Skyline's Flagship Fund to Merge With Its Smaller Siblings

And then there was one -- a struggling one at that.

Amid deep outflows, Skyline Asset Management wants its limping flagship (SKSEX)Special Equities fund to swallow its two other no-load funds, (SPEQX)Small Cap Value Plus and the barely 1-year-old Small Cap Contrarian, according to a proxy filed Monday with the Securities and Exchange Commission.

That'll leave the Chicago-based small-cap value specialist with just one retail fund and no current plans to offer more.

Skyline is among the roughly half of all fund companies that are experiencing net outflows this year, according to Financial Research of Boston.

As of Sept. 30, the three Skyline retail funds had $384.4 million in assets, and investors had withdrawn $147 million more than they'd invested in 1999, according to Skyline spokeswoman Michele Brennan. (Special Equities was closed to new investors until the end of last month.) The mergers will happen next February, pending shareholder approval.

When funds are merged, the fund with the strongest short-term record is usually the survivor. (See our series, When Funds Collide.) But that is not the case here. Special Equities ranks 2nd out of 25 small-cap value funds over the past 10 years, according to Lipper, but it has faded over the past five years. While the two newer funds aren't necessarily shooting the lights out, both are thumping their older brother.

Flagging Flagship Skyline Special Equities ranks 2 of 25 small-cap value funds over the past 10 years, but it's been downhill since then
Fund	YTD return	1-yr. return	3-yr. avg. annual return	5-yr. avg. annual return
(SKSEX)Skyline Special Equities	-12.3%	-8.3%	5%	10.6%
(SPEQX)Skyline Small Cap Value Plus	0.3	3.3	7.5	12.6
Skyline Small Cap Contrarian	10.3	7.3	N/A	N/A
Lipper Small Cap Value Funds Avg.	3.1	7.7	7.6	12.8
Russell 2000 small-cap index	9.5	17.2	10	13.1
Figures as of Nov. 18. Source: Lipper.

"This decision was not based on short-term performance. Special Equities still has one of the best long-term records in its category," says Brennan.

Brennan echoes the filing's reasoning in saying that the mergers are simply aimed at consolidating the shop's portfolio-management resources on one fund. The familiar rationale is that focusing on one portfolio, as opposed to three, can boost returns.

The merger actually may be a refreshing change, according to Frank Armstrong, a financial planner with Managed Account Services in Miami. "You usually take the worst performer and make it disappear in a merger. Here they are saying they're going to focus on what they know and try to do better."

Anything might please Special Equities' current shareholders given the Bronx cheer they're giving the fund this year. Through Sept. 30, investors have voted with their feet, yanking $92.8 million out of the fund's coffers. It's left with $306.9 million in assets, as of Sept. 30.

Special Equities has opened and closed several times since its 1987 inception, usually to control steep inflows that outpaced manager William Dutton's ability to put the cash to work. But TheStreet.com reported that last month the fund opened for a different reason: to control cash flow in the face of steep outflows. Opening the fund could help Dutton balance the money streaming out the back door with new dollars coming in the front door. Brennan says it's too early to tell if investors are starting to buoy the fund with new investments.

Investors haven't beaten a path to the other funds' doors either. Skyline's $150 million retail fund outflows are considerable because the firm has just $835 million combined retail and institutional assets. Brennan says Skyline's institutional clients, unlike Main Street investors, are not heading for the exits.

The filing estimates that in the merger, Special Equities will get about another $77 million, raising its assets to about $384 million. In the past, the fund has closed at lower asset levels. It had just $219 million at the end of 1996, one month before it closed to new investors. But those were better days when redemptions weren't such a problem.

Aside from the performance issue, the merger makes sense. Although the funds have gone in different directions, they all follow similar strategies focusing on small-cap value stocks. Also, shareholders of the two smaller funds will pay lower expenses. Special Equities charges 1.47% annually, compared with 1.51% for Small Cap Value Plus and 1.75% for Small Cap Contrarian, according to Morningstar. The average small-cap value fund's expense ratio is 1.52%.

Armstrong says investors shouldn't worry about investing with a one-fund shop, but "the underperformance is something you need to be concerned about."

Current investors should consider better-performing funds with lower fund expenses, while weighing tax consequences, the fund's long-term record and Dutton's long tenure, Armstrong says. Dutton has managed the fund since its inception, and was Morningstar's manager of the year in 1992.

On the other hand, the fund could be primed for a turnaround, Armstrong says. He's not alone.

"Maybe they just didn't have the resources to run three portfolios and keep good ideas in each. Maybe stepping up the firm's focus will improve performance," says Jim Folwell, a consultant with Boston-based fund researcher Cerulli Associates.

If Special Equities does stage a comeback, though, it will have to do it without Small Cap Contrarian manager Daren Heitman. Small Cap Value Plus manager Ken Kailin will join Dutton on Special Equities, but Heitman, whose fund tops its two siblings over the past year, will leave the firm following the merger.