When Neil Hennessy launched the Hennessy Funds 10 years ago, he knew that to stack up against the 8,000 competitors already in the game, he'd need to come up with a unique investment story.

"The challenges to entry in 1996 were the same as they are today. How are you going to distinguish yourself?" said Hennessy, who serves as president and portfolio manager of the six-fund family, as well as chairman and CEO of Hennessy Advisors of Novato, Calif.

For Hennessy, that differentiation was quantitative analysis, which in the mid-1990s was still a relatively obscure investment strategy. But unlike most quantitative analysis, which is empirical and highly complex, Hennessy's process uses simple formulas that even the layman can grasp. Those formulas are contained in the firm's fund prospectuses and posted at its website.

"What you see is what you get, and nothing can be changed without a shareholder vote," Hennessey said.

That straightforward approach has paid off, as the firm now boasts four Morningstar-ranked products and just over $2 billion in assets under management.

Industry-wide, however, Hennessy's story is becoming rarer every day, experts say. Not only are fewer entrepreneurs joining the game, more players are exiting. According to the New York-based consulting firm Strategic Insight, 15% of the fund managers that existed at the end of 2002 - some large, but mostly small - are no longer in business. In that same period, more than 1,300 portfolios were similarly liquidated or merged.

The Big Three

And hulking giants like Fidelity Investments, Vanguard Group and Capital Group's American Funds have been picking up the pieces. Collectively, according to Lipper of New York, the "big three" now manage close to $3 trillion of the $8.6 trillion in assets under management across 520 open-end mutual fund firms. That's nearly twice what the three firms controlled in 2000.

It's a shame, too, experts say, because small fund shops typically deliver superior performance. They're also a breeding ground for innovation and oftentimes are home to the industry's next star portfolio manager.

It's also a surprising development, because the industry itself has relatively few barriers to entry. Infrastructure costs, for example, have always been low. An abundance of third-party service providers allows entrepreneurs the time to focus exclusively on investment management and asset gathering. And a sharp increase in distribution channels in recent years, as well as the proliferation of the Internet, has given fund firms access to customers like never before.

"In today's marketplace, smaller fund shops have a real tough go of it," said Tim Armour, a managing director at Morningstar, during a recent conference discussion on the topic.

"Think of what it was like when we tried to get into college and compare it to today," he continued. "You can't make the grade any longer just because you're good at tennis and you got straight As in biology. You have to be good at everything."

Avi Nachmany, director of research at Strategic Insight, points to an overly price-sensitive consumer and the ability of big funds to take a page from the playbook of smaller funds.

"It has become difficult to be successful in this business when the only thing you have to deliver is beta and above-average costs," Nachmany said. At the same time, he added, "bigger firms, like American Funds and Vanguard, have experienced rapid growth through well-articulated investment processes," an expertise normally reserved for the smaller guys.

Hennessy admits that economies of scale, as well as deep marketing pockets, favor the big guys. But he also thinks too much is made of expense ratios, and smaller funds would be well served by underscoring that fact when they tell their investment stories.

"Charge what you want to charge," Hennessy said. "People are going to go with you, or they're not going to go with you, depending on net return."

For example, the Growth Fund of American at American Funds controls about $140 billion and has an expense ratio of 0.66%. A four-star Morningstar fund, it's beaten the S&P 500 over the last five years by 5.15%. The Hennessy Cornerstone Growth Fund, which also touts four stars from the Chicago fund tracker, has less than $1.5 billion under management and a much higher expense ratio of 1.23%. But it's up on the S&P 500 over the last five years by 15.19%, according to performance figures net of fees from Morningstar.

Performance, however, can be ephemeral, and with fewer products to offer as an alternative, smaller funds would again seem to be at a disadvantage. But Hennessy said small funds can overcome this disadvantage by communicating regularly with their shareholders. He recalled the bull market of 2000, "when people were throwing money into mutual funds" but had little investing experience. When the bear market arrived in 2001 and 2002, the losses scared many of them out of the market.

"Fortunately, we were able to make money in those markets, but the difference was people stuck with us because they knew how the money was being managed," Hennessy said.

If anything is tripping small funds, he said, it's an unfair regulatory environment.

"We didn't cause the problem in the mutual fund industry, yet we have to play by the same rules and it costs us more," said Hennessy, who thinks the future is bright for small funds that can control their operating costs.

Dave Mertens, a principal, marketing chief and the head of sales at Jensen Investment Management of Portland, Ore., which oversees the Jensen Portfolio, doesn't think small funds are out of favor, either. In fact, he thinks the trend is headed in the opposite direction.

"Over the last few years, there's been a resurgence in the popularity of small firms," Mertens said.

Ironically, he said, small funds have the scandal to thank. Sure, the regulatory measures have been expensive and they present a significant hurdle to newcomers, he said, but intermediaries can more easily get their arms around a smaller company.

"A broker/dealer, for instance, can really get to know a company of our size and turn over all the rocks," he said.

The Jensen Portfolio, a four-star Morningstar fund with a relatively Spartan expense ratio of 0.85%, was created in 1988 as a means for Jensen's high-net-worth clients to access the firm's investment discipline. The advisor previously focused on private wealth management.

To appeal to everyday investors, the firm stresses that it's an independent, employee-owned shop that "doesn't have to listen to the bad ideas of a parent company," Mertens said. The firm also underscores its "proven and distinct" investment process, which focuses on companies with 10-year track records. It only invests in 25 stocks. But while the firm has been successful telling that story - assets under management have gone from $100 million in 1996 to $2.2 billion today - Mertens said the firm has to be selective about which distribution channels it chooses.

For example, a fee-based platform within a broker/dealer works nicely for Jensen, but only if the firm is conducting its own analysis. Jensen simply doesn't have the manpower to travel around the country selling itself.

"It really depends on the decision-maker at the wirehouse," Mertens said.

Barry James, president of James Advantage Funds in Dayton, Ohio, said distribution is a significant challenge for his firm, too. The family of four funds, which will launch a fifth mid-cap product in the coming year, isn't on any major wirehouse platform but recently hired a wholesaler to focus exclusively on the registered investment advisor (RIA) channel.

James said one reason the fund shop likes the RIA channel, versus direct sales, is that "they don't turn away when the market goes down." But one of the best moves the firm has made in recent years is hiring a dedicated marketing executive. As a result, the James Advantage Funds name is appearing in the media more often, and that's helped drive an uptick in sales.

"I don't want to say we're a bunch of nerds and geeks around here," James said in an interview prior to appearing on CNBC's Kudlow & Co., "but we really enjoy research and analysis. Marketing has never been our strong suit."

(c) 2006 Money Management Executive and SourceMedia, Inc. All Rights Reserved.

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