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Friday, June 5, 2009

The Strange Case of An "Outstanding" Active Manager

I found an interesting article about fund manager Robert Rodriguez in the WSJ last week. But when I did a little more research about this "star fund manager" the story became more interesting.

According to the WSJ last week Rodriguez one of the "top" active mangers in the mutual fund arena doesn't seem to fee that either he or his colleagues have been showing much skill and value added. From the WSJ (my bolds) my comments in bold italics

FUND TRACKJUNE 5, 2009.Fund Managers in '08: 'We Stunk'
FPA's Rodriguez Doesn't Mince Words


One of the best-known mutual-fund managers minced no words with his industry colleagues, criticizing their poor performance last year.

Managers should learn from their mistakes and adjust accordingly, or face losing clients and possibly going out of business, said Bob Rodriguez, manager of FPA Capital Fund (trading symbol FPPTX).

While the Standard & Poor's 500-stock index was down about 38% in 2008, the vast majority of actively managed stock funds lagged behind that mark.

"Let's be frank about last year's performance," Mr. Rodriguez said. "In a word, we stunk. We managers did not deliver the goods and we must explain why."

In remarks to fund managers and investment advisers at the Morningstar Investment Conference last week, Mr. Rodriguez said part of the problem was that fund managers didn't appreciate the magnitude of the financial crisis. "Whether in stocks or bonds, it seems as though the same old strategies were followed -- be fully invested...and don't diverge from your benchmark too far," he said.

"If active managers maintain this course, I fear the long-term outlook for their funds, as well as their employment, will be at high risk," Mr. Rodriguez cautioned.

His criticisms were aimed at all fund managers, Mr. Rodriguez said, and he added that he accepted his own poor performance: FPA Capital Fund was down 35% last year. But he said that in his letter to shareholders he'd explain why he thought the losses were only temporary.

In other words I have faith in my own skills and I will outperform in the future, trust me, I will.

The fund is up about 25% so far this year.

more on that "stellar" performance below

"If portfolio managers and analysts cannot recognize the greatest credit blowoff in the last 80 years, when will they?" asked Mr. Rodriguez.

Mr. Rodriguez wondered what new procedures firms have put in place to make sure they don't make the same mistakes.

"These are questions that must be answered in order to regain and retain investor trust," he said.

Mr. Rodriguez said he's lost business since 2007 because he'd gone into cash. The losses included one $300 million client that left because his approach upset their asset-allocation model.

So his fund was down 34.8% in 2008 (compared to the S+P 500's -38%) even though he was heavily in cash ? He must have made some really terrible calls with the portion of his fund that was invested )

"We have been penalized for taking precautionary measures leading up to and during a period of extraordinary risk," he said.

Talk about lack of self awareness. His "precautionary mesures" still left his fund
-34.8% in 2008 and he was penalized for taking the appropriate "precaustionay measures"

(Mr. Rodriquez said in early March that from Jan. 1, 2010, he'll be taking a year's sabbatical to recharge his batteries. He plans to return on Jan. 1, 2011.)

Mr. Rodriguez said that he's once again bucking consensus, and late last year and early this year went hard into the market. Some 67% of his buys during that period were energy stocks.

More than half of his fund's stocks are energy-related -- a strategy that reflects his view of a changing world....

Mr. Rodriguez said that in the new world of lower returns, diversified mutual funds may struggle to beat their averages and benchmarks. "A more-focused strategy will be necessary to excel," he said. "If active managers continue to adhere to their old practices, we should see a contraction in the active mutual-fund management universe in the next five to 10 years."

So Mr. Rodrigues' solution to the market penalizing him for taking "precautionary measures" ramp up the risk with a heavily concentrated portfolio with 50% in energy stocks. This may work in the short term and it has so far this year, but he has clearly created a very risky portfolio. And if he continues to do what he said active managers need to do his portfolio performance will be highly dependent on his being successful when he takes extremely large sector bets.

I must say I find this speech given a few days ago rather surprising (to say th eleast ) considering the following interview he gave to Barron's in Feb of 2009

Barron's: Before we look ahead, let's review last year's equity market. What is your take?
Rodriguez: The equity market didn't surprise me. I warned that 2008 was going to be very tough -- and that the second half was going to be a lot rougher than the first half when the realization hit that corporate profits were going to be substantially less than expected. I also expected that the credit crisis was going to not only get worse, but that it was going to extend through 2008 and into 2009, which was not what a lot of people were expecting.


. Throughout '07 and '08, we had just under $1.2 billion of redemptions in all of the equity accounts, including the mutual fund, so we were fighting a rear-guard action.(WOW, apparently something changed in June 2009 (see above) about what he did in 2008)In the third quarter of '08, we had $300 million flow out from one account, a large banking relationship. The reasons given were that, all of a sudden, we had too much cash -- and that was upsetting their asset-allocation modeling. Secondly, they couldn't decide whether we were a small-cap value manager or a mid-cap value manager. So I said, 'May the pinheads of the world unite.

