Dear friends,

They’re baaaaack!

The summer silence has been shattered. My students have returned in endlessly boisterous, hormonally-imbalanced, self-absorbed droves. They’re glued to their phones and to their preconceptions, one about as maddening as the other.

The steady rhythm of the off-season (deal with something else falling off the house, talk to a manager, mow, think, read, write, kvetch) has been replaced by getting up at 5:30 and bolting through days, leaving a blur behind.

Somewhere in the background, Putin threatens war, the market threatens a swoon, horrible diseases spread, politicians debate who among them is the most dysfunctional and someone finds time to think Deep Thoughts about the leaked nekkid pitchers of semi-celebrities.

On whole, it’s good to be back.

Seven things that matter, two that don’t … and one that might

I spoke on August 20^th to about 200 folks at the Cohen Fund client conference in Milwaukee. Interesting gathering, surprisingly attractive city, consistently good food (thanks guys!) and decent coffee. My argument was straightforward and, I hope, worth repeating here: if you don’t start thinking and acting differently, you’re doomed. A version of that text follows.

Your apparent options: dead, dying or living dead

From the perspective of most journalists, many advisors and a clear majority of investors, this gathering of mutual fund managers and of the professionals who make their work possible looks to be little more than a casting call for the Zombie Apocalypse. You are seen, dear friends, as “the walking dead,” a group whose success is predicated upon their ability to do … what? Eat their neighbors’ brains which are, of course, tasty but, and this is more important, once freed of their brains these folks are more likely to invest in your funds.

CBS News declared you “a losing bet.” TheStreet.com declared that you’re dead.  Joseph Duran asked, curiously, “are you a dinosaur?” Schwab declared that “a great question!” Ric Edelman, a major financial advisor, both widely quoted and widely respected, declares, “The retail mutual fund industry is a dinosaur and won’t exist in 10 or 15 more years, as investors are realizing the incredible opportunity to lower their cost, lower their risks and improve their disclosure through low-cost passive products.” When asked what their parents do for a living, your kids desperately wish they could say “my dad writes apps and mom’s a paid assassin.” Instead they mumble “stuff.” In short, you are no longer welcome at the cool kids’ table.

Serious data underlies those declarations. The estimable John Rekenthaler reports that only one-third of new investment money flows to active funds, one third to ETFs and one third to index funds. Drop target-date funds out of the equation and the amount of net inflows to funds is reduced by a quarter. The number of Google searches for the term “mutual funds” is down 80% over the past decade.

Funds liquidate or merge at the rate of 400-500  per year. Of the funds that existed 15 years ago, Vanguard found that 46% have been liquidated or merged. The most painful stroke might have been delivered by Morningstar, a firm whose fortunes were built on covering the mutual fund industry. Two weeks ago John Rekenthaler, vice president and resident curmudgeon, asked the question “do have funds have a future?”  He answered his own question with “to cut to the chase: apparently not much.”

Friends, I feel your pain. Not that zombies actually feel pain. You know if Mr. Cook accidentally rips Mr. Bynum’s arm off and bludgeons him with it, “it’s all good.” But if you did feel pain, I’d be right there with you since in a Zombies Anonymous sort of way I’m obliged to say “Hello. My name is Dave and I’m a liberal arts professor.”

The parallel experience of the liberal arts college

I teach at Augustana College – as school known only to those of you blessed with a Scandinavian Lutheran heritage or to fans of the history of college football.

We operate in an industry much like yours – higher education is in crisis, buffeted by changing demographics – a relentless decline in the number of 17 year old high school graduates everywhere except in a band of increasingly sunbaked states – changing societal demands and bizarre new competitors whose low cost models have caught the attention of regulators, journalists and parents.

You might think, “yeah, but if you’re good – if you’re individually excellent – you’ll do fine.”  “Emerson was wrong, wrong, wrong: being excellent does not imply you’ll be noticed, much less be successful.” 

Remember that “build a better mousetrap and people will beat a path to your door” promise. Nope.  Not true, even for mousetraps. There have been over 4400 patents for mousetraps (including a bunch labeled “better mousetrap”) issued since 1839. There are dozens of different subclasses, including “Electrocuting and Explosive,” “Swinging Striker,” “Choking or Squeezing,” and 36 others. One device, patented in 1897, controls 60% of the market and a modification of it patented in 1903 controls another 15-20%. About 0.6% of patented mousetraps were able to attract a manufacturer.

The whole “succeed in the market because you’re demonstrably better” thing is certainly not true for small colleges. Let me try an argument out with you: Augustana is the best college you’ve never heard of. The best. What’s the evidence?

• We’re #6 among all colleges in the number of Academic All-Americans we’ve produced, #2 behind only MIT as a Division 3 school.
• We were in the top 50 schools in the 20^th century for the number of our graduates who went on to earn doctorates.
• National Survey of Student Engagement (NSSE) and the Wabash National Study both singled us out for the magnitude of gains that our students made over their four years.
• The Teagle Foundation identified use as one of the 12 colleges that define the “Gold Standard” in American higher education based on our ability to vastly outperform given the assets available to us.

And yet, we’re not confident of our future. We’re competing brilliantly, but we’re competing to maintain our share of a steadily shrinking pie. Fewer students each year are willing to even consider a small school as families focus more on price rather than value or on “name” rather than education. Most workers expect to enjoy their peak earnings in their late 40s and 50s.  For college professors entering the profession today, peak lifetimes earnings might well occur in Year One.  After that, they face a long series of pay freezes or raises that come in just below the CPI.  Bain & Company estimate that one third of all US colleges and universities are financially unsustainable; they spend more than the take in and collect debt faster than they build equity. While some colleges will surely fold, the threat for most is less closure than permanent stagnation and increasing irrelevance.

Curious problem: by all but one measures (name recognition), we’re better for students than the household names but no one believes us and few will even consider attending. We’re losing to upstart competitors with inferior products and lumbering behemoths. 

And you are too.

“The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings.”

Half of that is our own fault. We tend to be generic and focused on ourselves, without material understanding of the bigger picture. And half of your problem is your fault: 80% of mutual funds could disappear without any noticeable loss of investors. They don’t matter. There are 500 domestic large core funds. I’d be amazed if anyone could make a compelling case for keeping 90% of them open. More correctly, those don’t matter to anyone but the advisor who needs them for business development purposes.

