Finally, most fund directors are hardly in a position to think of themselves as “owners of the business representing other owners.” Their shareholdings, rarely made public and even more rarely reported in the press, ordinarily range from nominal to nonexistent. The recent proxy statements for the funds in one large fund complex, although anecdotal, are hardly unusual. The typical independent director owned shares in 10 of the 24 funds in the complex; the aggregate amount was 1,900 shares, or 190 shares per fund with a market value averaging about $3,000. The total: $30,000 invested in the shares of all of the funds the

TABLE 18.1 Average Fees Paid to Highest-Paid Fund Directors

Rank	1996	2008
1	$240,986	$312,794
2	184,750	294,115*
3	172,532**	289,071
4	145,629	260,211
5	141,683	258,175
Average	$177,116	$282,873
*The chairman of the board of this complex was paid $408,000.
**The chairman of the board of this fund firm, who was considered independent (unaffiliated with the manager), received $431,000 for his labors.

director serves. That financial interest, one might say, is modest to a fault. Given the pervasive nature of minimal personal financial commitments by directors, exemplified in this instance, there is clearly no necessary alignment of the interest of the directors with the interest of shareholders.

In all, mutual fund governance is riddled with conflicts—in the composition of the board, in the nature and frequency of the meetings, and in the level of directors’ fees—and the situation is exacerbated by the rarity of significant ownership of fund shares by independent directors. If this situation were not sufficient to give the management company de facto control over the fund, surely the fact that the company also typically provides virtually every service necessary to the fund—administration, portfolio management, and distribution, under what amounts to a single bundled contract—would be the icing on the cake in establishing that the management company, not the fund shareholder, is the master who will be served.

TEN YEARS LATER

The Levers of Control

Table 18.1 reflects the astonishing rise in fund directors’ fees over the past decade, which typically run nearly 20 percent higher than the fees paid to the directors of our giant industrial corporations, even though corporate directors are ultimately responsible for the management of the company while fund directors are primarily responsible only for hiring the company that manages the fund.

Ironically, in yet another example of the power of fund management companies to minimize the full disclosure that was once the industry’s hallmark, funds are no longer required to report the number of fund shares held by their directors. They report only ranges of holdings, the highest being $100,000 or more. So if a director who owned, say, $1 million of a fund’s shares liquidated $899,999 of those shares—leaving a holding of $100,001—there would be no way for shareholders to know of the change. Why the Securities and Exchange Commission (SEC) came to allow mutual funds—alone among all publicly held companies—to avoid full disclosure of director holdings remains a mystery. (Ditto for the SEC’s failure to require disclosure of the compensation paid to fund senior executives. The plot thickens.)

Nonetheless, we do know how often directors have no holdings of fund shares. In one of the largest complexes, surely not atypical, independent directors hold no shares—zero—in 121 of the 154 funds on whose boards they serve. Fund directors seem particularly averse to holding shares in the exotic funds created by fund marketers during the recent decade, a warning sign—however buried in the plethora of verbiage contained in fund prospectuses—that their approval of these funds came without enough confidence to attract their investment attention. For the investor considering such funds, caveat emptor!

The Consequences of Control

The results of this structure are clear. First, returns earned for mutual fund shareholders have been lackluster compared to market returns. Over the past 16 years, only 42 of 258 professionally managed equity funds outpaced the unmanaged all-market Wilshire 5000 Equity Index. In bond funds, the picture was even darker relative to appropriate unmanaged bond indexes. And in money market funds, outpacing an unmanaged index of short-term rates proved simply out of the question. No fund did so.

The principal reason for these consistent shortfalls is the drag of fund expenses. Let me apply a legal analogy to the field of financial services. I’ll call the equation Gross Return - Expenses = Net Return the constitutional principle, and the tenet “In efficient markets, mediocrity is the norm” the statutory law. But in the financial services arena, the constitutional principle cannot be amended, nor can the statute be repealed. They represent the immutable facts of financial life.

