Masters' Select Funds Flounder

Take a great idea. Hire terrific people to implement it. What do you get? Often in investing, you don't end up with what you expect.

That's the situation of the Masters' Select funds. The funds, which are run by teams of mostly top-notch managers, are stumbling this year. Look at the numbers. Masters' Select Equity has returned 4%, putting it in the bottom 3% among large-cap blend funds. International has earned 12% -- four percentage points behind the MSCI EAFE foreign index. Value has returned 9%, putting it in the bottom 9% among large-cap value funds. Smaller Companies has earned just 7% -- about half the return of the Russell 2000.

The 2006 numbers are undermining a couple of the funds' three-year numbers as well. Equity is in the bottom 29% of large-cap-blend funds over the past three years. Value ranks in the bottom 17% against large-cap value funds over the same period.

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"It's frustrating," says Ken Gregory, who supervises these unusual funds. "This year, particularly, we've given up a lot of performance."

I'm not writing about these funds merely as a journalistic exercise. I have my own money invested in Equity, and I've advised many of my friends to follow suit. Equity is in the Kiplinger 25, as are other funds run by many of the Masters' Select funds' managers.

How the funds work

Multiple managers run all the Masters' Select funds. Working independently, each manager is responsible for a percentage of a fund. In addition, each manger is allowed to invest in no more than 15 stocks.

The theory: A talented manager's favorite stocks will do better than the rest of his holdings. Such a fund, however, would be quite volatile. So Gregory hired several managers with varying investment approaches to run each of the funds.

I wouldn't have paid much attention to Gregory's grand scheme -- except that almost all the managers he has hired are terrific. What's more, he's a first-rate fund analyst himself and has shown a willingness to dump managers who lose their touch.

The lineup on Masters' Select Equity (MSEFX) includes Christopher Davis and Kenneth Feinberg of Selected American Shares; Longleaf Partners' Mason Hawkins; and Legg Mason's Bill Miller. I'm not keen on Craig Blum and Stephen Burlingame of TCW Select Equities -- but they're managing just 20% of the fund. Besides, you're getting Miller at a much lower expense ratio -- 1.18% -- than he charges on his own funds. And Longleaf is closed to new investors.

Masters' Select Value (MSVFX) is even more compelling. The managers are Miller; Hawkins; Oakmark's Bill Nygren; and Michael Embler and Peter Langerman, co-managers on the Mutual Series funds. New Mutual Series shareholders must pay a load to invest.

We took Masters' Smaller Companies (MSSFX) out of the Kiplinger 25 this year only because it was closed to new investors. Newly reopened, it offers Brandywine's Bill D'Alonzo, Ariel's John Rogers, FPA's Robert Rodriguez and Wells Capital Management's Dick Weiss. All are first rate. I'm not sold yet on Copper Rock's Mike Malouf and Tucker Walsh.

Masters' Select International (MSILX) is closed, but it has a good lineup, too.

So what in blazes has gone wrong? "Most of our managers are doing poorly compared to their benchmarks," Gregory says. "Most of our managers are underperforming -- and a couple are underperforming by a lot." He wouldn't mention names, but Legg Mason Value and TCW Select Equities are each ten percentage points behind the average large-cap-value and large-cap-blend fund this year. Their managers' picks for Masters' are probably doing at least as badly, though Gregory won't break out the performance of individual managers' selections.

"Historically, when we've had this happen, we've come out the other side with strong performance," Gregory says. "Our managers are long-term oriented, so they tend to add money to falling stocks, and ultimately they've made money."

Gregory and company spend a lot of time talking to the funds' managers, studying the numbers and discussing whether specific managers have merely hit rough patches -- or whether it's time to find someone new. I think they're blowing it by sticking with TCW Select Equities, and I think the Copper Rock team is a question mark -- but my record of assessing managers is hardly perfect either.

What it all means

The bottom line: Just as I suggested two months ago about Bill Miller, it's usually a buy signal when good funds falter. Everyone has bad years, and when the good managers rebound, they tend to pile up terrific numbers. That's because, as Gregory says, they're adding to controversial stocks that are falling.

Short-term records of funds are often misleading; longer-term records are what you should always focus on. And the longer-term records of all these funds are fine. Against peers over the past five years, Equity ranks in the top 17%, International in the top 9% and Value in the top 30%. Newer entrant Smaller Companies ranks in the top 27% among its competitors over the past three years.

Equity is a solid large-cap, core holding. Smaller Companies is one of the best small-cap offerings still open, though I'd pick Champlain Small Co Adv (CIPSX) ahead of it. Value may be the best single value fund on the market. International is a fine fund, too, but Dodge Cox International (DODFX) is much better. I'm not a fan of Gregory's new fund, Select Focused Opportunities (MSFOX), because the TCW pair run one-third of it.

Steven Goldberg is a freelance writer and former senior associate editor of Kiplinger's Personal Finance magazine.