First Light Funds, Coral Gables, Florida

Transcription

1 First Light Funds, Coral Gables, Florida February 28, 2007 To the Directors of the First Light Funds: What follows is a summary of the history and current status of the First Light Funds. While the First Light complex consists of 12 funds, the materials below focus on the three funds in the complex that currently have the most significant issues. These materials are intended to help you, the Board, prepare for the contract renewal process. The First Light Board holds two meetings as part of its 15(c) process the first is focused on analyzing the funds current situation and developing a strategy for dealing with management; at the second meeting, the Board acts on the contracts. You are about to convene for these meetings. Your goal is to develop strategies to deal with any performance- or expense-related issues that you identify with these three funds. In doing so, you should make use, to the extent you feel appropriate, of the tools, techniques and approaches that will be discussed in the plenary sessions. Some issues you might choose to focus on include: the role of risk in assessing performance; the appropriate time frame for assessing performance; what peer groups and benchmarks should be used to analyze fees and expenses; what (if any) is the relationship between the level of fees and the level of performance and what role profitability should play on the Board s evaluation of fees. You need not, however, limit yourselves to these considerations. Please keep in mind two things. First, while it may appear to be simple to identify how each of these funds should be fixed, you need to remember that you will also need to convince the management company that it should adopt the approaches you propose. As you identify strategies for addressing the problems you identify, you should also discuss what strategies you will employ to convince the management company that your proposed changes are also in their best interests and to deal with the concerns and objectives that management brings to the contract renewal process. Also keep in mind that, in the real world, you would ultimately be required to explain to shareholders what factors you considered in renewing the contracts. While you will not be required to draft that disclosure statement as part of this exercise, we do expect that each Mutual Fund Directors Forum: Directors Institute, February 2007

2 working group will ultimately discuss with the whole group what problems it identified, how it proposes to address those problems, and what strategies it will use to implement those solutions in its negotiations with management. * * * * * The Adviser - First Light Advisers ( FLA ) was a well-regarded boutique adviser that, in addition to a number of separate and institutional accounts, ran four domestic equity funds. Seven years ago, FLA was acquired by Davros & Company, a mid-size financial services firm. At the time of the acquisition, Davros offered three mutual funds to its clients. Davros, headquartered in St. Louis, focuses on what it sees as an underserved sector of the market individuals with between $500,000 and $5,000,000 in investable assets. The Fund Complex - Since the acquisition, Davros has increased the size and scope of the First Light Funds ( FLF ) complex; the complex now consists of twelve equity funds (specializing in various market sectors and market capitalizations) with total assets of about $30 billion. The $30 billion in fund assets represents around 40% of the total assets managed by Davros. The directors are aware that Davros is aggressively expanding the line of products that it offers its clients. These products range from separately managed accounts advised internally by Davros to alternative investments managed by third parties. Based on their ongoing discussions with Davros s management, the FLF Directors understand that: 1. Davros intends to continue to position the funds as key offerings to its clientele; and 2. Davros also intends to continue to distribute the funds through various fund supermarkets and other similar platforms. (About 70% of the complex s current assets come from Davros s own clients, while the remaining 30% of the assets have come in through other distribution channels.) As it has continued to expand its product offerings, Davros has also been upgrading the backoffice and compliance systems that support its operations. While the FLF Directors recognize that these investments have improved the operations of the funds, the consolidation of the various systems has also made it more complicated for the directors to evaluate how these shared costs are being allocated between Davros s fund operation and its other operations. This change is particularly relevant when the directors try to assess the reasonableness of the profitability methodology used by Davros to develop fund-by-fund profitability data in connection with the annual 15(c) process. The Board The FLF Board of Directors is comprised of seven Independent Directors and one interested Director. The interested Director is Charlie Hopkins, the CEO of Davros. Mr. Hopkins is an active participant at meetings and leads management s presentations on a number of subjects, including fees and expense data. John Davidson, Davros Chief Investment Officer, attends every Board meeting and leads the discussions of fund performance. The Board of 2

3 Directors meets five times a year. Both of its meetings in the second quarter focus on contract renewals. During the first meeting, the Independent Directors consider and discuss management s responses to 15(c) questionnaires previously submitted to management by Independent Directors counsel. The Board does not vote on any contracts during the first meeting. The second meeting is focused on management responses to questions and issues raised by the Independent Directors during the first meeting. The Board typically acts on the contracts during this second meeting. The information that follows and all accompanying materials are for the Board s consideration in connection with the coming meetings. * * * Jupiter Fund The Jupiter Fund, which was launched in January 1995, was the original First Light Fund. It has been managed by the same two portfolio managers since its inception. The comparative performance data presented to the Board indicates that the fund has strong gross and net performance against its peers for the ten- and five-year periods, but that its performance has lagged for the more recent three- and one-year periods. Over the past 18 months Jupiter Fund s performance vs. that of its peer group has declined significantly. The fund s performance against its benchmark (the S&P 500) has been competitive for each of the last five years. Jupiter Fund currently is described in its prospectus and in its marketing materials as focusing generally on established, large cap companies in the U.S. with strong growth prospects. Nonetheless, the fund s prospectus allows the portfolio managers to invest in equity securities of any market capitalization and from any geographic area. Despite this flexibility, the portfolio managers have historically invested (and continue to invest) between 80% to 90% of the fund s assets in securities of well-established U.S. companies. The fund does not invest in emerging markets securities, although it could. As a result of the investment decisions made by Jupiter Fund s two portfolio managers for the one- and three-year periods, the Fund has the lowest risk profile of any fund in its peer group. Jupiter Fund currently has assets of approximately $7.5 billion 25% of the assets in the First Light complex. In response to questions raised by the Board at prior meetings, management has noted that: the portfolio managers continue to invest in the same manner that brought them success during the first nine years of the fund, the strategy of investing mostly in U.S. securities is not currently in favor given the recent, relative strength of foreign markets, but that management and the portfolio managers are confident that performance will begin to improve as foreign markets loose some of their momentum, on a risk-adjusted basis, the fund s performance is competitive against that of its peer group, portfolio managers should be evaluated on a market cycle not on the basis of oneor two-year performance numbers, the comparative peer group into which Jupiter Fund falls does not provide an applesto-apples comparison because it is comprised of other large cap domestic equity funds that invest a higher percentage of their assets in foreign securities (typically 25% to 30%) including in emerging markets, and 3

