Objective and strategy

The fund’s first objective is to provide preservation of capital. Its secondary concerns are to provide income and long-term growth of capital. The fund invests primarily in fixed-income securities. It tilts toward shorter-term, investment grade issues while having the ability to go elsewhere when the opportunities are compelling. It also invests in foreign and domestic stocks, with a preference for dividend-paying equities. Finally, it may invest a bit in a managed futures strategy as a hedge. In general, though, bonds are 55-85% of the portfolio. In the past five years, stocks have accounted for 25-35% of the portfolio though they might be about 10% higher or lower if conditions warrant.

Adviser

Manning & Napier. Manning & Napier was founded in 1970 by Bill Manning and Bill Napier. They’re headquartered near Rochester, NY, with offices in Columbus, OH, Chicago and St. Petersburg. They serve a diversified client base of high-net-worth individuals and institutions, including 401(k) plans, pension plans, Taft-Hartley plans, endowments and foundations. It’s a publicly-traded company (symbol: MN) with $43 billion in assets under management. Of that, about $18 billion are in their team-managed mutual funds and the remainder in a series of separately-managed accounts.

Manager

The fund is managed by a seven-person team, headed by Jeffrey Herrmann and Marc Tommasi. Both of them have been with the fund since its launch. The same team manages all of Manning & Napier’s Pro-Blend and Target Date funds.

Management’s stake in the fund

We generally look for funds where the managers have placed a lot of their own money to work beside yours.  The managers work as a team on about 10 funds. While few of them have any investment in this particular fund, virtually all have large investments between the various Pro-Blend and Lifestyle funds.

Opening date

November 1, 1995.

Minimum investment

$2,000. That is reduced to $25 if you sign up for an automatic monthly investing plan.

Expense ratio

0.88% on $384.1 million in assets, as of July 2023.

Comments

Pro-Blend Conservative offers many of the same attractions as Vanguard STAR (VGSTX) but does so with a more conservative asset allocation. Here are three arguments on its behalf.

First, the fund invests in a way that is broadly diversified and pretty conservative. The portfolio holds something like 200 stocks and 500 bonds, plus a few dozen other holdings. Collectively those represent perhaps 25 different asset classes. No stock position occupies as much as 1% of the portfolio and it currently has much less direct foreign investment than its peers.

Second, Manning & Napier is very good. The firm does lots of things right, and they’ve been doing it right for a long while. Their funds are all team-managed, which tends to produce more consistent, risk-conscious decisions. Their staff’s bonuses are tied to the firm’s goal of absolute returns, so if investors lose money, the analysts suffer, too. The management teams are long-tenured – as with this fund, 20 year stints are not uncommon – and most managers have substantial investments alongside yours.

Third, Pro-Blend Conservative works. Their strategy is to make money by not losing money. That helps explain a paradoxical finding: they might make only half as much as the stock market in a good year but they managed to outperform the stock market over the past 15. Why? Because they haven’t had to dig themselves out of deep holes first. The longer a bull market goes on, the less obvious that advantage is. But once the market turns choppy, it reasserts itself.

At the same time, the fund has the ability to become more aggressive when conditions warrant.  It just does so carefully. Chris Petrosino, one of the Managing Directors at Manning, explained it this way:

We have the ability to be more aggressive. For us, that’s based on current market conditions, fundamentals, pricing and valuations. It may appear contrarian, but valuations dictate our actions. We use those valuations that we see in various asset classes (not only in equities), as our road map. We use our flexibility to invest where we see opportunities, which means that our portfolio often looks very different than the benchmark.

Bottom Line

Pro-Blend Conservative has been a fine performer since launch. It has returned over 6% since launch and 5.4% annually over the past 15 years. That’s about 1% per year better than either the Total Stock Market or its conservative peers. In general, the fund has managed to make between 4-5% each year; more importantly, it has made money for its investors in 19 of the past 20 years. It is an outstanding first choice for cautious investors.

Fund website

Manning & Napier Pro-Blend Conservative homepage. 

Fact Sheet

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Objective and strategy

This fund of funds seeks to provide long-term capital appreciation and income. As a fund of funds, Vanguard STAR invests in other Vanguard mutual funds.  It places 60% to 70% of its assets in common stocks through eight stock funds; 20% to 30% of its assets in bonds through two bond funds; and 10% to 20% of its assets in short-term investments through a short-term bond fund. The stock funds emphasize larger, well-established companies and the bond funds focus on securities issued by highly-rated borrowers. Vanguard calls it their “one fund option for investors looking for broad diversification across asset classes who can tolerate moderate market risk that comes from the volatility of the stock and bond markets.”

Adviser

The Vanguard Group, Inc. The Japanese bestow the designation “Living National Treasure” on individuals of incomparable skill who work to preserve precious elements of the culture. If the US had such as designation, Vanguard founder Jack Bogle would certainly qualify for it. He founded Vanguard in May, 1975 as the industry’s only non-profit, investor-owned fund complex; in the succeeding decades he has been consistently, successfully critical of marketing-driven investing fads and high expenses. Vanguard advertises “at cost” investing and their investor expenses are consistently the industry’s lowest. They advise 160 U.S. funds (including variable annuity portfolios) and about 120 funds for non-U.S. investors. In total they have 20 million investors and are responsible for more than $3 trillion in assets.

Managers

Michael Buek, William Coleman and Walter Nejman. The guys are mostly responsible for which of the portfolio’s funds get a bit more money and which get a bit less. The list of which funds they use hasn’t changed since 2001 and the fund’s asset allocation wobbles just a little. Their responsibilities are so administrative that from 1985 to 2009, the fund listed itself as having “no manager.”

Management’s stake in the fund

In general, you should look for funds whose managers invest a lot of their own money alongside your money. In this case, the managers have almost no investment in the fund but that’s not very important since their responsibilities are so limited.

Opening date

March 29, 1985

Minimum investment

$1,000. While Vanguard offers an automatic investing plan option, they don’t reduce the minimum for such accounts. That said, the STAR minimum is one-third of what Vanguard normally expects and the monthly minimum once you’ve opened an account is $1.

Expense ratio

0.34% on assets of $22.7 billion, as of July 2023.

Comments

Why invest in Vanguard STAR? There are three reasons to consider it.

First, the fund invests in a way that is broadly diversified and reasonably cautious. 60-70% of its money is invested in stocks, 20-30% in bonds and 10-20% in conservative short-term investments. Its stock portfolio mostly focuses on large, well-established companies and it gives you more exposure to the world beyond the U.S. than most of its peers do. International stocks constitute 21% of the portfolio but are only 13% for its average peer. That means investors are being given access to some additional sources of gain that most comparable funds skip.

Second, Vanguard is very good. There are two sorts of funds, those which simply buy all of the stocks or bonds in a particular index without trying to judge whether they’re good or bad (these are called “passive” funds) and those whose managers try to invest in only the best stocks or bonds (called “active” funds). Vanguard typically hires outside firms to manage their active funds and they do a very good job of finding and overseeing good managers. Vanguard and its funds operate with far lower expenses than its peers, on average, 0.19% per year for funds investing primarily in U.S. stocks. Even Vanguard’s most expensive funds charge less than half as much as their industry peers. Every dollar not spent on running the fund is a dollar that remains in your account.

