Objective

The fund seeks long-term capital appreciation and income, while trying to maintain a sense of “prudent investment risk over the long-term.”  RNCOX is a “balanced” fund with several twists.  First, it adjusts its long-term asset allocation in order to take advantage of tactical allocation opportunities.  Second, it invests primarily in a mix of closed-end mutual funds and ETFs.

Adviser

RiverNorth Capital, which was founded in 2000.  RiverNorth manages about $700 million in assets, including two funds, a limited partnership and a number of separate accounts.

Managers

Patrick Galley and Stephen O’Neill.  Mr. Galley is the chief investment officer for RiverNorth Capital.  Before that, he was a Vice President at Bank of America in the Portfolio Management group.  Mr. O’Neill is “the Portfolio Manager for RiverNorth Capital,” and also an alumnus of Bank of America.  Messrs Galley and O’Neill also manage part of one other fund (RiverNorth/DoubleLine Strategic Income, RNSIX), one hedge fund and 700 separate accounts, valued at $150 million.  Many of those accounts are only nominally “separate” since the retirement plan for a firm’s 100 employees might be structured in such a way that it needs to be reported as 100 separate accounts.  Galley and O’Neill are assisted by a quantitative analyst whose firm specializes in closed-end fund trading strategies.

Management’s Stake in the Fund

Mr. Galley and Mr. O’Neill each has invested between $100,000 – $500,000 in the fund, as of the January, 2011 Statement of Additional Information.  In addition, Mr. Galley founded and owns more than 25% of RiverNorth.

Opening date

December 27, 2006.

Minimum investment

$5,000 for regular accounts and $1,000 for retirement accounts.

This fund is closing at the end of June 2011.

Expense ratio

2.39% after minimal expense deferrals.

Comments

The argument in favor of RNCOX is not just its great performance.  It does have top flight performance credentials:

• five-star rating from Morningstar, as of June 2011
• a Lipper Leader for total and consistent returns, also as of June 2011
• annualized return of 9.2% since inception, compared to 0.6% for the S&P 500
• above average returns in every calendar year of its existence
• top 2% returns since inception

and so on.  All of that is nice, but not quite central.

The central argument is that RNCOX has a reason to exist, a claim that lamentably few mutual funds can seriously make.  RNCOX offers investors access to a strategy which makes sense and which is not available through – so far as I can tell – any other publicly accessible investment vehicle.

To understand that strategy, you need to understand the basics of closed-end funds (CEFs).  CEFs are a century-old investment vehicle, older by decades that conventional open-end mutual funds.  The easiest way to think of them is as actively-managed ETFs: they are funds which can be bought or sold throughout the day, just like stocks or ETFs.   Each CEF carries two prices.  Its net asset value is the pro-rated value of the securities in its portfolio.  Its market price is the amount buyers are willing to pay to obtain one share of the CEF.  In a rational, efficient market, the NAV and the market price would be the same.  That is, if one share of a CEF contained $100 worth of stock (the NAV), then one share of the fund would sell for $100 (the market price).  But they don’t.

Why not?  Because investors are prone to act irrationally.  They panic and sell stuff for far less than its worth.  They get greedy and wildly overpay for stuff.  Because the CEF market is relatively small – 644 funds and $183 billion in assets (Investment Company Institute data, 5/27/2009) – panicked or greedy reactions by a relatively small number of investors can cause shares of a CEF to sell at a huge discount (or premium) to the actual value of the securities that the fund sells.  By way of example, shares of Charles Royce’s Royce Micro-cap Trust (RMT) are selling at a 16% discount to the fund’s NAV; if you bought a share of RMT last Friday and Mr. Royce did nothing on Monday but liquidate every security in the portfolio and return the proceeds to his investors, you would be guaranteed a 16% profit on your investment.  Funds managed by David Dreman, Mario Gabelli, the Franklin Mutual Series team, Mark Mobius and others are selling at 5 – 25% discounts.

It’s common for CEFs to maintain modest discounts for long periods.  A fund might sell at a 4% discount most of the time, reflecting either skepticism about the manager or the thinness of the market for the fund’s shares.  The key to RNCOX’s strategy is the observation that those ongoing discounts occasionally balloon, so that a fund that normally sells at a 4% discount is temporarily available at a 24% discount.  With time, those abnormal discounts revert to the mean: the 24% discount returns to being a 4% discount.  If an investor knows what a fund’s normal discount is and buys shares of the fund when the discount is abnormally large, he or she will almost certainly profit when the discount reverts to normal.  This tendency to generate panic discounts offers a highly-predictable source of “alpha,” largely independent of the skill of the manager whose CEF you’re buying and somewhat independent of what the market does (a discount can evaporate even when the overall market is flat, creating a profit for the discount investor).  The key is understanding the CEF market well enough to know what a particular fund’s “normal” discount is and how long that particular fund might maintain an “abnormal” discount.

