the charts every years.”  By “right” I mean two things: they have an excellent investment discipline and they treat their shareholders with profound respect.

FPA gets it consistently right.

That alone is enough to warrant a place for FPA International Value on any reasonable investor’s due diligence list.

What are the markers of getting it right?  FPA describes itself as a “absolute value investors.”  They simply refuse to buy overpriced assets, preferring instead to hold cash – even at negligible yields – rather than lowering their standards.  It’s not unusual for an FPA fund to hold 20 – 40% in cash, sometimes for several years.  That means the funds will sometimes post disastrous relative returns – for example, flagship FPA Capital (FPTTX) has trailed 98-100% of its peers three times in the past ten years – but their refusal to buy anything at frothy prices pays off handsomely for long-term investors (FPPTX has posted top-tier results for the decade as a whole).  That divergence between occasional short-term dislocations and long-term discipline leads to an interesting pattern in Morningstar ratings: while three of FPA’s four established stock funds earn just three stars (as of late July 2012), all three also earn Silver ratings which reflects the judgment of Morningstar’s analysts that these really are top-tier funds.

The fourth fund, Steve Romick’s FPA Crescent (FPACX), earns both five stars and a Gold analyst rating.

Like the other FPA funds, FPA International Value is looking to buy world-class companies at substantial discounts.

We always demand that our investments meet the following criteria:

1. High quality businesses with long-term staying power.
2. Overall financial strength and ability to weather market dislocations.
3. Management teams that allocate capital in a value creative manner.
4. Significant discount to the intrinsic value of the business.

The managers will follow a good company for years if necessary, waiting for an opportunity to purchase its stock at a price they’re willing to pay.  Founding co-manager Eric Bokota said that they’d purchase if the discount to fair value was at least 33% but would begin “lightening up” on the position while the discount narrowed to 17%; that is, they buy deeply discounted stocks and begin to sell modestly discounted ones.

Mr. Bokota argues that the long-term success of the strategy rises as market volatility rises.  First, the managers have been assessing possible purchase targets for years, in many cases.  Part of that assessment is how corporate management handles “market dislocations.”  Bokota’s argument is that short-term dislocations strengthen the best companies by giving them the opportunity to acquire less-seasoned competitors or to acquire market share from them.  Second, their willingness to hold cash (around 22% of the portfolio, as of the end of July 2012) means that they have the resources to act when the time is right and an automatic cushion when the time isn’t.

Bokota holds that the fund has four competitive distinctions:

1. It holds stocks of all sizes, from $400 million to multinational mega-caps
2. It holds cash rather than lower quality or higher cost stocks
3. It maintains its absolute value orientation in all markets
4. It is unusually concentrated, with a target of 25-35 names in the portfolio.  As of late July, the portfolio is just below 25 names.  That’s consistent in line with Mr. Bokota’s observation that “anything north of 15 to 20 names” offers about as much diversification benefit as you’re going to get.

The fund’s early performance (top 1% of its peer group for the first seven months of 2012 with muted volatility) is entirely encouraging.  That said, there are three reasons for caution:

First, the management team is still evolving.  The fund launched in December 2011 with two co-managers, Eric Bokota and Pierre Py.  Both were analysts at Harris/Oakmark and they shared responsibility for the portfolio.  They were not supported by any research analysts, which Bokota described as a manageable arrangement because their universe of investable stocks is quite small and both he and Py loved research.  In July 2012, Mr. Bokota suddenly resigned for pressing personal reasons.  Py and FPA immediately began a search for two analysts, one of whom spokesman Ryan Leggio described as “a senior analyst.”  Their hope was to have the matter settled by the end of the summer, but the question was open at the time of this writing.

Second, this is the manager’s first fund.  While Mr. Py doubtless excelled as a member of Oakmark’s well-respected analyst corps, he has not previously been the lead guy and hasn’t had to deal with the demands of marketing and of fickle investors.

Third, FPA’s discipline lends itself to periods of dismal relative performance especially during sharply rising markets.  Sadly, rising markets are when investors are most willing to check portfolios daily and most likely to dump what they perceive to be “laggards.”  Investors with relatively high turnover fund portfolio (folks who “actively manage” their portfolios by trading funds in search of what’s hot) are likely to be poorly served by FPA’s steady discipline.

Bottom Line

FPA lends a fine pedigree to this fund, their first new offering in almost 20 years (they acquired Crescent in the early 1990s) and their first new fund launch in almost 30.  While the FPIVX team has considerable autonomy, it’s clear that they also believe passionately in FPA’s absolute value orientation and are well-supported by their new colleagues.  While FPIVX certainly will not spend every year in the top tier and will likely spend some years in the bottom one, there are few with better long-term prospects.

Fund website

FPAInternationalValue

Objective and Strategy

SFGIX seeks to provide long-term capital appreciation along with some current income; it also seeks to mitigate adverse volatility in returns. The Fund invests a significant amount of its net assets in the securities of companies located in developing countries. The Fund can invest in dividend-paying common stocks, preferred stocks, convertible bonds, and fixed-income securities.  The fund will invest 20-50% in developed markets and 50-80% in developing and frontier markets worldwide.

Adviser

Seafarer Capital Partners of San Francisco.  Seafarer is a small, employee-owned firm whose only focus is the Seafarer fund.

Managers

Andrew Foster is the lead manager and is assisted by William Maeck.  Mr. Foster is Seafarer’s founder and Chief Investment Officer.  Mr. Foster formerly was manager or co-manager of Matthews Asia Growth & Income (MACSX) and Matthews’ research director and acting chief investment officer.  He began his career in emerging markets in 1996, when he worked as a management consultant with A.T. Kearney, based in Singapore, then joined Matthews in 1998.  Andrew was named Director of Research in 2003 and served as the firm’s Acting Chief Investment Officer during the height of the global financial crisis, from 2008 through 2009.  Mr. Maeck is the associate portfolio manager and head trader for Seafarer.  He’s had a long career as an investment adviser, equity analyst and management consultant.  They are assisted by an analyst with deep Latin America experience.

Management’s Stake in the Fund

Mr. Foster has over $1 million in the fund.  Both his associate manager and senior research analyst have substantial investments in the fund.

Opening date

February 15, 2012

Minimum investment

$2,500 for regular accounts and $1000 for retirement accounts. The minimum subsequent investment is $500.

Expense ratio

1.60% after waivers on assets of $5 million (as of June, 2012).  The fund does not charge a 12(b)1 marketing fee but does have a 2% redemption fee on shares held fewer than 90 days.

Comments

The case for Seafarer is straightforward: it’s going to be one of your best options for sustaining exposure to an important but challenging asset class.

