Selecting Good Equity Mutual Funds - Weekly Blog # 540

Mike Lipper’s Monday Morning Musings

Selecting Good Equity Mutual Funds

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

Labor Day recognizes the value of human labor in our society. In this sense I want to recognize the value provided in the labor of equity portfolio managers and the perhaps even more difficult labor of selecting them as investment managers for fiduciary accounts and laborers who are direct and indirect beneficiaries of mutual funds.

In a teratological sense it has to do with the search for good and great managers, as well as the differences between the two. The differences between the two are not primarily the difference in skill level, but a difference in the type of skills. As is often the case, the difference in skills is not a difference in intelligence or effort, but one of personality. I will discuss selecting great managers in a subsequent blog.

A good bit of my effort in managing fiduciary accounts is directed at the selection of mutual funds intended to be held for an extended period of time. These mutual funds are often held through multiple market cycles to meet the long-term payment needs of beneficiaries. The task is to effectively screen through the 8,391 US Diversified Equity Funds and 4,487 world equity funds. I generally exclude the 2,264 sector and 5,901 mixed asset funds. Sector funds are better used with a market-timing overlay once the core of a diversified fund portfolio is in place. Mixed asset funds generally do not combine top skill sets in selecting stocks, bonds, and allocations. I prefer to use separate funds for each of those tasks.

One of the reasons many analysts of investment performance look to mutual funds as a laboratory, is not necessarily due to their skills, which aren’t bad, but due the longevity of the performance histories. Most funds have performance periods from inception to termination and every conceivable period in between. Furthermore, their portfolios are available periodically, with some delay. What makes the mutual fund laboratory even better is that there is a good sample of management companies (publicly traded), allowing for a better understanding of the economics of managing the fund and perhaps the incumbent motivations.  This is the laboratory that I have devoted a lifetime to following. Thus, I use my more than fifty years of working with this data and knowing many of the key players in my search for good and great funds for investment.

Finding Good Funds
To set the stage, a good place to start is performance, particularly relative performance as absolute results are too variable for sound analysis. The study of most statistical universes suggests that they produce bell shaped curves, with most of the participants gathered in the middle. For analytical purposes, the standard marketing approach of dividing performance into quartiles places inordinate importance on the 49th to 51st percentiles, which is why I much prefer to use quintiles. For any given time-period the relative rank of those in the middle quintile is not generally a good measure of skill, but of accidental or racing luck, which is not often repeated. In studying performance I see significant differences in the approach of the top and bottom quintile performers, which is worthy of further analysis.

In using relative rankings the length of the performance period is critical. Most often marketing needs focus on a single calendar year, five years, or even ten years. (The three-year period is often a trap, as the market frequently goes in a single direction during that time, often with no measure of performance in a down period.) In selecting funds for long term investors we are mostly interested in long term performance over different market cycles. For the most part, only commercially successful funds have very long-term records. We have developed a secondary analytical tool where we look at the frequency of quintile performance for each quarter, for five or ten-year periods. Episodic quintile placement for any given quarter, while an aid to understanding a fund, is not significant. What can be significant is both the frequency of placement and the trend in placements.

The Influence of Management Companies
Mutual funds are in the business of producing management fees for the owners of their management companies. This reality leads to the race for fund awards, particularly those awarded by the media. This often skews their views to the short-term. The commercial needs of the management company owners avoid fifth quintile performance, if at all possible. With the cyclical nature of performance, the unspoken prohibition against poor performance in a quarter often has the effect of reducing the chances of top quintile performance, which frequently occurs in the period following a decline. Further, in many cases this reduces the chance that the fund will have a great long-term record. However, it could still be a good fund for its investors and a commercially successful fund for the owners of the management company, its distributors and other influencers. A wise management company, no matter what the market serves up, will attempt to have at least one fund that is currently doing well, taking some of the performance pressure off good funds currently doing poorly. Poorly performing funds might create good buying opportunities for a savvy fund investor and their advisor.

