Rules to Live by for Directors of Active Funds

Jay KeeshanMutual FundsLeave a Comment

Many fund directors are asking what they can do to help shareholders of active funds – a product 90% of directors oversee. These funds face one huge hurdle: they underperform and undersell passively managed funds.

In 2016, $504 billion flowed into passive funds while $340 billion flowed out of actively managed funds, according to Morningstar Direct. Actively managed funds have also underperformed passive funds, on average and over recent time periods, by about 15% in most investment categories, according to Morningstar. Of course, there are exceptions.

So now active managers are trimming their funds’ fees. In 2016, the average asset-weighted expense ratio of an actively managed mutual fund was 0.82%, down from 0.98% a decade earlier. But directors of actively managed funds should not allow their managers to chase fees so low that they can no longer afford the hands-on features that make active management attractive. Or worse, so low that that active managers are systematically forced to become closet indexers.

The ’40 Act makes no distinction between the responsibilities of directors of actively managed and passive funds. However, all fund directors are required to apply their best business judgment and must be loyal to their shareholders. Directors of actively managed funds should have a slightly different mindset from those of passive funds.

Active managers need an explicit goal that their products perform better than those of their competitors. This requires skill, tenacity and daring. To sustain a competitive advantage, active managers must be continuously attentive and intellectually consistent. And to create the best product, they need to spend money. Directors responsible for overseeing these products must not be cheap. Focusing strictly on cutting fees and expenses will cause any competitive advantage to soon dissipate.

Active managers and their fund boards need to recognize that a good product is more important than lowering costs. Here are five rules directors of actively managed funds should live by.

Rule No. 1: Recognize that active management is expensive and performance really matters.

Fund directors are responsible for approving advisory fees, which enable advisers to pay for research, portfolio management and trading. Without genuine talent in these positions, active management is bound to fail, especially in a bull market. When the market turns down, active management is touted as having an advantage, but this won’t occur without imaginative research, talented portfolio managers and effective trading – all well supervised and coordinated.

Directors need to ensure advisers have enough resources devoted to supervising and supporting the investment functions so managers can effectively integrate their investment, operations and distribution activities.

Rule No. 2: Avoid closet indexing.

Related Content – August 29, 2017 Active/Passive Conversation About More Than Two Options

In a bull market, some active managers decide the most effective way to improve their ratings is to quietly adopt closet indexing.

This is difficult for fund directors to notice. However, they need to be aware of this possibility because it’s unfair to shareholders who are paying for active management. If directors do see that the fund is a closet indexer, they should urge management to charge a fee closer to that of passive funds.

Rule No. 3: Success is not possible with penny-pinching operations.

Directors of active funds need to pay attention to the way the manager pays for the middle office. This includes fund accounting functions, such as net asset value calculations and valuations that can be complicated by less-liquid, hard-to-price securities. These hard-to-value securities are usually needed to secure the desired investment niche. Fund directors must also pay attention to compliance expenses because they supervise the chief compliance officer and his or her activities.

Back-office operations are also critical. Active shareholders tend to move in and out of a fund more frequently than typical passive investors. As a result, directors need to keep a close eye on how much is spent on transfer agency and custodian functions, without being stingy.

Rule No. 4: Don’t obsess about brokerage commissions.

The cost of a single trade is not as important as the total cost of trading, which includes a lot more than just brokerage commissions. Part of the cost of trading can be the soft dollars that funds earn by doing trades through certain brokers.

Advisers of actively managed funds have an obligation to seek “best execution” of portfolio trades. Fund directors have an oversight responsibility to see that managers take this obligation seriously. As part of this responsibility, directors typically review commissions for trading purchases and security sales. Active management requires the best possible research, and some advisers decide to pay for this research by selling their funds’ securities through select brokers. Soft dollars can also pay for research tools that are essential for active management, such as Factset and Bloomberg.

Rule No. 5: Don’t force managers to skimp on marketing and distribution.

Managers sometimes pay for marketing and distribution expenses by charging 12b-1 fees, which directors must approve. Actively managed funds are more difficult to sell because they typically appeal to fewer investors than passive ones. Although the amount spent on marketing, other than the 12b-1 plan, is outside fund directors’ mandate, this expense is one that boards naturally care about. Fund boards should remember that the manager cannot invest money that’s not raised in the fund marketplace.

Directors of active funds must take care not to cut fees so low that the product becomes undesirable. They must be prepared to allow managers to spend money to keep their products competitive. Many believe there’s a bear market right around the corner and investors will soon be looking for actively managed products with the best possible relative returns. Investing in the necessary capabilities today is crucial for tomorrow’s success.

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