Miller Time

February 4, 2007

One of the big stories in mutual funds last year was the end to the famous  Bill Miller’s streak. In 2006 Legg Mason Value Trust (LMVTX) – the flagship fund managed by Miller – scored an unimpressive 5.9% return, missing the S&P 500 by a country mile (10%) and ended Miller’s impressive, unmatched, 15 calendar year streak of beating the most-benchmarked of indices. 

Although we note calendar year returns, Miller’s fund actually lost to the S&P 500 during several rolling 12-month periods.

While you can fool some of the people all of the time, and all of the people some of the time, most of the mutual funds under perform the S&P500 most of the time. Some funds l can be legitimately excused because they are lower risk than the S&P 500, a market cap weighted index of U.S. stocks. However, most cannot be excused.

One reason for the ongoing  poor performance is high management and fund operating fees as well as increased trading commissions incurred by the fund in an effort to beat the market. 

Bill Miller’s fund should have an even harder time beating the index because it is a very expensive fund. Technically, it is not even a no load fund due to its 1% 12b-1 fee –a.k.a. “level load.” That fee sits on top of the management fee and other expenses.

One device we use around here to analyze fund managers is by looking at risk-adjusted performance and backing out the effect of fund expenses – in other words, looking at how well a fund would have done if it were free.  That is one way to rate a fund manager’s skill without the baggage of fees, and useful for gauging the attractiveness of new funds run by the same manager. By this measure Bill Miller is even more impressive.

In his latest communiqué with shareholders, Bill Miller used his recent slump to explain his winning ways.  That is a good read.  Although he is discussing stock investing, most everything he says applies to choosing funds and building a fund portfolio, particularly with more and more stock-like, ultra-targeted sector and ETF funds coming down the pike.

Let’s take a look at the following skills Bill Miler can teach fund investors:

Miller often takes positions in out of favor stocks and waits. His turnover is around 10%, meaning he trades roughly 1 out of 10 of his positions each year. And he is not even liable for the tax consequences – the fund shareholders are! Frequent trading increases cost, but most importantly it just does not work. Most long-term fund winners have below average turnover.

Diversification guarantees  average returns, but concentration is not always a good idea. Diversifying for the sake of reducing risk does not add much value if what you are adding is not particularly attractive. You would be better off with larger stakes in stocks with more opportunity.

This advice is important in a world of tens of thousand of funds and ever growing fund categories (foreign, small cap blend anyone?). Just because a fund category exists does not mean you need to own a fund in it.

As for the concentration of fund holdings, in general we prefer funds with fewer than 75 holdings and relatively large stakes in the top 10 positions. Since we always own more than one fund, the concentration risk for each fund is not a big deal. It is very rare that a fund with more than 150 holdings is better than just owning a low fee index fund.

On the flipside – and this is what played a role in hurting Miller’s 2006 returns – concentration does not  help much when there is nothing worth concentrating into. Sometimes everything is more or less fully valued, if not overpriced. Indexing can be your best bet in such a market.  

Most fund managers – and therefore their funds – are too “value” or “growth” oriented. They own 100 “cheap” stocks with low price to earnings ratios or high dividends, or they own a bunch of fast growing tech names. Either strategy increases risk and lowers returns as they go in and out of style for years at a time – that is why most value funds had such poor performance in the late 1990s, and most growth funds had similar bad performances in the 2000-2002 bear market. 

Miller notes “factor diversification” – companies whose fundamental valuation factors differ. Owning 100 value stocks (or five value funds) is not diversification if they all move together. An investor is better off owning a few things that are cheap (for possible upside) yet are valued differently, like telecom, biotech, and large cap growth, small cap value, and Japan.

Miller owns Google and Amazon along with steel companies and other old economy traditional value stocks. Miller explains his earlier ho-hum performance (before the 15-year streak) as being the result of investing with such a set of rules for value. For the record, Miller currently is more optimistic about what normally are called growth stocks.

Bad news and bad past performance is a buying opportunity to Miller, who generally thinks what everybody is doing is a bad idea. Bill Miller’s best hits were with stocks client’s questioned by asking, “Don’t you read the papers?”

You want to focus on funds that have been out of favor for sometime. It should almost seem like a stupid investment – not stupid for high fees or bad management, but just being the seemingly wrong investment area in this market.

Focusing on the unknown future can seem risky but is better than looking backward. Miller tries to gauge how much a company can earn going forward – a difficult task but one with more potential than simply looking backward at the past success or failure. Looking beyond past performance of funds is equally critical to your future returns.