As manager for the Calvert Large-Cap Growth Fund/A (CLGAX), John Montgomery sounds more like a mathematician than a moralist. He stresses the quantitative criteria used in constructing the team-managed fund and downplays his own role. "Legally, you've got to have a portfolio manager with the authority to create the buy and sell tickets," he says. "But remember that computers are generating the buy and sell signals."
For a fund that aims to do good, the Calvert fund, ranked 5 Stars by Standard & Poor's, has had strong performance with its use of strict social screens. As of July 29, the $313.5 million portfolio registered a three-year annualized gain of 19.3%, vs. a rise of 10.6% for its large-cap growth peers and 12.6% for its benchmark, the S&P 500-stock index. For the one-year period ended in July, the fund surged 20.8%, vs. 14.1% for its peers and the 14% for the benchmark.
Expenses on the portfolio run at 1.61%, more costly than the average 1.44% expense ratio for its peers. Volatility runs slightly below that of its peers.
WEEDING OUT UNDESIRABLES. From a universe of 500 of the largest U.S. stocks by market capitalization, Montgomery's team selects 250 that qualify as growth stocks and then runs the data through Calvert's social screens to determine those that meet the adviser's seven core criteria. These range from environmental compliance to good corporate citizenship to respect for human and animal rights.
Companies engaged in what's defined as undesirable conduct, such as serious labor violations and the manufacture of tobacco products, weapons, and alcoholic beverages, are weeded out. Companies that pass those tests are then run through the financial models of Bridgeway Capital Management, the fund's subadviser.
Bridgeway boasts a lean cost structure, facilitated by reliance on computerization. The firm, founded by Montgomery, also mandates that none of its 20 employees can earn more than seven times as much as the lowest paid employee, and it pledges to donate a "majority" of its profits from investment-advisory fees to charity and nonprofit organizations.
BIGGEST HOLDINGS. As of July 26, Calvert Large-Cap Growth Fund had 88 holdings. The fund typically has about 70 issues, but Montgomery attributes the current number to strong cash inflows. By prospectus, the fund can hold as few as 60 stocks.
The fund's top sectors as of June 30 comprised information technology (25.4% of assets), consumer discretionary (17%), financial (14.8%), health care (11.3%), and energy (9%). The largest holdings as of that date: Walgreen (WAG) (2.2% of assets), Legg Mason (LM) (2.2%), EOG Resources (EOG) (2.2%), Nordstrom (JWN) (2.2%), and Dell (DELL) (2%).
Carol A. Wood of Standard & Poor's Fund Advisor spoke recently with Montgomery about his investing strategy. Here are edited excerpts of their conversation:
Q: How would you describe your investment philosophy?
A: The objective is to beat the market over long periods of time with a total risk profile roughly equal to the market. It's a large-cap growth fund, though we do diversify slightly on the perimeter. Typically, up to 5% of the fund is in smaller or mid-cap names.
Apart from that, we're quantitatively driven. I don't get on a plane to meet management. We don't look at any macroeconomic numbers, follow sectors of the economy, make sector bets, or any of that. It's just picking one good stock at a time.
Q: What else sets the fund apart?
A: We do three things top-down. One is cost management, specifically transaction costs. We use an outside evaluator, Plexus Corp., and our goal is to be in their top quartile -- we're in their best 10% on commission costs. We don't do any soft dollars with this fund.
The second is risk management. A lot of quant shops basically have one model, and this one has five. Each model is picking a smaller number of stocks, which tend to be pure and good diversifiers of each other.
The third is tax management. Our unofficial goal is to be in the top quartile of tax efficiency within our peer group.
Q: What are your five models?
A: We have two "opportunistic models." We also have a growth model, a growth-at-a-reasonable-price model, and a technically driven model. I'd call it our "momentum model."
Q: How is "opportunistic" defined in the models?
A: We're looking for opportunities to get in where we think there's a stronger probability of a shorter-term upside, 6 to 12 months.
If we just wanted the biggest return possible, we'd probably have only our two biggest return models. But half the investment objective has to do with risk, not just returns.
Q: Are you trying to balance different sectors?
A: No. We track industries and sectors, but we're not trying to match the sector representation of the S&P 500. More important is the balance of risk inherent to the fund.
For example, in 1999, we had a pretty good stable of tech and telecommunications stocks in the fund. They just went gangbusters, so we had a good year. But if you get too big in a volatile sector like technology, then risk alarms start going off. So in late 1999, we cut back on our technology stocks. This was a top-down decision. We had enough risk associated with technology and weren't going to add any more.
Q: How do the models and the criteria interact?
A: None of the top-down factors affect individual stock picks. They're more about execution. The transaction costs are not a constraint on which stocks to buy.
Likewise with tax management. If we've got a security with an 11-month track record, before it goes long-term, we try to harvest any losses as short-term.
Q: What are your buy and sell criteria for stocks?
A: The buy side is simply generated by the five models. The sell side hasn't been modeled to the same extent. Basically, we sell when reasons an individual model bought the stock are no longer true. If we get a stronger buy and don't have any cash, then we'll scan for the ones that are least highly ranked. Or when other reasons begin to drive the stock price, say a merger, we'll sell if we're anywhere near the kind of appreciation that you'd expect.
Q: Could you single out a holding and tell me how it reflects your investment style?
A: One that typifies this fund is Apple Computer (AAPL). We bought it in May, 2004, in an opportunistic model. A couple of months later, another model picked it up with a very strong buy signal, so we committed higher percentage of assets to it. About a month or ago, the risk characteristics jumped way up. It was at 3.8% of the fund in mid-June, and we trimmed it back recently to 1.1%.
Q: Are there any areas or sectors that you avoid?
A: No, not unless the social screens keep us out. The ones you classically expect not to see in the social screens would be energy and utilities, and some more mature industry cyclicals. We did have one utility stock not too long ago, but recently sold it. We've got 9.7% in energy-related stocks. That's the highest I've seen it in 10 years.
Q: Let's talk about returns. To what would you attribute the fund's three-year outperformance?
A: The longer you give me, the better the fund should look, especially vs. our peer group. We're beating everything since inception and over 10 years -- but interestingly, not by as wide a margin as we would like.
Large-cap growth has for five years been the dog part of the style box, which on a contrarian basis we think is very bullish for our fund. Even though this is a growth fund, my worldview is more contrarian. If the models are doing their job, and the market turns around in favor of large growth, we should look pretty good.
Q: When do you think large-cap growth is going to take off?
A: I think this is going to be a sweet part of market in five years. If you ask me about 12 months from now, I don't really have an opinion. No matter how significant a trend you have over the last few years, it can always go on another year.
Q: What's your response to critics of socially responsible funds, who say such funds don't outperform the index and often include companies faulted by activist groups?
A: I think it's a fair criticism, but the proof is in pudding. If you invested in our fund 11 years ago, you're doing better than an S&P 500 index fund. Of course, the past doesn't guarantee the future.
Forget about the emotional debate on social screening and look at performance. On the social-screening side, if you can sidestep some companies that blow up because of poor corporate governance or environmental lawsuits, you should do a little better in the long term. On the flip side, you've got a smaller universe of stocks, and for a quant shop that's on the negative.
However, I think we've slightly tweaked things in a positive direction with the Calvert social screens, if you are interested in the congruity of investing in the parts of the economy that you want to help. Or if you have an aversion to tobacco. Although Altria Group (MO) has done well over the last couple of years, it looks like a terminal industry to me. There isn't anything about it I want, from a social or an investment standpoint.