Managing A Crisis

Author: Eric Uhlfelder

11 November 2008, Financial Times Fund Management

Effectively communicating with investors during this market meltdown is as critical as portfolio management for retaining assets. But how managers approach the matter varies significantly across the industry, observes Eric Uhlfelder.

The Brandywine Fund, once renowned for it’s stock picking prowess, has slid more than 41 percent during the first ten months of the year, and now trades at a price not seen since the end of 2005. Fidelity’s Magellan, which had regained much of its lost luster over the last four years, has tanked nearly 46 percent, bringing it back to spring 2005 levels. And Legg Mason’s once venerated fund manager Bill Miller has seen his Value Trust lose more than half of its value. The last time it was trading at its current price was more than five years ago.

While these are just several of the more stunning losses reported by blue chip US mutual funds, the average US-domiciled equity fund hasn’t done much better. According to fund tracker Morningstar, US diversified equity funds have lost more than 36 percent for the year through October. On the debt side, long-term US bond funds are off nearly 14 percent.

While funds have their hands full trying to figure out a way to pullout of this dive, most are equally mindful of explaining this disaster to their investors. That’s simply not a matter of fiduciary responsibility. If they can’t restrain fundholders from selling off, managers will be forced to lock in losses to raise sufficient capital to payoff departing investors. This will make it even more challenging for them to regain any part of their former altitude when securities start to rally in earnest.

According to Karen Dolan, Morningstar’s director of fund analysis, September witnessed the largest net monthly outflow–$49 billion–the firm has ever since it started tracking such figures in January 2000. And she expects the selloff in October to be even greater.

With much at stake, this raises a tricky issue. Should funds go beyond their quarterly statements, offering more insight into management? Would greater transparency alter a fund’s strategy? Could it lead to reduced risk, especially since this bear market has left no place to hide, save for being in cash?

A sampling of mutual fund correspondences to investors shows funds are trying to explain their losses. Most reiterate belief in their underlying investment strategies and long-term faith in the market.

But two points are not adequately addressed. One is a paradox: managers’ sustained belief in the merits of individual securities whose values are getting decimated by a vicious selloff. Who’s behaving irrationally, the market or the managers? And two, given the disconnect between perception and reality, why are funds not employing greater risk control such as stricter stop-losses or greater use of options [when permitted] to limit declines? These issues fuels fear that if the market breaks down through current support levels, managers may again be caught helplessly watching their funds decline even further.

The most compelling thoughts on client communication comes from a hedge fund manager, James Harmon, a seasoned investor, who operates as far out on the risk plank as one can get–investing in frontier markets. Through the first three-quarters of 2008, Harmon’s Caravel Fund was off 28.9 percent, but topping the MSCI emerging and frontier market index by nearly 6 full percentage points.

“Today’s market presents a rare opportunity to prove yourself to your clients,” says Harmon, who has seen eight bear markets in his lifetime, acknowledging this being the nastiest. In addition to expediting distribution of quarterly performance reports, his team is contacting every one of the fund’s 110 clients to explain what has been happening to the fund and how management is responding to the crisis. Conversations last from 20 minutes to more than an hour. “Doing this is not only the right thing to do when people entrust you with their money,” he explains, “but it cements relationships.”

Since the crisis began, Caravel has lost just four clients. Harmon’s primary strategy, in effect since the beginning of the year, has been to build up cash. Currently over 40 percent of the fund, he expects the figure to be close to 50 percent by year’s end because he doesn’t feel the selloff is over. Accordingly, he has temporarily closed his fund.

In its typical candid fashion, the $2.7 billion Brandywine Fund, managed by William D’Alonzo, reported that “the September-quarter environment was bad, and our performance in it was worse…We are keenly aware that you expect and deserve better from us.” D’Alonzo reviewed investments that led to underperformance, but reiterates the firm’s commitment to its long-held strategy: visible, above-average earnings growth, modest price-to-earnings ratios, and solid balance sheets.

It’s curious when he says that current conditions “don’t present an unusual challenge for our investment strategy.” The fund’s ostensibly sound approach has already proved itself more vulnerable than the broad market, underperforming the S&P 500 by 860 basis points for the year through October. If pricing has only temporarily decoupled from stock fundamentals, his holdings could payoff. But one is left wondering how D’Alonzo will avoid getting hit if we are witnessing a secular degrading of equity values as a result of deleveraging and credit contraction. To be fair, it’s a question few managers can answer.

A leading bond-fund specialist, Loomis Sayles, was also straight-forward about its underperformance. The firm’s $15 billion flagship bond fund was off by nearly 27 percent for the year through October, a shocking decline for an investment-grade bond fund. In contrast, the Lehman Brothers Aggregate Bond Index was off just 170 basis points.

In a special letter to fundholders, Daniel Fuss and Kathleen Gaffney, co-managers of the fund, both accept and qualify responsibility for the fund’s collapse. They report having sidestepped toxic securitizations in 2007, only to have moved in too early into corporate credit markets. “Unprecedented market conditions, coupled with the timing of that reallocation and some specific security choices, have led to our recent underperformance,” they say.

But then they state that they manage for the long- not the short-term, where ephemeral underperformance will occur. Moreover, they believe that “during times of extreme market dislocation many of the best investment opportunities present themselves.” As an investor, it could be challenging to hear your fund telling you, don’t look back at what you’ve lost, look forward.

Legg Mason’s Bill Miller, who had topped the S&P 500 for 15 consecutive years through 2005, has been floundering ever since. His latest commentary references the likes of Buffett and Templeton, who believe that investors should buy at the point of maximum pessimism. Unfortunately, Miller acknowledges the difficulty of doing so as energy, financials, and homebuilder stocks he has purchased over the year continue to fall. But he tries to impart solace to his clients in his being a long-term optimist.

“Overall the mutual fund industry could be more candid about fund conditions and management,” concludes Laura Lutton, Morningstar’s associate director of mutual fund analysis. She would like to see more specific references to where funds have lost money and whether they intend to sustain, alter, or substantially change strategies to counter deteriorating conditions.

Lutton specifically targets large fund families, such as Fidelity, InvescoAim, and MFS, for sticking with plain vanilla descriptions when more fund-specific commentary is called for. She is finding, however, that some smaller funds, such as Oakmark, First Pacific Advisors, and Brandywine, are writing letters and special reports that go beyond regulatory requirements.

Whether this helps mitigate asset flight is uncertain. In this kind of relentless sell-off, with fund mandates that limit cash positions, many managers are in an impossible situation. But informing investors more like partners would seem to be an essential tack for funds to retain clients, especially as this nightmare plays out.


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