Third, STAR is the most accessible way to build a Vanguard portfolio. STAR builds its portfolio around 11 actively-managed Vanguard funds.  They are:

If you wanted to buy that same collection of funds one-by-one, you’d need to have $33,000 to invest. Dan Wiener, publisher of the well-respected Independent Advisor for Vanguard Investors newsletter, suggests eight funds in a model portfolio akin to STAR. That would require $24,000 upfront and you’d have to deal with the fact that PRIMECAP is no longer accepting new investors.

Bottom Line

STAR has been around for 30 years and has been a quiet, reliable performer. Its portfolio represents a cautious approach to some investment types (for example, stocks in the emerging markets) that its peers mostly avoid. Coupled with its substantial cost advantage over its peers, STAR has been able to outperform three-quarters of its peers. It has returned about 7% per year over the past decade, about 1% per year above the competition, but has been a little less risky. It’s a great all-around fund designed to do well year after year rather than post eye-popping returns over the short term.

Fund website

Vanguard STAR profile. You can keep track of your account by downloading the Vanguard app which works with iPhones, Android and Kindle. When you go to Vanguard’s “invest with us” page, here’s what you’ll see:

So you’ll need just seven pieces of information (eight if you include “your name”) to get started. When you’re asked what you’d like done with your dividends and capital gains, choose “reinvest them” so that the money stays in your account and keeps growing. Otherwise you’ll get them deducted from your account and mailed to you as a check.

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Objective and strategy

The fund seeks long-term total return, consisting of both current income and capital appreciation. It is a “fund of funds” that invests in the low-cost Institutional Class shares of other TIAA-CREF funds. It is designed for investors targeting a conservative risk-return profile. In general, 40% of the fund’s assets are invested in stocks and 60% in bonds. The managers can change those allocations by as much as 10% up or down depending upon current market conditions and outlook.

Adviser

TIAA-CREF. It stands for “Teachers Insurance and Annuity Association – College Retirement Equities Fund,” which tells you a lot about them. They were founded in 1918 to help secure the retirements of college teachers; their original backers were Andrew Carnegie and his Carnegie Foundation. Their mission eventually broadened to serving people who work in the academic, research, medical and cultural fields. More recently, their funds became available to the general public. TIAA-CREF manages almost $900 billion dollars for its five million investors. Because so much of their business is with highly-educated professionals concerned about their retirement, TIAA-CREF focuses on fundamentally sound strategies with little trendiness or flash and on keeping expenses as lower as possible. 70% of their investment products have earned four- or five-star ratings from Morningstar and the company is consistently rated as one of America’s best employers.

Manager

John Cunniff and Hans Erickson, who have managed the fund since its inception.

Management’s stake in the fund

We generally look for funds where the managers have placed a lot of their own money to work beside yours. Mssrs. Cunniff and Erickson each have $500,001 – $1,000,000 invested in the fund, which qualifies as “a lot.”

Opening date

December 9, 2011. Many of the funds in which the managers invest are much older than that.

Minimum investment

$2,500. That is reduced to $100 if you sign up for an automatic investing plan.

Expense ratio

0.76% on $310 million in assets, as of July 2023. 

Comments

Lifestyle Conservative offers many of the same attractions as Vanguard STAR (VGSTX) but does so with a more conservative asset allocation. Here are three arguments on its behalf.

First, the fund invests in a way that is broadly diversified and pretty conservative. 40% of its money is invested in stocks, 40% in high-quality bonds and the last 20% in short-term bonds. That’s admirably cautious. They then take measured risks within their various investments (for example, their stock portfolio is more tilted toward international stocks and emerging markets stocks than are their peers) to help boost returns.

Second, TIAA-CREF is very good. There are two sorts of funds, those which simply buy all of the stocks or bonds in a particular index without trying to judge whether they’re good or bad (these are called “passive” funds) and those whose managers try to invest in only the best stocks or bonds (called “active” funds). TSCLX invests in a mix of the two with active funds receiving about 90% of the cash. CREF’s management teams tend to be pretty stable (the average tenure is close to nine years); most managers handle just one or two funds and most invest heavily (north of $100,000 per manager per fund) in their funds. CREF and its funds operate with far lower expenses than its peers, on average, 0.43% per year for funds investing primarily in U.S. stocks. Even their most expensive fund charges 40% less than their industry peers. Every dollar not spent on running the fund is a dollar that remains in your account.

Third, Lifestyle Conservative is a very easy way to build a very well-diversified portfolio.  Lifestyle Conservative builds its portfolio around 15 actively-managed and three passively-managed TIAA-CREF funds.  They are:

Bottom Line

Lifestyle Conservative has been a fine performer since launch. It has returned 7.5% annually over the past three years. That’s about 2% per year better than average, which places it in the top 20% of all conservative hybrid funds. While it trails more venturesome funds such as Vanguard STAR in good markets, it holds up substantially better than they do in falling markets.  That combination led Morningstar to award it four stars, their second-highest rating.

Fund website

TIAA-CREF Lifestyle Conservative homepage there is also another website from which you can download the fact sheet which gives you updated information on what the fund has been investing in and how it’s doing. From there it’s easy to open a mutual fund account and set up your AIP.

If you’ve got an iPhone, you can manage your account with their TIAA-CREF Savings Simplifier app. If instead, you sport an Android device (all the cool kids do!), head over to the Play store and check out the TIAA-CREF app there. It doesn’t offer all the functionality of the iOS app, but it does come with much higher customer ratings.

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At the time of publication, this fund was named JOHCM International Select Fund,

Objective and strategy

The fund seeks long-term capital appreciation by investing in a compact portfolio of developed and developing markets stocks. The strategy combines fundamental analysis of individual equities with a top-down overlay which shapes country and sector weights. At the level of individual securities, the managers use a growth-at-a-reasonable-price; they characterize it as “a core investment style with a modest growth tilt.” They target firms with three characteristics:

• positive earnings surprises
• sustainably high or increasing return on equity, and
• attractive valuations.

At the country and sector level, they look for “green lights” in four areas:

• fundamentals
• valuations,
• beta, and
• price trend.

Those inquiries include questions about currency trends. They do not hedge their currency exposure. The portfolio holds around 30 equally-weighted positions. They are not hesitant “to weed out the losers.”

Adviser

J O Hambro Capital Management (JOHCM) is an investment boutique headquartered in London, but with offices in Singapore, New York and Boston. They were founded in 2001 and entered the U.S. market in 2009. As of March 2015, they managed $27.3 billion of assets for clients worldwide. Their US operations had $6.4 billion in AUM, with $3.1 billion in seven mutual funds.

Manager

Christopher Lees and Nudgem Richyal. Mr. Lees joined JOHCM in 2008 after 20 years with Barings Asset Management where he was, among other things, Lead Global High Alpha Manager. Mr. Richyal also joined JOHCM in 2008 from Barings where he ran large global resources and Latin American equity portfolios. Lees and Richyal have been working together for more than 12 years.  They manage about $15 billion in assets together, including the much younger, smaller and less accessible Global Equity Fund (JOGEX/JOGIX).

Strategy capacity and closure

$8 billion. As of May, 2015, the fund had about $2.8 billion in assets but the strategy, which is also manifested in separate accounts, was about twice that. In response, the advisor slated a “soft close” for July 2015. They would prefer to avoid a “hard close” but haven’t foreclosed that option. They anticipate reopening only if “we experienced significant redemptions, or if market conditions changed dramatically.”

Active share

94.2. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. An active share of 94.2 is extremely high for a fund with a large cap portfolio.

Management’s stake in the fund

None, which is understandable since the managers are British and the fund’s only open to U.S. investors. The managers do invest in the strategy through a separate vehicle but we do not know the extent of that investment.

