Mutual Funds
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The Ferraris of mutual funds: pricey and worth it
Generally, high fees are bad news. But these small funds -- which can't spread their costs over billions in assets -- can justify the extra cost with great returns.
By Timothy Middleton
It's a simple rule: Low fees are better than high fees. I won't pay up for any fund when I can get something just as good, at lower cost, elsewhere.
But here's a twist: There are some high-expense funds worth owning.
There are times when expensive funds are simply better than the cheaper alternatives. In particular, very small funds often have unusually high expenses, merely because of their size. And if the funds are small for good reason, and indeed benefit from being small, paying a premium to own them is an advantage, not an albatross.
Larger funds often have lower fees because they can spread management costs across their larger asset bases. "The cost of running a mutual fund, whether assets are $50 million or $500 million, is in the high six figures, either way," says John Orrico, manager of the $177.2 million Arbitrage Fund, an excellent, if expensive, fund.
Arbitrage is among four small funds that, though they are costly, haven't let costs handicap performance. In every instance the expenses pay for work that benefits shareholders, namely fees for managers and research, rather than to marketing, which only benefits brokers and fund-company profits.
Catching the merger wave
Arbitrage Fund (ARBFX): As I wrote a year ago, this fund's style is to invest in announced corporate takeovers, locking in the premium the purchaser is willing to pay over the market value of the target company at the time the deal is unveiled.
This fund is burdened with annual expenses of 1.95% of assets, at least a third higher than I would like. But in addition to its small size, Arbitrage Fund has unusual expenses. Since it sells the shares of acquiring companies short -- that is, it borrows and sells them in the expectation of buying them back more cheaply after the deal closes -- it has to pay dividends to the lending shareholders.
The fund receives those dividends itself, but the Securities and Exchange Commission requires them to be treated as income to fund shareholders. Separately, the passing along of those dividends to lending shareholders is treated as an expense.
So arbitrage funds are expensive by their nature. In addition, Arbitrage Fund's small size allows it to invest in deals too small to attract the attention of larger arbitrageurs who would have trouble buying enough stock to make it worth their while. August Technologies (AUGT, news, msgs) has a market capitalization of little more than $200 million. Arbitrage Fund has racked up gains of 30% since the beginning of January as three successive bidders have fought over the maker of electronic defect-detection systems.
Passing along gains, savings
Satuit Capital Micro Cap (SATMX): Robert Sullivan, manager of this portfolio, follows a classic growth-at-a-reasonable-price strategy, seeking to buy fast-growing companies at a discount. It invests in about 80 of these companies, so no single position accounts for more than about 2% of assets.
| Satuit Capital Micro Cap's top holdings | | Security | % of assets | Sector | 3-month stock price | | Argon (STST, news, msgs) | 1.8 | Defense | + 45% | | Harmonic (HLIT, news, msgs) | 1.7 | Telecom | + 52% | | Signature Bank (SBNY, news, msgs) | 1.6 | Finance | + 13% | | Radvision (RVSN, news, msgs) | 1.6 | Telecom | + 2.6% | | Geo Group (GGI, news, msgs) | 1.5 | Consumer services | + 34% |
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As of 1/31/2005, except stock prices, which are as of 2/15/2005.
Sources: Satuit Capital, MSN Money
Sullivan invests in tiny companies. The average market capitalization of the fund's holdings is $269 million. These are true micro-caps, which tend to be the fastest-growing companies. They are also not widely followed by stock analysts, creating the opportunity for managers like Sullivan to identify undiscovered gems.
Sullivan has found plenty of them. The fund was launched at the end of 2000, just as the worst bear market in at least three generations was beginning to bite. Despite that, it has racked up annualized returns since inception of 23.0%, as of Jan. 31. In that period it has beaten its benchmark, the Russell 2000 small-cap index, by about 7 percentage points a year.
Satuit's current expense ratio of 1.95% is down steeply from 2.80%, which is what investors paid when assets were half the current level. This is proof the manager is willing to share economies of scale with his shareholders.
A hedge-fund look-alike
Leuthold Core Investment (LCORX): Manager Steve Leuthold is an asset allocator. He shifts among equities, bonds, real estate and precious metals to capture some of the best returns in the mutual fund universe. The fund has an annualized gain since inception in 1995 of 11.5%, with about 20% less risk than the stock market.
Leuthold frequently has short positions, as well as long, in both stocks and bonds. Recently he has been shorting Treasury bonds because he feels long-term interest rates are due to rise. "The fund is certainly worth a look from investors seeking a way to access a hedge-fund-like strategy," says Morningstar analyst Jeffrey Ptak.
Leuthold has said his fund doesn't generate enough fees to pay for the research his approach requires. Effectively, he says, the fund is subsidized by institutional research his firm sells to Wall Street.
Meanwhile the fund's relatively small size, $605.1 million in assets, gives it the freedom to make significant bets on small stocks as well as large. The expense ratio, of 1.37%, is 11% higher than the average for its category, but most of those rivals are far larger, and have less flexibility to invest in small companies.
A bumpy ride, with a payoff
Hodges Fund (HDPMX): When I profiled this fund last August,
manager Don Hodges was praising Texas Pacific Land Trust (TPL, news, msgs), a land trust in the process of buying back all of its own shares. Since that column appeared, the land trust's shares are up 70%, one reason the fund itself has jumped more than 20% in that period, twice the market's gain.
This $81.5 million portfolio has an expense ratio of 1.75%. Morningstar classifies it as a mid-cap growth fund, and there are plenty of mid-cap growth funds around with lower expense ratios, including the excellent Meridian Growth (MERDX), whose ratio is 0.88%.
But Hodges isn't a true mid-cap fund: It's an all-cap fund that, as I reported last year, "doesn't fit into any investment orthodoxy." The managers, Hodges and his son, aren't afraid to take outsize risks, putting a third of assets into the fund's top 10 positions.
Risk-taking of this type means the fund doesn't behave like other funds. It beat the market by more than 50 percentage points in 2003, with a gain of 80.2%, having fallen four points more than the S&P 500 the prior year.
So it's strictly for long-term shareholders, those willing to ride out periods when Hodges and son bet wrong in order to enjoy the profits when the managers bet right. And the fund doesn't shoo away small investors. The minimum account size is only $250. At low-cost Vanguard it is $3,000.
These funds are expensive, and that's bad. As I noted in my column last week, cutting one percentage point from expenses can boost your account balance by nearly one-third over a 30-year investment period.
But if you truly get something extra for your money, in terms of better returns, it's worth it.
At the time of publication, Timothy Middleton didn't own any securities mentioned in this article.
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