A fund's sub-adviser can open new distribution channels, provide investment expertise, lend name recognition and, in some cases, create a conflict of interest, according to industry lawyers and observers.
Conflicts can sometimes arise when multi-managed funds hire an affiliated sub-adviser, said Geoff Bobroff, president of Bobroff Consulting of East Greenwich, R.I. Whether an affiliated sub-adviser has an advantage or is favored over an independent sub-adviser in the selection process is the crux of the issue, he said.
"The problem is people question the validity of the [selection process]," when there is an affiliated sub-adviser, he said.
Pressure to enhance earnings, industry consolidation and a growing trend to use sub-advisers to manage funds will raise the likelihood of conflicts between funds and affiliated sub-advisers, he said.
Situations in which managers fire independent sub-advisers and replace them with an affiliated sub-adviser are particularly suspicious, he said. That could produce a bait and switch situation in which shareholders invest in funds based on the sub-adviser and then discover that the sub-adviser has been replaced with an affiliate, Bobroff said.
That happened with Nvest Funds of Boston, he said. The firm replaced several independent sub-advisers to the company's star series of multi-managed funds with affiliated sub-advisers, Bobroff said.
In fact, last year Nvest filed a proxy statement with the Securities and Exchange Commission seeking to replace Janus Capital as an independent adviser and hire Loomis Sayles & Co. as an affiliated sub-adviser to its Star Worldwide Fund. Janus had sought to end its sub-advisory relationship with Nvest because it wanted, "to concentrate its assets under larger, more profitable advisory arrangements and because of their capacity limits in managing global and international assets," according to the proxy statement.
It also happened with a series of annuities offered by Alliance
Capital of New York. When Alliance purchased Sanford Bernstein, also of New York early this year, it fired T. Rowe Price of Baltimore, Md. as an independent sub-adviser to a group of its variable annuities, Bobroff said.
The number of multi-managed funds is on the rise and assets in them have grown from $86.8 million at the end of 1998 to $102 million at the end of last year, according to Financial Research Corp. of Boston.
Multi-managed funds do present the risk of creating a bait and switch situation using sub-advisers, said Mercer Bullard, founder and CEO of Fund Democracy of Chevy Chase, Md.
"You may have funds that have established themselves as having gotten all of these great outside managers and then what they do is sort of slip in the affiliate between the cracks for some of the funds," he said. "The bait and switch can definitely happen."
In all funds, there is an underlying tension between shareholders' best interests and the interests of the fund company, but there have not been any clear instances of companies using bait and switch tactics with sub-advisers, he said.
Moreover, the Securities and Exchange Commission needs to respect that natural tension, Bullard said.
"You don't want a rule that says you can't hire an affiliate if that would be the best deal and the managers need to find the best sub-advisers," he said. "You have to allow for the possibility that the best sub-adviser is an affiliate."
Many sub-advised funds have secured exemptions from the Investment Company Act of 1940 allowing them to make sub-adviser changes without shareholder approval. However, if an affiliated sub-adviser is added, the fund has to issue a proxy statement to shareholders seeking approval of the hire, Bullard said.
Most of the time, hiring an affiliated sub-adviser to manage a section of a fund poses no problems, but there are instances when it can present problems, said Pamela Wilson, a mutual fund lawyer with Hale & Dorr LLP of Boston.
"I don't think it's inherently inconsistent with the concept of a multi-manager fund to have affiliated sub-advisers," she said.
But if a fund markets itself as a fund that is independently sub-advised, or if shareholders are not aware that the sub-advisers are affiliated, better disclosure may be needed, she said.
"As a lawyer advising the fund, I would say if there's any doubt, you might want to get shareholder approval," she said. "You usually resolve doubts in favor of playing it safe."
That might not be a bad idea given that some regulators at the SEC take a more narrow view on the issue, according to Barry P. Barbash, a partner with Shearman & Sterling of Washington, D.C. and former director of the SEC's division of investment management.
"I think it goes back to what the person wanted when they were sold the fund," he said. "It really depends on how the funds are marketed."
