Third Avenue's Marty Whitman: In defense of managed mutual funds

The following is an excerpt from Third Avenue Fund's first quarter commentary. It is a letter written by Martin Whitman, chairman of the board at Third Avenue Trust and co-manager of the Third Avenue Value Fund Ticker:(TAVFX) In my opinion, the Investment Company Act of 1940, the principal law regulating the operation of mutual funds, has resulted in very, very important benefits to Outside, Passive, Minority Investors (“OPMIs”) because of the plethora of substantive protections it brings to OPMIs. I have been in the investment business nearly 60 years. During that time, it seems as if OPMIs were almost continuously being ripped off by various schemes which served primarily to enrich salesmen and promoters. These investment schemes included tax shelters – whether real estate, oil and gas, or other assets; unregulated investment companies, e.g., Bernie Cornfeld's Fund of Funds; trading systems; heavily margined portfolios; hedge funds; many emerging market investments; Initial Public Offerings (“IPO's”) where the gross spread is rarely below 7%; and Ponzi schemes. A good deal of the time many OPMIs ended up wiped out. Mutual fund investors are rarely, if ever, wiped out. It is virtually impossible, or at least, extremely difficult, for rip-offs to occur in the case of non-borrowing OPMIs who hold mutual fund shares in Regulated Investment Companies (“RICs”). This is so because the rules and regulations under the Act are so protective of OPMIs. Investors in mutual funds may lose money if a fund manager is stupid or incompetent – but they will virtually never lose money because of theft, extortionate fees, or managers who fund their speculations with large amounts of borrowing. In brief, the substantive protections delivered by the Act for the benefit of RIC shareholders can be summarized as follows:

1. 1) The ability of RICs to incur debt is strictly limited. As a matter of fact, most RICs never borrow, and the RICs run by TAM have never borrowed.
2. 2) Management compensation is limited. Fees rarely exceed 1.5% of assets under management. For RICs,there is no “2 and 20” which is common for hedge funds, i.e., a 2% management fee plus 20% of profits after a “bogey” of say 6%, has been earned.
3. 3) Affiliated transactions (i.e., with parties related to the RIC) are strictly controlled.
4. 4) Fund assets, i.e., the securities portfolios of the RIC, are held by highly responsible custodians.
5. 5)Fund management can invest only in accordance with the RIC's stipulated Investment Policy.
6. 6) Financial results are audited annually.
7. 7) In almost all cases, a majority of the management company's Board of Directors must be independent, i.e., not part of fund management or the fund management company.
8. 8) RICs are required to diversify if they are to obtain Subchapter M treatment under the Internal Revenue Code, and virtually all RICs do so. Subchapter M treatment provides that a RIC generally will not pay federal income taxes if it distributes virtually all of its annual net income and capital gains to its shareholders.

Though nobody seems to have meant it that way, the Act may be a product of genius. On the one hand, OPMIs receive excellent substantive protections to such an extent that they can be deemed to be getting close to an even break. On the other hand, promoters and managers of RICs are reasonably well compensated; money management tends to be a quite profitable business for fund managers, i.e., management companies able to achieve reasonable size and also enjoy reasonable persistence in terms of the amount of assets under management. Fund managers face onerous regulation under the Act, especially since the nature of the fund investment is to be passive, rather than to be control-conscious activists. Yet the managed fund industry seems to me, to attract quite competent money managers, especially among that group, which includes TAM, known as Value Investors. Index Funds, i.e., RICs which merely track a stock market index and do no fundamental research, have far lower fees, and far lower expenses, than managed funds. Yet investing in managed value RICs, such as the funds run by TAM, seems to have been much more profitable for OPMIs than investing in index funds, on average, most of the time and over the long run. Index funds are an outgrowth of believers in the Efficient Market. The Efficient Market Hypothesis (“EMH”) and Efficient Portfolio Theory (“EPT”) make up Modern Capital Theory (“MCT”); theories which underlie virtually all academic finance. Efficient market believers are of the view that market prices, at any time, are the best measure of the universal value of any business or any security for any purpose of measurement. Proof of the validity of this view, according to MCT, is the fact that no money manager outperforms any relevant price index consistently. Consistently is a dirty word; it means all the time. This consistency test is as phony as a three dollar bill. The most any money manager can do is outperform relevant indices on average, most of the time and over the long run. It seems as if many value funds have passed this latter test with flying colors indicating that there is no universal efficient market. If one does not believe in universal efficient markets, index funds don't seem to make a lot of sense. According to MCT, efficient markets are a general law, applying to “the market”. I think that is nonsense. There exist myriad markets, some of which are characterized by ad hoc (not universal for all purposes) efficiency; some markets are inherently highly inefficient in terms of setting rational prices and yet other markets are in between. Put simply, efficient markets constitute a special case, not a general law. Most OPMIs probably deal in relatively efficient ad hoc markets. In contrast, value investors, control investors, probably most distress investors and the best of the short sellers participate in markets characterized by inefficiencies. Value investors, control investors, distressed investors and skilled short sellers, tend to be very much involved in the in-depth fundamental analysis that permits them to make reasoned judgments about the existence of inefficient pricing. Whether or not a particular market tends toward ad hoc price efficiencies or not seems to depend on four factors:

