For example, the typical mutual fund turns over its entire portfolio at least once per year and owns 160 stocks. These are two things that often lead to mediocrity: Too much trading and too many stocks. (Nowadays, investors even flip the funds. Forty years ago, the average holding period was 14 years. Now, people flip funds every few years.)

All that churning fattens the brokers of the funds. And the funds often have unseemly arrangements to direct commissions to brokers who help market the funds. Owning all those stocks also means the fund managers often know little about what they own.

No individual stock matters much, nor does any single issue make much of a difference, so why bother looking at any of them in detail? It is little wonder the typical mutual fund puts in such an indifferent result.

But there is much more…

I’ve written about this topic broadly before, but a new book by Louis Lowenstein (The Investor’s Dilemma) really hammers these points home — along with some new ones. This is a book that will make your blood boil. You shouldn’t buy another mutual fund until you’ve given the ideas in this book some thought. I’m going to highlight the most important ideas for you in this section, and we’ll also look at some things you should look for in a mutual fund.

To begin, the individual investor is in quite a pickle. Lacking the necessary time, interest or aptitude for investing in stocks, he or she often looks, naturally, to professionals. Usually, this means tucking some money into a mutual fund.

But where to begin? The number of mutual funds out there grows like kudzu. There were 300 in 1980. There are over 4,800 today. Fidelity alone has over 300 funds, in 24 different flavors. You’ve no doubt seen the absurd slicing and dicing of mutual funds — mid-cap growth, small-cap value, large-cap blend, etc., etc. These are pointless distinctions. An investor should go where the value is — no matter where it is or what it’s called.

These mutual funds are huge forces in the market these days. They own one out of every four shares of stock out there. It was only 8% as recently as 1990.

The reason there are so many — and why they are so large — is because running money is extremely profitable. A lot of brainpower goes into figuring out how to get your money in a fund.

As becomes clear by reading Lowenstein’s book that most fund companies have little interest in how well investors actually do in their funds. Instead, mutual fund companies are most interested in growing the amount of assets they manage. This is how they get paid.

Lowenstein runs through the example of T. Rowe Price, which is generally held as one of the better fund houses. T. Rowe earns a net profit of 28% after taxes.

“It’s difficult to think of many legal businesses with comparable returns,” Lowenstein writes.

Now it becomes clear why Fidelity has over 300 funds. “Fidelity is a marketing construct,” Lowenstein writes, “not something fashioned to enhance the welfare of investors.” Lowenstein also points out that mutual fund groups spend more on marketing than they do running the funds.

Best Place to Be — Managing Funds, Not Investing in Them

So it’s not hard to understand why the management companies make all the money. Instead of investing in T. Rowe funds, you’d have done better investing in T. Rowe itself. Paul Samuelson, the famed economist, had a pithy quote on this: “There was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it.”

This is something the insiders understand well. Lowenstein goes through many examples. Brian Rogers, chief investment officer of T. Rowe, is one. Has only $1 million in T. Rowe’s funds. By contrast, he has $65 million in the management company. Again, he is not alone, nor is this at all atypical. Lowenstein has many more examples.

In the old days, there was no management company. The mutual fund was a true trust. The first open-end mutual fund to arrive on the scene opened its doors in Boston in 1924. A securities salesman named Edward Leffler hatched the idea, which Lowenstein calls “a uniquely American contribution to finance.” The Massachusetts Investors Trust (MIT) was the first of its kind anywhere in the world.

MIT held stocks for a long time, bought stock intelligently and had extremely low costs. There was no management company and no incentive to bilk shareholders. Today, investors accept 1% management fees as reasonable, even if assessed on billions of dollars of assets. This despite the fact that cost of managing money does not rise anywhere near proportionally with the funds invested. Fees should go down as funds get larger, although this almost never happens.

Over many years, the old MIT standard died out. The new way of doing things meant setting up a separate management company. Now fees suddenly skyrocketed.

In any case, the mutual fund industry is a mess today, filled with people just looking to keep pace with some benchmark. Are real estate stocks too high? Doesn’t matter if you’re running a real estate fund. You buy real estate stocks. All you gotta do is beat your benchmark. Even if it goes down 25% and you go down 20% — that’s success in today’s world.

It’s a sorry state of affairs. One fund describes in its shareholder letter a “fundamental…bottoms-up investment process” in a year when the fund turned over 305%. Again, this is not an outlier or hard-to-find example.

All this flipping means the old art of security analysis is dying. Few look through filings anymore. Nowadays, there is too much focus on what the price is doing. There is not enough on how the underlying business is doing. And there is this fetish about liquidity — the ability to buy and sell easily. Suffice it to say that if selling stock were more akin to the process of selling a house, investors would pay more attention to the details of what they were buying. I always think of Peter Lynch’s great quote:

“Investing without research is like playing stud poker and never looking at the cards.”

Too many funds invest without looking at the cards. But again, why bother when you own hundreds of stocks?