4 a more meaningful comparative source of performance information might be the fund s benchmark, the S&P 500. In reviewing the comparative expense peer group performance provided by management, the Board has noted that Jupiter Fund s advisory fee and total expenses are in the fourth quintile. (The first quintile denotes the lowest level of fees and the fifth quintile denotes the highest level.) The Board also has noted the fund profitability data, which shows that Davros has an advisory fee pre-tax margin of 82% from its services to the fund. Davros management has indicated that, while it is confident that performance will begin to improve, it is willing to impose a fee cap on the fund s total expenses so that the fund moves from the fourth quintile to the third quintile of its comparative expense peer group. Davros is proposing to keep the expense cap in place until performance improves. With the fee cap in place, Davros has indicated that the fund s net performance for the one-year period would move from the fifth quintile to the fourth quintile. Davros also has noted that the fee cap would reduce its profitability from the advisory agreement to 51%. Saturn Fund The Saturn Fund is a fund that focuses on identifying mid-to-large cap securities that represent attractive growth or value opportunities. The fund has about $2.3 billion in assets. The fund, which commenced operations in December 2000, has strong gross performance, which lands it in the first quintile of the five-, three- and one-year periods as compared to its peers. Net of expenses, the fund s performance is in the second quintile. Prior to managing the fund, the portfolio manager worked at Davros as an emerging markets analyst for four years. During that time he was considered a superstar analyst and his reputation has been equally good as a portfolio manager. Under the fund s prospectus, the portfolio manager is permitted to invest up to 30% of the fund s assets in emerging market securities. During most of its existence, between 25% to 28% of the fund has been invested in those securities. Saturn Fund s advisory fee is below the peer group median, though that reflects the existence of an advisory fee cap. There are no breakpoints in the advisory fee schedule. The transfer agent expenses for the fund are high compared to those of the peer group because the fund has a large number of small shareholder accounts, which drive up the transfer agency costs. As a result, Saturn Fund s total expenses are in the fourth quintile. Management has told the Board that it would like to remove the advisory fee cap, in light of the fund s strong performance record. Without the cap, the advisory fee would be in the third quintile and the total expenses would be in the fifth quintile. Eliminating the cap would not change the performance quintile into which the fund s net performance currently falls (as noted above, the second quintile). With the fee cap in place, Davros s pre-tax profitability from the advisory contract is 60%. However, Davros notes that it heavily promoted Saturn Fund when it was first launched and that its profitability from the fund was quite low during those first few years. Compared to other funds in the complex, Saturn Fund has the highest proportion of assets originating from external distribution channels. Pluto Fund According to its prospectus, the Pluto Fund invests at least 80% of its assets in securities of small cap U.S. companies. The prospectus notes that a company is considered small if it has a market cap of $2 billion or less. The prospectus has used this definition of small cap 4

5 for the last 12 years. The fund s performance against its peer group has oscillated significantly throughout the years. The most recent comparative gross performance data reflects that, for the ten-year period, the fund is in the third quintile, for the five-year period the fund is in the first quintile, for the three-year period the fund is in the fourth quintile and for the one-year period the fund is in the fifth quintile. For the last two quarters, the fund is in the fourth quintile and management indicates that it expects to see continued, improved performance. The fund has performed competitively against its benchmark (sometimes slightly better and sometimes slightly worse) during every period measured. The Pluto Fund was the first fund launched by Davros 20 years ago. Though the analysts supporting the investment decisions for this fund have changed over the years, the fund s portfolio manager continues to be Peter Davros, the founder of Davros & Company. The analysts currently supporting Mr. Davros have been doing so for the past two years. While Mr. Davros s compensation is tied, in part, to the performance of the Pluto Fund, his performance also is tied to the performance of a number of separate accounts which he manages. Several of these separate accounts pursue small cap strategies and have performed strongly over the last five years. Mr. Davros also is compensated on the basis of his managerial contributions to Davros & Company, where he serves as President. In response to questions raised by the Board at prior meetings, Mr. Davros has noted that: he continues to be committed to the Pluto Fund, the analysts currently supporting him in managing the fund are bright individuals on whom he relies to help him make security selections, he will not disclose to the Board his compensation because that is a private matter that goes well beyond the Board s responsibilities in overseeing the fund, he spends approximately one-third of his time managing the fund, one-third managing the separate accounts and one-third attending to his responsibilities as President and CEO of Davros. The Pluto Fund s advisory fee and total expenses are in the third quintile of its peer group. Management is not proposing any changes to the advisory fee and its pre-tax profitability from the advisory contract is 67%. Net of expenses, the fund remains in the same quintiles noted above. 5