Mutual fund shareholders have the legal right to vote on their funds' advisers and subadvisers. But what the law giveth, the
Securities and Exchange Commission
Over the past six years, the SEC has permitted dozens of so-called multimanager funds to fire and hire fund subadvisers without shareholder approval. What began as a reasonable accommodation of an unusual management structure has become a major loophole exploited by dozens of funds. These funds make no pretense of following a bona fide multimanager strategy, yet the SEC allows them to replace a fund's portfolio manager without consulting shareholders.
The Multimanager Exemption
The first multimanager exemption was granted in 1995 to
Frank Russell Funds
. Frank Russell says it pioneered the "multistyle, multimanager" investment method. Frank Russell picks the managers (or subadvisers, as they are known in the industry), and the managers pick the investments.
In the early 1990s, Frank Russell argued that investors chose its funds precisely to benefit from its manager-picking expertise, and that requiring shareholder approval of every new subadviser would impose unnecessary costs and delays. After more than four years of negotiations, the SEC gave Frank Russell an exemption from voting requirements.
Frank Russell appears to practice what it preaches. It manages 24 multimanager funds that employ 109 subadvisers. All but three of the funds (all money market funds) have had at least two subadvisers from inception, and seven of the 24 funds have had seven or more subadvisers. The funds have hired 65 new subadvisers and fired 36 subadvisers since 1996.
The best known multimanager fund,
Masters Select Equity, is managed by
Littman/Gregory Fund Advisors
. The fund allocates investment decisionmaking to six high-profile managers: Shelby and Chris Davis
(Davis NY Venture), Foster Friess
(Brandywine), Mason Hawkins
(Longleaf Partners), Bill Miller
(Legg Mason Value Trust,) Sig Segalas
(Harbor Capital Appreciation) and Dick Weiss
(Strong Advisor Common Stock).
Littman/Gregory has replaced two subadvisers on Master's Select Equity since 1998 and one on the five-manager
Master's Select International fund since 1999.
Multimanager in Name Only
The history of multimanager
EQ Advisors Trust
tells quite a different story. The trust, which offers 45 funds managed by Equitable, has never replaced a subadviser, and 42 of the 45 funds have never had more than one subadviser. Yet the EQ Advisors Trust, like Frank Russell and Master's Select, can fire subadvisers and hire replacements without a shareholder vote under the multimanager voting exemption it received in 1998.
American Skandia Advisor Funds
offers 25 "multimanager" funds, none of which has more than one subadviser. Between 1997 and 1999, ASAF replaced only two subadvisers, in each case following a shareholder vote. Nonetheless, ASAF was able to convince the SEC that getting shareholder approval was too burdensome and time-consuming. The SEC granted ASAF a multimanager voting exemption in 1999. ASAF has since replaced four subadvisers without shareholder approval.
ASAF's sister firm, the
American Skandia Trust
, offers 41 "multimanager" funds, many of which mirror ASAF funds. Again, not one of the 41 has ever had more than one subadviser. Since receiving the voting exemption, AST has replaced the subadvisers of four of the AST funds without shareholder approval.
American Skandia Senior Vice President Christian Thwaites argues that the multimanager voting exemption should be available whenever a manager monitors the subadviser's performance and advises the fund's directors about the hiring and firing of subadvisers.
The principle sounds appealing, except that it effectively repeals one of mainstays of legislation adopted in 1940 to protect fund shareholder interests against management abuses. Congress believed that giving unfettered control to a fund's manager or directors over who chooses the fund's investments was a bad idea. So it required that shareholders approve who manages their money.
Thwaites' argument is also inconsistent with the SEC's own interpretation of the scope of the multimanager voting exemption. In numerous nonpublic letters (obtained under the
Freedom of Information Act
) sent to funds that had requested exemptions, the SEC staff insisted that funds show "evidence of the type of 'multimanager' fund described in" Frank Russell's application.
The letters asked funds to demonstrate they were "using a bona fide multimanager strategy." To evaluate the funds' claims, the letters explained, the staff "examines the number of subadvisers employed for each portfolio, and the fund's operating history."
It is unclear how the Equitable and Skandia funds met this standard, as they never operated like a bona fide Frank Russell-type multimanager fund, and they offer at least 108 funds that have never had more than one subadviser.
