Highlights and Commentary
By Roy Weitz
(Originally posted November 1, 2005)
[Archive Table of Contents]

Something old, something new. Regulatory action is long overdue. A recent press release announcing the introduction of Delaware Small Cap Core might have caused your brow to furrow: Why is the press release announcing that Small Cap Core "is now available to investors" [italics added], when the press release also indicates that the fund's "inception date" was way back in December, 1998?.....A close reading of the press release -- a really close reading -- reveals that Delaware Small Cap Core is an "incubator fund," one of the industry's most cynical, most deceptive, entirely legal, and still largely unregulated practices.....For the first six-and-a-half years of its existence, Small Cap Core was in "limited distribution" (typically, this means that only Delaware employees and their families would have been allowed to invest in the fund).....Because Small Cap Core performed reasonably well during its "limited distribution" (i.e., incubation), Delaware allowed the fund to survive, and the fund is now smiling for the public with a fresh new face and a well-worn track record.....If the fund hadn't performed well during its incubation period, it would have been liquidated, and virtually no one outside of Delaware would have been aware of its failure.....This kind of cherry-picking is bad enough, but Delaware Small Cap Core compounds the cynicism and deception: During most of the incubation period, the fund had a different name, different managers, a different style of investing, a more concentrated portfolio, a small and stable asset base, a lower expense ratio, and it didn't extract a 12b-1 fee.....In other words, the current fund is essentially new, yet it's being marketed with a track record that was carefully cultivated under totally artificial conditions*.....When a fund comes to market with this kind of history, we offer just two words of advice: "Avoid it".....And when a fund company engages in tactics like this, remember, that company is giving you a clear demonstration of its values, and what it thinks of its customers.
* Fund Spy, morningstar.com, Karen Dolan, October 13, 2005. Delaware isn't alone in this practice. Since 1999, Putnam's board acknowledges that the firm has incubated 16 funds, only one of which made it to market. Yes, Putnam's board is in on it, the entity that's supposed to represent investor interests.


When you buy a mutual fund, one smart strategy is to look for an offering that's run by its founder.....It's even better if the founder has a good, long-term track record, follows a disciplined, consistent investment strategy, communicates well with shareholders, and has a significant amount of his own money invested in the fund.


What we said just above?.....Forget it, because thousands of individuals followed exactly this advice, invested in the Clipper fund, and now those people have been screwed.....The screwer is Clipper founder James Gipson, who announced that he's quitting the fund, effective at the end of this year.....Following Gipson out the door are two other long-time, key members of the Clipper management team.....All three guys are no doubt headed for a hedge fund, and the Clipper fund is most likely headed for management by the firm of Barrow, Hanley, Mewhinney & Strauss.....Why Barrow, Hanley?......Because Barrow, Hanley is owned by Old Mutual Asset Management, which also owns Pacific Financial Research, the firm that Gipson worked for while running the Clipper fund......Old Mutual loses Gipson, but Old Mutual wants to make sure that the management fees for Clipper remain in the same corporate family......In fact, Old Mutual is key to understanding this whole affair.....Gipson still looked like a founder of his fund, but he actually sold out of his management company about seven years ago (Gipson's company was initially purchased by UAM, which later sold it to Old Mutual).....Perhaps the lesson here is a narrow one: A founder who sells out to a large corporation is no more likely to stick around, long-term, than any other fickle fund manager.....Or, perhaps the issue raised by the Clipper fund is a much broader one, highlighting the important (and seldom-discussed) subject of "manager risk."


"Manager risk" isn't a difficult concept to grasp .....When you invest in an actively-managed fund, you're casting your lot with the fund's manager, and when the manager leaves you face at least two possibilities for a loss.....If you choose to bail out of your fund when your manager does, and your shares have built-in capital gains, you'll lose part of your investment to capital gains tax (this assumes, of course, that you own the fund in a taxable account).....If you stay with the fund, and the new manager isn't as successful as the previous manager, you suffer a potential opportunity loss, since you might have earned a better return by jumping to another fund.....Often, neither alternative -- leaving or staying -- is particularly attractive or clear-cut, and the departure of your fund manager forces you into an unwanted and often uncomfortable investment decision (or no decision at all, which is the same thing).....The management change at Clipper (above) tells us that no actively-managed fund can be considered immune from manager risk.....Today's entrepreneurial founder could be tomorrow's sell-out, or today's star employee/manager could be tomorrow's hedge fund turncoat.....For these reasons, I've recently started investing all of my own taxable money exclusively in index funds (I still invest my retirement plan money with active managers).....I'm willing to settle for the market rate of return on my taxable money, when the alternative is entrusting my investment to some potentially faithless manager.....Five or ten years down the road, when that manager decides to pack it in for a better opportunity, I refuse to be forced into a no-win investment decision.....I'm structuring my portfolio now, to avoid manager risk later on.


