Fund Boards Under the Microscope

"Despite the lapdog behavior of independent fund directors, we did not conclude [in a survey conducted the previous year] that they are bad people. They’re not. But sadly, 'boardroom atmosphere' almost invariably sedates their fiduciary genes."

-- Warren Buffett, from the 2003 Berkshire Hathaway Annual Report

Frankly, we could have picked just about any of the barbs among the scores presented by Warren Buffett in the last two letters he wrote for the annual reports for  Berkshire Hathaway (BRK.B). Buffett has been hard on mutual fund directors, and has reserved some particularly venomous words for the independent set that hasn't quite been acting so in his view. He notes that two of the most critical director responsibilities are to negotiate reasonable fees and to fire fund managers who aren't cutting the mustard, so to speak. Of course, with very few exceptions, the mutual fund world has seen little evidence of either job being taken very seriously.

But while it's not fair to tar the entire bunch with the same brush--there are, after all, some very competent boards, responsible for some especially well-run, fairly priced funds--there's no question that the issue of fund directorship is a critical one.

To provide investors with better insight into the governance of mutual funds, we've included a section we're calling Board Quality as part of our new Stewardship Grades for funds*. In particular, we've begun by focusing on some of the issues that we believe are central to understanding what motivates the decisions made by a fund's board of directors. We give credit, for example, to boards that boast significant independence and aren't overtaxed by having responsibility for an unwieldy number of funds. We also look at whether boards are truly and sufficiently independent from the advisors who run the funds that they oversee. Of course, money is important too. Our methodology favors boards with trustees who own at least as much in the funds they supervise as they earn each year for taking on those responsibilities. Boards that fail to address obvious problems, or that turn a blind eye toward unnecessarily high or rising fund costs, are also penalized. (Click here for a more complete explanation of our grading methodology.)

Role Models
As we've noted, it's important not to overlook cases in which boards work well. Take the one that oversees the Artisan Funds. With responsibility for seven funds, its trustees are much more likely to be on top of important issues than those covering 30, 50, or 100 funds--of which there are many. One feature that helps the Artisan Funds board stand out, meanwhile, is its commitment to ownership of the funds it covers. A recent decision stipulated that each trustee should hold at least twice as many dollars in fund shares as he or she earns in a year for sitting on the board. That far exceeds our benchmark of maintaining at least a one-to-one dollar relationship. Why such a heavy focus on trustee fund ownership? Because when all is said and done, nothing will provide as much incentive for board members to act in the best interest of shareholders as being subject to the same management and cost structures that they're responsible for overseeing.

The board at ICAP takes things in an equally good direction. As Morningstar's Kunal Kapoor  has noted, we're very enthusiastic about the fact that the ICAP fund board is paid in fund shares, a practice that we think should be adopted more broadly across the industry. Although there's nothing wrong with trustees earning cash for their labor, compensating them with fund shares goes a step further toward the aforementioned goal of aligning their interests with those of other shareholders.

Troubled Firms, Troubled Boards
While there are other well-run boards to which we can point, laggards are plentiful. Take the board that oversees all of the funds of both AIM and Invesco. Suffice it to say that we've been critical of issues at both firms, all the way from performance problems to involvement in the market-timing scandal uncovered in 2003. We recently went so far as to implore the trustees to take even more decisive action on some funds.

Beyond the obvious problems of what we view as wanting oversight, however, is the basic issue of fund ownership that illustrates our concern about trustees failing to think like shareholders. Of the 14 board members described in the funds' latest statement of additional information (an important distinction given the AIM/Invesco merger as well as resignations and replacements), fully half of them hold less than $100,000 across the roughly 100 funds each oversees. A few hold less than $50,000. Considering the wide breadth of choices available, and the fact that each generally earns in excess of $125,000 per year for his or her service, those numbers are less than inspiring. The great responsibility of covering such an extensive lineup of funds, meanwhile, is all the more notable when viewed in the light of policies the board has in place for AIM's managers to follow when casting proxy votes for companies held in fund portfolios. They specifically stipulate that votes should be withheld for trustees "that sit on the boards of an excessive number of companies."

When it comes to the AllianceBernstein funds themselves, we're at least optimistic. Although their advisor has been front and center in the industry's timing scandal, we've been impressed by the speed and depth with which current CEO Lewis Sanders has committed to reforming the company.

But while we echo Warren Buffett in assuming that the AllianceBerstein funds' board isn't made up of bad people, it's not one in which we're particularly confident. Four of its independent members have been around for 16 years, and the other two have served for at least six. Each oversees more than 40 funds and takes home a healthy paycheck of more than $200,000 per annum. It's hard to see what fund investors have gained in return. Thanks to pressure from New York Attorney General Eliot Spitzer, AllianceBernstein has agreed to lower its fees, which have been notoriously bloated for years. And prior to Sanders' reform efforts, the company stood for just about everything we found wanting in the fund industry. It's true that the Alliance funds' board had few industry role models for activism on which to rely, but that's not much of an excuse for allowing investors to be subjected to Alliance's hijinks for so long. Incidentally, not everyone on the board is as independent as he or she might appear. Although trustee David Dievler is deemed independent by SEC rules, his former career as an Alliance executive--as well as his $260,000 board paycheck--make it hard to view him as such.

Master of Which House?
Not all board members serving the funds run by Dreyfus oversee as many funds as the AIM or Alliance crowds. One of them has a pretty substantial load on his plate, though, and that's Dreyfus funds' board chairman Joseph DiMartino. He has oversight responsibility for a mind-boggling 191 funds. It's hard to imagine that one person could even name that many different mutual funds from memory, though he's got an advantage that most others lack. As other industry watchers have noted, DiMartino used to sit on the board of Dreyfus itself, and was at times either president or chief operating officer of the advisor. But while that doesn't make him an interested trustee according to the letter of the law--like Dievler at Alliance, he is actually counted as an independent trustee--it's awfully hard to imagine him pushing the boundaries of that role.

If his past affiliation with Dreyfus isn't sufficiently convincing, have a look at his salary. DiMartino takes home more than $800,000 per year in exchange for his board duties. At that rate, it's awfully hard to imagine anyone would be willing to rock the Dreyfus boat.

If an $800,000 payday were at stake, would you?

* The Morningstar Fiduciary Grade for funds was renamed the Stewardship Grade for funds as of Feb. 7, 2005.