Enter Patrick Galley and the RiverNorth team.  Mr. Galley used to work for Bank of America, analyzing mutual fund acquisition deals and arranging financing for them.  That work led him to analyze the value of CEFs, whose irrational pricing led him to conclude that there were substantial opportunities for arbitrage and profits.  After exploiting those opportunities in separately managed accounts, he left to establish his own fund.

RiverNorth Core’s portfolio is constructed in two steps: asset allocation and security selection.  The fund starts with a core asset allocation, a set of asset classes which – over the long run – produce the best risk-adjusted returns.  The core allocations include a 60/40 split between stocks and bonds, about a 60/40 split in the bond sleeve between government and high-yield bonds, about an 80/20 split in the stock sleeve between domestic and foreign, about an 80/20 split within the foreign stock sleeve between developed and emerging, and so on.  But as any emerging markets investor knows from last year’s experience, the long-term attractiveness of an asset class can be interrupted by short periods of horrible losses.  In response, RiverNorth makes opportunistic, tactical adjustments in its asset allocation.  Based on an analysis of more than 30 factors (including valuation, liquidity, and sentiment), the fund can temporarily overweight or underweight particular asset classes.

Once the asset allocation is set, the managers look to implement the allocation by investing in a combination of CEFs and ETFs.  In general, they’ll favor CEFs if they find funds selling at abnormal discounts.   In that case, they’ll buy the CEF and hold it until the discount returns to normal. (I’ll note, in passing, that they can also short CEFs selling at abnormal premiums to the NAV.) They’ll then sell and if no other abnormally discounted CEF is available, they’ll buy an ETF in the same sector.  If there are no inefficiently-priced CEFs in an area where they’re slated to invest, the fund simply buys ETFs.

In this way, the managers pursue profits from two different sources: a good tactical allocation (which other funds might offer) and the CEF arbitrage opportunity (which no other fund offers).  Given the huge number of funds currently selling at double-digit discounts to the value of their holdings, it seems that RNCOX has ample opportunity for adding alpha beyond what other tactical allocation funds can offer.

There are, as always, risks inherent in investing in the fund.  The managers are experts at CEF investing, but much of the fund’s return is driven by asset allocation decisions and they don’t have a unique competitive advantage there.  Since the fund sells a CEF as soon as it reverts to its normal discount, portfolio turnover is likely to be high (last year it was 300%) and tax efficiency will suffer. The fund’s expenses are much higher than those of typical no-load equity funds, though not out of line with expenses typical of long/short, market neutral, and tactical allocation funds.  Finally, short-term volatility could be substantial: large CEF discounts can grow larger and the managers intend to buy more of those more-irrationally discounted shares.  In Q3 2008, for example, the fund lost 15% – about three times as much as the Vanguard Balanced Index – but then went on to blow away the index over the following three quarters.

Bottom Line

For investors looking for a core fund, especially one in a Roth or other tax-advantaged account, RiverNorth Core really needs to be on your short list of best possible choices.  The managers have outperformed their peer group in both up- and down-markets and their ability to exploit inefficient pricing of CEFs is likely great enough to overcome the effects of high expenses and still provide superior returns to their investors.

Fund website

RiverNorth Funds

RiverNorth Core Opportunity

Fact Sheet

© Mutual Fund Observer, 2011.  All rights reserved.  The information here reflects publicly available information current at the time of publication.  For reprint/e-rights contact David@MutualFundObserver.com.

Since publication, this fund has merged into Fidelity Asset Manager 60%.

Objective

The fund seeks to maximize total returns.  It will, in theory, do that by making top-down judgments about the short- and long-term attractiveness of all available asset classes (domestic, international and emerging markets equities; domestic, international, emerging markets, high yield, investment grade and inflation protected bonds, floating rate loans, and ETNs; and up to 25% commodities).  It will then allocate its resources to some combination of Fidelity funds, a Fidelity-owned commodities fund based in the Cayman Islands, exchange-traded funds and notes, and “direct investments.”  They highlight the note that they might place “a significant portion of the fund’s assets in non-traditional assets” including market-neutral funds.

Adviser

Fidelity Management & Research Company, the investment advisor to all 300 Fidelity mutual funds.  Fidelity employs (give or take a layoff or two) 500 portfolio managers, analysts and traders and has $1.4 trillion in assets under management.

Manager

Jurrien Timmer and Andrew Dierdorf.  Mr. Timmer has been Fidelity’s Director of Market Research for the past 12 years and is a specialist in tactical asset allocation.  Mr. Dierdorf is a relative newcomer to Fidelity and co-manages 24 of Fidelity’s Freedom funds.

