Investors Take Note: Consolidations Are Likely

The mutual fund industry apparently hasn’t heard of Charles Darwin. Not just the strongest, fittest funds are surviving, but many weaklings are too.

Though the business is highly competitive and costly to enter, there hasn’t been anything like the shakeout going on in the savings and loan industry or the retrenchment of the brokerage business. Even the stock market crash of 1987 failed to stop the proliferation of funds or the evolution of new types of funds. What’s more, relatively few management companies have been swallowed by others.

However, a prolonged bear market in stocks or bonds could lead to more mergers and acquisitions. So it pays to think about what you should do in case your fund eats, or gets eaten by, a competitor.

If you have invested in a poor performer, you might even hope that it does get taken over. Sometimes the best thing a weak management firm can do for investors is sell out to a stronger rival.

“Usually, the acquiring company has the better investment track record; otherwise, the fund being purchased would still be in business,� explains Jon S. Fossel, president and chief executive of Oppenheimer Management Corp., which has been involved in three acquisitions in recent years.

When shareholders of a small fund get merged into a larger one, they usually benefit from economies of scale in the form of lower expenses. Even when the acquiring firm continues to run the portfolio as a separate entity, investors typically enjoy improved management, better service and the like.

There can be other advantages. When the New England purchased the three funds in the Investment Trust of Boston family in 1988, the company offered a plum to retain the shareholders it picked up in the deal. “We agreed to absorb all (management) expenses for two years,� says Henry Schmelzer, executive vice president with New England Securities in Boston.

Sometimes, a single fund might be sold to another company with more expertise in a specific investment area. Don Phillips, editor of Mutual Fund Values in Chicago, says this is what happened when Neuberger & Berman sold the assets in its high-yield bond fund to T. Rowe Price. Neuberger & Berman has many fine investment managers, Philips says, but the junk-bond portfolio never really meshed with the company’s generally conservative style.

Of course, there’s no guarantee of happy endings. You should carefully check out the new management team, its investment record and the level of expenses and fees. “It’s like starting over. You have to ask yourself if you would invest with the new fund group on your own,� says Kurt Brouwer of Brouwer & Janachowski, San Francisco-based investment advisers.

By the same token, you should stay alert when your fund absorbs the assets and shareholders of another company. “You have to find out what’s getting merged into your fund,� Phillips says. For example, it’s not good to see a lot of poor-quality, illiquid stocks or bonds coming in because your portfolio manager could have trouble selling off those assets at attractive prices.

Of course, the ultimate effect will also depend on the relative size of the two funds. “If you’re merging a $50-million fund into a $1-billion portfolio, it’s no big deal,� Phillips says.

Mergers involving two funds within the same family are often benign, especially when it’s a matter of consolidating portfolios run by the same manager. Sometimes, a company will combine small funds with generally similar investment objectives as a way to reduce costs.

Will mergers and acquisitions involving different companies increase in the future? It’s already happening, observers say, yet so far the industry has had little trouble absorbing the relatively small number of fund families that have gone up for sale.

Lipper Analytical Services of Summit, N.J., counts five mergers or buyouts of mutual fund companies (involving nearly 100 funds) so far this year. That compares to four in both 1989 and 1988, two in ’87 and ‘85, and six in ’86.

“The acquisition of management companies has picked up a bit,� says A. Michael Lipper, president of Lipper Analytical. “But at the same time, a number of other funds have started up.�

Keep in mind that some consolidations don’t necessarily involve unhealthy funds. This was the case when Shearson Lehman Bros. acquired E. F. Hutton in early 1989 and merged the latter’s portfolios into its own family, Lipper says, “The Hutton funds were fine, but the resulting group didn’t need two funds in each category.�

In the Investment Trust of Boston situation, Moseley Securities, the parent firm, was facing financial difficulties from operations unrelated to the mutual fund business, Schmelzer says. More than 40 companies expressed an interest in buying the fund group, he adds.

But with more than 3,000 stock, bond and money market portfolios, redundancy is a problem. Smaller funds, in particular, have trouble creating a niche for themselves. Insufficient money to advertise, market and promote makes it hard to attract enough investor dollars to turn a profit. To ensure a reasonably healthy debut, a sponsor needs to figure on spending at least $500,000 per fund in start-up costs, Fossel says.

And that’s just the beginning. Funds face ongoing expenses for marketing, shareholder services, portfolio management and other activities.

Some observers estimate that a typical fund needs $50 million to $75 million or so in assets to break even. Lipper believes that $150 million to $175 million is more realistic. “My definition of ‘break-even’ assumes all parties associated with the fund are getting full salary, that there’s a reasonable marketing effort going on and that the fund owner receives at least a Treasury-bill rate of return on the capital invested.�

Based on size, most funds wouldn’t meet that definition. In fact, only about one in four stock and bond portfolios tracked by Lipper had assets in excess of $150 million as of March 31.

To Fossel, the numbers add up to more buyouts and mergers in the future, including combinations of smaller portfolios within the same family. “Of the roughly 3,000 funds, about half have less than $50 million in assets,� he says. “It doesn’t take a genius to conclude that there has to be a lot of consolidation ahead.�

THE EXPLOSION IN MUTUAL FUNDS Despite tough competition and high entry costs, the number of mutual funds has risen substantially in recent years. This raises the possibility of a significant consolidation, especially if weakness in the stock market persists. The following chart shows the year-end total of stock, bond and money market portfolios. 1985: 1,610 1986: 1,930 1987: 2,403 1988: 2,790 1989: 2,975 1990: 3,040* *6 months Source: Upper Analytical Services