Recent events show the way to fix mutual funds' boards

Your Funds

Dollars & Sense

November 23, 2003|By CHARLES JAFFE

CURRENT events suggest that mutual fund boards are lying down on the job.

Recent history suggests that it doesn't have to be that way.

About 16 months ago, the board of directors of the Japan Fund (ticker SJPNX) dumped the fund's management company. The move was highly unusual, but looking at it in hindsight proves that it's just the kind of action that the industry needs more of, particularly when so many people are contemplating how to "fix" the fund industry.

The Japan Fund opened about 40 years ago as a closed-end fund and was operating as part of the Zurich Scudder Investments family until the fund's manager left after a merger with Deutsche Bank AG.

Because the fund was started independently, it had its own directors, rather than using the same trustees as other Scudder funds. That independence is at the heart of this story.

Japan Fund Chairman William Givens notes that the board had been unhappy with the way the fund was marketed and with some of the backroom services it was receiving from Scudder, "but until the manager left, we could not justify making a change."

Once the board thought a change might be warranted, it started reviewing its options.

That review is one that more boards should make. Think about the thousands of funds for which above-average costs and below-average performance are the norm.

Those problems were not ailing the Japan Fund. What's more, Zurich Scudder was promoting members of the old manager's team to fill its vacancy, and Deutsche had proved no slouch at managing funds that invest in Japan. Those factors meant that a review might persuade the board to stay put.

But Givens and the board believed that the fund could do better if run by Fidelity Investments, so they gave Scudder the hook and Fidelity control of the assets.

Though it was easy to be critical of the drastic move - and though I expressed concern that shareholders might be upset with a change not resulting from awful performance or corporate chicanery - it is difficult to quarrel with the results.

Since the start of July last year, according to Morningstar Inc., the Japan Fund is up more than 21 percent, more than twice the gains of Scudder Japanese Equity (ticker FJEAX) and roughly four times the return of the average fund investing in Japanese stocks.

Investors who left the fund to stick with Scudder have been coming back.

The real story, however, is not the success of the fund since the change. It's how the process worked in this case and how it has failed in so many others.

Givens, for one, has a good idea of why that is.

"The reason more boards don't do this is that they are captive to the managers," he says. "You've got directors who serve on dozens or hundreds of funds. I don't care if the paperwork says they are independent, can you imagine one of those boards moving, say, three funds to a different company? It can't happen in the current structure. The boards are not truly independent."

What's more, Givens notes that the structure hurts fund performance on the whole.

"If boards are not able to move assets from a low-performing manager to a better-performing manager, then the marketplace isn't working," he says. "If every board could do what we did - look for better management - then all of the lower performers would see their assets evaporate and the whole system would improve. Investors would get better returns."

The story of the Japan Fund is interesting for another reason. The directors didn't have to justify their reasons for the change to shareholders. The idea of ripping a fund from one management firm and moving it to the next is so unusual that the only requirement for directors is that they certify reasons for renewing a contract.

That regulation must change.

Just as investors are wondering whether they should pull money from funds tainted by scandal, so should directors of those funds be wondering whether it's time for a change. In funds directly affected by the problems, it's difficult to believe that directors can make a good case for sitting still.

To make sure independent directors do their job, here's a suggestion offered by Givens that is simple and brilliant: If a fund lags in the lowest quartile of its peer group for two years, directors should be required to get proposals from other managers. In that way, boards that are incapable of acting on their own might get busy and do their job. (Beyond performance, a brush with regulators in a civil action might also be cause for a review.)

Until that kind of change is made, investors should not feel good about the leadership they are receiving from their board of directors.

There's an 80-year history of directors doing the minimum to protect shareholders, instead of being a true guardian.

"You can make changes and have directors who really look out for investors," Givens says. "You just can't do it the way funds are being run now."

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