This fund is now the Carillon Reams Unconstrained Bond Fund.

Objective and Strategy

The fund seeks to maximize total return consistent with the preservation of capital.  The fund can invest in almost any sort of fixed-income instrument, though as a practical matter their international investments are quite limited.  The fund’s maturity will not normally exceed eight years, but they maintain the option of going longer in some markets and even achieving a negative duration (effectively shorting the bond market) in others.  They can use derivative instruments, such as options, futures contracts (including interest rate futures contracts), currency forwards or swap agreements (including credit default swaps) to enhance returns, increase liquidity and/or gain exposure to particular areas of the market.  Because they sell a security when it approaches fair market value, this may be a relatively high turnover fund.

Adviser

Scout Investments, Inc. Scout is a wholly-owned subsidiary of UMB Financial, both are located in Kansas City, Missouri. Scout advises the eleven Scout funds. As of June 30, 2012, assets under the management of the Advisor were approximately $22.37 billion.  Scout’s four fixed-income funds are managed by its Reams Asset Management division, including Low-Duration Bond (SCLDX), Core Bond (SCCYX, four stars) and Core Plus Bond (SCPZX, rated five star/Silver by Morningstar, as of October 2012).

Manager

Mark M. Egan is the lead portfolio manager of the Fixed Income Funds. Thomas M. Fink, Todd C. Thompson and Stephen T. Vincent are co-portfolio managers of the Fixed Income Funds. Mr. Egan joined the Advisor on November 30, 2010. He oversees the entire fixed income division of the Advisor, Reams Asset Management, and retains oversight over all investment decisions. Mr. Egan was a portfolio manager of Reams Asset Management Company, LLC (“Reams”) from April 1994 until November 2010 and was a portfolio manager of Reams Asset Management Company, Inc. from June 1990 until March 1994. Mr. Egan was a portfolio manager of National Investment Services until May 1990.

Management’s Stake in the Fund

Messrs. Egan, Fink and Thompson have each invested over $1,000,000 in the fund.  Mr. Vincent has between $10,000 – 50,000 in it.

Opening date

September 29, 2011.

Minimum investment

$1,000 for regular accounts, reduced to $100 for IRAs or accounts with AIPs.

Expense ratio

0.99%, after waivers, on assets of $45 million (as of October 2012).

Comments

There are 6850 funds of all kinds in Morningstar’s database.  Of those, precisely 117 have a better one-year record than Scout Unconstrained Bond.

There are 1134 fixed-income funds in Morningstar’s database.  Of those, precisely five have a better one-year record.

98.3% of all funds trail Scout Unconstrained between November 1, 2011 and October 30, 2012.  99.6% of all fixed-income funds trailed Scout for the same period.

Surprised?  You might not be if you knew the record of the management team that runs Scout Unconstrained.  Mark Egan and his team from Reams Asset Management have been investing money using this strategy since 1998.  Their audited performance for the private accounts (about $231 million worth of them) is stunningly better than the records of the most renowned bond fund managers.  The funds below represent the work of the three best-known bond managers (Jeff Gundlach at DoubleLine, Bill Gross at PIMCO, Dan Fuss at Loomis) plus the performance of the Gold-rated funds in Morningstar’s two most-flexible categories: multi-sector and world.

Annualized Performance Ending September 30, 2012

You’ll notice that the performance of Scout Unconstrained does not equal the performance of the Unconstrained Composite.  The difference is that the team bought, in the private accounts, deeply distressed securities in the 2008 panic and they’re now harvesting the rewards of those purchases.  Since the fund didn’t exist, its investors don’t have the benefit of that exposure. Clark Holland, a Portfolio Analyst on the Fund, reports that, “We strive to invest the separate accounts and the mutual fund as closely as possible so returns should be similar going forward.”

Just because I’m a cautious person, I also screened all bond funds against the trailing record of the Unconstrained Bond composite, looking for close competitors.  There were none.

But I’m not sure why.  The team’s strategy is deceptively simple.  Find where the best values are, then buy them.  The Reams website posits this process:

STEP 1: Determine whether the bond market is cheap or expensive by comparing the current real interest rate to historical rates.

STEP 2: Focus on sectors offering relative value and select securities offering the highest risk‐adjusted return.

STEP 3: Continually measure and control exposure to security‐ and portfolio‐level risks.

It looks like the fund benefits from the combination of two factors: boldness and caution.

It’s clear that the managers have sufficient confidence in their judgment to act when other hesitate.  Their 2012 Annual Report cites one such instance:

A contribution to performance in the asset-backed securities (ABS) sector can be traced to our second lien or home equity holdings, which strongly outperformed.  We purchased these securities at an extreme discount after the 2008-2009 financial crisis, when defaults on home equity loans were high. Since then, default rates declined, the perceived risk of owning these securities lessened, and the prices of the securities have risen sharply.

