Dear friends,

The craziness of summer always amazes me.  People, who should be out watching their kids play Little League, or lounging in the shade with a cold drink, instead fret like mad about the end of the (investing) world as we know it.  Who would have guessed, despite all of the screaming, that it’s been a pretty decent year in the market so far?  Vanguard’s Total Stock Market Index fund (VTSMX) returned 6.3% in the first six months of 2011.  The market turbulence in May and June still constituted a drop of less than 3% from the market’s late April highs.

In short, more heat than light, so far.

Justice Thomas to investors: “Sue the Easter Bunny!”

On June 13^th, the Supreme Court issued another ruling (Janus Capital Group vs. First Derivative Traders)  that seemed to embrace political ideology rather more than the facts of the case. The facts are simple: Janus’s prospectuses said they did not tolerate market-timing of the funds.  In fact, they actively colluded in it.  When the news came out, Janus stock dropped 25%.  Shareholders sued, claiming that the prospectus statements were material and misleading.  The Court’s conservative bloc, led by Skippy Thomas, said that stockholders could sue the business trust in which the funds are organized, but not Janus.  Since the trust has neither employees nor assets, it seems to offer an impregnable legal defense against any lies embedded in a prospectus.
The decision strikes me as asinine and Thomas’s writing as worse.  The only people cheerleading for the decision are Janus’s lawyers (who were active in the post-decision press release business) and the editorial page writers for The Wall Street Journal:

In Janus Capital Group Inc. v. First Derivative Traders, investors claimed to have been misled into buying shares of stock at a premium by prospectuses that misrepresented Janus Investment Fund’s use of so-called market timing. . .

The Court’s ruling continues a string of recent cases that put limits on trial-bar marauding, but the dissent by the four liberal Justices all but invites further attempts. As in so many legal areas, this Supreme Court is only a single vote away from implementing through the courts a political agenda that Congress has consistently refused to pass.

The editorial can sustain its conclusion only by dodging the fact (the business trust is a shell) and quoting Thomas’s thoughtless speechwriter/speechmaker analogy (which fails to consider the implication of having the writer and maker being the same person).   The Journal‘s news coverage recognized the problem with the ruling:

William Birdthistle, a professor at the Chicago-Kent College of Law, said the ruling disregarded the practical reality that mutual funds are dominated by their investment advisers, who manage the business and appoint the funds’ boards of directors.

“Everyone knows the fund is an empty marionette. It doesn’t do anything,” said Prof. Birdthistle, who filed a brief supporting the Janus investors. “You’re left with a circumstance where no one is responsible for this.”

The New York Times gets closer:

With Justice Clarence Thomas writing for a 5-to-4 majority, the Supreme Court has made it much harder for private lawsuits to succeed against mutual fund malefactors, even when they have admitted to lying and cheating.

The court ruled that the only entity that can be held liable in a private lawsuit for “any untrue statement of a material fact” is the one whose name the statement is presented under. That’s so even if the entity presenting the statement is a business trust — basically a dummy corporation — with no assets, while its owner has the cash.

Justice Thomas’s opinion is short and, from the mutual fund industry’s perspective, very sweet: Janus Capital Group and Janus Capital Management were heavily involved in preparing the prospectuses, but they didn’t “make” the statements so they can’t be held liable. . . Which means that there is no one to sue for the misleading prospectuses.

The ICI was publicly silent (too busy preparing their latest “fund expenses have too plummeted” and “America, apple pie and 12(b)1 fee” press releases,) though you have to imagine silent high-fives in the hallway.  I’m not sure of what to make of Morningstar’s reaction.  They certainly expressed no concern about, displeasure with or, alternately, support for the decision.  Mostly they conclude that there’s no threat in the future:

The ruling should not have a material impact on Janus mutual fund shareholders, according to Morningstar’s lead Janus fund analyst, Kathryn Young. Janus has had procedures in place since 2003 to prevent market-timing . . .

Uhhh . . .  Uhhh . . .  if those procedures are expressed as a sort of contract – communicated to investors – in the prospectus . . .  uhhh . . . hello?

The more pressing question is whether the decision also guts the SEC’s enforcement power, since the decision seems to insulate a firm’s decision-makers from the legal consequences of their acts.  It’s unclear why that insulation wouldn’t protect them from regulators quite as thoroughly as from litigators.

In short, you’ll have about as much prospect of winning a suit against the Easter Bunny as you will of winning against a fund’s fictitious structure.

The Odd Couple: Manager Gerry Sullivan and the Vice Fund (VICEX)

One of the fund industry’s nicest guys, Gerry Sullivan, has been appointed to run an awfully unlikely fund: VICEX.  Gerry has managed the Industry Leaders fund (ILFIX) since its launch.  The fund uses a quantitative approach to identify industries in which there are clear leaders and then looks to invest in the one or two leading firms.  The fund has a fine long-term record, though it’s been stuck in the mud for the past couple years.  The problem is the fund’s structural commitment to financial stocks, which have been the downfall of many good managers (think: Bruce Berkowitz, 90% financials, bottom 1% of large cap funds through the first half of 2011).  Since financial services match the criteria for inclusion, Sullivan has stuck with them – and has been stuck with them.  The rest of the portfolio is performing well, and he’s waiting for the inevitable rebound in U.S. financials.

