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MainStay Equity Index Fund: A Failure of Mutual Fund Governance

"Investment company directors have failed ... in negotiating management fees. Under the current system ... reductions mean nothing to 'independent' directors while meaning everything to managers. So guess who wins?"

-Warren Buffett, writing in the 2002 Berkshire Hathaway Annual Report.

If you even remotely follow the mutual fund industry, you will likely recognize that Buffett's appraisal of mutual fund directors is spot on. Their role, ostensibly, is to represent the mutual fund's shareholders, ensuring that the shareholders' interests are held high as they negotiate with the mutual fund's management company.

It's a wonderful theory, but one that, as Buffett indicates, has little relationship with the real world. Instead, mutual fund directors most often serve as "zombies" (in Buffett's words), mindlessly acquiescing to every management company initiative. The most recent affirmation of this sorry fact was the Securities and Exchange Commission's settlement with New York Life.
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The case concerned New York Life's MainStay Equity Index Fund. Like many index funds, this fund was designed to track the return of the S&P 500 Index. Unlike most index funds, the MainStay offering came with a guarantee: "If on the business day immediately after ten years from your date of purchase, the net asset value of a Fund share, plus the value of all cumulative reinvested dividends and distributions paid on the share during the ten-year period, is less than the price you initially paid for the Fund share, [New York Life] will pay you the difference between the price you paid and the [price] of a Fund share as of the close of business [on that date.]" (From the fund's initial prospectus.)

Even better, the fund's prospectus told investors that this guarantee was free of charge. Sounds like a great idea, right?

Well, there was a slight problem. It seems that while New York Life was telling the fund's investors that they were receiving this benefit at no cost, they were also telling the board of directors that the fund's well-above-average expense ratio (which, in many reports provided to the board, was the highest among its peers) was justified by that "free" guarantee.

The SEC's took issue with this bit of duplicity. Without, of course, admitting or denying guilt, New York Life will distribute up to $6.1 million to fund investors who ended up paying for something they were told was free.

Obviously the situation is an indictment of the fund's managers, who enjoyed marketing the "free" guarantee at the same time they reaped out-sized management fees (fees that, according to the SEC's report, provided a 163 percent profit margin one year).

But even more than that, the episode is an indictment of the fund's board of directors. Year after year, the board was provided reports that showed the fund's expense ratio was well above that which its peers were charging. The board didn't care. Year after year, those same reports showed that New York Life was earning enormous profits from the fund. The board didn't care. In 2003, the board was provided a third-party report that, according to the SEC, concluded: "(1) "[h]igh expenses are the main reason this fund ranks worst among its index-fund peers for the one-, three-, and five-year periods"; (2) the 'main culprit' for the Equity Index Fund's poor peer-group comparison was a management fee 'that is more than twice the peer-group average'; and (3) the Guarantee, although 'unique,' was 'of somewhat limited value.'" The board's response? They didn't care. They approved the proposed contract.

And of course, all along the board swallowed management's rationale for the inflated fees, despite the fact that they were either irresponsibly unaware of or aware but ignored the fact that the fund's prospectus alleged that the fund's guarantee was free.

If you think that sounds like the sort of neglect you would expect from a group of people who do not have any of their own money invested in the Fund in question, you would be right.

The MainStay Equity Index Fund's most recent Statement of Additional Information discloses that the fund's seven independent board members have, in total, nothing personally invested in the fund. Zero. Not one thin dime of their own money. And lest you think that these poor souls might not have the money to spare, the same document reports that those seven directors were well compensated for their "service," earning an average of $233,000 annually from the MainStay Funds.

Mutual fund investors, of course, have a right to expect much more from their representatives than the MainStay fund investors received in this case. But too often, again returning to Buffett, the investors' supposed watchdogs turn out to be cocker spaniels instead of Dobermans.

Unfortunately, there's little reason to expect that mutual fund directors will collectively begin living up to their responsibilities, so the onus remains on the individual investor: do business with firms you can trust, and entrust the stewardship of your assets to managers and directors who have demonstrated -- in actions, and not just words -- that they understand just who they serve and what is expected of them.

Image via Flickr user mikebaird CC 2.0