The asset class is emerging markets equities, primarily.  The argument for emerging markets exposure is well-known and compelling.  The emerging markets represent the single, sustainable source of earnings growth for investors.  As of 2010, emerging markets represented 30% of the world’s stock market capitalization but only 6% of the average American investor’s portfolio.  During the first (so-called “lost”) decade of the 21st century, the MSCI emerging markets stock index doubled in price. An analysis by Goldman projects that, over the next 20 years, the emerging markets will account for 55% of the global stock market and that China will be the world’s single largest market.  That’s consistent with GMO’s May 2012 7-year asset class return forecast, which projects a 6.7% real (i.e. inflation-adjusted) annual return for emerging equities but less than 1% for the U.S. stock market as a whole.  Real returns on emerging debt were projected at 1.7% while U.S. bonds were projected to lose money over the period.

Sadly, the average investor seems incapable of profiting from the potential of the emerging markets, seemingly because of our hard-wired aversion to loss.  Recent studies by Morningstar and Dalbar substantiate the point.  John Rekenthaler’s “Myth of the Dumb Fund Investor” (June 2012) looks at a decade’s worth of data and concludes that investors tend to pick the better fund within an asset class while simultaneously picking the worst asset classes (buying small caps just before a period of large cap outperformance).  Dalbar’s  Quantitative Analysis of Investor Behavior (2012) looks at 20 years of data and concluded that equity investors’ poor timing decisions cost them 2-6% annually; that is, the average equity investor trails the broad market by about that much.

The situation with emerging markets investing appears far worse.  Morningstar calculates “investor returns” for many, though not all, funds.  Investor returns take into account a fund’s asset size which allows Morningstar to calculate whether the average investor was around during a fund’s strongest years or its weakest.  In general, investors sacrifice 65-75% of their potential returns through bad (fearful or greedy) timing. That’s based on a reading of 10-year investor versus fund returns.  For T Rowe Price E. M. Stock (PRMSX), for example, the fund returned 12% annually over the last decade while the average investor earned 3%.  For the large but low-rated Fidelity E.M. (FEMKX), the fund returned 10.5% while its investors made 3.5%.

Institutional investors were not noticeably more rational.  JPMorgan Emerging Markets Equities Institutional (JMIEX) and Lazard Emerging Markets Equity Institutional (LZEMX) posted similar gaps.  The numbers for DFA, which carefully vets and trains its clients, were wildly inconsistent: DFA Emerging Markets I (DFEMX) showed virtually no gap while DFA Emerging Markets II (DFETX) posted an enormous one.  Rekenthaler also found the same weaknesses in institutional investors as he did in retail ones.

There is, however, one fund that stands in sharp contrast to this dismal general pattern: Matthews Asian Growth & Income (MACSX), which Andrew Foster co-managed or managed for eight years.  Over the past decade, the fund posted entirely reasonable returns: about 11.5% per year (through June 2012).  MACSX’s investors did phenomenally well.  They earned, on average. 10.5% for that decade. That means they captured 91% of the fund’s gains.  Over the past 15 years, the results are even better with investors capturing essentially 100% of the fund’s returns.

The great debate surrounding MACSX was whether it was the best Asia-centered fund in existence or merely one of the two or three best funds in existence.  Here’s the broader truth within their disagreement: Mr. Foster’s fund was, consistently and indisputably one of the best Asian funds in existence.

The fund married an excellent strategy with excellent execution. Based on his earlier research, Mr. Foster believes that perhaps two-thirds of MACSX’s out-performance was driven by having “a more sensible” approach (for example, recognizing the strategic errors embedded in the index benchmarks which drive most “active” managers) and one-third by better security selection (driven by intensive research and over 1500 field visits).  Seafarer will take the MACSX formula global.  It is arguable that that Mr. Foster can create a better fund at Seafarer than he had at Matthews.

One key is geographic diversification.  As of May 31, 2012, Seafarer had an 80/20 split between developing Asia and the rest of the world.  Mr. Foster argues that it makes sense to hold an Asia-centered portfolio.  Asia is one of the world’s most dynamic regions and legal protections for investors are steadily strengthening.  It will drive the world’s economy over decades.  In the shorter term, while the inevitable unraveling of the Eurozone will shake all markets, “Asia may be able to withstand such losses best.”

That said, a purely Asian portfolio is less attractive than an Asia-centered portfolio with selective exposure to other emerging markets.  Other regions are, he argues, undergoing the kind of changes now than Asia underwent a generation ago which might offer the prospect of outsized returns.  Some of the world’s most intriguing markets are just now becoming investable while others are becoming differently investable: while Latin America has long been a “resources play” dependent on Asian customers, it’s now developing new sectors(think “Brazilian dental HMOs”) and new markets whose value is not widely recognized.  In addition, exposure to those markets will buffer the effects of a Chinese slowdown.

Currently the fund invests almost-exclusively in common stock, either directly or through ADRs and ETFs.  That allocation is driven in part by fundamentals and in part by necessity.  Fundamentally, emerging market valuations are “very appealing.”  Mr. Foster believes that there have only been two occasions over the course of his career – during the 1997 Asian financial crisis and the 2008 global crisis – that “valuations were definitively more attractive than at present” (Shareholder Letter, 18 May 2012). That’s consistent with GMO’s projection that emerging equities will be the highest-returning asset class for the next five-to-seven years.  As a matter of necessity, the fund has been too small to participate in the convertible securities market.  With more assets under management, it gains the flexibility to invest in convertibles – an asset class that substantially strengthened MACSX’s performance in the past.  Mr. Foster has authority to add convertibles, preferred shares and fixed income when valuations and market conditions warrant.  He was done so skillfully throughout his career.

Seafarer’s returns over its first two quarters of existence (through 29 June 2012) are encouraging.  Seafarer has substantially outperformed the diversified emerging markets group as a whole, iShares Asia S&P 50 (AIA) ETF, First Trust Aberdeen Emerging Opportunities fund(FEO) which is one of the strongest emerging markets balanced funds, the emerging Asia, Latin America and Europe benchmarks, an 80/20 Asia/non-Asia benchmark, and so on.  It has closely followed the performance of MACSX, though it ended the period trailing by a bit.

Bottom Line

Mr. Foster is remarkably bright, thoughtful, experienced and concerned about the welfare of his shareholders.  He grasps the inefficiencies built into standard emerging markets indexes, and replicated by many of the “active” funds that are benchmarked to them. He’s already navigated the vicissitudes of a region’s evolution from uninvestable to frontier, emerging and near-developed.   He believes that experience will serve his shareholders “when the world’s falling apart but you see how things fit together.” He’s a good manager of risk, which has made him a great manager of returns.  The fund offers him more flexibility than he’s ever had and he’s using it well.  There are few more-attractive emerging markets options available.

