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Group Think

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When a space shuttle is launched, it takes hundreds of people to make it happen. You’ve got one group focused on flight speed, another watching the electrical systems, a third monitoring the astronauts’ health–and those are just a few of the people on the ground. Throw in some physicists, and a chemist or two, and you’ve got yourself a full army of folks with their own opinions, expectations, and skills all working toward the same goal.

But does having so many people focusing on one outcome cause more chaos than calm? In some situations,yes. That’s why the majority of the mutual funds out there have only one or two fund managers running the show. They make the final investment decisions, they determine when and where the next check will be invested, and if they’re correct in their theories, the investor makes money.

Consider, however, having not one or two fund managers, but almost 40. Meet Exeter Pro-Blend Conservative Term/A (EXDAX), one of several funds Rochester, New York-based Manning and Napier Advisors, Inc. has to offer. As the most conservative of four Pro-Blend life cycle funds, EXDAX is run by a group of research groups. This approach, as strange as it may sound, works well, and has since the fund’s inception in 1995.

Standard & Poor’s awards the fund five stars, while Morningstar gives it four. For the five-year period ended July 31, 2003, the fund had an average annualized total return of 6.4%, versus a total return of -1.1% for the S&P 500, and a total return of 1.6% for all balanced large-cap funds. Pro-Blend Conservative ranked 9th within the entire universe of 461 funds in this peer group.

To better explain this unusual hierarchy of research and investing, we spoke with Jeffrey Coons, a member of the fund’s investment policy group and co-director of research at Manning and Napier.

You’re a member of the fund’s investment policy group, but who is responsible for what in managing the fund? We have a very team-based process on the investment side that is driven by specific investment strategies. Our analysts–27 stock pickers–and 12 economists drive the day-to-day decisions. The management team of senior people is responsible for maintaining this process, making sure that it is operating well, and monitoring risk in the portfolio to ensure that we are in line with what we are trying to do from an objective standpoint.

The process starts with our investment policy group, which comprises about a half a dozen people who are each responsible for different research areas inside the firm.

Part of that group represents global investment strategies. They are responsible for macro-economic forces, trends, interest rates, markets, and currencies on a global basis. Then you have the fixed-income research area that focuses on interest rate trends, trends in the U.S. economy, and the yield curve. Then you have the quantitative strategies group, which is my group. We are responsible for some of the statistical work that is done in screening companies and opportunities, looking at sectors, looking at the overall market and its attractiveness.

So my group is half of that investment policy group and we bring in the top-down influence to help analysts understand what the macro-economic forces are, what the trends are, and also to help them understand where they should be fishing. Basically we are a bottom-up shop, which means our analysts drive most of the investment decisions, but we can help them better understand where those micro-opportunities are given the macro-economic forces.

Who has the final say? That is done on a stock-by-stock basis by our analysts. Most funds will have a portfolio manager that will interpose their view of what is going on in the world onto the types of stocks that are coming into the portfolio. We [instead] give guidance to our analysts and then monitor for quality control to make sure that the stocks going into the portfolio fit with what we do and who we are. Ultimately those 27 analysts are the ones looking for equity opportunities.

So that really gives your analysts a lot of power in picking the portfolio? Our view is that at some level the portfolio managers get in between the people who really understand the investments in the portfolio, so by sticking to the analysts we will be closer to the investment opportunity and not have an extra filter in there. For quality control, every stock that is brought into the portfolio will have two analysts that responsible for it. We have the primary analyst who makes the recommendation and the reviewing analyst whose [input] will also be attached to that stock, either positive or negative.

We always want to have someone on hand who understands what is going on with each of our companies.

What are you specifically responsible for? I do quantitative analysis of the markets and the economy.

Our bottom-up groups are divided into sectors on a global basis. We have one group that focuses on consumer related stocks globally, another group that looks at capital goods and materials globally, a group that does technology, one does sciences, and then a fifth group does services, including financial stocks or transportation or utilities. By dividing the world up into sectors but having the sectors covered on a global basis, we now have analysts evaluating entire industries to find opportunities that fit our strategies.

You’ll notice our portfolio is a global one, with U.S. and foreign stocks, and small and large companies.

Do you ever have a problem with too many people working on one fund? Everyone has such specific responsibilities, an industry that they are covering, or they are responsible for some element of our macro-economic view. It is a very flat but disciplined process.

In general, how would you characterize this fund? As a core government bond fund? We consider this to be the most conservative of our four life cycle funds. The funds are conservative term; moderate, which is slightly more aggressive; extended term; and then maximum term. In each of these funds you’ll find the same basic equity portfolio but with different asset allocation ranges, depending on the risk/return tradeoff appropriate for that client. Each fund goes through the same equity process, and the same research team works on all of them. When we make a recommendation for a stock, we will have different position sizes depending on the risk level appropriate for that fund.

Does this fund’s performance correlate well with the general bond indexes? The conservative term fund has a significant allocation to U.S. Treasury bonds so there is a correlation there. But you also have to understand that we range from about 5% to 30% in stocks, and that ends up being another source of diversification that will make it less correlated to some of the bond funds. It is very much a conservative asset allocation fund.

What do you look for in U.S. equities before you invest in them? Currently you have your highest exposure in health care and consumer discretionaries. What is it about those two sectors that appeal to you? Since April we have fallen off a little from consumer discretionaries as the market rallied in the second quarter, though health care still remains a big part of the portfolio.

We have three different strategies that we use to pick companies. The first is what we call our “strong profile strategy.” Here we are looking for growth companies that have a competitive advantage, allowing them to maintain high profit margins and growth despite competition. Health care stocks are a great example of that. We are in a tough point in the product cycle for some pharmaceutical companies. But when you think about the nature of the business, they have strong competitive advantages because of their research and development. Health care offers 10% to 15% revenue growth and you can’t find many sectors that have this type of intrinsic growth.

