Why The Funds Exist and the Role of a Core Holding
The first fund under the iMGP Funds family (formerly known as Litman Gregory Masters Funds) was launched December 31, 1996. Our Equity Fund 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 is our financial advisory affiliate and was founded in 1987 with a heavy research focus including very in-depth fund manager due diligence.)
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 iMGP Funds 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 the iMGP Funds, there were additional drivers behind the idea to launch the funds.
A Core Holding
As we were formulating the idea that led to the iMGP Equity Fund, 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 iMGP International Fund 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 iMGP 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, Chris Davis, 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 iMGP Equity Fund, the first fund in the iMGP Funds family. By creating our own funds and hiring the managers ourselves for the iMGP Funds, 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.
iMGP Funds as Core Holdings
With respect to the first requirement, diversification, we believe that each of the iMGP Funds 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 the Equity Fund and International Fund, 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.
As to the second requirement, the performance expectation for the iMGP 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 iMGP Funds will be able to maintain their edge, Litman Gregory Fund Advisors is responsible for monitoring the sub-advisors and their organizations to assess their ability to continue to execute the iMGP Funds strategy successfully. Our objective at Litman Gregory is for the funds to continue to deliver excellent 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 the funds. 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 shareholder letter.
Final Comments
Litman Gregory’s objective for the iMGP Funds to serve as core holdings is most relevant to the Equity Fund and International Fund. In fact, we believe that these two funds together could effectively serve as an entire equity portfolio. We view the Smaller Companies Fund as fit for the role of a core small-cap holding.
Since the first of the 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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