As you comb through the fund’s reports, you find discussions of “airline enhanced equipment trust certificates” and the successful exploitation of mispricing in the derivatives market:

High-yield index swaps (CDX) such as those we own, which represent groups of credit default swaps (CDS), usually are priced similarly to high-yield cash bonds. Due to somewhat technical reasons, a price gap opened, in the second quarter of this year, between the price of high-yield CDX index swaps and high-yield cash bonds .We took advantage of the price gap to buy the CDX index swap at an attractive price and captured a nice return when pricing trended back toward a more normal level.

One simple and bold decision was to have zero long exposure to Treasuries; their peers average 35%.   As with RiverPark Short Term High Yield, the fact that their strategy (separate accounts plus the fund) has attracted a relatively small amount of investment, they’re able to drive performance with a series of relatively small, profitable trades that larger funds might need to skip over.

At the same time, you get a sense of intense risk-consciousness.  Cautious about rising interest rates, the managers expect to maintain a shorter average duration as they look for potential investments. In his October 3, 2012 letter to investors, Mr. Egan lays out his sense of how the market is evolving and how his team will respond:

What to do? Recognize the reality of a challenging environment, focus on your realistic goals as an investor, and be ready to seize opportunities as they arise.  A well-known investor recently opined as to the death of equity as an asset class.  Our take is the death of static risk allocations, or even what constitutes risk, along with buy and hold investing.  The successful investor will be aware of the challenges we face as a society, understand the efficacy or lack of it in the various (mostly political) solutions prescribed, and allow volatility, and the inevitable mispricing that will result, to be your guide. Flexibility and nimbleness will be required.  For our part, we have positioned accounts in a cautious, conservative stance as the cost of doing so has rapidly declined. We may be early and we may forgo some modest gains in risk assets, but it is both appropriate and in keeping with the style that has generated returns well in excess of our peers over most time periods.

Bottom Line

You need to approach any “too good to be true” investment with care and diligence.  The track record behind SUBFX, which is splendid and carefully documented, was earned in a different sort of investment vehicle.  As assets grow, the fund’s opportunity set will change and, possibly, narrow.  That said, the managers have successfully invested substantial sums via this strategy for nearly 15 years; the fact that they’ve placed millions of their own dollars at risk represents a very serious endorsement.

Fund website

Scout Unconstrained Bond.  Mr. Egan also wrote a very good white paper entitled “Fixed Income: The Search for Total Returns in Volatile Markets” (March 2012).  If you’re intrigued by the fund, you’ll get a better sense of the managers’ approach.  Even if you’re not, you might well benefit from their discussion of “the growing risks of not taking risks.”

Fact Sheet

[cr2012]

This fund has been liquidated.

Objective and Strategy

Stewart Capital Mid Cap Fund seeks long-term capital appreciation.  It invests, primarily, in domestic midcap stocks.  While it is technically a “diversified” fund, the managers warn that they prefer to invest in “a relatively small number of intensively researched companies.”  They operationalize “relatively small” as 30-60.  They target firms that don’t need “large amounts of leverage to execute their business plan” and firms with sustainable business advantages (favorable demographics and long-term trends, high barriers to entry, good management teams, and high returns on invested capital).

Adviser

Stewart Capital Advisors, LLC, was founded in August 2005.  It is a wholly-owned subsidiary of S&T Bank, headquartered in Indiana, PA.  As of December 31, 2011, Stewart had $965 million in assets under management.

Managers

Matthew A. Di Filippo, Charles G. Frank, Jonathan V. Pavlik, Malcolm E. Polley, Helena Rados-Derr and Nicholas Westric.  Mr. Di Filippo is the senior manager and the adviser’s investment strategist.  Mr. Polley is president and CIO.  His investing career started on Black Monday, 1987 and includes 25 years of primarily-midcap investing.  Except for Ms. Rados-Derr and Mr. Westric, the managers have all been with the fund since inception.  Each of the managers also handles something like 100-300 private accounts.

Management’s Stake in the Fund

Modest.  Three of the managers have invested between $10,001-50,000 in the fund: Polley, Di Filippo and Pavlik.  The others have invested under $10,000.  I expressed my concern about such modest commitments to President Polley.  He writes:

I could require that staff invest solely in the fund, but realize that a portfolio that is solely mid-cap oriented for some folks does not meet their risk parameters.  Also, I want staff to invest in the fund on its merits. That said, I have exactly two investments: S&T Bank stock and the Stewart Capital Mid Cap Fund.  I also have two children in college and have been using some of my investment in that fund to pay for that expense.  So, I believe I put my money where my mouth is.

