Albert Nicholas is well aware that some prominent academics say stock pickers can’t beat their benchmarks over the long haul. He doesn’t have a Ph.D., yet he has good reason to disagree, Bloomberg Markets magazine will report in its April issue.
The Nicholas Fund, which he has run since 1969, has topped the Standard & Poor’s 500 Index by an average of 2 percentage points a year for the past 40 years and has beaten it every year since 2008. If you think that doesn’t make a big difference, consider this: A $10,000 investment in the Nicholas Fund in September 1974 was worth about $2 million in September 2014, roughly twice the value of the same investment in the index.
“Some guys who are smarter than I am say we can’t outperform like this,” says Nicholas, who turned 84 in January. “But we have done it, so I will leave it at that.”
Nicholas has been especially hot since the end of 2009, riding longtime holdings such as auto parts retailer O’Reilly Automotive, up fivefold in the five years ended on Dec. 31, and money manager Affiliated Managers Group, which tripled in the same period. Nicholas has owned stakes in both companies for more than a decade.
The numbers made the Nicholas Fund No. 1 in the diversified U.S. equities category in Bloomberg Markets’ annual ranking of mutual funds.
The winners in the rankings all pick individual stocks and bonds. The rankings are based on U.S.-domiciled funds with more than $250 million under management as of Dec. 31. Funds are ranked by total returns for one, three, and five years and by their Sharpe ratios for three and five years. The Sharpe ratio measures the performance of funds adjusted for risk. Each of the five measures is given equal weight.
Active managers have been on the defensive of late. In 2014, just 21 percent of the funds that pick U.S. stocks beat their benchmarks, according to Morningstar. Investors have noticed and voted with their feet, swapping their actively managed funds for low-cost index and exchange-traded funds.
Last year, actively managed mutual funds that buy U.S. stocks suffered a net $98 billion in redemptions, while domestic stock index funds and ETFs attracted a net $167 billion. ETFs, nearly all of which mimic indexes, received $95 billion of the total.
The two biggest recipients of mutual fund cash last year were Vanguard Group, the index fund leader, and Dimensional Fund Advisors, an Austin, Texas, firm that sells index funds with a bias toward small-cap and value stocks.
“Conventional active managers promised a lot they were not able to deliver,” says David Booth, Dimensional’s chairman. Booth’s mentor, University of Chicago finance professor Eugene Fama, who shared the Nobel prize in economics in 2013 for his work on efficient markets, is equally dismissive of stock pickers. In a 2009 paper he wrote with Kenneth French of Dartmouth College, Fama concluded that actively managed stock funds collectively return about the same as the stock market as a whole, minus the fees they charge.
Notwithstanding the academic research, the great bulk of fund money is still actively managed. Some $13.1 trillion was invested in U.S. mutual funds at the end of 2014. Of the $8.3 trillion in stock funds, 38 percent was passively managed. Yet that’s double the percentage at the end of 2004.
Although the money in U.S. ETFs has grown rapidly, from less than $100 billion in 2000 to $2 trillion today, it’s still a fraction of the total amount in mutual funds.
The increasing popularity of passive investing has forced stock pickers to speak up. The normally publicity-shy Capital Group, which runs the $1.1 trillion American Funds Complex, all of whose funds are actively managed, published two research papers in the past two years. One quoted statistics indicating that most American Funds offerings beat their benchmarks over time, while the other asserted that actively managed funds with low expenses and high manager ownership usually outperform.
The firm acted after it was hit by $250 billion of client redemptions from 2008 to 2013.
“We believe in what we do, even if at times the world doesn’t,” says Timothy Armour, Capital’s head of mutual funds.
No one at the $1.1 billion Thornburg Global Opportunities Fund, a unit of Santa Fe, New Mexico–based Thornburg Investment Management, thinks the indexes can’t be beaten. Since it was created in July 2006, the global stock fund has crushed its benchmark, the MSCI All-Country World Index, by an average of 6 percentage points a year. It tops the Bloomberg Markets ranking of global equities funds.
Thornburg was No. 1 in two categories. Left to right: Jason Brady of Strategic Income; Brian McMahon and W. Vinson Walden of Global Opportunities.
Co-manager W. Vinson Walden attributes the success to good research and a willingness to be patient. In 2010, the fund bought Brazil Foods, a São Paulo poultry producer whose shares were depressed by concerns about rising commodities prices. Walden saw something else: a low-cost producer with the potential to expand in Brazil and other emerging markets.
“We saw a nice tail wind that would last for years,” he says.
When the stock slumped again in 2013 due to management turnover, Walden bought more. As an active manager, he says, he can pounce when a company’s share price dips below its long-term value.
Brazil Foods traded at more than 60 reais a share on Dec. 31, up from 20 to 25 reais when the fund first purchased the stock.
“It’s been a gift that keeps giving,” Walden wrote in an e- mail.
Another luxury active managers enjoy: making a big bet on one stock. Longleaf Partners Small-Cap Fund started last year with 13 percent of its money in cement maker Texas Industries.
“We are not afraid to make an outsized bet where we like something,” says Ross Glotzbach, one of the managers of the $4.4 billion fund.
Texas Industries agreed to be bought by Martin Marietta Materials at a premium in January 2014, which helped the Longleaf fund earn the No. 1 ranking among small-cap U.S. equities funds.
The Longleaf small-cap fund, run by Tennessee-based Southeastern Asset Management, boasts roughly twice the return of its benchmark, the Russell 2000 Index, over the past 20 years. The fund’s managers will hold cash when they can’t find attractive stocks. Longleaf also buys beaten-down companies when it believes the long-term prognosis is bright. The fund added energy shares in the fourth quarter as oil prices collapsed.
