FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted June 1, 2007) [Archive Table of Contents]

For almost 11 years, we've been writing about things what we find interesting......Recently, we asked readers of the FundAlarm Discussion Board what they were thinking about, and you'll find some of their questions (and our answers) interspersed throughout this month's Highlights and Commentary.....We'd like to extend the same invitation to all FundAlarm readers: If you have a fund-related question, please drop us a line, and we'll try to select a few questions each month to answer.....We won't use your full name or identify you in any way, although we do ask that you include your full name with your question so that we may use your initials......While we won't be able to respond to questions individually, we promise to read every one and consider it carefully for publication, so send them in.

If your mutual fund is named Critical Math, and it's marketed on a Web site called unusualfund.com, you can't say that you haven't been warned.....The Critical Math Web site describes fund operations this way: "Systems so responsive that, depending on the market environment, we can be invested anywhere from 0% to 100% in either equities or money market instruments"......Performance since the fund's February 2006 inception has been dismal, but the fund's manager (a former insurance salesman turned financial planner) says that he's rolling out new timing models that will pull the fund out of its slump*.....If you're willing to cough up a 2.62% expense ratio you, too, can learn the ropes of market timing, along with the fund's manager.
* "The 3 worst new investment ideas," Tim Middleton, moneycentral.msn.com, May 1, 2007

Speaking of the Critical Math Fund (above), the very first words of the fund's prospectus read as follows:

This Prospectus describes the Critical Math Fund (the "Fund"), a series of Northern Lights Fund Trust, a Delaware statutory trust (the "Trust").

We suspect that many investors will skim these words, or pass them off as legal mumbo-jumbo.....But behind these words there's a mutual fund structure that's becoming increasingly common, and it's worth taking a closer look.....Officially, Northern Lights is what's called a "third-party series trust," and Critical Math is one trust (fund) in the Northern Lights series.....In practical terms, Northern Lights acts as the back-office outsourcing service (or "turnkey service provider") for Critical Math.....In effect, Critical Math plugs itself into the pre-existing Northern Lights trust, and Critical Math gets immediate access to most of the back-office fund services that it needs.....If you think in terms of mutual fund tinker toys (and who doesn't?), Northern Lights is equivalent to the center hub, below, while Critical Math is the red stick (the other sticks represent additional, unrelated funds that are also part of the Northern Lights series):

A fund like Critical Math benefits from this kind of structure because it can concentrate on managing money, and it can look to Northern Lights for almost all the services it needs (such as governance, compliance, fund accounting, distribution, etc.).....Northern Lights benefits because it can create one fund infrastructure, and then sell it to as many funds as want to plug into the hub.....But this kind of fund structure also brings some potential problems:

Because new funds can plug into an existing structure at relatively low cost, the barriers to entry are low, and it's easier than ever to enter the mutual fund business. This can be a real boon for the Jordin Sparks of the money-management world (i.e., talented and undiscovered), but it also can bring a lot of financial Sanjayas out of the woodwork.
When a fund signs on with a turnkey service provider like Northern Lights, the fund is assigned a pre-existing Board of Directors (you can think of it as Rent-a-Board). That Board could be supervising literally dozens of other unrelated funds, so the attention it can give to any single fund is limited. No member of the Board is likely to own even a single share of any fund that he or she is supervising, which means that Board members have no skin in the game. And if the Board pushes fund management too hard -- say, to lower its management fee -- the Board risks antagonizing a customer, who can easily take its business elsewhere.
Related to the previous point: The Board of a turnkey service provider is appointed by the service provider, so the Board is unlikely to suggest to a fund that it shop around for less expensive services. In this respect, as in setting management fees, the Board of a turnkey service provider can have serious conflicts of interest, and fund shareholders are unlikely to get the best possible representation.