Opening date

December 29, 2006. The fund converted to no-load on April 1, 2012.

Minimum investment

$1,000 or $100 for accounts with an automatic investment plan.

Expense ratio

1.50%, after waivers, on assets of $37.0 million.

Comments

I wandered by the Stewart Capital booth at Morningstar Investment Conference in June, picked up the fund’s factsheet and reports, and then stood there for a long time.  Have you ever had one of those “how on earth did I manage to miss this?” moments? As I looked at the fund’s record, that’s precisely what went through my mind: small, no-load, independent fund, great returns, low risk, low minimum investments.  Heck, they’re even in Steeler Country.  How on earth did I manage to miss this?

Part of the answer is that Stewart was not always a no-load fund, so they weren’t traditionally in my coverage universe, and their marketing efforts are very low-key.

There’s a lot to like here. The two reliable fund rating services, Morningstar and Lipper, agree that SCMFX is at the top of the midcap pack in both risk management and returns.  Here’s the Morningstar snapshot:

(Morningstar ratings, as of 10/30/12)

Morningstar’s estimate of tax-adjusted returns places Stewart in the top 1% of mid-cap funds over the past five years.

Lipper supports a similar conclusion:

(Lipper Leaders ratings, as of 10/30/12)

The fund has a striking pattern of performance over time. Normally good funds make their money either on the upside or the downside; that is, they consistently outperform in either rising or falling markets. Stewart seems to do both.  It has outperformed its peer group in eight of eight down quarters in the past five years (2008 – Q3 2012) but in only four of 11 rising quarters. But it still wins in rising markets. In quarters when the market has been rising, SCMFX gains an average of 10.65% versus 10.58% for its peer group, reflecting the fact that its “up” quarters rarely trail the market by much and sometimes lead it by a lot.

When I asked the simple question, “which mid-cap funds have been as successful? And screened for folks who could match or better Stewart over the past one, three and five year periods, I could find only four funds in a universe of 300 midcaps. Of those, only one fund, the $1.6 billion Nicholas Fund (NICSX), was less volatile.

That’s a distinguished record in a notably volatile market: 10 of the past 23 quarters have seen double-digit gains (six) or losses (four) for midcap stocks.

The fund is distinguished by effective active management. They buy the stocks they expect to outperform, regardless of the broader market’s preferences. They target stocks where they anticipate a 15% annual rate of return and which are selling at a discount to fair-value of at least 15%. Their question seems to be, “would we want to own this whole company?”  That leads them to buy businesses where the industry is favorably positioned (they mostly avoid financials, for example, because the industry only thrives when assets are growing and Stewart suspects that growth is going to be limited for years and years) and the individual firm has exceptional management. An analysis of the portfolio shows the result. They own high quality companies, ones which are growing much more quickly (whether measured by long-term earnings, cash flow, or book value) than their peers.  And they are buying those companies at a good price; their high-quality portfolio is selling at a slight discount (in price/earnings, price/sales, price/cash flow) to their peers.

Bottom Line

This is 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. Management has an entirely-admirable urge “to guard against … making foolish decisions” based on any desire to buy what’s popular at the moment.  They deserve a spot on the due diligence list for anyone looking to add actively-managed, risk-conscious equity exposure.

Fund website

Stewart Capital

Fact Sheet

[cr2012]

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

Objective

The fund seeks high current income and capital appreciation consistent with the preservation of capital, and is looking for yields that are better than those available via traditional money market and short term bond funds.  They invest primarily in high yield bonds with an effective maturity of less than three years but can also have money in short term debt, preferred stock, convertible bonds, and fixed- or floating-rate bank loans.

Adviser

RiverPark Advisors, LLC. Executives from Baron Asset Management, including president Morty Schaja, formed RiverPark in July 2009.  RiverPark oversees the six RiverPark funds, though other firms manage three of them.  RiverPark Capital Management runs separate accounts and partnerships.  Collectively, they have $567 million in assets under management, as of July 31, 2012.

Manager

David Sherman, founder and owner of Cohanzick Management of Pleasantville (think Reader’s Digest), NY.  Cohanzick manages separate accounts and partnerships.  The firm has more than $320 million in assets under management.  Since 1997, Cohanzick has managed accounts for a variety of clients using substantially the same process that they’ll use with this fund. He currently invests about $100 million in this style, between the fund and his separate accounts.  Before founding Cohanzick, Mr. Sherman worked for Leucadia National Corporation and its subsidiaries.  From 1992 – 1996, he oversaw Leucadia’s insurance companies’ investment portfolios.  All told, he has over 23 years of experience investing in high yield and distressed securities.  He’s assisted by three other investment professionals.