Here’s the test: would anyone pay good money to buy the fund from you? Get serious: half of all funds can’t draw even a penny’s investment from their own managers (Sarah Max, Fund managers who invest elsewhere). The level of fund trustee investment in the funds they oversee on behalf of the rest of us is so low, especially in the series trusts common among smaller funds, as to represent an embarrassment.

The question is: can you do anything? Will anything you do matter? In order to answer that question, it would help to understand what matters, what doesn’t … and what might.

Herewith: seven things that matter, two that don’t … and one that might.

Seven things that matter.

1. Independence matters. Whether measured by r-squared, tracking error or active share, researchers have generated a huge body of evidence that independent thinking is a prerequisite to outstanding performance. Surprisingly, that’s true on the downside as much as the upside: higher active managers perform better in falling markets than herd-huggers do. But herding behavior is increasing. Where two-thirds of the industry’s assets were once housed in “highly active” funds, that number is now 25% and falling.
2. Size matters. There is no evidence to suggest that “bigger is better” in the mutual fund world, at least once a fund passes the threshold of economic viability. Large funds face two serious constraints. First, their investable universes collapse; that is, if you have $10 billion to invest, there are literally thousands of small companies whose stocks become utterly meaningless to you and your forced to seek a competitive advantage against a few hundred competitors all looking at the same few hundred larger names. Second, larger funds become cash cows generating revenue essential to the adviser’s business. The livelihoods of dozens or hundreds of coworkers depend on having the manager not lose assets, much more than they depend on investment excellence. But money flows to “safe” bloated funds.
3. Alignment of interest matters. Almost all of us know that there’s a lot of research showing that good things happen when fund managers stake their personal fortunes on the success of their funds; in particular, risk-adjusted returns rise. Fewer people know that there appears to be an even stronger effect from substantial ownership by a fund’s trustees: high trustee ownership is linked to lower risk, higher active share and less tolerance of inept management. But, Morningstar reports, something like 500 firms have funds with negligible insider ownership.
4. Risk matters. Investors are far more risk-averse than they know. That’s one of the most frequently observed findings in the behavioral finance literature. No amount of upside offsets a tendency to crash. The sad consequence of misjudged risk is reflected in the Dalbar’s widely quoted calculations showing that investors might pocket as little as one-quarter of their funds’ returns largely because of excess confidence, excess trading and a tendency to run away as the worst possible time.
5. Focus matters. If the goal is to provide better (not necessarily higher, but perhaps steadier, more explicable, less volatile) returns than a broad market index, then you need to look as little like the index as possible. Too many folks become “fund collectors” with sprawling portfolios, just as too many fund managers to commit to marginal ideas.
6. Communication matters. I need to mention this because I’m, well, a professor of communication studies and we know it to be true. In general, communication from mutual funds to their investors (how to put this politely?) sucks. Websites get built for the sake of having a pretty side. Semi-annual reports get written because the SEC says to (but doesn’t say that you actually need to write anything to your investors, and many don’t). Shareholder letters get written to a template and conference calls are managed to assure that there’s no risk of anything interesting or informative breaking out. (If I hear the term “slide deck,” as in “on page 157 of your slide deck,” I’ll scream.) We know that most investors don’t understand why they’re invested or what their funds do. We know that when investors “get it,” they stay (look at Jared Peifer’s “Fund loyalty among socially responsible investors” for a study of folks who really think about their investments before making them). 
7. Relationships matter. Managers mumbling the mousetrap mantra believe that great performance will have the world beating a path to their door. It won’t. A fascinating study by the folks at Gerstein Fisher (“Mutual fund outperformance and growth,” Journal of Investment Management, 2014) offered an entirely maddening conclusion: good performance draws assets if you’re large, but has no effect on assets if you have under a quarter billion in assets. So how do smaller funds prosper? At least from our experience, it is by having a story that makes sense to investors and a nearly evangelical advocate to tell that story, face to face, over and over. Please flag this thought: it’s not whether you’re impressed with your story. It’s not whether it makes sense to you. It’s whether it makes enough sense to investors that, once you’re gone, they can explain it with conviction to other people.

Two things that don’t. 

1. Great returns don’t matter. Beating the market doesn’t matter. Beating your peers doesn’t matter. It’s impossible to do consistently (“peer beating” is, by definition, zero sum), it doesn’t draw assets and it doesn’t necessarily serve your investors’ needs. Consistent returns, consistently explained, might matter.
2. Morningstar doesn’t matter. A few of you might yet win the lottery and get analyst coverage from Morningstar, but you should depend on that about the way you depend on winning the Powerball. Recent feature on “Under the Radar” funds gives you a view of Morningstar’s basement: these seven funds were consistently excellent, averaged $400 million in assets and 12 years of manager tenure – and they were still “under the radar.” In reality, Morningstar doesn’t even know that you exist. More to the point: the genius of independent funds is that they’re not cookie-cutters, but Morningstar is constrained to use a cookie-cutter. The more independent you are, the more likely that Morningstar will give you a silly peer group.

This is not, by the way, a criticism of Morningstar. I like a lot of the folks there and I know they often work like dogs to get it right. It’s simply a reflection on their business model and the complexity of the task before them. In attempting to do the greatest good for the greatest number (and to serve their shareholders), they’re inevitably drawn to the largest, most popular funds.

The one thing that might matter? 

I might say “the Observer” does.  We’ve got 26,000 readers and we’ve had the opportunity to work with dozens of journalists.  We’ve profiled over 125 smaller funds, exceeding the number of Morningstar’s small fund profiles by, well, 120.  We know you’re there and know your travails.  We’re working really hard to help folks think more clearly about small, independent funds in general and by a hundred of so really distinguished smaller funds in particular.

But a better answer is: you might matter.

But do you want to?

It is clear that we can all do our jobs without mattering.  We can attend quarterly meetings, read thick packets, listen thoughtfully to what we’ve been told, ask a trenchant question (just to prove that we’ve been listening) … and still never make six cents worth of difference to anyone. 

There may have been a time, perhaps in the days of “a rising tide,” when firms could afford to have folks more interested in getting along than in making a difference.  Those days are passed.  If you aren’t intent on being A Person Who Matters, you need to go.

How might you matter?