Despite the astonishing growth of fund assets, fee rates continue to rise at an accelerating rate. This pattern of rising fees is not a new phenomenon; indeed, it almost seems eternal. Since the inception of the U.S. fund industry in 1924, minimum fee rates on new funds have edged persistently higher; they rose from 0.38 percent to 0.58 percent during the first six decades. (These are minimum fee rates, the lowest rates in the fee schedule, and are usually reached only at very substantial levels of future fund assets that may never be attained. Average rates are inevitably higher, usually substantially so.) During the 1980s and 1990s, however, the rate of increase tripled: the minimum fee rose from 0.58 percent to 0.72 percent—or almost 25 percent. And this increase came hand in hand with a 37-fold increase in fund assets, resulting in a far larger increase in fees. Figure 18.1 shows the near doubling of minimum fee rates paid by the average fund over the industry’s history.

What is more, new types of expenses—added to the management fees paid by the funds—have entered the fee structure. Fees are now paid to advisers who then select subadvisers, who get paid for doing the actual portfolio management, a fairly recent phenomenon. Since 1980, distribution fees charged directly to fund assets have become pervasive. These so-called 12b-1 fees, used solely to foster sales of new fund shares, are now imposed by 60 percent of all funds.

FIGURE 18.1 Management Fee Rates over Time (1920-2008, Base 100)

Rising advisory fee rates and new distribution fees, along with higher fund operating expenses, have combined to sharply raise fund expense ratios. During the past 15 years, for example, the expense ratio of the average equity fund has risen from 1.04 percent to 1.55 percent. During the same period, equity fund assets have risen 35-fold, from $80 billion to $2.8 trillion. Estimated expenses borne by equity funds have grown from $600 million to $34 billion—roughly a 60-fold increase.

Managers’ profits have grown even faster. Despite their widespread failure to outmanage yardsticks that are unmanaged, fund managers are now typically booking pretax profit margins in the range of 40 percent or more. And 50 percent to 70 percent margins doubtless exist before taking into account marketing expenditures—costs that benefit fund managers by increasing assets, but are borne by the fund shareholders. If these margins seem high, recognize that there are now thriving financial corporations that pay huge prices to buy investment advisory firms, simply for the right to receive 50 percent of their revenues. The advisory firms themselves continue to operate, making good money even after relinquishing fully one-half of their revenues.

Management companies are also being sold in the marketplace to financial services conglomerates at values that assume these remarkable margins will continue. These firms, anxious to make “one-stop shopping” available for their services, typically pay prices for fund managers’ firms equal to 3 percent to 5 percent of fund assets managed. For example, a manager of a $10 billion fund complex would be paid $300 million to $500 million, not a penny of which would go to the shareholders of the fund who created the value of the enterprise in the first place.

The clear conflict of interest in the division of rewards between management company owners and fund owners when companies are sold—and, far more fundamentally, in the setting of advisory fee rates that determine what share of a fund’s returns will go to each party—is the central issue facing the mutual fund industry, and it is the responsibility of fund directors to resolve it. I do not believe they can resolve it fairly if they attempt to serve two masters.

TEN YEARS LATER

The Consequences of Control

After rising by fully 50 percent—from 1.04 percent in 1983 to 1.55 percent in 1997—the expense ratio of the average equity fund at last leveled off and eased downward over the past decade-plus, averaging 1.3 percent in 2008. But the dollar amount of fund expenses has continued to soar. Total equity fund costs, estimated at $600 million in 1981 and $30 billion a decade-plus ago, are estimated at some $43 billion in 2008. That is a lot of money to pay to managements that, as a group, have consistently failed to outpace the stock market as a whole.

What the Law Says

The national public interest and the interest of investors are adversely affected . . . when investment companies are organized, operated and managed in the interest of investment advisers, rather than in the interest of shareholders . . . or when investment companies are not subjected to adequate independent scrutiny.

These words are the law, as articulated in the preamble of the Investment Company Act of 1940. The spirit of the law clearly says that shareholders must come first. Conspicuous by its absence from the statement is any suggestion that two masters—the shareholders, who own the fund, and the investment adviser, who controls it—should both be served. It is impossible to imagine that, in the mutual fund industry, either the letter or the spirit of the law is being observed.

