Toward Better Mutual Fund Governance

The financial crisis brought substantial change to the financial services industry, thanks largely to Congress’s post-crisis passage of the Dodd-Frank Act. Subjecting swaps and hedge fund managers to regulatory oversight and reforming the rules applicable to credit rating agencies are but a small sample those changes. Dodd-Frank did not, however, bring about any significant change the regulation of mutual funds—“pooled” investment entities that are regulated under the Investment Company Act of 1940 (“ICA”).

That circumstance may seem sensible, in that mutual funds are not widely regarded as having been a substantial contributor to the onset and severity of the financial crisis. Yet, the financial crisis did, in at least one respect, change the way that mutual funds operate. In particular, it produced a new model of mutual fund governance, one that may be superior to the governance model that has dominated the mutual fund industry for decades.

This is a momentous development, and an important one, given that there was substantial room for improvement—a product of the fact that, under the ICA, mutual funds are governed much like non-investment business enterprises (“operating companies”) are. As is the case for operating companies, a fund’s top executive decision-maker is its board of directors, which oversees and ultimately controls the fund’s operations. However, mutual funds—at least those that are structured and governed in the traditional way (the “traditional model”)—are very different from operating companies.

For starters, in the traditional model, a mutual fund’s board of directors is beholden to a firm that is completely separate from, and unaffiliated with, the entity—the fund—that the board is charged with overseeing, That other firm is the mutual fund’s manager—that is, the investment advisory firm that is responsible for investing and trading the fund’s assets and, therefore, for ensuring the fund’s profitability and success. Because the manager traditionally has been the party that creates (“sponsors”) the funds that it manages and that oversees all aspects of the funds’ operations, the manager has also been the party that selects the members of the board. Accordingly, if the board were to terminate the manager for any reason, then the fund—as well as any other mutual fund within the same fund group—would also likely terminate, as would each director’s position (and compensation) as to each of those of funds.

As a result of the manager’s dominant role, the board could be incentivized to act in accordance with the manager’s wishes, whatever they may be, and to refrain from terminating the manager’s relationship to any fund, however poorly the manager may have performed. Further, these potentially adverse incentives could be reinforced to the extent that, as is often the case, the manager has appointed one or more of its employees to the board. Beyond those concerns is the circumstance that, because virtually all of the personnel responsible for managing the funds’ day-to-day operations are employees of the funds’ manager, the board has limited practical ability to carry out its obligation to oversee each fund’s and its employees’ activities. After all, to do so, the board must effectively oversee the activities and employees of an entirely separate entity (the manager), for which the board has no formal responsibility.

These components of the traditional model are troublesome, if perhaps more so from a theoretical perspective than from a practical one. It is heartening, therefore, that a new type of fund structure has emerged—and, with it, a new model of fund governance. Like the traditional model, this alternative model contemplates the creation of multiple funds, or a fund group, but, unlike the traditional model, it relies on numerous managers, each of which manages one or a few funds within the fund group. In addition, no single manager acts as the guiding force—sponsor, operator, brand name—for the group. Rather, that role belongs to a third party firm, usually a mutual fund administration firm.

Because the fund group is not dominated by a single manager, the funds’ board of directors is not subject to the conflicts of interest that could arise from a too-close relationship between the board and the funds’ manager. Of course, similarly to the traditional model, the personnel of each new-model manager are responsible for carrying out the day-to-day activities of the fund or funds that the manager operates. Yet the new-model board is nonetheless able to have more control over the funds’ day-to-day operations because the power of each such manager is muted, as compared with a traditional-model manager. Both of these factors potentially allow the new-model board to be more effective than its traditional-model counterpart.

Perhaps surprisingly, the new model did not arise as a response to the concerns associated with the traditional model. Rather, the model is merely a by-product of the post-crisis emergence of multi-manager series trust, a form of organizational structure that emerged as smaller investment advisory firms, including many that had managed hedge funds and other types of private funds prior to the crisis, began looking to transport their investment strategies to the retail investor market. Without the series trust structure, those firms would be largely excluded from the mutual fund realm, given the considerable costs associated with sponsoring and operating a traditional-model fund group along the lines of those operated by Janus, Fidelity, Blackrock, and other large mutual fund managers. Managing a fund within a series trust is substantially less expensive, however, because it allows all managers within the trust and “their” respective funds to share many of the trust’s organizational and operational costs.

As one might expect, from a governance perspective, the multi-manager structure arguably has drawbacks of its own. Among other things, because managers in the new-model are often less well-established than larger managers and, because of that, often have less-well developed compliance infrastructures, those managers may pose greater compliance risk, as compared with larger mangers. However, these and other concerns are, it is hoped, relatively manageable. If that is the case, then the role of the board in the series-trust context may present one of the strongest arguments for the board’s continuing dominating role in the mutual fund regulatory regime.

The full chapter is available for download here.