Four for Friday ~ Mutual Fund Boards

A July issue of the Fortnightly linked to a paper that focused on the role of mutual fund directors, which said that “to be truly effective, a fund board must be an independent force in fund affairs rather than a passive affiliate of management.”  But, as quoted in an earlier posting about Pimco, the head of its fund board governance committee “said the board had learned about the Gross/El-Erian drama when they read about it in the paper, like everyone else.”

Those quotes sum up the divide that exists between the ideal state and the prevalent one.

Questions of independence

The most recent “Overview of Fund Governance Practices” issued by the Investment Company Institute and the Independent Directors Council leads with the statement that, “Fund boards, as a group, follow strong governance practices to best serve the interests of shareholders.”  Those organizations represent fund companies and their directors, so they are advocates as opposed to objective third parties.

The overview emphasizes the independence of directors, with 84% of fund complexes now having more than 75% of the seats held by independent directors.  68% of them have an independent board chair and 27% a lead independent director.  Meeting the definition of “independent” and acting independently are two different things, however, and a fund advisor can effectively control the fund board charged with overseeing it.

One aspect of that relationship was explored by John Rekenthaler in an article, “Do Fund Companies Have a Duty to Pass Along Economies of Scale?”  The short answer to the question is “no.”  Rekenthaler’s bottom line:

Neither habit nor the law suggest that fund directors will drive particularly tough bargains for the shareholders they represent.  For better or worse, that decision rests in investors’ hands.

New rules

Some SEC rules give specific responsibilities to fund boards, including two new ones, adopted separately in 2020.

Today is the compliance date for Rule 18f-4, which regulates the use of derivatives by mutual funds.  It requires a fund to have a written derivatives risk management program, and the board of directors needs to approve a derivatives risk manager who will report to it “to facilitate the board’s oversight of the fund’s derivatives risk management.”

Rule 2a-5 has a compliance date of September 8.  It deals with valuation practices — last addressed “in a comprehensive manner . . . over 50 years ago!”  (Exclamation point added.)  “The rule requires a board or its valuation designee to assess and manage material risks associated with fair value determinations; select, apply and test fair value methodologies; and oversee and evaluate any pricing services used.”

Given previous problems and numerous hot-button issues in regards to derivatives and valuation, these rules are not a surprise.  How each is interpreted and implemented is an indicator of the relationship between a fund board and the asset management firm working for it.  Has the process to date been marked by inquiry and a quest for understanding, or by wrapped-up solutions and rubber stamping?

Performance evaluations

As in other situations where asset managers are evaluated, performance is an easy thing for a fund board to observe.  At least it’s easy to see a series of numbers; interpreting them in a meaningful way is something else entirely.

A 2019 white paper from MFS, “On Board With a Long-Term View,” says that “confusion about the time horizons needed to measure risk and ultimately performance . . . creates misalignment, ultimately eroding understanding and the ability to achieve strong long-term outcomes for end-investors.”  The paper details the steps that MFS and the MFS Funds Board took to get “on the same page” regarding performance.

One key aspect of that was coming to an agreement that “the way we were presenting performance information at board meetings was not aligned with our portfolio objective of outperforming over a full market cycle.”  That is a common problem across the industry, yet managers and consultants and asset owners cling to reporting methods that lead with short-term results.

The paper illustrates one firm’s approach to dealing with some of the longstanding problems regarding performance, making it an example for others to follow, in intent if not in specifics.  (For contrasting examples, look for an upcoming posting on some of the issues with “performance tests” found around the ecosystem.)

Board assessments

The unique nature of mutual fund boards can impede the implementation of best practices for similar governing bodies due to the influence of the management companies.  Nevertheless, “Practical Guidance for Fund Directors on Board Self-Assessments,” a report from the Mutual Fund Directors Forum, touches on a number of important facets that a board should be considering.  For example, there are two pages of “Questions and Topics for Evaluation,” many of them the kinds of topics that often don’t get addressed by boards but make a huge difference in effectiveness, especially during times of stress.  (Also check out a posting summarizing “The High Impact Behaviors of the Most Effective Directors.”)