Yet no official voices are raised in protest. The Investment Company Institute’s Introductory Guide for Investment Company Directors focuses heavily on what are often, in truth, fairly trivial administrative issues, and ignores the major issue of control over the fund. The Guide explicitly endorses the concept of an existing external management company and, although it acknowledges the responsibility of directors to make a continuing evaluation of a fund’s performance, it makes no reference to comparative performance standards, the impact of fund expenses on fund returns, or readily available alternative governance structures. The Institute’s official position is that fund directors are the “watchdogs” of the industry, and that ought to be plenty good enough.

The Fund Director’s Guide Book of the American Bar Association reaffirms that very theme. The unaffiliated directors of a fund, it states, quoting from a U.S. Supreme Court decision, are placed in the role of “independent watchdogs” vested with “the primary responsibility for looking after the interests of shareholders.” That’s close to the mark in setting a worthy standard. But the Guide Book then delves into a myriad of issues—often technical and detailed—for boards to consider and never gets to the heart of the matter: de facto control of a fund by its investment adviser, resulting in shareholder returns that are overburdened by fees; returns to advisers that dwarf those earned by most corporations; the absence of express standards by which to evaluate fund performance; and nary a hint that a fund board could choose to eliminate the external management structure and employ its own staff.

Are the independent directors truly watchdogs, with an eye single to the interests of fund shareholders? That central question must be answered in considering the effectiveness of the governance structure of the mutual fund industry. The record of ever-rising fund costs in the face of market-lagging fund returns, along with an awkward board structure and a near absence of significant fund ownership by board members, hardly suggests that the watchdogs are very alert. Independent observers are beginning to voice their concerns about the situation. With his usual pungent wit, Warren Buffett expressed his view:

I think the independent directors have been anything but independent. The Investment Company Act, in 1940, made these provisions for independent directors on the theory that they would be the watchdogs for all these people pooling their money. The behavior of independent directors in aggregate since 1940 has been to rubber stamp every deal that’s come along from management—whether management was good, bad, or indifferent. Not negotiate for fee reductions and so on. A long time ago, an attorney said that in selecting directors, the management companies were looking for Cocker Spaniels and not Dobermans. I’d say they found a lot of Cocker Spaniels out there.²

It should go without saying that cocker spaniels are not noted for aggressive, guardian-of-the-home ferocity.

An Alternative Structure

No one asks why today’s external management structure, with its languid oversight by the board of directors, serves fund shareholders. Why does a $10 billion fund complex need a management company? It would not be atypical at an expense ratio level of 1.2 percent for the funds in the complex to spend $120 million per year: say, $20 million for investment management, $20 million for marketing and advertising, and $30 million for administration—a total of $70 million. The remaining $50 million would constitute the management company’s profits before taxes. Why wouldn’t it make sense to internalize management, slash marketing costs (which don’t benefit fund shareholders), and save, say, $70 million a year? Would it serve the economic interests of the adviser? Hardly. Would it serve the interests of the fund shareholders? Yes.

Today’s external management system exists only because it represents the status quo. And it won’t soon go away. But if fund directors stop, look, and listen to the clear statistical evidence that a causal link exists between performance and expenses, they will begin to recognize a simple principle: When the spoils of economic value are divided, costs matter.

This much is clear: The easiest and surest way for a fund to achieve the top quartile in investment performance among peer funds is to achieve the bottom quartile in expenses. Statistics bear out this principle. It is not very complicated. When fund directors come to grips with this fact, and press for sharp fee reductions and a share of the economies of scale for the funds they serve, fund investors will be well served.

Part of the problem today is that the directors fail to recognize that the inverse relationship between performance and expenses is causal. Instead, directors have become part of a process in which an adviser justifies fee increases by comparisons with the rates charged by advisers to other funds. Ostensibly independent fund consultants come before the fund board with a study of the fee rates paid by other funds with similar investment objectives and asset levels. Particularly if the funds’ fees are deemed below average (apparently a heinous sin calling for prompt atonement), they assure the directors that the funds would remain competitive under the new higher structure recommended by the management company. The recommendation is of course heartily endorsed by those fund directors who are employed by that same company; the independent directors rarely rock the boat.

