Update: The Blue Fund Group filed today to liquidate the Blue Fund (formerly Blue Large Cap Fund) "on or before June 29, 2008." The fund has been a very poor performer since its Oct. 2006 launch--per Blue Fund Group's website, the fund lost 16.5% of its value since inception. By contrast, the S&P notched a roughly 5% cumulative gain over that span.

Oddly, it appears that the fund's NAV fell by more than 10% on a single day--May 13th. The S&P was essentially flat that day, so it was a very bad day indeed for the Blue Fund.

When I called the fund company to inquire, a rep told me (to paraphrase) that the decline stemmed from market action as well as a "large shareholder redemption". Per the rep, the fund did not make a distribution that day. It's still not clear why a shareholder redemption--which should reduce the numerator (value of securities being redeemed) and denominator (# of fund shares being redeemed) in proportion to the fund's NAV--would cause the fund's NAV to decline.

Here's what the prospectus has to say about redemptions by the "large shareholder" in question.

The Mai Trust retains the right to submit one or more redemption requests from time to time with respect to its shares of The Blue Fund.  However, if the Mai Trust submits one or more redemption requests within 90 days after its initial investment in The Blue Fund, which occurred on March 19, 2008, the Mai Trust will reimburse The Blue Fund for the portion of the commission costs paid by The Blue Fund to liquidate the securities for the redemption request that would otherwise be borne by shareholders of The Blue Fund other than the Mai Trust.  Such portion of the commission costs will be calculated as follows for any redemption within 90 days after the date of the Mai Trust’s investment:  (a) divided by (b), with the result multiplied by (c), where (a) is The Blue Fund’s net assets attributable to shareholders other than the Mai Trust, (b) is the Funds’ net assets, and (c) is the commission cost related to the sale of assets relating to the payment of the redemption request by the Mai Trust.  The Mai Trust has also agreed that The Blue Fund may pay redemption proceeds within seven calendar days of any redemption order in accordance with Section 22(e) of the 1940 Act, notwithstanding the provision contained in the Prospectus that requires redemption proceeds to be paid within three business days of the redemption order.

Assuming that the fund company followed this redemption protocol to the letter, it would mean that shareholders beside Mai Trust didn't incur any transaction costs associated with the sale--meaning that onerous transaction costs would not explain the NAV decline.

Incidentally, assuming that the fund exercised its right to withold redemption proceeds for seven calendar days, that would mean the redemption request came in on/around May 5th or 6th...or right around the time the Wall Street Journal ran a piece (registration required) shining a light on the odd arrangement that the board had struck with the Mai Trust.

It's nerdy, but I like keeping an eye on new mutual fund and ETF filings. I've got an Edgar parser set-up for that very task and check it a few times each day for the latest, if not greatest, in new registrations and prospectus amendments. It's a nice window into industry product development or, for you glass-half-empty types, a canary in the coalmine for sniffing out potential problems or just plain weirdness.

Well, this past week brought us a few odd mutual fund filings, the first being a one-of-a-kind prospectus amendment (I've never seen anything like it), the other raising the question of whether imitation is indeed the sincerest form of flattery.

Blue Large Cap Fund

Let's start with the first--a prospectus amendment for a very small fund known as the Blue Large Cap Fund. That fund's mandate is to track an index consisting of S&P 500 firms that 'engage in business practices consistent with progressive values' and 'give the majority of their political contributions to Democractic candidates'. (Incidentally, the fund was holding a 10% cash stake as of 12/31/07...a 10% cash stake in an index fund...huh?) 

So, what happened? An investment trust bought $9.5 million worth of Blue Large Cap Fund shares earlier this week, representing 92% of the fund's assets. That trust's beneficiaries include an individual who controls a firm named Cornwall Equities LLC. And the relationship of Cornwall to the fund? It owns a 35% stake in the fund's advisor, Blue Investment Management.

