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The first Masters’ Select fund was launched December 31, 1996. Masters’ Select Equity was created because, as financial advisors, we wanted more control over the mutual funds we used in our client portfolios, and we had specific ideas about how to build a “better fund.” (Litman/Gregory
Asset Management, LLC (LGAM) is our financial advisory affiliate
and was founded in 1987 with a heavy research focus including
very in-depth fund manager due diligence.) Please click here for more details on the Litman/Gregory companies.
Over many years of conducting fund
due diligence, we came to believe that only a small percentage
of stock pickers are highly skilled and capable of consistently
outperforming their benchmarks over the long run. Moreover,
we found that most of the stock pickers we viewed as skilled
were not equally confident in the potential of all the
stocks they owned in their broadly diversified portfolios.
This got us thinking, if a stock picker is truly skilled
and can add value through active management, would the
same stock picker generate even higher returns over the
long run by holding fewer stocks, especially if they were
the ones that he/she strongly believed held the most promise?
We came to believe in this premise, and over time this
thinking evolved into the intellectual foundation supporting
the Masters’ Select concept:
- Use Litman/Gregory’s due
diligence skills to identify stock pickers that we believe
are highly skilled.
- Give each stock picker a mandate to own only their highest conviction holdings (a maximum of 15 stocks) in their own independently run sub-portfolio.
As originally conceived, each fund would be run by multiple stock pickers in order to harness the potential benefits of concentrated portfolios, while potentially avoiding the volatility inherent in a single highly concentrated portfolio.
Though these concepts were the
primary inspiration for Masters’ Select, there were
additional drivers behind the idea to launch the funds.
A Core Holding
As we were formulating the idea
that led to Masters’ Select Equity, we also saw the
potential to create a fund that was worthy of playing the core domestic equity holding role
in a portfolio. This became a primary objective of the
fund, and when Masters’ Select International was launched 11 months later we created it with the thought that it could also play the complimentary role of an international equity core holding. Though the core holding concept is less applicable to other more style-specific funds, as other Masters’ Select
funds have been launched, here too our objective has been
for each fund to be worthy of playing the core holding role in its category or group.
What is the significance of a core holding? The inference is that a core holding plays a central role in a portfolio. A core holding is a long-term investment, with other more specialized funds used to skew the portfolio to strategies or styles that are specifically targeted at any one time.
The core holding approach is certainly not one that all investors believe is necessary to the construction of intelligent portfolios. However, the idea developed from our experiences in our financial advisory business. There were three factors that influenced our appreciation for the concept of a core holding fund:
1) Most funds lose their performance edge as they grow
It has been our experience that
too often equity funds that we thoroughly researched and
enthusiastically bought for our investment management clients
subsequently changed, undermining our confidence in them.
Often these changes had to do with the growth in the fund
management firm’s business. Specifically, we’ve
observed that successful funds/money management firms often
are not realistic with respect to the amount of money they
can successfully run before they begin to lose some of
their edge.
As these funds/firms get bigger, they often expand the number of stocks they own while at the same time shrinking their universe. They have to shrink their universe because they can no longer invest a meaningful percentage of their assets in smaller companies without owning too much of the company or impacting the price of the stock through their buying or selling. We believe that the result is often a marginal reduction in their ability to add value. In a very tough business, a marginal reduction can be the difference between great success and mediocrity.
As financial advisors, when we
observe excessive growth in a fund our confidence is reduced,
leaving us with two unattractive options. We can continue
to hold the fund despite our lessened confidence, or sell
it, triggering a taxable gain and the need to find a replacement
fund. So the desire for a core fund to build a portfolio
around, based on high confidence that it can maintain its
performance edge over the long-term and justifiably be
a “permanent” holding, is appealing.
