It’s harder than ever to run a truly actively managed fund. Here’s how four firms execute unique – and successful – strategies. “We want to know that there’s intellectual thought, that there’s a process for buying companies, as well as for selling them”


Earning Their Keep


It’s harder than ever to run a truly actively managed fund. Here’s how four firms execute unique — and successful — strategies.

It’s not easy being an active fund manager these days. Market information that was once available to a privileged few now flows freely and quickly. Index funds and exchange-traded funds, meanwhile, make it possible to implement simple or sophisticated strategies cheaply and effectively.

And then there’s performance.

Last year, 66% of domestic equity managers underperformed relative to the Standard & Poor’s 1500 index, according to the S&P Dow Jones Indices SPIVA Scorecard. That’s a considerable improvement over 2011, when 84% of active managers lagged the benchmark, but it’s hardly vindication for stock-picking. Even managers dealing in the supposedly inefficient international markets have struggled to get an edge. Last year, just 56% of international funds and 54% of emerging-market funds managed to deliver that elusive, market-beating “alpha” they’re paid for. There have been consequences: Over the past five years, nearly 27% of actively managed domestic equity funds and 23% of international equity funds have merged or liquidated.

So what’s an active manager to do? Some end up as “closet indexers,” who charge too much for hugging the index. In 2011, only 11% of assets invested in actively managed large-company funds were in portfolios that deviated from their benchmark by more than 80%, according to Martijn Cremers, a Notre Dame professor who helped pioneer “active share,” a measure of how truly active an active manager is. However, “skilled managers are out there,” says Charlie Ruffel, managing partner at Kudu Advisors, a strategic advisory firm for asset managers. “The challenge is in identifying them.”

The standout managers tend to have standout firms behind them, equipping them with the research teams, technology, financial backing, and supportive culture needed to go above and beyond. Some favor more concentrated approaches, investing in a small number of their very best ideas. Others take pains to investigate or even involve themselves with the management of the companies they invest in. Some take creative approaches to data-crunching, creating new perspectives on the market, while others simply thrive in a culture of constantly questioning and defending their stock-picking and portfolio moves. “Up until five years ago, managers didn’t need to try so hard to stand out,” adds Ruffel. “We’re in a different place.” Experts, such as financial advisors and consultants who help institutions choose funds, are constantly evaluating managers, looking for a process that brings consistent outperformance. They’re also looking for lights and mirrors — actions that appear to be in the name of research but don’t add value. Too much activity, they say, can be a warning sign. For instance, a manager who spends a disproportionate amount of time or travel on a position that represents less than 5% of the portfolio “might be cause for concern,” says Jonathan Bergman, a managing director at TAG Associates in New York. In general, however, Bergman and his peers are reassured when they hear that management has gone to great lengths to gain extra insight into a holding. “We want to know that there’s intellectual thought, that there’s a process for buying companies, as well as for selling them,” he says.GRANTED, MOST INDIVIDUAL INVESTORS aren’t privy to fund-manager tales of company visits and retail reconnaissance trips. “Many investors would be hard-pressed to tell you what the expense ratio of their fund is, let alone its strategy,” says Brad Barber, a professor of finance at the University of California, Davis, and an expert in investor behavior. But those who are inclined to learn the nuances of a fund’s investment process can put together a mosaic using fund-company literature and public information.

Tim Courtney, chief investment officer at Exencial Wealth Advisors in Oklahoma City, starts by looking at fees. “The first thing we want to know is, How big a hole do they have to dig themselves out of?” he says. If an active manager charges higher-than-average expense ratios, his long-term returns should be proportionately higher than his peers and his benchmark. Turnover, he says, is also pretty telling, and not just because it has a big impact on trading costs. “If you’re an active manager, you’re saying that assets are mispriced, and it can take a long time for things to get fairly priced,” he adds.

Shareholder letters can be a good proxy for talking with a manager face-to-face. Fund managers should be able to articulate their approach and explain exactly how that translates to recent investment decisions. If the letters are banal, lack conviction, and lack a distinct point of view, you might question whether the same is true of the fund.