Management’s Stake in the Fund

Mr. Dierdorf has between $50,000 – 100,000 in the fund and Mr. Timmer had invested between $500,000 and $1,000,000.  Only two of the fund’s nine trustees (Albert Gamper and James Keyes) had large investments in the fund while six (including Abby Johnson) had nothing.  Fidelity’s directors make between $400,000 – 500,000 per year (sign me up!) and their compensation is pro-rated over the number of funds they oversee; as of the most recent SAI, each director had received $120 in compensation for his or her work with this fund.

Opening date

November 1, 2007.

Minimum investment

$2500 for a regular account and $500 for an IRA.

Expense ratio

1.00% on assets of $450 million.

Comments

From 2007 through June 2011, this was the Fidelity Dynamic Strategies Fund.  It was rechristened as Global Strategies on June 1, 2011.  The fund also adopted a new benchmark that increases international equity and bond exposure, while decreasing US bond and money market exposure:

Here’s the theory: Fidelity has greater analytic resources than virtually any of its competitors do.  And it has been moving steadily away from “vanilla” funds and toward asset allocation and niche products.  That is, they haven’t been launching diversified, domestic mid-cap funds as much as 130/30, enhanced index, frontier market, strategic objective and asset allocation funds.  They’ve been staffing-up to support those projects and should be able to do an exceptional job with them.

Fidelity Global Strategies is the logical culmination of those efforts: like Leuthold Core (LCORX) or PIMCO All-Asset (PAAIX), its managers make a top-down judgment about the world’s most attractive investment opportunities and then move aggressively to exploit those opportunities.

My original 2008 assessment of the fund was this:

In theory, this fund should be an answer to investors’ prayers.  In practice, it looks like a mess . . . Part of the problem surely is the managers’ asset allocation (mis)judgments.  On June 30 (2008), at the height of the recent energy price bubble, they combined “high conviction secular themes – commodities . . . our primary ‘ace in the hole’ for the period” with “our conviction, and our positive view on energy and materials stocks” to position the portfolio for a considerable fall.

Those errors had to have been compounded by the sprawling mess of a portfolio they oversee . . . The fund complements its portfolio of 38 Fidelity funds (28 stock funds, six bond funds and 4 money market and real estate funds) with no fewer than 75 exchange-traded funds.  In many cases, the fund invests simultaneously in overlapping Fidelity funds and outside ETFs.

The bottom line:

At 113 funds, this strikes me as an enormously, inexplicably complex creation.  Unless and until the managers accumulate a record of consistent downside protection or consistent up-market out-performance, neither of which is yet evident, it’s hard to make a case for the fund.

Neither the experience of the last two years nor the recent revamping materially alters those concerns.

Since inception, the fund has not been able to distinguish itself from most of the plausible, easily-accessible alternatives.  Here’s the comparison of $10,000 invested at the opening of Dynamic Strategies, compared with a reasonable peer group.

In short, the fund’s ability to actively allocate and to move globally has not (yet) outperformed simple, low-cost, low-turnover competitors.  In its first 13 quarters of existence, the fund has outperformed half the time, underperformed half the time, and effectively tied once.  More broadly, that’s reflected in the fund’s Sharpe ratio.  The Sharpe ratio attempts to measure how much extra return you get in exchange for the extra risk that a manager chooses to subject you to.   A Sharpe ratio greater than zero is, all things being equal, a good thing.  FDYSX’s Sharpe ratio is 0.34, not bad but no better than its benchmark’s 0.36.

The portfolio continues to be large (24 Fidelity funds and 45 ETFs), though much improved over 2008.  It continues to

By way of example:

• The fund holds three of Fidelity’s emerging markets funds (Emerging Markets, China and Latin America) but also 14 emerging markets ETFs (mostly single country or frontier markets).  It does not, however, hold Fidelity’s Emerging EMEA (FEMEX) fund which would have been a logical first choice in lieu of the ETFs.
• The fund holds Fidelity’s Mega Cap and Disciplined Equity stock funds, but also the S&P500 ETF.  For no apparent reason, it invests 1% of the portfolio in the Institutional class of the Advisor class of Fidelity 130/30 Large Cap.  In consequence, it has staked a bold 0.4% short position on the domestic market.  But why?

The recent changes don’t materially strengthen the fund’s prospects.  It invests far less internationally (15%) than it could and invests about as much (20%) on commodities now as it will be able to with a new mandate.  The manager’s most recent commentary (“Another Fork in the Road,” 04/28/2011) foresees higher inflation, lax Fed discipline and an allocation with is “neutral on stocks, short on bonds, and long on hard assets.”  The notion of a flexible global allocation is certainly attractive.  Still neither a new name nor a tweaked benchmark, both designed according to Fidelity, “to better reflect its global allocation,” is needed to achieve those objectives.