Fund website

Seafarer Overseas Growth and Income.  The website is remarkably rich, both with analyses of the fund’s portfolio and performance, and with commentary on broader issues.

Disclosure

In mid-July, about two weeks after this profile is published, I’ll purchase shares of Seafarer for my personal, non-retirement account.  I’ll sell down part of my existing MACSX stake to fund that purchase.

Objective and Strategy

ARLSX seeks to provide absolute returns (“equity-like returns,” they say) while minimizing volatility over a full market cycle.  The fund invests, long and short, mostly in US common stocks but can also take positions in foreign stock, preferred stock, convertible securities, REITs, ETFs, MLPs and various derivatives. The fund is not “market neutral” and will generally be “net long,” which is to say it will have more long exposure than short exposure.  The managers have a strict, quantitative risk-management discipline that will force them to reduce equity exposure under certain market conditions.

Adviser

Aston Asset Management, LP, which is based in Chicago.  Aston’s primary task is designing funds, then selecting and monitoring outside management teams for those funds.  As of March 31, 2012, Aston has partnered with 18 subadvisers to manage 26 mutual funds with total net assets of approximately $10.7 billion. Aston funds are available to retail investors, as well as through various professional channels.

Managers

Matt Moran and Daniel Johnson.  Both work for River Road Asset Management, which is based in Louisville.    They manage money for a variety of private clients (cities, unions, corporations and foundations) and sub-advise five funds for Aston, including the splendid (and closed) Aston/River Road Independent Value (ARIVX).  River Road employs 39 associates including 15 investment professionals.   Mr. Moran is the lead manager, joined River Road in 2007, has about a decade’s worth of experience and is a CFA.  Before joining River Road, he was an equity analyst for Morningstar (2005-06), an associate at Citigroup (2001-05), and an analyst at Goldman Sachs (2000-2001).  His MBA is from the University of Chicago.  Mr. Johnson is a CPA and a CFA.  Before joining River Road in 2006, he worked at PricewaterhouseCoopers.

Management’s Stake in the Fund

Mr. Moran and Mr. Johnson had between $100,000 and $500,000 as of April 30, 2012.  Those investments represent a significant portion of the managers’ liquid net worth.

Opening date

May 4, 2011.

Minimum investment

$2,500 for regular accounts and $500 for retirement accounts.

Expense ratio

2.75%, after waivers, on assets of $5.5 million.   The fund’s operating expenses are capped at 1.70%, but expenses related to shorting add another 1.05%.  Expenses of operating the fund, before waivers, are 8.7%.

Comments

Long/short investing makes great sense in theory but, far too often, it’s dreadful in practice.  After a year, ARLSX seems to be getting it right and its managers have a pretty cogent explanation for why that will continue to be the case.

Here’s the theory: in the long term, the stock market rises and so it’s wise to be invested in it.  In the short term, it can be horrifyingly irrational and so it’s wise to buffer your exposure.  That is, you want an investment that is hedged against market volatility but that still participates in market growth.

River Road pursues that ideal through three separate disciplines: long stock selection, short stock selection and level of net market exposure.

In long stock selection, their mantra is “excellent companies trading at compelling prices.” Between 50% and 100% of the portfolio is invested long in 15-30 stocks.

For training and other internal purposes, River Road’s analysts are responsible for creating and monitoring a “best ideas” pool, and Mr. Moran estimates that 60-90% of his long exposure overlaps that pool’s.  They start with conventional screens to identify a pool of attractive stocks.  Within their working universe of 200-300 such stocks, they look for fundamentally attractive companies (those with understandable businesses, good management, clean balance sheets and so on) priced at a discount that their absolute value.  They allow themselves to own the 15-30 most attractive names in that universe.

In short stock selection, they target “challenged business models with high valuations and low momentum.”  In this, they differ sharply from many of their competitors.  They are looking to bet against fundamentally bad companies, not against good companies whose stock is temporarily overpriced.  They can be short with 10-90% of the portfolio and typically have 20-40 short positions.

Their short universe is the mirror of the long universe: lousy businesses (unattractive business models, dunderheaded management, a history of poor capital allocation, and favorites of Wall Street analysts) priced at a premium to absolute value.

Finally, they control net market exposure, that is, the extent to which they are exposed to the stock market’s gyrations.  Normally the fund is 50-70% net long, though exposure could range from 10-90%.

The managers have a “drawdown plan” in place which forces them to become more conservative in the face of sharp market places.  While they are normally 50-70% long, if their portfolio has dropped by 4% they must reduce net market exposure to no more than 50%.  A 6% portfolio decline forces them down to 30% market exposure and an 8% portfolio decline forces them to 10% market exposure.  They achieve the reduced exposure by shorting the S&P500 via the SPY exchange-traded fund; they do not dump portfolio securities just to adjust exposure.  They cannot increase their exposure again until the Russell 3000’s 50 day moving average is positive.  Only after 10 consecutive positive days can they exit the drawdown plan altogether.

Mr. Moran embraces Benjamin Graham’s argument that “The essence of investment management is the management of risks, not the management of returns.”  As a result, they’ve built in a series of unambiguous risk-management measures.  These include:

• A prohibition on averaging down or doubling-down on falling stocks
• Stop loss orders on every long and short position
• A requirement that they begin selling losing positions when losses develop
• A prohibition on shorting stocks that show strong, positive momentum regardless of how ridiculous the stock might otherwise be
• A requirement to systematically reduce any short position when the stock shows positive momentum for five days, and
• The market-exposure controls embedded in the drawdown plan.

The fund’s early results are exceedingly promising.  Over its first full year of existence, the fund returned 3.7%; the S&P500 returned 3.8% while the average long-short fund lost 3.5%.  That placed the first in the top 10% of its category.  River Road’s Long-Short Strategy Composite, the combined returns of its separately-managed long-short products, has a slightly longer record (it launched in July 1, 2010) and similar results: it returned 16.3% through the end of the first quarter of 2012, which trailed the S&P500 (which returned 22.0%) but substantially outperformed the long-short group as a whole (4.2%).

The strategy’s risk-management measures are striking.  Through the end of Q1 2012, River Road’s Sharpe ratio (a measure of risk-adjusted returns) was 1.89 while its peers were at 0.49.  Its maximum drawdown (the drop from a previous high) was substantially smaller than its peers, it captured less of the market’s downside and more of its upside, in consequence of which its annualized return was nearly four times as great.