1. Figure out whether you have a reason to exist.  Ask “what’s the story supposed to be?”  Look at the prospect that “your” story is so painfully generic or agonizingly technical than it means nothing to anyone.  And if you’ve got a good story, tell it passionately and well. 
2. Align your walking and your talking.  First, pin your personal fortune on the success of your funds.  Second, get in place a corporate policy that ensures everyone does likewise.  There are several fine examples of such policies that you might borrow from your peers.  Third, let people know what your policy is and why it matters to them.
3. Help people succeed.  Very few of the journalists who might share your message actually know enough to do it well.  And they often know it and they’d like to do better.  Great!  Find the time to help them succeed.  Become a valuable source of honest assessment, suggest story possibilities, notice when they do well.  That ethos is not limited to aiding journalists.   Help other independent funds succeed, too.  Tell people about the best of them.  Tell them what’s worked for you.  They’re not your enemies and they’re not your competitors.  They might, however, become part of a community that can help you survive.
4. Climb out of your silo.  Learn stuff you don’t need to know.  I know compliance is tough. I know those board packets are thick. But that’s not an excuse.  Bill Bernstein earned a PhD in chemistry, then MD in neurology, pursued the active practice of medicine, started writing about asset allocation and the efficient frontier, then advising, then writing books on topics well afield of his specialties. Bill writes:  “As Warren Buffett famously observed, investing is not a game in which the person with an IQ of 160 beats the persons with an IQ of 130.  Rather, it’s a game best played by those with a broad set of skills that are rich not only in quantitative ability but also in deep historical knowledge, all deployed with an Asperger’s-like emotional detachment.”  Those of us in the liberal arts love this stuff.
5. Build relationships, perhaps in odd ways.  Trustees: you were elected to represent the fund’s shareholders so why are you hiding from them?  Put your name and address on the website and let them know that if they have a concern, you’ll listen. Send a handwritten card to every new investor, at least those who invest directly with the fund.  Tell them they matter to you.  Heck, send them an anniversary card a year after they first invest, signed by you all.  When they go, ask “why?”  This is the only industry I’ve ever worked with that has precisely zero interest in customer loyalty.
6. Be prepared to annoy people.  Frankly, you’re going to be richly rewarded, financially and interpersonally, for your willingness to go away.  If you try to change things, you’re going to upset at least some of the people in every room.  You’re going to hear the same refrain, over and over: “But no one does that.”
7. Stop hiring pretty good people. Hire great ones, or no one. The hallmark of dynamic, rising institutions is their insistence on bringing in people who are so good it kind of scares the folks who are already there. That’s been the ethos of my academic department for 20 years. It is reflected in the Artisan Fund’s insistence that they will hire in only “category killers.” They might, they report, interview several dozen management teams a year and still make only one hire every two or three years. Check their record of performance and market success and draw your own conclusion. Achieving this means that you have to be a great place to work. You have to know why it’s a great place, and you have to have a strategy for making outsiders realize it, too.

Which is precisely the point. Independence is not merely a matter of portfolio construction. It’s a matter of innovation, responsibility and stewardship. It requires that you look beyond safety, look beyond asset gathering and short-term profit maximization to answer the larger question: is there any reason for us to exist?

It’s your decision. It is clear to me that business as usual will not work, but neither will hunkering down and hoping that it all goes away. Do you want to matter, or do you want to hold on – hoping that you’ll make it through despite the storm?  Like the faculty near retirement. Like Louis XV who declared, “Après moi, le déluge”. Mr. Rekenthaler concludes that “active funds retreat further into silence.” Do you want to prove him right or wrong?

If you want to make a difference, start today. Start here. Start today. Take the opportunity to listen, to talk, to learn and to decide. To decide to make all the difference you can. Which might be all the difference in the world.

From Charles’s Balcony: Why Am I Rebalancing?

Long-time MFO discussion board member AKAFlack emailed me recently wondering how much investors have underperformed during the current bull market due to the practice of rebalancing their portfolios.

For those that rebalance annually, the answer is…almost 12% in total return from March 2009 through June 2014. Not huge given the healthy gains, but certainly noticeable. The graph below compares performance for a buy & hold and an annually rebalanced portfolio, assuming an initial investment of $10,000 allocated 60% to stocks and 40% to bonds.

So why rebalance?

According to a good study by Vanguard, entitled “Best practices for portfolio rebalancing,” the answer is not to maximize return. “If the sole objective is to maximize return regardless of risk, then the investor should select a 100% equity portfolio.”

The purpose of rebalancing, whether done periodically or by threshold deviation, is to keep a portfolio risk composition consistent with an investor’s tolerance, as defined by their target allocation. Otherwise, investors “can end up with a portfolio that is over-weighted to equities and therefore more vulnerable to equity-market corrections, putting the investors’ portfolios at risk of larger losses compared with their target portfolios.” This situation is evidenced in the allocation shown above for the buy & hold portfolio, which is now at nearly 80/20 stocks/bonds.

In this way, rebalancing is one way to keep loss aversion in check and the attendant consequences of selling and buying at all the wrong times, often chronicled in Morningstar’s notorious “Investor Return” tracking metric.

Balancing makes up ground, however, when equities are temporarily undervalued, like was the case in 2008. The same comparison as above but now across the most current full market cycle, beginning in November 2007, shows that annual balancing actually slighted outperformed the buy & hold portfolio.

In his book “The Ivy Portfolio,” Mebane Faber presents additional data to support that “there is a clear advantage to rebalancing sometime rather than letting the portfolio drift. A simple rebalance can add 0.1 to 0.2 to the Sharpe Ratio.”

If your first investment priority is risk management, occasional rebalancing to your target allocation is one way to help you sleep better at night, even if it means underperforming somewhat during bull markets.

Edward, Ex Cathedra: Money money money money money money

“The mystery of the world is the visible, not the invisible.”

                                                                    Oscar Wilde

This has been an interesting month in the world of mutual funds and fund managers. First we have Charles D. Ellis, CFA with another landmark (and land mine) article in the Financial Analysts Journal entitled “The Rise and Fall of Performance Investing.” For some years now, starting with his magnum opus for institutional investors entitled “Winning the Loser’s Game,” Ellis has been arguing that institutional (and individual) investors would be better served by using passive index funds for their investments, rather than hiring active managers who tend to underperform the index funds. By way of disclosure, Mr. Ellis founded Greenwich Associates and made his fortune selling services to those active managers that he now writes about with the zeal of a convert.

Nonetheless the numbers he presents are fairly compelling, and for that reason difficult to accept. I am reminded of one of my former banking colleagues who was always looking for the pony that he was convinced was hidden underneath the manure in the room. I can see the results of this thinking by scanning some of the discussions on the Mutual Fund Observer bulletin board. Many of those discussions seem more attuned with how smart or lucky one was to invest with a particular manager before his or her fund closed, rather than how the investment has actually performed. And I am not talking about the performance numbers put out by the fund companies, which are artificial results for artificial investors. No, I’m talking about the real results obtained by putting the moneys invested and time periods into one’s HP12C calculator to figure out the returns. Most people really do not want to know those numbers, otherwise they become forced to think about Senator Warren’s argument that “the game is rigged.”

