Fund Shareholders Research Articles

What Independent Directors Should 'Request' of Mutual Fund Advisers

The background to this study is the failure of mutual fund independent directors to fulfill their obligations as “shareholder watchdogs,” as defined in the Investment Company Act of 1940. Normative transparency of information is fund adviser disclosure proactively “requested” by independent directors to enable their fiduciary roles as “shareholder watchdogs.” U.S. District Judge Feess’s opinion in a mutual fund case of excessive fees provides a candid assessment of independent director performance. He supports the view that directors are likely to “go along” with mutual fund adviser plans and actions. This view suggests directors are unlikely to “request” normative information required to serve the “primary interests” of fund shareholders. The judge’s opinion includes numerous revealing insights on the performance [poor] of independent directors. These revelations and other relevant issues in the opinion provide case-based support for independent directors to “request” fund advisers to provide normative transparency of information for their analysis. To achieve normative transparency of information Independent directors and advisers of major funds known for shareholder stewardship must strongly, vigorously, and proactively work together to gain approval in Congress and/or the SEC. The outlook is not bright, but the goal is worthy of the challenge.

Mutual Funds and the New Total Expense Ratio

This article presents the construct of a <i>New</i> Total Expense Ratio built upon the concept of normative transparency of disclosure that presents the reality of adviser/distributor payments to brokers “behind the mutual fund curtain.” These payments are paid indirectly by fund shareholders by way of fund fee payments. Approval of the <i>New</i> Total Expense Ratio should foster significant prohibitions and changes in the types of huge payments made by mutual fund advisers from fund assets to brokers based on or derived from sales of adviser fund shares. <b>TOPICS:</b>Mutual fund performance, manager selection, risk management

Why Have Mutual Fund Independent Directors Failed as “Shareholder Watchdogs”?

This article discusses the four basic reasons why mutual fund independent directors have failed in their roles as “shareholder watchdogs” under the Investment Company Act of 1940.There is a current case before the Supreme Court that could find that an adviser charged its mutual funds’ shareholders excessive advisory fees. The author believes that without relief from the Supreme Court,mutual fund shareholders must continue to depend on inadequately empowered, motivated, and informed independent directors to do what they can as shareholder watchdogs.

Corporate Campaign Spending: Giving Shareholders a Voice

The Supreme Court has radically altered the legal landscape for politics with the 5-4 decision in the case Citizens United v. FEC, handed down on January 21, 2010. Turning back decades of statutory law, the Court has elevated the First Amendment rights of corporations to speak during elections, and has created a new paradigm for how political campaigns may be funded. The way that corporations “speak” is by spending money, usually to purchase advertisements that most individuals could not afford to finance.Now that the Court has held that publicly-traded corporations have the same First Amendment protections as individuals, limitations on Congress’ ability to regulate their spending will be severely constrained. That means that corporate treasury money – including the funds invested by individuals, mutual funds, pension funds and other institutional investors – can be spent on politics without alerting investors either before or after the fact. Under current laws regulating corporations, there is nothing that requires corporations to disclose to shareholders whether funds are being used to fund politicians or ballot measures, or how the political money is being spent. Moreover, shareholders have no opportunity to consent to the political use of corporate funds. This does not have to be the case. Britain has an alterative approach. In the U.K., companies disclose past political expenditures directly to shareholders. And more importantly, shareholders must authorize corporate political spending before a corporation uses shareholder funds on political spending. This report argues for the United States to change its securities laws in the wake of Citizens United to (1) provide notice to shareholders of any and all corporate political spending and (2) to require shareholder authorization of future corporate political spending.

Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship

Mutual Funds: Portfolio Structures, Analysis, Management, and Stewardship

The Economics of the Mutual Fund Trading Scandal

I examine the economic incentives behind the mutual fund trading scandal, which made headlines in late 2003 with news that several asset management companies had arranged to allow abusive--and, in some cases, illegal--trades in their mutual funds. Most of the gains from these trades went to the traders who pursued market-timing and late-trading strategies. The costs were largely borne by buy-and-hold investors, and, eventually, by the management companies themselves. A puzzle emerges when one examines the scandal from the perspective of those management companies. In the short run, they collected additional fee revenue from arrangements allowing abusive trades. When those deals were revealed, investors redeemed shares en masse and revenues plummeted management companies clearly made poor decisions, ex post. However, my analysis indicates that those arrangements were also uneconomic, ex ante, because--even if the management companies had expected never to be caught--estimated revenue from the deals fell well short of the present value of expected lost revenues due to poor performance in abused funds. Why some of the mutual fund industry&amp;amp;#x27;s largest firms chose to collude with abusive traders remains something of a mystery. I explore several possible explanations, including owner-manager conflicts of interest within management companies (between their shareholders and the executives who benefitted from short-term asset growth), but none fully resolves the puzzle. Management companies&amp;amp;#x27; decisions to allow abuses that harmed themselves as well as mutual fund shareholders convey a broader lesson, that shareholders, customers, and fiduciary clients be cautious about relying too heavily on firms&amp;amp;#x27; own self-interest to govern their behavior.

Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry

AbstractWe use a unique database on ownership stakes of equity mutual fund directors to analyze whether the directors’ incentive structure is related to fund performance. Ownership of both independent and nonindependent directors plays an economically and statistically significant role. Funds in which directors have low ownership, or “skin in the game,” significantly underperform. We posit two economic mechanisms to explain this relation. First, lack of ownership could indicate a director’s lack of alignment with fund shareholder interests. Second, directors may have superior private information on future performance. We find evidence in support of the first and against the second mechanism.

Myths About Mutual Fund Fees: Economic Insights on Jones v. Harris

Mutual funds stand ready at all times to sell and redeem common stock to the investing public for the net value of their assets under management. In the language of transaction cost economics, they are open-access common pools subject to virtually free investor entry and exit. The Investment Company Act (1940) requires mutual funds to be managed by an outside advisory firm pursuant to a written contract, which normally pays the adviser a small share of net asset value, say, one-half of one percent per year. Following 1970 amendments to the Investment Company Act imposing a fiduciary duty on advisers with respect to their receipt of compensation, a large number of private civil suits attempting to recover excessive fees have been filed against advisory firms. By failing to account for the transaction costs inherent in mutual fund organization, Congress, securities regulators, financial scholars, and even courts have misidentified a conflict of interest with respect to fund advisory fees, encouraging these frivolous suits. With free investor entry and exit and rational expectations, fund flows endogenize investor returns. Regardless of the level of the advisory fee, any expected abnormal return to a manager’s superior stock-picking skill will be competed away by investors chasing the prospect of capturing the associated rents. With shareholders having a common claim to fund assets, all expected rents will be either transferred to the manager in the form of higher total fee payments on a larger asset base or dissipated by added administrative costs. As a first approximation, the level of advisory fees is therefore irrelevant to fund shareholders. The best they can expect from placing their money in a managed fund is a normal competitive return after adjusting for risk and other factors. With the U.S. Supreme Court having recently granted certiorari in an excessive fee case appealing an arguably maverick opinion by Judge Frank Easterbrook of the Court of Appeals for the Seventh Circuit, it is essential that various myths about mutual fund fees be exposed to careful economic analysis.

Business Networks, Corporate Governance, and Contracting in the Mutual Fund Industry

ABSTRACTBusiness connections can mitigate agency conflicts by facilitating efficient information transfers, but can also be channels for inefficient favoritism. I analyze these two effects in the mutual fund industry and find that fund directors and advisory firms that manage the funds hire each other preferentially based on the intensity of their past interactions. I do not find evidence that stronger board‐advisor ties correspond to better or worse outcomes for fund shareholders. These results suggest that the two effects of board‐management connections on investor welfare—improved monitoring and increased potential for collusion—balance out in this setting.

