Proper due diligence can counter the lure of triple-digit returns

By Dan Hallett, CFA, CFP on March 1st, 2011

I was recently asked to comment for an article on a small, top-performing mutual fund – Redwood Global Small Cap. While the article included a couple of my comments, there was no room for some of the more striking statistics I found when doing a quick review of the fund’s filings. But the quick review I did could also serve as a guide to where to start when beginning to research a product for the first time. And such a review can help to ground investors that are seeing dollar signs after a hot run.

Regulatory review

Too many people often overlook very basic steps. In the case of a fund, particularly where it is managed by a third party, reviewing the information available in the public domain is easy to forget about – but it’s a critical first step. For Ontario, you can use the OSC’s Registration Check. For the rest of Canada, the CSA now maintains a national database for use by the public. The goal here is to verify the status and category of registration along with any terms, conditions or constraints on licensing.

Document review

Next stop is www.sedar.com which is a database of regulatory filings for mutual funds and publically-traded companies. You can find the full slate of regulatory filings for this fund on the SEDAR website. Even a preliminary, surface review should include a quick scan of a fund’s financial statements, management report on fund performance (MRFP), the prospectus and annual information form (AIF).

I won’t recount a full review but here are a few tidbits I stumbled on when taking a quick look through a couple of documents.

Redwood Global Small Cap had $723,372 in assets at the end of 2008, by which point the fund had lost 55% of its value. The fund grew to $1.3 million by mid-2009 but more of that growth was from performance than from inflows.
By the end of 2009, when the fund posted a sizzling 150% return, it boasted $4.9 million in assets. Then in the first half of 2010 – after the 150% return had been made – investors invested a net $2 million into the fund. At the end of September 2010, assets stood at more than $8.2 million.
Its reported management expense ratio (MER) for the first half of 2010 was 3.66%, which includes an estimated 0.78% accrued performance fee (which is only paid at year-end). Trading costs added another 5.63% annually, bringing the total costs of holding this fund for the first six months of 2010 to 9.3% annualized. Trading costs have added an average of 7% annually to the MER since the fund’s 2008 inception.
Of the 27 long positions held by the fund at June 30, 2010, 17 were warrants – most of which show a zero cost and most of which were showing a big accrued gain at that date.
I was quoted in the Globe & Mail article as citing the fund’s average turnover at about 700% annually. In fact, the average turnover is much higher. Two of the three years – 2010 and 2008 – were partial years. Annualizing the reported turnover rates for those years results in an average of 1,040% annually from mid-2008 through mid-2010.
This turnover is nicely illustrated by the fund’s wild swings in asset mix. At June 30, 2010 the fund’s cash position (net of that required to cover shorted securities) was 72%. Three months later, at September 30, 2010, cash was a lean 6% (and all short positions were closed). By January 31, 2011 cash was back at 25%.

To buy or not to buy

I have not come close to doing proper due diligence on this firm or fund. Accordingly, neither I nor our firm has an opinion of the fund. Given that this fund is very hedge-fund-like, it requires investors to do a lot of homework to assess the quality of this fund and its suitability for each investor’s particular circumstances.

One good sign revealed in the Globe & Mail article is the firm’s stated intention to cap the fund’s size at no more than $50 to $60 million. The high turnover combined with the fund’s focus on small and micro cap stocks requires a small asset base to have a hope of continuing the fund’s apparent strategy. Even then, however, triple-digit performance figures are simply not sustainable over any meaningful period of time. And time will tell if the firm actually caps this fund at the stated asset level. Plus, the wording around the fund’s performance fee is not as tight or complete as I’d like.

Whatever the case, I hope that investors don’t get lured into this volatile fund at the wrong time and for the wrong reasons (i.e. with unrealistic expectations of repeating its brief record). Canadians’ investing history is filled with such examples that have ended badly for investors. Don’t be another dubious entry in the investing history books.