An Alternative Mutual Fund Primer

For people without the time or experience, to invest in individual securities (and even for others), I am a big proponent of a significant allocation to mutual funds. Unfortunately, the majority of mutual funds are awful, particularly those that are advertised most heavilly and that are most popular with investors. With proper research, however, you can find some truly great investment funds and managers that should deliver strong returns over a long time horizon. Though there are many excellent resources online for selecting the proper mutual funds, there are several points of convential wisdom that I believe are innacurate and worth correcting. Please note that many of these pieces of advice assume you know the generally accepted basics (examine long term returns and drawdowns, watch for manager changes, etc.).

Debunking the underperformance myth

Before diving into specific recommendations, it is worth briefly discussing the active v. passive debate. In recent years, with the rise of ETFs, many people have put forth arguments that active investing does not make sense. They have pointed to statistics of overall underperformance of mutual funds v. the indexes, tax inefficiency, the efficient market myth, transaction costs, and a host of other arguments.

While this may be fair, on the average, a selection of the upper crust of mutual fund managers avoids many of the issues that passive proponents point to. Though the average mutual fund is junk, there is a significant subsection of funds and managers that have consistently outperformed the market over long periods of time, net fees and taxes. Though, statistically, it is possible (and expected) for this outcome to be observed, it is worth noting that many of these managers operate a simmilar strategy: value investing. In a past writing, by either Hussman or Buffett (I forget which one), they illustrated this logic through a brief anecdote, which went something like this:

If you went ahead and gave 1,000 monkeys money to invest, set them lose, and tracked performance over the next 20 years, you would expect there, by randomness, to be variance in their performance. Some, by sheer luck, will naturally have outperformed others, and the market as a whole. Lets say, of those 1,000 monkeys, by chance, 100 will have outperformed the market by 5% or more. By chance, this would be what we expect. But suppose that 80 of those 100 monkeys happened to come from a small town in Omaha, where a monkey named Warren Buffett had, for quite some time, been teaching the other monkeys a particular way of selecting stocks. Well, you may begin to wonder what was so special about Omaha and the monkey there, and whether or not they were onto something.

Unconventional mutual fund recommendations

There are several important factors when trying to find those monkeys that will outperform the market. Morningstar.com is a great resource for information, and although they have some excellent write ups, there are several areas in which my philosphy differs signficantly from theirs, as well as traditional mutual fund wisdom. First, some against the grain recommendations:

1) Fees do not matter if performance net fees is high:
Morningstar and other mutual fund commentators will often knock strong funds with high fees. Though there are many poor funds that have high fees, I believe high fees alone are no reason to avoid a particular fund. Better funds can charge higher fees, and still deliver better results, and it in general makes sense that you will often get what you pay for with fees. Observe the fees of the following two funds:
Fund A: 2% with a 1% deferred load
Fund B: .2%

Fund B appears to be a better value, but you get what you pay for. Fund B is IWM (the Russell 2000 index), with 5 year returns of 11% and high volatility. Fund B is Hotchkis and Wiley small cap value, with returns net fees of 15.8% over 5 years, despite significantly higher fees. For .2%, you get what you expect: a strategy that basically consists of buying whatever stocks are in the index, regardless of value. For the higher fees of Hotchkis and Wiley, you get a team of analysts and portfolio managers who have consistently outperformed the market.

2) Concentrated portfolios are often better than unconcetrated ones
In general, when selecting mutual funds, I prefer a concentrated portfolio. Fairholme fund (FAIRX) is one of my core holdings, with only 21 stocks and over 60% in their top 10 ideas. I prefer concentrated porfolios as I generally like to see managers put conviction (read: more money) in their best ideas. Lets say a manager holds 20 stocks, 5 of which they expect to appreciate 30%, and the other 15 they expect to appreciate 10%. One manager puts 50% 0f their fund in those top 5 ideas, while the other equal weights each idea. What is the peformance difference?

