Do Great CEOs Make Great Mutual Fund Advisors?

The recent news that  Wachovia  will acquire  Golden West Financial  shone a well-deserved spotlight on Herb and Marion Sandler, Golden West's co-CEOs. The husband-and-wife team has run the thrift, based in Oakland, Calif., since 1963, leaving a legacy matched by few in corporate America. They've compounded earnings at an annualized rate of 20% for more than two decades by taking a disciplined, long-term approach. But we wouldn't have named the Sandlers as Morningstar 2004 CEOs of the Year were it not for their commitment to shareholders. In fact, Morningstar equity analysts described Golden West as a "paragon of corporate governance."

Unfortunately, Golden West's shareholder friendliness hasn't extended to Atlas Advisers, a small mutual fund shop that it owns. Whereas Morningstar equity analysts assign Golden West Financial an A Stewardship Grade, Morningstar mutual fund analysts give the two Atlas funds that we cover,  Atlas Global Growth  and  Atlas Growth Opportunities , Cs for Stewardship. What accounts for this disconnect?

Stock Stewardship vs. Fund Stewardship
Morningstar evaluates stewardship for stocks and funds using completely distinct criteria, underscoring the fact that what makes a good company doesn't always make a good fund advisor. In explaining Golden West's A Stewardship Grade, Morningstar equity analyst Ryan Batchelor notes that "management's pay is modest, as is stock-option issuance; financial disclosure is excellent (the annual report is an absolute pleasure to read); and management runs the business conservatively, with great discipline and efficiency." He explains that the Sandlers have always taken a long-term focus, eschewing earnings guidance for investment that builds shareholder value over time.

Atlas, on the other hand, is a flawed mutual fund advisor. Its problems start with its board of trustees, which is chaired by none other than Marion Sandler. This is an all-too-common practice. Fund trustees are supposed to act as advocates for fund shareholders. But Sandler also has a fiduciary duty to shareholders of Golden West. What's in the best interest of fund investors (low fees, closing funds that are getting too big) can hurt earnings for management company shareholders. The fact that Golden West president Russell Kettell also sits on the board is another negative.

So is the fact that two of the four independent trustees have no personal money invested in Atlas Funds. Actually, Atlas' independent trustees only invest in one of the shop's stock funds (out of seven) and one of its bond funds. We think the level of personal investment in funds, which the SEC requires funds to disclose for both trustees and portfolio managers in their Statements of Additional Information, is a crucial data point. Personal investment equals a vote of confidence in the fund's mandate, in its security-selection process, and in the reasonableness of fees charged. Frankly, we don't see any better way for trustees to align their interests with their shareholders they are supposed to serve than by becoming shareholders themselves. When it comes down to it, will the trustees really fight for shareholder rights if they're getting paid more for serving on the board than they have invested in the funds, or for that matter, if they manage Atlas' parent company, Golden West?

One way to answer that question is to look at how well the board has negotiated fees. Atlas S&P 500 Index , designed to do nothing more than track the index, charges a whopping 0.57% expense ratio. By contrast, Vanguard, Dreyfus, and Fidelity all charge 0.20% or less for their S&P 500 Index funds.

Atlas' actively managed funds are all run by outside subadvisors. While Atlas deserves credit for picking quality shops like Oppenheimer Funds and Turner Investments to run its funds, we think the board could have gotten them at a cheaper price.  Atlas Global Growth's  expense ratio is 1.31%, which isn't high in relative terms but is pricey in absolute terms. It could be cheaper considering how much Oppenheimer Funds runs in the same style (upwards of $25 billion) and the fact that it can't cost Oppenheimer much to take on the Atlas account. We think the Atlas board could have bargained harder--taking a cue from shops like Vanguard and Harbor, which also use lots of outside managers.

On other criteria, too, Atlas comes up short. From the cursory information on Atlas' Web site, you wouldn't know that  Atlas Growth Opportunities  is subadvised by Oppenheimer Funds or that the portfolio managers' names are Chris Leavy and David Poiesz. Nor would you find an analysis of the fund's recent performance or an explanation of the managers' investment approach.

That's a far cry from the pleasurable reading of Golden West's annual reports.

What's Going On Here?
Frequent readers of this Web site and admirers of Vanguard founder Jack Bogle are familiar with a key conflict of interest that has long troubled the mutual fund industry. Atlas is a prime example of an asset manager that serves two masters--Golden West and fund shareholders--whose interests are at odds.

Bogle argues that the conflict is especially acute for publicly traded companies and for asset managers owned by big financial conglomerates. In a speech he recently gave to the Boston Security Analysts Society, Bogle declared: "[T]hese firms are in this business primarily to earn a return on their capital, not to earn a return on your capital as a fund investor." In Bogle's view, the conglomerates view their asset management operation as "another 'profit center' much sought for its predictable and growing asset-based revenue stream." He also cites a study showing that the best-performing funds tend to come from privately held companies, the next best from publicly traded firms, and the worst from fund shops that are part of financial conglomerates.

Golden West and the Atlas Funds are not alone in their divergent Stewardship Grades. Management company  Morgan Stanley (MS) gets a B for Stewardship, but several Morgan Stanley and Van Kampen funds get Ds. The same grades apply to  Wells Fargo (WFC) and some of its funds. We've assigned  Franklin Resources (BEN) an A Stewardship grade, but most Franklin funds get Cs.  Bank of America (BAC) gets a B, but some of its Columbia funds get Fs.

And then there's Wachovia, soon to become Atlas' ultimate parent company. Morningstar equity analysts assign  Wachovia  an A for Stewardship, but one fund advised by Evergreen Investment Management, a Wachovia subsidiary, receives a D from Morningstar fund analysts. Many others get Cs. We don't yet know if Atlas will be incorporated into Evergreen or if it will operate separately. Either way, we think there's room for improvement.