Ellis however makes a point that he has made before and that I have covered before. However I feel it is so important that it is worth noting again. Most mutual fund advertising or descriptions involving fees consist of one word and a number. The fee is “only” 1% (or less for most institutional investors). The problem is that that is a phrase worthy of Don Draper, as the 1% is related to the assets the investor has given to the fund company. Yet the investor already owns the assets. What is being promised then? The answer is returns. And if one accepts the Ibbotson return histories for large cap common stocks in the U.S. as running at 8 – 10% per year over a fifty-year period, we are talking about a fee running from 10 – 12.5% a year based on returns. 

Taking this concept one step further Ellis suggests what you really should be looking at in assessing fees are the “incremental fee as a percentage of incremental returns after adjusting for risk.” And using those criteria, we would see something very different given that most active investment managers are underperforming their benchmark indices, namely that the incremental fees are above 100% Ellis goes on to raise a number of points in his article. I would like to focus on just one of them for the remainder of this commentary. One of Ellis’ central questions is “When will our clients decide that continuing to take all the risks and pay all the costs of striving to beat the market with so little success is no longer a good deal for them?”

My assessment is that we have finally hit the tipping point, and things are moving inexorably in that direction. Two weeks ago roughly, it was announced that Vanguard now has more than $3 trillion worth of assets, much of it in passive products. Jason Zweig recently wrote an article for The Wall Street Journal suggesting that the group of fund and portfolio managers in their 30’s and 40’s should start thinking about alternative careers, possibly as financial planners giving asset allocation advice to clients. The Financial Times suggests in an article detailing the relationship between Bill Gross at PIMCO and the analyst that covered him at Morningstar that they had become too close. The argument there was that Morningstar analysts had become co-opted by the fund industry to write soft criticism in return for continued access to managers. My own observational experience with Morningstar was that their mutual fund analysts had been top shelf when they were interviewing me and both independent and objective. I can’t speak now as to whether the hiring and retention criteria have changed. 

My own anecdotal observations are limited to things I see happening in Chicago. My conclusion is that the senior managers at most of the Chicago money management firms are moving as fast as they can to suck as much money out of their businesses as quickly as possible. In some respects, it has become a variation on musical chairs and that group hears the music slowing. So you will see lots of money in bonus payments. Sustainability of the business will be talked about, especially as a sop to absentee owners, but the businesses will be under-invested in, especially with regard to personnel. What do I base that on? Well, at one firm, what I will call the boys from Winnetka and Lake Forest, I was told every client meeting now starts with questions about fees. Not performance, but fees are what is primary in the client minds. The person who said this indicated he is fighting a constant battle to see that his analyst pool is being paid commensurate with the market notwithstanding an assumption by senior management that the talent is fungible and could easily be replaced at lower prices. At another firm, it is a question of preserving the “collegiality” of the fund group’s trustees when they are adding new board members. As one executive said to me about an election, “Thank God they had two candidates and picked the less problematic one in terms of our business and causing fee issues for us.”

The investment management business, especially the mutual fund business, is a wonderful business with superb returns. But to use Mr. Ellis’ phrase, is it anything more now than a “crass commercial business?” How the industry behaves going forward will offer us a clue. Unfortunately, knowing as many of the players as well as I do leads me to conclude that greed will continue to be the primary motivator. Change will not occur until it is forced upon the industry.

I will leave you with a scene from a wonderful movie, The Freshman (with Marlon Brando and Matthew Broderick) to ponder.

“This is an ugly word, this scam.  This is business, and if you want to be in business, this is what you do.”

                               Carmine Sabatini as played by Marlon Brandon

Categories Morningstar doesn’t recognize: Short-term high-yield income

There are doubtless a million ways to slice and dice the seven or eight thousand extant funds into categories. Morningstar has chosen to create 105 categories in hopes of (a) creating meaningful peer comparisons and (b) avoid mindless proliferation of categories. We’re endlessly sympathetic with their desire to maintain a disciplined, manageable system. That said, the Observer tracks some categories of funds that Morningstar doesn’t recognize, including short-term high yield, emerging markets balanced and absolute value equity.

We think that these funds have two characteristics that might be obscured by Morningstar’s assignment of them to a larger category of fundamentally different funds. First, it causes funds to be misjudged if their risk profiles vary dramatically from the group’s. Short-term high yield, for example, are doomed to one- and two-star ratings. That’s not because they fail. It’s because they succeed in a way that’s fundamentally different from the majority of their peer group. In general, high yield funds have risk profiles similar to stock funds. Short-term high yield funds have dramatically lower volatility and returns closer to a short term bond fund’s than a high yield fund’s.

[High yield/orange, ST high yield blue, ST investment grade green]

Morningstar’s risk-adjusted returns calculation is far less sensitive to risk than the Observer’s is; as a risk, the lower risk is blanketed by the lower returns and the funds end up with an undeservedly wretched rating.

Bottom line: investors who need to earn more than the payout of a money market fund (0.01% ytd) or certificates of deposit (currently 1.1% annually) might take the risk of a conventional short-term bond fund (in the hopes of making 1-2%) or might be lured by the appeal of a complex market neutral derivatives strategy (paying 2% to make 3%). Another path that might reasonably consider are short-term high yield funds that take on greater risk but whose managers generally recognize that fact and have risk-management tools at hand.

The Observer has profiled three such funds: Intrepid Income, RiverPark Short-Term High Yield (now closed to new investors) and Zeo Strategic Income.

Short-term, high Income peer group, as of 9/1/14

Over the next several months we’ll be reviewing the performance of some of these unrecognized peer groups, in hopes of having folks look beyond the stars. 

To the New Castle County executives: I know your intentions were good, but …

Shortly after taking office, the new county executive for New Castle County, Delaware, made a shocking discovery: someone has nefariously invested the taxpayers’ money in two funds that (gasp!) earned one-star from Morningstar and were full of dangerous high yield investments. The executive in question, not pausing to learn anything about what the funds actually do, snapped into action. He rushed “to protect the County reserves from the potential of significant financial loss and undo risk by directing the funds to be placed in an account representing the financial security values associated with taxpayer dollars” by giving the money to UBS (a firm fined $1.5 billion two years ago in a “rogue trading” scandal). And then he, or the county staff, wrote a congratulatory press release (New Castle County Executive Acted Quickly to Protect Taxpayer Reserves).

