15

LOSING OUR WAY: WHERE ARE THE INDEPENDENT DIRECTORS?

The North American Securities Administrators
Association, Inc.
San Diego, California
October 21, 1991

IT SEEMS ALMOST endemic that, from time to time, every industry loses its way. In a burst of opportunism—or in ignorance of a changed world—firms and even entire industries have lost sight of the principles that made them successful. Scandalous conduct by major Wall Street firms is but a recent example. The automobile industry's failure to treat foreign competition seriously and to “drag its feet” on quality and safety is another. The savings and loan industry's massive move from home mortgages to real estate investments is yet another.

And, it seems to me, the mutual fund industry is in this same position today. In too many areas, we have lost our traditional bearings. Too many management companies—large and small alike—are engaged in a chase for more assets, and for more profits (with correlatively less profits to the shareholders we serve), no matter what the cost, and no matter whether or not the investor is fully and fairly informed.

Let me present, in the brief time allowed this morning, some of the concerns I have: (1) diseconomies of scale that should have been economies of scale; (2) fee increases and fee structures that are appalling; (3) the baneful effect of the notorious 12b-1 plans that encumber existing fund shareholders with the cost of attracting—for whatever reason—new fund shareholders; (4) disclosure in fund reports that, in some instances, verges on the outrageous; and, last but not least, (5) advertising that hawks “reward” and ignores the two other determinants of investment return—risk and cost. Then I'll conclude with some thoughts as to what, in my opinion, might be done about these problems.

1. DISECONOMIES OF SCALE When I came into this industry 40 years ago, it was an equity-based industry (i.e., no money market funds and few bond funds) with assets aggregating $2.5 billion, and an average fund expense ratio of 0.72%. Thirty years later, in 1981, assets of equity funds totaled $40 billion, and the average expense ratio was 1.04%—an average increase of one basis point (1/100 of 1%) per year.

Now, in 1991, with equity fund assets totaling $250 billion, the average expense ratio has risen to 1.45%—an average increase of four basis points per year, or four times as much. As a result, since 1981, industry expenses are up nearly eightfold from $470 million to $3.5 billion, with industry assets up only fivefold. The real issue is not why expense ratios are up by so much, or even at all. The issue is why they have not declined. For believe me, there are substantial economies of scale in this business—and my next two points—on management fees and 12b-1 plans—will examine why expenses have increased so far in excess of our industry's staggering rate of asset growth.

2. FEE INCREASES AND FEE STRUCTURES Despite the industry's awesome profitability, many mutual fund managers have in recent years extracted substantial fee increases from the funds they manage. How can these fee increases be justified? Well, each organization will have to answer that for itself, but I will give you just one extreme example.

The annual cost of managing one of the investment companies in a $5 billion complex was stated to be $820,000 for 1990. The previous annual fee was $5,370,000, which provided the adviser with a seemingly adequate operating profit of $4,550,000 per year. However, apparently it was not adequate enough; the fee was raised to $7,050,000, increasing the manager's annual profit to $6,230,000—or 88% of revenues. [These are not my calculations. They come directly from the Fund's proxy.]

Fee increases on existing funds, however, are only part of the problem. Failure to scale down fees in a material way to reflect clear economies of scale is another. But perhaps most significant is the high—one might even say unconscionable—costs sometimes imposed on new funds as they are formed. Here are two examples.

A money market fund was offered in 1987 with an expense ratio of 2.1% (last year it was 2.2%). Today, with yields on money market instruments at about 5.8%, the leading money market funds—with expense ratios in the 0.5% range—provide a net yield of roughly 5.3%. This fund's yield is 3.6%. (You must be wondering why anyone would own it.)

A $3 billion Government-Plus fund (perhaps more aptly named Government-Minus—its net asset value has dropped from $9.47 per share to $7.17 since it was first offered in 1987) has an expense ratio of 1.97%. The manager graciously has agreed to reduce its advisory fee, so the reported ratio is 1.92%. The advisory fee totalled $25,565,000 in 1990 (before that reduction of $1,675,000). What does the shareholder get for that awesome fee? A portfolio consisting of three repurchase agreements, one FNMA issue, two GNMA issues, and seven U.S. Treasury bonds. It simply doesn't seem like the fund should need $25 million worth of advice, particularly since, as I understand it, you don't need to do much, if any, credit analysis on a government bond portfolio. To add insult to injury, the first sentence in the President's letter in the 1990 Annual Report says: “As part of our continuing efforts to reduce expenses, we have combined in this report the annual report of the six (same organization's) fixed income funds.” Why don't shareholders redeem their shares? Probably because (a) they don't want to realize their losses; and (b) they would have to pay a commission—as high as 6%—to get out. (This so-called contingent deferred sales charge is one of the better kept secrets from mutual fund investors.)

