March 3, 2014 / 6:07 PM / 3 years ago

Excluded from rankings, Barrow fund outperforms

NEW YORK (Reuters) - One of the best-performing stock funds over the last three years is hiding in plain sight.

The tiny $20.6 million Barrow All-Cap Core Fund has returned an average of 17.7 percent a year to investors over each of the last three years, a performance that trails just one other fund of 1,051 in its large capitalization category: the $7.7 billion SunAmerica Focused Dividend Strategy Fund, which has notched a 19.2 percent annualized gain over the same time.

The Barrow fund has succeeded despite avoiding some of the fastest growing and most popular sectors, including financial services and technology.

Yet few investors are familiar with the fund due to a quirk in the performance rankings issued by Morningstar Inc and Lipper, a Thomson Reuters company, the fund-tracking services which financial advisors and lay investors use to find new funds.

In August 2013, the Barrow fund changed its legal structure from a private partnership to a more traditional mutual fund. Both of the aforementioned fund trackers will wait for three years from that conversion before including the Barrow fund in their comparative performance listings.

(Please note: Morningstar ran the comparisons cited here at the request of Reuters.)

That means investors mining the lists will not see the Barrow fund, even though both Lipper and Morningstar are continuing to measure its performance, just as they did before the conversion.

"We have to be content being one of the best-performing funds that people have never heard of," said David Bechtel, one of the principals at the Stanford, Connecticut-based firm, and one of the fund's three managers.

The fund concentrates a lot of its assets in small- and mid-cap companies, which have done very well in the last three years, so it runs the risk that market reversals could put its portfolio out of favor at about the same time as it starts garnering more attention.

QUANT-DRIVEN STRATEGY

The fact that the Barrow fund cannot count on its performance data to attract new assets is one irony for the numbers-driven company.

The fund relies on quantitative analysis: it eschews nearly all meetings with company management and big-picture calls to focus solely on publicly-available performance numbers.

At Barrow, some 10,000 companies are ranked monthly on the basis of their value components - metrics such as high cash flows, little debt and wide operating margins. The 180 to 200 stocks that look the most attractive are typically held for at least a year, at which point they are reevaluated. By design, the fund holds approximately a third of its assets in large-cap stocks, a third in mid-caps and a third in small-caps.

"It's almost engineering-oriented," said Bechtel, who once served as the treasurer of SunAmerica Inc.

The fund's strategy of holding both small- and mid-cap stocks has helped push its overall performance higher.

But investors should be wary that these higher-risk stocks may also hurt it, said Todd Rosenbluth, director of mutual fund research at S&P CapitalIQ.

"If we have a correction, this fund will lag large-cap value more than defensive funds," he said.

The screening-heavy process means that Bechtel and the fund's two other portfolio managers have little familiarity with company management or analyst projections. Instead, each position is rooted firmly in past performance and the managers intentionally have few opinions about a company's unique prospects.

For example, the fund recently added to its position in gunmaker Smith & Wesson Holdings Co, chiefly because of its year-over-year sales growth per share of 29 percent, its low leverage of 14 percent and its earnings yield of 22 percent.

Tobacco-maker Reynolds American Inc, meanwhile, makes it into the portfolio on account of its operating margins of up to 40 percent, its dividend yield of 5 percent and low leverage of 16 percent.

The fund does not make outsized bets on any one stock. Its largest position, Nu Skin Enterprises Inc, makes up just 1.5 percent of assets. Its second-largest holding, healthcare company United Therapeutics Corp, accounts for 1.3 percent of assets.

NO TECH, NO FINANCIALS

Where the fund differs the most from its competitors is in what it will not buy.

Its screening process blocks out four of the ten sectors that make up the benchmark S&P 500 index - all technology, telecom, utilities and financial stocks, for reasons that range from the technology sector's emphasis on future earnings potential to the financial sector's often-murky balance sheets.

"When we can't penetrate the true leverage on a balance sheet, we decide it's a game we can't win," said Bechtel.

Investors who want to buy into the fund can expect to pay an annual fee of $1.41 per $100 invested, a level slightly above the average of actively-managed funds. The fund comes with a yield of approximately 2 percent.

Reporting by David Randall, editing by G Crosse

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