The funds in question were RiverPark Short-Term High Yield (RPHYX) which is one of the least volatile funds in existence and which has posted the industry’s best Sharpe ratio, and FPA New Income (FPNIX), which Morningstar celebrates as an ultra-conservative choice in the face of deteriorating markets: “thanks to its super-low volatility, its five-year Sharpe ratio, a measure of risk-adjusted returns, bests all it but one of its competitors’ in both groups.”

The press release doesn’t mention how or where UBS will be investing the taxpayer’s dollars but it does sound like UBS has decided to work for free: enviable savings resulted from the fact that New Castle County “does not pay investment management fees to UBS.”

Due diligence requires going beyond a cursory reading. It turns out that The Tale of Two Cities is not a travelogue and that Animal Farm really doesn’t offer much guidance on animal husbandry, titles notwithstanding. And it turns out that the county has sold two exceptionally solid, conservative funds – funds with about the best risk-adjusted returns possible – based on a cursory reading and spurious concerns.

Observer Fund Profiles: AKREX and MAINX

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. 

Akre Focus (AKREX): the only question about Akre Focus is whether it can be as excellent in the future has it, and its predecessors, have been for the past quarter century. 

Matthews Asia Strategic Income (MAINX): against all the noise in the markets and in the world news, Teresa Kong remains convinced that your most important sources of income in the decades ahead will increasingly be centered in Asia.  She’ll doing an exceptional job of letting you tap that future today.

Elevator Talk: Brent Olsen, Scout Equity Opportunity (SEOFX)

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.

Brent Olson is the lead portfolio manager of the Scout Equity Opportunity Fund. He joined the firm in 2013 and has more than 17 years of professional investment experience. Prior to joining Scout, Brent was director of research and a portfolio manager with Three Peaks Capital Management, LLC. From 2010-2013, Brent comanaged Aquila Three Peaks Opportunity Growth (ATGAX) and Aquila Three Peaks High Income (ATPAX) with Sandy Rufenacht. Before that, he served as an equity analyst for Invesco and both a high-yield and equity analyst for Janus.

Scout Equity Opportunity proposes to invest in leveraged companies. Leveraged companies are firms that have accumulated, or are accumulating, a noticeable level of debt on their books. These are firms that are, or were, dependent on borrowing to finance operations. Many equity investors, particularly those interested in “high quality stocks,” look askance at the practice. They’re interested in firms with low debt-to-equity ratios and the ability to finance operations internally.

Nonetheless, leveraged company stock offers the prospect for outsized gains. Tom Soviero of Fidelity Leveraged Company Stock Fund (FLVCX) captured more than 150% of the S&P 500’s upside over the course of a decade (2003-2013). The Credit Suisse Leveraged Equity Index substantially outperformed the S&P500 over the same period. Why so? Three reasons come to mind:

1. Debt adds complexity, which increases the prospects for mispricing. Beyond the simple fact that most equity investors are not comfortable analyzing the other half of a firm’s capital structure, there are also several different kinds of debt, each of which adds its own complexity.
2. Debt can be used wisely, which allows firms to increase their return on equity, especially when the cost of debt is low and the stock market is already rising.
3. Indebtedness increases a firm’s accountability and transparency, since they gain the obligation to report to creditors, and to pay them regularly. They are, as a result, less free to make dumb decisions than managers deploying internally-generated capital.

The downside to leveraged equity investing is, well, the downside to leveraged equity investing.  When the market falls, leveraged company stocks can fall harder and faster than most.  By way of illustration, Fidelity Leverage Company dropped 55% in 2008. That makes it hard for many investors to hold on; indeed, by Morningstar’s calculations, Mr. Soveiro’s invested managed to pocket less than a third of his fund’s excellent returns because they tended to bail when the pain got too great.

Brent Olson knows the tale, having co-managed for three years a fund with a similar discipline.  He recognizes the importance of risk control and thinks that he and the folks at Scout have found a way to manage some of the strategy’s downside.

Here are Brent’s 200 words on what a manager sensitive to high-yield fixed-income metrics brings to equity investing:

We believe superior risk-adjusted relative performance can be achieved through long-term ownership of a diversified portfolio of levered stocks. We recognize debt metrics as a leading indicator for equity performance – our adage is “credit leads, equity follows” – and so we use this as the basis for our disciplined investment process. That perspective allows us to identify companies that we believe are undervalued and thus attractive for investors.

We focus our attention on stable industries with lots of free cash flow.  Within those industries, we’re looking at companies that are either using credit improvement through de-levering their balance sheet, though debt paydown or refinancing, or ones that are reapplying leverage to transform themselves, perhaps through growth or acquisitions. At the moment there are 68 names in the portfolio. There are roughly 50 other names that we’re actively monitoring with about 10 that are getting close.

We’ve thought a lot about risk management. One of the most attractive aspects of working at Scout is the deep analyst bench, and especially the strength of our fixed income team at Reams Asset Management. That gives me access to lots of data and first-rate analysis. We also can move 20% of the portfolio into fixed income in order to dampen volatility, the onset of which might be signaled by wider high-yield spreads. Finally, we can raise the ratings quality of our portfolio names.

Scout Equity Opportunity has a $1000 minimum initial investment which is reduced to a really friendly $100 for IRAs and accounts established with an automatic investing plan. Expenses are capped at 1.25% and the fund has about gathered about $7 million in assets since its March 2014 launch. Here’s the fund’s homepage. Investors intrigued by the characteristics of leveraged equity might benefit from reading Tom Soveiro’s white paper, Opportunities in Leveraged Equity Investing (2014).

Launch Alert: Touchstone Large Cap Fund (TLCYX)

On July 9, Touchstone Investments launched the Touchstone Large Cap Fund, sub-advised by The London Company. The London Company is Virginia-based RIA with over $8.7 billion in assets under management. The firm subadvises several other US-domiciled funds including:

Hennessy Equity and Income (HEIFX), since 2007. HEIFX is a $370 million, five-star LCV fund that The London Company jointly manages with FCI Advisors.

Touchstone Small Cap Core (TSFYX), since 2009. TSFYX is an $830 million, four-star SCB fund.

Touchstone Mid Cap (TMCPX), since 2011. TMCPX is a $460 million, three-star mid-cap blend fund.