Tips for Finding Good Funds

There are exceptions, though. There are some good mutual funds. Here are some helpful points to help you find them:

• Look for a small portfolio. The exact number is hard to say. Robert Rodriguez, a great fund manager, says 30-40. Joel Greenblatt says 32 stocks take out 96% of the risk of owning one. There is no right number, I imagine, just as there is no “right” amount of tequila in a margarita, but it probably lies somewhere in that range.
  
• Look at the turnover rate. You can find this info with the performance data. A low turnover rate would be something like 25% or less. That implies a holding period of four years.
  
• The fund should not be too large. The American Funds’ Growth Fund of America has $190 billion — way too large to meaningfully invest in anything but the biggest companies. “The damage that size does to performance is the dirty little secret of the fund management business,” says Jeremy Grantham. As a rule of thumb, I’d say less than $20 billion. Rodriguez capped his fund when it approached $2 billion. Again, the right number is hard to say, but it’s somewhere in that range.
  
• The intangibles are also important. Good fund managers often write good letters to shareholders, explaining their philosophy, talking about successes and failures. If you see boiler plate-type language, that’s not a good sign. Again, managers matter.

“True safety lies in a research-driven search for opportunities,” Lowenstein concludes. I couldn’t agree more. He points out how money management is often a “soulless business” in which people “don’t really enjoy the challenge of searching here and there, far and wide, for the values that have escaped the crowd.”

There are exceptions. “However, there are a few who not only take the challenge, but find a sense of self in doing the best they can for clients.”

The vast majority of my money is in stocks. I currently own only two mutual funds: the Fairholme Fund, run by Bruce Berkowitz, and the Third Avenue Value Fund, run by Marty Whitman. There are other good ones — Lowenstein talks about some in his book, and I have a list in my book Invest Like a Dealmaker. Some to consider in addition to Fairholme and Third Avenue are CGM Focus, Longleaf, First Eagle and FPA.

Otherwise, better to put together your own mutual fund, using resources like you’ll find here to help your decision-making.

Sincerely,
Chris Mayer
August 8, 2008

Cautiously Invest in Mutual Funds was originally featured in the Penny Sleuth.

It’s like any other brokerage firm, but it’s analysts cover stocks as ideas primarily for institutions, mutual funds and hedge funds — the buy side.

The buy side guys are the managers who are pulling triggers on large share positions each and every day. Traditionally, the buy side has its own analysts, but the workload is usually too great for them to cover all of the stocks they need to, so fund managers utilize sell-side analysts to come up with additional, fresh investment ideas. If a manager likes what a particular sell-side analyst provides him, he repays him by directing a certain amount of trades through that analyst’s trading desk. Frequently, trading desks make only pennies per share on institutional trades, but in sizable volume it can be a lucrative business.

That’s where the aversion to small-caps comes in.

If sell-side firms make a sizable portion of their money based on how many shares they trade, a small-cap stock trading 30,000 shares a day won’t be too attractive to them. They won’t want their analysts to waste time covering it…unless there is a lucrative banking deal attached to it…at which point you might question that analyst’s objectivity.

Let’s look at a sample of small-cap stocks and large caps:

The list of small-caps at the top has companies with market caps of around $250 million. Only one trades more than a million shares a day, but most of them trade less than 100,000 shares daily. The list of large-caps includes the largest companies traded on U.S. exchanges. The market caps of theses companies are in the hundreds of billions of dollars, and average trading volumes are many millions of shares a day.

As you can see, more sell-side analysts are covering the bigger names. The large-caps have more transactional value and greater banking needs. In short, there’s more money to make off of them than the minnows.

But how much value can one analyst in a sea of 34 others add about Microsoft? How much additional insight can be gleaned about Wal-Mart with 22 analysts already scrapping over every bit of information? How much time can any of the large-cap CFOs devote to speaking to any of these analysts? The answer to all of these questions is: Not much.

That’s one of the main reasons why I love small-caps.

There are a lot of truly undiscovered, or under-discovered gems, in this space. There are lots of opportunities for us to add value through our research. There is also the tendency for small-caps to outperform large-caps over long periods of time.

But forget about history for a moment.

Let’s just look back year-to-date at the top performing stocks so far in 2006:

Of the top ten performing stocks so far this year, nine of them are small-caps. On top of that, half of them have no sell-side analyst coverage!

So, when you see little or no analyst coverage on a small-cap you really like, don’t be scared away necessarily. It just could be the best opportunity around.

Until next time,
Craig Walters
November 2, 2006

Unnoticed Small-Cap Stocks was originally featured in the Penny Sleuth.

Hello again, Sleuths,

If you have been a devoted reader of my Technical Tuesday columns in Penny Sleuth, you know that my outlook for stocks in 2006 is — to put it mildly — bearish. If 2006 turns out to be a down year for equities, it will be more of a challenge to extract money from the market.

So the question becomes: how do you actually make money in a rocky market environment? One way is to subscribe to one or more of our newsletters we publish here at Agora Financial. We’ve got a diverse team of accomplished financial editors who regularly uncover special situations that can make you money in any market climate.

