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6 Understanding Mutual Fund Strategies and Fundamental Risk To make mutual funds work for you, you’ve got to understand their strategies and risks. Knowing a strategy enables you to properly evaluate performance, adopt reasonable expectations, and build a portfolio of funds that work together. We just discussed how looking at past returns can help you to set expectations. That’s really the “what” side of the puzzle, and this is the “why.” This isn’t part of the formula we’ll use in picking funds, but it’s a key piece of qualitative research that you need to know. I’ll take you through the risks and the strategies so that you can invest wisely. You’ll feel a lot more confident about your ability to invest when you can separate the deep-value strategies from the relative-value funds. 45 c06.indd 45 1/6/09 3:12:19 PM 46 fund spy This and the following chapters will help you get a handle on the qualitative part of fund picking. When you buy a fund, you should understand what it does and be able to articulate why you bought it and why you’d sell it. One financial planner told me that when a new client brings him a portfolio, he doesn’t know what he owns or why he owns it. The following chapters will help you to be sure you’re not in that boat. Fundamental Risks All strategies have risks. After all, you don’t get returns for taking on zero risk. The key is to understand them and be sure they are worth taking. Here are some key risks: 䉴 Concentration risk. Funds with a high percentage of assets in their top holdings aren’t necessarily riskier than other funds, but they can be. Some take on a lot of individual stock risk. For example, if a fund has a stock position over 10 percent or a few over 5 percent, it’s more vulnerable to problems at an individual company than other funds would be. See Oakmark Select’s (OAKLX) problems from a huge bet on Washington Mutual, for example. The fund had a 16 percent weighting in the stock when it was trading for around $50, and it didn’t get out until around $3 or $4 a share, just before regulators seized Wamu. Interestingly, some other funds—such as Fairholme (FAIRX), Longleaf Partners (LLPFX), and FPA Capital (FPACX)—have muted that risk by holding a big cash stake. 䉴 Sector risk. Besides having a lot in a single stock, a sizable weighting in a single sector runs big risks because sometimes everything in an industry goes in the tank at the same time. When a fund has more than 30 percent in a sector, it’s courting sector risk. Marsico Focus (MFOCX) has significant stock risk, but manager Tom Marsico is careful to diversify among sectors so that one industry can’t take the fund down. c06.indd 46 1/6/09 3:12:20 PM understanding mutual fund strategies 47 Conversely, a slew of growth funds, including White Oak (WOGSX) had huge technology weightings in 1999 and were barbecued when the bear market hit. More recently, Clipper’s (CFIMX) 50 percent weighting in financials hurt it in the financial meltdown of 2007–2008. 䉴 Price risk. When a stock is trading for a high valuation, disappointing news will spur much larger losses than one with a low valuation. Essentially high valuation means high expectations. The 2000 to 2002 bear market was all about price risk. You had some sound companies whose stocks were trading at insane valuations of 75 or 100 times earnings, as though growth were limitless. When their growth slowed, the stocks got crushed, even though they were still growing faster than most companies. The further a fund is to the right side of the Morningstar Style Box, the greater the price risk. 䉴 Business risk. At the heart of every stock fund is the risk that the businesses of the stocks they own will deteriorate. Some lose their competitive advantage; others see their whole industry collapse. Managers devote a lot of energy to avoiding these situations, but it happens to even the best of them. 䉴 Market risk. Stocks and bonds lose money from time to time. That’s how it works, so don’t fire your manager for losing money in a bear market. Rather, you need to prepare your portfolio for occasional downturns by staying long-term and diversifying. 