Highlights and Commentary
By Roy Weitz
(Originally posted September 1, 2006)
[Archive Table of Contents]

Everybody who writes about mutual funds eventually seems to get around to the subject of mutual fund expenses.....Now it's our turn: We took a look at all 3-ALARM and NO-ALARM funds in this month's FundAlarm database, and we expected that NO-ALARM funds (i.e., the good ones) would generally have lower expense ratios than 3-ALARM funds (i.e., the lousy ones).....We weren't disappointed.....In fact, as shown in the table below, we were a bit surprised that the NO-ALARM funds were so consistently less expensive -- in some cases, by huge amounts:


Classified this month as:
3-ALARMNO-ALARM
Average expense ratio of all small-cap funds1.74%1.47%
Average expense ratio of all mid-cap funds1.67%1.23%
Average expense ratio of all large-cap funds1.42%1.22%
Average expense ratio of all balanced funds1.47%1.30%
Average expense ratio of all international funds1.87%1.55%

It's tough to know whether NO-ALARM funds performed better because they're cheap, or whether NO-ALARM funds are cheap because they're just generally better funds -- this is always a dilemma when talking about expense ratios.....In the spirit of the upcoming political season, we'll go on record as stating that both explanations are valid: NO-ALARM funds start life with better prospects, including lower expense ratios, and those lower expense ratios eventually mean more dollars in investor pockets (i.e., better fund performance).....You'll notice that no specialty funds are included in the table above, because when we look at specialty funds the expense-ratio story becomes a bit more cloudy:


Classified this month as:
3-ALARMNO-ALARM
Average expense ratio of all communications funds2.10%1.29%
Average expense ratio of all financial funds1.69%1.84%
Average expense ratio of all health funds2.06%1.57%
Average expense ratio of all precious metals funds1.32%1.72%
Average expense ratio of all natural resources funds1.47%1.51%
Average expense ratio of all real estate funds1.73%1.36%
Average expense ratio of all technology funds2.07%1.99%
Average expense ratio of all utilities funds1.60%1.49%

We're not sure why the average NO-ALARM fund in three specialty categories (financial, precious metals, and natural resources) is actually more expensive than its 3-ALARM equivalent, but we have a theory: At least two of these categories (metals and natural resources) have been extremely hot of late, and it seems likely that performance in hot categories isn't as sensitive to high expense ratios......Overall, however, we think there's strong evidence that good performance coupled with low expenses isn't a coincidence, but is almost certainly cause and effect -- and that's the same opinion almost everyone else reaches when they look at this issue.


A correction and an apology: In last month's FundAlarm, we ran an item about the liquidation of the Rational Investor mutual fund.....We noted that the fund nicked investors for $1.50 per share before it dissolved, and we stated that fund manager James Dlugosch, through his management firm, had treated that money as a reimbursement of expenses he had previously advanced to the fund (pursuant to an agreement to cap fund expenses).....This is not correct: Neither Mr. Dlugosch nor his management firm received any of the money that was held back upon liquidation of Rational Investor, and Mr. Dlugosch's management firm will never recoup the significant amount of money advanced to the fund during its lifetime.....We sincerely regret this error, and we apologize to Mr. Dlugosch and our readers.....We'd also like to thank Mr. Dlugosch for the civil manner in which he attempted to resolve his concerns.....At one point in our discussion, Mr. Dlugosch indicated that he has always tried to be "one of the good guys" in the money management business.....Our brief interaction suggests that, indeed, he is.


Back in February 2004 we ran the following item, which described still another market-timing scandal at the Janus funds:

Money managers like charity work, in part because it helps them make contacts, but contacts can cut both ways.....In late 2001, Warren Lammert was manager of Janus Mercury, and Lammert met Gregory Trautman while both were involved in epilepsy-related causes.....Lammert invited Trautman to visit Janus headquarters, and soon Trautman's brokerage firm was making extensive market-timing trades for hedge-fund clients in a number of Janus funds, including Lammert's own (Trautman appears to have been the most active timer that Janus ever allowed, eclipsing even Edward Stern, of Canary Capital, who first got Janus in hot water back in September).....There seems little doubt that Trautman was market-timing Janus Mercury with Lammert's full knowledge and consent.....The only real question is when Lammert first became aware of Trautman's activities: Some sources say that Lammert knew what Trautman was up to from the beginning, in late 2001, while others say he didn't figure out what was going on for about a year (which wouldn't say much for Lammert's managerial savvy, but that's another story).

