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Investors Urged to Scrutinize Contracts: Advisor Contracts Deemed as Critical as Executive Pay


As regulators wrangle with how individual companies disclose stock options and executive pay, mutual fund experts are now urging shareholders to take a close look at their advisor contracts to see what they are paying the people who run their funds.

After all, just as owners of individual stocks may be looking at whether they believe a chief executive deserves discounted stock options and use of a private jet, shareholders should know just where their money is going.

"It's the advisor who really makes or breaks the fund," said Faten Sabry, a vice president with NERA Economic Consulting in New York. And like CEOs, what shareholders pay their advisors varies widely.

For a $9.5 trillion industry in which one half of all U.S. households have a stake, it's no small issue, either.

In a study of federal filings for 9,000 mutual funds between 1995 and 2005, NERA found that advisors' fees consistently accounted for the largest chunk of fund expenses. But how much that meant in advisors' pockets ranged from as little as 20 basis points to 180 points, Sabry's study found.

"That begs the question, what accounts for these differences?" Sabry said during a presentation by the SEC Historical Society in Washington, broadcast over the Internet last week.

One is investment risk. NERA found that while advisors of slow-and-steady bond funds are paid, on average, 40 basis points, those managing the far more turbulent capital appreciation funds often collected as much as 90 and 100 basis points, with the average among this fund class being about 80.

Another factor is a fund's overall size. Contracts may specify that a manager get paid either a flat fee, so no matter what the size of the fund, the rate stays the same, or according to breakpoints, so that as the assets under management rise, the number of basis points the advisor takes drops, thereby shifting the savings gained through economies of scale to investors.

"It does appear that if your mutual fund agrees on breakpoints, shareholders are getting a good deal contractually," Sabry said. About one third of the funds studied relied on breakpoint contracts.

But things are not always as they seem. When NERA compared funds with flat rate contracts, to breakpoint contracts, sometimes flat rate contracts resulted in lower fees overall, leaving fund boards, as fiduciaries, with inconclusive data when weighing what type of contract might best serve investors.

Both approaches are misguided, placing the emphasis on sales, rather than performance, said Mercer Bullard, shareholder rights advocate, professor and founder of Fund Democracy of Oxford, Miss.

"It's not clear to me why fund managers' stock-picking ability is rewarded based on sales," Bullard said. "It ignores that much of the fund's growth is due not to the performance of the fund, but to the sales department convincing the shareholders to buy shares."

Advocates for flat fee and breakpoint models argue that advisors still will strive for good performance, since that's what lures new investors, and their money, in the door, said Elaine Buckberg, a vice president with NERA.

But that gives boards of directors little reason to look closely at these contracts, and even less information upon which to evaluate them. "Trustees have the option of negotiating [fees] or even dropping the nuclear bomb, [by saying], We're going to fire you,'" said Patrick Conroy, a senior consultant with NERA. "The management company never gets fired."

Performance-based advisor fees change that dynamic, Conroy said.

A model where a fund's advisor fees is linked directly to the fund's performance also helps insulate fund boards against charges of allowing excessive fees, he said. Since 2004, mutual fund boards of directors, as fiduciaries, must disclose to investors how their fees are being spent, so that the investors can evaluate whether they are deriving value-essentially, that they are getting the most investment bang for their buck.

Fiduciaries that fail to put the interest of their investors risk facing a lawsuit, in an area where case law has come down steadfastly on the side of investors.

Still, relatively few mutual fund companies have adopted a performance-based approach. Of the roughly 8,000 mutual funds trading today, only about 200 base advisor compensation on investment returns. Part of the reason for that is some fund board members, especially independent board members, may not completely understand the nuances of how fees are structured, Sabry said. Furthermore, different advisors offer different services, from research to trading to prospectus printing, complicating the formula for evaluating the value of their services.