Management’s Stake in the Fund

Mr. Sherman has over $1 million invested in the fund.  At the time of our first profile (September 2011), folks associated with RiverPark or Cohanzick had nearly $10 million in the fund.  In addition, 75% of Cohanzick is owned by its employees.

Opening date

September 30, 2010.

Minimum investment

$1,000.

Expense ratio

1.25% after waivers on $197 million in assets (as of September 2012).  The prospectus reports that the actual cost of operation is 2.65% with RiverPark underwriting everything above 1.25%.  Mr. Schaja, RiverPark’s president, says that the fund is very near the break-even point.

There’s also a 2% redemption fee on shares held under one month.

Comments

The good folks at Cohanzick are looking to construct a profitable alternative to traditional money management funds.  The case for seeking an alternative is compelling.  Money market funds have negative real returns, and will continue to have them for years ahead.  As of June 28 2011, Vanguard Prime Money Market Fund (VMMXX) has an annualized yield of 0.04%.  Fidelity Money Market Fund (SPRXX) yields 0.01%.  TIAA-CREF Money Market (TIRXX) yields 0.00%.  If you had put $1 million in Vanguard a year ago, you’d have made $400 before taxes.  You might be tempted to say “that’s better than nothing,” but it isn’t.  The most recent estimate of year over year inflation (released by the Bureau of Labor Statistics, June 15 2011) is 3.6%, which means that your ultra-safe million dollar account lost $35,600 in purchasing power.  The “rush to safety” has kept the yield on short term T-bills at (or, egads, below) zero.  Unless the U.S. economy strengths enough to embolden the Fed to raise interest rates (likely by a quarter point at a time), those negative returns may last through the next presidential election.

That’s compounded by rising, largely undisclosed risks that those money market funds are taking.  The problem for money market managers is that their expense ratios often exceed the available yield from their portfolios; that is, they’re charging more in fees than they can make for investors – at least when they rely on safe, predictable, boring investments.  In consequence, money market managers are reaching (some say “groping”) for yield by buying unconventional debt.  In 2007 they were buying weird asset-backed derivatives, which turned poisonous very quickly.  In 2011 they’re buying the debt of European banks, banks which are often exposed to the risk of sovereign defaults from nations such as Portugal, Greece, Ireland and Spain.  On whole, European banks outside of those four countries have over $2 trillion of exposure to their debt. James Grant observed in the June 3 2011 edition of Grant’s Interest Rate Observer, that the nation’s five largest money market funds (three Fidelity funds, Vanguard and BlackRock) hold an average of 41% of their assets in European debt securities.

Enter Cohanzick and the RiverPark Short Term High Yield fund.  Cohanzick generally does not buy conventional short term, high yield bonds.  They do something far more interesting.  They buy several different types of orphaned securities; exceedingly short-term (think 30-90 day maturity) securities for which there are few other buyers.

One type of investment is redeemed debt, or called bonds.  A firm or government might have issued a high yielding ten-year bond.  Now, after seven years, they’d like to buy those bonds back in order to escape the high interest payments they’ve had to make.  That’s “calling” the bond, but the issuer must wait 30 days between announcing the call and actually buying back the bonds.  Let’s say you’re a mutual fund manager holding a million dollars worth of a called bond that’s been yielding 5%.  You’ve got a decision to make: hold on to the bond for the next 30 days – during which time it will earn you a whoppin’ $4166 – or try to sell the bond fast so you have the $1 million to redeploy.  The $4166 feels like chump change, so you’d like to sell but to whom?

In general, bond fund managers won’t buy such short-lived remnants and money market managers can’t buy them: these are still nominally “junk” and forbidden to them.  According to RiverPark’s president, Morty Schaja, these are “orphaned credit opportunities with no logical or active buyers.”  The buyers are a handful of hedge funds and this fund.  If Cohanzick’s research convinces them that the entity making the call will be able to survive for another 30 days, they can afford to negotiate purchase of the bond, hold it for a month, redeem it, and buy another.  The effect is that the fund has junk bond like yields (better than 4% currently) with negligible share price volatility.