The SEC has finally gotten around to nailing Lammert, and the SEC's civil allegations basically parallel those in the item above: In November 2001, Lammert personally made a deal with brokerage firm Trautman Wasserman, allowing Trautman clients to market-time $50 million in and out Janus Mercury (two Janus marketing execs helped administer the Mercury deal, and the marketers also cut separate deals to allow market timing of other funds).....Before Lammert was done violating federal securities law, the SEC also alleges that he made a second market-timing deal, with brokerage firm Brean Murray & Co......Lammert, who never disclosed either deal to Mercury's directors or shareholders, will now have his day before a judge, and here's what we predict will happen: No admission by Lammert that he did anything wrong, a penalty equal to less than what he earns in a month at his hedge fund company, and -- if the SEC really decides to play hardball -- a suspension from the securities industry for a period that is shorter than Lammert's usual summer vacation.....Meanwhile, Lammert's job will never be in jeopardy, his career prospects will be as bright as ever, and we wouldn't be surprised if Lammert's SEC troubles actually become a perverse badge of honor in the strange world that he now inhabits.


What have you done for me lately? If you own Legg Mason Value (LMVTX), you might want to take a look at its data table in this month's FundAlarm:



Yes, fund fans, it's true: Legg Mason Value has underperformed its benchmark for the past 12 months, three years, and five years, and it's now classified as a 3-ALARM fund.....But wait (you ask) isn't this the legendary fund run by legendary manager Bill Miller, and hasn't the fund outperformed the S&P 500 for 15 years in a row?.....Yes, that's also true, but what we're dealing with here is an issue of timing: The performance table, above, runs from August 1, 2001 through July 31, 2006, and when you look at Legg Mason Value for periods other than full years, its overall performance can be considerably less than legendary -- and that's especially true when you consider the fund's dismal record so far in 2006 (down 9.40% through July 31 vs. +3.27% for Vanguard 500 Index).....To his credit, Bill Miller has repeatedly made this same point.....For example, if you look at Legg Mason Value for each twelve month period starting August 1, 2001, and carry that out for 60 months (i.e., five years), there's nothing about the fund that would particularly catch your eye:

Performance period
(August 1 of indicated year,
to July 31 of following year)		Legg Mason Value vs.
Vanguard 500 Index
2001-8.23%
2002+20.58%
2003-2.99%
2004+5.64%
2005-11.4%

Calendar-year track records, like Miller's, are curiosities, which relate only coincidentally to the one investment goal that really matters: Having the most possible money in your account at the end of a given time period.....In fact, all the attention on Miller's record tells us more about the media than it does about Miller' skill as a stock picker.


More than 55 years ago, Fred Schwed published a funny, devastating look at Wall Street called Where Are the Customers' Yachts?, and ever since then we're guessing that many wealthy money managers, who might otherwise have wanted a yacht, decided that they didn't need one after all.....Which brings us to Bill Miller, manager of Legg Mason Value.....According to the rumor mill, earlier this summer Miller bought a yacht that is almost a football field long (280 feet), to be used for vacations and charter rentals*.....Initially, Miller refused to discuss his yacht at all, but eventually he acknowledged that the vessel was bigger than a row boat and smaller than 280 feet.....Now, a source within Legg Mason puts Miller's yacht at 190 feet -- by our calculation, that works out to about 15 feet for every point his fund trails the S&P 500 so far this year.
* "Penthouse to the Outhouse," Jonathan R. Laing, Barron's, August 14, 2006


New-fund guru David Snowball notes that Bridgeway Funds "continues to set itself apart" from the rest of the fund world.....In an industry that often won't even mention the death of a fund manager, the Bridgeway Web site devotes a long, moving page to the life - and now, death - of one of the firm's employees.