Ultimately, fund managers who stand out have cultivated a consistent process that drives consistent results. Barron’s examined four strategies that have proven themselves — alternative approaches to data, exhaustive company visits, “devil’s advocate” debates, and the use of industry specialists — and took a closer look at some managers who exemplify each strategy.

The Number Cruncher

In 2004, Newport Beach, Calif.–based Research Affiliates unveiled a new breed of index, one that isn’t merely weighted by market value, but also by companies’ economic footprints, as measured by factors such as sales, cash flow, dividends, and book value. There is now an estimated $84 billion invested in products based on the RAFI Fundamental Index strategies.

Rob Arnott, the firm’s founder, says he takes great pride in these indexes, but he doesn’t exactly consider himself a passive manager. “I believe that the markets are not entirely efficient, and that active management has a role, but that it usually goes astray,” says Arnott, 58, who also manages the $34 billion Pimco All Asset fund (ticker: PASAX) and $33 billion Pimco All Asset All Authority(PAUAX) funds, which can invest in virtually any asset class and aim to deliver strong after-inflation returns.

Arnott uses data to keep the emotion out of investing — the primary reason active management goes astray. He relies heavily on economic models he’s been following and fine-tuning for more than three decades. “I’ve always believed that using models can help us not fall prey to the most dangerous aspect of investing, which is human emotion,” he says. “In early 2009, when we were ramping up aggressiveness, I was scared, but ultimately the bargains in some asset classes were so impressive that Armageddon was necessary for these asset classes to fail to deliver.”

While vast amounts of data go into this model — it doesn’t have a name, though it probably should — it analyzes historical yields and growth rates of more than 25 different asset classes to estimate forward rates of return. “There are nuances, and that’s the secret sauce,” says Arnott. “But you could take our basic building blocks of yield-plus-growth and capture two-thirds of the value.”

Most investors should be so lucky. In 2008, when the S&P 500 plunged 37%, All Asset Authority was down 7.5% and All Asset was down 16%. Both funds are lagging behind the market this year; chalk it up to Arnott’s stingy allocation to equities, which he thinks have more risk than most people realize. “Today, investors are less worried about downside risk than missing the last nickel in front of a steamroller,” he says. “It’s time to say ‘thank you’ to the market and take some risk off the table.”

His model agrees. “From day to day, the model rarely surprises us,” says Arnott. “It will trim what’s becoming popular and buy what’s falling out of favor.” Arnott and his team occasionally augment the model to adjust for circumstances that — for now, anyway — it doesn’t capture. In early 2003, for example, on the eve of the war in Iraq, “It was evident that war in a resource-rich area of the world would boost commodity prices,” says Arnott. “We said, ‘Whatever the model tells us, we’re going to own 5% to 10% more.’ ” Likewise, between 2006 and 2012, seeing that liability-driven investment strategies — often used by pension plans to match expected returns with their future payouts — would boost demand for long-term government securities, the team added 5% to 10% to the model’s prescription.

Arnott is quick to point out that the model is the product of human hypothesis and inputs. Walk through Research Affiliates, and you’ll encounter people who spend their days focusing on “anything from big picture with no immediate-investment applications, to the intermediate picture with some possible immediate-investment implications,” says Arnott, who works alongside Jason Hsu, the firm’s chief investment officer, and 24 research and investment professionals, nine of whom have Ph.D.s. The vibe is “quasi-academic” with researchers obsessing about everything from understanding the key drivers of inflation to forecasting how declining birth rates will affect the capital markets. “But unlike academia,” says Arnott, “our end goal is to make money for our clients.”

The Globe-Trotter

Laura Geritz can count on two hands the number of days she spent in the office during the first quarter this year. The co-manager of three international funds at Wasatch Advisors in Salt Lake City isn’t exactly a slacker. On the contrary, between last year and her travels so far this year, she has logged more than 167,000 airline miles and visited 24 different countries on five different continents.

In fact, Geritz, 40, and the other eight members of the international team tend to spend most of their time abroad visiting companies, talking fiscal policy with local bankers, wandering the aisles of grocery stores and shopping malls, and chitchatting with hired drivers. “When you spend 10 hours a day in a car with a local driver, you learn a lot about a country,” says Geritz, who co-manages the $1.9 billion Wasatch Emerging Markets Small Cap fund (WAEMX), which is up an average of 14% a year over the past three years and ranks in the top 1% of its emerging-markets category.

