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Fund Focus: Bear Funds Come Roaring Back as Market Rally Slides

Michael Shari — Fri, 18 Jun 2010 09:00:00 EST

Filed under: Economy, Investing, Goldman Sachs , Thomson Reuters

It's hard to know how to pick a decent mutual fund at a time like this. After all, why would you want to put your money into an index-based fund when all the benchmarks they cling to look like they're headed down the drain? And why would you want to pay the higher fees that actively managed mutual funds charge when the relatively small number of stocks they include could fall even faster than the benchmarks they are trying to beat?

Enter bear funds, which do two things: rise when the market is falling, and fall when the market is rising. Their fees may not be cheap, but they tend to make money at times like these. They did well from the second half of 2007 to the first quarter of 2009, when the U.S. stock market plunged deeper than ever since the Great Depression. Then, when the market rallied from the second quarter of 2009 to the first quarter of this year, bear funds lost money.

But since April 26, when the rally started to slide off a cliff, with more than a little shove from the Europe debt crisis and the unemployment scare in America, bear funds have been looking like the smartest investments on the planet.

Betting Against the Market

How do bear funds work? They short stocks, meaning they sell stocks they don't yet own in the belief that the prices will fall. To do this, they borrow stocks from their brokers, sell them, and then replace them by buying them later at a lower price.

These funds have done more than just protect their client's investments over the last nine weeks. In fact, they were among the best performing mutual funds during this period. In other words, some bear funds are not just beating the Standard & Poor's 500, but are actually making money for investors.

Of the 50 funds that delivered the highest total returns between April 26 and June 10 -- excluding exchange-traded funds -- 33 mutual funds were classified as "dedicated short-bias" funds by Lipper, a unit of Thomson Reuters (TRI) in Denver that tracks mutual funds. "They are all shorting the market," says Lipper research manager Jeff Tjornehoj, who compiled the list.

The names that appear repeatedly on this list are those of large fund families like Direxion Funds, Rydex Investments and Profunds, while smaller shops like Comstock Partners and Leuthold Weedly Capital Management also claim several spots.

Top Performer: Expect Volatility

The top performer, the Direxion Monthly Small Cap Bull 2x Fund (DXRSX), was up a stunning 31.92%. The index fund is leveraged -- meaning it uses instruments such as debt or derivatives to boost the amount of shares it owns -- by 200% and seeks to beat the monthly returns of its benchmark, the Russell 2000 Index, by 200%.

Of its modest $27.8 million in assets, the fund's largest allocations are in financial services (22%), consumer discretionary (16%) and technology (16%). It's managed by a team of quantitative analysts at Rafferty Asset Management, a quantitative investment firm in Boston, who rely largely on software to pick stocks instead of visiting the companies they invest in. Because it's an index fund, instead of an actively managed fund, the fees -- at 1.86% -- are lower than you would expect for an active short fund.

But you can also expect this Direxion fund to be even more volatile than the average bear fund for a couple of reasons. First, the companies in that particular Russell index are small, which means their stock prices tend to move around a lot. Second, the use of leverage amplifies the rise or fall of fund's performance - in this case, by 200%. Still, because it seeks monthly returns instead of daily ones, the fund isn't nearly as volatile as leveraged exchange-traded funds at Rafferty, which actually warns individual investors away.

Validation for Pessimists

In general, the managers of the actively managed funds on the Lipper list - that is, the folks who take the trouble to visit or at least read about the companies they invest in - tend to be doomsday theorists. It can get a little scary to hear them lay out their gruesome investment theses explaining why they're convinced the worst is yet to come.

Take Charlie Minter, a co-manager of the Comstock Capital Value Fund (DRCVX), which rose a mere 11.88%, ranking 22 out of 50 funds on the list. Based in Yardley, Pa., Minter believes the stock market is falling in response to a widespread, well-placed fear that the combination of public and private debt will lead to a prolonged period of deflation as prices for American products fall, further depreciating the dollar.

He estimates total public and private debt at $55 trillion -- about four times the U.S. gross domestic product. One of the $164 million fund's most lucrative investments thus far, he says, is a short position on Goldman Sachs (GS) stock.

"What is taking place is that the debt of this country has become overwhelming. We are going to wind up just like Greece," he warns. Greek debt woes triggered the Europe debt crisis this spring, which contributed to the current U.S. stock market slump.

But remember: Any bear-market fund doing well steps a little closer to its own doomsday when the market turns back up. If you ever invest in one, your first challenge will be to withdraw while the market is still falling -- or at least still bottom-crawling.

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Fund Focus: Henderson Opens a Window on Better Dividend Yields Outside the U.S.

Michael Shari — Tue, 01 Jun 2010 06:00:00 EST

Many of the fund managers I've met have lived and breathed finance ever since they were in college if not earlier. Some even bought their first stock before they grew hair under their armpits, usually with money saved from their allowance or a summer job.

But Alex Crooke, the British fund manager of the Henderson Global Equity Income Fund (HFQAX), which picks global stocks in a manner that's sensible enough to make any investor think hard about how much money to keep in the U.S. at turbulent times like these, did not grow up with money on his mind.

Crooke was an astrophysics student at Manchester University in the UK before he decided against isolating himself on a remote island with only his telescope to talk to. When he left college in 1990, he took the math he had learned in astrophysics and applied it to his first job as an analyst covering the U.S. stock market for at the Equitable Life Assurance Society of the UK.

He was never thrilled with what he saw in the U.S. For starters, not as many American companies paid dividends as did European and Asian ones. "The U.S. sort of lost its way from the mid-80s onwards. Management paid itself endless options and, therefore, is generally fixated on generating a higher share price and not often thinking about generating a total return to shareholders."

So in 1994, he panned his telescope across the rest of the globe and went to work as a portfolio manager at Henderson Global Investors, an asset management firm in London that now manages about $10 billion in assets. He found that on average, more companies outside the U.S. paid dividends. Also, he found that the best-run companies focused on making sure they had enough cash left over after paying management and reinvesting it in the company to pay dividends. He saw them as a better long-term bet than American ones simply because they were likely to have enough cash on hand to stay in business come hell or high water.

In December 2006, Crooke started using his craft as a portfolio manager of the newly launched Henderson Global Equity Income Fund, an SEC-registered mutual fund that is open to U.S. investors with a low $500 minimum initial deposit. With $652.4 million in assets, the fund invests all over the world but only buys companies that pay dividends.

"You are in a subset of companies that generate cash and, therefore, that is a better form of company than one that is consuming capital in the hope of generating cash," says Crooke. "It's a safer way of investing, really."

To pick stocks, Crooke uses a financial ratio called dividend yield, a reliable indicator of how much cash flow an investor gets in return for every dollar invested. This is calculated by dividing a company's dividend by its share price. The idea is to strike the right balance between high dividends and low stock prices.

Since the fund started, Crooke has harvested some of the best dividend yields in Challenger Financial Services Group (ASX:CGF) of Australia, Asia Cement (1102.TW) of Taiwan, and Centrica PLC (CNA.L), a British natural gas company.

Crooke has big plans for the Global Equity Income Fund. "When you look at 30, 40 or 50-year studies of market returns, it's the stocks with dividend yield, and the investment of that income, that generates half of the returns," he says. Since 2006, the average dividend yield on the fund is 4% to 5% a year, says Crooke.

For the 12 months through May 27, the fund is up 5.95%, which was 0.79 percentage points behind its benchmark, the MSCI EAFE index, which covers markets in Europe, Australasia and the Far East. Over the past three years, the fund is down 8.79%, but was still 3.94 points above the index.

The fund is a clear example of income investing, which is all about buying stocks that provide a steady stream of cash. Income started to look a lot more interesting than other equity strategies in May when the stock market became about as predictable as the Spring weather.

Another element of stability in this fund is that focuses on established businesses and avoids investing in new issues. "We haven't had anything blow up on us," says Crooke. "We don't like losing money. That's the golden rule."