David Snowball also notes a recent Wall Street Journal article about Bond God Bill Gross, who's apparently having a meltdown because his fund is trailing the competition so far this year....."Mr. Gross is famously competitive and says he isn't happy with the results. The firm's returns are 'a constant report card on who you are,'" said Mr. Gross, to which Mr. Snowball responds: "How sad."
"A Bond Star's Plays Turn Riskier," Gregory Zuckerman, August 23, 2006


According to Fidelity Investor's Weekly, Fido's fund managers are a pretty well-read bunch.....Aside from reading the usual business and investing books (The Intelligent Investor by Benjamin Graham, The Essays of Warren Buffett, etc.), several Fidelity managers are venturing farther afield.....For example, Jonathan Shelon, co-manager of the Fidelity Freedom funds, claims to be reading Homer's The Odyssey, while Christine Thompson, manager or several Fidelity muni bond funds, is reading The Kite Runner, a novel by Khaled Hosseini.....When we put out a request to FundAlarm's extensive network of spies and moles, we got some interesting insights into the reading habits of several other fund managers:



If you don't try, you'll never know how dishonest you can be: Class "B" mutual fund shares carry a contingent deferred sales charge (CDSC), which means that an owner typically must pay a penalty if the shares are sold before seven years.....But the CDSC is waived by the fund company if the seller is disabled, which apparently gave some Citigroup brokers a bright idea: Let's claim that our clients who want to sell "B" shares are disabled, even if they aren't, so they can avoid the CDSC.....Sure enough, after more than 100 brokers had requested more than 2,400 improper disability waivers, Citigroup has been hit with fines and restitution totaling more than $1 million.....Citigroup brokers even submitted four disability waivers on behalf of hedge funds..... Although any number of hedge funds have sucked over the years, to our knowledge no hedge fund has ever been alive, let alone disabled.
Thanks to Linkster Ted, of the FundAlarm Discussion Board, for bringing this item to our attention


Separated at birth?




Tom Bailey, founder
and former CEO of Janus
Japan's new Kaburobo,
which will soon be available
to help individual investors
buy stocks. Up to 10 Kaburobo
models will be available,
each programmed with a different,
back-tested investment strategy.


Calling all fund geeks Can you name the only active Fidelity fund manager who doesn't have a college degree?
(The answer can be found two items below)


A couple of years ago, a group of starry-eyed plaintiffs brought a lawsuit against American Century, alleging that the Kansas City company charged excessive fees for managing its mutual funds.....On July 31 of this year, the plaintiffs simply gave up their fight, and the case was dismissed.....The plaintiff's main obstacle, as with so many similar cases, was the so-called Gartenberg standard, named for Irving Gartenberg who sued Merrill Lynch (almost 25 years ago) for excessive management fees in its money market fund.....Gartenberg not only lost his lawsuit, his name forever became associated with the impossible legal standard promulgated by the federal appeals court that heard his case..... According to the Gartenberg standard, no mutual fund management fee will be deemed excessive unless it is:

"...so disproportionately large that it bears no reasonable relationship to the services rendered and could not have been the product of arm's-length bargaining [between the fund's directors and management firm]"

In other words, "abandon all hope ye shareholders who enter here"....The recent American Century plaintiffs also were hobbled by an obtuse and hostile judge, who refused to let them present evidence of the much lower management fees that prevail in many non-mutual fund accounts, such as pension funds.....The judge ruled that non-mutual fund fees were "irrelevant" to the American Century case, which is about as dumb as saying that the prices of Toyota cars are "irrelevant" to someone shopping for a Honda.....If (according to Gartenberg) fund directors negotiating fees must focus on the "services rendered" by fund management, then all services similar to fund management -- such as pension management -- are highly relevant, and should be open for consideration by directors when setting mutual fund fees.....The fund industry maintains that pension fund management fees aren't comparable to mutual fund management fees, because mutual funds provide different services and are structured differently from pension funds.....What the fund industry conveniently overlooks is that (a) the core of every mutual fund and pension fund consists of a security selection service, (b) it is possible to price only this security selection service, and (c) mutual funds continue to hugely overcharge for the identical security selection services offered by pension plans.....Someday, in some court, some judge or jury will be allowed to consider evidence that mutual funds gouge their customers for the security selection service, and someday a mutual fund company will be found liable for charging excessive management fees.....That's not much comfort, but it will happen.


