This is an often-overlooked aspect of investment analysis.
A version of this article was published on Sept. 9, 2011.
Many citizens take the election of government officials quite seriously, as they should. These elected officials will go to Washington, D.C., or to our state capitals in an effort to represent us and our political beliefs. They are tasked with making hundreds, if not thousands, of decisions that will affect our everyday lives. In making these decisions, they should embody the interests of the citizens that elected them. At least, that's the ideal on which our electoral system is based. This is also the ideal for the board of directors of a closed-end fund, but shareholders take these elections far less seriously.
First and foremost, many investors don't take the time to vote on any of the important issues affecting their funds. Those that do often rubber-stamp the status quo or the board's recommendations. If the board of directors is qualified, has performed the appropriate due diligence, and has demonstrated that it has shareholders' best interests in mind, voting with the board may be the right decision. But I would venture to guess that most shareholders don't even know the number of directors on a given fund's board, much less whether or not the directors are qualified or have made decisions in the past that have shown their alignment with shareholders' best interests.
Most investors find corporate governance issues a dry distraction from the far more interesting and dynamic analysis of discounts and premiums, distribution rates, and investment performance. But the directors, if they truly take their fiduciary responsibilities seriously, should significantly influence these aspects. Ultimately, a fund's success or failure lies with its board of directors, and yet many investors couldn't care less about their ability to influence that board. For long-term shareholders--the owners of the fund--such negligence makes little sense.
Barry Olliff, chief executive officer and chief investment officer at City of London Investment Group, periodically revises a white paper discussing his views on corporate governance in CEFs. The most recent revision was released in November 2013 and is available here. Olliff has considerable credibility on this topic. Not only has he been investing in CEFs for half a century, but his firm invests in funds and then attempts to persuade those funds' directors to implement more shareholder-friendly policies.
We agree with many of Olliff's criticisms of boards of directors in the United States. For many directors, the norm is often serving on hundreds of boards, with no specialized breakdown of functions, which means a single fund may have only minutes devoted to a discussion of it each year. This is because many boards meet in person just once or twice a year for usually one full day. Aside from time constraints, there are a number of other important issues we believe investors should pay close attention to when evaluating a fund's board of directors.
That many directors adopt a do-nothing attitude regarding persistent discounts or premiums is just one quite troubling aspect of director inaction. Many boards proclaim that if they institute discount-control mechanisms, they are supporting short-term shareholders and harming the interests of long-term shareholders. We find such arguments mind-boggling, as all shareholders would benefit from a lower tracking error. And yet, with regularity, directors issue press releases rehashing their status-quo proclamation that long-term investors don't care about discount-control mechanisms. They may as well state that their fund isn't interested in enabling its investors' asset-allocation and investment-objective needs. Let's face it: Allocation of capital to a CEF is an exhibition of faith that the CEF will perform alongside--if not outperform--the underlying asset class; given director insensitivity to tracking error (large premiums and discounts), such faith is often misguided, to say the least.
A strong board of directors will not only establish but also implement discount-control mechanisms. A common practice is for a fund to participate in a repurchase program if its discount remains wider than a pre-established level during a stated measurement period. It's also important for directors to address persistently high premiums. As a premium increases, the fragility of that premium escalates, which means there is a much greater risk of a crash. In other words, the share price is more likely to fall (usually because of negative market sentiment) even if the underlying portfolio's net asset value stays the same, increases, or drops more slowly than the share price.
There is also the problem of funds (and directors) providing minimal information to investors and providing it in a less-than-timely manner. In fact, most funds clear the absolute minimum hurdle to meet regulatory compliance. Shareholders benefit from direct and frequent communication with the board of directors and managers. Most fund companies regularly communicate with shareholders through press releases and annual reports, but shareholders should have an avenue to ask questions of and hear from directors as well. This is typically allowed at annual shareholder meetings, but many investors cannot travel to attend such meetings. Considering the availability of webcasts, video conferencing, and the like, CEFs should hold regular conference calls with at least one representative from the board (along with managers), allowing shareholders to ask questions. Of course, we are not advocating for the violation of Regulation Fair Disclosure, which prohibits CEFs from discussing nonpublic information, but boards and managers should be more open to answering appropriate questions directly from shareholders. Many funds do hold regular management calls, but most do not include board members and many closely monitor audience participation.
Cozy Relationships With Managers
The relationship between a manager and the board of directors is especially important. If a manager is not performing up to par, the board should not hesitate to take action. In the real world, however, this is a very rare occurrence--at least in the U.S. A truly independent board with no ties to the manager or the fund company would be better equipped to make such a tough decision. Olliff believes (and we agree) that directors should lay out clear measurable criteria for manager evaluations and share these expectations with shareholders. A manager is, after all, under contract to run a portfolio. If he is unable to do so successfully, the board should not hesitate to fire that manager. While this is difficult to judge as an outsider, shareholders can look at past decisions made by the board to determine whether it has the tendency to push back.
Perhaps the most shocking issue that we have come across is the lack of share ownership by directors. Unfortunately, it is the exception rather than the rule for board members to own shares of the funds for which they are fiduciaries. With little to no share ownership, how can directors' interests truly be aligned with those of shareholders? Board members who do own shares tend to own insubstantial amounts--it is overwhelmingly the case that total share ownership for a board as a whole is less than 1% of outstanding shares. Share ownership by board members is as important as ownership by managers, as both are making decisions that will impact shareholder value.
Usually, a board's structure is classified, which means there are different classes, or groups, of directors. This allows boards to stagger term expirations, which can insulate the fund from a takeover attempt. A typical director's term is three years, and they are usually up for re-election by shareholders after each term expires. In addition, while most investors believe that directors are elected into office by a majority of shareholders, this isn't actually the case. Directors are often re-elected by a plurality voting standard, which means the candidate receiving the most votes gets elected. For example, if half of the shares were not voted and a candidate received 26% of the shares voted, he or she would win re-election. Under a majority voting standard, the candidate would have to receive 50% plus one of all outstanding shares to win the vote. Because many investors do not vote, the majority standard is considered to be more stringent and less commonly used. In general, we prefer to nonclassified boards, where the entire board is up for re-election yearly, as we believe this is a good antidote for director entrenchment. We also like to see majority voting standards, as we believe every shareholder vote matters and that this standard makes proxy proposals more difficult to pass.
Boards have a responsibility to shareholders, and shareholders have a responsibility to be active investors. To get started--or for a refresher--I encourage everyone to take the time to read Olliff's paper. Ensuring that your directors are acting in your interests benefits all investors.