When I was in grade school, we didn't have Google to answer all our inexhaustible questions about a given subject. Instead, we had to learn the hard way: schoolroom documentaries. You remember them, right? A chipper narrator, over the strains of peppy Muzak, would cogently explain everything about a thorny topic, usually titled something like
Nuclear Power and You
The fact that these programs are parodied today in everything from
The Full Monty
stands as a testament to how oddly effective they were. For today's column, I'd like to take a page from the old schoolroom format to address a crucially important issue regarding mutual fund investors: the role of the board of directors at mutual funds, especially independent directors. Let's call it:
Your Independent Director and You
Remember, class: Independent directors are your front line of defense in safeguarding your interests as an investor -- the
Securities and Exchange Commission
unofficially deputizes them as watchdogs. However, most of the 95 million investors have very little understanding of the responsibilities of the 3,000 or so independent directors at funds nationwide. And, frankly, it could be said that some independent directors don't have a full understanding of their responsibilities to investors, either.
Indeed, the performance of fund directors has been attacked this year by two giants among investing luminaries: Warren Buffett and Jack Bogle. In a letter to
investors, the Sage of Omaha likened fund directors to zombies in they way they rubber-stamp managers. Meantime, the Vanguard founder has deemed independent directors "lapdogs in disguise" for aligning themselves more closely with the fund firms rather than the investors they are supposed to serve.
The widening scandal regarding fund firms allowing abusive trading of funds raises the question, "
Where were the independent directors and should they have prevented this?" Nonetheless, other industry watchers insist the system has been hugely successful in its 63 years, even if it needs improvements. "Mutual fund boards actually work, maybe not as well as they will in the future," said C. Meyrick Payne, senior partner at Stamford, Conn.-based fund industry consultant Management Practice Inc. "It didn't work well this time, and it's a dreadful thing. But the worst thing that could happen is for everyone to say, 'See, I told you it didn't work' and get rid of directors."
As the role of fund boards draws closer scrutiny, let's take a more complete look at these boards, the functions they serve and, yes, address some of the shortcomings.
What Is a Mutual Fund Board of Directors?
A mutual fund's board is comprised of affiliated and independent directors who oversee a fund, which includes monitoring manager performance and compliance issues, approving fees charged to investors and setting contracts with the various entities that are necessary for the fund's operation -- distribution, trading and so on.
The parameters for fund boards were put firmly in place more than six decades ago, with the Investment Company Act of 1940 -- and they have been upgraded from time to time over the years. Under these rules, fund boards differ substantially from corporate boards in the paramount role assigned to independent directors in assuring the interests of fund holders are met.
Corporate boards have to look out for the interests of shareholders. While a fund firm and fund investors have some common interests -- among them, that the funds perform well -- there are some areas where their interests diverge -- among them, fund firms benefit from maximizing fee collection, while fund investors benefit from the lowest fee structure. Theoretically, fund boards -- especially independent directors -- are charged with monitoring all potential conflicts and serving as "watchdogs" for the interest of the fund holders.
"The fund industry has for a long time been way ahead of the corporate world -- their requirements for independence have been statutorily imposed since 1940," said David Ruder, former SEC chairman and head of the Mutual Fund Directors Forum, which works to educate directors on their responsibilities.
Under the "best practices" guidelines issued by the Investment Company Institute, the fund industry's trade group, two-thirds of a fund's board should be comprised of independent directors -- meaning they have no affiliation with the fund firm itself.
"Boards have overall responsibility for the funds," said Bob Plaze, associate director of the SEC's Division of Investment Management. "Taking care of fund shareholders is their responsibility."
What Are the Boards' Specific Responsibilities?
Directors are charged with several vital functions, which generally fall into three governance camps, according Ronald Gilson, a professor at Stanford and Columbia universities. "They play fiduciary for fund investors. They play a regulatory role for compliance issues. And third, there's a contractual governance issue," said Gilson, who also serves as an independent director for American Funds.