Opening date

July 29, 2009 for the institutional class, March 31, 2010 for the retail class.

Minimum investment

$2,000 for Class II retail shares, $25,000 for Class I institutional shares.

Expense ratio

1.21% for investor shares and 0.98% for institutional shares on assets of $5.9 billion, as of July 2023.

Comments

It’s hard to find fault with JOHCM Select International. As of 31 March 2015, the five-year-old fund has the best performance of any international large growth portfolio:

Remarkably, those returns have not come at the expense of heightened volatility. Here’s the Observer’s risk-return profile for JOHAX’s performance against its international large-growth peers since inception.

Here’s the interpretation:

• JOHAX has made rather more than twice as much as its peers; 98% total since inception, which comes to 14.4% per year.
• Raw volatility is in-line with its peers; the maximum drawdown, peak-back-to-peak recovery time, the Ulcer Index (which measures a combination of the depth and length of a drawdown) and downside deviation are not noticeably higher than its peers.
• Measures of the risk-return trade-off (the Sharpe, Sortino and Martin ratios) are all uniformly positive.

What about that “bear decile”? On face, it’s bad: the fund has been among the worst 20% of performers during “bear market months.” In reality, it’s somewhere between inconsequential and positive. “Bear markets months” are measured by the movement of the S&P 500, which isn’t the benchmark here, and there have been only eight such months in the fund’s 60 months of existence. So, arguably inconsequential. And it’s potentially positive: JOHAX has such a high degree of independence that it sometimes falls when its benchmark is rising (three months) and rises when its benchmark is falling (3X) and it sometimes falls substantially more (3X) or substantially less (7X) than its benchmark.

JOHAX has thereby earned the highest possible ratings from Morningstar (Five Stars, but no analyst rating because they’re off Morningstar’s radar), Lipper (Lipper Leader, not that anyone really notices, for Total Return and Consistent Returns) and the Observer (it’s a Great Owl, which means it has top-tier risk-adjusted returns than its peers in every trailing measurement period).

How do they do it?

Good question. The portfolio is very distinctive. It currently holds about 30 names, which makes it the most compact international large-growth portfolio on the market and one of the 10 most compact international large cap portfolios overall. The shares are all equally-weighted, which is both rare and useful.

They claim to be benchmark agnostic, and that’s reflected in their sector and country weights. The fund’s most recent portfolio report shows huge divergences from its benchmark in most industry sectors.

Similarly, their regional allocations are distinctive. The average international large cap fund has twice as much in Europe as in Asia; JOHCM weights them equally, at about 42% each. That Asian overweight is likely to become much more pronounced in the near term. When they close out existing positions, they sometimes just add the proceeds to their existing names. As of mid-2015, however, they’re reallocating toward Japan and emerging Asia, where all of their top-down indicators are turning positive.

They describe Japan as “one of the cheapest developed markets in the world, [which] has finally embarked upon significant Western-style corporate restructuring, which is driving some of the fastest-growing earnings revisions and returns on equity in the world.” One spur for the change was the creation of a Nikkei 400 ROE index, which tracks companies “with high appeal for investors, which meet requirements of global investment standards, such as efficient use of capital and investor-focused management perspectives.” They point to tool-maker Amada as emblematic of the dramatic changes, and substantial price appreciation, possible once Japanese corporate leaders decide to reorient their capital policies in ways (the issuance of dividends and stock buybacks) that are shareholder-friendly. Amada failed to be included in the initial index, which led management to rethink and reorient.

They are unwilling to stick with stocks which are deteriorating; they repeated invoke the phrase “weeding out the losers,” which they describe as “selling stocks that were broken fundamentally and technically.” Their process seems to find a fair number of losers, with turnover running between 50-80%. That’s about in-line with comparable funds.

The managers believe they have “an idiosyncratic approach to stock picking that means [they] tend to look in parts of the market largely ignored by more traditional growth investors.” All of the available statistical evidence seems to validate that claim.

Bottom Line

Before you rush to join the party, consider three caveats:

• Independence comes with a price: when you’re structurally out-of-step with the herd, there are going to be periods when your performance diverges sharply from theirs. There will be periods when the managers look like idiots and when you’ll feel (poorly-timed) pressure to cut and run.
• Trees don’t grow to the sky: as both Morningstar’s research and ours has demonstrated, it’s exceedingly rare for managers to decisively outperform their peers for extended periods and impossible for them to do so for much more than three consecutive years. Even Buffett’s longest win streak is just three years, which matches his longest losing streak and perpetually fuels the “has Buffett lost it?” debate.
• Closing is not a panacea: the advisor has determined that it’s in the best interests of current shareholders for the fund to restrict inflows. They’ve made that decision relatively early; they’re closing at about two-thirds of strategy capacity, which is good. Nonetheless, academic and professional research both show that performance at closed funds tends to sag. It’s not universal, but it’s a common pattern.

There are no evident red flags in the fund’s construction, management or performance. There’s an indisputably fine record at hand. Folks interested in an idiosyncratic portfolio of high growth international names should review their options quickly. Investors who are hesitant to act quickly here but can afford a high minimum might consider the team’s other U.S. fund, JOHCM Global Equity (JOGEX). It’s small, comparable to their European global fund and off to a fine start; the downside is that the minimum investment is $25,000.

Fund website

JOHCM International Select. Be patient, the navigation takes a while to get used to. If you click on the “+” in the lower right of each box, new content appears for you. There’s parallel, but slightly different, content on the webpage for the fund’s European version, JOHCM Global Select, which has a bunch US stocks since, for their perspective we are a “foreign” investment.

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Objective and strategy

The fund pursues long-term capital appreciation. They look to invest in a compact portfolio of 30-50 undervalued stocks. The fund is nominally all-cap but the managers have traditionally had the greatest success in identifying and investing in small cap stocks. The fund looks for “well-seasoned companies with strong market positions, identifiable catalysts for earnings improvement and [exceptional] management.” They have strong sector biases based on valuations but will not invest in tobacco, liquor, or gaming companies based on principle. For a small cap value fund, with predominantly domestic based holdings, it has unusually high exposure to international markets. They systematically track macro conditions and have the ability to move largely to cash as a defensive measure but have not done so.

Adviser

Towle & Co. Towle was founded in 1981 and is headquartered in St. Louis. They provide investment advice to institutional and private investors through the fund, partnerships and separately managed accounts. The firm had approximately $560 million in assets under management as of December 31, 2014.

Manager

The Fund’s portfolio is managed by an investment team comprised of J. Ellwood Towle, CEO, Christopher Towle, Peter Lewis, James Shields and Wesley Tibbetts. Together, they share responsibility for all day-to-day management, analytical and research duties. Other than Mr. Shields, the team has been in place since the fund’s inception. The team also manages two partnerships and about 75 separate accounts, all of which use the same strategy.

Strategy capacity and closure

The strategy’s capacity, in all vehicles, is viewed to be approximately $1 billion, but highly dependent on market conditions and opportunities. They have previously closed when they did not feel comfortable taking on new money.

Active share

98.6 “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. An active share of 98.6 reflects a very high level of independence from its benchmark, the Russell 2000 Value index.

Management’s stake in the fund

The elder Mr. Towle has over $1 million in the fund and owns 6.5% of its shares, as of January 2015. The Towle family is the largest investor in the fund and in the strategy. The family has over 90% of their wealth invested in the strategy. All of the managers have invested in the fund. The younger Mr. Towle has between $50,000 and $100,000. Mr. Lewis has between $100,000 and $500,000.  Messr. Tibbetts and the newest manager, Messr. Shield, have modest investments. None of the trustees have invested in the fund, but then they oversee 76 funds and have virtually no investment in any of them.