Most bottoms-up fund managers will talk up the importance of meeting with company management to get a read on what’s really happening at a company (see “What Fund Managers Don’t Want to See,” at bottom of this article.). In the ultra-inefficient world of tiny companies in emerging markets, it’s the difference between finding hidden gems and getting bamboozled.

The universe of potential ideas is huge, covering thousands of companies. To narrow it down, Geritz and her colleagues divvy the emerging and frontier universe into sectors, and screen for growing companies with high-quality balance sheets. They’ll do what research they can at home, but at some point — particularly with companies not covered by sell-side analysts — they pack their bags. “We screen very diligently, and that determines what companies we visit,” she says. “But getting in the country and knowing the culture is so important.”

Once on the ground, the numbers start to come to life. Sometimes, what appears to be just a decent company based on the numbers reveals itself as a great opportunity. This was the case with India’s division of Castrol India (CSTRL.India), which they picked up in 2009 and continue to own today in two funds. “We didn’t get a sense for just how good the business was until we went to India,” says Geritz.

Of course, the opposite is often true. A couple of years ago, the team visited the sprawling offices of a Chinese financial company that had recently gone public. “But there were only two people there, an [investor relations] person and what looked like an auditor,” she says. “It didn’t feel right.” In other cases, the problems aren’t as immediately apparent. “The more time you can spend with management, the more they will talk,” says Geritz. In another example, she recounts sitting down with managers of a Bangladesh fuel supplier that had done well. Yet, when pressed on its five-year strategy, “they had some crazy ideas,” she says. “I thought it was a ‘buy’ walking in, but walking out, it was a clear pass.”

In fact, the difference between the good and bad companies in most of the areas Geritz covers becomes clear pretty quickly, she says. In that respect, adding value to the process is far easier than with, say, larger domestic stocks. Still, those discoveries are hard-earned. Not only is Geritz on the road for months out of the year, but she packs her days with company meetings and uses her evenings to catch up on all the work she’d be doing if she were in the office.

Geritz is about to leave for a three-week trip to Vietnam, soon followed by a four-country tour in Africa. The job never gets boring. Still, it’s not exactly what one imagines of a globe-trotting financier. Brown water, frequent power outages, and upset stomachs are all hazards of the job. Glamorous? “Come spend a few days with us in a hotel in Zimbabwe and see for yourself,” says Geritz, laughing.

Devil’s Advocate

At many investment firms, tearing apart the ideas of star fund managers is career suicide. At Harris Associates, the Chicago-based value shop that runs the Oakmark funds, it’s not only encouraged (and financially rewarded), but it’s also part of a decades-long tradition called “devil’s advocate.” Throughout the year, the investment team’s 22 analysts volunteer to “DA” (yep, they use it as a verb) the firm’s top holdings or entire sectors by researching and presenting reasons not to own a company or, at the very least, rethink its valuations.

Matt Logan, 29, an analyst and one of Harris’ more enthusiastic devils, says he was pleasantly surprised when he joined the firm seven years ago and soon found himself going head-to-head with the likes of Clyde McGregor, manager of the $18.6 billionOakmark Equity & Income (OAKBX), and Bill Nygren, manager of the $8.6 billionOakmark fund (OAKMX). “They don’t just tolerate people challenging their ideas, they relish it,” says Logan.

The tradition dates back to the late 1980s, when the firm brought in a University of Chicago professor to give a workshop on decision theory and critique the investment team. “He said our big danger was ‘groupthink’ and made suggestions that turned into what is now the devil’s advocate process,” says McGregor, 60, adding that all of the firm’s analysts are generalists by design. “We want people to be comfortable stepping on each other’s toes and willing to challenge the conventional point of view.”

The culture at Oakmark encourages young analysts like Matt Logan, right, to routinely and actively challenge the picks of veteran investors like Clyde McGregor, manager of Oakmark Equity & Income.