Some dreadful funds have signed up with third-party series trusts, but also some little gems (see below), so it doesn't make sense to avoid a fund simply because it's structured this way......But if you do put your money with a fund that outsources everything, you should do so with your eyes open: In an industry known for mostly useless Boards of Directors, you probably have one of the most useless of all.
For more on this subject, see an excellent two-part series by Jeffrey Ptak at morningstar.com ("Playing Chicken with Investors")

A selected list of funds that are part of a third-party series trust (above):

Name of third-party series trust	Name of fund
Northern Lights Fund Trust	Autopilot Managed Growth
	Biondo
	Critical Math
Advisors Inner Circle Fund*	Cambiar (all)
	Champlain Small Company
	ICM Small Company
	Perimeter Small Cap Growth
	Rice Hall James (all)
	WHG (all)
Advisors Series Trust	Al Frank
	Chase Growth
	Edgar Lomax
	Leeb Focus
	Phocas Real Estate
	Teberg
RBB Fund Inc. (PFPC)	Bogle Small Cap Growth
	n/i funds (all)
	Schneider Small Cap Value
Unified Series Trust	Appleseed
	Archer Balanced
	Chinook Emerging Growth
	Crawford Dividend Growth
	Dobson Covered Call
	Polynous Growth
	Roosevelt Anti-Terror Multi-Cap

* Includes Advisors Inner Circle Fund II

A question from FundAlarm reader Charley S.:

I've got several fund investments with very successful long-time managers (Marty Whitman, Hakan Castegren for example) who are in their 70's and even 80's. How can I satisfy myself that their designated successors are going to be as capable at investing as I've grown accustomed to with the talented geezers? Do the fund companies provide any useful resume info. on the designated successors?

A response from Roy: I've found that fund manager resumes are pretty much useless for decision-making purposes. Mostly, I think, you have to assume (or hope) that Geezer is going to hand over his life's work only to a Worthy Successor. When it comes to Geezer successions, "trust but verify" is probably the best practice. Trust that Geezer has done the right thing, but verify Geezer's decision by closely comparing Worthy Successor's performance to both benchmark and peer group, and keep comparing for a long time.

Money-market funds have more assets than ever ($2.4 trillion), and the sector is still growing rapidly, as money-fund managers scramble for even the smallest yield advantage......There are currently 146 money-fund providers in the U.S., and each one needs experts in risk management, credit research, and analysis, even as they buy increasingly complex, exotic and potentially risky securities.....Given an industry this large, competitive, and fast-moving, it stands to reason that not all participants are properly staffed or equally talented, which means more opportunity than ever before for a serious mistake.....Not a prediction here, just an observation of several trends that, historically, suggest there may be some bumps in the road ahead.
"Rising money-fund risks raise specter of default," Megan Johnston, Financial Week, May 21, 2007

In last month's Highlights and Commentary, we predicted that financial advisers might soon be competing on the basis of their recommended retirement withdrawal rates.....That's because the typical 4% withdrawal rate, which is widely used today, requires a fairly large pot of money to start with, and advisers who back higher withdrawal rates are likely to be more popular with their clients (higher withdrawal rates later = less pain now).....Here's a real-world insight from a FundAlarm reader and fee-only CFP, suggesting that the retirement-withdrawal marketing battle has already begun.....Our reader draws an interesting parallel to another recent marketing battle, which already has resulted in financial casualties:

"Over the last couple of years several potential clients have left never to return because I told them that they'd need more money for retirement than other advisors (mostly insurance agents in my town). While I too hope for some miracle "cure" to the 4% withdrawal rate, this is beginning to sound like what happened with Universal Life policies in the 80's. Whoever fed in the larger projected returns got the business. It didn't take the financial salespeople long to figure that one out. Pity the poor guy who modeled reasonable interest rates back then rather than the then-current 10%. He probably went out of business 'cause the policy premiums were much higher than what the competition showed. Over the last many years I've had to pity the policy holders as I pointed out that their insurance policies were going to lapse long before they could afford them to."

Someone will always be around to sell you the dream, but you get to live the nightmare alone.

