It's the Conflict of Interest, Stupid
May 17, 2004
Mutual fund industry critics need not look far to find the root cause for the industry's scandals. The problem lies in the industry's predominant governance structure. Aside from the Vanguard Group, external management is the order of the day, meaning that conflicts of interest over fund expenditures aren't just common, they are inherent. Equally inherent is the risk that the external manager will allow practices that serve its interests, to the detriment of fund shareholders.
Not a Misguided Few
Fund industry apologists have sought to explain away the late-trading and market-timing scandals as the dirty work of a few misguided employees. I see it differently. I say these problems are simply manifestations of the double-dealing encouraged by the fund industry's dysfunctional management structure.
Anyone doubting this ought to read New York Attorney General Eliot Spitzer's complaint against Canary Capital. What you find is clear evidence that fund managers and their affiliates made a cold-blooded, calculated decision to profit privately by selling to outsiders the right to cheat fund shareholders. They did this because their loyalties were conflicted. Selling the right to cheat fund shareholders, after all, enriched the investment advisor and its affiliates. The fund managers' loyalty to the external advisor, in other words, trumped their sense of duty to fund shareholders.
Another piece of evidence showing that the fund industry's problems are rooted in managers' divided loyalties is found in Massachusetts Secretary of State William Galvin's complaint against Putnam Investments arising out of the Boilermakers Union's market timing. Exhibit nine in that complaint spells out the Putnam managers' financial motive for letting the union's officials time Putnam funds: $100 million of additional union money for Putnam to manage.
The added costs generated by conflicted decision-making represent a tax paid by shareholders of externally managed funds. Sometimes the tax has been levied secretly, as happened in the late-trading and market-timing scams. Another secret scam involves directed-brokerage payoffs, whereby a fund's brokerage costs are kited, the better to reward those selling fund shares. Fund share sales, of course, profit the fund's advisor. There is no evidence that spending fund assets to generate new sales is cost-effective for the owners of those diverted assets, the fund's shareholders.
It is a mystery to me how fund directors whose shareholders are already being assessed for the maximum amount of 12b-1 fees have been able to justify allowing the diversion of additional assets via directed-brokerage payments used to subsidize the fund underwriter's distribution efforts. Diverting fund assets to pay distribution costs outside of 12b-1 is a bad idea.
Fund directors doubting this might want to review the Fund Director's Guidebook, prepared by an American Bar Association task force, and note this language: "Fees characterized as distribution-related must be made pursuant to a Rule 12b-1 plan." The guidebook goes on to instruct that 12b-1 fees are "the exclusive means by which a fund may use its assets to bear the cost of selling, marketing or promotional expenses associated with the distribution of its shares." (Emphasis added.) Directed-brokerage payments made to spur or reward fund share sales are distribution-related expenditures made for selling, marketing or promotional purposes.
There is a word that describes directed-brokerage payments made by funds outside the confines of their 12b-1 plans. The word is "illegal."
Another secret levy born of conflicts of interest comes in the form of soft-dollar kickbacks to the investment advisor. Once again, these are generated by overpaying for fund brokerage. This mechanism enables the advisor to off-load onto fund shareholders part of the cost of providing advisory services, a chore for which the advisor is already lavishly compensated.
The ubiquitous fund industry practice of soft-dollar kickbacks to fund managers achieves two goals, both good for the advisor and bad for fund shareholders. First, the kickbacks fatten the advisor's bottom line, while, second, they keep an array of advisory costs from hitting the fund's expense ratio and thus becoming visible to shareholders.
The quintessential conflict, of course, is advisory fees. The crucial ingredient that investors pay for when they buy shares in an actively managed mutual fund is professional management. A dollar more for the advisor means a dollar less for the fund shareholders to split up. Thus, fund advisory fees present the mother of all conflict-of-interest issues stemming from the fund industry's flawed governance system.