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COLUMN-Is there a Great Past Performance Penalty?
June 5, 2012 / 12:31 PM / 5 years ago

COLUMN-Is there a Great Past Performance Penalty?

(The author is a Reuters contributor. The opinions expressed are his own.)

By A. Michael Lipper

June 5 (Reuters) - As we are in the finals of the hockey season, I wonder whether there is a penalty box for funds that have had great long-term investment performance.

Recently, I attended the annual Investment Day for the Sequoia Fund. At the meeting, a lead portfolio manager indicated he and many of their analysts did not invest directly in the fund, but instead own stock in the companies held in the portfolio.

Why? Because the fund had large, unrealized capital gains - at 40.9 percent of market value at year-end - and they did not want to pay taxes on those gains when the fund eventually sells some of its long-term winners such as Valeant Pharmaceuticals International Inc and Berkshire Hathaway Inc.

Two other examples of funds that have large, unrealized capital gains are the closed-end General American Fund (33.7 percent at the end of the first quarter) and the open-end Tweedy Browne Global Value Fund (34.5 percent as of March 31). These funds are value-oriented, buying stocks that are selling well below what an intelligent strategic buyer would pay.

For the most part, they invest in companies run by entrepreneurially driven management who either founded the company or have substantial holdings. The companies themselves have something unique about them relative to the rest of their industry. One example of such a company in General American Investors is Epoch Holding Corp. That makes the managers of the funds that hold such companies in essence, collectors of rare specimens that are rarely sold after they have been added to portfolios.

Should these funds be avoided by long-term investors? Funds that stick with companies for the long haul typically have low portfolio turnover and, most often, are on the opposite side of a trending market, so they are unlikely to get out of meaningful positions at the top of any market.

For example, Tweedy’s turnover is 9 percent. That means funds such as this are likely to underperform at peaks. Buy-and-hold portfolios will normally not be the topic of admiration at the cocktail parties for celebrating new highs.

Despite these drawbacks, these funds merit a place in many long-term oriented investment accounts. The skills to find these somewhat hidden jewels of investing require deep analytical approaches and, most importantly, finely tuned patience that most investors do not possess. Often the investments in these funds represent the choices of some of the best and brightest mangers - those who have not been “conventionalized” by being a graduate of well-known business schools or working at large companies. As these funds are, by nature, value-oriented, they will, in time, sell their vastly overpriced merchandise.

In terms of choosing which funds to buy, one must look into how the fund is managed. The advantage of these funds is that they will sell some of their holdings when, in Sir John Templeton’s words, they find “better bargains.”

I suspect that at least one of the Stanley Cup games will be won by a short-handed team that has one of its players in the penalty box. Along the same lines, the penalty of large, unrealized gains means that a fund is prohibited from producing a winning performance.

The current market has shifted to the significant buyers being capital-gains tax-neutral investors such as 401(k), 457, 403(b), IRA and tax-exempt institutions and charities. These investors often increase their chances of profiting by investing with collectors of winning stocks rather than investing with those that either no longer hold winners or never owned them in bulk. The penalty box makes it more difficult, but the odds favor that the best hockey team, and investors will win in the long run. (Follow us @ReutersMoney or here; editing by Lauren Young, Beth Pinsker Gladstone and Andre Grenon)

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