Bottom Line

I have often been skeptical of Fidelity’s funds and have, I blush to admit, often been wrong in that skepticism.  Undeterred, I’m skeptical here, too.  As systems become more complex, they became more prone to failure.  This remains a very complex fund.  Investors might reasonably wait for it to distinguish itself in some way before considering a serious commitment to it.

Fund website

Fidelity Global Strategies

© Mutual Fund Observer, 2011.  All rights reserved.  The information here reflects publicly available information current at the time of publication.  For reprint/e-rights contact David@MutualFundObserver.com.

Objective

The fund seeks long-term capital growth by investing exclusively in stocks of companies with significant exposure (50% or more of assets or revenues) to countries with developing economies and/or markets. That investment can occur through ADRs and ADSs.  Investment decisions are made in accordance with Islamic principles. The fund diversifies its investments across the countries of the developing world, industries, and companies, and generally follows a value investment style.

Adviser

Saturna Capital, of Bellingham, Washington.  Saturna oversees five Sextant funds, the Idaho Tax-Free fund and three Amana funds.  The Sextant funds contribute about $250 million in assets while the Amana funds hold about $3 billion (as of April 2011).  The Amana funds invest in accord with Islamic investing principles. The Income Fund commenced operations in June 1986 and the Growth Fund in February, 1994. Mr. Kaiser was recognized as the best Islamic fund manager for 2005.

Manager

Nicholas Kaiser with the assistance of Monem Salam.  Mr. Kaiser is president and founder of Saturna Capital. He manages five funds (two at Saturna, three here) and oversees 26 separately managed accounts.  He has degrees from Chicago and Yale. In the mid 1970s and 1980s, he ran a mid-sized investment management firm (Unified Management Company) in Indianapolis.  In 1989 he sold Unified and subsequently bought control of Saturna.  As an officer of the Investment Company Institute, the CFA Institute, the Financial Planning Association and the No-Load Mutual Fund Association, he has been a significant force in the money management world.  He’s also a philanthropist and is deeply involved in his community.  By all accounts, a good guy all around. Mr. Monem Salam, vice president and director of Islamic investing at Saturna Capital Corporation, is the deputy portfolio manager for the fund.

Inception

September 28, 2009.

Management’s Stake in the Fund

Mr. Kaiser directly owned $500,001 to $1,000,000 of Developing World Fund shares and indirectly owned more than $1,000,000 of it. Mr. Salam has something between $10,00 to $50,000 Developing World Fund. As of August, 2010, officers and trustees, as a group, owned nearly 10% of the Developing World Fund.

Minimum investment

$250 for all accounts, with a $25 subsequent investment minimum.  That’s blessedly low.

Expense ratio

1.59% on an asset base of about $15 million.  There’s also a 2% redemption fee on shares held fewer than 90 days.

Comments

Mr. Kaiser launched AMDWX at the behest of many of his 100,000 Amana investors and was able to convince his board to authorize the launch by having them study his long-term record in international investing.  That seems like a decent way for us to start, too.

Appearances aside, AMDWX is doing precisely what you want it to.

Taken at face value, the performance stats for AMDWX appear to be terrible.  Between launch and April 2011, AMDWX turned $10,000 into $11,000 while its average peer turned $10,000 to $13,400.  As of April 2011, it’s at the bottom of the pack for both full years of its existence and for most trailing time periods, often in the lowest 10%.

And that’s a good thing.  The drag on the fund is its huge cash position, over 50% of assets in March, 2011.  Sibling Sextant International (SSIFX) is 35% cash.  Emerging markets have seen enormous cash inflows.  As of late April, 2011, emerging markets funds were seeing $2 billion per week in inflows.  Over 50% of institutional emerging markets portfolios are now closed to new investment to stem the flow.  Vanguard’s largest international fund is Emerging Markets Stock Index (VEIEX) at a stunning $64 billion.  There’s now clear evidence of a “bubble” in many of these small markets and, in the past, a crisis in one region has quickly spread to others. In response, a number of sensible value managers, including the remarkably talented team behind Artisan Global Value (ARTGX), have withdrawn entirely from the emerging markets. Amana’s natural caution seems to have been heightened, and they seem to be content to accumulate cash and watch. If you think this means that “bad things” and “great investment values” are both likely to manifest soon, you should be reassured at Amana’s disciplined conservatism.

The only question is: will Amana’s underperformance be a ongoing issue?

No.

Let me restate the case for investing with Mr. Kaiser.

I’ve made these same arguments in profiling Sextant International (SSIFX) as a “star in the shadows.”

Mr. Kaiser runs four other stock funds: one large value, one large core international (which has a 25% emerging markets stake), one large growth, and one that invests across the size and valuation spectrum.  For all of his funds, he employs the same basic strategy: look for undervalued companies with good management and a leadership position in an attractive industry.  Buy.  Spread your bets over 60-80 names.  Hold.  Then keep holding for between ten and fifty years.

