Mutual funds with steadily increasing assets are generally positive indicators for fund directors and shareholders alike. However, declining assets in a fund are just as likely. The purpose of this article is to highlight some of a fund director’s responsibilities, particularly in the contract renewal process, when the asset base is shrinking.
The first order of business for the fund director is to assess the situation. The key analysis is to differentiate between market appreciation (or depreciation), actual investment performance and fund inflows or outflows. This allows directors to determine if relatively poor investment performance, ineffective marketing, strategy popularity or other drivers may be causing the outflows. The second analysis is to understand if the declining asset base is confined to a few funds or if the impact is occurring throughout the fund family. Complex-wide shrinkage compounds the effect as there are fewer assets to spread the fixed expenses across and the marketing problems may be systemic.
A fund director’s responsibility under these circumstances is, as always, one of good governance. This includes the oversight of the fund advisor who is responsible for reversing the outflow by adding or substituting investment capability, improving marketing and retention efforts and keeping the costs competitive. This article groups the fund directors’ oversight responsibilities into four categories: ensuring competitive fees and expenses, assessing that the investment advisor has the resources and capability to improve investment performance, ensuring that marketing and sales efforts, especially those funded by 12b-1distribution fee, is effective, and confirming that personnel and compliance policies are in place to maximize the chances of future success.
Cost Effective Fees and Expenses
The expenses of a fund with declining assets are likely to increase because there are in all probability fewer shareholders and smaller holdings over which to spread the fixed costs. At least a portion of the administrative, transfer agency, custody, compliance and legal costs remain constant even as assets decrease. To mitigate these effects, agreements with the various service providers can be reviewed to provide possible pricing flexibility. Also, at contract renewal time, the independent directors might ask for expense caps or fee waivers on those funds which have total expense ratios in excess of their competition. If expenses become excessive or the fund becomes too small to effectively manage, the fund directors may want to ask for a merger with a similarly styled fund in the complex, or even liquidation.
A fund director’s responsibility is to ensure, to the extent possible, that the shareholders have a reasonable chance of earning a fair return. Investment performance can be negatively affected by declining assets. The portfolio manager may have to maintain a large holding of cash, or stand ready to liquidate positions promptly, or maintain a line of credit so as to have cash available for redeeming shareholders. Similarly the manager may have higher turnover and associated trading costs because of the need to shrink the investment portfolio. These redemptions may themselves lead to capital gains for the shareholders who are left in the fund. Large redemptions often carry a high opportunity cost because the portfolio manager is effectively precluded from chasing emerging opportunities. Additionally the total amount of brokerage commissions tends to decrease as a fund shrinks, making proprietary or third party research more difficult and expensive to obtain.
If poor investment performance is the underlying reason for the loss of assets, then the independent directors may have a responsibility to ask for a change in portfolio manager or even the substitution of an outside sub-advisor.
Marketing and Sales Strategies
Fund directors regularly debate whether or not they have any responsibility for marketing and distribution of the fund they govern, especially when a fund is losing assets. What cannot be denied is that the directors must ensure that the 12b-1 fee is spent for the benefit of the existing shareholders. That benefit may come in the form of better retention of shareholders or improved shareholder services. When assets are leaving a fund, or worse, an entire fund family, this justification may become more problematic. One aspect of the manager’s proof that 12b-1 fees are still justified is to show that without them the distribution network, whether captive or contracted, will no longer support the product and the outflows will quickly intensify.
Effective Personnel and Compliance Policies
Above all the independent directors must ensure that the manager is indeed viable, particularly with regard to doing what each fund’s prospectus commits, to complying with the law and related regulations, to following accurate and timely valuation procedures, ensuring compliance processes, and to retaining the talent necessary to manage the business. The shareholders interest is only fulfilled if there is sufficient research, investment and trading capability to provide a reasonable chance of performance success. Valuation of the remaining portfolio can be particularly taxing for the fund advisor and director, particularly if the most marketable positions are liquidated first.
In summary, no one likes to talk about what to do when a fund or fund family loses assets. If it is only a temporary challenge then the fund directors probably have little concern. But if it is a sustained and continuing trend, the independent fund directors will need to pay particular attention to safeguarding the interests of the remaining shareholders.