Portfolio manager Cale Smith on investing, Spoke Funds®, and Islamorada in the Florida Keys.

Good quote from Bruce Berkowitz of Fairholme Funds, who was just named Morningstar’s U.S. mutual fund manager of the year for 2009.

I’ve had a lot of fun and continue to enjoy myself. We expand our circle of competence – slowly. We hopefully get better and wiser and don’t make the same mistake twice. After about 30 years I’ve made my fair share of mistakes.

I have a trick I use: I put all of my family’s money into the fund.

I’m using every device I know of to make sure we maintain a level playing field and put ourselves in the shoes of our shareholders. The only way to do that is to become as large a shareholder as possible.

Amen. But it’s only a “trick” in mutual fund world. Otherwise, it’s a Spoke Fund®, knowhatImean?

Here’s the whole interview. H/t @ManualofIdeas

The below originally went out in my last letter to investors. I’m reproducing it here for the benefit of any investors or Spoke Fund managers who haven’t seen it yet.

Q. Do the returns I see in your Tarpon Folio ads exactly mirror the performance of all your investors’ accounts?

A. Great question I’ve gotten lately from potential investors and other portfolio managers considering launching Spoke Funds® of their own.

The answer is “no.” Here’s why, in several parts.

First, for investors: rarely will your own returns match the advertised historical returns of any fund you may see. Ours are no different. (Thus, the disclaimers.) Many variables explain the difference, some of which are specific to a Spoke Fund®. More on those below if you’re interested.

With regards to future performance, please understand that we will likely never see another period where the portfolio increases as much over a nine month period as it has since launching Tarpon. My goal when I launched Tarpon was for everyone to earn 15% a year. Then, in five years, we’d double our money. That remains my goal today. We have taken advantage of some truly exceptional circumstances lately, but it will likely be years before we ever see so many compelling values spread so widely across the market again.

So, to be clear, our returns over the next few years will not look like those of the previous few months. That won’t be for a lack of effort on my part, mind you. I still expect to outperform as much as is safely possible over the long term. But those are just the odds. Quality companies are simply no longer as dirt cheap as they had been, and the price we pay for them determines our ultimate returns.

The next part of this answer gets a little wonky. While it’s probably geared more for other Spoke Fund® managers, I’ll include it here, too, for any investors who care to read more.

The question brings up a couple of other important points regarding differences between investors’ returns and those you see in our ads. The first, again, is that performance figures are historical snapshots, not future guarantees, as most investors realize thanks to the disclaimers in the ad and/or common sense. In the case of Tarpon, those advertised returns are also the actual, post-commissions-and-fees, pre-tax returns for a $12,000 portfolio of my own money outside of my family’s other investments in Tarpon, set up specifically to report performance. Our performance is presented using a simple holding period return for now, as I believe it’s the most objective during this first year. (I’ll talk more about geometric averages down the road). Currently, at the end of every month, I record the value of that tracking account, divide it by the $12,000 minimum required investment we started with in the tracking account, subtract 1 and, walla, that’s our return since inception as a percentage.

FOLIOfn computes performance differently, however, as you may have noticed when checking your account. FOLIOfn relies on the same method of calculating returns that mutual funds do – the “modified Dietz” formula. Tarpon’s returns calculated using modified Dietz have been at times considerably higher than the returns I publish, but that’s okay by me because (1) conservative numbers are a good thing and (2) I’d rather our returns reflect the logic of my calculator than the accounting logic of massive portfolios.

The other reason your returns may differ from what is advertised in the local papers and our website is because of what’s called “drift.” Because investors come onboard at different times, each of you are buying shares of Tarpon companies at different prices. The number of shares of each individual company that you own in your account will differ from the number of shares of each company owned in the tracking account, too. That’s because I buy stocks in your account according to a percentage-based portfolio weighting that I control for Tarpon through the FOLIOfn back end. So, any differences between your account’s performance and the Tarpon tracking account are most easily explained by (a) when you invest and (b) the number of shares you are initially buying of each individual company, according to a portfolio weighting formula that I determine.

To date, the “drift” or difference in performance between each account in the Spoke Fund® and the Tarpon tracking account has not been large enough to be a concern to me. Some drift is to be expected given the huge swings in the market over the last year, which further amplify the impact of the variables above. More to the point, though – I’ve rebalanced Tarpon’s portfolio weightings twice since launching the fund nine months ago. Those rebalances have the effect of bringing that drift close to zero for all investors. I do not currently have nor do I plan to create a rigid rebalancing schedule, but I suspect once or twice a year will probably be a reasonable average looking ahead.

Another key point about those numbers: on the day you invest with us, you buy shares in all companies as determined by the most recent portfolio weightings I have loaded into FOLIOfn – not the current weightings of the fund itself as measured by the Tarpon tracking account. That initial “sync” will create some future drift between your results and the tracking account from that day forward, but it is intentional. I do it because (1) that drift will be negated during the next rebalance, and (2) even then that initial drift is still still in your best interest. Otherwise, on the day you invest, you’d effectively be buying shares in those companies that have already gone up the most in price. And that’s just, well, dumb. I want you buying more shares of the most undervalued companies, all things being equal.

That last point hints at yet another reason why I believe the Spoke Fund® model is superior to the mutual fund model; because I as the portfolio manager can invest your money in accordance with the portfolio weightings that I want you to have. Mutual fund managers cannot make that first day tweak. The day you invest in a mutual fund, you are effectively buying more of the shares that have already gone up the most. Add that in with the other strikes against the mutual fund model, and it becomes even harder for your money to outperform – even at the hands of the most talented mutual fund managers in the world.

In summary, then – no, your returns will not exactly match those presented in our marketing material, particularly in volatile markets. But they should be close enough. When investing in Spoke Funds®, also realize that a small degree of occasional “drift” is the trade-off for incrementally better long-term returns.

So take all fund performance ads with a grain of salt. They should be viewed only as a historical measure of portfolio management skill. In fact, a statistician will tell you that track records are effectively useless at predicting future performance until a fund manager has at least a 25 year history. I would say that I’ll be on the beach long before then except, well, I already am.

If you have any questions, by all means please let me know.

From a WSJ article on a new report by Harvard professor John Coates on the non-partisan Committee on Capital Markets Regulation.

On taxes paid by investors in mutual funds:

I was struck as an investor as much as an academic by how unfair the process is, especially for middle-class people. We’ve set up a system that punishes people who can’t afford to invest in hedge funds.

The article continued:

Mr. Coates said the U.S. mutual-fund industry is hampered by tough restrictions imposed by the Investment Company Act [of 1940] that make the industry dependent on the Investment Management Division of the SEC for growth and innovation. The SEC division hasn’t kept pace with the growth of the fund industry, Mr. Coates said.

Long live Spoke Funds®.