American Beacon The London Company Income Equity (ABCYX), since 2012. It’s another LCV fund with about $275 million in assets.

The fund enters the most crowded part of the equity universe: large cap domestic stock.  Depending on how you count, there are 466 large blend funds. The new Touchstone fund proposes to invest in 30-40 US large cap stocks.  In particular they’re looking for financially stable firms that will compound returns over time.  Rather than looking at earnings per share, they “pay strict attention to each company’s sustainability of return on capital and resulting free cash flow and balance sheet to derive its strategic value.”  The argument is that EPS bounces, is subject to gaming and is not predictive.  Return on capital tends to be a stable predictor of strong future performance.  They target buying those firms at a 30-40% discount to intrinsic value and holding them for relatively long periods.

It’s a sound and attractive strategy.  Still, there are hundreds of funds operating in this space and dozens that might lay plausible claim to a comparable discipline. Touchstone’s president, Steve Graziano, allows that this looks like a spectacularly silly move:

If I wasn’t looking under the hood and someone came to me to launch a large cap core fund, I’d say “you must be crazy.”  It’s an overpopulated space, a stronghold of passive investing.

The reason to launch, Mr. Graziano argues, is TLC’s remarkable discipline.  They’ve used this same strategy for over 15 years in its private accounts.  Their large core composite has returned 9.7% annually over the last decade through June 30, 2014. During the same time, the S&P500 returned 7.8%.  They’ve beaten the S&P500 over the past 3, 5, 10 and 15 year periods.  The margin of victory has ranged from 130-210 bps, depending on the time period.

The firm argues that much of the strategy’s strength comes from its downside protection: “[Our] large cap core strategy focuses on investing primarily in conservative, low‐beta, large cap equities with above average downside protection.”  Over the past five years, the strategy captured 62% of the market’s downside and 96% of its upside.  That’s also reflected in the strategy’s low beta (0.77, which is striking for a fully-invested equity strategy) and low standard deviation (12.6, about 300 bps below the market’s).

Of the 500 or so large cap blend funds, only 23 can match the 9.7% annualized10-year returns for The London Company’s Large Core Strategy. Of those, only one (PIMCO StocksPlus Absolute Return PSPTX) can also match its five-year returns of 20.7%.

The minimum initial investment in the retail class is $2500, reduced to $1000 for IRAs. The expenses are capped at 1.49%. Here’s the fund’s homepage.  While it reflects the performance of the separate accounts rather than the mutual fund’s, TLC’s Large Cap Core quarterly report contains a lot of useful information on the strategy’s historic profile.

Pre-launch Alert: PSP Multi-Manager (CEFFX)

In a particularly odd development, the legal husk of the Congressional Effect Fund is being turned to good use.  As you might recall, Congressional Effect (CEFFX) was (along with the Blue Funds) another of a series of political gestures masquerading as investment vehicles. Congressional Effect went to cash whenever (evil, destructive) Congress was in session and invested in stocks otherwise. Right: out of stocks during the high-return months and in stocks over the summer and at holidays. Good.

The fund’s legal structure has been purchased by Pulteney Street Capital Management, LLC and is soon to be relaunched as the PSP Multi-Manager Fund (ticker unknown). The plan is to hire experienced managers who specialize in a set of complementary alternative strategies (long/short equity, event-driven, macro, market neutral, capital structure arbitrage and distressed) and give each of them a slice of the portfolio.  The management teams represent EastBay Asset Management, Ferro Investment Management, Riverpark Advisors, S.W. Mitchell Capital, and Tiburon Capital Management. The good news is that the fund features solid managers and a low minimum initial investment ($1000). The bad news is that the expenses (north of 3%) are near the level charged by T’ree Fingers McGurk, my local loan shark sub-prime lender.

Funds in Registration

Our colleague David Welsch tracked down 17 new no-load, retail funds in registration this month.  In general, these funds will be available for purchase by around Halloween.  (Caveat emptor.) They include new offers from several A-tier families including BBH, Brown Advisory,and Causeway.  Of special interest is the new Cambria Global Asset Allocation ETF (GAA), a passive fund tracking an active index.  Charles is working to arrange an interview with the manager, Mebane Faber, during the upcoming Morningstar ETF conference.

Manager Changes

Chip reports a huge spike in the number of announced manager or management team changes this month, with 73 recorded changes, about 30 more than we’ve being seeing over the summer months. A bunch are simple games of musical chairs (Ivy and Waddell & Reed are understandably re-allocating staff) and about as many are additions of co-managers to teams, but there are a handful of senior folks who’ve announced their retirements.

Top Developments in Fund Industry Litigation – August2014

Fundfox is the only intelligence service to focus exclusively on litigation involving U.S.-registered investment companies, their directors and advisers. Publisher David Smith has agreed to share highlights with us. For a complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

New Lawsuits

• Davis was hit with a new excessive-fee lawsuit regarding its N.Y. Venture Fund (the same fund already involved in another pending fee litigation). (Chill v. Davis Selected Advisers, L.P.)
• Alleging the same fee claim but for a different damages period, plaintiffs filed an “anniversary complaint” in the excessive-fee litigation regarding six Principal LifeTime funds. (Am. Chems. & Equip., Inc. 401(k) Ret. Plan v. Principal Mgmt. Corp.)

Order

• The court partly denied motions to dismiss a shareholder’s lawsuit regarding four Morgan Keegan closed-end funds, allowing misrepresentation claims under the Securities Act to proceed. (Small v. RMK High Income Fund, Inc.)

Certiorari Petition

• Plaintiffs have filed a writ of certiorari seeking Supreme Court review of the Eighth Circuit’s ruling in an ERISA class action that challenged Fidelity‘s use of the float income generated by transactions in retirement plan accounts. (Tussey v. ABB, Inc.)

Briefs

• Davis filed a motion to dismiss excessive-fee litigation regarding its N.Y. Venture Fund. (Hebda v. Davis Selected Advisers, L.P.)
• Putnam filed its opening brief in the appeal of a fraud lawsuit regarding its collateral management services to a CDO; and the plaintiff filed a reply. (Fin. Guar. Ins. Co. v. Putnam Advisory Co.)
• Plaintiffs filed their opposition to Vanguard‘s motion to dismiss a lawsuit regarding investments by two funds in offshore online gambling businesses; and Vanguard filed its reply brief. (Hartsel v. Vanguard Group, Inc.)