䉴 Credit risk. Bond funds with corporate bonds or emerging-marketsgovernment bonds are taking on some risk that the bonds will default. You can see this risk in the fund portfolio’s overall credit rating. Investment grade runs from BBB to AAA and government. Below BBB are junk bonds. Funds with credit risk tend to enjoy smooth sailing for a few years, and then there will be a shock to the system and credit risk will be punished for a year or two before rebounding. In fact, the fear of defaults can lead to big losses for a fund even if it doesn’t suffer defaults. For example, c06.indd 47 1/6/09 3:12:20 PM 48 fund spy in 2002, the implosions of Enron and WorldCom led investors to avoid any corporate bond with any perceived weakness, and funds with large corporate bond stakes were hit hard. Most of these funds later rebounded to recoup their losses because the feared defaults didn’t happen. Still, it illustrates the point that high-yield funds or any fund with a good chunk of junk bonds are suited for long-term holding periods even though we tend to think of bond funds as fit for shorter time periods. 䉴 Interest-rate risk. This is the other side of bond fund risks. Interest-rate risk measures the extent to which a fund will get hit if interest rates rise. We measure this with duration. Typically, the lower the yield and the longer the maturity, the higher the interest-rate risk. Interest-rate and credit risk are sort of two sides to a teeter-totter. A junk bond fund has muted interest-rate risk because its yield compensates you for a pop in interest rates. A long-term Treasury fund has no credit risk but tons of interest-rate risk, as its low yield is little compensation when rates surge. Too many investors have made the mistake of thinking a fund with little or no credit risk has no risk at all. 䉴 Liquidity risk. This is a more arcane concept, but when it does appear, it’s ugly. The problem happens when a fund manager finds she can’t sell her holdings easily and quickly. A fund with losses can slip into a terrible downward spiral if its holdings are so illiquid that its losses spur redemptions and then the redemptions spur more losses because the fund manager has to sell securities at fire-sale prices, and the cycle gains steam. In March 2008, you could see this happening at Schwab YieldPlus (SWYPX), because its net asset value fell every single day, even when similar bond funds were up. The scary thing is that the fund’s holdings were once quite liquid, but the market dried up. 䉴 Emerging-markets risk. Emerging markets have outsized returns and outsized losses because they are based on rickety economies that work well in some environments but can fall apart in others. Every emerging c06.indd 48 1/6/09 3:12:21 PM understanding mutual fund strategies 49 market has been through brutal sell-offs. The risks are special because emerging markets tend to have less dependable rule of law where governments can seize company assets. Consider what the Russian and Venezuelan governments have done to oil companies that they don’t like. Other times, we’ve seen emerging markets collapse because they were too dependent on outside financing, and once that money started to run away it had a domino effect. 䉴 Currency risk. As I’m writing this, it doesn’t feel like a risk from here in the heart of the United States. Currency risk means that if you have money in foreign currencies and they fall against the dollar, you lose money. Lately, the dollar has been pummeled and that has been a boon to foreign-stock and foreign-bond funds, most of which don’t hedge their currency exposure. Still there are other times when the dollar has risen and taken a bite out of foreign-stock investors’ returns. Before you invest in a foreign fund, find out if it hedges its currency exposure so you’ll know what to expect. Key Stock Fund Strategies Now let’s talk about strategies. When you read a description of a strategy or listen to a manager, pay particular attention to selling criteria. Depending on your personality and investing background, some strategies will sound clever and some will sound a little crazy. I have my own biases, but I’ve been watching long enough to know that most strategies have their merits and none are foolproof. Even the best strategies can be screwed up. Likewise, every strategy is going to have ups and downs. The markets rotate favor among different strategies and sectors and no manager is immune to a down year or two. From Warren Buffett to Peter Lynch to Michael Price to the best team-managed funds at American and Dodge & Cox, you can find years when they were in the red or lagged the market by a wide margin. That’s usually the best time to buy. c06.indd 49 1/6/09 3:12:21 PM 50 fund spy Regardless of the strategy, there are a few things to look for in every case. You want managers that stick to their guns and do not chase what’s trendy at the moment. Yet you want them to remain diligent and keep an eye out for fundamental changes. The same goes for fund companies. Whenever value managers start getting fired and replaced with growth managers, you know value is about to have a great run, and vice versa. In short, you want discipline. If