Shakeup at a Subpar Emerging-Markets Fund

For decades, certain mutual fund firms have delegated the day-to-day management of their funds' portfolios to others. For example, though Vanguard serves as the advisor of its actively managed funds, it has long relied on subadvisors to pick the securities for many of those portfolios. In fact, Vanguard and many others don’t stop with just one choice: The advisors often assign two, three, or even more subadvisors to separately manage portions of the same fund.

Those subadvisor lineups aren't carved in stone, though. A fund's advisor can make changes. At a multimanaged fund with five subadvisors targeting different areas of the stock market, for example, that might mean swapping the small-cap value specialist for a new firm focusing on the same universe. Or--in a practice that has become common at Vanguard in recent years--the advisor simply adds a new firm without subtracting any of the existing members, expanding the number of subadvisors as the fund’s asset base grows.

Rarely, though, does an advisor sweep out an entire lineup of subadvisors and install a whole new crew. But that's what happened in October at  USAA Emerging Markets (USEMX).

There One Day, Gone the Next
Until that time, USAA Emerging Markets, which currently has $1.4 billion in assets, had been run by managers from two different subadvisors, Batterymarch Financial and The Boston Company. Batterymarch had been added in October 2006; prior to that, The Boston Company had been the sole subadvisor since June 2002.

Performance under those two firms was not impressive. The fund’s return from the beginning of November 2006 through the end of September 2012 lagged both the MSCI Emerging Markets Index and the diversified emerging-markets category average by substantial margins. The fund also trailed both benchmarks during the prior period when The Boston Company was the sole subadvisor.

So USAA took action. Instead of adding another firm and handing them a portion of assets, or swapping out just one of the two subadvisors, USAA wiped the slate clean. It replaced Batterymarch and The Boston Company with three new firms. (A USAA spokesman says that in addition to performance issues, the firm also considered the way in which the different subadvisor portfolios worked together as a whole.)

Now Lazard Asset Management gets the bulk of assets, with Brandes Investment Partners and Victory Capital Management dividing the remainder. The USAA asset-allocation team may make small adjustments from time to time in the amount of assets under each subadvisor's control. (For more details, Premium Members can look at the  new analysis of the fund by Morningstar senior fund analyst William Samuel Rocco.)

Although the three current subadvisors are all solid shops with significant emerging-markets experience, it remains to be seen how the new arrangement will perform in practice over time. What’s most noteworthy was the drastic nature of the action.

Taking Its Measure 
Should more firms make dramatic moves of this nature?
There are sound arguments on both sides. You could say this example should be emulated by others--and not only by advisors overseeing subadvisors. Even more critically, boards of directors, who are charged with choosing and evaluating advisors, could stand to act more resolutely on occasion. (That applies whether the advisor runs the portfolio itself or farms out that duty to subadvisors.)

Many funds are run by unexceptional in-house managers using commonplace strategies and have mediocre records over time to show for it. In such situations it might not be enough for the advisor to substitute one of its own portfolio managers for another, or to make minor adjustments in the fund's strategy. Perhaps the advisor itself should be replaced. Boards of directors almost never make that move.

That said, boards should not be replacing their advisors--or advisors their subadvisors--every few years. The portfolio turnover that would likely result could cause substantial taxable capital gains distributions, for one thing. More importantly, even the best managers have suffered through periods of underperformance only to bounce back strongly. Shareholders would likely be worse off if skilled managers are routinely sent packing after a couple of subpar years.

Some advisors of multimanager funds are in fact too eager to alter their subadvisor lineups, substituting firms every few years in a way that's confusing and unsettling. Shareholders might understandably feel there’s little reason to own a fund where it's unclear which managers from which firms will be making portfolio decisions a few years down the road. Meanwhile, many investors choose funds specifically for the talent in the subadvisor lineup (some of whom may not be accessible in any other way). They wouldn't be pleased to see the advisor routinely fiddling with the subadvisor roster at such funds.

Therefore, the USAA Emerging Markets overhaul should not be considered a template for advisors or fund boards to follow regularly. Advisors and fund boards should, however, file this makeover away in their memory banks. It is an option they may never need to take, but which should be seriously considered if the time comes when a decisive management change truly is in the best interests of a fund's long-term shareholders.