John C. Bogle, founder of the Vanguard Group lectured a Columbia University audience earlier this month and what he said was both surprising and illuminating. His lecture focused on the problems leading up to our current financial crisis. While pointing a finger at the usual suspects (lenders, mortgage brokers, regulators, Wall Street traders, borrowers), he said that there was a whole other class that is partially to blame. What he said, in essence, is that our mutual fund managers let us all down.
Unlike fifty years ago, when individuals owned stocks in publicly traded firms and voted their shares, today institutional investors (mutual funds and other money management firms) control more than 70 percent of those publicly traded companies. When you own stock through a mutual fund, for example, you don’t own the stock directly. Rather, the mutual fund money manager owns the stock and you own a share of the mutual fund. Money management institutions therefore wield great power and influence over corporate America.
Over the course of the past decade, however, few of those institutions played an active role in board structure and governance, director elections, executive compensation, stock option proxy proposals or dividend policies in the companies that they owned.
So instead of the “ownership society” of fifty years ago, we now have an “agency” society. But Mr. Bogle claims that these agents were asleep at the switch during the better part of the last decade.
“How could so many highly skilled, highly paid securities analysts and researches have failed to question the toxic-filled, leveraged balance sheets of Citigroup and other leading banks and investment banks?” Mr. Bogle asked.
“Given their forbearance as corporate citizens,” Mr. Bogle said, “these managers arguably played a major role in allowing the managers of our public corporations to exploit the advantages of their own agency.”
In his view, the agents have failed to serve their clients – mutual fund shareholders, pension beneficiaries and long term investors. Instead, the agents served themselves through fees while not performing the type of due diligence that might have protected their investors from enormous losses.
Regular readers of this column note that I constantly harp on the responsibilities of a fiduciary. In the estate planning arena, a fiduciary might be someone who holds another’s durable power of attorney or who is named to act as a trustee of a trust. In such a setting, the fiduciary is supposed to act impartially to his own interests while instead acting in the best interests of those who granted him a power to act. Here Bogle says that mutual fund managers should have a similar fiduciary duty to the mutual fund shareholders, and that they failed to live up to that standard.
Consequently, Bogle says that the government must apply a federal standard of fiduciary duty to institutional money managers. This would force them to vote their stock holdings in a manner that would demand corporate officers and directors to act in a responsible way towards their owners. “We need Congress to pass a law establishing the basic principle that money managers are there to serve their shareholders…And the second part of the demand is that fiduciaries act with due diligence and high professional standards.”
The problem is that some money management firms are also publicly traded. This raises some serious conflict of interest issues because their executives must serve not only the mutual fund clients but also the shareholders of the money management firm itself.
Consider that fees for mutual fund investors are often much higher than those that the same firm imposes on its pension clients, for example. Mr. Bogle pointed out that the three largest money managers charge an average fee rate of 0.08 percent to pension customers, compared to 0.61 percent to mutual fund shareholders.
So the question arises as to whether the mutual fund managers are there to serve the executives and shareholders of the mutual fund firm itself or the shareholders holding its mutual fund offerings. The Investment Company Act of 1940 states that “mutual funds should be managed and operated in the best interests of their shareholders, rather than in the interests of advisers.”
Bogle suggested one solution is to separate the money management units of each institution from the larger, publicly traded firms. A bank would therefore spin off its mutual fund unit which would then be owned by the mutual fund shareholders.
While it’s unlikely that the mutual fund industry will embrace Bogle’s ideas, perhaps holding money managers to a higher fiduciary standard would work towards a solution.
©2009 Craig R. Hersch