The mutual fund scandals of 2003 may be fading from memory, but fresh developments in other segments of the financial market have opened old wounds. How does the fund industry regain public trust? It's a question top of mind for fund managers, chief executives and the boomer advisors that recommend their funds.
Public confidence in the financial services sector as a whole has been newly--and profoundly--shaken by Ponzi schemes, bank failures and perceived regulatory impotence. A recent surge in net mutual fund inflows indicates regulatory safeguards have reassured investors that the industry is putting their best interests above its own. But the fund industry and its watchdogs continue to push initiatives designed to strengthen transparency, accountability and adherence to fiduciary responsibility.
"I think investors are paying more attention to the issue of stewardship [of their investment capital] than maybe they were two or three years ago," says Laura P. Lutton, associate director of mutual fund analysis at Morningstar. "The longer you are going to hold an investment, the more important the stewardship issue becomes. It's really important to know that a mutual fund will be a good caretaker of capital over the long term."
Caretaking hasn't been a strong suit for some fund managers of late, contends John C. Bogle, founder and chairman of the Vanguard Group. In a speech at this year's IA Compliance Summit in Washington, D.C., he said, "Stewardship seems to have been left in the dust" in the fund industry.
Because in many cases they will be managing shareholder capital for several decades, target date funds are a prime example of how responsible stewardship can be critical over the long run, says Lutton, who oversees (and helped design) Morningstar's five-year-old stewardship grading program for mutual funds. That long-term responsibility apparently is not lost on the fund industry. In June, a working group within the Investment Company Institute, a leading fund industry trade group, urged securities regulators to adopt new disclosure principles for target date funds to give investors "a clearer picture of how target date funds operate and the risks and benefits of these increasingly popular investment options."
Funds would be required to provide investors with information on the meaning of its target date, the asset-allocation "glide path" it follows and the appropriate uses of that fund for investors in specific age groups. According to ICI General Counsel Karrie McMillan, target fund sponsors "can and should do more to ensure better investor understanding."
While their inflows are large and increasing, target date funds represent but one segment of the mutual fund universe. On a broader scale, the Securities and Exchange Commission finalized rules late last year requiring fund companies to make available a short-form summary prospectus that provides investors with a thumbnail overview of fund strategies, fees, governance, etc.
But fund industry leaders such as Bogle contend that even stronger measures are necessary to empower and protect mutual fund investors. He's advocating adoption of a new federal fiduciary standard that would require fund managers to put the long-term interests of fund shareholders ahead of their own short-term speculative interests.
In his speech, Bogle blamed recent upheaval in the financial markets partly on fund managers' increasing emphasis on self-interested, short-term speculative investment strategies.
"Above all else," he said, "it must be unmistakable that government intends, and is capable of enforcing, standards of trusteeship and fiduciary duty under which money managers operate with the sole purpose and in the exclusive benefit of the interests of their beneficiaries--largely the owners of mutual fund shares and the beneficiaries of our pension plans."
To reverse a trend in which, according to Bogle, turnover among actively managed equity funds rose from 16 percent in the 1970s to an average 95 percent in 2008, he suggests a federal fiduciary standard that would guarantee mutual fund shareholders:
- The right to have their money-manager agents act solely on their behalf;
- The right to rely on due diligence by managers, in the services, the mutual funds, and the financial products that they offer;
- The guarantee that agents will be responsible corporate citizens, restoring to their principals the neglected rights of ownership of stocks; and
- The elimination of all conflicts of interest that could preclude the achievement of these goals.
- Such a standard, Bogle asserts, would resolve a fundamental conflict of interest within many fund management firms, whose "owners are in business to maximize the returns on their capital, not to maximize the returns of the capital of their mutual fund investors."
While lawmakers and administration officials debate the merits of Bogle's proposal, organizations such as Morningstar and Fiduciary360 have taken it upon themselves to provide advisors and investors with third-party tools for screening and evaluating individual funds and fund families based on criteria related to stewardship and fiduciary responsibility.
Morningstar grades about 1,000 of the largest mutual funds for stewardship, evaluating them in five categories--regulatory issues, board quality, manager incentives, fees and corporate culture--to arrive at a score between zero and 10. A letter grade from A to F is then derived from that score, with a score in the 9 to 10 range earning a fund an A grade, a score of 7 to 8.5 earning a B grade, and so on.
Since their inception, the stewardship grades have gained an increasingly prominent role in the fund evaluation process, Lutton says.
One reason they have gained credence, she explains, is their correlation to fund performance. A 2008 study by researchers at two New York universities found that funds receiving good stewardship grades outperformed funds with bad stewardship grades by 10 to 16 basis points per month from September 2004 to December 2006, and that among the five factors on which funds are scored, board quality and fees showed "the most explanatory power." The conclusion offered by study authors: "corporate governance significantly affects [fund] performance."
Executives at Fiduciary360 have found a similar correlation with the fi360 fiduciary scoring system they launched in 2003 to quantitatively evaluate funds and fund families on how well they meet a minimum set of due diligence criteria that reflect prudent fiduciary management.
"There's a definite correlation, where [fund] companies with poor fiduciary scores also happen to be the companies we hear [negative things] about in the news," says Andy Frommeyer, fi360's director of products and services.
Fiduciary360 scores funds in some 250 families on a quarterly basis in nine categories: regulatory oversight; minimum track record; organizational stability; fund assets; composition consistent with asset class; style consistency; expense ratio/fees relative to peers; risk-adjusted performance relative to peers; and performance relative to peers.
The fi360 scoring system is proving most useful to investment advisors and fund wholesalers, according to Frommeyer. "It very much helps them structure their practices for the screening, selection and ongoing monitoring of funds. Many of them are using it as a primary driver in their analysis."
Third-party systems for rating mutual fund stewardship and fiduciary practices have filled a glaring void in how funds are evaluated, says fi360 President and CEO Blaine Aikin. "Overall, they have provided the industry with a very meaningful set of tools for making better decisions" about fund investments.
For that reason, Aikin says he expects screening tools that go beyond traditional performance yardsticks will continue to gain prominence, not only among investors but also among those charged with protecting their interests. "With advisors and even in the regulatory arena, I think we're going to see a greater reliance on third-party verification, because it's useful and easy to understand."