Chapter 13. The Watchdogs Are Cocker Spaniels, Not Dobermans 1
Chapter 13. The Watchdogs Are Cocker Spaniels, Not Dobermans [1]
Who would you rather be, a shareholder of Alliance Quasar Fund, or a director of the Alliance funds, based on the information in the next paragraph? If you have trouble answering this question after reading the following, finance might not be your strong suit! As a shareholder of Alliance Quasar Fund, from 1997 through 2001 you would have earned 0.17 percent per year ”that's 17 hundredths of one percent a year on average, far below the return on Treasury bills. For this you would have paid an annual expense ratio of 1.67 percent, compared to an average expense ratio for other funds of this type of 1.42 percent. Alternatively, as one of the six independent directors of the 38 Alliance funds, in the year 2000 you would have earned an average of $186,432. [2]
Here is a sobering statistic: There are approximately 700 fund families in the United States, such as Fidelity, Vanguard, Janus, Wasatch, Northern, and so forth. Of these 700, about two dozen have annual meetings where shareholders can interact with fund managers. Who speaks for the shareholders, and what rights do they really enjoy? Consider, as one example, Franklin Resources, a publicly traded company that manages mutual funds. Because it is publicly traded, stockholders of the corporation are guaranteed the disclosure of certain information about the company ”a guarantee enforced by the SEC. The CEO of Franklin Resources made $600,000 in salary in a recent year, with a bonus of $460,000 in a good year ($0 bonus if a bad year). The CEO also owns about 47 million shares of stock in the company, worth almost $2 billion when the stock is trading at around $45. All of this information has to be disclosed in documents issued by the company. The company's stockholders can reasonably assume that the CEO has the maximization of their welfare at heart because his or her welfare is intimately tied to the company's success. The bad news is for the company's mutual fund shareholders. Generally, they do not know much if anything about their managers' motivations. This includes important items such as how much they make, any incentives provided to them, or if they invest their own money in the fund. Why? Very simply, much stricter disclosure standards exist for stocks than funds. Publicly traded corporations must disclose information on a quarterly basis, and this information is quite extensive . Therefore, stockholders have detailed earnings information that can be no older than a few months, and might be as fresh as a few weeks. Furthermore, stockholders receive an annual report mailed to them and can access required SEC filings online. For mutual fund shareholders, however, disclosures occur only twice a year about the portfolio holdings of the fund. [3] Such information may be between two and eight months old, a big difference from the situation for stockholders. For example, a fund with a fiscal year ending in June could provide the required information at the end of August.
Don't look for this situation to change soon. The ICI is the trade group for mutual funds and speaks for the industry. In August 2001 the ICI sent a letter to the SEC opposing more frequent disclosures of the portfolio holdings of mutual funds. Their argument was that if more frequent disclosures of fund holdings are made, traders might determine what stocks the funds are buying and act first, driving prices higher. Of course, given any reasonable lag in disclosing portfolio positions more often, such as 30 or 60 days, it is difficult to see how this would be significant. The prevailing attitude of the ICI is not encouraging for shareholders. The general counsel for the organization was quoted as saying, with regard to more frequent disclosure, "The risks of harm to fund shareholders far outweigh any potential benefits." [4]
Mutual funds are unique in that they are the only companies required by law to have independent directors. If all else fails, the fund's directors look out after the shareholders, right? Wrong! Shareholder protection in this regard leaves a lot to be desired. Once again, mutual fund shareholders face problems they often do not realize even exist. This is true across the board, including shareholders who are knowledgeable enough to know about the Investment Company Act of 1940, the basis of mutual fund regulation. This act is widely hailed, and rightly so, as a very successful piece of legislation that has helped ensure a fair, fraud-free, well-run industry with strict disclosure of information standards. As in the case of a corporation, mutual fund shareholders look to fund managers to run the fund on their behalf , and in their best interests. Exactly like corporations, the mutual funds have a board of directors that is charged with looking after the interests of the shareholders. However, the watchdogs supposedly in place to ensure that the fund is being managed for the shareholders often are not doing their jobs. These watchdogs are the independent directors of the fund, similar to the board of directors of a corporation. The Investment Company Act of 1940 states that a fund is to have independent directors who play a " disinterested " role. The majority of a fund's directors must be independent, which means they cannot have business or family ties to the fund company for which they serve as a director. Fund directors have a legal obligation to shareholders. Under the Investment Company Act of 1940, the interests of fund shareholders must be placed ahead of the interests of the fund managers and those that distribute the funds. However, it often appears that shareholder interests are not being