Fund Focus: Masters' Select Offers Diversification -- With Risks

It's never easy to pick a mutual fund, as I've noted before. If you pick an equity fund, for instance, there's a wide spectrum of investment styles and cap sizes to choose from, and then there are thousands of mutual funds that invest in the fashion you favor.

And they can be expensive, too. The ones that sound really tempting can have high fees of 2% of your assets and require a minimum deposit of around $10,000. You can leave the choice to a registered investment advisor or a broker-dealer, but you could wind up paying a second layer of fees.

This is the conundrum that has plagued every individual investor since the Investment Act of 1940, which created the modern mutual fund. It's also the angle that Litman/Gregory Fund Advisors, a registered investment advisor that administers nearly $6 billion in Orinda, Calif., was working from when they launched the Masters' Select Equity Fund (MSENX) in April last year. (It's the new retail version of a more expensive institutional fund that Litman/Gregory has managed since December, 1996.)

Unusual Access for Retail Investors

According to Jeremy DeGroot, who manages Masters' Select, it was intended to give individual investors who aren't particularly rich an opportunity to pick a single mutual fund that would be completely diversified across equity investment styles and cap sizes -- and run by active stock-pickers from institutional money-management firms that have respectable track records and are generally inaccessible to most retail investors.

"We're finding great stock-pickers, having them focus on their best ideas and creating a mandate where they're thinking long-term and not worrying about shorter term underperformance or volatility because you've got other managers to provide that diversification," says DeGroot.

Just to be clear here, Masters' Select is not an automated target-date fund that mechanically moves your assets out of equity and into fixed income as you get older. It's not an expensive fund-of-funds that charges two layers of management and performance fees, either. Litman/Gregry charges a relatively low management fee of 1.56% and uses it to pay seven different institutional managers to pick 10 to 15 stocks each for a portfolio of 90 stocks. The minimum deposit is only $1,000.

Allocation With a Strong Track Record

The portfolio is neatly divided into five sleeves, each of which makes up 20% of its assets. Two small-cap managers, Freiss Associates and Wells Capital Management, invest one sleeve in a blended growth-and-value style known as "growth at a reasonable price", or GARP.

Two growth managers, Sands Capital Management and Turner Investment Partners, invest another sleeve in in large-cap value stocks. Another GARP manager, Davis Selected Advisors, invests a sleeve in large-cap stocks. Southeastern Asset Management invests a sleeve in large-cap value stocks. The last sleeve is managed by Harris Associates, which invests in large-cap value stocks.

Personally, I find it puzzling that the assets are broken up into large round percentages that almost anyone could devise on the back of an envelope. DeGroot says the allocations are based on Litman/Gregory's past experience of what has worked best for their private clients, which is a four-to-one ratio of large-cap to small-cap stocks, and large-cap stocks spread evenly among growth, value and blended styles.

"Saying it should be 17% and 23% would be false precision," DeGroot told me over a cup of coffee. "That's not going to drive the performance as much as the general weightings."

Not That Safe?

What's much more important, DeGroot stresses, is finding talented stock pickers. "You need to get access to these guys, dig in really deep and understand their investment approach -- which we don't think just anybody can do."

But it's not clear that Masters' Select is a safe bet. For one, no matter how diversified this fund is, you'd still be putting all of your eggs in one basket if you picked this fund as a substitute for a smattering of mutual funds.

Also, Masters' Select is highly exposed to the same risk that all active stock pickers face. On average, they only get their stock picks right a little more that half the time -- and even less than that in some years, according to studies by consulting firms McKinsey & Co. and Towers Watson.

That's one reason why a lot of investors have stopped trying to pick active managers and are moving their money into passive index funds that hug benchmarks like the Standard & Poor's 500 Index, for better or worse.

Stock-Picker Shuffle

Just take a look at the fund's performance, which was horrific during the stock-market crash. Masters' Select underperformed the S&P 500 by 9.9 percentage points in 2008 -- a year in which the index was down 37% -- and delivered a memorable 46.9% loss for the year.

Masters' Select now has $347.7 million in assets, and investors aren't exactly throwing money at it. Morningstar, the Chicago-based mutual fund data provider, gives this fund only two out of five stars.

DeGroot says he and his colleagues have been working hard to improve this fund's performance. Until they assessed the stock-pickers last year, one of them was Legg Mason Value Trust, which had beaten the S&P 500 for 15 years straight until 2007, when it ran into performance problems. Southeastern took Value Trust's place.

To some extent, DeGroot's rethink seems to be having the desired results. During the past 12 months, Masters' Select has registered a total return of 46.8%, beating 89% of the similarly diverse funds that Morningstar covers. The question is whether the convenience of leaving all those head-aching decisions to someone else is worth the risk. It could take a few years before anyone can say for sure.