It also substantially eased the pain on the market’s worst days.  The Russell 3000, a total stock market index, lost an average of 3.6% on its fifteen worst days between the strategy’s launch and the end of March, 2012.  On those same 15 days, River Road lost 0.9% on average – which is to say, its investors dodged 75% of the pain on the market’s worst days.

This sort of portfolio strategy is expensive.  A long-short fund’s expenses come in the form of those it can control (fees paid to management) and those it cannot (expenses such as repayment of dividends generated by its short positions).  At 2.75%, the fund is not cheap but the controllable fee, 1.7% after waivers, is well below the charges set by its average peer.  With changing market conditions, it’s possible for the cost of shorting to drop well below 1% (and perhaps even become an income generator). With the adviser absorbing another 6% in expenses as a result of waivers, it’s probably unreasonable to ask for lower.

Bottom Line

Long-term investors need exposure to the stock market; no other asset class offers the same potential for long-term real returns.  But combatting our human impulse to flee at the worst possible moment requires buffering that exposure.  With the deteriorating attractiveness of the traditional buffer (bonds), investors need to consider non-traditional ones.  There are few successful, time-tested funds available to retail investors.  Among the crop of newer offerings, few are more sensibly-constructed or carefully managed that ARLSX seems to be.  It deserves attention.

Fund website

ASTON / River Road Long-Short Fund

2013 Q3 Report

2013 Q3 Commentary

This fund has been liquidated.

Objective

The fund’s investment objective is capital appreciation which it pursues by maintaining long and short equity positions.  It typically invests in domestic stocks (92% as of the last portfolio) and typically targets stocks with market caps of at least $100 million.  The managers look at both industry and individual stock prospects when determining whether to invest, long or short.  The managers may, at any point, position the fund as net long or net short.  It is not designed to be a market neutral offering.

Adviser

Wasatch Advisors of Salt Lake City, Utah.  Wasatch has been around since 1975. It both advises the 19 Wasatch funds and manages money for high net worth individuals and institutions. Across the board, the strength of the company lies in its ability to invest profitably in smaller (micro- to mid-cap) companies. As May 2012, the firm had $11.8 billion in assets under management.

Managers

Ralph Shive and Mike Shinnick. Mr. Shinnick is the lead manager for this fund and co-manages Wasatch Large Cap Value (formerly Equity Income) and 18 separate accounts with Mr. Shive.  Before joining Wasatch, he was a vice president and portfolio manager at 1^st Source Investment Advisers, this fund’s original home. Mr. Shive was Vice President and Chief Investment Officer of 1st Source when this fund was acquired by Wasatch. He has been managing money since 1975 and joined 1st Source in 1989. Before that, he managed a private family portfolio inDallas,Texas.

Management’s Stake in the Fund

Mr. Shinnick has over $1 million in the fund, a substantial increase in the past three years.  Mr. Shive still has between $100,000 and $500,000 in the fund.

Opening date

August 1, 2003 as the 1^st Source Monogram Long/Short Fund, which was acquired by Wasatch and rebranded on December 15, 2008.

Minimum investment

$2,000 for regular accounts, $1,000 for retirement accounts and for accounts which establish automatic investment plans.

Expense ratio

1.63% on assets of $1.2 billion.  There’s also a 2% redemption fee on shares held for fewer than 60 days.

Our Original Comments

Long/short funds come in two varieties, and it’s important to know which you’re dealing with.  Some long/short funds attempt to be market neutral, sometimes advertised as “absolute returns” funds.  They want to make a little money every year, regardless of whether the market goes up or down.  They generally do this by building a portfolio around “paired trades.”  If they choose to invest in the tech sector, they’ll place a long bet on the sector’s most attractive stock and exactly match that it with a short bet on the sector’s least attractive stock.  Their expectation is that one of their two bets will lose money but, in a falling market, they’ll make more by the short on the bad stock than they’ll lose in the long position on the good stock.  Vice versa in a rising market: their long position will, they hope, make more than the short position loses.  In the end, investors pocket the difference: frequently something in the middle single digits.

The other form of long/short fund plays an entirely different game.  Their intention is to outperform the stock market as a whole, not to continually eke out small gains.  These funds can be almost entirely long, almost entirely short, or anywhere in between.  The fund uses its short positions to cushion losses in falling markets, but scales back those positions to avoid drag in rising ones.  These funds will lose money when the market tanks but, with luck and skill, they’ll lose a lot less than an unhedged fund will.

It’s reasonable to benchmark the first set of funds against a cash-equivalent, since they’re trying to do about the same thing that cash does.  It’s reasonable to benchmark the second set against a stock index, since they aspire to outperform such indexes over the long term.  It’s probably not prudent, however, to benchmark them against each other.

Wasatch Long/Short is an example of the second type of fund: it wants to beat the market with dampened downside risk.  Just as Oakmark’s splendid Oakmark Equity & Income (OAKBX) describes itself as “Oakmark with an airbag,” you might consider FMLSX to be “Wasatch Large Cap Value with an airbag.”  The managers write, “Our strategy is directional rather than market neutral; we are trying to make money with each of our positions, rather than using long and short positions to eliminate the impact of market fluctuations.”

Which would be a really, really good thing.  FMLSX is managed by the same guys who run Wasatch Large Cap Value, a fund in which you should probably be invested.  In profiling FMIEX last year, I noted:

Okay, okay, so you could argue that a $600-700 million dollar fund isn’t entirely “in the shadows.” . . . the fact that Fidelity has 20 funds in the $10 billion-plus range all of which trail FMIEX – yes, that includes Contrafund, Low-Priced Stock, Magellan, Growth Company and all – argues strongly for the fact that Mr. Shive’s charge deserves substantially more investor interest than it has received.

As a matter of fact, pretty much everyone trails this fund. When I screened for funds with equal or better 1-, 3-, 5- and 10-year records, the only large cap fund on the list was Ken Heebner’s CGM Focus (CGMFX).  In any case, a solid 6000 funds trail Mr. Shive’s mark and his top 1% returns for the past three-, five- and ten-year periods.

Since then, CGMFocus has tanked while two other funds – Amana Growth (AMAGX) and Yacktman Focused (YAFFX) – joined FMIEX in the top tier.  That’s an awfully powerful, awfully consistent record especially since it was achieved with average to below-average risk.

Which brings us back to the Long/Short fund.  Long/Short uses the same investment discipline as does Large Cap Value.  It just leverages that discipline to create bets against the most egregious stocks it finds, as well as its traditional bets in favor of its most attractive finds.  So far, that strategy has allowed it to match most of the market’s upside and dodge most of its downside.  Over the past three years, Long/Short gained 3.6% annually while Large Cap Value lost 3.9% and the Total Stock Market lost 8.2%.  The more impressive feat is that over the past three months – during one of the market’s most vigorous surges in a half century – Long/Short gained 21.2% while Income Equity gained 21.8%.  The upmarket drag of the short positions was 0.6% while the downside cushion was ten times greater.

