Study Raises Questions About the Vigilance of the Family Watchdog

Mutual fund trustees, those independent watchdogs entrusted with guarding the investor chicken coops, might not be as vigilant against prowling pinstriped foxes as commonly thought.

That’s the upshot of a recent study from Morningstar Inc. of Chicago. The fund research firm examined the levels of trustee pay at 82 large fund families against the amount in fees that trustees allow fund companies to charge--and found that a connection seems to exist between the two.

A fund’s board of trustees is one of the last things people look at before investing in a mutual fund, if they think of it at all. Past performance, expenses, the portfolio manager, the range of available shareholder services and other factors rate much higher, and rightly so.

Yet the trustees, or directors as they are also known, do matter. They are empowered to fire a fund’s advisory or management company; approve its advisory contract, including management fees; and make structural changes such as adopting a 12b-1 marketing plan. They manage a key line of defense that oversees the vast mutual fund industry, which receives spotty oversight by government regulators and operates without any form of federal deposit insurance.

Each fund’s board is composed of two types of trustees: representatives of the management company and independents. It’s the latter members--unaligned business people, academics and former politicians and other celebrities--who bear the sole burden of watching out for shareholders. Of all the parties who draw paychecks from fund companies, they are the only ones entrusted with this singular mission. Among the key ways they do this is by pressuring the management company to keep costs down, including its own advisory fees, which eat into fund returns.

Yet the Morningstar study reveals a “disturbing pattern” of trustees collecting higher paychecks at firms that saddle shareholders with the heftiest fees.

For example, at fund families where trustees each pull in $100,000 or more, expenses average 1.06% a year on stock funds and 0.89% on taxable bond portfolios. But where trustee pay is less than $25,000, the comparable figures are 0.91% and 0.66%, respectively.

Morningstar excluded 12b-1 fees from the above averages, reasoning that these outlays wind up in the pockets of brokers and financial planners, not the fund companies themselves. But if such fees were included, the relation between high expenses and high trustee salaries would be even stronger.

“This unexpected link between trustees’ salaries and fund family expenses raises serious questions about the role independent trustees play in protecting shareholders,” says Michael Mulvihill, the Morningstar analyst who conducted the study.

At some firms it reflects a company culture that often “works more to the benefit of a fund’s advisors than to its shareholders,” he adds.

Mulvihill stressed that the study was focused on the industry as a whole, not individual companies. It’s difficult to draw conclusions about specific mutual fund groups, he said, because compensation may depend on a number of factors that have little to do with fees, such as the number of portfolios trustees oversee, the number of meetings they attend, and even investment styles or strategies of the underlying funds, which might require more or less oversight.

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For example, the average trustee pay of $128,000 a year at Fidelity Investments in Boston is not excessive given the Fidelity funds’ moderate expenses and the large number of portfolios involved, Mulvihill said.

He cited the American Funds of Los Angeles and the Vanguard Group in Valley Forge, Pa., as families that pay modest trustee fees in relation to the number of mutual funds and assets under management, and that pass along low costs to shareholders.

“It’s very clear in the minds of all trustees at Vanguard that we represent shareholders,” said Larry Wilson, chairman and chief executive of chemical manufacturer Rohm & Haas in Philadelphia and a trustee for Vanguard’s nearly 100 mutual funds.

Conversely, Mulvihill named Alliance Capital Management of New York and Boston-based Colonial Funds as groups that pay trustees generously and charge high fees.

Representatives at both firms downplayed the significance of the Morningstar study. For example, Duff Ferguson, an assistant vice president at Alliance, said families such as Alliance with a large number of relatively small portfolios will tend to have higher expenses on average.

“Our expenses will decline as assets grow,” he predicted.

One problem with analyzing trustee pay involves tracking down the numbers. Investors must request a statement of additional information, also known as Part B of the prospectus, for each fund they own.

And as noted above, it’s not easy to make comparisons among trustee compensation at various fund companies because this is somewhat an apples-to-oranges exercise.

“In any situation, there might be legitimate reasons why families pay trustees relatively high fees,” says Mulvihill. “But at least a study like this raises questions.”