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Fund Focus: Osterweis Has a Key Metric That's Proven Its Worth

Michael Shari — Mon, 24 May 2010 09:00:00 EST

Filed under: Columns, Investing

You could be forgiven for wondering why you should keep your money in a mutual fund in this not very merry month of May. After all, the European Union's debt crisis is spiraling, the U.S. is becoming the Unemployed States of America and a combination of jittery investors and computer programs that move faster than the firms that created them stand a decent chance of pushing the stock market over the edge at any given moment.

But it may not be as hard as you think to find a perfectly decent mutual fund at a time like this. Equity funds out there do have track records for outperforming the stock market -- and beating the vast majority of their peers -- over long-term periods like 10 or 15 years, through good times and bad. This small minority of funds isn't celebrated most of the time because they tend not to appear at the top of the charts when the market is on the way up. They're run by relatively quiet, nerdy types who spend a lot more time crunching numbers in their cubicles and figuring out how to shield their clients from the worst effects of the next storm than they spend promoting themselves.

Take the Osterweis Fund (OSTFX). With $1 billion in assets, this midcap equity fund grew 11.26% over the last 15 years, beating the Standard & Poor's 500 stock index by 7.14 percentage points. That was a better total return than 87% of comparable mutual funds, according to Morningstar, a fund-rating firm in Chicago.

Avoiding What's "Moving Straight Up"

Compared to its peers, the Osterweis Fund's best years were the worst ones for most of the mutual fund industry. In 2002, when the S&P 500 fell by 22.1%, Osterweis fell by only 11.67%, which was a better showing than 99% of its peers, according to Morningstar. In 2008, when the S&P 500 fell by 37%, the fund lost only 29.23%, which was better than 89% of its peers. As the market rallied in 2009, Osterweis beat the index by 4.66 percentage points. Since Jan. 1, it has been just about as flat as the index.

To put it simply, Osterweis tries hard not to lose money and, in the process, cushions the blow during a crash. It does this partly by selling stocks in sectors that become all too popular. "We stay away from anything that is moving straight up," Matthew Berler, a co-manager of Osterweis in San Francisco, told me over lunch in Midtown Manhattan this week. In the late 1990s, the fund stayed away from dot-coms and other darlings of the tech boom, which famously became the tech crash of the early 2000s. Later, the fund got out of financial stocks before they started to sink under the subprime mortgage implosion of 2007.

More important, the fund's portfolio managers use a highly disciplined method of finding stocks that tend to outperform the stock market over the long term. They seek out companies that don't need to use very much of their earnings to stay in business and therefore have a lot of so-called free cash left over to invest in future growth. To find these companies, they use a metric known as free cash yield, which is calculated by looking at earnings per share, subtracting maintenance capital, adding cash to reflect ways the company can generate more cash in the future, subtracting cash to account for inflation, and dividing the result by the company's stock price.

"Free cash yield is the single most important metric that there is," Berler says. "I don't know why most mutual funds don't use it as a core metric."

Staying in Orbit

Osterweis is indeed one of a small minority of mutual funds that uses free cash yield as a core metric. It has led Osterweis managers to surprisingly resilient stocks like Digital Globe (DGI), a satellite imagery company that earns about three-quarters of its revenue from the U.S. government. Adjusted for about $120 million in depreciation on its satellites currently in orbit, Digital Globe's free cash flow at $2.50 per share, which divided by its current share price of $25.40, comes to a free cash yield of about 10%, Berler estimates.

He compares the free cash yield on stocks to the yield on long-term Treasurys, which are the closest thing to a risk-free investment in the U.S. Of course, the yield on Digital Globe is a lot higher than a 10-year T-bill, despite the obvious risks inherent in launching a satellite into orbit and keeping it out of the path of space junk.

Yet Digital Globe has risen about 40% since Osterweis bought it for about $18 a share last summer. The stock had fallen sharply on fears that the launch of the company's third satellite could fail even though, as Berler points out, the odds of that are less than 2%, and the satellites are insured. He was also emboldened by the Obama administration's decision to outsource pieces of the space industry to the more cost-effective private sector.

Most mutual funds pick stocks based on various measures of earnings or book value. But free cash yield isn't exactly rocket science, and any portfolio manager who uses it as a yardstick will be in a position to compare the forward rate of return for any stock with that of any stock or bond. Osterweis is among the precious few that wields that power -- and it will no doubt come in handy in the months to come.

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Fund Focus: Brian Stack Charts a Profitable New Course for Pioneer Fund

Michael Shari — Fri, 14 May 2010 10:42:00 EST

Filed under: Columns, People, Investing

The stock market crash of 2008 was brutal for all mutual funds. The vast majority of them hemorrhaged value, and their portfolio managers spent much of the year pointing to the safely undeniable fact that the Standard & Poor's 500 Index fell 37% that year, and arguing to their clients that they wouldn't have done much better by taking their money across the street to a competing fund.

By and large, the last thing on any manager's mind was to use the crash as a strategic opportunity to chart a new course, clean up his fund's portfolio, change the way it invested, begin again with a clean slate, and start delivering dramatically better returns than his peers.

Well, at least one manager did precisely that, and I was fortunate enough to sit down for lunch with him in Midtown Manhattan a few months ago. Brian Stack is the portfolio manager of the Pioneer Growth Opportunities Fund (PGOFX), a small-cap growth stock fund that truly stunk until Pioneer Investments in Boston decided a management change was in order. In September 2008, Pioneer hired Stack and his team away from the hedge fund firm they'd founded, Long Trail Investment Management, and gave them carte blanche to do as they pleased with Growth Opportunities.

Not long after Stack took over, Growth Opportunities was a shooting star. The fund wasn't just rising with the rally of 2009 -- it was outpacing other small-cap growth funds. In 2009, the fund grew 43%, beating 89% of its peers. So far this year, the fund is up 9.2%, more than double the S&P 500, and it now has $650.1 million in assets.

The fund's performance is unrecognizable from previous years. In 2008, it fell 35.4%, almost in line with the S&P 500. In 2007, it fell 3.9% while the index grew 5.5%. In 2006, the fund grew only 4.8% while the index was up 15.8%.

A Fresh Start, and a Fresh Method

What are Stack and his team doing differently from the fund's previous managers? It's hard to know exactly what his predecessors were doing, since Pioneer won't bring them to the phone. According to Stack, they were using a quantitative investment process, which relies on computer programs to predict changes in stock prices.

"My purpose was to turn it into a bottom-up fundamental product," he says, referring to the more common investment process by which real live humans decide which companies to buy after visiting their offices, interviewing their managers and maybe even visiting their factories.

But Stack also had timing on his side. He was quick to recognize the stock market crash as an opportunity to clean out the portfolio and buy pretty much any stock he wanted because, in a year when the market fell faster than it had since the Great Depression, every stock out there was suddenly affordable. "Any manager in this business was at liberty to restructure their portfolio and look at the opportunities that arose," he says.

Buying Priceline at the Right Time

For growth managers like Stack, who are trained to buy expensive stocks under the assumption that they will keep trading upward, it was like being a kid in a candy store. He pounced on growth stocks that might have looked a little pricey before the crash. One was Priceline.com (PCLN), the Internet-based travel service, which had fallen 66% from $139.66 on May 13, 2008, to $47.07 on Nov. 16, 2008. Since then, Priceline has more than quadrupled in price, closing at $212.89 on May 13.

Stack thought investors had sold Priceline down for the wrong reason, and expected it to come back up once they came to their senses. "It was driven down by the presumption that consumers would not travel in a recession. But Priceline allowed consumers to name their own price, becoming part of the solution when hotels and airlines decided it was better to sell at a price point rather than allow rooms and seats to go empty," he says.

It's not easy to make such a great stock pick, particularly in the small-cap arena. Small-cap stocks are difficult to get a handle on because precious little market research is available on them. The research departments of Wall Street investment banks find it uneconomical to cover companies with market caps below $2 billion because they're too small for a trading desk to make much money from selling their stock, he says.

That makes for a labor-intensive exercise for Stack and his team, who travel farther to see small companies than they would to see an S&P 500 corporation. The small ones tend not to be based in cities with large airports. And because they are seen as risk assets, they are more volatile than S&P 500 stocks.

