What the Heck Do Fund Directors Actually Do?

Fund directors are in the news. The Supreme Court gave them some slack in the Harris ruling but underlined the importance of fund companies getting them complete information and directors comparing mutual fund fees with those of comparable institutional funds. Yet, fund directors do their work behind closed doors and disclosure is limited, so it's awfully tough to know whether directors are asking difficult questions.

Laura Lutton, Ryan Leggio, and I spoke with Bruce Crockett, independent trustee & chairman of Invesco AIM Funds' board and a member of the Investment Company Institute's Board of Governors (the investment industry's trade association). Crockett has been more open than most directors about what the board actually does. He's even gone so far as to publish his e-mail address in shareholder communications so that any AIM shareholder can communicate directly with him. Here's the transcript.

Russ Kinnel: Can you give us a quick rundown of your take on the Supreme Court's Harris ruling?

Bruce Crockett: It was a very sound decision on the part of the Supreme Court. It obviously reaffirmed Gartenberg, and it established a very high standard, what I would call a "Delaware court standard" for second guessing directors.

It seems to me that the directors are being told to do what the good directors have been doing all along. Not too much has changed.

Clearly, there are some academics who [have] said things like, "Well, this opens the door for fee cases."

I would argue that the door was always open for fee cases, in a sense. I don't see this as opening the door any wider. In fact, I see it establishing an even higher threshold. If the directors are doing their job--they're diligent, they have access to all the information, and they're prudent in the process that they go through in making their determination--I don't see how fee cases will go anywhere.

This case argues that there are differential fees between institutional and retail funds that directors should take into account. Well, I'll submit to you that where they're relevant, directors have been taking them into account all along.

But I'll give you a perfect example of why, in most cases, they don't make a lot of sense and they aren't relevant. You've got Joe Schmo, average investor. He's got $5,000 in the  AIM Constellation Fund , and he pays a 50 basis-point fee for that service, including record-keeping and the whole works.

Morgan Bank comes to Invesco and says, "We want to invest our $500 million plan in your assets. We want an overall umbrella fee of 30 basis points, and we'll do the record-keeping or we'll have an outside record-keeper."

First of all, in this instance, you're now comparing apples and oranges, because Morgan Bank doesn't need record-keeping. Second of all, Invesco has made the business decision to make an accommodation to Morgan Bank because of the magnitude of the money that they're going to invest in the complex.

In a sense, in that same mutual fund, the Aim Constellation Fund, you've got some people in there at 50 basis points, and you've got some people in there at 30 basis points. That's the specific target that the tort bar has been after.

But, as I hope I've illustrated, it really doesn't make a lot of sense to compare cases like that. We'll look at a more broad scale. We'll look at other cases where we might be looking at apples and apples, as opposed to apples and oranges.

Russ: Right. Your central point is that the mutual fund management fee pays for a lot more than management.

Bruce: It sure does.

Russ: Is the fund board able to see what the actual management charge is?

Bruce: Is it possible for us to unbundle it and really get at the individual pieces? That's a little fuzzy because of all the allocation methodologies that go into cutting up fees and costs. That's never been an easy job, but to the extent where it is possible, we have, and we will continue to look at those things. In talking to the general counsel at AIM, John Zerr, because we're getting ready to go into the 15(c) [expense-ratio review] process in a couple of weeks here I said, "John, is this going to change how you do business any?"

He said, "Well, get ready for quite a data dump. If, in the past, we've summarized things and showed you various fees, you're going to get all the detail now. We don't ever want to be in a position of not having given it to you."

Now, that, in a sense, is going to put the onus on us to analyze it, or get it analyzed or get some help to get it analyzed, so we can make those determinations. But I think that's a good response, and that's a specific response to the outcome of this ruling at the Supreme Court.

In my mind, it's a whole, healthy process. The court gave boards and independent directors a lot of respect, which I think was appropriate. As I said, it reaffirmed Gartenberg, and on we go.

