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Missing the Point

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On December 30, I’m watching CNBC when Tom McManus, CIO at Bank of America, launches into a dissertation on “Growth vs. Value in ’06.” During the course of his analysis, he discusses Google, the stock. The shrewd interviewer points out that Google was one of the top holdings of the Legg Mason Value Fund managed by the legendary fund manager, Bill Miller. Yes, that same value fund manager that has exceeded the returns of the S&P 500 for the past fifteen years consecutively, and yes, that same Google, henceforth to be known as the beacon of value investing with its low P/E ratio, consistent earnings, and undervalued stock price. Huh?

Back up a few weeks to the Investment Advisor Summit in Florida, which included a panel discussion on the constraints style boxes place on mutual fund managers. Craig Callahan, a decent fund manager in his own right, jumpstarted the discussion with a self-serving pontification on the damage done to investors by confining fund managers to Morningstar’s style boxes. The way Mr. Callahan sees it, asking a fund manager to conform his mutual fund with the fund’s prospectus is only slightly less harmful to the typical investor than Enron’s off-balance-sheet accounting structure. If he had it his way, fund managers would be free to pick and choose whatever equity suits their palate on that particular day. Freedom to the Fund Manager! I was surprised by the civility by which my fellow financial planners digested Mr. Callahan’s diatribe. I opted for a different approach. I asked a question that was, in reality, a snotty derision intended to put down the man. Power to the Planner!

It’s not that I don’t see Mr. Callahan’s point. I’m willing to accept his data showing that style constraints rob investors of 300 basis points of return annualized. I even accept that allowing a fund manager latitude in choice will, on average, provide a higher return to my clients. That seems like a good thing. I mean, more money is typically the winning side in the good versus bad equation, right?

Wrong! Yes, it’s true our clients ask us to make money for them. However, with equal conviction, they ask us to mitigate risk for them. How can I invest their hard-earned dollars in a fund designed to provide exposure to a specific sector of the investment spectrum when I cannot be assured that three months later that same sector will continue to be represented? Moreover, how do I align a client’s risk tolerance and expected rate of return with a fund when I have no idea of the extent to which the standard deviation of the fund may either expand or contract, as the fund manager chases after her latest fling? I don’t have a problem allowing a fund manager to express her stock-picking creativity. My clients and I just need to know the framework of the chosen discipline.

Let me submit a piece of advice for fund managers and financial planners. Managers, if you find style boxes too constraining, start a hedge fund. You won’t have to disclose a thing, and if you’re any good, you’ll make a lot more money. For planners, become even more familiar with exchange-traded funds. They are mandated to remain in line with the index to which they are linked and, on average, save your client 100 bps on expenses.

Clive Cholerton

President, Spectrum Assets

Boca Raton, Florida


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