In the interim, he’s been appointed manager of two very distinctive, sector-limited funds:

Generation Wave Growth Fund (GWGF), a sort of “megatrends” fund targeting the health care, financial services and technology sectors, and

Vice Fund (VICEX), which invests in “sin stocks.”  It defines those as stocks involved with aerospace/defense, gaming, tobacco and alcoholic beverages.

I’m sure there are managers with less personal engagement in sin industries than Gerry (maybe John Montgomery, he of the church flute choir, at Bridgeway), but not many.

Almost all of the research on sin stocks reaches the same conclusion: investing here is vastly more profitable than investing in the market as a whole.  Sin stocks tend to have high barriers to entry (can you imagine anyone starting a new tobacco company?  or a new supersonic fighter manufacturer?) and are often mispriced because of investor uneasiness with them.  Over the medium- to long-term, they consistently outperform both the market and socially-responsible indexes.  One recent study found a global portfolio of sin stocks outperforming the broad market indexes in 35 of 37 years, with “an annual excess return between 11.15% and 13.70%”  (Fabozzi, et al, “Sin Stock Returns,” Journal of Portfolio Management, Fall 2008).

About two-thirds of the portfolio will be selected using quantitative models and one-third with greater qualitative input.  He’s begun reshaping the portfolio, and I expect to profile the fund once he’s had a couple quarters managing it.

Who You Callin’ a “Perma-bear”?

Kiplinger’s columnist Andrew Feinberg wrote an interesting column on the odd thought patterns of most perma-bears (“Permanent Pessimists,” May 2011).  My only objection is his assignment of Jeremy Grantham to the perma-bear den.  Grantham is one of the founders of the institutional money manager GMO (for Grantham, Mayo, and van Otterloo).  He writes singularly careful, thoughtful analyses – often poking fun at himself and his own errors (“I have a long and ignoble history of being early on market calls and, on two occasions, damaged the financial well-being of two separate companies – Batterymarch and GMO”) – which are accessible through the GMO website.

Feinberg notes that Grantham has been bearish on the US stock market for 20 years.  That’s a half-truth.  Grantham has been frequently bearish about whatever asset class has been most in vogue recently.  The bigger questions are, is he wrong and is he dangerous?  In general, the answers are “sometimes” and “not so much.”

One way of testing Grantham’s insights is to look at the performance of GMO funds that have the flexibility to actually act on his recommendations.  Those funds have consistently validated Grantham’s insights.  GMO Global Balanced, Global Equity Allocation and U.S. Equity Allocation are all value-conscious funds whose great long-term records seem to validate the conclusion that Grantham, skeptical and grumpy or not, is right quite often enough.

Who You Callin’ “Mr. Charge Higher Prices”?

This is painful, but an anonymous friend in the financial services industry sent along really disturbing ad for a webinar (a really ugly new word).  The title of the June 8^th webinar was “How to Influence Clients to Select Premium-Priced Financial Products and Services! (While Reinforcing Your Valuable Advice).”    The seminar leader “is known as Mr. Charge Higher Prices because he specializes in teaching how to get to the top of your customer’s price . . . and stay there!”

Sound sleazy?  Not at all, since the ad quotes a PhD, Professor of Ethics saying that the seminar leader shows you how to sell high-priced products which are also “higher-value products that more closely align with their goals and objectives.  [He] teaches them how to do so with integrity and professionalism.”  Of course, a quick internet search of the professor’s name and credentials turns up the fact that his doctorate is from an online diploma mill and not a university near London. It’s striking that seven years after public disclosure of his bought-and-paid-for PhD, both the ethicist and Mr. Higher Prices continue to rely on the faux credential in their advertising.

And so, one simple ad offers two answers to the question, “why don’t investors trust me more?”

Two Funds, and why they’re worth your time

Really worth it.  Every month the Observer profiles two to four funds that we think you really need to know more about.  They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention.  They might come from a great boutique or be offered by a top-tier manager who has struck out on his own.  The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought.  This month’s two new funds:

RiverPark Short Term High Yield (RPHYX): put your preconceptions aside and pick up your copy of Graham and Dodd’s Security Analysis (1940).  Benjamin Graham was the genius who trained the geniuses and one of his favorite investments was “cigar butt stocks.”  Graham said of cigar butts found on the street, they might only have two or three good puffs left in them but since they were so cheap, you should still pick them up and enjoy them.  Cigar butt stocks, likewise: troubled companies in dying industries that could be bought for cheap and that might still have a few quarters of good returns.

You could think of RiverPark as a specialist in “cigar butt bonds.” They specialize in buying high-yield securities that have been, or soon will be, called.  Effectively, they’re buying bonds that yield 4% or more, but which mature in the next month or two.  The result is a unique, extremely low volatility cash management fund that’s earning several hundred times more than a money market.

Stars in the shadows: Small funds of exceptional merit. There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar.  Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples).  Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention.  There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight gf them.

The stars are all time-tested funds, many of which have everything except shareholders.

The selection of this month’s star was inspired by a spate of new fund launches.  As a result of some combination of anxiety about a “new normal” investing world dominated by low returns and high volatility, fund companies have become almost obsessive about launching complex, expensive funds, whose managers have an unprecedented range of investment options.  Eight of the nine no-load funds on July’s funds in registration page represent that sort of complex strategy:

• Litman Gregory Masters Alternative Strategies
• PIMCO Credit Absolute Return Fund
• PIMCO Inflation Response Multi-Asset
• PIMCO Real Income 2019 and 2029
• PIMCO Tax Managed Real Return Fund
• Schooner Global Absolute Return Fund
• Toews Hedged Commodities Fund

The same thing’s true of the May and June lists: 75% “alternative strategy” funds.