My understanding is that at least one consultant omits from the comparisons the expense ratios of the industry’s lowest-cost provider—which happens to operate on an at-cost basis. As a result, the costs of competitive funds are overstated, giving an extra nudge to the justification of the proposed fee increases. Given this omission, the fund directors considering the study are left in the dark about the possibility that there are alternative ways to run a fund. This practice suggests that the consultant knows exactly what his or her job is: to provide fodder that justifies the proposal for a fee hike.

In any event, this ratcheting-up process is almost precisely identical to the process by which executive compensation is set in corporate America. (Has a consultant ever recommended that compensation to the CEO be slashed?) It can lead only to an upward spiral in executive salaries, bonuses, and stock options. We observe that same phenomenon in mutual fund expense ratios in today’s exuberant and unfettered financial environment. What is more, these rising fee rates are being hugely leveraged by soaring fund assets, driving the total dollars of fees to staggering and ever-ascending levels. A typical reaction among shareholders who become aware of these levels is: “There ought to be a law” against them. There is a law—the Investment Company Act, cited earlier—but no one seems to pay much attention to it.

Legal Action Coming?

Perhaps there will be a new law—or, at least, renewed legal recourse under the existing law. Earlier, I noted the correlation showing that shareholders tend to pay more in expenses at funds that pay directors higher fees. Specifically, equity fund families that paid directors at least $100,000 charged fee rates 16 percent higher than funds that paid directors less than $25,000—especially astonishing because the funds paying large directors’ fees have assets many times greater than the others. As a result, the dollar amounts of fees paid by the giant funds are far larger relative to their smaller cousins than the higher fee rates themselves would suggest.

A recent article in the Columbia Law Review suggested that the findings of the Morningstar study could well fit the legal definition of “undue influence.”³ Were undue influence to be the issue before the court, the article pointed out, a plaintiff would need to show that these three standards of evidence could be met in order to make the case for undue influence of a fund board that approved excessive management fees: opportunity, motive, and susceptibility. The article continued: “Since funds are created and managed by the adviser, proving opportunity by demonstrating the dependence of outside directors on the adviser . . . should be fairly simple. . . . Because of the percentage nature of management fees, advisers have sufficient motive to exert dominating influence over directors so as to cause them to approve advisory contacts that benefit the advisers but hurt fund shareholders. . . . [The results of the Morningstar expense study] show that outside directors are susceptible to the adviser because of the position of control the latter possesses over the former.”

The article correctly notes that the benefits of mutual funds “do not justify investment advisers taking undeserved windfall gains out of the investment capital of others.” That is the crucial issue, no matter how problematic it might be to resolve in a court of law.^ah So far, the industry has been virtually impregnable in the courts, which have basically found that the approval of management fees by directors should be heavily weighed, provided that the directors are not dominated by the adviser, have been fully informed that fees could be recaptured by the fund, and have made a reasonable business decision to forgo that recapture. Given this legal background, it would take a long reach indeed to suggest that a novel legal action based on the undue-influence standard would prevail, no matter how clear its merits. But stranger things have happened. More probably, however, long-overdue relief from excessive mutual fund fees will come from a different source—a sort of moral suasion by legislative and regulatory officials.

TEN YEARS LATER

Legal Action Coming?

In the 1999 edition, I noted the possibility that legal action might—against all odds—at last clarify the nature of fee setting in the mutual fund industry. As I mentioned in Chapter 15, a case that is now before the U.S. Supreme Court is based largely on the right of fund shareholders to pursue litigation on the grounds that fund advisers charge independent non-fund clients (largely pension funds) far lower advisory fees than they charge the mutual fund clients that they control. The crucial factor in persuading the Supreme Court to review an earlier appellate court decision essentially endorsing the status quo was apparently the powerful dissenting opinion written by widely respected Judge Richard Posner.

Interestingly, Judge Posner gave heavy weight to the very “ratcheting-up” effect I described in the 1999 edition, comparing the peer-based compensation system that has enriched corporate executives with the peer-based setting of fund fee rates, in both cases, ignoring the creation (or, more likely, destruction) of investment value. To make matters worse, the typical fund fee comparison is based solely on rates, usually ignoring the staggering dollar amount of fees. The difference between an annual fee rate of 0.8 percent may not seem excessive relative to a fee rate of, say, 0.65 percent for a peer fund. But suppose that the “low-cost” fund had assets of $50 billion—generating fees of $325 million—while the “high-cost” fund had assets of $1 billion—generating fees of $8 million. Whose conscience would not be shocked by that $317-million-dollar disparity?

