You may not have heard of their job, and you don’t know their names, but these people help you protect clients.
They’re the members of mutual fund independent review committees (IRCs). These IRCs—typically teams of three or four people with backgrounds in accounting, regulation and investing—weigh in on conflicts of interest. They’re independent of the fund companies they work with; unitholders pay the members through fund fees, and the members choose their own successors.
If a manager wants to buy stocks underwritten by her fund’s parent company, the IRC must approve. If she wants to conduct an inter-fund trade or reorganize funds, the IRC must consent. Under NI 81-107, the IRC must review any situation in which a reasonable person would perceive a conflict of interest.
After B.C. introduced the HST, for instance, Vancouver’s Steadyhand Investment Funds asked its IRC to approve the corresponding fee increase, says Tom Bradley, president. Committees can’t veto fee changes, but they can make recommendations.
“We like to hear their input, but their formal duties are strictly to assess any conflicts of interest that come along,” says Bradley. His committee oversees six funds, and has three members, including a chair. The IRC’s annual report shows regular members are paid $5,000 a year, while the chair makes $7,000. They each get an additional $500 per meeting.
By comparison, RBC, one of Canada’s largest fund managers, has an IRC with nine members, including the chair. Those members were paid a total of $373,613 in 2013.
Most committees meet quarterly, either privately or with fund management, to keep abreast of what’s happening. They’ll also meet when management asks for advice on how to handle a conflict of interest. And, under certain pre-agreed conditions, they can issue standing instructions that allow management to proceed without the IRC’s explicit approval, such as when changing sub-advisors.
When Capital International Asset Management Canada wanted to merge some of its funds, for example, president Mark Tiffin took his case to the IRC. They ensured there were no conflicts and that unitholders were treated fairly, he says.
“We’re aware that we have biases,” he adds from his Toronto office. “So we welcome the chance to go to the IRC and say, ‘Here’s [what] we’re thinking; help us out.’ ”
Committees in context
Beyond the IRC, advisors should also look at a firm’s corporate stewardship before making an investment decision.
“Corporate culture is going to be the biggest determinant of investor experience at any fund company,” says Christopher Davis, director of manager research at Morningstar Canada in Toronto. He analyzes a firm’s corporate culture, including manager tenure and retention; its alignment with unitholders’ long-term interests; fee competitiveness; and regulatory history.
Morningstar research finds that firms with higher stewardship grades, including strong corporate culture and lower fees, had better-performing funds. Top-rated funds also had better survival rates.
Advisors should ask if managers themselves invest in the funds they oversee. “That demonstrates conviction in their process and their firm,” Davis says. “Also, how do the fund companies pay the managers? Are they paid on long-term performance, or based on short-term performance and asset growth? If it’s the latter, that’s where their priorities are probably going to lie.”
A firm with a pro-investor corporate culture will have well-staffed and well-funded research teams, he adds. They’ll also close funds before they become too large to function effectively. “Lastly, look at the overall fees. If the fees are reasonable across a fund company’s line-up, that’s a sign they treat fundholders in a fair manner,” says Davis.
For example, Morningstar says firms with good stewardship treat investors the same, whether they’re working with a fee-only or commission-based advisor. Fund companies with lower stewardship rankings take an extra cut from those clients’ returns without adding services. So, if an advisor’s trailing fee is 0.5%, and the MER is 0.45%, the client of a commissioned advisor may be charged 1.3%, instead of 0.95%.
Broader criteria are more effective than examining an IRC on its own, because “it’s always difficult to tease out whether it’s the [committee] or the fund company that’s been doing the lion’s share of the work,” says Davis.
Also, he adds, committees can’t enforce their decisions, which is a weakness. So, he says, “I wouldn’t attribute a fund company’s fundholder-friendly actions to [them]. In the U.S., I’ve heard top leadership of fund companies say, ‘We did this because the board pushed us.’ I’ve never heard anybody in Canada say, ‘We did this because the IRC told us to.’ ”
American fund companies have boards of directors, who oversee the individual funds similar to corporate ones, representing investors. They’re tasked with ensuring fair returns at a fair price, and they have more power than IRCs.