Selection Begins with Elimination
In the search for equity funds likely to result in low portfolio turnover, you must find funds that are likely to be in the portfolio in the future. We first create a universe of funds that has over the last ten years performed at least half the time in the second and third quintiles quarterly. (Those that performed better are candidates for the great funds category, which will be discussed in the future, as they have different characteristics than the steady-eddy good funds. Those with poorer quarterly ranks should be put aside as potential turnaround candidates for future study. Recognize that in utilizing the 40 quarter filter, we are looking for a fund that is in the second and third quintile at least half the time rather than beating its peers 40% of the time.) The ten-year period should begin with the fifth calendar quarter after the lead portfolio manager has assumed responsibility. The investment strategy should also have remained reasonably consistent in order to avoid both a start-up period, when the fund is not fully invested and has primarily cash on hand, and a replacement period where a new manger needs to change the old manager’s portfolio. Performance is the initial attraction but is far from the only or even the main consideration in fund selection.

Other Considerations
Most of the other preferred critical characteristics require one or more visits to the portfolio manager and others at the fund site, as well as understanding:

• The philosophy behind the investment strategy
• Management controls applied to the manager and portfolio
• Functions the manager is responsible for e.g. analysis, marketing, department and firm management
• The long-term psychic and financial rewards and risks influencing both the manager and the organization
• The level of manager involvement in the analysis of good and poor performers in the portfolio

The next set of criteria depend on the boards of the fund and management company.

• Are most of the board comprised of successful investors?
• Do some of the board have experience managing intellectual property producing individuals?
• How friendly are the directors with management?
• What are the firm’s business prospects and how will that impact the fund?
• Is the group communicating effectively?

The Importance of Comfort
Dealing with humans and being a student of history, we know that everything won’t go well. This is the exact point where comfort becomes critical. News events like a change in portfolio management, a significant change from external sources, or poor fund or market performance can shake one’s confidence in the analysis and raise questions as to why the fund should be held. (Perhaps one should also be concerned with fund or market performance that is too good.) Additionally, many other people need to remain comfortable with the fund: the portfolio manager, the investment management of the group, the distribution channels, the regulators, and all members of the investment committee.

We Can Help
For a few of our subscribers I would be happy to discuss your fund/manager selection process confidentially.

You Can Help Us
Please add to our knowledge of finding great funds and managers as we prepare our blog on selecting great managers. 

Forthcoming Blog: CHANGE INEVITABLE, PROGRESS NOT

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Copyright © 2008 - 2018

A. Michael Lipper, CFA

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Selling, Risk, and Liquidity

Introduction

“Drive for show, but putt for dough” is an old expression on how to win at golf. The vast majority of investment advice is about buying securities that are expected to go up in price. However, the terminal value of investing is the final conversion of paper wealth to spendable cash.

While investors in individual securities can benefit from my thoughts, my comments are directed at institutional and high net worth investors that have one or more portfolios of mutual funds. Those that own multiple portfolios of mutual funds should modify these comments due to the different expected timespans for each portfolio. (These can be discussed privately, if you would like.)

Drive for show

When a competitive golfer addresses his or her tee shot at a crowded first tee almost all the comments will be on the distance and direction of the first shot. However, the first shot is only positioning for the follow-on shots and in the end the key is how many shots it takes to complete the hole. Thus to some extent the first shot is like relative performance versus peers or benchmarks. If all you know is how good the drive off the first tee is, you really won’t know about the ultimate success of the player. Therefore, what the investor wants to capture is the cash conversion from the ultimate sale as one can not spend relative performance.

The more professional golf observer would pay attention to the form of the golfer, the particular club that was used, the amount of power the player used in hitting the ball, and the tactical position of where the first shot landed. If I knew these things I would be in a much better position to judge whether I wanted to bet on the success of the player rather than just remark that he/she hit a nice first shot. Applying this to the fund selection puzzle, I am much more interested in the process and procedures followed by the manager of a fund than their current relative performance.

