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Tuesday, December 15, 2009

Two More Examples Of Why You Shouldn't Own Actively Managed Mutual Funds

I have written numerous times of the many pitfalls of owning actively managed mutual funds, two recent articles highlighted two major problems with actively managed funds.My comments in blue
my bolds

Style Purity:
  The investor who purchases an actively managed mutual fund does not really know what he owns. The category or "strategy" of the mutual fund may or may not accurately reflect what the fund actually holds. Take for example this recent  WSJ article on equity mutual funds holding gold in their portfolios:

Funds Take a Shine to Gold

Some Managers Fear Inflationary Effect of Stimulus; Others See Fuel for Returns


Mutual funds that seldom indulged in commodities now have a lot riding on gold.

Diversified stock funds have been purchasing actual gold bullion, and also piling into gold exchange-traded funds and stock of gold-mining companies. They've been doing it partly as insurance against a worrisome monetary situation and possible inflation, and partly to goose their returns. 

In the past, some funds dabbled with gold-mining stocks occasionally, but seldom owned bullion, says Bridget Hughes, an analyst with fund tracker Morningstar Inc. The funds are joining a crowd of big-time players, such as hedge-fund operator John Paulson, who have rushed into gold. "They're taking small positions, as protection," Ms. Hughes says of the mutual funds. "This is not a short-term move for them."

Among funds, the most active buyers have been in the large-capitalization growth category, says Financial Research Corp. Since June, these funds boosted exposure to metals and to mining equity, most of that in gold, to an average 3% of their portfolios, from 0.9%. .....

"I didn't own gold before, but when I heard Washington talking about a new economic stimulus, I changed my mind," says Steven Leuthold, head of Leuthold Core Investment fund, which began buying bullion three months ago. Gold now makes up 2% of the $1.4 billion in the wide-ranging fund, whose positions include airline, bank and tech stocks. "This is insurance in case the house burns down."

These fund managers all express varying degrees of unease about what they see as willy-nilly government expansion of the monetary base world-wide to combat the recession. "We're creating money by fiat, and gold is historically the best protection against that," says First Eagle's Mr. Deshpande.

"I don't go home glad that I'm holding gold, and in fact, I hate it," says Stephen Leeb, whose Leeb Focus expanded gold assets from 5.3% last summer to 11.6%. "But the world is in trouble, and that depresses me."

Unlike many diversified managers, Michael Avery, co-manager of the $19 billion Ivy Asset Strategy, isn't new to gold. He pumped up the fund's bullion stake from 10% of assets two years ago to 17% in late 2008, amid the worst of the financial crisis. This year, he sold some to reap profits and is standing pat at 14%........

Why is this a bad thing ? Because one purchases a stock fund as part of the stock allocation of one's portfolio. If that fund is holding commodities such as gold it throws off the asset allocation. Presumably the investor that wanted a commodity/gold allocation would have already done so through an investment vehicle clearly designated as holding gold. Call me old fashioned but I think diversified equity funds should hold equities. Using exchange traded funds and preserving style purity one would hold equity exchange traded funds and a gold exchange traded instrument for the gold allocation.  And label me a skeptic but it makes me a little uneasy to see a fund manager that never before held gold to jump in for the first time three months ago smart move or late to the party ? Of course since these are actively traded funds that only report their portfolios on a quarterly basis, investors will only know that the fund has increased, decreased or even eliminated its gold position after the fact. Which makes it impossible for an investor to carefully monitor and control his asset allocation.

Manager Risk

Many investors purchase actively managed mutual funds in order to get access to a "genius manager" that will generate extraordinary returns. It is well documented that it is difficult if not impossible to identify such managers in advance and that there is little persistence in performance. But the recent upheaval and fund manager TCW illustrates another risk: there is no guarantee that the "star manager" will remain at the helm of the fund you invest in. You may think you are investing with a manager but in fact you are investing with the fund, the manager is ultimately a free agent.

The episode at TCW is not common but neither is it unique and it is certainly part of the inherent risk in owning an actively managed fund. From the WSJ. My comments in blue, my bolds

Trial by Fire for Managers Now Running Fund at TCW


A week ago, Tad Rivelle was managing some $30 billion, mostly in high-quality, broadly diversified bond portfolios. Now, he is also running $65 billion worth of complex mortgage securities and other bonds left behind by an ousted star bond manager.