Here’s Morningstar’s rating (as 4/26/11) of the four equity funds that Mr. Kaiser manages:

In their overall rating, every one of Mr. Kaiser’s funds achieves “above average” or “high” returns for “below average” or “low” risk.

Folks who prefer Lipper’s rating system (though I’m not entirely clear why they would do so), find a similar pattern:

I have no idea of how Lipper generated the low consistency rating for International, since it tends to beat its peers in about three of every four years, trailing mostly in frothy markets.  Its consistency is even clearer if you look at longer time periods. I calculated Sextant International’s returns and those of its international large cap peers for a series of rolling five-year periods since with the fund’s launch in 1995.  I looked at what would happen if you invested $10,000 in the fund in 1995 and held for five years, then looked at 1996 and held for five, and so on.  There are ten rolling five-year periods and Sextant International outperformed its peers in 100% of those periods.  Frankly, that strikes me as admirably consistent.

At the Sixth Annual 2010 Failaka Islamic Fund Awards Ceremony (held in April, 2011), which reviews the performance of all managers, worldwide, who invest on Islamic principles, Amana received two “best fund awards.”

Other attributes strengthen the case for Amana

Mr. Kaiser’s outstanding record of generating high returns with low risk, across a whole spectrum of investments, is complemented by AMDWX’s unique attributes.

Islamic investing principles, sometimes called sharia-compliant investing, have two distinctive features.  First, there’s the equivalent of a socially-responsible investment screen which eliminates companies profiting from sin (alcohol, porn, gambling).   Mr. Kaiser estimates that the social screens reduce his investable universe by 6% or so.  Second, there’s a prohibition on investing in interest-bearing securities (much like the 15 or so Biblical injunctions against usury, traditionally defined as accepting an interest or “increase”), which effective eliminates both bonds and financial sector equities.  The financial sector constitutes about 25% of the market capitalization in the developing world.   Third, as an adjunct to the usury prohibition, sharia precludes investment in deeply debt-ridden companies.  That doesn’t mean a company must have zero debt but it does mean that the debt/equity ratio has to be quite low.  Between those three prohibitions, about two-thirds of developing market companies are removed from Amana’s investable universe.

This, Mr. Kaiser argues, is a good thing.  The combination of sharia-compliant investing and his own discipline, which stresses buying high quality companies with considerable free cash flow (that is, companies which can finance operations and growth without resort to the credit markets) and then holding them for the long haul, generates a portfolio that’s built like a tank.  That substantial conservatism offers great downside protection but still benefits from the growth of market leaders on the upside.

Risk is further dampened by the fund’s inclusion of multinational corporations domiciled in the developed world whose profits are derived in the developing world (including top ten holding Western Digital and, potentially, Colgate-Palmolive which generates more than half of its profits in the developing world).  Mr. Kaiser suspects that such firms won’t account for more than 20% of the portfolio but they still function as powerful stabilizers.  Moreover, he invests in stocks and derivatives which are traded on, and settled in, developed world stock markets.  That gives exposure to the developing world’s growth within the developed world’s market structures.  As of 1/30/10, ADRs and ADSs account for 16 of the fund’s 30 holdings.

An intriguing, but less obvious advantage is the fund’s other investors.

Understandably enough, many and perhaps most of the fund’s investors are Muslims who want to make principled investments.  They have proven to be incredibly loyal, steadfast shareholders.  During the market meltdown in 2008, for example, Amana Growth and Amana Income both saw assets grow steadily and, in Income’s case, substantially.

The movement of hot money into and out of emerging markets funds has particularly bedeviled managers and long-term investors alike.  The panicked outflow stops managers from doing the sensible thing – buying like mad while there’s blood in the streets – and triggers higher expenses and tax bills for the long-term shareholders.  In the case of T. Rowe Price’s very solid Emerging Market Stock fund (PRMSX), investors have pocketed only 50% of the fund’s long-term gains because of their ill-timed decisions.

In contrast, Mr. Kaiser’s investors do exactly the right thing.  They buy with discipline and find reason to stick around.  Here’s the most remarkable data table I’ve seen in a long while.  This compares the investor returns to the fund returns for Mr. Kaiser’s four other equity funds.  It is almost universally the case that investor returns trail far behind fund returns.  Investors famously buy high and sell low.  Morningstar’s analyses suggest s the average fund investor makes 2% less than the average fund he or she owns and, in volatile areas, fund investors often lose money investing in funds that make money.

How do Amana/Sextant investors fare on those grounds?

In every case, those investors actually made more than the nominal returns of their funds says is possible.  Having investors who stay put and buy steadily may offer a unique, substantial advantage for AMDWX over its peers.

