Consider Selling PBHG Funds

On November 13, Pilgrim Baxter & Associates, the advisor to the PBHG funds, and a unit of Old Mutual PLC, announced that founders Gary Pilgrim and Harold Baxter had resigned because of the former's investment in a hedge fund and the latter's knowledge of the arrangement. On November 20, the Securities and Exchange Commission and the New York state Attorney General's office brought charges of fraud against the men.

This is significant because, while plenty of serious accusations have been levied during this scandal, only a handful of cases have resulted in formal charges. It should be noted that Pilgrim Baxter does not agree with all of the facts that these bodies cite.

Long before the current market-timing scandal, we had named two of PBHG's largest funds,   PBHG Growth  and  PBHG Emerging Growth , as  Analyst Pans. This is the equivalent of a sell recommendation. The seriousness of the latest news, discussed below, reinforces this view.

Timing Practices Deserve Severe Criticism
According to Attorney General Eliot Spitzer's complaint, Pilgrim invested in a hedge fund, Appalachian Trails, which was permitted to rapidly trade in and out of PBHG Growth (which Pilgrim had managed from 1985 until last week), PBHG Emerging Growth, and  PBHG Technology & Communications Fund  from 1998 through at least 2001. The firm also allegedly had a deal with broker-dealer Wall Street Discount Corporation (WSDC) that allowed clients of WSDC to make short-term trades in PBHG funds. In addition to allowing this company to jump quickly between the funds and a money market fund, Baxter reportedly provided the portfolio holdings of some PBHG funds to WSDC to help their timing efforts, another way that high-priced accounts received special privileges.

If true, Pilgrim's actions and Baxter's approval of them show that the pair was willing to put personal financial gain ahead of fiduciary duty to their shareholders. The SEC charge indicates that Pilgrim committed his own money to Appalachian in an effort to shield himself from short-term losses resulting from his mutual funds' volatile momentum style. Regulators suggest that, in effect, Pilgrim expected investors to show confidence in his process by staying invested in PBHG funds in good times and bad, but he didn't have the stomach to do so himself. Moreover, the funds' momentum style would have made timing particularly damaging to those investors. 

Also significant in this case is the extent to which market-timers appear to have been exploiting PBHG funds for short-term gains. Defenders of firms implicated in facilitating market-timing claim that timers don't have the critical mass to affect long-term shareholders' performance. But the Attorney General's complaint against Pilgrim Baxter indicates that a WSDC client's assets in one PBHG fund (likely Emerging Growth, given its asset size at the time), stood at $100 million, or 10% of the fund, in May 2000 and that one PBHG employee deemed the amount "disruptive." If the fund's portfolio manager had to keep cash on hand to meet this client's potential redemptions, it may have been substantial enough to keep the fund from fully participating in gains when stocks were rising. On July 12, 2001, timing assets in PBHG Growth were 14% of assets, according to Spitzer's complaint.

Further, the regulators charge that PBHG noticed the downside to accomodating market-timers, but failed to turn away big-ticket accounts. Although the firm limited the number of exchanges that could be made between any equity fund and PBHG Cash Reserves Fund in June 1998 and again in late 2001, it allowed Appalachian and WSDC to slide by, presumably because of their connections with upper management and the amount of assets they invested with the firm.

Firm's Other Foibles
A high-flying firm in the mid-1990s, PBHG's fortunes have faded in recent years. 

Momentum investing was once the domain of PBHG and a few other firms, who were able to reap gains by picking up shares of rapidly growing companies that were poised for a pop when they satisfied or exceeded Wall Street's quarterly earnings expectations. The style gained popularity in the 1990s, though, making it harder for PBHG to profit from it. Moreover, the firm has been unable to retain managers--at least four former stars left for other fund shops or hedge funds in the late 1990s--and it has always had fewer analysts than momentum shops like AIM and American Century.

And, as has been well documented, the funds' performance has been volatile. This profile has led to performance-chasing on the part of fund investors and ultimately disappointing results for shareholders first attracted by the funds' impressive short-term results. Indeed, the return on the average dollar invested in funds such as PBHG Growth and PBHG Emerging Growth has been much lower than published total returns for the funds.

Moreover, steps to address investors' tendency to chase performance, including quickly closing the trendy PBHG New Opportunities and PBHG Limited funds to new investors shortly after their launches in the late 1990s, met with unintended results. While erratic flows didn't dog these funds, shareholder attrition and hot-and-cold performance did. Each was merged out of existence earlier in 2003.

Our Conclusion
As we have written in recent weeks, we have established criteria for assessing a fund company's prospects, and have applied them in this case.

It appears that Baxter and Pilgrim, rather than a large number of PBHG employees, were responsible for allowing the trading abuses to go on at the firm. Moreover, it seems that the timing activity had stopped by December 2001. Current CEO David Bullock arrived in July 2003, long after the violations took place. Still, top individuals appear to have been complicit in the trading abuses. And given the large sums invested by timers, and their apparent influence over the firm's policies, we regard these allegations as very serious.

Pilgrim Baxter also scores poorly on many of the quality-of-management and governance standards that we apply. Most notably, investors in PBHG funds, on a dollar-weighted basis, have fared poorly; the firm's record in launching new funds has been spotty at best (PBHG Global Technology and Communications has also been merged away); its current crop of managers lacks significant experience (the longest-tenured have only been at the helm for half a decade); and risk controls clearly need improvement. 

Owing to these considerations, our recommendation is that investors consider selling their holdings in PBHG funds after taking into account the transaction costs and taxes involved in such a move. The recommendation does not apply to funds that are subadvised by other firms under the Old Mutual umbrella, such as  PBHG Clipper Focus  and  PBHG IRA Capital Preservation . These and other funds have investment merit and we have no reason to suspect that Baxter or Pilgrim had any influence over the trading policies of these funds. In fact, many came into the PBHG family after the timing activity stopped.

Bullock has talked about taking constructive steps to repair the firm, and in a recent conversation listened with interest to our ideas for setting things right. For example, we expect that the firm will be putting specific language in the funds' prospectuses that prohibits market-timing, as well as instituting redemption fees. We will contemplate removing PBHG from our "consider selling" list when we have more confidence that PBHG has implemented (and is consistently enforcing) the appropriate measures, and when it has addressed its quality-of-management issues.