I have noted before that the literature from a fund company or categories from services such as Morningstar are seldom useful in evaluating actively managed fund.
The FPA Capital Fund mentioned in the above article is categorized by Morningstar as a mid cap value fund. Yet its portfolio which is 50% energy related has little in common with mid value indices: the state street spdr mid value etf is 7.8% energy, the vanguard energy etf is 9.1%.

And the literature from the fund company itself is of limited usefulness

Here is the description of the FPA Capital Fund's investment strategy on their website my bolds.

This price-driven equity style attempts to exploit market inefficiencies among stocks of smaller companies. Intense research is required to build the high level of knowledge and confidence necessary to realistically evaluate unpopular situations. Great attention is paid to the minimization of potential risk. The disciplined selection process is designed to minimize business risk by applying specific fundamental criteria: strong balance sheets, free cashflow, an understandable and successful business strategy under capable management, and unique business characteristics, which may include proprietary technology or a dominant market position. Qualifying companies have a history of generating high return on equity or demonstrate the potential to do so. FPA's value bias focuses on companies with long-term records; over 70% of holdings have at least 10-year histories.

Research concentrates on economic and market sectors either heavily discounted or simply ignored and involves basic computer screens for balance sheet and return data, the study of industry periodicals and research reports from select Wall Street sources, and in-depth interviews with company principals. Valuation considerations are applied to this list of potential investments, seeking to minimize market risk during the process of accumulation. New purchases are concentrated in companies with relatively low Price/Normalized Earnings, low Price/Pretax Cashflow, low Price/Book Value, low Price/Replacement Value and low Market Cap/Total Revenues. A contrarian outlook allows ownership of companies at prices already reflecting a negative perception by the marketplace. FPA believes this to be a relatively low-risk approach to the smaller cap markets given a reasonable time horizon.
Sorry but imo holding a portfolio that is 50% energy related does not consist of "sectors...simply ignored" by other investors or evidence of a "contrarian outlook".

Interestingly I also found this article

The best fund manager of our time

Robert Rodriguez has accomplished the unheard-of-feat: driving staggering returns in both a stock and a bond fund for more than two decades.
By Jason Zweig, Money Magazine senior writer/columnist

(note the byline: Jason Zweig now of the WSJ intelligent investor column and a frequent advocate of index investing)

April 8, 2008: 9:43 AM EDT
(Money Magazine) -- To invest in a mutual fund is to make a bet on the future. Whether that bet pays off is a function of how skillful the fund manager is, how lucky he is, how well the market does and how well the manager treats you.

The first two factors are very difficult to measure or predict, and the third is impossible to know in advance. But the fourth is quite easy to evaluate. You want a fund manager who will charge reasonable fees, keep his fund from growing too big for your own good, think independently and courageously and communicate his actions and intentions clearly....

Last June (2007), Rodriguez gave a speech that warned of the coming credit crisis so accurately that it reads with hindsight as if he had been peering into a crystal ball.
Taking his own warnings to heart, Rodriguez raised cash to levels high enough to withstand a nuclear war: 43% in FPA Capital and roughly 66% in New Income. In December he declared a formal moratorium on buying any stocks or high-yield bonds until he felt it was safe to invest again - essentially putting both portfolios into a state of suspended animation. As of press time he has not lifted that moratorium.

Sorry but the above is almost impossible to understand: his cash levels were high enough "to withstand nuclear war" yet his fund lost 34.8% in 2008. Doing a little back of the envelope calculation and assuming the cash position as having zero retun that would mean that his stock holdings in 65% of his portfolio would have to have lost 53.5% !....

and despite his anticipating the financial crisis and "nuclear proofing" his portfolio by his own assessment his performance in 2008 was terrible (at least in the second round of public retrospection).

Bottom line:

Even "great active managers" have difficulty timing the market

Active managers often hold portfolios far different than the category assigned to the fund or the strategy described in fund literature.
Fund managers often take big risks by holding heavily concentrated portfolios (by industry or individual stock)...this "star manager" advocates this as the best future investing strategy for active fund managers. His logic: in order to outperform indices. In Rodrigues' words:
in the new world of lower returns, diversified mutual funds may struggle to beat their averages and benchmarks. "A more-focused strategy will be necessary to excel," he said.

Well the above is really a tautology: in order to beat their averages significantly a manager will have to hold a concentrated portfolio than the index. Of course that is true and of course if the manager is wrong he will significantly underperform the index. And from Finance 101 we know that the more concentrated portfolio the riskier the portfolio. So Rodrigues prescription for the fund manager of the future:
take more risks and assume you will be right. Let the buyer (fund investor) beware.

note the byline: Jason Zweig, now of the WSJ and a frequent advocate of index investing investing. I guess his hope for active managers has faded as well

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