About 50 "market neutral" or "long-short" funds have been in existence for at least five years, and the worst-performing fund of the lot, by a significant margin, is Phoenix Market Neutral.....TFS Market Neutral has been one of the best-performing funds of its kind for the past couple of calendar years, and the managers who apparently know how to do market neutral (TFS) recently wrote to the directors of lagging Phoenix Market Neutral, proposing to take over the latter fund.....Alas, there will be no relief here: A spokesman for Phoenix has equated the TFS inquiry to junk mail, and says the TFS letter isn't even worth a response....."It's not the way anyone picks a portfolio manager," sniffed the Phoenix spokesman.....No, here's the way you're supposed to pick a manager, with Phoenix as your guide: Hire a captive team and let them squander shareholder money in a futile attempt to reach even the 90th percentile of their peer group.....Then, refuse all reasonable offers of help.
"Shakespearean drama," Chuck Jaffe, marketwatch.com, May 13, 2007

The Phoenix fund family has rolled out its new corporate slogan, "Where excellence grows".....Phoenix Market Neutral, the abysmal fund that refuses to seek better management (above), will be using a variation of the new slogan, "Where excellence has never been known."
FundAction, April 30, 2007

A question from FundAlarm reader T.A.:

What is the largest percentage of the dollars in a given portfolio that should be in a single mutual fund? For example, if I have 8 funds, what percentage (maximum) of the portfolio’s total dollars should be in the most favored fund? I’ve heard suggestions such as 15% or 20%, but I don’t really know how much difference it might make, or why.

A response from Roy: The folks who run target-date retirement funds would tell you that it's OK to put 100% of your money in one fund (i.e., theirs). But if you do this, and you pick the wrong target-date fund, you're screwed, so 100% in any single fund just seems foolish. At the other end of the spectrum, I'd suggest that each fund should represent at least 5% of your portfolio. If you aren't comfortable committing to at least 5%, it seems pretty clear that you lack confidence in the fund.

Between these extremes, there's no right answer. It wouldn't shock me to see a "core" holding (e.g., a well-diversified large-cap blend fund) account for 50% or more of a portfolio, at any stage in a person's life, although 20% to 25% is probably more common. (You do have a core fund, don't you?) As a fund moves away from the core, its percentage representation in your portfolio should decrease. If a non-core fund represents more than about 20% of your portfolio, you probably want to have a really good reason.

One more thought, although you probably know this already: The best time to decide on percentage allocations is before you buy your funds (that's the idea behind an asset allocation plan). Once you own eight funds, it's a bit late to be deciding on your allocations, although better late than never.

For many years, a company named First Command Financial Services sold garbage mutual funds to America's military personnel, and Fidelity was one of the chief suppliers of the garbage (these were the so-called "contractual" or "systematic" funds, like Fidelity Destiny, with obscene upfront expenses that could take a decade or more to work off).....Congress recently clamped down on such funds, and First Command was fined and banished from this sleazy business.....Last month, two Fidelity brokerage units were fined $400,000 for preparing and distributing marketing brochures with misleading and wildly inaccurate claims about the Destiny funds.....It's difficult to say exactly how much Fidelity earned from managing these garbage funds over their lifetime, but that amount is certainly millions of dollars more than this ridiculously small fine.....In other words, Fidelity has come out way ahead financially by enabling the exploitation of thousands of military personnel who deserved much, much better.....Fidelity has said that it regrets the "errors" in its sales brochures, and it has "taken steps" to ensure that errors of this sort do not occur in the future......Among those steps, FundAlarm has learned that Fidelity is negotiating to buy a corporate soul.....Once Fidelity acquires a soul, misguided ventures like the Destiny funds should be much less likely.

A mutual fund prospectus is a serious legal document, and fund managers have an obligation to follow their prospectus to the letter.....That's the crux of a lawsuit filed by two former managers of JennisonDryden municipal bond funds, Robert Waas and Robert Germano.....Waas and Germano worked for Prudential Investment Management, Inc., the subadvisor of the funds, and the managers claim that in 2004 Prudential ordered them to abandon the prospectus objective of maximizing current income, and adopt a new objective that included maximizing price appreciation and outperforming the Lehman Brothers Municipal Bond Index.....Prudential acknowledges that the managers got new orders, but Prudential contends those orders didn't amount to a change in the prospectus objective (Prudential has the report of an outside law firm to back up its contention).....Waas and Germano allege that for several months they were pressured into complying with the new mandate and, during that time, they were allowed to review the outside lawyers' 15-page report for just half an hour, and were forbidden to make copies or take notes.....Waas eventually was fired, Germano quit, and now they want reinstatement or damages......Last summer, most of their former funds were merged into Dryden National Municipals Fund, so damages seems like their only shot.
"Fund managers sue Pru," Richard Newman, northjersey.com, April 25, 2007; FundAction, April 30, 2007

