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As Oakmark Grows, Investors Loom Large

Oakmark's investing-centric corporate culture is solid, but lower fees would be welcome.

Following big inflows of new cash and a major change in the ranks of its executive staff, Oakmark's culture remains investing-centric and shareholder-aligned. The firm has room for improvement when it comes to costs, but Oakmark shareholders can feel confident that they've entrusted their wealth to a firm whose commitment to its clients largely correlates with its managers' investment prowess.

Assets Spike
The shop has enjoyed eight consecutive quarters of healthy inflows, taking in an estimated $1.7 billion in the first quarter of 2011 alone. At more than $40 billion, total net mutual fund assets are at an all-time high according to Morningstar's data, having nearly doubled since the first quarter of 2009. Including separately managed and subadvised accounts, Harris' firmwide assets stood at $62.5 billion at the close of 2010.

The shop's asset spike could be worrisome, at least in theory. In practice, except in the case of David Herro's  Oakmark International Small Cap (OAKEX), the firm's dramatic asset growth represents little cause for concern. Oakmark's managers primarily target highly liquid large-cap stocks, an area of the market where market-impact risk--the risk of moving prices against the funds as managers build or exit positions--is negligible. And while International Small Cap's $1.7 billion makes it one of the industry's largest foreign small/mid-cap funds, Oakmark has demonstrated its willingness to protect shareholders' interests by reining in inflows when asset bloat threatens.

With more than $20 billion under management, for example, moderate-allocation offering  Oakmark Equity & Income (OAKBX) has been closed to most third-party platforms since May 2010. International Small Cap itself was closed to new investors for more than half of the last decade.

Headcount and Transitions
With roughly a third of Oakmark's assets residing in international portfolios, the firm has taken additional steps to ensure it has the capacity needed to run significant sums of international money. Though the firm's overall investment-staff headcount has remained steady, several new analysts have joined the international side of the shop in recent years.

All told, the firm's roster includes 11 portfolio managers and 15 investment analysts, two of whom also have portfolio management responsibilities. Win Murray--who joined in 2003 and whom long-time portfolio manager Bill Nygren identifies as one of Oakmark's future leaders--serves as associate director of research.

Oakmark's staff is clearly a seasoned crew, and a steady one as well: Median manager tenure at the shop ticks a bit above 11 years. And while a number of managers have left the firm over the years, their departures haven't jeopardized investment continuity. For example, when former Oakmark International and International Small Cap comanager Mike Welsh exited in 2005, David Herro--a manager on both funds since their inceptions in the 1990s--remained in place. Herro's continued presence minimized the impact of Chad Clark's 2009 departure from International Small Cap's management team, too.

Similarly, when  Oakmark Global (OAKGX) comanager Greg Jackson left the firm in 2003, the shop tapped Clyde McGregor--a three-decade Oakmark veteran--to join Welsh at the helm of that world-stock fund. And when Welsh left, Rob Taylor, a seasoned Oakmark analyst, got the nod to replace him. (In 2008, Taylor also joined Herro as comanager of Oakmark International.) Worth noting, too, is that the firm's portfolios are built from a common list of approved stocks--another means of ensuring consistency when investment talent moves on.

Despite its fine transition track record, Oakmark's admirable temperance when it comes to launching new funds could pose career-path problems for analysts who aspire to become managers at the firm. In recent years, only Taylor has made that leap. What's more, although the firm believes that, despite the 2004 shuttering of Oakmark Small Cap, its approach can work in the domestic-equity small-cap arena--and while its leaders have at least considered the possibility of a fixed-income product--no new funds are currently in the pipeline. The shop's most recent offering is the concentrated  Oakmark Global Select (OAKWX). Launched in 2006, veterans Nygren and Herro are in charge there.

A New President
Oakmark's thoughtful management extends beyond the investment staff to the firm's corporate ranks. July 2010, Oakmark appointed Kristi Rowsell president of The Oakmark Funds. Despite her impressive pedigree, the choice seemed unusual, at least at a glance. The 44-year-old Rowsell certainly has many years of fund-industry experience, joining Oakmark advisor Harris Associates in 1995 from Calamos Asset Management, where she worked for roughly three years. Rowsell, however, has never been a portfolio manager or an investment analyst herself. A certified public accountant, she served as Calamos' treasurer, and prior to her recent promotion, she was president of Harris Associates (a role she retains) as well as the firm's chief financial officer.