Is there reason to be cautious?  Sure.  Three factors are worth noting:

1. For better and worse, the fund is 50% cash, as of 3/31/11.
2. The fund’s investable universe is distinctly different from many peers’.  There are 30 countries on his approved list, about half as many as Price picks through.  Some countries which feature prominently in many portfolios (including Israel and Korea) are excluded here because he classifies them as “developed” rather than developing.  And, as I noted above, about two-thirds of developing market stocks, and the region’s largest stock sector, fail the fund’s basic screens.
3. Finally, a lot depends on one guy.  Mr. Kaiser is the sole manager of five funds with $2.8 billion in assets.  The remaining investment staff includes his fixed-income guy, the Core fund manager, the director of Islamic investing and three analysts.  At 65, Mr. Kaiser is still young, sparky and deeply committed but . …

Bottom line

If you’re looking for a potential great entree into the developing markets, and especially if you’re a small investors looking for an affordable, conservative fund, you’ve found it!

Company link

Amana Developing World

© Mutual Fund Observer, 2011.  All rights reserved.  The information here reflects publicly available information current at the time of publication.  For reprint/e-rights contact David@MutualFundObserver.com.

Objective

The fund seeks current income and long-term capital appreciation.  The managers invest in a combination of blue chip stocks, investment grade intermediate-term bonds, convertible securities and cash.  In general, at least 25% of the portfolio will be bonds.   In practice, the fund is generally 70% equities.  The portfolio turnover rate is modest, typically 25% or below.

Adviser

Founded in 1979 Luther King Capital Management provides investment management services to investment companies, foundations, endowments, pension and profit sharing plans, trusts, estates, and high net worth individuals.  Luther King Capital Management has seven shareholders, all of whom are employed by the firm, and 29 investment professionals on staff.  As of December, 2010, the firm had about $8 billion in assets.  They advise the five LKCM funds and the three LKCM Aquinas funds, which invest in ways consistent with Catholic values.

Manager

Scot Hollmann, J. Luther King and Mark Johnson.  Mr. Hollman and Mr. King have managed the fund since its inception, while Mr. Johnson joined the team in 2010.

Management’s Stake in the Fund

Hollman has between $100,00 and $500,000 in the fund, Mr. King has over $1 million, and Mr. Johnson has a pittance (but it’s early).

Opening date

December 30, 1997.

Minimum investment

$10,000 across the board.

Expense ratio

0.81%, after waivers, on an asset base of $19 million (as of April 2011).

Comments

The difference between a successful portfolio and a rolling disaster, is the investor’s ability to do the little things right.  Chief among those is keeping volatility low (high volatility funds tend to trigger disastrous reactions in investors), keeping expenses low, keeping trading to a minimum (a high-turnover strategy increases your portfolio cost by 2-3% a year) and rebalancing your assets between stocks, bonds and cash.  All of which works, little of which we have the discipline to do.

Enter: the hybrid fund.  In a hybrid, you’re paying a manager to be dull and disciplined on your behalf.  Here’s simple illustration of how it works out.  LKCM Balanced invests in the sorts of stocks represented by the S&P500 and the sorts of bonds represented by an index of intermediate-term, investment grade bonds such as Barclay’s.  The Vanguard Balanced Index fund (VBINX) mechanically and efficiently invests in those two areas as well.  Here are the average annual returns, as of March 31 2011, for those four options:

Notice two things: (1) the whole is greater than the sum of its parts. LKCM tends to return more than either of its component parts.  (2) the active fund is better than the passive. The Vanguard Balanced Index fund is an outstanding choice for folks looking for a hybrid (ultra-low expenses, returns which are consistently in the top 25% of peer funds over longer time periods).  And LKCM consistently posts better returns and, I’ll note below, does so with less volatility.

While these might be the dullest funds in your portfolio, they’re also likely to be the most profitable part of it.  Their sheer dullness makes you less likely to bolt.  Morningstar research found that the average domestic fund investor made about 200 basis points less, even in a good year, than the average fund did.  Why?  Because we showed up after a fund had already done well (we bought high), then stayed through the inevitable fall before we bolted (we sold low) and then put our money under a mattress or into “the next hot thing.”  The fund category that best helped investors avoid those errors was the domestic stock/bond hybrids.  Morningstar concluded:

Balanced funds were the main bright spot. The gap for the past year was just 14 basis points, and it was only 8 for the past three years. Best of all, the gap went the other way for the trailing 10 years as the average balanced-fund investor outperformed the average balanced fund by 30 basis points. (Russel Kinnel, “Mind the Gap 2011,” posted 4/18/2011)

At least in theory, the presence of that large, stolid block would allow you to tolerate a series of small volatile positions (5% in emerging markets small caps, for example) without panic.

But which hybrid or balanced fund?  Here, a picture is really worth a thousand words.

