Most directors, whether they serve corporate or fund boards, agree that owning shares in the entity they govern is important. Ownership is tangible proof that the interests of the board are consistent with those of the shareholders they represent. This MPI Bulletin examines fund director share ownership policies but more importantly addresses how directors acquire those shares. Over many years of consulting to fund boards we have come to believe that independent directors should acquire their shares from the same retail channel that regular investors do; that is through a financial representative, broker or through the direct sales process.
This concept involves not only owning the same investment that fund shareholders do, but also, where possible, sharing the same buying experience, paying the same fees and receiving the same disclosure and other materials. Although fund board members do not, prima facie, have to concern themselves with issues associated with the broker/dealer, it is important to confirm that the shares of the funds they govern are accurately portrayed and follow the investment principles discussed in the prospectus.
It is also useful to know what the distribution channel thinks about the fund family and its investment management capability. More often than not a 12b-1 distribution plan provides compensation for a financial representative to provide service at the time of sale and thereafter. Fund directors have to annually approve the 12b-1 distribution plan. By acquiring fund shares through the retail channel a director experiences the same service as a regular investor.
In our firm’s surveys of fund governance, we have found that roughly half of fund board either strongly recommend or require that directors own shares in the complex they govern.
“Roughly half of fund board either strongly recommend or require that directors own shares in the complex they govern.”The manner in which this policy is applied can be quite different; for example, some funds require that directors own at least one year’s retainer compensation worth of shares in any of the funds within three years of joining the board. Others allow shadow ownership to be acquired as deferred directors’ fees. Most allow their directors to own shares in any fund within the complex; few require investment in all the funds. After all they argue, not all funds are suitable investments for individual directors; for example a tax exempt single state bond fund may not a sensible investment for a director who lives in a different state. Some fund families allow directors and management company employees to acquire fund shares without loads, as long as they meet minimum purchase and other requirements specified in the prospectus.
Some examples of ownership policy were provided in a BoardIQ article in July 2013. William Blair Funds requires one half of the director’s retainer to be owned; Franklin Templeton requires one year’s compensation with three years of joining the Board; Putnam has a policy that each director will own shares in every Putnam fund.
Directors at most public corporations own shares in their companies. We estimate that more than two thirds of corporate directors own shares in the company they govern either through share option plans or stock grants. In the mutual fund space, closed end funds often have a similar policy. For example, Aberdeen and Credit Suisse Closed End Funds recommend 50% of a director’s annual fee be owned in fund shares.
The disclosure requirement for fund directors is publish the amount of fund ownership in the complex in six groups: no shares, between $1 and $10,000, between $10,001 and $50,000, between $50,001 and $100,000 and over $100,000. This disclosure is said to be a balancing act between providing useful information to the investing public without being intrusive or detrimental to the directors themselves.
What really seems to matter is not how much a director has in fund shares, but rather if he/she does not own any at all. The void is more of a red flag to a potential shareholder.
For several years, Morningstar tried to assess “stewardship” grades by, in part, evaluating the fund ownership of independent directors. However in about 2011, Morningstar eliminated this metric on the grounds that it was difficult to measure and not necessarily causal for improved performance. Academics have often tried to equate share ownership by directors, both corporate and fund, with improved performance. For us, we have seen no conclusive proof either way. But we are sure that potential investors, or their representatives, take note if the directors are not sharing the same risk and rewards as they are.
In sum, owning fund shares is an important indication that fund directors are eating the same cooking as fund shareholders, but, we believe just as important is for directors to acquire their shares in the same manner as the majority of the retail investors whose interests they represent.