David Hobbs, president of Cook & Bynum, and I were talking at the Cohen Fund conference about the challenges facing fund trustees.  David mentioned that he encourages his trustees to follow David Smith’s posts here since they represent a valuable overview of new legal activity in the field.  That struck me as a thoughtful initiative and so I thought I’d pass David H’s suggestion along.

A cool resource for folks seeking “liquid alts” funds

The folks at DailyAlts maintain a list of all new hedge fund like mutual funds and ETFs. The list records 52 new funds launched between January and August 2014 and offers a handful of useful data points as well as a link to a cursory overview of the strategy.

I stumbled upon the site in pursuit of something else. It struck me as a cool and useful resource and led me to a fair number of funds that were entirely new to me. Kudos to Editor Brian Haskin and his team for the good work.

Briefly Noted . . .

Arrowpoint Asset Management LLC has increased its stake in Destra Capital Management, adviser to the Destra funds, to the point that it’s now the majority owner and “controlling person” of the firm.

Causeway’s bringing it home: pending shareholder approval, Causeway International Opportunities Fund (CIOVX) will be restructured from a “fund of funds” to “a fund making direct investments in securities.” The underlying funds in question are institutional shares of Causeway’s two other international funds – Emerging Markets (CEMIX) and International Opportunities Value(CIVIX) – so it’s hard to see how much gain investors might expect. The downside: the fund needs to entirely liquidate its portfolio which will trigger “a significantly higher taxable distribution” than investors are used to. In a slightly-stern note, Causeway warns “taxable investors receiving the distributions should be prepared to pay taxes on them.” The effect of the change on the fund’s expense ratio is muddled at the moment. Morningstar’s reported e.r. for the fund, .36%, doesn’t include the expense ratios of the underlying funds. With the new fund’s expense ratio not set, we have no idea about whether the investors are likely to see their expenses rise or fall. 

Morningstar, due to their somewhat confused reporting on the expense ratios of funds-of-funds, derides the 36 basis point fee as “high”, when they should be providing the value of the expense ratio of both the fund and it’s underlying holdings. (Thanks, Ira!)

Effective August 21, FPA Crescent Fund (FPACX) became free to invest more than 50% of its assets overseas.  Direct international exposure was previously capped at 50%.  No word yet as to why.  Or, more pointedly, why now?

Jeffrey Gundlach, DoubleLine’s founder, is apparently in talks about buying the Buffalo Bills. I’m not sure if anyone mentioned to him that E.J. Manuel (“Buffalo head coach Doug Marrone already is lowering the bar of expectation considerably for the team’s 2013 first-round pick”) is all they’ve got for a QB, unless of course The Jeffrey is imagining himself indomitably under center. That’s far from the oddest investment by a mutual fund billionaire. That honor might go to Ned Johnson’s obsessive pursuit of tomato perfection through his ownership of Backyard Farms.

On or about November 3, 2014, the principal investment strategies of the Manning Napier Real Estate and Equity Income will change to permit the writing (selling) of options on securities.

Another tough month for Marsico.  With the departure (or dismissal) of James Gendelman,  Marsico International Opportunities (MIOFX) loses its founding manager and Marsico Global (MGBLX)loses the second of its three founding managers. On the same day they lost their sub-advisory role at Litman Gregory Masters International Fund (MNILX).  Five other first-rate teams remain with the fund, whose generally fine record is marred by substantially losses in 2011.  In April 2012, one of the management teams – from Mastholm Asset Management – was dropped and performance on other sides of 2011 has been solid.

Royce Special Equity Multi-Cap Fund (RSMCX) has declared itself, and its 30 portfolio holdings, “non-diversified.”

T. Rowe Price Spectrum Income (RPSIX) is getting a bit spicy. Effective September 1, 2014, the managers may invest between 0 – 10% of the fund’s assets in T. Rowe Price Emerging Markets Local Currency Bond Fund, Floating Rate Fund, Inflation Focused Bond Fund, Inflation Protected Bond Fund, and U.S. Treasury Intermediate Fund.

SMALL WINS FOR INVESTORS

Effective immediately, 361 Global Macro Opportunity, Managed Futures Strategy and Global Managed Futures Strategy fund will no longer impose a 2% redemption fee.

That’s a ridiculously small number of wins for our side.

CLOSINGS (and related inconveniences)

On September 19, 2014, Eaton Vance Multi-Cap Growth Fund (EVGFX) will be soft-closed.  One-star rating, $162 million in assets, regrettable tendency to capture more downside (108%) than upside (93%), new manager in November 2013 with steadily weakening performance since then.  This might be the equivalent of a move into hospice care.

Effective September 5, 2014, Nationwide International Value Fund (NWVAX) will close to new investors.  One star rating, $22 million in assets, a record the trails 87% of its peers: Hospice!

OLD WINE, NEW BOTTLES

Effective October 1, 2014, Dunham Loss Averse Equity Income Fund (DAAVX/DNAVX) will be renamed Dunham Dynamic Macro Fund.  The revised fund will use “a dynamic macro asset allocation strategy” which might generate long or short exposure to pretty much any publicly-traded security.

Effective October 31, 2014, Eaton Vance Large-Cap Growth Fund (EALCX) gets renamed Eaton Vance Growth Fund.  The change seems to be purely designed to dodge the 80% rule since the principle investment strategies remain unchanged except for the “invests 80% of its assets in large” piece.  The fund comes across as modestly overpriced tapioca pudding: there’s nothing terribly objectionable about it but, really, why bother?  At the same time Eaton Vance Large-Cap Core Research Fund (EAERX) gains a bold new name: Eaton Vance Stock Fund.  With an R-squared that’s consistently over 98 but returns that trailed the S&P in four of the past five calendar years, it might be more accurately renamed Eaton Vance “Wouldn’t You Be Better in a Stock Index Fund?” Fund.

Oh, I know why that would be a bad name.  Because, the prospectus declares “Particular stocks owned will not mirror the S&P 500 Index.” Right, though the portfolio as a whole will.

Eaton Vance Balanced Fund (EVIFX) has become a fund of two Eaton Vance Funds: Growth and Investment Grade Income.  It’s a curious decision since the fund has had substantially above-average returns over the past five years.

Effective on October 1, 2014. Goldman Sachs Core Plus Fixed Income Fund becomes Goldman Sachs Bond Fund

On or around October 21, 2014, JPMorgan Multi-Sector Income Fund (the “Fund”) becomes the JPMorgan Unconstrained Debt Fund. Its principal investment strategy is to invest in (get ready!) “debt.” The list of allowable investments offers a hint, in listing two sorts of bank loans first and bonds fifth.

