Fund Focus: Discovering Institutional Funds for Individual Investors


Chris McIsaac has been investing in mutual funds ever since his boyhood in Edmonton, Alberta, where he deposited his summer-job wages of about 1,000 Canadian dollars into a growth-oriented Altamira fund.

"At the age of 15, I guess growth sounded good to me," he recalls. Better still, the fund made money, taking him south of the border and helping to pay for his first year at St. Joseph's University in Philadelphia.

Twenty years later, the 35-year-old McIsaac is armed with an MBA from Harvard Business School and 13 years of experience at Vanguard, the gargantuan mutual fund complex in Valley Forge, Pa., where he has held several positions. He's the kind of person from whom an investor can learn a lot about how to pick mutual funds.

An Alternative to Dull Index Funds

As principal of Vanguard's portfolio review group, McIsaac's job is to vet and hire small firms to manage bits and pieces of Vanguard's sky-high $1.35 trillion asset pile. The point is to give Vanguard's clients an alternative to its singularly dull and unambitious index funds, which pretty much mimic benchmarks like the Standard & Poor's 500 Index.

But McIsaac is picky. He and his team will only consider so-called active portfolio managers who actually visit the companies they invest in and meet the executives -- a research method that's supposed to beat the benchmarks. They also make sure that every portfolio manager they interview is executing his strategy as he describes it.

"If you say you are 'using a dividend discount model to value companies,' then the portfolio has to show that," says McIsaac.

Top Performers Not Always Needed

Ironically, stellar performance is not the main criterion that McIsaac holds portfolio managers to. If a fund has been in the top quartile for too long, his rule of thumb is that it could soon sputter out and slow down. So he sometimes prefers managers who actually have performance problems but are in the process of fixing them.

"A one-star fund is more likely to be a five-star fund over the next three years than a five-star fund is," says McIsaac. "That's a lesson we try to keep at the fore of our mind when we choose managers."

Over the years, the portfolio review group has built up a sort of fund-of-funds business within Vanguard that now employs 33 outside firms that manage $315 billion of Vanguard's assets in 75 different investment strategies. That's the same amount of money that T. Rowe Price was managing, in total, in June 2009.

In the process, McIsaac is discovering fine institutional managers who have gone unnoticed by mutual fund investors. Institutional managers tend to charge lower fees than retail mutual fund managers because they're accustomed to taking large deposits from pension funds and other big investors for whom the minimum deposit is about $200 million. At Vanguard, the economies of scale are such that when a new fund manager comes aboard, he or she has an instant mandate to manage billions of dollars in assets.

"We are a big client for them," he says. "We are an institution for them."

Doubling Clients' Money

After looking at about 300 funds last year and speaking with the managers of many of them, Vanguard announced its latest product, the Vanguard Explorer Value Fund (VEXPX), on March 16. It's managed by three firms that specialize in managing small and mid-cap stocks, a style that some fund managers used to double their clients' money -- or more -- over the past 12 months. But the performance of these funds is mixed, and McIsaac says they were selected mainly for their strong investment discipline.

One of the three firms is Cardinal Capital Management of Greenwich, Conn. Cardinal delivered a total return of 34.6%, net of fees, to institutional investors in its Small-to-Mid Cap Value Equity Strategy during 2009, according to the most recent numbers available from the company. That was safely above its benchmark, the Russell 2500 Value Index, which was up 27.7% for the year. But it fell 4.8% during the three years ended Dec. 31, 2009, underperforming the Russell 2500 by 7%.

Another is Sterling Capital Management of Charlotte, N.C. The BT&T Sterling Capital Small Cap Value Fund (SPSCX) soared 54.5% in 2009, after losing 32.6% in 2008. In both years, it beat the S&P 500 by a long shot. But it was down 3.1% during the three years through Dec. 31, 2009, beating the S&P by just 2.6%.

The third is Frontier Capital Management of Boston, which declined to disclose its performance. But this is Vanguard's second hiring of that firm, which is already one of the managers of the Vanguard Morgan Growth Fund (VMRGX).

Diversity Rules

As is the norm for Vanguard's outside managers, each of the three firms hired for Explorer Value is being assigned to a different arm of the fund to even out the ups and downs in the years to come. If one fund falters, the second or third could rise or remain flat, softening the impact on a Vanguard client. (Every dollar you invest in this fund gets distributed equally to all three managers.)

"We think there is a benefit and an advantage in that diversity," says McIsaac.

So, as McIsaac and his have team assembled it, Explorer Value would help you spread your risk around a bit while still staying within a single investment strategy. But this fund still isn't for the faint of heart -- or the light on cash. The minimum deposit is $10,000, the norm for retail funds that are managed by institutional firms.

Originally published