We don’t list load-bearing funds, in general, but recent registrations and launches there show the same pattern:

• Franklin Templeton Global Allocation
• BlackRock Credit Opportunities
• BlackRock Emerging Market Long/Short Equity
• Parametric Structured Commodity Strategy Fund
• Neuberger Berman Global Allocation

The question is: if managers asked to execute a simple strategy (say, buying domestic stocks) couldn’t beat a simple index (the S&P 500), what’s the prospect that they’re going to soar when charged with executing hugely complex strategies?

This month’s star tests the hypothesis, “simpler really is better”:

ING Corporate Leaders Trust Series B (LEXCX): at $500 million in assets, you might think LEXCX a bit large to qualify as “in the shadows.”  This 76 year old fund is almost never in the news.  There’s never been an interview with its manager, because it has no manager.  There’s never been a shift in portfolio strategy, because it has no portfolio strategy.  Born in the depths of the Great Depression, LEXCX has the industry’s simplest, more stable portfolio.  It bought an equal number of shares of America’s 30 leading companies in 1935, and held them.  Period.  No change.  No turnover.  No manager.

The amazing thing?  This quiet antique has crushed not only its domestic stock peers for decades now, it’s also outperforming the high-concept funds in the very sort of market that should give them their greatest advantage.  Read on, Macduff!

Nassim Taleb is launching a Black Swan ETF!

Or not. Actually just “not.”

Nassim Taleb, a polymath academic, is the author of Fooled by Randomness (2001) and The Black Swan: The Impact of the Highly Improbable (2007).  The latter book, described by the Times of London as one of the “Books that helped to change the world,” argues that improbable events happen rather frequently, are effectively unpredictable, and have enormous consequences.  He seems to have predicted the 2007-09 meltdown, and his advice lends itself to specific portfolio actions.

Word that “Taleb is launching a black swan ETF” is rippling through various blogs, discussion boards (both here and Morningstar) and websites.  There are three small problems with the story:

1. Taleb isn’t launching anything.  The original story, “Protect Your Tail,” from Forbes magazine, points to Taleb’s former investment partner and hedge fund manager, Mark Spitznagel.  The article notes, “After Taleb became seriously ill the duo shut the fund. Taleb has since given up money management . . .”
2. It’s not clear that Spitznagel is launching anything.  Forbes says, “In July Universa intends to tap the financial adviser market by offering its own black swan ETF. The fund will mimic some of the strategies employed by its institutional-only hedge fund and will have an expense ratio of 1.5%.”  Unfortunately, as of late June, there’s no such fund in registration with the SEC.
3. And you wouldn’t need it if there was such a fund.  Spitznagel himself calls for allocating “about 1% of an investment portfolio to fund such a ‘black swan protection protocol.'”  (Hmmm… in my portfolio that’d be about $12.50.)  If you wanted to have some such protection without a fund with a trendy name, you could adopt Taleb’s recommendation for a “barbell strategy,” in which you place 80% into stable investments, like government bonds and cash, and 20% into risky ones, such stocks and commodities.

Oddly enough, that comes close to describing the sort of strategy already pursued by funds like Permanent Portfolio (PRPFX) and Fidelity Strategic Income (FSICX) and those funds charge half of the reported “black swan” expenses.

Briefly noted:

Long-time SmartMoney columnist, James B. Stewart has moved to The New York Times.  Stewart helped found the publication and has been writing the “Common Sense” column for it for 19 years, yet the letter from the editor in that issue made no mention of him and his own final column offered his departure as an afterthought. On June 24^th, his first column, also entitled “Common Sense,” appeared in the Times.  Stewart’s first story detailed the bribery of Mexican veterinarians by Tyson Foods.  He’ll be a Saturday columnist for the Business Day section of the paper, but they’re no word on what focus – if any – the feature might have.

For those interested in hiking their risk profiles, Matthews Asia launched its new Matthews China Small Companies Fund (MCSMX) on May 31, 2011.  As with most Matthews funds, there’s a lead manager (Richard Gao, who also manages Matthews China MCHFX) and a guy who’s there in case the manager gets hit by a bus (Henry Zhang, also the back-up guy on Matthews China).

Possible investors will want to read Andrew Foster’s new commentary for Seafarer Capital.  Andrew managed Matthews Asia Growth & Income (2005-2011) before leaving to found Seafarer.  While he has not yet filed to launch a mutual fund, Andrew has been posting a series of thoughtful essays on Asian investing, including several that focus on odd numbers and Chinese finance.  He promises in the next essay to look at BRICS in general but will also “touch upon China’s elevated (some would say breakneck) pace of investment, and what it means for the future of that country.”

Investors will also want to look at the prevalence of financial fraud in Chinese companies.  A recent Barron’s article provides a list of 20 Chinese firms that had a stop trading on the NASDAQ recently, a sign that their American accountants wouldn’t sign-off on the books.  While Matthews has a fine record and Gao promises extensive face-to-face meetings and fundamental research, these seem to be investments treacherous even for major firms.

Vanguard’s new actively managed emerging-markets fund, Vanguard Emerging Markets Select Stock (VMMSX) launched at the end of June.  It will complement their existing emerging markets index fund (VEIEX), the largest e.m. fund in existence.  Vanguard has four high-quality sub-advisors (M&G Investment Management, Oaktree Capital Management, Pzena Investment Management, and Wellington Management) none of whom have yet run an emerging markets funds.  Minimum investment is $3000 and the expense ratio is 0.95%, far below the category average.Rejoice!  AllianceBernstein is liquidating AllianceBernstein Global Growth (ABZBX). It’s no surprise, given the fund’s terrible performance of late.