This is a risk versus return scatterplot for domestic balanced funds.  As you move to the right, the fund’s volatility grows – so look for funds on the left.  As you move up, the fund’s returns rise – so look for funds near the top.  Ideally, look for the fund at the top left corner – the lowest volatility, highest return you can find.

That fund is LKCM Balanced.

You can reach exactly the same conclusion by using Morningstar’s fine fund screener.  A longer term investor needs stocks as well as bonds, so start by looking at all balanced funds with at least half of their money in stocks.

There are 302 such funds.

To find funds with strong, consistent returns, ask for funds that at least matched the returns of LKCM Balanced over the past 3-, 5- and 10-years.

You’re down to four fine no-load funds (Northern Income Equity, Price Capital Appreciation, Villere Balanced, and LKCM).

Finally, ask for funds no more volatile than LKBAX.

And no one else remains.

What are they doing right?

Quiet discipline, it seems.  Portfolio turnover is quite low, in the mid-teens to mid-20s each year.  Expenses, at 0.8%, are low, period, and remarkably low for such a small fund.  The portfolio is filled with well-run global corporations (U.S. based multinationals) and shorter-duration, investment grade bonds.

Why, then, are there so few shareholders?

Three issues, none related to quality of the fund, come to mind.  First, the fund has a high minimum initial investment, $10,000.  Second, the fund is not a consistent “chart topper,” which means that it receives little notice in the financial media or by the advisory community.  Finally, LKCM does not market its services.  Their website is static and rudimentary, they don’t advertise, they’re not located in a financial center (Fort Worth), and even their annual reports offer one scant paragraph about each fund.

What are the reasons to be cautious?

On whole, not many since LKCM seems intent on being cautious on your behalf.  The fund offers no direct international exposure; currently, 1% of the portfolio – a single Israeli stock – is it.  It also offers no exposure (less than 2% of the portfolio, as of April 2011) to smaller companies.  And it does average 70% exposure to the U.S. stock market, which means it will lose money when the market tanks.  That might make it, or any fund with substantial stock exposure, inappropriate for very conservative investors.

Bottom Line

This is a singularly fine fund for investors seeking equity exposure without the thrills and chills of a stock fund.  The management team has been stable, both in tenure and in discipline.  Their objective remains absolutely sensible: “Our investment strategy continues to focus on managing the overall risk level of the portfolio by emphasizing diversification and quality in a blend of asset classes.”

Fund website

LKCM Balanced

© Mutual Fund Observer, 2011.  All rights reserved.  The information here reflects publicly available information current at the time of publication.  For reprint/e-rights contact David@MutualFundObserver.com.

Objective

The fund seeks total return by investing, long and short, in the entire investable universe. It starts with a sensible neutral asset allocation and tries to “add alpha around the edges.” The fund parallels the firm’s Topaz hedge fund. It can short stocks, to a maximum of 30%. Unlike other hedge funds, Topaz avoids extensive leverage and highly concentrated bets. The fund will do likewise.

Adviser

GRT Capital Partners. GRT was founded in 2001 by Gregory Fraser, Rudolph Kluiber and Timothy Krochuk. GRT offers investment management services to institutional clients and investors in its limited partnerships. As of 2/1/11, they had over $300 million in assets under management and were experiencing healthy inflows. They also manage GRT Value (GRTVX) and ten separate account strategies.

Manager

The aforementioned Gregory Fraser, Rudolph Kluiber and Timothy Krochuk. Mr. Fraser is the lead manager. He managed Fidelity Diversified International (FDIVX) from 1991 to 2001. Before that he analyzed stuff (shoes, steel, casinos) for Fidelity. Mr. Kluiber, from 1995 to 2001, ran State Street Research Aurora (SSRAX), a small cap value fund. Before that, he was a high yield analyst and assistant manager on State Street Research High Yield. Mr. Krochuk managed Fidelity TechnoQuant Growth Fund from 1996 to 2001 and Fidelity Small Cap Selector fund in 2000 and 2001. Since 2001, they’ve worked together on limited partnerships and separate accounts for GRT Capital. All three managers earned BAs from Harvard, where Mr. Kluiber and Mr. Fraser were roommates. Messrs Kluiber and Fraser have both earned MBAs from UCLA and Pennsylvania, respectively.

Management’s Stake in the Fund

Not yet reported. That said, the managers own the advisory firm, and Mr. Krochuk attsts that “all of our managers own shares in their products” and “most of our net worth is in those products.”

Opening date

December 8, 2010.

Minimum investment

$2500, reduced to $500 for IRAs.

Expense ratio

2.39% on assets of $10 million.