When a devil targets a stock, the three-person domestic investment committee (McGregor, Nygren, and Robert Levy) or two-person international committee (David Herro and Rob Taylor) vote on whether to stay the course. Though most holdings stick — the bar is high for getting into the portfolio in the first place — devils routinely persuade managers to take a second look.

That was the case about two years ago when 26-year veteran analyst John Raitt critiqued avionics company Rockwell Collins (COL), which was an Equity & Income holding. He argued that a slower-than-expected recovery and a shift from the higher-margin commercial-aircraft-supply business to military and defense, among other things, warranted a lower earnings multiple. The analyst who had recommended the stock (a.k.a. the angel) made a compelling rebuttal, pointing to the company’s position as a market leader, proven management, and high-margin aftermarket sales. Still, the group decided to monitor the holding closely and ultimately lowered its sell target, which is typically 90 cents on the dollar based on its intrinsic value estimate. McGregor sold the stock in January 2011, when it was near its five-year high of about $67 a share, a decision that proved opportune. The stock plummeted the following summer to $45 a share and has only recently broken $60 again.

All told, looking at the dark side of a holding or sector seems to have served these investors well. Four of the seven Oakmark funds rank in the top 1% or 2% of their respective categories for five-year results, according to Morningstar. McGregor’s Equity & Income fund is the lone laggard over that time frame, with average annual returns of 4.5% a year, putting it smack in the middle of its moderate-allocation category. McGregor attributes these results not to the fund’s equity holdings but to his decidedly defensive stance on the fixed-income side, which is currently parked in short-term government and agency debt. The fund’s 15-year returns, it’s worth noting, average 8.8% a year, better than 99% of its peers.

A few years ago, Harris decided to give the devils an even more prominent role by bringing them in early to poke holes in new investment ideas. Now, when analysts and fund managers present their best ideas at the firm’s weekly stock-selection meeting, they must face their demons.

The Specialists

Eddie Yoon’s parents, a retired radiologist and dentist, were hoping their son would pursue medicine. He started on the pre-med track at Brown University, but switched to finance his junior year. “They said if this career in finance doesn’t work out, medicine can be your backup plan,” says Yoon, 33.

No such luck. After an internship at JPMorgan the summer before his senior year, Yoon was not only hooked on the markets, he had also landed himself a job as an analyst following health care. Today, he heads up the 12-person health-care-sector research team at Fidelity Investments and manages five specialty funds, including the $3 billionFidelity Select Health Care fund (FSPHX), which is up 12.7% annually over the past five years. While Yoon spends plenty of time obsessing about cash-flow estimates and expiring patents, he spends just as much time talking with clinicians, traveling to genome conferences, and reading the fine print of clinical trials. Mom and Dad are proud.

When Yoon moved to Fidelity in 2006, the firm was in the early stages of creating a specialist track for analysts and portfolio managers. Until then, analysts tended to switch sectors every two or three years to bring fresh eyes to the coverage. “Sometimes, analysts can fall in love with management teams, or they do just the opposite and get soured,” says Chris Bartel, the firms’ director of global equity research.

But important institutional knowledge was getting lost in the shuffle, particularly in highly technical areas, such as information technology, chemicals, and biotechnology. Meanwhile, many Wall Street firms were consolidating their research teams and at a time when the pervasiveness of technology and growth in developing markets called for more specialized knowledge.

As a remedy, Fidelity introduced a “career analyst” track whereby specialists like Yoon could stay put. Fidelity’s huge research staff — about 130 analysts strong — still has roving analysts who bring new perspectives to their areas of coverage, but every broad sector is anchored by one or more analysts who know their industries inside and out. “One of my fundamental beliefs is if you do better research, you can find meaningful insights that you can capitalize on,” says Yoon, who aims to keep volatility low in the Select Health Care fund by investing a large chunk of the fund’s assets in companies that can grow earnings regardless of the economic backdrop.

One such insight came out of his fascination with genome-sequencing. “One of the first stocks I pitched at Fidelity was Illumina [ILMN],” says Yoon, who is a regular at the Advances in Genome Biology and Technology meeting. Fidelity began investing in the company, which makes tools for sequencing, in 2006, when it was trading in the teens. Yoon was a fan for years but began reducing his position in early 2011 when the stock tipped past $70. “At the end of the day, I’m an investor,” says Yoon of the importance of not getting too enamored by scientific discovery.