"We Don't Try to Shoot the Lights Out"

Add up all these headaches, and it can take decades of experience to get it right in the small-cap game, says Stack. He has been at it for 23 years, but that's not all he has going for him. Perhaps more importantly, Stack has a background in hedge funds, where he developed a sharp nose for risk-taking.

After more than eight years as a growth fund manager at MFS Investment Management, he left in 2001, the year after the dot-com crash, to co-found Cyllenius Capital, a hedge fund that BlackRock (BLK), the world's largest money management firm, acquired in 2002. Then he managed both mutual funds and hedge funds for BlackRock until 2004, when he and his team broke off on their own, forming Long Trail, where they stayed from 2005 to 2007.

To hear Stack tell it, he has surprised himself with Growth Opportunities' performance. "We don't try to shoot the lights out," he says. "We look at potential for revenue growth, healthy and defensive profit margins, and returns on invested capital."

That, of course, turned out to be a recipe for fast and sudden growth in the wake of the financial crisis.

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Fund Focus: Mutual Series Keeps a Private Equity-Like Window Open

Michael Shari — Fri, 07 May 2010 09:00:00 EST

Filed under: Investing, Stock Picks

It has been said that when the capital markets are on the way up, there's not much work for a mutual fund manager to do except turn the lights on when he arrives at the office and turn them off at the end of the day. This is because the vast majority of mutual funds don't use the most adventurous or ambitious methods to invest your money. They simply buy stocks or bonds on the public market from traders, the fees for which get passed on to the investor.

That's the main difference between mutual funds and the private equity funds, which are only for "sophisticated" investors who invest hundreds of thousands of dollars at a time. Very few mutual fund managers would ever contemplate taking the time or the risk of scouting out a company that needs to raise capital in a hurry and then offering to buy a chunk of its equity or one of its bank loans. This is cheaper than buying stocks or bonds on the market, particularly if the company in question is desperate to sell. But it also requires a much deeper level of research than most mutual funds can muster.

Franklin Mutual Series Funds

But there's one mutual fund family that acts like a private equity fund when it wants to, and you don't have to be rich to use it. It's the Franklin Mutual Series Funds, which is run by Peter Langerman and a team of portfolio managers and analysts in Short Hills, N.J. Part of the Franklin Resources (BEN) complex, Mutual Series is a value shop that focuses on "distressed situations" that make companies desperate, which is not an unusual strategy per se. But a prospectus filed with the Securities and Exchange Commission certainly makes an uncommon claim -- that Mutual Series funds can and will make "direct purchases" of equity or debt from the companies it invests in.

The Mutual Series funds also act like hedge funds when they want to. The prospectus says they can invest in derivatives.

I caught up with Langerman between meetings in Midtown Manhattan with financial advisers, broker dealers and other gatekeepers who are in the business of picking your mutual funds for you. (You may not actually be aware that you employ these people, particularly if you have entrusted your retirement savings to a large financial institution.) He was quick to point out that private-equity-like investments are "just one piece of the arsenal" at Mutual Series and that its "core investments" are the publicly traded stocks and bonds that fill those gray tables on the back pages of the Wall Street Journal.

Buying Direct Equity Stakes

But then Langerman referred me to one of his analysts, Luis Hernandez, whose job is to seek out and recommend direct purchases. Hernandez told me he was working on several complex investments that were at various levels of completion. He declined to discuss most of them, but he went into detail on one that had closed last October, when Mutual Series joined several other investors in a consortium that bought an equity stake worth about $150 million directly from West Coast Bancorp (WCBO), a publicly listed regional bank based in Lake Oswego, Ore.

The investment was made by Mutual Financial Services (TEFAX), a mutual fund with $449 million in assets, when the bank's stock sold for about $1.30 a share more than six months ago. It closed at $3.28 on May 5, more than double the purchase price.

Before closing the deal, Hernandez spent months trying to figure out why West Coast was so desperate to raise cash and deciding whether it was a safe investment. Shortly before the real estate market fell apart in 2007, the bank had started issuing loans that were used for a double purpose -- buying land and building buildings on said land -- which gave the bank a double whammy. Hernandez concluded that West Coast was well managed and had a sound consumer banking franchise, but needed money to shore up its capital base. Then the bank issued new shares, which Mutual Series and the other investors snapped up. (He declined to disclose the value of Mutual Series's portion.)

Talking Like a Private Equity Manager

Now, I've covered institutional and retail investing for longer than I care to admit. But I had never heard an analyst at a retail mutual fund talk like a private equity manager until I spoke with Hernandez. Mutual Series is certainly treading in institutional territory, but the intended investor is not a state pension fund in California or a university endowment in Cambridge, Mass. It's Joe Schmoes like you and me. The fees are small, and so are the minimum required deposits. Mutual Financial charges only 1.24% of your investment, and the minimum deposit is just $1,000.

It would be nice if all of Mutual Series's investments had performed as well as the West Coast deal since the financial crisis. In fact, Mutual Financial has performed worse than the Standard & Poor's 500 Index every calendar year since 2007, and it's still trailing the index year-to-date.

What gives? "It's not a secret that we are conservative investors," explains Hernandez. "The investments we make are for the long term."

Only for Investors With Patience

And so it goes for private equity investors, too. If you stray away from the public market, you have to be patient enough to wait years for an acceptable return -- regardless of how that market is performing. Mutual Financial beat the S&P 500 by 7.7 percentage points a year on average for 10 years through May 5, according to Morningstar (MORN), which tracks mutual funds in Chicago.

Few mutual funds can make that claim. Then again, very few of them claim to make direct purchases.

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Fund Focus: Masters' Select Offers Diversification -- With Risks

Michael Shari — Fri, 30 Apr 2010 11:25:00 EST

Filed under: Columns, Investing

It's never easy to pick a mutual fund, as I've noted before. If you pick an equity fund, for instance, there's a wide spectrum of investment styles and cap sizes to choose from, and then there are thousands of mutual funds that invest in the fashion you favor.

And they can be expensive, too. The ones that sound really tempting can have high fees of 2% of your assets and require a minimum deposit of around $10,000. You can leave the choice to a registered investment advisor or a broker-dealer, but you could wind up paying a second layer of fees.

This is the conundrum that has plagued every individual investor since the Investment Act of 1940, which created the modern mutual fund. It's also the angle that Litman/Gregory Fund Advisors, a registered investment advisor that administers nearly $6 billion in Orinda, Calif., was working from when they launched the Masters' Select Equity Fund (MSENX) in April last year. (It's the new retail version of a more expensive institutional fund that Litman/Gregory has managed since December, 1996.)

Unusual Access for Retail Investors

According to Jeremy DeGroot, who manages Masters' Select, it was intended to give individual investors who aren't particularly rich an opportunity to pick a single mutual fund that would be completely diversified across equity investment styles and cap sizes -- and run by active stock-pickers from institutional money-management firms that have respectable track records and are generally inaccessible to most retail investors.

"We're finding great stock-pickers, having them focus on their best ideas and creating a mandate where they're thinking long-term and not worrying about shorter term underperformance or volatility because you've got other managers to provide that diversification," says DeGroot.

Just to be clear here, Masters' Select is not an automated target-date fund that mechanically moves your assets out of equity and into fixed income as you get older. It's not an expensive fund-of-funds that charges two layers of management and performance fees, either. Litman/Gregry charges a relatively low management fee of 1.56% and uses it to pay seven different institutional managers to pick 10 to 15 stocks each for a portfolio of 90 stocks. The minimum deposit is only $1,000.

Allocation With a Strong Track Record

The portfolio is neatly divided into five sleeves, each of which makes up 20% of its assets. Two small-cap managers, Freiss Associates and Wells Capital Management, invest one sleeve in a blended growth-and-value style known as "growth at a reasonable price", or GARP.

