Morningstar: Old Mutual UK Select Mid Cp Acc Fund

Old Mutual UK Select Mid Cp Acc fund is losing its star manager, but that doesn’t mean investors should be rushing for the door.

Chetan Modi, fund analyst at Morningstar, comments: Richard Watts, who will be taking the helm of this fund when Ashton Bradbury steps down at year end, has a tough act to follow. Bradbury has been one of the more successful UK equity managers in his tenure here. That said, we believe Watts is a good choice to helm the offering. He joined the Old Mutual UK Mid and Small cap team as an analyst in 2002 and was appointed deputy manager for the mid cap fund in July 2006. Watts has also been co-managing a segregated mid cap mandate with Bradbury since November 2006, so he should be well versed in this fund’s investment process.

We are further encouraged that Bradbury will still have some involvement in the fund, albeit from a higher level. Under Bradbury, the fund's process has incorporated a macro-economic view on which areas of the market are the most attractive, and Bradbury will continue to chair the group that determines that view.

While we don’t think investors should be overly concerned about the management change at this fund, we have also seen a number of recent management changes on Old Mutual’s other funds, as well as changes at the top of their quant strategies team. We believe the small/mid-cap team should be reasonably isolated from the impact of these other changes, as the team operates as a largely autonomous unit in terms of research. However, we'll be keeping a close eye on the situation.

We would in any case stress the inherent risks that this fund harbours. After a few years of benign market conditions, a tough market environment materialised in mid-2007 and mid-caps bore the brunt of the downturn. The FTSE 250 ex Investment Trust index posted a hefty loss of 18.37 per cent from 1 June 2007 through to 31 January 2008, although Bradbury managed to limit this fund's loss in the period to just 14.65% with smart moves to raise cash and cut property and financials exposure.

The road ahead for this fund is far from far from clear. Now that lenders are less willing to finance deals and growth than they were in the past, a source of capital appreciation has been removed from the market. Moreover, mid caps typically have higher volatility than large cap issues, and can be punished in downturns as investors flee to the perceived safety of large-cap issues as we have seen by the fund's performance in the second half of 2007.

There are always worries when a manager of Bradbury's calibre leaves a fund to which he has contributed so much, and rightly so. Until we see more of what Watts can do, his execution will remain open to question. We think Watts has gained sufficient experience under Bradbury to make it worthwhile for investors to stay on, but we retain our previous view that it might not be the best time to be adding to one's holding in mid-caps.

Strategy

Ashton Bradbury blends top-down and bottom-up approaches to pick out those companies which are or he believes have the potential to exhibit strong earnings and high cash flow yields. The investable universe is those companies which fall between the FTSE 100 and the Hoare Govett Smaller Companies index a market capitalisation of £500 million is usually the lower limit. He also looks for companies that have the potential to be re-rated as a result of strong growth and greater financial stability. Bradbury will use recommendations from sell-side analysts and carry out modelling work on a company's earnings and cash flows after his assessment of its management and top-down sector view. Old Mutual announced that Ashton Bradbury will step down at the end of 2008, and that this fund will be managed by Richard Watts from the beginning of 2009. While this is obviously a great loss for shareholders given the success and experience of Bradbury, we think Watts is a suitable candidate to run this fund. Watts was a senior associate in the investment management division of PricewaterhouseCoopers before working as an equity analyst at Orbis Investment Advisory for two years. In 2002, Watt joined the UK Mid and Small cap team at OMAM as an analyst and then became deputy manager of this fund in July 2006 - he has also been managing a segregated UK small and mid cap mandate with Bradbury since November 2006.

The fund does not have any formal limits on its sector exposure but Bradbury is cognisant of heavy overweight positions and the risks these pose to the fund. Bradbury will cut holdings if a sector's prospects look less favourable or if a company misses its earnings target or announces an earnings shock. In order to manage risk, he will limit the fund's exposure to a single company at 3% and will not own more than a third of a company's total stock. From 2009 onwards, Richard Watts will run the fund. We don't anticipate large changes to the fund's strategy, but he will hold slightly fewer stocks (around 70-75 holdings) in the portfolio by taking out holdings which account for less than 0.5 per cent of the fund.

Management

Bradbury has been appointed to the newly created position of Head of Equities at Old Mutual Asset Management but he will continue to chair the UK mid- and small -cap team monthly investment strategy meetings that set the macro view for this fund. As part of the reshuffle in the UK small and mid cap team at OMAM, Dan Nickols, manager of Old Mutual UK Select Small Cap will take over from Bradbury as the Head of OMAM's small and mid cap team from 1 January 2009.

In recent months we have also seen a number of further management changes on Old Mutual's Asian Select, Select Managed, Global Dynamic, Extra Income and Global Strategic Bond funds, as well as changes at the top of their quantitative strategies team. While we do not believe that these changes specifically effect the management of this fund we continue to monitor any changes that may affect the group's overall capabilities.

There is a total of £1.7bn in assets currently being managed across the desk. Senior members across the desk participate in revenue share agreements across all the funds. We think OMAM could do better in aligning the interests of fund shareholders and managers. The incentives in place emphasise revenues derived from the fund rather than creating shareholder value through outperformance. We like that OMAM are willing to cap funds once capacity becomes an issue but they have also shown a willingness in the past to raise management fees to protect their revenue streams.