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Do Your Funds Carry Succession Risk?

Things to consider when choosing a fund with a veteran manager.

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Any fund run by a talented manager carries with it succession risk--the risk that a leader will leave his or her post without finding a worthy person to take over. Some managers have done a good job preparing for the day when they won't run their funds anymore. For example, a manager might bring on a comanager who shares the same investment philosophy and the two work side by side for a number of years. Other fund shops, like American Funds and Dodge & Cox, avoid most succession risk by assigning a group of managers to each fund. Other fund shops, such as T. Rowe Price, have helped mitigate succession risk by hiring a deep pool of analysts and managers, encouraging them to work closely together, and working hard to retain the best ones.

To identify funds that are worthy of further investigation into succession issues because their leaders have very long tenures, we ran a simple screen for funds with at least one manager whose tenure has lasted 20 years or more and with 10-year trailing returns that rank in the top third of their respective categories. The screen returned 23 equity and fixed-income funds as of Dec. 18, 2007. The group represents less than 2% of the funds currently under coverage and runs the gamut in terms of Morningstar analyst recommendations, although more than half are recommended or Analyst Picks.

This list includes several past Morningstar Fund Manager of the Year winners: Jerry Palmieri of Franklin Growth (FKGRX), Robert Rodriguez of FPA Capital (FPPTX), Mario Gabelli of Gabelli Asset AAA (GABAX), and Bill Gross of PIMCO Low Duration (PTLDX) and PIMCO Total Return (PTTRX).

Some of these managers seem to have successors waiting in the wings--even if they haven't explicitly named anyone as a successor and even if the manager shows no signs of stepping away from day-to-day fund management. For example, we think Robert Rodriguez has groomed Dennis Bryan and Rikard Ekstrand, who were recently promoted to comanagers of FPA Capital. If Rodriguez were unable to manage his funds, Bryan and Ekstrand would likely be able to step in. Similarly, PIMCO grabbed headlines this fall when it announced that former manager Mohamed El-Erian would return to the firm after a short stint managing Harvard University's endowment. El-Erian, who will be PIMCO's co-CEO and co-chief investment officer, is widely believed to be Gross' successor.

While succession seems fairly clear-cut at some funds, it's less so at others. Take Kenneth Heebner, who has run  CGM Mutual (LOMMX) for more than 25 years and is one of Morningstar's candidates for Domestic Equity Fund Manager of the Year honors in 2007. He has put up great absolute and relative returns by mixing macroeconomic calls with his own fundamental research, holding relatively few stocks, loading up on a few sectors, and trading frequently. His strategy seems very dependent on his views, and he's given no public indication as to who would manage his funds if he were unable. There's also little information available on the analyst support behind the funds, so it's hard to say how well the funds may be run without Heebner.

Another manager who has been tight-lipped about succession is V. Jerry Palmieri, Franklin Growth's skipper of more than 40 years. Palmieri operates as a one-man show, which differs greatly from the management setup at other Franklin funds. Neither he nor Franklin have named a successor, which we find concerning.

Morningstar Analyst Reports will often discuss whether a long-tenured manager has put in place a succession plan. And Morningstar's Stewardship Grades are also a way to determine which funds with long-tenured managers are likely to be in good shape if their leaders step down. That's because the Corporate Culture component of a fund's Stewardship Grade factors in how well the firm has attracted and retained talent over the years.

To narrow down our list of 23 funds, we also screened for funds with Stewardship Grades of C or higher. The screen brought our list to 13 funds as of Dec. 18, 2007. (Two of these, FPA Capital (FPPTX) and Vanguard Health Care (VGHCX), are closed to new investment.)

 FPA Capital (FPPTX)
 Franklin Growth A (FKGRX)
 Franklin Income A (FKINX)
 Legg Mason Partners Aggressive Growth A  (SHRAX)
 Legg Mason Partners Appreciation A (SHAPX)
 PIMCO Low Duration Instl (PTLDX)
 PIMCO Total Return Instl (PTTRX)
 T. Rowe Price Equity Income (PRFDX)
 Vanguard Health Care (VGHCX)
 Vanguard High-Yield Corporate (VWEHX)
 Vanguard Short-Term Investment-Grade (VFSTX)
 Vanguard Star (VGSTX)
 Vanguard Wellesley Income (VWINX)

Although Palmieri at Franklin Income is a notable exception, nearly all of the other funds have decent succession plans or at the very least deep benches. For example, Vanguard Wellesley Income's (VWINX) manager, Jack Ryan, has been at the helm for 21 years. Ryan plans to run the equity portion of this conservative-allocation fund until June 2008. During this transition time he'll be working with his successor, W. Michael Reckmeyer III, who has been with Wellington Management for more than a decade. The fact that Earl McEvoy will continue to run the fixed-income slice of this fund also gives us a lot of confidence, because he's also been at the controls for more than two decades.

Morningstar.com Premium Members can run this screen themselves by  clicking here. (Note that the results may change as funds come in or drop out of the screen over time.) Not a Premium Member? You can still run this screen by taking a free, 14-day Premium Membership trial.

Karin Anderson has a position in the following securities mentioned above: VGSTX. Find out about Morningstar’s editorial policies.