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Portfolio > Mutual Funds > Equity Funds

Why Reserve Loves Orphans

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Best known for creating the money market fund in 1970 and the FDIC-insured money market sweep account in 1997, Reserve Funds is taking a new tack. It is acquiring small equity fund managers that have succumbed to the pressures of complying with regulations and the rising costs of distribution and marketing.

New York-based Reserve has been building its stable of equity funds on a low level for some time. It got more deliberate about growing its Hallmark Funds unit last year after realizing that it could use its deep pockets to help independent managers lessen their compliance load and distribute and market their funds, says Eric Lansky, senior vice president at Reserve. The Financial Research Corporation has found that four fund families–American Funds, Vanguard, Fidelity, and Barclays Global Investors–accounted for 82% of all mutual fund sales in 2004. Lansky says this shows there “is a real threat that great managers and innovative ideas are being forced out or are not entering the fund marketplace due to barriers like excessive regulation, compliance, and marketing and distribution costs.”

Indeed, Reserve has identified 453 mutual funds with less than $50 million apiece managed by independent managers. The nation’s seventh-largest fund company, Reserve decided last year to approach some of these smaller funds. “There are some really great funds out there that need a greater platform,” Lansky says.

Reserve provides back-office services to the funds it acquires, but it leaves asset management to the fund manager, who becomes a sub-advisor. Reserve “wants to represent a platform of independence, of private asset managers who are running funds,” Lansky says. “As simple as that seems, that doesn’t seem to exist in the marketplace.”

Another benefit for shareholders when Reserve takes over a fund is that fees decrease–often by as much as 40%. Fees can drop that drastically “because we’re offering institutional as well as retail class shares,” Lansky says. Reserve is “a $30 billion asset management company, so we can take advantage of economies of scale.”

Compliance Headaches

Ross Frankenfield, a research analyst at FRC, says the fund industry is seeing more and more mergers, buyouts, or adoptions (see chart below) “where you have a small manufacturer who’s tired of the headaches that all of the increased legal and regulatory issues are causing.” Managers who agree to fund adoptions “want to stay on as a sub-advisor or investment manager–which is their core value–and they’re willing to take a hit to their advisory fee to be adopted by a larger organization that has greater distribution,” he says. In most cases, he says, “the hit to the advisory fee is significant.” But Lansky adds that managers generally want to stay on because “they enjoy running a mutual fund.” Besides, he says, “closing a fund is expensive, and it’s not a shareholder benefit because it becomes a taxable event.”

Geoff Bobroff, a financial services consultant in Greenwich, Rhode Island, notes that about 50 funds were adopted in 2003 and ’04. “But those have tended to be funds with good records.” The only two fund families that were bought out for regulatory reasons, he says, were Bear Stearns, which sold its funds to Dreyfus, and Barr Rosenberg Funds, bought by Charles Schwab. “For the most part, I think funds are trying to leverage other people’s distribution,” Bobroff says.

In October, Reserve added three funds to its Hallmark family: Trainer Wortham First Mutual Fund, now Hallmark First; Trainer Wortham Total Return Bond Fund, renamed Hallmark Total Return Bond; and the Froley, Revy Convertible Securities Fund, now known as Hallmark Convertible Securities. In January, Reserve acquired Segall Bryant & Hamill’s Mid-Cap Growth Fund, which has been renamed Hallmark Mid-Cap Growth.

With the latest acquisitions, Reserve now has $170 million in 11 funds. “We’ve always had a small family of equity funds managed by independent advisors; they’ve just existed as an offering, and not as a core part of our strategy,” Lansky says. The fund family expects to reach $250 million by year-end via more acquisitions. Reserve is targeting funds with assets between $15 million and $50 million. Before acquiring a fund, “the first question we ask is, ‘What is the purpose of your fund, and is it achieving your objective?’ Then we determine whether we can help them achieve that goal,” Lansky says.

Bobroff says although Reserve has been “fussing with different forms of equity funds, sub-advised by those whom they believe are good managers, for the last four or five years,” the fund firm’s “assets are still largely in money funds.” The fund company’s new acquisition binge “may be a new avenue they are going down, but it’s still not a proven distribution machine for equity products,” he says.

Assets in Reserve’s Cash Sweep Account at the end of 2004 totaled $990 million, a 53% increase over year-end 2003 assets of $649 million. Year-end 2004 assets in Reserve Insured Deposits totaled $5.8 billion, a 75% jump over year-end 2003 assets. While assets in money funds were down industrywide last year, Reserve’s money funds ended 2004 with $24 billion in assets, an 18% increase over 2003 numbers. Growth in money funds has been great because “at the end of the day, every client segment has cash; whether markets are going up or down, there is still that cash component, and you’re diversified,” Lansky says. Reserve has also “been really successful in the regional and community banking sector; 70 banks are now distributing our solutions.”

Reserve has also been lobbying lawmakers to enhance competition among funds, and improve fund governance. Chairman Bruce Bent, the creator of the money market fund, told the Senate Banking Committee last year, through testimony presented by James Glassman, a resident fellow at the American Enterprise Institute, that investors should be allowed to sell shares of a mutual fund for any reason–poor performance, high management fees, or scandal–without incurring taxes. The one provision would be that the proceeds would have to be reinvested in a similar fund within 30 days. While no legislation has been introduced, “those in Washington have been responsive” to the idea, Lansky says.

Washington Bureau Chief Melanie Waddell can be reached at [email protected].


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