FOOL ON THE HILL

Trust This Fund

Finding a good mutual fund isn't easy. Hidden fees, manager turnover, and the irrational behavior of other shareholders can really hurt returns. But there are some great funds out there. The Longleaf Funds has a strong track record and a business philosophy that forges a long-term partnership with investors.

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By Zeke Ashton
September 25, 2002

I'm not big on mutual funds, as a general rule. You have to look out for hidden fees: Redemption fees, 12b-1 fees, loads, and transaction costs all take a cut out of your hard-earned investment money. Index funds are often a better choice.

On the one hand, at least you'll get the market average grade without paying all the frictional costs. On the other hand, I'm not sure people are going to be very happy with the average stock market grade for the next several years.

As you might imagine, I am a big believer that the serious individual investor has a great chance, especially in this environment, to outperform most large, actively managed funds.

But not everybody has the time, temperament, or interest to do the amount of work it takes to run a 10- or 20-stock investment portfolio. Even for those who do like to manage their own investments, it's not a bad thing to have some money allocated to a good mutual fund or two. Fortunately, there are some great mutual fund companies out there, if you look hard enough.

The Longleaf Partner fund family, managed by Southeastern Asset Management, is one mutual fund company that gets it right. Southeastern Asset Management was founded in 1975 by its current chairman, Mason Hawkins, along with three partners. For the next dozen years, the company built a reputation as shrewd value investors by managing large, private-client portfolios with a value-oriented philosophy.

It now offers three funds: the large-cap Longleaf Partners Fund, the Small-Cap Fund, and the International Fund. All have been outstanding performers over the years, and all are ranked four stars or above by Morningstar.

A mutual fund should be a partnership
You get an inkling that this is a better kind of mutual fund when you open the Longleaf prospectus. Instead of boilerplate language, it first describes the company's investing philosophy and process in two paragraphs of plain, easy-to-understand English. Then investors are treated to Longleaf's governing principles. And, really, these principles tell you pretty much all you need to know about the Longleaf Funds. Here are the first two:

  • We will treat your investment in Longleaf as if it were our own.
  • We will remain significant investors with you in Longleaf.

Southeastern Asset Management introduced its Longleaf Partners Fund in 1987 in order to allow its managers to invest alongside its clients. According to Hawkins, fund investing "should be a partnership between the people managing the money and the people investing in the funds." It is a cornerstone of the company's philosophy that their own money ride beside their investors'. And this isn't just talk.

Here's another excerpt from its prospectus.

To align our interests with those of shareholders and prevent conflicts of interest, our Code of Ethics requires all employees to limit their investments in equities to Longleaf Partners Funds, unless granted clearance by a compliance committee.

Another sign of its commitment to invest along with its shareholders is that its employees are also required to invest 100% of their bonuses and profit-sharing payments in the firm's funds. This is beyond extreme, but many large mutual fund companies have been fined by the SEC over the years as a result of portfolio managers making trades in their personal accounts that created alleged conflicts of interest.

As you might imagine, Southeastern Asset Management isn't one of them. And the employees don't seem to mind the restrictions. Today, Southeastern Asset Management has over $18 billion in assets under management, and employees have over $175 million invested in the three Longleaf Funds.

I believe that it is hugely important for a fund manager to have his or her own skin in the game. Not only does this provide a strong incentive for the manager to perform. But just as importantly, there is a strong disincentive for poor performance or excess risk.

Making money with investors, not from them
Another Hawkins saying is that a mutual fund manager should "make money with its clients, not from them." Of course, every mutual fund needs to charge a reasonable asset management fee from its investors. But many funds are loaded with hidden charges.

Here's another principle of the Longleaf Funds:

  • We will not impose loads, holding periods, exit fees, or 12b-1 charges on our investment partners.

Many of you have had the experience of calling to redeem shares in a mutual fund, only to find out that your fund takes one last cut of your money just for the privilege of getting your money back. In addition to eliminating such hidden charges, Longleaf has actually reduced its asset management fees as its assets have grown. Each of the Longleaf Funds started out with a 1.5% total expense limit, which included asset management fees of 1.00% annually. Today, the Longleaf Partners Fund total expense ratio is less than 1.00% annually, of which asset management fees comprise around 0.77% per year.

Looking for the right investors
A fund's performance is almost as dependent upon the composition of its shareholder base as it is on its managers' skills. The next four principles of the Longleaf Funds are concerned primarily with attracting and cultivating long-term investors and discouraging "hot money" investors and market timers who jump from fund to fund.

  • We will discourage short-term speculators and market timers from joining us, the long-term investors in Longleaf.
  • We will continue our efforts to enhance shareholder services.
  • We will communicate with our investment partners as candidly as possible.
  • We will consider closing the Funds to new investors if closing would benefit existing shareholders.

Again, what's important here is not that the company writes this stuff down in a prospectus somewhere and forgets, but that these principles are taken to heart.

Southeastern Asset Management is one of the few fund groups that hold an annual meeting (just like a publicly traded company). Shareholders are given a chance to talk to the people who manage their hard-earned money and to ask questions. The company's shareholder reports are straightforward and informative, and investors are given every opportunity to understand the fund's investment approach.

It doesn't hesitate to close its funds to new investors when it is having trouble finding attractive investments. The Longleaf Partners Fund has been closed at times in the past, and the Small-Cap Fund has been closed to new investors since 1997. The company also monitors its investor base carefully for signs of short-term flippers. If an investor of size sells within three months of buying, that investor is not permitted to buy Longleaf Funds again.

A consistent investment approach
There isn't much turnover at Southeastern Asset Management. There are only eight investment analysts and portfolio managers, and most have large ownership stakes in the business. Its investing philosophy hasn't changed much in the past 25 years: They look for good businesses, run by good people, and won't pay more than 60% of what they think the business is worth.

Of course, like all mutual funds, the Longleaf Funds don't beat the market every year. But they do beat it over time. More importantly, the funds have set a standard for treating shareholders like partners, and the company's success is a great example for the professional money management industry to follow.

Zeke Ashton is a former full-time analyst and writer at The Motley Fool, and is now the managing partner of Centaur Capital Partners, LP, a money management firm in Dallas, Texas. Please send your feedback to zashton@centaurcapital.com. At the time of publication, Zeke did not have an investment in any Longleaf Funds.