Fund Alarm- Oct. 2010 Article on PRPFX- Must Read

[hrux]

The following is a copt of David of Fund Alarm's comments on PRPFX.  Needless to say he is not a fan although several of his readers are.  Attempt to post the link although not sure if it will work.... http://www.fundalarm.com/arc0810.htm


Permanent Portfolio: Unlikely Superstar?

"I was prepared, from the outset, to dislike Jason Zweig’s recent article on the $6 billion Permanent Portfolio Fund (PRPFX) ("Unlikely Superstar: How a Forgotten Fund Got Hot in a Hurry," WSJ, September 18-19, 2010). Mr. Z., however, produced an essay more thoughtful than the headline assigned to it.

For those unfamiliar with Permanent Portfolio, the fund holds a series of uncorrelated assets, some of which are likely to thrive regardless of the state of the market or of the economy. Harry Browne propounded the underlying notion in the 1970s. He saw the strategy as, of all things, a way to run toward the despised stock market rather than away from it. The fund’s asset allocation never changes, except in the sense that sharp market fluctuations might temporarily throw it out of whack. Give or take a little, the fund invests:

20% in gold

5% in silver

10% in Swiss francs

15% in real estate and natural resources stocks

15% in aggressive growth stocks

35% in cash and U.S. bonds

The fund has produced perfectly splendid results over the past decade, with an annualized return of 10.7% and a 2008 loss of only 8%. The fund is no-load, it takes only $1000 to get in and expenses are 0.8%.

Mr. Zweig’s article makes two points. First, much of the fund’s success is driven by mania. Bill Bernstein of Efficient Frontier Advisors wrote an essay critical of Permanent Portfolio’s newfound popularity. Fifty-five percent of the fund is in bonds and gold, which Bill Bernstein describes as being in the midst of "a non-stop beer-and-pizza party." Those same wildly attractive assets, over the long term, have been dismal losers. Mr. Bernstein reports:

Diversifying asset classes, as Harry Browne knew well, can benefit a portfolio. The secret is deploying them before those diversifying assets shoot the lights out. Harry certainly did so by moving away from gold and into poorly performing stocks and bonds in the late 1970s. Sadly, this is the opposite of what the legions of new TPP adherents and PRPFX owners have been doing recently—effectively increasing their allocations to red-hot long Treasuries and gold. Consider: over the long sweep of financial history, the annual real return of long bonds and gold have been 2% and 0%, respectively; over the decade ending 2009, they were 5% and 11%. ("Wild About Harry")

Second, all of the money that poured in will – just as quickly – pour out. "[M]any of its new buyers," Zweig opines, "seem to be seeking capital appreciation – chasing this fund the same way they chased Internet funds in 1999 and 2000. They could leave just as quickly." Mr. Bernstein is rather more pointed: "During the frothy 1990s stock market, however, investors abandoned the fund in droves."

That is, by the way, an enormous problem for the remaining shareholders. The rush out forces the manager to sell, without regard to the wisdom of selling, just to meet redemptions.

Some of FundAlarm’s most thoughtful professional investors use Permanent Portfolio as a core position in their more conservative portfolios, providing substantial and consistent profits for their clients in the process. Despite that fact, I have never warmed up to the fund, and doubt that I ever will.

Setting aside the fact that it’s an index fund that charges 0.8%, I’m troubled by two things. First, the manager has neither closed nor even discussed the possibility of closing the fund. In most cases, responsible managers seek to dissuade a mindless inrush of (highly profitable) cash. Vanguard imposes high investment minimums, for example, $25,000 in the case of its Health Care fund (VGHCX). Oakmark restricts access through third-party vendors for several of its funds. Bridgeway, Artisan, Leuthold, Wasatch and others simply close their funds. Permanent Portfolio, instead, welcomed an additional $3,000,000,000 in the first eight months of the year – which provides an additional $24,000,000 in revenue to the advisor. In 2009, Mr. Cuggino’s firm, of which he is sole owner, received $31,286,640 in fees from the fund. In 2010, that’s likely to approach $60,000,000.

Mr. Cuggino does report "I’ve educated people right out of our fund." Given that the fund’s website dubs it "a fund for all seasons" and the manager is a frequent speaker at money shows, it’s not clear exactly who he has talked away or how.

