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



The sloth: Sleeps
15 to 18 hours a day

The snail: Moves at
0.03 miles per hour

The roy: Rarely touches
his portfolio

Now that my place in the animal kingdom has been properly identified, we can proceed with our annual look at my personal mutual fund portfolio..... As of December 31, 2005, my complete mutual fund holdings were as follows:

Roy's Mutual Fund Portfolio
(in alphabetical order)
  • Allianz RCM Global Technology D (DGTNX)
  • Bridgeway Ultra-Small Company Market (BRSIX)
  • Buffalo Small Cap (BUFSX)
  • Cohen & Steers Realty Shares (CSRSX)
  • FBR Large Cap Financial (FBRFX)
  • Vanguard 500 Index (VFINX)
  • Vanguard European Stock Index (VEURX)
  • Vanguard Health Care (VGHCX)
  • Vanguard Total Stock Market VIPERs (VTI)
  • Wasatch Global Technology (WAGTX)
  • Weitz Partners Value (WPVLX)
This list doesn't include ProFunds Short OTC Inv. (SOPIX), which I owned
as part of my ongoing market-timing experiment (see below).

Compared to last year, no funds have fallen off this list, and only one fund has been added (Wasatch Global Technology).....(As I discussed in last month's Highlights and Commentary, I sold a portion of my Allianz tech-fund holding, and invested in the Wasatch offering, to express my displeasure with the way Allianz handled a proxy vote/fund merger early in 2005).....On a dollar-weighted basis, my portfolio returned about 7% for the year, which isn't nearly as good as 2004 (19%), but still respectable considering that the markets in 2005 were quite a bit more challenging.....What's fair for Judge Alito (see last month's Highlights and Commentary) is also fair for me, so I ran my portfolio through the "X-Ray" tool at troweprice.com.....Overall, my portfolio is allocated about 79% to U.S. stocks, 15.5% to foreign stocks, 5% to cash, and 0.5% to "other".....This seems about right for me, although I might bump-up my foreign exposure by directing some new money to Vanguard European Stock Index, or by adding an emerging markets fund.....My portfolio's capitalization and style breaks down as follows:


The numbers in red (which I have added) represent totals across each row and column.....Thus, reading across, my portfolio is allocated 52%, 28%, and 20% to large-cap, mid-cap and small-cap stocks, respectively......If I were designing my ideal portfolio, this is probably more mid-cap exposure than I would dial in.....But many of my mid-cap stocks are held by my specialty funds (tech and real estate in particular), so if I want to own these specialty funds it looks like I'll have to accept a relatively heavy mid-cap weighting.....Reading down (i.e., across all capitalization ranges), my portfolio is allocated 29%, 32%, and 39% to value, core (or "blend"), and growth, respectively.....This is probably more growth exposure than I need or want but, again, many of these growth stocks come from my specialty funds (tech and health care this time), and the specialty funds are going to stay.

Are there any surprises in my portfolio?.....A few:

This is the seventh year in a row that I don't show any bond funds in my portfolio and, from time to time, FundAlarm readers ask me why I've left such a gap......In general, I feel that bond fund managers don't do a great job managing interest rate risk, which means that bond funds often suffer during periods of rising interest rates (like now).....Bond funds also help cushion the bumps in a portfolio, which are typically caused by stock funds.....But if you can handle the bumpy ride that comes with owning an all-stock fund portfolio -- and I think I can -- then bond funds don't serve much purpose.....Another reason for taking a pass on bond funds is suggested by Canadian finance professor Moshe Milevsky.....I can't say that I knew about Milevsky's work before I stopped owning bond funds, but what Milevsky says makes sense......Basically, Milevsky believes that each person's human capital -- which he defines as the present value of future earnings, net of income taxes and expenses -- should be viewed as an asset class, and considered in every personal portfolio allocation......A person who has a relatively secure job (and I'm fortunate to be in that category, I think) can look forward to an assured income stream for a predetermined number of years, which is essentially the description of a high-quality bond.....In a sense, people with secure jobs are bonds, and if they add traditional bonds or bond funds to their portfolios they risk being too heavily invested in that category.....On the other hand, people who work in volatile industries, like technology or finance, are more like growth stocks, and a generous helping of traditional bonds (or bond funds) could help dampen volatility and diversify their portfolios.....Milevsky is still refining his concept of human capital by profession and asset category, to the point where he'll be able to describe a tenured university professor (for example) as "70% inflation-indexed bond, 30% nominal bond".....I'm not sure that this level of precision will do much to help the average investor.....But Milevsky's big-picture insight is a good one, and relatively easy to understand: Each investor's employment situation should be considered as part of his or her portfolio design.
"Gauging whether a client is a stock or a bond," Rick Miller, InvestmentNews, February 7, 2005; an introductory article by Milevsky ("Is Your Client a Bond or a Stock?") can be found at http://www/ifid.ca/pdf_newsletters/NL_AE2003NOV.pdf


