Directors of small funds have always faced challenges with respect to the level of resources and economies of scale these funds have compared to their larger counterparts, but an onslaught of additional complexities has been compounding the challenges in recent years. With these evolving market trends placing the dilemma for directors of small funds in stark relief, it’s worth asking: How are small funds to survive growing fee constraints and consolidation trends, particularly amidst the rapid influx of new regulations that stretch limited resources and emerging technologies that are likely to result in a sea change for fund compliance and operations? Directors of small funds may benefit from taking stock of the current mechanisms they use for oversight and considering whether to adapt their approach to the evolution of the mutual fund industry, and the pressures on small funds in particular.
As a threshold matter, small-fund directors should evaluate why each fund is small and determine if the level of assets under management is to be expected given the fund’s inception date, target audience, or investment strategy, or whether there is an issue that merits further inquiry by the board. Directors may have clear answers to this based on their evaluation of a fund’s profitability and discussion with the fund’s adviser about its long-term viability. Small-fund directors should remain apprised of fund flows and asset levels, and in some cases may wish to undertake a deeper dive into the cause of low asset levels.
When is Small a Concern?
Small funds may remain small because they were developed for a limited target audience, such as to provide an investment product with a lower investment minimum for family and/or friends of the firm, or if another strategic reason exists to maintain the fund within an adviser’s portfolio, such as to provide a wide variety of options available for distribution platforms. Advisers should be able to explain to directors how a particular fund fits into its overall product offering, distribution plan, and revenue stream. Directors should be mindful that small funds with a concentrated investor base could present unique liquidity issues, and that these funds may be particularly at risk of rapidly losing assets if a large shareholder were to redeem.
In circumstances in which ongoing poor performance is driving low asset levels, directors can discuss the underlying causes with the adviser. Advisers may seek to develop a performance improvement plan under which they can provide the board updates on a designated timeline. In some cases, poor performance may simply be the result of a fund’s focus on a certain asset class that is temporarily out of favor in the markets. In other cases that don’t benefit from efforts to improve performance over the longer term, advisers may wish to discuss with the board whether a fund merger would be appropriate or, in a worst-case scenario, a fund liquidation that would involve a tax consequence for fund shareholders.
In assessing such scenarios, directors may want to consider the adviser’s ability to support each small fund in the context of its fund profitability, flows, and short- and long-term viability, as well as the extent to which the adviser may be devoting resources to preserve competitive expense ratios. The negative impact on advisers of supporting a small fund can be particularly pronounced when outflows result in increased expense ratios. Small-fund directors should maintain an ongoing dialogue with fund management about contractual fee waivers and the impact of expense reimbursements.
Distribution Challenges, Vendor Oversight
For small funds that either continue to lose assets or fail to grow over time, directors may want to look into whether distribution challenges exist, which may be due to the ongoing reducing of shelf space by intermediaries. Larger funds not only have an increased number of channels available to them, but they also have much lower barriers to entry than their smaller counterparts. These difficulties are exacerbated by the dwindling use of 12b-1 funds across mutual funds of all sizes. In addition, new funds are faced with platform requirements for a performance history of varying lengths in order to be eligible for placement. Small-fund directors should be kept apprised of the current distribution landscape and outlook for the funds in their purview, management’s strategy to respond to ongoing pressure from distributors, and the rising market share of passive investments.
Efficient oversight of fund service providers can present additional challenges to small-fund directors working with advisers that have limited resources. Small-fund directors are well versed in considering current service provider engagements on a routine basis and assessing performance and fee levels. If available, boards may seek to review comparative fee data from service providers that provide similar services on a similar scale as part of this process. This data may provide helpful leverage to negotiate lower fees both in the stand-alone or multiple series trust context for a variety of fund service providers that have flexibility in their pricing model. Small-fund directors may also evaluate their vendor oversight periodic review process and consider requesting that a formalized template for compliance and risk review be adopted if this has not already been implemented.
Board Materials: Streamlining the Process
Directors of small funds may also seek to create efficiencies in the processes for the production and review of board materials. Developing streamlined processes can be an initial invaluable step for small-fund directors to obtain the information they need even if the resources of an adviser are limited. Boards may wish to review their board materials with fresh eyes to consider whether the documentation provided by management and compliance represents the best and highest use of limited resources. Boards may find that there are materials that no longer serve their purpose with respect to the board’s review or be able to identify materials that have become unwieldy and could use a pare down.
Boards may also consider discussing with fund management or compliance whether and how in-house teams might leverage artificial intelligence or other technologies to create efficiencies in their production of board materials, and whether in-house teams could leverage outside third-party resources in order to provide boards with specialized expertise.
Small-fund directors already need to be more hands-on with respect to their oversight responsibilities given the resource constraints of their fund service providers, and refining the development and content of materials for review can lighten the load throughout the process, from production to review.
Reviewing Compliance, Education Resources
The rapid influx of new regulations has placed tremendous burdens on fund compliance teams, and this has proved to be particularly burdensome for small funds. This impact has been compounded by rising compliance costs and limited qualified compliance personnel. Boards are aware that fund CCOs face a considerable burden and that attracting and retaining compliance personnel can be challenging. As small-fund directors assess new rule requirements, they should continue to discuss the adequacy of resources with CCOs in executive sessions and inquire about the extent and impact of rising regulatory compliance costs.
Directors would benefit from paying close attention to indications that compliance teams are strained, by checking in with the CCO often or looking for other signs, such as a rise in material compliance violations or staffing issues. In some cases, outsourcing of compliance tasks or even the CCO role can be an appropriate way to help meet the burden of new regulatory requirements, provided that sufficient oversight protocols are in place. In other cases, automation of certain compliance tasks, shifting from manual to electronic processes, or the incorporation of artificial intelligence tools may be helpful. Boards are also cognizant of the importance of retaining their CCOs and have been diligent in helping to make sure that their CCOs are fairly compensated as a retention tool.
Developing a strategic approach for board education can also greatly benefit small-fund directors. Directors of small funds are less likely to have specialized experts presenting to them in the boardroom. Utilizing educational resources provided by industry organizations can provide extensive background information on a wide variety of topics under a board’s purview. Plugging into the networks of these industry organizations can also be exceptionally valuable for small-fund directors as a means to discuss approaches to board oversight issues and challenges with small-fund director peers. Directors may also consider compiling—or asking fund management to compile—lists of free educational webinars and other resources on industry hot topics so they can best leverage available resources in order to stay current with industry developments.
In a rapidly evolving mutual fund industry, small-fund directors are well served to stay two steps ahead of the game with respect to their oversight strategy. The prevalence and staying power of small funds is no longer a foregone conclusion, and directors may wish to take a fresh look from the ground, as well as from 30,000 feet. Is there a reason that a small fund is small and is that reason still applicable, or do directors need to look more closely at the facts and circumstances behind low or dwindling assets? Directors of small funds that are not at risk may find it beneficial to take a fresh look at their approach to holistic oversight to continue to best serve fund shareholders in an effective and efficient manner. It is not in the best interest of investors to lose access to smaller funds, and fund directors may be in the best position to help fund management sharpen pencils so that small funds do not evaporate in the rising tide of challenges that may include increasing industry consolidation, fee pressures, and regulatory burdens.
Dianne M. Descoteaux has been senior counsel at Mutual Fund Directors Forum since October 2023. Prior to joining MFDF, she was associate general counsel at the Investment Adviser Association, and before that was general counsel and compliance director at Cipperman Compliance Services, LLC, now a part of ACA Group. Descoteaux also has served as an investment management attorney at SEI Investments, Morgan, Lewis & Bockius LLP, and Morrison & Foerster LLP.