2) Avoid the trend toward style purity
Over the last decade we’ve grown troubled by the style-specific focus that has become the norm in the industry. Years ago, stock pickers relied on their investment process to help them identify stocks that met their investment criteria. While most tended to own stocks that had common characteristics defined by their investment process, they did not bother thinking about what style label (growth, value or blend) might be given to the stocks by third parties. These would have amounted to artificial constraints, as opposed to the natural constraints that flowed from their investment process. Unfortunately, as time has passed we believe that the advent of the style box, the perception that exposure to all styles is necessary, the growth of the consulting and financial advisory industries, and the gross misperception that style purity and purity of investment philosophy are the same thing, have all combined to constrain the flexibility of some stock pickers. We believe this mentality is a triumph of marketing (e.g., look at our fund, we’re style pure!) and also heavily influenced by the insecurity of some financial advisors and consultants to show clients that they can add value (by tracking style drift and ensuring the “proper” exposure to various styles). In our opinion, this overemphasis on style purity is artificial, reflects false precision and has not been a value-added development. Stock pickers who followed this trend have lost the freedom to find good stocks consistent with their investment approach. This happens when appealing stocks are found in segments of the market deemed inconsistent with the manager’s
stock-picking style, as defined by the consultants and
quantitative fund ranking systems.
Great stock pickers and their teams,
including Bill Nygren, Bill Miller, Chris Davis, Glen Bickerstaff,
Mason Hawkins, Bob Rodriguez and Dick Weiss ignored this
trend. Many others did not. This industry shift offered
another incentive for us to hire stock pickers we viewed
as highly skilled and give them a mandate to find great
stocks, without any worries about being true to an assigned
style that did not accurately reflect their investment
approach. Said another way, we set out to create an ideal
structure that we believed would give stock pickers the
freedom to build their best portfolios. In our opinion,
a core fund should be reflective of this type of thinking
because in skilled hands it’s likely to result in
better long-term performance. Unfortunately, in the fund
world it has become increasingly hard to find.
3) After-tax returns vs. tax efficiency
We also came to understand that effective management of taxable client monies required: 1) a distinction between after-tax returns and tax-efficiency; and 2) a reduction in the client’s portfolio turnover. With respect to tax-efficiency versus after-tax returns, it is, of course, strong after-tax returns that benefit our clients, not mere tax-efficiency. We therefore would prefer a fund with a 10% after-tax return and mediocre tax efficiency to one with an 8% after-tax return and excellent tax-efficiency. With respect to the second point, financial advisors and investors who often change the mix of funds in a portfolio, and do so by triggering capital gains, are adding tax liability. If these changes maximize after-tax return then they are justified, but we believe it is generally better to own a great fund that can be held for many years, thereby avoiding the need to sell and trigger a gain. This also supports the core holding concept because a successful core fund that delivers high pre- and after-tax returns, and therefore justifies itself as a very long-term holding, also facilitates good after-tax returns by not tempting the investor to sell, thereby triggering the investor’s built-in gains.
The desire to create an exceptionally high quality fund that had the potential to stay that way for a long time was part of the inspiration for Masters’ Select Equity, the first fund in the Masters’ Select fund family. By creating our own funds and hiring the managers ourselves for Masters’ Select, we are able to control the number of stocks owned, the breadth of the mandate, and separate the money they run for us from the money they run for others.
What Makes a Great Core Holding?
If the intention is for each fund to serve a core holding role, this begs the question of what makes a good core holding. We believe there are three critical requirements of a good actively managed core holding:
- The fund should be diversified enough so that its downside performance over periods as short as a year is unlikely to be higher than its benchmarks, on average.
- There must be a very strong basis for believing that the fund will beat a passively managed alternative over the long-term. Without a high degree of confidence based on sound reasoning, an index fund becomes a better alternative.
- There must be a high degree
of confidence in the fund management and their ability
to maintain the fund’s edge over many years. This
confidence is the basis for believing that the fund can
be held for many years.
