When Funds Collide, Survivors Often Suffer

Mergers Cause Sleepless Nights at SEC
Combining Capital Gains May Be Your Loss
Name Change Is a Shortcut to a New Image

Breaking up is hard to do. But marriage can be just as painful when it comes to your mutual fund.

While the mutual fund industry portrays mergers as nonevents, meshing portfolios and investment objectives can increase fees and usher in a period of underperformance. There can be unwelcome tax consequences as well. (See Combining Capital Gains May Be Your Loss.)

A recent study from Georgia Tech's Dupree College of Management finds that fund mergers actually cut into as much as two-thirds of the surviving fund's peer-adjusted returns during the following year. So if a fund outperformed its peers by 10% before the merger, it would beat its peers by less than 4% after tying the knot.

And its expenses would rise by 0.03% on average.

"It's hard to imagine what would be the benefit for the acquiring fund's shareholders," says Edward Nelling, an assistant professor at Georgia Tech, who co-authored the study with Narayanan Jayaraman and Ajay Khorana. "The good ones are dragged down by the bad ones."

Mergers on the Rise

Breakneck consolidation of the financial services industry has made fund mergers commonplace, whereas just five years ago they were a relative rarity. In 1994, there were just 24 mergers, according to fund tracker Weisenberger. Last year, the total rose to 378, and in this year's first half, 212 occurred.

The urge to merge is exacerbated by the glut of funds. With more than 6,800 equity funds tracked by Lipper, many firms find themselves offering redundant products or pursuing too-specialized market niches.

Three Funds Can Be Hard to Swallow ... PaineWebber Global Equity A merged with Global Growth, European Growth and Global Growth and Income.

For example, Invesco got rid of eight funds in June by merging several with similar objectives. Among the changes: The Small Company Value fund was merged into the (FIEGX)Small Company Growth fund and the European Small Company fund was merged into the (FEURX)European fund.

"It really was to simplify our product line," says spokeswoman Molly Cisneros. "We've had a lot of senior management and marketing people over the last 10 or so years who were trying to meet demand at any given time. The products that may have been hot for a year weren't perhaps the place to be at a later time."

... But Even One Fund Can Be Tough to Digest ... Smith Barney Special Equities A merged with Telecom Growth.

Industry watchers have long berated mutual fund firms for using mergers as a vehicle to bury bad track records. For example, Invesco European Small Company fund lost 17.8% in the year before its demise, ranking 107th of 108 funds in its category.

Fund executives counter that mergers are a practical way to achieve economies of scale by folding assets of smaller, lagging funds -- which typically have higher expense ratios -- into larger, more successful ones.

... Even If Your Symbol Is MALOX. Merrill Lynch Global Allocation merged with the Balanced Fund for Investment and Retirement.

But according to the Georgia Tech study, expenses typically don't fall, and the process takes a toll on the performance of the surviving fund.

For example, the (HSEAX)Smith Barney Special Equities fund returned 22.8% in the year leading up to its merger with the Smith Barney Telecommunications Growth fund in October 1996, according to Lipper. That performance was better than nearly two-thirds of its small-cap peers. But for the 12 months after the merger, it had a loss of 7%, putting it in the bottom 2% of all small-cap funds. And its expense ratio rose by 2 basis points to 1.19%.

Smith Barney spokeswoman Connie Kain blamed the fund's underperformance on weakness in the small-cap sector, but that doesn't explain why Special Equities slipped vs. its peers. As for the expense ratio, she says any comparison should be based on the fund's 1995 expense ratio of 1.43%, not 1996's 1.17%, even though the merger didn't happen until Oct. 18, 1996.

"At least that puts it a little bit more into perspective," she says.

The Georgia Tech study looked at 742 mergers from 1994 to 1997 and found that, on average, for the year before a merger, acquiring funds outperformed their peers by 1.3%. After the merger, they only outperformed by 0.5%.

Not surprisingly, the study has not been received with open arms by the mutual fund industry.

Geoff Babroff, an industry consultant, questions the study's methods. He says that because the report compares past performance with subsequent results -- something that goes against the industry mantra that past results do not predict future returns -- the study is little more than academic poppycock.

"I'm not surprised, but miffed in a way that we have academics doing basic 101 thinking," says Babroff, who has 30 years of hands-on experience in the industry. "One should not be too surprised at the one-plus-one results."

Some Shareholders Benefit

The flip side, of course, is that the swallowed funds' shareholders experience a rise in returns (as much as two-fold) and a drop in expenses (by an average of 14 basis points) during the year after the merger.

Take the case of the Oppenheimer Time fund, which merged into the (OPTFX)Oppenheimer Capital Appreciation fund in June 1995. According to Lipper, Time lost 4.2%, ranking 77th among 80 mid-cap peers during the year before the merger. But one year after the merger, former Time shareholders enjoyed the 32.6% peer-beating return of Capital Appreciation.

Ironically, shareholders of target funds get to vote on whether they want to merge, but shareholders of acquiring funds do not.

"Typically, the [surviving] fund doesn't change. It just gets new assets," says Robert Zutz, a partner in securities law at Kirkpatrick & Lockhart in Washington, D.C. In fact, shareholders of acquiring funds sometimes aren't even notified that a merger is about to take place, he says.

But others suggest the acquiring fund does change because it is weighed down with the lagging portfolio of the target fund. And the Georgia Tech study found that postmerger turnover rates didn't increase dramatically, suggesting such an effect may occur more often than thought.

"It would seem that the case with the fund mergers is similar to the overall case that you see with the corporate mergers, where the shareholders of the target company tend to win, and the shareholders of the acquirer tend to lose," says Nelling.

That said, not all mergers end in disappointing returns for the acquiring fund. The aforementioned Oppenheimer Capital Appreciation fund has absorbed four funds since 1991 and still ranks in the top 26% of its peers over the past five years, according to Morningstar.

Ultimately, the question of whether fund mergers are good or bad for shareholders must be decided by the Securities and Exchange Commission. For a look at the SEC's treatment of mergers, see our story Mergers Cause Sleepless Nights at SEC.

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