The role of the independent board of directors of a mutual fund continues to evolve and be scrutinized. As recently as October, industry associations were encouraging the Securities and Exchange Commission to re-examine the role of the independent board and pragmatically rationalize its legal and regulatory duties, suggesting that some components may be better served by the fund adviser than the independent directors. Many believe that the burden that falls on the independent directors is not a reflection of an appropriate division of labor between the board and the adviser and doesn’t fairly consider their respective qualifications and roles.
While one can debate this evolving trend, certainly we all would agree that the board’s role has expanded under the existing legal and regulatory framework. Further, no one would disagree that the centerpiece of the board’s duties remains the oversight of the adviser’s performance in generating returns for fund shareholders. Whether in connection with the board’s annual investment advisory contract renewal efforts under Section 15(c) of the Investment Company Act or pursuant to the board’s general oversight responsibility, performance review is the cornerstone of the board’s duties. Directors regularly examine a fund’s gross, net and comparative performance as they strive to create investment returns for mutual fund shareholders.
Active Management Challenges
Review of active manager performance has become a more complicated endeavor in recent times. The case for active management has been under attack for a seemingly long period of time with regular comparisons made every day between actively managed mutual funds on the one hand and index funds and exchange-traded funds on the other. Market reality reflects that many actively managed funds trail their benchmarks and static competition, calling into question the value of the fees advisers are paid. The problem is exacerbated in part by the fact that as some actively managed mutual funds lag their index-based counterparts, assets have migrated to those static funds. When index-based funds gather more assets, they purchase all the names in their index while maintaining the index weighting. This across-the-board buying activity by these funds may have the effect of driving up the price of all the underlying securities.
The combination of this phenomenon with the recent broad market increases has led to a lack of volatility in the market. Lack of market volatility provides a challenge for stock pickers in their effort to outperform the market and the index-based competitors. When market prices are generally higher, it is difficult to add value from pure stock selection. Adding to the active manager’s woes is the fact that actively managed mutual funds generally have higher expense ratios than the index-based funds. When we add to these performance challenges (i) the impact of the Department of Labor fiduciary rule, (ii) pressure from retail brokerage firms to reduce overall mutual fund costs and (iii) the tightening of advisory firm profit margins, we find a uniquely difficult period for actively managed mutual fund advisers. While mutual fund advisers deal with these issues each day, the same realities are also relevant to independent boards of mutual funds in connection with their oversight function.
When the Department of Labor announced its proposed rules on the creation of a fiduciary duty for broker-dealers selling to retirement accounts, it did not take long for broker-dealers to recognize that as a practical matter this new regulatory structure would impact non-retirement retail accounts in the same way as retirement accounts. In fact, the American Funds “clean shares” no-action letter noted that broker-dealer intermediaries needed to have both types of clients treated the same way. In many cases, an individual client may purchase funds from a broker for both a retirement account and a non-retirement account. It is not practical to think those two types of accounts can be treated differently. This reality drove broker-dealers and fund companies to seek to modify mutual fund costs and structures to accommodate this new “normal” reality for the selling broker-dealer.
What Lower Costs Will Mean
Whether it was the development of a “T-share class” structure, with an identical load and service fee used by all fund companies, or a clean share class structure that would offer a no-load agency trade with no 12b-1 fees and the imposition of a commission by the selling broker at the brokerage account level, we have seen a clear desire on the part of broker-dealers to have the fund companies adopt lower cost structures and more consistent economic models across the fund industry. This allows brokers to sell lower-cost products that have fees that do not differ materially from fund group to fund group. This trend caused uncertainty and was a drag on mutual fund sales this year.
On the other hand, one could argue that the creation of these lower-cost mutual fund structures is also more aligned with the lower-cost structures of ETFs with lower expense ratios, fewer 12b-1 fees, no sales load options and, in the case of clean shares, a commission paid at sale in the client’s brokerage account. It may be an unintended consequence, but the recent uncertainties and lower cost structures for mutual funds indirectly may provide mutual funds with a more “apples to apples” cost comparison to ETFs. When cost structures are more aligned, actively managed funds may have a stronger ability to generate superior net returns and compete with ETFs on a performance basis. Superior relative performance may lead to a slowdown or reversal in the migration from actively managed funds to ETFs. This slowdown may dampen the rising tide of stock prices that comes from ETF growth and lead to more overall price volatility. All of this may be good news for active managers. At a minimum, it will give active managers a more even playing field with ETFs and index funds and give them an opportunity to present positive performance comparisons.
Impact on Boards
Mutual fund boards examine the performance and cost structure of their funds as compared to the relevant benchmarks and peer groups generally in connection with regular oversight and, more precisely, in connection with the Section 15(c) review. While a board typically may not compare performance of an actively managed mutual fund to a static ETF, if the result of these noted changes reduces fund cost structures and facilitates a positive comparison of actively managed mutual funds to their index fund counterparts, boards may oversee a growth in fund assets for those active managers that can utilize the new “normal” reality to create outperformance.
Either way, boards will have a clearer view of the active manager’s relative performance when cost structures are more aligned. This new reality may provide stock pickers with the chance to use the new lower cost paradigm to their benefit by enhancing performance over static products. While this recent period may have imposed extraordinary challenges on active managers and the funds they advise, there may be a silver lining that the new “normal” may change the landscape enough to give active managers a chance to turn the tide of positive relative performance and change the debate on the value of active management more generally. This also will support the job of the board in overseeing actively managed advisers by giving directors a clearer picture of relevant comparative performance from a more level cost playing field, which may ultimately generate higher returns for fund shareholders.
Michael R. Rosella is a partner and global chair of Paul Hastings’ Investment Management Practice, based in New York. His practice reflects a diversified array of investment company structures, including representation of mutual funds, closed-end funds, unit investment trusts, business development companies, exchange-traded funds, and private investment vehicles.