a fund is supposed to buy companies with accelerating earnings but it buys a distressed stock with declining earnings, it may be time to head for the exit. In addition, you want to see the manager excel at executing that strategy. If deep-value funds are having a great run but yours isn’t keeping up with its peers, you should take a close look at whether there’s a good reason for that. For example, I was optimistic that Bob Stansky could do well at Fidelity Magellan (FMAGX) with his contrarian growth strategy. It wasn’t on our recommended list, but I thought it was a pretty good fund. Essentially, the fund was so big that Stansky aimed to go against the flow on growth, so that he was buying when others wanted to sell. Thus, the fund’s footprint would be fairly small. So, I was tolerant of weak returns from 2000 to 2002 because growth stocks were getting crushed and the fund was only a little off the pace of other growth funds. In addition, he had made a smart move into tech during a previous sell-off. But then in 2003, tech stocks were so cheap that they had a big rally, and Magellan was nowhere to be found. Stansky missed the boat, and that’s when it was clear things were not working at Magellan. Every manager will make mistakes, but if the manager makes a bunch of mistakes in an area that is supposed to be his expertise, that’s a problem. If a fund’s calling card is in-depth accounting analysis so that the managers know a company’s balance sheet and business better than the rest, I’m going to worry if some major holdings have accounting scandals. Janus was supposed to be a fundamentals-driven growth shop, but it lost its shirt on Enron. Janus managers were buying near the top, which means not only c06.indd 50 1/6/09 3:12:21 PM understanding mutual fund strategies 51 did they miss the accounting tricks but also they looked at Enron’s rapid growth rate and its huge P/E and said it could grow even faster to justify that huge valuation. They showed poor judgment in evaluating management, in understanding valuation, and in assessing risk. It’s also worth asking if the fund’s past success can be repeated. When a strategy is working well, it often attracts lots of imitators who go after similar stocks and drive down the returns of the strategy. To get a fund with staying power, you need to find one that can do something better than others. Usually, that means something that is difficult or expensive to replicate. For example, Dodge & Cox, Wellington, and American Funds do better fundamental research than other big fund companies because they have a huge number of smart, experienced analysts who take ownership of their contributions to the firm. Everyone knows that and would like to be like them but it takes a ton of money and about 30 years to get there. Or in other cases, managers have developed a complex strategy that isn’t easily imitated. That’s what you want. A Guide to Top Stock Fund Strategies Let’s take a look at some of the most important schools of thought on stock investing. I’ll tell you some of the key adherents, the basics of the strategy, the usual sector biases, and the finer points of sell strategies. Some of these strategies are closely associated with a founding father, while others came from a few different investors, so I’ve labeled the latter with clear genealogy after the founding father. Ben Graham’s Deep-Value School Ben Graham cut his teeth in the Depression when fundamental analysis was an unusual thing. So, he was focused on protecting against losses and found there was a lot of safety in buying very cheap stocks where you got something for almost nothing. A company with an asset such as land or c06.indd 51 1/6/09 3:12:21 PM 52 fund spy cash worth $100 million whose market capitalization valued it at only $25 million was a good bet in Graham’s eyes. Thus, buying a really undervalued, crummy company could be much safer than buying an apparently strong company whose shares could fall sharply just with a mildly disappointing earnings report. The catch today is that it’s easy to run screens for some of those bargains so that they tend not to last. In addition, some of those deep-value stocks are cheap for a good reason, and therefore may not have the upside of better companies. Typically, deep-value managers are buying industries when things look bleak and betting on a return to past norms. Thus, a deep-value stock doesn’t have to transform into the greatest company in America to be a winner. At one of Morningstar’s annual investment conferences, Jim Barrow said he hated many of the companies he owned. To make money, Barrow has to be able to figure out which companies are so poorly run (or inclined to cook