During the 2008 crash, Oppenheimer Rochester National Muni A (ORNAX ) lost over 50% of its worth. It was one of the very worst performers. Before that it had been one of the best. Investors were clearly not expecting that type of drawdown that fast. In an article our firm wrote near the end of 2008, we discussed the oft-misunderstood tobacco revenue bonds, which made up a substantial portion of ORNAX’s bond purchases. The uncertainty of these bonds, coupled with investors’ general misunderstanding of them, led them to be mispriced and under-appreciated. These bonds are still mispriced and under-appreciated today. And they still make up the largest of ORNAX’s holdings, at around 22%. However, when we recently looked under ORNAX’s hood, we found something more interesting. Management has decided on a philosophy that could lead them to enter the property management business, a move that should concern any investor.

First: some things never change. The crowd continues to be wrong. In 2008, ORNAX lost because the credit markets were imperiled and its holdings were relatively illiquid. Poor pricing led to an investor outflow causing more selling of illiquid bonds. This has a similar effect as a run on a bank, exacerbating the impact of the market. At the bottom, investors began to chase yield and value, which ORNAX had in abundance after the fall. Then the opposite problem occurred: there were not enough good, high-yield municipal bonds to go around. When this happens, the fund has to buy new bonds at higher prices along side the investor inflow and thus reducing the yield for all investors.

So what has changed? Ron Fielding until just over a year ago managed ORNAX. Fielding’s single-minded purpose for the fund was to buy the highest yielding municipal bonds anywhere. At the time he left, the management continued to follow Fielding’s idea and model. Through all the funds past volatility, it was always guided by Ron Fielding’s vision. However, the current managers have decided that things may change. During a conference call on June 8 Troy Willis and Scott Cottier revealed that the fund is no longer simply looking to buy the highest yielding municipal paper, but that it has broken away from Fielding’s idea to begin a new life in property management.

This trailblazing move is a response to the large number of dirt bonds that are being defaulted on, primarily in Florida. Of ORNAX’s roughly 21% exposure to dirt bonds, 10-13% are Florida dirt bonds that have defaulted. But not to worry—the fund’s managers see this as a great opportunity. They figure that these bonds were for the cost of developments on the property and that now, when they foreclose, the fund will receive both the land and the developments. Consequently, ORNAX has decided that they will become the first bond fund to actually go through the prolonged legal procedures necessary to repossess these properties, which amount to about 2.5% of their total holdings.

When it comes to high-yield bonds (“junk bonds” as they used to be called), some of them will lose their value entirely. When junk bonds are bought, the buyer understands this possibility (or at least they should have been told this from the person selling them!). Investors accept it because the cash flow from the bonds is so high—the buyer gets paid for taking on that level of risk. ORNAX used to understand that. Investors who bought ORNAX expected the uncertainty and volatility that comes with that risk. Currently, the non-accrual rate for the fund is at 4.8%. Those familiar with junk bonds understand that this rate may vary significantly over time and that the value of ORNAX might fluctuate plenty, even as much as the S&P 500. But investors will still buy, so long as that plentiful stream of tax-free income continues to flow. Put it this way, it took a 50% drawdown in 2008 to get investors to really freak out and start selling.

However, instead of remaining a junk bond buying fund, simply seeking out the highest-yielding municipal bonds, ORNAX’s managers have decided that it may now repossess and manage these foreclosed properties. The bond managers have many ideas about what to do with their newly acquired holdings. Now investors are expected to trust these fund managers to competently manage property that was received from bad bonds. These managers are paid to buy junk bonds. Why should investors believe that ORNAX would do a better job managing the properties than the owners who are foreclosing on them? Realistically, they will probably hire a third party to manage the real estate transactions, but you still have to wonder about a management team that is going outside their core competency of analyzing credit.

Although the Florida dirt bond problem concerns only 2.5% of ORNAX’s assets at this time, what if the problem spreads? What if Obama decides not to back up municipalities? What if Congress determines that they ran out of checks this week or next? Will ORNAX end up owning and managing a significant amount of property? Will this former junk bond fund become a REIT? Probably not, but it seems like unforeseen black swan events are growing by the day.

