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Fund Spy

High Time for Manager Incentive Disclosure

Finally, signs that fund investors will get treated with respect.

Things are looking up for fund investors. The market is finally in the black and the SEC appears set to pursue some much-needed improvements in fund regulation. On Monday, the commission signaled it was in favor of greater disclosure on fund manager incentives and mutual fund fees. In response to a letter from Rep. Richard Baker, the commission also suggested that it may take a more active role in assuring that fund directors are independent.  On Wednesday, Baker responded with his own set of proposals.

If the SEC follows through on these comments, it would be a big win for mutual fund holders. Perhaps most important would be a requirement for fund companies to disclose fund managers' incentives. Incentives affect the way a fund manager runs a fund and therefore would be very helpful for investors who want to be sure that a manager's interests are aligned with theirs. For example, if you hold a fund in a taxable account, you might not be well served by a manager whose bonus is based on pretax returns.

To me this is a natural: After all, stockholders know what a CEO's bonus is based on, what he or she is paid, and how many shares he or she owns in the company. Why not give fundholders equal rights to know what the CEO of their investment company's incentives are?

However, the SEC said this kind of disclosure might be difficult in situations where a manager runs multiple accounts or a team of managers runs a fund. I'm not convinced that this is all that great a hurdle. Fund companies spend a lot of time on managers' compensation packages, and they usually use the same system for all managers, so that a team-managed fund may use the same incentives for each manager. Further, if a fund manager's incentives are largely based on the performance of another fund, that's valuable information for investors. For example, Fidelity compensates its sector fund managers based on how their stock picks perform in the firm's big diversified funds rather than how their sector funds perform.

New Proposal on a Questionable Practice
Baker proposed that brokers be required to reveal when they have a greater incentive to sell one fund over the other. Specifically, some fund companies have "revenue sharing" agreements in which they give money to branches that meet a certain threshold of sales. While it may not go directly to the broker, it does give the broker a hidden incentive to push one fund company over another.

Revealing this type of information would be a welcome change. Investors are best served when their advisors are viewing different investments on a level playing field. You can see what happens when brokerages get behind funds for reasons other than attractiveness of investment. For example, during the bull market three big brokerage houses launched funds that drew in more than $1 billion before their inception date. After they were launched, the funds suffered poor performance and didn't get meaningful inflows again. So why would so many brokers put their clients in funds with no track records? Clearly, the brokers had an additional incentive during the subscription period but did not have one after the launch date. Had they truly believed in the funds, you'd likely have seen inflows continue after the launch.

Managers' Fund Holdings
On the equally important matter of managers' fund holdings, the SEC's comments were a little more discouraging. The commission said this would be useful information but that incentive information would be even more important. To me, they're both very important and I'm not sure why it should be one or the other. Rather than making piecemeal changes on manager incentives, I'd like to see the SEC step up and say fund investors are entitled to the whole package--just like stock investors are.

Knowing whether managers have hundreds of millions of dollars in their funds, or conversely, have no money in their funds, is far more telling than their compensation. It's no accident that fund managers who have a lot of money in their funds are much more aware of tax consequences and are more likely to manage for the long haul. On the flip side, fund managers in high-cost funds are much less likely to own their funds. They might invest in cheaper separate accounts instead. Thus, disclosure would provide fund companies with a powerful new incentive to lower costs and provide shareholders with insight into whether a manager believes in his or her fund.

Soft Dollars, Trading Costs, and Turnover
Meanwhile, the SEC said it would like to increase disclosure on soft dollars, but that it lacks the power to do so. The commission said that there was a clear potential for conflicts of interest to arise in the area of soft dollars.

With regard to trading costs, the SEC didn't have much to offer. It said that estimating trading costs, as Jack Bogle has suggested, would be too difficult. Instead, it suggested requiring that funds make turnover ratios more prominent and said it would consider requiring a discussion of the link between turnover and costs. Finally, the commission said it is considering requiring funds to set a top limit to their turnover.

I'm a little dubious that either measure would be very helpful. First, investors won't likely respond to a turnover number--it's when you put those figures in dollar terms or possibly basis points that investors might understand the impact. Second, I'm not sure it's practical to name an outside limit to turnover. Among other things, sizable redemptions could drive up a fund's turnover, so it would be difficult to name an outer limit.

Expense Ratios
The SEC also sounded rather unconcerned with rising expense ratios. Overall, the commission argued, costs have come down over the past two decades as rising expenses are offset by falling commissions. Further, it said that the weighted expense ratio in 2002 was about the same as it was in 1999. However, the SEC noted that this was because money has shifted into bond funds, which are cheaper than stock funds. This is a crucial point because it means equity fund expenses are increasing. A shift into bond funds should have lowered the overall weighted expense ratio, but it was flat because of ever-rising costs in stock funds.

Fund Boards
Finally, the commission said it would look at ways to improve fund boards, such as prohibiting funds from counting relatives as independent directors. The boards, after all, are the ones responsible for fund costs. So far, they have proved to be a remarkably passive group that is willing to sign off on ridiculous increases in expense ratios. As long as there are funds with expense ratios over 2.00%, we'll know there are directors who aren't doing their jobs.

The SEC suggested that Congress should raise the required level of independent directors from 40% of a board to a majority. "The majority requirement would permit the independent directors to control the 'corporate machinery,' i.e., to elect officers of the fund, call meetings, solicit proxies and take other actions without the consent of the investment adviser. This statutory change would ensure that all fund boards have the benefits of a board with an independent majority, " the SEC wrote.  On Wednesday, Rep. Baker went them one better by proposing a law requiring that two thirds of fund directors be independent.

Both proposals make sense, though it's unlikely that this alone would make boards into the activists that fund investors need. Too often independent board members draw more in salary than they have in the funds they are monitoring. In such a case, they aren't terribly independent and clearly don't have their interests in line with shareholders'. Why not require independent directors to have more money in the fund they monitor than they draw in compensation from the fund company?

On the whole, the SEC's report is good news for fund investors. If the agency follows through on its comments on manager compensation, fund boards, and cost disclosure, investors will be in a better position to make sound decisions.

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