TCS Daily

Fund Follies

By James K. Glassman - May 24, 2004 12:00 AM

Investors punished mutual funds in the 2003 late-trading and market-timing scandals the old-fashioned way -- by withdrawing their money and going somewhere else. For instance, shareholders last year pulled $29 billion out of the funds of Putnam Investment Management, one of the miscreants, and added $36 billion to Vanguard, none of whose 75 funds was tainted.

Regulators and law-enforcement officials have exacted punishment as well. Last week, Strong Financial and its CEO agreed to pay $175 million to settle charges. The scandal, which involves 19 funds, has led to the dismissal or resignation of 60 fund executives and the assessment of over $1 billion in penalties.

But, for regulators and some members of Congress, none of this is enough. So the Securities and Exchange Commission is considering 17 changes in rules governing funds. Nearly all of these putative reforms, like most of those that followed the Enron and WorldCom scandals, are unnecessary and, in many cases, will do more harm than good.

The centerpiece for reformers is a requirement that the chairman of each of America's 8,124 mutual funds be independent -- that is, not affiliated with the firm that advises and manages it.

In his campaign for this cause, Rep. Michael Oxley (R-Ohio), who heads the House Financial Services Committee, released a study Thursday that purported to show a correlation "between management-affiliated fund chairmen and the market-timing and late-trading scandals." In a letter to SEC Chairman William Donaldson, Oxley wrote, "The statistics I uncovered are startling."

They are nothing of the kind. College freshmen would flunk their Economics 101 exams if they assigned merit to a study like the one being promoted by Oxley.

The study found that 16 of the 19 funds implicated in the scandal "have had management-affiliated chairman at some point during the alleged or admitted violations." In other words, 84 percent of the chairmen of the scandal-tainted firms were not independent. Thus, on the surface, it appears that firms with affiliated chairmen are at high risk for poor corporate governance.

But what does 84 percent mean in this case? Is it high or low?

I asked one of Oxley aides if the study had used a control. In other words, did it determine the proportion of non-independent chairmen for all mutual funds? If we know that, then we can get an idea of whether 84 percent might be a significant figure, or just a random result.

There was no control, I was told, but the helpful aide directed me to research by Geoffrey Bobroff and Thomas Mack, filed with the SEC by Fidelity Investments as part of a comment letter in March. That study examined all fund houses with assets of at least $10 billion or more (more than four-fifths of total industry assets) and found that 43 out of 57 funds had affiliated, or non-independent chairmen. That's 75 percent -- not far from 84 percent, which means that the Oxley study, with its universe of just 19 funds, is statistically insignificant.

The Bobroff-Mack study itself, however, produces some powerful data on fund fees and performance, showing that the crusaders are dead wrong when they argue that independent boards are more investor-friendly than management-led boards.

Critics, for example, contend that mutual funds charge high fees because affiliated chairmen don't look out for their shareholders. To the contrary, the Bobroff-Mack study found that funds with independent chairmen have fees averaging a minuscule one basis point (or 0.01 percent) less than those with affiliated chairmen. And, when the results are asset-weighted (that is, the size of the funds is taken into account), the funds with affiliated chairmen have fees averaging 16 basis points lower than those with independent chairmen. Thus, management-led boards are cheaper by an average of more than one-tenth.

Now look at what really counts for investors -- annual returns. The Bobroff-Mack study found that, over the past 10 years, funds with independent chairmen ranked in the 48th percentile, "using Morningstar's fund rankings within style-based peer grounds," while funds with affiliated chairmen ranked in the 59th percentile. The average Morningstar rating for the independently chaired funds was 2.6 stars (out of 5), compared with 3.1 stars for management-chaired funds. On an asset-weighted basis, the difference is even wider: 2.9 stars for independent-chaired funds, 3.7 stars for management-chaired.

Even if the Oxley study had shown that the prevalence of scandal was significantly higher for management-chaired than for independent-chaired funds, the research would have indicated only correlation, not causation. The cock's crowing doesn't cause the sun to rise.

If there were any validity to the theory that management-led funds have a propensity to poor corporate governance, one would expect that the largest management-led funds would be the worst miscreants. But the 250 funds managed the top three firms (Vanguard, Fidelity and American) -- with a total of $1.6 trillion in assets at the end of 2003 -- were all chaired by management, and were all scandal-free.

That should come as no surprise. Who has more incentive to direct a fund so that it gains a reputation for low fees, high returns and integrity? A chairman with no financial connection to a fund's management, or the management itself?

"Almost all of the several dozen academic studies on independence have found [either] that it has no correlation with company performance or that companies generally perform worse when they have more outsiders on their boards," wrote Mark Hulbert, editor of the Hulbert Financial Digest, in the New York Times last year. Hulbert was referring to boards of conventional corporations, but the analogy holds with mutual funds.

In the viciously competitive mutual-fund marketplace, where the top five fund houses account for just one-third of all assets, managers understand that disappointed investors can easily vote with their feet. If they didn't believe it, the proof is now in: Last year, three tainted fund families alone -- Putnam, Janus and Amvescap -- lost $52 billion in assets in a year when the rest of the industry was a big gainer.

Yes, despite incentives to play straight, some managers will cheat, and even though the late-trading and market-timing scandals had only a tiny financial effect on investors, swift and tough punishment -- by the market and by regulators -- was appropriate.

But that's where the story should end. Putting independent chairmen at the helm of every mutual fund is a foolish measure which may, in the end, lead to higher fees and worse performance.


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