Two growth managers, Sands Capital Management and Turner Investment Partners, invest another sleeve in in large-cap value stocks. Another GARP manager, Davis Selected Advisors, invests a sleeve in large-cap stocks. Southeastern Asset Management invests a sleeve in large-cap value stocks. The last sleeve is managed by Harris Associates, which invests in large-cap value stocks.

Personally, I find it puzzling that the assets are broken up into large round percentages that almost anyone could devise on the back of an envelope. DeGroot says the allocations are based on Litman/Gregory's past experience of what has worked best for their private clients, which is a four-to-one ratio of large-cap to small-cap stocks, and large-cap stocks spread evenly among growth, value and blended styles.

"Saying it should be 17% and 23% would be false precision," DeGroot told me over a cup of coffee. "That's not going to drive the performance as much as the general weightings."

Not That Safe?

What's much more important, DeGroot stresses, is finding talented stock pickers. "You need to get access to these guys, dig in really deep and understand their investment approach -- which we don't think just anybody can do."

But it's not clear that Masters' Select is a safe bet. For one, no matter how diversified this fund is, you'd still be putting all of your eggs in one basket if you picked this fund as a substitute for a smattering of mutual funds.

Also, Masters' Select is highly exposed to the same risk that all active stock pickers face. On average, they only get their stock picks right a little more that half the time -- and even less than that in some years, according to studies by consulting firms McKinsey & Co. and Towers Watson.

That's one reason why a lot of investors have stopped trying to pick active managers and are moving their money into passive index funds that hug benchmarks like the Standard & Poor's 500 Index, for better or worse.

Stock-Picker Shuffle

Just take a look at the fund's performance, which was horrific during the stock-market crash. Masters' Select underperformed the S&P 500 by 9.9 percentage points in 2008 -- a year in which the index was down 37% -- and delivered a memorable 46.9% loss for the year.

Masters' Select now has $347.7 million in assets, and investors aren't exactly throwing money at it. Morningstar, the Chicago-based mutual fund data provider, gives this fund only two out of five stars.

DeGroot says he and his colleagues have been working hard to improve this fund's performance. Until they assessed the stock-pickers last year, one of them was Legg Mason Value Trust, which had beaten the S&P 500 for 15 years straight until 2007, when it ran into performance problems. Southeastern took Value Trust's place.

To some extent, DeGroot's rethink seems to be having the desired results. During the past 12 months, Masters' Select has registered a total return of 46.8%, beating 89% of the similarly diverse funds that Morningstar covers. The question is whether the convenience of leaving all those head-aching decisions to someone else is worth the risk. It could take a few years before anyone can say for sure.

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Fund Focus: Marc Heilweil's Five-Star Instinct Beats the Spreadsheets

Michael Shari — Fri, 23 Apr 2010 09:00:00 EST

Filed under: Columns, Investing, Exxon Mobil, Coca-Cola Company, Tiffany & Co, GlaxoSmithKline

I recently sat down for lunch at a polite restaurant on Union Square West in Manhattan with a veteran fund manager who shocked me with his down-to-earth approach to investing. I was already impressed by the top-notch long-term returns that Marc Heilweil had achieved with his Marathon Value Portfolio (MVPFX). But I was absolutely unprepared to hear him describe the old-fashioned, brazenly intuitive investment process by which he throws conventional stock-picking tools to the winds and follows his instincts to buy well-run businesses at the rare moments when they're cheap.

Few people have heard of this Atlanta-based lawyer-turned-investor who has set foot on "the geographical" Wall Street only "three or four" times in his life -- most recently on the morning before our lunch in mid-April. And even fewer people invest with him, whether it's in the $35 million Marathon mutual fund that he has run since March 2000 or in the $350 million in separate accounts that he has managed for high-net-worth investors since 1977. And no analyst at Morningstar or any other fund-tracking firm covers Marathon because it's too small.

Yet Heilweil's few clients are loyal, and they've stayed with him through the financial crisis. His large-cap blended value-and-growth equity fund beat 98% of its peers in 2008, when it fell a mere 23.33% while the Standard & Poor's 500 Index plunged 37.0%. For the past 12 months, the fund has grown a mere 37.82%, falling behind 94% of other large-cap blend funds. Heilweil reckons the other funds grew faster by loading up on the stocks that he has shunned -- financially distressed, often poorly run companies that tend to lead a rally after a market crash. Nevertheless, Marathon has truly distinguished itself over the last 10 years with a total return of 6.14% on an annualized basis, which was better than 97% of its peers. This track record has earned it a five-star rating from Morningstar, the highest grade that the Chicago-based fund-tracking firm can bestow upon a mutual fund.

Even more compelling than Heilweil's investment returns are the methods by which he has achieved them. At the age of 64, the Yale Law School graduate admits that he never learned how to "operate" a spreadsheet, leaving such electronic wonders to his two-person investment staff. The file cabinets in his Atlanta office are crammed with hard-copy annual reports and other documents that he spends his days poring over. He rarely travels, instead waiting for executives of companies to pass through town.

Creative Ways to Buy Well-Run Companies Below Market Value

So how does Heilweil pick stocks? "There's no metric," he says. "I don't rely on projections. I'm a business investor. I'm looking for good business models and good managers."

Heilweil is essentially investing on instinct. That has led him away from airlines and textile companies, which he considers generally badly run. And it has led him to pharmaceutical companies like GlaxoSmithKline (GSK), consumer non-durables like Coca-Cola (KO), and lubricant manufacturers like Graco (GGG).

His instincts also led him to go against the herd and bet on luxury goods during the recent financial crisis. He bought Tiffany & Co. (TIF) for $20.96 a share in November 2008. Investors had sold the stock down by 62.64% from $56.10 in October 2007 on fears that the market crash would kill the renowned jeweler's sales. But the stock has more than doubled since he bought it, trading at $49.48 after hours on April 21. "It's the 'blue box' draw. They do well at marketing that image around the world," he says.

Heilweil finds creative ways to buy well-run companies below market value. One such stock was Exxon Mobil Corp. (XOM), which he has long regarded as overpriced. So when the world's biggest oil company announced last December that it was going to acquire natural gas producer XTO Energy (XTO), and that XTO shareholders would receive 0.7098 shares of Exxon stock per share of XTO stock, he jumped at the chance. "I bought XTO to own Exxon," he says. He paid $46.82 for XTO shares earlier this year, and by April 21, it had risen to $48.40. That was 70.3% of Exxon's share price of $68.92. Considering the lower price he paid for XTO, he says, he expects he'll end up having paid "not too large a premium" for Exxon.

Heilweil is a long-term, buy-and hold investor. Marathon has a low turnover rate of 42%, meaning that less than half of the 77 stocks and handful of bonds in the portfolio get replaced in a given year. That draws the attention of senior managers of the companies that Marathon owns, making it more likely that they will return Heilweil's calls than those of fund managers who switch stocks more frequently.

Low turnover has the added benefit of keeping trading costs down. But Marathon is so small that after covering other costs, such as regulatory compliance and compensation for the analysts, there's not enough fee revenue left to pay the portfolio manager. "I have not made a dime from the fund," he says, explaining that he supports himself by managing money for his high-net-worth clients. There's nothing left over for marketing, either. As a result, despite Marathon's performance, this five-star fund could remain an undiscovered gem for many years to come.

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Fund Focus: For Pro-Blend, Not Beating the S&P Just Won't Do

Michael Shari — Sat, 17 Apr 2010 08:00:00 EST

Filed under: Columns, Investing

At the end of 2008, the Manning & Napier Pro-Blend Maximum Term Series (EXHAX) marked its 10th consecutive year of beating the Standard & Poor's 500 Index, a feat that precious few mutual funds apart from Legg Mason Value Trust have ever achieved. This achievement was all the more astonishing because this 15-year-old fund is a half-sister to a reasonably conservative family of target-date funds that were pioneered in the early 1970s by Manning & Napier Advisors, which now runs $30 billion in assets 264 miles northwest of Wall Street in Fairport, New York.

