The W$J ran a story earlier in the week on mutual fund voting (see here). The story reported on the somewhat old news that academic research has “found no evidence of fund companies tailoring their votes to specific business relationships,” contrary to earlier claims by shareholder activists. The article is nonetheless of interest because it describes the varying processes mutual fund companies use in deciding how to vote.

One thing I’ve found puzzling about mutual fund voting is that the SEC requires fund investment advisers to vote the shares in the portfolios they manage. The SEC asserts that “[t]he duty of care requires an adviser with proxy voting authority to monitor corporate events and to vote proxies.” This requirement has more or less spawned the proxy advisory industry and the attendant fees paid by mutual funds to ISS, Glass Lewis and the like for their voting advice. In my mind a specific fiduciary duty to vote is foolish. Certainly, the voting of proxies by mutual fund managers should be subject to the duty of care and loyalty. But a fund manager should be free to decide that it’s in the best interest of a fund for the manager to not to spend the time and money involved in voting. At least a fund manager should be able to disclaim the fiduciary duty to vote by saying as much in the fund prospectus. Personally, I would rather a fund not spend money on proxy advisers or voting thereby reducing fund expenses. I’m in complete agreement with the sentiment expressed in the article–if a fund manager does not agree with a company’s direction, they should either not invest or sell as opposed to attempting to change the direction of the company through voting. As for index funds that don’t have this luxury, I don’t care. I invest in these funds to get the market return. I don’t want to pay higher expenses in the event the index fund manager decides to engage in shareholder activism. Leave it to the hedge funds and keep my expense ratios low.

According to this WSJ article, Google has asked the SEC to declare that Google is not an “investment company” and therefore not subject to the Investment Company Act of 1940. This seems like an odd request, but it highlights the broad sweep of the definition of investment company. Section 3(a)(1)(C) of the ICA provides that an investment company is any issuer “engaged . . . in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.” The problem for Google is the “owning” language. Google currently owns about $5.8 billion in marketable securities and has total assets of $14.4 billion. Hence, it’s right at the 40% threshold. Google also has $4 billion in cash, some of which it would like to invest in marketable securities . However, moving cash to securities would result in in Google blowing through the 40% threshold, thus the exemption request. Both Microsoft and Yahoo! have faced the same issue in the past and filed exemption requests which the SEC granted.

The Investment Company Institute (ICI), the mutual fund industry trade organization, recently published a survey entitled “Understanding Investor Preferences for Mutual Fund Information.� Click here for the survey and here for an ICI press release with highlights of the survey. Here’s some the findings:

• Mutual fund investors focus primarily on fees, historical performance, and risk when purchasing funds.
• Recent fund investors make little use of prospectuses or shareholder reports. Around two-thirds of investors did not consult fund prospectuses or shareholder reports in making their purchase decisions.
• Few investors reviewed information about a fund’s portfolio manager (25 percent), proxy voting policies (15 percent) or board of directors (15 percent).

These findings are not surprising to me as I would be in the majority on each one.

The survey also includes several findings that go to internet usage by mutual fund investors, mainly, that they have ready access, are comfortable using it, and use it frequently. It’s obvious that these findings are directed at the SEC. The mutual fund industry wants the SEC to adopt the “access equals delivery model� for mutual fund materials. Under the model, a fund can meet delivery requirements by posting materials on the web and notifying investors of their availability instead of mailing hardcopies. The SEC recently adopted the model for prospectus delivery and has proposed a rule applying it to proxy materials. Investment companies, however, are specifically excluded from coverage.

I’m in favor of extending the model to mutual funds. As I’ve said before, hardcopy distribution requirements are simply inefficient and wasteful in the internet age. Further, as the ICI survey points out, few investors even look at mutual fund prospectuses or shareholder reports. Switching to the model will result in cost savings for the funds.  These savings will presumably be passed on to investors, especially given investor focus on fund fees as demonstrated by the survey.

John Bogle, the founder of the Vanguard mutual fund company and pioneer of indexing has launched a blog called The Bogle Blog. I’ve long been a Bogle fan and have owned shares in Vanguard’s S&P 500 index fund for over a decade. Welcome to the blogosphere Mr. Bogle!

I recently published an article on section 36(a) of the Investment Company Act of 1940. Section 36(a) provides a federal cause of action for “a breach of fiduciary duty involving personal misconduct in respect of any registered investment company� by an officer, director, investment adviser, or principal underwriter of an investment company, among others. Although the article is dated October 2005, it did not actually come out until two months ago. Hence, I was pleased to discover today that a court has already cited it (S.E.C. v. Treadway, Slip Copy, 2006 WL 1293499, S.D.N.Y.); that is, until, I read this part of the courts opinion:

One commentator has suggested that “involving personal misconduct” should be interpreted to incorporate the substance of the business-judgment rule–an enumerated party under section 36(a) is not liable for what turns out to be a bad business decision as long as the party made the decision “on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.” William K. Sjostrom, Jr., Tapping the Resevior: Mutual Fund Litigation Under Section 36(a) of the Investment Company Act of 1940, 54 U. Kan. L.Rev. 251, 302 (2005) (quoting Aronson v. Lewis, 473 A.2d 805, 812 (Del.1984)). One court in this district has found that the business judgment rule applies to claims under Section 36(b) of the Investment Company Act, which imposes a fiduciary duty with respect to investment advisers’ compensation, against an investment company’s independent directors. See Reserve Mgmt. Corp. v. Anchor Daily Income Fund, Inc., 459 F.Supp. 597, 611 (S.D.N.Y.1978). Although Sjostrom’s effort to fill the interpretive gap is well-intentioned and well-argued, it fails to account for the fact that the benefit of the business judgment rule is ordinarily extended only to disinterested and independent parties.