Concentrated: (.5*.3)+(.5*.1)=20%
Unconcentrated: 1*.10=10%

Though a concentrated fund may experience higher volatility, the overall volatility of a properly balanced portfolio using mutual funds will be minimal. If, for example, you invest in 4 equity funds, each of which have a concentrated portfolio of 20 holdings, your overall equity porfolio will be 80 holdings. Keep in mind that many of these holdings are likely also conglomerates, which are made up of multiple business divisions and thus can often represent 5 to 10 different companies. In this way, investing in 4 concentrated funds would give you a stake in potentiall hundreds of businesses, which arguably is too diversified.

3) Volatility can be your friend, if it has the right correlation
Volatlity is mostly a bad thing when the correlation between your different investments is all related. If you have all your money in large cap US financial stocks (generally low volatility), you will likely experience volatility in the same direction all the time, resulting in sizeable swings in your portfolio value. When diversified across multiple asset classes, industries, currencies, and strategies, you can build a portfolio such that something of yours is likely to be always going up. Though the individual components of the diversified portfolio may each have higher volatility on their own, the overall volatility of your porfolio will be less than when invested in a single mid to low volatility asset class. If you chose the right investments and asset claseses, you should be able to construct a portfolio with significantly less volatility than the stock market, which is also capable of outperforming the stock market over a long period of time. In other words, if your stock advisor telling you you must accept lower returns and put more money in bonds if you want to experience less risk, it is probably time to find a new stock advisor with more progressive views of asset allocation.

A good example of this point are foreign funds with unhedged currency exposure. Currency exposure is a great way to get uncorrelated volatility, with the potential for amplified returns if you believe in the immeninent decline of the dollar. In fact, without foreign currency exposure, investing in foreign stocks provides little diversification as the majority of equities head in the same direction on the way down.

4) Look for a competitive advantage and added value
Most funds operate somewhat similarly: they have the same value screens, peform the same analyses, and generally invest in the same stocks (many mutual funds invest in so many stocks, for example, that they are essentially ETFs. With each of my largest mutual fund holdings, I can usually point to something that fund does that is different or better than other funds. Hussman has a unique hedging strategy that signficantly reduces volatility, while creating long term returns that outperform the market. Bridgeway aggressive investors (BRAIX) has propriety quantitative models that have consistently outperformed the stock market over the last 10 years. Fairholme, Dodge & Cox foreign (DODFX), and Hotchkis and Wiley small cap all come from fund families that have consistently outperformed the market, and have some of the best investment talent around.

5) Operating history is nice, but not nessecary
Though I alway prefer funds with a long operating history, many of the best funds close long before they get to prove themselves in this way (particularly funds focusing on small caps). If you want to get into many of these top performing funds befor they close to new investors, you need to invest before the fund has shown a long operating history. As a rule of thumb, I will often eagerly invest in a new fund by a reputable company regardless of early returns, as long as the new fund is in a strategy that that fund has done well with in the past. Examples of fund families whose funds close rapidly and are generally respected include Dodge & Cox, Hotchkis and Wiley, Wasatch, Bridgeway, and Royce.

6) Exotic does not mean risky or bad
With the popularity of hedge funds and their strategies (e.g. long short, arbitrage, etc.), new mutual funds are emerging with new strategies that offer lower volatility or inverse correlations to typical investments. Hussman, for example, often gets knocked because people do not understand his strategy, and see his recent underperformance as a failure (when, for the most part, it is not). Though I believe people should not invest in strategies they do not understand, that does not mean these are bad strategies (or not worth reading about to learn how they work). Funds such as hussman are the only way to benefit off some of the more sophisticated strategies that the uber-rich have enjoyed, for years, with hedge funds, that are finally being made available to individual investors.

In the coming weeks, I will follow up with more articles on mutual funds and overall porfolio construction, as I believe some of the more popular conventional wisdom in this area to be more popular than it is wisdom.