A big part of the job entails evaluating the performance of the fund's adviser -- the folks managing the fund. They must monitor the performance of the adviser managing the fund, negotiate the contracts with the advisers -- "seeing if funds are getting what they pay for," Ruder says -- and decide whether to keep or change the fund's managers and advisers.
In addition to hiring the fund's managers, boards also have to hire the various intermediaries and third-party providers who help keep the fund operating. Meanwhile, the rather complicated business of fund pricing, distribution and trading -- several of the issues that converge in the abusive-trading scandal -- also fall under the purview of fund directors.
Lastly, boards are enlisted by the SEC to help ensure funds comply with the laws that govern the industry. "There are a lot of laws written around compliance issues, but the performance issue is clearly where the public's interest is," said Management Practice's Payne.
What Are the Potential Conflicts of the Job?
As with virtually anything that involves at least two parties and money between them, there are some areas where fund investors and fund firms' interests are misaligned.
"What's good for the management company may not be good for the shareholders," said Jeff Kiel, vice president of Global Fiduciary Review at Lipper. "Managing that relationship is the role of directors, and it gets very little attention from the SEC."
While a great effort has been made by regulators and the industry to push for greater independence among its directors, critics say directors too often come to view their role as looking out for the needs of the fund firm, not the individuals. Several reasons are cited for this, among them: Directors have regular contact with the firms, but not with investors; directors are hired and paid by the firms; and the fund firms at times set the agenda for the board.
What Constitutes an Independent Director?
Everybody likes the notion of independent directors -- now, the industry recommends at least two-thirds of all directors be independent, up from 40% in 1940. The problem is: What exactly does independent mean?
Basically, independent means the directors must have no current affiliation with the management firm. However, often times, independent directors are longtime executives from the fund firms who retired a few years ago. While they may bring an insider's perspective to the proceedings, critics have duly noted that it's hard to consider them independent.
There have also been some instances where family members or close relations turned up as "independent directors," such as manager Ryan Jacob's uncle at the Jacob Internet fund a few years back -- which led syndicated columnist Charles Jaffe to quip that anyone who was invited to the manager's bar mitzvah doesn't quality as independent. Thankfully, the ICI has recently added to its list of best practices the prohibition of "close family members" of employees to serve as independent directors. Subsequently, Mr. Jacob's fund switch his uncle, Leonard Jacob, to an "affiliated director" from an "independent director."
"What's an independent director exactly? Family members, retirement fund company executives seem a bit questionable," said Morningstar's Kapoor.
Even without the presence of rather obvious conflicts of interests that may call the director's independence into question, there is also the concern that directors come to view their function as serving the fund firms, not the fund shareholders.
"Boards are hopelessly conflicted, and the reason is the management company has complete control over the entire operation," said Vanguard's Bogle. "They appoint and pay the fund officers, the chairman of the management company is usually the chairman of the funds -- it's hard for directors to speak up."
While "independence" is a tricky subject, former SEC Chairman Arthur Levitt probably summed it up best when he said that "director independence is more a state of mind than a legal status."
Are Independent Directors, in General, Effective in Their Jobs?
The answer to this question depends on who you ask -- some industry watchers think the boards were asleep at the wheel instead of monitoring for potential trading abuses that have recently been uncovered. Others, meanwhile, say they are doing a fine job and, until last month, didn't really have reason to expect such fraudulent behavior. The answer also varies from board to board.
"It's my impression that most of the fund directors are quite able and quite interested in serving investors -- they do not lay back," said the Mutual Fund Directors Forum's Ruder. "On the other hand, there are some directors who are not well informed and not very active.
Lipper's Kiel agrees, noting that sometimes smaller fund groups don't have enough money to afford big-name directors. Also, educating directors on there roles is a resource issue. However, the Directors Forum, the SEC and other groups have stepped up to fill the need to educate directors about their responsibilities.