Redeemed debt (which represents 33% of the June 2011 portfolio) is one of five sorts of investments typical of the fund.  The others include

• Corporate event driven (18% of the portfolio) purchases, the vast majority of which mature in under 60 days. This might be where an already-public corporate event will trigger an imminent call, but hasn’t yet.  If, for example, one company is purchased by another, the acquired company’s bonds will all be called at the moment of the merger.
• Strategic recapitalization (10% of the portfolio), which describes a situation in which there’s the announced intention to call, but the firm has not yet undertaken the legal formalities.  By way of example, Virgin Media has repeatedly announced its intention to call certain bonds in August 2011.  Buying before call means that the fund has to post the original maturities (7 years) despite knowing the bond will cash out in (say) 90 days.  This means that the portfolio will show some intermediate duration bonds.
• Cushion bonds (14%), a type of callable bond that sells at a premium because the issued coupon payments are above market interest rates.
• Short term maturities (25%), fixed and floating rate debt that the manager believes are “money good.”

What are the arguments in favor of RPHYX?

• It’s currently yielding 100-400 times more than a money market.  While the disparity won’t always be that great, the manager believes that these sorts of assets might typically generate returns of 3.5 – 4.5% per year, which is exceedingly good.
• It features low share price volatility.  The NAV is $10.01 (as of 6/29/11).  It’s never been high than $10.03 or lower than $9.97.  Their five separately managed accounts have almost never shown a monthly decline in value.  The key risk in high-yield investing is the ability of the issuer to make payments for, say, the next decade.  Do you really want to bet on Eastman Kodak’s ability to survive to 2021?  With these securities, Mr. Sherman just needs to be sure that they’ll survive to next month.  If he’s not sure, he doesn’t bite.  And the odds are in his favor.  In the case of redeemed debt, for instance, there’s been only one bankruptcy among such firms since 1985 and even then the bondholders are secured creditors in the bankruptcy proceedings.
• It offers protection against rising interest rates.  Because most of the fund’s securities mature within 30-60 days, a rise in the Fed funds rate will have a negligible effect on the value of the portfolio.
• It offers experienced, shareholder-friendly management.  The Cohanzick folks are deeply invested in the fund.  They run $100 million in this style currently and estimate that they could run up to $1 billion. Because they’re one of the few large purchasers, they’re “a logical first call for sellers.  We … know how to negotiate purchase terms.”  They’ve committed to closing both their separate accounts and the fund to new investors before they reach their capacity limit.

Bottom Line

This strikes me as a fascinating fund.  It is, in the mutual fund world, utterly unique.  It has competitive advantages (including “first mover” status) that later entrants won’t easily match.  And it makes sense.  That’s a rare and wonderful combination.  Conservative investors – folks saving up for a house or girding for upcoming tuition payments – need to put this on their short list of best cash management options.

Financial disclosure

Several of us own shares in RPHYX, though the Observer has no financial stake in the fund or relationship with RiverPark.  My investment in the fund, made after I read an awful lot and interviewed the manager, might well color my assessment.  Caveat emptor.

Fund website

RiverPark Short Term High Yield

Fact Sheet

[cr2012]

Objective

The fund seeks a combination of growth and income. Northern’s Investment Policy Committee develops tactical asset allocation recommendations based on economic factors such as GDP and inflation; fixed-income market factors such as sovereign yields, credit spreads and currency trends; and stock market factors such as domestic and foreign earnings growth and valuations.  The managers execute that allocation by investing in other Northern funds and outside ETFs.  As of 6/30/2011, the fund holds 10 Northern funds and 3 ETFs.

Adviser

Northern Trust Investments.  Northern’s parent was founded in 1889 and provides investment management, asset and fund administration, fiduciary and banking solutions for corporations, institutions and affluent individuals worldwide.  As of June 30, 2011, Northern Trust Corporation had $97 billion in banking assets, $4.4 trillion in assets under custody and $680 billion in assets under management.  The Northern funds account for about $37 billion in assets.  When these folks say, “affluent individuals,” they really mean it.  Access to Northern Institutional Funds is limited to retirement plans with at least $30 million in assets, corporations and similar institutions, and “personal financial services clients having at least $500 million in total assets at Northern Trust.”  Yikes.  There are 51 Northern funds, seven sub-advised by multiple institutional managers.

Managers

Peter Flood and Daniel Phillips.  Mr. Flood has been managing the fund since April, 2008.  He is the head of Northern’s Fixed Income Risk Management and Fixed Income Strategy teams and has been with Northern since 1979.  Mr. Phillips joined Northern in 2005 and became co-manager in April, 2011.  He’s one of Northern’s lead asset-allocation specialists.

Management’s Stake in the Fund

None, zero, zip.   The research is pretty clear, that substantial manager ownership of a fund is associated with more prudent risk taking and modestly higher returns.  I checked 15 Northern managers listed in the 2010 Statement of Additional Information.  Not a single manager had a single dollar invested.  For both practical and symbolic reasons, that strikes me as regrettable.