But the portfolio managers in Fairport were not celebrating. That's because 2008 was the year the stock market was crushed and the S&P fell 37% -- and Pro-Blend beat the index by only 1.6 percentage points. "It's a little bittersweet when you cap a performance record like that in a market that was as brutal as it was," says Christian Andreach, a managing director of Manning and one of 10 portfolio managers of Pro-Blend.

It's surprising that such a uniquely diverse and thrifty fund could have been dragged so far down. Unlike its target-date siblings, Pro-Blend is an aggressive, actively-managed, fully-invested mutual fund that does not confine itself to any asset class or investment style. It owns bonds as well as stocks, and it invests across the equity spectrum in both growth and value styles, and in companies of all sizes. It also crosses geographic borders, from Western Europe to emerging markets. And Pro-Blend is a consummate bottom-crawler, buying stocks at a discount to fair value of at least 25%, according to Andreach.

But Pro-Blend dug a hole for itself two years ago when investors were convinced that the Wall Street crash would have an even more devastating effect on emerging markets. So the fund's holdings in emerging markets and even U.S. companies that depended on those markets for revenue went through the floor. As the dollar started to look like a safe haven, the fund's British stocks took a beating. The fund also owned U.S. banks that got pummeled even if they weren't distressed.

"Easy Money Opportunities" Getting Harder to Find

Andreach and his colleagues haven't lost a moment trying to dig out Pro-Blend since the market hit bottom in March 2009. In the process, they found themselves buying growth stocks like Google (GOOG), Cisco Systems (CSCO) and EMC Corp. (EMC) that were valued as cheaply as classic value stocks like banks. Prices for these three stocks have roughly doubled from their lowest levels in the crash. "We saw competitive capacity coming out of the market, and we thought these companies would be the ones left standing when the economy recovered," says Andreach. They made similar bets on SouthWest Airlines (LUV), United Parcel Service (UPS) and FedEx (FDX).

As a result, Pro-Blend grew modestly, by 43%, during the 12 months through April 15, when it had $678 million in assets. But even at that rate, the fund is starting to fall behind the S&P 500, underperforming the index by 1.88 percentage points during those 12 months. And the rest of the year could prove to be a far greater challenge as Andreach and his co-managers find it a lot harder to find such "easy money opportunities" in the wake of the rally, he says.

That's why Pro-Blend recently made a contrarian bet on health care stocks that many investors won't touch for fear that the new health care reform law signed by President Barack Obama on March 23 could somehow prevent pharmaceutical companies from recouping the cost of developing drugs. The fund is buying companies that Andreach says are insulated from such political risks because they are on the diagnostic side of the industry. Yet their stock prices still fell in the last week of March too, presenting a buying opportunity for the fund.

One of these companies is Quest Diagnostics Inc. (DGX), which conducts blood tests and other tests ordered by doctors. Another is Inverness Medical Innovations Inc. (IMA), which sells products used to test patients for pregnancy, cancer and other medical conditions. Another is Gen-Probe Inc. (GPRO), which screens blood for the Red Cross.

Andreach believes the rest of the year could prove far more challenging as stocks of all styles and sizes start to look way overpriced. In the near term, he predicts that stock prices will become increasingly volatile. So the fund is taking a defensive posture, recently selling shares of two supermarket chains, Kroger (KR) and Safeway (SWY), which that Andreach says normally do well when the economy is recovering.

It would be hard to find a less subtle hint that the recovery is -- at least in the eyes of Manning & Napier -- threatened. "Our outlook is not for another market crash," says Andreach. "But prospective returns are not going to be as robust as they were six months ago."

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Fund Focus: Just Ignore These Funds' Triple-Digit Returns

Michael Shari — Fri, 09 Apr 2010 12:20:00 EST

Filed under: Columns, Investing, ETFs

It's not often that I spot a fund that appears to have tripled or quadrupled in just a year. So imagine my shock when, poring over a spreadsheet provided by Lipper, a unit of Thomson Reuters in Denver that tracks mutual funds, I found several funds that appeared to have delivered returns in that stellar range during the 12 months through Feb. 26.

Four members of the Direxion Funds family practically danced off my screen. In a year when the Standard & Poor's 500 Index grew by a mere 70%, Direxion Emerging Markets Bull 3X Shares (EDC) was up 345%, Direxion Technology Bull 3X Shares (TYH) 289%, Direxion Large Cap Bull 3X Shares (BGU) 208%, and Direxion Financial Bull 3X Shares (FAS) 213%.

Who's behind these gravity-defying financial instruments? Direxion Funds is run by Rafferty Asset Management, a quantitative investment firm in Boston. But they're different from mutual funds. These are exchange-traded funds, or ETFs, which are governed under the same law that created modern-day mutual funds, the Investment Company Act of 1940.

Instead of actively investing in stocks or bonds, most ETFs passively invest in indexes like the S&P 500 -- the type of benchmark that's unlikely to triple or quadruple in a year. Also unlike mutual funds, ETFs are listed on exchanges, where they trade like shares of common stock.

More Than Meets the Eye

But what explains the seemingly stellar returns of these particular ETFs? They're leveraged -- and that also makes them extremely risky.

The Securities and Exchange Commission granted Direxion exemptive relief from the so-called '40 Act on Oct. 31, 2008, allowing these fund to invest in derivatives. This can multiply the value of the stocks or bonds in the index a fund is pegged to. So a fund that's, say, three-times leveraged would chalk up a fat return of 30% if the face value of its investments increases by just 10% - but it can just as easily fall 30% if its investments lose 10% of their value. Intraday returns can be even more volatile, says Andy O'Rourke, senior vice president of Direxion.

The risk involved in these ETFs goes even further than all that would imply. Analysts who cover them say their annual returns simply aren't what they appear to be. In fact, they're completely misleading.

Direxion has set a target for each of these funds to deliver a return of 300% per day, amazingly enough. But they're so volatile that since Direxion launched the first of its 34 leveraged ETFs in November 2008, they've been known to fall at times when the indexes they're pegged to were rising, and to rise at times when the same indexes were falling, says O'Rourke.

"Only for Sophisticated Investors"

So an investor who put money into one of these funds on Feb. 27, 2009, and kept it there for a year actually might have lost money, depending on the time of day that he bought the fund and then sold it. "The math in these funds is not logical," warns Jeff Tjornehoj, a research manager at Lipper. "These funds are only for sophisticated investors."

Paul Justice, an analyst who covers ETFs for Morningstar, a fund-rating firm in Chicago, has a simpler take on how the math has worked in leveraged Direxion funds since they started trading in the midst of the financial crisis. "It's the dead-cat-bounce phenomenon when you have a crash followed by a rally," he says. "The fact that they [Direxion] even put out a yearly performance chart is misleading."

That's why the SEC advised investors last June not to leave their money in any leveraged ETFs for longer than a single day. It's also why some brokerages have banned their financial advisers from using them, says Justice.

Split-Second Timing

So what should an individual investor do with a Direxion leveraged ETF? "The first thing I would say to an individual investor who's primarily focused on a long-term buy-and-hold strategy is to not pay attention to our funds and forget they ever saw them," says O'Rourke.

To be sure, some do-it-yourselfers buy Direxion leveraged ETFs on platforms like Charles Schwab and Fidelity, says O'Rourke. But the vast majority of investors are large financial institutions that seek out volatility to maximize intraday returns, such as the proprietary trading desks of Wall Street banks and, of course, hedge funds, he says. They account for the lion's share of the approximately $5 billion in assets currently in the 34 funds. These institutions buy the funds in the morning and literally monitor them all day until they find the right moment to withdraw before the market closes. If individuals were to do this, he says, they would have to "quit their day jobs."

Tempting as that may sound, particularly in an era of 10% unemployment, you would be wise to stick to plain-vanilla mutual funds -- or at least to ETFs that aren't leveraged.

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Fund Focus: RS Small Cap Growth Returns From the Depths of 2008

Michael Shari — Fri, 02 Apr 2010 12:30:00 EST

Filed under: Columns, Investing, Investing Basics

Every now and then, I come across a portfolio manager who has an interesting take on investing -- and just happens to be recovering from some kind of nightmare. The retelling of it can be instructive in unraveling one of the great mysteries of life on Wall Street. That is, how to pick a great mutual fund -- or how to spot a bad one.

