Be different than the indexes--and execute, execute, execute!
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By John Rekenthaler | 04-11-17 | 06:00 AM | Email Article

Mixing the Assets
 FPA Crescent  manager Steve Romick was in Morningstar's offices last week. When asked about competition from index funds, he looked puzzled. They are not on his radar, he responded.

John Rekenthaler is Vice President of Research for Morningstar.

Usually when an active fund manager says that, it's time to reach for your wallet; you're being hustled. In this instance, however, that claim is true. There's no index fund--or other active fund, for that matter--that behaves like Crescent. There is no close substitute for Crescent.

Crescent's divergence begins with its asset allocation. The fund currently has about 60% of its assets in stocks, 44% in bonds and cash, and 4% short stocks. (Investment convention reports this allocation as 60% + 44% - 4% = 100%.) Netting the long and short stocks leads to an effective allocation of 56% equities, 44% bonds. There's nothing unique about that; an allocation index fund could easily mimic that position.

However, it would be tougher to mimic Crescent's asset allocation over time. Notably, Romick built up cash during the financial crisis, with the fund's cash stake peaking at a whopping 45% entering fourth-quarter 2008. Unlike almost every other manager who had the foresight--or good fortune--to dodge the worst of that year's stock-market blows, Romick quickly put some of that protection back to work. Over the next six months, he reinvested 7 percentage points' worth of his cash, into securities that rebounded sharply from their lows.

Perhaps one could devise a market-timing model that would have been savvy enough to hold more cash before the market plummeted than before it recovered. Perhaps … although real-world examples of such successes were few and far between. However, that model would have been hard-pressed to incorporate Romick's fixed-income strategy. In addition to varying Crescent's stock weighting, Romick shuffles its fixed-income position, sometimes favoring relatively risky bonds, at other times preferring the safety of cash.

Big Changes Over Time
Thus, the fund's bond stake was negligible through 2008, soared above 30% in early 2009 as Romick snapped up high-yielding, lower-quality bonds that had been pummeled by the financial crisis (at the time, he believed that many companies' bonds were an even better deal than their stocks), dropped again to almost nothing, jumped again over 30%, and is now again modest.

No index fund will do that. Nor will such funds place 20% of their equity investments into energy, then gradually reduce that percentage over several years, so that now energy stocks make up almost nothing at all. As for Crescent's stock selection, it is not particularly quirky, in part because the fund's large size prevents it from establishing big positions in small companies, but it is far from indexlike either.

In summary, Crescent owns several types of assets rather than one; it varies that asset mix over time, sometimes dramatically; the sector weightings of its stocks often differ sharply from those of any index, and they too vary over time; and, finally, its stock selection is idiosyncratic. All those items not only ensure that the fund will wander far from any index, but they also forestall competition from active funds that use algorithms--unless such funds can somehow replicate what lies inside Romick's head.

Getting It Right
None of this would matter if Crescent had performed poorly. Standing alone is no virtue unless that independent stance leads to success. In Crescent's case, it has. The fund's rare feat of finishing in the top quarter of its investment category (defined by Morningstar as the "allocation--50% to 70% equity" group--the closest of various possible misfits) during both the down year of 2008 and then the recovery of 2009 continues to boost its 10-year numbers. But its 2013-14 returns were also relatively strong, as was last year's 10.3% gain.

True, there's no guarantee that the next time this fund zigs, that the financial markets won't zag. But there is more evidence in support of Romick than I have so far offered. His tenure dates to the fund's origin, in 1993, and since that time Crescent has only placed in the bottom quarter of its category on two occasions--the New Era bull-market years of 1998 and 1999. It promptly made up all that lost ground and more by finishing number one in its category in 2000, then number one again in 2001. It would land in the top half of its category for the next 10 years, until that streak was snapped in 2012.

So, the fund has pedigree.

One drawback: FPA saddles the fund with a flat 1.00% management fee that does not decline with scale. Crescent's overall expense ratio is 1.09%, which wouldn't be bad for a fund in a small company's 401(k) plan, where costs tend to be high because of a lack of scale. But for a $17 billion fund, in today's marketplace, that amount is steep indeed. Crescent may be immune from direct poaching by index funds--but it is not invulnerable to the industry's increasing price pressures. At some future point, it may need to revisit that price.

The Times They Are A-Changin'
The winner of The Wall Street Journal's most recent Winners' Circle contest, for the best-performing fund of the past 12 months, is a $164 million fund that is closed to new investors and managed by a company that has eight employees. Small potatoes, right?

Not anywhere near as small as they once were. In 2003, The New York Times profiled Bernie Klawans, who ran Valley Forge Fund from … Collegeville, Pennsylvania. (Hey, Valley Forge sounded cooler.) From The Times:

''It's a very conservative fund where you can sleep at night," said Klawans. "I try to double to triple what savings accounts offer.'' Managing the fund, which has about $8.7 million in assets, occupies 10 to 15 hours of his week at most, leaving him plenty of time for racing his Sunfish sailboat, playing bridge and tending to several other part-time businesses. ...

Besides his management fee, his fund's expenses amount to about $25,000 to $30,000 annually. He pays $5,000 for an audit and another $1,400 for insurance against possible fraud as required by the Securities and Exchange Commission. The fund has a board of six, including him, and he pays the other directors $99 each to attend six meetings annually at his house. ''In the summer, they're on the porch,'' he said.

Sadly, Valley Forge Fund shuttered its doors last year, after 45 years in the business. The industry lost one of its most colorful players. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

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