A special report looks at the fund managers leading their specialist sectors

Any study of fund management in the US will show that there are many different ways to make money. Everyone has a different process - some are very simple and others are just esoteric.

Intech’s Large Cap Growth fund is consistently the top performer in the quant stock funds sector, bettered only marginally by Simms Capital Management’s Equity Growth fund over five years. Intech’s investment process is akin to rocket science. Intech pioneered the use of supercomputers and vector processors in portfolio optimisation and in realistic and precise simulation of mathematical investment strategies.

The Large Cap Growth portfolio is drawn from the S&P/BARRA growth index, a subset of the S&P 500. Intech was set up by Bob Fernholz, who has held academic positions in mathematics and statistics at Princeton University and the City University of New York. Large Cap Growth seeks to outperform its benchmark by an average of about 3% annually over the long term. The innovative element of Intech’s approach derives from the fact that no estimates are necessary for the future rates of return of the stocks in the portfolio. Fernholz explains: In practice, such estimates are based on analysts’ forecasts and such forecasts are susceptible to error. Intech’s process is based on established mathematical principles.”

The class act in the high yield sector is Penn Capital’s Active High Yield fund with top performance over one and five years, and bettered only by Nicholas Applegate’s High Yield Bond fund over three years. Vice president and partner Christian Noyes says the portfolio has two components, core and non-core, each representing 50% of the market value of the fund.

On the core side, the aim is simply to deliver an income of anywhere from 9-11% depending on market conditions. Penn Capital invests in A- and B-rated companies with between 30 and 50 holdings on the core side - solid companies with secure debt and cash payers.

“On the non-core side,” says Noyes, “we are looking to add value, taking 2-5% positions in undervalued companies, distressed bonds which may have fallen from par to 0.80 short term. It also has a high yield equity component which fits in with the total return opportunity we are looking for in the non-core part of the fund. Because virtually every industry represented on the S&P 500 is represented in the high yield bond market.

“Up to 20% can be invested in distressed equity of groups which are restructuring. So we invested in Macy’s when it was restructured in 1995 and more recentlywe held a company called Bib, a children’s bedding company that was subsequently bought out and we were able to sell at a substantial profit. So it’s a value-driven, total return approach to high yield. And the good thing is you get paid while you wait for the security to come good.”

The high yield market experienced a significant price correction during the third quarter. During August, the market posted its worst single-month decline since September 1990. Liquidity had been the primary reason for the fall-off, as in 1990 when the only market maker was Drexel Burnham. “Now we have 30 major underwriters of high yield debt, and these are not 1990 conditions. The problem is they are also making markets in global debt and with the troubles in Russia - investors are running away from anything that involves risk, so there’s a liquidity crunch,” says Noyes.

The market looks priced for a recession, he says. “As of October 23, the average spread to Treasuries on the CSFB High Yield index was 7.6%. Six months ago it was 3.92%. In that time, the conditions haven’t changed that much. The one-year trading default index has not fallen. There may yet be an uptick in defaults but it won’t be significant. So this is not a fundamental issue, it’s technical. Market makers are not allowing capital onto their desks. They want to clear their desks and prepare for a very strong 1999.”

The high yield group at Mackay Shields is managed through the equity division. Mackay’s Steve Hecht comments: “We believe high yield bonds are an equity hybrid that contain similar risks and rewards as equities. In virtually every phase of our investment process we attempt to control risk and limit defaults. Our security selection process is a bottom-up, total return approach. Emphasis is placed on current income while minimising risk to principal and locating catalysts for capital appreciation.”

In constructing the portfolio, Murray Shields follows strict diversification criteria. No more than 4% of one position and no more than 15% in a single industry. This results in a portfolio of 60-80 issues. Hecht adds: “As important as it is to buy a security right it is also necessary to know when to sell. This is very important in high yield management because the upside on a bond is limited as price appreciates and it becomes call constrained”.

On the equity side, Bear Stearns’ fund chief Wayne Angell notes: “The simple fact is that the US economy outperformed everyone’s expectations in the third quarter. We are over a year into the Asian financial crisis and, as expected, net trade has exerted a significant drag on economic growth. However, despite this, real GDP growth has averaged 3.4% over the last four quarters, which is almost exactly in line with the average growth rate over the prior three years. Pessimistic demand-side models have consistently underestimated economic growth as the economy has performed exceptionally under severe stress.”

Value investing funds have continued to produce impressive returns and managers in this sector remain confident that good performance can be maintained. A typical value fund is one where the manager buys securities that appear to be undervalued in relation to the long-term earning power or asset value of their issuers. Legg Mason Value may appear to be a classic example of this approach, with an exceptional record over three and five years to match it. But there is in fact no growth or value bias in the group analyst’s stock recommendation; the ‘best overall investment ideas’ are supported. Chief fund manager Jeff Wardlow says: “From the beginning, we have viewed the ongoing use of proprietary research in the investment decision-making process as a major contributor to the consistency of investment performance. This broad perspective ensures a constant freshening of the investment universe and avoidance of style-related rigidity.”

Loomis Sayles has one of the largest and most experienced internal research capabilities of any independent investment management firm. Wardlow adds, “It is a unique strength that we monitor every recommendation of our analysts to evaluate if it was the correct judgment relative to the market.”

The fund continues to be heavily exposed to the financial and technology sectors. The top performers during the third quarter were Dell Computer (11.52%), Philip Morris (2.86%) and Kroger (2.19%).

Loomis Sayles is at the top of both three and five year tables with its Core Value fund. It has continued to outperform the benchmark in the second half of 1998. The market has been led by large and mega-cap growth stocks, however, Loomis believes these stocks to be overpriced and has increased allocations in defensive sectors such as utilities and healthcare in an effort to offer stability to the portfolio while reducing allocations in sectors it feels are susceptible to global instability. Its biggest holdings are Raytheon (2.60%), Tenet Healthcare Corp (2.54%), Exxon (2.43%), Fleet Financial ( 2.32%), Abbot Labs (2.24%), BP (2.18%) and IBM.

Eagle Asset Management’s Growth Equity programme invests in medium- to large-cap stocks. Chief investment officer Ken Corba says: “By combining the characteristics of growth, quality and time, the investment process is designed to capture the powerful compounding effect of a growing enterprise.” The group sets a minimum three-year expected return of 50%.

Cutler & Co’s Core Value Trust aims to achieve above market returns, while assuming less risk than the general market. Quality companies that are industry leaders and maintain strong value fundamentals are the main components of this strategy, which is aimed at investors whose primary objective is total portfolio return. John Nyheim, senior portfolio manager, says, “Few active managers have consistently outperformed the market. Our superior performance has come from a strong, well defined discipline which identifies value in both stock and industry selection.” Nyheim describes Cutler’s approach as “eclectic and opportunistic; our core-value strategy is highly qualitative”.”

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