It's too early to decide which of those two labels fits the 13-year-old fund RS Small Cap Growth Fund (RSEGX). But its astute and experienced portfolio manager, Alison Thacker, who started running the fund in January 2007 with three co-managers in San Francisco, appears to be in the process of dragging it out of the worst-in-class category. That's where the fund landed in 2008. Now, Thacker is elevating it to a more appealing status.

Thacker's investment theme is compelling enough. She likes small-cap stocks because a small company tends to earn almost all of its revenue from a single product line. That gives the company more of an incentive to expand its market share than a large, diversified competitor that has multiple product lines. The large-cap company might just take a foot off one pedal to step on another at different points in various product cycles. "A small-cap company is truly able to participate in a product or service, almost as a pure growth play," she says.

Her methods also look sensible. She uses quantitative screens to distill the small-cap universe of about 3,000 stocks. Those that don't meet her criteria for long-term revenue growth, free cash flow, operating margin and other metrics get filtered out. That leaves a few hundred stocks to start doing fundamental research on -- visiting their offices, meeting their executives and so on. From that pool, she and her co-managers pick the approximately 80 stocks that the fund owns at any given time.

It Was a Very Bad Year

Thacker's first real test as portfolio manager came in 2008, the year the Standard & Poor's 500 Index fell 37%. This fund's performance was bad not only in absolute terms, but in relative terms as well. RS Small Cap fell 45.6%, not only worse than the S&P but also worse than 82% of the small-cap growth funds in the database of Morningstar, the Chicago-based firm that ranks mutual funds.

Thacker blames the underperformance on one of the smallest segments of the portfolio: "Somewhere between zero to 10% of the fund we invest in promising early-stage growth companies. Those can include IPOs and biotech. But I would say, in general, those were the types of companies in 2008 that investors did not want to own."

Ryan Leggio, a Morningstar analyst who covers this fund, has a simpler take on what went wrong. "It was just bad stock-picking," he says. "They were tested in a crisis, and they have to be retested in another." That, he says, could take years.

A Change for the Better

As the dust settled on the market crash, Thacker replaced some of the largest stocks in the fund. She says one that went was PROS Holdings (PRO), which sells predictive-analytics software suites to corporations to help them determine prices for their own products. But the financial crisis and a competing product cast a pall over PROS's future revenue growth. The stock fell 81% from $19.62 in December 2007 to $3.79 in March 2009, and closed at $9.93 on April 1.

A new company in the portfolio is Align Technology (ALGN), a dental-appliance maker that sells aligners, which are a clear plastic alternative to metal braces. The fund bought the stock for $17 to $18 between December last year and February this year, Align closed at $19.58 on April 1. It's now one of the 10 largest holdings. Melissa Chadwick-Dunn, one of Thacker's two co-managers, says Align could see its market share multiply.

From the fund's performance over the last 15 months, it's pretty obvious that Thacker and her two co-managers picked better stocks than they ones they threw out. In 2009, the fund grew by 47.7%. That was a better total return than 89% of the small-cap growth funds Morningstar covers. From Jan. 1 to March 31 this year, the fund is up 8.27%, beating 78% of its peers.

But RS Investment Management, which employs the portfolio managers, still hasn't found it easy to get people to invest in this $499 million fund. Investment flows have been flat for the last couple of years, meaning that investors are depositing no more than they're withdrawing. Apart from the underperformance in 2008, one reason could be that the minimum investment is $2,500, while some other funds require only $1,000. Or it could be the management fee, which was unusually high at 1.51% until January, when it was reduced to a below-average 1.35%.

Look Around Before Commiting

Statistically speaking, small is the right cap-size to invest in. Small-cap stocks outperformed large caps by more than three percentage points during the last 10 years, according to the American Association of Institutional Investors. But it's not clear that growth is the right style. Remember the Internet craze of the late 1990s? Startups that didn't even have profits saw their market cap grow rapidly. Thacker, who was an intern at Putnam Investments when she was studying for her MBA at Harvard Business School, recalls hearing "specious measures like eyeball count" being used to value Internet companies.

But if you've got your heart set on small-cap growth -- whatever the reason -- you might want to look at a few other mutual funds that claim to follow a similar strategy before you actually make a commitment. The more attractive ones, according to Morningstar, are Bridgeway Small-Cap Growth (BRSGX), Masters' Select Smaller Companies (MSSFX), Vanguard Explorer (VEXPX) and Wasatch Small Cap Growth (WAAEX). But do take care. These funds all did worse than the S&P 500 in 2008 and are now in the process of what looks like a long climb back up -- though not necessarily with the same extreme degrees of pain and euphoria as the RS fund.

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Fund Focus: Is Value Investor Tom Forester the Canary in the Coal Mine?

Michael Shari — Fri, 26 Mar 2010 08:00:00 EST

Filed under: Columns, Investing

It will never be easy to pick the right mutual fund, but it was just about impossible in 2008, the market's worst year in living memory. That was the year the Standard & Poor's 500 Index fell 37%, and you no doubt lost a chunk of retirement savings that you haven't recovered yet.

Well, there was one long-only equity mutual fund that didn't lose money in 2008. It was very small, almost completely unknown, and made a barely noticeable profit. The Forester Value Fund (FVALX), named after its founder and portfolio manager, Tom Forester, finished that cataclysmic year with a relatively handsome return of 0.4% -- yes, less than half a percentage point -- on what was then just $50.2 million in assets.

The fund has grown to $102 million in assets since then, but it's not shooting out the lights. It delivered a total return of 18.1% in 2009, underperforming the S&P 500 by 8.37 percentage points. Then it grew 2.3% from Jan. 1 to March 24, which was 3% worse than the S&P.

"On an absolute basis, we are lagging a little bit," admits Forester.

Good Stocks in 2008 Made Lower Gains in 2009

Forester, 51, is a conservative, large-cap value investor who gravitates toward stability. Some of the best-performing stocks in his portfolio didn't get beaten up badly during the crisis. They are large, stable companies like McDonalds (MCD), which is up 15% over the past year, and Johnson & Johnson (JNJ), which is up 38%.

They also fit his rubric for stocks that are trading at historically low price-to-earnings multiples. "You get the best performance out of low PE stocks," says Forester, who was working for famed value investor David Dreman until he launched his own fund in 1999. "I have used price-to-book to value companies, but their book has changed. At least I know what their price and earnings are."

The irony is that many of the large, stable companies in his portfolio did not soar with the market recovery over the last 12 months. The reason is that they did not get beaten down badly enough to have a trough to leap out of. So they almost became a liability, helping to weigh down the performance of his fund. Another reason is that only about 75% of the fund is actually invested in stocks because, he says, many large-cap value stocks just look too expensive to buy. Over the past 12 months, Forester has performed worse than 27% of other large-cap value funds tracked by Morningstar, a fund rating firm in Chicago.

"The markets are trading at about 20 times earnings. Historically, the average is about 14. So things are looking pretty rich right now," he says.

Forester Won't Join in the "Dash to the Trash"

The large-cap value equity funds that are beating Forester got their lift from distressed stocks that had further to climb during the past 12 months, such as large banks with exposure to home loans and mortgage-backed securities. "In 2009, it was kind of a dash to trash," he says. "It's a Pavlovian effect. People didn't know where the bottom was going to be, but once we hit the bottom, people rushed in because that's always what happens."

Sure, bottom-fishing at the right time last year could have given Forester's performance a boost this year. But he has decided to underweight banks in his portfolio because he's not sure they are out of the woods yet. He cites federal government statistics that show an overhang of millions of home foreclosures this year, and a softening of home prices last November and December. He predicts that banks will ultimately be forced to take more write-offs.

"Right now, people are saying, 'It's all done, don't worry about it, they're minting money right now, banks are the place to be.' And I just don't agree with that," says Forester.

Is Another Correction Around the Corner?

