Year-end letters provide opportunities for candor, explanation, and connection.
Sometime in the past month, you should have received the annual reports for some of your mutual funds in the mail or online. (Funds that end their fiscal year on Oct. 31 sent the reports a couple of months earlier.) These documents contain much of interest, such as a fund's holdings, expense ratio, turnover rate, and the amount of money paid to its board of directors. Most of this information appears in a standardized format. But one section can take almost any shape the fund company or manager wants: the letter to shareholders.
This letter, or "management commentary," is worth reading. In many cases, it can provide you with a window into your manager's thinking and provide insights that would be difficult to obtain even by intensive study of all the other available information. And if the letter fails to take advantage of that potential, that in itself can be telling.
What Should Be There
While a rewarding letter can appear in a variety of styles, it should contain certain elements. Most important is clear writing. Without that, all else would be of little use.
Managers must present their points in a way that's easy to understand, and lively enough to grab and keep the reader's interest. A boring or incomprehensible piece will not be read. Moreover, one reason to peruse the letter is to gain an appreciation for the personality and character of the man or woman you've entrusted with your money. That cannot come through if the prose sounds as if it were written by a robot (or worse, a bureaucrat).
This does not mean that managers must strive to be entertainers, with reports full of witty anecdotes and one-liners. If a jovial tone isn't natural, they shouldn't force it. The important thing is for a real person to show through.
Of course, the content is equally important. Shareholder letters should include plenty of details, not just vague overviews. They should discuss specific decisions made about individual securities or about types of holdings, including the reasons for these moves. If certain stocks, sectors, or countries are vastly over- or underweighted in the portfolios versus indexes or peers, or are controversial, the letters should tell shareholders why they were purchased, sold, or maintained at the same weighting. Did the manager decide to make a change of course at some point during the year? If so, the letter should explain to shareholders the thinking behind the action.
Evaluating performance is important, too. This section should not consist only of bare-bones descriptions such as "Contributors included sectors A, B, and C, and detractors included stocks X, Y, and Z." (Too many letters use nearly that exact language without further elaboration.) Mistakes require special attention. Very few managers come right out and say, clearly and unequivocally, "My decision to buy X (or not to sell Y) was a mistake," and explain why they did so and what they learned from the experience.
Perhaps managers--and their fund company overseers--think an admission of error will raise doubts about competence. But shareholders who expect perfection probably won't be long-term shareholders anyway. In fact, though it might seem counterintuitive, clear explanations of mistakes can instill confidence in shareholders. Such discussions provide evidence that their manager is a straight shooter. More important, they show that he is a thoughtful, analytical type who knows when something has gone wrong and who tries to learn from the experience.
A Deeper Understanding
Also helpful are broader discussions of the fund's strategy and approach. This can become repetitive for longtime shareholders, but it's invaluable for those who haven't seen it before. (The prospectus contains a brief description of strategy, but that is typically less detailed or goes unread.) Shareholders who feel well informed about their fund's strategy and who understand that it tends to underperform in certain conditions will be more likely to hang on rather than sell impulsively the first time it falls behind.
Ideally, shareholder letters would also cover any meaningful personnel changes that occurred during the year. Few letters bring up this topic. At best, if a comanager leaves, it might merit a brusque one-line reference. Turnover among the analyst corps typically is not mentioned at all. It's understandable why fund companies don't rush to reveal analyst departures if they don't have to, but they should do so and balance it by providing the more encouraging details about new arrivals. Providing details about the individuals who back up the named manager(s) can further instill in shareholders a feeling of partnership with those who are investing their money. It also puts shareholders in a better position to make an informed decision on whether to stick with the fund if the manager leaves or retires.
Together for the Long Haul
A letter that includes all of the above would enable shareholders to understand and appreciate their fund far better than most currently do. (A future Fund Spy column will include examples of letters that do achieve this goal, or at least come close.) Shareholders who do their part by reading the letters will know what happened, why it happened, and most important, what's likely to happen in the future. They won't be able to forecast the fund's exact future returns, of course, but they'll have a solid grasp of how the manager, and the fund, will likely act in a variety of conditions.
Receiving such communications makes shareholders feel they've invested with people with identifiable personalities, opinions, and convictions, rather than a faceless corporate entity. As noted, such shareholders are more likely to hold on through a rough patch to reap the benefits of long-term investing. Over time, that type of ownership tends to work out better for shareholders and fund companies alike.