Mutual Fund Directors' Response to Poor Performance
Written by C. Meyrick Payne, Senior Partner, Management Practice Inc.   

Mutual Fund directors often wrestle with what should be the appropriate response to poor investment performance in one of the funds that they govern. Some incorrectly describe the range of tools available to directors as "a feather or a sledgehammer". These critics believe that the directors can only mildly chastise the management company or alternatively lift the advisory contract. Nothing could be further from the truth, particularly as the troublesome fund is usually part of a larger complex where there are a variety of organizational alternatives. Invariably the top executives of the management company are just as anxious to correct poor performance as the independent directors. The purpose of this article is to enumerate some effective alternatives, which generally fall into three categories; organizational, fee-related and structural. Each of these is discussed below.

Organizational Changes

There are three organizational alternatives.

Beef up the support provided to the portfolio manager. In the recent bear market, new money has left certain equity funds and entered money market, occasionally taxing the ability of the portfolio manager to rebalance the portfolio. This strain might be particularly evident when layoffs have occurred. The directors might request that the top executives of the management company adopt a team approach to portfolio management or add to the dedicated research capability.


Change the portfolio manager. The advantage of being a director of a fund in a large complex is that there is an established investment management infrastructure within which a portfolio manager can move around. Performance may be poor because the specific portfolio manager is bored or burned out with his or her present responsibilities. The directors might ask for a new portfolio manager as part of a normal program of rotation.


Add a sub-advisor. A more severe remedy is for the directors to insist upon retaining a sub-advisor. This might occur when the fund has grown or shrunk dramatically, taxing the capabilities of the investment manager. Alternatively the investment requirements of the fund might have become much more complicated, such as when the energy crisis hit California or when the World Trade Center was destroyed. Adding a sub-advisor will almost always require that the primary management company pays out between 40 and 60 percent of its fee.
Fee-Related Changes

There are two fee-related responses.

Request a temporary waiver of the advisory fee. Since the management fee is usually the largest individual component of fund expense, the directors may feel justified in asking the investment advisor to temporarily waive part or its entire fee until performance improves. The advantage of this is that it clearly demonstrates that the directors are concerned and are not prepared to reward poor performance. On the other hand reducing the fee may do nothing to correct the underlying problem.


Add a performance component to the advisory fee. Some fund groups have adopted a performance fee to reward improvements or penalize continued disappointments. In such a case the directors have to decide how big the incentive should be, how improvements are to be measured and over what time period. In a recent case, the incentive component was set at plus or minus 8% to 12% of the existing fee with improvement measured on a one-year basis compared to an agreed peer group.
Structural Changes

There are four structural changes that directors might adopt.

Merge the Fund. A fund with continuing poor performance serves little or no purpose. The directors might well feel that they are best representing the shareholders ' interest by merging the fund in with another.


Ask the management company to make an acquisition so as to bolster its capability. Recommending an acquisition may seem outside the authority of Fund directors, but when offered as an alternative to lifting the entire advisory contract, it seems to be the lesser of two evils. The management company is just as anxious to improve performance as the directors and will welcome constructive ideas.


Delay the introduction of a new fund pending performance improvement. If the directors believe that the management company is overtaxed, they might well delay the introduction of a new fund. While this is probably outside their legal authority, it is certainly preferable to canceling the advisory contract.


Close the fund to new investors. In a case where sudden inflows of new money has made the fund difficult to manage or stretched the management company's resources, the directors may feel justified in closing it to new investors. The directors' responsibility is the existing shareholders, not the ones who are precluded from investing.

In summary the independent directors have a great many alternatives in addressing poor performance which are neither a "feather nor a sledgehammer".