Opening date

October 31, 2011. The underlying strategy has been in operation since January 1, 1982.

Minimum investment

$5,000, which is reduced to $2,500 for various tax-advantaged accounts.

Expense ratio

1.10% on assets of $108 million, as of July 2023. There’s also a 2% redemption fee on shares held fewer than 90 days.

Comments

There are two persistent investing anomalies worth noting. The first is “the value premium.” Value has persistently outperformed growth over the long-term in every size of stock. One 2013 essay claims that every Russell value index, everywhere in the world, in every sector, has outperformed its growth counterpart since inception. It’s true for the Russell 1000, 2000, 2500, Global 3000 ex-US, EMEA, Global ex-US ex-Japan, Global ex-US Large Cap, Greater China, Microcap, the whole shebang. In many instances, the long-term return from value investing is two or three times greater than in growth investing. Value investing is, in short, a free lunch in a business that swears that there are no free lunches.

The second anomaly is the almost no actively-managed value fund captures the value premium. That is, investors who bill themselves as dyed in the wool value guys have far wimpier performance than the theory says they should. Value funds tend to prevail over long periods but by less than you’d expect. That reflects the fact that very few of these guys invest in the sorts of deeply undervalued stocks that create the value premium. Instead, they’re sort of value-lite investors who liberally hedge their exposure to really cheap stocks with a lot of cheap relative to the rest of the market stocks. The reason’s simple: these stocks are cheap for a reason, they’re often fragile companies in out-of-favor industries and they have the potential to make investors in them look incredibly stupid for a painfully long stretch.

Few investors are willing to risk that sort of pain in pursuit of the full potential of deeply undervalued stocks. Towle & Co. is one of those few. They’ve managed to stick with their convictions because they haven’t had to worry a lot about skittish investors fleeing. In part that’s because they work really hard, mostly with separate account clients, to partner with investors who buy into the strategy. And, in part, it’s because they are their own biggest client: The Towle family has over 90% of their wealth invested in the strategy.  Happily, their convictions have reaped enormous gains for long-term investors.

While Towle assesses a wide variety of valuation metrics, a primary measure is price-to-sales. They focus on sales rather than earnings for two reasons. Topline measures like sales directly measure a firm’s vitality (are they able to sell more stuff at better prices each year?) which is important for a discipline that relies on buying robust growth at value prices. And topline measures like sales are harder to fudge than bottom line measures like earnings; a lot of financial engineering goes into “managing” earnings which makes them a less reliable measure.

Towle’s portfolio sports a price-to-sale ratio of 0.26 while its benchmark is four times pricier: 1.03. The Total Stock Market Index sells at 1.61, a 600% higher price. By that measure, only one other stock fund (out of 2300 domestic equity funds) has such a deeply undervalued portfolio. By measures such as price-to-book, Towle’s stocks sell at a 30% discount (0.91 versus 1.45) to its benchmark and a 65% discount (0.91 versus 2.52) to the broader stock market.

In the long term, this strategy has performed well. There are about two dozen small cap value funds with 20 year track records. Precisely one of those, the long-closed Bridgeway Ultra-Small Company Fund (BRUSX), has managed to outperform the Towle strategy. In the very long term, Towle has performed astonishingly well. Here are the stats for performance since the strategy’s inception in 1982:

That said, a free lunch is still not a free ride. Over shorter periods, and sometimes over quite lengthy periods, deep value stocks can remain stubbornly undervalued and unrewarding. While the strategy has a three decade track record, the mutual fund has been in operation for about four years and has married substantially above average returns with even more substantially above average volatility.

The fund’s sector concentration – lots of consumer cyclicals, energy and industrials but very little tech, pharma or utilities – contributes to the potential for short-term volatility. In addition, the managers occasionally make mistakes. Joe Bradley, one of the folks at Towle, says of the strategy’s 2011 performance, “we made some bad choices and we stunk it up.” Indeed the strategy posted three disastrous years this century in which they trailed their benchmark by double digits: 2000 (-1 versus +22.8), 2008 (-49.9 versus -28.9) and 2011 (-17.4 versus -5.5). Two of those three lagging years was then followed by phenomenal outperformance: 2001 (42.8% vs 14.0) and 2009 (101% vs 20.5). The portfolio, Mr. Bradley reports, became like a too-tightly compressed spring; when the rebound occurred, it was incredibly powerful.

Bottom Line

Towle Deep Value positions itself a “an absolute value fund with a strong preference for staying fully invested.” While most absolute value funds often pile up cash, Towle chooses to turn over more rocks – in under covered small caps and international markets alike – in order to find enough deeply undervalued stocks to populate the portfolio. The fund has the potential to play a valuable role in a long-term investor’s portfolio. Its focus is on a volatile and sometimes-despised corner of the market means that it’s not appropriate as a core holding but its distinctive strategy, sensible structure, steady discipline and outstanding long-term record makes it a serious contender for diversifying a portfolio heavily weighted in large cap stocks.

Fund website

Towle Deep Value Fund. It’s a pretty Spartan site. Folks seriously interested in understanding the strategy and its performance over the past 34 years would be better served by checking out the Towle & Co. website.

Fact Sheet

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This fund profile was previously updated on March 1, 2013. You can find an archive of that profile here.

Download a .pdf of this profile here.

Objective and Strategy

Seafarer seeks to provide long-term capital appreciation along with some current income; it also seeks to mitigate volatility. The portfolio has two distinctive features. First, the fund invests a significant amount – 20-50% of its portfolio – in the securities of companies which are domiciled in developed countries but whose earnings are driven by emerging markets. The remainder is invested directly in developing and frontier markets. Second, the fund generally invests in dividend-paying common stocks but the portfolio might contain preferred stocks, convertible bonds, closed-end funds, ADRs and fixed-income securities. The fund typically has much more exposure to small- and mid-cap stocks than does its peers. On average, 80% of the portfolio is invested in common stock but that has ranged from 71% – 86%.

Adviser

Seafarer Capital Partners of San Francisco. Seafarer is a small, employee-owned firm that advises the Seafarer fund in the US and a €45 million French SICAV, Essor Asie Opportunités. The firm has about $190 million in assets under management, as of March 2015.

Managers

Andrew Foster is the manager, as well as Seafarer’s cofounder, CEO and CIO. Mr. Foster formerly was manager or co-manager of Matthews Asia Growth & Income (MACSX), Matthews’ research director and acting chief investment officer. He began his career in emerging markets in 1996, when he worked as a management consultant with A.T. Kearney, based in Singapore, then joined Matthews in 1998. Andrew was named Director of Research in 2003 and served as the firm’s Acting Chief Investment Officer during the height of the global financial crisis, from 2008 through 2009. Andrew is assisted by Kate Jacquet, Paul Espinosa and Sameer Agrawal. Ms. Jacquet has been with Seafarer since 2011; Messrs. Espinosa and Agrawal joined in 2014.

Management’s Stake in the Fund

Mr. Foster has over $1 million in the fund. None of the fund’s trustees have an investment in any of the 32 funds they oversee.

Opening date

February 15, 2012

Minimum investment

$100,000 for institutional share class accounts, $2,500 for regular retail accounts and $1000 for retirement accounts. The minimum subsequent investment is $500. In a spectacularly thoughtful gesture, individuals who invest directly with the fund and who establish an automatic investment plan on their accounts are eligible for a waiver of the institutional share class’s minimum investment requirement. The folks at Seafarer argue that they would like as many shareholders as possible to benefit from lower expenses, so they’re trying to manage an arrangement by which their institutional share class might actually be considered the “universal” share class.