Laura Lutton: Do you work with consultants or others to help you put some of the numbers that you get from AIM in context?

Bruce: Until this point, we have never used outside consultants to help us look at rates or fees or some of the cost-allocation methodologies. I'm not saying that we will have to, but we may. That's something we'll take up at our next meeting and make a determination.

So, in a sense, you could argue that [the Supreme Court ruling] has caused us to possibly change how we do business a little bit. But in general, I would say that we're doing what we've always been doing, as it relates to 15(c).

Gartenberg's been around a long time, and we've never used it. It's just like a checklist. You get through the 33 things and you're done. It's just a guidepost along the way to the process. And the other thing I would say is, in a sense, 15(c) goes on all year long. It isn't something that happens just in May and June.

We're getting reviews and updates on transfer agency costs and custodial costs, and things all year to help put us in context, so we're not overwhelmed come May and June.

Russ: Who determines what funds should be used in the peer group 15(c)? In the Harris ruling, one piece of evidence showed that Oakmark's fund board compared Oakmark Select with just nine other funds. Obviously, you can find a lot of actively managed, no-load, large-cap funds. Is the peer group something that the board controls at AIM?

Bruce: I think you'll take comfort in this: The same peer groups that are used for performance measurement for the portfolio managers are used in evaluating fees and expenses. They don't get to forum shop. You can't have one set of peers for one purpose and one set for another. There are instances, now and then, where the management will come to us and say, "Well, this Lipper category, even though Lipper has put us in this fund X in this category, we don't really think it should be in that category, for the following reasons."

We could theoretically make an exception, but those are few and far between. As I said, we just don't allow the management company to go form shop. It's pretty long-term looking, and it's pretty rigorous. It's pretty specific, and there isn't a lot of wiggle room.

Laura: Are the funds in those peer groups chosen because they're a similar size, in terms of assets under management, or the strategy is similar? Do you know how the peer group is established?

Bruce: Both of those things go into it. In the absence of other information, we rely on the groups that Lipper or Morningstar puts people in, and management would have to come with a compelling reason why it wouldn't. For example, if you had an energy fund and for some reason the portfolio manager never invested in petroleum stocks, as ludicrous as that might sound, well then to compare it with the Lipper energy fund universe might not be applicable. We might have to make an adjustment because they didn't have portfolio stocks, or they didn't have petroleum stocks in the portfolio.

But in general, we want things to be as absolutely comparable as possible in terms of size and in terms of investment philosophy.

Russ: Can you give us an outline of what have been the key accomplishments of the AIM board in the last couple of years?

Bruce: For a couple of years now, there isn't a fund in the complex that has a 12b-1 fee higher than 25 basis points, and we're very careful as to whom we let have 12b-1s and whom we don't. If the funds are closed, we won't let them charge a fee even though there could be legitimate reasons for ongoing relationships with the existing shareholders. So that's pretty well under control.

In terms of fees, we basically say, given the universe that we compare you with, your fees have to be lower than more than half of them before we'll even consider it. If not, you'd better waive some fees. You'd better do something. We don't want outliers beyond that.

Then, of course, we have the age-old battle of underperformance and how long you allow that to go on, and when do you change portfolio managers, when do you merge funds? We're very strict on (not) allowing them to merge funds into funds to get rid of bad performance. They also need to ensure that the tax consequences are positive. They have to do the right thing for the shareholders in general. We hold them to a really high standard.

I've got to tell you that the team at Invesco, they're the real deal. They get it; they understand it. What Phil [Taylor] (head of Invesco AIM) and Marty [Flanagan] (CEO of  Invesco (IVZ)) have done in terms of reorganizing the place and getting the emphasis on the right things has been incredible. I know Morningstar's management rating finally came up. That was really deserved. Phil's really got control of that place and performance is better, and the place is better run than ever.

