Study will fuel reform debate

Your Funds

April 10, 2005|By CHARLES JAFFE

IT LOOKS as if the mutual fund industry is about to reopen a reform battle and will use an interesting new study as the first shot.

The research doesn't support what the fund world is pushing, but that is almost inconsequential.

The matter is interesting not only because it will affect investors, but also because the research shows fund owners an indicator that might change the way some people evaluate funds.

The study, "Does Skin in the Game Matter," was written by four college professors. It looks at whether funds perform better when directors hold shares. The short summary of its findings is that when directors have their money in a fund, the fund tends to perform better.

On a risk-adjusted basis, funds in which directors have money riding along with that of ordinary shareholders can do up to 4 percentage points better per year.

That's interesting, but not relevant to the issue where the study will fuel debate.

Fund industry insiders suggest that the study can be used to refocus attention on the need for independent directors to oversee mutual funds. Last year, the Securities and Exchange Commission adopted a rule that requires 75 percent of fund directors, including the chairman, to be independent of the fund-management company.

The rule is to go into effect next year, although the U.S. Chamber of Commerce has challenged it in court. It was enacted despite the objections of two of the five SEC commissioners and over howls of protest from the fund industry.

Opponents of the rule suggest that the study is relevant because it shows that stock ownership has a direct impact on performance, whether the director involved is independent or a corporate hack. Moreover, it does not show any difference in that performance between interested and independent directors.

That's a misdirection play.

"One thing that comes out quite strongly is that non-independent directors - the guys affiliated with the management company - can have a really strong, positive effect on performance, so long as their interests are aligned with shareholders," says David Weinbaum of the Johnston Graduate School of Management at Cornell University, one of the study's co-authors.

"But we found that all directors can have a positive impact; they tend to have the biggest impact when they are shareholders themselves."

Directors helped funds perform better by helping to reduce fees.

Supporters of the new rule on independent directors have suggested that boards need to think more like shareowners than like corporate management, particularly when it comes to approving cost increases. The new study showed that fees tend to be lower at funds where directors have a big ownership stake.

Researchers said that about 32 percent of independent directors and 40 percent of the ones with corporate ties hold shares in the funds they oversee, but they noted that more than 80 percent of directors invest in funds run by the family.

The fund industry, in the form of the Investment Company Institute, long ago recognized that having directors as investors was a "best practice" for the business, which makes you wonder why virtually all directors aren't shareholders.

Aligning directors with shareholders makes obvious sense, but it doesn't mean that regulators should go back on their plans and allow the divided loyalty of interested directors to continue. That would be a step backward in fund reform, and it's not a step regulators should be considering, regardless of the next academic study that could be used to support it.

Chuck Jaffe is senior columnist for MarketWatch. He can be reached at jaffe@marketwatch.com or Box 70, Cohasset, MA 02025-0070.

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