Mr. Rivelle is one of the founders of Metropolitan West Asset Management LLC, which agreed Friday to be acquired by TCW Group Inc. The same day the deal was reached, TCW booted its investment chief, Jeffrey Gundlach, who had piled up outsize returns in recent years by buying beaten-down mortgage securities. Much of Mr. Gundlach's team followed him out the door. The result was that Mr. Rivelle and his 30-person investment team had to manage TCW bond portfolios, starting immediately.

Such abrupt transition of investment responsibility is rare in the history of asset-management deals. The MetWest team needed to swiftly convince investors that it could fill the shoes of Mr. Gundlach, nominated recently as bond-fund manager of the decade by investment-research firm Morningstar Inc.

Arriving at TCW just hours after the announcement, Mr. Rivelle knew the integration had to begin at break-neck speed.

"Anything can happen in a situation like this," says Eric Jacobson, director of fixed-income research at Morningstar. "There's plenty of room to screw things up."

Friday night, MetWest mortgage specialists Mitch Flack and Bryan Whalen started diving into the portfolios managed by Mr. Gundlach. Though MetWest runs $18 billion worth of mortgage portfolios, it is known more as a generalist bond manager, whereas Mr. Gundlach was intensely focused on the niche. The MetWest team worked through the weekend to familiarize themselves with all the holdings. "Bryan and Mitch are the two most bleary-eyed individuals," Mr. Rivelle says.

At 5.a.m. Monday, Mr. Rivelle arrived at the TCW offices. Redemptions started rolling in. Investors yanked more than $1 billion that day from the roughly $12 billion TCW Total Return Bond Fund. On Tuesday, managers had to sell about $450 million worth of nonagency mortgage-backed securities to meet redemptions. Depending on market conditions from day to day, such securities can be extremely tough to trade. Mr. Rivelle says the bonds traded well, selling at or near where they had been valued on TCW's books. Managers also reduced cash and agency mortgages held in the fund to keep the asset allocation similar to the way Mr. Gundlach had left it....

Mr. Rivelle rejects the notion any bond manager has a secret formula that can't be replicated. Bond selection "doesn't rely upon some supercomputer or massive brain," he says. Which leads me to the conclusion one is better off indexing,

MetWest's and TCW's flagship mutual funds have some similarities but also some big differences. Managers of both portfolios saw great value in nonagency mortgage-backed securities last year and now devote roughly one-third of assets to these holdings. But Metropolitan West Total Return Bond Fund is a broad mix of corporate debt, mortgages, government securities and other holdings, while the TCW Total Return Bond Fund is almost entirely in mortgages. And the TCW fund had more than 30% of fixed-income holdings in bonds rated "single-B" or lower as of Sept. 30, according to Morningstar, while the MetWest fund had only higher-quality bonds.

Mr. Rivelle says he may tweak the mix of holdings Mr. Gundlach left behind. "There are ways to upgrade the portfolio, and we're studying those," Mr. Rivelle says. "There are securities that we think are weaker levels of 'Alt-A,' " he says, referring to a category of riskier mortgages.

The managers would be wise to shift to more easily traded holdings, since they may be hit with more sizable redemptions, says Morningstar's Mr. Jacobson. If Mr. Gundlach resurfaces at a new firm, they should expect "another wave of selling" as some clients follow the ousted manager, he says.

"We're not simply being reactive," Mr. Rivelle says. "We want to ensure there's an ample measure of liquidity" to meet redemptions.

By December 11 TCW reported redemptions of 30% of the funds assets.

What are the consequences of all this unanticipated events at TCW Total Return Bond Fund for Investors:

  1. One's assets are no longer managed by a "top manager" with expertise in lower quality complex mortgage securities the current manager has limited expertise in this area.
  2. It is unclear whether the fund's new manager will pursue the same strategy as the previous manager thus making it difficult to monitor one's fixed income allocation.
  3. The fund has had to liquidate large parts of its portfolio due to redemptions it is unclear how that has changed the risk and prospective return characteristics of the portfolio. It is also highly possible that these sales can generate taxable gains for investors.
  4. Since there is a high likelihood of further redemptions, the fund must hold larger than customary levels of cash and liquid securities. Such securities generally have lower yields than the instruments held in the long term holdings of the fund.
Needless to say none of these problems would have occurred with exchange traded bond funds.

Food for thought:

the one year return for the TCW total return fund is 21.84%. The LQD high grade corporate bond etf has a return of 17.74%, the high yield bond fund HYG 50.69%.

So a mix if 85% high grade corporate bond and 15% high yield would have generated higher return at lower cost, full transparency and none of the headaches associated with "manager risk"

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