Expense ratio

0.97% for retail shares and 0.87% for institutional shares, on assets of $2.4 Billion (as of July 2023).

Comments

Our contention has always been that Seafarer represents one of the best possible options for investors interested in approaching the emerging markets. It’s not a question of whether we’re right but, rather, of why we are.

Seafarer has three attributes that set it apart:

1. Its approach is distinctive. Mr. Foster’s hope is to outperform his benchmark (the MSCI EM index) “slowly but steadily over time.” He describes the approach as a “relative return strategy” which pursues growth that’s more sustainable than what’s typical in developing markets while remaining value conscious. It’s grounded in the structural realities of the emerging markets.

   A defining characteristic of emerging markets is that their capital markets (including banks, brokerages and bond and stock exchanges) cannot be counted on to operate. In consequence, you’re best off with firms who won’t need to turn to those markets for capital needs. Seafarer targets (1) firms that can grow their top line steadily in the 7-15% per annum range and (2) those that can finance their growth internally. The focus on the top line means looking for firms that can increase revenues by 7-15% without obsessing about similar growth in the bottom line. It’s almost inevitable that EM firms will have “stumbles” that might diminish earnings for one to three years; while you can’t ignore them, you also can’t let them drive your investing decisions. “If the top line grows,” Mr. Foster argues, “the bottom line will follow.” The focus on internal financing means that the firms will be capable of funding their operations and plans without needing recourse to the unreliable external sources of capital.

   Seafarer tries to marry that focus on sustainable moderate growth “with some current income, which is a key tool to understanding quality and valuation of growth.” His preference is to buy dividend-paying stocks, but he often has 20% or more of the portfolio invested in other sorts of securities. The dividends are not themselves magical, but serve as “crude but useful” tools for identifying firms most likely to preserve value and navigate rough markets.

2. Its performance is first rate. That judgment was substantiated in early March 2015 when Seafarer received its inaugural five-star rating from Morningstar. They’re also a Great Owl fund (as of May, 2015), a designation which recognizes funds whose risk-adjusted returns have finished in the top 20% of their peers for all trailing periods. Our greater sensitivity to risk, based on the evidence that investors are far less risk-tolerant than they imagine, leads to some divergence between our results and Morningstar’s: five of their five-star EM funds are not Great Owls, for instance, while some one-star funds are.

   Of 219 diversified EM funds currently tracked by Morningstar, 18 have a five-star rating (as of mid-March, 2015). 13 are Great Owls. Seafarer is one of only 10 EM funds (representing less than 5% of the peer group) that are both five-star and Great Owls.

3. Its commitment to its shareholders is unmatched. Mr. Foster has produced consistently first-rate shareholder communications that are equally clear and honest about the fund’s successes and occasional lapses. And he’s been near-evangelical about reducing the fund’s expenses, often posting voluntary mid-year fee reductions as assets permit. Seafarer is one of the least expensive actively-managed EM funds available to retail investors.

In the three years through April 30, 2015, the fund’s annualized return was 10.8% which placed it in the top 2% of all EM equity funds. Rather than trumpet the fund’s success, Mr. Foster warned, both in letters to his shareholders and on the Observer’s conference call that investors should not expect such dominant returns in the future. “Our strategy ideally matches the anemic growth conditions that emerging markets have experienced lately,” he says. As growth returns, other strategies will have their day in the sun. Seafarer, meanwhile, will continue pursuing firms with sustainable rather than maximum growth.

Bottom Line

Mr. Foster is remarkably bright, thoughtful, experienced and concerned about the welfare of his shareholders. He thinks more broadly than most and has more experience than the vast majority of his peers. The fund offers him great flexibility and he’s using it well. There are few more-attractive emerging markets options available.

Fund website

Seafarer Overseas Growth and Income. The website is remarkably rich, both with analyses of the fund’s portfolio and performance, and with commentary on broader issues. One emblem of Mr. Foster’s commitment to having you understand what the fund is up to is a remarkably complete spreadsheet that provides month-by-month and year-by-year data on the portfolio, dating all the way back to the fund’s launch. Whether you’d like to know what percentage of the portfolio was invested in convertible shares in April 2014 or how the fund’s regional exposure affected its performance relative to its benchmark in 2013, the data’s there for you.

Disclosure

The Observer has no financial ties with Seafarer Funds. I do own shares of Seafarer and Matthews Asian Growth & Income (purchased during Andrew’s managership there) in my personal account.

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At the time of publication, this fund was named Queens Road Small Cap Value.

Objective and strategy

The fund pursues long-term capital growth by investing, primarily, in a diversified portfolio of US small cap stocks. The advisor defines small cap in relation to the Russell 2000 Value Index; currently that means stocks with capitalizations under $3.3 billion. The portfolio is assembled by looking at stocks with low P/E and P/CF ratios, whose underlying firms have strong balance sheets and good management. The fund, which holds 39 common stocks and shares in one closed-end fund, is nominally non-diversified. The fund’s cash position is a residue of market opportunities. In times when the market is rich with opportunities, they deploy cash decisively. In 2009, for instance, they moved to under 3% cash. As markets have increasingly become richly-priced, the cash stake has grown. Over the past five years it has averaged 24% which is also where it stands in early 2015.

Adviser

Bragg Financial Advisors, headquartered in Charlotte, NC, just across from the Dowd YMCA. They used to be located on Queens Road. Bragg is a family firm with four Braggs (founder Frank as well as sons Benton, John and Phillips) and one son-in-law (manager Steven Scruggs) leading the firm. It has been around since the early 1970s, and manages approximately $850 million in assets. A lot of that is for 300 families in the Charlotte region.

Manager

Steven Scruggs, CFA. Mr. Scruggs has worked for BFA since 2000 and manages this fund and Queens Road Value (QRVLX). That’s about it. No separate accounts, hedge funds or other distractions. He does not have research analysts but the firm’s investment committee oversees the progress of the portfolio as a whole.

Strategy capacity and closure

Based on the liquidity of their holdings, that is their ability to get into and out of positions without disrupting the market, they anticipate about $800 million in capacity. They’d likely soft close the fund at $800 million and hard close it “not far north of that.”

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. The advisor does not calculate active share for their funds. Mr. Scruggs argues that, “By the nature of our process, we’re not going to look like the index. Whether that’s a good thing or a bad thing, I can’t say.” Indeed, measured by sector weightings, the fund is demonstrably independent: the fund’s portfolio weights differ dramatically from its peer group in 10 of 11 industry sectors that Morningstar tracks.

Management’s stake in the fund

Mr. Scruggs has invested between $100,000 and $500,000 in the fund. Though modest in absolute terms, he explains that he has “the overwhelming bulk – 90-95% – of my liquid investments” in the two funds he manages. In addition, all of the fund’s independent trustees have invested in it; three of the four have investments in excess of $100,000. Especially given their modest compensation, that level of commitment is admirable, rare and helpful.

Opening date

June 13, 2002

Minimum investment

$2500 for regular accounts, $1000 for tax-sheltered accounts.

Expense ratio

1.24% on assets of $77 million.

Comments

Sometimes our greatest, and least understood, advantages, come from all of the things we don’t have. Like distractions. Second-guessers. Friends who talk us into trying hot new fashions. Or the fear of being canned if we make a mistake.