Relative performance is a rearward looking device. We get paid to make future judgments and thus I am much more interested in the way  managers addresses their task, such as:

a)    What tools are likely going to be used?

b)   The time spent on studying the opportunities

c)    What comparisons with other opportunities in the present or past time periods?

d)   Compensation pressures, which might impact decisions?

e)    What does one know about the competitors that are playing in the game?

f)     And finally, what is the pattern of flows going into and out of the fund?

Since our major investments occur after several visits or points of contact, any changes in these processes or procedures need to be understood. We expect there to be changes as we live in a dynamically changing investment world. If there were no changes there is an increase of being blindsided.  Each of the items listed above can have an impact on future performance beyond general changes in the market. Our objective is to use process and procedure changes as early warning signals to begin to exit a meaningful position. To quote Sir John Templeton, “Progress requires change. Focus on where you want to go, instead of where you have been.”

Three reasons to sell

The first reason to sell is an actual or expected change in the nature of the account. This is particularly true if the account requires a higher than expected conversion to cash for operational spending needs.

The second reason to sell is actually to buy; the late Sir John said “the reason to sell is to buy a better bargain.” (We have had the honor and pleasure of supplying special data reports to him and also being called down to Nassau to consult with him and his colleagues.)

The third reason to sell is if some important deterioration in the process being used or fundamental change in the longer-term outlook for the investment occurs.

What to sell

Anytime one needs to add or subtract from a portfolio, the whole account should be reviewed. The change is an opportunity to partially redirect the course of the portfolio. Thus, the first pass should be to see whether the various components of the portfolio are properly balanced in today’s environment and future focus. This could be the ideal time to reduce a position that has gotten to be way out of balance. Depending on the nature of the account the natural barriers might be 10%, 20%, and 25% for an individual sector. In terms of a balanced account, the fixed income range should be between 25% and 60% with equities between 40% and 75% in most cases. If one is not hurried, changes should be averaged in or out over at least three time periods which can be days, weeks, months, or quarters.

The role of risk

If the account is all of the money of an institution or an individual without any expected new money coming into the account, a prudent investor needs to weigh the impact of a loss of capital on future spending needs. In the same light the investor needs to understand that the risk of not growing capital and therefore income can be a bigger risk than some downside diminution particularly after taxes and likely high inflation. While I am very conscious that various studies have shown that individuals feel a loss 2 ½ times more than a similar amount of gain, nevertheless for most tax-exempt institutional accounts whose demands go up on a countercyclical basis when economic times are poor, the risk to the organization of not growing the capital base is worse. A less than optimum capital base puts extreme pressure on earned income and fund raising in difficult times.

The role of liquidity

Another former client, Howard Marks, of Oaktree Capital Management wrote about liquidity in this week’s Barron’s. He said that liquidity is not important until it becomes vitally important. Further he characterizes liquidity as transient and paradoxical. Liquidity is the ability to get the last published price in a transaction, particularly when one is selling in troubled times. Normally mutual fund investors are not concerned about liquidity because when they place their redemption order they know it will be executed at the price (net asset value) calculated for the next close of the market. However, some fund investors may be surprised by the gap between one day’s price and the next one.

Some SEC commissioners and certain members of the US Congress are concerned about the potential evaporating liquidity in the bond market including US government issued debt. The professional investors (hedge funds) invested in various debt and equity Exchange Traded Funds (ETFs) could overwhelm the marketplace with a wall of redemptions, which will probably be met by the market makers immediately selling the heavily weighted securities in the ETFs which will put more price pressure on the final net asset value for the ETF and the companion mutual fund.

As a student of the market for over fifty years I would urge fund holders not to panic during troubled periods and add to the forced sales. Well designed investment portfolios of mutual funds should survive the decline and could be very well positioned for a subsequent rise.

Question of the week: For your accounts is there more risk on the upside of not generating enough future capital than on the downside of avoiding forced losses?  

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Copyright © 2008 - 2015

A. Michael Lipper, C.F.A.,
All Rights Reserved.
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Will Fund Classification Hurt Your Fund Selection?