Schwab plans to liquidate Schwab YieldPlus (SWYSX), a fund which once had $12 billion in assets.  Marketed as a higher-yield alternative to money markets, it blew apart in 2008 – down 47% – and Schwab has spent hundreds of millions on federal and state claims related to the fund, and faced charges filed by the SEC. Schwab will liquidate Schwab Tax-Free YieldPlus (SWYTX) and Schwab California Tax-Free YieldPlus (SWYCX) at the same time.

Vanguard Structured Large-Cap Growth liquidated on May 31, 2011.

John Hancock Classic Value Mega Cap (JMEAX) will liquidate on Aug. 19, 2011.

Calvert Large Cap Growth (CLGAX) will merge into Calvert Equity (CSIEX), assuming that shareholders (baaaa!) approve.  They’ve got the same management team and Calvert will lower CSIEX’s expenses a bit.

Morgan Stanley Special Growth (SMPAX) will soon merge into Morgan Stanley Institutional Small Company Growth (MSSGX).

ING Value Choice (PAVAX) and ING Global Value Choice (NAWGX) will close to most new investors on July 29, 2011.

Nuveen Tradewinds Value Opportunities (NVOAX) and Nuveen Tradewinds Global All-Cap (NWGAX) will close to most new investors on August 1, 2011.

Fidelity Advisor Mid Cap (FMCDX) will change its name to Fidelity Advisor Stock Selector Mid Cap on August 1, 2011.

JPMorgan Dynamic Small Cap Growth (VSCOX) and JPMorgan Small Cap Growth (PGSGX) will close to most new investors on August 12, 2011.

The MFO Mailbag . . .

I receive a couple dozen letters a month.  By far, the most common is a notice that someone goofed up their email address when signing up our e-mail notification service or registering for the site.  Regrets to Wolfgang and fjujv1.  The system generated a flood of mail reporting on its daily failure to reach you.  For other folks, please double-check the email you register with and, if you have a spam blocker, put the Mutual Fund Observer on your “white list” or our mail won’t get through.

Is there a Commentary archive (Les S)?  Yes, Les, there is.  You just can’t see it yet.  Chip is adjusting the site navigation and, within a week, the April through June commentaries will be available through links on the main commentary page.

Will the Observer post lists of Alarming, Three-Alarm and Most Alarming Three-Alarm funds (Joe B, Judy S, Ed S)?  Sorry, but no.  Those were Roy’s brainchild and I lack the time, expertise and passion needed to maintain them.  Morningstar’s free fund screener will allow you to generate lists of one-star funds, but I’m not familiar with other free screening tools aimed at finding the stinkers.

Is it still possible to access stuff you’d written at FundAlarm (Charles C)?  Not directly now that FundAlarm has gone dark.  I’d be happy to share copies of anything that I’ve retained (drop an email note), though that’s a small fraction of FundAlarm’s material.  There’s an interesting back door.  Google allows you to search for cached material by site.  That is, for example, you can ask The Google if it could provide a list of all references to Fidelity Canada that appeared at FundAlarm.com.  To do that, simple add the word site, a colon, and a web address to your search.

Fidelity Canada site:fundalarm.com

If the word “cached” appears next to a result, it means that Google has saved a copy of that page for you.

Shouldn’t Marathon Value be considered a Star in the Shadows (Ira A)?  Yes, quite possibly. Ira has recommended several other find small funds in the past and Marathon Value (MVPFX) seems to be another with a lot going for it.  I’ll check it out.  Thanks, Ira.  If you’ve got a fund you think we should look at more closely, drop a line to David@MutualFundObserver.com, and I’ll do a bit of reading.

In closing . . .

Thanks to all the folks who’ve provided financial support for the Observer this month.  In addition to a half dozen friends who provided cash contributions, either via PayPal or by check, readers purchased almost 250 items through the Observer’s Amazon link.  We have, as a result, paid off almost all of our start-up expenses.  Thanks!

For July, we’ll role out three new features: our Amazon store (which will make it easier to find highly-recommended books on investing, personal finance and more), our readers’ guide to the best commentary on the web, and The Falcon’s Eye.  (Cool, eh?)  Currently, if you enter a fund’s ticker symbol in a discussion board post, it generates a pop-up window linking you to the best web-based resources for researching and assessing that fund.  In July we’ll roll that out as a free-standing tool: a little box leading you to a wealth of information, including the Observer’s own fund profiles.

Speaking of which, there are a number of fund profiles in the works for August and September.  Those include Goodhaven Fund, T. Rowe Price Global Infrastructure and Emerging Markets Local Currency Bond funds, RiverPark Wedgewood Fund and, yes, even Marathon Value.

Until then, take care and keep cool!

David

Dear friends,

After a lovely month in England, I returned to discover that things are getting back to “normal” again in the financial markets.

Top executives of publicly traded money management firms got raises averaged 33% “as improved financial results and increases in assets under management put them further away from the market turmoil of years past” (Randy Diamond, “Good times rollin’ once again for money manager execs,” Pensions and Investments Online, May 16 2011). While paltry by bankers’ standards, some of the money firm chiefs should be able to cover their mortgages: Larry Fink of BlackRock took home $24 million, while Janus CEO Richard Weil and Affiliated Managers Group CEO Sean Healey each got $20 million.