If you were in a room with a million touch-typing monkeys (ignore the smell), would you be able to pick out the monkey who'd eventually produce Hamlet?.....Seems impossible, or purely a matter of chance, and that's exactly the point diehard indexers make about active fund managers: Sure, there will always be another Peter Lynch or Bill Miller, but picking him out ahead of time -- like picking out the Shakespearean monkey -- is beyond the ability of any human.....An executive at Dimensional Fund Advisors (DFA), the academic-minded and slightly arrogant über-indexers, makes the point even more colorfully.....At the end of the day, he says, "you can't distinguish professional money managers from the universe of orangutans."*
* "Ditching the Monkey," Eric J. Savitz, Barron's, January 9, 2006


Is it really impossible, as they say at DFA, to distinguish between a professional money manager and an orangutan?.....One of the images, below, zooms in on red-haired money manager Christopher Davis (Selected American, etc.), while the other is a close-up of orangutan hair.....If you can distinguish the professional money manager from the orangutan, congratulations: You've proven that academic index theorists aren't right all of the time.


Christopher Davis or an Orangutan?

Answer at the bottom of this page


Welcome back, Porky. It takes a pig to know one, so tell us what's been happening at the Schroder funds.


Porky
 Thanks, Roy. Schroder is trying to push through a fee increase for three of its funds, and the details are distressingly similar for all of them. I'm going to focus on the largest of the three funds -- Schroder U.S. Opportunities -- to see exactly what these trough-suckers are up to:*

  • Shareholders of Schroder U.S. Opportunities (SCUIX) currently pay a base management fee of 75 basis points (0.75%), and the fund has about $160 million in assets. Once the fund reaches $250 million in assets (and after a few intermediate breakpoints), the current schedule calls for the base fee to drop to 60 basis points.

  • Schroder is asking for a new base management fee of 100 basis points, and Schroder want to entirely eliminate the fund's breakpoints.

  • Schroder justifies the fee increase by promising a substantial, additional commitment of resources to its U.S. investment operations. Sounds good, until you read on, and discover that those "resources" will be devoted to the "sponsorship and promotion of Schroder mutual funds in the United States." In other words, shareholders are being asked to approve a 33% fee increase so that Schroder will have more money to market its funds, which will help make the funds as fat as I am, which will eventually cost shareholders even more money when those fat funds fail to perform. (Schroder also claims that it's losing money on its fund business, and the new fee is more in line with the fee paid by some of its non-fund clients. Altogether now: Who cares?)

Over the past 36 months -- roughly the tenure of the current manager -- Schroder U.S. Opportunities has returned almost exactly the same as its self-selected benchmark (the Russell 2000 index), and that's hardly the kind of performance to reward with a 33% fee increase. The Schroder trustees (i.e., directors) should have snorted in the face of Schroder's fund managers (I can show them how), and refused to even consider a fee increase until this fund proves that it can outperform its benchmark for a sustained period of time. Instead, the directors -- several of whom don't own a single share of this (or any other) Schroder fund -- rolled over as easily as my Aunt Mae on a hot day in a mud puddle.

Shareholders! Rise up! Vote your proxies "NO!"

* The other funds are Schroder International and Schroder U.S. Large Cap Equity



In general, mutual fund directors do a lousy job of negotiating the lowest possible management fee for fund shareholders (for example, see the Schroder item, above).....Fortunately, there's plenty of room for improvement: In theory, fund directors already have enormous power, and they could turn overnight from lapdogs to watchdogs if they wanted to.....Congress also could give directors a boost, by making clear that directors act as fiduciaries for fund shareholders, and the SEC could kick things up a notch by providing specific guidance for directors who negotiate management fees (for example, the SEC could instruct fund directors to use much-lower pension plan management fees as the standard for setting mutual fund fees).....While we're not certain that any of these things will happen, at least there's the potential for positive change, and that's a good thing.....But not everyone agrees that the current fund-director system is worth fixing, and there's a growing movement to dismantle some or all of today's fund governance structure in the name of "competition" and "free markets."

Attorney Stephen West, who's currently a trustee (director) of the Pioneer funds, is the father of the board-emasculation movement, thanks to his 1980 proposal that would have eliminated fund boards entirely.....West has since toned-down his proposal, and he now calls for keeping fund boards but generally removing their power to negotiate management fees and terminate management contracts (this would be an optional structure, and funds could continue to exist, or new funds could be created, with traditional board powers).....Instead of a management fee negotiated with directors, each fund company would unilaterally set an all-inclusive fee for each mutual fund -- in effect, this would be the fund's expense ratio (funds of this type would be called "Unified Fee Investment Companies," or UFICs).....According to West, UFIC investors could more easily compare expenses across all UFICs, and more easily exercise their economic judgment -- in other words, investors could avoid expensive UFICs altogether, or vote with their feet if a UFIC's expense ratio were raised to an unacceptable level.....Unfortunately, real-world fund investing is much messier than West's dream world of perfectly rational economic beings and frictionless markets.....In the real world, UFIC investors who didn't like the fee unilaterally set by their fund company might be trapped by large, built-in capital gains.....And, as a practical matter, many investors in UFICs through 401(k) plans wouldn't be able to make any kind of move, because they'd be locked into the fund menu chosen by their employer.

