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JUNE 20, 2005


Why Boutiques Have An Edge
Owner-managers bring passion to fund investing. After all, that's where their cash is

In some respects mutual funds are like restaurants. If you want a really good meal, you stay away from the big chains and seek out that tiny bistro whose owner is also the chef. Owners bring a high degree of passion to the job because there is so much on the line. "A manager who is also the fund company's owner wants to make money for shareholders because his reputation and his enterprise are at stake," says John Deysher, owner of Bertolet Capital and manager of Bertolet's Pinnacle Value Fund. "Failure can mean bankruptcy."

Any advantage that small owner-managed fund groups may have over corporate behemoths has not been statistically proven. But the record is full of examples of boutique funds whose performance far exceeds that of their peers. Eleven of the 20 top-performing diversified domestic equity funds over the past 10 years are managed by their founders. That's a large number if you consider that the vast majority of funds are run by big fund complexes.

Most of these top funds are no longer undiscovered. Luminaries such as Bridgeway Ultra-Small Company Fund and

Calamos Growth Fund are either closed to new investors or are so large that they're not the nimble players they once were. One thing that has been statistically proven is that size matters. "Asset size plays an important role in performance," says Jim Peterson, who heads mutual-fund research at Schwab Center for Investment Research in San Francisco. "Funds that get too large have trouble putting money to work." Some of the yet undiscovered gems of fund-dom, such as Auxier Focus Fund (AUXFX ) and Runkel Value Fund, are still small enough to be agile.

It's not a coincidence that Auxier and Runkel are also the managers' names. "Think of the confidence -- the pride -- it takes to name a fund after yourself," says Barry Glassman, an investment adviser at Cassaday & Co. in McLean, Va. "If the person's name is on the door, he's going to be around for a long time." According to a study Glassman conducted in 2003 of the 500 largest equity funds, 15 of the 16 named after their managers were still run by their founding manager, and the 16th, Davis New York Venture (NYVTX ), was run by the founder's son, Chris Davis. What's more, 14 of those funds had beaten the Standard & Poor's 500-stock index over the past five years -- 11 of them over the past 10.

These boutique funds tend to be more flexible in their investments, searching for absolute, not relative, return. They're not satisfied to be down 10% even if their benchmark is down 12%. What's also important is that these managers have most of their personal assets in the fund. Notes Schwab's Peterson: "It powerfully aligns their objectives with shareholders'."

There are some disadvantages to such tiny funds. They often lack the research capabilities of larger firms. And it can be difficult to keep expense ratios down since assets are too few to cover costs (though some funds in our table have low expenses). Worse, an owner-manager could take advantage of his fund's investment flexibility to make some big bets that eventually go bad.

Finding these little treasures takes some effort. Often it's a matter of watching for funds that do well in various scoreboards. If you go to their Web sites, you might learn that the managers had experience at a larger company before setting off on their own. Prior to launching Pinnacle Value Fund in 2003, manager Deysher spent 12 years as an analyst at Royce & Associates, one of the oldest and largest fund companies specializing in small-cap investing. Deysher has an edge on his ex-employer because Pinnacle Value, also a small-cap value fund, has only $11.5 million in assets. So it's easy for Deysher to buy tiny illiquid stocks, such as textile maker Quaker Fabric (QFAB ), which has a market cap of just $50 million and trades for one-third its book value. That's much harder to do at a larger fund because it's impossible to buy enough of such a small company's shares to make a difference in a large portfolio.

TrendStar Small-Cap Fund (TRESX ) has a similar story. Co-managers Tom Laming and James McBride both previously worked at top-performing Buffalo Small Cap Fund (BUFSX ), Laming as co-manager and chief equity strategist for a decade and McBride as lead analyst for three years. With just $125 million in its coffers, TrendStar is able to invest in the small companies that are now out of their former fund's reach. "We have a similar strategy to Buffalo's," says McBride, "but that fund became so huge it was unwieldy. We'll close this one to new investors at $400 million." Buffalo Small Cap has $1.8 billion and is closed to new investors.

Another reason for going with owner-run funds is continuity of management. A talented manager at a large fund company may get promoted, poached by another firm, or leave to start a hedge fund. That's less likely to happen with an owner-run fund. "I will do this as long as my health remains good," says Randall Eley, the manager of the $13.5 million Edgar Lomax Value Fund (LOMAX ), which Eley founded in 1997, and named for his grandfather, who inspired him to become an investor. Eley didn't work for a large fund company, but he does have a track record of managing accounts for individual investors that dates back to 1990.

Eley buys large-cap stocks selling at a discount to the average price-earnings ratio of the S&P 500. In running his own fund, Eley says, he doesn't feel any pressure to hew to a benchmark, as many managers at the bigger firms do. His fund is concentrated, typically holding just 35 to 40 stocks, and he is not afraid to load up on a particular sector if it's out of favor. Right now he has about a quarter of the fund in financial services. Although Eley shows flexibility in his stockpicking, he still focuses mainly on large-cap stocks.

Several of the boutique funds take flexibility to another level. "We have the ability to invest wherever the risk is low and the returns are high," says Jeff Auxier, manager of the Auxier Focus Fund. Auxier's willingness to invest in stocks and bonds of any stripe has produced powerful results. His fund's 9.3% five-year annualized return ranks in the top 3% of all moderate allocation funds, according to Morningstar. More important to Auxier, the fund has had just one down year in its six-year history. That was 2002, when it lost 6.8% vs. the S&P 500's -22.1% return.

Manager Charles Smith of Fort Pitt Capital Total Return (FPCGX ) also has a go-anywhere style. To him the most important decision is not what stocks to be in, but whether to be in stocks or bonds. "An investor's returns are far more influenced by their asset-allocation decision than their stock selection," he says. "We want to make that decision." This does not mean the fund winds up being like the typical balanced fund, with a certain percentage always in stocks or bonds. Right now, Smith has nothing in bonds because yields are too low, but he will start moving into them if yields on long-term Treasuries hit 6.5%. At double-digit yields, he would go to 100% bonds, something he did in the early 1980s when he managed individual accounts with Ron Muhlenkamp. He later co-managed the Muhlenkamp Fund.

More often than not, unique funds come from the boutiques. Pennsylvania Avenue Event-Driven Fund specializes in merger arbitrage, typically the domain of hedge funds. Only two other mutual funds manage money this way, both also at boutique firms. One of them, Merger Fund (MERFX ), is closed to new investors, and the other, Arbitrage Fund, has a higher expense ratio and worse performance than Pennsylvania Avenue, according to Bloomberg Financial Markets. Pennsylvania manager Thomas Kirchner attributes part of his fund's success to its tiny $500,000 asset base. In 2004 the fund was up 26.8% while its competitors treaded water. For sure, Kirchner needs the fund to get larger -- it would take $5 million in assets to turn a profit. But that's not so large that it would preclude investing in the smallest deals, which the larger players don't consider.

Manager Jonathan Ferrell's Rock Canyon Top Flight Fund (TOPFX ) also goes his own way in cribbing from hedge fund strategies. He practices momentum investing, which often means rapid trading. He also sells stocks short. Rock Canyon has a 3.03% expense ratio -- exorbitant for a mutual fund but reasonable for a hedge fund.

If you find the right fund, there's a chance you could invest in it for life. "I sometimes joke with my partners that I'm going to be here running this fund when I'm 95 and covered with cobwebs," says Fort Pitt's Smith, who's 45. "I sometimes say, though not too loudly: 'I'd do this without being paid."' That's the kind of passion for investing that fund shareholders should seek out.

By Lewis Braham

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