Pension plans are moving back into hedge fund investing.  According to the consulting firm Prequin, pension plans have 6.8% of their money in hedge funds now compared to 3.6% in 2007.  One motive for the change: hedge funds have returned 6.8% on average over the decade compared to 5.7% for the plans’ stock investments.  By increasing exposure to hedge funds, the plans can mask the magnitude of their uncovered commitments.  That is, they can project higher future returns and so argue that they’ll surely be able to cover their apparently huge deficits.  (“Pensions leap back to hedge funds,” WSJ, May 27 2011)

Rich folks are losing interest in managing their own investments, and are back to handing money over to their “wealth managers” to shepherd.  In 2009, 69% of high net worth investors wanted to take “an active role” in managing their investments.  It’s down to 47% in 2011, which Clifford Favrot of Delta Financial Advisers describes as “returning to normal” (“Rich relax a bit but stay on guard,” WSJ, May 27 2011).

In general, any time folks decide that it’s time to stop worrying, it’s time to start worrying.  Worrier par excellence Jeremy Grantham of GMO argues that the strong performance of risk assets – both stocks and bonds – is detached from the underlying economy.  His advice: “the environment has simply become too risky to justify prudent investors hanging around, hoping to get luck.  So now is not the time to float along with the Fed, but to fight it.”  While Grantham ruefully admits “to a long and ignoble history of being early on market calls” (well, sometimes two years early), he’s renewed his calls to concentrate on high quality US blues and emerging market equities (“Time to be serious – and probably too early – once again,” GMO Quarterly Letter, May 2011).

Part of Wall Street’s Normal: Gaming the System

Folks who suspect that the game is rigged against them have gotten a lot of fodder in the last two months.  A widely discussed article in Rolling Stone Magazine (“The Real Housewives of Wall Street,” April 2011) looks at how federal bailout money was allocated.  In general: (1) poorly and (2) to the rich.  While Stone is not generally a voice of conservatism, its story might have a comfortable home even in the National Review:

. . . the government attempted to unfreeze the credit markets by handing out trillions to banks and hedge funds. And thanks to a whole galaxy of obscure, acronym-laden bailout programs, it eventually rivaled the “official” budget in size — a huge roaring river of cash flowing out of the Federal Reserve to destinations neither chosen by the president nor reviewed by Congress, but instead handed out by fiat by unelected Fed officials using a seemingly nonsensical and apparently unknowable methodology.

Stone argues that “the big picture” of a multi-trillion dollar bailout is simply too big for human comprehension, but that you can learn a lot by looking through the lens of the assistance given a single firm: Waterfall TALF Opportunity.  While Waterfall received a pittance – a mere quarter billion compared to Goldman Sachs $800 billion – Waterfall was distinguished by the credentials of its two chief investors: Christy Mack and Susan Karches.

Christy is the wife of John Mack, the chairman of Morgan Stanley. Susan is the widow of Peter Karches, a close friend of the Macks who served as president of Morgan Stanley’s investment-banking division. Neither woman appears to have any serious history in business, apart from a few philanthropic experiences. Yet the Federal Reserve handed them both low-interest loans of nearly a quarter of a billion dollars through a complicated bailout program that virtually guaranteed them millions in risk-free income.

Stone details the story of the women’s risk-free profits, courtesy of a category of bailout program they describe as “giving already stinking rich people gobs of money for no ****ing reason at all.”  Waterfall investors put up $15 million, then received $220 million in federal funds with the promise that they could receive 100% of any investment gains but be responsible for only 10% of any investment losses they incurred.  It’s a fascinating, frustrating story.

Happily, the women wouldn’t need to worry about investment losses as long as they accepted guidance from the world’s best investors: members of the U.S. House of Representatives.  A study in Business and Politics examined the financial disclosure records of all the members of Congress.  They concluded that somehow members of Congress outperformed the stock market by “6.8% per annum after compounding – better than hedge-fund superstars.”  U.S. Senators performed even better.  While it’s possible that House members are simply smarter than hedge fund managers, the authors darkly conclude “We find strong evidence that Members of the House have some type of non-public information which they use for personal gain” (“Fire Your Hedge Fund, Hire Your Congressman,” Barron’s, 05/26/2011).

It’s the world’s scariest ad!

Remember Larry, Darryl and Darryl from the old Newhart TV show?  The three deranged brothers launched their first business – “Anything for a Buck”. They’ll do anything for a buck. If it’s something cool like digging up an old witch’s body from the cellar, they might even pay you the buck!

Apparently they’re now the masterminds behind iShares, whose slogan seems to be “anything can be an ETF!”

Fairholme Fund wobbles

Fairholme Fund (FAIRX), a huge, idiosyncratic beast run by Morningstar’s equity manager of the decade, Bruce Berkowitz, has had a bad year.  The fund trails its average peer by 15 percentage points of the past year and ranks in the bottom 1% of large cap value funds for the past quarter, two quarters and four quarters (as of June 2011).  The fund sucked in $4 billion of anxious money in 2010 after a long, remarkable run.  Predictable as the rains in spring, $1 billion of assets rushed back out the door in April alone (per Morningstar fund flow estimates).  That’s three times worse than any other month in its history.

