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| | Mutual Funds
Is your fund watching out for you?
The big fund complexes move a lot of money. So why haven't they used their weight to shareholders' advantage? Here's how some are starting to own up to their newfound sense of responsibility.
By Timothy Middleton
If you want to know why your mutual funds are in the tank, you dont have to look any further than the auditors opinion at the end of the annual report. Recent scandals have shown you can trust an Internet chain letter more.
Investors are not going to be willing to pay as highly for stocks as they have in the past, says John Markese, president of the American Association of Individual Investors. Going forward, trust in accountants opinions is going to be reduced substantially, which introduces another investment risk, and investors have to be compensated for that risk.
Confidence in American equities is unraveling. Scandal after scandal has unfolded in the last year, each one traceable to a board of directors that failed to do its job -- a board elected by shareholders, most of whom are institutions. Yet mutual funds until now have consciously avoided any oversight role in corporate governance.
There are signs the fund industry is awakening to its responsibility to more carefully watch the moneys shareholders have entrusted to it. Fidelity Investments, the largest complex, is threatening to put pressure on corporate boards that overpay top executives. Vanguard Group, second largest, is mulling changes to its rules that would rein in conflicts of interest among certified public accountants.
We may have reached the juncture where you cant be a totally passive investor, says Geoff Bobroff, principal of a fund consulting firm in East Greenwich, R.I. Mutual funds and other institutions basically own the marketplace, and maybe we are at a point in time in which (they) have to take a more active role.
Trusting management
Traditionally, fund complexes have adopted rules that explicitly direct portfolio managers to vote in favor of management proposals during the annual proxy season. The idea is to let management do its job.
We see ourselves as managers of mutual funds, not managers of companies, says Conrad Herrmann, head of equity portfolio management for Franklin Advisers. Jack Brennan, chief executive of Vanguard, says, As mutual fund managers, we have no intention of managing a corporations affairs.
There have been a few exceptions, notably Marty Whitman of Third Avenue Value Fund (TAVFX) and the Mutual Series of funds formerly run by Michael Price. They intentionally seek distressed companies they believe can be set right with new management, which they help install.
Other fund complexes dont seek out such situations, but sometimes find themselves in them. Heartland Funds has assets of $1.4 billion but invests in companies with a median market cap of $160 million. Thus it frequently finds itself a 5% or even 10% owner of companies -- and an activist owner. It led a group of institutional investors who ousted the chief executive of ICN Pharmaceuticals (ICN, news, msgs), Milan Panic. (This is a person, not an emotional state in northern Italy.)
But sometimes even activists such as Heartland do what most of Wall Street does instead -- vote with its feet rather than its proxies. In the first quarter, it lost a fight against management of Gehl Co. (GEHL, news, msgs), a maker of farm machinery, and promptly slashed its holdings of the $77.2 million (market cap) company by nearly 40%.
Keeping greed in check
But now comes a new age, in which senior executives snatch literally hundreds of millions of shareholder dollars from their pals on the board, while chief financial officers spin dross into gold with the greedy connivance of their auditors and the benign neglect of regulators.
This newfound greed is beginning to shake the fund industrys assumptions.
The industrys leader is Fidelity Investments, which by itself accounts for around 10% of the total volume of equities traded every day. Fidelity is a large shareholder of myriad companies -- it owns 12.7% of Gehl, for example (and did not sell out after the proxy defeat).
After the discovery that Enron (ENRNQ, news, msgs)s senior executives had drained hundreds of millions of dollars from the now-bankrupt energy trader, Fidelity announced that it is considering withholding its votes to re-elect directors who sanction what it regards as excessive compensation.
By itself, withholding such votes is an empty gesture; like Fidel Castro, corporate directors are unopposed when they stand for re-election. But seldom do insiders control more than 50% of such votes, and were institutional shareholders to band together and nominate their own slate of directors in a proxy fight, many a hand-picked Friend of the Boss could find himself off the board.
Vanguard, meanwhile, has a proxy oversight committee, chaired by Brennan. It particularly dislikes stock options as a form of compensation, because they dilute the companys earnings for other shareholders, and votes against them.
In the wake of the Enron/Andersen scandal, Vanguard also toughened its stance on non-audit work performed by a companys auditors. Brennan says some non-audit duties, such as tax compliance, are best done by the auditor, but general consulting of the sort Andersen performed is an obvious conflict of interest.
So before it will vote in favor of a companys auditor, Vanguard says it will demand a break-down of all services, a much more detailed accounting than the Securities & Exchange Commission requires, before it will support management.
These initiatives havent exactly sparked a mutiny among investors, large or small. Putnam Investments, one of the nations five-largest fund complexes, declines even to talk about the matter. Mark Hulbert, whose Hulbert Financial Digest tracks stock and fund investment newsletters, says he cant recall seeing a single story about governance in any of them.
Time to speak up
Pressure is, nevertheless, building for fund managers to take a more activist stance in monitoring the governance, as well as the other operations, of their shareholdings. Investors are disgusted! fumes Don Phillips, managing director of Morningstar.
When the fund consulting company held its annual convention for managers and financial advisers last week, Phillips says advisers warned managers to just say no to these ridiculous compensation packages, and to remove some of the incentives that are causing people to do this very aggressive accounting that continues to blow up.
The two issues -- compensation and accounting -- are strongly linked. Corporate America leaped into stock options in the 1990s, offering them by the scores of millions to executives who could up the stock price. The easiest way to do that is to cook the books.
Corporate brass, meanwhile, demanded an ever-expanding array of emoluments, including cash that is labeled as a loan but will not be repaid. The WorldCom meltdown struck all these chords. The since-ousted chief executive had more than $400 million of company loans, and that was a trifle compared with as much as $3.8 billion in allegedly fraudulent accounting gimmicks, aimed at propping up the option-linked share price.
Vanguard and TIAA-CREF have long been known as relatively activist investment managers, unafraid to vote against entrenched managements. Mario Gabelli is another, and so is Bill Miller of Legg Mason. As a class, value managers are more apt to be activist shareholders than growth managers because they buy distressed companies often in need of reforms, and they hold onto them longer.
It may seem odd that Vanguard and TIAA-CREF, which are primarily indexers, are among the most vocal critics of corporate abuses. Active management would seem to be a prerequisite for an activist stance against misbehaving companies. But companies employ active management, as well as passive, and boosting shareholder returns often involves eliminating waste, at which Vanguard and TIAA-CREF excel.
In the main, however, active fund managers are more apt than indexers to pick up their pencils in proxy season and fire off votes of no confidence when they dislike a companys policies
Remarkably, many, and possibly most, mutual funds dont even examine the proxies that arrive with their annual reports. Instead they hire companies such Institutional Shareholders Services, which does this for them and recommends how its more than 950 clients should vote on issues that range from electing directors to hiring auditors.
That may change. Markese predicts regulators, from the National Association of Securities Dealers to the SEC, will draft new rules governing the independence of a corporations board. This change is in process, he says, and institutional investors putting pressure on corporations on these issues can only help.
Proxy season is tied to the annual meeting, which is typically held in the spring and is therefore over for this year. So investors have plenty of time to let their mutual funds know that, like Howard Beale in the movie Network, theyre mad as hell and theyre not going to take this anymore.
At the time of publication, Timothy Middleton didnt own any of the securities mentioned in this article.
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