3. 12B-1 DISTRIBUTION PLANS Such plans, stripped of all of the verbiage, amount to charging existing fund shareholders for the cost of bringing in new shareholders. Since their introduction in 1980, they have become the rule rather than the exception. Today, 1,861 funds—58% of the 3,226 funds in existence—have such plans. In total, 12b-1 plans cost mutual fund shareholders a cool $1.23 billion last year, representing, in and of itself, an addition of 0.26% to the expense ratios of the funds that incur them.

These distribution plans are often said to enable funds to build their assets, thereby engendering economies of scale. However, the fact is that—except for the very smallest funds—the economies of scale are a fraction of the amount spent to garner them. That is to say, even a fund with a base advisory fee of 0.75% that is scaled to 0.50% as assets rise—a reduction that goes far beyond anything I have seen—would literally never recover its sunk costs from a 0.50% distribution fee. I would add, perhaps a bit cynically, that spreading such items as auditors fees and shareholder report costs over a larger asset base are highly unlikely to provide measurable benefits.

These plans are also said to enable funds to improve their returns by better assuring cash inflow, thus minimizing the likelihood that share redemptions will require funds to liquidate portfolio holdings when stock prices are declining. That I have seen no evidence whatsoever that this objective will be accomplished is not the point. The fact is that, even if distribution plans do build cash flow, there is no evidence whatsoever that funds with positive cash flow have better returns; nor that cash outflow creates portfolio management problems (the need to sell securities) that are any different from those created by cash inflow (the need to buy securities).

It should be apparent to a novice, furthermore, that funds cannot spend themselves into success. A poor-performing fund, for example, could spend (and many do) millions of dollars in vain to overcome the shortcomings of its investment adviser. Funds—like all other corporations—should have no guaranteed right-to-life.

But I am not saying that 12b-1 plans are totally wrong. Rather, I am saying that they can be justified, only when, first, the capital investment represented by distribution expenditures can be recaptured to benefit the fund shareholders who are paying the bills; and second, when full and clear disclosure is provided. The truth, as a shareholder proxy statement should say, but does not, is this: “This plan will increase your expenses and commensurately reduce your returns. There is no realistic expectation either that cash inflow will enhance, or outflow diminish, the fund's performance. While an increase in fund assets may be beneficial or harmful to shareholders, it will have the certain effect of increasing advisory fees, providing additional revenues which the adviser may expend to benefit the fund, or to sell more shares, or to receive additional profits, or all three.”

4. FUND REPORT DISCLOSURE The quality of disclosure to fund shareholders in shareholder reports is too often superficial, and the quantity minuscule. Many reports are bereft of the most basic information on the fund's returns during the year and over the long term. Often there are no standards for evaluation of performance (i.e., market indexes or peer groups with comparable objectives), and there is almost never a word from the fund's chief executive—normally the chief executive or an officer of the adviser, but nonetheless responsible to the fund's directors—about whether the fund's results were regarded as satisfactory or unsatisfactory. Too many fund reports make up in glossiness what they lack in substance.

The annual report of the money market fund with the 3.6% yield (described above) does not even state the fund's yield at year-end. (Nor is it published in the weekly press reports showing current money market fund yields.)

In the annual reports of two equity funds in the same mutual fund complex, one states that it outpaced the return of the Standard & Poor's 500 Stock Index for the year, provides the data, and brags about it. The other, having fallen short, does not provide the data, and is silent about it.

A high-yield bond fund, after a disastrous fiscal 1990, provides an annual report, in living color, printed on heavy coated paper, with lots of lovely photographs, and a statement that “negative newspaper headlines raised concern among investors in high yield bonds.” Buried deep in the financial statements at the end of the report, is the first and only reference to the fact that during the year the net asset value dropped from $7.48 to $6.30 per share.

5. FUND ADVERTISING I believe it has gotten completely out of hand. It hawks “return” and virtually ignores—except in tiny footnotes—risk and cost. This has become an industry of which it can be truly said: Don't forget to read the fine print. And that is hardly a compliment.

“We're number one” advertising is, in my view, philosophically outrageous. While all ads note that “past results cannot be predicted in the future,” it seems to me that there is an implicit suggestion that if an investor wants to be number one in the future, that is the fund he should buy. Of course, the linkage between past and future is in fact close to zero—and those who publish the ads know it. Such advertising is also mathematically ridiculous. There are so many time periods, and so many funds, with so many objectives, and with such a variety of asset sizes, it should almost be an embarrassment not to be number one in something. Here's just one example: “Number one in performance”—but only among 12 growth funds with assets between $250 million and $500 million, for the period March 31, 1971, to March 31, 1991. (For the prior 12 months, the fund ranked 18 of 24 funds.)