That was a tough process because we went through founder-itis and a warm cozy place in Houston, and now it's one world at Invesco. They've made a huge transformation and metamorphosis of the place. It hasn't been easy, and there are fits and starts, but it's working and they're getting there. They're really doing a first-rate job. In fact, it makes the board's job relatively easy because we don't fight over things.

They know what our standards are. I meet with these people regularly, and there are no surprises come May and June when it comes to 15(c), and we don't have to go twist their arm to get them to do the things that are necessary to put the shareholder's interests first because they know where we stand and what we want, and they make sure we get it. So it's really a pretty good thing.

Another thing we did was look into proxy voting. While the board had oversight over proxy voting, we might not have been doing quite the job we should've been or maybe delegated or relegated too much of it to management. So we set up an ad hoc committee at the time to look at proxy voting and to rewrite the standard operating procedures as to how and when management would vote.

It was a joint effort between the management and the committee of the board, and we came up with a new policy. Management set up a committee to vote the proxies. It had a lot of teeth. I think in this last year, in 50-some percent of the cases of proxies, they voted against management on at least one issue in that proxy. We keep really good statistics on this. We follow it year to year.

We actually took it from an ad hoc committee and made it a formal committee, Valuation, Distribution and Proxy Oversight. It took on more than a life of its own, and both management and the board got really serious about voting proxies. The thing that's really good about it is it shows the ability of the management company and the board, the independent trustees, to work together to make effective progress. That was a big step.

Russ: What makes the board start to look at an underperforming fund more closely? What triggers might lead you to want to make a change at the fund, and how does all of that work with Invesco AIM management?

Bruce: Our six in-person board meetings last two and a half days, and we spend about a day and a half on performance. The investment committee consists of three subcommittees that basically looked at equity, fixed-income, money market [funds]. They aren't broken down exactly that way, but between the subcommittees, we get to every single fund in the complex. Within each of the subcommittees, each director has funds specifically assigned to them to keep track of.

Then there's a process of exception reporting where we look at funds where performance is really good or really bad, because it's not OK to have great performance for the wrong reasons, just like it is OK to have poor performance for the right reasons.

So we've really gotten serious about attribution analysis, and we're trying to carry that to a level where we truly understand how and why the funds are doing what they're doing, and then being able to discern whether that's good or bad. To the extent the red flags get raised, those portfolio managers get called onto the carpet and have to explain what's going on.

If the poor performance continues for the wrong reasons, it's not like we've got to put a gun to the management's head, because they get it, too. They don't want to have 1- and 2-star funds sitting out there, because people don't buy them. So they're very quick in a relative sense to say, "We've got to do something here."

So one of the first steps that usually happens is they'll change portfolio managers and then you've got to give them some time to see if the performance improves, and those get tracked pretty carefully. If the performance gets back on track, that's good. They still get watched. At some point or another, somebody else is in the barrel and we worry about them more than we might otherwise would have.

At this point, on a dollar-weighted basis, Invesco/AIM has more funds with 4- and 5-star rankings than any time in their history. That's for three years, and pretty soon will be true for five years as well.

That's a pretty good story because if you think back to before the market burst in 2000, 2001, when the shop was extensively a momentum shop and had a disproportionately large amount of their assets in those categories and were doing quite well, the dollar-weighted performance is still better today than it was back then. I think that's a real accomplishment. Shortly we will be going through the assimilation of all of the Van Kampen funds and the Morgan Stanley retail funds. There are going to be initially 200 some odd funds in the complex. We've set up an ad hoc committee that's going to deal with all of that and report to the board, because it's inevitable that there will be some consolidations and a lot of work will have to go into looking at how the shareholders benefit and what the tax-loss current forward positions are with the combinations and so on and so forth.

I don't know exactly what the number is going to be, but if that 250 isn't down to 100 and some within a year, I'd be very surprised. I think that there's just a lot of duplication and there'll be a natural fit for getting the number down dramatically.

Russ: And it sounds like you already have some experience in dealing with fund mergers. Can you outline briefly what is it that you look for to say this is an acceptable merger?