It’s sometimes dubbed “addition by subtraction.” Thomas Gray famously celebrated the virtue of being far from the temptation of the “in” crowd in his poem “Elegy Written in a Country Churchyard” (1751):

Far from the madding crowd’s ignoble strife
Their sober wishes never learn’d to stray;
Along the cool sequester’d vale of life
They kept the noiseless tenor of their way

How madding might the investment crowd be? Mr. Scruggs commends for your consideration a classic essay by Jeremy Grantham,  My Sister’s Pension Assets and Agency Problems. Mr. Grantham has been managing the pension investments for one of his sisters since 1968. She’s, in many ways, the ideal client: she’s not even vaguely interested in what the market has or has not been doing, she doesn’t meddle and isn’t going to fire him. That’s a far cry from the fate of most professional investors.

The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price.

There are many other inefficiencies in market pricing, but this is by far the largest. It explains the discrepancy between a remarkably volatile stock market and a remarkably stable GDP growth, together with an equally stable growth in “fair value” for the stock market. This difference is massive – two-thirds of the time annual GDP growth and annual change in the fair value of the market is within plus or minus a tiny 1% of its long-term trend. The market’s actual price – brought to us by the workings of wild and wooly individuals – is within plus or minus 19% two-thirds of the time. Thus, the market moves 19 times more than is justified by the underlying engines!

Investors’ fears and fads feed off each other, they do what’s “hot” rather than what’s right, they chase the same assets and prices rise briskly. Until they don’t.

The success of the two small funds managed by Mr. Scruggs for Queens Road is remarkable. He has no fancy strategies or sophisticated portfolio tools. He measures a firm’s earnings and cash flow against normal, rather than abnormal, earnings. He tries to determine whether the management is likely able to continue growing earnings. If he sees a good margin of safety in the price, he buys. His preference is to be broadly diversified across sectors and industries to reduce the impact of sector-specific risks (such as oil price or interest rate changes). He won’t buy overpriced stocks just for the sake of obtaining sector exposure (he has no investments at all in five of Morningstar’s 11 sectors while his average peer has 24% of their portfolio in those sectors) but, on whole, he thinks broader exposure is more prudent than not. In the past year, his portfolio turnover has been zero. In short, he’s not trying to outsmart the market, he’s just trying to do his job: prudently compound his investors’ capital over time.

Mr. Scruggs believes that his fund will be competitive in healthy rising markets and superior in declining ones but will likely trail noticeably in frothy markets, those driven by investor frenzy rather than fundamentals. He anticipates that, across the entirety of a five-to-seven year market cycle, he’ll offer his investors somewhat better than average returns with much less heartburn.

So far he’s been true to his word. QRSVX has returned a solid 10.25% per year run inception through the end of 2014 while its benchmark made just 9% which greater volatility. A $10,000 investment at inception would have grown to $34,400 by April 2015 – about $4,000 more than his peers would have earned.

The question is: how does Queens Road stand up to the best funds, not just to the average ones. The short answer is: really quite well. The table below compares the performance of Queens Road to the three SCV funds that Morningstar designates as “the best of the best” and the low-cost default, Vanguard’s index. This data all reflects performance over the current market cycle, from the last peak in November 2007 to March 2015. For the sake of clarity, we’ve highlighted in blue the best performer in each category.

What do we see?

• All of the funds have been above-average performers, besting their SCV peer group by 0.2 – 1.7% per year.
• Queens Road has strong absolute returns but the lowest absolute returns of the group.
• Once risk is taken into account, however, Queens Road posts the best performance in every category. Its loss during the 2007-09 crash was smaller (Max Draw), its tendency to lose in falling markets (Downside Deviation) was smaller, and its risk-adjusted returns (Sharpe, Sortino, Martin and Return group) were all the best in class.

The advisor illustrates the same point by looking the fund’s performance during all of the quarters in which the Russell 2000 Value index fell:

For those counting, the fund outperformed its benchmark in nine of 10 down quarters.

When they don’t find stocks that are unreasonably cheap given their companies’ prospects, they let cash accumulate. As of the last portfolio disclosure, cash about 24% of the portfolio. That doesn’t reflect a market call, it simply reflects a shortage of stocks that offer a sufficient margin of safety:

[H]istory says we’re due for a pullback and we think it makes sense to be prepared. How do we prepare? As we’ve often said, by not making a drastic move in the portfolio. As esteemed money manager, Peter Lynch once said, “Far more money has been lost by investors trying to anticipate corrections than has ever been lost in corrections themselves.”

So why hasn’t he fallen into the trap that Mr. Grantham describes? That is, does he actually have a sustainable advantage as an investor? The fund’s 2014 Annual Report suggests three:

This is where we think we have an advantage …. First, we live in Charlotte, North Carolina, far away from the investment swirl and noise of New York, Boston or Chicago. Second, we are not a huge fund shop with a massive sales force/marketing division. Fall behind your peers for a few quarters, or heaven forbid, you lag for a couple of years at a big fund shop, and you’ve got the marketing guys in your office asking you, “What are you doing wrong? You gotta change something.” Third, we believe in our process. Collectively, our fund manager, investment committee, Board of Directors, and family have over $3 million of our own money invested in our Queens Road Funds … We understand the investment process. We are comfortable under-performing during certain periods. And we have the patience to stay the course.

Bottom Line

Most of us are best served by funds whose managers speak clearly, buy cautiously, sell rarely, and keep out of the limelight. It’s clear that thrilling funds are a disastrous move for most of us. The funds that dot the top of last year’s performance list have a real risk of landing on next year’s fund liquidation list. Investors who understand the significance of “for the long-term” in the phrase “stocks for the long-term” come to have patience with their portfolios; that patience willingness to let an investment play out over six years rather than six months distinguishes successful investors from the herd. Based on his record over the past 13 years, Mr. Scruggs has earned the designations patient, disciplined, successful. If you aspire to the same, the two Queens Road funds should surely be on your due-diligence list.

Fund website

Queens Road Small Cap Value fund

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Objective

Pinnacle Value seeks long-term capital appreciation by investing in small- and micro-cap stocks that it believes trade at a discount to underlying earnings power or asset values. It might also invest in companies undergoing unpleasant corporate events (companies beginning a turnaround, spin-offs, reorganizations, broken IPOs) as well as illiquid investments. It also buys convertible bonds and preferred stocks which provide current income plus upside potential embedded in their convertibility. The manager writes that “while our structure is a mutual fund, our attitude is partnership and we built in maximum flexibility to manage the portfolios in good markets and bad.”

Adviser

Bertolet Capital of New York. Bertolet has $83 million in assets under management, including this fund and one separate account.

Manager

John Deysher, Bertolet’s founder and president. From 1990 to 2002 Mr. Deysher was a research analyst and portfolio manager for Royce & Associates. Before that he managed equity and income portfolios at Kidder Peabody for individuals and small institutions. The fund added an equities analyst, Mike Walters, in January 2011 who is also serving as a sort of business development officer.

Strategy capacity and closure

The strategy’s maximum capacity has not been formally determined. It’s largely dependent on market conditions and the availability of reasonably priced merchandise. Mr. Deysher reports “if we ever reach the point where Fund inflows threaten to dilute the quality of investment ideas, we’ll close the Fund.” Given his steadfast and enduring commitment to his investment discipline, I have no doubt that he will.

Active share

99%. “Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Pinnacle’s active share is typically between 98.5-99%, indicating an exceedingly high level of independence.