Bruce Berkowitz didn’t dodge the fund’s problems in a May 11 conference call with investors:

Here are my thoughts on the Fairholme Funds recent performance: horrible, [and] that’s the summary in hindsight and it may be to be expected over the short term.

We’ve always stated in our reports that short-term performance should not be over emphasized. It’s the long term that counts. This is not the first time we’ve underperformed; it won’t be the last time and I don’t think it’s reality to outperform every month, quarter or year.

So it’s been lousy for months, we’ve been losing, we’re way underperforming, and it may stay lousy for more time.

He argues that the short-term problem is his decision to buy financial stocks (now 90% of the portfolio), which is expects to continue buying.  “We need to buy low and buy lower and buy lower. Even when the crowd yells you’re wrong. This is how we’ve achieved our performance over the past decade and this is how we will achieve our performance in the next couple of decades.”

One of his highest-visibility holdings, St. Joe Corporation (JOE) a Florida land company.  They started as a paper mill, got rich, got stupid, bought a bunch of stuff they shouldn’t have (brokerage firms, for example), had no debt but made no money.  After a long battle, Fairholme took control of St. Joe in March, forcing out the CEO and much of the board.

Why care?

There’s an interesting argument that St. Joe was less important for its huge land holdings than for its ability to make investments that Fairholme itself cannot make.  A fascinating article in Institutional Investor notes:

St. Joe may not seem like a major prize in the big scheme of things, with a market value of just $2.4 billion, but Berkowitz and Charles Fernandez, his No. 2 at Fairholme for the past three and a half years, saw a huge opportunity. Not only did they think that the company’s real estate operations could be worth a lot more in the future, they saw St. Joe as a way to buy assets that a regulated mutual fund would be prohibited from owning directly. In essence, if successful, they could transform their flagship Fairholme Fund into something akin to a hedge fund or an investment vehicle like Warren Buffett’s Berkshire Hathaway.

“We’re trying to go in a direction we think most mutual funds will be going — where we have the flexibility to do private transactions and public transactions, and the ability to do what makes sense for our shareholders,” Berkowitz says. (“Fairholme’s Bruce Berkowitz Is Beating Hedge Fund Managers at Their Own Game,” Institutional Investor, 05/19/2011).

Indeed, in his conference call, Berkowitz says, “JOE is, at its heart, an asset manager.”

The possibilities are intriguing.  In his interview with the Observer, Mr. Berkowitz argued that Fairholme’s size ($20 billion in assets) was critical to its future.  While many observers felt the fund was too unwieldy, Berkowitz argues that only its size allows it to become party to a set of expensive, unconventional opportunities.

Beyond the simple matter of corporate restructurings, bankruptcies and other conventional “special situations,” managers are looking increasingly far afield for opportunities.  Hedge fund manager David Einhorn, who lost big to Berkowitz in the St. Joe fight, recently announced a $200 million investment in the New York Mets.   And bond maestro Jeff Gundlach pushed the investment potential of gemstones at a recent investment conference:

[Gundlach] likes gold for its “Biblical street cred, if such a thing is possible.” But he advocates gem stones over gold. “Gold has shown itself to be money and pretty. Gems have also shown themselves to be money and prettier,” he says.  (Mark Gongloff, gundlach-leads-off-with-prostitutes, WSJ Marketbeat blog, 05/25/2011

Hmmm . . . perhaps Newt Gingrich’s reported $500,000 bill with Tiffany’s isn’t just egregious excess: it’s creative portfolio management.

This never turns out well: the emerging markets debt obsession grows

A lot of emerging market debt funds are now coming to market, many of them specializing in debt priced in some local currency.  By Morningstar’s estimate, of the 20 emerging-markets local-currency funds, 14 have been opened in the last year.  These funds are a vote against the future of the US dollar and in favor of currencies supported – largely – by commodity-producing economies and growing populations.  Among the recent notable entrants:

Harbor Emerging Markets Debt (HAEDX) launched on May 2, 2011, and invests in securities that are economically tied to emerging markets, or priced in emerging-markets currencies. It’s being sub-advised, as all Harbor funds are.  The subadvisor is Stone Harbor Investment Partners whose Stone Harbor Emerging Markets Debt (SHMDX) has returned 10.5% annualized since inception. Harbor Emerging Markets Debt has an expense ratio of 1.05% and a $1000 minimum.

Aberdeen Asset Management launched Aberdeen Emerging Markets Debt Local Currency (ADLAX) on May 2, 2011. Brett Diment will lead the team responsible for managing the fund.

Forward Management launched Forward Emerging Markets Corporate Debt (FFXIX) on May 3, 2011. The fund will invest mainly in emerging-markets corporate debt, and will be subadvised by SW Asset Management. David Hinman and Raymond Zucaro will manage the fund.

T. Rowe Price launched T. Rowe Price Emerging Markets Local Currency Bond on May 26. The fund will invest in bonds denominated in emerging-markets currencies or derivatives that provide emerging-markets bond exposure.  Andrew Keirle and Christopher Rothery who manage the fund also have been managing a similar strategy for institutional investors in the T. Rowe Price Funds SICAV–Emerging Local Markets Bond Fund since 2007. That said, the institutional fund has consistently trailed T. Rowe Price Emerging Markets Bond (PREMX) since inception.

HSBC filed to launch HSBC Emerging Markets Debt, which will invest primarily in U.S.-dollar-denominated while Emerging Markets Local Debt will invest in local-currency debt. Both should come on-line on June 30, 2011.