We've all heard the saying, "putting lipstick on a pig," but have you ever wondered how pigs get access to lipstick in the first place?.....Now we know: Putnam has been selected to manage the retirement plan for cosmetics firm Elizabeth Arden.

Thanks to Linkster Ted, of the FundAlarm Discussion Board, for bringing this item to our attention. Ted continues to post his links almost every day, and those links continue to be the best, free mutual fund education you can find, anywhere. Give Ted a try today.

A question from FundAlarm reader J.G.:

I own Weitz Partners and if my memory is correct I believe you do also. I have owned this fund for many years and over the last few years have reduced the amount of my position. I now own in excess of 1300 shares. At this time, I am considering closing the position completely. I invest long term and do not change funds frequently. No one can expect a fund manager to always be in the top 10%, but I am beginning to think that this manager is making a cardinal mistake. It looks to me that he had a rather large position in sub-prime lending. Any manager could have been caught up in that fiasco. But it seems to me that he does not unwind a faulty position. It almost seems like obstinance or perhaps not watching closely. In any event I sure would relish your input before I make my final decision. If in fact I do sell, 1/3 would be redeployed in each of the following funds which I also own: TIBIX [Thornburg Investment Income Builder I], PEIDX [Allianz NFJ Dividend Value D], and FMIHX [FMI Large Cap]. If you do the same any ideas how you would redeploy?

A response from Roy: This is a timely question. Please see the next item.

Will Wally Weitz continue to manage the vast Roy Weitz fortune?

The issue: I personally own shares of Weitz Partners Value (WPVLX), and a couple of months ago I expressed concern about the way manager Wally Weitz had handled the fund's large position in Countrywide Financial (CFC). Specifically, it seemed to me that Wally had been blindsided by the subprime mortgage crisis, which (at the time) chopped about 20% of CFC's market value, and cost the fund about 1.4% of its net asset value.

Since then: Wally has addressed the subprime meltdown, and his handling of the Countrywide position, in the fund's annual report (dated March 31, 2007, and filed with the SEC on May 4). Here's the relevant section of Wally's recent shareholder letter (the underlining has been added by FundAlarm, the bold appears in the original):

"Since rising interest rates hurt Countrywide’s origination volumes, earnings have been on a plateau around $4 per share for three years. The stock has traded between $30 and $45 during that time and we have regularly bought more shares in the low-to-mid $30’s and reduced our position in the $40’s. As fears deepen and the possibility of a temporary, but severe, hit to Countrywide’s earnings looms, we have chosen to hold our position. Our rationale is that we do not know that it will go much lower, and we strongly believe that it should sell at much higher levels in the future. The alternative is to sell our position now with the hope of avoiding some temporary markdowns but risk missing our chance to repurchase the position before the stock recovers. Stocks have a way of bottoming long before the bad news is over and the good news appears. We sold some Berkshire Hathaway A shares in the 1970’s at $510 per share for some short-term reason, and with the stock now at $109,800 per share we’re beginning to think we are not going to get it back for $510."

Well, of course Wally didn't "know" what Countrywide was going to do -- a money manager never "knows" what any stock will do -- but managers still must make decisions. It seems to me that money management is a business of probabilities as much as anything else and, if the probability of a loss from Countrywide was greater than the probability of a gain, shareholders deserve a better explanation for why Wally didn't avoid that loss. It also seems disingenous for Wally to claim that selling CFC might have caused him to miss out on an upswing. If a manager bails out when a stock starts dropping, it seems easy enough to trigger a buy order on the way back up at an appropriate price. Maybe Wally was concerned about transaction costs, maybe the dollar amount involved was too large for such a move, or maybe that's a trading strategy he just doesn't believe in, but he should have said so. The example with Berkshire Hathaway is simply unconvincing. Countrywide is not Berkshire Hathaway and, in any case, Wally did buy shares of Berkshire Hathaway -- thousands of them -- between $510 and $109,800, even if they weren't exactly the "same" shares that he sold.

