Whose Fund Is It, Anyway? The key to preventing future abuses: recognizing that mutual funds belong to their shareholders, not to their managers
(MONEY Magazine) – For the fund industry to really clean up its act, I believe it's got to undergo a fundamental change in the way it thinks about itself and its investors. Specifically, fund companies have got to start treating shareholders as owners of the funds rather than as renters. That crucial distinction has important ramifications for how fund companies should manage funds and what we as investors and owners should expect from our funds. And unless such a revolutionary change in mind-set occurs, I'm not convinced that any reforms will have a lasting effect.
The concept of fund ownership is easily misunderstood. We know that we own the money in our individual accounts. But I'm not sure shareholders realize that, collectively, we also own the funds. Confusion about this point isn't surprising. The very way we speak of funds implies that they belong to the fund companies. They're the Putnam funds, the Strong funds, the Nations funds and so forth. The fund company's name appears on the prospectus, the advertisements and our statement. But we shareholders own not just our investment but the fund as a whole.
Where do the fund companies fit in? They're the hired help, the management companies we employ to invest the fund's assets--our assets--and to oversee the day-to-day details. Fund companies don't own the fund any more than a contractor you might hire to fix your roof would own your house. The Investment Company Act of 1940--the federal legislation that governs funds--is clear about this, stating that as a matter of public interest, funds must be organized, operated and managed for the benefit of their shareholders, not of the fund company.
In practice, things don't always work out this way. Too often fund companies treat us as if we were customers in their store rather than owners of the store, as if they own the fund's assets and have the right to control them for their own benefit. A telling example of this can be found in an e-mail from a Janus funds executive that New York State attorney general Elliot Spitzer cited: "Our stated policy is that we do not tolerate timers. As such, we won't actively seek timers, but when pressed and when we believe allowing a limited/controlled amount of timing activity will be in JCG's [Janus Capital Group's] best interests (increased profitability to the firm) we will make exceptions under these parameters."
Hey guys, read the Investment Company Act. You're supposed to manage the fund for the shareholders' interests. I think this attitude goes to the heart of the fund scandals. Too many fund companies seem to have the idea that they, not we, own the fund, and that the fund's assets should be managed for "increased profitability to the firm" rather than for increased profitability to shareholders.
Once you think of funds from the perspective of shareholders as owners and fund companies as employees, you begin to see some of the issues raised by the fund scandals in a new light. Take the question of whether investors ought to bail out of Putnam, Strong, Alliance or the other firms caught up in the scandals. In some cases, jettisoning the fund and moving on may be the right response. But if you start from the premise that shareholders are owners, there's another possibility: Perhaps the shareholders should stay put and give the fund company the boot. In other words, fire Janus, Putnam, Strong or whomever and bring in a new adviser, just as you would fire a contractor if you found him pilfering. After all, if I own a fund in a taxable account and have a big stash of capital gains, why should I have to sell and incur taxes because the fund company has screwed up?
There's no question that shareholders have the right to change managers. Section 15 of the Investment Company Act explicitly states that the fund's contract with the investment adviser "may be terminated at any time, without the payment of any penalty" by the fund's board of directors or by a majority vote of the shareholders, on not more than 60 days' notice.
In reality, this right is rarely invoked and can be controversial even when it is. Many observers felt that the attempt by directors of the Yacktman fund to unseat manager Donald Yacktman in 1998 for allegedly straying from the fund's investment philosophy was unwarranted. (The coup failed, as did a similar attempt in 1997 to oust Louis Navellier from the Navellier funds.) So I'm not suggesting that directors and shareholders use this power as a first response. We often choose a fund because it is run by a particular fund company or manager. We certainly don't want fund companies being replaced for occasional underperformance or minor infractions.
But even the Investment Company Institute, the industry trade organization, recognizes that there can be times when shareholders may want to consider giving a fund company its walking papers. In an address to an ICI directors' workshop in April, ICI general counsel Craig S. Tyle noted that, among other things, the power to terminate an advisory contract "allows the directors to take drastic action when circumstances warrant, for example, if a fund's adviser has committed fraud or serious mismanagement." I don't want to jump the gun before accused fund companies and executives have a chance to defend themselves. But if the allegations that have been made to date turn out to be close to accurate, I'd say this could very well be one of those times when booting a fund company may be justified. In fact, I can't imagine why directors of many of the funds implicated in this scandal wouldn't at least be discussing the possibility already.
WHO'S MINDING OUR STORE?
Of course, even though we shareholders technically own our funds, we're not sufficiently organized to exercise the privileges and responsibility of ownership on our own. So we rely on the fund's board of directors.
Under current law, half of a fund's directors are typically allowed to be "affiliated" directors--that is, they can have ties to the investment adviser or other companies that do business with the fund. Essentially, such directors have an inherent conflict of interest. They have an obligation to represent the interests of their employer, but at the same time they must represent the interests of shareholders, even though those interests may be at odds. For that reason, we especially rely on the fund's independent directors, who are supposed to be free from any significant ties to the adviser and thus able to consider shareholders' interests above all.
Question is, have fund boards, with their mix of independent and nonindependent directors, effectively represented fund owners' interests? That's a difficult question to answer definitively. But consider this: When the SEC surveyed 88 large fund companies representing 90% of the industry's assets last year, it found that 50%--that's right, half--appear to have allowed investors to time their funds even though that practice was inconsistent with the prospectus. Given that fact alone, I think it's fair to say that fund boards overall haven't been defending fund owners' rights diligently.
TAKING BACK CONTROL
There are many steps that the fund industry can take--make that must take--to restore the balance of power to fund shareholders. And because so much is at stake--essentially, the life savings of some 95 million Americans who have more than $7 trillion invested, either directly or through retirement accounts, in funds--I'm sure that many of the reforms that are percolating in Congress and under consideration by the SEC will be enacted in the near future.
But new regulations alone won't be enough. If the fund industry truly wants to reclaim investors' trust and keep it for the long term, it's going to have to change its mind-set and start treating us like the owners we are.
Senior editor Walter Updegrave is the author of Investing for the Financially Challenged (Warner Books). You can reach him at firstname.lastname@example.org.