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A fund fires a winner -- and keeps it quiet
To save money, Phoenix Small Cap Value replaced a great manager with a mediocre one. Big investors got to follow John LaForge to his new fund. The little guys had to read the fine print.
By Jon D. Markman
John LaForge posted an enviable track record over the past five years as a contrarian small-cap stock-picker, racking up a 15% annual gain in Phoenix Small Cap Value Fund (PDSAX) -- better than a majority of his peers and way better than the broad market.
Investors who paid a hefty fee for access to his stewardship looked forward to his guidance in this difficult year. And yet many may not know that LaForge, who served as manager of the fund since 1997 from an office in Florida, was quietly fired by The Phoenix Cos. (PNX, news, msgs) on Oct. 31 and replaced by an in-house manager with a subpar record in what the company describes as a cost-cutting move.
His exit provides one more example of ways in which mutual fund companies take advantage of ambiguous disclosure rules, act in ways that benefit professionals over private investors and may actually harm fund shareholders in an attempt to benefit their own company shareholders.
In this case, several financial institutions with funds under LaForges control learned of his termination in late October, quickly withdrew their money from Phoenix and followed him to his new operation under the aegis of FA Asset Management, a division of investment bank First Albany (FACT, news, msgs). But private investors and small financial advisers were not informed of the manager change until two months later. And new investors would need to ask the right questions, or read between the lines of a long prospectus, to learn that management of the fund with the strong record in Morningstar and Lipper databases had changed.
Paul Moroukian, a financial adviser in New York who had personal and client money in the fund, said Phoenix hardly told him about the change, simply sending a single form letter on Dec. 8 that headlined the funds new name and not articulating any reason for the management switch. Phoenix left us in the lurch, he said. We understand theyve got to do whats in the best interests of their company, but at least tell us why it benefits us to substitute a manager with a good track record for one that doesnt.
LaForge moreover said he has heard from several financial advisers who had recommended the fund to clients that they did not learn of the fund-management switch until they called him to discuss his outlook this year. They had no idea, he said, noting that advisers are inundated with mail from fund companies, particularly at years end.
Its about cutting costs and its costing you profits
Why would a fund company jettison a top performer? A Phoenix marketing representative said the companys relationship with LaForge was terminated in an effort to consolidate operations, not to improve performance. Its kind of ironic to get rid of a manager whos doing well," but from a cost-management point of view it made sense, he said.
If thats the kind of answer youd expect from bureaucrats at an insurance company rather than entrepreneurs at a dedicated fund-management company, youre on to something.
In the mid-1990s, the board of dowdy Phoenix Home Life Mutual Insurance in Connecticut embarked on a build-and-buy program to create an investment management arm and put a sexy wealth management spin on their dull but profitable business. LaForge and his partner, Chris Bertelsen, were hired to build a core value product. The company slapped the made-up name Hollister on their small-cap and large-cap funds to give them some class. And at the same time, Phoenix went out and bought whole or majority interests in a series of prominent specialized fund-management firms around the country, including Kayne Anderson Rudnick Investment Management in Los Angeles; Roger Engemann & Associates in Pasadena, Calif.; Seneca Capital Management in San Francisco; and Zweig Advisers in New York.
During the subsequent bear market, the performance of most of the mutual fund products created by those purchased firms was demonstrably subpar. Phoenix-Engemann Capital Growth (PHGRX), for instance, declined 18%, 35% and 25% in 2000, 2001 and 2002, for a five-year return of -8.9% -- thudding to the 88th percentile of its class.
Phoenix, which too late determined that it had bought into the asset-management business at the top of the cycle, began to bleed money and assets. Bears critical of the companys losses, at a time when other insurers were doing fine, pushed the stock down as low as $6 in early 2003 from prior highs in the mid-$20s. Shareholders demanded improved expense control, and Phoenix obliged last year by closing down several subsidiaries and consolidating staff.
Obfuscating truth
Although LaForge and Bertelsen had compiled a better record than most of their peers at Phoenix, they were let go last fall as part of the shakeup. The small-cap value fund, minus the Hollister brand name, was then turned over to a manager in the companys Phoenix/Zweig unit named Carlton Neel who had previously put in an unremarkable stint prior to 2002 as manager of the small-cap blend fund Phoenix Appreciation (PZAAX). That funds return, at 7.1% annualized over the past five years, was worse than 95% of its peers, according to Morningstar data.
Its easy to see now why Moroukian is upset. But it gets worse, from his perspective, because in addition to handing Neel the small-cap fund, Phoenix also heaped four more portfolios on his plate: Phoenix Appreciation, Phoenix Market Neutral (EMNAX) and two closed-end funds. (The return of the market-neutral fund, which Neel has run since inception, is worse than 81% of peers, according to Morningstar data.) In other words, Phoenix saved money by piling more work on a fund manager with an already unimpressive record.
