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February 2009 Mutual Fund Red Flags

Layoffs could hinder a rebound at these funds.

Ryan Leggio, 02/10/2009

This article originally appeared in Morningstar FundInvestor, an award-winning newsletter that presents investment strategies and tracks 500 funds.

Red Flags is designed to alert you to funds' hidden risks. Such risks can take many forms, including asset bloat, the departure of a solid manager, or a focus on an overhyped asset class. Not every fund featured is a sell, and in fact some are good long-term holdings. But investors should be prepared for a potentially bumpier ride in the near future.

Widespread market declines usually mean at least one thing for investment-management firms: layoffs. But these cuts don't come at a good time and are not a positive development for shareholders--just as the market starts to provide compelling buying opportunities, the people running mutual funds are being let go or reorganized. When assets under management and profits decline, it is understandable for firms to cut back staff in order to remain profitable. In past downturns, though, the most vulnerable areas were in sales and back office staff, which don't affect shareholders as much. This time, however, the market downturn is happening alongside a lengthening recessionary environment, and we are seeing many professional staff cuts as well, which include research analysts and portfolio managers.

If the stresses from dramatic market declines aren't enough, some firms have seen such dramatic reductions in assets that layoffs were widespread. AllianceBernstein saw its assets under management decrease by approximately $30 billion, or 6.2%, in November alone. The firm's research staff, which the firm had steadily built up over the last few years, has been reduced by an estimated 8% to 10% to around 151 equity and 62 fixed-income analysts. The layoffs coincide with the retirement of CEO Lewis Sanders after a 40-year career at the firm. Sanders took over as CEO in early 2003 and guided the firm through a series of market-timing charges later that year. Neither of these developments strikes us as positive for AllianceBernstein fund owners.

MFS Investment Management of Boston is also grappling with layoffs. The firm recently laid off 90 people, some of whom were investment-management professionals. MFS executive Robert Manning doesn't believe that the consolidation of noncore products will affect shareholders and doesn't anticipate any further cuts in the investment staff. We are not as confident as Manning on either count.

Other Boston firms are in the same boat. Boston Company Asset Management laid off 90 people, nearly 30% of its staff, because of last year's stock market plunge. The company said that its assets under management fell 47% over the past year. The investment group, part of the Bank of New York Mellon Corp., manages the Dreyfus mutual funds. Fidelity Investments and State Street have announced numerous layoffs over the past few months.

Even when managers are not being directly laid off, there are some that are being essentially laid off by Mr. Market. That is, a number of mangers nearing retirement age are deciding to call it quits as the stresses of a new bear market outweigh the benefits of a few more years of employment. Most troubling is that we have seen a few seasoned managers leave at the same time that their funds are struggling. At RS, longtime manager John Wallace retired from RS MidCap Opportunities RSMOX, leaving big shoes to fill for the remaining managers. Meanwhile, Stephen Lampe retired from Delaware Trend DELTX after being with the firm since 1998. These are just a few of the many examples we have seen in the last few months. These departures were not announced as layoffs, but we wonder if the timing would have been different if we were in a roaring bull market.

It is unlikely that layoff activity has peaked. Markets retested their November lows in January, and billions of dollars keep flowing in low-return money markets, keeping the pressure on firms. It seems that more large firms are cutting professional staff this time around compared with the last bear market. These continued cuts could hurt a firm's ability to rebound when the market finally does rally.

Ryan Leggio is a mutual fund analyst with Morningstar.

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