As a corporate law professor, I obviously know that the BJR can be rebutted by proving a director has a conflict of interest, etc. I mention this in my article and was not trying to suggest it should be any different in the context of 36(a). So there was no reason for me to “account for the factâ€? because I was not arguing otherwise. Unfortunately, it looks like the court misinterpreted (or perhaps defense counsel purposely misinterpreted) this part of my article. But at least the court said the article was “well-argued.”

Now available on the SEC’s website is a transcript of a April 27, 2006 speech by SEC Commissioner Paul Atkins given to the Investment Adviser Association. There’s nothing particularly surprising in the speech given Atkins’ well-publicized opposition to many of former Chairman Donaldson’s initiatives, but it is still a good read.

In particular, he focuses on the mutual fund rule requiring independent chairmen and 75% independent boards. Here’s a quote:

To be honest, the tortured history of this rule is quite a curiosity for me. It is an unlikely subject of such a pitched battle. Its proponents have praised it as being the supposed “centerpiece” of the SEC’s regulatory scheme for mutual funds. But, as the court of appeals has now pointed out twice to the SEC, the agency has failed to take an honest look at the costs and benefits of the rule, as the law requires us to do. Never mind that some of the more egregious offenses in the late-trading and market-timing scandals occurred at funds with independent chairmen and 75% independent boards. Never mind that the rule is inherently anti-competitive in that its burdens fall especially heavily on start-ups, who have a harder time coaxing and paying non-affiliated people to serve on boards, much less to commit the time necessary to serve as chairman.

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Today’s W$J has an article detailing tech oriented measures being pushed at the SEC by Chairman Cox. These measures include:

• Offering incentives to companies to disclose financial information in a way that tags various pieces of data — such as revenue, profit margins and reserves — so that investors can compare companies against each other and across industry groups.

• Weighing the creation of a new benchmark that would allow investors to evaluate mutual funds’ performances after taxes and fees, akin to the auto miles-per-gallon results calculated by the Environmental Protection Agency.

• Proposing to allow companies to bypass paper forms entirely for shareholder votes — unless specifically requested by an investor — and to post proxy statements and the like on a Web site.

The article notes that the measures “are tweaked to reflect Mr. Cox’s free-market view that financial markets armed with information can discipline companies, an alternative to government regulation.â€? But under a free-market view, is there even a need for the first two measures? Specifically, doesn’t the market already provide convenient means to compare companies and mutual funds? For example, for access to various analytical tools, research reports, etc. that allow you to compare companies, just open an account at E*Trade.com. As for mutual funds, see Morningstar.com. If investors want more information than is being provided at these and other sites, won’t the market respond accordingly?

I’m certainly in favor of the SEC making it easier for the market to respond by, for example, improving EDGAR to allow companies to make their filings more user friendly, if the companies so choose (and maybe this is all Cox has in mind; the article isn’t clear on this point). However, I’m dubious of the government mandating a specific format for disclosure or a specific auto miles-per-gallon calculation for mutual funds. As Geoff has pointed out, disclosure requirements have costs beyond implementation. Bottom line: Let the market handle it.

A recent W$J article reports that a number of mutual funds have amended their fund investment policies to allow the funds to engage in hedge-fund-like investment strategies such as the use of derivatives, leverage and short-selling.  I think this is a favorable development because it increases the types of investment options available to everyday investors.  Others may not see it this way: 

[S]ome analysts and financial advisers caution that when traditional mutual funds adopt alternative investment strategies, it could bring added risk and higher fees.  Some advisers also fear that mutual funds may be rushing into a hot strategy just as hedge funds’ performance is beginning to cool.

The “added risk� and “higher fees� criticism seems little more than a statement of the obvious.  Alternative investments, by their nature, are more risky and involve higher fees.  What really matters though is whether a fund’s net risk-adjusted return beats the applicable benchmark.

It should be noted that even with appropriate changes to mutual fund investment policies, mutual funds cannot engage in various strategies to the same extent hedge funds can.  This is because mutual funds are subject to regulations under the 1934 Act and the Investment Company Act (ICA) (among others); hedge funds are not.  These regulations include, for example, limitations on margin borrowing and investing in restricted securities.  Interestingly, the ICA empowers the SEC to adopt limitations on short-selling and margin borrowing specifically for investment companies, but to date it has not.  Look for the SEC to do so if any of these hedge-fund-like mutual funds implode.

Today’s W$J has an article about mutual fund name changes entitled “The Bull Market in Mutual-Fund Name Changes.” Last year 719 funds changed their names, up from 505 the year before. Some name changes are the result of acquisitions. For example, following the acquisition of various Strong mutual funds, Wells Fargo changed their names to include “Wells Fargoâ€? instead of “Strongâ€? (this was a no-brainer as Strong was embroiled in the mutual fund trading scandal). Many name changes, however, are pure marketing moves. For example, Merrill Lynch is re-branding its funds as Princeton Portfolio Research & Management “because it wants brokers outside the Merrill network to feel more comfortable selling the funds.â€?

A name change can attract new investors to a fund. According to the article:

A 2003 academic study that looked at funds in the “growth,” “value,” “small” and “large” categories found that funds that had changed their names over the years reviewed attracted 22% more money than other funds of a similar size and investment strategy that didn’t change their names. These flows are concentrated in funds that made a name change that is in line with a popular investment style, because investors tend to associate good performance with these names.

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