the books) that management will run the company into the ground from those companies that have mediocre managers who won’t miss the layups that come their way when the industry’s fortunes turn for the better. Nonetheless, this is a strategy that generally protects the downside pretty well, at the cost of some returns. Some of the best funds in this group have low-risk but marketlike returns. That sounds boring, but in down markets it can be beautiful, and over the long haul it can win. Many academic studies have found that value stocks outperform growth stocks over the long haul, although I wouldn’t assume that it’s guaranteed to be true over your particular investment horizon because what’s in favor tends to rotate from year to year. Selling Most deep-value managers are patient, low-turnover investors, but when a stock rallies, they typically sell in order to keep price risk in check. Some, like Bob Rodriguez of FPA funds, are more willing to let their winners ride, c06.indd 52 1/6/09 3:12:21 PM understanding mutual fund strategies 53 and will hold stocks even as they move into the growth side of the Morningstar Style Box. Risk Business risk is a key risk. Managers’ greatest fear is called a value trap. That refers to stocks that look like values based on their price relative to past earnings but the catch is that those earnings are going to continue to shrink rather than rebound. Low prices provide some margin for error, but if the business is a dud, it’s still a bad investment. Think about airline stocks. One manager once quipped that it would be worth the money to pay someone full-time to remind him never to buy airline stocks. They often look cheap, but the industry’s cutthroat pricing has made airline stocks a horrible investment. Practitioners These are Tweedy, Browne; Barrow Hanley (Vanguard Windsor II, VWNFX); Wellington’s Philadelphia branch (Vanguard Windsor, VWNDX); Oakmark, except Bill Nygren; Charlie Dreifus (Royce Special, RYSEX); Bob Rodriguez of FPA, FPACX; John Rogers of Ariel, CAAPX; and Southeastern Asset Management (Longleaf, LLPFX). Momentum Investing This is the polar opposite of deep-value investing. Stocks that rise sharply have a tendency to continue rising for a while. In addition, companies whose earnings beat Wall Street quarterly earnings estimates tend to beat them the next quarter. These key observations are at the heart of momentum strategies. The study of behavioral finance provides an explanation for why this works, even though it sounds kind of silly. Researchers have found that people consistently underestimate change in the investment world and elsewhere. Say a company has a hot new product, and you expected profit margins to be 50 percent and earnings growth to be 15 percent. Instead, the company c06.indd 53 1/6/09 3:12:22 PM 54 fund spy reports margins of 60 percent and profit growth of 20 percent, and the stock takes off. So, you might split the difference and boost your expectations to 55 percent and 18 percent for the next quarter, but instead you see 65 percent margins and 22 percent growth, and the momentum investors get a quick reward. Next, that hot product starts to cool off (see what happened to Motorola and the RAZR phone), and the trends worsen much faster than investors expected. The momentum investor gets out quickly, though not at the top because they waited until the first round of bad news came out. Momentum managers are in a constant arms race. Lots of hedge funds, mutual funds, and day traders are testing out new wrinkles in momentum. Once something works, others pick up on it and the advantage is quickly squandered. In fact, some momentum models stop working as soon as they go from backtesting to the real world, so fickle is the world of momentum. Watch how a fund sells stocks for a clue as to whether it’s a momentum fund. Do stocks get tossed for even minor disappointments or fear of a minor disappointment? I once moderated a panel of growth managers and I asked them what they would do if they expected a holding to miss the next quarter’s earnings estimates by one penny per share. The two growthat-a-reasonable-price managers said they’d hold on, but Brandywine’s Foster Friess said he’d dump it and look for something better. That’s momentum in a nutshell. Risk Momentum can deliver big returns quickly, but man, is it risky. The reason is that these funds are loaded with price risk. When a momentum stock disappoints, it gets absolutely crushed. If you look at the track records of momentum funds, you’ll see a wild mix of huge gains and big losses. So you either have to have great timing or a high pain threshold to make any money in them. c06.indd 54 1/6/09 3:12:22 PM