Private firms and public money

08Jul06

Andrew Bary in a piece for the quarterly mutual fund section in Barron’s tackles a topic that is relevant to all investors, not only mutual fund investors. For some time now privately held firms have been outperforming their publicly owned peers in gathering assets. Although it was not mentioned in the article one can trace this outperformance directly to the end of the Internet bubble.

There are two main threads to the article. The first is that consciously or not mutual fund investors have been flocking to funds run by privately held mutual fund companies.

Investors typically don’t care whether a manager is public or private, but maybe they should. A Fidelity study a few years ago — remember, Fidelity itself is privately held — found that the performance of private firms’ mutual funds clobbered that of funds overseen by public outfits. Many private firms consistently shine. Among them: Dodge & Cox, Southeastern Asset Management (which runs the Longleaf funds), Davis Advisors and Capital Research & Management Group, which operates the hugely popular American funds.

Private companies also are winning the battle for assets, with the aid of low expense ratios that boost their investment performance. […] American, Fidelity, Vanguard, Dodge & Cox and Dimensional — all private — account for six of the top 10 asset gainers.

The second thread is what it means for the management companies themselves. By eschewing the public markets these firms are in all likelihood leaving money on the table. The trade-off is that these firms generally create a better working environment that allows for independent thinking and have a sharper focus on fundholder welfare.

Private firms can do certain things more easily to benefit performance. They can close popular funds to new investors, take contrary investment positions and start new funds only when investment opportunities appear to be ripe, rather than coming out with one because marketing types think the company should participate in a certain sector or a fad.

Indeed the biggest selling point for these firms is that they can take concentrated, contrarian positions that can lead to periods of underperformance. This is a necessary element for a firm that is looking to generate market beating returns.

David Swensen devotes the entirety of Chapter 9 in his (now classic) book, “Pioneering Portfolio Management” to the required elements for a successful investment management firm. Not surprisingly being privately held by the actual investment managers is a necessary element.

By selecting investment managers with an entrepreneurial orientation, fiduciaries improve the chances for investment success. Large, multiproduct, process-driven, financial services entities face the daunting hurdle of overcoming bureaucratic obstacles to creative decision making. Small, independent firms with excellent people focused on a well-defined market segment provide the highest likelihood of identifying the intelligent contrarian path necessary to achieving excellent investment results. (p. 260)

One of the disappointing elements of Swensen’s follow-up book geared towards individual investors, “Unconventional Success: A Fundamental Approach to Personal Investment” is that he recommends individual investors use an index-centric investment approach. We were disappointed that he in a sense “punted” and did not really try to adapt his institutional approach for individual investors. In this approach ETFs are a viable vehicle for portfolio construction.

If by abandoning the world of open-end mutual funds for exchange traded funds one thinks they avoid this entire question – think again. The fact of the matter is that the ETF world is dominated by firms that are publicly traded. ETFs run by State Street (STT), Barclays (BCS), PowerShares*, even upstart WisdomTree (WSDT) all operate under the aegis of public firms. This raises the question: would we see the rush of narrowly focused, me-too ETFs if these firms were private? One will never know, but a reasonable guess is that this land grab might be a bit more measured if these firms were private. Just a guess.

The so-called “siren song” of initial public offerings for these money management firms is a big theme in the Bary article. If and when these large, privately held investment companies decide to go public in a major way then one can logically suspect that a market top will not be too far behind.

The challenge for individual investors who still want open-end mutual funds is where can they turn for information? The Bary article is disturbing in that the rush of inflows into funds run by private firms is generally quite high. There still are small, start-up mutual funds out there, but one needs to look far and wide.

Morningstar.com remains the gold standard for mutual fund information, but tracking down funds from small, independent firms is not necessarily their focus. A relatively new, good starting point is The Annex over at FundAlarm.com. The focus there is on start-up funds from both large and small fund companies alike. In short, there probably is no single, best source for this information. Motivated investors will need to be vigilant in seeking out information on these independent, “entrepreneurial” managers.

*Powershares Capital Management is in the process of being acquired by AMVESCAP PLC (AVZ) a publicly traded company.

Update:  We continued this discussion in two follow-on posts:   ETF hurdles and Funds off the beaten path.

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