“They’re overseeing the operations of the fund, as well as negotiating the fees on behalf of shareholders,” says Laura Lutton, director, fund of funds research, at Morningstar in Chicago. “They also approve fund launches, so before a fund goes to market, the board signs off on strategy.”
Unlike the IRC, where members choose their own successors, American fund managers often choose board members, and shareholders approve that board. Members of American boards are paid hundreds of thousands of dollars a year, and their activities are detailed in funds’ Statements of Additional Information. American boards can also replace underperforming managers, though they rarely do, says Davis. And they’ve been effective at keeping fees down. “They argue for economies of scale to be passed along to the fund holders. You rarely see that in the Canadian market,” he says. “Even when you look at some funds that are offered in both the U.S. and Canada, the U.S. version will have fee break points. The bigger the fund gets, the cheaper it becomes.”
The hedge fund experience
Historically, hedge fund boards have been weak, but firms have appointed members with more expertise since the financial crisis, says Ray Carroll, CEO of Breton Hill Capital in Toronto.
“Board members might have been on as many as 100 other boards, so [they wouldn’t] know the fund well. The fund manager could essentially control the board,” says Carroll. “What 2008 highlighted is that the board does matter, because it’s the board that decides if they’re going to suspend redemptions.” A hedge fund board can also gate the fund, check that the fund’s valuation policy is being followed, and sign off on financial statements, he adds.
Breton Hill’s board has the same mix of expertise as an IRC, but it also has two professional directors, including Roisin Addlestone. She’s a Cayman Islands-based director with Carne Group, a firm that supplies directors to hedge funds.
“In the hedge fund space, there’s a whole cottage industry of independent outfits with full-time directors who are in the second stages of their careers. They’ve done 20 years as something else, such as lawyers, administrators or auditors,” explains Addlestone, who was a lawyer before becoming a director. She sits on the boards of 17 fund groups.
While most members will have strong financial backgrounds, “the key is making sure directors are proactive about monitoring,” she says. “There are a number of directors out there who, if they’re told to do something by the manager, they’ll just do it. A more proactive director might say, ‘Why are we doing it?’ ‘Why is this good for the investors?’ ”
It’s difficult for investors to tell whether a board is of the proactive or the rubber-stamp variety, she says. Meetings are private, though some funds will publicize a general agenda. To peek behind the curtain, investors can ask directors how the board works.
“If the manager just treats the board as another service provider, and is more of a ‘Here, sign this’ type, rather than a collaborative person […] you’ll probably be able to flush that out in a conversation fairly quickly,” she says.
Are IRCs effective?
“If an advisor is choosing a fund for a client and it’s down to two or three strategies, looking at the governance and choosing the fund with the better profile is going to be in the client’s best interest over the long term,” says Lutton.
And the review committee is only a small part of stewardship, say the experts. “Their power is the power of persuasion,” says Davis. “But if they don’t have any authority (except settling conflicts of interest), if they don’t have a stick, there’s no reason to necessarily listen to them.”
He adds, “Even [if we’re giving the committee] more power, it would be unlikely that it would be the driving force behind the investor experience. The quality of the corporate culture, and how closely aligned [the] manager’s incentives are with the unitholders, will be a bigger driver.”
Bradley says that for small, private firms that don’t underwrite securities, IRCs typically add to costs without doing much work. But he’s glad IRCs exist. “Regulators in Canada, with regard to conflicts of interest [at] big institutions, have not been diligent enough. So we’ll take our medicine, and pay our IRC members, for the sake of those big institutions having IRCs.”
Another issue surrounding IRC effectiveness is that IRCs must wait for managers to refer potential conflicts to them, instead of investigating on their own, says Tiffin.
But that approach has failed: in 2013, the OSC ruled Crown Hill Capital misled both its investors and IRC. Crown Hill had allegedly told them that a deal—using 60% of its AUM to buy outside investment funds—was in unitholders’ best interests, which the OSC said was a “shocking” mischaracterization. The regulator fined Crown Hill $20 million.
In the end, Tiffin says a good review committee “may be a case of the dog that didn’t bark. When the manager and the IRC are managing well, you will have conflicts avoided that you are never going to hear about.”
Originally published in Advisor's Edge Report
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