That’s pretty consistently true for the fund’s quarterly returns over the past several years.  In rising markets, Long/Short makes money though trailing its sibling by 2-4 percent (i.e., 200-400 basis points).  In failing markets, Long/Short loses 300-900 basis points less.  While the net effect is not to “guarantee” gains in all markets, it does provide investors with ongoing market exposure and a security blanket at the same moment.

Bottom Line

Lots of seasoned investors (Leuthold and Grantham among them) believe that we’ve got years of a bear market ahead of us.  In their view, the price of the robustly rising market of the 80s and 90s will be the stumbling, tumbling markets of this decade and part of the next. Such markets are marked by powerful rallies whose gains subsequently evaporate.  Messrs. Shive and Shinnick share at least part of that perspective.  Their shareholder letters warn that we’re in “a global bear market,” that the spring surge does not represent “the beginning of an upward turn in the market’s cycle,” and that prudence dictates that they “not get too far from shore.”

An investor’s greatest enemy in such markets is panic: panic about being in a falling market, panic about being out of a rising market, panic about being panicked all the time.  While a fund such as FMLSX can’t eliminate all losses, it may allow you to panic less and stay the course just a bit more.  With seasoned management, lower-than-average expenses and a low investment minimum, FMLSX is one of the most compelling choices in this field.

Fund website

Wasatch Long-Short Fund

Fact Sheet

Objective

The fund pursues the reassuring objective of long-term total returns and capital preservation.  The plan is to shift allocation between equity and debt based on management’s judgment of the asset class which offers the best risk-return balance.  Equity can range from 25 – 75% of the portfolio, likewise debt.  Both equity and debt are largely unconstrained, that is, the managers can buy pretty much anything, anywhere.  The two notable restrictions are minor: no more than 50% of the total portfolio can be invested outside the U.S. and no more than 15% may be invested in Master Limited Partnerships, which are generally energy and natural resources investments.

Adviser

Osterweis Capital Management.  Osterweis Capital Management was founded in 1983 by John Osterweis to manage money for high net worth individuals, foundations and endowments.   They’ve got $5.3 billion in assets under management (as of March 31 2012), and run both individually managed portfolios and three mutual funds.

Manager

John Osterweis, Matt Berler and Carl Kaufman lead a team that includes the folks (John Osterweis, Matthew Berler, Alexander (Sasha) Kovriga, Gregory Hermanski, and Zachary Perry) who manage Osterweis Fund (OSTFX) and those at the Osterweis Strategic Income Fund (Carl Kaufman and Simon Lee).  The team members have all held senior positions with distinguished firms (Robertson Stephens, Franklin Templeton, Morgan Stanley, Merrill Lynch). Osterweis Fund earned Morningstar’s highest commendation: it has been rated “Gold” in the mid-cap core category.

Management’s Stake in the Fund

Mr. Osterweis had over $1 million in the fund, three of the managers had between $500,000 and $1 million in the fund (as of the most recent SAI, March 30, 2011) while two others had between $100,000 and $500,000.

Opening date

August 31, 2010.

Minimum investment

$5000 for regular accounts, $1500 for IRAs

Expense ratio

1.50%, after waivers, on assets of $43 million (as of April 30 2012).  There’s also a 2% redemption fee on shares held under one month.

Comments

There are, broadly speaking, two sorts of funds which mix both stocks and bonds in their portfolios.  One sort, often simply called a “balanced” fund, sticks with a mix that changes very little over time: 60% stocks (give or take a little) plus 40% bonds (give or take a little), and we’re done.  I’ve written elsewhere, for example in my profile of LKCM Balanced, of the virtue of such funds.  They tend to be inexpensive, predictable and reassuringly dull.  An excellent anchor for a portfolio.

The second sort, sometimes called an “allocation” fund, allows its manager to shift assets between categories, often dramatically.  These funds are designed to allow the management team to back away from a badly overvalued asset class and redeploy into an undervalued one.  Such funds tend to be far more troubled than simple balanced funds for two reasons.  First, the manager has to be right twice rather than once.  A balanced manager has to be right in his or her security selection.  An allocation manager has to be right both on the weighting to give an asset class (and when to give it) and on the selection of stocks or bonds within that portion of the portfolio.  Second, these funds can carry large visible and invisible expenses.  The visible expenses are reflected in the sector’s high expense ratios, generally 1.5 – 2%.  The funds’ trading, within and between sectors, invisibly adds another couple percent in drag though trading expenses are not included in the expense ratio and are frequently not disclosed.

Why consider these funds at all?

If you believe that the market, like the global climate, seems to be increasingly unstable and inhospitable, it might make sense to pay for an insurance policy against an implosion in one asset class or one sector.  PIMCO, for example, has launched of series of unconstrained, all-asset, all-authority funds designed to dodge and weave through the hard times.  Another option would be to use the services of a good fee-only financial planner who specializes in asset allocation.  In either case, you’re going to pay for access to the additional “dynamic allocation” expertise.  If the manager is good (see, for example, Leuthold Core LCORX and FPA Crescent FPACX), you’ll receive your money’s worth and more.

Why consider Osterweis Strategic Investment?

There are two reasons.  First, Osterweis has already demonstrated sustained competence in both parts of the equation (asset allocation and security selection).  Osterweis Strategic Investment is essentially a version of the flagship Osterweis Fund (OSTFX).  OSTFX is primarily a stock fund, but the managers have the freedom to move decisively into bonds and cash if need be.  In the last eight years, the fund’s lowest stock allocation was 60% and highest was 93%, but it tends to have a neutral position in the mid-80s.  Management has used that flexibility to deliver solid long-term returns (nearly 12% over the past 15 years) with far less volatility than the stock market’s.  The second Osterweis Fund, Osterweis Strategic Income (OSTIX) plays the same game within the bond universe, moving between bonds, convertibles and loans, investment grade and junk, domestic and foreign.  Since inception in 2002, OSTIX has trounced the broad bond indexes (8.5% annually for nine years versus 5% for their benchmark) with less risk.  The team that manages those funds is large, talented, stable . . . and managing the new fund as well.

Second, Osterweis’s expenses, direct and indirect, are more reasonable than most.  The current 1.5% ratio is at the lower end for an active allocation fund, strikingly so for a tiny one.  And the other two Osterweis funds each started around 1.5% and then steadily lowered their expense ratios, year after year, as assets grew.  In addition, both funds tend to have lower-than-normal portfolio turnover, which decreases the drag created by trading costs.

