The fund company gets your checks, but it's someone else who calls the shots.
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By Christopher Davis | 10-01-09 | 06:00 AM | Email Article

Here's something you might not know: Mutual fund companies really don't control the funds they run. Fund firms do manage the assets, of course, but the final word on who does and doesn't manage a fund comes from a fund's board of directors, not fund companies. By law, it's actually the board that hires the fund company to run the fund. Although it's rarely happened, a board can even fire the fund company and hire another one.

Christopher Davis is Director of Fund Analysis at Morningstar Canada.

For fund investors, the board is probably the most important entity you haven't heard much, if anything, about. How do you learn more about it and whether it's doing the right things? Read on.

Why do fund boards exist, and what's their job?
Mutual funds have boards of directors for a similar reason as corporations do. The interests of fund companies and fund shareholders are often at odds, just as they sometimes are for corporate bigwigs and their stockholders. Fund shareholders want low fees, for example, while fund companies generally want higher fees to pad their bottom lines. Fund shareholders may want their funds to stay small and nimble, while fund companies might want them to grow large so they can collect more in fees. Fund shareholders could be better off if fund companies avoid launching trendy flavor-of-the-month offerings, but the lure of short-term profits often proves too great. How else can anyone explain the spate of Internet-fund launches in 1999 and early 2000?

On matters where the interests of fund companies and fund shareholders conflict, it's the board's duty to take the side of shareholders. They've got the task of ensuring shareholders are getting a fair shake on fees and that assets aren't becoming unwieldy. And if performance isn't up to snuff or managers aren't staying true to their strategies, it's the board's job to speak up. That's what the board should be doing, at least.

How do you find out who's on your fund board?
A fund gives details about who's on its board in a document called the statement of additional information, which is filed annually, along with the prospectus, with the SEC. The list is typically divided into "interested" or "inside" directors, who are employed by the fund company, and "independent" directors, who have no current ties to the firm. Pay close attention to the ratio of interested to independent directors (the SEC requires a two-thirds majority of independent directors in most instances) and to whether the board chairman is a fund company insider or independent. Because independent directors don't represent the fund company, they're less likely to be beholden to its interests than inside directors.

The SAI contains other useful nuggets of information about the board as well, such as how much each of the directors gets paid. The SEC also requires board members to disclose how much they invest in the funds they oversee. (However, because this information is displayed in dollar ranges with the upper limit peaking at $100,000, no one knows the board's actual commitment to the fund.) Some fund companies simply provide total dollar amounts invested across an entire lineup, but others helpfully break out investments by individual fund, too.

Fortunately, it's becoming easier to track down the SAI. Morningstar.com provides a link to the SAI, among other SEC documents, under the "Filings" tab of any fund report. A fund company must mail the SAI to you upon request, and most fund companies post them on their Web sites. They're also available on the SEC's Web site.

What should a good board look like?
Good governance is often by design. Think of the U.S. government. If the executive branch overreaches, for instance, the courts can apply the brakes. Fund boards operate on the same separation-of-powers principle--the board checks the power of the fund company on behalf of fund shareholders. Yet this balance is thrown out of whack when boards are led by fund company executives. For example, Fidelity founder Ned Johnson is also the chairman of Fidelity's fund board. Fidelity's fund board has done a lot of things right, such as keeping fees low and, in recent years, closing some of the firm's largest funds. But the board has also tolerated mediocre performance and changes in management at many of the firm's smaller and midsized funds.

That's just one argument in favor of an independent chairman for fund boards. While an independent chair won't guarantee that a board will always do right by shareholders, it at least increases the odds that they will. An independent chair might pack more punch if the board is dominated by independent directors, so look for cases where they make up an overwhelming percentage of its makeup. Unfortunately, lawsuits have prevented the SEC from implementing a rule requiring fund boards to have independent chairpersons, with at least three fourths of the board made up of independent directors. But this is as good a standard as any for shareholders to uphold their funds to. That's not to say you should avoid funds with boards that don't have an independent chairman or a supermajority of independent directors, but all else being equal, you should give preference to those that do.

Moreover, it stands to reason that directors with substantial investments in the funds they oversee are more likely to act in shareholders' interests than those who don't. For our Stewardship Grade, we measure the depth of the directors' investments by comparing them with how much they receive in annual compensation. You shouldn't be impressed by a director's $10,000 to $50,000 investment if he's pulling down $100,000 a year for his efforts.

It's telling which funds are popular among the directors. For instance, Longleaf's directors invest across the family's lineup, but Fidelity's barely touch the firm's huge suite of sector- and industry-focused Select funds. If the board had invested more in the Select funds, perhaps it might have been more worried by those offerings' notoriously high manager turnovers.

How does a good board behave?
Of course, it's one thing that the board is predisposed to doing its job well and quite another that it actually does so. Boards that tolerate underperforming managers for long stretches aren't doing their jobs well. If they let asset bases balloon, remain content with high costs, and don't push for lower fees on funds that are growing in size, then they aren't doing their jobs well, either. By contrast, a good board replaces managers who have underperformed over the long haul while showing patience for good investors whose investment styles are out of favor. They close funds before they get too big and make sure shareholders benefit from bigger asset bases with lower expenses.

One good gauge of a board's quality is found outside of the SAI in a fund's annual report. The SEC mandates that boards explain why they've approved the fund's contract with its advisor every year. You'll often find a lot of legal boilerplate language in this disclosure, with funds saying little more than that the board examined the fund's management, performance, and fees relative to a peer group before approving the contract. That might be acceptable if your fund boasts low costs and an indisputably terrific long-term track record. But more often than not, that won't cut it. Especially if your fund is costly and its returns mediocre or poor, you deserve to know what peer groups the board used to determine that fees and performance were good enough and why it thinks matters will improve in the future.

Still, don't reward fund boards for candor alone. Providing an explanation for an unshareholder-friendly practice isn't a substitute for good judgment.

Conclusion
To be sure, the quality of fund boards isn't the only thing upon which you should base your investing decisions. After all, you should be doing some of the homework that boards are doing. You should be looking for the same traits as boards--good long-term records, seasoned management, and moderate costs. But if you have a good board in your corner, it's a lot easier to be confident in your fund choices.

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Christopher Davis does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.
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