And how much of this are new investors told? Very little. In the Phoenix Small Cap Value Funds current prospectus, there is no mention of the fact that the 15% annualized five-year record was put up by managers no longer associated with the fund. It would be up to new investors to deduce it by reading the following on page 12: Since Oct. 31, 2003, Mr. Neel serves as the equity investment team leader for the Small Cap Value Fund and for the Appreciation Fund of Phoenix Trust. Likewise, in a 34-page Statement of Additional Information about the Phoenix Small Cap Value Fund there is no mention that a change in management has occurred. For all anyone knows, Neel could have been a member of the funds prior management team, which he was not.
Of course, its hard to pull this sort of stunt on professionals. So while retail fund owners were forced to accept his replacement or forfeit their 5.75% initial sales charge, LaForge was allowed, with Phoenixs blessing, to take the accounts that he managed for state, municipal and labor-union pension funds to his new firm. Our record was so good that they knew no institutional clients would stay at Phoenix anyway if they were going to switch their accounts, he said.
Moroukian and other financial advisers are now stuck in the uncomfortable position of having to tell clients they should now exit Phoenix Small Cap and pay a new 5.75% sales charge to another fund company. He said he has studied the Phoenix/Zweig style that Neel represents and does not think its demonstrably mediocre market-timing and asset-allocation model works. In fact, hes so frustrated with Phoenix over this change and lack of communication that hes considering firing the company as his own firms retirement-plan administrator, as well.
4 big lessons
The lesson of this saga is at least fourfold: First, get your life insurance from a dedicated insurance company, and get your investment management from a dedicated investment company. Insurers actuarial approach to business tends not to mesh well with the freedom of thought emblematic of the most creative portfolio managers. Second, keep in mind that management is critical to an actively managed funds success. If a company changes the management of your fund, assume the worst and investigate the track record of your new leader. Third, dont assume a fund company will make changes obvious to you: Study the management section of prospectuses regularly and, if anything looks fishy, speak up and ask questions.
And finally, on the regulatory side, investment firms should be required to explicitly state on sales materials and in prospectuses the names of managers most responsible for a funds track record. Doing otherwise is duplicitous, as prospective clients may be lured into a product under false pretenses.
Fine Print
So what is LaForges market outlook now for new clients? Employing typical skepticism, he does not like commodities such as copper, steel, gold, timber and paper. They make a great story but as a contrarian, the prices are just too crazy -- Id have a hard time playing into that game, he said. . . . Instead, he prefers underloved technology companies at the front of new product cycles and small specialty drug makers. Tops on his tech list is Brocade Communications Systems (BRCD, news, msgs), designer and developer of storage-area network hardware and software. The stock soared as high as $115 in 2000 and fell as low as $3.50 last year, but the new product that LaForge expects to drive sales and earnings going forward is a new switch called Dazzler thats aimed at the cost-conscious lower end of the storage market. He points to prodigious free cash flow, 60% gross margins, steadily growing revenue ($550 million in past 12 months) and reasonable valuation. . . . Among other relatively cheap small and mid-cap techs, he likes old-favorite Sirius Satellite Radio (SIRI, news, msgs) under $3, as well as broadband fiber-to-the-curb plays such as Advanced Fibre Communications (AFCI, news, msgs), Sonus Networks (SONS, news, msgs) and JDS Uniphase (JDSU, news, msgs). . . . LaForges top idea in small pharma is Penwest Pharmaceuticals (PPCO, news, msgs), developer of a time-release technology for orally delivered drugs as well as a partner with other companies on specialty versions of current therapies. One of those is Oxymorphone ER -- a competitor to the much-abused OxyContin -- which has already been tentatively approved by the Food and Drug Administration but is critically awaiting word on whether one more clinical trial might be required. He also is buying generic drug makers Andrx (ADRX, news, msgs), Pharmaceutical Resources (PRX, news, msgs) and Impax Laboratories (IPXL, news, msgs). . . . To learn more about FA Asset Management, visit its Web site. LaForges area, Classic Value, is described nicely as the attempt to build a comfortable portfolio from uncomfortable stocks. . . . To learn more about Phoenix Investment Partners, visit its Web site. Here is the page that lists prospectuses for its Small Cap Value Fund and many others. . . . Learn more about Moroukian at his firms Web site. . . . Learn more about Brocade Communications Systems at its Web site. . . . Penwest describes its drug-delivery systems here.
Jon D. Markman is publisher of StockTactics Advisor, an independent weekly investment newsletter, as well as senior strategist and portfolio manager at Pinnacle Investment Advisors. While he cannot provide personalized investment advice or recommendations, he welcomes column critiques and comments at jdmmail@fastmail.fm. At the time of publication, Markman had a position in the following securities mentioned in this column: Phoenix Cos.
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