Bottom Line

Many investors would benefit from using a balanced or allocation fund as a significant part of their portfolio.  Well done, such funds decrease a portfolio’s volatility, instill discipline in the allocation of assets between classes, and reduce the chance of self-destructive bipolar investing on our parts.  Given reasonable expenses, outstanding management and a long, solid track record, Osterweis Strategic Investment warrants a place on any investor’s due-diligence short list.

Fund website

Osterweis Strategic Investment

Quarterly Report

Fact Sheet

Objective and Strategy

The fund pursues long-term growth by investing in 30-50 undervalued global stocks.  The managers look for four characteristics in their investments:

1. A high quality business
2. A strong balance sheet
3. Shareholder-focused management and
4. The stock selling for less than it’s worth.

Generally it avoids small cap caps.  It can invest in emerging markets, but rarely does so though many of its multinational holdings derived significant earnings from emerging market operations.   The managers can hedge their currency exposure, though they did not do so until the nuclear disaster in, and fiscal stance of, Japan forced them to hedge yen exposure in 2011.

Adviser

Artisan Partners of Milwaukee, Wisconsin.   Artisan has five autonomous investment teams that oversee twelve distinct U.S., non-U.S. and global investment strategies. Artisan has been around since 1994.  As of 3/31/2012, Artisan Partners managed $66.5 billion of which $35.8 billion was in funds and $30.7 billion is in separate accounts.  That’s up from $10 billion in 2000. They advise the 12 Artisan funds, but only 6% of their assets come from retail investors

Managers

Daniel J. O’Keefe and David Samra, who have worked together since the late 1990s.  Mr. O’Keefe co-manages this fund, Artisan International Value (ARTKX) and Artisan’s global value separate account portfolios.  Before joining Artisan, he served as a research analyst for the Oakmark international funds and, earlier still, was a Morningstar analyst.  Mr. Samra has the same responsibilities as Mr. O’Keefe and also came from Oakmark.  Before Oakmark, he was a portfolio manager with Montgomery Asset Management, Global Equities Division (1993 – 1997).  Messrs O’Keefe, Samra and their five analysts are headquartered in San Francisco.  ARTKX earns Morningstar’s highest accolade: it’s a Five Star star with a “Gold” rating assigned by Morningstar’s analysts (as of 04/12).

Management’s Stake in the Fund

Each of the managers has over $1 million here and over $1 million in Artisan International Value.

Opening date

December 10, 2007.

Minimum investment

$1000 for regular accounts, reduced to $50 for accounts with automatic investing plans.  Artisan is one of the few firms who trust their investors enough to keep their investment minimums low and to waive them for folks willing to commit to the discipline of regular monthly or quarterly investments.

Expense ratio

1.5%, after waivers, on assets of $149 million (as of March 31, 2012).

Comments

Can you say “it’s about time”?

I have long been a fan of Artisan Global Value.  It was the first “new” fund to earn the “star in the shadows” designation.  Its management team won Morningstar’s International-Stock Manager of the Year honors in 2008 and was a finalist for the award in 2011. In announcing the 2011 nomination, Morningstar’s senior international fund analyst, William Samuel Rocco, observed:

Artisan Global Value has . . .  outpaced more than 95% of its rivals since opening in December 2007.  There’s a distinctive strategy behind these distinguished results. Samra and O’Keefe favor companies that are selling well below their estimates of intrinsic value, consider companies of all sizes, and let country and sector weightings fall where they may. They typically own just 40 to 50 names. Thus, both funds consistently stand out from their category peers and have what it takes to continue to outperform. And the fact that both managers have more than $1 million invested in each fund is another plus.

We attributed that success to a handful of factors:

First, the [managers] are as interested in the quality of the business as in the cost of the stock.  O’Keefe and Samra work to escape the typical value trap by looking at the future of the business – which also implies understanding the firm’s exposure to various currencies and national politics – and at the strength of its management team.

Second, the fund is sector agnostic. . .  ARTGX is staffed by “research generalists,” able to look at options across a range of sectors (often within a particular geographic region) and come up with the best ideas regardless of industry.  That independence is reflected in . . . the fund’s excellent performance during the 2008 debacle. During the third quarter of 2008, the fund’s peers dropped 18% and the international benchmark plummeted 20%.  Artisan, in contrast, lost 3.5% because the fund avoided highly-leveraged companies, almost all banks among them.

In designated ARTGX a “Star in the Shadows,” we concluded:

On whole, Artisan Global Value offers a management team that is as deep, disciplined and consistent as any around.  They bring an enormous amount of experience and an admirable track record stretching back to 1997.  Like all of the Artisan funds, it is risk-conscious and embedded in a shareholder-friendly culture.  There are few better offerings in the global fund realm.

In the past year, ARTGX has continued to shine.  In the twelve months since that review was posted, the fund finished in the top 6% of its global fund peer group.  Since inception (through April 2012), the fund has turned $10,000 into $11,700 while its average peer has lost $1200.  Much of that success is driven by its risk consciousness.  ARTGX has outperformed its peers in 75% of the months in which the global stock group lost money.  Morningstar reports that its “downside capture” is barely half as great as its peers.  Lipper designates it as a “Lipper Leader” in preserving its investors’ money.

Bottom Line

While money is beginning to flow into the fund (it has grown from $57 million in April 2011 to $150 million a year later), retail investors have lagged institutional ones in appreciating the strategy.  Mike Roos, one of Artisan’s managing directors, reports that “the Fund currently sits at roughly $150 million and the overall strategy is at $5.4 billion (reflecting meaningful institutional interest).”  With 90% of the portfolio invested in large and mega-cap firms, the managers could easily accommodate a far larger asset base than they now have.  We reiterate our conclusion from 2008 and 2011: “there are few better offerings in the global fund realm.”

Fund website

Artisan Global Value Fund

RMS (a/k/a FundReveal) provides a discussion of the fund’s risk/return profile, based on their messages of daily volatility, at http://www.fundreveal.com/mutual-fund-blog/2012/05/artgx-analysis-complementing-mutual-fund-observer-may-1-2012/

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Objective and Strategy

Tributary Balanced Fund seeks capital appreciation and current income. They allocate assets among the three major asset groups: common stocks, bonds and cash equivalents. Based on their assessment of market conditions, they will invest 25% to 75% of the portfolio in stocks and convertible securities, and at least 25% in bonds. The portfolio is typically 70-75 stocks from small- to mega-cap and turnover is about half of the category average.  They currently hold about 50 bonds.

