Shareholders of the Vanguard International Value Fund can expect to lose a greater percentage of their returns to tax distributions and costs associated with portfolio reallocation as a result of the firm's decision late last month to replace the fund's adviser, according to industry consultants and analysts.

The Vanguard Group of Malvern, Pa. announced July 28 that it fired Phillips & Drew of London, the fund's sub-adviser. The sub-adviser was replaced August 1 by Hansberger Global Investors of Fort Lauderdale, Fla. Vanguard reached its decision after the fund's board of directors reviewed Phillips & Drew's investment process and philosophy, the fund's performance and the firm's research and analysis procedures, according to John Demming, a Vanguard spokesperson.

The decision was made in the shareholders' best interests, said John J. Brennan, CEO and chairman of Vanguard.

Firing a sub-adviser is not common and is not done lightly by a fund company because replacing one is expensive and time-consuming, said Fred Schafer, CEO and president of Evaluation Associates of Norwalk, Conn., a consulting firm that specializes in helping funds select sub-advisers.

"The expenses have to do with changing the portfolio," Schafer said. "The incoming sub-adviser is going to hold a different group of securities and you will incur all of those transaction costs and that can be one to four percent of the assets. That can take a nasty bite out of your return. Those costs, in addition to the capital gains taxes incurred by reallocating a fund's portfolio, are ultimately shouldered by the shareholders."

Replacing an international value fund's sub-adviser is especially tricky because many of the securities held in the portfolio are illiquid, increasing the cost and the time it takes the new adviser to implement its portfolio strategy, Schafer said.

Engineering a smooth hand off from one sub-adviser to the next is also fraught with potential problems that can delay the transfer and keep the fund from operating.

"You have a lot of parties involved at the point of transition and you have to get all of those parties together which is not easy to do and that can be a huge problem," Schafer said.

One of the biggest risks in switching a sub-adviser is the down time in the fund's operations, he said.

"Any way you cut it, you'll be inactive in the market and if the market goes against you, you can take a hit," he said. "Some of the portfolio could be very illiquid stocks. I always hold my breath when we're doing a transition and hope the market is relatively calm."

Replacing a fund's sub-adviser can interrupt a fund's operations for up to a week, he said.

Because there are myriad pitfalls in the transition, Vanguard is very cautious about firing a sub-adviser and has an established procedure for evaluating them, said Demming. The firm has a group dedicated to monitoring the 24 Vanguard funds that are sub-advised, he said. The group watches for style drift and management and investment philosophy changes. Each sub-adviser's portfolio manager is required to meet with the funds' board of directors annually, he said.

Phillips & Drew may have been replaced because of poor performance in addition to changes that have taken place at the firm, said Roy Weitz, a financial advisor and publisher of Fund, a website that tracks manager changes in the fund industry.

"I think they just got nervous," he said. "They don't like change and if it's external change or style drift or portfolio turnover, it appears disorganized and disorganization is not conducive to good management."

Like other funds in the value category, the Vanguard International Value Fund has suffered from lackluster performance recently, according to Morningstar of Chicago. The three-star fund has lost 2.74 percent year to date as of Aug. 1.

"Its success depends on an ability to determine what will wake up a sleepy stock. The fund hasn't been right enough to make it a standout," according to Morningstar.

Performance coupled with UBS Asset Management's decision to combine the investment management and research departments of Phillips & Drew and UBS Brinson, both of London, could have prompted Vanguard to replace Phillips & Drew, Weitz said.

Phillips & Drew managed the fund for four years and had not changed its investment philosophy for the fund in that time, said Anne Baker, a spokesperson for UBS Brinson. While she declined to comment on why Vanguard replaced Phillips & Drew, she said the firm's merger with UBS Brinson was a big change, adding nearly 400 new employees to the firm.

Vanguard does not have high turnover of its asset managers and probably weighed its options carefully before deciding to replace Phillips & Drew, Weitz said.

"[Vanguard] doesn't want to look like idiots to their shareholders," he said. "They wait a few years to replace a sub-adviser unless there is something extraordinary. It's a marriage of convenience ... for public display purposes they need to look happier than they might be at any time."

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