In the conference call, these managers revealed that they have altered ORNAX’s philosophy from that established by Ron Fielding. While the cash flow and performance of the fund have been impressive, it is no longer the same beast. And who knows how it will act in the future?

Enterprising investors should realize that, though the uncertainty of ORNAX’s changing philosophy leads to a greater risk that is not accounted for in its current price, it could seed an incredible opportunity in the future. If the Florida dirt bond mess spreads and the fund decides to continue to repossess properties, then it will go from holding relatively illiquid municipal bonds to extremely illiquid real estate. This change could cause an exodus from the fund. Considerable investor outflow, together with the challenge of valuing illiquid property in this ‘40 Act NAV mutual fund, could once again cause tremendous opportunity to buy ORNAX at a much lower valuation. Enterprising investors should put ORNAX on their radar—and beware.

Sources:

Oppenheimer Funds

Oppenheimer Articles

Matthews Pacific Tiger (MAPTX)  hold 18.22

PIMCO Total Return D (PTTDX) hold 11.10

T. Rowe Price New Era (PRNEX) hold 37.94

Loomis Sayles Bond Retail (LSBRX) buy 13.42

Gateway A (GATEX) buy 24.48

AQR Diversified Arbitrage (ADANX) buy 10.74

Matthews Asia Pacific Equity Income  (MAPIX) buy 12.19

Eaton Vance Floating Rate A (EVBLX) sell 9.00

JP Morgan Alerian (AMJ) buy 28.57

Vanguard REIT Index ETF (VNQ) buy 48.48

Rydex Managed Futures Strategy H (RYMFX) hold 25.29

Scout International (UMBWX) hold 26.17

Oakmark International I (OAKIX) buy 15.91

Harbor Real Return Institutional (HARRX) sell 10.47

Oppenheimer Rochester National Muni A (ORNAX) sell 7.19

Natixis ASG Diversifying Strategies A (DSFAX) buy 9.81

*Individual investment results will vary depending upon buy and sell dates.

…Even Jim Cramer, who ran a successful hedge fund for years until exhaustion led to an early retirement, still gets on TV each day to yell about all the things he learned over the years. He just can’t give it up…

We set out to compare two broad-based and heavily traded REIT ETFs in order to discover if they have different compositions and how any differences effect long-term performance. After a basic review of the holdings a few things stood out. The difference in performance could be attributed either to the inclusion of mortgage REIT’s into IYR’s composition or to the heavier weight of VNQ’s top sector positions within the category. We did not find enough differences between the compositions of the two ETF’s over time to warrant a strong opinion either way. In the end, long-term cost structure and trading liquidity appear to have the greatest impact.

General Overview

VNQ and IYR are two ETF’s composed of a collection of REITs (Real Estate Investment Trusts). VNQ is issued by Vanguard Group, Inc. and is designed to track the MSCI (Morgan Stanley Capital International) U.S. REIT Index. IYR is issued by iShares Funds and is designed to track the Dow Jones U.S. Real Estate Index. Both indices aim to be benchmarks that measure the performance of publicly traded REITs. VNQ only trades in equity REITs, while IYR also trades in mortgage REITs.

Composition Comparison

There are currently 134 publicly traded REITs in the United States. Of these, 111 are equity REITs. VNQ is comprised of 98 REITs, all equity REITs—73% of all REITs and 88% of all equity REITs. IYR is composed of a total of 76 REITs, 57% of all REITs. IYR’s 71 equity REITs comprise 68% of the equity REITs on the U.S. market.

The two funds are composed largely of the same holdings. 61 REITs are shared by both (92% of those in Vanguard’s fund and 83% of iShares’s). Though Vanguard’s fund has more unique holdings, these make up only 7.31% its NAV, whereas 18.85% of iShares’s NAV are unique holdings. Most of this difference is due to iShares’s inclusion of mortgage REITs, which total 7.41% NAV. The rest of the equity difference between unique holdings of the two funds is due to iShares’s greater focus on specialty REITs, which compose 5.20% of its NAV, but only 1.03% NAV of Vanguard’s ETF.