You'd think tons of investors would have discovered the fund by now and thrown their hard-earned cash at Forester and his two-person research staff in Chicago. But they haven't. As the old adage goes, "Mutual funds are not bought, they are sold," and Forester never got around to hiring anyone to market his fund until this February. Another reason could be that his fund requires a minimum deposit of $2,500, more than twice as high as the average street-level fund. Since the fund passed the $100 million mark at the end of last year, he says, a registered independent advisor and a couple of insurance companies have started talking to him about the possibility of managing their clients' money.

Financial analysts are also talking to Forester because they have learned to use him as the proverbial canary in the coal mine. The last time he became this defensive was in 2007, when the financial crisis was mounting, says Ryan Leggio, an analyst at Morningstar, which rates the Forester Value Fund at five stars on the firm's five-star scale.

Of course, Forester is the first to deny that he is waving a red flag. "I don't expect things to fall off a cliff again like in '07. But I do expect things to trend down," he says.

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Fund Focus: Discovering Institutional Funds for Individual Investors

Michael Shari — Fri, 19 Mar 2010 09:00:00 EST

Chris McIsaac has been investing in mutual funds ever since his boyhood in Edmonton, Alberta, where he deposited his summer-job wages of about 1,000 Canadian dollars into a growth-oriented Altamira fund.

"At the age of 15, I guess growth sounded good to me," he recalls. Better still, the fund made money, taking him south of the border and helping to pay for his first year at St. Joseph's University in Philadelphia.

Twenty years later, the 35-year-old McIsaac is armed with an MBA from Harvard Business School and 13 years of experience at Vanguard, the gargantuan mutual fund complex in Valley Forge, Pa., where he has held several positions. He's the kind of person from whom an investor can learn a lot about how to pick mutual funds.

An Alternative to Dull Index Funds

As principal of Vanguard's portfolio review group, McIsaac's job is to vet and hire small firms to manage bits and pieces of Vanguard's sky-high $1.35 trillion asset pile. The point is to give Vanguard's clients an alternative to its singularly dull and unambitious index funds, which pretty much mimic benchmarks like the Standard & Poor's 500 Index.

But McIsaac is picky. He and his team will only consider so-called active portfolio managers who actually visit the companies they invest in and meet the executives -- a research method that's supposed to beat the benchmarks. They also make sure that every portfolio manager they interview is executing his strategy as he describes it.

"If you say you are 'using a dividend discount model to value companies,' then the portfolio has to show that," says McIsaac.

Top Performers Not Always Needed

Ironically, stellar performance is not the main criterion that McIsaac holds portfolio managers to. If a fund has been in the top quartile for too long, his rule of thumb is that it could soon sputter out and slow down. So he sometimes prefers managers who actually have performance problems but are in the process of fixing them.

"A one-star fund is more likely to be a five-star fund over the next three years than a five-star fund is," says McIsaac. "That's a lesson we try to keep at the fore of our mind when we choose managers."

Over the years, the portfolio review group has built up a sort of fund-of-funds business within Vanguard that now employs 33 outside firms that manage $315 billion of Vanguard's assets in 75 different investment strategies. That's the same amount of money that T. Rowe Price was managing, in total, in June 2009.

In the process, McIsaac is discovering fine institutional managers who have gone unnoticed by mutual fund investors. Institutional managers tend to charge lower fees than retail mutual fund managers because they're accustomed to taking large deposits from pension funds and other big investors for whom the minimum deposit is about $200 million. At Vanguard, the economies of scale are such that when a new fund manager comes aboard, he or she has an instant mandate to manage billions of dollars in assets.

"We are a big client for them," he says. "We are an institution for them."

Doubling Clients' Money

After looking at about 300 funds last year and speaking with the managers of many of them, Vanguard announced its latest product, the Vanguard Explorer Value Fund (VEXPX), on March 16. It's managed by three firms that specialize in managing small and mid-cap stocks, a style that some fund managers used to double their clients' money -- or more -- over the past 12 months. But the performance of these funds is mixed, and McIsaac says they were selected mainly for their strong investment discipline.

One of the three firms is Cardinal Capital Management of Greenwich, Conn. Cardinal delivered a total return of 34.6%, net of fees, to institutional investors in its Small-to-Mid Cap Value Equity Strategy during 2009, according to the most recent numbers available from the company. That was safely above its benchmark, the Russell 2500 Value Index, which was up 27.7% for the year. But it fell 4.8% during the three years ended Dec. 31, 2009, underperforming the Russell 2500 by 7%.

Another is Sterling Capital Management of Charlotte, N.C. The BT&T Sterling Capital Small Cap Value Fund (SPSCX) soared 54.5% in 2009, after losing 32.6% in 2008. In both years, it beat the S&P 500 by a long shot. But it was down 3.1% during the three years through Dec. 31, 2009, beating the S&P by just 2.6%.

The third is Frontier Capital Management of Boston, which declined to disclose its performance. But this is Vanguard's second hiring of that firm, which is already one of the managers of the Vanguard Morgan Growth Fund (VMRGX).

Diversity Rules

As is the norm for Vanguard's outside managers, each of the three firms hired for Explorer Value is being assigned to a different arm of the fund to even out the ups and downs in the years to come. If one fund falters, the second or third could rise or remain flat, softening the impact on a Vanguard client. (Every dollar you invest in this fund gets distributed equally to all three managers.)

"We think there is a benefit and an advantage in that diversity," says McIsaac.

So, as McIsaac and his have team assembled it, Explorer Value would help you spread your risk around a bit while still staying within a single investment strategy. But this fund still isn't for the faint of heart -- or the light on cash. The minimum deposit is $10,000, the norm for retail funds that are managed by institutional firms.

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Fund Focus: Investing in Troubled Manufacturers Pays Off

Michael Shari — Fri, 12 Mar 2010 10:00:00 EST

Filed under: Investing

Every now and then, I come across a mutual fund that delivers amazing returns but still manages to avoid getting noticed by the crowd. At the moment, I'm talking to the portfolio managers of the little-known Delafield Fund (DEFIX), a value-oriented equity mutual fund in New York that invests in small and mid-size companies that are working themselves out of what banks like to call "special situations."

J. Dennis Delafield and Vincent Sellecchia, the fund's veteran portfolio managers, have a knack for buying troubled companies that recover with a vengeance. Working with just three analysts who spend their time visiting these companies, it delivered a stunning total return of 120.3% during the 12 months through Mar. 10. That was nearly double the return for the Standard & Poor's 500 Index as the whole stock market bounces back from the brink. The Delafield Fund also beat 91% of the other value-oriented mutual funds that invest in small- or mid-cap companies, according to Morningstar Inc., a mutual fund rating agency in Chicago.

Yet investment flows into this fund have been almost flat over the past year, meaning that investors have deposited only marginally more money than they have withdrawn. So why would such a great-looking fund be so rudely neglected? It can't be the fund's size, which is a respectable $715 million in assets. It's not the track record of the 17-year-old fund, which outperformed more than 90% of similar small- and mid-cap value funds during the last three, five and 10-year periods, according to Morningstar. And it's priced at street level with a minimum deposit of only $1,000 and a fee that works out to 1.26% of your investment.

Troubled Manufacturers Is Its Sweet Spot

The fact is that it takes more guts than money to invest in this fund. Its sweet spot is in troubled manufacturers that are being sold down by shareholders who won't take the time to understand that their problems are temporary. Maybe they're passing through a low point in a business cycle, working through an awkward merger or undergoing a painful debt restructuring. If the portfolio managers are satisfied that a company's balance sheet shows it stands a decent chance of survival, they pounce on the stock even while it's still falling.

That alone would be enough to scare off most investors. But these portfolio managers wait patiently for the stock to bottom out and bounce back when investors see that the company has recovered. Fundholders were sorely tested through a knuckle-whitening year in 2008, when the fund fell 37.6% -- 60 basis points worse than the S&P 500 in the market's worst year in living memory.

