Expertise and Experience: Criteria for a New Fund Director Print E-mail
Written by C. Meyrick Payne, Senior Partner of Management Practice Inc. (MPI),   

Management Practice Inc. (MPI) are consultants to the Independent Directors of Mutual Funds. The important selection criteria are underlined for convenience.

In the course of a year about 100 new fund directors are appointed by the existing trustees or elected by the fund shareholders. The SEC has made it quite clear that nomination and selection is a matter for the existing independent directors, although the manager, like anyone else, might suggest candidates. In either case, setting the criteria for a candidate is an important part of the process. Our firm, MPI, has helped many Nominating Committees with this process. This Bulletin highlights some of the major findings from our work.

When establishing new director criteria, the most important step is to think clearly about what personal characteristics, skills and expertise is likely to be needed for the next five to ten years. A mutual fund director, like a federal judge, is a long term appointment (perhaps as much as 20 years) and there are precious few ways to undo the appointment if a poor choice is initially made.


The mutual for mutual funds clearly involve more complexity, more knowledge of accounting/auditing, more emphasis on trading practices, more understanding of sales and distribution practices, more knowledge of complex securities, derivatives and options, and greater ability to negotiate economies of scale for the fund shareholders.

It goes without saying that a new fund director must be intelligent, prepared to work hard and committed to the interests of the fund shareholders. Added to these personal characteristics are an ability to spend considerable amounts of time (a new director should expect to spend no less than 200 hours per year).

The law and good sense also require that a new director is truly independent of the advisor. While a former employee might in fact be absolutely impartial and have a unique knowledge of how the advisor operates, many boards, as well as Mutual Fund Directors Forum and Morningstar, now consider that any prior service with the advisor, or any of its affiliates, taints the perception of a director's independence. To this, some boards also add the independence criteria that a candidate not have a significant personal or business relationship with the advisor or its affiliates.

More than 50% of the household decision to purchase mutual funds is made by women; and an increasing percentage of funds are held by minorities. According to an MPI survey only about 20% of mutual fund directors are female and even less are minorities. As a result, it is hardly surprising that boards often seek female or minority candidates, but not to the exclusion of all other criteria. Many boards also like to find candidates who live or work near to the other directors or the advisor. The number of meetings and need to be "on call" have made geographic proximity, or at least travel flexibility, desirable.

The need to have an "Audit Committee Financial Expert" means that former CFOs and retired partners from audit firms, particularly those with 1940 Act experience are strongly in demand. Of course, knowledge of the legal and regulatory environment is a virtue, but there are already many of those in-place and the requirement to have independent counsel tends to suggest that additional lawyers are not needed on the board.

A new criteria might be knowledge of outsourcing practices and vendor relationship. After all a mutual fund technically outsources virtually all its operations and increasingly, the independent directors are interested in a "fair" price for these services. Fair typically means the price at which a knowledgeable third party would charge for managing a similar function.

The SEC has placed great emphasis on a fund obtaining "best execution" for its trading practices. As a result, a new criterion for board membership might include knowledge of brokerage allocation, order flow and total (trading) cost analysis. Similarly, the recent scandals arose partly because there was insufficient knowledge about how fund shares are sold and the motivations which underlie them. As a result, knowledge of fund marketing, obtained as a financial advisor, retirement planner, fund wholesaler or marketing executive might be valuable.

Much of a fund's administration expense is allied to operations, call centers and customer relationship management software and systems. Furthermore, these functions are often outsourced, sometimes to an affiliate of the management company. The Nominating Committee might well consider experience with these functions as an important criteria for new directors.

Recently, there has been much emphasis on the need for fund boards to participate in decisions about how to vote the fund's proxies in the best interests of the shareholders. A Nominating Committee might consider that knowledge of how stock options and poison pills dilute the equity of existing stockholders of stock as important.

Mutual fund boards have had to become much more sophisticated about complex forms of equities and fixed income investments, particularly warrants, calls, puts and other options. Structured notes and derivative securities are often beyond the understanding of a typical mutual fund board and adding a new director who has had experience with them might be important. Of course, the downside of this is that the board should not get into micro-management of the fund's portfolio.

Similarly, many active managers boast that they obtain their "alpha" (or return above the appropriate benchmark) through excellent research. Some fund boards might consider that experience as stock analyst as important. For the same reason, a Nominating Committee might seek a new director who understands the investment process, such as momentum investing, quantum analysis or attribution analysis. Many management companies proclaim that they have to pay large sums to retain the best portfolio managers; a fund board might want to add a new member who can test this theory.

In conclusion, adding a new independent fund director is a rare opportunity to broaden the decision making capability of the board. As a result, the Nominating Committee should carefully consider its future needs, as well as its existing strengths and weaknesses, in selecting its selection criteria.

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