Bruce: Usually it relates to which fund survives. Sometimes it's a close call as to which is a surviving fund, and that impacts which performance history you get to bring. They can't just take a small fund with great performance and merge a big fund with lousy performance into it and say that the surviving fund is the small fund. That just doesn't work. Also tax considerations: How big is the tax-loss carryforward, and can that be used on a going-forward basis, or is it likely to expire? Also, if the net combination is going to resolve into a lower fee, that's great.

We effectively won't allow funds to merge without the breakpoints or the fees at least being waived as opposed to having to go to shareholders to get to the point where nobody is disadvantaged vis-a-vis this combination.

If you think about it and you think about AIM over the years, it's an incredible amalgamation of fund complexes going back to when Ted Bauer and Bob Graham and Gary Crum were out acquiring individual funds like the Constellation Fund and the Weingarten Fund. Then they bought the CIGNA complex in the early '90s. They bought the GT Global complex. They bought Invesco. Now we're in the process of buying the Van Kampen and Morgan Stanley retail. So in a sense, the company has been a continuing amalgamation and integration of complexes and funds over a 20-year period.

So it's not really new to us. I have enough gray hair and have been around this long enough. In fact, I was in a sense a product of that because I joined the AIM board from the CIGNA Funds and prior to that, the INA funds. So I've been through a ton of these already.

Russ: Will the Van Kampen merger lead to multiple boards?

Bruce: Absolutely not. We're going to have one board. I'm a firm believer in that. I think separate boards are an excuse for management and the boards not to work as effectively together to get a combination. The one thing that it does show is that the directors, independent directors, have a lot of say in the process. I honestly think one of the reasons that Morgan Stanley wound up getting out of the retail business was they never could find a way to get the Van Kampen and the Morgan Stanley retail funds merged into a common board. Wayne Whalen at Van Kampen fought them tooth and nail for more than a decade.

As a part of the process of putting this deal together, we negotiated. Wayne and I sat down with the Morgan Stanley folks as well and basically came up with what the board governance was going to look like before the deal was consummated.

In fact, Gorman [James Gorman, CEO of Morgan Stanley] and Flanagan had kind of shaken hands on what the investment side of the deal was going to look like. And then it was up to us, the boards, the independent boards, and it meant myself and Wayne sitting down and negotiating all of the social issues, the governance issues.

We've got four people coming over from their board. Right now, we're 12 and two, so it'll make us 16 and two for a short period of time. But we've also got four or five people retiring in the next five years due to mandatory retirement. So in my mind, we're bigger in the short run when all this integration work is going to have to take place. It gives us the arms and legs and historical perspective from each side to get all that work done. Then when the assimilations and amalgamations are done, we'll shrink back down to a 12-person board or so over the next five years.

Russ: Do those directors departing Van Kampen have to be paid a severance?

Bruce: That's between Morgan Stanley and Invesco.

Russ: It's not coming out of the fundholders' pockets?

Bruce: Absolutely not. The directors who are not coming over to the Invesco/AIM fund board will stay on the closed-end fund boards until they are ultimately assimilated. So there's a little something left over for them to do.

Russ: You have published your e-mail address in shareholder communications. What kind of dialog have you had with investors?

Bruce: It's fascinating. In fact, I just responded to a guy this morning that sent me an e-mail that said the performance was crap and he wanted to know what I was going to do about it. Fortunately, I was an investor in the same fund, so I was able to cry in my beer with him a little bit. But I went through the whole litany of what we were doing, and we changed portfolio managers.

I've had my e-mail address out about four years now, and I probably get 10 e-mails a month. It tends to spike up after the fiscal year ends, when the annual reports or the semiannual reports come out. And of course in January when the people get their statements, it gives them a reason to e-mail, if they so choose.

One third are almost cranky or "pranky," and they just wax off on whatever it is. And I usually don't even respond to them, because I don't want to lower myself to their level to fight with them. And they don't necessarily want a response; they're just venting.