But many of the stocks that dragged the fund down in 2008 turned out to be the same ones that drove it straight back up through the roof during the past 12 months. This is where Delafield and Sellecchia have proved themselves to be better stock-pickers than their peers. Before they buy a company, they take a close look at its free cash flow, which they define as funds from operations minus capital spending and dividends. That tells them how much cash the company has left over to pay down their debt, make acquisitions or buy stock.

Free Cash Flow Drives The 'Investment Process'

"We are willing to buy companies that are very troubled," says Sellecchia. "We buy them based on their balance sheets. Free cash flow drives our investment process. And that came home in spades in the last 18 months. We had several investments that went up several-fold from the bottom."

Their methodology led Delafield and Sellecchia to buy Sonoco Products (SON), which manufactures metal and cardboard tubing, as well as Maxwell House coffee cans and Pringles potato chip containers. They bought it in March 2009 for about $15 to $20 a share, where it had fallen from $35 in September 2008 on fears that its clients would get slaughtered by the recession and demand for Sonoco's products would fall.

"It was a nice company with good cash flows," says Sellecchia. Then Sonoco slashed costs -- consolidating 19 separately run businesses into six and closing a plant in Orrville, Ohio -- and the operating profit from its consumer packaging business for 2009 increased by 30%. The stock went back up, trading at about $30 on Mar. 9 this year.

Funds Are Concentrated On 'Middle America'

They also bought Albany International (AIN), a leading maker of fabric that is used in paper mills, when it was shutting down plants in the U.S. and Europe and expanding in Asia -- a process that consumed capital and ramped up leverage. "We were willing to accept this leverage because we understood how they were going to get out of it," says Sellecchia. The fund bought Albany as it tumbled down from about $34 in August 2008 to about $5 in March 2009, as investors instinctively sold all highly leveraged companies at the height of the financial crisis. But then the stock rose more than four-fold, to about $23 in March this year.

As a result, the fund's assets are concentrated in what Sellecchia calls Middle America -- manufacturers of everything from industrial chemicals to factory equipment to consumer electronics. Such companies are prone to corporate restructuring exercises that scare off squeamish investors, creating an opportunity for Delafield and Sellecchia.

The fund has 46.3% of its assets in industrials, which is about triple the amount held by similar funds in the value universe, says Michael Breen, an analyst at Morningstar, a mutual fund rating agency in Chicago. "They seem to understand that to outperform the pack, you have to break from the pack, and then they deliver their results," says Breen.

Some 20% Of Assets Are In Cash

To make sure it can invest in new opportunities, the fund keeps about 20% of its assets in cash. But not all of Delafield's and Sellecchia's ideas turn out to be good. For example, they bought Axcelis Technologies (ACLS), which makes equipment that is used to manufacture semiconductors, for nearly $6 a share in June 2008. Then the stock fell into a steep slide after the company missed a product cycle and lost market share. The fund sold the stock for about $4, just before it plummeted to 21 cents a year ago. (It was trading at 52 cents on Mar. 9).

Apart from the risks involved, this fund has other characteristics that would be considered blemishes by the brokers, financial advisors and other intermediaries who pick mutual funds for the vast majority of America's individual investors. Delafield Asset Management Inc., which employs the portfolio managers and analysts, came under new ownership last September when Natixis Global Asset Management sold it to Tocqueville Asset Management.

Such a transaction can raise a red flag that the new owners could somehow meddle in the portfolio managers' investment process, which could cause them to lose their touch. But, according to Morningstar's Breen, the new owners have left Delafield and Sellecchia alone, and their investment process continues as always.

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DailyFinance Welcomes Michael Shari and 'Fund Focus'

Michael Shari — Fri, 05 Mar 2010 11:30:00 EST

Filed under: Columns, Investing

A lot of mutual fund columns start out by asking what your investment goals are. Are you perhaps shopping for a fund that will grow at a particular rate over a certain number of years so you can send little Ashley to college a decade from now? Or maybe you just need to take the edge off those monthly car payments.

Then they'll say something like: Here's a nifty fund that follows a value or growth-oriented investment style, has a good three- or five-year track record and even has the Morningstar seal of approval -- and leave you thinking it's the healthiest thing since sliced tofu. That is, if you haven't dozed off on your futon and dropped your Kindle by then.

Well, I say wake up! That's no way to help you pick a decent mutual fund. It barely gets you past the supermarket shelf of the 401(k) provider, broker, financial adviser or insurance firm to whom you've no doubt entrusted a juicy morsel of your life savings. And it certainly won't give you the clarity you need to make a critical decision that, if flubbed, could make you hate yourself a few years later.

A Better Way

Here's where my new Fund Focus column on DailyFinance comes in. I'm going to take a somewhat harder but far more instructive approach to finding out if a mutual fund is a worthwhile investment. And that's to examine its investment strategy -- through the eyes of the portfolio manager who actually runs it.

Sure, the manager will have a standardized investment style, whether it's large-cap value or small-cap growth, high-yield bonds or core fixed income. And his research process may impress. The fund may have an in-house team of "bottom-up" or "fundamental" analysts who spend half of their time visiting companies the fund owns. Or the analysts might be chained to their desks, using "quantitative" or "computer-driven" research that relies on customized software to predict stock prices.

But that's only part of what you need to know. It's only when you take a portfolio manager's perspective that you really start to understand that how well he executes his strategy makes all the difference. In the end, that's what distinguishes a great mutual fund from mediocre ones that claim to follow an identical strategy.

It's not just the fund's investment style and research process. It's how the manager actually picks stocks and bonds. Ultimately, it's how well he understands certain companies that are widely misunderstood that allows him to buy them for less than the market will pay later, year after year.

Getting Managers to Talk -- Honestly

You usually don't see mutual funds covered this way, but that's how I'll do it in Fund Focus. This is a lot harder than taking the usual approach of chasing funds based on their past performance according to fund-rating outfits like Lipper and Morningstar, and hoping those picks will put your hard-earned money to work gainfully over the next three or 30 years.

It's not so easy to sit down with a portfolio manager and get him to reveal how he executes his strategy -- if he's willing to tell you anything at all. Getting a money manager to open up involves him not only bragging about how often he gets it right but also admitting how frequently he gets it wrong. Mutual funds are required by law to tell the Securities and Exchange Commission which stocks and bonds they own four times a year, but those disclosures are only snapshots. No portfolio manager is required to tell you why he bought those securities, on what date he bought them, how much he paid for them, or when, and for how much he wants to sell them.

In fact, chances are you'll never have that conversation with a portfolio manager. But as a financial journalist covering money-management firms from my perch in Brooklyn, N.Y., I have that conversation all the time. In Fund Focus, I'll share my insights every week in plain English without the excruciating jargon that plagues many investing columns. (Of course, the column's name just happens to be a technical term for the market segment where a mutual fund's assets are concentrated.)

Week after week, the column will focus on a different fund manager and discuss how he executes his strategy. Most of these funds are priced at street level with low fees and low minimum deposits. Some of them have stayed below the radar because they have merely millions of dollars in assets instead of billions. Or their track record might have what some people would consider a blemish, such as a past period of crummy performance or a recent change in managers.

Unknown Winners

For example, we'll look at large-cap value equity funds that have been ignored since getting submerged by big bank stocks during the financial crisis but are now swimming back to shore faster than their peers. One such fund is the Hotchkis & Wiley Diversified Value Fund (HWCAX), which surged 97.3% during the 12 months through March 3. We'll also look at small-cap equity funds that were overlooked partly because the small companies they own are illiquid and hard to predict. One of those is the Aegis Value Fund (AVALX), which soared, incredibly, by 181.9% during the same 12 months. And we'll look at even more obscure ones like the Matthews Asia Small Companies Fund (MSMLX), which is up 136.33% during the same year even though it doesn't have an office in Asia.

No one could have predicted the astounding returns that these relatively unknown funds have achieved over the past 12 months. During the same period, the Standard & Poor's 500 index was up 64.3% -- a steep rise, to be sure, but not nearly as a great as those three funds. So, if you take the time to understand how portfolio managers execute their strategy, mutual funds can give you the power to put some of your savings to work with a big payday down the road.

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