Furthermore, the SEC staff required that each multimanager fund "hold itself out to the public as employing the multimanager structure." Yet the EQ, ASAF and AST funds effectively hold themselves out as conventional, single-manager funds.
The prospectuses of these funds include no discussion of their purported multimanager philosophy and refer only briefly to the restriction of shareholders' voting rights authorized by the SEC. Their prospectuses prominently highlight, however, the identities and expertise of each fund's subadviser.
In contrast, the Frank Russell touts its multimanager, multistyle philosophy as a primary selling point. It relegates the names of the subadvisers to the back of its prospectus.
The EQ, ASAF and AST funds even advertise the subadviser in the name of the fund, notwithstanding a nonpublic SEC letter to the EQ funds stating that the SEC staff was unwilling to support an exemption if a subadviser's name is part of the fund's name.
The staff argued that including the subadviser's name "suggests that investors should not rely on the Manager, but rather on the
subadviser whose name is part of the
Yet EQ offers a
T. Rowe Price International Stock
Morgan Stanley Emerging Markets Equity
Calvert Socially Responsible
fund. Notwithstanding the names of these funds, shareholders have no say in whether the managers they initially hired to manage their money would continue to do so in the future, because that decision is left to Equitable.
If you had invested in the
ASAF Oppenheimer Large-Cap Growth
fund in 1999, by May of 2000 you would have found yourself holding shares of the
ASAF Alliance Growth
supporters in Florida who inadvertently voted for
, your investment with Oppenheimer months later showed up in Alliance's hands.
A Growing Trend
This multimanager voting exemption is likely to spread, as the use of subadvisers is on the rise, according to a recent study by
Financial Research Corporation
. FRC found that one in nine funds uses a subadviser, representing $425 billion in fund assets. Investors poured $33 billion into subadvised funds in 1999, representing 10% of fund net sales, according to FRC.
In a second study released last month, FRC found that the use of subadvisers was particularly pronounced among variable annuity providers, such as Equitable and American Skandia. A variable annuity is an insurance product through which you can invest in a mutual fund and receive tax deferral and certain insurance benefits.
FRC found that out of 7,234 variable annuity funds, 4,787, or 66%, were subadvised. With subadvised variable annuities capturing 80% of total inflows into variable annuities, FRC concludes that shift toward subadvised funds will continue.
Continuing this trend, shareholders of the
funds recently agreed to forfeit their voting rights and to allow Prudential to replace subadvisers without shareholder approval.
If Prudential holds true to form, its "multimanager" Jennison funds will continue to have only one subadviser -- Jennison. Of the 10 Prudential funds that originally obtained a 1996 multimanager voting exemption, six have never had more than one subadviser, and the remaining four had never had more than two.
Institutional Shareholder Services
, a firm that advises institutional investors about proxy votes, advised its clients to oppose Prudential's proposal because it "gives a disproportionate degree of control to management at shareholders' expense." "What shareholders often don't realize is that the manager will typically hire one subadviser, if at all, and not exercise the potential this type of management structure allows," says Erin McNally, senior mutual fund analyst at ISS.
Variable annuity providers have shifted to the multimanager structure because their in-house money managers "too frequently fail to provide solid performance," explains FRC. Normally, using an outside manager to improve performance means giving up the advisory fee to an outside company.
But the multimanager structure enables the provider to skim a piece of the advisory fee off the top before passing it along to the subadviser. If the subadviser objects, the annuity provider can replace it without having to get shareholder approval.
Paying Frank Russell a fee for actively overseeing multiple subadvisers makes sense, but it's unclear what shareholders are paying Equitable, American Skandia and Prudential to do when their funds retain a single subadviser for years on end. Not surprisingly, FRC found that subadvised funds carry higher-than-average management fees.
Disappearing Voting Rights
The SEC's indiscriminating granting of voting exemptions to all comers has effectively repealed the right to approve fund advisers for thousands of shareholders and threatens to do so for thousands more.
And as I'll discuss later this week, the voting exemptions also effectively strip shareholders of their right to approve increases in the manager's advisory fees. Furthermore, there are serious questions about whether the exemptions are even legally valid.
Mercer Bullard, a former assistant chief counsel at the Securities and Exchange Commission, is the founder and CEO of Fund Democracy, a mutual fund shareholder advocacy group in Chevy Chase, Md. He welcomes your feedback at