Family plan

As marketing costs mount, more smallish funds are putting themselves up for adoption by fund families and splitting fees with them. So far everyone seems happy.

“We started our Focused Value Fund in 1996, and we ran it ourselves with no marketing,” recalls Richard Pzena, founder and CEO of New Yorkbased Pzena Investment Management. “The idea was that if we put together a good record, some day we would figure out what to do with it.”

By 2002 the concentrated deep-value fund had delivered consistently top-notch performance, beating the S&P 500/Barra value index by an average annual 311 basis points over the preceding five years (though it of course lagged the Standard & Poor’s 500 index during those bubbly years for growth stocks). Yet the fund had reeled in just $20 million in assets.

Pzena put his fund up for adoption in late 2002 and found a taker in John Hancock Advisers. Assets were transferred to Hancock, which became the fund’s adviser; it was rebranded the John Hancock Classic Value Fund (though the track record at Pzena still counted, critically, for marketing purposes); and Pzena’s team continued to manage the portfolio as the subadviser. The two firms split the management fee roughly 50-50.

“Our value story is an easy one to tell,” says Pzena, “and Hancock’s sales force was eager for something to sell.”

Their eagerness paid off. As of late March, the John Hancock Classic Value Fund reported $2.2 billion in assets. Pzena is not the least concerned that the surge in assets, or influence from John Hancock, will impinge on his portfolio management methods. “They hired us for our style, and they want us to continue with it,” he explains.

Fund adoptions have been around since the early 1990s. But in the past few years, the swapping of track records for marketing muscle has become particularly attractive to small managers and the distributors that adopt their funds. Although small and midsize fund families have long had to pay up to distribute their products, last year’s Securities and Exchange Commission ban on directed brokerage -- funds’ sending their trading commissions to brokers as a reward for selling their shares -- has made distribution tougher and more costly.

“The SEC rule has increased the effective cost for a small or medium-size manager to market its funds,” points out Barry Barbash, head of the investment management practice at New Yorkbased law firm Shearman & Sterling and former chief of investment management regulation at the SEC. In addition, the cost of adhering to postscandal SEC regulations, such as appointing a chief compliance officer and making Sarbanes-Oxley disclosures, has further burdened smaller firms and made them more inclined to seek relationships with larger fund firms or Wall Street brokerages.

According to Boston-based consulting firm Financial Research Corp., in 2003 and 2004 the mutual fund industry reported 17 adoption deals involving 50 funds with a combined $5.3 billion in assets. Dreyfus Corp., John Hancock Advisers and Pioneer Investment Management have adopted funds to fill specific gaps in their product lines, while Constellation Investment Management Co., a start-up fund distributor based in Berwyn, Pennsylvania, has built its $2 billion asset base with a series of 14 adoptions starting in November 2004. In the bear market years of 2001 and 2002, by contrast, ten individual funds run by six small managers were adopted by four large fund companies. Combined assets in the ten funds: just $583 million.

For the acquiring fund family, adoptions can strengthen a product line that is either incomplete or weak in a particular category.

Holders of the would-be adopted fund must vote to approve the deal. Often they stand to benefit from lower expense ratios under the wing of the larger distributor. After the vote, fund assets are transferred to the adopting family. The management fee is usually split equally between the adopting family and the original manager, which becomes the new subadviser. The subadviser contracts typically run for three years and can be renewed. Like any advisory agreement, though, they are revocable with little notice. Little or no cash changes hands, and lawyers, not investment bankers, handle the requisite documents. The distributor assumes the costs of compliance, administration, recordkeeping, shareholder servicing -- everything but portfolio management, which is always the exclusive domain of the subadviser.

But unlike most subadvising arrangements, in which a fund company contracts with an investment firm to manage a fund or two behind the scenes, mutual fund adoption is meant to be a genuine partnership. The subadviser relationship is actively promoted to make the most of the adoptee’s track record and reputation. Some adopting distributors identify the original manager in the new fund name.

“Legally, it’s like any other subadviser relationship in that the manager can be fired at any moment,” says Lars Schuster, director of subadvisory research at FRC. “The key is that there is a track record from the adopted manager.” The value of that record is reflected in the even sharing of fees; in standard subadviser relationships the manager might only receive one quarter of the revenues.