1. 1) Who are the market participants?
2. If the participants in the market are short-run focused and untrained in fundamental value analysis, then you're in an efficient market. Most individual investors and mutual funds probably find themselves here. Value investors, control investors, distress investors and skilled short-sellers operate elsewhere, but here, in efficient market land, you'll find almost all of the finance professors and economists in the United States. This is the market for those who focus on short-term securities prices. They encounter severe market risk as securities prices fluctuate from day to day.
3. 2) How complex is the security being analyzed?
4. If the security being analyzed is analyzable by reference to only a very limited number of computer programmable variables, you can bet your bottom dollar that the security will trade in a market characterized by an ultra high degree of short-run price efficiency. If analyzing the security is a complex matter – e.g., in common stock analysis TAM puts great weight on balance sheet credit-worthiness while most others emphasize earnings or cash flow forecasts – the market prices will tend to show great price inefficiencies from the point of view of the TAM value analyst. Indeed, if the common stock being analyzed is the issue of a going-concern with a perpetual life where the corporation has no near-term exit strategy, then for many purposes the pricing of that common stock issue will reflect pricing inefficiencies. Three types of securities are analyzable by reference to a very limited number of computer programmable variables and thus tend to trade in a market that is highly efficient in the short run. These three types are as follows:
• - Credit instruments without credit risk, e.g., U.S. Government Bonds.
• - Derivatives, including options and convertibles.
• - Risk arbitrage, i.e., where the great weight of probability is that there will be a relatively determinant workout in a relatively determinant short period of time, say, a publicly announced merger.
5. 3) How long is the market participant's time horizon?
6. Insofar as the market participant is short-term conscious, for the participant's purposes, the market will tend to be highly efficient. Insofar as the participant's timing is long term, or indeterminate, the market will tend to be highly inefficient. Take for example, the manager of a Leveraged Buy Out Fund, who in the case of one of his successful buy-outs is seeking an IPO for the successful investment as an exit strategy. The manager knows that the IPO market is extremely capricious. There are times when a common stock issue can be marketed at super attractive prices (say 1999) and times when a new issue can't be sold at any price (say 2008). For the manager, the IPO market is inefficient so he takes a five year view, confident that sometime during that interim he will succeed in having an IPO exit at a highly attractive (inefficient for the OPMI) price.
7. 4) How strict are the external forces imposing price discipline on the issuer or the issue?
8. There are all sorts of forces imposing discipline on issuers and issues. These forces include competition, government regulation, boards of directors, attorneys, accountants, labor unions. Insofar as there are strict external forces imposing discipline, prices will tend to reflect an ad hoc price efficiency. For example, look at the pricing in markets for U.S. Government Bonds. Insofar as the external force imposing discipline is weak, prices will tend to reflect underlying price inefficiencies. For example, it is generally accepted that OPMIs place great weight on accounting earnings as reported. Insofar as auditors are lax (e.g., permit insurance companies to under reserve for losses), market prices will reflect an overpriced common stock, an inefficiency in the eyes of most observers.

In MCT, there is a theory that the OPMI markets are efficient because information, when made public, impacts market prices. The problem is that most market participants don't know what information is important, and they don't know that they don't know. The tendency is that what short-run speculators think is important is information. Such speculators tend to be extremely short-run conscious, overestimate the importance of reported earnings for most companies, especially short-run estimates of income; invest trying to pick market bottoms; have a technical-chartist approach; ignore balance sheets and net asset values; emphasize macro factors rather than details about an issuer or issue; and are more interested in figuring out what “the average opinion of the average opinion” might be rather than have an independent judgment about underlying value. To believe that the buy-sell actions of these market participants determine anything close to a universal price efficiency is to believe in the “tooth fairy”. It is simply unscientific to equate OPMI pricing with a universal efficiency; there just is no basis for concluding that there are rational reasons pointing to a relationship between OPMI pricing and other values such as the value of control. My family and I have substantial funds invested in Third Avenue Value Fund. We have no funds invested in index funds. So far, that has been the right way to go most of the time, on average and over the long term. For a demonstration of this, read Ian Lapey's TAVF quarterly letter where TAVF's annual performance is compared with the annual performance of the S&P 500 and the MSCI World Index. For the full first quarter commentary, click here.