The table below shows the difference in composition between the funds, organized by type[1]

Vanguard’s fund is more diversified by individual holding, with 37 unique holdings, but iShares’s is more balanced between different types. iShares includes two types Vanguard does not that make up a significant portion of its portfolio (10.07% NAV). In general, Vanguard invests more equity in the larger REIT types, while iShares distributes its investments more evenly amongst the different types. Vanguard’s ETF is therefore more susceptible to changes in a single type of REITs than is iShares’s.

Of the largest individual holdings in each, the only significant difference between the ETF’s is with those holdings that are unique to the iShares fund. Of the top ten largest REIT holdings, only one is held uniquely and in significantly differing amounts, a mortgage REIT held by iShares (Annaly Capital Management (NLY); 4.42% IYR’s NAV). Of the holdings that compose over 1% NAV of the ETF’s, Vanguard has no unique holdings, whereas 8 of iShares’s holdings are unique and in total compose 15.28% NAV. In general, iShares has a greater concentration of equity in individual holdings, where Vanguard is invested in a greater total number of REITs. Overall, iShares’s fund is less concentrated both in types of REITs and in individual stocks than is Vanguard’s.

The two funds have roughly the same 5-year annualized turnover rates, Vanguard’s at 13% and iShares’s at 18%. However, iShares’s fund’s turnover rate varies widely, from only 7% in 2008 to a full 29% in 2007. Vanguard’s fund, on the other hand, only varies between 10-17%.

Performance Comparison

Neither funds’ performance differs significantly from its underlying index in a given year. However, due to differences in fees, Vanguard’s fund slightly outperforms the MSCI U.S. Real Estate Index whereas iShares’s fund slightly underperforms the Dow Jones U.S. Real Estate Index. These slight annual differences result in Vanguard outperforming its index by .54% in a five-year period when iShares underperformed its by 1.32% in the same period. Vanguard’s fund has an annual fee of only .15% compared to iShares’s of .48%. Supposing a 5% annual return, this difference in fees adds up to 1.58% over a 5-year period. It was curious that dividend yield did not have a consistent effect of the differences in year-to-year total return.

Yearly pre-tax return, dividend yield, & turnover rate of VNQ, IYR since 2005.

One could conclude that over time both ETF’s have done a fine job of tracking the overall REIT market for a low cost. However, at this point with the uncertainty of interest rate markets and government intervention of mortgage paper, VNQ may be a better alternative with its lack of direct mortgage exposure. Ultimately, it is a coin toss. For trading purposes IYR has superior liquidity when tight spreads and fast execution are needed. Going forward it may come down to relative differences in yield that could become a deciding factor. For cash flow oriented portfolios a higher yield would be more beneficial if, over the longer term, total return remained constant. This may be the focus of follow up studies on these two investment vehicles.

Sources

us.ishares.com/home.htm

www.djindexes.com/mdsidx/index.cfm?event…

www.google.com/finance?q=NYSE:VNQ

www.morningstar.com

www.reit.com

www.vanguard.com

*Individual investment results will vary depending upon buy and sell dates.