OFF TO THE DUSTBIN OF HISTORY

If you’ve ever wondered how big the dustbin of history is, here’s a quick snapshot of it from the Investment Company Institute’s latest Factbook. In broad terms, 500 funds disappear and 600 materialize in the average year. The industry generally sees healthy shakeouts in the year following a market crash.

Ron Rowland, founder of Invest With an Edge and editor of AllStarInvestor.com, maintains the suitably macabre ETF Deathwatch which each month highlights those ETFs likeliest to be described as zombies: funds with both low assets and low trading volumes.  The August Deathwatch lists over 300 ETFs that soon might, and perhaps ought to, become nothing more than vague memories.

This month’s entrants to the dustbin include AMF Intermediate Mortgage Fund (ASCPX)and AMF Ultra Short Fund (AULTX), both slated to liquidate on September 26, 2014.

AllianceBernstein International Discovery Equity (ADEAX) and AllianceBernstein Market Neutral Strategy — Global (AANNX)will be liquidated and dissolved (how are those different?) on October 10, 2014.

Around December 19^th, Clearbridge Equity Fund (LMQAX) merges into ClearBridge Large Cap Growth Fund (SBLGX).  LMQAX has had the same manager since 1995.

On Aug. 20, 2014, the Board of Trustees of Voyageur Mutual Funds unanimously voted and approved a proposal to liquidate and dissolve Delaware Large Cap Core Fund (DDCAX), Delaware Core Bond Fund (DPFIX) and Delaware Macquarie Global Infrastructure Fund (DMGAX). The euthanasia will occur by late October but they did not specify a date.

Direxion Indexed CVT Strategy Bear Fund (DXCVX) and Direxion Long/Short Global Currency Fund (DXAFX)are both slated to close on September 8^th and liquidate on September 22^nd.  Knowing that you were being eaten alive by curiosity, I checked: DXCVX seeks to replicate the inverse of the daily returns of the QES Synthetic Convertible Index. At base, it shorts convertible bonds.  Morningstar designates the fund as Direxion Indxd Synth Convert Strat Bear, for reasons not clear, but does give a clue as to its demise: it has $30,000 in AUM and has fallen a sprightly 15% since inception in February.

Horizons West Multi-Strategy Hedged Income Fund (HWCVX) will liquidate on October 6, 2014, just six months after launch.  In the interim, Brenda A. Smith has replaced Steven M. MacNamara as the fund’s president and principal executive officer.

The $100 million JPMorgan Strategic Preservation Fund (JSPAX) is slated for liquidation on September 29^th.  The manager may have suffered from excessive dedication to the goal of preservation: throughout its life the fund never had more than a third of its assets in stocks.  That gave it a minimal beta (about 0.20) but also minimal appeal in generally rising markets.

Oddly, the fund’s prospectus warns that “The Fund’s total allocation to equity securities and convertible bonds will not exceed 60% of the Fund’s total assets except for temporary defensive positions.”  They never explain when moving out of cash and into stocks qualifies as a defensive move.

Parametric Market Neutral Fund (EPRAX) ceases to exist on September 19, 2014.

PIMCO, the world’s biggest bond fund shop and happiest employer, is trimming out its ETF roster: Australia Bond, Build America Bond, Canada Bond and Germany Bond disappear on or about October 1, 2014.  “This date,” PIMCO gently reminds us, “may be changed without notice at the discretion of the Trust’s officers.”  At the same time iShares, the biggest issuer of ETFs, plans to close 18 small funds with a combined asset base of a half billion dollars.  That includes 10 target-date funds plus several EM and real estate niche funds.

Prudential International Value Fund (PISAX), run by LSV, will be merged into Prudential International Equity Fund (PJRAX).  Both funds are overpriced and neither has a consistent record of adding much value, though PJRAX is slightly less overpriced and has strung through a decent run lately.

PTA Comprehensive Alternatives Fund (BPFAX) liquidates on September 15, 2014. I didn’t even know the PTA had funds, though around here they certainly have fund-raisers.

In Closing . . .

Thanks, as always, to all of you who’ve supported the Observer either by using our Amazon link (which costs you nothing but earns us 6-7% of the value of whatever you buy using it) or making a direct contribution by check or through PayPal (which costs you … well, something admittedly).  Nuts.  I really owe Philip A. a short note of thanks.  Uhhh … sorry, big guy!  The card is in the mail (nearly).

For the first time ever, the four of us who handle the bulk of the Observer’s writing and administrative work – Charles, Chip, Ed and me – are settling down to a face-to-face planning session at the end of the upcoming Morningstar ETF Conference. Which also means that we’ll be wandering around the conference. If you’re there and would like to chat with any of us, drop me a note and we’ll get it set up.

Talk to you soon, think of you sooner!

Dear friends,

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

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

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

Ken Mayer, some rights reserved

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

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

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

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

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

(Reuters, Jim King)

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

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

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

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

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

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

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

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

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

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

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

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

Recovery Time

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

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

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

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

Long time MFO board contributor Bee posted recently:

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

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

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

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

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

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

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

Flash Geeks and Other Vagaries of Life …..

By Edward Studzinski

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

                Gamal Abdel Nasser

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

What aren’t you reading this summer?

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

How are yours?

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

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

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

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

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

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

What aren’t you drinking this summer?

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

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

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

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

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

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

Observer Fund Profiles:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Funds in Registration

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

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

Manager Changes

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

Top Developments in Fund Industry Litigation – July 2014

Fundfox is the only intelligence service to focus exclusively on litigation involving U.S.-registered investment companies, their directors and advisers. Publisher David Smith has agreed to share highlights with us. For a complete list of developments last month, and for information and court documents in any case, log in at www.fundfox.com and navigate to Fundfox Insider.

New Lawsuit

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

 Order

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

 Briefs

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

Answer

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

– – –

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

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

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

Updates

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

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

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

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

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

Briefly Noted . . .

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

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

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

SMALL WINS FOR INVESTORS

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

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

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

CLOSINGS (and related inconveniences)

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

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

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

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

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

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

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

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

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

OLD WINE, NEW BOTTLES

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

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

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

OFF TO THE DUSTBIN OF HISTORY

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

Grazie!

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

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

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

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

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

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

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

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

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

In Closing . . .

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

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

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

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

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

Here are some ways to make support easy:

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

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

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

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

As ever,