Answer to the mutual fund geek question (above): Scott Offen, manager of Fidelity Value Discovery, is the only Fidelity manager without a college degree (heck, he's probably one of only a handful of managers without an MBA).....Offen, age 46, is a college dropout who started as a temporary file clerk in Fido's research library.....Eventually, he moved up to equity analyst (1985), and has covered more than 15 industries and managed eight sector funds in his years with Fidelity.....Memo to all 29-year old college dropouts who aspire today to emulate Offen's success: It ain't gonna happen
"Surprising Discovery," Katy Marquardt, Kiplinger's, September 2006



Roy's Excellent Market-Timing Adventure:
Month Eleven: Holy ****, I didn't lose money this month!

August was a pretty good month for the market, and at least this time I was on the correct side of it.....Intelli-Timer didn't issue any new signals for the month, so I ended August "long," the same way I ended July (in this case, as it has been for the entire experiment, a long position is represented by ProFunds OTC Inv, or OTPIX).....Overall, my account increased 4.70% for the month, and it's now down a little less than 8% since inception, as indicated below:

MonthDate of
signal
(1) 		Type of
signal		Fund
bought/held
(2)		Acct value
(beginning)		Acct value
(ending)
(3), (4) 		Change in
acct value
for month		Change in
acct value
since inception
October, 200510/16LongOTPIX$5,000.00$5,080.09 +1.60%+1.60%
November, 2005No new signalLong still in effectOTPIX$5,080.09$5,484.89+7.97%+9.70%
December, 200511/29ShortSOPIX$5,484.89$5,381.32-1.89%+7.63%
January, 2006No new signalShort still in effectSOPIX$5,381.32$5,378.51-0.05%+7.57%
February, 20061/29LongOTPIX$5,378.51$5,186.30-3.57%+3.73%
March, 2006No new signalLong still in effectOTPIX$5,186.30$5,193.62+0.14%+3.87%
April, 2006No new signalLong still in effectOTPIX$5,193.62$5,257.84+1.24%+5.16%
May, 2006May 16/
May 25		Cash/
Long		OTPIX$5,257.84$4,938.37-6.08%-1.23%
June, 2006June 12CashNA
(Cash)		$4,938.37$4,659.14-5.65%-6.82%
July, 2006June 29LongOTPIX$4,659.14$4,395.56-5.66%-12.09%
August, 2006No new signalLong still in effectOTPIX$4,395.56$4,602.20+4.70%-7.96%
Notes:
(1) Signal was executed (i.e., fund bought) on the next business day.
(2) OTPIX=ProFunds OTC Inv.; SOPIX=ProFunds Short OTC Inv.
(3) Cut-off for valuation and account activity is 26th day of the respective month.
(4) Account value includes value of fund shares only. Cash in the account, as well as interest earned on the cash, is ignored. Brokerage commissions are paid out of this free cash, and commissions are not included in return calculations. Dividends are reinvested.


Even better than a decent absolute return for August, I gained some ground on every one of the usual FundAlarm benchmarks (see the table below), which is the first time that's happened since -- well, a long time.....However, from the inception of this experiment, I still trail every FundAlarm benchmark by at least 1,500 basis points (15%), which is almost certainly an insurmountable hurdle to clear by October 16, 2006, when this experiment is scheduled to end:

Current month
(7/27 thru 8/26)		Since inception
(10/17/05)
Schwab International Index Inv (SWINX) 3.70% 21.06%
Vanguard 500 Index (VFINX) 2.29% 10.50%
Vanguard Small Cap Index (NAESX) 0.48% 9.91%
Dreyfus Mid Cap Index (PESPX) -0.11% 8.19%
Vanguard Balanced Index (VBINX) 1.81% 7.44%
Roy's market-timing account 4.70% -7.96%
Sorted by return "Since inception"; benchmark returns assume that dividends are reinvested


In fact, with 51 days to go until this experiment ends, I'd be thrilled just to get back my original $5,000, plus trading commissions.

To be continued....


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FundAlarm © Roy Weitz, 2006