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PBHG's Clipper clone fails my scandal test
The mutual fund mess has taught me it's easy to look at the wrong issue when trying to figure out whether your fund is doing the right thing. Here are some guidelines to follow when digging into a fund's governance practices.
By Timothy Middleton
Just days after I picked the manager of PBHG Clipper Focus PBHG fund as one of the industry's five best (See The 5 best fund managers in the business), the funds distributor became embroiled in the ugliest scandal ever to befall mutual funds.
As a fund shareholder, I immediately began to analyze whether my financial interest was compromised. It didnt take long to realize that it was -- but not in the way I imagined.
To find that out, I had to go through a long process, one probably not much different than what many fund shareholders are going through these days. After all, the fund-industry scandal, which involves improper trading that may have hurt long-term shareholders, has caused many of us to wonder whether it's time to find another place to put our money. Some may choose exchange-traded funds (See Build a portfolio that repels fraud), but others will stick with mutual funds. If they do, they'll want to dig deep into their new prospects before buying.
Here's what I found.
I didnt heed the red flags
Superficially, PBHG Clipper Focus PBHG fund (PBFOX) passes the scandal test with flying colors. I was struck by the willingness of the funds manager -- my superstar pick, Jim Gipson -- to confront the issue forthrightly and immediately. PBHGs co-founder, Gary Pilgrim, is accused of participating in rapid trading of his own funds, but Im satisfied Clipper Focus wasn't among them.
But as I dug deeper, I became convinced that the venality at the heart of the scandal -- the insatiable urge to snatch unearned profits out of the hands of shareholders who did earn them -- had indeed infected my fund. When I shared my concerns with Christopher Traulsen, the analyst who covers Clipper Focus for Morningstar, I found myself in perfect agreement with his conclusion: This fund doesnt have fund holders best interests at heart.
Since the scandal broke in early September, Ive been exploring its origins in an attempt to discern what warning flags investors should look for to protect themselves against abuse. In prior columns, Ive enumerated several I think are key.
Scandal-resistant funds have low expenses, keeping more profits in the hands of the investors who earned them. They have heavy insider ownership, signaling the alignment of interests between the funds shareholders and its custodians, including trustees. And trustees display independence, not unaccountable subservience to a financial factory that cranks out me-too funds for brokers to sell on commission.
My fund lacked all of these scandal-resistant traits, and every one of these red flags was waving. But I simply had overlooked them. I was looking in the wrong place -- at Gipson, rather than at his business partners at PBHG.
Clipper Focus: free from rapid trading
Gary Pilgrim faces federal and state charges that, in 2000 and 2001, a hedge fund in which he and his family were major investors engaged in rapid trading of PBHG fund shares, including those of PBHG Growth (PBHGX), the companys flagship, which Pilgrim managed.
His co-founder, Harold Baxter, is accused of furnishing information to a small brokerage firm whose clients similarly traded to the detriment of long-term shareholders, according to complaints by the Securities and Exchange Commission and New York's attorney general.
Both men have resigned from the adviser to PBHG Funds, Pilgrim Baxter & Associates.
Clipper Focus fund wasnt brought into the PBHG family until December 2001. By then the rapid trading had ended. When I asked Gipson whether his portfolio had been involved in rapid trading, he said, The answer is definitely no, and I can go into great detail on that.
Aside from the fact PBHG didnt absorb the fund until after the abuses had ended, Gipson pointed out that he and his company, Pacific Financial Research, retained total control of the funds assets. That is, it's a sub-adviser to the fund.
Sub-advisers, or hired third-party managers, commonly are used in the fund business to bring experience to a fund the adviser itself doesnt have. PBHG is a go-go growth shop, while Clipper Focus is a value fund. PBHG has a number of sub-advised funds and, according to Morningstar, none of them evidently were exploited by the rapid traders.
Clipper vs. Clipper Focus
Gipson, normally an aloof man who shuns interviews, responded to my call about the scandal immediately. It was clear that he understands how seriously the scandals threaten the industry. Most of the industry is acting as if the scandals were mere peccadilloes, unworthy of more than a slap on the wrist.