Comments

Investors are often panicked by the simple fact that virtually no asset class is attractively priced any longer. Cash is at zero. Bonds have a near zero real return, with the spread between the riskiest bonds and Treasuries collapsing to 4.6%. U.S. stocks have nearly doubled in under two years while emerging markets and REITs have risen by even more. Gold, a classic inflation hedge, has risen from $272 in 2000 to $1363 in February 2011.

The argument that no asset class is undervalued does not mean that it’s impossible to make money; just that you’re less likely to make it with a static asset allocation and exposure to market indexes. That, at least, is the argument advanced by Tim Krochuk and the good folks at GRT Capital Partners in support of their new absolute return fund. “Active management is,” he argues, “oversold while ETFs are screaming skyward.”

Mr. Krochuk’s argument is that managers need the flexibility to make gains wherever an uncertain market offers them, a strategy which requires the ability to invest both long and short, in a wide variety of asset classes.

GRT Absolute Return (GRTHX), launched in December, offers three distinctive features.

First, it has a sensible neutral allocation. By shifting the classic 60/40 split between stocks and bonds to a 55/35/10 split between stocks, bonds and cash, GRT produced a benchmark with great stability that outperformed the traditional allocation in 100% of the rolling five year periods they studied. From 2005 – 10, GRT’s neutral allocation returned 31% while a 60/40 split returned 20% and the S&P500 was in the red.

Second, it doesn’t try to over-promise or over-extend itself. GRT has a remarkably vibrant quant culture, and their studies conclude that “a little shorting goes a long way.” As a result, the fund won’t short more than 30%, which provides “major downside protection” as well as contributing alpha in some markets. How much downside protection? A 2004 asset allocation study, published by T. Rowe Price, gives a hint. They studied the effects of various broad asset allocations (100% stock, 80% stock/20% bonds, and so on). In general, reducing your stock exposure by 20% reduces the average down year loss by 4%. For example, a portfolio 80% in stocks lost an average of 10% in its down years. Dropping that to 60% stocks cut the average loss to 6.5%. There was surprisingly little loss in returns occasioned by easing up on stocks: a static 60% stock portfolio earned 9.3% per year over 50 years while 80% stocks earned 10%.

We can, Krochuk concludes, “add alpha by investing around the edges of a good allocation benchmark.” They also avoid leverage, which dramatically boosts returns — but only if you’re very right and have impeccable timing. The underlying portfolio will be well diversified, rather than making a series of hedge fund-like bets on a small basket of securities. They’ve found that they can use U.S. blue chip stocks (liquid and dividend paying) in lieu of a large cash stake. And the managers invest major amounts in their funds. The prospect of losing much of your life savings, Mr. Krochuk notes, has a wonderfully sobering effect on investor behavior.

Finally, the fund has Greg Fraser (and company). Mr. Fraser, the lead manager, performed brilliantly at Fidelity Diversified International (FDIVX) for a decade, outperforming in both rising and falling markets. In the five years before FDIVX, he was one of Fidelity’s top stock analysts. In the decade since FDIVX, he’s run both a long/short hedge fund and a natural resources hedge fund for GRT. As I noted in my profile of GRT Value (GRTVX) and my March 2011 cover essay, G, R & T represent a major pool of time-tested talent.

GRT employs another half dozen managers on their private accounts, and several of those have outstanding records as mutual fund managers. While those managers do not directly contribute to this fund, their presence strengthens the fund in at least two ways. First, there’s an ongoing flow of information between the managers; informally on a daily basis and formally at monthly meetings. Second, the advisor monitors the performance of each of its 10 strategies every day. Those strategies are, in normal times, uncorrelated. A spike in correlations has been a reliable sign of an impending market fall. That information is available only to GRT and allows them to anticipate events and adjust their portfolio positions.

Bottom Line

The price of entering the fund ($2500) is low, though the price of staying in is rather high (2.39% at the outset). That said, highly active, alternative-investment funds are pricey are a group (the $1.4 billion Wintergreen fund charges 2%, for example) and expenses are likely to fall as assets rise. As importantly, the managers have a record of earning their money. Beyond GRTVX’s strong performance, there’s also decades of great absolute and risk-adjusted returns posted by all three members of the management team. Ensconced now in a partnership of their own creation, with a sensible corporate structure and a cadre of managers whose work they respect, there’s good reason to believe the GRT will achieve their goal of becoming “a mini-Wellington.” That is, an exceedingly stable firm dedicated to providing strong, sustainable long-term gains for their clients.

Fund website

GRT Capital Partners, then click on “mutual funds” in the lower right. The funds portion of the site has minimal information (links to the prospectus, SAI and required reports but not a profile, holdings, commentary or performance). The rest of the site, though, has a fair amount of relevant information to help folks understand the management team and their approach.

© Mutual Fund Observer, 2011.  All rights reserved.  The information here reflects publicly available information current at the time of publication.  For reprint/e-rights contact David@MutualFundObserver.com.