Adviser

Tributary Capital Management.  At base, Tributary is a subsidiary of First National Bank of Omaha and the Tributary funds were originally branded as the bank’s funds.  Tributary advises seven mutual funds, as well as serving high net worth individuals and institutions.  As December 31, 2011, they had about $1.1 billion under management.

Managers

Kurt Spieler and John Harris.  Mr. Spieler is the lead manager and the Managing Director of Investments for the advisor.  In that role, he develops and manages investment strategies for high net worth and institutional clients. He has 24 years of investment experience in fixed income, international and U.S. equities including a stint as Head of International Equities for Principal Global Investors and President of his own asset management firm.  Mr. Harris is a Senior Portfolio Manager for the advisor.  He joined Tributary in 2007 and this fund’s team in 2010.  He has 18 years of investment management experience including analytical roles for Principal Global Investors and American Equity Investment Life Insurance Company.

Management’s Stake in the Fund

Mr. Spieler has over $100,000 in the fund.  Mr. Harris has $10,000 in the fund, an amount limited by his “an interest in a more aggressive stock allocation.”

Opening date

August 6, 1996

Minimum investment

$1000, reduced to $100 for accounts opened with an automatic investing plan.

Expense ratio

1.22%, after a minor waiver, on $59 million in assets (as of 2/29/12).

Comments

Tributary Balanced does what you want to “balanced” fund to do.  It uses a mix of stocks and bonds to produce returns greater than those associated with bonds with volatility less than that associated with stocks.   Morningstar’s “investor returns” research supports the notion that this sort of risk consciousness is probably the most profitable path for the average investor to follow.

What’s remarkable is how very well, very quietly, and very consistently Tributary achieves those objectives.  The fund has returned 7.6% per year for the past decade, 50% better than its peer group, but has taken on no additional risk to achieve those returns.  Its Morningstar profile, as of 3/28/12, looks like this:

Its Lipper rankings, as of 3/28/12, parallel Morningstar’s:

We commissioned an analysis of the fund by the folks at Investment Risk Management Systems (a/k/a FundReveal), who looked at daily volatility and returns, and concluded “FOBAX is a well-managed, safe, low risk Moderate Allocation fund.

• Its low volatility, high return performance is visible in cumulative 5 year, latest cumulative one year and latest quarter analysis results.
• Its Persistence Rating (PR) is 60, indicating that it has maintained an “A-Best” rating over most of last 20 quarters.
• This is also evident from the rolling 20 quarters Risk-Return ratings which have been between “A-Best” and “C-Less Risky.”

Our bottom line opinion is that FOBAX seems to be one of the better managed funds in the Moderate Allocation class.”

SmartMoney provides a nice visual representation of the risk-return relationships of funds.  Below is the three-year scatterplot for the balanced fund universe.  In general, an investor wants to be as near the upper-left corner (universe returns, zero risk) as possible.  There are three things to notice in this graph:

1. Three funds form the group’s northwest boundary; that is, three that have a distinguished risk-return balance.  They are Tributary, Vanguard Balanced Index (VBINX) which is virtually unbeatable and Calvert Balanced (CSIFX) which provides middling returns with quite muted risk.
2. The only funds with higher returns (Fidelity Asset Manager 85% FAMRX and T. Rowe Price Personal Strategy Growth TRSGX than Tributary have far higher stock allocations (around 85%), far higher volatility and took 70% greater losses in 2008.
3. Ken Heebner is sad.  His CGM Mutual (LOMMX) is the lonely little dot in the lower right.

To what could we attribute Tributary’s success? Mr. Spieler claims three sources of alpha, or positive risk-adjusted returns.  They are:

1. They have a flexible asset allocation, which is driven by a macro-economic assessment, profit analysis and valuation analysis.  In theory the fund might hold anywhere between 25-75% in equities though the actual allocation tends to sit between 50-70%.
2. Stock selection tends to be opportunistic.  The portfolio tilts toward growth stocks and the managers are particularly interested in emerging markets growth stocks.  The neat trick is they pursue their interest without investing in foreign stocks by looking for US firms whose earnings benefit from emerging markets operations.  Pricesmart PSMT, for example, has 100% of its operations in South America while Cognizant Technology Solutions CTSH is a play on outsourcing to South Asia.  They’re also agnostic as to market cap.  Measured by the percentage of earnings from international sources, Tributary offers considerable international exposure.  They etimate that 48% of revenues of for their common stock holdings are from international sales. That compares to an estimated 42% of international sales for the S&P 500.
3. Fixed-income selection is sensitive to duration targets and unusual opportunities. About 20% of the portfolio is invested in taxable municipal bonds, such as the Build America Bonds.  Those were added to the portfolio when irrational fear gripped the fixed income market and investors were willing to sell such bonds as a substantial discount in order to flee to the safety of Treasuries.  Understanding that the fundamentals behind the bonds were solid, the managers snatched them up and booked a solid profit.

The managers are also risk-conscious, which is appropriate everywhere and especially so in a balanced fund.  The stock portfolio tends to be sector-neutral, and the number of names (typically 70-75) was based on an assessment of the amount of diversification needed for reasonable risk management.

Bottom Line

The empirical record is pretty clear.  Almost no fund offers a consistently better risk-return profile.  While it would be reassuring to see somewhat lower expenses or high insider ownership, Tributary has clearly earned a spot on the “due diligence” list for any investor interested in a hybrid fund.

Fund website

Tributary Funds.  FundReveal’s complete analysis of the fund is available on their blog.

This profile has been updated. Find the new profile here. 

Objective and Strategy

MASNX seeks to achieve long-term returns with lower risk and lower volatility than the stock market, and with relatively low correlation to stock and bond market indexes.  Relative to “moderate allocation” hybrid funds, the advisor’s goals are less volatility, better down market performance, fewer negative 12‐month losses, and higher returns over a market cycle. Their strategy is to divide the fund’s assets up between four teams, each pursuing distinct strategies with the whole being uncorrelated with the broad markets.  They can, in theory, maintain a correlation of .50 relative to the US stock market.

Adviser

Litman Gregory Fund Advisors, LLC, of Orinda, California. At base, Litman Gregory (1) conceives of the fund, (2) selects the outside management teams who will manage portions of the portfolio, and (3) determines how much of the portfolio each team gets.  Litman Gregory provides these services to five other funds (Equity, Focused Opportunities, International, Smaller Companies and Value). Collectively, the funds hold about $2.4 billion in assets.

Manager(s)

Jeremy DeGroot, Litman Gregory’s chief investment officer gets his name on the door as lead manager but the daily investments of the fund are determined bythree teams, and Jeff Gundlach. There’s a team from FPA led by Steve Romick, a team from Loomis Sayles led by Matt Eagan, a team from Water Island Capital led by John Orrico.  And Jeff Gundlach.