Opening date

Northern Institutional Balanced, this fund’s initial incarnation, launched on July 1, 1993.  On April 1, 2008, this became an institutional fund of funds with a new name, manager and mission and offered four share classes.  On August 1, 2011, all four share classes were combined into a single no-load retail fund but is otherwise identical to its institutional predecessor.

Minimum investment

$2500, reduced to $500 for IRAs and $250 for accounts with an automatic investing plan.

Expense ratio

0.68%, after waivers, on assets of $18 million. While there’s no guarantee that the waiver will be renewed next year, Peter Jacob, a vice president for Northern Trust Global Investments, says that the board has never failed to renew a requested waiver. Since the new fund inherited the original fund’s shareholders, Northern and the board concluded that they could not in good conscience impose a fee increase on those folks. That decision that benefits all investors in the fund. Update – 0.68%, after waivers, on assets of nearly $28 million (as of 12/31/2012.)

Comments

The case for this fund can be summarized easily.  It was a perfectly respectable institutional balanced fund which has become dramatically better as a result of two sets of recent changes.

Northern Institutional Balanced invested conservatively and conventionally.  It held about two-thirds in stocks (mostly mid- to large-sized US companies plus a few large foreign firms) and one-third in bonds (mostly investment grade domestic bonds).   Northern’s ethos is very risk sensitive which makes a world of sense given their traditional client base: the exceedingly affluent.  Those folks didn’t need Northern to make a ton of money for them (they already had that), they needed Northern to steward it carefully and not take silly risks.  Even today, Northern trumpets “active risk management and well-defined buy-sell criteria” and celebrates their ability to provide clients with “peace of mind.”  Northern continues to highlight “A conservative investment approach . . . strength and stability . . .  disciplined, risk-managed investment . . . “

As a reflection of that, Balanced tended to capture only 65-85% of its benchmark’s gains in years when the market was rising but much less of the loss when the market was falling.  In the long-term, the fund returned about 85% of its 65% stock – 35% bond benchmark’s gains but did so with low volatility.

That was perfectly respectable.

Since then, two sets of changes have made it dramatically better.  In April 2008, the fund morphed from conservative balanced to a global tactical fund of funds.  At a swoop, the fund underwent a series of useful changes.

The asset allocation became fluid, with an investment committee able to substantially shift asset class exposure as opportunities changed.

The basic asset allocation became more aggressive, with the addition of a high-yield bond fund and emerging markets equities.

The fund added exposure to alternative investments, including gold, commodities, global real estate and currencies.

Those changes resulted in a markedly stronger performer.  In the three years since the change, the fund has handily outperformed both its Morningstar benchmark and its peer group.  Its returns place it in the top 7% of balanced funds in the past three years (through 8/25/11).  Morningstar has awarded it five stars for the past three years, even as the fund maintained its “low risk” rating.  Over the same period, it’s been designated a Lipper Leader (5 out of 5 score) for Total Returns and Expenses, and 4 out of 5 for Consistency and Capital Preservation.

In the same period (04/01/2008 – 08/26/2011), it has outperformed its peer group and a host of first-rate balanced funds including Vanguard STAR (VGSTX), Vanguard Balanced Index (VBINX), Fidelity Global Balanced (FGBLX), Leuthold Core (LCORX), T. Rowe Price Balanced (RPBAX) and Dodge & Cox Balanced (DODBX).

In August 2011, the fund morphed again from an institutional fund to a retail one.   The investment minimum dropped from $5,000,000 to as low as $250.  The expense ratio, however, remained extremely low, thanks to an ongoing expense waiver from Northern.  The average for other retail funds advertising themselves as “tactical asset” or “tactical allocation” funds is about 1.80%.

Bottom Line

Northern GTA offers an intriguing opportunity for conservative investors.  This remains a cautious fund, but one which offers exposure to a diverse array of asset classes and a price unavailable in other retail offerings.  It has used its newfound flexibility and low expenses to outperform some very distinguished competition.  Folks looking for an interesting and affordable core fund owe it to themselves to add this one to their short-list.

Fund website

Northern Global Tactical Asset Allocation

Update – 3Q2011 Fact Sheet

Fund Profile, 2nd quarter, 2012

2013 Q3 Report

[cr2012]

Objective and strategy

The fund seeks to provide long-term total return by investing in common and preferred stocks, convertibles and REITs. The manager attempts to invest in high quality, small- to mid-cap firms (those with market caps between $100 million and $5 billion). He thinks of himself as having an “absolute return” mandate, which means an exceptional degree of risk-consciousness. He’ll pursue the same style of investing as in his previous charges, but has more flexibility than before because this fund does not include the “small cap” name.

