Why Mutual Fund Directors Fail the Shareholders They Represent

Common Sense on Mutual Funds | John C. Bogle | ISBN: 9780470597484

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“No man can serve two masters.” Bogle quotes Matthew at the start of Chapter 18, then spends the rest of the chapter showing that mutual fund directors are the one group in American business that tries anyway.

Corporate boards exist to create long-term value for shareholders. Fund boards exist to watch the management company that runs everything, approve fee contracts that keep that company profitable, and maybe, if they feel like it, think about fund performance.

That is not my exaggeration. Bogle writes out what the implicit fund board mission statement would look like if you translated director behavior into words.

The levers of control

Fund governance is stacked from the start:

• The board chair is usually also the management company CEO
• One in three or four directors is affiliated with the adviser
• Independent directors are often picked by the manager
• Directors meet four times a year
• Director pay at top fund complexes averaged $177,000 in 1996, nearly double what Fortune 500 directors earned

Morningstar found a clear link: the more directors get paid, the more shareholders pay in fund expenses. Independent directors often own almost nothing in the funds they oversee. In one large complex, typical independent directors held about $30,000 total across 10 of 24 funds.

And the management company provides administration, portfolio management, and distribution under one bundled contract. The shareholder is supposed to be in charge. The adviser is actually in charge.

The consequences: fees up, returns down

Over 16 years, only 42 of 258 equity funds beat the Wilshire 5000. Bond funds did worse relative to indexes. No money market fund beat its benchmark.

The drag is expenses. Minimum advisory fee rates on new funds rose from 0.38% at industry birth to 0.72% by the late 1990s. Average equity fund expense ratios went from 1.04% to 1.55%. Equity fund assets grew 35-fold while total fees grew 60-fold to $34 billion.

Fund managers book 40% to 70% pretax profit margins. Management companies sell for 3% to 5% of assets under management. A $10 billion complex might fetch $300 million to $500 million. None of that goes to the fund shareholders who built the value.

Cocker spaniels, not Dobermans

Warren Buffett’s line in this chapter is famous: management companies look for Cocker Spaniels, not Dobermans, when selecting independent directors. They rubber-stamp deals, never push for fee cuts, and treat performance as optional.

The Investment Company Act of 1940 says funds must be organized for shareholders, not advisers. The SEC and the Investment Company Institute mostly focus on administrative trivia instead.

Bogle’s alternative is simple: a $10 billion fund complex does not need an external manager earning $50 million in profit. Internalize management, cut marketing, pass savings to shareholders. The easiest way to reach the top performance quartile is to land in the bottom expense quartile. Statistics back that up.

Fee consultants compare funds to peers, never to Vanguard’s at-cost model, and recommend increases. It works exactly like CEO pay ratcheting.

Legal pressure and Bogle’s six principles

Bogle saw legal action coming on fee setting, especially cases where advisers charge pension clients far less than mutual fund clients for the same work. Judge Richard Posner’s dissent on the “ratcheting-up” of fund fees mirrored Bogle’s argument.

Ten years later, nothing changed. Directors stayed Cocker Spaniels. Bogle’s updated prescription is a federal fiduciary standard with six principles: clients must be king, due diligence required, corporate citizenship restored, honest distribution, reasonable fees measured in dollars not just rates, and no public ownership of fund management companies.

What still rings true

Fund expense ratios eased slightly after 1997, but total fee dollars kept climbing because assets grew. Director pay kept rising too. Disclosure of director holdings got worse, not better.

If you own actively managed funds from a publicly traded parent company, you are paying a satellite to orbit your capital. The board is supposed to protect you. Bogle’s evidence says most boards protect the manager instead.

That is the governance problem underneath everything else in this book.

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