Gipson is a patient, low-turnover value investor, in contrast to Pilgrims momentum-based growth approach. He made his bones with Clipper fund (CFIMX), which has one of the best records in the industry going back nearly 20 years.
Gipson launched Clipper Focus five years ago to satisfy the interest of some investors, including me, who wanted undiluted access to his best stock ideas. Clipper fund goes heavily to cash when Gipson is defensive -- its more than 30% cash now. Clipper Focus is always fully invested.
Clipper Focus consistently has delivered superior returns to Clipper fund. In the five years ended Oct. 31, Clipper Fund trailed Clipper Focuss annualized return of 10.43% by nearly three-quarters of a percentage point.
Clipper fund itself exhibits no red flags. Its expense ratio is 1.07%, well within reasonable bounds. Gipson is a large investor in it, and so are the funds trustees, or its board of directors. Every outside trustee owns at least $100,000 worth of fund shares (the maximum disclosure the SEC requires), every one has served since the funds inception and every one is a director of no other mutual funds.
Clipper Focus, alas, is a different story. In the case of both funds, I conducted my research largely online, with the SECs Edgar database. Prospectuses and proxies and plenty of other paperwork are readily accessible, although also somewhat impenetrable, as lawyer-written regulatory filings tend to be.
Whos on board?
From a governance point of view, Clipper Focus has nothing in common with its sibling except for this: Gipsons firm is owned by a South African insurance company, Old Mutual; so is Gary Pilgrim's.
Clipper Focus was brought into the PBHG family as part of a plan to wring extra profits out of the brand name by selling traditionally no-load funds through brokers. The fund I originally bought as Clipper Focus Fund now has the improbable name of PBHG Clipper Focus PBHG. The first set of initials refers to the brand name and the second to the no-load share class. Clipper Focus now has three other share classes sold by brokers.
All 29 PBHG funds have the same three outside directors, John Bartholdson, Jettie M. Edwards and Albert A. Miller. Among all 29 funds, according to the firms most recent filings, only Miller has invested at least $100,000 with the complex. Edwards has invested less than $100,000, Bartholdson less than $50,000.
Bartholdson is chief financial officer of Triumph Group (TGI, news, msgs), a manufacturer in suburban Philadelphia, where PBHG is headquartered. Miller is a retired department-store executive. Edwards is a California-based consultant with Syrus Associates who also oversees more than 50 other mutual funds for Provident Investment and EQ Advisors.
How anyone could be expected to be a tough, independent shareholder advocate for 29 different mutual funds is one issue. To do it for more than 80 surpasses my understanding. My calls to my trustees -- who legally represent shareholders, not management -- were returned by a PBHG spokesman, who said all three declined to comment.
A suitable alternative
Clipper Focus' expense ratio has risen this year to 1.45%, Morningstar calculates, 36% more than Clipper Fund. But Gipson doesnt get a penny of the difference. It goes, eventually, to Old Mutual. All Old Mutual has ever done for me is to drag me into a financial morass created for its own enrichment.
If PBHG Clipper Focus were the only top-performing large-capitalization value fund in which I could possibly invest, I might find myself conflicted between principle and principal. But it's not.
Plenty are available. The obvious alternative is Clipper fund. Another is Dodge & Cox Stock (DODGX). This venerable fund, whose outstanding record is nearly twice as long as Clippers (and seven times longer than that of Clipper Focus), has managers with decades of experience who are heavy investors in their product. The expense ratio is a thrifty 0.54%. It also has a better record than Clipper Focus over the last five years, with annualized returns of 12.01%.
In accordance with MSN Money policy, I will wait three days after this column appears to sell PBHG Clipper Focus. I may, depending on the results of my further due diligence, invest the proceeds in Dodge & Cox Stock.
I guess Gary Pilgrim has done me a favor. Unwittingly, he has helped me upgrade my portfolio.
Tax warning
Mutual funds are required to make distributions of income and capital gains at least annually, and they usually do so in December. Many equity funds have big tax-loss carry-forwards from the bear market, but you should check with a funds sponsor before buying shares in a taxable account. Wait until after the distribution to buy.
At the time of publication, Tim Middleton owned the following equities mentioned in this column: PBHG Clipper Focus. He intends to sell the fund at least three days after this column is published.
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