David Herro, Morningstar’s International Stock Fund Manager of the Decade, feels optimistic about his Oakmark International Fund this year. While maintaining its objective of long-term capital appreciation, OAKIX has continually achieved strong performance since its inception in September1992. By averaging 11% per year, it has outperformed the MSCI World ex U.S. Index which averaged 7% per year over the same period. This fund normally invests in undervalued securities in at least five countries outside of the United States. David believes that when it comes to shopping around for undervalued companies, the international marketplace provides the widest range of opportunities. He assesses the value of a company primarily on its ability to generate cash flow and also on its quality of management, market share, and degree of pricing power.What sets him apart from other managers is that he puts disciplined stock selection ahead of industry or country selection. There seems to be a common consensus among investors that growth always equals opportunity. David will argue, in fact, that the opposite is true. “It all has to do with price and valuation” one must look at individual stock valuations to get the answer. We believe it is a monumental investment error to simply put your money in those places that had a good macro economic run or impressive recent performance. He says, “The best way to navigate is to know your course ahead of time. Know the risk factors of the markets, avoid fads or trends, and never invest if there’s a lack of proper investment or regulatory infrastructure.” Going into the new decade, David Herro remains focused on doing what he does best: buying businesses when they are cheap and selling them when they become expensive. Though this is vastly different from the conventional approach of jumping into the hot sector, industry, or country, he believes that their philosophy will continue to serve their shareholders well in 2010. Some of the hot countries at the moment include emerging markets. Although David believes emerging markets will propel global economic growth, the fund does not expect to invest more than 35% of its assets in securities of companies based in emerging markets.
The fund is currently positioned with holdings in Europe (71.4%), Asia (18.4%), Latin America (3.7%), North America (3.4%), Australasia (2.9%), and the Middle East (0.2%). The three most heavily weighted sectors in the portfolio include consumer discretionary (36.4%), followed by financials (17.6%) and industrials (13.9%). The Fund has approximately 19% underlying euro exposure, 37% underlying Swiss franc exposure, and 24% underlying Japanese yen exposure hedged. One country getting a lot of attention from the fund is Japan, which has 3 companies in the fund’s top ten holdings. David believes there is opportunity in the Japanese equity market for the long-term. On a valuation basis, almost two-thirds of the Japanese stock market is trading below its book value whereas the return on those book values (ROE) is increasing, albeit from low levels. For the first time in decades in Japan, there are companies that are both low in price and are managed by people concerned with achieving acceptable returns. Expect David to keep an eye on new buying opportunities in Japan throughout 2010. Since Portfolio, LLC sees Japan as a country with few long-term economic prospects; we think investing in it needs to be done with a philosophy of deep value versus growth.

This is not a solicitation to buy or sell and is for informational purposes only.

Scout International Fund – UMBWX

Lee Munson and Lorn Davis interview James L. Moffett

In the world of mutual funds, only a handful of names stand out and James L. Moffett, CFA stands tall among them. Running the Scout International Fund (Ticker: UMBWX) since its inception in 1993, Mr. Moffett has garnered a reputation for running a tight ship that repeatedly beats its competitors and the domestic market over the long term. His strategy has remained consistent and simple: look at the international economic, political, and market conditions to choose which countries to invest in. Then, select the best blue chip companies each country has to offer in view of each economy’s prospects. Distinct from his competition, Mr. Moffett does not have analysts scattered in every country. Instead, he simply works with what is available to him and thus sticks to companies with a track record that have substantial product/service bases and financials. With this straightforward approach, he has, since the inception of the fund, managed to return 9.16% vs. 4.84% from the benchmark MSCI EAFE (Europe, Australasia, and Far East) index. So, not only does UMBWX have a solid foundation, but also a strategy we at Portfolio Asset Management can explain to our clients.

We recently were given the opportunity to ask Mr. Moffett some questions regarding his experience in managing an international stock fund and his current views on the market. We began by asking him what differences and similarities he has found in investing both domestically and internationally throughout his career. His answer came in three parts: first addressing the psychological aspect of investing abroad, followed by his simple method of checking the economic situation of a foreign country and finally, the cultural/political concerns. He began by saying that his “experience leads him to conclude the differences between our and foreign markets are bigger, but more subtle than they appear to be. In contrast, there are a lot of similarities we overlook.” As all investors undoubtedly know, at any given moment there is one or more “sure thing” to invest in, and this is magnified when considering markets beyond our own. Mr. Moffett’s experience has led him to understand the finer points of these frenzies so that he may be able to clearly differentiate them from actual trends worth investing in. He says, “For many investors, buying foreign stocks requires overcoming some domestic prejudices. In the process we often make the foreign market look better than it is; make it look like a unique opportunity to get in on the start of something big.” With all the talk about Brazil, Russia, India and China, other emerging markets, and even frontier markets, the present day investor is bombarded with more sensational “investable opportunities.” Mr. Moffett asks himself the pertinent question of whether or not he has learned anything given the fund’s 4.2% exposure to Brazil. He claims he has and expounds how:
1. A similarity. Market psychology works the same around the world.
2. A simple method of telling whether the situation in a country is worth investing in or not: “Look at balance of payments numbers and bank reserves you can see the rotten situations. Mexico, Thailand, Russia, and Brazil were swamped with foreign investment which covered up huge trade deficits. Today, some of the countries run a balance of payments surplus and have accumulated substantial reserves.”
3. As much as we want countries to become more investment friendly, “cultures change more slowly than we might hope. One way to measure this process is to look at how governments change. Brazil, Chile, and Mexico have had several successful transitions. This is more than having elections. We measure it by how the existing government goes out of office.”