Adviser

Aston Asset Management, LP. It’s an interesting setup. As of June 30, 2012, Aston is the adviser to twenty-seven mutual funds with total net assets of approximately $10.5 billion and is a subsidiary of the Affiliated Managers Group. River Road Asset Management LLC subadvises six Aston funds; i.e., provides the management teams. River Road, founded in 2005, oversees $7 billion and is a subsidiary of the European insurance firm, Aviva, which manages $430 billion in assets. River Road also manages five separate account strategies, including the Independent Value strategy used here.

Manager

Eric Cinnamond. Mr. Cinnamond is a Vice President and Portfolio Manager of River Road’s independent value investment strategy. Mr. Cinnamond has 19 years of investment industry experience. Mr. Cinnamond managed the Intrepid Small Cap (ICMAX) fund from 2005-2010 and Intrepid’s small cap separate accounts from 1998-2010. He co-managed, with Nola Falcone, Evergreen Small Cap Equity Income from 1996-1998.  In addition to this fund, he manages six smallish (collectively, about $50 million) separate accounts using the same strategy.

Management’s Stake in the Fund

As of October 2011, Mr. Cinnamond has between $100,000 and $500,000 invested in his fund.  Two of Aston’s 10 trustees have invested in the fund.  In general, a high degree of insider ownership – including trustee ownership – tends to predict strong performance.  Given that River Road is a sub-advisor and Aston’s trustees oversee 27 funds each, I’m not predisposed to be terribly worried.

Opening date

December 30, 2010.

Minimum investment

$2,500 for regular accounts, $500 for various sorts of tax-advantaged products (IRAs, Coverdells, UTMAs).

Expense ratio

1.42%, after waivers, on $616 million in assets.

Comments

While some might see a three-month old fund, others see the third incarnation of a splendid 16 year old fund.

The fund’s first incarnation appeared in 1996, as the Evergreen Small Cap Equity Income fund. Mr. Cinnamond had been hired by First Union, Evergreen’s advisor, as an analyst and soon co-manager of their small cap separate account strategy and fund. The fund grew quickly, from $5 million in ’96 to $350 million in ’98. It earned a five-star designation from Morningstar and was twice recognized by Barron’s as a Top 100 mutual fund.

In 1998, Mr. Cinnamond became engaged to a Floridian, moved south and was hired by Intrepid (located in Jacksonville Beach, Florida) to replicate the Evergreen fund. For the next several years, he built and managed a successful separate accounts portfolio for Intrepid, which eventually aspired to a publicly available fund.

The fund’s second incarnation appeared in 2005, with the launch of Intrepid Small Cap (ICMAX). In his five years with the fund, Mr. Cinnamond built a remarkable record which attracted $700 million in assets and earned a five-star rating from Morningstar. If you had invested $10,000 at inception, your account would have grown to $17,300 by the time he left. Over that same period, the average small cap value fund lost money. In addition to a five star rating from Morningstar (as of 2/25/11), the fund was also designated a Lipper Leader for both total returns and preservation of capital.

In 2010, Mr. Cinnamond concluded that it was time to move on. In part he was drawn to family and his home state of Kentucky. In part, he seems to have reassessed his growth prospects with the firm.

The fund’s third incarnation appeared on the last day of 2010, with the launch of Aston / River Road Independent Value (ARIVX). While ARIVX is run using the same discipline as its predecessors, Mr. Cinnamond intentionally avoided the “small cap” name. While the new fund will maintain its historic small cap value focus, he wanted to avoid the SEC stricture which would have mandated him to keep 80% of assets in small caps.

Over an extended period, Mr. Cinnamond’s small cap composite (that is, the weighted average of the separately managed accounts under his charge over the past 15 years) has returned 12% per year to his investors. That figure understates his stock picking skills, since it includes the low returns he earned on his often-substantial cash holdings. The equities, by themselves, earned 15.6% a year.

The key to Mr. Cinnamond’s performance (which, Morningstar observes, “trounced nearly all equity funds”) is achieved, in his words, “by not making mistakes.” He articulates a strong focus on absolute returns; that is, he’d rather position his portfolio to make some money, steadily, in all markets, rather than having it alternately soar and swoon. There seem to be three elements involved in investing without mistakes:

• Buy the right firms.
• At the right price.
• Move decisively when circumstances demand.

All things being equal, his “right” firms are “steady-Eddy companies.” They’re firms with look for companies with strong cash flows and solid operating histories. Many of the firms in his portfolio are 50 or more years old, often market leaders, more mature firms with lower growth and little debt.

