Mutual fund industry critics need not look far to find the root cause for the industry's scandals. The problem lies in the industry's predominant governance structure. Aside from the Vanguard Group, external management is the order of the day, meaning that conflicts of interest over fund expenditures aren't just common, they are inherent. Equally inherent is the risk that the external manager will allow practices that serve its interests, to the detriment of fund shareholders.
Not a Misguided Few
Fund industry apologists have sought to explain away the late-trading and market-timing scandals as the dirty work of a few misguided employees. I see it differently. I say these problems are simply manifestations of the double-dealing encouraged by the fund industry's dysfunctional management structure.
Anyone doubting this ought to read New York Attorney General Eliot Spitzer's complaint against Canary Capital. What you find is clear evidence that fund managers and their affiliates made a cold-blooded, calculated decision to profit privately by selling to outsiders the right to cheat fund shareholders. They did this because their loyalties were conflicted. Selling the right to cheat fund shareholders, after all, enriched the investment advisor and its affiliates. The fund managers' loyalty to the external advisor, in other words, trumped their sense of duty to fund shareholders.
Another piece of evidence showing that the fund industry's problems are rooted in managers' divided loyalties is found in Massachusetts Secretary of State William Galvin's complaint against Putnam Investments arising out of the Boilermakers Union's market timing. Exhibit nine in that complaint spells out the Putnam managers' financial motive for letting the union's officials time Putnam funds: $100 million of additional union money for Putnam to manage.
The added costs generated by conflicted decision-making represent a tax paid by shareholders of externally managed funds. Sometimes the tax has been levied secretly, as happened in the late-trading and market-timing scams. Another secret scam involves directed-brokerage payoffs, whereby a fund's brokerage costs are kited, the better to reward those selling fund shares. Fund share sales, of course, profit the fund's advisor. There is no evidence that spending fund assets to generate new sales is cost-effective for the owners of those diverted assets, the fund's shareholders.
It is a mystery to me how fund directors whose shareholders are already being assessed for the maximum amount of 12b-1 fees have been able to justify allowing the diversion of additional assets via directed-brokerage payments used to subsidize the fund underwriter's distribution efforts. Diverting fund assets to pay distribution costs outside of 12b-1 is a bad idea.
Fund directors doubting this might want to review the Fund Director's Guidebook, prepared by an American Bar Association task force, and note this language: "Fees characterized as distribution-related must be made pursuant to a Rule 12b-1 plan." The guidebook goes on to instruct that 12b-1 fees are "the exclusive means by which a fund may use its assets to bear the cost of selling, marketing or promotional expenses associated with the distribution of its shares." (Emphasis added.) Directed-brokerage payments made to spur or reward fund share sales are distribution-related expenditures made for selling, marketing or promotional purposes.
There is a word that describes directed-brokerage payments made by funds outside the confines of their 12b-1 plans. The word is "illegal."
Another secret levy born of conflicts of interest comes in the form of soft-dollar kickbacks to the investment advisor. Once again, these are generated by overpaying for fund brokerage. This mechanism enables the advisor to off-load onto fund shareholders part of the cost of providing advisory services, a chore for which the advisor is already lavishly compensated.
The ubiquitous fund industry practice of soft-dollar kickbacks to fund managers achieves two goals, both good for the advisor and bad for fund shareholders. First, the kickbacks fatten the advisor's bottom line, while, second, they keep an array of advisory costs from hitting the fund's expense ratio and thus becoming visible to shareholders.
The quintessential conflict, of course, is advisory fees. The crucial ingredient that investors pay for when they buy shares in an actively managed mutual fund is professional management. A dollar more for the advisor means a dollar less for the fund shareholders to split up. Thus, fund advisory fees present the mother of all conflict-of-interest issues stemming from the fund industry's flawed governance system.
The root problem is easily seen. The fund's advisor controls the fund's board and, in essence, negotiates with itself over fees. Anyone doubting the external advisor's power over fund boards need look no further than the recent Bank of America settlement with Spitzer and the SEC. As part of the settlement, eight of the 10 Nations Funds directors were canned, demeaning action about which they were not even consulted about in advance. The Charlotte Observer reported one fired fund director's reaction: "I was surprised. I would think if they were going to recommend that kind of resolution, they would have consulted the board." I would think so, too. Evidently, the conflicted BofA/Nations Funds management operation not only was dysfunctional, it was non-functional.