Introduction

I have crossed the street to focus on fund and manager selection. In my former role at Lipper Analytical, now Lipper, Inc., a Thomson Reuters affiliate, I wanted to contribute something of benefit for the various fund groups and their directors as subscribers. This was accomplished by creating smaller competitive leagues and subdividing the list by increasingly narrow fund objectives, using total net asset groupings, and measuring performance in five different time periods per weekly report. Over time there were multiple opportunities to be highly ranked.

As a selector on the other hand, I search for a fund or funds that fit a specific need in terms of a combination of portfolio, expense and management skills both at the portfolio and business levels. Absolute performance is critical for some accounts. In other cases relative performance is very important. My concern is that most benchmarks be they securities or fund indices are not structured to meet the real needs of the accounts for which I have responsibility. Part of the problem is that the labels attached to various measuring sticks are not descriptive enough.

Small Caps

Many small cap funds are benchmarked against the S&P 600 Index. Institutional  “gate keepers” or first level filters mistakenly believe the 600 represents a pure play measure of American small cap companies. They are correct that all 600 have their legal domicile in the United States and/or have their main market in the US. According to McGraw-Hill Financial’s survey of the components of their S&P 600 Index, in 2012 these companies have identified that 38.97% of their revenues were generated overseas and perhaps more revealing, 33.2% of their taxes were paid overseas. Clearly there was a great deal of variety as to these small companies’ foreign involvement. In examining the roster I found twenty-three companies that had over 50% of their sales from overseas sources.  As a matter of fact I found four which had foreign sales of over 75%. Since for many years sales outside of the US have been (in local currency terms) growing faster than in the US, I am willing to bet that a number of funds that are characterized domestic small caps are in reality global or possibly international small caps either now or will be in future statement statistics.

The near-term future

Small cap funds may be particularly interesting now. The higher quality small cap funds had a relatively good third quarter performance (see many of the Royce^* funds). I am guessing that the underlying quality companies had significant foreign sales. This is particularly important on this Sunday when the Financial Times reported that the Brookings Institution announced that the global economy is coming back, being led by the richer countries. For the moment the classification of small cap appears to be working. Nevertheless, from a selector’s view point it is a flawed classification.

^* Owned by some of our accounts

Better Classifications

Originally funds were slotted into classifications solely on what the funds’ marketing people claimed they were. Over time this yielded to the language in the prospectus created by the firms’ lawyers. Increasingly their descriptions became so broad that they could do almost anything permissible under the law. We then started to use fundamental standards as to earnings growth, price to book value, yield, market capitalizations and other measures. The data sources for these were the unadjusted financial statement statistics.

As both the fund business has grown and the complexities of the markets have expanded, more useful classifications are needed.  I have already pointed out that higher quality Small Cap funds started to produce better performance in the third quarter after lagging for more than a year. This is clearly an example where one or more measures of quality will help selectors.  Other such measures might have to do with the difference between turnover in dollars vs. turnover in names, operating margins adjusted for net interest, trading liquidity measured against free float and there are others.  Some of these measures would be particularly useful in comparing companies with different accounting systems in different countries.

Bottom line: Pure performance ranking numbers in one period are not an important selection device today.

What screening devices do you use?  Please let me know.

Readers’ Service

In last week’s post I mentioned that Colin Camerer, a Caltech professor that we supported with help for his post-doc students, had just won a MacArthur fellowship, often called a Genius Award.  He sent me his collaborative article in the Neuron magazine, entitled, “In the Mind of the Market: Theory of Mind Biases Value Computation During Financial Bubbles.”  The work shows that during a bubble, the “smart guys/gals” get caught up playing what we used to call “the bigger fool theory.”  Please let me know if you would like me to email the article to you.

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Copyright © 2008 - 2013 A. Michael Lipper, C.F.A.,
All Rights Reserved.
Contact author for limited redistribution permission.

