The overall operations of a mutual fund are under the supervision and authority of a board of directors or board of trustees.
By law, these boards shall act in good faith; in a manner the director or trustee reasonably believes to be in the best interests of the shareholder of the mutual fund; and with the care that an ordinarily prudent person in a like position would use under similar circumstances. For their services, the members of the board receive compensation.
Understanding The Board Of Directors’ Responsibilities
The board has several responsibilities:
One primary responsibility is to review and approve the mutual fund’s registration statement – or prospectus – that is filed with the SEC and provided to investors. By law, this document must contain all information that an investor would consider important when making an investment decision. Equally important, this document must be truthful. Because the board has ultimate authority over the statements made in a prospectus, it is responsible for any misstatements in the prospectus or omissions of material fact.
Another primary responsibility of the board is to hire the investment adviser that manages the mutual fund’s investment portfolio. The hiring process is done on an annual basis, but only one candidate is typically considered – the incumbent investment adviser. In what seems to smack of a conflict of interest, that same investment adviser typically selects the board of the mutual fund, the very same people who approve their contract and compensation. Therefore, the investment adviser will have strong relationships with the board it carefully recruited.
So that the investment adviser does not pack the board with its own employees, federal law requires that, in most in cases, a majority of the board cannot be associated with the investment adviser (e.g. employee, director, owner). Even then, the members of the board may not be as independent as they appear on paper.
The strong ties between the board and the investment adviser may run deep and disincentivize the board to put the shareholders’ interest ahead of those of the investment adviser. At some point the shareholders may need to assert their rights, particularly when a board fails to remove and replace an investment adviser of a mutual fund that suffers abysmal performance year after year.
Shareholders who harbor thoughts of changing their board should know that replacing board members is nearly impossible because the states where most mutual funds are organized (e.g. Massachusetts) have effectively eliminated the requirement of holding annual shareholder meetings to elect board members on the premise that shareholders can “vote with their feet.” Another option would be to file claims against the board for breach of their fiduciary duty to the shareholders. Lawsuits by individual investors against a mutual fund board are rare because most individual investors simply opt to redeem their shares at a loss and invest elsewhere.
Most mutual fund boards are diligent and thoughtful. However, a few may be there for the paycheck. Shareholders who turn their backs on habitual underperformers only sustain the most ineffective investment advisers and perpetuate a board process that ignores fiduciary duty and keeps these advisers at the helm and pays them fees. Rather than voting with your feet, lawsuits may be necessary to bring discipline to the process.
The Mutual Fund Maze: Wrapping Up
Today, over half of U.S. households own mutual funds with total assets of approximately $26 trillion, according to the Investment Company Institute. Having spent over two decades working with mutual funds around the world, I wrote this series to give you a few signposts to help you navigate the mutual fund maze. Given the likelihood that one day you will be evaluating a mutual fund investment, it is important to know the lay of the land before investing, and whether or not a mutual fund’s investment objectives match yours.
- Is it growth over time, current income, growth and income, or preservation of capital? Know the types of securities the mutual fund will invest in and their investment risks.
- Will it be stocks, bonds, large cap, small cap, U.S. or international? Know who is managing the mutual fund, how much you will pay, and how the mutual fund’s historical investment performance compares to appropriate benchmarks, such as the S&P 500 Index.
This information will be found in the mutual fund’s prospectus. Read it. Finally, if over the long term the mutual fund is failing its objectives, remember that the Board of Directors are fiduciaries responsible for looking out after your best interest. Become an activist and hold them accountable. And above all, happy investing!
Charles Field is Managing Partner of the San Diego office of Sanford Heisler Sharp and Chair of the firm’s Financial Services Litigation Practice Group.
Read the rest of the series: