Never mind that Cliff guy.

Cale’s NotesA free summary of an investing book you should have read...if you’d only had the time. 

Cale Smith • csmith@islainvest.com • Islamorada Investment Management • Issue No. 1

Distributed with permission of the publisher.

The Investor’s DilemmaBy Louis Lowenstein

Summarized and distributed with permission of the publisher.

Note from Cale:

“If you continue to do what you’ve always done, you’ll continue 

to get what you’ve always got.” ­ Yogi Berra

Louis Lowenstein died in April of 2009.  He was, as his obituary noted, an in;luential business law professor and former corporate executive who for almost thirty years chronicled the excesses of Wall Street while warning of the dangers of short‐term investing.  

I prefer, however, the description that Barron’s magazine gave of Mr. Lowenstein in 1998:

“Merrill Lynch, meet your worst nightmare.”

I had the pleasure of an all‐too‐brief email exchange with Louis a year prior to his passing.  I’d read “The Investor’s Dilemma” and had enjoyed it thoroughly.  We shared a common philosophy in value investing, and perhaps more notably, a shared distrust of mutual funds. 

A few months later, as the credit and subprime mortgage crisis began to rock the markets, I left my job, took out a blank sheet of paper, and began to ;igure out how to build a fund I would be proud of managing.  The result of that effort is now called a spoke fund.  This book served as a blueprint in more ways than one.

So, please enjoy.  The ideas in here are worth spreading. And long live spoke funds.   

                                  

                      Cale Smith Islamorada Investment Management

csmith@islainvest.com

The Investor’s Dilemma By Louis Lowenstein Summarized by Cale Smith, Managing Partner, Islamorada Investment Management Reproduced with permission of the publisher Introduction “There is something rotten in the mutual fund industry.” That’s how Louis Lowenstein begins – by relaying his core belief about the mutual fund industry: the industry has betrayed investors by changing the goal and character of the industry. Originally designed to support the well being of investors in the long term, mutual funds have become instead a large repository of cash and funds to be abused by managers whose primary concern is not to invest wisely, but to accumulate assets under management to fatten the coffers of the management company. The industry, according to Lowenstein, has abandoned its fiduciary duty to investors and has instead turned into a marketing machine, “making a nice business for themselves.” Chapter 1- Mutual Funds: A Painful Birth Chapter 1 examines the birth of the mutual fund industry and the changes to the industry since its established foothold in the 1920’s. Lowenstein explains that although the industry has seen various abuses and scandals since inception, the original idea of pooling funds was a simple and good one that delivered many benefits to investors. Unfortunately, mutual funds no longer deliver those benefits today. The industry began in late 19th century Britain, when a pool of funds opened for smaller investors who were willing to purchase government debt. The idea was not new: it was based on an earlier idea held by the Dutch who correctly reasoned that pooled money would give investors the opportunity to diversify, enter into large markets which were otherwise inaccessible, and afford them greater liquidity. The pooled money industry had a heyday in the 1920’s, when a complete lack of any meaningful regulations enabled everything from dramatic fund implosions to outright embezzlement. Soon after, the new Securities and Exchange Commission expressly outlawed the more egregious practices of the funds. In 1924, with the birth of the Massachusetts Investor’s Trust (MIT), the beginning of the mutual fund industry as we know it today formally began. This MIT fund was unique in that it was the first “open end” fund, which provided a degree of liquidity and fairness that had not been present before. In an open-ended fund, investors wishing to cash out their holdings in the funds could sell their stake back to the issuer at a price that reflected the price of the portfolio securities divided by the shares outstanding at the time. The value of the idea, other than increased liquidity for investors, came in the form of greater transparency (disclosure of securities present in the fund) and greater liquidity.

Lowenstein suggests that MIT was a “trust fund, not just in form but in substance.” Along with the greater transparency, there are two other characteristics that, for Lowenstein, are evidence that a fund is working under fiduciary duty: people personally invested in the fund managed the fund, and the trustees of the fund received payment based on performance. The payment for performance included receiving no management payment if the fund did not make a return, and a constantly diminishing management fee, which reflected the passing along to customers of the savings generated by the increased economies of scale. The industry inevitably began to change soon after, however, and ultimately three characteristics emerged to ruin the model of open-ended funds: the abandonment of fiduciary duty, an increase of fees, and a steady focus by funds on gathering more assets. The breach in fiduciary duty is exemplified, according to Lowenstein, by the creation of a management company to oversee the funds. The management company, owned by the fund managers, soon was seen as a marketing construct that needed to generate returns for its owners. As this conflict of interest became apparent, Lowenstein argues, fees begun to rise – even in the MIT fund. Lowenstein tells us that by 1969 the downward trend for management fees reversed itself entirely, and went from 0.19% expense ratio in 1976 to a 1.2% in 2003. Thirdly, as the emphasis shifted to profitability for the management company, the funds turned their focus to gathering more assets. As the amount of funds under management increase, the cost to manage them decreases: there is an inherent economy of scale. But the savings were not passed on to the fund holders. Instead, management fees increased, but were now applied to a larger pool of funds. The monetary benefit for the management company became too good to pass up, Lowenstein tells us, and although MIT’s assets have grown seven times, total fees increased 36 times. Lastly, this new focus on generating returns for the management company spawned too many funds - all with the focus of capturing those assets. This inevitably hurts investors because performance declines and, perhaps as a result, the funds begin to trade energetically, generating even further fees for investors. Chapter 2- Searching for Rational Investors in a Perfect Storm Having explained the inherent problems with the mutual fund industry, Lowenstein in Chapter 2 explores the behavior and characteristics of “value funds.” Value funds, says Lowenstein, are managed by investors that subscribe to the Graham-and-Dodd theory of investing, which teaches that investing should be the result of careful, painstaking research, and securities should be bought at a price lower than their inherent value. These smart investors, Lowenstein argues, not only exist but are outperforming the market as a whole - consistently. So, he reasons, it is worth the time to look at their characteristics more closely. First, however, Lowenstein explains the difference between value investing and the academic’s maxim of the Efficient Market Theory (EMT). EMT teaches that stock prices reflect all available information in the market- that prices of securities fluctuate up or

down in response to trading by “smart investors” who take advantage of new information and quickly bring prices in line with to the “correct” value of the security. The logical conclusion of the theory is that no investor can outperform the market for long because all the available information about a company has already been factored into the current price of its shares. Lowenstein makes two points to deflate the EMT: firstly, markets are not efficient all of the time, and secondly, markets are susceptible to human irrationality and subjectivity. The lack of efficiency in the markets, Lowenstein tells us, is exemplified in the bubbles: the rise of the S&P 500 Index Fund to $400 billion in the late 90’s was clearly not efficient. Companies were overvalued, trading at prices that did not reflect their lack of revenues or net income. This, Lowenstein tells us, is the second problem: traders are not rational, but are susceptible to the media frenzy that at that time was pushing “new economy” stocks and generated a huge surge in market prices. To further debunk the Efficient Market Theory, Lowenstein presents us with the most indisputable data of all: the Goldfarb 10, a group of 10 funds that consistently outperformed the market (as measured by the S&P 500, the market index). The Goldfarb 10 returned on average 10.8% in the five years 1999-2003, as compared to a negative return of 0.57% for the index. Furthermore, the Goldfarb 10 returned on average 13.49% in the 10 years ended Aug. 31, 2005 as compared to a 9.85% return on the index. After establishing that value investors do indeed exist and that they can generate a return on the market, Lowenstein turns to outlaying the characteristics of these funds.

1) Limited Number of Stocks. Value investors buy a limited number of stocks and are heavily concentrated. In 2003, the Goldfarb 10 held an average of 54 stocks in their portfolio, as compared to 160 average stocks held in the portfolios of typical mutual funds. The portfolio concentration bespeaks of careful, bottom-up research and leads to the funds’ ability to take advantage of the upward swing in prices of a security. Another characteristic of these funds is that they hold large amounts of cash- as Lowenstein says, it is preferable not to buy at all than to buy at inflated prices.

2) Low portfolio turnover. Value funds, in this case the Goldfarb 10, held securities, on average, for about five years, compared to the average mutual funds’ holdings of 10 months. The reduced portfolio turnover directly benefits investors by reducing the trading costs of the funds, but, more importantly, the low portfolio turnover tells us that the value funds define “portfolio risk” as “business risk”: they purchase securities as they would a company. By doing this, value managers safeguard against swings in the market and instead focus on the company’s ability to improve performance.

3) Eating your own cooking. Managers are heavily invested in the funds they manage. This marks credibility and integrity for Lowenstein, and, furthermore, helps to further establish the sense of fiduciary duty in managers. As an offshoot of this increased sense of fiduciary duty, managers can close the fund to further investors to protect those currently in the fund.

4) Graham and Dodd Investing: Theme and Variations. All value fund managers follow a Graham and Dodd value of investing, which focuses on building a portfolio that has a comfortable margin of safety. The margin of safety concept relies on the idea that one must purchase shares at a price much lower than the intrinsic value of the security, so that downswings in the market do not affect the intrinsic value of the portfolio. The margin of safety concept of investing must be demonstrated numerically and/or with clearly reasoned positions: the value of the underlying business must be succinctly explained.

One last characteristic of value investors: they are a small number of the funds in the marketplace, and Lowenstein provides us with two reasons for this. The first one is that value investors exploit market inefficiencies, and good opportunities to do so would disappear if there were too many. Secondly, few managers or management companies can withstand the pressure to follow the crowd or to follow the whimsy of the market. These funds are self-directed and have long investment horizons. Chapter 3- The Anatomy of the Stock Market In this chapter, Lowenstein examines how the stock market works. Lowenstein earmarks four factors that combine to make the stock market a daunting prospect to a relatively inexperienced investor: securities are intangibles and easily created, security analysis is complex and difficult, stocks trade in an almost entirely secondary market, and there is excessive liquidity in the market. Before plunging into an analysis of the factors, however, Lowenstein takes pains to explain that there is a startling but sometimes overlooked problem in the market: a stock represents ownership of a specific company, but its price does not necessarily reflect the underlying value of the company. Although there is a tendency to equate the company value with the price of its outstanding shares, Lowenstein reminds us again of the boom-and-bust periods that we have seen in the market, where share prices were artificially inflated by speculation. Speculation, Lowenstein tells us, is very different from investing: in speculation, one seeks to know how a stock price will behave, not necessarily how the business itself will perform. When one speculates, one buys paper; when one invests, one buys a piece of a company. The first factor of the stock market that Lowenstein analyzes follows closely on this thought - that stocks are intangibles and can be easily created. Stocks are instruments that are easily created and can be issued at almost no cost. Historically, this had led to several abuses, including issuance of high quantities of stock just to, for instance, block a takeover attempt. Most recently, this abuse has taken the form of stock peddling, in which investors are urged to follow a security, rather than the company underlying it. The second factor he discusses is the complexity and difficulty of security analysis. For serious investors, analyzing a security in terms of the present value of future (but by no means certain) income stream of the underlying business is a painstaking and

time-consuming task. It requires enormous discipline, the ability to cope with uncertainty, and skill. Since prices are affected by the behavior of a public that is, to a certain extent, irrational, the difficulty in staying the course and properly analyzing new information is further compounded. The need to calculate, recognize and maintain a margin of safety is crucial for value investing, but it is also difficult to do. Thirdly, stocks trade in a secondary market, which means that stocks are not produced and consumed in quantity. In essence, as Lowenstein tells us, since other products like wheat are consumed in the form of bread, it is easier for stocks to zoom into overinflated price territory. After all, who would pay $50 for a loaf of bread? Since stocks are not consumed, the price set on them is almost arbitrary. This leads to an intense preocupation with the behavior of the market, not the behavior of the business that underlies the stock. Last but not least, the stock market is impressively liquid. The turnover rate in 2004 for the stock market was 97%, as compared to 14% in 1960. Stock derivatives and other financial instruments have compounded and increased liquidity in the stock market so that stock is held for months rather than years. There are two problems with such excessive liquidity. Firstly, as black Monday in 1987 showed, when faced with unreasonable dumping and computerized trading, liquidity is illusory- traders seeking to sell cannot because the market is over flooded with sell orders, and regular investors cannot find, or even place, a sell order. No one buys. Secondly, liquidity promotes excessive trading and irresponsible buying and selling. Since you can dissolve a position very quickly, investors are not as careful with their research. Speculators are attracted by this liquidity, which in turn affects the prices of securities since security prices are to a large extent subjective, or set emotionally. In all, the stock market is a difficult and unfriendly place in which prices are set somewhat arbitrarily and research can be comfortably avoided due to excessive liquidity. This hostile atmosphere is not easy to navigate, and in turn creates the necessity for specialists and market “seers” who pretend to take the mystery out of investing. Chapter 4- Investing at Warp Speed After explaining the peculiar nature of the stock market, Lowenstein turns next to an evaluation of the mutual fund industry. Specifically, the focus of this chapter is mutual fund performance and excessive trading. First, of course, Lowenstein provides us with some background on the mutual fund industry and its impressive growth. At the end of 2007, there were 4,800 equity mutual funds with total assets of $6 trillion. As a whole, mutual funds represent about $10 trillion. More importantly, over 90 million people own shares of stock funds. Although there has been great growth in the industry, performance has not kept pace.

In fact, as Lowenstein points out, the funds themselves have lagged the market while still copying closely its ups and downs. What the funds have been doing instead of performing is trading- constantly and excessively. On average, a mutual fund turns over its portfolio 100% or more a year. Performance has suffered because of it: taking a sample of 15 surviving mutual funds, Lowenstein has found that for the five years ended Aug. 31, 2005, these funds returned –8.89%, as compared to a negative return of 2.71% on the S&P 500. Excessive trading in a mutual fund is problematic on two levels. On the one hand, investors are charged with the fees incurred in trading, which increases management fees and robs investors of higher returns. Second and more importantly, as the fund size increases, the funds’ trading affects market prices in such a way that the fund cannot take full advantage of the trade. A large, multi-billion dollar fund buying a specific stock to accumulate a position in it is likely to drive the prices up so that the fund is cheated in that it is no longer buying at the lowest possible price. Similarly, if the fund is trying to liquidate a position, it is likely that its own trading will drive prices down, which could cost investors gains. In both cases, investors do not see the returns that they could otherwise make if the funds stopped vigorous trading. The market movement generated by the funds has a further impact both on the funds itself and the market at large. As funds trade, they attract speculators, not investors, into their fund. Since speculators have a shorter investment time span, they exert pressure on the fund to “do something”- to move with the market, which spurs further trading by the fund, affecting prices at large. Lowenstein argues that there is a viable but simplistic alternative to investing in a mutual fund: buying an index fund. Under this strategy, an investor can hope to make the market’s return: about 10% on average every year. The problem with this strategy is twofold. First, timing matters: an index fund can return 10% every year, but it does not hedge against market losses. An investor thinking about retirement money is forced to deal with the idea that at the time of his or her retirement, the market might be down. Secondly, regular investors are not likely to “buy and hold” the index, it is difficult to decide upon an index to buy, and even more difficult, to hold it through all market highs and lows. A regular investor, Lowenstein argues, must invest in a good fund - but they have to tread carefully to choose the right one. Chapter 5- Greed is Good: The Appeal of Publicly Owned Fund Management Company In this chapter, Lowenstein presents an overview of the mutual fund management industry and its inherent conflicts of interest, using investment management company T. Rowe Price (TROW) as an example. The overriding conflict of interest here, Lowenstein argues, is that fund managers of a publicly traded company are primarily responsible to the shareholders of the fund management company—not the investors

of the mutual fund itself. As such, managers focus on growing assets under management (AUM) to generate more revenue in the form of management fees for the management company. Performance of the fund takes a back seat, and the fiduciary duty that managers are entrusted with is violated. Lowenstein begins the chapter with an overview of the industry. The first thing we learn is that the industry is insanely profitable. In 2005, TROW had net profit margins of 28% and an 80% return on assets. The industry’s profitability has its basis in the scalability of the business, the fact that its customers (mutual fund shareholders) are locked-in due to time constraints and inexperience in handling money, and thirdly, a general disregard on the part of the public for fees levied by mutual funds…perhaps because investors believe that these financial intermediaries have their best interests at heart. Conflicts of interest. The fundamental problem with having a management company managing a fund is that management fees depend on assets under management, not fund performance. Therefore, it stands to reason that fund management companies are obsessed with increasing the asset base rather than with the performance of the fund. The problem is further compounded when individual managers are incentivized through the issuance of stock options for the management company-- after all, they are employees of that company. Lowenstein reveals to us that Brian Rogers, the chief investment officer at TROW, had at 2005 a measly $1 million invested in the funds that TROW managed, but had stock options on TROW totaling $65 million. Lowenstein tells us that managers at TROW have “hardwired their incentives so that, as the assets grow, so do their personal piggy banks.” Meanwhile, performance of the TROW funds suffered- in the 10 years ended in 1999, only two large cap growth funds outperformed the S&P 500- in both cases by less than 1%. Growing the assets. The focus on growing assets has definitively adverse effects on the investors on the mutual funds. Firstly, as we have seen, performance suffers when compared to market as a whole. Funds are able to get away with this unimpressive performance by shifting the focus from market-based comparisons to benchmarking—comparing their performance to a fund that tracks the sector their “style discipline” follows. Funds have reverted to index tracking- something any investor could do at a fraction of the price charged by actively managed funds. Thus, investors are cheated of returns they could achieve elsewhere in the market, and duped into believing that the returns presented are actually beneficial. Also relevant is that as mangers strive to grow assets, marketing expenses for the fund increases, representing fees that must be borne by investors. Investors are further harmed because, as the size of the fund swells, the investment landscape- the ability of the fund to take a meaningful position in a security- shrinks. Furthermore, increased fund size dilutes the ownership and the position of the previous investors, so that older investors see their returns shrivel as newer ones are brought on board.

Lack of fund oversight. Independent fund directors are supposed to oversee the behavior and performance of managers of the funds. In reality, however, the boards are spread thin and are in general unwilling to look at performance too closely. In the case of TROW, each director sits on the board of all the funds. Typically, board meetings for all the funds happen on one day. Eight managers share responsibility for two multi-billion dollar funds. It is evident that there is a fundamental lack of oversight in this industry- in sharp contrast to any other business, in which shareholder meetings, independent directors, and a disclosure of managers’ divided loyalties would be required. The Greed Factor. After analyzing the above problems of the mutual fund industry, Lowenstein turns to look at profitability for the industry. Profitability has come from the enormous economies of scale - whose savings are not passed on to investors. Management fees, instead of diminishing as more assets are brought under management, have been steadily increasing at TROW, from 0.50% in 1955 to 0.56% in 2006. Assets under management, however, have exploded from $4 million in 1955 to $14 billion in 2006. Bear in mind that in economies of scale, costs do not rise with assets under management. Candor becomes a casualty. Disclosure statements and mechanisms for the mutual fund industry are lengthy, bulky, and hard to manage for experts- not to mention laypeople. Fund documents, particularly a 200+ page Statement of Additional Information, are not investor friendly and do not contain useful information like the management stake in the funds they manage. The lack of clear information, argues Lowenstein, moves us away from free markets and allows the abuses by funds to continue unchecked. Form Over Substance: Shame on the SEC. Lowenstein argues that the SEC has failed investors in mutual funds by allowing a double standard in disclosure: the management companies are required to disclose to their shareholders all relevant information about their company, while fund shareholders are laden with unclear, unfriendly, and incomplete information about their managements’ pay and other conflicts of interest. The Failure of Candor runs Deep. The lack of disclosure in the mutual fund industry, its ineffectual managers, and the general unwillingness to share information (or to share only marketing-heavy information) has not only breached the fiduciary duty of the funds, but it has also prompted a turnover of mutual fund securities by investors. No longer confident in the mutual fund industry, investors are turning over their securities faster than ever before. They are burdened with the problem of too much choice, or choosing among a plethora of well-marketed but not investment-savvy vehicles, like funds categorized by “investing styles.” At the very least, Lowenstein tells us, candor should require accessible disclosure to hard facts such as expense ration, turnover, total return of the fund, and clearer benchmarks, such as how the fund performed against the market. Furthermore, full disclosure should include the

identity of the managers and a candid explanation by the fund manager regarding the funds’ investment style and commentary on current market conditions. Chapter 6 - The Investor’s Dilemma: Long on Life Expectancy, Short on Income, and Searching for Guidance In the central chapter of the book, Lowenstein presents what he calls, “a crisis of moral imagination,” which is the problem that people today are facing with mutual funds. The problem is simple: as the population lives longer and pension plans dry up, the public is forced to dabble in the stock market in order to ensure retirement in old age. Funds - in the sense of a pooled amount of money- are still a good vehicle to take advantage of everything the market can offer, but very few in the industry today have the means and the inclination to honor their fiduciary duty and to maintain the investors’ best interest at heart. The crisis is further compounded by conflicts of interest at fund companies. Long on life expectancy. The increase in life expectancy has generated a financial problem for those entering old age today. The population is growing older, and birth rates are declining: this means that corporations will have to support about twice the current number of retirees, but with only 18% of the workforce. Corporations, faced with a lengthening life span for employees, have either been forced or have concluded they should scale back on the pension plans that were a mainstay of life in the 1950’s. Short on Income. Lack of income for retirement is primarily due, according to Lowenstein, to the disappearance of pension plans and an increased reliance on 401(k) plans to ensure retirement. The disappearance of pension plans is a nationwide phenomenon. Only 20% of private sector employees are now covered under a pension plan. Turning to a 401(k) plan, which now cover about 40% American workers, does not ensure income in retirement, Lowenstein tells us. There are two problems with 401(k) plans: the worker must decide how much to save today for the future, and how best to earn future income. How much to save is a tricky calculation: by current estimates, workers should have been putting away about 14% a year for 30 years to maintain their current living situation - but most 401(k) plans only cover 10%. Similarly, how much is needed to secure future income is a problem: by Lowenstein’s calculations, someone making $50,000 a year will require 75% of that income to cover their retirement. Social Security will only cover about 35% of that, so that leaves the employee to find about $20,000 a year to cover future expenses. It is no wonder, then, that people turn to the stock market to bridge the gap in income. The problem with turning to the stock market, of course, is that it has been almost conclusively proven that people in general, and inexperienced investors in particular, are “frightfully poor investors.” The failings are numerous: switching too often in stocks and funds; a tendency to trail the market, which causes them to suffer losses along with it; impatience in decision-making; overconfidence; and, last but not least,

a tendency to “herd” or follow the crowd in investing. Another factor is paying undue attention to the market price of a security instead of the value provided by the company that underlies it. Searching for Guidance. The dismal performance of inexperienced investors is further worsened, Lowenstein argues, by terrible advice floating in from every corner of the market: from fund managers, analysts, and media. Bad advice promotes momentum investing- the tendency to follow the crowd. The cacophony of sound is due to, first, the inability to predict the market-in general no one is able to predict how the market as a whole will behave. Secondly, the proliferation of advice is due to the army of so-called specialists who must maintain a façade of respectability in order to further their interests - collecting assets to manage. Lowenstein presents the bubble of 1999 and the subsequent crash as an example of how “professional advice” was unable to safeguard investors. By 2000, it was clear that the market was overheating. Security prices were unreasonably high, with nothing tangible or financially sound to support the elevated prices. The story, however, was how the “old economy” was fading and the “new economy stocks” such as dot-coms, were going to take their place. Analysts, who should be looking closely at and with growing alarm at the security prices, were cheering the market on. This was in large part self-serving: the firms they worked for underwrote some of the security issuances, so it was in analysts’ best interest in general to promote further price inflation. Their recommendations were categorically dismal. Mutual funds used the bull market to follow the crowd, taking advantage of their indisputably large size to force the market upwards with their purchases. At the same time, mutual funds decided to increase advertising to attract more assets. That advertising, though effective, was not linked to performance or even to hard facts about the funds themselves. In fact, advertising frequency can be linked to poor subsequent performance. The media, disappointingly, also followed the crowd by synthesizing the latest “wisdom” and distilling it for readers. To Lowenstein, many of these articles were almost advertising: making lists of “good buy” stocks that were actually trading at inflated prices; capitalizing on trends that were not carefully researched; and, worse of all, interviewing and passing on the advice of managers who were later proved wrong – and in one case - fraudulent. The financial media, Lowenstein tells us, also is looking out for its best interests: ad dollars from mutual fund companies and attracting a readership which wanted good news, not problems. Chapter 7- The Industrialization of Mutual Funds In this chapter, Lowenstein explores the mutual fund industry’s transformation from a money-management machine to a profit-driven marketing construct focused on the

accumulation of assets. Mutual funds, although entrusted with the safekeeping of our money for retirement, has turned into a retail-oriented, productized industry. Lowenstein explores in this chapter the mechanics of this marketing machine, and how the marketing and sale of these funds works. This is very similar to, well, soap, believe it or not. Towards the end of the chapter, Lowenstein also explores the consequences that the industrialization of mutual funds has caused. How the Marketing of Mutual Funds came to Look like Soap. Mutual fund management companies are not satisfying our requirements for careful money management. Instead, they are creating an unnecessary set of “needs” by productizing their services. The first similarity to product marketing is the proliferation of funds: Fidelity, the largest investment company in the U.S., has about 24 mutual funds, all of them designed to fill the “shelf space” at available brokerages. The intent is to offer the pretense of choice, but customers need guidance and direction, not choice, in a mutual fund. Investors need someone to manage their money, not to make more decisions about managing the money. The second element of the mutual fund marketing construct is the movement of managers around products: the emphasis here is on the brand, not on the manager him or herself. But money management, Lowenstein is quick to point out, is not like soap- the manager is crucially important to the funds he or she oversees. Thirdly, consisting of what were really marketing companies bent on asset accumulation, the mutual fund industry has shifted the required skill sets of its personnel to marketing rather than money management. At Fidelity, for instance, there appears to be one analyst for every two funds. The rest of the personnel there are looking out for Fidelity, not investors. As a marketing business, the firm must (and will) spend most of its money on, well, marketing. In order to capture those economies of scale, cash outlays for marketing expenses at mutual fund companies is typically double the cash spent to manage the funds. Fund managers are not crucial to these companies. Marketing expertise is. Lastly, the fourth element of this marketing scheme is the manipulation of data to make the products more agreeable. Funds with sub-par performance are routinely dissolved or absorbed into larger funds. At Fidelity, for instance, 28% of funds that existed between 2002-2006 eventually disappeared. Industrialization of Mutual Funds. Now that we have seen how the marketing structure works, Lowenstein explains the nuts and bolts of the products that they roll out – or how, in essence, the funds are managed. In an effort to simplify the creation of products and to continue to keep costs low, fund complexes have turned to both narrowing and increasing product lines by requiring “style consistency”- such as mid cap growth or large cap value. The intent of simplifying the product is twofold: one, it makes the product more accessible to the salesmen: the brokers and consultants, whose role in selling the fund has become so

prominent that they have become the true customers of the fund. By creating a narrow definition of the fund, the fund becomes more accessible for understanding and easier to manipulate for the broker. In his or her planning during asset allocation sessions, he or she can quickly pull out a fund labeled “large cap growth” and put it in the investor’s shopping basket. The second reason for productizing investment styles is that it saves managers a lot of time and even more money. It is just not worth it to scour the investment landscape for opportunities. This eliminates the “need” for a good manager, and is slowly leading to the death of security analysis. As it becomes crucial for the manager to “track the benchmark” of his or her particular asset type, fundamental understanding of the stock market and value investing disappears. The consequences are felt down the line, where brokers and retail-level personnel are turning to computer modeling based on marketing criteria to craft portfolios that are based on assumptions of market stability - and ignore the investing needs of many customers. Retail-level salesmen: asset allocation, portfolio rebalancing. At the heart of the marketing machine are the point-of-sale personnel: the retail brokers, who have become as devoid of analysis as the fund managers. More importantly, Lowenstein tells us, brokers are generating for themselves a series of fads and fashions in order to churn out more business. The current broker mania for asset allocation is based not on security analysis, but on the marketing needs of the funds. Through computerized formulas, brokers can pick and choose which funds fall in which asset allocation - without a clue which securities the fund might own. Portfolio rebalancing, another current trend, would have investors shuffle stocks and funds around once a year to minimize exposure and volatility. This also relies on the “investment style” idea, which has no rational basis to begin with. Rebalancing and asset allocation, does however, serve two crucial purposes in the industry. It justifies the reason for being of the broker, and it generates fees for the brokers and planners. Since most brokers work not for fees generated by buy and sell transactions, the current fad of rebalancing is both profitable, and, conveniently, shows that brokers “know what they are doing.” Problems with Fund Benchmarking. In prior sections, we saw that mutual funds barely track the market index- their performance is based on the benchmark for their specific investment style. This is done with a view to conceal the true return and performance of the fund – or in other words, to make the fund more appealing and easy to sell to investors. More importantly, however, fund benchmarking generates passivity in the funds. Since managers are tracked against the benchmark, there is a tendency to mimic the index(es) that the fund tracks while trying to derive a few basis points here and there from high-flying securities (although, not necessarily, high-flying companies).

The third problem generated by benchmarking of this style is that the rating system it generates permeates the literature surrounding investing. Funds are ‘starred’ by Morningstar or any other rating company, and investors fail to realize that the performance is relative to an investment style whose entire sector may be out of favor with the market. Thus, it is easy to see, as Lowenstein tells us, that Morningstar’s five-star rated funds, to which advice-starved investors flock, tend to under perform the market as a whole by significant amounts. In the whole, the industry has transformed itself into a “Witches’ Brew” of mediocre performance and bad advice. Chapter 8- Through a Window…. Darkly

This chapter deals with the greed and dishonesty of the fund industry, and some practices which are not only unethical but borderline illegal. Among these, the author explores the use and abuse of 12b-1 fees, revenue sharing and soft dollars. The chapter ends with an entreaty for further disclosures in an easy to read format. 12b-1 fees. Rule 12b-1 was adopted in the 1980’s, and it allowed mutual funds to charge investors in the fund a fee to cover the marketing and expenses of the fund. Originally, it was thought that the fee could assist with the recuperation of the industry, which had suffered a blow in the 1970’s, and would help investors in the fund through increasing the fund size. The fee is still in effect, and it is good money: it can be about 1% per year, ad in 2006 amounted to $11.8 billion industry-wide. Although the reason for the fee has disappeared, less than 5% of the fee itself is used for marketing: instead, it has become a revenue stream for the managing companies. Multiclass Fund Shares. Although funds are supposed to ease investing for us, they are now allowed, through rule 18f-3, to offer several types of shares that are all structured differently. Some shares will allow for 12b-1 marketing fees to be tacked on, and others would not. To the end consumer, some classes of shares are better suited to them- depending on the holding period that they intend to have the shares for, and so on and so forth, but the conflict of interests that we saw before are also present here. Since brokers and planners stand to benefit from different types of shares, there is a clear incentive in the form of a kickback of the 12b-1 fee for them to sell a specific type of share- whether it’s A, B, or C. The industry consistently and usually “forgets” to share all the hidden fees and types of shares with the end consumer. Inflated trading commissions. In order to influence and attract broker attention to a specific fund, funds in the past had consistently inflated their trading commissions, which served as a marketing tool to encourage brokers to choose their fund to press onto consumers. If a fund wished to attract the attention of a specific brokerage house- say, Merrill Lynch with its army of financial advisors - it might not only trade through Lynch brokerages, but those trades would be at inflated commissions. Therefore, Lynch was

receiving a significant incentive to push the trading of those funds in house. Until the practice was modified to what is today now known as “revenue sharing,” it was clear that the funds’ choice of brokerage house was directly affected by the amount of business that that brokerage house generated. To make the issue even murkier, a portion of the commission generated by the brokerage houses would be “stepped out,” or shared, with whatever retail establishment had first brought in the customer that generated the sale. Your financial adviser is likely most interested in selling you a specific stock in a specific fund – and not for your benefit, but rather his company’s bottom line. Soft Dollars. “Soft dollars” represents money paid to a brokerage firm over and above the current market cost for trades. In return, the brokerage firm offers research and cost-saving services: a way for the management company to dispense with expenses. Although the investor pays soft dollars as additional fees, the original management fee should have covered research and cost-saving services. Lowenstein is pretty emphatic opinion: “soft dollars should be discontinued—period.” Revenue Sharing. Revenue sharing is “pay to play” dollars- the inflated rated commissions referred to above, now shifted to the management company. They must be disclosed, and they are. but not upfront in an easy to understand way. In fact, the fund prospectus, which carries this information, is typically only distributed after the sale has been completed. The unfairness and misleading character of revenue sharing is best explained through a case involving the fourth largest brokerage firms in the U.S. The firm had compiled a list of “preferred funds” as part of their customer literature, giving the impression that these funds were elite. In fact, those seven funds had revenue-sharing agreements with the brokerage company, and its brokers’ performance bonuses were aligned with sales of those same seven funds. Even at Schwab, revenue sharing cash inflows can run 40 basis points (0.40%) annually. And although revenue sharing involves some brokerage firms, all investors in the fund pay this fee in the form of trading commission. Outright Fraud. In order to present a truly accurately view of the mutual fund industry, the author relates the story of Citigroup’s dealings with First Data. First Data, a transfer agency company, renegotiated a contract for these functions with Citigroup. Citigroup ended re-contracting with First Data through a subsidiary, at considerable cost savings. In a fraudulent move, Citigroup pocketed the costs savings - $89 million- money that belonged to the funds that needed the service in the first place. Safeguarding the investors in mutual funds. Two basic safeguards will help to protect investors: transparency and good watchdogs. In transparency, everything begins with improving the disclosures in three ways: a) present the information that is needed to make a good decision, b) present the information accessibly and usefully, and c) present it a time when it would affect the buying decision. Specifically, Lowenstein urges for all point of sale documents to include: a broad market

index, such as the S&P 500, as a benchmark; the funds’ turnover ratio; and a disclosure of the amount of money the managers in the fund have invested in it. The information should not be too lengthy and it should clearly explain the total returns of the fund and what portion of those returns go to the management company – with those numbers presented in absolute terms: no ratios, or percentages…or maybe, he concedes, in addition to the ratios and percentages. As for the other side of the safeguards, the watchdogs, Lowenstein has little good to say about them. Using the term “lapdogs,” Lowenstein suggests that boards have failed investors in the funds at almost every turn. He charges them with improper oversight on the following: adopting 12b-1 fees, improper research on perspective fund buyers, improper “passing on” of the economies of scale, failure to focus on large turnover ratios, at funds, failure to question managers on their lack of investment in the fund and failure to prevent revenue sharing agreements and the like, or at least to look at them properly. He furthermore questions the structure of the boards themselves: independent directors should not be spread so thinly, should not be paid as highly, and should not oppose the SEC’s suggestion to make an independent director the head of the board of directors. Chapter 9- How to Pick a Mutual Fund The last chapter of the book, a guide to investors, has three overriding themes: 1) you must provide for your own retirement, specifically through the stock market; 2) as an investor, you must understand your limitations and realize that you are susceptible to the market pressure; and 3) you must choose - but after careful research. The realization that investing is difficult has already been explained in the book, but in this chapter Lowenstein exhorts the reader to realize that investing requires a steadiness of mind and purpose that most people are not likely to posses. The author warns against the fear of losing money, which unhinges investors and leads them to walk with the crowd by buying and selling at lousy times. To aid you in picking a mutual fund, Lowenstein has two fundamental pieces of advice and some other very specific ones. The two fundamental pieces of advice are that good managers matter, and that good mutual funds typically enjoy writing about their investment style, philosophy, and goals. Reading their literature critically is crucial to your research of a fund, and should not be put aside. Doing your research might begin with purchasing the Morningstar Funds 500 database and then beginning to look for funds featured in the analyst list that have a low turnover ratio. Then begin carefully researching the fund’s literature. Lowenstein’s guidelines for picking a fund are as follows:

1) Small portfolio. Funds should not hold more than 30 or 40 stocks. Read the fund manager’s letters to find out their rationale for holding these companies. Often, they will betray a Graham-Dodd value investing insight.

2) Low turnover rate. Turnover rate is at the bottom of the five-year performance table. Turnover ratio should be 25% or less. The turnover rate tells us about the managers’ ability to weather market trends.

3) Check five year and ten year fund performance. This will enable you to understand how the fund performed both in the ups and the down periods of the market. It will also give you a sense of the best managers among the funds.

4) They eat their own cooking. Managers should be heavily invested in the fund, to show that they are willing to support their picks. This may involve requesting the Statement of Additional Information (SAI).

5) Look for funds that talk about searching for companies with good management and can explain what good managers are.

6) Select experienced companies and managers. Managers should have gone through full business cycles of boom and busts.

7) Fund should not be too large. Look for funds that have previously closed to investors. Keep in mind that large-cap funds and small-cap funds have different ceilings of size.

8) Research further funds that talk about looking at companies currently out of favor. This usually signals that the fund is looking for a deep value discount.

9) Try to choose generalists instead of sector funds. Sector funds are susceptible to business risks affecting those sectors: with generalists, the business risks are so diverse that the portfolio is likely to be better balanced.

Buying index funds, Lowenstein tells us, is a good strategy for very long-term holding. Indexing protects investors from themselves and avoids the market-timing problem of moving with the crowd. However, indexing does not provide exceptional returns, just market returns. It also requires a long investment horizon and for practical retirement purposes, that might present a real problem. At the time of your retirement, the market could be considerably below where you’d prefer it to be. The most important conclusion of this chapter, and really of the entire book, is this: Careful research pays off, and self-knowledge as an investor does, too. Understand that you are likely to make mistakes, and adjust accordingly. Also, spoke funds rule! (Note: that last line may not have actually been in the book).

mutual fund spoke fund

Copyright 2009 | Islamorada Investment Management | www.islainvest.com

SPOKE FUNDFund manager invests most of liquid net worth

All accounts linked to core portfolio

No taxes are passed on to investors

No hidden expenses or fees

Everyone can customize portfolio holdings

Investors can vote shares themselves

Actions of investors have no impact on others

MUTUAL FUNDFund manager is usually not an investor

All investorsʼ money goes into one big pool

All taxes are passed on to investors

Hidden expenses and fees

Everyone holds identical portfolio

Investors cede voting power to fund company

Actions of large investors can hurt returns of smaller investors

VS.

Comparison Matrix Tarpon Folio Average Mutual Fund

Fees & ExpensesOne Time Fees

Front-end Load None 1.2%1

Back-end Load None 3.0% 2

Distribution (12b-1 fees) - No-load funds None 0.25%3

Distribution (12b-1 fees) - Load funds None 0.5%4

Early redemption fees None. It's your money Up to 5%Ongoing Fees

Portfolio Management & Fund Administration 1.25%6 1.46%7

Trading Commissions Included 0.27%8

Total Expenses including Trading Commissions 1.25% 1.73%

TaxesControl of capital gain taxes? Yes, 8 different ways NoAbility to harvest losses to offset gains? Yes NoTotal annual return lost to taxes Minimal 4%9

Tax reporting info Download into Quicken or print and attach Manually enterPortfolio

Number of stocks in fund 16 140 10

Turnover < 50% 89%11

Types of securities"Go-anywhere". Undervalued domestic equities

in all market caps and industries"In a box." Investments only as defined by

original charter.Expected risk Lower than market Equal to the marketMinimum account size $20,000 $2,500Downloadable into Quicken? Yes NoPreliminary Reading 15 page Investment Advisory Contract 150+ page ProspectusAccount Statements Every month, stored online forever Sent quarterly in mail.Check writing Yes. Free No

Automatic investing plans Yes. FreeYes. Pay fees for trades, ticket charges and/or

transaction fees.Electronic Funds Transfer Yes. Free No. May pay fees for some transfers.Portfolio monitoring 24/7 online access & easy to understand tools Once a quarterDownloadable to Quicken Yes NoProtection and insurance SIPC protection and cash is FDIC insured Privately insured but no FDIC insurance

Portfolio ManagementAccess to Portfolio Manager by investor 24/7 NoneDifferent classes of funds for institutions No YesTrade allocation policy All investors get shares at same cost basis. Cost basis of shares can differ.Is portfolio manager invested in fund? Yes. Significant portion of net worth. NoExclude stocks you do not want to own? Yes NoProxy Voting You can vote. Portfolio Manager votes.Portfolio reviews Anytime. Just call. None

Notes1 Investment Company Institute (ICI) Fact Book, 2007, page 58.2,3,4,5 Yahoo! Finance Mutual Funds Center: http://finance.yahoo.com/funds/how_to_choose/article/100601/Load_vs__No-Load_Funds

7 ICI Fact Book, 2007, page 60.8 Karceski, Livingston, O'Neal, "Mutual Fund Brokerage Commissons," January 2004.9 Shoven, Dickson and Sialm, "Tax Externalities of Equity Mutual Funds," April 2008. 10,11 Morningstar.

6 The Tarpon Fund's portfolio management fee is based on performance. The management fee rate and total expense ratio may be higher than the rate shown above after reflective of performance adjustments.

Islamorada Investment Management (IIM) is a value investing firm based in the Florida Keys. We manage two portfolios for our investors, located throughout the U.S. We are an independent, fee-only firm, which means we never get paid through commissions or referrals. We like to think our mission is to save investors from mutual funds. Our flagship fund, the Tarpon Folio, was named after a fish. Our second spoke fund was named after a lizard. Our T-shirts read, “One geek in the Keys is worth two suits in the city.” So although we’re good at what we do, we don’t take ourselves too seriously. Think Warren Buffett meets Jimmy Buffett.

About Islamorada Investment Managementwww.islainvest.com(305) 522-1333

Tarpo

n FOLIO

A smarter way to invest from way off Wall Street.Growth for long-term investors.The Tarpon Folio is an innovative alternative to actively managed mutual funds. It’s a spoke fund, which combines the best parts of a mutual fund, hedge fund and separately managed accounts. The fund is open for anyone with at least $20,000 to invest.

The Tarpon Folio is more transparent, invests in fewer companies and is signi!cantly less expensive than the vast majority of mutual funds. Managed us ing value invest ing principles, the portfolio seeks to maximize long-term appreciation while minimizing the risk of permanent loss.

The Tarpon Folio invests in companies with under-appreciated competitive b a r r i e r s t r a d i n g a t h i s t o r i c a l l y inexpensive prices. The fund contains almost all of the life savings of our portfolio manager’s family. Using novel technology, that core portfolio is linked to separate, secure investor accounts. Trades made in the core portfolio are executed simultaneously across all investor accounts. So we’re all in it together.

Fees are 1.25% of assets on an annual basis and are assessed monthly, which means our fees in dollar terms vary depending on how well the portfolio performs.

Turnover, taxes and trading are minimized. Each investor’s account is also protected by three types of insurance for up to $9.0 million.

Tarpon Folio

companies

7 Things We Look For When Investing:

1. A moat around the business.Significant competitive barriers are essential in long-term investing.

2. Attractive owner’s earnings.Predictable profitability, adjusted for non-cash charges and capital expenditures used to maintain earnings power, is critical.

3. A large margin of safety.To protect us from market downturns or analytical errors.

4. High odds of large gains.Temporarily unfavorable conditions can present tremendous opportunity.

5. Management we can trust.Not all company executives truly think like business owners. We want to invest with those who do.

6. Simple businesses.We stick to businesses we understand and that do just one or two things very well.

7. Superior financials.If the proof is not already in the numbers, it probably won’t show up in the price.

QuestionsEmail info@islainvest.com or call (305) 522-1333.

LinksTarpon Folio vs Mutual FundY’all Street MoviePortfolio Manager’s BlogNews & ArticlesOur Fiduciary OathJoin our Email List

What companies are in the Tarpon Folio?As of December 31, 2010, the fund holds shares of 16 companies. The largest holding

by market cap is Google (GOOG) and the smallest holdings are several regional banks. The Tarpon Folio is a “go-anywhere” fund, meaning it is not limited to any particular size of company nor industry.

What are the fund’s characteristics?All companies held are domestically listed.

The market capitalization of holdings breaks down as follows: 58% small- and microcap, 18% midcap, and 24% large cap. The average trailing P/E ratio of the holdings in the fund is 13.5 Sectors represented include energy,

! n a n c i a l s , c o n s u m e r s t a p l e s , telecommunications, healthcare, industrial products, media and transportation.

What is the track record of the fund?From launch in November 2008 through December 31, 2010, the Tarpon Folio has returned 110%. However, we caution

investors that such returns are highly unlikely to continue.

Why does the fund own so few stocks?The ability to own a concentrated portfolio further differentiates the Tarpon Folio from a mutual fund.

Statistics indicate that after purchasing six or eight stocks in different industries, the bene!t of adding more stocks to a portfolio in an effort to decrease risk is small.

In addition, overall market risk – the broad up and down movement in the general market – cannot be eliminated by adding more stocks to a portfolio. We estimate that owning 15 stocks eliminates approximately 93% of the

nonmarket risk of owning just one stock.

Who is the portfolio manager, and how much has he invested in the Tarpon Folio?The portfolio is managed by Cale Smith, the managing partner of Islamorada Investment Management. An MBA, he has worked in telecommunications, investor relations and as an analyst at a

hedge fund and several research !rms. He has invested a six-!gure amount in the fund and can be reached at csmith@islainvest.com.

How are fees calculated?A #at 1.25% fee on a $100,000 portfolio would result in fees of $1,250 a year, or $312.50 a quarter. However, in the

Tarpon Folio, if after the !rst quarter the value of the portfolio declined to $90,000, our fees for that quarter would decline to $281.25. If after the !rst quarter the portfolio increased to

$110,000, our fees would be $343.75. Our total compensation across all accounts varies signi!cantly depending

on our ability to grow investors’ wealth. Can I invest through an IRA?Yes. In addition to individual and joint taxable accounts, investors can open tax-deferred accounts. We can set up all IRAs (regular, Roth, rollover and SEP) as

wel l as custodial accounts and revocable trusts.

How can I sign up?By going to our homepage here, clicking on the “How To Invest” link in the Quick Links menu at left, and !lling out the online form. Once the form is submitted, we’ll use your input to draft

our standard investment advisory agreement, then email it to you to electronically sign. Once that has been executed, we’ll send instructions on how to fund your new account held at

our custodian FOLIOfn.