Another way to pull out profits from a struggling market is to find the sector or sectors that are able to buck the trend. In fact, you may recall that I devoted two columns last December to point out the profit potential just waiting to be plucked in the gold and precious metals markets. Boy, did that turn out to be an understatement!

Downside of the Market: Looking for Golden Opportunities… Besides Gold

I hope you took advantage of that information to pad your trading or investment account. Needless to say, gold stocks exceeded my expectations and put a ton of money in the pockets of astute traders and investors in a hurry. Or maybe a more accurate way to put it is that the gold sector reached the 2006 goals I laid out for it in a little over a month.

Gold has pulled back quite a bit from its lofty heights of two weeks ago. But I think there are still more profits to be had in this shiny corner of the market. So, Sleuthers, I suggest you continue to keep an eye on it.

But there is another way to make money in a down market. Remember the old saying, “The trend is your friend”? While it’s gratifying — and profitable — to buck the trend by ferreting out the few sectors able to soar in a down market, it’s actually easier to put your money in a sector that’s traveling in tandem with most other equities. And if I’m right about 2006, that trend will be pointing south.

What I’m getting at is that there is still another way to score gains while the market is taking a header. Why not take a walk on the short side and trade or invest in areas of the market where prospects appear poor and where equities are likely to suffer alongside the market averages?

Doesn’t it make sense — if the market proves to be as weak as I think it may be — to locate an anemic corner of the investment world and implement a trading or investing strategy that seeks to profit from continued weakness in that sector? It’s not as conventional an approach for most people as buying stocks. But it can be just as lucrative.

How can you attempt to profit from trading or investing on the short side of the market? There are several ways you can do it.

Downside of the Market: Short Funds

First, you don’t even need to look at specific market sectors. You can simply invest your money on the overall downside of the market. There are a number of ways to do this.

You can short an exchange-traded fund (ETF) that acts as a proxy for a broad or well-known market index. There are several of these ETFs that have been created to mimic the return of different broad-based market indexes. Three of the better-known market-based ETFs are the SPDRs (SPY:AMEX), which tracks the S&P 500; the Nasdaq 100 Trust Shares (QQQQ:NASDAQ), which follows the Nasdaq 100; and the DIAMONDS Trust, Series 1 (DIA:AMEX), which mirrors the return of the Dow Jones Industrials. But there are others as well.

If you are not comfortable — or are unfamiliar — with the concept of shorting, you can buy put options on a major index or broad-based ETF. There are two advantages of purchasing a put option. First, unlike shorting a security, your risk of loss when purchasing an option is limited to the amount of your investment. Second, you have the opportunity to earn outsized profits from relatively modest market moves through the concept of leverage.

But options aren’t for everyone. So there is another way you can capitalize on negative market moves. And it’s more conservative — and simpler — than either of the two alternatives I just mentioned. You can invest in a mutual fund.

Now, what’s different about this type of mutual fund from others you may have purchased is that it seeks to profit by a decline in the market. There are a number of mutual fund companies that offer funds that are inversely correlated to a specific market index. In other words, if you think a particular market average is going to decline, you can invest in a mutual fund that is inversely correlated to that index. If your assessment is correct and the index drops, your mutual fund should correspondingly increase in value.

Some mutual fund companies even offer funds that are leveraged so you can reap magnified rewards from market moves in your favor. For example, certain funds enable you to earn 1.5% or 2% for every percentage point decline in the market index you have a bearish outlook on. Just keep in mind that if you invest in one of these leveraged market-indexed mutual funds, not only is your potential for gains heightened, but so is your risk of loss.

Now, if you want to really get in gear with the market trend and attempt to profit from a correct negative market forecast — and stack the odds of success more firmly in your favor — you could bet on the downside of a particular sector or industry. I find this approach to be a particularly attractive one. I say that because it’s my philosophy that the best way to make money in equities is to buy the strong stocks and short the weak ones.

Downside of the Market: ETFs

The approaches you could employ to exploit the perceived weakness of a certain market sector are similar to those I just described for capitalizing on a general market move south — with the exception of investing in bearish mutual funds. There are a host of ETFs tailored to specific market sectors that you could elect to short. You can also buy puts on several of those ETFs. Or you can target a handful of stocks within a market sector to either short or to buy puts on.

Whichever approach you choose, you will likely be rewarded if your bearish assessment of a particular sector proves to be accurate. And if you act on that forecast while overall market conditions are also poor — you will have further increased your chances of success.

So what sector looks ripe for a fall if the overall market should take a powder in 2006? Ah, dear Sleuths, for the answer to that question you will have to read my next column in two weeks. At that time, I’ll take the technical temperature of one corner of the equities world whose prospects over the next several months appear dim. Until then, if the market seas do turn rough and you are wondering how to turn a profit — you may want to consider taking a walk on the short side.

Trade well,

Mark Bail
February 14, 2006

Downside of the Market: Take a Walk on the Short Side was originally featured in the Penny Sleuth.