Management’s stake in the fund

Mr. Deysher has in excess of $1,000,000 in the fund, making him the fund’s largest shareholder. He also owns the fund’s advisor. Two of the fund’s three independent directors have invested over $100,000 in the fund while one has only a nominal investment, as of the May 2014 Statement of Additional Information.

Opening date

April Fool’s Day, 2003.

Minimum investment

$2500 for regular accounts and $1500 for IRAs. The fund is available through TD Ameritrade, Fidelity, Schwab, Vanguard and other platforms.

Expense ratio

1.32%, after waivers, on assets of $31.4 million, as of July 2023. There is a 1% redemption fee for shares held less than a year.

Comments

By any rational measure, for long-term investors Pinnacle Value is the best small cap value fund in existence.

There are two assumptions behind that statement:

1. Returns matter.
2. Risk matters more.

The first is self-evident; the second requires just a word of explanation. Part of the explanation is simple math: an investment that falls by 50% must subsequently rise by 100% just to break even. Another part of the explanation comes from behavioral psychology. Investors are psychologically ill-equipped to deal with risk: we hate huge losses and we react irrationally in the face of them but we refuse to believe that they’re going to happen to us, so we rarely act appropriately to mitigate them. In good times we delude ourselves into thinking that we’re not taking on unmanageable risks, then they blow up and we sit for years in cash. The more volatile the asset class, the greater the magnitude of our misbehavior.

If you’re thinking “uh-uh, not me,” you need to go buy Dan Kahneman’s Thinking, Fast and Slow (2013) or James Montier’s The Little Book of Behavioral Investing (2010). Kahneman won the Nobel Prize for his work on the topic, Montier is an asset allocation strategist with GMO and used to be head of Global Strategy at Société Générale.

John Deysher does a better job of managing risks in pursuit of reasonable returns than any other small cap manager. Since inception, Pinnacle Value has returned about 9.9% annually. 

Using the Observer’s premium MultiSearch tool, we were able to assess the ten-year risk adjusted performance of every small cap value fund. Here’s what we found:

Those rankings are essentially unchanged even if we look only at results for the powerful Upmarket cycle that began in March 2009: Pinnacle returned an average of 11.4% annually during the cycle, with the group’s best performance in six of the seven measures above. It’s fourth of 94 on the Martin ratio.

We reach the same conclusion when we compare Pinnacle just against Morningstar’s “Gold” rated small cap value funds and Vanguard’s SCV index. Again, these are the 10-year numbers:

So what does he actually do?

The short version: he buys very good, very small companies when their stocks are selling at historic lows. Pinnacle looks for firms with strong balance sheets since small firms have fewer buffers in a downturn than large ones do, management teams that do an outstanding job of allocating capital including their own, and understandable businesses which tends to keep him out of tech, bio-tech and other high obsolescence industries.

For each of the firms they track, they know what qualifies as the “fire sale” price of the stock, typically the lowest p/e or lowest price/book ratios at which the stock has sold. When impatient investors offer quality companies at fire sale prices, Mr. Deysher buys. When they demand higher prices, he waits.

There’s an old saying, Wall Street is the place where the patient take from the impatient. Impatient investors tend to make mistakes. We are there to exploit those mistakes. We are very patient. When we find a compelling value, we step up quickly. That reflects the fact that we’re very risk adverse, not action adverse. John Deysher

His aspiration is to be competitive in rising markets and to substantially outperform in falling ones. That’s pretty much was his ten-year performance chart shows. Pinnacle is the blue line levitating over the 2008 crash; his peer group is in orange.

Pinnacle’s portfolio is compact, at 37 names.  Since fire sales are relatively rare, the fund generally sits between 40-60% in cash though he’s been willing to invest substantial amounts of that cash in a relatively short period. Many of his holdings are incredibly small; of 202 small cap value funds, only five have smaller average market caps. And many of the holdings are unusual, even by the standard of microcap value funds. Some trade over-the-counter and for some he’s virtually the only mutual fund holding them. He also owns seven closed-end funds as arbitrage plays: he bought them at vast discounts to their NAVs, those discounts will eventually revert to normal and provide Pinnacle with a source of market-neutral gain.

Bottom line

The small cap Russell 2000 index closed February 2015 at an all-time high. An investment made six years ago – March 2009 – in Vanguard’s small cap index has almost quadrupled in value. GMO calculates that U.S. small caps are the most overvalued equity class they track. If investors are incredibly lucky, prices might drift up or stage a slow, orderly decline. If they’re less lucky, small cap prices might reset themselves 40% below their current level. No one knows what path they’ll take. So Dirty Harry brings us to the nub of the matter:

You’ve gotta ask yourself one question: “Do you feel lucky?” Well, do ya, punk?

Mr. Deysher would prefer to give his investors the opportunity to earn prudent returns, sleep well at night and, eventually, profit richly from the irrational behavior of the mass of investors. Over the past decade, he’s pulled that off better than any of his peers.

Fund website

Pinnacle Value Fund. Yuh … really, John’s not much into marketing, so the amount of information available on the site is pretty limited. Jeez, we’ve profiled the fund twice before and never even made it to his “In the News” list. And while I’m pretty sure that the factsheet was done on a typewriter…. After two or three hours’ worth of conversations over the years, it’s clear that he’s a very smart and approachable guy. He provides his direct phone number on the factsheet. If I were an advisor worried about how long the good times will last and how to get ahead of events, I’d likely call him.

Fact Sheet

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At the time of publication, this fund was named Osterweis Strategic Investment.

Objective and strategy

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

Adviser

Osterweis Capital Management. Osterweis Capital Management was founded in 1983 by John Osterweis to manage money for high net worth individuals, foundations and endowments. They’ve got $10 billion in assets under management (as of December 31, 2015), and run both individually managed portfolios and four mutual funds. Osterweis once managed hedge funds but concluded that such vehicles served their investors poorly and so wound them down in 2012. (Their argument is recapped in the “Better Mousetrap” article, linked below.) The firm is privately-held, mostly by its employees. Mr. Osterweis is in his early 70s and, as part of the firm’s transition plan, has been transferring his ownership stake to a cadre of key employees. At least six of the eight co-managers listed below own 5% of more of the adviser.

Managers

John Osterweis, Matt Berler and Carl Kaufman lead a team that includes the folks (John Osterweis, Matthew Berler, Alexander “Sasha” Kovriga, Gregory Hermanski, and Nael Fakhry) who manage Osterweis Fund (OSTFX) and those at the Osterweis Strategic Income Fund (Carl Kaufman, Simon Lee and Bradley Kane). The equity team manages over 300 separate accounts; the fixed-income team handles “a small number” of them. The team members have all held senior positions with distinguished firms (Robertson Stephens, Morgan Stanley, and Merrill Lynch).

Strategy capacity and closure

Mr. Kaufman was reluctant to estimate capacity since it’s more determined by market conditions (“in 2008 we could have put $50 billion to work with no problem”) than by limits on the asset classes or team. Conservatively estimated, the fixed-income team could handle at least an additional $4 billion given current conditions.

Active share

“Active share” measures the degree to which a fund’s portfolio differs from the holdings of its benchmark portfolio. High active share indicates management which is providing a portfolio that is substantially different from, and independent of, the index. An active share of zero indicates perfect overlap with the index, 100 indicates perfect independence. Typically active share is calculated only for equity funds, so we do not have a calculation for OSTVX. The equity sleeve of this fund is the same as the flagship Osterweis Fund (OSTFX), whose active share is 94 which reflects a very high level of independence from its benchmark.