Like many successful managers, Mr. Cinnamond pursues a rigorous value discipline. Put simply, there are times that owning stocks simply aren’t worth the risk. Like, well, now. He says that he “will take risks if I’m paid for it; currently I’m not being paid for taking risk.” In those sorts of markets, he has two options. First, he’ll hold cash, often 20-30% of the portfolio. Second, he moves to the highest quality companies in “stretched markets.” That caution is reflected in his 2008 returns, when the fund dropped 7% while his benchmark dropped 29%.

But he’ll also move decisively to pursue bargains when they arise. “I’m willing to be aggressive in undervalued markets,” he says. For example, ICMAX’s portfolio went from 0% energy and 20% cash in 2008 to 20% energy and no cash at the market trough in March, 2009. Similarly, his small cap composite moved from 40% cash to 5% in the same period. That quick move let the fund follow an excellent 2008 (when defense was the key) with an excellent 2009 (where he was paid for taking risks). The fund’s 40% return in 2009 beat his index by 20 percentage points for a second consecutive year. As the market began frothy in 2010 (“names you just can’t value are leading the market,” he noted), he let cash build to nearly 30% of the portfolio. That meant that his relative returns sucked (bottom 10%), but he posted solid absolute returns (up 20% for the year) and left ICMAX well-positioned to deal with volatility in 2011.

Unfortunately for ICMAX shareholders, he’s moved on and their fund trailed 95% of its peers for the first couple months of 2011. Fortunately for ARIVX shareholders, his new fund is leading both ICMAX and its small value peers by a comfortable early margin.

The sole argument against owning is captured in Cinnamond’s cheery declaration, “I like volatility.” Because he’s unwilling to overpay for a stock, or to expose his shareholders to risk in an overextended market, he sidelines more and more cash which means the fund might lag in extended rallies. But when stocks begin cratering, he moves quickly in which means he increases his exposure as the market falls. Buying before the final bottom is, in the short term, painful and might be taken, by some, as a sign that the manager has lost his marbles. He’s currently at 40% cash, effectively his max, because he hasn’t found enough opportunities to fill a portfolio. He’ll buy more as prices on individual stocks because attractive, and could imagine a veritable buying spree when the Russell 2000 is at 350. At the end of February 2011, the index was close to 700.

Bottom Line

Aston / River Road Independent Value is the classic case of getting something for nothing. Investors impressed with Mr. Cinnamond’s 15 year record – high returns with low risk investing in smaller companies – have the opportunity to access his skills with no higher expenses and no higher minimum than they’d pay at Intrepid Small Cap. The far smaller asset base and lack of legacy positions makes ARIVX the more attractive of the two options. And attractive, period.

Fund website

Aston/River Road Independent Value

2013 Q3 Report

2013 Q3 Commentary

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Objective and Strategy

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

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

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

Adviser

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

Managers

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

Management’s Stake in the Fund

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

Opening date

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

Minimum investment

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

Expense ratio

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

Comments

I can explain what Cook and Bynum do.

I can explain how they’ve done.

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

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

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

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

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

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

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

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

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

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

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

Bottom Line

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

Fund website

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

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Objective and Strategy

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

Adviser

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

Managers

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

Management’s Stake in the Fund

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

Opening date

December 1, 2011.

Minimum investment

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

Expense ratio

1.35% on assets of $8 million

Comments

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

FPA gets it consistently right.

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

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

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

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

We always demand that our investments meet the following criteria:

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

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

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

Bokota holds that the fund has four competitive distinctions:

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

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

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

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

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

Bottom Line

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

Fund website

FPAInternationalValue

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Objective and Strategy

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

Adviser

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

Managers

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

Management’s Stake in the Fund

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

Opening date

February 15, 2012

Minimum investment

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

Expense ratio

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

Comments

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

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

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

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

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

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

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

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

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

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

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

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

Bottom Line

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

Fund website

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

Disclosure

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

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Objective and Strategy

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

Adviser

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

Managers

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

Management’s Stake in the Fund

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

Opening date

May 4, 2011.

Minimum investment

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

Expense ratio

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

Comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bottom Line

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

Fund website

ASTON / River Road Long-Short Fund

2013 Q3 Report

2013 Q3 Commentary

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This fund has been liquidated.

Objective

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

Adviser

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

Managers

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

Management’s Stake in the Fund

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

Opening date

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

Minimum investment

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

Expense ratio

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

Our Original Comments

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

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

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

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

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

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

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

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

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

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

Bottom Line

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

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

Fund website

Wasatch Long-Short Fund

Fact Sheet

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