That background contrasts notably with that of previous Oakmark president John Raitt. Raitt came to the position after serving as the shop's U.S. director of research and, earlier in his career, an investment officer at Northwestern Mutual.

Reading the tea leaves of the transition therefore led to questions. Could Rowsell's elevation signal a change in Oakmark's investing-centric culture? Under the direction of Harris' former CFO, would the shop focus more on its own bottom line than its clients', with distribution, marketing, and new-product initiatives perhaps becoming more central than has been the shop's historical norm?

That doesn't seem likely. Recent conversations with (among others) Rowsell, Nygren, and Dr. Gary Wilner--the independent chairman of Oakmark's fund board--underscored the ways Rowsell's appointment complements and will likely bolster Oakmark's investment-focused culture. In at least one respect, it already has: Freed from the administrative responsibilities required of the president's role, Raitt has returned to the work he enjoys most: investment analysis and research. Bob Levy, moreover, remains in the organization's top spot as Harris' chairman and chief investment officer.

Skin in the Game
Although Oakmark has been on a winning streak, the firm hasn't been anxious to launch new funds. A fixed-income vehicle might seem a natural opportunity for the shop, for example. But as Nygren explained during our discussion, it isn't clear how Oakmark's approach to security selection would fare in an area where trading-related concerns (e.g., the liquidity of the securities the firm favors, varying levels of new-bond issuance) can trump even the most thorough fundamental research. Indeed, while by prospectus the bond sleeve at Equity & Income can comprise as much as 60% of assets, the managers regard it in part as a holding pen for cash to put to work in equities (which can rise to 75% of assets) as opportunities warrant.

As that example helps illustrate, new-product discussions at the firm are driven by investment considerations--not perceptions of market opportunity--and by investment professionals. Global Select came about because Nygren and Herro wanted to work more closely together and because the fund's concentrated approach meshes with the way the duo prefer to invest their own money.

Not coincidentally, all Oakmark managers have more than $1 million invested in the funds they run--and they have plenty of close company: At the end of 2010, Rowsell noted in her President's Letter that "the employees of Harris Associates, our families, the Funds' officers and trustees have more than $260 million invested in The Oakmark Funds."

Fee Trouble
That Oakmark's managers and employees are also significant Oakmark investors is chief among the several ways the shop aligns its interests with shareholders'. There is one critical respect, however, in which those interests aren't sufficiently aligned: Fees. Despite the tremendous asset growth Oakmark has enjoyed, the shop hasn't been especially aggressive in lowering fees.

Between the first quarters of 2009 and 2011, for example, the  Oakmark Fund (OAKMX) and its concentrated  Oakmark Select (OAKLX) sibling have enjoyed asset increases of roughly 90% and 66%, respectively. Yet both funds' Morningstar fee-level scores are above average, indicating that they're pricey relative to category rivals sold though comparable distribution channels. And despite its status as one of the fund industry's largest foreign small/mid-cap offerings, International Small Cap's price tag is--like that of siblings International and Global Select--merely average. Finally, while Oakmark Global's expense ratio falls below its relevant rivals', the fund's current price (1.15%) is just one basis point below its 2008 figure, even though assets have ballooned by more than $1 billion since then.

Of all Oakmark's offerings, only Equity & Income's expense ratio approaches the level of alignment shareholders should expect when it comes to costs. Below average at 0.79%, the fund's price is the lowest in its history. Given its girth, though--Equity & Income is the moderate-allocation group's sixth largest fund--it should cost even less. The funds' overall cost is a key reason why the Oakmark family earns a B from Morningstar for corporate culture, rather than an A.