Management’s stake in the fund

Four of the eight team members had investments in excess of $1 million in the fund, a substantial increase since our last profile of the fund. The four younger members of the team generally have substantial holdings. As of December 31, 2013, none of the fund’s independent trustees (who are very modestly compensated for their work) had an investment in the fund. Two of the five had no investment in any of the Osterweis funds they oversee.

Opening date

August 31, 2010

Minimum investment

$5000 for regular accounts, $1500 for IRAs and other tax-advantaged accounts.

Expense ratio

0.97% on assets of $166.6 million (as of July 18, 2023).

Comments

Explanations exist; they have existed for all time; there is always a well-known solution to every human problem — neat, plausible, and wrong. H.L. Mencken, “The Divine Afflatus,” New York Evening Mail, 16 Nov 1917.

If you had to invest in a portfolio that held a lot of fixed-income securities which of the following would you prefer, a fund that’s “more conservative than the portfolio’s credit profile suggests,” which “shines when volatility is considered” and its “lowest 10-year Morningstar Risk score” or one that suffers from “a lack of balance,” is “one-sided,” “doubles down on related risks” and “is vulnerable to contractions”?

Good news! You don’t have to choose since those excerpts, all from Morningstar analyst Kevin McDevitt’s latest analyses, describe the exact same portfolio: Osterweis Strategic Income (OSTIX), which serves as the fixed-income portion of the Osterweis Strategic Investment Fund’s portfolio.

How does the same collection of fixed-income securities end up being praised for their excellent low risk score and being pilloried for their riskiness? Start with the dogmatic belief that “investment grade” is always safe and good and that “high yield” is always dangerous and bad. Add in the assumption that the role of fixed-income in a stock/bond hybrid “is to provide ballast” and you’ve got a recipe for dismissing funds that don’t conform to the cookie-cutter.

Neither assumption is universally true which is to say, neither should be used as an assumption when you’re judging your investments.

Is high-yield always riskier than investment grade?

No.

There are two sources of risk to consider: interest-rate risk and credit risk. Investment grade bond investors thrive when interest rates are falling; they suffer loss of principal when interest rates rise. The risk is systemic: all sorts of intermediate-term bonds are going to suffer about equally when the Feds raise rates. Fed funds rate futures are currently forecasting a 50% prospect of a 0.25% rate hike in April and an equal chance of a 0.50% hike by October. Credit risk, the prospect that a bond issuer won’t be able to repay his debt, is idiosyncratic. That is, it’s particular to individual issuers and it’s within the power of fund managers to dodge it. In a strengthening economy, interest rate risks rise and credit risk falls. Because ratings agencies under-react to changing conditions, companies and entire sectors of the economy might have substantially lower credit risk than their “non-investment grade” ratings imply. Mr. Kaufman, one of the managers, reports on the case of “one firm in the portfolio which cut its outstanding debt in half, has lots of free cash flow and was still belatedly downgraded.” Likewise, the debt of energy companies was rated as investment grade while the sector was imploding; now that it has likely bottomed, it’s being reclassified as junk.

The Osterweis team argues that it’s possible to find lots of opportunities in shorter term high yield debt, in particular of companies that are fundamentally stronger than outdated ratings reports recognize. Such firms, Mr. Kaufman argues, offer the best risk-return tradeoff of any fixed income option today:

We invest in fixed-income for absolute return. We’re playing chicken right now, betting that interest rates won’t rise just yet. When the music stops, people are going to get hurt. I don’t like to make bets. I want to control what I can control. Investment grade investors win only if interest rates go lower. Look at what’s going to happen if nothing happens. The yield on the 10-year Treasury is 1.673%. That’s what you would get for returns if nothing happens.

Is fixed-income always the portfolio’s ballast?

No.

There are, broadly speaking, two sorts of funds which mix both stocks and bonds in their portfolios. One sort, often simply called a “balanced” fund, sticks with a mix that changes very little over time: 60% stocks (mostly domestic large caps) plus 40% bonds (mostly investment grade), and we’re done. They tend to be inexpensive, predictable and reassuringly dull. An excellent anchor for a portfolio, at least if interest rates don’t rise.

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

Why consider these funds at all?

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

Why consider Osterweis Strategic Investment?

There are two reasons. First, Osterweis makes sense in an uncertain world. Osterweis Strategic Investment is essentially the marriage of the flagship Osterweis Fund (OSTFX) and Osterweis Strategic Income (OSTIX). OSTFX is primarily a stock fund, but the managers have the freedom to move decisively into bonds and cash if need be. In the last 10 years, the fund’s lowest stock allocation was 60% and highest was 96%, but it tends to have a neutral position in the upper-80s. Management has used that flexibility to deliver solid long-term returns (7.3% over the past 15 years, as of 1/21/2015) with a third less volatility than the stock market’s. Osterweis Strategic Income (OSTIX) plays the same game within the bond universe, moving between bonds, convertibles and loans, investment grade and junk, domestic and foreign. This plays hob with its long-term rankings at Morningstar, which has placed it in three very different categories (convertibles, multi-sector income and high-yield bonds) over the past 10 years but now benchmarks all of its trailing returns as if it had been a high-yield bond fund all along.

For now, the fund is dialing back on its stock exposure. Mr. Kaufman reports:

We can invest 75%/25% in either direction. Our decision to lighten up on stocks now – we’ve dropped near 60% – determined by opportunity set. We’re adding fixed income now because we’re finding lots of great value in the short-term side of the market. Equities might return 6% this year and we think we can get equity-like returns, without equity-like risk, in fixed-income portfolio.

In his recent communication with shareholders, he writes:

We prefer to add risk only when we see a “fat pitch,” of which there are precious few at this time … at current yields there is no investment grade “fat pitch.” Our focus remains on keeping duration short and layering-in higher yielding paper, especially on sharp corrections in the market like we have seen recently. We believe that the appropriate time to take a swing at investment grade bonds will be when yields are much higher and the economy is teetering towards recession.

Second, Osterweis’s expenses, direct and indirect, are more reasonable than most. The 1.15% ratio (as of the most recent prospectus) has been dropping steadily and is at the lower end for an active allocation fund, strikingly so for a tiny one. And the other two Osterweis funds each started around 1.5% and then steadily lowered their expense ratios, year after year, as assets grew. In addition, both funds tend to have lower-than-normal portfolio turnover, which decreases the drag created by trading costs.

Bottom Line

It is easy to dismiss OSTVX because it refuses to play by other people’s rules; it rejects the formulaic 60/40 split, it refuses to maintain a blind commitment to investment grade bonds, its stock sector-, size- and country-weightings are all uncommon. Because rating systems value herd-like behavior and stolid consistency, these funds may often look bad. The question is, are such complaints “neat, plausible and wrong”? The fund’s fixed income portfolio have managed a negative down-market capture over the past 12 years; that is, it rises when the bond market falls, then rises some more when the bond market rises. Osterweis closed down their hedge fund business, concluding that many investors would derive much more benefit, more economically, from using a balanced fund as a significant part of their portfolio. Given reasonable expenses, outstanding management and a long, solid track record, Osterweis Strategic Investment warrants a place on any investor’s due-diligence short list.

Fund website

Osterweis Growth & Income Fund. There’s a link to a really nicely-reasoned, well-written piece on why, to be blunt, hedge funds are stupid investments. Osterweis used to run one and concluded that they could actually serve their investors better (better risk/return balance, less complexity, lower expenses) by moving them to a balanced fund. 

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