Prospects for the smaller fund: greater opportunity and risks

Since 1967, Julian A. Lerner has been successfully running the Charter Fund and its $95 million in assets from Dallas. His is one of many ``small'' funds founded and managed by one or two people who have a particular investment philosophy and skill they can sell as an independent, public mutual fund. By this fall, however, the Charter Fund will no longer be independent.

``I've sold the management company,'' Mr. Lerner says. The buyer is AIM Advisors Inc. of Houston, a larger (though not huge), diversified manager of mutual funds. Lerner will continue to manage the fund from Dallas as portfolio manager, while AIM will take care of marketing, distribution, and shareholder services. AIM is also buying the Weingarten Equity Fund of New York, another small no-load fund.

Charter and Weingarten are joining several other small funds that have been sold or closed in recent years. In some instances the acquired funds keep their status as separate investment vehicles, but sometimes they and the name are taken over by another fund managed by the new parent.

Several years ago, for instance, a group of investors in Boston founded the Foursquare Fund. It avoided investments in alcohol, tobacco, drug, and certain other industries. The fund remained independent for a few years but was evenutally sold to the Eaton Vance Group in Boston, which maintained Foursquare's objectives. Later, however, its assets were absorbed by another Eaton fund and the Foursquare name and its objectives disappeared.

Lerner has several reasons for selling his fund; some are personal, and some reflect the changing nature of the mutual fund business. It's just harder for a small fund to keep going, he says.

He defines a small fund as anything less than $250 million in assets. If that seems like a lot for a small fund, consider that Fidelity Investments in Boston has about $40 billion under management.

In Charter's case, the $95 million is just too small to keep up with the big guys.

``We're a small group and we spend an inordinate amount of time on administrative affairs,'' Lerner says. Also, the costs of advertising and marketing the fund have been prohibitive, especially if he wants his small newspaper and magazine ads to be noticed among the much bigger and more numerous ads from funds like Fidelity, Vanguard, T. Rowe Price, Franklin, and Scudder.

This has been especially hard on a no-load fund like Charter, which has to pay for those ads out of whatever profits the investment company makes. Under AIM, Lerner expects, that will change.

``They'll probably go to a full load,'' or sales commission, he says. Current investors would be able to continue adding money without charge, but new ones would have to pay up to 8 percent for sales, marketing, and distribution costs.

If a respected and fairly successful fund like Charter cannot survive on its own, is the small-fund species doomed? Where can an investor turn if he or she wants to feel a part of a small ``club'' of people benefiting from the wisdom and expertise of an individual owner/portfolio manager?

``The general assessment I hear is that it's very, very difficult'' for a small fund to survive, says Sheldon Jacobs, editor of the No-Load Fund Investor, a newsletter. The big funds have ``tremendous marketing clout,'' he adds, and so they tend to pick up the bulk of the new dollars coming into mutual funds.

Also, a small fund has to find a special niche of investment philosophy or strategy. ``It's hard to find a niche when Fidelity is coming out with over new 25 sector funds,'' he notes.

There are a couple of ways a small fund can make it, he says. First, it can ``luck out and come in among the top three or four funds with an outstanding performance record.'' This will bring some publicity in newspapers, magazines, and newsletters.

Second, it can be founded and managed by someone with a good reputation. While that reputation may only spread among financial professionals, they can send in enough cash to get the fund started so it can eventually come up with a noticeable performance.

``In the old days you could put an ad in the papers and start a mutual fund,'' recalls Reg Green, publisher of the Mutual Fund News Service in San Francisco. ``Now with the great growth in the number of funds around, the small ones just get swamped. Even if you've got a good record, it doesn't stand out against the weight of the competition.''

While Mr. Green does not think the end of the small, independent mutual fund is inevitable, ``there's more likelihood of it happening now than anytime I can remember.''

But if the big mutual fund companies are creating new funds every month, aren't investors' choices even greater -- and perhaps more confusing -- than ever?

``Anything that reduces the variety of choice is unfortunate,'' Green contends. ``It means that fewer of these up-and-coming companies are going to be available.''

``For every guy that sells out, the field is exploding with dozens more funds,'' Mr. Jacobs counters. ``If anything, there's too much of a choice.''

One way some small funds are trying to stay independent is by relinquishing their no-load status so they can advertise more broadly. Some have adopted 12b-1 plans, named after a Securities and Exchange Commission rule. This rule permits a fund to use a small share of assets -- usually 2 percent or less -- for marketing and distribution costs. As long as this measure is fully disclosed to current and prospective investors, this is not a bad way for a fund to stay independent.

Some funds, however, use the 12b-1 provision and still tout themselves as no-load funds, without clearly explaining how it can reduce their expected return.