well protected. For a typical mutual fund, the fund's chairman invites directors to serve on the board. The officers of the fund are the ones who control the agenda for the board meetings. The combination of the fund officers directing the meetings and the fund directors being well paid is often a lethal one from the standpoint of shareholder interests. And the directors are well paid. Fidelity pays its directors between $215,000 and $265,000. Not bad work if you can get it, but it pales in comparison to Morgan Stanley and Merrill Lynch, where directors average more than $500,000 in salary. Is it any wonder a number of critics believe that many fund directors are overpaid, underworked, and simply not effective? The industry response is that directors have helped ensure a well-functioning investment opportunity with minimal problems for many years . Of course, in the strong bull market of the 1990s, it was easy for everyone to look good. According to John Bogle, five of the highest paid mutual fund directors receive fees that average $386,000 (not counting annual pensions of more than $100,000 in two cases). [5] What is interesting is that the directors for the financial conglomerates that run these funds average only $47,000 in compensation. According to Bogle, a study done by Morningstar a few years ago reported that for the 10 highest paying fund complexes, the annual fee for an independent director averaged $150,000. In contrast, the directors' fee paid by the 10 highest paying Fortune 500 companies was about half of that amount.
Supposedly, Warren Buffett has said that as watchdogs, the role they are supposed to play, fund directors are "cocker spaniels, not Dobermans." [6] Given the typical submissive role of directors in the United States, and the financial incentives for going along with the desires of fund management, is it any wonder that the mutual fund landscape is constantly changing, with funds coming and going; that portfolio turnover has soared as managers pursue the golden grail of performance, generating in the process higher transaction costs and heavier taxes to be paid by shareholders as a result of all the buying and selling; that expense ratios charged to shareholders have risen over time, costing more and more? Who is protecting the shareholders' interests?
Instead, what is happening is the reverse: Funds take actions supposedly designed to help shareholders, and perhaps they do. However, they also impose burdens on some investors. With the tremendous growth in mutual fund assets and their popularity with investors, the industry has in some ways become complacent, and has also thrown up some new obstacles for some investors.
Many of the largest fund complexes ”Fidelity, T. Rowe Price, and Dreyfus, for example ”now charge fees for accounts that drop below some specified level, often $2,000. The fee can be as low as $10, and as high as $100 for some funds sold by brokerage firms. An investor who has an account that declines in value either because of poor performance or because of market declines can switch the money in such a fund to an alternative fund in the same complex easily and simply. For example, an investor could choose to do this if an equity fund was declining in value and the investor thought it made sense to switch to a money market account or some other conservative fund. The only problem is that the investor might have to meet the higher minimum requirement of the fund that is switched to or be forced to close the fund account. Thus, as a result of a market decline, an investor might actually be forced to close an account. Fund complexes are also increasing the minimum amount needed to open an account. Vanguard, known for its service and dedication to shareholders, has raised the minimum on four of its funds from $10,000 to $25,000. The minimum on its Admiral Shares, which have even lower costs than its regular funds, is $50,000. Franklin Templeton, Strong Funds, and Van Kampen have also raised the minimums on some of their accounts. Other fund minimums are hefty as well, such as the Dreyfus Basic Money Market Fund and the Dreyfus Basic U. S. Government Money Market Fund, both with minimums of $25,000. As the head of a company that encourages small-account customers to invest on a monthly basis said, fund firms "used to be more friendly to the small investor." [7]
There might be some light at the end of the tunnel. In January 2002, the SEC put into effect new rules that require more disclosure from directors. Shareholders have three sources of information about a fund's directors: the fund's annual report, the Statement of Additional Information (a report filed annually and available from the fund on request), and any proxy statements that involve the election of directors. Under the new rules, every fund's annual report has to provide a much clearer disclosure of basic information about directors, including who they are and where they can be contacted. Previously, this information was available only in the Statement of Additional Information, which most shareholders did not know existed. The Statement of Additional Information, like the fund's annual report, must disclose the following types of information about a fund's directors: basic information about the directors, including who they are, their occupations, and how long they have served as directors; the number of portfolios overseen; and whether they hold other outside directorships. In addition, the statement must disclose a director's aggregate holdings in the fund family and any conflicts of interest. Perhaps of most interest, the statement must also discuss the basis for approving a fund adviser's contract.  |
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