Heartland and a Matter of Trust

Heartland Value has been getting a lot of attention lately. And why not? The fund (symbol HRTVX) returned 28% last year, putting it in the top 1% of funds that specialize in undervalued small companies. It has fallen 1% so far this year through Jan. 19, but most other small-company value funds are down, too.

And Heartland Value is hardly a flash in the pan. Over the past ten years, it has returned an annualized 14.5%, putting in the top 11% of its peer group. Since Bill Nasgovitz launched the fund in late 1984, it has returned an annualized 16% -- an average of four percentage points per year better than the small-company Russell 2000 index, according to Morningstar.

And there are other reasons to like this fund. Nasgovitz, 62, has been investing for nearly 40 years, and his Milwaukee-based firm runs just three other funds, all specializing in value investing. They aim to do one thing well, which is a hallmark of many first-class fund companies.

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On most counts, Heartland Value is the kind of fund that inspires me to do cartwheels. On most counts. Not, unfortunately, on all counts.

The bad news: Nasgovitz, the firm's president, was at the helm in 2000 when two high-yield muni funds blew up. That was six years ago, notes Aaron Picard, the firm's affable public relations spokesman. But I have trouble overlooking it.

It turned out that the recorded prices on many securities in the two funds were much higher than what they could actually fetch in the marketplace. Consequently, Heartland was forced to slash the price of each fund twice in just over two weeks. The net loss to shareholders: $93 million, according to the Securities & Exchange Commission. (Heartland maintains that the losses totaled less than $70 million.) After a class-action lawsuit was filed, Heartland agreed to pay shareholders $14 million.

The SEC's original charges were devastating. It alleged that Nasgovitz tipped off some buddies in advance that Heartland was going to mark down the funds' prices, and they responded by selling their shares. Last fall, however, a federal judge in Wisconsin threw out the allegations of insider trading.

Still outstanding are charges by the SEC that Heartland officials knew the bonds were mispriced but deliberately kept that fact secret. In its complaint, the SEC says that an e-mail to Nasgovitz dated one month before the funds were re-priced warned that the funds' share prices should "expect to take a 20% haircut." The SEC alleges that Nasgovitz and other Heartland officials "tried to cover up their pricing fraud."

Nasgovitz denies the SEC charges. He blames the problems largely on a bear market in high-yield munis and structural flaws in the high-yield muni marketplace. Many of these securities trade so infrequently that it's difficult and sometimes impossible to get an accurate market price on them, he says. Nasgovitz says his firm did the best job that it could, but obviously didn't do a good enough job. "We're embarrassed," he says. "We didn't live up to our responsibilities."

Heartland continues to dispute the charges. And its victory on the insider-trading charges raises questions about the validity of the entire SEC case. The judge said the SEC's work on the insider-trading charge was sloppy. Still, I want to see what happens to the rest of the case.

Heartland Value was one of my favorite funds back in the 1990s. I grew concerned, however, that Nasgovitz might have been growing more interested in building an empire than in managing money. That's a phenomenon I've seen with several talented money managers. Mario Gabelli is the name that springs to mind first. Ron Baron seems to suffer from a lesser form of that same ambition.

Nasgovitz had no business starting a junk muni fund, even if he wasn't managing it. That's easy to see in hindsight. But that's a mistake that's easily forgiven -- especially since Nasgovitz agrees with that judgment. He seems to be doing a good job of sticking to his knitting nowadays.

That said, Nasgovitz should have closed Heartland Value by now. The fund has $2 billion in assets -- an awful lot for a fund that often buys the smallest of small caps. But without the SEC charges, I'd count the asset growth merely as a concern in an otherwise first-class fund. After all, performance remains sparkling.

Nothing, however, in mutual fund investing is more sacrosanct that the accuracy of its daily pricing. If even half of what the SEC says about the management of the Heartland muni fund is true, I'm leery of the entire operation. Why invest with a shop you can't trust?

Steven T. Goldberg is an investment adviser and freelance writer.