Charles A. Jaffe | Fund boards not primed to change

There are no hostile takeovers in mutual funds.

Bad managers are entrenched until they resign or the fund's directors give them the boot. Shareholders generally have no say in the matter; unlike a corporation where dissident investors can slug it out on the open market, most mutual funds don't even have to tell customers when they make a management change.

Lousy funds can go on indefinitely.

It's such a recipe for complacency that legendary investor Warren Buffett said in the 2002 annual report of Berkshire Hathaway Inc. that "a monkey will type out a Shakespearean play before an independent mutual fund director will suggest" firing an inept manager.

For proof, consider the strange case of the Phoenix Market Neutral fund and TFS Capital, the management firm that wants to run the $66 million portfolio, as it appears to be the perfect example of how insulated management is from hostility that might actually lead to improved performance.

On April 12, Richard Gates of TFS Capital sent a letter to the board of directors of Phoenix Market Neutral. Here is my quick translation of the two-page letter:

"Your current management team sucks at managing this fund. We run a similar fund, and we actually make money for shareholders doing it, so let us run the money."

Gates has a point.

Phoenix Market Neutral (EMNAX) is one of the worst funds in its peer group, with annualized losses for every meaningful time period since its inception in 1998. The fund is an "analysts' pan" at Morningstar Inc., and it ranks dead last in its category for "tax-adjusted return" over the last five years.

By comparison, the TFS Market Neutral fund (TFSMX) has an annualized gain of almost 15 percent since its launch in September 2004. One big negative is the firm's longevity; TFS was founded in 1997, and its funds are less than three years old.

Both market-neutral funds take a quantitative approach to their long-short, hedge-fund-like style of investing. Examine the prospectus documents of the two funds, and it is clear their objectives and methods are substantially similar.

Look at Phoenix's annual report to shareholders, and the company's message from the president, George Aylward, says that "the board's focus is on investment performance and serving the best interests of shareholders."

Gates' letter suggested that living up to such a statement should include seeking out a manager who can actually make money for shareholders.

"In all other industries, there is competition and people bidding for services," Gates said in an interview. "All we want is to open up the mutual fund business to a little competition. . . . They have almost nine years of track record, ample opportunity to display their talents or lack thereof. . . . We're not expecting a boondoggle; we're confident that if the board searched for a new manager - and picked us from the competition - we could go in there, add value, and make the shareholders better off."

TFS will not get that chance. In fact, it will not even get a response.

Joe Fazzino, a spokesman for Phoenix Investment Counsel, suggested that the letter was roughly the equivalent of junk mail.

"Phoenix Investment Counsel gets calls on a regular basis from sub-advisers, and we have no obligation to respond to each unsolicited marketing proposal," Fazzino said. "This is more along the lines of the guy from Sprint calling and saying 'Why don't you switch telephone companies?' It happens all the time, and it's not the way anyone picks a portfolio manager."

But fund-industry insiders and boardroom observers say the TFS letter is anything but routine, and they suggested that in the world of stocks, it would have demanded a response. They wonder why a fund firm would ignore it.

"It's a shot across the bow, and while it may be a non-gentlemanly way of doing things, the board has to respond to this," said Ralph Ward, editor of the Boardroom Insider newsletter. "Not answering raises a question of just how independent the board really is."

Added Kurt Schact, managing director of the CFA Centre for Financial Market Integrity: "This is more proof of why investors shouldn't think that an independent board is going to make any decision other than what's good for the people who seeded the fund and set things up. . . . I'd think they're obligated to respond in some way."

TFS may push the issue and approach shareholders directly, but it will not gain much traction; shareholders could wake up and leave the Phoenix fund in favor of TFS, but there is no mechanism to overthrow the empire. More fights for fund control would be a good thing for investors, but you'd make more money wagering on the monkey to finish typing Macbeth.

Said Gates: "If it's unseemly to ask board members to make a decision that looks out for the best interest of shareholders, we shouldn't go through the exercise of approving advisory contracts every year. . . . It's just a show."