Interview with a Fund Director: A Window to Failure

Morningstar recently posted a lengthy interview with Bruce Crockett, the independent chairman of the Invesco AIM fund family. It's the first time I can ever recall an independent director sitting down to be interviewed about the role they play in fund governance, and I give Crockett a great deal of credit for his willingness to do so.

But in addition to gaining some insight into a fund director's role, I think that a reader of the interview will also catch a glimpse of just what is wrong with mutual fund governance.

Right off the bat, Morningstar's Russ Kinnel asks Crockett for his take on the Supreme Court's decision in Jones v. Harris Associates. In justifying the fact that lies at the heart of the case -- that fund managers charge their fund investors higher fees for managing money than they charge institutional clients -- Crockett says:

" You've got Joe Schmo, average investor. He's got $5,000 in the AIM Constellation Fund, and he pays a 50 basis-point fee for that service, including record-keeping and the whole works. Morgan Bank comes to Invesco and says, 'We want to invest our $500 million plan in your assets. We want an overall umbrella fee of 30 basis points, and we'll do the record-keeping or we'll have an outside record-keeper.'

First of all, in this instance, you're now comparing apples and oranges, because Morgan Bank doesn't need record-keeping. Second of all, Invesco has made the business decision to make an accommodation to Morgan Bank because of the magnitude of the money that they're going to invest in the complex."

Yes, mutual funds require a host of services that institutional clients may not, and it would not be fair to compare a fund's total expense ratio to the fees paid by institutional clients. That is why the Harris case was concerned with the fees two groups of investors pay for one specific service: asset management.

Second, the primary appeal of mutual funds is that they allow investors to pool their resources. So when Joe Schmo places his $5,000 in AIM Constellation fund, his assets are joined with those of thousands of other investors, and they benefit from economies of scale.

The relevant comparison that Crockett is looking for, then, is not an individual investor with $5,000 and an institution with $500 million. Rather, it is the $3.2 billion that Constellation fund investors owned versus the $500 million institution. The question then becomes why individual investors, with more than six times the assets, would be charged, in this case, nearly $19 million in advisory fees ($3.2 billion X 0.59 percent) while the institution would pay just $1.5 million ($500 million X 0.3 percent).

One reason that is often offered for this discrepancy is that the fund investors are represented in fee negotiations by fund directors -- like Crockett -- who are paid by the funds they serve. Institutions, on the other hand, negotiate with the fund manager directly. The clear evidence suggests that they're able to drive a much harder bargain in doing so. And the fact that Crockett either thinks his fund's expense ratio is much lower than it actually is, or that it includes services that it does not, doesn't inspire a lot of hope in his ability to negotiate lower fees on behalf of the investors he represents.

Crockett joined the AIM board in 1992 when the firm acquired CIGNA funds, where he had been a director since the mid-1980s. He's obviously a man who knows his way around a mutual fund boardroom.

Given that background, I was intrigued by his answer to a question regarding managers sharing economies of scale with investors, in which Crockett said "I'm a big believer in economies of scale. I think it works. I think the cost per unit to deliver a product goes down."

Super. Given that belief, I took a look at a fund that Crockett is surely familiar with. As a director, he's overseen what's currently known as Invesco Select Equity for some 25 years -- both at AIM and CIGNA. When AIM acquired the fund in 1992, its largest share class carried an expense ratio of 1.17 percent, and had total assets of $168 million. Today, the fund's A class shares have $217 million in assets, and carry an expense ratio of 1.64 percent. The manager, then, hasn't just failed to share any economies of scale, they've actually increased their revenue from this fund by nearly 50 percent. During that period AIM has extracted an estimated $58 million in fees from Select Equity investors.

Crockett also spent a lot of time talking about dealing with underperformance, so let's take a look at performance Select Equity investors have received in exchange for those fees. Since 1992, the fund has earned an average annual return of 5.2 percent, while the S&P 500 has earned 7.6 percent annually. Cumulatively, Select Equity investors have earned barely half of the return provided by the fund's benchmark. Clearly, the fund is a long-term stinker -- it's been rated one or two stars by Morningstar in 15 of those 17 years. (Let's hear it for those two years of three-star ratings!)

Crockett is apparently well aware of this fact, evidenced by the fact that, despite having overseen this particular fund for nearly three decades, and the fact that he was paid over $500,000 last year alone for his services, he does not have a single dime invested in Select Equity.

Perhaps if he, like (presumably) many of the fund's actual shareholders, had a substantial portion of his nest egg invested in this fund, he might be a little less patient with a fund that's working on a two-decade long dry spell.

Finally, Morningstar touched upon a tremendously important issue that's often overlooked: the source of the information directors receive. By Crockett's own admission, the board hires no outside consultants to assist them in their work. All of the information they receive regarding performance, expenses, and comparisons of both to industry peers comes directly from the fund manager.

Even the most well-intentioned director is incapable of gaining the sort of expertise in six or so annual board meetings that will allow them to match wits with a fund executive who has a strong financial interest in maintaining the status quo. Yet despite this clear asymmetry, directors rarely bother to enlist outside experts to assist them in their decision making, and instead just blithely accept that whatever information the manager provides them is all that is necessary for them to do their job.

This isn't meant to denigrate Crockett -- or any fund director -- personally. Indeed, as a group, they're largely very intelligent, well respected, and highly accomplished in their fields. But despite their sparkling resumes and good intentions, the clear evidence indicates that fund directors as a group are failing in their role to safeguard the interests of the shareholders they represent.

The unfortunate truth is that most fund boardrooms are not host to hotly contested debates and vigorous negotiations. They're clubs, in which all of the members are extraordinarily well compensated and lack any real motivation to rock the boat or appear to be disagreeable in front of their peers. Their failure is, in large part, simply a result of human nature.

That doesn't make it right, or acceptable. But until a better system of fund governance is devised, investors should assume that they're on their own in looking out for their best interests.