Here's where it gets interesting: The trust in question has received approval from the fund's board to buy puts (that is, options to sell at a specified price) on up to 35 of the portfolio's 70-plus stocks. In other words, a trust that stands to benefit an individual who has an ownership interest in the advisor has gotten permission to hedge its exposure to stocks that the same advisor has selected for the portfolio. How's that for a ringing endorsement of the strategy! (Given that Blue Investment Management's form ADV doesn't appear to disclose Cornwall's ownership interest, it leads one to believe that Cornwall bought a stake in Blue very recently, perhaps coincident with its purchase of Blue Large Cap shares.)

Gratio Value Fund 

The other filing is for a newly launched fund, Gratio Value (GRVLX).

Now, right off the bat, I'll concede that the strategy actually sounds pretty sensible--the manager will screen for stocks that have high earnings yields (i.e., low valuations, as earnings yield is the inverse of P/E) and high returns on invested capital (which is a variant of more-familiar profitability measures like return on equity and return on assets). That approach isn't all that far a cry from the tack that we take here at Morningstar. For instance, return on invested capital is a key input when we're evaluating the durability of a firm's competitive advantage, or 'economic moat', and we're typically most enamored with high-quality businesses that consistently churn out high ROICs.

The problem? Well, the Gratio fund's strategy sounds almost identical to the approach that noted author and investor, Joel Greenblatt, laid out in his bestselling tome 'The Little Book That Beats the Market'. Greenblatt also maintains a companion website, Magic Formula Investing, that investors can use on their own to screen using his 'magic formula', which the site describes as follows:

For “cheap stocks”, the formula uses earnings yield (the inverse of P/E, it is simply earnings divided by market capitalization). However, for the magic formula we make a couple of adjustments. These adjustments account for differing debt levels and tax rates between companies. We feel these adjustments, on average, give us a better estimate of “earnings yield” than a simple P/E or E/P measure. These adjustments are discussed in the appendix section of the book.

For “good stocks”, the formula uses return on capital. Many analysts use a simple return on equity calculation (earnings/equity) or return on assets (earnings/assets) ratio to determine return on capital. As with earnings yield calculations, we make a couple of adjustments that account for differing debt levels and tax rates between companies. We also compare earnings to the total “net working capital” plus “net fixed assets” required to generate operating profits. Intangible assets are excluded as described in detail in the book.

However, these adjustments are not the “magic”. The magic formula would still work well without these specific adjustments. Simply, companies that can be purchased at low P/E’s and that achieve high ROA’s or ROE’s have also significantly beaten the market on a historical basis.

I've got no problem with managers drawing inspiration from other investors/thinkers. Heck, our equity approach borrows heavily from Warren Buffett (who, in turn, was strongly influenced by his mentor, Ben Graham), after all. So, if Greenblatt does for Gratio what Buffett did for Morningstar, more power to 'em.

But if you ape another strategy--as it appears Gratio is doing in this case--shouldn't it cost a heckuva lot less than 1.15%, which is the management fee the fund is slated to levy? Yes, I'd acknowledge that the manager is waiving a large chunk of expenses to keep the net expense ratio capped at 1.15%1.35%. And, yes, I'd also acknowledge that the manager is overlaying some socially-responsible screens (no alcohol, tobacco, porn) and can override the 'Gratio formula' in certain cases, a service for which it deserves to be paid. And, yes, the manager has discretion to invest 20% of the fund's assets as it sees fit. And, no, the manager doesn't deserve to go without compensation for creating an investable version of the 'magic formula', if that was in fact part of the aim here. But 115 basis points? If the fund grows, then one would expect the management fee (after waivers) to settle at around 90-100 basis points. But after you add in 12b-1 and 'other' fees, you're still back at 1.35%.

And did I mention that they'll rebalance the portfolio 'approximately annually'? (Meaning that it will be more-or-less static throughout the year...leading one to wonder what the manager will be doing in the interim to earn the 90-100 basis points in management fee it's slated to earn.)

Just to put this in context, the strategy is 80% passively managed, which is akin to the rules-based quasi-active portfolios that dot the ETF landscape these days. What do those ETFs go for? The PowerShares 'Dynamic' ETFs, for instance, typically cost 0.60%. If you grossed that up to go apples-for-apples with Gratio (which is 80%, not 100%, passive), then it's around 0.75%, or nearly half the Gratio fund's post-waiver price.

It's a promising strategy. But it could be cheaper.