“We are contrarians, and we like to buy things for less than they’re worth,” Glotzbach says.
The stampede to index funds and ETFs is not as pronounced among bond managers as among stock pickers. Only about 19 percent of the money in bond mutual funds and ETFs is indexed, according to Morningstar. Still, active bond managers have to demonstrate they are worth the higher fees they charge compared with indexers.
Daniel Ivascyn has done that. The $40 billion Pimco Income Fund he has run since 2007 outperformed 99 percent of peers over the five years ended on Dec. 31, while returning an average of 11.6 percent a year. Its benchmark, the Barclays U.S. Aggregate Index, gained an average of 4.5 percent annually.
The numbers were good enough to earn Pimco Income the top ranking among U.S. corporate bond funds for the second year in a row. They also helped Ivascyn win a new job, group chief investment officer. He got the title after bond legend Bill Gross abruptly left Pimco in September.
Ivascyn and co-manager Alfred Murata divide their fund into two buckets: one with high-yielding assets that will do well in a strong economy, and the other with investments that can thrive if the economy weakens. A longtime Ivascyn favorite filled the first pail last year: bonds made up of mortgages that aren’t backed by Fannie Mae, Freddie Mac, or Ginnie Mae. Those bonds have rallied as the U.S. housing market has revived.
“We still like them, and they have become safer and more predictable,” Ivascyn says. Ivascyn also bet on Australian government bonds, which rose as the Australian economy weakened because of a slump in commodities prices. Pimco Income’s managers say their ability to regularly adjust the mix of assets -- rather than blindly mimic an index -- is critical to their performance, especially in an environment of ultralow interest rates.
Thornburg Investment was a double winner in the Bloomberg Markets ranking. Its $1.3 billion Strategic Income Fund topped the global bonds category, with average returns of 7.1 percent over three years and 7.8 percent over five.
Co-manager Jason Brady says his ability to buy income- producing securities anywhere in the world is crucial to the fund’s success. The fund topped its category despite a 3.2 percent return in 2014, due in part to the fact that it missed out on much of the rally in government bonds.
“The risk/reward didn’t look that good to us,” Brady says. “Too many of the buyers, like the Federal Reserve, don’t care if they make money.”
Brady has concentrated on corporate debt, including high yield. Because most of his bonds are denominated in dollars, the fund wasn’t hurt in 2014 as the dollar strengthened against most currencies. One of Brady’s holdings, Odebrecht Offshore Drilling Finance, a Brazilian supplier of ships that explore for oil, yields about 13 percent, a reflection of investor concern about plummeting oil prices.
“There is a lot of risk, but we also have a lot of protection,” Brady says.
Albert Nicholas, known to friends as Ab, almost chose another field that offered the kind of competitive challenge he thrives on. A star basketball player at the University of Wisconsin, he was offered $6,000 a year in 1954 to play for the Milwaukee Hawks in the National Basketball Association. He took a financial job instead for $4,200.
“I think I made the right decision,” he says.
Nicholas opened his own Milwaukee-based investment firm in 1967 and two years later started the Nicholas Fund. His 45 years running one fund make him the third-longest-serving mutual fund manager in the U.S., after Ernest Monrad, 84, of Northeast Investors Trust, and Rupert Johnson Jr., 74, of the Franklin DynaTech Fund.
Nicholas’s firm runs six mutual funds and a total of $5 billion in assets. His son David, 53, is co-manager of the Nicholas Fund and lead manager of the $715 million Nicholas II fund, which buys midcap stocks, and the $323 million Nicholas Limited Edition fund, which invests in small caps.
After a strong start in the 1960s, the Nicholas Fund lost 53 percent in the recession of 1973 and 33 percent in 1974. Nicholas changed his strategy. He abandoned the chase for hot stocks and looked for companies he could hang on to -- steady growers with strong balance sheets and limited exposure to the ups and downs of the economy. The idea was to make money by avoiding steep plunges.
“We have two principles,” he says, adapting an old joke. “The first is: Don’t lose money. The second is: Don’t forget principle No. 1.”
Nicholas’s focus on avoiding losses helped him in 2008, when he beat 93 percent of peers, and in 2011, when he beat 96 percent as the S&P 500 gained 2.1 percent. He largely avoids banks, cyclical businesses, and commodities producers, including energy companies.
“I don’t know anyone last year who said oil was going to fall 50 percent,” he says. “So much for predicting.”
O’Reilly Automotive is a longtime Nicholas favorite. The Springfield, Missouri–based retailer grows steadily in good economic times and bad.
“When the economy struggles, people keep their cars longer,” he says.
Nicholas first put the stock in his fund in the third quarter of 2002, when it sold for an average of just over $14 a share. On Feb. 17, the price was $206. He is hanging on to the stock, though it looks expensive on paper.
“We are patient with great companies, even if they are a little overvalued,” he says.
AMG has also been in the portfolio since 2002 and had appreciated roughly fivefold since then as of Dec. 31. The Beverly, Massachusetts, firm buys up small money managers and gives their executives an incentive to continue to perform well. AMG owns a stake in Yacktman Asset Management, whose AMG Yacktman Fund boasts an average return of 12.4 percent over the five years ended on March 16.
Nicholas has known bad times. His experience with losing money in the 1970s, and again in 2001 and 2002, when he bought plunging tech stocks too soon, has shown him it doesn’t take much to fall behind. Yet he is not about to sit down with a textbook by Eugene Fama.
“We think if we stick to our philosophy and protect people on the downside, we can produce a pretty good record,” he says. “The past 40 years has proved that.”