Back in June, we reported that Mutual Series brain trust David Winters was leaving to start his own fund....Winters' Wintergreen Fund opened for business on October 14, and it presents potential investors with a dilemma: How much is too much to pay for a good manager (or at least a manager who has a reasonable chance of being good)?....Right out of the gate, Winters is charging a steep 1.50% management fee, a 0.25% 12b-1 fee, and 0.20% of other expenses, for a total expense ratio -- 1.95% -- that borders on the brazen.....Winters would probably justify the management fee by noting that his approach to investing is research-intensive and expensive, but we have a feeling that Winters hasn't hired a huge staff of analysts, so most of that juicy management fee will go right back to Winters anyway.....Also, Winters almost certainly recognizes that it would be tough to start his fund with a low management fee, and raise it later, even if the fund performs well, so he's decided to go with an aggressive fee structure from the start.....Let's say, for the sake of argument, that Winters is clearly overcharging for his management services on this fund.....That still doesn't mean he wouldn't be able to make you some money, maybe even more money than another manager who comes cheap.....And there's certainly no reason you'd have to stay with Winters forever.....Maybe you decide to invest in his new fund, hope that his best ideas quickly pan out, then you take your profits and jump to a more reasonably-priced offering......Personally, I thought that I might be interested in this fund, and I am, but I simply can't accept a 1.95% expense ratio.....But many others will eagerly invest in this fund, and their decision may prove better than mine.


When you sign on to a mutual fund Web site, you don't expect to see a picture of Caterpillar construction equipment:



If you conclude from that the Preferred Group of Mutual Funds has some affiliation with Caterpillar, you are correct: The Preferred funds are run by Caterpillar Investment Management Ltd., which is a subsidiary of Caterpillar Inc., the equipment manufacturer.....What you might not deduce from this affiliation is the extent to which Caterpillar's retirement plans dominate all ten Preferred mutual funds: Caterpillar plans own at least 92% of two Preferred funds, at least 75% of five funds, and at least 25% of the remaining three funds.....Recently, Caterpillar Inc. decided to quit the investment management business and, in the process, Caterpillar's retirement plans will be pulling their money out of the Preferred funds*.....Most of the Preferred funds are run by outside firms (i.e., subadvised), so day-to-day operations shouldn't be disrupted by Caterpillar's move, at least in the short run.....Also, Caterpillar Inc. has agreed to cover costs associated with any unusual Preferred fund redemptions, as well as cap fund expense ratios and absorb any future fund liquidation costs.....Still, Caterpillar's move is bad news for Preferred's non-Caterpillar shareholders, and there's simply no good reason to stay with these funds.....If you own any Preferred funds, you'll probably want to start looking for alternatives.
* Fund Times, morningstar.com, Dieter Owen Bardy, October 4, 2005

The Preferred funds (above) didn't exactly hide Caterpillar's involvement, but only a shareholder who dug deep into the Statement of Additional Information would have discovered the extent to which Caterpillar's retirement plans dominated these funds.....Last year, when the Boeing 401(k) plan bailed out of Invesco Technology and took almost half of the fund's assets with it, we wondered why huge ownership positions (like Caterpillar's) aren't routinely disclosed up front in the risk section of the prospectus.....Clearly, if one entity (such as a retirement plan) owns more than 90% of your mutual fund, that's an investment risk, and you should be able to read about it along with all the other investment risks.....The lawyers for the Preferred funds didn't see it that way, but it's the lawyers for the SEC who really matter.....This is an easy problem to fix, so how about some SEC initiative in this area?