Who incentivizes the mutual fund manager, new or old shareholders?

Abstract This study tests whether mutual fund shareholders continue to trade in response to fund returns after they make their initial investment in fund shares. It decomposes the relationship between fund returns and shareholder flow in a large, proprietary panel of all shareholder transactions in one midsize no-load mutual fund family. Results show that both new and old shareholders buy shares during periods of good returns; however, shareholder outflow is essentially unrelated to fund returns. This lack of a return-sell relationship is not driven by locked-in pension assets, shareholders’ ignorance of ongoing fund returns, or embedded capital gains. However, there is evidence that exchanges between equity funds in the family are related more strongly to returns of the destination fund than to returns of the origination fund. This may indicate that flow between equity mutual funds is driven by shareholders buying new funds rather than selling old funds. Supermarket shareholders are smart insofar as they exchange into funds that subsequently outperform their prior funds during their individual holding periods.

The Economics of the Mutual Fund Trading Scandal

I examine the economic incentives behind the mutual fund trading scandal, which made headlines in late 2003 with news that several asset management companies had arranged to allow abusive--and, in some cases, illegal--trades in their mutual funds. Most of the gains from these trades went to the traders who pursued market-timing and late-trading strategies. The costs were largely borne by buy-and-hold investors, and, eventually, by the management companies themselves. ; A puzzle emerges when one examines the scandal from the perspective of those management companies. In the short run, they collected additional fee revenue from arrangements allowing abusive trades. When those deals were revealed, investors redeemed shares en masse and revenues plummeted; management companies clearly made poor decisions, ex post. However, my analysis indicates that those arrangements were also uneconomic, ex ante, because--even if the management companies had expected never to be caught--estimated revenue from the deals fell well short of the present value of expected lost revenues due to poor performance in abused funds. ; Why some of the mutual fund industry's largest firms chose to collude with abusive traders remains something of a mystery. I explore several possible explanations, including owner-manager conflicts of interest within management companies (between their shareholders and the executives who benefitted from short-term asset growth), but none fully resolves the puzzle. Management companies' decisions to allow abuses that harmed themselves as well as mutual fund shareholders convey a broader lesson, that shareholders, customers, and fiduciary clients be cautious about relying too heavily on firms' own self-interest to govern their behavior.

Selection or Influence? Institutional Investors and Corporate Acquisitions

This paper shows that the presence of large public pension fund shareholders particularly reduces ex ante bad acquisitions. When firms with large public pension fund presence do acquire other firms, they perform relatively better in the long-run. Other institutional investors have either the opposite effect or no effect. To establish the direction of causality between institutional ownership and observed corporate merger and acquisition decisions, it is crucial to identify the sources of exogenous variations in institutional ownerships. This paper introduces two instrumental variables, one of which borrows the concept of a Bartik'' instrument from the labor economics literature.

The End of “Soft Dollars”?

Over the past few decades, mutual fund shareholders have paid to brokerage and investment banking firms billions of dollars in so-called soft-dollar commissions that have far exceeded the costs of executing the transactions. Over the years, the U.S. SEC’s inconsistent interpretations of pertinent sections of the Securities Exchange Act of 1934 have generally allowed the continued use of soft dollars for the payment of not only brokerage commissions but also research products and services. This article discusses the history of the practice and suggests two approaches that may hasten the end of the era of soft dollars: client commission-sharing arrangements and paying for research directly in cash. See comments on this article.

