Searching for and Suffering Great Funds - Weekly Blog # 545

Mike Lipper’s Monday Morning Musings

Searching for and Suffering Great Funds

Tied to Columbus Day Image Control

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

My Perspective
Commercially for the most part, I manage mutual fund only long-term accounts for both institutions and wealthy individuals. In general, I and my associate Hylton Phillips-Page attempt to construct equity portfolios that contain Good Funds and Great Funds. The dividing line between the two is the long-term fear and greed ratio. In some cases this can be translated into the tolerance for embarrassment. To paraphrase what Warren Buffett has said, he would prefer an investment whose path is an uneven compound growth of 12 % over a more even 10%.

Our Three Bucket Tasks
Exercising experience, judgement, and a lot of performance and portfolio data, we divide the fund universe into three buckets.

• The first bucket are possible candidates for the great fund managers, which is a small group. 

• The second bucket are the good funds that most of the time produce satisfactory results. 

• The third and largest bucket are the other funds, which should be studied to identify characteristics to be avoided. These observations require long records to be reviewed and entail visits to managers, their staff, competitors, and clients.

Numbers Filters
Analyze the fund’s record under the same portfolio manager, pretty much the same staff, senior management, and the same investment and commercial goals. Some minor adjustments can be made, but if there are too many we need to begin the analysis at the point where these inputs are reasonably stable. Thus, a stable universe is created.

The next step is to compare the manager’s relative quarterly performance quintile among the appropriate peer group over 40 quarters. A good manager’s performance will be in the mid quintile and the next highest performance quintile between 24 and 30 times during the 40 quarters. In the remaining quarters the preponderance of the quarters should favor the top quintile over the bottom quintile.

Great managers will spend most of their time in the best quintile. However, the second most likely placement will be in the bottom quintile. Those quarters need to be examined carefully. Great managers are often out of phase with the current market and give up current market opportunity for capital preservation. Thus, the worst quintile performance is often a small absolute gain or loss. Large losses need special explanation. It would help if a bad quarter is followed by a top quintile performance.

The Human Filter
Investments are an art form based on a mix of personalities operating at the same time. Too often investors treat the short hand of numbers as reality. The interaction of the various personalities throughout the ecosystem of the fund drives the results. In discussions with the various participants, total intellectual honesty should not be expected. I have learned to group responses into categories in order to build a more complete picture from the various fragments. The following is an example of this approach:

Good Fund Managers limit their cash to 5-10% of assets and are politically sensitive in their organizations to clients. They try to avoid excess volatility and are often top-down thinkers, motivated by the long-term prospects of promotion translated into money.

Great Managers will use cash as a residual, primarily when they can’t find attractive holdings. Thus, cash holdings in extreme cases could rise to 50%. They are very individualistic in many of the things they do. They will occupy the best and worst quintiles more frequently than the more controlled good managers. Great managers are very bottoms-up and are detail oriented in their thinking. Their preferred time-period is a lifetime, but they will sell when disappointed. These are “rare ducks” who are quite introspective and may not provide the best interviews. Rarely will they enter crowded stocks and are contrarian by nature. They are hard-working and would probably fit in with the current Chinese work effort of 12-hour days, six days a week. When focused, they are good observers of people and consumer trends. They feel deeply when they make mistakes and try to learn from them, even though they often repeat the same types of mistakes. When they are early into a stock they can hold the position for a long period of time. These can produce what Peter Lynch called “ten baggers”, or gains of ten times or more the original investment.

Image Control/ Columbus Day Perspective
Most successful professional investors are by nature private people and don’t like to discuss their current investment thinking. Several r of them overcome their shyness, driven by commercial needs, to bring new money under their management. Often, others have the responsibility to use the successful investor’s record and skills to make them both rich. One of the fears of the successful manager is that the public relations machine will exaggerate the investor’s accomplishment.

Monday in the US we have a national holiday, Columbus Day, to celebrate the popular view of his discovery of America. In truth, he never landed on the North American continent. Prior to his voyage, at least two other explorers landed here. Nevertheless, there are aspects of his life that some of the Great Managers have paralleled in their own careers. These are:

1. A man of great conviction [right in concept and wrong in details]
2. Could not raise the money for the exploration at home and went abroad to Spain.
3. Leveraged the Queens’ jewels to get the needed cash.
4. Diversified risks by having three ships, tow returned.
5. Lost control of the theme upon completion of his successful voyage.
6. His discovery was an excuse for US politicians to grant an important urban political group of union workers a national holiday. No similar holiday exists in either Spain or Italy.

Thus, an investor’s success becomes a commercial vehicle for the greater success of others.

Where to Hunt?
As every single day is a day to think about the search for great managers, what does last week possibly signal?

1. For the week, six of the seven biggest market performance leaders tracked commodities. 
2. Five of the seven worst performers were stock indices.
3. While most funds declined, there were some winners that gained more than 1% for the week - Base Metals Funds, Agricultural Commodity Funds, Precious Metals (Gold) Funds, Natural Resources and Energy Funds. DOES THIS MEAN THAT THE MARKET IS MORE CONCERNED ABOUT INFLATION THAN GROWTH?
4. Longer-term targets of future opportunity: Longevity Care and Management, Food allocations, Disruptions to come from AI/VR, TIPS.

Conclusions:

• The world is changing in both identifiable and unidentifiable ways.

• Good equity managers perform credibly well most of the time.

• The rare great managers will find ways to make a lot of money, but it won’t be a comfortable ride unless one builds that likelihood into ones’ expectations.

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Copyright © 2008 - 2018

A. Michael Lipper, CFA
All rights reserved

Contact author for limited redistribution permission.

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

Did you miss my blog last week?  Click here to read.

Did someone forward you this blog?  To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2018

A. Michael Lipper, CFA

All rights reserved.

Contact author for limited redistribution permission.