| What Can Trustees Actually do About Levitt's Criticisms of Mutual Funds? |
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| Written by C. Meyrick Payne, Senior Partner, Management Practice Inc. | |
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Arthur Levitt may have become even more influential now that he is no longer Chairman of the SEC. Certainly his book, Take on the Street, is influencing legislators and regulators in the post-Enron era. His chapter detailing the "seven deadly sins" of the mutual fund industry is particularly damning. Whether a diligent fund director agrees or disagrees, it would be foolhardy to dismiss Levitt's criticism as ill-informed or casual. This MPI Bulletin begins to answer the question "What should fund directors do about them?" In a post-Enron, Sarbanes-Oxley dominated world, just following the rules is not enough. Trustees are expected to apply principles to an ever-changing environment. Being a monitor is not enough; being an activist is required. The secret lies in interpreting what activist means. Levitt's book may provide some guidance. Chapter 2 highlights seven deadly sins of mutual funds that are captioned below. Alongside each of these are some thought starters of what fund directors could do about them. High fees strangle returns: Keep fees reasonable in proportion to investment return. This guidance is only partially practical as the sales charges are contractual; with the exception of ensuring that contractual provisions of the distribution agreements pass along breakpoints along to large investors, there is not much the directors can do. With regard to the 12b-1 fee, the directors have to approve it annually, but they also understand that it is built into the economic arrangements between the fund manager and its distributors. Changing the 12b-1 fee can severely impact the profitability of the sponsor or disturb long established distribution patterns, but that does not let them off the hook. The management fee can, and routinely is, scaled down by the independent directors as assets rise. In addition, scaling back fees paid to affiliated service providers, such as an in-house, transfer agent or fund accounting provider is a possibility. The tax trap: Keep taxes low; avoid churning of portfolio investments. Historically fund directors have avoided decisions that impact the portfolio or trading strategy of the investment advisor. While holding fast to their mission of safeguarding investors, the fund directors should remember that the shareholders did not retain them to invest their money. Of course, fund directors, like everyone else, in the fund industry should lobby to defer the tax on capital gains and reinvested dividends until an investor actually sells the funds. Kickbacks, compensation and clunkers: Ensure best execution of trades; efficient use of soft dollars; reasonable fund and management expenses, including salaries; transparency and meaningful disclosure of performance and fees. The law and regulations are clear that directors must ensure that fund shareholders receive best execution and that any commission rebates are spent for research or for the benefit of fund shareholders. Fund directors also have responsibility to ensure that expenses are reasonable in comparison to other funds of approximately the same size, which offer the same investment objective and style. The directors have a responsibility to shareholders to see that disclosure is meaningful and timely. Indexed or managed funds: Disclose that actively managed funds rarely outperform index funds. Levitt's admonition that fund's disclose that indexed funds often outperform actively managed funds should not inadvertently encourage fund directors to usurp an investor's right to chose. While many investors may choose the low cost, indexed approach others prefer to pursue an actively managed strategy. Fund directors are empowered to disclose facts, not to override investor choice. The culture of performance: Avoid misleading investors about performance; particularly implying that past performance is indicative of a "culture of performance" which is likely to reoccur in the future. Levitt makes the point that stellar performance of one fund may, through misleading advertising, convince an investor that the "culture of performance" is likely to rub off on other funds in the same complex. Levitt suggests that fund directors have responsibility to debunk such a misleading message. Practice what you preach: Force investment management to focus on the long term, and avoid short-term speculation. Mutual fund professionals understand the benefit of diversified risk, professional management and compounding are the real benefits of mutual funds and that they are only truly valuable over the long term, rather than the short. Levitt expects directors to enforce a long-term philosophy in every action taken by fund management. You can't judge a fund by its name: Ensure that fund names are indicative of their investment style and that advertising is not deceptive. Fund directors must ensure that fund names are not misleading, causing an investor to believe they are following one strategy when the fund is persuing another. Levitt implies that fund directors should stop style drift. Some of Levitt's seven criticisms of mutual funds are actionable by fund trustees, but others are better targeted at Congress and even the SEC itself. Trustees do what they can to safeguard the investor, but they are not empowered to rewrite the law or reinterpret the regulations. |
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