If the directors speak up, fund's investors benefit

Your Funds

Your Money

May 16, 2004|By CHARLES JAFFE

NAPOLEON IS reported to have said that "impossible" was not in his vocabulary.

I'm taking it out of mine, too, because something I always considered an unwinnable long-shot happened recently: A mutual fund invited me to be one of its independent directors.

Satan must be wearing a parka right about now, especially when you consider the guys who wanted to take a chance on me.

I can't accept the job, as writing about funds and helping to direct one would be a conflict of interest. But the thought of becoming a director is interesting, as I believe I'd be a fund management company's worst nightmare, an active director prepared to ask awkward and difficult questions.

What's more, it made me recognize that investors would benefit from thinking not just like an owner of the fund - which they are - but like a director.

If fund management can't answer your toughest questions about its strategy and ability to serve you, it doesn't deserve your money.

With that in mind, let's examine some of the tough questions that would have faced the folks at TFS Capital in Richmond, Va., a hedge-fund company that has filed registration papers for its first mutual fund. It hopes to launch the TFS Market-Neutral Fund in July.

For starters, you should be aware that I am no big fan of market-neutral funds, which attempt to use a hedge fund's strategy in an ordinary mutual fund. Market-neutral is a strategy designed to profit in all conditions, regardless of the market. Too often in the 20 or so funds that follow the strategy, it has meant "flat performance in all market conditions."

TFS Capital appears ready to try the kind of arbitrage-based market-neutral strategy that has worked best when translated into mutual funds, but management would be on a short leash.

The question a director - and a shareholder - should be asking management: "How long are we waiting to prove this strategy?"

Plenty of funds are born of ideas that sound good, and stick around because investors believe management has an ability to deliver.

But half of all funds are below-average performers. If a fund can't prove its worth, it shouldn't be allowed to continue. Within three years of my becoming a director, I would have been asking management to liquidate if results were consistently below average.

Shareholders shouldn't stick around even that long.

The new fund has capped expenses at 2.5 percent, not quite double the average equity fund and is likely to be charging that much until it can build up assets.

Once assets grow, a fund should be able to charge less. Directors have a responsibility to push a fund toward lower costs, because that's in the best interest of shareholders.

If TFS can't get costs down to the average level of roughly 1.4 percent - and as a director I would have been pushing for such a reduction - after the first three years, I'd be ready to pull the plug.

Investors should be willing to tolerate above-average costs only where they are comfortable that the investment premise can deliver oversized returns even after the costs are accounted for.

Of course, for TFS to survive its early years and drop costs, it would have to be a success, at which point its size would become an issue.

Larry Eiben of TFS noted that they believe their strategy will work with a fund of between $225 million and $500 million.

Investors looking at a new fund should be aware that when money rushes in performance might change. They should expect management to put the brakes on cash in-flows until they are sure the strategy will stand up.

Controlling the fund so that current shareholders benefit - even if management is turning away potential profits - is a key job for which most directors have done poorly.

One other issue that will dog TFS Capital is that the company runs hedge funds and, soon, mutual funds. That's a combination that currently has regulators unsettled, and it should make investors nervous, too.

While TFS' first job is to work for its hedge clients - they were there first - directors and shareholders need to make sure that management's incentives are in the right place.

That means management should have money in the mutual fund, and not just the hedge issues. As a director, I'd be demanding that. Shareholders should inquire about it too.

Eiben acknowledged that both directors and shareholders have a right to be skeptical about a new fund following a strategy.

"Hopefully, we can prove that this works to directors and for the shareholders," Eiben said. "If not, then we shouldn't expect to stay around for very long. Shareholders have a right to expect results, and they should expect directors who ask tough questions and demand a lot of management."

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