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The Role Of Institutional Managers
The failure of our newly empowered agents to exercise their responsibilities to ownership is but a part of the problem we face. The field of institutional investment management—the field in which I’ve now plied my trade for almost 58 years—also played a major, if often overlooked, role.
As a group, we veered off course almost 180 degrees from stewardship to salesmanship, in which our focus turned away from prudent management and toward product marketing. We moved from a focus on long-term investment to a focus on short-term speculation. The driving dream of our adviser/agents was to gather ever-increasing assets under management, the better to build their advisory fees and profits, even as these policies came at the direct expense of the investor/principals whom, under traditional standards of trusteeship and fiduciary duty, they were duty-bound to serve.
Conflicts of interest are pervasive throughout the field of money management, albeit different in each sector. Private pension plans face one set of conflicts (i.e., minimizing plan contributions helps maximize a corporation’s earnings), public pension plans another (i.e., political pressure to invest in pet projects of legislators) and labor union plans yet another (i.e., pressure to employ money managers who are willing to “pay to play”). But it is in the mutual fund industry where the conflict between fiduciary duty to fund shareholder/clients often directly conflicts with the business interests of the fund manager.
Perhaps we shouldn’t be surprised that our money managers act first on their own behalf.
As Vice Chancellor Leo E. Strine Jr., of the Delaware Court of Chancery has observed, “It would be passing strange if ... professional money managers would, as a class, be less likely to exploit their agency than the managers of the corporations that make products and deliver services.”
In the fund industry—by far the largest of all financial intermediaries—that failure to serve the interests of fund shareholders has wide ramifications. Ironically, the failure has occurred despite the clear language of the Investment Company Act of 1940 that demands that, “mutual funds should be managed and operated in the best interests of their shareholders, rather than in the interests of (their) advisers.”2
Here, in summary form, are just a few examples of how far so many fund managers have departed from that basic fiduciary principle, clearly enunciated in the 1940 Act:
1. The domination of fund boards by chairmen and chief executives who also serve as senior executives of the management company that controls the funds.
2. The mutual fund “time zone trading” scandals that came to light in 2003, in which some 23 companies—including many of the largest firms in the field—were implicated.
3. “Pay-to-play” distribution agreements using fund brokerage commissions (“soft dollars”) to finance share distribution that benefits the adviser.
4. As fund assets soared during the 1980s and 1990s, fund fees grew even faster, reflecting higher fee rates, as well as the failure of managers to adequately share the enormous economies of scale with fund shareholders.
5. Rising expense ratios for established funds; the average ratio of the seven largest funds of 1960 rose from 0.48 percent to 1.02 percent in 2003, an increase of 144 percent.3
6. Managing assets for giant pension funds for fees that are dwarfed by those that they charge the mutual funds that they control. Three of the largest advisers, for example, charged an average fee rate of 0.08 percent to their pension clients and 0.61 percent to their funds, resulting in annual fees averaging $600,000 for the pension funds and $56 million for the mutual funds (presumably while holding the same stocks in both portfolios).
7. Spending enormous amounts on advertising—almost $500 million in the last two years alone—to bring in new fund investors, using money obtained from existing fund shareholders.
8. Creating exotic and untested “products” that have far more ephemeral marketing appeal than investment integrity.
Given such failures as these, doesn’t Justice Stone’s warning that I cited at the outset seem even more prescient?
Let me repeat the key phrases: The separation of ownership from management ... corporate structures that ... vest in small groups control over the resources of great numbers of small and uninformed investors ... corporate officers and directors who award to themselves huge bonuses ... financial institutions which consider only last, if at all, the interests of those whose funds they command.
Just as we ignored the fiduciary principle all those years ago, so we have clearly continued to ignore it in the recent era. The result in both cases, using Justice Stone’s words: The loss and suffering inflicted on individuals, the harm done to a social order founded upon business and dependent upon its integrity, are incalculable.
[Despite all the negative changes] in the very nature of corporate ownership, we have failed to change the rules of the game. Indeed, in the financial sector, we have rolled back most of the historic rules regulating our securities issuers, our exchanges and our investment advisers. While we should have been improving regulatory oversight and administering existing regulations with increasing toughness, both have been relaxed, ignoring the new environment and therefore bearing much of the responsibility for today’s crisis.
Of course American society is in a constant state of flux. It always has been, and it always will be. I’ve often pointed out that our nation began as an agricultural economy, then became largely a manufacturing economy, then largely a service economy, and most recently an economy in which the financial services sector had become its dominant element. Such secular changes are not new, but they are always different, so enlightened responses are never easy to come by.
To deal with the new and complex economic forces our failed agency society has created, of course we need a new paradigm: a fiduciary society in which the interests of investors come first, and ethical behavior by our business and financial leaders represents the highest value.
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