Fund Lawyers, Trustees and Money, Oh My!

• By Max Rottersman
• On 12:00 pm EST, Wednesday January 21, 2009

HANOVER, NH (ETFguide.com) - Andrew 'Buddy' Donohue runs the SEC Division of Investment Management. If you're in a mutual fund, he's there to protect your interests.   He recently spoke at the Investment Company Institute (ICI)  2008 Securities Law Developments Conference.  The ICI is a lobbying group for the fund industry.  

Referencing shareholders who feel ripped off by 12b-1 fees, Mr. Donohue lamented, 'When I spoke to you at this conference last year, I laid out two initiatives I expected to pursue: rule 12b-1 reform and investment adviser recordkeeping modernization. I have a personal level of disappointment that I was unable to achieve my goals.'

Mr. Donohue, a former Merrill Lynch executive, has continued a tradition, set by Paul Royce, his predecessor, in keeping the work of trustees and their fund counsel (lawyers) behind closed doors.  Mr. Royce landed at American Funds, which took in $448 million in fees from shareholders in December, 2008, which wasn't even a good month.  That's $5 billion per year.  Nice place to work.

The 1940 Act wisely says that a management company can't charge you any fee it wants, but must have a 'disinterested' person who is not employeed by the manager to approve the contract. That person is called a Trustee of the Fund.  It was a great idea, but the SEC turned a blind eye as the industry found a way to silence trustees.  It's called money.

To keep trustees from having a bad day while reviewing these management contracts, Merrill Lynch  trustees (now Blackrock), are paid over $200,000 each.  What's involved? Four to eight meetings a year.  What sane person wouldn't sit in a conference room for $20,000 a day?   There are almost 700 trustees who collect over $100,000 a year to open dense and unreadable board books from Lipper, Morningstar and Strategic Insight.    

You can boil these books down to seven to twelve lines of text, the list of other funds to which your fund compares itself when setting fees.  The process is called 15c contract renewal because that's the section of the 1940 Act which begins 'Approval of contract to undertake service as investment adviser.'  It's important to understand that funds are not owned by the managers.  For example, the board of the Magellan fund could replace Fidelity with Vanguard as advisor.  This power, though almost never  used, is another reason any rational manager would want to keep the trustees mollified. 

At a recent conference for trustees, Mr. Donohue asked the rhetorical question, 'For a fund with an expense cap that has experienced an increase in its expense ratio due to a decline in asset values or redemptions, is it appropriate to modify or eliminate the expense cap? What standard will the board employ to determine any such modification? Similarly, many funds use funds in a 'peer group' as a benchmark to analyze fees charged and expense ratios incurred. Boards should be mindful in evaluating funds within a peer group that the funds that historically may have comprised this peer group may no longer be a member of that group or have comparable assets under management.'

Put another way, Mr. Donohue is saying what the managers already know, the peer groups are often flawed.  But there's no way for a shareholder to know.  It's kept secret. This could have easily been fixed by Paul Royce, who chose not to require funds to list their peer groups during his work on so-called disclosure reform.  Instead, Mr. Royce,  added hundreds of lines of legalese that no one reads into the very prospectuses Mr. Donohue then tried to shorten.

Understanding the importance of peer groups is simple.  If you ran a school district and were shopping for school buses and your superintendent came to you with Bus A and asked you to pay X amount what would you do?  You'd ask, how much do the other busses cost.  You would ask for a list of comparable buses.  Bus, B, C, D, etc.  You would not ask for description of how many wheels each bus has; you would not ask for a description of their seats.  Yet that's what the SEC has choses to disclose in our prospectuses.

You have to wonder about Mr. Donohue's knowledge of how boards operate when he  says 'many funds use peer groups'.  Many?  They all do.  How could the not?  Can you imagine a manager going to his board and saying, 'I'm going to charge 2% to the fund because I think it's fair' and the board saying, 'as long as you think it's fair that's good enough for us--hey, what's for lunch!'  Peer groups are the bedroock of board review.  