The largest deal to date is Charles Schwab & Co.'s November 2003 adoption of 11 top-performing mutual funds, with a combined $1.7 billion in assets, managed by AXA Rosenberg Investment Management. In addition to the venture with Schwab, the Orinda, California, firm manages $55 billion for institutions.

As part of the deal with AXA Rosenberg, Schwab created a new mutual fund brand, Laudus Funds, for the adopted portfolios, which were rebranded Laudus Rosenberg. (Schwab’s name remains on its 43 in-house products.)

“We wanted to establish a fund family with a different target audience and positioning -- independent advisers and 401(k) platforms -- versus the retail focus of the existing Schwab funds,” explains Laudus Funds president Jana Thompson, who had previously served as a vice president in Schwab’s investment advice unit. Under the new arrangement, AXA Rosenberg gets just under half of the old fee rate on the assets at the time of adoption; 40 percent of the fees on the first $2.5 billion in new assets brought in by Laudus marketing; and one third of the fees on new assets above that mark.

Both organizations are pleased with the results, Thompson reports. “Taking into account that we closed the U.S. small-cap fund -- which had constituted about two thirds of the assets -- to new accounts, we’ve more than doubled the open funds,” she says.

In February 2004, Pioneer Investment adopted the $9.5 million large-cap growth and the $16.5 million small-cap growth funds of Chicago-based Oak Ridge Investments. By the end of last year, assets had grown to $104 million in the large-cap fund and to $102 million in the small-cap fund. Pioneer has adopted seven funds in all, part of a strategy to aggressively grow assets.

How have the adoptions worked out? Of the 70-odd funds taken in since 1999, 23 have more than doubled their assets, reports FRC. These include five of the 11 Schwab funds, two of four adopted by John Hancock and four of six funds adopted by Dreyfus from Bear Stearns Asset Management. Of the remaining funds, 30 report smaller asset gains and 12 show declines.

Five other adoptions, one of which is the John Hancock Classic Value Fund, have grown from tiny asset bases to more than $500 million in assets apiece. In September 2002, Evergreen Investment Management Co. adopted Grantham, Mayo, Van Otterloo & Co.'s $144 million Asset Allocation Fund; at year-end 2004 it reported $4.4 billion in assets.

One of the earliest deals is a striking success story. Turner Investment Partners’ $270 million Growth Equity Fund was adopted by Vanguard Group in 2000. Assets in the rebranded Vanguard Growth Equity Fund had grown to $721 million by the end of this February, an especially impressive gain given that growth investing has been out of favor since the stock bubble burst.

“Five years later we say it was a win-win-win,” notes Robert Turner, the Berwyn, Pennsylvaniabased management firm’s CEO. “It’s a win for the shareholder,” he says, because the fund’s expense ratio has fallen from 82 basis points to 42 basis points under the Vanguard umbrella. “Of course it’s a win for us,” he adds. “We didn’t have the reach that Vanguard has.” And for Vanguard, known mostly for its index, bond and value stock funds, the adoption provided a high-beta large-cap growth portfolio.

“Part of the advantage for us is that an adopted fund comes in with a performance record, which helps in the marketing,” says Joseph Brennan, head of Vanguard’s portfolio review group.

In one of the few adoption transactions to go awry, Turner handed over its $45 million large-cap growth fund to Merrill Lynch Investment Managers at the same time that it made its deal with Vanguard. Turner reclaimed the fund in 2002 after assets had declined to $5 million.

“It came back with fewer assets,” says CEO Turner. “There was a lot of change going on, and the benchmark was down more than 20 percent for three years running, so we were going to lose investors anyway. Fortunately, our attorneys had the foresight to say, ‘If you don’t hold up your end of the bargain, we’d like to have it all back.’”

Megan Frank, a spokeswoman for Merrill Lynch Investment Managers, comments, “Although we believed in the structure of the adoption deal, the market environment was not the best for a momentum growth product.”

For many Wall Street firms, adoptions have a particular appeal: Because the distributor collects only half of the fund’s management fees, the product is not seen as proprietary.

“Fund adoptions could help sidestep the conflict-of-interest issues of in-house funds,” says Darlene DeRemer, a partner at Grail Partners, a Boston-based boutique investment bank. “In the current environment adoptions could become more interesting to brokerage firms.”