Yoon supplements his own in-depth research in life sciences and health-care equipment with expertise from his fellow specialists. If he wants to know the nuances of the Affordable Care Act, he turns to Steve Bullock, who manages the Fidelity Select Medical Delivery fund (FSHCX) and is well versed in Washington. When it comes to medical advances in emerging markets, he confers with international analyst Jeff Stevens. For insight into biotechnology, he turns to analyst Eirene Kontopoulos, a Harvard Medical School Ph.D. in neuroscience, and industry veteran Rajiv Kaul.

When Kaul arrived at Fidelity in 1996, biotechnology was still a relatively new area where there was opportunity for “neophytes” like him. Kaul took particular interest and managed to stay put. “Biotech is an industry that most people are afraid of,” he says, and understandably, since “most drugs that go into clinical trials fail.” Since taking over the $4.2 billion Fidelity Select Biotechnology fund (FBIOX) in 2005, Kaul has managed to avoid most of the big failures. The fund is up an average of 17.6% a year over the past five years, better than 95% of its health-care-sector peers and more than twice that of the Standard & Poor’s 500.

Indeed, biotechnology — and health care in general — is an area where the gap between the haves and have-nots is particularly extreme, says Yoon. Over the long term, investors might do well riding the coattails of a passive fund, but with careful research, he says, “you can own the biggest winners and avoid the biggest losers.”

What Fund Managers Don’t Want to See

Investors who take a bottoms-up approach often talk about the importance of meeting with executives and seeing company headquarters and facilities for themselves. “We want to find good management, and you can’t tell that from a glossy annual report,” says Richard Cook, manager of the Cook & Bynum fund (ticker: COBYX). “You have to find ways to get a window into their world.”

What are they looking for? In a nutshell: professional, but not ostentatious, companies run by down-to-earth executives who know their businesses and are respected by their employees. Now, here’s what they don’t want to see.

Fancy cars and vanity plates: “What kind of car the CEO drives is a great indicator of their approach to life and management,” says Brian Frank, manager of the Frank Value fund (FRNKX). Ditto goes for over-the-top corporate headquarters — complete with expensive art, lush gardens, and koi ponds — as well as executives wearing bling-bling watches, rings, and cuff links.

Pictures with famous people: “It’s a declaration of victory, which we don’t like to see as investors,” says Mitch Rubin, manager of the RiverPark Large Growth fund (RPXFX). He’d rather see family photos or pictures from company events than snapshots of the CEO with professional athletes and celebrities.

Ping-pong tables and other gimmicks: Having worked as a software engineer before moving into investing, Kim Forrest, an analyst with the Fort Pitt Capital Total Return fund (FPCGX), understands what drives engineers and other creators — and it’s not chair massagers or 24-hour frozen-yogurt bars. “That’s just gilding the lily,” she says.

Charitable causes that don’t add up: Investors are all for corporate giving if it aligns with the company mission and enhances the brand, but box seats at the symphony for the C-suite or big gifts to the top dog’s favorite cause “is giving away shareholder money,” says Cook.

Long-distance leaders: “The management team is the body and soul of the company,” says Rubin, who bristles when he hears about a CEO who doesn’t live in the same city or state as the company headquarters. “If they set themselves apart, have different rules and different offices, it speaks of someone who is more about self-aggrandizement than the success of the business.”

Clueless CEOs: Keith Trauner, co-manager of the GoodHaven fund (GOODX), recalls a company meeting where he asked the CEO to talk about his four largest customers. “He deferred to the CFO,” says Trauner, who, needless to say, wasn’t impressed.

Too much talk about the stock: John Buckingham, CIO of AFAM Capital, jokes that when companies come calling, it’s time to sell the stock. “Frankly, we’d rather the managers ran the business than run around the country promoting the stock,” he says. Regardless of where fund managers meet executives, “anything that sounds like they’re selling their stock makes us suspicious,” says Cook. “We much prefer management to be focused on their customer and let us figure out if their stock is cheap.”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (, the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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