“Right now, at this very moment, the companies we have invested in are working hard on your behalf to create shareholder value. How do we find such dedicated companies. You see, from our vantage point we have a front row seat to the greatest technological revolution mankind has ever seen. So if there is a company positioned to benefit from the revolution, you can bet there’s a good chance we already know about them.” from 1999 Annual Report to Shareholders, Berkshire Focus

“The performance of the Fund and international equity markets has been exceptional over the past three years—on an annualized basis the Fund was up 32.2% and the MSCI EAFE was up 23.7%. We do not think this level of returns is sustainable and encourage shareholders to have more conservative expectations of future returns.” from 2005 Annual Report, Dodge & Cox International Stock Fund

Successful managers manage expectations as well as they manage money. Note how the Dodge & Cox report tempers expectations within the first section of the document. This is not out of the ordinary. Berkshire Focus wasdn’t the only fund with a great 1999. Dodge and Cox Stock returned 20.2% that year. But page two of their annual report from that year begins:

“Some investors allege that we are in a new paradigm and that historical precedent and traditional valuation methods no longer apply. We disagree. We think four of the most dangerous words in investing are this time is different. We offer two examples of previous periods of extreme investor enthusiasm for a particular economic sector…”

Berkshire Focus had reason to be excited: it had returned 142,9% for the year in 1999. Hindsight is 20-20, and no chicken littles were getting much airplay at the end of 1999, but the Berkshire Focus Report is ecstatic from cover to cover. To the managers’ credit, six pages into the report, it does indeed state “we feel it is important, however, to remind our shareholders that we are certain such extraordinary returns are unsustainable over the long-term.” This disclaimer, however, is rendered impotent by the exuberant tone of the whole report, entitled, “From Our Perspective We see a World of Unlimited Investment Opportunities.” The opportunities were not realized: had you invested at that moment in the fund you’d have lost 80% of your principle through the end of 2005.

Sometimes you can’t avoid a front-end load. If your employer, for instance has a long-term relationship with a broker who sells front-end loaded funds, you may be stuck with them. And many of them are fine funds. Oppenheimer and PIMCO are two highly respected fund families with some of the best managers in the industry and the returns to prove it, yet we would sparingly recommend some of their funds to new investors with no-load options.

The other fees you need to look out for are management fees. According to Morningstar there are over 4,500 funds with expenses below 1%. We suggest you consider these funds first, since this is a loss that is manageable. While some of the more specialized asset classes – commodities producers, emerging markets, foreign stock, U.S. Microcaps – will carry a higher expense ratio, your core U.S. holdings should have more reasonable expenses: Under 1% for U.S. Equities; Under 1.5% for all other asset classes.

Imagine that you and I are fund managers. Your fund has $250 million in total assets; mine has $15 billion. We both discover the same great, undervalued small cap that’s got a great business and is poised to take off. It has a $400 million market cap, 1 million shares outstanding at $4 a share. In order for you to invest 1% of your fund into this company, you’ll have to shell out $2.5 million – less than 1% of the shares outstanding. You could do this without significantly affecting the stock price. In order for me to invest 1% of my fund in this company I’d have to shell out $150 million – three-quarters of its current market cap. Worse yet, as my big orders (because I’m dollar-cost averaging) come in, the stock price would rise because my orders are increasing demand significantly. As a result, I will be forced to take a smaller stake in the company. When it finally takes off, your smaller fund will benefit more.

Responsible fund managers close funds to new investment before a fund gets too big. How big is too big? For a small cap fund, most people say $10 billion. I say $5 billion. There are plenty of talented fund managers that specialize in small caps, why handicap them? For a large cap fund, if it exceeds $25 billion it is likely to move the market with significant moves.

But change can be a good thing, if it is properly motivated. In 2005, for example, Oppenheimer changed it Small Cap Value fund to the Small- and Mid-Cap Value Fund. This allowed the fund more flexibility as its assets grew. It also allowed the fund to maintain attractive holdings that had grown from small-caps to mid-caps. The fundamental strategy of the fund’s stock picking did not change, only the asset class expanded. The fact that the fund is a consistently strong performer highlights the fact that this was not a change enacted in order to bring in new investors (out of duress); rather, this was a change enacted to benefit current investors.