PIMCO Developing Local Markets (PLMDX) will be renamed PIMCO Emerging Markets Currency on August 16, to reflect a slight strategy shift. The fund holds positions in short maturity local bonds and currency derivatives.  The change will give the managers a bit more freedom to choose which countries to pursue.

Emerging market bond funds have returned an average of 12-13% annually over the past 10-15 years. On face, easier and more diverse access to these assets should be a good thing.  Remember two things:  First, the asset class has done so well that future returns are likely modest.  Grantham, Mayo, van Otterloo (GMO) projects real returns on emerging market debt of just1.7% annually over the next 5-7 years (Asset Class Return Forecast, 04/30/2011).   That’s well below their projection for E.M. stocks (4.5% real) or U.S. blue chip companies (4.0%).   Second, much of those gains took place when relatively few investment companies were interested.  In 2003 for example, investors placed only $14 billion to work in emerging market debt.  Fidelity New Market Income (FNMIX) earned 31% that year. In 2010, it was $72 billion and the Fido fund returned 11%.  As more funds pile in, profits are going to become fewer and opportunities thinner.  While E.M. debt is a valid asset class, joining the herd rushing toward it might bear a moment’s reflect.

Funds worth your attention

Really worth it.  Every month the Observer profiles two to four funds that we think you really need to know more about.  They fall into two categories:

Most intriguing new funds: good ideas, great managers. These are funds that do not yet have a long track record, but which have other virtues which warrant your attention.  They might come from a great boutique or be offered by a top-tier manager who has struck out on his own.  The “most intriguing new funds” aren’t all worthy of your “gotta buy” list, but all of them are going to be fundamentally intriguing possibilities that warrant some thought.  This month’s two new fund:

Fidelity Global Strategies (FDYSX): this relatively young fund has one of Fidelity’s broadest, most ambitious mandates.  In June 2011, it was rechristened to highlight a global approach.  It’s not clear that the changes are anything more than pouring old wine in a new bottle.

Stars in the shadows: Small funds of exceptional merit.  There are thousands of tiny funds (2200 funds under $100 million in assets and many only one-tenth that size) that operate under the radar.  Some intentionally avoid notice because they’re offered by institutional managers as a favor to their customers (Prospector Capital Appreciation and all the FMC funds are examples).  Many simply can’t get their story told: they’re headquartered outside of the financial centers, they’re offered as part of a boutique or as a single stand-alone fund, they don’t have marketing budgets or they’re simply not flashy enough to draw journalists’ attention.  There are, by Morningstar’s count, 75 five-star funds with under $100 million in assets; Morningstar’s analysts cover only eight of them.

The stars are all time-tested funds, many of which have everything except shareholders.  This month’s star:

RiverNorth Core Opportunity (RNCOX): going, going, gone as of June 30.  This former “most intriguing new fund” is larger than most “stars,” but it deserves recognition for two reasons.  First, it’s truly a one-of-a-kind offering.  Second, its imminent closing makes this the idea time for potential investors to do their research and make a decision before regrets set in.

Research on the cutting edge of “duh”

Investment managers and strategies plow through an enormous amount of behavioral research these days, trying to use the predictable patterns of human (i.e., investor) behavior to better position their portfolios.  That said, a remarkable amount of published research in the area seems to cry out “duh!”

On unusually warm days, people are more likely to believe in global warming than they are on cold days, according to a survey of 1200 Americans and Australians by the Center for Decision Sciences at the Columbia Business School.

In a related study, people sitting in a steadily warming room are more likely to believe in global warming than those who are not.

On sunny days, investors are more like to choose stocks over bonds but when it’s ridiculously hot, investors become cranky and markets become volatile.

By the way, if you hand folks a warm drink, they’re more likely to rate you as a “warm” person than it you hand them a cold drink.

Extreme market volatility is bad for investors’ hearts: among Chinese investors anyway.  A 1% market jump correlates with a 2% jump in heart attacks among Chinese investors (and you thought you had problems with emerging markets’ volatility).

If you build more highways, that is, if you make driving easier and more convenient, people drive more, according to a study soon to be published in the American Economic Review.

Work is stressful, which can be scientifically measured by checking levels of the stress hormone cortisol.  A new study in the Journal of Family Psychology suggests that women’s stress levels drop when their husbands are helping with chores, but it’s the opposite for men: Their stress levels fall when their wives are busy while they’re relaxing. Oddly, the scientists didn’t report results for families in which dad did the housework, and mom relaxed.

Briefly noted:

Janus did something right and cool: kudus to Janus for publicizing the investments made by each manager in each fund, as well as in Janus funds as a whole.  While this information is purely available (it’s in the Statement of Additional Information), I know of no other fund company that brings it all together in one place.  For those interested, check here to see how serious their Janus manager is about his or her fund.

Janus Venture (JAVTX) reopened to new investors on May 6 and launched a series of new share classes (A, C, S and I).  As usual, it’s not clear why Janus re-opened the fund: it has a larger portfolio ($1.3 billion) for a small cap fund, the largest in its history, and small caps are already coming off an extended run.  The best reason to take the fund seriously, at least if you can access it without a load, is the strength of its new management team.  Janus Triton (JATTX) managers Chad Meade and Brian Schaub have run Venture for less than a year, but have made a real difference in that time.  They’ve decreased the fund’s concentration and eliminated some of its micro-cap exposure, and have generated very solid returns.  Triton, also a small cap fund, has been an exceedingly solid performer for Janus and noticeably less volatile than the typical Janus fund.  The advantage of a fee cap (holding total expenses to 1.05% for the next year) makes it more attractive still.

