Flexibility is the key to the number-one performance of Fundamental Portfolio Advisors Inc.'s municipal bond funds - and has allowed the firm to make some unorthodox investment decisions.
Fundamental's president and chief executive officer, Vincent Malanga, and chief portfolio strategist Lance Brofman say they prize the ability to move quickly when circumstances change.
As a result they have portfolios packed with unusual holdings, including some controversial California certificates of participation, 40- year zero-coupon bonds, a big stake in New York City general obligations, and inverse floaters.
Their approach has largely paid off, according to the 1995 performance figures provided by Lipper Analytical Services Inc.
Fundamental's California Muni Fund was number one among all municipal funds, with a total return of 32% in the year. The High-Yield Municipal Bond Fund was also number one in its class, with a total return of 25.68% for 1995, according to Lipper.
The Fundamental New York Muni Fund did less well, being held back by a defaulted issue that is not making any payments. This portfolio's total return was a respectable 15.90% for 1995, but its income was the worst in its class, at 3.85% for the year.
Malanga said Fundamental has deliberately organized its operations to give itself flexibility.
"In a lot of the larger shops, they will have very similar investment policy committees that give their managers very strict guidelines," he explained.
"We have an investment policy committee, but we established the guidelines in a very loose manner precisely to give us the ability to respond fast to particular circumstances."
Nuclear Engineering
Brofman maintained that his and Malanga's academic backgrounds also play a part.
"We both have Ph.D.'s," he said. "I have a Ph.D. in options and futures and a degree in nuclear engineering."
Malanga has a Ph.D. in economics and has been an economist for many years, including a spell with the Federal Reserve Bank of New York from 1973 to 1975.
As a result, Brofman said, he and Malanga are more "interested in complex things, willing to look at things other people won't."
The whole concept of the fund bears that out: Brofman claims that his New York fund, created in 1980, was the first-ever single-state portfolio, pioneering the concept of triple tax-free investing.
Brofman acknowledged that the funds' small size may have helped their performance. The California fund has $18.2 million in assets, the New York fund $220 million, and the high-yield fund $1.5 million.
"Some of the things we bought, it's easy to buy $1 million but you can't buy $100 million," he said. "But there are a lot of funds that are smaller than the California fund that the California fund beat.
"It gives you flexibility but it doesn't make you make the right decisions."
Examples of Fundamental's independent outlook on the market include last year's Foothill/Eastern Transportation Corridor deal, which performed particularly well. When the offering was brought to market, Fundamental bought about $12 million face value for the California fund and $1 million face value for the high-yield fund, in both cases acquiring 40-year zero- coupon bonds as a reflection of its positive outlook on interest rates.
About 75% were sold after the first day when a positive employment report boosted municipal prices, bringing in two to three points on the bonds. More have been sold subsequently and the California fund has about $1 million face value now, Brofman said.
Balancing the Budget
Another example is New York City GOs, which Brofman considers "grossly underrated."
"New York City has the strictest controls of any government anywhere," he explained.
"They have balanced their budget for about 20 years. Every year they have a budget gap, then every year they close the budget gap."
This year, plugging the hole could be as simple as not enacting tax cuts promised by Mayor Rudolph Giuliani, Brofman said.
In addition, New York, the richest and most diversified city in the U.S., could easily raise its current relatively low property tax rates.
Furthermore, Brofman said, the Giuliani administration appears to be doing the right things, such as tackling crime and breaking cartels that raise the cost of doing business.
Brofman also believes that factors in the municipal market hold down prices on the city's GOs.
Because all the debt is issued in one form rather than through authorities or with dedicated revenue sources, many New York mutual funds run up against diversification limits and are unable to buy as much of the city's debt as its level of issuance would indicate.
Securities and Exchange Commission diversification standards require that no holding be more than 5% of the total, Brofman said. But Fundamental works to Internal Revenue Service standards of diversification that allow 25% - the level Brofman owns.
He also believes that the "revolving door" of analysts moving between rating agencies and bond insurers is holding down the city's rating.
Fundamental also goes its own way by holding Federal Housing Administration secondarily insured issues.
These have been trading perhaps 15 to 20 basis points cheaper than other insured issues, Brofman said.
For example, an underlying double-B bond may be brought up to double-A by the FHA support, and then triple-A with traditional bond insurance.
However, it would trade below an insured single-A bond, Brofman said, because some investors argue - wrongly in his view - that the underlying bond is only a double-B and that this should determine its trading level.
Kmart Corp. bonds from various issuers have done well in the high-yield fund. At one point Brofman took his holding to $150,000 of the $1.5 million fund.
Old Shopping Centers
He sold some last week at 8%, a significant profit since at one time he was buying at 10% yields.
In some cases, the bonds back shopping centers 10 or 20 years old that now have no problem covering their debt service, whether Kmart is there or not, Brofman explained.
Some other unorthodox holdings include:
* California. The state's bonds in general and Orange County bonds in particular did well for the fund in the wake of the county's bankruptcy declaration, Brofman said.
Successful purchases included Orange County bonds insured by Financial Guaranty Insurance Co. bought with yields 50 basis points above market levels, and Orange County Transportation Authority bonds that took a hit just because of its name, he said.
* Bakersfield, Calif., COPs. These are zero-coupon securities with an escrow account composed of Treasury Strips.
The technique has been controversial, Brofman said, but he is happy with the performance.
* Inverse floaters. Brofman is not afraid to use these. Twenty-four percent of his New York fund was made up of them as of April 30, 1995, according to CDA/Spectrum Bondwatch, although Brofman said he had since sold some.
They helped Fundamental's performance in 1995, he said.
Particular attractions include the low prices and their ability to allow investors to effectively borrow at short-term rates and invest long term.
Bullish Outlook
Fundamental's investment approach is based on an interest rate outlook, Malanga explained.
He said the firm had been "very positive" coming into 1995, and positioned itself accordingly.
For 1996, his positive outlook for bonds continues.
"Just looking at the underlying fundamentals, we see the economy is probably skirting an outright recession but being generally soft and posting sub-par growth throughout the year," Malanga said.
He expects the fed funds rate to drop at least 50 basis points by the end of the year.
Malanga's one caveat is whether there will be progress on balancing the budget - although he believes a deal is "inevitable," even if it takes a complete overhaul of government in this year's elections.
Malanga and Brofman believe a flat tax will not pass, making municipals very attractive at the moment.
Brofman pointed out that one of the arguments put forward for reforming the tax system is to avoid a double levy on investment income.
No Flat Tax
But in the fixed-income markets, he pointed out, only the $1.4 trillion corporate bond market out of the $12 trillion total suffers from this problem, so if they are not taxed at the individual level, they are not taxed at all.
The municipal market is currently discounting a cut in the tax rate from 40% to 20%.
Even if municipals are taxed in the future, existing bonds will be grandfathered.
Owners of these will do well, Brofman said, because there will be strong demand and little supply.
Furthermore, callables will do best because the tax change will dry up municipalities' refunding activity - since it will be more expensive to issue new debt - and remove the incentive to call outstanding bonds.
As a further positive for the municipal market, he drew attention to the expected drop in supply from $303 billion in 1993 to $150 billion this year.