In his dissent, Judge Posner wrote that “executive compensation in large publicly traded firms often is excessive because of the feeble incentives of boards of directors to police compensation.... Competition in product and capital markets can’t be counted on to solve the problem because the same structure of incentives operates on all large corporations and similar entities, including mutual funds.” We can only hope that this wisdom prevails.

Congress and the SEC

In Washington, D.C., there are at least faint stirrings that today’s comfortable (for advisers) status quo may be changing. The staff of the SEC’s Division of Investment Management is “starting to take a hard look . . . at fund groups that enjoy high profitability, but provide shareholders with relatively poor performance and relatively high expenses.” Congressmen Gillman (R, Ohio) and Markey (D, Massachusetts) have expressed significant concerns about fund fees and directors’ diligence.

More recently, SEC Chairman Arthur Levitt—to my mind, the best champion for the rights of the mutual fund shareholder in the SEC’s history—has begun to focus on the issue. At a recent meeting of Investment Company Institute members, Chairman Levitt set forth his views. His first level of concern was the pervasive inadequacy of fund disclosure about the impact of fees and expenses on returns: “I don’t have to tell this audience that a 1 percent fee will reduce an ending account balance by 17 percent over 10 years.” In fact, the 2-plus percent all-in cost for the average equity fund would reduce the amount of capital accumulated by about 24 percent over 10 years, and 39 percent over 25 years. (The exact figures depend on the actual rate of return.)

In the same talk, Chairman Levitt expressed his concern about the proper role of a fund’s board by asking rhetorically, “When is a director independent? What are the respective roles of the board and the shareholders in selecting and terminating the fund’s adviser?” After stating that “fees have to be questioned,” he added that “no one should ‘buy into the myth’ that fund directors need not be as strong, vigilant, or independent as corporate directors. Those who do [buy into the myth] are making excuses for the directors who don’t have the time or the interest to stand up for shareholders. . . . Funds whose directors forget whom they represent won’t be long for the business.”⁴

The SEC chairman also announced that he would soon convene a roundtable “to work toward consensus on whether changes are needed in the current system of [fund] governance.” He closed his commentary by saying: “I expect directors to remember whom they serve—fund shareholders—and I expect fund directors to be tireless in the pursuit of shareholders’ interests.”

Those words may well be the start of some long-overdue improvements in the fund governance system. Chairman Levitt’s strongest statements so far from his bully pulpit should help create the initial momentum needed to broaden public recognition of the negative implications of the industry’s intertwined issues of fund costs, directors’ duties, and industry structure. Congressional inquiry would provide a further opportunity to consider the preamble of the 1940 Act and its relevance to the industry’s embarrassing record on fees. A new federal standard of fiduciary duty for directors would well serve fund shareholder interests. And an activist press, focusing more heavily on the mediocrity of traditional portfolio management and on the impact of costs as the enemy of long-term returns, would be another major plus. In all, this moral suasion—translated into increased investor awareness and concordant decisions about fund selection—might finally awaken directors to their trustee responsibilities.

Empty Suits?

The financial press has begun, however haltingly, to pay attention to whether mutual fund directors are honoring their responsibilities. In mid-1998, the New York Times ran a front-page article headlined: “When Empty Suits Fill the Board Room,” featuring a giant photo of empty suits surrounding a boardroom table. The article noted that “to almost any degree that directors hesitate, individual investors stand to lose,” and contrasted, in unflattering terms, the duties fulfilled by the boards of publicly held corporations and by the boards of mutual funds. The Times went on to describe how “the balance of power has kept shifting from fund directors and toward the companies that conceive, market, and manage mutual funds.”

