A guide to the Statement of Additional Information.
This article originally appeared in the June/July 2012 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
At face value, the SEC’s Form 485BPOS seems dry. Stretching dozens of pages, funds’ annual Statement of Additional Information is mostly skimmable. OK, skippable. But like diamonds, truffles, and other gems, there’s good stuff under the surface. Patient investors will find within the SAI important information.
1 Make Control+F Your Friend
To get to the juicy bits, employ your computer’s “Find” function. That will surface a word-search function so you can skip to the parts of the filing that are most relevant to your research.
The first stop is “fund manager incentives.” The SAI details, for example, how much fund managers invest in the funds they run. The ownership is expressed in a range, starting at zero and maxing out at more than $1 million. Morningstar considers ownership in the top, more-than-$1-million range to be an industry best practice. After all, the industry negotiated these disclosure ranges with the SEC when ownership reporting was first required in 2005. That said, most fund managers invest nothing in the funds they manage. That’s less true for equity funds, more true for bond funds.
To be sure, there are good reasons why managers don’t make big investments, especially if it’s a niche fund like a short-term bond fund or a sector-specific equity fund. And managers who reside outside the United States may not purchase fund shares. But these exceptions are relatively rare and usually aren’t applicable to the many core stock and bond funds for which there’s no manager ownership. What’s more, Morningstar finds that managers who invest heavily in the funds they manage— in that more-than-$1-million range—tend to run funds that have done very well and have lower fees. As such, it seems reasonable to ask, If the fund managers aren’t eating their own cooking, should your clients be?
2 Find How Managers Get Paid
Funds also are required to describe in the SAI the criteria used to establish the fund managers’ compensation. Some descriptions are more thorough than others, and there’s usually more detail about the criteria for the managers’ bonus than for salary, which typically is a smaller portion of the managers’ annual compensation.
The description of the bonus criteria can help you determine whether the fund managers’ financial incentives and your clients’ financial incentives are aligned. If a manager is getting paid based on his fund’s assets under management, for example, he is probably a lot more interested in how his fund is marketed than is a competitor who is evaluated primarily on his fund’s long-term returns.
The SAI also may detail whether the fund manager’s bonus may include an equity award in the fund’s advisor. Sometimes, the equity is shares in a publicly traded company, but in other cases, it’s phantom stock or a partnership in a private firm. In any event, such equity stakes can help retain management talent, but they also can introduce conflicts of interest, particularly when it comes to growing funds’ asset bases or introducing new funds, neither of which always benefit current shareholders.
3 Dig Into Board Pedigree
The SAI also lists who is on the fund’s board of directors. The board has important duties. It negotiates the fund’s expense ratio on behalf of fund shareholders. It approves new fund launches, as well as mergers and liquidations. Most importantly, it votes whether to renew the fund advisor’s management contract each year. For this work, fund shareholders pay the independent directors fees ranging from a few thousand to hundreds of thousands of dollars.
The SAI names each of the directors, details their professional and other board duties, age, and compensation. These details should indicate whether the directors have relevant industry experience, making them wellequipped to govern a lineup of funds. The SAI also indicates whether the board is led by an independent chairman (an industry best practice) or an insider—usually an executive of the fund company.
A fund’s SAI disclosure doesn’t have all of the information you need to make an investment decision, but these details are worth tracking to make sure that the team behind a fund’s success shares with fundholders the same objectives and similar incentives.