For three years beginning in 2000, the Jensen fund performed well, while the market didn't:


Total return % for calendar year:
200020012002
Jensen J fund 20.040.03-10.97
S&P 500 Index-9.10-11.89-22.10
Jensen vs. S&P 500 Index+29.14+11.92+11.13

During the three years that the Jensen fund performed well, it received a huge amount of favorable press coverage, and the fund's assets grew dramatically:


Total return % for calendar year:
200020012002
Jensen J fund 20.040.03-10.97
S&P 500 Index-9.10-11.89-22.10
Jensen vs. S&P 500 Index+29.14+11.92+11.13
Fund assets (millions)*$30.5$46.1$473.4
* As of May 31 of respective year

In recent years, the Jensen fund hasn't performed well, although fund assets continue to explode:


Total return % for calendar year:
200020012002200320042005
(YTD)
Jensen J fund 20.040.03-10.9716.066.01-2.39
S&P 500 Index-9.10-11.89-22.1028.6910.882.77
Jensen vs. S&P 500 Index+29.14+11.92+11.13-12.63-4.87-5.16
Fund assets (millions)*$30.5$46.1$473.4$1,453$2,046$2,680
* As of May 31 of respective year

Unfortunately, the past few years aren't an anomaly.....In fact, for the five years preceding 2000, the Jensen fund also didn't perform well, and its small asset base barely grew:


Total return % for calendar year:
19951996199719981999200020012002200320042005
(YTD)
Jensen J fund27.6121.0622.9916.7016.7120.040.03-10.9716.066.01-2.39
S&P 500 Index37.5822.9633.3628.5821.04-9.10-11.89-22.1028.6910.882.77
Jensen vs. S&P 500 Index-9.97-1.90-10.37-11.88-4.33+29.14+11.92+11.13-12.63-4.87-5.16
Fund assets (millions)*$9.9$11.3$14.5$19.9$24.5$30.5$46.1$473.4$1,453$2,046$2,680
* As of May 31 of respective year

It's possible that Jensen is simply a good bear-market fund (although we'd like to see more evidence).....It's also possible that Jensen will run up ten consecutive years of benchmark-beating performance, and we will win the Nobel Prize in Mutual Funds.....But let's return to earth: If you're an investor who's inclined to chase hot funds, may we suggest that you study these tables carefully, because the story told here is a classic one: A mediocre fund has a few good years, money pours in, and then the fund reverts to its history of mediocrity.....Through a combination of luck, media hype, and all-too-willing investors, the Jensen fund has been able to garner about $2.6 billion more than it deserves.....Now what?



Roy's Excellent Market-Timing Adventure:
Month Three: Reboot

As noted in last month's Highlights and Commentary, I received my first Intelli-Timer signal -- to go "short" -- on September 21.....On average, the Intelli-Timer system has generated a new signal every 29 days, so I assumed it would be about a month until I received the next signal.....I assumed wrong: On September 29, just six trading days after the short signal, Intelli-Timer told its subscribers to go long (i.e., place a bet that the market would rise) .....The next day (September 30), when I went to execute the long signal, I discovered that the value of my trading account had dropped to $4947.88, which meant that I didn't have the $5,000 needed to buy the minimum amount of the long position (ProFunds OTC Investor (OTPIX)).....My broker (Scottrade) wasn't able to post additional funds to my account for another two trading days, and that meant I would be two days late executing the Intelli-Timer signal.....Since the timing experiment was now ruined, due to my lack of foresight in dealing with investment minimums, I decided to sell my short position, call off the current experiment, and wait for the next new signal to begin the experiment all over again.....I also added $500 to my account, to avoid any future problems with the $5,000 minimum purchase requirement.....I hope.

Astute readers have already figured out why my account had dropped below $5,000: I was "short" the market, based on the September 21 Intelli-Timer signal, but the market continued to move upwards.....Indeed, during the time the short signal was in place (September 22 through September 30), the NASDAQ 100 Trust Shares (QQQQ) actually rose 2.1%, which caused my short position to drop by the same 2.1%.

I didn't know it at the time, but it was a good thing that I bailed out when I did.....From the date the long signal would have been executed (September 30), through October 7, the QQQQ dropped 2.9%.....On October 7, Intelli-Timer sent an e-mail to its subscribers, suggesting that a stop-loss signal might be coming (this is a signal to go into cash; in effect, the Intelli-Timer computer throws up its arms and says "I don't know what's going on").....Sure enough, the market continued to drop, the stop-loss was triggered on October 12, and Intelli-Timer subscribers were advised to move into cash.....Had I been able to stay with the Intelli-Timer system, I figure that I would have been down another 4.3%, on top of my actual 2.1% loss.....Quite a bit of fuss and confusion, considering that I easily could have generated a loss like that all by myself.

