SEC Provides Big Win for Fund Investors

The SEC handed fund investors a huge victory Wednesday by requiring disclosure of fund managers' investments in their funds and their bonus structures. This information will be quite useful in helping investors find managers whose incentives are aligned with theirs. In fact, many fund investors have told us this is the piece of information that they would most like to see. In a Fund Spy poll conducted in January 2003, 74% of readers said they'd value added disclosure on incentives and bonus structure while just 3% said no new disclosure was needed.

The Details So Far
The official rules have not been published, so not all of the details are available yet, but this is what we know so far.

The rules will require that managers disclose their investments in their funds in bands with the top band being $1 million and over. Fund companies will also have to disclose the structure for portfolio manager bonuses. For example, a manager might receive a bonus equal to 100% of her base salary for producing top-quartile pretax returns over the trailing three years. Another manager might be compensated based on growth in assets. Taken together, it's a good bet the first manager would push to close her fund to new investors sooner than the second. Put another way, portfolio managers are profit maximizers, and they manage their funds with bonuses and their investments in their funds in mind. Thus, this information will prove very helpful to planners, brokers, and investors alike in assessing the suitability of a particular fund.

In order to keep the requirements manageable, the SEC opted to limit the management-incentive disclosures to a fund's top five managers. As part of this, fund companies will have to disclose those managers' names and will no longer be able to list funds as being "team managed." Further, the SEC will not require disclosure of incentives at other accounts managed by the portfolio manager. The SEC will require, however, that the fund companies disclose the other accounts run by the top five portfolio managers and the total dollar value of assets run in that strategy.

This last point will be a big help for investors who want to get a handle on whether a manager is running too much money. Sometimes it appears from the fund level that the manager has a modest sum of assets under management, but he or she actually could be running much more in the identical strategy in separate accounts or other funds.

Overall, we believe these new rules will have a strong cost-benefit profile. While some proposed rules, such as the hard close, could be potentially costly for fund firms, manager compensation and investment information is readily available to the fund companies, and the SEC's staff estimates it will cost just $840 per fund to add this disclosure.

A Vital Service to Investors
In effect, the new rules will provide fund investors with vital information similar to the information on insider sales and CEO bonus structures that has long been available to stockholders. In fact, over the years, hundreds of fund managers have told us how important it is to them that a company's top managers "eat their own cooking."
 
Some have agreed that the same principle should be applied to fund managers. When Jason Yee took over  Janus Worldwide , for example, he pledged to "commit to investing substantial capital alongside my fellow shareholders in the Fund to align our interests." Many other managers, including Bill Nygren of  Oakmark (OAKMX), Mason Hawkins of  Longleaf Partners (LLPFX), and Chris Davis of  Selected American (SLASX), have said they have aligned their interests with shareholders by investing large sums in their funds.

Morningstar has been a strong advocate for more manager/shareholder alignment, and has been pushing for more disclosure for years. (See past columns in June 2003, January 2003, and August 2001; our comment letter with the SEC; and our testimony before Congress.)

We've heard two rather weak arguments against providing this information. First, some have said that managers of specialized funds such as gold funds or single-state muni funds shouldn't be required to invest all their money in their funds. We agree, and no rational person would disagree. In fact, the rules don't require investment in the funds, and fund companies will be able to explain why a manager doesn't invest in his or her fund in their filings. We've also heard that it would be an invasion of privacy. But mutual funds are technically publicly traded investment companies with thousands of investors. If you choose to run a public company, whether it's a fund or another type of business, you have to recognize that the rights of the company's owners to material information about the company must at times supercede your individual right to privacy.

Manager Name Disclosure and Directed Brokerage
As mentioned above, fund companies will now have to disclose manager names, rather than simply listing funds as team managed, as part of the new incentive disclosure requirements. Fund shops will also be required to describe the role served by each of the five managers with the greatest impact on the fund. This will also be a great benefit for investors because in the past, fund companies were able to obscure manager turnover and the qualifications of management by simply listing management teams.

In addition, the commission voted to ban the practice of directed-brokerage commissions. Although it has probably escaped the notice of most investors, this practice creates some unhealthy conflicts of interest. Directed brokerage involves a fund company rewarding a brokerage for selling its funds by placing trades with that brokerage.

In theory, fund investors' interests were safeguarded by the requirement that the fund companies could direct trades only in cases where the broker offered "best execution." In practice, it was very difficult for outside parties to verify this and, in fact, there's evidence that such arrangements were abused at investors' expense in cases where fund companies agreed to pay multiples of the brokers' standard commission rates. Further, directed brokerage gives brokers an incentive to base mutual fund recommendations to their clients on business relationships with the fund companies that send them trading business, rather than on the suitability of an investment for a client.

In all, today marks a red-letter day for fund investors. The SEC has made it much easier for investors to find fund managers who are encouraged to do right by shareholders without creating an undue burden on fund companies or managers.