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Fund Spy

Fixing Mutual Fund Boards

Directors need the tools and the time to do right by fund investors.

Can the recent late-trading and market-timing scandal be laid at the feet of mutual fund directors? No. The directors could have reviewed compliance systems, but it's hard to imagine the fund company telling the board of directors that they were bending the rules. Fund directors could and should press for fair value pricing, but again, I wouldn't lay the scandal on the boards.

However, fund boards are a party to much of what ails mutual funds: rising expense ratios, frequent manager changes, and a disconnect between managers' incentives and fundholder interests. It's not that directors are stupid or corrupt. They're smart, well-meaning people, but they don't have the information or time needed to do their job effectively.

Fund boards are supposed to operate at arms length from fund companies so that they're a counterweight to corporate boards, which are working for stockholder profitability. They negotiate fees and they hire and fire management so that, in theory, each fund is operating in an open market for money-management services. In practice, though, boards don't exercise those powers, thus making them a poor match for corporate boards.

Directors Need Better Information
Fund directors get a report called a 15(c) report which shows how the fund stacks up on expenses and performance. It could be a very meaty report which would spur directors to action. However, the fund company gets to decide what goes into the report and how it is presented. And they tend to use the lowest standard available. For example, a broker-sold emerging-markets fund with $300 million in assets might compare its costs and returns with those of other funds of similar size sold through a similar channel. The strong implication is that you want expenses to be average for the group and performance that's a little better than average.

But that's hardly important to the fund investor. They want a good return that will be competitive with the biggest funds in the category. After all, they can buy those funds, too. Imagine a CEO of a small software company telling her board of directors that by entering the operating system market, they can earn a return on investment comparable to that of other small companies selling operating systems. Oh, and that ROI is 2%. Naturally, the board is going to tell the CEO to take a flying leap. They can buy  Microsoft (MSFT) stock and get a much higher return from operating system sales.

The fund industry and the SEC should set much higher standards for 15(c) reports. The standard should be that a fund is measured by its ability to provide reasonable returns and get investors to reach their goals. The report should detail how likely it is that the fund will be able to match or exceed index funds and other top funds in the category. If it's highly unlikely, then the fund should fold up its tent and allow investors to buy a better fund.

Specifically, the report should show directors how shifts in the fund's expense ratio help or hurt the chances that the fund can outperform its benchmark.

In addition, when funds merge or make other big changes, boards should get a third-party fairness opinion just as corporate boards do.

Fewer Boards, More Investment
If you look at what fund directors are paid and their investments in the funds they serve, it's easy to see why they feel divided loyalties. Typically, a director at a big firm will serve on 50 fund boards, receive more than $100,000 in compensation, and invest in only a handful of the funds they serve. 

In such cases, directors don't have the time to do a thorough review of each fund, and if they don't own the fund, they don't have much incentive to ensure fund shareholders are treated well. Defenders of the practice say that independent directors can form subcommittees to make the task more manageable. But then you're down to about three directors overseeing maybe 25 funds. That's still way too much.

By contrast, corporate directors typically invest a sizable sum in the companies whose boards they serve on. And in the wake of the Enron scandal, most companies adopted a best practice guideline of limiting directors to four boards at most. So why not bring independent fund directors up to that standard by requiring them to invest more in each fund than they receive in total compensation from the fund complex? This would solve the incentive problem and effectively limit the number of boards directors can afford to sit on.

Reviewing Manager Pay Incentives
Fund directors should ensure that a manager's incentives are in line with the interests of the fund's investors. If most shareholders own the fund in taxable accounts, then most of the manager's bonus should be based on aftertax returns. If the fund is considered a long-term holding, then performance incentives should be long-term.

It's also important to have modest short-term performance goals but very high long-term goals. In order to avoid giving the manager an incentive to take unseemly risks for short-term gains, the manager's bonus should reward him for providing a slightly better-than-average one-year return but not boost that bonus above that amount even if he crushes the competition over such a brief stretch. By contrast, the incentive system should reward a manager's stellar long-term performance--say, top-decile returns over five years--with potentially larger bonuses. All of this could be simply displayed in a table that shows the manager's incentives and how each relates to fundholder goals.

These types of changes are necessary to ensure that boards of directors and the funds they serve are held to higher standards.

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