West's proposal might seem like a bad term paper submitted by a sophomore Economics major, but it looks like West is about to get the backing of the American Enterprise Institute and the Brookings Institution.....Not to be outdone, Republican Senator Rick Santorum is reportedly getting ready to introduce a bill that would revive West's original proposal, and completely abolish mutual fund boards*.....Just a couple of years after the mutual fund scandals, it's difficult to imagine either of these radical restructuring proposals making much headway.....Then again, the large fund companies remain desperately afraid that fund directors might start asserting their economic power which, as we noted above, is potentially enormous.....With some well-placed lobbyist money, and a Congress that might be susceptible to a bogus free-market argument, who knows what could happen?
"Fund Directors: Headed for Extinction?", Beagan Wilcox, boardiq.com, January 17, 2005; thanks to FundAlarm reader Chuck Gerut for bringing this item to our attention


Stephen West (above) doesn't believe that fund boards should negotiate management fees, yet Mr. West still serves as a director of the Pioneer funds (for which he received about $106,000 in 2004).....Perhaps it's time for Mr. West to resign, and turn his job over to someone who actually believes in what he's doing.


We saw the following teaser on E*Trade's mutual fund Home page, and we had our doubts:


Lower-cost than Vanguard? Lower-cost than Fidelity? Where did these guys come from all of a sudden?.....Anyhow, we were curious, so we clicked through the link and, sure enough, E*Trade shows a passel of low-cost index funds:


Ah, but there's a catch: When you follow that little superscript 2, you discover that E*Trade's index funds are low-cost only because of some heavy-duty expense waivers, which are guaranteed only until April 30, 2006 (in the fine print that follows, "ETAM" stands for "E*Trade Asset Management"):


In other words, E*Trade is basically trying 2 put one over on you.....We've never understood why a business would want to lure new customers with half-truths, especially a business that's based on trust and long-term relationships.....Then again, we didn't pay much attention in our marketing class, so we probably missed that lesson.



Roy's Excellent Market-Timing Adventure:
Month Four: No new signal, lots of action, little change

The Intelli-Timer system didn't issue any new signals during January, which means that I held my short position -- ProFunds Short OTC Inv (SOPIX) -- for the entire month.....If you followed the market during January, you know that short was not the place to be for the first half of the month, as U.S. stock markets rose quite sharply......During the second half of January, however, the markets fell almost as dramatically as they rose, and a short position looked pretty smart.....Overall, the ups and downs of the market basically offset each other, and my timing account ended the month within three dollars of where it started, for a tiny loss of -0.05%:

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%
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 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.


It would have been nice if Intelli-Timer had moved me into a long position for the first half of January, when the markets rose, and then back into the short position for the last half of the month.....But that's not the way the system works, as Intelli-Timer informed its subscribers in a regular weekly e-mail dated January 7.....According to the folks at Intelli-Timer, the early-January rise in the markets was a "news-induced" event (i.e., it looked like the Fed was going to stop increasing interest rates), and news-induced events can't be predicted by any "mid- or long-term mechanical trading system" such as Intelli-Timer.....I'd like to think that the late-January decline in the markets was vindication of the Intelli-Timer system but that, too, seemed due to news-induced events (weak earnings reports, rising oil prices, higher interest rates with a hint of recession, etc.).....Since there's hardly a day that goes by without market-moving news, I'm not sure how a subscriber is supposed to know when the Intelli-Timer system is successfully calling the market, and when (as in January 2006) the system is overshadowed by external events.....Perhaps I'll figure this out as the experiment progresses.

Compared to the usual FundAlarm benchmarks, the performance of my market-timing account (since inception) has fallen to the middle of the pack:

Current month
(12/27 thru 1/26)		Since inception
(10/17/05)
Vanguard Small Cap Index (NAESX) 5.18% 12.85%
Schwab International Index Inv (SWINX) 4.31% 9.65%
Roy's market-timing account -0.05% 7.57%
Dreyfus Mid Cap Index (PESPX) -1.81% 7.55%
Vanguard 500 Index (VFINX) -0.01% 6.99%
Vanguard Balanced Index (VBINX) -0.05% 4.84%
Sorted by return "Since inception"; benchmark returns assume that dividends are reinvested


In fact, the average return of all five FundAlarm benchmarks since October 17 (8.38%) is higher than my return from the Intelli-Timer system.....In other words, if I had simply invested $1,000 in each of the FundAlarm benchmarks, I'd be ahead of my Intelli-Timer account by about $40 right now (even more if I count my market-timing brokerage commissions).....Perhaps this, too, will change over time.

To be continued...


Briefly noted:



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