Costs and Courtroom Drama
Three other points are worth noting in connection with Oakmark's costs. First, while Morningstar's Stewardship Grade methodology breaks fund fees out as a distinct, quantitative subcategory, costs clearly bear on the caliber of a shop's culture and therefore require qualitative as well as quantitative assessment. A fund's price tag is a significant indicator of its likely future success, and except perhaps for level of managerial investment, no other detail reveals as much about the way a shop aligns itself with shareholders: An advisor's revenue, after all, represents an investor's foregone returns. In this area, Oakmark has work to do.

Second, like many firms, Oakmark uses soft-dollar arrangements to help defray research expenses. The practice is perfectly legal and used pervasively throughout the fund industry. It isn't consistent with best stewardship practices, however. Paying inflated brokerage commissions (i.e., soft dollars) to cover research costs has a direct and measurable impact on a shareholder's bottom line, but the value of the research obtained via soft dollars is difficult if not impossible to quantify.

The shop once had this right, too. In 2005--partly in anticipation of an expected SEC regulation that many thought would abolish the practice--Oakmark voluntarily stopped using soft dollars. That ruling failed to materialize, and the firm subsequently resumed soft-dollar arrangements.

That decision was regrettable. Given Oakmark's stature in terms of its current size (the 39th largest fund manager by assets) and investment excellence (four of its seven funds boast 5-star Morningstar Ratings; two sport 4-star ratings), the shop is well-positioned to lead by example, raising the bar for stewardship broadly while further aligning its interests with those of its shareholders.

Finally, there is the matter of Jones v. Harris Associates. This case--a legal test of the latitude a fund company enjoys when establishing fee structures--isn't yet closed. In March 2010, however, the Supreme Court unanimously sided with Harris, vacating an appellate court's contrary ruling and remanding the case back to district court where the plaintiffs will have another opportunity to prove Harris violated its fiduciary duty.

The Supreme Court's action reaffirmed a longstanding legal precedent (codified in Gartenberg v. Merrill Lynch Asset Management, Inc.) that, among other things, permits fund companies to charge non-mutual fund investors (institutional and separately managed account holders, for example) lower fees than those paid by fund investors.

As of this writing, the district court has yet to issue a new ruling.

Process and Performance
Notwithstanding Oakmark's higher fund costs, investors in the firm's funds have enjoyed remarkable investment success. Results here have stemmed from a sensible, clearly repeatable approach to value investing, too. Unusual in the limited emphasis the process places on relative valuations, Oakmark stands out among value shops for its willingness to invest significant sums in areas of the market that many rivals tread only lightly in, if they tread in them at all.

As of April 2011, for example, Nygren's flagship Oakmark fund sports outsized exposure to economically sensitive consumer names and overweight slugs of technology stocks--hardly traditional value fare. Media companies are similarly well-represented, but the fund sports dramatic underweight stakes in energy and consumer staples stocks.

For his part, David Herro--Morningstar's International Stock Fund Manager of the Decade--has been a vocal proponent of Japanese equities in recent years, despite the seemingly intractable negative sentiment about that country's stock market. Unsurprisingly, all of Oakmark's foreign and international funds feature above-category-average exposure to Japan.

High Conviction Contrarians
As an example of Oakmark's investing-centric culture in practice, Herro's forceful reiteration of his views about Japanese equities following the country's March 2011 earthquake is apt. Arguing that the precipitous slide of the country's equity markets had little correlation with the true worth of Japan's companies, Herro indicated that, if the gap between stock prices and fundamental value persisted, he would be inclined to purchase additional shares of his funds' Japanese holdings.

A high-conviction contrarian, Herro's response encapsulates much of what's admirable about Oakmark's process and its investing-centric culture. Focusing on "true business value"--Oakmark's phrase for its estimate of a firm's private-market acquisition price--can require patience. As shareholders know, it can also generate tremendous wealth: In addition to notching superior total returns, the shop's funds generally boast strong, long-term investor returns as well.

That its typical shareholders have stuck with the firm through frothy times and lean ones too underscores not only the acumen of Oakmark's managers but also the firm's strong stewardship profile. There is room for improvement, but Oakmark's investing-centric culture is solid.

Shannon Zimmerman has a position in the following securities mentioned above: OAKLX. Find out about Morningstar’s editorial policies.