Management’s Stake in the Fund

None yet reported.

Opening date

September 30, 2011.

Minimum investment

$1000 for regular accounts, $500 for IRAs.  The fund’s available, NTF, through Fidelity, Scottrade and a few others.

Expense ratio

1.74%, after waivers, on $230 million in assets (as of 2/23/12).  There’s also a 2% redemption fee for shares held fewer than 180 days.  The expense ratio for the institutional share class is 1.49%.

Comments

Investors have, for years, been reluctant to trust the stock market.  Investors have pulled money for pure equity funds more often than they’ve invested in them.  An emerging conventional wisdom is that domestic bonds are at the end of a multi-decade bull market.  Investors have sought, and fund companies have provided, a welter of “alternative” funds.  Morningstar now tracks 262 funds in their various “alternative” categories.  Sadly, many such funds are bedeviled by a combination of untested management (the median manager tenure is just two years), opaque strategies and high expenses (the category average is 1.83% with a handful charging over 3% per year).

All of which makes MASNX look awfully attractive by comparison.

The Litman Gregory folks started with a common premise: “In the years ahead, we believe there will be mediocre returns and higher volatility from stocks, and low returns from bonds . . . [we sought] “alternative” strategies that we believe are not highly dependent on tailwinds from stocks and bonds to generate returns.”  Their search led them to hire four experienced fund management teams, each responsible for one sleeve of the fund’s portfolio.

Those teams are:

Matt Eagan and a team from Loomis-Sayles who are charged with implementing an Absolute-Return Fixed-Income which centers on high-yield and international bonds, with the prospect of up to 20% equities.  Their goal is “positive total returns over a full market cycle.”

John Orrico and a team from Water Island Capital, who are charged with an arbitrage strategy.  They manage the Arbitrage Fund (ARBFX) and target returns “of at least mid-single-digits with low correlation” to the stock and bond markets.  ARBFX averages 4-5% a year with low volatility; in 2008, for instance, is lost less than 1%.

Jeffrey Gundlach and the DoubleLine team, who will pursue an “opportunistic income” strategy.  The goal is “positive absolute returns” in excess of an appropriate broad bond index.  Gundlach uses this strategy in at least one hedge fund, a closed-end fund, DoubleLine Core Fixed Income (DLFNX) and Aston and RiverNorth funds for which he’s a subadvisor.

Steve Romick and a team from FPA, who will seek “contrarian opportunities” in pursuit of “equity-like returns over longer periods (i.e., five to seven years) while seeking to preserve capital.”   Romick manages FPA Crescent (FPACX) which wins almost universal acclaim (Five Star, Gold, LipperLeader) for its strong returns, risk consciousness and flexibility.

Litman Gregory picked these teams on two grounds: the fact that the strategies made sense taken as a portfolio and the fact that no one executed the strategies better than these folks.

The strategies are sensible, as a group, because they’re uncorrelated; that is, the factors which drive one strategy to rise or fall have little effect on the others.  As a result, a spike in inflation or a rise in interest rates might disadvantage one strategy while allow others to flourish. The inter-correlations between the four strategies are low (though “how low” will vary depending on market conditions).  Litman anticipates a correlation between the fund and the stock market in the range of 0.5, with a potentially-lower correlation to the bond markets.  That’s far lower than the two-year correlation between U.S. large cap stocks and, say, emerging markets stocks, REITs, international real estate or commodities.

The record of the sub-advisors speaks for itself: these really do represent the “A” team in the “alternatives without idiocy” space.  That is, these folks pursue sensible, comprehensible strategies that have worked over time.  Many of their competitors in the “multi-alternative” category pursue bizarre and opaque strategies (“hedge fund index replicant” strategies using derivatives) where the managers mostly say “trust us” and “pay us.”  On whole, this collection is far more reassuring.

Can Litman Gregory pull it off?  That is, can they convert a good idea and good managers into a good fund?  Likely.  First, the other Litman funds have been consistently solid if somewhat volatile performers.

(all ratings as of 3/30/2012)

Second, Alternative Strategies is likely to fare better than its siblings because of the weakness of its peer group.  As I note above, most of the “multi-alternative” funds are profoundly unattractive and there are no low-cost, high-performance competitors in the space as there is in domestic equities.

Third, the fund’s early performance is promising.  We commissioned an analysis of the fund by the folks at Investment Risk Management Systems (a/k/a FundReveal), who looked at daily volatility and returns, and concluded:

Despite its short existence, the daily returns produced by the fund can indicate the effectiveness of fund investment decision-making . . . We have analyzed the fund performance for 126 market days, using the last 2 rolling quarters of 63 market days each. The daily FundReveal information makes it possible to get an idea of how well the fund is being managed. . . Based on the data available, MASNX is a safe fund which maintains very low risk (volatility). This is important in turbulent and uncertain markets. It is one of the top ranking funds in the safety category. Very few funds have higher ADR (average daily return) and lower Volatility than MASNX.

IRMS and I both add the obvious caveat: it’s still a very limited dataset, reflects the fund’s earliest stages and its performance under a limited set of market conditions.

The final question is, could you do better on your own?  That is, could you replicate the strategy by simply buying equal amounts of four mutual funds?  Not quite.  There are three factors to consider.  First, the portfolios wouldn’t be the same.  Litman has commissioned a sort of “best ideas” subset from each of the managers, which will necessarily distinguish these portfolios from their funds’.  Second, the dynamics between the sleeves of your portfolio – rebalancing and reweighting – wouldn’t be the same.  While each portfolio has a roughly-equal weight now, Litman can move money both to rebalance between strategies and to over- or under-weight particular strategies as conditions change.  Few investors have the discipline to do that sort of monitoring and moving.  Finally, the economics wouldn’t be the same.  It would require $10,000 to establish an equal-weight portfolio of funds (the Loomis minimum is $2500) and Loomis carries a front load that’s not easily dodged.  Assuming a three-year holding period and payment of a front load, the portfolio of funds would cost 1.52% while MASNX costs 1.74%.

Bottom Line

In a February Wall Street Journal piece, I nominated MASNX as one of the three most-promising new funds released in 2011.  In normal times, investors might be looking at a moderate stock/bond hybrid for the core of their portfolio.  In extraordinary times, there’s a strong argument for looking here as they consider the central building blocks for their strategy.

Fund website

Litman Gregory Masters Alternative Strategies.  The fund’s FAQ is particularly thorough and well-written; I’d recommend it to anyone investigating the possibility of investing in the fund.  IRMS provides the more-complete discussion of MASNX on their blog.

2013 Q3 Report

Fund Facts