The &lt;i&gt;Total&lt;/i&gt; Expense Ratio: The Reality of Distribution Fees 'Behind the Mutual Fund Curtain'

This study uses the portion of a new Total Expense Ratio construct that discloses the reality of adviser/distributor payments of distribution fees (hidden) to sales brokers behind the mutual fund curtain. Distribution fees consist of dealer (broker) concessions, account servicing (12b-1) fees), types of revenue sharing payments, and soft-dollar trades. Distribution fees are one of four categories in the Total Expense Ratio, the others being (1) management fees, (2) other expenses, and (3) transaction costs.Distribution fees and their sub-categories are the scope of this study, but adoption of the complete Total Expense Ratio would provide mutual fund investors with normative transparency of disclosure of its four categories and their sub-categories. Such transparent disclosure would provide necessary, but not sufficient, conditions for complete adoption of transparent disclosure to the full scope of fund adviser managerial and regulatory practices and decisions.Adoption of the complete Total Expense Ratio with normative transparency of disclosure followed by prohibition of 12b-1 fees, revenue sharing payments, and soft-dollar trading requires strong action by fund independent directors, the fund industry, and, most importantly, by Congress and the SEC. Only a few fund advisers are likely to join in this effort to change their very profitable status quo. But, fund shareholders deserve to receive their fiduciary protections under law.

Why Have Mutual Fund Independent Directors Failed as 'Shareholder Watchdogs'?

There are four basic reasons why mutual fund independent directors have failed in their roles as “shareholder watchdogs” under the Investment Company Act of 1940. The first reason is the Act’s flawed regulatory structure that insufficiently empowers independent directors to meet their fiduciary responsibilities under the Act. The Act in fact “outsources”oversight of fund advisers to independent directors, but fails to adequately empower them through direct SEC adviser oversight.The SEC thus relies on independent directors to oversee fund advisers and protect shareholder interests. But, the lack of effective adviser oversight (also including director acquiescence and ignorance) has led to numerous improper practices that conflict with fund shareholder interests.The second reason mutual fund independent directors have failed as shareholder watchdogs reflects the flawedstructure of fund boards. The 40Act gives independent directors a specified set of responsibilities, of which approval of fund advisory fee contracts and those with other service providers are primary. Research has shown significant relationships between size of fund advisory fees and number of independent directors, the number of independent directors relative to the total number of fund directors, and percentage of adviser’s fund and other fund assets subject to director oversight.The third reason for failure of mutual fund independent directors to act as shareholder watchdogs is the failure of the 40Act and the SEC to provide for normative transparency of disclosure of adviser practices. Normative disclosure isessential to directors and certainly shareholders being able to monitor adviser practices. This is a very important issue as there are numerous generally hidden adviser conflicts of interest that reduce shareholder assets and returns. If Congress and the SEC were to require wide-ranging and detailed disclosure that comprise normative transparency, much of what is needed in improved egulation, including the ability ofindependent directors to perform as effective shareholderwatchdogs, would be provided.The fourth reason why mutual fund independent directors are not effective shareholder watchdogs is that Federal courts have historically refused to hear shareholder petitions of excessive mutual fund advisory fees relative to the value of shareholder services. Since the precedents laid down in the 1982 Gartenberg case, courts have left effective oversight of excess advisory fees to assumed [incorrectly so] “arms length” negotiations between advisers and independent directors based on the assumption [incorrectly so] that fund markets are price competitive.These precedents may well fall if the Supreme Court in its fall 2009term rules adviser Harris Associates charged its Oakmark funds shareholders excessive advisory fees. Without this relief, mutual fund shareholders must continue to depend on inadequately empowered and informed independent directors to do what they can as shareholder watchdogs. This would be a sad commentary given the “laundry list” of self serving adviser practices that reduce shareholder assets and returns, but which are effectively hidden from shareholders,especially retail investors.

Mutual Funds and the New Total Expense Ratio

This study presents the construct of a New Total Expense Ratio built upon the concept of normative transparency of disclosure that presents the reality of adviser/distributor payments to brokers behind the mutual fund curtain. These payments paid indirectly by fund shareholders by way of fund fee payments. The New Total Expense Ratio includes: (1) management fees, (2) distribution fees, (3) other expenses, and (4) transaction costs. Sub-categories are also included.Approval of the New Total Expense Ratio should foster significant prohibitions and changes in types of the huge payments made by mutual fund advisers from fund assets to brokers based on or derived from sales of adviser fund shares. However, the road to approval of the Ratio and prohibition or change in its revealed types of adviser/distributor payments (by way of fund fee payments) to brokers will require enormous widespread efforts against fund advisers who will fight to the bitter end to keep their most profitable status quo.