From all this has risen a growing problem with legal and trustee costs.  In general, a mutual fund's professional costs have significantly outpaced inflation (they've followed asset growth as if your money is their money).  This means that as the value of your wealth has flattened out, the operational expenses you pay are now 80% greater than they were eight years ago.  In 1999, the legal costs for mutual funds was $152 million.  In 2007 that figure ballooned to $276 million.  Eight years ago trustees spent $132 million on themselves, now they cost $270 million.   They've doubled their pay while your money stagnated.

Trustees would probably point to the big increases in 2004 and 2005 as coming behind the mutual fund scandal of 2003.  Sarbanes-Oxley certainly put more pressure on boards and counsel.  But why should the shareholders bear the sins of the managers?  Should the managers pay the cost of additional regulation?  It seems not. The SEC let the shareholders pay.

Legal, board and other professional costs are established by fixed contracts.  Now, in order for the funds to pay the lawyers and trustees it must either allow the expense ratio to rise or obtain a reimbursement from the manager.  Thanks to Mr. Royce, Mr. Donohue and years of SEC neglect, shareholders have ended up with highly paid Trustees who don't disclose the most important data they review, seven to twelve lines of text that say more than any hundred pages of prospectus boilerplate.

What Mr. Donohue might be suggesting is that the trustees let the fund fees rise above the expense caps.  This is in the lawyers and board's interest.  If they don't allow expenses to rise they will have to cut their pay.  People don't like to cut their pay.  And boards aren't designed in a way that you can just fire a few of them.  In fact, you can't fire any of them.

When you look at the latest annual report for the Putnam Fund For Growth and Income (NasdaqGM: PGRWX - News), for example, you'll notice that its expense ratio for 2008 is 1.00%.  In 2007 it was 0.92%.  If you add up the legal and director costs for the fund you arive at the $529,000 that the Putnam fund shareholders, from just this one fund, paid to lawyers and directors. (John A. Hill, the press-savvy board chair, collects almost $400,000 from Putnam).  All things equal, next year the fund will be at 1.01%. 

Boards have taken a very accomodating stance towards International funds.  They always seem to have high legal costs. The Artio International Equity A (NasdaqGM: BJBIX - News) has recent legal costs of $1.4 million and board costs of $868,000. To put this in perspective, a similar international fund, the exchange-traded fund (ETF) iShares S&P Global 100 Index Fund (NYSEArca: IOO - News) has a total cost of $3.4 million. Add in Artio's registration fees, auditing and 'other' expenses and the professional fees alone at this one Artio fund cost more than what it costs Barclays to run their entire Global 100 Fund. 

Some fund are so large they can absorb lots of legal fees without moving the expense ratio. The Federated Mutual Shares Fund (NasdaqGM: TESIX - News), spent $2 million legal fees for 2007.  That's more than double AARP total budget for all four of its mutual funds, from the AARP Aggressive Fund (NasdaqGM: AAGSX - News) to the AARP Conservative Fund (NasdaqGM: AACNX - News). 

Run-away fixed costs are an industry wide problem.  And the costs of legal counsel and trustees cuts to the heart of fiduciary care.  Again, should the people watching your money double their wealth when yours is flat?  On this, Mr. Donohue is sadly silent.  Will lawyers and trustees cut their pay?  Or will they wait for the market to come back?  Better yet, will they come up with a different compensation plan?

Because there are small fund companies that may go out of business from a spike in operational costs, Mr. Donohue's argument is reasonable.  But in the industry, it's well known that expense caps do not harm any of the major fund companies.

If Mr. Donohue had the shareholder's interests at heart he would have said, I know many managers are feeling the pain of lower fees, but you must protect the shareholder's interest.  If the fund company can't operate efficiently enough to provide a fair value to its shareholders than it must take responsibility for its inefficiencies by not passing them onto the shareholder.  But he didn't say that.

While the SEC has ignored fee abuse, these funds have worked hard to deliver low-cost alternatives.  AARP, E*Trade, Dodge and Cox, Fidelity Spartan Funds, Vanguard and most ETFs.  You can compare their funds to yours at FundAnalyze.com. 

Max Rottersman is aprincipal of Hanover Technology Group, LLC. His opinions don'tnecessarily represent the views of ETFguide.com or Yahoo Finance. Hedoes not own shares in the funds above and does not have a consultingrelationship with them.

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