Recent events: As of May 29, Countrywide was down only about 6% for the year. The fund is performing better, too: Overall WPVLX is up about 2.5% for the year, which is nothing to write home about, but also no reason to bail out.
Do I hold the fund, or sell it?: This is a tough call. I believe Wally could have provided a better explanation of his actions and thought process, and I'm disappointed and frustrated that he didn't. Wally's poor explanation of how he handled Countrywide also might reflect a larger failure in his firm's process or procedures, which would be reason enough to dump him. On the other hand, what seemed like a lousy call at the time has been overtaken by events, and Wally's decision to hold Countrywide now seems like a no-harm, no-foul kind of situation. A truly bad decision rescued by subsequent events shouldn't be excused, but we still don't know enough to determine if this was a bad decision. Also, Countrywide aside, Weitz Partners Value has had a good twelve months, and I hate to bail out of a fund that is (finally) on a roll. I've decided not to sell WPVLX, at least through the end of the year.

As thousands of investors still await restitution from their scandal-tainted mutual funds, let's take a look at another program that was designed to help investors who were harmed: In April 2003, when regulators settled with investment banks for misleading stock research, $85 million of the settlement was set aside for federal and state investor-education efforts.....The federal investor-education program, initially led by the SEC, collapsed in 2005, and the SEC turned over its share of the investor-education money (about $50 million) to the NASD Investor Education Foundation.....So far, the NASD Foundation has given away just $2.1 million of its money, and the head of the Foundation doubts that he will be able to give away more than about $25 million in the next eight years or so (at that time -- surprise, surprise -- any remaining money will be used to support the Foundation's own programs).....The $30 million earmarked for state investor-education programs was given to the newly formed the Investor Protection Trust ("IPT"), and so far the IPT has managed to give away only about $8.5 million.....Among the state programs supported by the IPT: a $210,000 project on Minnesota public radio to broadcast generic, 40-second consumer protection messages in a variety of languages, including English, Spanish, Ojibwa, Hmong, and Amharic (oh, what FundAlarm could do with $210,000, although not in Spanish, Ojibwa, Hmong, or Amharic).....Several states pooled their investor-education allotment and awarded a $1.6 million grant to develop the public television series Money Track.....The series has averaged about 450,000 viewers per episode, less than half the average audience for reruns of Mama's Family.
"The Money Pit," Janet Paskin, SmartMoney, June 2007

A question from FundAlarm reader J.P.:

I turned my boss on to [FundAlarm] a couple of months back. Just today he mentioned that the data was old (i.e. the Data Tables read "updated 3/31" when it's 5/24). I'm pretty sure I know the answer, but how about that for a Q&A?

A response from Roy: This is a matter of logisitics, technology, and budget. FundAlarm is updated once a month, on the first of the month (on May 24, when your boss looked at the site, the update had occurred on May 1). Since it's impossible for me to obtain, analyze, and format data for the month that has just ended (for the May 1 update, that would have been April), the data always lags by one month (hence, the data as of "3/31"). Theoretically, fund data could be current as of the preceding day, but that's both expensive and technologically challenging, and it would be impossible for FundAlarm to remain a free site if I offered that feature. For what it's worth, I've found that even lagging data gives an excellent take on almost every fund. To put it another way: Even if FundAlarm provided up-to-the-minute data, I believe that readers would still reach the same general conclusion (buy, sell, hold) for almost every fund.

Mutual fund directors got a raise of 15.5% in 2006, which was the fifth consecutive year of double-digit pay increases for this mostly useless group.....Median director compensation at the largest firms was just under $172,000.
FundAction, May 7 2007

Citigroup has agreed to acquire the Bisys Group, a mutual fund service provider, for $1.47 billion.....Bisys comes with a reputation as a scandal-tainted kickback facilitator, which Citigroup also will acquire, at no extra charge.