Should We Appreciate Bonds? Part II

Cocktail parties for charities often reveal more investment concerns than those expressed in an organization’s formal meetings with investment advisers or investment committee members. In this age of unusually high fixed income yields and low total returns from common stocks, taking advantage of spreads for capital appreciation, not primarily income and capital preservation, can be unnerving. The question of whether this new approach is a sound one for a fiduciary has been expressed by members of several charity boards and committees.

As many of our regular readers know “Monday Morning Musings” is written largely on Sunday evening. As some also may know, on Sundays I spend time with Barron’s, the oldest and (and in my view) the finest statistical package of data. I also use the weekend to peruse my old mutual fund analysis reports, now produced by Lipper, Inc. With these resources in hand I can more fully address the propriety of using credits, in this case corporate bonds, to make money for fiduciary accounts.

Each week Barron’s publishes a list of the 40 corporate bonds with highest estimated trading volume for the week. One of the most useful columns in this display is the estimated spread between the current yield and those of US Treasuries of similar maturities. As there are all kinds of buyers of bonds in the secondary market, these spreads vary widely from the lowest, 79 basis points (0.79% of 1.00%) to 1175 basis points. The suggested strategy is to buy investment quality corporate bonds whose spreads with treasuries are 300 to 400 basis points above a more “normal” spread of 100 basis points. In examining the April 17th list, I found there were seven bonds with a 400 point spread, and eight with a 500 point spread. The proposed strategy presumes a mini-portfolio of about four bonds, so there are a sufficient number of candidates in the most liquid of cases.

A more difficult question as to what is the “normal” spread, sent me to look up the data from the year-end Lipper Fixed Income Fund Performance Analysis Report Certificate Edition for 2006. The data is somewhat like comparing apples with oranges as to their weight and caloric content. Nevertheless, this was all that was available to me over the weekend. There are three distinct mutual fund peer groups which can be compared: General US Treasury Bond Funds, Corporate Bond Funds - A Rated and Corporate Bond Funds – BBB rated. As distinct from the proposed strategy that only includes four issues, each bond fund in the peer group may own more than 100 individual bonds. Each fund only has to assure the SEC and my old firm that the majority of its holdings meet the minimum credit rating in the title of the peer group assigned to them.

Another complication is that funds have expenses which are deducted before the yield and total returns are calculated. By adding back the average total expense ratio to the reported yield, we get the average gross yield in the average portfolio. As of the end of March 2009, the adjusted yield spreads compared with treasuries were 246 basis points for the “A” rated Bond Funds, and 327 basis points for the “BBB” rated Funds. Using the same approach for year-end 2006, the spreads were 174 basis points for the “A” rated and 231 basis points for the “BBB” rated funds. Therefore there appears to be the historic possibility of a 96 basis point pick up using funds alone, which leaves no room for security selection skill.

While we professional investors fixate on relative performance and yields, our clients spend actual dollars, not basis points, so absolute return becomes critical to them.

At the time when one expects to use an investment, a decline in the absolute is extremely painful. So what can go wrong with the proposed strategy? The credit quality of the owned bonds can decline. (In theory, this is answered by the chosen manager following both the issued bond and the underlying stock on a day-to-day basis.) The next major risk, and one that I feel is much more likely, is that inflation and not deflation becomes the problem, causing investors to demand and get higher yields on new issues of US Treasuries. The higher yields on the new issues will drive the yields on existing bonds higher and therefore prices lower. While the spreads could questionably narrow, the prices of the bonds will decline under those circumstances. (One possible counter argument is that a balanced portfolio with a majority of equity investments, often drive equity prices higher initially.)

The fundamental question facing the fiduciary is whether the odds on tightening in the near term future far outweigh the longer term risk of specific credit problems and/or rapid inflation. My attitude is that the strategy could work well in the hands of a skilled active manager of selected bonds, but not a strategy to be recommended for individual investors or most institutional investors. The next cocktail party questions should be around demonstrable skills, not investment policies.

(This post is a follow up to my March 30, 2009 Blog entitled,
“Should We Appreciate Bonds?”)