Second, the manager’s interests are not aligned with his investors. Though Mr. Cuggino has had a long association with the fund and has managed it since 2003, he’s been very reluctant to invest any of his own money in it. The fund’s 2006 Statement of Additional Information reports, "As of April 30, 2006, Mr. Cuggino and his immediate family members owned no shares of the Fund." A year later that changed, but in an odd way. The SAI now reports that Mr. Cuggino 2,3 owns "over $100,000" in fund shares. Those footnotes, though, indicate that "As of April 30, 2010, Mr. Cuggino owned shares in each of the Fund’s Portfolios through his ownership of Pacific Heights."

Which seems to say, the company buys the shares for him. And the company likely pays him well. My favorite passage from the 2010 SAI, with emphasis added,

Pacific Heights, of which Mr. Cuggino is the manager and sole member (also its President and Chief Executive Officer), compensates Mr. Cuggino for service as the portfolio manager for each of the Fund’s Portfolios. As the manager and sole member of Pacific Heights, Mr. Cuggino is the owner of Pacific Heights and determines his own compensation. Mr. Cuggino’s compensation from Pacific Heights is in the form of a share of Pacific Heights’ total profits.

So he collects a salary ("not based directly on the performance of any of the Fund’s Portfolios or their levels of net assets") for serving as the firm’s president and gets to allocate to himself (apparently at his discretion) a share of the firm’s considerable profits.

What does he do with his money, if not invest it alongside his shareholders? I don’t know, though the SAI contains the slightly-nervous warning that

Actual or apparent conflicts of interest may arise because Mr. Cuggino has day-to-day management responsibilities with respect to each of the Fund’s Portfolios and certain personal accounts. The management of the Fund’s Portfolios and these other accounts may result in Mr. Cuggino devoting unequal time and attention to the management of the Fund’s Portfolios and these other accounts.

Mr. Cuggino is subject to the Fund’s and Pacific Heights’ Amended and Restated Code of Ethics, discussed in this SAI under "Code of Ethics," which seeks to address potential conflicts of interest that may arise in connection with Mr. Cuggino’s management of any personal accounts. There is no guarantee, however, that such procedures will detect each situation in which a potential conflict may arise.

There is no reason to believe that Mr. Cuggino has done, is doing or ever will do anything improper in his management of the fund (unless sopping up assets to generate huge fees is wrong). Nonetheless, given the tremendously foul history of the fund under its previous management (after repeated violations of SEC rules, Morningstar became so disgusted that they dropped commentary on the fund for 15 years), a far more transparent approach would seem appropriate."

[MediumTex]

There are too many weak points in that article to attempt to address each of them.

Overall, the writer of the article seems to have a shallow understanding of the PP in general.

It is certainly a potential problem for PRPFX (or ANY fund) to have massive redemptions, but i don't see that this is a bigger problem for PRPFX than any other fund.  For example, has anyone seen an article cautioning against buying Vanguard Wellesley because of what might happen in the event of massive redemptions?

As for Cuggino not owning that much of the fund, who cares?  PRPFX's performance is a function of its design, not how many shares Cuggino owns.

Thanks for posting the article.  Just more market pundit noise, the Wall Street equivalent of an ad for vinyl siding on the AM dial. 

[craigr]

I don't know enough about the fund to comment on the article in depth. If you can run your own portfolio and not use a money manager (even a fund manager) that is always best. This way you don't have to worry about manager risk, higher fees, etc. But some people do not want to do this or cannot for whatever reason and that leaves the commercial fund.

FWIW. I would suspect that most fund managers have little of their own assets in their own funds. This is not something I would do personally if I ran a fund (I eat my own dog food because I think managers should have skin in the game along with the people trusting them to manage their money). But if that bothers people they can just not use the fund and save over 0.50% a year in management fees and run their own index fund version in the 4x25% split. This is always the #1 option in my mind. 

[foglifter]

"... it’s an index fund that charges 0.8%," - that's an odd statement, I don't know where he got this from. Perhaps it's better to call PRPFX a passively-managed active fund meaning its moderate turnover rate is comparable with some true index funds.

I own PRPFX in my taxable account (outside of my PP portfolio) only because I like it's tax efficiency.

[Plurimus]

Thanks hrux for posting this article! I especially enjoyed the article of Jason Zweig, which Fund Alarm is referring to, as it seems better researched.
I recently read The Intelligent Investor of Benjamin Graham with comment of the mentioned Jason Zweig, which is a contrarian/value investing bible. So although it advises to pick stocks according to certain criterias, which is against the passive investing belief, I still love it's simplicity.
I confess that I still do some stock picking for my equity share in the portfolio instead of buying the index, but this is also partially due that the main index of my home country Switzerland is so strongly weighted in Pharma and Banking stocks that I simply sleep better, when I know that my equity investments are in some other sector equities.