I wasn't on the sidelines for long.....On October 16, Intelli-Timer issued a new, "rather strong" long signal (their description).....On October 17, I started the experiment all over again by purchasing 84.331 shares of ProFunds OTC Investor (OTPIX), at 59.29 per share (that's $5,000 worth of the fund, plus Scottrade's standard $17 transaction charge).....Through October 26, the cut-off for this month's issue of FundAlarm, my investment results were as follows:


MonthDate of
signal
(1) 		Type of
signal		Fund
bought
(2)		Acct value
(beginning)		Acct value
(ending)
(3), (4) 		Change in
acct value
for month
October, 2005Oct.16LongOTPIX$5,000.00$5,080.09 +1.60%
Notes:
(1) Signal was executed (i.e., fund bought) on the next business day.
(2) OTPIX=ProFunds OTC Inv.
(3) Cut-off for valuation is 26th day of the month.
(4) Account value includes value of fund shares only. Cash in the account, as well as interest earned on the cash, is ignored.


Here's the performance of my market-timing account from October 17 through October 26, ranked against the performance of each FundAlarm benchmark for the same period (benchmarks are listed in descending order of return):

Roy's market-timing account 1.60%
Dreyfus Mid Cap Index (PESPX) 0.88%
Vanguard Small Cap Index (NAESX) 0.59%
Vanguard 500 Index (VFINX) 0.12%
Vanguard Balanced Index (VBINX) 0.00%
Schwab International Index Inv (SWINX) -0.82%

So far, all this proves is that the NASDAQ (long) was a good place to be for a few days at the end of October 2005.....For this go-round of the market-timing experiment, I've think I've finally worked out the operational kinks, and I'm expecting things to go smoothly from here on out.


Mutual fund companies love to introduce new products, because new products allow them to tell new stories, and new stories give fund companies the opportunity to capture new investors.....Often, however, there's less to these new financial products than the stories would lead you to believe.....Case in point: Several fund companies are planning, or have recently introduced offerings designed to produce "absolute" returns.....The absolute-return fund is an import from the world of hedge funds, which presumably gives it a hint of glamour, but the basic goals of an absolute-return fund are anything but sexy: To deliver relatively modest, steady, and positive returns no matter what the stock and bond markets are doing.....For example, UBS Dynamic Alpha is less than a year old, it already has more than $1 billion under management, and part of the reason for the fund's quick success is that it has great story to tell: No matter what the market environment, investors in UBS Dynamic Alpha are being told that they'll earn a steady five hundred basis points (5 percent) above the inflation rate*......What these investors aren't being told (no surprise) is that a number of perfectly conventional funds have already returned five percentage points above the inflation rate for at least the past five calendar years (2000 through 2004).....If you find the concept of absolute return appealing, you might wonder why you should take a chance on a new, untested fund, when you can put your money with a proven performer.....The accompanying page lists 18 funds from this month's FundAlarm database, and each fund has proven itself to be a reliable absolute-return performer (even if absolute return isn't one of the fund's stated goals).....Not surprisingly, there are quite a few real estate funds on this list, but there's an equal number of financial funds, as well as a balanced fund (Bruce), and even a core holding (Yacktman).....These funds don't come with any special story, but if they get you to the same place, who cares?
* "Mutual funds try to play hedge game," Karen Damato, The Wall Street Journal, October 7, 2005


There's always something new to scare the **** out of mutual fund investors: Commodities trading firm Refco recently imploded.....When Refco went down, one of its related entities "was helping to administer" (i.e., holding) about 6% of Leuthold Core Investment Fund, in the form of "industrial metals".....There's a chance that Leuthold Core's investment may be in jeopardy, but a letter from Steven Leuthold, posted on the Leuthold funds Web site, sheds almost no light on the subject.....Let's take a quick step back: According to the most recent semi-annual report for Leuthold Core Investment (March 31, 2005), the fund owned "physical industrial metals" in two different categories: "physical metals" and "prepaid forward contracts"......Presumably, both types of holding have been ensnared in the Refco collapse, but Leuthold's letter doesn't make this clear.....Although Leuthold says that lawyers have been hired to protect the interests of fund investors, he doesn't discuss whether one category of metal investment is subject to greater legal risk than the other (we're guessing that the physical metals would be in greater jeopardy, but we don't really know).....Finally, Leuthold doesn't even hint at who who's going to pay for the lawyers (i.e., the fund or his management firm), or how much the lawyers might cost.....As a professional, Leuthold probably views this incident as a minor bump in the road which, at worst, will have a relatively minor effect on his fund.....But judging from posts on the FundAlarm Discussion Board, as well as e-mails we've received from Leuthold investors, fund shareholders perceive these events much more urgently.....The aforementioned letter from Steven Leuthold promises to "keep all shareholders" informed of Refco-related developments.....Maybe the next one will be better.


Briefly noted:
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