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Five Suggestions for American Funds' Directors

How the funds' trustees could be fighting harder for shareholders.

Paul Herbert, 04/10/2006

Below is an excerpt from the February issue of the Morningstar Fund Family Report on American Funds. To review a risk-free trial issue, click here. Fund Family Reports on Fidelity and Vanguard are also available.

Like public companies, every mutual fund has a board of directors charged with looking after shareholders' best interests. In the aftermath of the fund-trading scandal, it became clear that some boards might not have been taking their duties seriously enough.

I've looked at the trustees of the American funds, and overall, I have a favorable opinion of the job they're doing. For one, there are different boards for the respective funds, so in general each member oversees a manageable number of investments. And, as of 2005, each fund has an independent chairperson, which, in principle at least, lessens the influence that the fund firm has over the board's thinking.

So as far as director quality goes, I think investors in the American funds have gotten a pretty good deal. I still think the boards could be fighting even harder for shareholders, though, and below I've laid out some suggestions as to how they could do so.

1. Get Serious About Asset Size

It will come as no surprise to regular readers that I'm taking up this matter first. I've written much about asset size at American, but with the unprecedented rapid growth and large sizes of many of the funds, I would be derelict in my duty as a mutual fund analyst if I didn't bring it to the boards' attention. The boards have discretion to close the funds and should bear responsibility if they falter as a result of their girth.

American Funds Growth Fund of America's AGTHX board indicated in the fund's most recent annual report that in reviewing Capital Research and Management's advisory contract, it considered "the ability of its organizational structure to address the recent growth in assets under management."

But I think the trustees of Growth Fund of America and other bulging funds should further inform shareholders of the specific metrics it has looked at to conclude that all's well on the size front. For instance, has the board looked at the individual portfolios that make up each fund and determined whether they are at or near capacity? Has the board evaluated whether any of the portfolio counselors on the fund is overextended when her or his responsibilities at other funds are taken into account? Has it contracted with outside sources to study the impact of a fund's trades on its performance? It's hard to tell from the statement above whether this important work has been carried out.

Ultimately, the board is responsible to current shareholders, whose performance may be compromised because the advisor is getting saddled with additional assets. The trustees must indicate that they have the statistical ammunition--and willingness--to step in and close the funds, even if it's an unpopular move with Capital Research and Management and some of its constituents.PAGEBREAK

2. Evaluate and Discuss Personnel Decisions

American's vast investment staff and multiple decision-maker style means that manager changes are rarely as worrisome as they are at competitors' funds. But that pleasant situation doesn't acquit the boards of asking tough questions about the firm's decisions to add or replace individual managers. In fact, it may be more important at American right now because the rosters of skippers at its growing funds seem to be changing somewhat quickly, and retirements have led to manager changes at funds that have not been as popular, too.

For example, the board should interview any new managers and the executives who appointed them. In communications with shareholders, the board should discuss the new manager's strategy and how it may impact the fund's profile.

3. Champion Better Disclosure

I'd like to see the board push for more and more timely information from American Funds, particularly relating to managers' names, biographies, and personal investments, as discussed below.

Rapidly growing funds often add new managers as assets come in, but the Securities and Exchange Commission only requires the firm to disclose the names of those fiduciaries overseeing at least 5% of assets once a year in a new prospectus. I don't mind if I don't know the name of a manager running a very small sliver of assets--a list of 20 or so names may be information overload. But I'd like the firm to let me know of the new manager's vitals as soon as she or he is running a significant amount of assets, rather than simply once a year as is currently required.

And, while American's managers are among the best in the business when it comes to investing in their own funds, I'd like the tables in the funds' documents to include information about each individual's investment across all funds in the family. Some other firms offer that information, which helps to show a manager's commitment to the firm's discipline.

4. Reconcile Pricing Discrepancies

Relative to other firms, American Funds has done a much better job of passing on its significant economies of scale to shareholders. The funds' expense ratios are much lower than those of similar offerings that carry sales loads, thanks, most recently, to two waivers that reduced management fees by 5%. Another factor contributing to the downward trend in fees: The board has also annually added new management-fee breakpoints at higher asset levels.

So why am I complaining? Because I don't understand why some larger funds cost more than some smaller offerings do. As an example, Growth Fund of America, with $128.3 billion in assets, carries an expense ratio of 0.66% of assets, while $16.9-billion American Funds American Mutual's AMRMX annual costs come in at 0.56%. I suspect that the difference arises from the fact that the boards of the respective funds examine their fees relative to those of the median fund in its category, and in this case large-value funds such as American Mutual are considerably cheaper than large-growth funds such as Growth Fund of America.

Of course, there isn't any reason why a growth fund should be more costly than a value fund. The board should recognize this convention's artificiality, and reduce its growth funds' management fees.

5. Take Pay in Fund Shares

American's board members typically invest greater amounts in the funds they govern than they receive in annual remuneration, which is the financial standard that we apply to determine if boards are motivated to pay close attention to shareholders' wishes. But I still think the best way to ensure that directors' incentives and shareholders' interests are aligned is for trustees to take their pay in fund shares. Such a compensation scheme would force directors to have even more skin in the game, further aligning their interests with those of fund owners. It would also be an expedient way to help directors who do not invest much in the funds (such as new board members) to meet our benchmark.

The board of one firm we follow not only pays its directors in shares, but also bars them from selling their shares as long as they serve on the board. If American's boards wanted to be at the cutting edge of their profession, they would follow this firm's lead.

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