The story closed with two surprises. First, it seemed to view favorably fund structures outside of the United States, under which “fund directors are not responsible for setting a fund’s management fee. Free from questions about the economics of a fund’s management contracts, directors could spend their time monitoring a manager’s business practices [such as] whether investment guidelines are being followed.” Ignoring substance and honoring process, however, would seem a peculiar approach to solving the industry’s “empty suit” director syndrome in the public interest. The article’s second surprise was its abject failure to recognize the entirely different governance structure of the one giant mutual fund complex in which the funds own and control their own management company—and which operates at costs about 75 percent below industry norms, delivering its fund shareholders savings of upward of $3 billion per year. Warren Buffett has said that fund directors could save investors $10 billion annually if they would put into practice some of the policies that follow from this different governance structure. In fact, such savings could easily top $30 billion each year.

Summing Up

The focus of corporate directors on shareholder value in the United States has virtually revolutionized the way corporations operate throughout the world. In contrast, the failure of mutual fund directors to observe the primacy of shareholder value has resulted from the limited oversight of boards of directors that serve as timid watchdogs, seemingly ignorant of the principle that costs matter.

This difference radiates from the directors’ mission statement. For corporate directors, it is: “Do or die.” Enhance shareholder value or else. For fund directors, it is: “Accept the status quo.” Provide no more than watchdog oversight accompanied by inaction, and accept the creation of shareholder value that is far short of optimal. Or, using Mr. Buffett’s formulation: Model yourselves not on Dobermans, but on cocker spaniels.

How can the industry best accomplish an alignment of interests between directors and shareholders? Common sense would dictate an effective and simple start: Have the board of the fund set down in writing—and publish in the fund’s annual report—its own mission statement. It would be a good beginning.

Some 50 million faceless and voiceless fund shareholders have been entranced by receiving the magnificent blessings of the long bull market, without realizing that they have received far less than their fair share of these blessings. They deserve better from the directors they have elected to represent them. These directors must serve one master, and only one master: the fund shareholders who trusted them to protect their interests.

The full verse in Matthew’s gospel is: “No man can serve two masters, for either he must hate the one and love the other, or else he will hold to the one and despise the other. Ye cannot serve God and mammon.” In effect, under the Investment Company Act of 1940, fund shareholders are designated as the gods who are to be served. But the wealth they might otherwise have had has been sharply eroded by excessive fund expenses, while great wealth, surely a proxy for mammon, continues to be reaped by mutual fund managers. Fund directors have a responsibility to serve those who elected them, who trusted them, and who created the fund with their own investments. The shareholders of a fund enterprise must be its master.

TEN YEARS LATER

Fund Directors

Despite the best intentions of the SEC and the strong urging of its then-chairman Arthur Levitt, there is no evidence whatsoever that fund directors have become “tireless in the pursuit of shareholders’ interests.” So after yet another decade in which directors have remained, yes, “cocker spaniels” rather than “Dobermans,” I have come to believe that not only mutual fund managers, but all institutional money managers, should be subject to a federal standard of fiduciary duty, a principles-based (rather than rules-based) standard, that enumerates the responsibilities of those agents who manage other people’s money in today’s failed agency society; and the self-evident rights of the principals that they are duty-bound to serve. These six principles would set the framework for the new fiduciary society that I envision:

1. The right of investors to have their money managers/ agents act solely on their behalf. The client, in short, must be king.

2. The right to rely on due diligence and high professional standards on the part of our money managers and securities analysts in their appraisal of securities for fund portfolios.

3. The assurance that our agents will act as responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks, and demanding that corporate directors and managers meet their fiduciary duty to their own shareholders.

4. The right to demand some sort of discipline and integrity in the distribution of mutual funds and in the financial products offered by fund marketers.

5. The establishment of advisory fee structures that meet a “reasonableness” standard based not only on rates but on dollar amounts, and their relationship to the fees and structures available to other clients of the manager.

6. The elimination of all conflicts of interest that could preclude the achievement of these goals, including barring the public (or conglomerate) ownership of mutual fund management companies.

Together these six principles would require that mutual funds be “organized, operated and managed in the best interests of their shareholders, rather than in the interests of their advisers” the sound—but largely ignored—standard specified in the Investment Company Act of 1940. Let’s call this combination of principles the gospel according to Matthew, under which “no manager can serve two masters,” and those who invest their capital in mutual funds will at last be the sole master.