And then, another third I get are, "My husband died. I don't know how to get a hold of who can help me with my fund." Or, "I need to get this form so I can do this or transfer this." And I can get those questions to the right people, and they handle it really quickly.

The other third are legitimate, thoughtful e-mails, and obviously these are the ones I really like and that raise good points--sometimes things I hadn't thought of. I take my time to send them a response. I've got a couple of pen pals now because of doing this. It's an interesting and rewarding part of my job.

There are a number of other independent chairmen who have started doing the same thing, like Don Pratt (of American Century). I really knew I was on to something when Phil Taylor came to me here recently and said, "You know, I'm going to put my e-mail address in the letter." And I said, "Well, that's really good, Phil. That's cool."

You know, when I first did it, people were saying, "Geez!" The lawyers were all nervous. They thought I'd gone off my rocker. "Well, you're going to use an AIM e-mail address aren't you?" In other words, so the lawyers can, in a sense, see what I said.

I said, "No, I'm going to use my personal one."

"Well, you're going to review these through the lawyers before you respond, aren't you?"

And I said no. I said, "You know, I'm the independent chairman. I'm going to do it my way." And so far, it's worked. I haven't been sued, and it's been rewarding, and I like it.

Russ: What about communicating the board's actions?

Bruce: I'm not afraid to talk about that, where we've made changes or fee reductions. They're part of the negotiation process. I get into changes in management or whatever. It's a bully platform, in a sense. I like it.

Laura: If you were looking in from the outside, what would you look at to determine if the fund board was serving shareholders well?

Bruce: I know it's hard to look in from the outside. But many of the things that we talked about here today, effective but not abusive use of 12b-1 fees, trading practices, custodial costs, transfer agent costs, fees in general. There are some data points out there that you can look at that will tell you how and if the board is being effective. For example, in AIM's case, where there's not a single fund where the fee's above the median for its peer group, that's pretty good.

It doesn't mean it's perfect. I got a letter from one shareholder, which was pretty thoughtful, and he said, "Well, what's so good about being 51st percent?" Now, it really isn't 51st percent, but the point was if you get to 51 and you get a bye, why shouldn't it be lower? Why don't you want to be like Vanguard? Why don't you want to have the lowest fees in the universe? So you can't please everybody all the time. But at least there are some indicators out there that you can look at to tell whether and how effective things are.

Ryan Leggio: Some AIM fund expenses are above median. Aim Trimark  is at 2.2% for world-stock funds and the median for Morningstar's peer group is somewhere around 1.50%, maybe even 1.70%.

Bruce: Yeah, I would have to go look at that specifically. That may not be the peer group that we're comparing it with in that case or there may be a reason for that.

When we get the information, everybody's below. But we may be comparing apples and oranges there. I can do a little research into that and let you know. But I can guarantee you that we take all that seriously. Sometimes funds are so small, we'll give them a bye until they get up to a certain size, if it's an incubator fund or whatever. We've had some trouble with transfer-agency fees because everything was being done in-house and it took a while for them to get those costs under control, but they seem to be doing well. With the AUM coming back up now, that's taken care of it.

Laura: One of the other things that we look at is what kind of funds has the board approved for launch or merger, but we've heard members of other boards say, "Well, by the time it gets to us, the horse is out of the barn from a launch standpoint, and there's not that much that we can do." What's your take on that?

Bruce: Well, now with the Van Kampen and Morgan Stanley funds coming in, there almost isn't any area where Invesco won't have a presence. So the waterfront is effectively covered. Van Kampen was very strong in municipals, very strong in value, various things AIM hadn't been traditionally as strong at. The two really go together quite nicely. AIM has not been aggressive at coming out with kind of the fund of the month, which is good in a sense. But also the procedures that it takes to get a fund launched are such that the board actually has encouraged them to speed the process up for the exact same reasons you say. Once they've made a decision to do something, if you don't get it done relatively quickly, you know, the horse could be out of the barn.