While the question of whether they were asleep at the wheel is subject for debate, most industry watchers agree that a residual benefit of the unseemly scandal is that fund boards will aim to be much more vigilant.
How Much Do Directors Get Paid? How Are They Compensated?
Fund directors aren't hurting on a salary level, but most industry watchers think they are fairly compensated. The average fund director at the 50 largest firms earned $113,000 last year, up 8.2% from 2001, according to Payne's Management Practice. The average pay was lower at smaller firms.
Most directors are paid in cash. However, some fund watchers would like to see fund directors paid in fund shares -- which would more closely align their interests with those of shareholders. "When you pay them in fund shares, it would be more meaningful," said Morningstar's Kapoor, who believes fund directors should have more money in the funds than in remuneration from the fund company.
How Often Do Boards Meet?
Boards at smaller fund firms typically meet four times a year, while directors at larger fund firms may meet 11 times a year for two days at a time, according to Management Practice.
More than $100,000 for 11 meetings a year sound like nice work if you can get it, right? Yes, but fund directors have been kept busy. Many fund directors say 2001 was an especially busy year with the myriad corporate scandals at
, and the fund scandal this year may mean fund directors are putting in more hours at the office.
How Many Fund Boards Do Directors Sit On?
This is an issue that raises eyebrows for some critics. Fund directors at larger firms routinely sit on more than 25, 50 even 100 funds' boards. Fidelity, for instance, has one 14-member board for its 277 funds -- this is known as a unitary board. Of course, smaller fund firms may have unitary boards -- such as Dodge & Cox Funds, for instance -- but the potential concern seems less acute when the firm has a half-dozen or so funds.
"These guys often sit on number boards -- I don't know if they can name all the boards they are on," said Kapoor. The biggest problem this raises is whether a fund board can realistically take a granular approach to each fund's management and reasonably study the effectiveness of scores of fund managers. However, even some board critics, such as Vanguard's Bogle, acknowledge that it would be difficult and costly to have separate boards for a smaller number of funds.
"I like the idea of a unitary board," said Frischling. "It's not like you have 83 different companies."
But How Can One Board Serve All Those Funds Effectively?
Good question. Management Practice's Payne and others say that directors should -- and often do -- have resources at their disposal to do a good deal of research and monitoring of the funds.
"You shouldn't expect directors to do all the spade-digging, but you should expect them to get it done," Payne said. "They have independent counsel; they also have the capability to harness resources. This is how an effective board works."
One way to make the job easier, say many critics: Let the board have its own independent staff. This isn't as feasible at smaller fund firms, but directors at largest firms should push for it.
Why Don't They Ever Fire Lousy Advisers and Managers?
This is this question Buffett raised in his letter to shareholders, noting "a monkey will type out a Shakespeare play before an 'independent' (his quotes) mutual fund director will suggest that his fund look at other managers, even if the incumbent manager has persistently delivered substandard performance."
Regarding firing a fund adviser, he's right -- a board at Fidelity isn't going to drop Fidelity as the advisory firm and then hire, say,
T. Rowe Price
. Industry officials question the value of such a notion, however, saying people buy a Fidelity fund because they want a Fidelity fund.
The other issue here is fund managers specifically -- the skipper the advisory firm pays to put your assets to work. In one respect, Buffett is again right; while directors do pay a significant amount of time on performance, they rarely fire the manager.
However, this is a bit of a misnomer. When fund investors get those letters from their fund firm saying a new manager was brought in to co-manage a fund or that an underperforming fund would be merged with another fund, many times these are actions taken by the directors. It's not exactly firing a manager, but it is taking the reins away. According to Morningstar, fund firms in 2002 changed the manager at 12.8% of the 5,772 funds the firm tracked. In other words, while the underperforming skipper doesn't get publicly tarred and feathered (although some investors might not mind that) -- they do often lose their gigs.