Journalists are funny. You can almost hear the breathlessness in Neal Anderson’s prose: “The MFWire has learned that the Boston-based mutual fund giant is re-branding the large cap blend fund as the Fidelity Global Strategies Fund. . . “(“Fido Shifts a Fund’s Name and Strategies,” 05/04/2011).  True enough, but it’s not exactly as if you needed a secret contact to find this out: Fidelity duly submitted the paperwork and it was made publicly available a week before in the SECs EDGAR database.

RiverNorth Core Opportunity (RNCOX) will close to new investors on June 30, 2011.  You really might want to read the new fund profile this month.

The Quant Funds have a new name.  They’re now the Pear Tree Funds because the former name “no longer reflects the true nature of the mutual fund family.”  At base, the funds have three sub-advisors (Polaris, PanAgora and Columbia Partners), not all of who are quant investors and the advisor felt “the former name no longer reflects the true nature” of their funds.  Apparently “pear trees” (dense, brittle and short-lived) comes closer.

During the FundAlarm hiatus, Fidelity launched Fidelity Conservative Income Bond (FCONX).  It’s an ultra-short term bond fund run by Kim Miller.  While he’s been with Fidelity for 20 years, his management experience is limited most to money market funds, though he was on the team for several of the Asset Manager and municipal bond funds.  The fund’s expense ratio is 0.40% and it has accumulated $100 million in assets in three months.  (A slow start for a Fido fund!)

Similarly, the BearlyBullish fund registered in March and launched in early May.  At base, it’s a mid- to large-cap stock fund, mostly invested in the US and Canada.  When the managers’ market indicators turn negative, the fund simply moves more of its assets to cash.  That strategy worked in 2008, when the separately managed accounts that use this system dropped 24% while the broad market dropped by 37%.  It’s run by a team from Alpha Capital Management.  The investment minimum is $1000 and the expense ratio is 1.49%.

Nuveen Quantitative Large Cap Core (FQCAX) changed its name to Nuveen Quantitative Enhanced Core.

Old Mutual Strategic Small Companies (OSSAX) changed its name to Old Mutual Copper Rock International Small Cap. The fund also changed its strategy from a domestic small-cap strategy to an international small-cap strategy.

Pending shareholder approval on June 27, Madison Mosaic Small/Mid-Cap Fund will become NorthRoad International Fund (MADMX) and the Fund’s investment objective will be changed from “long-term growth” to “long-term capital appreciation by investing in non-U.S. companies.” Under the proposal, total fund operating expenses will decrease from 1.25% to 1.15% (annualized). Madison owns a majority stake in New York-based NorthRoad already.  Northroad handles institutional accounts now and their three managers have good credentials, both in previous employment (Lazard Asset Management in a couple cases) and colleges (Williams, Columbia, Yale).  The Small/Mid-Cap fund drew negligible assets and was only a so-so performer in its short life, so this is likely a substantial gain for the firm and its shareholders.

Dreyfus Core Value will merge into Dreyfus Strategic Value (DAGVX) on Nov. 16.

MFS Core Growth (MFCAX) will merge into MFS Growth (MFEGX).

Munder Large-Cap Growth has merged into Munder Growth Opportunities (MNNAX).

RidgeWorth Large Cap Quantitative Equity (SQEAX) will merge into RidgeWorth Large Cap Core Growth Stock (CFVIX) on July 15.

Loomis Sayles Disciplined Equity liquidated on May 13.

William Blair Emerging Markets Growth (BIEMX) will close to new investors on June 30.  Heartland Value Plus (HRVIX) closed to new investors in mid-May.  Heartland noted some skepticism about the state of the small cap market in justifying their close.

In closing . . .

Google Analytics offers fascinating snapshots of the Observer community.  7000 people have visited the site and about a thousand drop by more than once a day.  Greetings to visitors from Canada, Spain, Israel, Mexico and the U.K. – our most popular countries outside the U.S.  A cheery smile to the women who (secretly) use the Observer: research just released by the market-research firm Mintel Group discovered that women, more than men, were likely to make their investments through mutual funds (“Girls just want to have funds,” Barron’s, 05/21/2011).  Over half of all the folks who wrote me before the launch of the Observer were women who relied on FundAlarm’s research and discussions, though most admitted to never feeling quite brave enough to post.

Men, contrarily, were more likely to use ETFs, stocks, options and futures – and to trade actively.  (Note to the guys: stop that!)

In addition, a special wave to our one visitor from Kenya, who seems faithfully to have read every page on the site!

Thanks to all the folks who’ve provided financial support to the Observer of the past month.  Thanks especially to the six friends of the Observer who made direct contributions through PayPal.  In response to a couple notes, I’ve also posted my snail mail address for the sake of people who want to either write or send a check (which dodges PayPal’s fees).   In addition, our Amazon link led to 244 purchases in May, which contributes a lot.  Thanks to you all!

A special thanks to Roy Weitz, who stepped in as moderator during my three weeks in England.

We read, and respond to, everything we can.  Chip continues to monitor the Board’s technical questions and I try to handle any of the emailed notes.  If you have a question, comment, compliment or concern, just write me!

If you write, please remember to include your name and contact information.  I’m always interested in learning about funds or investment trends that intrigue you, but I’m exceedingly wary of anonymous tips.

Take care and I’ll see you again on July 1!

David