Reverse Engineer Your Mutual Fund

"Reverse engineering" is a process of studying an end product (a machine, computer chip, software program) to determine how it was designed and manufactured. The objective is to learn from and improve on someone else's design.

I recently wrote a column on techniques to improve your investing strategies. One technique that I didn't cover, reverse engineering a successful mutual fund, deserves its own column.

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Generally, portfolio managers like to reveal as little about their strategies as possible to avoid Wall Street from "front running" (taking positions in advance of a big order) their trades and to limit "free riding" (one stock picker blindly copying another's trades).

However, mutual fund managers are required to publish their holdings at least twice a year. It's not real-time data, but mutual fund strategies don't turn on a dime, so even six-month-old data are indicative of what is in the fund now.

Such information is summarized in shareholder reports and at financial information companies, including TheStreet.com and Morningstar. And an analysis of such data can often uncover strategies.

What makes a fund good to analyze? A fund ranked in the top 10% of its category for five to 10 years is a good place to start. The stock market cycle lasts on average about five years. Plenty of funds with exciting short-term returns (e.g., one month, three months, one year) exist, but this is usually from luck, not strategy.

For this exercise, I will consider the LMVTXLegg Mason Value Trust fund, which has the distinguished record of beating the S&P 500 for the past 11 years.

Check the Fund Family Web site

Thanks to the Internet, most fund families now maintain Web sites that include prospectuses and shareholder reports. Prospectuses offer a general description of the fund, performance history, general strategy and risk factor.

Start at the Legg Mason Fact Sheet page for this fund, and then skim over the prospectus. Don't be confused by the fact that descriptions of several funds are combined in a single document. Pay particular attention to the sections labeled "Principal Investment Strategies" and "Principal Risks."

Strategy and Holdings

Shareholder reports are produced at least annually, with some fund companies publishing quarterly. Legg Mason's report for the Value Trust is dated year-end 2001, but an interim report (which was released at least to mutual fund information companies) shows holdings as of March 31, 2002. In this report, the portfolio manager, William Miller, comments on the returns relative to the average and highlights four elements he thinks will enable the portfolio to deliver excess returns:

1. Financial services stocks (e.g., banks).

2. Growth companies with expected growth rates of at least 10%, but with multiples that are less than the market: UnitedHealth Group UNH, Waste Management WMI and Fannie Mae FNM.

3. Neglected industries, such as supermarkets.

4. Cyclicals that should do better when the economy improves, including Lucent LU, Nextel NXTL and Eastman Kodak EK.

5. Companies underpriced because their business models are in transition (e.g., Amazon.com AMZN.

Next step -- check whether the portfolio matches the stated strategy. The shareholder report states that financial services stocks account for 32.2% of the portfolio, compared with the S&P 500's weighting of about 19%. UnitedHealth and Waste Management are the top two holdings. Fannie Mae is 14th. Albertson's ABS and Kroger KR, both supermarkets, account for 7.2% of the portfolio. Amazon, Lucent, Nextel and Kodak are all represented in the portfolio, which contains only 35 stocks. So Miller is following the plan he laid out in the shareholder letter.

More Information From Morningstar

Now look at Morningstar's write-up of this fund. Certain sections, such as the "Inside Scoop," are available only to subscribers, but you can sign up for a 30-day free trial.

Critical information:

1. This fund's recent returns are trailing its peer group. Is this the year the streak ends?

2. Asset allocation is nearly 100% in stocks -- a decision by a fund manager known for holding cash if he doesn't like the near-term outlook.

3. Sector weightings -- double the S&P 500's allocation in financials, but substantially underweight in technology and health care.

4. News articles about the fund include alerts about substantial new holdings -- for example, one article highlights a new investment in Tyco TYC in the first quarter. Does Miller see value where others see accounting problems?

Scrutinize the Holdings

Morningstar lists the top 25 holdings, which comprise two-thirds of this portfolio.

The shareholder report indicates new positions (e.g., Tyco), as well as whether positions are larger, smaller or unchanged compared with the previous report. Dell DELL and IBM IBM, which had been larger holdings according to the Dec. 31 report, are no longer in the top 25, according to the latest update, and may well have been sold.

Generally, health care and financial services positions are being reduced (indicating some profit-taking), while positions in technology (e.g., Qwest Q and Nextel) are being increased (indicating some bottom feeding).

Conclusions

This portfolio manager's definition of a "value" stock is fairly liberal, encompassing just about the entire universe of large-cap and ultralarge-cap stocks.

He's not afraid to deviate from stock market sector weightings, and his strategy seems to follow the sector rotation strategy I outlined in "How to Choose the Right Sectors for This Economy."

Although 35 stocks is a relatively concentrated portfolio, no one position accounts for more than 6.5% of assets (generally 10% is a dangerous concentration).

Profits are being taken in financial services and new positions are being formed, particularly in beaten-down telecommunications companies.

If you want to replicate this portfolio exactly, just buy the fund. Even with a heavy expense ratio of 1.69% and the annual capital gains tax bill, you'll probably get better results than if you tried to match the fund, position for position. However, if you want to manage individual stock positions, then use the insights gleaned from this analysis to guide your own decisions.