Who Sets the Agenda for Director Meetings?
In the better fund companies, Ruder said, the lead director or chairman is an independent official who takes the lead in setting the board's agenda. However, roughly two-thirds of fund boards don't have an independent chairman -- which means the agenda may be set by a director affiliated with the firm.
Vanguard's Bogle and others complain that, often times, the board's agenda is set by the fund firms themselves -- and not enough by the independent directors. Similarly, Morningstar's Kapoor frets that the 15-C reports that firms give directors regarding their funds don't have to meet any specific standards.
"These reports aren't as useful as they could be," Kapoor said. "One of the things that bothers me is that most fund firms get to pick their peer group of funds when comparing costs. If you have an expense ratio that's high but your comparing your fund with higher-expense ratios, that's not a fair comparison."
What Are the Best Suggestions to Improve Boards?
The SEC put a number of reforms in place regarding fund directors in 2001, including mandating that boards should have a majority of independent directors. But in light of the current scandal, there is a near-unanimous belief that boards need to become more independent, more diligent and more effective.
Among the best suggestions: Disallow former fund executives to serve as independent directors. Case in point: The media has often reported the fact that Joseph DiMartino serves as chairman of Dreyfus Funds' board as "independent," even though he was president and chief operating office of the firm until 1995. Meanwhile, his compensation -- $816,000 for monitoring 191 funds -- has raised eyebrows.
Fund firms and these directors can talk till the cows come home that they can effectively serve as independent, but the fact is, most investors don't buy it. "This is especially true where the former management company executives, now independent directors, are paid statistically more than the other directors," Payne wrote recently. "It is time that mutual fund boards recognize that perception is reality."
On a related note, boards would be well-served appointing an independent director as chairman -- which is now the case at one-third of all fund boards.
Lipper's Kiel also suggests greater transparency in the voting process at boards. "If the voting records were published in a fund's statement of information, personalizing the directors' decisions would make them think a little bit more about how it would appear." Kiel frets, however, that turning the job into an extremely transparent exercise might narrow the pool -- and that it's hard to get individual investors to port over reams of pages about fund governance and voting records. That may be true -- but big institutional investors might pay closer attention.
Lastly, Bogle suggests giving the fund chairman a small staff to help collect more information "would be a major improvement."
What Should Directors Be Focusing On?
The hot-button issues facing directors currently are clearly late trading, market-timing and fund pricing and distribution issues.
The rise and increasing importance of intermediaries such as Security Trust, the trade-execution firm and trustee that allegedly helped Canary late trade funds "under the radar" -- without the funds' knowledge -- "is an issue that has to be addressed on an industry basis and a regulatory basis," said Barbash.
"The SEC has to come to resolution on how funds are sold. When salesmen have different incentives for selling funds, is that made known to investors? That's something that's been crying for attention for some time," Barbash said. Barbash also said soft-dollar arrangements between funds and brokers need to be addressed, because they don't "project the securities industry or the investment management firms in the best light."
These are issues boards should examine, as will legislators and regulators. Meanwhile, directors would also be well-served paying closer attention to three vital areas: fees, fees and fees.
How Can Investors Get in Touch With Directors?
Directors are there to represent the individual -- so individuals should help them help you. If individuals wish to raise questions or concerns about a mutual fund, its performance, costs or management, they should contact the board.
Investors can do that in two ways. First, the Statement of Additional Information typically includes lots of -- you guessed it -- additional information about the fund, including specifics on the directors. If funds don't provide it automatically, call them and ask to get it sent to you -- or see if it's on the firm's Web site. Dodge & Cox's SAI, for instance, details how much money each director has invested in Dodge & Cox funds. The SAI should include some way to contact the board.
If this is too elaborate, try option No. 2: Call the fund firm and ask how you can get in touch with the directors. Now, directors aren't in the business of answering routine customer-service questions every day, and they shouldn't be. Nonetheless, they are there to serve you.