Investor Learning and Mutual Fund Advertising and Distribution Fees

Barber, Odean, and Zheng’s (2005) analysis of mutual fund front-end loads, sales commissions, and operating expenses finds that over the past several decades ordinary investors have “learned” what it is they value in choice of funds. And, fund advisers learned early on to provide what attracts ordinary investors to particular funds - larger advertising. While advertising now represents only two percent of 12b-1 fees, it remains large enough in absolute terms to be effective in attracting ordinary investors and increasing fund flow. The resulting growth in fund asset size has benefited advisers with additional economies of scale and larger dollar receipts of operating expenses, including management fees and 12b-1 fees. Fund shareholders thus pay major asset and performance penalties by giving such little consideration to fund operating expenses, especially component 12b-1 fees.Distribution fees, a major category of the New Total Expense Ratio, are the focus. Distribution fees (%) include (1) selling group payments of (a) dealer (broker) concessions and (b) account servicing fees; (2) revenue sharing payments net of adviser fall-out benefits that include (a) broker marketing pools, (b) broker (bonus) compensation, (c) syndicated distributions, (d) sub-transfer agency fees, and (e) networking fees; and (3) soft-dollar trades net of rebates to advisers. Mutual fund distribution fees have major agency conflicts with fund shareholder assets and performance. Fund adviser/distributors should be prohibited from using fund assets to make distributor fee payments to brokers. Brokers should include any of what are currently called broker (dealer) concessions, account servicing fees, and component revenue sharing payments they wish to impose as one time upfront charges at time of investor share purchase. Further, fund adviser fall-out benefits on revenue sharing payments and soft-dollar trades should be prohibited by regulation.

Agency costs, governance, and organizational forms: Evidence from the mutual fund industry

Using a comprehensive sample of mutual funds and fund families for the period 1992–2004, this study examines the impact of fund management companies’ organizational forms on the level of agency costs within mutual funds. We find that, all else being equal: (1) funds managed by public fund families charge higher fees than those managed by private fund families; (2) public fund families acquire more funds than private fund families; and (3) funds of public fund families significantly underperform funds of private fund families. Collectively, these findings suggest that agency costs are higher in mutual funds managed by public fund families. Our results are consistent with the idea that the agency conflict between the fund management company and fund shareholders is more acute for public management companies because of their shorter-term focus.

Supreme Court Amicus Brief of Law Professors in Support of Certiorari, Jones v. Harris Associates, No. 08-586

Amici curiae law professors filed this brief to urge the Court to grant the petition for certiorari and to clarify the proper scope of the fiduciary duty under Section 36(b) of the Investment Company Act that investment advisers owe to mutual fund shareholders with respect to the compensation that advisers receive. The brief addresses the Seventh Circuit's decision to disavow the long-established Gartenberg precedent and to hold, instead, that so long as an adviser make[s] full disclosure and play[s] no tricks, a plaintiff cannot prevail in a Section 36(b) action. Amici argue that the Seventh Circuit's decision creates a circuit split, elides a critical provision from the statutory text, and engages in a superficial market analysis.

UNITARY BOARDS AND MUTUAL FUND GOVERNANCE

AbstractA unique governance structure for mutual funds is unitary board—one board overseeing all funds in the entire family. We find strong evidence for unitary board as an effective governance mechanism. Funds with unitary boards are associated with lower fees, are more likely to pass the economies of scale benefits to investors, are less likely to be involved in trading scandals, and rank higher on stewardship. In contrast, funds with larger or more independent boards charge higher fees and rank lower on stewardship. Our findings indicate that unitary boards of small size, rather than independent boards, may be more beneficial to fund shareholders.