Bad Legal Advice
External fund managers have gotten used to extravagant compensation, in part, I believe, because fund directors have been getting poor legal advice. If stories I've heard are correct, it seems that fund board members have been misled into believing that any advisory fee yielding a profit margin south of 70% to 80% is fine.
These same directors evidently have been told to pay no attention to what the fund's advisor sells its portfolio advisory services for in the open market to pension funds and others, since comparing such free market prices to fund market prices is like "comparing apples to oranges." Weak-thinking (or non-thinking) directors who accept either piece of lame legal advice need to be sure they have a lot of liability insurance coverage.
Highlighting the division between what's good for the advisor versus what's good for the mutual fund are the results of a recent Washington University study into how pay for mutual fund managers is structured. In a normal company, those working for the business are rewarded principally based on how well the business they manage performs. The fund industry is different. According to managers at mutual funds and other investment advisory firms, the two leading factors affecting their bonuses were the advisory firm's "profitability or stock market performance," and "generating new business" for the advisor. It should come as no surprise, then, that we find fund managers allowing outsiders to cheat fund shareholders in exchange for "sticky" assets for the advisor to manage, or in exchange for new advisory business in other forms.
With conflicts rampant, normal fiduciary standards go by the boards. Bank managers presumably would think twice before selling outsiders the right to loot bank customers' savings accounts. Yet Bank of America's managers evidently had no compunction over selling to Canary Capital for cash money (disguised as supposed "wrap fees"), the right to drain fund assets. Adding insult to injury was the fact that some of Canary's late trading and market timing was facilitated with money lent by the bank itself (the better for the bank to profit off the lending).
The ICI-SEC Connection
This commentary on the fund industry's ingrained conflicts of interest would be incomplete without comment on fund managers' powerful and well-financed head cheerleader, the Investment Company Institute. Until very recently, the ICI seemed to be running a satellite office for the SEC's division of investment management.
The ICI epitomizes the conflicts of interest plaguing the fund industry. When money is the issue, as it often is where fiduciary duties are in question, the ICI relentlessly works to protect fund sponsors' profit margins, to the detriment of fund shareholders whose assets are diverted to pay the ICI's lobbying bills. That the ICI finds nothing wrong with taking money from fund shareholders to lobby against shareholders' pecuniary interests is predictable in an industry rife with conflicts of interest, an industry that has grown fat and comfortable flouting basic fiduciary standards.
The behavior of the fund industry's managers is certain to change for the better, simply because it cannot get any worse. The questions are how and when improvements will come. My view is that Congressional action will either come to nothing or will be at most cosmetic. I say this because intense congressional scrutiny of the fund industry in the late 1960s basically came to naught, leaving fund sponsors more entrenched than ever. Today we confront a fund management industry standing as a $7.5 trillion colossus. Fund managers today are a much more robust, wily and well-heeled lobbying force than they were 30 years ago. Scratch Congressional action as a likely source of productive change.
The SEC likewise is not a promising source of leadership. True, the SEC promotes itself as the "investor's advocate." But it is one thing to talk a good game and another thing to perform. Lately, goaded by Attorney General Spitzer and Massachusetts Secretary of State Galvin, both the division of investment management and the Commission have tried to make up for lost time. Don't get your hopes up. The SEC can be counted on to buckle under to political pressure when crunch time arrives. It has a history of being out-foxed and out-hustled by the ICI and fund sponsors. The agency's ineffectual efforts to control the $9.5 billion boondoggle it created through adoption of Rule 12b-1 is a prime example of how the ICI and fund sponsors can be counted on to outmaneuver the regulators when big money is on the line.
Change, when it comes, will be ushered in by lawyers and judges, for lawsuits are a far more likely source of reform. Legal precedents currently favor the fund management industry, but they will whither under attack from wave after wave of more determined, better prepared plaintiffs' lawyers and their expert witnesses. Assets of $7.5 trillion give fund managers a lot of lobbying clout, but huge pools of cash in the hands of unscrupulous managers invite legal attacks, too. Lawyers intent on putting fund managers' actions in a bad light have been given a lot of material with which to work. Lawsuits seeking to enforce basic fiduciary duties are being brought daily against fund sponsors and directors, and they will continue to be brought so long as those who lead the fund industry are perceived as attractive targets.
Fund industry leaders not interested in being sued need only recognize a simple truth: Divided loyalty does not excuse diminished loyalty. External managers must learn to treat the fund industry shareholders they serve as if they were the managers' only constituency. When they start giving fund shareholders the same quality and cost of service fund shareholders would receive were no conflict of interest involved, external fund managers will commence living up to their fiduciary duties.
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