This last point helped answer a question that we had been looking over for the past few holdings reports about whether he intended to stay out of Russia and China, even though China was specifically being touted as the “Economic Engine” of the world. Mr. Moffett continued, “One reason we don’t invest in Russia is their capitalist economy is not that different from a hundred years ago when the Romanovs ran the country. China is an intriguing mix of state control and economic loosening, again reflecting their long commercial history and long government from the top. India is the world’s largest democracy, but it labors under an incredibly inefficient bureaucracy.” This response reassured us of Mr. Moffett’s unshakeable commitment to safe capital growth in the international context and also that the fees charged by the mutual fund are paying for the experience of Mr. Moffett. However, this doesn’t mean that he will not in the future invest in a country such as China. As stated above, he looks to measure the progression into more capital friendly environments by how the existing government goes out of office.

Having covered this broader topic of the similarities and differences Mr. Moffett has observed while investing internationally, we asked him about how the fund was positioning itself for the unwinding of global quantitative easing by the various central banks. His response was simple and to the point, that the fund wasn’t too concerned about quantitative easing due to its being the stock market. More specifically, he says, “In the spring we drew down our cash reserves to modest levels and put most of the money in financials where we were substantially underweighted. As an unwind, we will probably restore this underweight.” The withdrawal of reserves worldwide is used as an indicator by Mr. Moffett, for “such a withdrawal should coincide with an economic recovery. As our portfolio is positioned for modest growth with overweights in consumer healthcare and technology, we think we should be in good shape going forward.” This optimism for the future of the fund is well seated when looking at the historical performance of the fund over the past 1, 3, 5, and 10 years, because not only has the fund consistently beat its benchmark indices (the MSCI EAFE and the Lipper International Fund Index), but it has actually managed to stay positive going back 3 years, a feat neither of its benchmarks were able to accomplish. Therefore, it is reasonable to accept Mr. Moffett’s optimism and we expect to see a continued strong showing by the fund as the global recovery develops.

A major factor in the development of the global economy is demand for energy and minerals. It has been China’s appetite for these that have given the country the label of the Global Economic Engine, as this demand indicates new economic development. So we asked Mr. Moffett how he would weigh the US, China and oil exporters. He responded that the fund has a neutral strategy on oil prices and is equally weighted in energy stocks in comparison with the benchmark. But given that he invests in international markets in addition to the US market, we were curious as to how the fund was going to deal with the savings from lower energy prices in the US versus the resulting losses sustained by energy exporters. Mr. Moffett granted us, “Lower energy prices are a tough call. While the worldwide economy has substantial oil and gas in storage, the production/consumption balance is tight. Major producers are under investing in new production. The swing factor is Chinese demand which keeps rising, not just for energy but most minerals. We have increased our weighting in steel and iron ore production. In terms of geography, we have increased our weight in Brazil and Korea.”

Wrapping up, the UMB Scout International Fund has been a steady, safe source of income for any investor looking to diversify through the international markets. Managed with a simple, fundamentally solid top down strategy, the fund really becomes attractive due to the experience of the management team led by Mr. Moffett. Under his wise direction the fund has managed to provide investors with impressive results over its 16-year history compared with its benchmark. Having the opportunity to have Mr. Moffett answer questions we had regarding the way he runs his fund and how he views the global economic situation enlightened us to the careful and precise manner in which he approaches the fund. Instead of running with what his gut tells him, Mr. Moffett has clear guidelines for countries and companies that must be met in order to be considered for investment. This thorough methodology is a welcome sign that Mr. Moffett takes his fiduciary duty seriously and gives us, at Portfolio Asset Management, confidence that the fund is a responsible and income generating investment.

*Individual investment results will vary depending upon buy and sell dates.