In the past few years, much fund advertising has resembled white-sale ads that would do Bloomingdale's credit. Much of this advertising is based on being the “highest yielding” money market and bond funds, in that position only because their advisers have temporarily waived their fees, hoping to attract investors who won't notice it when the fees go up. (I hope it is not inappropriate to note that this practice would seem to fly in the face of Section 15(a)(i) of the Investment Company Act, which says that advisory contracts must “precisely describe all compensation.”) Speaking of these off-again fees, one industry observer said: The mutual fund industry has its own law of gravity: What goes down, must come up. Again, it was not intended as a compliment.

So much for my litany of charges: They all spring from essentially the same source: an increasingly pervasive philosophy that this is just another consumer products business, rather than a trust service offered for the prudent management of other people's money. The mutual fund industry has, I acknowledge, elements of both, but I believe that during the era of the 1980s—and continuing today—the business aspect (a drive for market share, no matter what the cost) has sharply increased, and the fiduciary aspect (sound investment programs, fairly priced and fully explained) reduced commensurately.

Assume, for the purpose of argument, that my concerns are valid. What can be done to protect the investors in your own states?

STATE SECURITIES REGULATIONS I believe that the gradual elimination of state expense ratio limitations since 1978 (and, where they still exist, almost total waiving of the requirements “on demand”) has played a major role in the rise of fund expense ratios. Under these limitations, essentially, large funds were limited to 1% expense ratios, small to 1½%. (You should recall that the industry average itself is now nearly 1½%.) However, I also believe it is unrealistic to expect their return, nor do I believe that state oversight of fund literature and advertising would prove effective, even if it were feasible.

THE MEDIA The press has virtually ignored fund proxies that propose advisory fee increases and 12b-1 plans. With 37,000,000 mutual fund shareholders out there, it is hard to believe that these specific fee changes, and these trends as well, are not news. But when there is no glare of sunlight when added costs are imposed on shareholders, a major governor for over-reaching is abandoned. It is probably too late to worry about this, for the continuing escalation of fees cannot go on forever. (I don't think.) But the interest of the investing public would be served by more publicity about fund costs. It would also do no harm if there were less press focus on the “best” funds for the prior quarter or year, because it generally results from mere chance. That some fund will be number one is just as certain as that, in 1,024 flips of a coin, someone will flip heads ten times in a row. The difference is that the successful coin flipper goes ignored, while the successful portfolio manager is lionized and credited with extraordinary skill—at least for the moment.

THE SECURITIES AND EXCHANGE COMMISSION I believe that the Securities and Exchange Commission should promptly move forward with its proposed rule that would require each fund to provide in its annual report a Management Discussion and Analysis (MD&A) of its results. This discussion would include complete data on fund performance, comparative data for various standards (appropriate market indexes and peer groups), and a narrative providing commentary on the year's results and how they are evaluated. Of even greater importance, I also urge the Commission, in its forthcoming Investment Company Amendments Act, to require an express statutory fiduciary duty standard for mutual fund directors. With such a federal fiduciary standard, I believe the problems that I have addressed will be largely solved.

THE INDEPENDENT DIRECTORS OF THE FUNDS The independent directors have a solemn responsibility to place their sole focus on the best interest of mutual fund shareholders. But, for mutual funds, this principle has never been, as far as I know, formally articulated and codified. A federal fiduciary standard would, I believe, be a forceful reminder to directors that fee increases must be fully justified, that expenditures on distribution must carry at least the possibility of being recouped, that annual reports must portray specific fund returns (and how the directors have evaluated them), and that new shareholders who join the fund do so only through advertising that includes full and open disclosure about risk and cost—and not in tiny footnotes—as well as return.

What I am recommending scarcely goes beyond the philosophy expressed in the original Investment Company Act of 1940, which was passed 51 long years ago: “The national public interest and the interest of investors are adversely affected … when investors do not receive adequate, accurate, and explicit information, fairly presented … or 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.” Clearly, that language has been honored more in the breach than in the observance, so my proposal would simply codify those worthy objectives.

Let me conclude by emphasizing that this is a great industry, providing financial services that are useful, if not essential, for investors. But, investors would benefit from some hearty price competition (to reduce prices, not to increase them), and far more complete and candid disclosure. For we have, perhaps understandably after a golden decade of growth that has taken fund assets from $100 billion to $1.2 trillion, lost our way, as we have departed to too great a degree from the principles that got us here in the first place. While not all firms in this business have participated in the problems I have described, I think it is fair to say that all of us—Heaven knows, including Vanguard!—have room for improvement. And in the long run, any improvement that helps to make mutual funds a better investment is in the best interest of our shareholders, to say nothing of ourselves as fund managers.

In short, I am confident that this industry will return to its original bearings, if we will but respond positively to these three questions:

• “Whose money is it that we manage?” Our fund shareholders’ money.
• “Who represents these shareholders?” The independent directors.
• “Where are the independent directors?” I hope they will be back soon.