Masters’ Select Funds as Core Holdings
With respect to the first requirement,
diversification, we believe that each Masters’ Select fund is adequately diversified. The multi-manager structure not only makes it highly likely that each fund will have exposure to an adequate number of stocks and industries, but it also ensures that the stocks will be picked based on differing methodologies, thereby bringing another kind of diversification to the fund’s portfolio. In the case of Masters’ Select Equity and International, both funds have diversification to different styles of stock picking (e.g., growth and value) and market caps. In the case of Smaller Companies, the diversification across stock picking styles is present, but obviously the fund is focused on small-cap stocks. In the case of Value, the fund’s portfolio diversification reflects different approaches to value stock picking. The fund also has some foreign exposure and has the ability to own some small-cap stocks. (Note: Value is technically defined as a “non-diversified” fund
because it has the potential to be concentrated
at a level that would cause it to fail technical tests
that measure whether it qualifies as a “diversified fund.” However, thus far it has always met the fund industry’s
diversification test and we believe it is likely to continue
to do so most of the time, if not at all times.)
As to the second requirement, the
performance expectation for the Masters’ Select Funds is primarily a function of 1) the effort we put into due diligence and the resulting quality of the stock pickers; and 2) the mandate for each manager to focus on only a small number of their best stock picking ideas. This is a distinctive structure and so far we believe it has delivered.
With respect to the final requirement,
that there be a high degree of confidence that the Masters’ Select Funds will be able to maintain their edge, Litman/Gregory Fund Advisors is res ponsible for monitoring the sub-advisors and their organizations to assess their ability to continue to execute the Masters’ Select strategy successfully. Our objective at Litman/Gregory is for the funds to continue to deliver exc ellent long-term performance consistent with each fund’s
mandate while exhibiting downside performance, especially
over one-year time periods or longer, in line with or better
than the benchmarks.
Our pursuit of this objective relies
heavily on our up-front due diligence work and our ongoing
monitoring of each subadvisor. This monitoring has occasionally
resulted in manager changes, though our intent is to have
manager turnover that is as low as possible. We conduct
extremely thorough due diligence in order to reduce the
chance of making manager selection mistakes. This due diligence
is focused on assessing the stock picking skills as they
relate to running a concentrated portfolio, and also the
firm’s culture, organizational structure and business vision. We assess the ability of the management firm to keep their key people, and we also seek to understand how they expect to grow and how that growth may impact Masters’ Select.
We seek to work with firms of high integrity who believe
that their long-term interests are promoted, first and
foremost, by maintaining a very high performance level
for their clients. We believe that this broad due diligence
focus helps to minimize the number of mistakes we may make.
At the fund level, we closely monitor the portfolio to watch out for unintended industry or stock concentrations (since the managers pick stock independently of each other), and we watch for opportunities to enhance after-tax performance where prudent. We have also committed to closing each fund at low asset levels in order to maintain plenty of flexibility for each stock picker to pursue his highest conviction ideas.
We believe our interests are aligned with our shareholders. Litman/Gregory employees and principals have sizable investments in each fund and, when combined with our investment management clients, we are by far the largest investors in the funds. The dollar value of these investments are outlined in our first quarter 2004 shareholder letter.
Final Comments
Litman/Gregory’s objective for the Masters’ Select Funds to serve as core holdings is most relevant to Masters’ Select Equity and International. In fact, we believe that these two funds together could effectively serve as an entire equity portfolio. Masters’ Select Value, by virtue of its manager diversity, can serve as either a core value holding (to deliver some or all of a portfolio’s value exposure) or as a core holding in its own right for investors who have a value bias and like the idea of a value fund with a mix of successful, yet somewhat different value managers. We view Masters’ Select
Smaller Companies as fit for the role of a core small-cap
holding.
Since the first of the Master’s Select Funds launched in 1996, we believe they have proven themselves as excellent core holdings for investors relying on them as a permanent allocation within their portfolio. Investors can also rely on our commitment to placing shareholders interests above our own.
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