If you're in the business for the long run, it should take care of itself. But there are opportunities that you do legitimately want to take advantage of. What I've said to the management is I don't want the board to be the reason for delaying a launch.

So if for some reason you need to get to market and you need to have a special meeting either telephonically or in person, we'll do it. Just don't ever be in a position where you're blaming us because you didn't get to market when you wanted to. That puts the onus back on them to do what they've always done but maybe a little faster. As I've said, they've never really abused it, and they're not out there with the fund of the month.

Russ: If they did come out with a fund of the month, what would you do?

Bruce: Well, it depends on the context. In certain markets it might make sense and in others it might not. Invesco, as a complex, is in everything. They have a huge ETF company. They've got a big money manager in Canada, big one in the U.K. They're investing in China and India. They're really becoming a global department store. So someday will there be a mid-cap Burma fund? Maybe.

Laura: In the funds' annual reports, the board includes a letter that describes its evaluation of the advisor prior to renewing the advisory contract. Is that letter a fair window into the board's process?

Bruce: We get a lot of legal input into that, and it kind of mirrors Gartenberg, and it's a road map to help get through the process. But yes, that's a big deal. We have two meetings almost back to back, a month apart in May and June. In May, the information is disseminated and discussed and evaluated; then the board has another 30 days to go back to management and say, "Here's what we like, here's what we don't like." Then that gives them time to make the adjustments as necessary to come back with something that we're prepared to approve. A lot of negotiations go on in that 30-day period to make sure we are where we want to be and they're where they want to be. And that's where, in a sense, the rubber meets the road and the negotiations take place.

Laura: Boards also talk about the "nuclear option"--firing the advisor. If you got into a situation where there was a particular strategy that the board didn't think was being run well, would you consider hiring a subadvisor for a fund or two?

Bruce: The answer is yes. If it ever came to that, where they just couldn't reach agreement, going out and hiring a subadvisor--that would make all the sense in the world.

Laura: Have you ever gotten to that point with AIM?

Bruce: No, because management's always been accommodating enough and understood that they don't want to get put in that position. So they'll waive fees. They'll do something. They'll change portfolio managers. They'll do something to keep it from getting to that point.

Russ: One thing that came out in some of the cases was that fund boards had a hard time getting a handle on the managers' incentives. Do you feel like you're getting the information you need?

Bruce: Oh, we used to have trouble with that when Mark Williamson was there and he didn't want to disclose, for competitive reasons, portfolio-manager compensation. We worked at this and worked at this, and we came up with a way of looking at it on an analog scale. We don't necessarily know exactly what portfolio manager X makes, but we know what proportion of his salary is short-term incentive, what proportion is long-term, what he owns in stock. And we can weight it all and then compare that with the performance of the fund and make a determination as to whether there's teeth in the way they compensate their fund managers.

AIM Invesco has been very forthcoming in that regard. And that's a real improvement. We pushed for it, but it's just been part of the kind of mutual cooperation and respect that the two sides have gained for each other. And it's worked really well, and we've made real progress there. That was another thing I should have listed when we were talking about things that had been accomplished.

Ryan: How do you feel the economies of scale are going to be passed on to shareholders? Are you guys going to have a consultant look over how economies of scale have been passed on in the past and other examples with large funds merging?

Bruce: Well, management has made a commitment to pass a specified amount that I don't want to disclose, and we're going to hold them to that and measure against it. Whether we use outside consultants or not remains to be seen. But this has to benefit the shareholders or the whole combination doesn't make sense, does it?

I'm a big believer in economies of scale. I think it works. I think the cost per unit to deliver a product goes down. I think everybody wins in a deal like this if it's done right.

Ryan: It'd be fair that after looking at this [Van Kampen purchase], if I see a fund that is charging 90 basis points, and it's now $4 billion bigger, and now it's just charging 88 basis points ...

Bruce: That's not reasonable.

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