So we search for companies that are well positioned with product cycles that should be hitting in late 2004 or early 2005, and when the rest of the market is not willing to pay for those growth opportunities, we can find them at value prices.

The second strategy is what we call “hurdle rate.” That is the way we invest in cyclical industries like material or energy stocks. We are looking for are industries that are not earning very high returns on capital. When those industries start earning high returns, you find people starting to close plants, getting out of the business, bankruptcies occurring. That’s usually when the strongest companies in the industry are gaining market share and eating up the weaker competitors. Eventually supply and demand will come back into balance and returns to the industry will improve and the strong competitors will be survivors when they come out of that cycle. Then when we sell that company, the returns are high enough for people to start building again in the industry.

The third strategy is “bankable deal,” which is a typical value strategy. What we look for are companies that are trading at about 50 cents on the dollar in terms of their asset value or the value of their cash flow. Typically, if a company isn’t being managed very well, or if the markets don’t appreciate the cash that a company can generate, stocks can trade down. When stocks get into that shape, management is forced to improve the productivity of the assets, and companies will change what they are doing to get more efficient.

Do you stick with one cap size when investing in equities? It doesn’t matter, because with smaller companies we will just buy smaller positions. Ultimately we tend to be a large-cap domestic portfolio. But we do have exposure to international, small-cap, and mid-cap companies. Those opportunities will come, and the exposure adjusts depending on where the opportunities are. When the U.S. market was very expensive a few years ago, we had a little more in international stocks than we do today after a three-year bear market. We can now find some great large-cap U.S. companies that have prices we didn’t dream we would ever get.

Your foreign exposure is just over 5.5%. What countries are you invested in, and why? A lot if it is in Europe. We like companies like Nestl?, which are good large-cap consumer names. In some of the material stocks, there is a little bit of emerging market exposure such as in Brazil. In the cyclical companies, we go where there are low-cost competitors, and sometimes that is in the emerging markets. We try to find the best companies on a global basis and we think about the country risk factors if we are going to buy them, and at what price. But we have flexibility to go anywhere the best companies are.

What do you look for in a corporate bond? We are looking for very similar characteristics in corporates to the stock side in terms of the profile strategy. We are looking for companies with a limited downslide in their earnings because of their strategic positioning or because their industry has already gone through its tough time and should improve.

Why are you so heavy in Treasury notes? We want quality. We want shorter-term maturities in this fund. Some of the other life cycle funds [use] longer-term maturities because the time horizon of those investors is longer term. We keep the maturity for this fund at intermediate-term bonds. If you look at the over all portfolio, it is probably somewhere between the 40% to 50% range intermediate bonds of the total assets.

Some would argue that as rates begin to rise there will be little or no opportunity in bonds. Do believe that is the case? Are you doing anything in response to rising interest rates? We believe that Treasuries in particular got expensive partly because of foreign central banks buying Treasuries. It pulled Treasuries lower than where they might be at this point in the economic cycle. As a result, we have shortened up on our maturities to take advantage if interest rates do rise. We have also been trying to look for stocks because that is where we see a lot of opportunity for growth even in a conservative fund. We have shortened up the duration with the view that we are going to lock in higher yields at some point here. We do not feel that inflation is a problem because global competition will keep it relatively low.

What is your expectation from the bond market over the next six months? We will probably have a bias toward rising rates and buy longer-term maturities if there is a big selloff. We do not believe inflation to be a long-term concern.

Your cash holding is just under 3%. Is it always this small? We believe cash is a legitimate asset class, but we are maintaining a limited cash exposure because of how low money market yields are versus just going out one to two years on the curve.

Your fund’s dividend yield is nearly 2%. Will the dividend tax relief affect your fund? We always like the idea of having a stable source of income including dividends. In our process we are looking for companies with strong free cash flow. We also have a value approach to pricing companies, and with that you tend to get companies with slightly higher dividend yield. The tax will be lowered on dividends but ultimately we don’t see it as a concern for the bond market. It won’t change anything that we do, though; our strategy is to find the best companies and to look at them on a total return basis.

What sort of inflows have you experienced in the fund? Has investor confidence over the past two years increased your fund’s total assets? The funds have done exceptionally well in the bear. Even our most aggressive fund, the one focused mostly in stocks, is still positive for the bear market. We have really seen a lot of interest in our life cycle funds. Right now there is a big push for a lot of advisors to use a life cycle fund in 401(k) plans to help diversify their participants’ or clients’ portfolios.

Where do you see this fund fitting into someone’s portfolio? This is definitely for someone preparing for retirement. We are looking at this fund for someone with three to five years until they need to take withdrawals, or for someone who is in the process of taking withdrawals where preservation of capital is more important. We have the other life cycle options that cover the other time frames and risk tolerances.

How much of your sales are made through the advisor channels? We are not a retail name, so we don’t have a lot of retail distribution. A lot of it is either through advisors, 401(k) plans, or direct relationships.

Is there a ceiling to the size of your fund? Currently assets stand at nearly $17 million. How large do you want it to become? This group and this process are able to handle a very large portfolio. The way we manage the money, and given the liquidity and the large-cap nature of the stocks, we could easily run several hundred million dollars without any impact on the performance or the quality of the fund.

Why should someone invest in your fund as opposed to a similar fund? For advisors who want a manager who is going to actively make an asset allocation decision and focus on controlling risk in the bear market as well as being competitive in the bull market, we think that that is what this fund is all about. We are going to make the asset allocation decision and we are going to make a decision based on the current economic market environment over time. That [approach] has helped us preserve capital and still given us competitive returns.