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Rekenthaler Report

Reasons Not to Invest in Boutique Funds

Small isn't always beautiful.

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Fool Me Once

Boutique funds are enticing. While the major fund companies struggle to put their new assets to work, rehashing their portfolios with the same old ideas, younger rivals are unburdened. They have fresh ideas that can be easily implemented, with few (if any) copycat investors following their trades.

I was once a disciple. When asked by journalists to recommend funds, I typically selected boutiques, for the reasons given above. Besides, everybody already knew about Fidelity and American Funds. Where was the glory in mentioning them? Fortunately, I could showcase my knowledge by suggesting a small fund offered by an upstart company. That would demonstrate my expertise. (Yes, there I was.)

I believe no more. Too many boutique funds have disappointed, and too few have shone. Worse, the ones that disappointed tended to be the funds that had previously succeeded, while those that later dazzled were wallflowers. American Heritage (ATHIX), Kaufmann Fund (KAUIX), and PBHG Growth burst to prominence, only to fizzle (although the former two still exist, rather surprisingly, albeit under new management). Meanwhile, the top 20-year performers include the Bruce (BRUFX) and Hennessy Focus (HFCSX) funds, which I don't remember anybody touting at the time.

Perhaps somebody possessed the ability to tell when a boutique fund's initial record was meaningful, and when it misled, but not I. With some effort, I could reliably identify a fund's risks, to understand what market environments might prove harmful, but recognizing potential dangers is not predicting performance.

Forecasting organizational fortunes proved no easier. Berger, Montgomery, Strong, and Robertson Stephens were once fashionable providers, but are no more. Yet Baron, Wasatch, and William Blair continue to chug along. As it turned out, boutiques frequently crash because of poor risk controls. They thrive when market conditions favor their investment style, but then collapse under adversity. Unfortunately, recognizing such problems before the fact is a very difficult task.

The Warning Light

In a sense, this column's admonition is not required. Occasionally an upstart company gathers attention and significant assets--most notably, Cathie Wood's ARK funds--but overall, the fund industry is currently dominated by giants. However, this sales trend owes primarily to the overwhelming popularity of index funds, which boutiques rarely offer (and if they do, those indexes tend to be highly specialized exchange-traded funds that behave like actively managed funds). Should active management return to favor, so, I suspect, would inflows into boutique funds.

So, consider today's column a pre-emptive strike. When I conducted a Google search on "boutique fund companies," the first five pages yielded nary a negative word. They should have. Some boutique funds will perform superbly. It's even possible that such funds, on average, will beat their larger rivals, although that outcome is unlikely given their higher expense ratios. But the full story about boutique funds is less happy than is conveyed by those five Google pages.

Shallow Pockets

This week's news highlighted an additional concern about small fund companies: their lack of deep pockets, should a mishap occur. When the leading fund sponsors err, they seek to protect their reputations. After all, a highly publicized mistake with one fund could cost them a great deal of business elsewhere. Consequently, they may exceed their legal obligations when responding--for example, by using their own money to prop up money market funds. At the very least, such organizations obey the terms of their prospectuses.

The situation is different with boutique firms. If the problem with the fund is so large that it outstrips the company's resources, then shareholders are out of luck. Thus, while several retail mutual fund providers suffered money market losses in September 2008, only Reserve Primary Fund neglected to make its fund whole--because the company could not. The fund had dropped $785 million on its Lehman Brothers position; the firm did not have that many assets on its book.

In Reserve Primary's case, the fund eventually returned 99 cents on the dollar to its shareholders, who were out the final 1%. Disappointing, to be sure, but strictly speaking, Reserve Primary shareholders had no cause for complaint. (Of course, many saw the matter otherwise, subjecting the fund to a bevy of lawsuits.) Their fund had failed industry convention, not the legal letter.

An Infinite Problem

Not so for Infinity Q Fund, the travails of which I detailed this past March, in "Infinity Q: The Fund That Checked All the Wrong Boxes." Boy, did the fund ever. When that article was published, the fund had been shuttered by the SEC, ostensibly because management had overvalued 18% of its "Level 3 assets"--esoteric investments that cannot be priced with full accuracy. The fund was scheduled to liquidate its investments and distribute the proceeds to shareholders.

That process is now largely complete, and what a fiasco it turned out to be. The SEC reports that when the fund was closed, on Feb. 18, its stated value was $1.73 billion. However, after selling its assets, Infinity Q found itself with only $1.25 billion, for a 28% decline. How shareholders could lose more than the entire amount of its Level 3 assets is a tale for another occasion, but not surprising when dealing with complex funds that are deceitfully run. Usually, many shoes drop.

The news gets worse yet. Not only did the fund sustain a shocking investment loss, much of which apparently owes to fraud, but shareholders may end up paying their own legal bill! That's right. The board of directors asserts that, according to the prospectus, the Infinity Q organization "is responsible for paying any costs for liquidating the fund." However, states the board, "Infinity Q has denied its responsibility to pay those expenses and rejected the [board's] demand." Similarly, Infinity Q has refused to pay any claims or legal fees that arise from allegations of "willful misfeasance, bad faith, gross negligence, or reckless disregard."

In response, the board has set aside $750 million--60% of the remaining assets--from the fund itself to meet these potential obligations. Yikes! I don't believe that a major fund family would respond to a fund board in that fashion, because of reputational damage. But Infinity Q faces no such pressure. It has no mutual fund business left to lose.

Wrapping Up

This article should not be mistaken for an argument against investing in boutique funds. At times, specific opportunities overcome general precepts. Also, that forecasting the fortunes of boutique funds is difficult does not make the project impossible. Some investors may possess the knowledge and insight necessary to accomplish the task. Rather, my intent is to provide the other side of the story. Yes, as others tend to write, there are reasons to buy boutique funds--but there are also reasons to abstain.

 

John Rekenthaler (john.rekenthaler@morningstar.com) has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.